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Emerald Investments Limited Partnership v. Allmerica Financial Life Insurance and Annuity Co.

February 20, 2008


Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 02 C 05251-John F. Grady, Judge.

The opinion of the court was delivered by: Posner, Circuit Judge.


Before POSNER, WOOD, and SYKES, Circuit Judges.

Emerald, the plaintiff in this diversity suit (governed by Illinois law) for breach of contract, obtained a verdict and judgment for $1.1 million against the defendant, Allmerica. Allmerica contends that Emerald should not have been awarded any damages apart from the cost of a $150,000 surrender fee discussed later in this opinion. Emerald, cross-appealing, wants greater damages than the jury awarded; but on the view we take of the case, the cross-appeal is academic.

Allmerica sells variable annuities both directly to annuitants and to intermediaries who resell to annuitants. An annuity is in effect a reverse life-insurance contract: you pay a lump sum to the insurance company in exchange for a promise to pay you an income for life; the longer you live, and also the higher the return from investing the lump-sum purchase price (that investment generates the variable component in a variable annuity), the better you do. Allmerica allows the purchaser to place the purchase price in any one of a number of mutual funds with which the company has an arrangement. One of these is the Scudder International Fund.

Emerald, which one might have thought an intermediary customer, in March 1999 bought $5 million worth of variable annuities from Allmerica and later increased its investment to hundreds of millions of dollars. Emerald was not interested in reselling its variable annuities to prospective retirees, however. It wanted to engage in arbitrage. An arbitrage opportunity arises when the same thing is being sold at two different prices and the difference is due to some oversight or other error, or to price discrimination (charging different prices for the same good or service on the basis of different intensities of consumer demand for it), rather than to costs of transportation or other circumstances that might place the good in different markets and thus prevent uniform pricing. The arbitrageur spots the artificial price difference, buys at the lower price, and resells at the higher price. The effect is to bring about price uniformity, which terminates the arbitrage opportunity. Arbitrage is a socially useful activity because if the same good or service, costing the same and traded or tradable in the same market, is selling at different prices, one of those prices is too high (excluding the case in which one of the goods is selling below cost, in which event the price is too low) from the standpoint of an efficient allocation of resources.

Emerald had noticed that identical securities were selling at different prices in mutual fund accounts offered to the purchasers of Allmerica's variable annuities. The mutual funds set the prices that they charge for shares in their funds at 4 p.m. New York time, which is when the New York Stock Exchange closes. Those prices are a composite of the prices of the shares (in publicly held companies) owned by the fund. (On the pricing of mutual fund shares, see generally SEC, "Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings: Proposed Rule," 68 Fed. Reg. 70,401 (Dec. 17, 2003); DH2, Inc. v. SEC, 422 F.3d 591, 592-93 (7th Cir. 2005).) In the case of shares traded on foreign exchanges and therefore included in the Scudder International Fund, as the name implies, the price of a mutual fund share was, during the period relevant to this suit, a composite of the closing prices of the company shares (the shares owned by the fund) in the principal foreign exchange on which they were traded. Suppose the exchange had closed at 11 a.m. New York time (4 p.m. in London). In that event the share prices that the mutual fund would use to compute the price of its own shares at 4 p.m. New York time would be five hours old. During that interval, the prices of the foreign-traded shares may have risen or fallen in aftermarket trading or in trading on an exchange that was still open. Suppose those prices had risen. The mutual fund shares, since their prices are a function of the prices of the shares owned by the fund, would be underpriced.

To take advantage of the discrepancy between the composite price and the prices of the fund's constituent assets, Emerald would buy shares in the mutual funds minutes before it was 4 p.m. in New York (so as not to attract imitators, who would bid up the price of the shares in their eagerness to buy them) and sell them the next day, or within a few days, once the price of the foreign-traded shares was reflected in the price of the mutual fund shares. See also Kircher v. Putnam Funds Trust, 403 F.3d 478, 480-81 (7th Cir. 2005), vacated for want of jurisdiction, 547 U.S. 633 (2006).

Emerald financed its purchases of shares in the Scudder International Fund by transferring money from the Allmerica money-market fund in which it parked its investment in annuity contracts when it was not engaged in arbitrage. When the contract with Emerald had been made, Allmerica had allowed buyers of its annuities to transfer their investments to any other mutual fund with which Allmerica had an arrangement. But Emerald's frequent transfers between the money-market fund and the Scudder International Fund were a pain to both Allmerica and Scudder. The transfers were large-as much as $111 million. Scudder had to keep a large amount of cash on hand, which it would have preferred to invest, in order to redeem shares in its fund when Emerald, having bought the shares because it believed them underpriced, decided soon afterward to return to its money-market fund. Scudder's other investors suffered and so therefore did Allmerica, since its variable-annuity contracts lost value.

Had Allmerica known that Emerald was buying variable annuities in order to engage in international time-zone arbitrage, it would not have sold to Emerald, at least in the quantity it did; other sellers of variable annuities had stopped dealing with Emerald. In December 2001, Allmerica limited the number of transfers that its customers could make from the Scudder International Fund to another account to one per month. That action precipitated this suit. To add insult to injury, when Emerald later withdrew its money from Allmerica, Allmerica charged a $150,000 surrender fee, which Emerald had to pay to get its money out. The district judge ruled that the imposition of the limit was a breach of contract, and Allmerica does not contest the ruling.

In July 2004, after this suit was brought, Allmerica, perhaps anticipating the district judge's ruling on the transfer limitation, closed the Scudder International Fund (and other international funds in which market timing was likely to occur) to new investments. With the international funds closed, no longer could Emerald transfer money into them from the money-market fund. The district judge ruled that this method of stopping market timing was not a breach of Allmerica's contract with Emerald-which makes us wonder whether any damages should have been awarded for the acknowledged breach of contract noted in the preceding paragraph. A breach of contract to be actionable has to cause the plaintiff's injury. Had Allmerica not broken its contract, it almost certainly would have done what it did when it was sued for breach-closed the fund to new investments-so that Emerald's loss of profits from arbitraging would have been the same.

Allmerica doesn't make that simple argument, however. Instead it argues that the damages awarded by the jury were unforeseeable, and alternatively that they were hopelessly speculative. The first argument relies on the venerable precedent of Hadley v. Baxendale, 9 Ex. 341, 156 Eng. Rep. 145 (1854), which, as we noted in EVRA Corp. v. Swiss Bank Corp., 673 F.2d 951, 955-56 (7th Cir. 1982), has been received into Illinois's common law. Allmerica argues that Hadley and the cases in Illinois and elsewhere that follow it stand for the proposition that damages for breach of contract are limited to those that are "foreseeable" when the contract is made, and that the trading profits that Emerald claims to have lost as a result of the breach were not foreseeable to Allmerica in March 1999 because Emerald did not tell Allmerica that it was buying variable annuities in order to engage in arbitrage, and on a large scale.

Allmerica overreads Hadley and the cases following it. They are cases about special handling. The Hadleys owned a flour mill. The millshaft broke, and the Hadleys hired Baxendale to transport the broken millshaft to a shop that, using the broken millshaft as a model, would make a new one. Because the Hadleys had no spare, the mill was shut down until the new millshaft arrived, and they incurred substantial losses. The receipt of the new shaft was delayed as a result of a breach by Baxendale of its contract of carriage. The court held that the Hadleys could not recover the profits they had lost because of the delay. Had they wanted Baxendale to take special care to get the new millshaft to them by the contractually specified deadline, they should have negotiated for that care, that special handling; undoubtedly Baxen-dale would have demanded a higher price.

An Illinois case illustrates this point. The plaintiff in Siegel v. Western Union Telegraph Co., 37 N.E.2d 868 (Ill. App. 1941), had delivered $200 to Western Union with instructions to transmit it to a friend of the plaintiff's. The money was to be bet (legally) on a horse, but this was not disclosed in the instructions to Western Union, which misdirected the money order; as a result it did not reach the friend until after the race was over-in which the horse that the plaintiff had intended to bet on won and would have paid $1650. The plaintiff sued Western Union for the $1450 in lost profit (which was conceded- there was no question that he would have bet on the horse that won), and failed on the authority of Hadley v. Baxendale. 37 N.E.2d at 871. Or imagine a professional photographer who after spending months in the Himalayas taking pictures to be used in advertising mountain-climbing gear drops off his roll of film at the nearest Walgreens when he returns to the United States and Walgreen loses it, and he sues Walgreen for his lost profits. He would lose. Had he wanted Walgreen to ...

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