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ONG v. SEARS

September 14, 2005.

THOMAS G. ONG for THOMAS G. ONG IRA and THOMAS G. ONG, individually and on behalf of all others similarly situated, Plaintiffs,
v.
SEARS, ROEBUCK & CO., SEARS, ROEBUCK ACCEPTANCE CORP., ALAN LACY, PAUL J. LISKA, GLENN R. RICHTER, KEVIN T. KELEGHAN, K.R. VISHWANATH, KEITH E. TROST, GEORGE F. SLOOK, LARRY R. RAYMOND, THOMAS E. BERGMANN, CREDIT SUISSE FIRST BOSTON, GOLDMAN, SACHS & CO., MORGAN STANLEY, BEAR, STEARNS & CO., INC., LEHMAN BROTHERS and MERRILL LYNCH & CO., INC., Defendants.



The opinion of the court was delivered by: REBECCA PALLMEYER, District Judge

MEMORANDUM OPINION AND ORDER

Plaintiffs Thomas G. Ong, Thomas G. Ong IRA, and State Universities Retirement System of Illinois ("State Universities") bring this federal securities class action lawsuit on behalf of (1) all those who purchased, pursuant to a prospectus, securities issued by defendant Sears, Roebuck Acceptance Corp. ("SRAC"), a wholly-owned subsidiary of Defendant Sears, Roebuck & Co. ("Sears"), between October 24, 2001 and October 17, 2002 (the "Class Period"), in any of three debt securities offerings dated March 18, May 21, and June 21, 2002, and (2) all those who, during the Class Period, purchased publicly traded securities issued by SRAC before the Class Period and actively traded them through the public markets and over national securities exchanges.

Sears is one of North America's largest general retailers. In addition to its retail division, Sears provides financing to its customers through private label credit cards and installment plans. SRAC's principal business is purchasing Sears' short-term notes and account receivable balances, which it finances through public sales of SRAC Notes. Defendants Alan Lacy, Glenn R. Richter, Paul J. Liska, Keith E. Trost, George F. Slook, Larry R. Raymond, Thomas E. Bergmann, Kevin T. Keleghan, and K.R. Vishwanath were all officers or directors of Sears, SRAC, or both. Defendants Credit Suisse First Boston Corporation ("CSFB"), Goldman, Sachs & Co. ("Goldman Sachs"), Morgan Stanley & Co., Inc. ("Morgan Stanley"), Bear, Stearns & Co., Inc. ("Bear Stearns"), Lehman Brothers Inc. ("Lehman Brothers"), and Merrill Lynch & Co., Inc. ("Merrill Lynch") were all underwriters of the three SRAC debt securities offerings at issue in this case.

  Plaintiffs allege that Sears manipulated information regarding its credit card operations to make those operations appear "more stable and profitable than they actually were," which artificially inflated the market value of SRAC debt securities. Specifically, Sears misrepresented its reliance on subprime creditors; selectively reported delinquency and charge-off rates; and disguised portfolio losses in order to generate high levels of reported receivables that Sears knew would prove uncollectible. Plaintiffs claim that Defendants all made materially false and misleading statements or omissions in connection with Sears' credit card operations in violation of §§ 11, 12(a)(2), and 15 of the Securities Act of 1933, 15 U.S.C. §§ 77k, 77l(a)(2), and 77o; and §§ 10(b) and 20(a) of the Securities Exchange Act of 1934 ("SEA"), 15 U.S.C. § 78j(b) and 78t(a), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5.

  On September 27, 2004, this court granted in part and denied in part Defendants' four separate motions to dismiss Plaintiffs' October 16, 2003 Amended Class Action Complaint. Ong ex rel. Ong IRA, ___ F. Supp. 2d ___, 2004 WL 2534615 (N.D. Ill. Sept. 27, 2004). In response, Plaintiffs filed a Second Amended Class Action Complaint ("SAC"), adding a variety of new allegations and a new plaintiff, State Universities. Defendants, with the exception of Merrill Lynch,*fn1 insist that the changes to the SAC are not sufficient to remedy the flaws identified by the court, and seek dismissal of Counts Two, Four, Five, Seven, Eight, and Nine. For the reasons stated here, the motions are granted in part and denied in part.

  BACKGROUND

  The extensive procedural and factual background of this case is set forth in this court's September 27, 2004 Memorandum Opinion and Order. See Ong, 2004 WL 2534615, at *2-15. The SAC largely repeats the allegations from the prior Complaint, as reflected below. This opinion assumes the reader's familiarity with the earlier decision and attempts to recite relevant facts only as necessary to resolve Defendants' current motions to dismiss.

  Sears is one of the largest general retailers in North America. As part of its operations, Sears provides financing to customers through private label credit cards and installment plans. SRAC, Sears' wholly-owned subsidiary, is primarily in the business of purchasing short-term notes or receivable balances from Sears. SRAC funds these purchases by issuing debt securities such as commercial paper, medium term notes, and "other borrowings" (collectively, "SRAC Debt Securities") to the public. (SAC ¶¶ 12, 13, 46, 47.)*fn2 Three SRAC Debt Securities offerings are at issue in this case: (1) $600 million of 6.70% notes due April 15, 2012, offered pursuant to an Indenture dated May 15, 1995 (the "Indenture"), a Registration Statement and accompanying Prospectus dated September 3, 1998 (the "Registration Statement"), and a Prospectus and Prospectus Supplement dated March 18, 2002 (the "3/18/02 Offering"); (2) $1 billion of 7.0% notes due June 1, 2032, offered pursuant to the Indenture, the Registration Statement, and a Prospectus and Prospectus Supplement dated May 21, 2002 (the "5/21/02 Offering"); and (3) $250 million of 7.0% notes due July 15, 2042, offered pursuant to the Indenture, the Registration Statement, and a Prospectus and Prospectus Supplement dated June 21, 2002 (the "6/21/02 Offering"). (Id. ¶ 2.) Plaintiffs all allegedly purchased SRAC Debt Securities during the Class Period. (Id. ¶¶ 9-11.)

  Mr. Lacy was Sears' Chief Executive Officer, President, and Chairman of the Board throughout the Class Period. Mr. Richter has been Sears' Chief Financial Officer since October 4, 2002 and also served as Sears' Senior Vice President, Finance prior to that date. Mr. Liska was Sears' Chief Financial Officer until Mr. Richter took over in October 2002. He also served as a director of SRAC. Mr. Trost was the President of SRAC as well as a director of the company. Mr. Slook, also a director of SRAC, was SRAC's Vice President of Finance. Mr. Raymond served as a director of SRAC, as did Mr. Bergmann, who was also Chief Accounting Officer and Controller of Sears. Mr. Keleghan was President of Sears' Credit and Financial Products segment and "an Executive Vice President from the start of the Class Period until October 4, 2002, when he was forced to resign." Mr. Vishwanath was Sears' Vice President of Risk Management until the company terminated his employment on October 16, 2002. (Id. ¶¶ 14-22.)

  CSFB, Goldman Sachs, Morgan Stanley, Bear Stearns, Lehman Brothers, and Merrill Lynch are all integrated financial services institutions that provide securities, investment management, and credit services to corporations, governments, financial institutions, and individuals. CSFB and Goldman Sachs were joint "book runners" — i.e., managing underwriters — for the 3/18/02 Offering of SRAC Debt Securities. Morgan Stanley, Bear Stearns, and Lehman Brothers were all joint lead managers for the 5/21/02 Offering. Morgan Stanley was also the book runner for that offering. Merrill Lynch was the book runner for the 6/21/02 Offering. (Id. ¶¶ 33-38.) A. The Relationship Between Sears and SRAC

  SRAC's operating income is generated primarily from the earnings on its investments in Sears' short-term notes and account receivables. In addition, Sears determined the amount of SRAC's earnings by requiring SRAC to maintain a set ratio of earnings to fixed expenses. Plaintiffs allege that, "[a]s a result, the yield on SRAC's investment in Sears notes is directly related to SRAC's borrowing costs, i.e., the yield under which SRAC can issue and sell its Debt Securities." It is in Sears' financial interest to keep SRAC's borrowing costs as low as possible because the less SRAC pays purchasers of its Debt Securities, the less Sears must pay to borrow from SRAC. (Id. ¶ 48.)

  Given the inter-relationship between Sears and SRAC, "industry analysts and the rest of the market looked to the finances, financial condition and present and future operations of Sears when assessing the investment prospects for SRAC Debt Securities." (Id. ¶ 49.) When industry analysts viewed Sears favorably, SRAC was viewed favorably as well; when Sears experienced a downward change in its financial condition, SRAC's financial condition suffered as well. (Id. ¶¶ 49-54.) According to Plaintiffs, "the intertwining of the finances and operations of SRAC and Sears cause the SRAC Debt Securities to take on the status of a direct investment with Sears itself." (Id. ¶ 56.)

  B. Sears' Credit Problems

  For many years, Sears was one of the largest credit card issuers in the country. (Id. ¶ 62.) Prior to 1993, Sears stores accepted only Sears' own proprietary credit cards ("Sears Cards") and those cards could only be used to make purchases at Sears. (Id. ¶ 63.) When Sears began accepting general credit cards in 1993, the company saw a drastic decrease in the use of its Sears Cards; by mid-2000, 24 million of the 60 million Sears Cards were either inactive or carried a zero balance. (Id.) At the same time, Sears' retail sales were also in decline due to increased competition from discount retailers like Wal-Mart and Kohl's. (Id. ¶ 64.)

  In late 2000, Sears began to issue a Sears MasterCard, a general purpose credit card that could be used wherever MasterCard was accepted. The cards carried higher lines of credit and generated fee income for Sears when used at non-Sears locations. Sears hoped that the Sears MasterCard would "stimulate sales and help regain income Sears had lost in recent years due to the decline of its proprietary cards." (Id. ¶ 66.) In November 2000, Mr. Lacy, who had been named President and CEO of Sears just a month earlier, identified the Sears MasterCard as a top area for growth within the company. (Id. ¶¶ 65, 67.)

  By February 2001, the Sears MasterCard carried $1.4 billion in receivables and Sears, through its subsidiary Sears National Bank, had become one of the top 25 bank card issuers. A February 15, 2001 article in American Banker reported that Mr. Keleghan, President of Sears Credit, had described Sears MasterCard users as "a very pristine group, almost too pristine. . . . We don't expect significant delinquencies since we're starting out with a low-risk group." (Id. ¶ 69.) Sears' retail segment continued to decline over the next several months, but Mr. Lacy asserted at an April 19, 2001 analysts presentation that Sears' credit segment had "a strong portfolio quality overall" and was "a great business" and "strategically very important" to Sears. (Id. ¶¶ 70, 71.)

  Despite these representations, Sears credit operations actually suffered from several weaknesses and problems which were hidden from the market. Those weaknesses, described below, ultimately led to an announcement that Sears planned to sell the credit business. (Id. ¶ 73.)

  1. Reliance on Subprime Creditors

  During the Class Period, Sears aggressively marketed its credit cards, particularly the Sears MasterCard, to "create the appearance of a growing, profitable loan portfolio." (Id. ¶ 74.) To that end, Sears intentionally lowered its acceptable credit profile so that more consumers would qualify for credit cards, and adopted aggressive marketing strategies designed to appeal to low-income or unstable borrowers. Sears also offered multiple credit cards and increased credit limits to customers who did not qualify for such benefits. (Id.) At the beginning of the Class Period, approximately 54% of Sears' credit portfolio consisted of subprime borrowers, compared with a United States industry average of 36.6%. By the end of the Class Period, the portfolio was still nearly half subprime. (Id. ¶¶ 75, 76.)

  2. Selective Reporting Techniques

  In addition to targeting subprime creditors, Sears misleadingly reported the charge-off and delinquency rates*fn3 of its credit cards on a portfolio-wide basis rather than separating out the performances of the Sears Card and the Sears MasterCard. The Sears MasterCard had higher credit limits than those traditionally offered under the Sears Card, as well as lower delinquency and charge-off rates. According to the Plaintiffs, "[t]hese factors, when combined with the dramatic increases in MasterCard receivables, declining Sears proprietary card receivables, [and] the fact that the Sears proprietary card portfolio was much larger than the new MasterCard portfolio, created an interesting phenomenon during the Class Period." Specifically, though both portfolios were separately experiencing a "striking rise in delinquencies and charge-offs every quarter," the combined portfolios reflected delinquencies and charge-offs that were relatively stable "because the Sears Card receivables overweighted the average of the two groups." (Id. ¶¶ 78-80.)

  3. Disguised Losses

  Plaintiffs allege that Sears also engaged in practices designed to disguise losses to its credit portfolio. Sears National Bank, which Sears created in 1995, is not subject to the same rules and regulatory oversight as ordinary bank card issuers.*fn4 Thus, Sears was able to adopt more lenient credit policies than its competitors. (Id. ¶ 82.) For example, Sears charged-off delinquent credit card loans after 240 days compared with 180 days by competitors. (Id. ¶ 82(a).) Sears also deferred charge-offs by relying on generous "renewal" policies, such as offering to make a delinquent account "current" if a customer made a single, minimum payment, and then closing the account and implementing an installment plan to collect the balance due. In addition, Sears "cured" or "re-aged" delinquent accounts (i.e., converted them to current status) after receiving only two consecutive minimum payments; federal regulations require three consecutive minimum payments prior to re-aging. (Id. ¶ 82(b)-(c).)

  Sears also adopted promotional programs, such as zero percent financing, that allowed cardholders to minimize or avoid payments for periods of up to a year. This made it "difficult, or even impossible, for cardholders to fall behind in their payments and allowed Sears to delay reporting such accounts as delinquent." (Id. ¶ 82(d).) In addition, Sears repeatedly lowered the required minimum monthly payments, which allowed individuals with poor credit histories to purchase higher priced items on more extended payment schedules. This practice increased Sears' income from finance charges but also increased its exposure to bad debt. (Id. ¶ 82(e).) Finally, though it is industry practice to report delinquencies after 30 days, Sears did not report them until after 60 days. (Id. ¶ 82(f).) According to Plaintiffs, these policies misled investors as to the true quality of Sears' credit portfolio. (Id. ¶ 83.)

  4. Fraudulent Billings

  A final practice that served to weaken Sears' credit portfolio was fraudulent billings on customer accounts. Sears strongly encouraged its employees to induce customers to purchase additional services, including life insurance, credit protection, and extended warranties, whenever they bought a Sears product. "The incentives to make such sales were so strong that it became a regular practice for salespersons to put such items on customers' accounts without their knowledge or consent." (Id. ¶ 84.) This, in turn, "helped drive up the high levels of reported receivables that Sears knew to be uncollectible." (Id.)

  C. False and Misleading Statements

  Plaintiffs allege that Defendants issued numerous false and misleading statements to deceive the investing public into believing that Sears' credit operations were "far better, more successful and profitable, than was actually the case." (Id. ¶ 85.) See Ong, 2004 WL 2534615, at *5-12. For purposes of the pending motions to dismiss, there is no dispute that Plaintiffs have sufficiently alleged that the relevant Defendants made false and misleading statements and, thus, the court will not repeat them here.

  The court notes generally, however, Plaintiffs' allegations that between the third quarter of 2001 and the second quarter of 2002, Defendants issued SEC Form 8-Ks and Form 10-Qs reflecting "strong" and "stable" credit portfolio quality. (Id. ¶¶ 72, 104.) In truth, the Sears Card and Sears MasterCard portfolios were excessively weighted towards the subprime market and, when viewed separately, each reflected rising delinquency and charge-off rates. (Id. ¶¶ 77, 80, 104, 110, 145, 174-75.) Nevertheless, Defendants made statements at analysts meetings, in press releases, and during investor conference calls confirming the stable and pristine quality of the portfolios and projecting significant increases in earnings each year. Indeed, by July 18, 2002, a Sears press release quoted Mr. Lacy as saying that Sears expected a 22% increase in full year comparable earnings. (See generally id. ¶¶ 86-158); Ong, 2004 WL 2534615, at *5-12. D. Sears Reveals Its Credit Problems

  Plaintiffs allege that the true state of Sears' credit portfolios finally began to emerge in October 2002. On October 4, 2002, Sears issued a press release abruptly announcing that Mr. Liska had replaced Mr. Keleghan as Sears' Executive Vice President and President of Credit and Financial Products. On October 7, 2002, Sears issued a press release reaffirming its July 18, 2002 projection of a 22% increase in comparable earnings per share, but stating that: "The company now expects comparable earnings increases . . . in the mid-single digit percent range in its credit and financial products segment." (Id. ¶¶ 159-62.) This represented a significant decrease from earlier projections; as of July 18, 2002, Sears had projected credit segment growth "in the low double digits." Sears' stock started to trade down in response to the revised projections. (Id. ¶ 162.)

  Later that day, Mr. Lacy spoke to investors during a conference call and "reaffirm[ed]" Sears' projection of a 22% increase in earnings per share. With respect to Mr. Keleghan, Mr. Lacy explained that "Kevin left the company at my request, because I lost confidence in his personal credibility. . . . His departure is not related to business performance and does not indicate a change in our credit strategy." (Id. ¶¶ 163-65.) Financial services firm W.R. Hambrecht issued a report commenting on Mr. Keleghan's departure as follows: "[W]e got incrementally bad news. . . . CEO Lacy stated that he asked Keleghan to leave because he had lost confidence in Keleghan's personal credibility. We don't know what that means, exactly, but we believe it bodes poorly for Sears Credit operations which represent approximately 65% of operating profit and creates even greater uncertainty about the quality of earnings at the credit division." (Id. ¶ 168.) By the close of business on October 7, 2002, the price of Sears stock had fallen from $37.64 to $32.25. (Id. ¶ 166.) The price of SRAC Debt Securities issued pursuant to the 6/21/02 Offering also fell from $24.81 per share on October 8, 2002 to $21.91 per share on October 10, 2002. (Id. ¶ 167.) On October 17, 2002, Sears issued a press release announcing that it would be increasing its allowance for bad debt by $222 million. The charge against earnings required to cover this increase reduced Sears' earnings for the quarter by 26% as compared to the prior year. Despite having ten days earlier projected a 22% increase in earnings per share that year, Sears now estimated earnings per share would increase only 15%. (Id. ¶ 171.) In an analysts meeting conducted by conference call that day, Mr. Lacy attributed Sears' problems in its credit business to the duplicity of Mr. Keleghan and Mr. Vishwanath:
[I]t became clear to me that Kevin [Keleghan] was not being forthcoming about these issues that this business was facing . . . and had become a barrier to getting an objective situation assessment as to what was happening in our business and I terminated him for basically my personal loss of confidence in him relative to his personal credibility . . . You should also know that during the course of our analysis we determined that the VP of Risk Management and Credit [Mr. Vishwanath] had also withheld information and had led us to terminate his employment effective yesterday.
(Id. ¶ 172.)

  When Mr. Liska took over the conference call, he admitted that "[o]ne of the disclosures that [we] make today centers around a portion of our portfolio that is Middle American. A large portion of the proprietary card, our proprietary card portfolio is Middle America." (Id. ¶ 173.) In an analysts meeting a year earlier, Mr. Keleghan had explained, "we try to target the middle market," distinguishing that group from the "subprime" market; in this October 2002 meeting, in contrast, Mr. Liska refers to "Middle America" as another way of saying "subprime": "It is generally recognized that [M]iddle America accounts deteriorate more quickly in a tough economy than prime accounts do." Though he suggested that the proportion of Sears borrowers that were subprime was declining, Mr. Liska acknowledged that Sears' credit portfolio had been heavily subprime for years: "In 1998 Middle America balances represent[ed] 60% of our portfolio. They represent 48% today. Last year the segment represented 54% of our portfolio." (Id. ¶ 174.) In response to Sears' disclosures, W.R. Hambrecht reported that Sears' "shocking 26% decrease in earnings . . . stunned the Street and all in attendance" at the analysts meeting. "Frankly, it was the realization of our worst-case scenario regarding the state of the company's credit operations, which represent more than 60% of Sears' operating profit." (Id. ¶ 176.) Indeed, the price of Sears stock fell $10.80 per share (approximately 32%) to close at $23.15 on October 17, 2002, and there was "extraordinary trading volume" that day of 36 million shares, 12 times greater than Sears' daily trading average of 2.9 million shares during the Class Period. SRAC Debt Securities also fell 8.6% from $24.05 per share on October 16, 2002 to $21.99 per share on October 17, 2002, "on trading of 153,600 Notes, six times the daily trading average of 25,000 shares." (Id. ¶¶ 177, 178.) Shortly before the end of the Class Period, SRAC had announced its intention to offer approximately $800 million of three-year SRAC Debt Securities at an interest rate of 13 to 14 basis points above the one-month London Interbank Offered Rate ("Libor").*fn5 (Id. ¶¶ 53, 179.) After the October 2002 announcements, however, the debt securities were priced at 38 points above Libor. (Id. ¶ 180.)

  On November 12, 2002, Sears filed its Form 10-Q for the third quarter of 2002. In that report, Sears for the first time revealed to investors how the Sears MasterCard and Sears Card portfolios had both been deteriorating during the Class Period. Sears explained that "[b]ecause the MasterCard portfolio has a lower delinquency rate than the Sears Card, the growth in the MasterCard portfolio coupled with the decline in the Sears Card portfolio led to an improvement in the total portfolio delinquency rate as compared to the third quarter of 2001." Sears also stated that it "charges off accounts at 240 days where[as] most bankcard issuers charge off at 180 days. Therefore Sears' delinquency rate is not directly comparable to participants of the bankcard industry." (Id. ¶¶ 182, 183.) With respect to its re-aging policies, Sears disclosed that
[t]he Company's current credit processing system charges off an account automatically when a customer's number of missed monthly payments reaches eight, except that accounts can be re-aged once per year when a customer makes two consecutive ...

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