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Joyce v. Morgan Stanley & Co.

August 19, 2008


Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 06 C 4754-Samuel Der-Yeghiayan, Judge.

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


Before BAUER, WOOD, and EVANS,Circuit Judges.

Edward T. Joyce and his fellow plaintiffs were shareholders and option holders in 21st Century Telecom Group, Inc. ("21st Century"). (We refer to them here as the Shareholders.) This case is one of many that arose when the telecommunications industry fell upon hard times around the end of the 1990s. 21st Century and a company called RCN Corporation entered into a merger agreement on December 12, 1999, under which RCN was to acquire all of 21st Century's common shares. Defendant Morgan Stanley & Co., Inc. ("Morgan Stanley") advised 21st Century in connection with the deal. To the Shareholders' great dismay, between the date of the merger agreement and the effective date of the merger, April 28, 2000, the market value of RCN stock plummeted. In the end, the Shareholders' newly acquired RCN stock was worthless.

The Shareholders believe that Morgan Stanley ought to compensate them for their losses. Although Morgan Stanley was acting as the financial advisor to the 21st Century corporation, they maintain that it should also have given advice to the Shareholders about how to minimize their exposure to a potential loss in value of RCN stock. Morgan Stanley did not do so, in their opinion, because implementation of the proper hedging strategies probably would have depressed the value of RCN stock-an outcome Morgan Stanley sought to avoid because it was operating under a conflict of interest caused by its prior business relationship with RCN. Morgan Stanley moved to dismiss the complaint based on the Shareholders' alleged lack of standing, their failure to state a claim, and their failure to sue within the statutory limitations period. The district court granted the motion to dismiss, and we affirm the dismissal on the merits.


In its motion to dismiss, Morgan Stanley argued that the Shareholders did not have standing to sue because their claim is derivative rather than direct. It contends that they are bringing a suit that should be brought by the corporation, and they have not gone through the proper channels to obtain authority to bring the suit in a derivative capacity. Morgan Stanley comes to this conclusion by observing that the Shareholders' damages resulted from the drop in stock price, and that type of harm is generally a direct harm to the corporation through the diminution of its assets and only an indirect harm to the Shareholders; in addition, the harm is not unique to these plaintiffs but rather is common to all shareholders.

This argument misconceives the Shareholders' claim, and to the extent that the district court relied on "standing" as a ground for dismissing the case, it erred. Whether or not the argument is compelling, the Shareholders are actually asserting that the failure to hedge, rather than the drop in stock prices, caused their losses. In other words, they think that Morgan Stanley prevented them from taking self-help measures that would have insulated their personal portfolios from the drop in value suffered by RCN. The Shareholders may not rely on the drop in stock value as the cause or measure of their damage, because (as they concede) Morgan Stanley had nothing to do with that price drop. By contrast, it is possible to see the failure to hedge as a cause-in-fact of the Share-holders' financial loss, and they have alleged that this failure was caused by a breach of an alleged duty that Morgan Stanley owed to them. Because 21st Century as a corporation did not suffer any loss related to a lack of advice about hedging (since 21st Century received no RCN stock in the transaction), the Shareholders assert that their claim is direct rather than derivative. We are willing to go this far (but little farther) with their argument. The real issue is whether any such duty exists at all.


Turning to the merits, Morgan Stanley argues that the Shareholders have failed to state a claim. The law recognizes two types of fraud, actual and constructive. The Shareholders concede that they failed to allege actual fraud. Instead, they say that they are pleading some type of constructive fraud, and they add that this kind of claim should not be subject to the heightened pleading requirements of FED. R. CIV. P. 9(b).

Unlike actual fraud, constructive fraud "requires neither actual dishonesty nor intent to deceive, being a breach of legal or equitable duty which, irrespective of the moral guilt of the wrong-doer, the law declares fraudulent because of its tendency to deceive others." Pottinger v. Pottinger, 605 N.E.2d 1130, 1138 (Ill. App. Ct. 1992). Constructive fraud includes "any act, statement or omission which amounts to positive fraud or which is construed as a fraud by the courts because of its detrimental effect upon public interests and public or private confidence." Id. This claim requires the existence of a confidential or fiduciary relationship. Indeed, a plaintiff claiming constructive fraud "must show that defendant (1) breached the fiduciary duty he owed to plaintiff and (2) knew of the breach and accepted the fruits of the fraud." Prodromos v. Everen Secs., Inc., 793 N.E.2d 151, 158 (Ill. App. Ct. 2003).

The Shareholders did assert that Morgan Stanley owed them a fiduciary duty and that there was a confidential relationship between themselves and Morgan Stanley. They attached to their second amended complaint a fairness opinion issued by Morgan Stanley to the board of directors of 21st Century. Morgan Stanley's opinion notes that 21st Century "ha[s] asked for our opinion as to whether the Consideration to be received by the holders of shares . . . is fair from a financial point of view to such [share]holders." (Emphasis added). The complaint alleges that "[a]t the time Morgan Stanley was engaged, it knew . . . that the persons to be benefitted by its services were the 21st Century stockholders . . . ."; it continued with the allegation that "Morgan Stanley knew its fairness opinion would be relied on by RCN's shareholders [sic- apparently it meant 21st Century's shareholders] in deciding to vote for the merger sale to RCN." (Emphasis added). Finally, it asserted that "[a]s a result of its engagement, Morgan Stanley owed 21st Century and The Shareholders a duty of full and fair disclosure." (Emphasis added).

The Shareholders also pleaded a conflict of interest relating to the fiduciary duty that Morgan Stanley allegedly owed to them. In the engagement letter, Morgan Stanley explicitly disclosed the potential conflict of interest: "Morgan Stanley has been advising RCN Corporation ('RCN') in connection with the Transaction. RCN and 21st Century have requested that Morgan Stanley discontinue providing services to RCN and instead provide services to the Company. The Company understands that Morgan Stanley may use the same team members for this engagement." The Shareholders allege that there was a nefarious purpose behind RCN's suggestion that Morgan Stanley advise 21st Century:

Unbeknownst to 21st Century, the real reason why RCN wanted Morgan Stanley to be 21st Century's advisor was to ensure that RCN's interests would not be harmed by the advice given to 21st Century's shareholders. Morgan Stanley understood that this was ...

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