CHAPTER TWO - RESOURCE MATERIALS - cadds-edu.org

CHAPTER TWO - RESOURCE MATERIALS

332 F.Supp. 544 United States District Court,

E. D. New York.

Dudley FEIT, Plaintiff, v.

LEASCO DATA PROCESSING EQUIPMENT CORPORATION et al., Defendants.

No. 69 Civ. 1329. | Aug. 26, 1971.

Class action by shareholder of insurance company who accepted issuer corporation’s tender offer to exchange issuer’s stock for insurance company stock against issuer corporation, its directors and the dealer-managers of the tender offer to recover damages which resulted from alleged material omissions from registration statement and prospectus. The District Court, Weinstein, J., held, inter alia, that fact that insurance company had available approximately $100,000,000 of “surplus surplus” was material fact and omission of such fact from registration statement and prospectus with respect to tender offer to stockholders of insurance company was omission of material fact within statute which creates civil liability for material misstatements and omissions contained in a registration statement. Judgment in accordance with opinion.

Attorneys and Law Firms

*549 Sidney B. Silverman, New York City, for plaintiff; Joan T. Harnes, Jewel H. Bjork, New York City, of counsel.

Willkie, Farr & Gallagher, New York City, for Leasco Data; Anthony Phillips, L. Robert Griffin, New York City, of counsel.

Simpson, Thacher & Bartlett, New York City, for Lehman Brothers; Rogers Doering, Charles Edelman, Dean C. Rohrer, New York City, of counsel.

Shearman & Sterling, New York City, for White Weld; Robert F. Dobbin, Joseph McLaughlin, New York City, of counsel.

Opinion

MEMORANDUM AND ORDER

WEINSTEIN, District Judge.

This case raises the question of the degree of candor required of issuers of securities who


offer their shares in exchange for those of other companies in take-over operations. Defendants’ registration statement was, we find, misleading in a material way. While disclosing masses of facts and figures, it failed to reveal one critical consideration that weighed heavily with those responsible for the issue-the substantial possibility of being able to gain control of some hundred million dollars of assets not required for operating the business being acquired. [1] [2] [3] Using a statement to obscure, rather than reveal, in plain English, the critical elements of a proposed business deal cannot be countenanced under the securities regulation acts. The defense that no one could be certain of precisely how much was involved in the way of releasible assets is not acceptable. The prospective purchaser of a new issue of securities is entitled to know what the deal is all about. Given an honest and open statement, adequately warning of the possibilities of error and miscalculation and not designed for puffing, the outsider and the insider are placed on more equal grounds for arms length dealing. Such equalization of bargaining power through sharing of knowledge in the securities market is a basic national policy underlying the federal securities laws.

I. PROCEEDINGS

In this class action plaintiff seeks damages resulting from alleged misrepresentations and omissions in a registration statement prepared in conjunction with a 1968 offering of a “package” of preferred shares and warrants of Leasco Data Processing Equipment Corporation (Leasco) in exchange for the common stock of Reliance Insurance Company *550 (Reliance). He is a former shareholder of Reliance who exchanged his shares for the Leasco package. Suit was commenced in October 1969 on behalf of all Reliance shareholders who accepted the exchange offer between August 19, and November 1, 1968.

It is alleged that Leasco (1) failed to disclose an approximate amount of “surplus surplus” held by Reliance and (2) failed to fully and accurately disclose its intentions with regard to reorganizing Reliance or using other techniques for removing surplus surplus after it had acquired control. These failures, it is claimed, represented material misrepresentations or omissions in violation of Sections 11, 12(2), and 17(a) of the Securities Act of 1933 (15 U.S.C. §§ 77k, 77l(2), and 77q(a)), Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 (15 U.S.C. §§ 78j(b), 78n(e)), and Securities and Exchange Commission Rule X-10B-5 (17 C.F.R. § 240.10b-5).

Defendants are Leasco, the issuer; Saul P. Steinberg, Leasco’s chief executive officer; Bernard L. Schwartz, Leasco’s President; Robert B. Hodes, Leasco’s general counsel and a director; and White, Weld & Co. and Lehman Brothers, the dealer-managers. In addition to denials, the answers raise a number of defenses.

II. THE EXCHANGE OFFER


During the period August 19, through November 1, 1969 Leasco offered one share of convertible preferred stock and one-half warrant of Leasco in exchange for each share of Reliance common stock tendered. The preferred shares offered carried a $2.20 annual dividend and a conversion value of $55 if converted into common stock. The warrants permitted the holder to purchase Leasco common stock for $87 per share at any time up to June 4, 1978.

Reliance common shares had a market value of approximately $30 in December of 1967. As word of an impending takeover attempt spread, the price rose gradually to a high of $99⅞ during the tender offer period. The price of Leasco common shares was also rising during this period. On August 16, 1968, the last trading day before the exchange offer was effective, Leasco common stock closed at $87⅝ while its warrants were listed at a high bid of $43. Reliance shares were then selling at $66¼.

By September 13, 1968, 3,994,042 shares of Reliance, amounting to 72% of those outstanding, had been tendered and Leasco had obtained control of Reliance. Leasco ultimately acquired 97% of Reliance’s common stock by the termination of the tender offer on November 1, 1968.

III. SURPLUS SURPLUS

A. Definition of Surplus Surplus

Reliance’s surplus surplus is the central element in this litigation. Leasco’s desire to acquire it provided much of the original impetus for the exchange offer. Lack of disclosure of facts relating to the amount of surplus surplus and Leasco’s intentions concerning its use, as well as the materiality of those omissions provide the basis of plaintiff’s complaint. Finally, the method and difficulty of ascertaining its amount is critical to the defendants’ affirmative defense. We cannot proceed without examining the concept.

Reliance is a fire and casualty insurance company subject to stringent regulation by the Insurance Commissioner of Pennsylvania. Such a company is required by the regulatory scheme to maintain sufficient surplus to guarantee the integrity of its insurance operations. Such “required surplus” cannot be separated from the insurance business of the company. That portion of surplus not required in insurance operations has been referred to as surplus surplus. In a widely relied upon report to the New York Insurance Department, the matter was summed up as follows: “The ‘required surplus’ is one that will be adequate to cover for a reasonable period of time any losses and expenses larger than those predicted and any declines *551 in asset values, including all chance variations in the crucial factors of the operation. Any surplus beyond this cover is ‘surplus surplus’ which, by definition, is unneeded; it may be treated quite differently in the process of regulation.” State of New York Insurance Department, Report of the Special Committee on Insurance Holding Companies at 43 (Feb. 15, 1968) (hereinafter referred to as Insurance Department Report).


Simply put, surplus surplus is the highly liquid assets of an insurance company which can be utilized in non-regulated enterprises. While the importance of the concept has only recently received full recognition the idea is not new; it was previously referred to as “redundant capital.”

Insurance companies are not generally permitted to engage in non-insurance business activities. If, therefore, surplus surplus is to be of any practical use it must be separated from the insurance operation with its concomitant regulatory restrictions.

In 1967 Carter, Berlind & Weill undertook a study of fire and casualty companies. The result was a report by Edward Netter submitted in August 1967. It develops the concept of “The Financial Services Holding Company,” envisioning modification of the corporate structure of the typical fire and casualty company to permit more flexible utilization of its resources-particularly surplus surplus. Netter postulated a one-stop, comprehensive financial institution servicing virtually all of the consumer’s financial needs. Aggressive use of capital redundancy (surplus surplus) was a critical element in Netter’s analysis. He estimated Reliance’s capital redundancy at $80,000,000 as of December 31, 1966.

Leasco’s interest was aroused by the Netter Report. Michael Gibbs, Leasco’s Vice President for Corporate Planning, subsequently prepared a “Confidential Analysis Of A Fire And Casualty Company” based “to a large extent” on Reliance. He worked from the Netter Report to illustrate the specific benefits to Leasco of increased earnings per share and leverage potential in acquiring and reorganizing a fire and casualty company with large surplus surplus. His initial idea was to establish a parent holding company to which the fire and casualty company (Reliance) could transfer its surplus surplus-freeing it from regulatory restriction-while continuing to operate as an insurance subsidiary. In his opinion such an acquisition was potentially extremely valuable to Leasco. As he noted:

“II. SPECIFIC ADVANTAGES FOR LEASCO

If Leasco could acquire control of an F & C *** (3) large sums of capital for computer leasing would be available, (4) an aggressive acquisition and investment company (the holding company) would initially have a large sum of available capital in addition to potential debt leverage. ** (6) Leasco can create a true financial services company.” Gibbs estimated Reliance’s surplus surplus at $125,000,000 as of June 30, 1967 or $100,000,000 as of the end of 1967.

These two documents, along with the Insurance Department Report, provided the impetus for Leasco’s take-over bid. Steinberg considered surplus surplus “important to Leasco” and A. Addison Roberts, Reliance’s President, came away from negotiations with the impression that “one important aspect of Reliance that commended itself to Leasco was Reliance’s surplus surplus.” Leasco protected its interest in the surplus surplus by including a provision in an August 1, 1968 agreement with Reliance requiring its management to provide the maximum amount then available to the holding company Leasco would form.


B. Disclosures Concerning Surplus Surplus

The only statements in the prospectus with regard to surplus surplus appears on page five. It neither mentions the amounts that Leasco’s management had *552 in mind nor suggests the importance of Reliance’s possible surplus surplus. It reads: “The Company [Leasco] believes that this Exchange Offer is consistent with the announced intention of the Reliance management to form a holding company to become the parent of Reliance. That intention was communicated to Reliance stockholders on May 15, 1968 by A. Addison Roberts, the president of Reliance, who wrote that the holding company concept would serve the interests of Reliance and all its stockholders ‘by providing more flexible operations, freedom of diversification and opportunities for more profitable utilization of financial resources.’ The Company supports those objectives and intends to do all it can to promote their realization as soon as practicable. *** Reliance will diligently pursue its previously announced intention to form a holding company which Reliance will provide with the maximum amount of funds legally available which is consistent with Reliance’s present level of net premium volume. ***”

C. Parties’ Contentions With Regard To Surplus Surplus

Plaintiff contends that anything as important to the overall transaction as the amount of surplus surplus should have been disclosed by some sort of approximation. He asserts that such a computation could, in fact, have been made by the techniques used by Netter and Gibbs with information in Leasco’s possession or that sufficient additional data could have been obtained to arrive at a reliable estimate. He further claims that while Leasco disclosed its intention to form a holding company to make use of Reliance’s resources, it should also have disclosed that Leasco was considering other plans for separating surplus surplus from the insurance operation by reorganization and liquidation of Reliance or by declaration of a special dividend.

Defendants, in contrast, maintain that such omissions were not material because “*** the stockholders who exchanged Reliance shares for the Leasco package would not have been deterred from doing so by an estimate of surplus surplus, but rather would have been made all the more anxious to tender.”

This belief stems from their perception that a large block of liquid assets in the hands of an aggressive acquisition-oriented company like Leasco would have made the Leasco package even more attractive than Reliance shares. They also assert that such an inclusion would have been “bullish” in violation of SEC standards-it would have made the prospectus a selling document.


Defendants’ second principal argument is that surplus surplus could not have been calculated by Leasco because an accurate estimate required (1) access to Reliance’s financial data, (2) the judgment of its management, and (3) the opinion of the insurance commissioner, all of which were denied Leasco by the hostility of Reliance’s management and its attempts to obstruct the take-over bid.

Finally, defendants contend that any other proposals for removing surplus surplus from Reliance were simply matters being considered by counsel. They never reached the level of a specific plan by Leasco during the pendency of the exchange offer.

D. Computation of Surplus Surplus

The problem and the variety of methods of determining surplus surplus were discussed in the New York Insurance Department Report in the context of how an insurance department should determine what is “required surplus.” A variety of techniques were set out: “The ‘required surplus’, which should be assured by regulation, is easy to state in the abstract, but difficult to implement in practice. It calls for analysis of the variables that the surplus *553 to policyholders is expected to cover. Essentially they are three. First the surplus must absorb any basic insurance costs (losses and expenses) which are in excess of the premiums charged. Second, the surplus must absorb any under-valuation of loss or claim reserves. Third, the surplus must absorb any declines in asset values. To this should be added any surplus required to finance necessary growth. “Well-known rules-of-thumb for making approximations have been developed. The so-called ‘two-to-one’ rule constitutes an approximation to the specification of required surplus, and can be applied in the absence of anything better. Under most circumstances it is surely too stringent when used as a test of solidity. The rule is based on a theory developed by a former New York Insurance Department Chief Examiner and was utilized in the first draft of the 1939 Recodification of the Insurance Law as a yardstick for payment of dividends. “A similarly rough, but probably much too liberal, approximation is found in the English statutes. A non-life insurer must have a surplus of at least £>>>>50,000 if the general premium income of the company in the previous year did not exceed £250,000, a fifth of that income if it exceeded £250,000 but not £ 2,500,000, or the aggregate of £500,000 and a tenth of the amount by which that income exceeded £2,500,000. “The insurance regulatory personnel of some states have concluded that premium writings of three times policyholders’ surplus is safe but that four times is risky. Sometimes this is made a little more sophisticated by adding common stock investments to premium writings, in recognition of the fact that surplus must cover not only bad operational experience but also a stock market decline. In actual administration in a department as competent as New York’s actual application can be still more refined and discriminating, though New York, like the others, relies more on judgment than on precise quantitative standards.”


The difficulties set out by the New York Insurance Department Report were also perceived as realistic problems by the insurance industry. Roberts, President of Reliance, and a cooperative witness of defendants was of the opinion that what needed consideration was: (1) the relationship of premium writings to surplus; (2) underwriting results; (3) investment policy of the company; (4) its re-insurance arrangements or treaties; (5) exposure to catastrophies; (6) adequacy of loss and premium reserves; (7) quality and characteristics of the agency plan or company; and (8) the quality of management. He indicated that some of the data pertaining to these criteria were not matters of public record.

He concluded that the evaluation of these factors was largely a matter of judgment and nearly impossible without full access to company data.

Similarly, Steinberg, Chief Executive Officer of Leasco, considered the rules of thumb method discussed by the Insurance Department Report and used in both the Netter and Gibbs memoranda to be “unreliable” methods of determining surplus surplus given the lack of access to Reliance management. Consequently, he considered the estimates contained in these documents to be inaccurate and undependable. He testified that he himself had never arrived at an estimate he considered accurate with any degree of certainty throughout the preliminary stages and even through the exchange offer period. Thus, he stated, when the question of including such an estimate in the prospectus arose it was decided on the advice of counsel not to include one.

According to defendants, the result of this pervasive feeling of uncertainty about the accuracy of the estimates put forward by Netter and Gibbs, or any estimate, was that none of the principals in the exchange offer ever calculated surplus *554 surplus, commissioned anyone to compute it, or even attempted to estimate it. Nor did the underwriters attempt at any time to obtain an estimate from Reliance. In fact, they did not even communicate with Reliance.

This is not to suggest that no estimate of surplus surplus was available to Leasco during the negotiations and exchange offer period-the Netter Report had estimated it at $80 million and Gibbs had indicated $100 and $125 million as his approximations. A range of $50-$125 million was discussed at meetings between Reliance and Leasco in October 1968. Leasco simply, according to defendants’ testimony, considered these estimates speculative in light of their then state of knowledge of Reliance.

Nor should it be inferred that an estimate could not have been obtained at least by Roberts, who was, of course, privy to Reliance’s data. He stated bluntly that he could have made such a calculation “damn quickly” if given a reason to do it. He had not calculated it because he was never presented with a specific need to do so. No one from either Leasco or the underwriters ever asked him to calculate surplus surplus during the pendency of the exchange offer, but he could have done so if asked. Whether he might or would have is one of the subsidiary issues in this litigation.

IV. BACKGROUND OF THE EXCHANGE OFFER


A. January to August 1, 1968.

Following the submission of the Gibbs memorandum on January 11, 1968, Leasco developed an active interest in acquiring Reliance. By April 3rd of that year it had taken a substantial position in Reliance stock-132,000 shares, roughly 3%, worth over four million dollars.

As early as February 9, 1968 Roberts received word from a partner in a Philadelphia brokerage firm that Leasco was interested in buying Reliance. Accordingly, he sent a letter to his stockholders on May 15, 1968 indicating that Reliance intended to form a holding company to become the parent company of Reliance. This would benefit Reliance and its stockholders “*** by providing more flexible operations, freedom of diversification and opportunities for more profitable utilization of financial resources through the Holding Company concept.” While this document implies recognition of surplus surplus and indicates an intention to aggressively utilize it, the term itself was not used nor did Roberts calculate it because “[t]his was more or less a public relations maneuver” to demonstrate Reliance’s progressive attitude and forestall a takeover bid. This letter was subsequently referred to by Leasco on page five of its prospectus, quoted above.

Representatives of Leasco and Reliance met in early June, 1968 to discuss the possibility of a merger between the two companies. Steinberg tried to convince Roberts of the potential for creating new opportunities in the financial service company area. He believed that a merger of a sound insurance company with a company like Leasco which had a strong technological base “would make an exciting combination.” Reliance was not particularly interested in the prospect, but Roberts said he would present any specific proposal to his board; none was suggested at that time. Because of the general nature of these discussions, surplus surplus was never specifically discussed and apparently no calculations were made.

Leasco announced a tender offer for Reliance shares on June 22, 1968. At that time it offered one convertible debenture having a principal amount of $110 and paying annual interest of $4.00 and one warrant for every two Reliance shares tendered. The Reliance management wrote to its shareholders on June 24, advising them not to act in haste with regard to the offer.

Hodes, a member of Leasco’s board and a partner in its counsel’s law firm, by telegram dated June 24, 1968 requested Reliance’s cooperation in the preparation of a registration statement on SEC Form S-1 in conjunction with *555 the registration of the Leasco shares into which the debentures were convertible and promised to promptly furnish Reliance with proofs of the registration statement for its comments. Roberts replied, by telegram dated July 1, 1968, that:

“*** the Reliance Executive and Finance Committee is studying Leasco’s proposal. Reliance cannot incur the expense and potential liability of preparing and supplying the information requested until the Board of Directors has determined whether the Leasco proposal is in the best interests of Reliance and its stockholders.”

A copy of the preliminary registration statement filed with the SEC on July 8, 1968 was sent


to Roberts on July 9, along with a request for advice as to its accuracy. Similarly, a copy of an actuarial consultant’s report on Reliance was forwarded to Reliance with a request for comments on July 12. Roberts responded on July 15 that “[w]e are studying the requests made in your letter of July 9th and will advise you in due course.” Reliance apparently never complied with these requests for information.

During the greater part of July the posture of the Reliance officers toward the exchange offer and Leasco was one of hostility, apparently motivated by the conviction that the offer was not in the best interests of Reliance and its shareholders and further by its concern with regard to Leasco’s intentions toward them personally should the offer succeed.

Speaking of the first meeting between Leasco and Reliance in June, Roberts testified: “I was less than friendly about it because I was not interested, and they were pursuing it rather vigorously.” He similarly characterized a subsequent meeting held in Philadelphia in late July: “*** [T]he discussion was about whether we can make an amicable arrangement, an affiliate [sic] or merger, and discussion was rather abrasive. I guess I was the leading character in that respect.” (emphasis added).

Perhaps the best expression of this relationship was provided at trial by Saul Steinberg: “It is somewhat hard for me to characterize it, but, I think that Mr. Roberts viewed-he constantly has characterized this as he was a king and we were about to make him a baron, and the relationship was always on a personal basis, cordial, but I think that I certainly had a lot of respect for him and I still do ***-but it was cold. It *** wasn’t friendly, we were taking over his company.” (emphasis added).

Reliance filed a lawsuit against Leasco in mid-July, the purpose being “to inhibit the tender offer.” Subsequently, on July 23, 1968, Roberts wrote a strong letter to his shareholders expressing opposition to the proposed exchange offer: “Your Board of Directors has very carefully weighed the pros and cons of the Leasco offer in the preliminary prospectus and strongly recommends that you reject the proposed exchange of Leasco Debentures and Warrants for your Reliance Stock.” (emphasis in original).

He listed the following as the reasons for not tendering: (1) the exchange was a taxable transaction; (2) Leasco was small and was spending large fees on the exchange offer itself; (3) the debentures would be subordinated to other debts; (4) Reliance stockholders would be contributing a disproportionate share of earnings and assets in the combined company; (5) Leasco common stock had never paid a dividend; (6) the debentures and warrants had no voting power; (7) any tender was irrevocable and eliminated the Reliance shareholder’s ability to take advantage of favorable market changes during the exchange period; and (8) if earnings were to drop off the highly leveraged capitalization of Leasco might cause “financial stringencies.”

Indicating that the Board of Directors did not believe Leasco’s long term prospects *556 were as good as its high price-earnings ratio would suggest, he summed up management’s


position: “[W]e are recommending that you do not accept the Leasco paper. The other alternatives presently available are that you hold your investment or sell your shares on the open market.”

This document is particularly significant because of the insight it provides regarding the depth of opposition to the exchange offer as late as July 23. Viewed in conjunction with the failure to provide information and the filing of the law suit, it is clear that Roberts’ group was prepared to employ a full panoply of defensive techniques in an attempt to bust the exchange offer. Such resolve in late July becomes crucial in light of conduct on and after August 1, 1968.

The final paragraph of the July 23 letter relates directly to the problem of the alleged omissions to state an amount of surplus surplus. Reliance management informed its shareholders that Leasco might not be the only possible tenderor and impliedly suggested that they not accept the first offer made.

“In considering these alternatives you should know that in the last several weeks Reliance management has negotiated with several other companies and has received a number of offers. In the judgment of your Board, all of these were, like Leasco’s proposal, not sufficiently attractive to warrant recommendation to you at this time. We are continuing to have talks with several other interested companies and your management promises to take all possible steps to consummate an affiliation with an investment quality company and insure that your long term investment remains sound, secure and profitable.”

In short, they implied a better deal if the tender offer were frustrated.

This promise to actively seek an alliance was made more credible by the fact that the Netter report had been distributed on Wall Street so that the attractiveness of fire and casualty companies was known to security analysts. Roberts’ testimony was that many of his shareholders believed that the company was “going to be raided”; he was aware as early as May, 1968 that “many mutual funds were buying this stock” in anticipation of takeover bids.

Shortly after this letter was sent to Reliance shareholders, its management once again met with Leasco to discuss a possible affiliation or merger. It was this meeting which was described as “abrasive” by Roberts. It accomplished nothing and the relationship between the two apparently did not improve until later in July when representatives of Leasco and Reliance met. They worked out the substance of an agreement which modified the offer somewhat and gave Reliance management very substantial personal benefits in exchange for withdrawal of active opposition to the exchange offer and assurances of cooperation in setting up a holding company. The results of these discussions were confirmed in a contract executed August 1, 1968.


B. August 1 to August 19, 1968.

The August 1st agreement represents the end of open hostility, tacit acceptance of a Leasco takeover, and at least the beginning of a rapprochement between the two management groups. Thereafter, an effective working relationship commenced between what was to be parent and subsidiary. While the personal relationships may not have warmed immediately, the business associations improved considerably to the point that Reliance’s management “cooperated with them within reason” after around mid-September and actively after October 18, 1968.

The avowed purpose of entering into the August 1st agreement was that “Reliance has heretofore expressed opposition to Leasco’s proposed Exchange Offer, and *** Leasco desires that Reliance withdraw such opposition”. Leasco agreed that if it should acquire a majority of Reliance shares it would *557 nevertheless vote its shares for at least five years to maintain a majority of the existing Reliance Board of Directors. It bound itself not to elect more than one-third plus one of the directors of Reliance. In effect it reposed a voting trust in the old management.

Roberts was guaranteed his position as director and chief executive officer of Reliance. His associates covenanted to cooperate in setting up a holding company to release from insurance operations “the maximum amount of funds available”-i. e., Reliance’s surplus surplus.

As is apparent, a primary function of the agreement was to protect Leasco’s interest in Reliance’s surplus surplus. Because the voting trust arrangement denied Leasco day-to-day control of Reliance for five years, it required that Roberts and his associates do nothing to diminish profitability and thus limit its financial resources and that they form a holding company to make the maximum amount of surplus surplus available to the Leasco controlled holding company.

The contract protected Reliance management from liability arising from the tender offer itself:

“Nothing contained herein shall be deemed to require Reliance or its management or the stockholders to recommend to the stockholders of Reliance that they accept the Exchange Offer or to oblige Reliance to cooperate in the preparation of any Registration Statement in connection therewith or to assume or take any liabilities or responsibility in connection therewith.”

While Roberts was willing to withdraw his opposition and even cooperate, he clearly did not wish to incur any liability for a registration statement which he was not preparing. He thus avoided any affirmative duty to formally involve himself in the registration process and denied Leasco the use of his name on the registration statement.

The critical significance of this document arises from the assurances it provided the Reliance management that (1) the ordinary insurance business of the company would not be interfered with by non-insurance interests and (2) there would be no major disruption of the


prerogatives of Reliance’s management team as a result of a successful exchange offer. Thus, the two principal reasons for anxiety and opposition by Reliance officials were resolved favorably.

In addition to the security guaranteed by the August 1, 1968 contract, Roberts reaped a number of substantial personal benefits. His salary was increased from $80,000 to $100,000 a year shortly thereafter. He was granted an option to purchase 5,000 shares of Leasco at 30% of the market price when granted-$27.15-which he exercised on October 23, 1968 when Leasco shares were selling at $114.25. Thus, during the pendency of the exchange offer Roberts was the recipient of an $87.10 per share discount, or a bonus of approximately $435,000. He also received a future option on 10,000 additional shares. Finally, he was accorded a position on the Leasco Board of Directors. Roberts took further pains to protect and preserve his own financial well being. He kept his substantial holdings of Reliance shares without tendering. Whatever happened to Reliance shareholders, he was to be well taken care of.

Immediately after the August 1st reconciliation, Reliance withdrew the lawsuit it had filed against Leasco. It mailed its shareholders a letter stating that whether to exchange was a decision they would have to make and indicating that Leasco had increased the offer and granted management a voting trust. Roberts apparently also furnished Leasco with a stockholders list enabling it to transmit the prospectus and formal tender offer.

Prior to the withdrawal of Reliance’s opposition Leasco had offered one debenture and one warrant for each two Reliance shares tendered. Leasco finally offered one preferred share and one-half warrant for each share tendered. Whether the final package was in fact *558 more advantageous than the original offer is not clear. What is clear, however, is that while the original package was taxable to the tenderor on an installment basis only as he realized gain, the final offer was taxable immediately.

The Reliance management group realized the tax disadvantage to the Reliance shareholders, who might have to pay tax on the exchange before receiving any proceeds with which to pay it. Nevertheless, it dutifully maintained the neutrality bargained and paid for in the August 1st contract. Having accepted the imminent takeover on August 1st, Roberts was no longer concerned with details such as tax consequences to his own shareholders to whom he owed a fiduciary duty.

Roberts’ withdrawal of opposition, acceptance of Leasco’s takeover, and subsequent cooperation during the pendency of the exchange offer, when viewed in light of his own poor opinion of the package offered, provides important insight into the state of his mind-an issue critical to defendants’ contention that he would not have cooperated in helping compute surplus surplus. True to his own evaluation of the merits of the Leasco exchange offer, Roberts refused to tender his own shares. It is clear that the neutral posture taken by Roberts after August 1, 1968 was not that of an elected corporate officer who believed that the exchange offer was necessarily in the best interests of his shareholders, but rather the stance of a pragmatic business man who perceived that a tender of shares at a premium over market price was likely to be successful and that it was better to acquiesce-advancing his personal fortune in the process-than to incur the displeasure of the raiders.


Roberts also made it clear that nothing occurred between July 23, and August 1, to change any of the eight specific reasons stated in his letter of opposition dated July 23. The August 1st agreement did not make these factors any less compelling.

Shortly after the August 1st agreement was consummated, a revealing exchange of letters occurred between the Deputy Insurance Commissioner of Pennsylvania and Roberts. On August 2nd the Deputy Commissioner inquired about the Leasco takeover, the existence and extent of surplus surplus, and the position of Reliance’s management on the takeover and its future course of action.

Roberts’ reply on August 6th expressed the belief that the activity in Reliance stock foretold a takeover bid and that “*** the rumors had turned into reality in that we were receiving calls from companies interested in acquiring Reliance, commencing several months ago.” He further stated that in his opinion Reliance did have surplus surplus which could be removed from the insurance operation but that it was very “difficult to measure with exactness”-a somewhat disingenuous reply in view of his testimony at the trial that he could have computed it quickly. Most revealing, however, is his attitude toward the Leasco exchange offer. “The Reliance management did not seek the affiliation with Leasco. In fact, our Board of Directors much preferred that our Company not be owned by non-insurance interests; however, in the light of what has taken place we have accepted the fact that Leasco will probably obtain control of the Company. If so, we have agreed *** “(b) That Leasco will receive our cooperation in forming a holding company with their having the right to withdraw any surplus funds of Reliance within the framework of satisfying the regulatory authorities that sufficient funds are kept in the business for it to be operated with at least its present premium income. “If the answers to these questions are not sufficient for your purpose, will you please advise us as we will be very happy to elaborate on any points or *559 questions you might wish to present to us.”

At this date Roberts still had not expressed in writing a specific opinion regarding surplus surplus. He had, however, indicated his resignation to the Leasco takeover, his intention to cooperate with Leasco, and his willingness to answer any inquiry by the insurance department regarding surplus surplus and its disposition. Roberts’ state of mind reflected that of other members of the Reliance board as of August 19, 1968 when the Leasco registration statement became effective and the exchange offer commenced.

C. The Exchange Offer Period-August 19, to November 1, 1968.

The exchange offer was so successful in the early days that by September 13, 72% of the shares had been tendered and Leasco had acquired control. The offer was extended for the


second time on September 16, with a supplement to the prospectus indicating the success of the takeover. Between August 1, and mid-September, Roberts had, according to defendants’ testimony, not been in direct contact with Leasco as he awaited the outcome of the exchange offer. But as it became certain that Leasco would be his employer, he abandoned his neutral stance. “Q Now then, Mr. Roberts, during the changeover period, you and other members of Reliance’s management team cooperated with Leasco, did you not? “A Well, let’s put it this way, August the first we stopped opposition of keeping the agreement [sic]. The next time I talked to people from Leasco or anyone in the Reliance management to my knowledge, there may have been other talks but I am not aware of them, the first time I did was the middle of December [sic] [September], when Leasco got control of over 80% of the stock. From that time we cooperated with them within reason. “Q *** you and the management team cooperated in good faith after mid-September of 1968? “A That’s correct.”

The exchange offer was extended four more times. As Roberts became more accustomed to the takeover his cooperation “within reason” became “active cooperation” by October 18-the date of the last extension.

On that date Roberts himself mailed a letter to the remaining Reliance shareholders describing the exchange offer, indicating the recent performance of Leasco securities on the market, and informing them that Leasco intended to declare a dividend of 48 cents on December 1, 1968 which they would not receive if they did not tender by November 1st. He concluded:

“Although the Reliance management makes no recommendation as to the Leasco Exchange Offer, we do wish to point out that in view of Leasco’s having over 90% of the Reliance stock, you will be a minority stockholder if you retain the Reliance stock. We strongly recommend that you reconsider you position and consult your financial advisor or broker as to whether you should accept the Leasco offer or take other possible courses of action.”

Roberts purpose in writing this letter was admittedly to induce intransigent stockholders to tender their shares-though, as already noted, he himself never tendered.

During the exchange period discussions were carried on between Hodes, Leasco’s counsel, and Peter Korsan, counsel for Reliance, regarding methods of ultimately separating Reliance from its surplus surplus, and, if possible, effecting a tax savings for Leasco. Roberts was aware of these discussions. In the course of these meetings a range of $50-$125 million of surplus surplus was discussed. The figure was, however, apparently not Korsan’s. During this period each of the principals was conducting an independent legal and factual investigation of reorganization schemes, *560 holding company concepts, and tax consequences to Leasco.


In at least one instance Korsan had discussions with the general counsel for the Pennsylvania Insurance Department in connection with formation of a holding company. In a memorandum to Roberts dated September 27, 1968 Korsan estimated the maximum surplus which could be distributed to a holding company by way of dividend under Pennsylvania law would be $125 million, but Leasco was not, according to defendants’ testimony, made privy to this estimate.

So far as relevant to this litigation, the major Leasco concern during this tender period was how Reliance might be reorganized to accomplish tax savings. While several legal variations were explored during September and October they remained merely matters for consideration by counsel and never rose to the level of corporate plans.

Plaintiff, Dudley Feit, tendered his shares on October 14, 1968-long after it was clear that the tender offer would be successful and after Roberts and his associate Korsan were actively cooperating with Leasco. At no time was the discussion of surplus surplus in the prospectus changed, despite the fact that a number of supplements were issued. The exchange offer terminated on November 1, 1968.

V. THE POST EXCHANGE OFFER PERIOD

After November 1, both management teams continued their studies of alternatives for reorganizing Reliance. Korsan met with a representative of the Insurance Department on November 14 and discussed a range of surplus surplus. On December 20, 1968, however, the Insurance Department was as yet uncertain as to how determination of surplus surplus related to actuarial studies. Reliance had not obtained approval for separation of a specific amount.

A. The January 1969 Registration Statement

Highly significant with respect to Leasco’s claims that it could give no estimate of surplus surplus was the fact that it did just that a few months after the tender period ended. It did so with no more data than it had during the exchange offer period.

Leasco filed a Form S-1 Registration Statement with the SEC on January 31, 1969 with a prospectus dated February 3, 1969. This registered various securities to be issued in the future among which were the common shares which could be obtained upon exercise of the warrants contained in the exchange package. The prospectus quite properly discussed Leasco’s recently acquired insurance business and the plan for reorganizing Reliance to Leasco’s benefit: “Reliance and the Company are in the process of seeking to cause a reorganization of Reliance, subject to regulatory approvals, the effect of which will be to eliminate minority interests and to make available to the Company, for use in its various business and acquisition activities, approximately $125,000,000 of excess surplus of Reliance. It is the opinion of Leasco that this amount represents funds which Reliance has on hand in excess of


the legal requirements of its business. No assurance can be given that such excess funds will ultimately be made available to the Company in such amount or that if so made available that such funds will be profitably utilized by the Company.” (emphasis added).

This paragraph was also included in a draft of a preliminary prospectus prepared in June of 1969, but never made effective.

Barely three months after the termination of the exchange offer when Leasco sought to sell its own shares, rather than acquire Reliance’s, it included the type of qualified approximation of surplus surplus which plaintiff contends was material to the August 19, 1968 exchange offer. Leasco’s lawyer, Hodes, sought to justify this surprising change in position by testifying that the inclusion resulted from the development of a “decent working relationship.” He further testified that this new relationship had *561 conferred previously denied access to Reliance and the Insurance Commissioner and that both were consulted before including the estimates.

The Court has concluded, however, that Hodes’ recollection is not accurate. Roberts was not consulted. He acquiesced after the paragraph on surplus surplus had been written by the same Leasco personnel who had participated in drafting the exchange offer prospectus. Roberts’ deposition on the point was, at best, equivocal: “Q Who brought up the subject of surplus-surplus? A As I recall, I became aware of it because there was a $125 million figure put in the prospectus. Q What did you say about this? A I asked where the figure came from. Q Who did you ask? A One of the people who was working on the prospectus. ‘Q What did they say? A I don’t recall that they had any definite answer. Maybe it came from Mike Gibbs. I don’t know. Nobody knew. They haven’t asked me about it. That’s why I was rather curious.”

It is clear that the Insurance Commissioner had not been consulted about the use of this $125,000,000 figure.

VI. THE DEALER MANAGERS’ ROLE

The dealer managers, White, Weld & Co. and Lehman Brothers, played a somewhat limited


the legal requirements of its business. No assurance can be given that such excess funds will ultimately be made available to the Company in such amount or that if so made available that such funds will be profitably utilized by the Company.” (emphasis added).

This paragraph was also included in a draft of a preliminary prospectus prepared in June of 1969, but never made effective.

Barely three months after the termination of the exchange offer when Leasco sought to sell its own shares, rather than acquire Reliance’s, it included the type of qualified approximation of surplus surplus which plaintiff contends was material to the August 19, 1968 exchange offer. Leasco’s lawyer, Hodes, sought to justify this surprising change in position by testifying that the inclusion resulted from the development of a “decent working relationship.” He further testified that this new relationship had *561 conferred previously denied access to Reliance and the Insurance Commissioner and that both were consulted before including the estimates.

The Court has concluded, however, that Hodes’ recollection is not accurate. Roberts was not consulted. He acquiesced after the paragraph on surplus surplus had been written by the same Leasco personnel who had participated in drafting the exchange offer prospectus. Roberts’ deposition on the point was, at best, equivocal: “Q Who brought up the subject of surplus-surplus? A As I recall, I became aware of it because there was a $125 million figure put in the prospectus. Q What did you say about this? A I asked where the figure came from. Q Who did you ask? A One of the people who was working on the prospectus. ‘Q What did they say? A I don’t recall that they had any definite answer. Maybe it came from Mike Gibbs. I don’t know. Nobody knew. They haven’t asked me about it. That’s why I was rather curious.”

It is clear that the Insurance Commissioner had not been consulted about the use of this $125,000,000 figure.

VI. THE DEALER MANAGERS’ ROLE

The dealer managers, White, Weld & Co. and Lehman Brothers, played a somewhat limited

role in the exchange offer. Leasco’s attorneys accepted primary responsibility for preparation of the registration statement with the brokerage houses performing only the “due diligence” function. This function as described by representatives of the firms-Fred D. Stone of White, Weld and Sidney Kahn of Lehman Brothers-included a line by line review of the prospectus accompanied by demands for documentation of particular statements included in the draft by Leasco as well as independent investigation of books and records. These “due diligence” meetings were held on June 28 and 29 and July 1, 2, 3, and 5, 1968 at Leasco’s attorney’s office in New York.

White, Weld and Lehman are not precisely in pari materia in this case. White, Weld had representation on Leasco’s board after June 17, 1968 and had participated in four prior offerings by Leasco, while this was Lehman’s first experience with Leasco.

White, Weld had accumulated data gathered as part of the prior offerings. They thoroughly reviewed Leasco’s audit statements with Leasco’s accountant, Touche, Ross & Company. They also examined the report of an actuary firm hired to examine Reliance.

With regard to surplus surplus, Stone, for White, Weld, was well informed. As early as 1965 he worked with the concept-then known as “redundant capital”-in conjunction with staving off a tender offer and later, in 1968, he participated in forming a holding company. He received the Netter Report and the Gibbs Memorandum in January or February of 1968 and requested a copy of the New York Insurance Department Report sometime after June 22. When Leasco raised the question of including an estimate of surplus surplus, he concluded that surplus surplus could not be computed accurately because there was no factual basis for such a computation in the absence of access to Reliance’s management and the insurance commissioner.

Stone had in mind Leasco’s requests for information and the lack of response when he gave this opinion. He was at no time disabused of the notion that Reliance would not provide data to assist in an approximation of surplus surplus. Since, based on his own experience, he had high regard for the competence of both Leasco’s representatives and its law firm, there was no reason for him to suspect that they would be withholding relevant information. For this reason he relied on their representation, implied *562 and actual, that the situations with regard to access to Reliance management remained unchanged. This accorded with his usual practice of relying upon the issuer or its counsel to produce relevant material from its files rather than to personally inquire into corporate developments such as negotiations between target and acquiring companies. Consequently, he made no effort to directly contact either Reliance or the Pennsylvania Insurance Commissioner about surplus surplus.

Counsel for the dealer managers, Bell, Boyd, Lloyd, Haddad & Burns of Chicago, examined the corporate records of Leasco, its corporate minutes, director actions and basic contracts. Jack M. Whitney, II, a former SEC Commissioner, was the lawyer primarily in charge of the dealer manager’s duties. He participated in the extensive “due diligence meetings” conducted in New York where the preliminary prospectus was examined. When the subject of Reliance’s intention to form a holding company arose during these meetings Whitney became involved in a discussion of surplus surplus. He was admittedly uninformed about the concept and those present at the meeting, particularly Stone of White, Weld, undertook to edify him. Following intensive exploration of the concept and the limitations inherent in


attempting to approximate it, he rendered an opinion that an estimate could not properly be included in the prospectus.

On August 13, 1968-barely six days before the registration statement became effective-Whitney received yet further confirmation of his opinion of July in the form of a copy of a letter from Wilkie, Farr & Gallagher to the SEC. It reads: “Certified financial statements of Reliance Insurance Company are not included in the Amendment since that company has continued to refuse to cooperate in the making of the Exchange Offer. Although the Reliance Insurance Company management is not actively opposing the Exchange Offer they have expressly declined to support or recommend it and have accordingly declined to furnish information in connection with this Registration Statement.” (Emphasis supplied.)

On August 21 and September 18, 1969, Whitney sent a written favorable opinion to the dealer managers regarding the accuracy and completeness of the registration which became effective August 19, 1968.

The position of the dealer-managers that surplus surplus should not be estimated was, the Court concludes, based upon information furnished by Leasco that Reliance continued to refuse to cooperate. This was not true. Roberts and Reliance had not been asked to confirm estimates after August 1st when the probabilities of a successful takeover became increasingly great. But the dealer-managers were not aware that such cooperation was available.

VII. THE SECURITIES STATUTES

Plaintiff seeks relief under three separate sections of the 1933 Securities Act. Section 11 creates civil liability for material misstatements and omissions contained in a registration statement. 15 U.S.C. § 77k. Section 12(2) imposes civil liability on a seller who uses such misrepresentations in any sale whether or not by registration statement. 15 U.S.C. § 77l(2). Section 17(a) makes it unlawful to sell securities by the use of an “untrue statement of a material fact” or any omission of a material fact (15 U.S.C. § 77q(a); civil liability is arguably also available to an injured buyer under this section, but the issue has not been definitely resolved. See Globus v. Law Research Service, 418 F.2d 1276, 1283-1284 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S.Ct. 913, 25 L.Ed.2d 93 (1970); VI L. Loss, Securities Regulation 3913-3914 (1969).

Plaintiff also asserts that the Securities Exchange Act of 1934 provides relief under both Section 10(b)-pursuant to Rule X-10b-5-and Section 14(e). 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5; 15 U.S.C. § 78n(e). The former makes it unlawful “to make any untrue statement of a material fact” in connection with the *563 purchase or sale of “any security”, while the latter creates the same illegality “in connection with any tender offer or request or invitation for tenders.” Civil liability has been established for violation of Rule 10b-5. See SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1968), cert. denied sub nom, Coates v. SEC & Kline v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969) (liability under Rule 10b-


5); Fischman v. Raytheon, 188 F.2d 783 (2d Cir. 1951) (establishes civil remedy under Rule 10b-5). It also can be based on Section 14(e). See Mills v. Electric Auto-Lite Company, 396 U.S. 375, 90 S.Ct. 616, 24 L.Ed.2d 593 (1970) (Section 14(a) and Rule 14a-9 use the same operative language found in Section 14(e)); J. I. Case v. Borak, 377 U.S. 426, 84 S.Ct. 1555, 12 L.Ed.2d 423 (1964) (same).

The case before us involves misrepresentations included in a registration statement. While liability might well lie under the other broader provisions urged by plaintiff, we will focus on Section 11. It deals exclusively with registration statements such as the one before us. Before turning to our discussion of Section 11 a few comments on the disclosure philosophy of the federal securities laws are necessary in order to establish the setting in which the requirements of Section 11 must be applied.

VIII. DISCLOSURE

A. Disclosure Policy [4] The keystone of the Securities Act of 1933, and of the entire legislative scheme of the securities laws, is disclosure. Knauss, A Reappraisal of the Role of Disclosure, 62 Mich.L.Rev. 607 (1964). The 1933 Act is almost exclusively preoccupied with accurate disclosure of facts, favorable and unfavorable. Folk, Civil Liabilities Under the Federal Securities Acts: The BarChris Case, 1 Securities L.Rev. 3, 13, 16-17 (1969) (reprinted from 55 Va.L.Rev. 1 (1969)). “All the Act pretends to do is to require the ‘truth about securities’ at the time of issue”. Douglas and Bates, The Federal Securities Act of 1933, 43 Yale L.J. 171 (1933). See also F. Wheat, Disclosure to Investors 10, 46 (1969) (hereinafter referred to as The Wheat Report); Comment, BarChris: Due Diligence Refined, 68 Colum.L.Rev. 1411 (1968). “The emphasis on disclosure rests on two considerations. One relates to the proper function of Federal government to investment matters. Apart from the prevention of fraud and manipulation, the draftsmen of the ‘33 and ‘34 Acts viewed that responsibility as being primarily one of seeing to it that investors and speculators had access to enough information to enable them to arrive at their own rational decisions. The other, less direct, rests on the belief that appropriate publicity tends to deter questionable practices and to elevate standards of business conduct.’’ The Wheat Report at 10.

See Douglas and Bates, The Federal Securities Act of 1933, 43 Yale L.J. 171, 172 (1933). [5] A primary objective is to place potential securities purchasers on a parity with their vendors to the extent practicable. Folk, Civil Liabilities Under the Federal Securities Acts: The BarChris Case, 1 Securities L.Rev. 3, 20 (1969) (reprinted from 55 Va.L.Rev. 1 (1969)). The Act’s “fundamental purpose *** was to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry.” SEC v. Capital Gains Research Bureau, 375 U.S. 180, 186, 84 S.Ct. 275, 280, 11 L.Ed.2d 237 (1963). See also In re Investors Management Company, et al.,


Sec.Exch.Act Release No. 9267, S.E.C. No. 3-1680, memorandum at 6-9 (SEC July 29, 1971). The focus on disclosure reflects the insight gained by experience that without complete, accurate and intelligible information about a company, investors cannot make intelligent investment decisions with regard to its securities. The Wheat Report conceives of the information requirement as an effort to assure *564 the integrity of the free market for securities: “A classic statement of the purposes of provisions designed to inform the trading markets is found in the report of the House Committee on the ‘34 Act: ‘No investor, no speculator can safely buy and sell securities *** without having an intelligent basis for forming his judgment as to the value of the securities he buys or sells. The idea of a free and open public market is built upon the theory that competing judgments of buyers or sellers as to the fair price of the security brings about a situation where the market price reflects as nearly as possible a just price. Just as artificial manipulation tends to upset the true function of an open market, so the hiding and secreting of important information obstructs the operations of the markets as indices of real value. There cannot be honest markets without honest publicity.”’ The Wheat Report at 50.

Another commentator views disclosure as a prerequisite to accurate determination of intrinsic value: “Because of the nature of securities, a buyer cannot make an immediate value judgment, as he would with tangible items. He must look behind the piece of paper and examine the merits of the company which has issued the security. The buyer must of necessity rely on the information given to him and on material generally available from the company. The less information available, the less the market price will be representative of the security’s true value and the greater will be the opportunity for fraud.” Knauss, A Reappraisal of the Role of Disclosure, 62 Mich.L.Rev. 607, 610 (1964).

Cf. Ratner v. Chemical Bank New York Trust Company, 329 F.Supp. 270, 276 (S.D.N.Y.1971) (“Truth in Lending Act”, 15 U.S.C. § 1601 et seq., requires disclosure of interest rates in order “to put the borrower in possession of the pertinent information before the plunge ***”).

The second-and for our purposes less important-goal of the full disclosure policy is deterrence. This consideration arose from excesses of the 1920’s and the havoc subsequently wreaked on investors. The drafters accepted as an article of faith and common sense that if management must bare all on pain of civil and criminal liability its dirty intra-corporate linen will be cleaned before the registration statement is filed. Concomitantly, such disclosure has the prophylactic effect of promoting general business integrity. “Brandeis, to whom many give credit for being the strongest advocate for full disclosure, also directed his principal fire against the big companies. His famous quotation, ‘sunlight is said to be the best of disinfectants; electric light the most efficient policeman,’ was made in relation to the amount of underwriting commissions received by J. P. Morgan & Co. for their role in selling securities of major companies.” Knauss, A Reappraisal of the Role of


Disclosure, 62 Mich.L.Rev. 607, 614 (1964).

See also The Wheat Report at 50-51.

B. Effective Disclosure

The ultimate goal of the Securities Act is, of course, investor protection. Effective disclosure is merely a means. The entire legislative scheme can be frustrated by technical compliance with the requirements of the Securities and Exchange Commission’s Form S-1 for preparation of registration statements in the absence of any real intent to communicate. It is for this reason that the SEC, through its rule making power, has consistently required “clearly understandable” prospectuses. The Wheat Report at 78.

Unfortunately, the results have not always reflected these efforts. “[E]ven *565 when an investor [is] presented with an accurate prospectus prior to his purchase, the presentation in most instances tend[s] to discourage reading by all but the most knowledgeable and tenacious.” Knauss, A Reappraisal of the Role of Disclosure, 62 Mich.L.Rev. 607, 618-619 (1964). These documents are often drafted so as to be comprehensible to only a minute part of the investing public. “There are also the perennial questions of whether prospectuses, once delivered to the intended reader, are readable, and whether they are read. The cynic’s answer to both questions is ‘No’; the true believer’s is ‘Yes’; probably a more accurate answer than either would be: ‘Yes’-by a relatively small number of professionals or highly sophisticated non-professionals; ‘No’-by the great majority of those investors who are not sophisticated and, within the doctrine of SEC v. Ralston Purina Co. [346 U.S. 119, 73 S.Ct. 981, 97 L.Ed. 1494], are not ‘able to fend for themselves’ and most ‘need the protection of the Act.’’’ Cohen, “Truth in Securities” Revisited, 79 Harv.L.Rev. 1340, 1351-1352 (1966).

See also The Wheat Report at 77-78.

In at least some instances, what has developed in lieu of the open disclosure envisioned by the Congress is a literary art form calculated to communicate as little of the essential information as possible while exuding an air of total candor. Masters of this medium utilize turgid prose to enshroud the occasional critical revelation in a morass of dull, and-to all but the sophisticates-useless financial and historical data. In the face of such obfuscatory tactics the common or even the moderately well informed investor is almost as much at the mercy of the issuer as was his pre-SEC parent. He cannot by reading the prospectus discern the merit of the offering.

The instant case provides a useful example. Ignoring, for the moment, the alleged omissions which are the subject of the plaintiff’s complaint, the passage in which Leasco’s intentions with regard to surplus surplus are “disclosed” in the short excerpt set out at page 552, supra. This revelation, while probably technically accurate with regard to Leasco’s then intentions respecting surplus surplus, was hardly calculated to apprise the owner of shares of Reliance


common stock that Reliance held a large pool of cash or near-cash assets which were legally and practically unnecessary for the efficient operation of the insurance business, and that Leasco intended to remove those assets “as soon as practicable.” More important, it does not reveal Leasco’s estimates of the extent of those assets. A conscientious effort by the issuer and its counsel would have produced a more direct, informative and candid paragraph about Leasco’s intended reorganization of Reliance. They might have effectively disclosed, in understandable prose-as they did in January of 1969-the essence of the plan to the shareholders they were soliciting.

C. Disclosure to Whom?

The view that prospectuses should be intelligible to the average small investor as well as the professional analyist, immediately raises the question of what substantive standard of disclosure must be maintained. The legal standard is that all “material” facts must be accurately disclosed. But to whom must the fact have material significance?

In an industry in which there is an unmistakable “trend toward a greater measure of professionalism *** with the accompanying demand for more information about issuers” “a pragmatic balance must be struck between the needs of the unsophisticated investor and those of the knowledgeable student of finance.” The Wheat Report at 9-10. There are three distinct classes of investors who must be informed by the prospectus: (1) the amateur who reads for only the grosser sorts of disclosures; (2) the professional advisor and manager who studies the prospectus closely and makes his decisions based on the insights he *566 gains from it; and (3) the securities analyst who uses the prospectus as one of many sources in an independent investigation of the issuer.

The proper resolution of the various interests lies in the inclusion of a clearly written narrative statement outlining the major aspects of the offering and particularly speculative elements, as well as detailed financial information which will have meaning only to the expert. Requiring inclusion of such technical data benefits amateurs, as well as experts, because of the advice many small investors receive and the extent to which the market reflects professional judgments. The Wheat Report at 52. Such “[e]xpert sifters, distillers, and weighers are essential for an informed body of investors”. Cohen, “Truth in Securities” Revisited, 79 Harv.L.Rev. 1340, 1353 (1966).

Mr. Justice Douglas, then teaching at Yale, commented in 1933 that: “[T]hose needing investment guidance will receive small comfort from the balance sheets, contracts, or compilation of other data revealed in the registration statement. They either lack the training or intelligence to assimilate them and find them useful, or are so concerned with a speculative profit as to consider them irrelevant. *** [E]ven though an investor has neither the time, money, nor intelligence to assimilate the mass of information in the registration statement, there will be those who can and who will do so, whenever there is a broad market. The judgment of those experts will be reflected in the market price. Through them investors who seek advice will be able to obtain it.” Douglas, Protecting The Investor, 23 Yale Rev. (N.S.) 508, 523-524 (1933) (quoted in The Wheat Report at 53).


The Wheat Report further notes: “that a fully effective disclosure policy would require the reporting of complicated business facts that would have little meaning for the average investor. Such disclosures reach average investors through a process of filtration in which intermediaries (brokers, bankers, investment advisors, publishers of investment advisory literature, and occasionally lawyers) play a vital role.” The Wheat Report at 52. “The significance of disclosures which have an initial impact at the professional level has been heightened by recent changes in the securities business. Most important of these is the enormous growth of intermediation in investment. The relative importance of such professional money managers as bank trust departments, pension fund managers, investment counseling firms and investment advisors to mutual funds and other investment companies is greater than ever before.” The Wheat Report at 54. [6] The significance of these observations is that the objectives of full disclosure can be fully achieved only by complete revelation of facts which would be material to the sophisticated investor or the securities professional not just the average common shareholder. But, at the same time, the prospectus must not slight the less experienced. They are entitled to have within the four corners of the document an intelligible description of the transaction.

D. Enforcement.

The Securities Act provides a full panoply of enforcement procedures.

A considerable in terrorem effect is generated by the SEC’s examination of registration statements and its use of orders refusing to permit registration statements to become effective (15 U.S.C. § 77h(b)) and stop orders when uncorrected misrepresentations appear (15 U.S.C. § 77h(d)). “A stop order may not be merely a death warrant for the particular financing; it may also be a severe or even fatal blow to the registrant and, at very least, is likely to touch off the civil liability provisions if securities have been sold.” Cohen, “Truth In Securities” Revisited, 79 Harv.L.Rev. 1340, 1355 (1966). Section 20(b) of the 1933 *567 Act authorizes injunctive relief against any person who is about to violate any of the provisions of the Act-in this context anyone who proposes to distribute a prospectus containing material misstatements or omissions. 15 U.S.C. § 77t(b). Furthermore, the Commission may transmit evidence of such violation to the Attorney General for criminal prosecution (15 U.S.C. § 77t(b)) and anyone who wilfully violates the disclosure requirements of the statute or SEC rules is subject to a $5000 fine or five years imprisonment or both. 15 U.S.C. § 77x. “Moreover, the SEC may suspend or expel those who violate the securities acts or suspend trading in a particular stock.” Globus v. Law Research Service, 418 F.2d 1276, 1285 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S.Ct. 913, 25 L.Ed.2d 93 (1970).

But this power of the SEC to intercede is, as a practical matter, limited to more flagrant


misstatements and omissions obvious on the face of the prospectus or from other information at hand. To expect the hard pressed SEC staff to conduct an independent field study of every prospectus is unrealistic. Cf. Douglas and Bates, The Federal Securities Act of 1933, 43 Yale L.J. 171, 212 (1933).

The civil liability sections of the 1933 Act, when properly applied, act as independent and effective enforcement provisions. A “class action under Fed.R.Civ.P. 23 could be particularly effective and appropriate in remedying violations of the securities acts *** compensatory damages, especially when multiplied in a class action, have a potent deterrent effect.” Globus v. Law Research Service, 418 F.2d 1276, 1285 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S.Ct. 913, 25 L.Ed.2d 93 (1970). Cf. Ratner v. Chemical Bank New York Trust Company, 329 F.Supp. 270, 280 (S.D.N.Y.1971) (private attorney general in “Truth in Lending Act”). The principal purpose of civil liability in the 1933 Act is, in fact, deterrent rather than compensatory. “There is a danger in discussing civil liability in connection with the Securities Act that both the purpose of the Act and the emphasis of the discussion will be misunderstood. It is not the object of the Act simply to provide a legal remedy for the investor who has bought securities upon a false representation, to compensate him for a loss incurred. Even the provisions for civil liability are calculated to be largely preventive rather than redressive. Both in the extent of liability imposed-the variety of persons to whom the liability is attached, the bases of the liability, and the persons in whose favor it runs-and in the limitation of the amounts recoverable, the in terrorem function of the Act is evidenced. But even this purpose of securing preventive vigilance and caution on the part of the persons concerned is only coordinate with, or probably subordinate to, another object. The Act seeks not only to secure accuracy in the information that is volunteered to investors, but also, and perhaps more especially, to compel the disclosure of significant matters which were heretofore rarely, if ever, disclosed. Civil liability is imposed largely as one appropriate means of accomplishing these ends, not as the end itself, or, on the other hand, as the only means. While, then, discussion of the Act may properly be directed to the different provisions separately, it is apt to be misleading, and more covertly disingenuous, if the principal objectives are not constantly pushed to the front.” Shulman, Civil Liability and the Securities Act, 43 Yale L.J. 227 (1933).

The Second Circuit has recently adopted this early view of the in terrorem function of Section 11: “Civil liability under section 11 and similar provisions was designed not so much to compensate the defrauded purchaser as to promote enforcement of the Act and to deter negligence by providing a penalty for those who fail in their duties.” *568 Globus v. Law Research Service, 418 F.2d 1276, 1288 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S.Ct. 913, 25 L.Ed.2d 93 (1970).

See also III L. Loss, Securities Regulation 1831 (1969); Cohen, “Truth in Securities” Revisited, 79 Harv.L.Rev. 1340, 1355 (1966); Douglas and Bates, The Federal Securities Act of 1933, 43 Yale L.J. 171, 173 (1933); Comment, BarChris: Due Diligence Refined, 68 Colum.L.Rev. 1411 (1968).


[7] Criminal liability is necessarily predicated on proof of specific intent to violate the Act, while civil liability is established after a showing of failure to exercise reasonable care in preparing registration statements. Only primary reliance on civil liability can protect investors from the “climate of laxity” or “lethargy” which has characterized the preparation of some registration statements. Folk, Civil Liabilities Under the Federal Securities Acts: The BarChris Case, 1 Securities Law Rev. 3, 8-9 (1969) (reprinted from 55 Va.L.Rev. 1 (1969)).

The courts face a dual responsibility when presented with a claim for civil relief. They must adjudicate the particular claim for relief presented by the plaintiff, and simultaneously vindicate the full disclosure policy of the Securities Act for the protection of the entire investing public.

IX. SECTION 11

Section 11(a) of the Securities Act of 1933 provides for civil liability for misstatements and omissions in a registration statement. 15 U.S.C. § 77k(a). It reads:

“(a) In case any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security (unless it is proved that at the time of such acquisition he knew of such untruth or omission) may, either at law or in equity, in any court of competent jurisdiction, sue-”

A. The Alleged Omissions

(1) Failure to Disclose Methods of Reorganization Other Than the Holding Company Concept

During the exchange offer period several memoranda and letters were exchanged between Hodes, Leasco’s counsel, and various other attorneys for Reliance and Leasco. It is apparent that various methods of reorganization were being seriously investigated by a number of attorneys for Leasco and Reliance. Leasco’s president, Schwartz, was kept apprised of the progress of these inquiries by Hodes. [8] Despite this research activity, none of these investigations ever crystallized during the exchange offer period sufficiently to be characterized as “plans” of Leasco. They were never presented to the Leasco Board nor were they even discussed in any detail with members of Leasco’s management. They were, rather, merely possible alternatives for consideration by counsel. Such preliminary contingency planning need not be included in the prospectus under


the circumstances of this case.

(2) Failure to Include an Estimate of Surplus Surplus

The failure to include an estimate of surplus surplus raises a more serious question. There is no doubt that Leasco had in its possession at least three estimates of Reliance’s surplus surplus-$80,000,000 as of December 31, 1966 contained in the Netter Report and $125,000,000 or $100,000,000, at June 30th and December 31, 1967 respectively, both approximated in the Gibbs Memorandum. In addition they had available the rules of thumb for calculation contained in the New York Insurance Department Report. Leasco could have used these estimates or commissioned an independent computation based on public information. This figure could have been included with the sort of qualifying statement included *569 in the January, 1969 prospectus. Whether the failure to do so places liability on the defendants under Section 11 is the question now presented.

B. Materiality. [9] [10] Only if the omission complained of is “material” within the meaning of Section 11 can liability be found. The SEC has defined the term by looking to what a reasonably prudent investor reasonably ought to know before buying a security. It reads: “The term ‘material’, when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters as to which an average prudent investor ought reasonably to be informed before purchasing the security registered.” 17 C.F.R. § 230.405(l).

Speaking of this definition in one of the few reported Section 11 cases, Judge McLean summed the matter up succinctly by emphasizing the need to know “facts which have an important bearing upon the nature or condition of the issuing corporation or its business.” Escott v. BarChris Construction Corp., 283 F.Supp. 643, 681 (S.D.N.Y.1968). [11] [12] Judge McLean quite properly placed emphasis on the need to disclose those facts which revealed the “condition” of the issuer because the facts omitted in BarChris related to the stability of the issuing company and the continuing security of the investment. It is clear, however, that facts other than the condition of the issuer bearing on the value, qua price, of the securities in question must be disclosed with the same scrupulousness. The issuer must disclose any fact “which in reasonable and objective contemplation might affect the value of the corporation’s stock or securities”. Kohler v. Kohler Co., 319 F.2d 634, 642 (7th Cir. 1963) (emphasis added). See Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1171 (2d Cir. 1971); SEC v. Texas Gulf Sulphur, 401 F.2d 833, 849 (2d Cir. 1968), cert. denied sub nom. Coates v. SEC and Kline v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969); List v. Fashion Park, 340 F.2d 457, 462 (2d Cir.), cert. denied sub nom. List v. Lerner, 382 U.S. 811, 86 S.Ct. 23, 15 L.Ed.2d 60 rehearing denied, 382 U.S. 933, 86 S.Ct. 305, 15 L.Ed.2d


344 (1965). BarChris cannot be read as permitting exclusion of important facts merely because they involve the condition of the company being taken over rather than the issuer since these facts will bear on the relative value of the issuer’s securities. [13] Some probability that the investor’s decision would be affected by disclosure is a prerequisite to a finding of materiality. The degree of probability that it would have such an impact has been differently stated by the courts. They have focused on the effect on the reasonable purchaser, variously asking whether he “might” or “would” or “might well have been” affected by the information; they have asked whether it is “reasonably certain” that the information would have had a “substantial effect” or whether it “might” have had a “significant propensity” to affect him.

In List v. Fashion Park, 340 F.2d 457 (2d Cir.), cert. denied sub nom. List v. Lerner, 382 U.S. 811, 86 S.Ct. 23, 15 L.Ed.2d 60, rehearing denied, 382 U.S. 933, 86 S.Ct. 305, 15 L.Ed.2d 344 (1965), the Second Circuit used the word “would” to suggest the applicable level of probability. “The basic test of ‘materiality’ *** is whether ‘a reasonable man would attach importance [to the fact misrepresented] in determining his choice of action in the transaction in question.”’ List, supra at 462 (quoting from Restatement, Torts § 538(2) (a)) (emphasis added). “The proper test is whether the plaintiff would have been influenced to act differently ***.” List, supra at 463 (emphasis added).

See *570 SEC v. Great American Industries, Inc., 407 F.2d 453, 459-460 (2d Cir. 1968), cert. denied, 395 U.S. 920, 89 S.Ct. 1770, 23 L.Ed.2d 237 (1969); III L. Loss, Securities Regulation 1431 (1969). This test implies a fairly high probability.

Subsequently, in the leading case of SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1968), cert. denied sub nom. Coates v. SEC and Kline v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969), the Second Circuit used several different verbal formulations of materiality. Discussing an “insider’s” obligation to disclose under Rule 10b-5, it indicated that the duty “arises only in ‘those situations which are essentially extraordinary in nature and which are reasonably certain to have a substantial effect on the market price of the security ***.”’ SEC v. Texas Gulf Sulphur, supra at 848 (emphasis added).

The Court also mentions the tests quoted above from List and Kohler v. Kohler, 319 F.2d 634, 642 (7th Cir. 1963). It shifted from the “would” of List to the standard of “may”: “Thus, material facts include not only information disclosing the earnings and distributions of a company but also those facts which affect the probable future of the company and those which may affect the desire of investors to buy, sell, or hold the company’s securities. “In each case, then, whether facts are material within Rule 10b-5 when the facts relate to a particular event and are undisclosed by those persons who are knowledgeable thereof will depend at any given time upon a balancing of both the indicated probability that the event


will occur and the anticipated magnitude of the event in light of the totality of the company activity.” SEC v. Texas Gulf Sulphur, supra, 401 F.2d at 849 (emphasis added).

Discussing materiality in the context of Section 14(a) of the Securities Exchange Act of 1934 the Supreme Court utilized an even less stringent test than Texas Gulf, indicating that a “material fact” was one “of such a character that it might have been considered important by a reasonable shareholder who was in the process of deciding how to vote. This requirement [is] that the defect have a significant propensity to affect the voting process ***” Mills v. Electric Auto-Lite Company, 396 U.S. 375, 384, 90 S.Ct. 616, 621, 24 L.Ed.2d 593 (1970) (emphasis added in part).

The use of “propensity” in the context of a proxy situation is particularly significant to the instant case since the Reliance shareholders were, in effect, being asked to “vote” a merger with Leasco by accepting the exchange offer.

Just this year the Second Circuit has once again employed “might” as the applicable standard of probability, further reducing the force of the word by adding to it “well have.” Applying the test articulated in List, Kohler, Texas Gulf Sulphur, and Mills v. Electric Auto-Lite, the court held that “the question of materiality becomes whether a reasonable man in [the investor’s] position might well have acted otherwise than to purchase if he had been informed ***.” Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1171 (2d Cir. 1971) (emphasis added). The issue, it was said, is whether the disclosure “could well influence” the decision of the investor. Id. at 1172. See also Gilbert v. Nixon, 429 F.2d 348, 355-356 (10th Cir. 1970); Johns Hopkins University v. Hutton, 422 F.2d 1124, 1128-1129 (4th Cir. 1970); Demarco v. Edens, 390 F.2d 836, 840-841 (2d Cir. 1968).

Most recently the Securities and Exchange Commission indicated that certain information “was material because it ‘was of such importance that it could be expected to affect the judgment of investors whether to buy, sell or hold *** stock [and, i]f generally known, *** to affect materially the market price of the stock.”’ In re Investors Management Company, et al., Sec. Exch. Act Release No. 9267, S.E.C. No. 3-1680, *571 memorandum at 9 (SEC July 29, 1971) (emphasis added).

While these verbal formulations by the courts and the SEC taken individually fail to prescribe a precise standard, they do evince a trend toward broadening the definition of materiality and concomitantly raising the requirement of disclosure where the law requires full disclosure. Cf. Wiesen, Disclosure of Inside Information-Materiality and Texas Gulf Sulphur, 1 Securities L.Rev. 267, 288-290, 310-311 (1969) (reprinted from 28 Md.L.Rev. 189 (1968)); 2 A. Bromberg, Securities Law; Fraud SEC Rule 10b-5 § 8.3, p. 199 (1970) (“Rule is applied to subtler or milder cases”).

Commentators have not been much more successful than the courts in precisely defining the concept of materiality. Thus, an early writer concluded that “a material fact is any piece of information having fairly predictable results either on the value of the securities or on the outsider’s estimate of that value.” Comment, The Prospects for Rule X-10B-5: An Emerging


Remedy for Defrauded Investors, 59 Yale L.J. 1120, 1145 (1950) (emphasis added). It was later suggested that materiality “be limited to those situations which are essentially extraordinary in nature and which are reasonably certain to have a substantial effect on the market price of the security if disclosed.” Fleischer, Securities Trading and Corporate Information Practices: The Implications of the Texas Gulf Sulphur Proceeding, 51 Va.L.Rev. 1271, 1289 (1965) (emphasis added).

What is called for is “[s]ome sort of reasonable-man, objective test of investment, judgment, intrinsic value, or (in the case of a publicly traded security) significant market effect”. 2 A. Bromberg, Securities Law: Fraud SEC Rule 10b-5 § 8.3, p. 199 (1970). [14] [15] A fair summary of the rule stated in terms of probability is that a fact is proved to be material when it is more probable than not that a significant number of traders would have wanted to know it before deciding to deal in the security at the time and price in question. What is statistically significant will vary with the legal situation. Cf. Rosado v. Wyman, 322 F.Supp. 1173, 1180-1181 (E.D.N.Y.1970), aff’d, 437 F.2d 619 (2d Cir. 1970). Being a formal and legally required document, a prospectus must satisfy a high standard of disclosure-i.e., disclosure is required when only a relatively small percentage of traders would want to know before making a decision. Anything in the order of 10% of either the number of potential traders or those potentially making 10% of the volume of sales would seem to more than suffice.

Putting the test in mathematical terms may, perhaps, be useful in permitting surveys and quantification of results in future litigation. But even if mathematical models buttressed by valid sampling techniques for determining trader reactions were possible and economically feasible in litigations of this sort, no such approach was attempted by the parties in this case. [16] [17] Since no data except the unpersuasive suppositions of opposing experts were produced at the trial to show how potential traders would have viewed the information at issue, we are forced to analyze the facts in terms of alternative courses of conduct available to a hypothetical reasonably prudent shareholder constructed by the Court. In nonquantitative terms a fact is “material” in a registration statement whenever a rational connection exists between its disclosure and a viable alternative course of action by any appreciable number of investors. Materiality is then a question of fact to be determined in the context of a particular case. Cf. SEC v. Texas Gulf Sulphur, 401 F.2d 833, 849 (2d Cir. 1968), cert. denied sub nom. Coates v. SEC and Kline v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969); Escott v. BarChris Construction Corp., 283 F.Supp. 643, 682 (S.D.N.Y.1968); Painter, Inside Information: Growing Pains for the Development of Federal Corporation Law Under Rule 10b-5, 65 Colum.L.Rev. 1361, 1379 (1965); Fleischer, Securities *572 Trading and Corporate Information Practices: The Implications of the Texas Gulf Sulphur Proceeding, 51 Va.L.Rev. 1271, 1289-1290 (1965); Ruder, Pitfalls in the Development of a Federal Law of Corporations by Implication Through Rule 10b-5, 59 Nw.U.L.Rev. 185, 195 (1964). [18] The information with respect to the availability of tens of millions of dollars of surplus surplus is so significant that under any test proposed it is material. A substantial percentage of the reasonable persons holding shares of Reliance would want to know what Leasco’s estimate and plans were respecting this asset before deciding to exchange on the terms offered. It would be unrealistic to expect an average shareholder of Reliance to know what


the surplus surplus position of his company was; no proof was submitted suggesting that he would know this. Leasco did have this information as the result of its own detailed studies which had required a substantial outlay of money and executive time.

According to Steinberg, Reliance’s surplus surplus was “important to Leasco” and played a significant part in Leasco’s interest in Reliance. Similarly, Roberts came away from his many discussions with Leasco with the distinct impression that “one important aspect of Reliance that commended itself to Leasco was Reliance’s surplus surplus.”

The size and availability of this resource was so important that Leasco included a clause in the August 1, 1968 contract which was intended to protect Leasco’s interest in the surplus surplus after the takeover was consummated. Having relinquished control of the insurance operation for five years, Leasco simply could not afford the risk that the critical objective of the whole deal could be frustrated by a recalcitrant Reliance management.

The significance of this intense interest in surplus surplus is that by failure to disclose the size of the fund Leasco hoped to acquire, it effectively denied the Reliance shareholders knowledge of one of the principal factors underlying the transaction. This insufficiency prevented accurate evaluation of the degree of interest of Leasco. Knowledge of the intensity of demand is essential to determination of a fair price in a market economy.

Failure to disclose the size and nature of such fiscal resources has much the same effect as failure to disclose geological reports indicating undeveloped minerals sources. Cf. SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1968), cert. denied sub nom. Coates v. SEC and Kline v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969).

In the absence of an estimate of surplus surplus the Leasco package may have been very attractive, offering as it did a substantial premium over the price of Reliance shares. But with full disclosure the Reliance shareholder might well have reconsidered the value of his shares. Moreover, such disclosure may have motivated the market-influenced as it is by professionals and institutional investors-to revalue the Reliance shares making the Leasco offer relatively less attractive. See Wheat Report at 52-54. The consequence of such a reevaluation would be either a refusal to exchange or an upward revision of the exchange offer package by Leasco. [19] Defendants argue that regardless of the importance of such an estimate its disclosure would not have affected the Reliance shareholders’ decision to exchange since Leasco was offering such a substantial premium for the Reliance shares that the attractiveness of the offer in cash terms would have overcome any doubts created by knowledge of a substantial amount of surplus surplus. This contention blinks the fact of professional surveillance of Reliance as attested to by Roberts. A substantial possibility exists that the Reliance shares were significantly undervalued in the market because of the general traders’ ignorance of the magnitude of the possible surplus surplus. Its disclosure, when subjected to both professional and non- *573 professional analysis, might well have appreciably reduced or eliminated the premium by raising Reliance’s market price. Moreover, mere fairness of the deal is not an excuse not to reveal material facts. Cf. Mills v. Electric Auto-Lite Company, 396 U.S. 375, 381-382, 90 S.Ct. 616, 620, 24 L.Ed.2d 593 (1970).


Nor is it speculative to postulate that Reliance shareholders might have chosen to hold their shares in light of Reliance’s May 15, 1968 announcement of an intention to form a holding company to more fully utilize its financial resources. That announcement, by itself, may not have induced a reevaluation of the stock, but when dovetailed with a disclosure that something in the order of 100 million dollars might be so used, it would almost certainly have caused at least the professional and a substantial number of non-professional shareholders to consider the effect of such a reorganization on Reliance.

Any second thoughts generated by this information would have been further buttressed by Roberts’ letter of July 23, 1968 to his shareholders. He describes in some detail the relative disadvantages of owning Leasco shares. Since the principal attraction in the exchange was the considerable market premium being offered by Leasco, the offer may well have become less desirable, in light of the speculative nature of Leasco securities, if the shareholder knew that the premiums were not as great as had initially appeared.

Thus disclosure of the huge block of under-utilized liquid assets held by Reliance logically opened two reasonable alternatives to accepting the Leasco exchange offer-either to hold the shares in expectation of future Reliance prosperity or to exchange only if Leasco offered a more favorable exchange ratio more accurately reflecting Reliance’s true worth. Moreover, it is not improbable that full disclosure of the extent of surplus surplus may have led Reliance shareholders to conclude that a similar interest might have been generated in other aggressive, acquisitive companies, particularly since Roberts had stressed precisely such a possibility in his July 23, letter of opposition previously quoted at pages 555-556, supra.

A realization, brought on by disclosure of a huge block of near cash assets, that another tender offer might be in the offing, would have presented at least three possible reasons for not exchanging pursuant to the exchange offer. First, the shareholder could simply have held his shares in expectation of a better offer consistent with Roberts’ letter of July 23.

Second, the institutional investors who were already interested in Reliance might have begun to purchase Reliance securities on the open market in anticipation of a more attractive offer stimulated by the disclosure of the amount of surplus surplus. Such an event would have affected the exchange offer in two separate but related ways-(1) those who were selling to the mutual funds and pension plans would not be exchanging and (2) the price of Reliance would have risen, reflecting the increased demand for the stock, consequently, diminishing the relative attractiveness of the Leasco package. Both of these conditions could have altered the nearly unanimous acceptance of the proposed tender offer by Reliance shareholders.

Third, with full disclosure of surplus surplus the anticipation of a better exchange offer may actually have been realized during the exchange offer period resulting in acceptance of the other offer or at least deterring acceptance of the Leasco offer.

Defendants have argued that the very fact of professional interest in Reliance coupled with wide distribution of the Netter Report eliminates the materiality of any disclosure of and estimate of surplus surplus. The Nutter Report was distributed, however, in August of 1967, fully a year before this registration statement was effective. Defendants cannot be heard to argue that noninsurance oriented, albeit professional, investment advisors will recall the estimate contained *574 in a report read a year earlier when presented with as cryptic a


disclosure of possible surplus as we have in this case. It is a different matter to say-as we now do-that, given a concrete figure and plans to use it, they might have searched for that report and then realized its implications.

The Second Circuit told us in the Texas Gulf Sulphur case that the conduct of the parties themselves may give significant, possibly determinative, insight into the question of materiality. SEC v. Texas Gulf Sulphur, 401 F.2d 833, 851 (2d Cir. 1968), cert. denied sub nom. Coates v. SEC and Kline v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969). In Texas Gulf Sulphur the insider defendants purchased shares and calls based on information of a possible mineral strike without adequately disclosing such information to the public. The court found this conduct highly probative on the issue of materiality-it was obviously important information to the insiders since it motivated their purchase. That was a Rule 10b-5 case involving a proceeding by the Securities and Exchange Commission, and while our case involves a private suit on a registration statement under Section 11 of the 1933 Act, the lesson is transferable. [20] Leasco included an estimate of surplus surplus in its January 31, 1969 registration statement. When it was offering its own securities, not trying to acquire those of a target company, it considered the size and quality of these assets held by its newly acquired subsidiary material and accordingly included such information. While not determinative, such conduct certainly has great evidentiary value in evaluating the significance and impact of such a disclosure on potential traders.

The central point in this analysis is not whether any one of the alternatives discussed would necessarily have been adopted by the “average prudent investor,” but whether they are consistent with a disclosure-however carefully qualified-of an estimate of surplus surplus. We cannot say that such an inclusion was so trivial or inconsequential that an investor would be acting manifestly illogically if he refused to exchange his Leasco shares after it was disclosed. The importance of surplus surplus to Leasco, the significant interest of the securities professionals, and the general interest in capital-rich insurance companies all combine to make estimates of surplus surplus a material fact that should have been available to the Reliance shareholders when asked to exchange their shares for the Leasco package.

The solicited Reliance shareholders who received the prospectus in question “ought reasonably to [have been] informed” of an estimate of surplus surplus “before purchasing” the Leasco package. 17 C.F.R. § 230.405(l). It was a fact which these investors needed to “make an intelligent, informed decision whether or not to buy the security.” Escott v. BarChris Construction Corp., 283 F.Supp. 643, 681 (S.D.N.Y.1968). It was a matter which had “an important bearing upon the nature or condition *** or *** business” of Reliance tending to deter acceptance of the exchange offer (id.) and “which in reasonable and objective contemplation might [have affected] the value of [Reliance’s] stock.” Kohler v. Kohler, 319 F.2d 634, 642 (7th Cir. 1963). See Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1171 (2d Cir. 1971); SEC v. Texas Gulf Sulphur, 401 F.2d 833, 849 (2d Cir. 1968), cert. denied sub nom. Coates v. SEC and Kline v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969); List v. Fashion Park, 340 F.2d 457, 462 (2d Cir.), cert. denied sub nom. List v. Lerner, 382 U.S. 811, 86 S.Ct. 23, 15 L.Ed.2d 60, rehearing denied, 382 U.S. 933, 86 S.Ct. 305, 15 L.Ed.2d 344 (1965). It was a fact to which “a reasonable man would attach


importance in determining” whether to accept the Leasco exchange offer. List v. Fashion Park, supra at 462. It was “reasonably certain to have a substantial effect on the market price” of Reliance shares and *575 which may have affected “the desire of [shareholders] to *** sell, or hold” their shares. SEC v. Texas Gulf Sulphur, supra, 401 F.2d at 848-849. Disclosure would have had “a significant propensity to affect” the decision to exchange. Mills v. Electric AutoLite Company, 396 U.S. 375, 384, 90 S.Ct. 616, 621, 24 L.Ed.2d 593 (1970). An approximation of surplus surplus, if included in the prospectus, “might have influenced [the Reliance shareholder’s] decision” to exchange his shares; “A reasonable man in [the Reliance shareholder’s] position might well have acted otherwise than to [exchange] if he had been informed ***”; such a disclosure “could well influence” the decision of the Reliance shareholder. Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1171-1172 (2d Cir. 1971).

Our finding that by failing to include an estimate-or-range-of surplus surplus in the registration statement Leasco “omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading” establishes plaintiff’s cause of action. 15 U.S.C. § 77k(a). All that remains is to consider the defenses provided by Section 11 and whether the defendants have sustained their respective burdens of proof with regard to those defenses.

C. Leasco [21] Section 11 creates almost absolute liability in the issuer. See Escott v. BarChris Construction Corp., 283 F.Supp. 643, 683 (S.D.N.Y.1968); III L. Loss, Securities Regulation 1724 (1969); Douglas & Bates, The Federal Securities Act of 1933, 43 Yale L.J. 171, 190 (1933); Shulman, Civil Liability and the Securities Act, 43 Yale L.J. 227, 248 (1933); Comment, BarChris: Due Diligence Refined, 68 Colum.L.Rev. 1411, 1412 (1968). [22] [23] Section 11(a) does provide all defendants with an affirmative defense that the plaintiff knew of the omission, but no evidence has been introduced that would indicate that either the plaintiff Feit, or any member of the class he represents, knew or had available an estimate of surplus surplus for Reliance. Proof that any particular member of the class had such knowledge may be presented at the next stage of the litigation on the issue of whether that individual is entitled to his share of damages.

Our finding of materiality has the effect of creating liability in the issuer and establishing that plaintiff is entitled to recovery at least against Leasco. The extent of such recovery will be discussed below.

D. Due Diligence of the Directors-Steinberg, Schwartz & Hodes

Before analyzing the due diligence defenses presented by these defendants we must consider whether they are all properly treated together. Steinberg and Schwartz are and were,


respectively, Chief Executive Officer and President of Leasco-clearly “inside” directors. Hodes is a partner in the law firm which represents Leasco; he held no management office.

The leading case of Escott v. BarChris Construction Corp., 283 F.Supp. 643 (S.D.N.Y.1968) drew a distinction between directors who were officers of BarChris and its director-lawyer, Grant, who occupied a position analagous to Hodes’ at Leasco. Judge McLean treated Grant as an “outside” director despite the fact that he had been a director for eight months prior to the public offering in question and had prepared the registration statement. The court then held Grant to a very high standard of independent investigation of the registration statement because of his peculiar expertise and access to information and held him liable for failure to meet that standard. BarChris, supra at 689-692.

The assignment of “outside director” status to the lawyer in BarChris represented the court’s conclusions on the facts peculiar to BarChris. It does not preclude a finding that “in some cases the attorney-director may be so deeply *576 involved that he is really an insider.” Folk, Civil Liabilities Under the Federal Securities Acts-the BarChris Case, 1 Securities L.Rev. 3, 39 (1969) (reprinted from 55 Va.L.Rev. 1 (1969)). This is the case presented by Hodes. [24] Hodes has been a director of Leasco since 1965-three years or more at the time of this registration statement. He participated extensively in the discussions leading up to the exchange offer for Reliance shares as early as the fall of 1967 and was constantly involved in the deal throughout both the preliminary and execution stages of the transaction. He, or a representative of his law firm, attended all meetings and was consulted on all matters pertaining to this acquisition. He was directly responsible for preparation of the registration statement and initiated all of the research regarding reorganization of Reliance and separation of its surplus surplus. He kept Leasco’s Schwartz apprised of the progress on possible alternatives for Reliance. The testimony and exhibits at this trial make it clear that insofar as surplus surplus is concerned Hodes was so intimately involved in this registration process that to treat him as anything but an insider would involve a gross distortion of the realities of Leasco’s management.

Section 11[b] (3) (A) provides a “due diligence” in investigation defense to all defendants but the issuer. “(b) Notwithstanding the provisions of subsection (a) of this section no person, other than the issuer, shall be liable as provided therein who shall sustain the burden of proof (3) that (A) as regards as part of the registration statement not purporting to be made on the authority of an expert, and not purporting to be a copy of or extract from a report or valuation of an expert, and not purporting to be made on the authority of a public official document or statement, he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material required to be stated therein or necessary to make the statements therein not misleading;” 15 U.S.C. § 77k(b) (3) (A). [25] The defendant must establish (1) that he conducted a reasonable investigation and (2) that


after such investigation he had reasonable ground to believe and did believe the accuracy of the registration statement. Thus, a defendant may fulfill his burden of investigation and still not have reasonable cause to believe in the completeness of the prospectus or he may simply fail in his duty to investigate. Liability will lie in either case. [26] The standard of reasonableness which applies is that of a reasonably prudent man managing his own property As stated in Section 11(c): “In determining, for the purpose of paragraph (3) of subsection (b) of this section, what constitutes reasonable investigation and reasonable ground for belief, the standard of reasonableness shall be that required of a prudent man in the management of his own property.” 15 U.S.C. § 77k(c)

There is little judicial gloss on this defense. See Escott v. BarChris Construction Corp., 283 F.Supp. 643, 683 (S.D.N.Y.1968). Cf. Gilbert v. Nixon, 429 F.2d 348, 357 (10th Cir. 1970) (Section 12(a)); Demarco v. Edens, 390 F.2d 836, 842-843 (2d Cir. 1968) (same). In fact, Judge McLean’s opinion in BarChris is the only one we have found which treats the subject at any length. The key to reasonable investigation as expressed in that opinion is independent verification of the registration statement by reference to original written records. The facts in BarChris revealed a consistent pattern of directors and underwriters who relied on the oral word of management regarding the accuracy of the registration *577 statement. They made little, if any, effort to verify management’s representations by reference to materials readily available such as corporate minutes, books, loan agreements, and various other corporate agreements. [27] Judge McLean makes it plain that a completely independent and duplicative investigation is not required but, rather, that the defendants were expected to examine those documents which were readily available. Speaking of the attorney-director’s contentions he noted: “It is claimed that a lawyer is entitled to rely on the statements of his client and that to require him to verify their accuracy would set an unreasonably high standard. This is too broad a generalization. It is all a matter of degree. To require an audit would obviously be unreasonable. On the other hand, to require a check of matters easily verifiable is not unreasonable. Even honest clients can make mistakes. The statute imposes liability for untrue statements regardless of whether they are intentionally untrue. The way to prevent mistakes is to test oral information by examining the original written record. “There were things which Grant could readily have checked which he did not check. For example, he was unaware of the provisions of the agreements between BarChris and Talcott. He never read them.” BarChris, supra, 283 F.Supp. at 690.

This theme of an obligation of reasonable verification is also reflected in the commentators’ analysis of the BarChris case. See Wyant & Smith, BarChris: A Reevaluation of Prospectus Liability, 3 Geo.L.Rev. 122, 135-137 (1968); Comment, BarChris: Easing the Burden of “Due Diligence” Under Section 11, 117 U.Pa.L.Rev. 735, 744-748 (1969); Comment, Escott v. BarChris Construction Corporation: Section 11 Strikes Back, 21 Stan.L.Rev. 171, 184


(1968); Comment, BarChris: Due Diligence Refined, 68 Colum.L.Rev. 1411, 1418 (1968). Cf. United States of America v. Squires, 440 F.2d 859, 863 (2d Cir. 1971). The reasonable investigation-verification-requirement is simply one means of promoting the full disclosure policy of Section 11. “The purpose of the civil liability imposed by section 11 is to protect the investor through full disclosure, and the standards of reasonable investigation must be framed in light of this goal. They should also reflect the two criteria set forth in the legislative history: (1) the importance of the role played by each participant in the scheme of distribution and (2) the reliance that the investor is justified in placing upon each participant. These criteria seem to be satisfied by a requirement that some of the parties to the registration process play a more adverse role vis-a-vis management than they may have in the past. The less a participant relies on management, the more the investor may rely on the involvement of the participant in the registration process.” Comment, BarChris: Due Diligence Refined, 68 Column.L.Rev. 1411, 1419 (1968). [28] In BarChris the management directors were found to have known about the misrepresentation and therefore the only question of reasonable investigation arose in the context of non-insider verification of information provided by those inside directors. These standards nevertheless apply equally to insider verification of the accuracy and completeness of data and statements they propose to include in the registration statement. Inclusion or omission of an item without a reasonable investigation or verification will lead to liability for these inside directors just as surely as if they actually knew of the inaccuracy or had no reasonable belief in the accuracy. [29] What constitutes “reasonable investigation” and a “reasonable ground to believe” will vary with the degree of involvement of the individual, his expertise, and his access to the pertinent information and data. What is reasonable *578 for one director may not be reasonable for another by virtue of their differing positions. “It was clear from the outset, however, that the duty of each potentially liable group was not the same. The House report on the bill that became the original Securities Act stated that the duty of care to discover varied in its demands upon the participants with the importance of their place in the scheme of distribution and the degree of protection that the public had a right to expect from them. It has been suggested that although inside directors might be better able to show that they undertook some investigation, the outside director could more easily demonstrate that the investigation he actually undertook was sufficient to sustain his defense.” Comment, BarChris: Due Diligence Refined, 68 Colum.L.Rev. 1411, 1416 (1968).

See Escott v. BarChris Construction Corp., 283 F.Supp. 643, 690 (S.D.N.Y.1968); Folk, Civil Liabilities Under the Federal Securities Acts: The BarChris Case, 1 Securities L.Rev. 3, 53-54 (1969) (reprinted from 55 Va.L.Rev. 1 (1969)); Comment, BarChris: Easing the Burden of “Due Diligence” Under Section 11, 117 U.Pa.L.Rev. 735, 738 (1969). [30] [31] Inside directors with intimate knowledge of corporate affairs and of the particular transactions will be expected to make a more complete investigation and have more extensive knowledge of facts supporting or contradicting inclusions in the registration statements than outside directors. Similarly, accountants and underwriters are expected to


investigate to various degrees. Each must undertake that investigation which a reasonably prudent man in that position would conduct.

BarChris imposes such stringent requirements of knowledge of corporate affairs on inside directors that one is led to the conclusion that liability will lie in practically all cases of misrepresentation. Their liability approaches that of the issuer as guarantor of the accuracy of the prospectus. “This ruling suggests that an inside director who, either as an officer or in some other capacity, has intimate familiarity with the corporate affairs or handles major transactions, especially those as to which false statements or omissions appear in the prospectus, is least able to establish due diligence. BarChris indicates that for such an individual knowledge of the underlying facts precludes showing ‘reasonable ground to believe’ or belief in fact as to the truth of the non-expert statements. In substance, there is a strong though theoretically rebuttable presumption that he had no reasonable ground to believe or belief in fact that the registration statement was accurate. Since an individual so situated will also have difficulty showing an absence of reasonable grounds of belief or belief in fact that expertised portions contain no misleading statements or omissions, a similar although less weighty presumption is present there. It would be fair to say that this postulated presumption arises when the intimate connection of the individual with the affairs of the issuer is demonstrated. Such an individual comes close to the status of a guarantor of accuracy.” Folk, Civil Liabilities Under the Federal Securities Acts: The BarChris Case, 1 Securities L.Rev. 3, 25 (1969) (reprinted from 55 Va.L.Rev. 1 (1969)).

Comment, BarChris: Due Diligence Refined, 68 Colum.L.Rev. 1411, 1420 (1968). It is with this strict standard in mind that we must approach the question of whether these three inside directors have established their defenses. [32] As already indicated, defendants’ principle claim is that they considered including an estimate and decided against such action because of the uncertainties of computation. Steinberg and Hodes were both convinced, according to their testimony, that the estimates they had obtained were not reliable and that a *579 reliable one could not be achieved with the data available. The key to all of their arguments is the unavailability of Reliance’s management and the Pennsylvania Insurance Commissioner. We find that the director-defendants failed to fulfull their duty of reasonable investigation and that they had no reasonable ground to believe that an omission of an estimate of surplus surplus was not materially misleading.

(1) Lack of Belief in Surplus Surplus Estimates.

These defendants did not have reasonable grounds to believe that the estimates of $80, $100, and $125 million in their possession were so inaccurate that one or all of them could not have been included in the prospectus with a carefully drafted qualifying statement similar to the one accompanying the inclusion in the January 31, 1969 registration statement. Defendants


argue that the $125 million figure included in that prospectus was more reliable because Roberts had been consulted and approved the figure. This contention is rejected as unbelievable on the basis of the entire situation and Roberts’ own testimony that he himself brought up the subject of the figure included in the draft prospectus because he had never seen it before and was curious as to its origin.

Defendants also maintain that the Pennsylvania Insurance Commissioner had been consulted and approved the figure contained in the February prospectus. This is not true.

It appears that the estimates prepared by Netter and Gibbs were considered sufficiently reliable by those defendants to predicate major expenditures in time and money in mounting the takeover drive. The $125 million estimate was used as a working figure in the research concerning reorganization alternatives for Reliance during and after the tender period. The defendants did not have reasonable grounds to believe that the estimates they already had were so inaccurate as to warrant exclusion from the prospectus.

(2) Hostility of Roberts.

Defendants also argue that the management of Reliance, particularly Roberts, was so hostile to the exchange offer that the information necessary to calculate surplus surplus accurately was unavailable throughout the entire exchange offer period. They further contend that this hostility denied them standing before the Insurance Commissioner and hence his approval of a meaningful approximation. The facts of Roberts’ relationship with Leasco do not support this contention.

It is true that Roberts evinced considerable hostility to both the exchange offer and Leasco prior to August 1, 1968. Peace was made on that date at a considerable financial gain to Roberts and cooperation began at once and increased in intensity.

The Court can reach but one conclusion in the face of the facts set out in Part IV B, supra-Roberts would have cooperated in the calculation of an amount of surplus surplus after August 1, 1968 if he had been asked. He testified that he could have arrived at an estimate “damn quickly” if necessary, and it is our finding based on his testimony, our observation of him on the stand, and the sense of the situation that he would have done so-or at least would have provided the information necessary for such a calculation.

Defendants have made much of the provision inserted in the August 1st agreement which insulates Reliance from any obligation “to cooperate in the preparation of any Registration Statement *** or to assume or take any liabilities or responsibility in connection therewith.” Roberts, it is argued, insisted on this clause in order to avoid supplying any information to Leasco. Defendants suggest that this represents a continued hostility and refusal to cooperate which existed throughout the exchange offer period.

We interpret this paragraph differently. It is patent that Roberts would have been unwilling to lend his name to a registration *580 statement to which he was basically opposed, thereby incurring the possibility of liability such as that we are here discussing. He was very cautious


and protected himself from any formal involvement in the registration process. We cannot conclude from this exercise of caution that he would not have provided data on an informal, or general basis, not for attribution, but rather to aid Leasco’s own people in their calculations.

Defendants moved to reopen the trial after the court announced its tentative findings indicating its conclusion regarding Roberts probable cooperation. Accompanying a proffer of proof in support of that motion was an affidavit executed by Roberts. This affidavit confirmed the Court’s impression of him as a meticulous man who protected himself at all times. His affidavit indicates that at no time would he have provided information for inclusion in the prospectus. It did not state that he would not have provided general information or data or that he would have refused to confirm the calculation of others.

After hearing the Court’s interpretation of Roberts’ first affidavit defendants submitted another which indicated in substance that he would have provided no information whatsoever through September 16, 1968, but that after that time he would have provided general information. He reiterated that he would never have provided information leading to an estimate of surplus surplus. This second affidavit does not weaken our impression that Roberts would have cooperated during the pendency of the exchange offer. We cannot credit his statement that none of the general information he would have provided would have led Leasco to an estimate of surplus surplus. Furthermore, we conclude that he would have supplied general information at any time after August 1, not just after September 16. Even if we were to credit his assertion that September 16 was the first date at which he would have cooperated-which we do not-we are left with the conclusion that for more than half the exchange offer period he was available at the beck and call of Leasco for information. The defendants neither beckoned nor called.

The critical point of this analysis is that Leasco, and particularly the three inside defendants, knew of the rapprochement with Reliance and were cognizant of all its ramifications. Being able, aggressive businessmen they must be held to an understanding of the implications of Roberts tacit abdication of his duty to his shareholders in return for personal benefits. It could not but have occurred to them that after August 1st he might have been receptive to inquiries about surplus surplus and other corporate information. By relying on a state of facts which existed in June and July they ignored the obvious potential source of invaluable information they had acquired by consummation of the August 1, 1968 contract.

We find that these three defendants did not have reasonable ground to believe that omission of an estimate of surplus surplus from the registration statement was justified on the ground that they did not have access to the pertinent data on Reliance or entre to the Insurance Commissioner. Roberts would have provided both had he been asked. They ignored this fact in concluding that an accurate estimate of surplus surplus could not be developed by Leasco. They failed to exercise that high degree of care imposed upon them by Section 11.

(3) Lack of Adequate Inquiry.

Even if both of our prior conclusions regarding the lack of reasonable ground to believe in


the accuracy of the registration statement were in error, these insider-defendants have nevertheless failed in their duty to reasonably investigate the accuracy of the prospectus. The uncontroverted testimony of two of the defendants themselves-Steinberg and Hodes-was that neither they nor anyone else in Leasco ever attempted to obtain a compuation of surplus surplus beyond those of Leasco’s Gibbs.

*581 Surplus surplus was a crucial element of the plan to acquire Reliance. Yet, no one connected with Leasco commissioned an estimate by an insurance consultant; no one asked any Leasco employee to calculate it; Hodes never ordered one of his law firm’s associates to attempt to arrive at a figure; and certainly no one made inquiry of one man who would have easily produced a figure-Roberts.

These defendants proceeded on the assumption that they could not arrive at an accurate figure without making the attempt. They may have failed-although we do not believe they would have-but they were bound by their duties under Section 11 to attempt to verify their conclusion that it was not calculable. It is this sort of laxity and oversight to which the requirement of reasonable investigation is directed and which Judge McLean held unacceptable in BarChris. By assiduously proving that they never had figures other than those previously alluded to these defendants have persuaded the court that they failed to vindicate their responsibility of due diligence. [33] Nor can it be argued that they need not have attempted the computation or made any inquiry because such gestures would have been futile. Roberts testified that any one knowledgeable in the insurance field might have arrived at a considered figure. Section 11 requires an attempt to make use of such expertise. Hodes, Schwartz and Steinberg are liable along with the issuer, Leasco.

E. Due Diligence of the Dealer-Managers-White, Weld & Co. and Lehman Brothers. [34] Section 11 holds underwriters to the same burden of establishing reasonable investigation and reasonable ground to believe the accuracy of the registration statement. The courts must be particularly scrupulous in examining the conduct of underwriters since they are supposed to assume an opposing posture with respect to management. The average investor probably assumes that some issuers will lie, but he probably has somewhat more confidence in the average level of morality of an underwriter who has established a reputation for fair dealing. Judge McLean expressed the proper relationship between underwriters and management in BarChris: “In a sense, the positions of the underwriter and the company’s officers are adverse. It is not unlikely that statements made by company officers to an underwriter to induce him to underwrite may be self-serving. They may be unduly enthusiastic.” Escott v. BarChris Construction Corp., 283 F.Supp. 643, 696 (S.D.N.Y.1968).

In light of this adverse position they must be expected to be alert to exaggerations and rosy outlooks and chary of all assurances by the issuer. Their duty is to the investing public under


Section 11 as well as to their own self-interest and that duty cannot be taken lightly. “Such adversity is required since the underwriter is the only participant in the registration process who, as to matters not certified by the accountant, is able to make the kind of investigation which will protect the purchasing public. Management may be so hard pressed for cash and so incorrigibly optimistic that they will accept or undervalue the risk of civil liability. The directors, as noted above, are not free to assume an adverse role, and in any event they are not entirely free from the pressures on and optimism of management. The SEC simply does not have the staff to verify independently even the more dubious registration statements. Only the underwriter and the accountant are free to assume an adverse role, have little incentive to accept the risk of liability, and possess the facilities and competence to undertake an independent investigation. They may therefore reasonably be required to share the burden of verification. “The duty of the underwriter, then, is not merely limited to listening to management’s explanations of the company’s affairs. Rather he must make an investigation reasonably calculated to reveal all of those facts which would *582 be of interest to a reasonably prudent investor. If he undertakes such an investigation, he will not be liable for material misrepresentations which his efforts did not uncover. If he does not, he will be liable for all misrepresentations which such an investigation would have uncovered. “It is difficult to speculate as to what would constitute an investigation reasonably calculated to reveal those facts which would be of interest to a reasonably prudent investor. Of course all would agree that the underwriter should read minutes and important contracts and check out any inconsistencies in the representations of management. But the spirit of Judge McLean’s opinion undoubtedly requires something more.” Comment, BarChris: Due Diligence Refined, 68 Colum.L.Rev. 1411, 1421 (1968). [35] Dealer-managers cannot, of course, be expected to possess the intimate knowledge of corporate affairs of inside directors, and their duty to investigate should be considered in light of their more limited access. Nevertheless they are expected to exercise a high degree of care in investigation and independent verification of the company’s representations. Tacit reliance on management assertions is unacceptable; the underwriters must play devil’s advocate. Comment, BarChris: Due Diligence Refined, 68 Colum.L.Rev. 1411, 1417 (1968). See Escott v. BarChris Construction Corp., 283 F.Supp. 643, 696-697 (S.D.N.Y.1968); Folk, Civil Liabilities Under the Federal Securities Acts: The BarChris Case, 1 Securities L.Rev. 3, 61 (1969) (reprinted in 55 Va.L.Rev. 1 (1969)); Comment, Escott v. BarChris Construction Corporation: Section 11 Strikes Back, 21 Stan.L.Rev. 171, 180 (1968). Cf. SEC v. North American Research and Development, 424 F.2d 63, 82-84 (2d Cir. 1970); Globus v. Law Research Service, 418 F.2d 1276, 1288 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S.Ct. 913, 25 L.Ed.2d 93 (1970); Hanly v. SEC, 415 F.2d 589, 595-597 (2d Cir. 1969). [36] We find that the dealer-managers have just barely established that they reasonably investigated the surplus surplus concept as it related to Reliance and that they had reasonable ground to believe that omission of a specific figure was justified.

The evidence indicates a thorough review of all available financial data by White, Weld &


Co. and its counsel. They independently examined Leasco’s audit and the report of an actuary on Reliance. They made searching inquiries of Leasco’s major bank. Whitney, counsel to the dealer-managers, undertook a study of Leasco’s corporate minutes, records and major agreements.

Regarding surplus surplus, the dealer-managers were particularly careful in their inquiries of Leasco. Stone of White, Weld had considerable prior experience with surplus surplus. He was fully aware of the complexity of the computation problem. The Netter Report, Gibbs’ Memorandum and New York Insurance Department Report were all referred to at the due diligence meetings held late in June and early in July of 1968 in New York where representatives of Leasco and the dealer-managers reviewed the proposed registration statement line by line. Based on these reports and on his own expertise, Stone briefed Whitney, lead counsel for the underwriters.

Whitney and Stone were informed by Leasco that Roberts was hostile to the exchange offer-which, in fact, was the case in early July when these meetings were held; that he would not cooperate by providing either information or an estimate of his own; and that he would not verify the approximations they already had in their possession. This assertion was reinforced by Roberts’ June 24, 1968 letter to his shareholders urging them “not to act in haste” and by his May 15, 1968 letter concerning his intention to form a holding company for Reliance. Counsel for White Weld was also aware of Hodes’ June 24, 1968 telegram to Roberts requesting cooperation in the preparation of a registration statement *583 and of Roberts’ reply of July 1, indicating that Reliance would not then comply.

Based on the information supplied by Leasco and confirmed by examination of these documents, Whitney rightly concluded that as of July 5th Roberts would not cooperate either by providing an opinion, by furnishing the critical data, or by verifying the estimates included in the Netter Report and Gibbs’ Memorandum. In his opinion surplus surplus could not then be calculated with any accuracy.

The underwriters did not themselves contact Roberts because they had ascertained to their satisfaction that he would not be cooperative. Throughout July, Whitney and Stone were in constant contact with Leasco representatives regarding the progress of the exchange offer. During this period they received yet further verification of Roberts’ intransigence which reconfirmed Whitney’s opinion and certainly could not have provided a reasonable ground to reject his earlier conclusion. First, they learned of the subsequent requests for information directed to Roberts on July 9 and July 12 and of his evasion of such inquiries on July 15. They were, of course, aware that Roberts had filed a law suit seeking to inhibit any exchange offer. Finally, any doubt which may have lingered regarding Roberts’ attitude was dispelled by his July 23rd letter of opposition to his shareholders in which he discussed in detail the reasons why the offer should be rejected.

We find, therefore, that it is somewhat more probable than not that as of August 1, 1968 the dealer-managers had sufficient verification of their previous conclusion concerning the possibility of accurately computing surplus surplus. They still had reasonable ground to believe that omission of such a figure was not misleading.

The dealer-managers were, however, undoubtedly aware of the August 1st contract between


the Reliance management and Leasco and absent any further verification, their failure to recognize the implications of this agreement might well create liability for the same reasons expressed in our discussion of the defenses of the directors. But Whitney was in continuous contact with Leasco after August 1st and was apparently never disabused of the notion that Roberts remained recalcitrant. This view was conclusively buttressed by receipt of a copy of a letter dated August 13, 1968 from Kenneth J. Bialkin of Wilkie, Farr & Gallagher to the SEC, set forth at page 562, supra, stating that Reliance officials “have *** declined to furnish information.” Receipt of this letter served to reconfirm Whitney’s belief that neither data nor advice would be forth-coming from Roberts. The registration statement became effective six days later, on August 19, 1968.

Though the finding might have gone the other way, on balance we conclude that the dealer-managers conducted a reasonable investigation and reasonably verified Leasco’s representations that access to Reliance’s management was precluded by Roberts’ attitude. We note in passing that neither of the underwriters had their names on the January, 1969 Leasco prospectus which did rely on the $125 million estimate of surplus surplus.

Both White, Weld & Co. and Lehman Brothers have established their due diligence defenses with regard to this registration statement.

X. SECTION 12(2), SECTION 17(A), SECTION 10(B) AND RULE 10B-5, AND SECTION 14(E)

The gravamen of plaintiff’s action concerns the accuracy of the registration statement filed in connection with Leasco’s exchange offer. Congress specially tailored Section 11 to provide liability for misrepresentations and omissions of material fact in such documents. It wrestled with the delicate problem of what degree of liability to impose on different classes of defendants and arrived at a unique resolution. Thus it considered imposing insurer’s liability on directors as well as on the issuer but rejected such a harsh rule in favor of the due diligence defenses now provided. See *584 Martin v. Hull, 67 App.D.C. 284, 92 F.2d 208, 210, cert. denied, 302 U.S. 726, 58 S.Ct. 47, 82 L.Ed. 561 (1937). Similarly, it created fine distinctions between liability for “expertised” and “non-expertised” sections of the registration statement. 15 U.S.C. § 77k(b). It also provided liability for experts on a different basis from that imposed on other defendants. See Escott v. BarChris Construction Corp., 283 F.Supp. 643, 697-698 (S.D.N.Y.1968). [37] In light of our finding of liability under this carefully wrought provision, we need not now decide the serious questions of liability under Section 12(2) and Section 17(a) of the 1933 Act (15 U.S.C. §§ 77l and 77q) or under Section 10(b), Rule 10b-5, and Section 14(e) of the 1934 Act (15 U.S.C. § 78j(b), 17 C.F.R. 240.10b-5, and 15 U.S.C. § 78n(e)). We do not, by this action, mean to imply that liability under Section 11 in any way precludes recovery under any other section of the securities laws. Cf. SEC v. National Securities, 393 U.S. 453, 468, 89 S.Ct. 564, 572-573, 21 L.Ed.2d 668 (1969); Silver v. New York Stock Exchange, 373 U.S. 341, 357, 83 S.Ct. 1246, 1257, 10 L.Ed.2d 389 (1963); Diamond v. Oreamuno, 24 N.Y.2d 494, 502, 301 N.Y.S.2d 78, 84, 248 N.E.2d 910 (1969). We find merely that a recovery in this case under Section 11 fully vindicates the full disclosure policy of the


securities laws and provides plaintiffs with a fair and just measure of compensation. See Gilbert v. Nixon, 429 F.2d 348, 355 (10th Cir. 1970). [38] It may be that liability would lie under Section 12(2) since the elements prerequisite to recovery are essentially the same-materiality of the omission and failure to exercise reasonable care. See Gilbert v. Nixon, 429 F.2d 348 (10th Cir. 1970); Johns Hopkins University v. Hutton, 422 F.2d 1124 (4th Cir. 1970); Demarco v. Edens, 390 F.2d 836 (2d Cir. 1968). Such liability would be merely duplicative of Section 11 on the facts of this case. It does, as plaintiff urges, offer rescission as an alternative to damages, but such relief is unrealistic on these facts. Many members of the class have already divested themselves of the Leasco package and those who still hold it would, if granted rescission, be winning the dubious benefit of being minority shareholders in a corporation totally controlled by Leasco. Damages under Section 11 provide a more equitable remedy.

Serious, unresolved ambiguities surrounding the scienter requirement in Rule 10b-5 and possibly Section 14(e) of the 1934 Act and 17(a) of the 1933 Act are presented to any court asked to decide liability under all three of these general anti-fraud provisions. See Globus v. Law Research Service, 418 F.2d 1276, 1290-1291 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S.Ct. 913, 25 L.Ed.2d 93 (1970); SEC v. Texas Gulf Sulphur, 401 F.2d 833, 854-855, 866-868 (2d Cir. 1968), cert. denied sub nom. Coates v. SEC and Kline v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969). Cf. SEC v. Capital Gains Research Bureau, 375 U.S. 180, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963). In-as-much as we conclude that Section 11 provides a complete remedy for the plaintiff-class and the investing public, we intimate no conclusion regarding applicability of plaintiff’s alternative prayers for relief under other theories.

XI. DAMAGES

Plaintiff has urged numerous remedies on the Court but now seems to press only four: (1) statutory damages under Section 11; (2) a “conversion” measure of damages for those who have sold the Leasco package-i. e., the difference between the price at which they sold the package and the highest price Leasco traded at within a reasonable period after disclosure; (3) rescission for those who still hold the Leasco package; or (4) restitution-the difference between the price they received for their Reliance shares and that at which they sold the *585 Leasco package or its current value if they still hold it. The latter three proposals are predicated largely on liability pursuant to the general anti-fraud provisions discussed above, not Section 11. [39] Section 11(e) sets out an explicit measure of damages for those entitled to recover under Section 11(a). It provides for the difference between what was paid for the security and its value at the time the suit was brought, what it was sold for before suit, or what it was sold for after suit was commenced if that figure is greater than the value at the time the suit was started. It reads in pertinent part: “The suit authorized under subsection (a) of this section may be to recover such damages as shall represent the difference between the amount paid for the security (not exceeding the


price at which the security was offered to the public) and (1) the value thereof as of the time such suit was brought, or (2) the price at which such security shall have been disposed of in the market before suit, or (3) the price at which such security shall have been disposed of after suit but before judgment if such damages shall be less than the damages representing the difference between the amount paid for the security (not exceeding the price at which the security was offered to the public) and the value thereof as of the time such suit was brought: Provided, That if the defendant proves that any portion or all of such damages represents other than the depreciation in value of such security resulting from such part of the registration statement, with respect to which his liability is asserted, not being true or omitting to state a material fact required to be stated therein or necessary to make the statements therein not misleading, such portion of or all such damages shall not be recoverable.” 15 U.S.C. § 77k(e).

Cf. Martin v. Hull, 67 App.D.C. 284, 92 F.2d 208, cert. denied, 302 U.S. 726, 58 S.Ct. 47, 82 L.Ed. 561 (1937); Shonts v. Hirliman, 28 F.Supp. 478 (S.D.Cal.1939); Thorn v. Austin Silver Mining, 171 Misc. 400, 12 N.Y.S.2d 675 (Sup.Ct.1939).

Initially we must determine “the amount paid for the security.” The security here is the Leasco package of one preferred share and one-half warrant; the consideration surrendered for it was one share of Reliance common stock. Testimony of plaintiff’s expert comparing the intrinsic rather than the market value of Leasco and Reliance shares is not persuasive. It is too speculative for purposes of assessing damages in this case. [40] We recognize that once a plaintiff has shown that the defendant has violated his substantive rights and that he is entitled to damages, he ought not to be held to the high level of proof required for other elements of this case. The somewhat speculative nature of damages ought not to prevent a plaintiff from recovering; where there is a substantial question, the facts must be construed, within reasonable limits, against the tort feasor.

Plaintiff also argues that the value of the Reliance stock should be taken to be that amount publicized by Leasco as the amount received for purposes of computing capital gains on the Reliance shares-$72⅞. This figure represented the market price of the Leasco package on September 13, 1968, the last trading before Leasco accepted the 72% of Reliance shares tendered and declared the exchange offer effective. [41] Plaintiff’s proposed figure for Reliance is unacceptable for two reasons. First, it represents the amount received, not paid, as of that date and Leasco was admittedly offering a premium in order to induce tenders. Second, the prospectus in question was submitted in support of a solicitation of tender. We assume, therefore, that the plaintiff evaluated the exchange proposal based upon *586 the information it contained. The first page of the prospectus lists $66¼ as the closing price of Reliance on August 16, 1968, the last day of trading before the effective date of the registration statement. Presumably, Reliance shareholders used that figure in deciding whether the Leasco package offered was attractive enough to accept. August 16 was the last day of free trading unaffected by the prospectus so that the price of Reliance shares on that day is the best indication we have of open market valuation. We assume that his sum represented the amount that the offerees intended to


relinquish in return for Leasco securities. Accordingly, we find that $66¼ was “the amount paid for” the Leasco package.

Unpersuasive are defendants’ contention that the $66¼ figure is too high, representing as it does appreciation in the market price of Reliance resulting from the imminence of the exchange offer. The simple answer is that demand has always played an inseparable role in determination of price. The appreciation Leasco speaks of is merely a reflection of the market’s recognition of the attractiveness of Reliance as the subject of acquisition. It was Leasco’s own desire to purchase Reliance which helped create this increment in price; having caused the inflation it cannot now complain that it was not really worth that much. Under the market conditions then prevailing this price did represent the actual value of Reliance. [42] This determination of the “amount paid” does not entirely resolve the damage question. Section 11(e) provides a causation defense to a defendant who “proves that any portion or all of such damages represents other than the depreciation in value of such security resulting from such part of the registration statement, with respect to which his liability is asserted ***.” 15 U.S.C. § 77k(e). We cannot consider any damages caused, not by defendants’ omissions, but by independent forces. See Fox v. Glickman, 253 F.Supp. 1005, 1010 (S.D.N.Y.1966). Cf. Escott v. BarChris Construction Corp., 283 F.Supp. 643, 703-704 (S.D.N.Y.1968). [43] We take judicial notice of the very drastic general decline in the stock market in 1969. See Revised Proposed Rules of Evidence for the United States District Courts and Magistrates, Rule 201(b)(2)(March 1971). Standard and Poor’s Daily Stock Price Index rose gradually from 98.68 on August 16, 1968 to a high of 109 in both November and December of 1968 and then dropped back to 97.97 on October 27, 1969-the date this suit was commenced. It continued to drop for some months thereafter. The Dow Jones Price Average arose from about 917 in early September 1968 to a high of 996 in December 1968 and plunged 135 points to 860.28 on October 27, 1969. [44] In light of the decline, which extended beyond October 27, 1969, we cannot but conclude that some portion of the diminution of Leasco’s price was due to market factors which would have affected any security and that, to that extent, plaintiff’s damages were not “caused” by the omissions in the registration statement. See Fox v. Glickman, 253 F.Supp. 1005, 1010 (S.D.N.Y.1966).

The damage figure should be adjusted to take account of the market decline. Of the two market indexes referred to above, Standard and Poor’s is preferable for our purposes because it is based on a larger sample of securities and is less likely to reflect trends unique to one industry. The adjustment will be made by multiplying the “amount paid” ($66¼) by the reciprocal of the decline in Standard and Poor’s from August 16, 1968 to the day of sale of the Leasco securities by a member of the plaintiff’s class.

Before turning to the actual method of computation, two additional considerations must be noted. First, the Leasco package or portions of it will be deemed sold on the date of the sale of preferred shares. We choose to focus on the preferred *587 shares for this determination


because the warrants are much more speculative and trading in them will not as clearly indicate the investor’s intention to divest himself of the securities obtained in exchange for his Reliance shares. Moreover, since one share of preferred Leasco was distributed for each share of Reliance common relinquished, the direct comparison of prices is facilitated by determining damages on the date of sale of the preferred. If, in any case involving large holdings, this arbitrary decision creates unfairness, sales of preferred and warrants can be separately treated.

Absent some special situation, a class member will be deemed to have sold an entire unit of the Leasco package each time he made a sale of one share of preferred regardless of whether he contemporaneously sold warrants or whether he sold them in the exact ratio contained within the package. Damages will therefore be computed by comparing the market-adjusted “price paid” with the value of an entire unit of the Leasco package on the day of sale of the preferred.

An element of arbitrariness is inherent in such rigid determinations. Some plaintiffs will undoubtedly recover less than they would under a formula precisely determining the percentage of the Reliance share which should be apportioned to each portion of the Leasco package on the day of sale, thereby achieving exact comparison for warrants sold as well as preferred. Conversely, some members of the class will receive windfalls. But any other method would entail allocating the value of the Reliance shares between the warrants and preferred shares and any such apportionment necessarily entails its own element of arbitrariness. The ratio of preferred to warrant price has fluctuated widely.

Particularly in a class action the damage question must be approached pragmatically. It is important that the dispute be ended and that we fashion a remedy which provides substantial fairness. Too much precision might destroy efficacy as a result of an expensive attempt to obtain a measure of damages suitable to each of possibly thousands of shareholders.

The second preliminary matter which must be dealt with is that Leasco declared a five for two split of its warrants effective February 12, 1969. Therefore, an investor who sold his Leasco preferred shares on or after that date will be deemed to have sold one and one-quarter warrant as well as one preferred share at the prices quoted on the date of sale. As a practical matter these are the only plaintiffs who we will have to consider since the price of the Leasco package did not drop below $66¼ until late in June of 1969 and those who divested themselves earlier will recover no damages.

Plaintiffs’ and defendants’ attorneys agree that the Leasco package, including adjustment for the warrant split, had an average price of $71 on October 27, 1969-the date this law suit was commenced. For those who presently hold Leasco preferred shares or who sold them after October 27, 1969 there can be no recovery.

We turn now to the actual method of computation to be used in determining recovery for those who sold Leasco securities before October 27, 1969. (1) The Standard and Poor’s index for the day of the sale will be divided by 98.68-the Standard and Poor’s reading on August 16, 1968-yielding the reciprocal of the general market decline. (2) The quotient obtained in Step 1 above will be multiplied by $66.25 to arrive at a market-adjusted “price paid” for the Leasco package. If the product obtained is greater than $66.25 then $66.25 will be used as


the base figure since we are considering only declines in the market. (3) For each share of Leasco preferred sold add the market quotation for such share on the date of its sale to 1¼ times the market price of Leasco warrants on that day. (4) The damages to be recovered on each share sold will be determined by subtracting the sum derived in Step 3 from the “price paid” as determined in Step 2.

A brief example may help to clarify the computation. If an investor sold 100 *588 shares of Leasco preferred on some hypothetical date in July 1969 he would be deemed to have sold 125 warrants as well as the 100 shares. Assume that the Leasco preferred were selling at $42 and the warrants at $11 with the Standard and Poor’s at 95 on that date. The plaintiff’s damages resulting from that sale are determined as follows: (1) Divide the Standard and Poor’s reading of 95 by 98.68 yielding .96. (2) Multiply .96 by $66.25 obtaining an adjusted “price paid” of $63.60. (3) Add $42 to $11 times 1.25 for an amount received of $55.75. (4) Subtract $55.75 from $63.60 yielding per share damages of $7.85. Thus our hypothetical investor’s recovery upon the sale of 100 Leasco preferred is $785.

XII. CONCLUSIONS

Members of the plaintiff-class are entitled to recover money damages pursuant to Section 11 of the Securities Act of 1933. 15 U.S.C. § 77k. The failure to include an estimate of surplus surplus in the registration statement filed in conjunction with this exchange offer was an omission of a material fact required to be stated to prevent the statements from being misleading. The three individual director-defendants who have appeared, Hodes, Schwartz and Steinberg, failed to make a reasonable investigation with regard to inclusion of such an estimate and did not have a reasonable ground to believe that this failure was not an omission to state a material fact. The issuer, Leasco, and these three directors are jointly and severally liable to the class. 15 U.S.C. § 77k(f).

The two dealer-manager defendants-White, Weld & Co. and Lehman Brothers-performed a reasonable investigation with regard to the propriety of an inclusion of an estimate of surplus surplus and had a reasonable ground to believe and did believe that the failure to include such a figure was not an omission to state a material fact. Accordingly they have established their due diligence defense and are not liable to the class.

So ordered.

Parallel Citations

Fed. Sec. L. Rep. P 93,163


346 F.Supp.2d 628 United States District Court,

S.D. New York.

In re WORLDCOM, INC. SECURITIES LITIGATION This Document Relates to:

All Actions

No. 02 Civ. 3288(DLC). | Dec. 15, 2004.

Synopsis Background: In consolidated securities class action arising from the collapse of issuer, a telecommunications giant, investors sought to hold issuer’s underwriters liable based on claims that financials incorporated in the registration statements for two bond offerings contained material misstatements and omissions. The parties filed cross-motions for summary judgment.

Holdings: The District Court, Cote, J., held that: [1] underwriters could not rely on an accountant’s comfort letters for interim financial statements in presenting reliance defense under Section 11 of the Securities Act concerning false or misleading registration statements; [2] genuine issues of material fact existed as to whether discrepancy between issuer’s E/R (expense to revenue) ratio and that of its competitors in audited figures the Form 10-K raised a red flag and whether issuer’s statement of its assets raised a red flag and imposed upon the underwriters an obligation to inquire further, precluding summary judgment in favor of underwriters of reliance defense; [3] issuer’s principal’s dependence on issuer’s financial health was insufficient to constitute a red flag that he may have caused a manipulation of issuer’s financial statements so as to impose duty of inquiry upon underwriters; [4] genuine issues of material fact existed as to whether failure of registration statement to describe merger problems and their impact on issuer was a material omission; [5] genuine issues of material fact existed as to whether registration statement adequately disclosed the alleged precarious state of issuer’s profit margins in a major component of its business and the impact of that problem on its business as a whole, and as to whether disclosures regarding the burden of issuer’s debt load were adequately disclosed; and [6] underwriters had no obligation to disclose in issuer’s registration statement information


about their own internal credit ratings for issuer or their own hedging strategies for issuer’s debt that they held.

Motions granted in part and denied in part.

Attorneys and Law Firms

*633 Max W. Berger, John P. Coffey, Steven B. Singer, Chad Johnson, Beata Gocyk-Farber, John C. Browne, Jennifer L. Edlind, David R. Hassel, Bernstein Litowitz Berger & Grossman LLP, New York, NY, Leonard Barrack, Gerald J. Rodos, Jeffrey W. Golan, Mark R. Rosen, Jeffrey A. Barrack, Pearlette V. Toussant, Barrack, Rodos & Bacine, Philadelphia, PA, for Lead Plaintiff in the Securities Litigation.

Jay B. Kasner, Susan L. Saltzstein, Cyrus Amir-Mokri, Steven J. Kolleeny, Skadden, Arps, Slate, Meagher & Flom LLP, New York, NY, Thomas J. Nolan, Jason D. Russell, Los Angeles, CA, for Underwriter Defendants.

George R. Kramer, Securities Industry Association, Washington, D.C., Marjorie E. Gross, The Bond Market Association, New York, NY, Davis Polk & Wardwell, New York, NY, for amici curiae the Securities Industry Association and The Bond Market Association.

Opinion

OPINION AND ORDER

COTE, District Judge.

TABLE OF CONTENTS

Introduction........................................................................................................................... 634 Background ........................................................................................................................... 635 Procedural History ....................................................................................................... 635 WorldCom and its Role in the Telecommunications Industry..................................... 637 Ebbers’ Dependence on WorldCom Stock .................................................................. 639 WorldCom’s Accounting Strategies ............................................................................ 640 Andersen and the 1999 Form 10-K.............................................................................. 643 2000 Offering............................................................................................................... 645 Late 2000 Investment Banking Transaction ................................................................ 649 The Underwriter Defendants’ Credit Assessment of WorldCom as of Early 2001..... 649 2000 Form 10-K........................................................................................................... 652 2001 Offering............................................................................................................... 652 Discussion ............................................................................................................................. 655 I. Legal Framework...................................................................................................... 656 A. Section 11........................................................................................................... 656


B. Section 12........................................................................................................... 659 II. Lead Plaintiff’s Motion for Partial Summary Judgment.......................................... 660 III. The Underwriter Defendant’s otion for Summary Judgment: The Financial Statements ................................................................................................................ 661 A. Role of the Underwriter ..................................................................................... 662 B. The “Due Diligence Defenses ............................................................................ 662 C. Accountants as Experts ...................................................................................... 664 D. Integrated Disclosure, Shelf Registration, and Rule 176 ................................... 666 E. Case Law: Reliance Defense .............................................................................. 671 F. Case Law: Due Diligence Defense ..................................................................... 674 G. The Application of the Law to This Motion ...................................................... 678 1. Audited Financial Statements ....................................................................... 678 a. 2000 Registration Statement .................................................................... 678 b. 2001 Registration Statement .................................................................... 680 i. Goodwill and Asset Impairment ......................................................... 680 ii. Ebbers’ Personal Finances................................................................. 681 iii. E/R Ratio .......................................................................................... 681 2. Interim Financial Statements ......................................................................... 681 IV. The Underwriter Defendants’ Motion for Summary Judgment: Ommissions ....... 685 A. 2000 Registration Statement .............................................................................. 685 1. Sprint Merger ................................................................................................. 687 2. Conflicts of Interest........................................................................................ 688 3. Risk Factors ................................................................................................... 690 B. 2001 Registration Statement .............................................................................. 692 1. Downgrading WorldCom as a Credit Risk .................................................... 695 2. Use of Proceeds.............................................................................................. 696 3. Risk Factors ................................................................................................... 697 Conclusion ............................................................................................................................ 697


*634 This Opinion addresses issues related to an underwriter’s due diligence obligations. Following the conclusion of fact discovery, several of the parties in this consolidated securities class action arising from the collapse of WorldCom, Inc. (“WorldCom”) have filed for summary judgment. This Opinion resolves the motions for summary judgment filed by Lead Plaintiff for the class, who seeks a declaration that certain of the WorldCom financials incorporated in the registration statements for two WorldCom bond offerings contained material misstatements; and by the underwriters for those same bond offerings, who seek a declaration that they have no liability for any false statements in the WorldCom financials that accompanied the registration statements or for the alleged omissions from those registration statements. It is undisputed that at least as of early 2001 WorldCom executives engaged in a secretive scheme to manipulate WorldCom’s public filings concerning WorldCom’s financial condition. Because those public filings were incorporated into the registration statements for the two bond offerings, the underwriters are liable for those false statements unless they can show that they were sufficiently diligent in their investigation of WorldCom in connection with the bond offerings. Through these motions, the Lead Plaintiff emphasizes that the underwriters did almost no investigation of WorldCom in connection with their underwriting of the bond offerings for the company, and because they did essentially no investigation, will be unable to succeed with their defense that they were diligent. The Lead Plaintiff contends moreover that there were “red flags” that should have led the underwriters to question even the audited financials filed by WorldCom. For their part, the underwriters emphasize that WorldCom management concealed *635 the fraud from almost everyone within WorldCom, from WorldCom’s outside auditor, and from the underwriters themselves. They assert that they were entitled to rely on WorldCom’s audited financial statements as accurately describing the company’s financial condition, and also on the comfort letters that WorldCom’s outside auditor provided for the unaudited


financial statements. While they have not moved for summary judgment on the adequacy of their due diligence efforts per se, they do argue that those efforts should not be measured solely by the work that they undertook in connection with the bond offerings themselves, but should be assessed against a background of their long term familiarity and work with the company. They also argue that much of the information that was allegedly omitted from the bond registration statements was already known to the public. For the following reasons, the Lead Plaintiff’s motion is granted in part. The underwriters’ motion is also granted in part.

Background

These summary judgment motions require, in varying amounts of detail, an understanding of the industry in which WorldCom operated, some of the accounting issues that affected the reliability of the WorldCom financial statements, and the due diligence work performed by the underwriters in connection with the two bond offerings. The facts recited here are either undisputed or as shown by the party resisting summary judgment, unless otherwise identified. A brief description of the history of this litigation and the context for the summary judgment motions precedes the factual recitation.

Procedural History WorldCom announced a massive restatement of its financials on June 25, 2002. It reported its intention to restate its financial statements for 2001 and the first quarter of 2002. According to that announcement, “[a]s a result of an internal audit of the company’s capital expenditure accounting, it was determined that certain transfers from line cost expenses1 to capital accounts during this period were not made in accordance with generally accepted accounting principles (GAAP).” The amount of transfers was then estimated to be over $3.8 billion. Without the improper transfers, the company estimated that it would have reported a net loss for 2001 and the first quarter of 2002. On July 21, it filed for bankruptcy. A restatement of WorldCom’s financials was issued in 2004 in connection with WorldCom’s emergence from bankruptcy. WorldCom restated its financial information for the years ending 2000 and 2001. The restatement included approximately $76 billion in adjustments, which reduced WorldCom’s net equity from approximately $50 billion to approximately minus $20 billion. Securities litigation addressing the accuracy of WorldCom’s financial statements commenced in the Spring of 2002. Those class actions filed in this district were consolidated on August 15, 2002. The Judicial Panel on Multi-District Litigation (“MDL Panel”) transferred the securities litigation pending in federal courts to this district and all of the actions, both individual (“Individual Actions”) and class actions, were consolidated for pre-trial purposes on December 23, 2002. In re WorldCom, Inc. Sec. Litig., No. 02 Civ. 3288(DLC), 2002 WL 31867720 (S.D.N.Y. Dec.23, 2002). *636 This litigation is referred to as the Securities Litigation.2


The consolidated class action complaint in the Securities Litigation was filed on October 11, 2003, and the first wave of motions to dismiss that pleading were resolved in an Opinion of May 19, 2003. In re WorldCom, Inc. Sec. Litig., 294 F.Supp.2d 392 (S.D.N.Y.2003). Fact discovery in the Securities Litigation concluded on July 9, 2004.3 Before its conclusion, Citigroup, Inc., Citigroup Global Markets Inc. f/k/a/ Salomon Smith Barney Inc. (“SSB”), Citigroup Global Markets Limited f/k/a/ Salomon Brothers International Limited, and Jack B. Grubman (“Grubman”) (collectively “Citigroup Defendants”) settled the class action lawsuit. A fairness hearing on the $2.575 billion settlement was held on November 5, 2004, and the settlement was approved. In re WorldCom Sec. Litig., No. 02 Civ. 3288(DLC), 2004 WL 2591402 (S.D.N.Y. Nov.12, 2004). SSB had functioned was the co-lead underwriter for the two bond offerings issued by WorldCom that are at issue in the class action: one in May 2000 (“2000 Offering”) and one in May 2001 (“2001 Offering”). Grubman, an SSB employee, was the leading telecommunications analyst covering WorldCom and it is alleged that he had issued reports urging investors to purchase WorldCom securities when he knew that WorldCom’s financial statements did not accurately disclose information that was material to investors. The plaintiffs asserted that SSB’s desire to obtain WorldCom’s investment banking business caused it to issue misleading analyst reports that urged investors to purchase WorldCom securities. The class action complaint alleged that the Citigroup Defendants violated not just the strict liability statutes governing securities offerings, but also the securities statutes that forbid fraud, including Section 10(b) of the Securities Exchange Act of 1934 (“Section 10(b)” and “Exchange Act”). The defendants in the class action, as named in a Corrected First Amended Class Action Complaint of December 1, 2003, include former WorldCom executives Bernard J. Ebbers (“Ebbers”), WorldCom’s CEO, and Scott Sullivan (“Sullivan”), WorldCom’s CFO; members of WorldCom’s Board of Directors (“Director Defendants”), investment banks that underwrote the 2000 and 2001 Offerings,4 and Arthur Andersen LLP (“Andersen”), WorldCom’s former auditor. The plaintiffs allege that the Underwriter Defendants *637 violated Sections 11 and 12(a)(2) of the Securities Act of 1933 (“Section 11”, “Section 12(a)(2)”, and “Securities Act”), 15 U.S.C. § 77k and § 77l, and that Andersen violated Section 11 of the Securities Act and Section 10b of the Exchange Act. On August 20, 2004, summary judgment motions were filed by parties to the class action. The trial is scheduled to begin on February 28, 2005. The Lead Plaintiff has moved for partial summary judgment, and the Underwriter Defendants have moved for complete summary judgment.5 The Lead Plaintiff moves for summary judgment on its Sections 11 and 12(a)(2) claims with respect to certain statements in WorldCom’s financial filings that the Lead Plaintiff contends are indisputably false and material. WorldCom’s financial filings were incorporated into the registration statements for the 2000 and 2001 Offerings. The allegedly false statements on which the Lead Plaintiff’s motion is based relate to the reporting of WorldCom’s line costs, capital expenditures, depreciation and amortization, assets, and goodwill.


The Underwriter Defendants move for summary judgment on the Sections 11 and 12(a)(2) claims against them with the argument that it is undisputed that they conducted reasonable due diligence with respect to the WorldCom financial statements that were incorporated into the registration statements for the 2000 and 2001 Offerings. They argue in particular that they were entitled to rely on WorldCom’s audited financial statements and had no duty to investigate their reliability unless they had reasonable grounds to believe that they were not accurate, and that they were also entitled to rely on the “comfort letters” from WorldCom’s auditor for the interim unaudited WorldCom financial statements. With respect to the alleged material omissions that are also a basis for those same Securities Act claims, the Underwriter Defendants contend that none of the omissions are actionable, for instance, because the information was already publicly disclosed or was not material. The parties have made extensive submissions in connection with these competing motions. Because of the analysis which follows, it is only essential to set forth a small portion of the factual material presented through these motions. The essential facts as shown through the evidence presented with these motions include the following.

WorldCom and its Role in the Telecommunications Industry Ebbers founded a long-distance telephone service provider in 1983 in Mississippi. His company grew by purchasing other small long-distance companies throughout the late 1980s and early 1990s. The company went public in 1989, and by 1993 it was the fourth largest long-distance carrier in the United States. It took the name WorldCom in 1995. Congress enacted the Telecommunications Act in 1996, 47 U.S.C. § 251 et seq., which encouraged competition in local and long-distance telephone services. At this same time, the Internet was expanding rapidly and there was a demand for increased *638 bandwidth.6 To meet that demand and in response to the intense competition, telecommunications companies made substantial capital investments in fiber optic networks and telecommunications infrastructure. Between 1996 and 1999, WorldCom completed several major acquisitions that helped diversify or enlarge its business. Through a merger with MFS Communications, Inc., WorldCom acquired UUNET Technologies Inc., which was the world’s largest Internet service provider and which had a substantial fiber optic cable network. It acquired CompuServe Corporation and ANS Communications Inc., which gave WorldCom a large Internet dial-up communications network. The acquisition of SkyTel Communications, Inc. gave WorldCom an expertise in the wireless business. In 1998, WorldCom acquired MCI Communications (“MCI”), a company whose revenues were more than two and half times greater than WorldCom’s. With that acquisition WorldCom became the second largest telecommunications company in the world. Its share price, which had been approximately $8 per share in 1994, increased to $48 per share by September 1999. As noted, by the late 1990s, the telecommunications industry was growing increasingly competitive. Regional companies were entering the long-distance market, long-distance carriers were entering the local call market, and many companies were seeking to provide


Internet services. Some analysts expressed concerns about WorldCom’s weakness in wireless technologies and the increased competition it faced in the long-distance telephone service market, where competition was driving prices down. On October 5, 1999, WorldCom announced that it had agreed to merge with Sprint in a transaction valued at $129 billion. With this acquisition, WorldCom would get Sprint’s wireless business and address some of the concerns expressed about its competitive posture in the telecommunications market. The market initially reacted enthusiastically to the announcement, but as time passed WorldCom’s share price fell dramatically. On May 18, 2000, attorneys in the Antitrust Division of the United States Department of Justice formally recommended to their division chief that the merger be blocked. On July 13, WorldCom announced that it was terminating its merger agreement with Sprint. By the end of August 2000, WorldCom’s stock was trading in the low $30s. On September 5, 2000, WorldCom announced that it had entered into a $6 billion merger agreement with Intermedia. Intermedia had a local exchange carrier business and owned a web hosting business, Digex. WorldCom hoped to sell the local carrier business and to take advantage of the Digex Internet business. With the acquisition of Intermedia, WorldCom assumed massive debt obligations. WorldCom paid approximately $250 million a quarter to fund Intermedia’s business and approximately $300 million a year to support Digex’s capital expenditure needs. WorldCom was unable to find a buyer for the Intermedia local carrier business. On November 1, 2000, WorldCom announced that its revenues for 2001 would not be as high as previously estimated. WorldCom indicated it was issuing “new financial guidance due to continuing competitive pressures in the telecommunications *639 industry, increased spending to support the Company’s growth initiatives and other economic factors.”

Ebbers’ Dependence on WorldCom Stock Ebbers’ personal finances were dependent on the rise and fall of WorldCom’s stock price. The majority of his wealth was concentrated in his holdings of WorldCom stock. He pledged essentially all of his WorldCom stock to secure loans that he used to acquire other businesses and to fund their operations. Most of his personal debt was held by affiliates of Citibank and Bank of America. As described above, WorldCom’s stock price fell during 2000. By the Fall of 2000, Ebbers began receiving substantial margin calls from Bank of America’s private bank. Because Ebbers had already pledged all of his holdings to secure his personal debt, he was unable to pledge any additional stock. On September 6, WorldCom agreed to extend Ebbers a $50 million loan to cover the margin calls. Within a few weeks, Ebbers faced additional margin calls. When WorldCom refused a request for an additional loan, Ebbers entered into a forward sale of three million WorldCom shares to raise $70 million. The sale was reported by the media on October 4, and WorldCom’s stock price dropped nearly 8%, to $24.93. In early October 2000, Citibank issued margin calls to Ebbers. Its affiliate SSB had a


significant investment banking relationship with WorldCom, and SSB agreed to guarantee payment of Ebbers’ personal debt to Citibank.7 On October 27, WorldCom agreed to loan Ebbers an additional $25 million and to guarantee an additional $75 million of Ebbers’ debt to Bank of America, staving off additional margin calls. In mid-November, the guarantee was increased to $100 million. By the end of 2000, WorldCom had extended a total of $200 million in loans and guarantees to Ebbers. The loans increased to over $250 million by May 2001. On April 11, 2001, Ebbers met with the private banking arm of J.P. Morgan and requested a loan of $40 million to refinance $20 million of his debt to Bank of America relating to his investment in a yacht building business, and to invest another $20 million in building additional yachts. The investment bankers encouraged their bank to accommodate Ebbers, and in June, J.P. Morgan gave Ebbers a personal line of credit of $20 million. An April 26 memorandum analyzing Ebbers’ personal financial situation noted that “Ebbers has used his wealth in WCOM to fund his investments,” principally in a yacht building business, timber, motels, a trucking company and the largest working ranch in North America. The memorandum continued,

Unusual for a CEO of this type, he has virtually no other marketable securities.... To finance these private investments, Ebbers has accumulated substantial margin loans against his WCOM shares. Last fall, when the share price of WCOM declined substantially, his *640 largest lender, Bank of America, issued some well-publicized margin calls. In order to forestall a sale of the Chairman’s shares and risk further downward pressure on the share price[,] WCOM stepped in and replaced Bank of America as lender on $75 million and provided an additional guaranty on the remaining $186 million loans outstanding.... While Bank of America seems comfortable for the moment, the current margin structure of his debt and the illiquid nature of his other assets provides little room for movement in the WCOM share price.

(Emphasis supplied.) The memorandum added that Ebbers had a “highly leveraged balance sheet with $315 million in debt structured as margin loans against his [WorldCom] shares. 80% leverage against WCOM shares.”

WorldCom’s Accounting Strategies WorldCom’s single largest operating expense was its line costs. This item accounted for roughly half of its expenses and was so material that it was reported as a separate line item on its financial statements. WorldCom’s ratio of line cost expense to its revenue was called the E/R ratio, was used as a measurement of its performance, and was also publicly reported in its SEC filings. The lower the ratio, the better the performance. The parties dispute the extent to which WorldCom’s financial statements were intentionally and materially false before the first quarter of 2001. They do not dispute, however, that


senior management in WorldCom manipulated the public reports of WorldCom’s line costs beginning in the first quarter of 2001 through shifting a portion of them to capital expenditures accounts, and that this manipulation was criminal.8 The manipulation reduced the reported line costs and resulted in a lower E/R ratio. Before capitalizing the line costs in 2001, WorldCom had engaged in other strategies to reduce the apparent magnitude of its line costs. One example will suffice. During 2000, WorldCom released reserves or accruals that had been set aside to cover anticipated costs, and used them to offset line costs. These reserves had been maintained to cover additional bills that WorldCom had estimated it might receive from outside service providers.9 By releasing these reserves, line costs appeared smaller. Prior to 2000, WorldCom had a 24-month billing reserve for invoices it had not yet received. This reserve covered its estimated exposure for a rolling 24-month period. In the first quarter of 2000, WorldCom management decided to reduce the period of time covered by the reserve from 24 to twelve months. WorldCom divided the impact from this change in policy between the first and second quarters of *641 2000: $59 million was released in the first quarter; $77 million was released in the second quarter. In the last quarter of 2000, WorldCom reduced the period from twelve months to 90 days and released $70 million in reserves in that quarter. Unable to reduce reserves further, and still wishing to conceal the magnitude of WorldCom’s expenses and artificially inflate WorldCom’s reported income, senior management of WorldCom started in 2001 to capitalize WorldCom’s line costs. They would review WorldCom’s financial results toward the end of each quarter in order to decide how much of the line cost expenses to capitalize. The capitalization of line costs was unsupported by any contemporaneous analysis or records, and was a violation of GAAP. It is undisputed that it constituted fraud. The capitalization fraud began on Friday, April 20, 2001, when Troy Normand, WorldCom’s Director of Legal Entity Reporting in General Accounting, directed that line costs be reduced by $771 million by booking that amount of line costs in an entry labeled “prepaid capacity.” Between that day and Tuesday, April 24, WorldCom personnel allocated the line costs expenses to WorldCom’s two tracker stocks10 and other business units. This manipulation was necessary to make the E/R ratio for the first quarter of 2001 “fairly consistent” with the E/R ratio for the prior quarter. Andersen was unaware of the manipulation of line costs through this capitalization scheme. On April 26, WorldCom issued a Form 8-K.11 That Form 8-K falsely represented WorldCom’s financial condition. The Lead Plaintiff contends that two WorldCom documents from March and April 2001, if reviewed, would have revealed the discrepancy between WorldCom’s actual financial condition and its public reports.12 A March 20, 2001 document, which is labeled “2001 Line Cost Budget/Final Pass/Corporate Financial Planning,” reveals that WorldCom internally projected line costs to be materially higher than what it was reporting for line costs in 2001. The document projects line costs for the first quarter at $4.65 billion. On April 26, 2001, it publicly reported in its Form 8-K first quarter line costs of only $4.1 billion, or half a billion


dollars less. The 2001 Line Cost Budget document also showed that WorldCom expected an E/R ratio of 47.6% for 2001, based on $19.2 billion of line costs on $40.3 billion of revenue. WorldCom had reported an E/R ratio of 39.6% in 2000. The document attributes the difference to several factors, including the fact that WorldCom could no longer release line cost reserves.13 The *642 document cryptically lists dollar values as “tasks” and computes the effect of the “task” on WorldCom’s E/R ratio. For instance, a “Task of $100M improves E/R to 40.7%.” Overall, the document reflects a “proposed 2001 task” in the amount of $471 million. WorldCom’s Capital Expenditure Report, prepared on a monthly and quarterly basis by its Financial Planning Department, described its capital expenditures. The March 2001 Capital Expenditure Report was distributed on April 20, 2001. It reported that WorldCom’s capital expenditures (excluding software) were $1.691 billion for the first quarter. On April 26, however, WorldCom’s Form 8-K publicly reported that the first quarter capital expenditures were $544 million more or $2.235 billion.14 The significance of the Capital Expenditure Report was self-evident. On May 1, 2002, after the March 2002 report was distributed, one co-conspirator e-mailed a colleague: “Where do I sign my confession?” Another complained, “Why did you distribute this report? I thought we were never again distributing this.... No need to reply but do not distribute again.” The improper capitalization of line costs continued through the first quarter of 2002. WorldCom’s internal audit department had completed its last audit of WorldCom’s capital expenditures in approximately January of 2002, and had not uncovered any evidence of fraud. In May of 2002, it began another audit of the company’s capital expenditures. The fraudulent capitalization of line cases was uncovered as a result of a May 21 meeting between the company’s internal auditors and the WorldCom director in charge of tracking capital expenditures. During that meeting the director used the term “prepaid capacity” to explain the difference between two sets of schedules that he was being shown. The auditors were unfamiliar with the term. After asking questions of several people about “prepaid capacity,” Eugene Morse, a member of WorldCom’s internal audit group, used a new software tool to investigate WorldCom’s books and was able to uncover the transfer of line costs to capital accounts in a matter of hours.15 On June 17, David Myers, WorldCom’s former controller, admitted to the internal audit team that there was “no support” for the prepaid capacity entries and that there was “no standard” supporting the entries. He explained that the “entries had been booked based on what they thought the margins should be.” Myers told the team, “if we couldn’t get the costs down that we might as well shut the doors of the business, that we can’t continue.” On June 20, during a meeting in which Sullivan was confronted with the fraud, Myers told internal audit that the capitalization of line costs had started in the first quarter of 2001. As of that time, the internal audit *643 team thought that the capitalization of line costs had begun in the second quarter of 2001, and was no longer trying to find out how far back the entries went.


Andersen and the 1999 Form 10-K16 Andersen had been the auditor for WorldCom or its predecessors for almost twenty years. It issued an unqualified or “clean” opinion for the WorldCom annual financial statements for 1997 through 200017 After the public disclosure of the accounting fraud, Andersen withdrew its support for the WorldCom 2001 Form 10-K, but it never withdrew its audit opinions for the 1999 or 2000 Form 10-Ks. The WorldCom 1999 Form 10-K, for the year ending December 31, 1999, was dated March 30, 2000. It included detailed discussions of a number of the items that are central to the parties’ motions for summary judgment. Its description of the business of WorldCom included the following: “MCI WorldCom leverages its facilities-based networks to focus on data and the Internet. MCI WorldCom provides the building blocks or foundation for the new e-economy.... MCI WorldCom provides the broadest range of Internet and traditional, private networking services available from any provider.” The 10-K described nine mergers since 1995. In describing the merger agreement with Sprint, it defined its strategy as an effort

to further develop as a fully integrated telecommunications company positioned to take advantage of growth opportunities in global telecommunications. Consistent with this strategy, the Company believes that transactions such as the MCI Merger, the CompuServe Merger, the AOL Transaction, the SkyTel Merger and, if consummated, the Sprint Merger, enhance the combined entity’s opportunities for future growth, create a stronger competitor in the changing telecommunications industry and allow provision of end-to-end bundled services over global networks, which will provide new or enhanced capabilities for the Company’s residential and business customers. In particular, the Company believes that if consummated, the Sprint Merger will enable the combined company to: (i) offer a unique broadband access alternative to both cable and traditional telephony providers in the United States through a combination of digital subscriber line (“DSL”) facilities and fixed wireless access using the combined company’s “wireless cable” spectrum; (ii) continue to lead the industry with innovative service offerings for consumer and business customers; and (iii) continue as an effective competitor in the wireless market in the United States.

In a section labeled “transmission facilities,” the 1999 Form 10-K explains that it owns long-distance, international and multi-city local service fiber optic networks with access to additional fiber optic networks through lease agreements with other carriers. It also owns and leases trans-oceanic cable capacity. WorldCom uses what it calls “ring topology.” The network backbones for this system are installed in conduits owned by WorldCom or leased from third parties. The lease arrangements *644 “are generally executed under multi-year terms with renewal options and are non-exclusive.” To serve its customers in buildings that are not located directly on the fiber network described in the Form 10-K, WorldCom leases lines from local exchange carriers and others. The 1999 Form 10-K described WorldCom’s ability to generate profits as depending in part


“upon its ability to optimize the different types of transmission facilities used to provide communications services.” While the Company’s own networks were “typically” the most effective transmission routes, “a variety of lease agreements for fixed and variable cost (usage sensitive) services” ensured “diversity and quality of service.” The “rapid and significant” changes in technology were also discussed. In describing rates and charges, the Form 10-K explained that its rates “are generally designed to be competitive.” It reported that to date, “continued improvement in the domestic and international cost structures” had allowed the Company to maintain “acceptable margins.” The topics of competition and regulation were discussed at length. WorldCom represented that it expected that competition, which was already extreme, would “intensify in the future.” After discussing different business competitors, the 1999 Form 10-K reported that “WorldCom may also be subject to additional competition due to the development of new technologies and increased availability of domestic and international transmission capacity.” It noted that the desirability of its fiber optic network could be adversely affected by changing technology, and that it could not predict which of many future product options would be important. It noted that the Telecommunications Act of 1996 had removed barriers to competition. Once the Bell operating companies were allowed to offer long-distance services, they would be in a position “to offer single source local and long-distance service similar to that being offered” by WorldCom. It predicted that the increased competition would result in increased pricing and margin pressures. As for its data communications services, including Internet access, that was also extremely competitive. “The success of MCI WorldCom will depend heavily upon its ability to provide high quality data communications services, including Internet connectivity and value-added Internet services at competitive prices.” In its lengthy description of the regulatory environment, the 1999 Form 10-K noted that access charges are a principal WorldCom expense. WorldCom was attempting to bring access charges down to cost-based levels. Voice revenues for 1999 were described as having increased by 6% over the prior year because of a 10% gain in traffic. “These volume and revenue gains were offset partially by anticipated year-over-year declines in carrier wholesale traffic as well as federally mandated access charge reductions that were passed through to the consumer.” Line costs “as a percentage of revenues” for 1999 were reported to be 43% as compared to 47% for 1998. “Overall decreases are attributable to changes in the product mix and synergies and economies of scale resulting from network efficiencies achieved from the continued assimilation of MCI,” and other companies into the Company’s operations.

Additionally, access charge reductions that occurred in January 1999 and July 1999 reduced total line cost expense by approximately $363 million for 1999. While access charge reductions were primarily passed through to customers, line costs as a percentage of revenues *645 were positively affected by over half a percentage point for 1999.


The report explained that the “principal components of line costs are access charges and transport charges.” It added that WorldCom’s “goal is to manage transport costs through effective utilization of its network, favorable contracts with carriers and network efficiencies made possible as a result of expansion of the Company’s customer base by acquisitions and internal growth.” WorldCom’s total debt was reported to be $18.1 billion. It had available liquidity of $8.7 billion under its credit facilities and commercial paper program and from cash. Its aggregate credit facilities were $10.75 billion. WorldCom represented that the development of its business “will continue to require significant capital expenditures.” Failure to have access to sufficient funds for capital expenditures on acceptable terms or other difficulties in managing capital expenditures “could have a material adverse effect on the success” of WorldCom. Andersen consented to the inclusion of its March 24, 2000 audit report in the Form 10-K. In that report, Andersen represented that it had audited WorldCom’s balance sheets, and statements of operations, shareholders’ investment and cash flows. It reported that

[w]e conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit ... provide[s] a reasonable basis for our opinion.

In our opinion, based on our audit ..., the financial statements referred to above present fairly, in all material respects, the financial position of MCI WorldCom, Inc. and subsidiaries as of December 31, 1999 ..., in conformity with accounting principles generally accepted in the United States.

2000 Offering On May 24, 2000, WorldCom conducted a public offering of debt securities by issuing approximately $5 billion worth of bonds (“2000 Offering”). It filed a registration statement dated April 12, 2000, and prospectus supplement dated May 19, 2000 (collectively “2000 Registration Statement”) that incorporated by reference among other things the WorldCom Form 10-K for the year ending December 31, 1999, and its Form 10-Q18 for the quarter ended March 31, 2000. SSB was the book runner and, with J.P. Morgan, was the co-lead manager.19 The April 12, 2000 Registration Statement20 began with a warning that


*646 [w]e have not authorized anyone to give any information or to make any representations concerning the offering of the debt securities except that which is in this prospectus or in the prospectus supplement.... You should rely only on the information contained in or incorporated by reference into this prospectus. The document then explained that it was part of a registration statement that was filed with the SEC using a “ ‘shelf’ registration process.”

Under this process, we may sell any combination of the debt securities described in this prospectus in one or more offerings up to a total dollar amount of $15,000,000,000. This prospectus provides you with a general description of the securities we may offer. Each time we sell securities, we will provide a prospectus supplement that will contain specific information about the terms of that offering. The prospectus supplement may also add, update or change information contained in this prospectus.

In describing recent developments, the 2000 Registration Statement focused exclusively on the merger agreement with Sprint. It warned that consummation of the merger was subject to various conditions, including regulatory approval. In describing how the proceeds would be used from the sale of debt securities, it represented that the proceeds would be used “for general corporate purposes. These may include, but are not limited to, the repayment of indebtedness, acquisitions, additions to working capital, and capital expenditures.” The 2000 Registration Statement included a section labeled “experts.” It explained that the year-end WorldCom consolidated financial statements

have been audited by Arthur Andersen LLP, independent public accountants, as indicated in their report with respect thereto, and are included in the MCI WorldCom’s Annual Report on Form 10-K for the year ended December 31, 1999, and are incorporated herein by reference, in reliance upon the authority of such firm as experts in accounting and auditing in giving such reports.

Among the “undertakings” contained in the 2000 Registration Statement was the obligation to file during the period in which sales were being made, a post-effective amendment to “reflect in the prospectus any facts or event arising after the effective date of this registration statement (or the most recent post-effective amendment hereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in this registration statement.” The May 19, 2000 Prospectus Supplement explained that the net proceeds from the $5 billion offering would be used to “repay commercial paper, which was issued for general corporate purposes.” It announced that following that repayment, WorldCom expected “to incur additional indebtedness....” The document briefly explained WorldCom’s business. The bulk of the document addressed the proposed Sprint merger, described Sprint, and presented an


unaudited pro forma condensed combined financial statement for the merged entity. It warned that “the merger is subject to the receipt of consents and approvals from various government entities, which may jeopardize or delay completion of the merger or reduce the anticipated benefits of the merger.” The document also included the following explanation of the relationship between the Underwriter Defendants and WorldCom:

The underwriters and their affiliates have performed certain investment banking and advisory and general financing *647 and banking services for us from time to time for which they have received customary fees and expenses. The underwriters and their affiliates may, from time to time, be customers of, engage in transactions with and perform services for us in the ordinary course of their business. Salomon Smith Barney Inc. has acted as financial advisor to WorldCom in connection with the Sprint merger, for which it has received certain fees and for which it expects to receive additional fees upon the closing of the Sprint merger. In addition, Salomon Smith Barney will receive a financial advisory fee in connection with this offering.

Each of the Underwriter Defendants involved in the 2000 Offering has stated that it relied on the due diligence performed by SSB. Many of the Underwriter Defendants had underwritten prior WorldCom offerings or had other dealings with WorldCom prior to the 2000 Offering. For example, J.P. Morgan was involved in an offering of WorldCom securities in 1998 and participated in syndicating credit extended to WorldCom that same year. Bank of America had a web of relationships with WorldCom and considered itself the “leading capital provider” to WorldCom since 1990. Among other things, it participated in the securitization of WorldCom’s accounts receivable and a private placement for WorldCom in the 1990s, participated in an April 1998 bond offering by WorldCom, and was a lead manager of the WorldCom acquisition of MCI in 1998. The prospectus supplement for the 2000 Offering did not include a section labeled “risk factors.” Several weeks earlier, on April 30, an investment banker at SSB sent a draft prospectus supplement to a more senior SSB banker with a detailed list of risk factors included in it. Under the heading “Risk Factors,” the draft itemized risk factors relating to the Sprint merger, WorldCom’s business, and competition in the telecommunications industry, among other things.21 At the request of WorldCom, the risk factors section was removed.22 The only written record of due diligence performed by the Underwriter Defendants for the 2000 Offering is a May 26 memorandum prepared by Cravath, Swaine & Moore (“Cravath”), counsel to the Underwriter Defendants. The memorandum reflects due diligence conducted from May 15 to 23.23 It describes a May 17 telephone conversation in which Sullivan was asked questions about the Sprint merger, whether WorldCom had experienced problems *648 integrating either SkyTel or MCI, and whether there were any other material issues.24 In that conversation, Sullivan predicted overall growth for the year 2000 would be about 14%, represented that the proceeds for the 2000 Offering would be used to repay “commercial


debt,” reported that WorldCom was experiencing a very competitive environment but that there were no changes in that environment since 1999, and stated that there were no other material issues than the ones he described in the call. The memorandum then outlines the board minutes for WorldCom, lists its public filings, refers to its press releases, and discusses Sprint documents. J.P. Morgan’s 1998 Overview of the Debt Underwriting Process was still in effect in 2000 and contained the following descriptions of an underwriter’s responsibility.

In our role as an underwriter or distributor of securities, performance by J.P. Morgan entities of an appropriate due diligence investigation of the issuer serves a variety of important purposes. The most obvious key advantage of proper due diligence is protection against unexpected news regarding the issuer or its business having an adverse effect of the pricing and/or placement of the offered securities during the primary distribution and in the immediate aftermarket.

From a legal perspective, under the securities laws of the U.S. and several other jurisdictions, due diligence creates an affirmative defense to underwriter/distributor liability for misstatements or omissions of material facts in offering documents. In practical terms, this means that if the market value of the offered securities declines weeks, months or years after closing and unhappy investors sue the issuer and the underwriters, on the theory that the underlying reason for such market decline should have been disclosed in the offering document, then J.P. Morgan should be able to avoid an expensive adverse judgment, so long as we can demonstrate that we conducted an appropriate due diligence investigation of the issuer and its business in connection with the offering....

At least as importantly, due diligence reduces the possibility of commercial and reputational losses arising out of such misstatements and provides us with an opportunity to demonstrate to the issuer client our professionalism, our understanding of its business and our commitment to the transaction.

In order to successfully establish a due diligence defense, underwriters and securities distributors may not take at face value representations made to them by the issuer and its representatives, but rather must demonstrate they made a reasonable investigation of the facts to ensure there is no misstatement or omission of a material fact in the offering documents....

Generally such investigation will focus on discussions with and information provided by the issuer and its counsel and accountants, although it may be appropriate, in the case of some issuers and industries, to include meetings with outsiders, such as consultants with industry expertise, major suppliers or dominant customers.

(Emphasis supplied.) Andersen created an undated worksheet in connection with WorldCom’s first quarter *649 2000 unaudited financial statement. The worksheet was an eleven-page Andersen form entitled “U.S. GAAS Review of Interim Financial Statements of a Public Company,” and was a vital step in preparing a “comfort letter” for a company and underwriters. The form


reflects tasks to be performed, with boxes to indicate whether the task had been “done” or was “N/A.” Most of the tasks had one of those two boxes checked, some had both boxes checked, and one task-reading the financial statements and disclosures in the client’s draft Form 10-Q-was left blank. Brief comments were handwritten next to some of the tasks. The form paragraph that appears directly above the engagement partner’s signature, states: “Based on the results of the review procedures, we are not aware of any material modifications that should be made to the interim financial statements for them to be in conformity with generally accepted accounting principles consistently applied.” A “comfort letter” for the first quarter 2000 unaudited financial statement is dated May 19, is eight pages long, and indicates that it is written at the request of WorldCom. In it, Andersen reaffirms its audits, including those incorporated in the 2000 Registration Statement. It warns that having not audited any financial statements for any period subsequent to December 31, 1999, it is unable to express any opinion on the unaudited consolidated balance sheet of WorldCom as of March 31, 2000, or the results of operations or cash flows as of any date subsequent to December 31, 1999. The letter indicates, however, that Andersen had performed the procedures specified by the American Institute of Certified Public Accountants for a review of interim financial information as described in SAS No. 71 on the unaudited condensed consolidated balance sheet as of March 31, 2000, and related statements, and had made certain inquiries of WorldCom officials who have responsibility for financial and accounting matters. Andersen represented that nothing had come to its attention as a result of that work that caused Andersen to believe that “[a]ny material modifications should be made to the unaudited condensed consolidated financial statements [for the first quarter of 2000], incorporated by reference in the Registration Statement, for them to be in conformity with generally accepted accounting principles” or that “[t]he unaudited condensed consolidated financial statements ... do not comply as to form in all material respects with the applicable accounting requirements of the Act and the related published rules and regulations.” The letter concludes that it is offered to “assist the underwriters in conducting and documenting their investigation” of the affairs of WorldCom in connection with the offering of securities covered by the 2000 Registration Statement. A two page May 23 Andersen letter reaffirmed the May 19 letter.

Late 2000 Investment’ Banking Transactions As already described, in November 2000, WorldCom announced that it would be creating two tracking stocks. J.P. Morgan and SSB were involved in this project. On December 14, 2000, WorldCom conducted a $2 billion private placement of debt. J.P. Morgan was the lead manager and sole book runner for that private placement.

The Underwriter Defendants’ Credit Assessment of WorldCom as of Early 2001 In February 2001, several of the Underwriter Defendants downgraded WorldCom’s credit rating due to their assessment of WorldCom’s deteriorating financial condition. Then, during the weeks that followed, several of the Underwriter Defendants made a commitment *650 to


WorldCom to help it restructure its massive credit facility. In doing so, there is evidence that at least some of the Underwriter Defendants internally expressed concern again about WorldCom’s financial health. WorldCom had required the banks to participate in the restructuring of the credit facility if a bank wished to play a significant role in its next bond offering, the 2001 Offering. That offering turned out to be the largest public debt offering in American history. The Lead Plaintiff contends that the evidence of the Underwriter Defendants’ concerns about WorldCom’s financial condition in the months immediately preceding the 2001 Offering undercuts their contention that the due diligence that they performed in connection with the 2001 Offering was reasonable. As noted, several of the Underwriter Defendants downgraded WorldCom as a credit risk in February 2001. At the same time, one of the major credit rating agencies publicly announced that it was downgrading long-term WorldCom debt. On February 22, Bank of America downgraded WorldCom’s credit rating from 3 to 4, citing its lack of revenue growth, margin deterioration, the likelihood that WorldCom revenue from its long-distance business would continue to decline, the increasing competitive landscape, WorldCom’s increasing debt load, and concerns regarding its strategic direction following the failure of the merger with Sprint. On February 27, a J.P. Morgan document reflects that the bank reduced its internal “senior unsecured” risk rating for WorldCom from A2 to BBB1 because of WorldCom’s “weakened credit profile and continued pressure on its MCI long-distance business segment.”25 The internal report noted that WorldCom’s cash flow had moved from a positive to a “Cash Burn” of negative $137 million. It also emphasized WorldCom’s high ratio of debt. The report observed that “[i]t remains to be seen if WCOM can stabilize cash flows and increase profitability in its MCI segment while supporting the capital requirements for the high growth data business in an increasingly competitive environment.”26 On February 27, Standard & Poor’s (“S & P”) also downgraded WorldCom’s credit rating, albeit just its ratings on WorldCom’s long-term debt instruments. Those were downgraded from a rating of A- to BBB+. S & P simultaneously removed WorldCom from its previously imposed “creditwatch.” S & P did not revise its ratings for WorldCom’s short-term debt. S & P explained that the downgrade reflected WorldCom’s “heightened business risk profile” because of competitive challenges and pricing pressures in the voice and data markets. It observed that the risk was “somewhat offset by the company’s financial flexibility and experienced management.” It described the outlook for WorldCom as “stable.” In late February, Deutsche Bank downgraded WorldCom as part of a global credit review because of price declines in the long-distance market and WorldCom’s need to generate cash. The credit review listed WorldCom’s credit status as “[p]erformance concerns” and the bank’s credit strategy and risk appetite as “[r]isk appetite reduced.” *651 Within weeks of these decisions to downgrade WorldCom’s credit rating, the Underwriter Defendants had to consider whether to participate in WorldCom’s restructuring of its credit facility, which was a line of credit extended to WorldCom by several of the


banks, and whether to compete for investment banking positions in the bond offering that WorldCom hoped to undertake that Spring. WorldCom had a $10.25 billion credit facility with affiliates of some of the banks and it wanted to restructure that facility in a $8 to 10 billion transaction. WorldCom informed banks that they could only participate as an underwriter on the 2001 Offering if they agreed to participate in the restructuring. WorldCom also let banks know that the greater a bank’s commitment to the credit facility, the greater the role it could have in the offering. With a commitment of at least $800 million to the new credit facility, a bank was promised a role as “joint book running manager” in the offering.27 Bank of America calculated that if it were successful in becoming a joint book running manager, it could earn 20 to 25% of an expected investment banking fee of $10 to 12.5 million. There is evidence that several of the Underwriter Defendants28 decided to make a commitment to the restructuring of the credit facility and to attempt to win the right to underwrite the 2001 Offering, while at the same time reducing their own exposure to risk from holding WorldCom debt by engaging in hedging strategies, such as credit default swaps.29 For example, as early as March 23, J.P. Morgan identified one of its three key objectives in connection with the restructuring of the credit facility and its participation in the 2001 Offering as: “to minimize exposure after $800MM initial commitment....” The memorandum recommended developing a strategy that would give up some participation in the 2001 Offering in return for reducing the bank’s exposure under the credit facility down to $600 million. It concluded, “Lets [sic] make this a true team effort: first class execution for the client, attractive economics for JPM and the minimum credit exposure.” (Emphasis supplied.) Within less than a month, J.P. Morgan wanted to reduce its exposure to $500 million. By May 22, through a carefully managed entry into the market, J.P. Morgan had entered a $150 million credit default swap, out of a goal of $200 million, to reduce its exposure in the event of a default by WorldCom. J.P. Morgan personnel structured its activities so that neither WorldCom nor any of J.P. Morgan’s investment banking rivals would learn what it was doing. A May 16 e-mail captured the problem with these words: “if WCOM gets any sense that we’re laying off exposure DURING the syndication process (and wouldn’t SSB love to pass that along), it would not be good news. Understandably” this point is “Jennifer’s *652 greatest and principal concern.” (Emphasis in original.) Jennifer Nason was the bank’s due diligence team leader for the 2001 Offering. Bank of America was in a particularly precarious position. It had been the sole lead arranger and sole book manager for a $10.75 billion senior credit facility for WorldCom in August 2000. It was one of five arrangers for a $2 billion WorldCom trade receivable securitization program. As of March 2001, it had an exposure of approximately $1.5 billion to WorldCom. This exposure was concentrated in a syndicated credit facility of about $600 million, an accounts receivable securitization of $306 million, and a commitment of $175 million to Intermedia. Bank of America sought to make a commitment of $800 million to the restructured credit facility and yet reduce its overall exposure to WorldCom to no more than $500 million through credit default swaps and other devices, again, without telling WorldCom.30 Those within Bank of America, who were recommending that the bank participate in the restructuring of the credit facility in order to be eligible to play a lead investment banking role in the 2001 Offering, argued in a March 28 memorandum that it was


likely that WorldCom would never need to draw on its credit facility-in their words: “No funding anticipated.”

2000 Form 10-K The April 26, 2001 WorldCom Form 10-K for the year ending 2000 explained that, if approved by WorldCom’s shareholders, the company would create two separately traded tracking stocks to correspond to “the distinct customer bases” served by its businesses. It advised shareholders that if they did not approve the creation of the two stocks, the company would still realign its businesses into the two distinct service entities. With respect to long-distance services, the document reported that revenue fell in 2000 in absolute terms and as a percentage of total WorldCom revenues. In its description of operations, line costs were shown as a decreasing percentage of revenues for each year from 1998 to 2000, beginning with 45.3% in 1998, and ending at 39.6% in 2000. The Form 10-K explained that the improvement was a result of increased data and dedicated Internet traffic.

2001 Offering Through the 2001 Offering WorldCom issued $11.9 billion worth of notes. The May 9, 2001 registration statement and May 14, 2001 prospectus supplement (collectively, “2001 Registration Statement”) for the 2001 Offering incorporated WorldCom’s 2000 10-K and first quarter 2001 Form 8-K dated April 26, 2001. J.P. Morgan and SSB served as co-book runners. Each of the Underwriter Defendants for the 2001 Offering have stated that they relied on the due diligence performed by SSB and J.P. Morgan. Cravath again represented the Underwriter Defendants. A May 16, 2001 memorandum prepared by Cravath describes the due diligence *653 conducted from April 1931 through May 16, 2001 in connection with the 2001 Offering.32 On April 23, the Underwriter Defendants forwarded due diligence questions to WorldCom. The due diligence for the 2001 Offering included telephone calls with WorldCom on April 30 and May 9, and a May 9 telephone call with Andersen and WorldCom. The due diligence inquiry also included a review of WorldCom’s board minutes, 1998 revolving credit agreement, SEC filings, and press releases from April 19 to May 16, 2001. During the April 30 telephone call, two bankers from J.P. Morgan and SSB, and two attorneys from Cravath spoke with Sullivan. Sullivan explained that WorldCom intended to use half of the proceeds from the 2001 Offering “to repay the balance of its outstanding commercial paper, to retire debt and to fund a portion of the Company’s negative free cash flow.” When asked whether WorldCom had significant reserves for bad receivables, Sullivan responded that WorldCom had a general $1.1 billion reserve. Sullivan indicated that WorldCom was comfortable with the current earnings per share, that there were no issues that could affect the company’s credit rating, and that the company had nothing material to disclose that had not been discussed with the investment bankers. When asked about the


competitive environment, Sullivan answered that

the general economic slowdown has not had a material impact on the Company’s business, however the telecommunication environment has affected the Company. In particular, he was surprised that receivables declined in the first quarter. Despite this, the Company is selling through the rough parts of the telecommunications slowdown and the number of new installations is still strong.

On May 9, Sullivan confirmed that there were no material changes since the April 30 telephone call. On May 9, a banker from J.P. Morgan and two Cravath attorneys spoke by telephone with Sullivan and Stephanie Scott of WorldCom and with representatives of Andersen. Andersen indicated that it had not issued any management letters to WorldCom and that there were no accounting concerns. WorldCom and Andersen assured J.P. Morgan that there was nothing else material to discuss. In neither the April 30 due diligence telephone call nor the May 9 call did Sullivan disclose the $771 million capitalization of line costs. On May 9 and 16, Andersen issued comfort letters for the WorldCom first quarter 2001 financial statement. The 2001 comfort letters stand in contrast to the 2000 comfort letter, which expressed that nothing had come to Andersen’s attention to cause it to believe that “[a]ny material modifications should be made to the unaudited condensed consolidated financial statements described in 4(a)(1), incorporated by reference in the Registration Statement, for them to be in conformity with generally accepted accounting principles” or that “[t]he unaudited condensed consolidated financial statements ... do not comply as to form in all material respects with the applicable accounting requirements of the Act and the related published rules and regulations.” In 2001, by comparison, the letters indicated that nothing had come to Andersen’s attention that caused it to *654 believe that the financial statements “were not determined on a basis substantially consistent with that of the corresponding amounts in the audited consolidated balance sheets of WorldCom as of December 31, 2000 and 1999, and the consolidated statements of operations, shareholders’ investment and cash flows for each of the three years in the period ended December 31, 2000....” A J.P. Morgan banker and a Cravath attorney noticed the absence of the “negative GAAP assurance” in the 2001 comfort letter. An SSB banker noted that the issue was important to understand but advised against getting “too vocal” about it since “WorldCom’s a bear to deal with on that subject.” Some of the investment bankers responsible for performing due diligence in connection with the 2001 Offering were aware of their own bank’s credit concerns regarding WorldCom, and some were not. For instance, the lead investment banker for J.P. Morgan testified that she was unaware of her bank’s memorandum downgrading WorldCom’s risk rating. Two investment bankers at Deustche Bank testified that they were aware that their bank had downgraded WorldCom’s credit rating. One testified that he believed that the downgrading was “too early”; the other testified that the downgrading was not inconsistent with the information that was in the public domain.33


The 2001 Offering was preceded by a road show in America and Europe in which WorldCom, J.P. Morgan, and SSB made presentations to convince potential investors to purchase the bonds. A script for that presentation begins with the following statement:

Welcome to WorldCom’s Multi-billion Global Debt Offering Roadshow presentation.... On behalf of J.P. Morgan and SSB as joint bookrunners, our joint lead managers, and co-managers, we are excited about the WorldCom credit story and this debt offering.... We value WorldCom’s senior debt at low single A with a stable credit trend.... WorldCom’s financial position gives it the strongest credit profile of any of the largest broadband providers.

Later in the script, there were representations about WorldCom’s revenue in 2000 and a representation that the peak in the company’s capital expenditures was behind it. The script included a comparison of 1999 and 2000 credit ratios for WorldCom. This comparison suggested an improving trend in revenues and in the “EBITDA34 coverage ratio” from 1999 to 2000. The comparison of 1999 and 2000 credit ratios appears in the script despite an April 24 comment by a J.P. Morgan analyst that those credit ratios were “misleading” because WorldCom’s “financial profile will be more leveraged in 2001.” She suggested substituting long term target ratios. The May 9 Prospectus for the 2001 Offering explained that it was part of a registration statement filed with the SEC using a “ ‘shelf’ registration process” that permitted it to sell any combination of debt securities in one or more offerings up to a total remaining dollar amount of just under $12 billion. It warned that the investor “should rely only on the information *655 incorporated by reference or provided in this prospectus and any supplement. We have not authorized anyone else to provide you with different information.” It described the use of proceeds as “for general corporate purposes,” which may include “repayment of indebtedness, acquisitions, additions to working capital, and capital expenditures.” The remainder of the prospectus described the debt securities that would be offered. At the end of the document, it advised that WorldCom’s year-end financial statements for each of the years in the three-year period ending December 31, 2000 had been audited by Andersen, and were incorporated by reference “in reliance upon the authority of such firm as experts in accounting and auditing in giving such reports.” The Prospectus Supplement contained information about WorldCom, including selected financial information. Under a section labeled “recent developments,” it announced that the WorldCom group revenue increased over the same period in 2000, but that the MCI group’s revenues had declined. It described the use of proceeds as “for general corporate purposes, including to repay commercial paper, which was issued for general corporate purposes.”35 After describing the underwriters’ commitments to buy portions of the 2001 Offering, the 2001 Registration Statement advised that

the underwriters and their affiliates have performed certain investment banking, advisory and general financing and banking services for us from time to time for which they have received customary fees and expenses.


The underwriters and their affiliates may, from time to time, be customers of, engage in transactions with and perform services for us in the ordinary course of their business. Certain of the underwriters and their affiliates have in the past and may in the future act as lenders in connection with our credit facilities.

Discussion

Summary judgment may not be granted unless the submissions of the parties taken together “show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law.” Rule 56(c), Fed.R.Civ.P. The moving party bears the burden of demonstrating the absence of a material factual question, and as such, “always bears the initial responsibility of ... identifying those portions of the ‘pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any,’ which it believes demonstrates the absence of a genuine issue of material fact.” Celotex Corp. v. Catrett, 477 U.S. 317, 323, 106 S.Ct. 2548, 91 L.Ed.2d 265 (1986) (quoting Fed.R.Civ.P. 56(c)); accord Koch v. Town of Brattleboro, 287 F.3d 162, 165 (2d Cir.2002). In making this determination the court must view all facts in the light most favorable to the non-moving party. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247, 106 S.Ct. 2505, 91 L.Ed.2d 202 (1986); Celotex, 477 U.S. at 323, 106 S.Ct. 2548. “A dispute regarding a material fact is genuine if the evidence is such that a reasonable jury could return a verdict for the nonmoving party.” Mount Vernon Fire Ins. Co. v. Belize NY, Inc., 277 F.3d 232, 236 (2d Cir.2002). When the moving party has asserted facts showing that it is entitled to summary *656 judgment, the opposing party must “set forth specific facts showing that there is a genuine issue for trial,” and cannot rest on the “mere allegations or denials” of the movant’s pleadings. Rule 56(e), Fed.R.Civ.P.; accord Burt Rigid Box, Inc. v. Travelers Prop. Cas. Corp., 302 F.3d 83, 91 (2d Cir.2002). While evidence as a whole must be assessed to determine whether there is a trial-worthy issue, Bickerstaff v. Vassar Coll., 196 F.3d 435, 448 (2d Cir.1999), conclusory statements are insufficient to defeat a motion for summary judgment. Opals on Ice Lingerie v. Body Lines, 320 F.3d 362, 370 n. 3 (2d Cir.2003). Throughout its consideration of a motion for summary judgment, a court “may rely only on admissible evidence.” Ehrens v. Lutheran Church, 385 F.3d 232, 235 (2d Cir.2004). Thus, in determining whether to grant summary judgment, this Court must (1) determine whether a genuine factual dispute exists based on the admissible evidence in the record; and (2) determine, based on the substantive law at issue, whether the fact in dispute is material.

I. Legal Framework The “primary innovation” of the Securities Act was the creation of duties in connection with public offerings, principally “registration and disclosure obligations.” Gustafson v. Alloyd Co., 513 U.S. 561, 571, 115 S.Ct. 1061, 131 L.Ed.2d 1 (1995). The Securities Act “was


designed to provide investors with full disclosure of material information concerning public offerings of securities in commerce, to protect investors against fraud and, through the imposition of specified civil liabilities, to promote ethical standards of honesty and fair dealing.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976). The purpose of the Act was to “eliminate serious abuses in a largely unregulated securities market.” United Hous., Found., Inc. v. Forman, 421 U.S. 837, 849, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975). Liability under Section 11 of the Securities Act flows from the requirements for filing a registration statement. Liability under Section 12(a)(2) flows from the requirement to distribute prospectuses.

A. Section 11 [1] Section 11 of the Securities Act provides that any signer, director of the issuer, preparing or certifying accountant, or underwriter may be liable if “any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading.” 15 U.S.C. § 77k(a).36 Purchasers of securities issued *657 pursuant to a registration statement may sue if they purchased at the time of the initial public offering, or if they are “aftermarket purchasers who can trace their shares to an allegedly misleading registration statement.” DeMaria v. Andersen, 318 F.3d 170, 178 (2d Cir.2003). A registration statement “means a filing that includes the prospectus and other information required by section 7 of the Securities Act.” 12 C.F.R. § 16.2(m). A prospectus is defined as “an offering document that includes the information required by section 10(a) of the Securities Act.” 12 C.F.R. § 16.2(l). Section 7(a) of the Securities Act provides that registration statements must be accompanied by the information and documents specified in Schedule A of the Act, which sets forth thirty-two items that must be included in a registration statement. 15 U.S.C. §§ 77g(a), 77aa. Section 7(a) also authorizes the SEC to enact “rules or regulations” so that “disclosure fully adequate for the protection of investors is otherwise required to be included within the registration statement.” 15 U.S.C. § 77g(a). Pursuant to Section 7(a), the SEC issued Regulations S-X, 17 C.F.R. § 210 et seq., and S-K, 17 C.F.R. § 229 et seq. Regulation S-X governs the form and content of financial statements required to be included in a registration statement. Regulation S-K dictates the non-financial information that must be included in a registration statement.37 In a catch-all provision, the SBC regulations also provide that “[i]n addition to the information expressly required to be included in a registration statement, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading.” 17 C.F.R. § 230.408 (emphasis supplied). See DeMaria, 318 F.3d at 180. [2] [3] Section 11 of the Securities Act “was designed to assure compliance with the disclosure provisions of the Act by imposing a stringent standard of liability on the parties who play a direct role in a registered offering.” Herman & MacLean v. Huddleston, 459 U.S. 375, 381-82, 103 S.Ct. 683, 74 L.Ed.2d 548 (1983). This design reflects Congress’ sense that


underwriters, issuers, and accountants bear a “moral responsibility to the public [that] is particularly heavy.” Gustafson, 513 U.S. at 581, 115 S.Ct. 1061, 131 L.Ed.2d 1 (1995) (quoting H.R.Rep. No. 85, 73d Cong., 1st Sess., at 5 (1933)). As a result, such parties will be found to have violated Section 11 whenever “material facts have been omitted or presented in such a way as to obscure or distort their significance.” I. Meyer Pincus & Assoc. v. Oppenheimer & Co., 936 F.2d 759, 761 (2d Cir.1991) (citation omitted). [4] [5] In determining whether a registration statement is materially misleading, the “central inquiry” is “whether defendants’ representations, taken together and in context, would have misled a reasonable *658 investor about the nature of the investment.” I. Meyer Pincus, 936 F.2d at 761 (citation omitted).38 A material fact is one that “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” DeMaria, 318 F.3d at 180 (citation omitted). See also Ganino v. Citizens Util. Co., 228 F.3d 154, 162 (2d Cir.2000). Material facts may “include not only information disclosing the earnings and distributions of a company but also those facts which affect the probable future of the company and those which may affect the desire of investors to buy, sell, or hold the company’s securities.” Kronfeld v. Trans World Airlines, Inc., 832 F.2d 726, 732 (2d Cir.1987) (citation omitted). An omitted fact may be immaterial if it is “trivial,” or “so basic that any investor could be expected to know it.” Ganino, 228 F.3d at 162 (citation omitted). In a similar vein, a misrepresentation may be immaterial as a matter of law where “adequate cautionary language [is] set out in the same offering.” Rombach, 355 F.3d at 173 (citation omitted). Materiality remains, however, “a mixed question of law and fact.” Ganino, 228 F.3d at 162. Since materiality is necessarily a “fact-specific inquiry,” Basic. Inc. v. Levinson, 485 U.S. 224, 240, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988), courts within the Second Circuit have “consistently rejected a formulaic approach to assessing the materiality” of misrepresentations. Ganino, 228 F.3d at 162. [6] Because of the fact-intensive inquiry that accompanies any analysis of materiality, a registration statement or prospectus must be read “as a whole.” DeMaria, 318 F.3d at 180 (citation omitted). See also Rombach, 355 F.3d at 172 n. 7; Olkey v. Hyperion 1999 Term Trust, Inc., 98 F.3d 2, 5 (2d Cir.1996). “The touchstone of the inquiry is not whether isolated statements within a document were true, but whether defendants’ representations or omissions, considered together and in context, would affect the total mix of information and thereby mislead a reasonable investor regarding the nature of the securities offered.” Halperin v. eBanker Usa.com, Inc., 295 F.3d 352, 357 (2d Cir.2002). Or, as the Second Circuit has explained even more recently, the inquiry must focus not on whether “particular statements, taken separately, were literally true, but whether defendants’ representations, taken together and in context, would have misled a reasonable investor about the nature of the securities.” DeMaria, 318 F.3d at 180 (citation omitted). A prospectus violates Section 11 “if it does not disclose material objective factual matters, or buries those matters beneath other information, or treats them cavalierly.” Id. (citation omitted). Section 11 provides two affirmative defenses. First, the statute provides an affirmative defense where a defendant can prove that the loss in value of a security is due to something


other than misleading statements within a registration statement. Specifically, Section 11(e) provides:

[I]f the defendant proves that any portion or all of such damages represents other than the depreciation in value of such security resulting from such part of the registration statement, with respect to which his liability is asserted, not being true or omitting to state a material fact required to be stated therein or *659 necessary to make the statements therein not misleading, such portion of or all such damages shall not be recoverable.

15 U.S.C. § 77k(e). A defendant’s burden in establishing this defense is heavy since “the risk of uncertainty” is allocated to defendants. Akerman v. Oryx Comm., Inc., 810 F.2d 336, 341 (2d Cir.1987); see also McMahan & Co. v. Wherehouse Entm’t, Inc., 65 F.3d 1044, 1048-49 (2d Cir.1995). [7] In addition, Section 11 provides an affirmative defense of “due diligence,” which is available to defendants other than the issuer of the security. See Huddleston, 459 U.S. at 382, 103 S.Ct. 683; Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F.2d 341, 370-71 (2d Cir.1973). The standard that applies to this defense varies depending on whether the misleading statement in the registration statement is or expressly relies on an expert’s opinion. The due diligence defense is discussed further below.

B. Section 12 Section 12(a)(2) of the Securities Act (formerly Section 12(2)) allows a purchaser of a security to bring a private action against a seller that “offers or sells a security ... by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements ... not misleading.” 15 U.S.C. § 77l(a)(2). The section entitles the buyer

to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.

Id.; Commercial Union Assurance Co. v. Milken, 17 F.3d 608, 615 (2d Cir.1994); see also Randall v. Loftsgaarden, 478 U.S. 647, 655, 106 S.Ct. 3143, 92 L.Ed.2d 525 (1986) (“§ 12(2) prescribes the remedy of rescission except where the plaintiff no longer owns the security.”). [8] Section 12 turns on status, not scienter: It imposes liability without requiring “proof of either fraud or reliance.” Gustafson, 513 U.S. at 582, 115 S.Ct. 1061; see also Rombach, 355 F.3d at 164. A plaintiff need only show “some causal connection between the alleged communication and the sale, even if not decisive.” Metromedia Co. v. Fugazy, 983 F.2d 350, 361 (2d Cir.1992) (citation omitted). “Reliance by the buyer need not be shown, for § 12(2) is a broad anti-fraud measure and imposes liability whether or not the purchaser actually


relied on the misstatement.” Id. (citation omitted). [9] [10] Defendants may be liable under Section 12(a)(2) either for selling a security or for soliciting its purchase. First, Section 12 creates a cause of action against sellers who “passed title, or other interest in the security, to the buyer for value.” Pinter v. Dahl, 486 U.S. 622, 642, 108 S.Ct. 2063, 100 L.Ed.2d 658 (1988); see also Wilson v. Saintine Exploration & Drilling Corp., 872 F.2d 1124, 1126 (2d Cir.1989) (applying Pinter’ s § 12(1) analysis to what is now § 12(a)(2)); Capri v. Murphy, 856 F.2d 473, 478 (2d Cir.1988) (same). To be liable as a seller, the defendant must be the “buyer’s immediate seller; remote purchasers are precluded from bringing actions against remote sellers. Thus, a buyer cannot recover against his seller’s seller.” Pinter, 486 U.S. at 644 n. 21, 108 S.Ct. 2063. As underwriters in a firm commitment underwriting become the owners of any unsold shares, they may be liable as sellers for direct sales to the public. In re WorldCom, Inc. Sec. Litig., 219 F.R.D. at 283. *660 [11] Second, persons who are not in privity with the plaintiff may be liable if they “successfully solicit[ed] the purchase, motivated at least in part by a desire to serve [their] own financial interests or those of the securities owner.” Pinter, 486 U.S. at 647, 108 S.Ct. 2063; see also Commercial Union Assurance Co., 17 F.3d at 616. In finding that Section 12 included liability for solicitation, the Supreme Court observed that “[t]he solicitation of a buyer is perhaps the most critical stage of the selling transaction .... [and] the stage at which an investor is most likely to be injured.” Pinter, 486 U.S. at 646, 108 S.Ct. 2063. [12] Section 12(a)(2) provides affirmative defenses that parallel those available for a Section 11 claim. First, the statute prohibits recovery to the extent that

the person who offered or sold such security proves that any portion or all of the amount recoverable ... represents other than the depreciation in value of the subject security resulting from such resulting from such part of the prospectus or oral communications, with respect to which liability of that person is asserted....

15 U.S.C. § 77l(b). In addition, Section 12(a)(2) provides an affirmative defense of reasonable care. See Royal Am. Managers, Inc. v. IRC Holding Corp., 885 F.2d 1011, 1019 (2d Cir.1989).

II. Lead Plaintiff’s Motion for Partial Summary Judgment Lead Plaintiff moves for partial summary judgment on the issue of whether certain statements regarding WorldCom’s financial condition in its financial statements, that were incorporated into the 2000 and 2001 Registration Statements, were false. With respect to the 2000 Registration Statement, the Lead Plaintiff’s motion is addressed to the reporting of line costs and depreciation and amortization. With respect to the 2001 Registration Statement, the Lead Plaintiff’s motion is addressed to the reporting of line costs, capital expenditures, and assets and goodwill. The Underwriter Defendants concede that the reporting of line costs and capital expenditures


for the first quarter of 2001 was false. They resist summary judgment regarding the falsity of any other line of financial reporting with respect to the 2000 and 2001 Registration Statements. They assert that Andersen’s professional judgment regarding certain items has not been shown to be unreasonable. For example, they argue that Andersen used reasonable judgment in deciding that MCI’s workforce and customer base should be included in goodwill. They also assert that there are disputed issues of fact regarding the materiality of certain of the alleged false statements. For example, they argue that only those statements that are relevant to cash flow would be material to bondholders since bondholders are entitled to be paid principal and interest regardless of the price movements in a company’s stock. The Underwriter Defendants argue in addition that the Lead Plaintiff’s motion does not address their affirmative defense of due diligence and their entitlement to rely on Andersen’s audits and comfort letters. They argue that they are entitled to further discovery of Lead Plaintiff’s experts and of ten “embargoed” witnesses,39 the latter of whom they contend will agree *661 that no amount of due diligence would have uncovered the accounting fraud.40 Since there is no material issue of fact in dispute regarding the falsity of WorldCom’s first quarter financial statement for 2001 insofar as it reported WorldCom’s line costs, or the materiality of that false statement to investors purchasing notes in the 2001 Offering, the Lead Plaintiff is entitled to summary judgment on the issue of whether the Registration Statement for the 2001 Offering was false and misleading. The Lead Plaintiff’s motion for summary judgment on the 2000 Offering, and on any other purported false statement made in connection with the 2001 Offering is denied.

III. The Underwriter Defendants’ Motion for Summary Judgment; The Financial Statements The Underwriter Defendants move for summary judgment with respect to the financial statements that were incorporated into the Registration Statements. They assert that there is no dispute that they acted reasonably in relying on Andersen’s audits and comfort letters. The Underwriter Defendants contend that they were entitled to rely on WorldCom’s audited financial statements and had no duty to investigate their reliability so long as they had “no reasonable ground to believe” that such financial statements contained a false statement. They also assert that they were entitled to rely in the same way on Andersen’s comfort letters for the unaudited quarterly financial statements incorporated into the Registration Statements. Before analyzing the Underwriter Defendants’ arguments, it will be helpful to describe the legal and regulatory framework surrounding the “due diligence defenses,” which are in turn composed of a reliance defense and a due diligence defense. Following a brief description of the role of the underwriters, the Opinion will discuss the due diligence defenses under Sections 11 and 12(a)(2); the role of accountants as experts; the enactment in the 1980s of integrated disclosure, shelf registration, and SEC Rule 176, as well as their impact on underwriters’ due diligence obligations; the reliance defense as described in case law and the impact on that defense of the existence of red flags; and the case law regarding the due diligence defense. With that background, the specific argument presented by the Underwriter


Defendants will be addressed.

*662 A. Role of the Underwriter An underwriter is commonly understood to be a “person who buys securities directly or indirectly from the issuer and resells them to the public, or performs some act (or acts) that facilitates the issuer’s distribution.” In re WorldCom, Inc. Sec. Litig., 308 F.Supp.2d 338, 343 (S.D.N.Y.2004) (citation omitted). As the SEC has observed, in enacting Section 11, “Congress recognized that underwriters occupied a unique position that enabled them to discover and compel disclosure of essential facts about the offering. Congress believed that subjecting underwriters to the liability provisions would provide the necessary incentive to ensure their careful investigation of the offering.” The Regulation of Securities Offerings, SEC Release No. 7606A, 63 Fed.Reg. 67174, 67230, available at 1998 WL 833389 (Dec. 4, 1998) (“SEC Rel. 7606A”). At the same time, Congress specifically rejected the notion of underwriters as insurers. H.R. Conf. Rep. No. 73-152, at 277 (1933); SEC Rel. 7606A, 63 Fed.Reg. at 67230. Rather, it imposed upon underwriters the obligation to “exercise diligence of a type commensurate with the confidence, both as to integrity and competence,” placed in them by those purchasing securities. H.R. Conf. Rep. No. 73-152, at 277. [13] Underwriters must “exercise a high degree of care in investigation and independent verification of the company’s representations.” Feit v. Leasco Data Processing Equip. Corp., 332 F.Supp. 544, 582 (E.D.N.Y.1971). Overall, “[n]o greater reliance in our self-regulatory system is placed on any single participant in the issuance of securities than upon the underwriter.” Chris-Craft, 480 F.2d at 370. Underwriters function as “the first line of defense” with respect to material misrepresentations and omissions in registration statements. 2 Gary M. Lawrence, Due Diligence in Business Transactions § 2.03A (2004) (“Lawrence, Due Diligence” ). As a consequence, courts must be “particularly scrupulous in examining the[ir] conduct.” Feit, 332 F.Supp. at 581; see also In re Enron Corp. Sec., Derivative & ERISA Litig., 235 F.Supp.2d 549, 612-13 (S.D.Tex.2002).

B. The “Due Diligence” Defenses The phrase “due diligence” does not appear in the Securities Act, but two of the affirmative defenses available under Section 11(b) are collectively known as the “due diligence” defense. See Lawrence, Due Diligence § 2.03A. The first such defense provides that “as regards any part of the registration statement not purporting to be made on the authority of an expert,” a defendant will not be liable upon a showing that

he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading.

15 U.S.C. § 77k(b)(3)(A) (emphasis supplied). This defense is understood as “a negligence standard.” Hochfelder, 425 U.S. at 208, 96 S.Ct. 1375. The SEC has described the duty of an underwriter to conduct a reasonable investigation as follows:


By associating himself with a proposed offering [an underwriter] impliedly represents that he has made such an investigation in accordance with professional standards. Investors properly rely on this added protection which has a direct bearing on their appraisal of the reliability of the representations in the prospectus. The underwriter who does not *663 make a reasonable investigation is derelict in his responsibilities to deal fairly with the investigating public.

41 SEC 398 [1961-1964 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 76,904, 1963 WL 63647 (Feb. 27, 1963). There is a different standard that applies when a Section 11 defendant is entitled to rely upon the opinion of an expert. “[A]s regards any part of the registration statement purporting to be made on the authority of an expert,” a defendant other than that expert will not be liable if he demonstrates that

he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became effective, that the statements therein were untrue or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading.

15 U.S.C. § 77k(b)(3)(C) (emphasis supplied).41 Although the requirements of due diligence vary depending on whether the registration statement has been made in part or in whole on the authority of an expert, the standard for determining what constitutes a reasonable investigation and reasonable ground for belief is the same: “[T]he standard of reasonableness shall be that required of a prudent man in the management of his own property.” 15 U.S.C. § 77k(c). Courts have distinguished between these two standards by labeling them the due diligence defense and the reliance defense, referring in the latter case to the reliance permitted by the statute on an expert’s statement. See, e.g., Kaplan v. Rose, 49 F.3d 1363, 1371 (9th Cir.1994); In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1421 (9th Cir.1994); Ackerman v. Schwartz, 947 F.2d 841, 845 (7th Cir.1991); Feit, 332 F.Supp. at 576. Section 12(a)(2) has a defense of reasonable care that is less demanding than the duty of due diligence imposed under Section 11. Section 12(a)(2) provides that a defendant shall not be liable if he “sustain[s] the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission” which is “necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading.” 15 U.S.C. § 77l(a)(2). Thus, while Section 11 imposes a duty to conduct a reasonable investigation as to any portion of a registration statement not made on the authority of an expert, Section 12(a)(2) does not make any distinction based upon “expertised” statements and only requires the defendant to show that it used reasonable care. This difference is attributable to the emphasis placed on the importance of registration statements and the underwriter’s vital role in assuring their accuracy. See John Nuveen & Co. v. Sanders, 450 U.S. 1005, 1009, 101 S.Ct. 1719, 68


L.Ed.2d 210 (1981) (Powell, J., dissenting from denial of cert.). Because Section 11 imposes a more exacting standard, *664 this Opinion principally addresses the law that applies to Section 11.

C. Accountants as Experts [14] Although Section 11(b) furnishes different standards, depending on whether a statement is made on the authority of an expert, the statute does not define the term “expert.” Section 11(a)(4) lists professions that give a person authority to make a statement, which on consent can be included in a registration statement. 15 U.S.C. § 77k(a)(4). The list of professions includes an accountant. Id. Thus, while Section 11(b) does not define the term expert or explain what sort of documents and/or work constitutes that “made on an expert’s authority,” it is settled that an accountant qualifies as an expert, and audited financial statements are considered expertised portions of a registration statement. See, e.g., In re Software Toolworks Inc. Sec. Litig., 50 F.3d 615, 623 (9th Cir.1994); Enron, 235 F.Supp.2d at 613; SEC Rel. 7606A, 63 Fed.Reg. at 67233. [15] Not every auditor’s opinion, however, qualifies as an expert’s opinion for purposes of the Section 11 reliance defense. To distinguish among auditor’s opinions, some background is in order. While financial statements42 are prepared by the management of a company, an accountant serving as the company’s auditor may give an opinion as to whether the financial statements have been presented in conformity with GAAP. This opinion is given after the accountant has performed an audit of the company’s books and records. Audits are generally completed once a year, in connection with a company’s year-end financial statements. There are ten audit standards with which an auditor must comply in performing its annual audit. They are known as Generally Accepted Auditing Standards (“GAAS”). If an auditor signs a consent to have its opinion on financial statements incorporated into a company’s public filings, the opinion may be shared with the public through incorporation. Public companies are also required under the Exchange Act to file quarterly financial statements, which are referred to as interim financial statements. While not subject to an audit, interim financial statements included in Form 10-Q quarterly reports are reviewed by an independent public accountant using professional standards and procedures for conducting such reviews, as established by GAAS. The standards for the review of interim financial statements are set forth in Statement of Auditing Standards No. 71, Interim Financial Information (“SAS 71”). When a public company files a registration statement for a sale of securities, the auditor is customarily asked by underwriters to provide a comfort letter. The comfort letter will contain representations about the auditor’s review of the interim financial statements. Guidance about the content of comfort letters is contained in the Statement on Auditing Standards No. 72, Letters for Underwriters and Certain Other Requesting Parties (“SAS 72”). There is frequently more than one comfort letter for a transaction: an initial comfort letter, and a second or “bringdown” comfort letter issued closer to the time of closing. In order for an accountant’s opinion to qualify as an expert opinion under Section 11(b)(3)(C), there are three prerequisites. First, it must be reported in the Registration


Statement. Second, it must be an audit opinion. Finally, the accountant *665 must consent to inclusion of the audit opinion in the registration statement. In an effort to encourage auditor reviews of interim financial statements, the SEC acted in 1979 to assure auditors that their review of unaudited interim financial information would not subject them to liability under Section 11. See Accountant Liability for Reports on Unaudited Interim Financial Information, SEC Release No. 6173, 1979 WL 169953, at *1 (Dec. 28, 1979) (“SEC Rel. 6173”). The SEC addressed the circumstances in which an accountant’s opinion can be considered an expert’s opinion for purposes of Section 11(b) and made it clear that reviews of unaudited interim financial statements do not constitute such an opinion. Under Rule 436, where the opinion of an expert is quoted or summarized in a registration statement, or where any information contained in a registration statement “has been reviewed or passed upon” by an expert, the written consent of the expert must be filed as an exhibit to the registration statement. 17 C.F.R. § 230.436(a), (b). Yet written consent is not sufficient to convert an opinion or review into an expertised statement. Rule 436 provides that notwithstanding written consent, “a report on unaudited interim financial information ... by an independent accountant who has conducted a review of such interim financial information shall not be considered a part of a registration statement prepared or certified by an accountant or a report prepared or certified by an accountant within the meaning of sections 7 and 11” of the Securities Act. 17 C.F.R. § 230.436(c) (emphasis supplied). Rule 436 also defined the term “report on unaudited interim financial information.” It consists of a report that contains the following five items:

(1) A statement that the review of interim financial information was made in accordance with established professional standards for such reviews;

(2) An identification of the interim financial information reviewed;

(3) A description of the procedures for a review of interim financial information;

(4) A statement that a review of interim financial information is substantially less in scope than an examination in accordance with generally accepted auditing standards, the objective of which is an expression of opinion regarding the financial statements taken as a whole, and, accordingly, no such opinion is expressed; and

(5) A statement about whether the accountant is aware of any material modifications that should be made to the accompanying financial information so that it conforms with generally accepted accounting principles.

17 C.F.R. § 230.436(d).43 In promulgating Rule 436, the SEC contrasted accountants’ review of year-end financial statements with those of interim financial data, remarking that

The objective of a review of interim financial information differs significantly from the objective of an examination of financial statements in accordance with generally accepted auditing standards. The objective of an audit is to provide a reasonable basis for expressing an opinion regarding the financial *666 statements taken as a whole. A review


of interim financial information does not provide a basis for the expression of such an opinion, because the review does not contemplate a study and evaluation of internal accounting control; tests of accounting records and of responses to inquiries by obtaining corroborating evidential matter through inspection, observation, or confirmation; and certain other procedures ordinarily performed during an audit. A review may bring to the accountant’s attention significant matters affecting the interim financial information, but it does not provide assurance that the accountant will become aware of all significant matters that would be disclosed in an audit.

Accountant Liability for Reports on Unaudited Interim Financial Information Under Securities Act of 1933, SEC Release No. 6127, 1979 WL 170299 (Sept. 20, 1979), at *3 (citation omitted) (“SEC Rel. 6127”) (emphasis supplied). Rule 436 underscores that SAS 71 reports and SAS 72 letters are not expertised statements within the meaning of the Section 11 reliance defense. Specifically, in finalizing Rule 436, the SEC directed that

[i]n any suit for damages under Section 11(a), the directors and underwriters should not be able to rely on SAS No. [71] reports on interim financial data included in a registration statement as statements “purporting to be made on the authority of an expert ... which they had no ground to believe ... were untrue ...” under Section 11(b)(3)(C). Rather, underwriters and directors should be required, as has previously been the case whenever unaudited financials are included in a registration statement, to demonstrate affirmatively under Section 11(b)(3)(A) that, after conducting a reasonable investigation, they had reasonable ground to believe, and did believe, that the interim financial data was true.44

SEC Rel. 6173, 1979 WL 169953, at *4 (emphasis supplied). Given this, the SEC expects that “underwriters will continue to exercise due diligence in a vigorous manner with respect to SAS No. [71] reports.” Id. at *4. [16] In sum, underwriters can rely on an accountant’s audit opinion incorporated into a registration statement in presenting a defense under Section 11(b)(3)(C). Underwriters may not rely on an accountant’s comfort letters for interim financial statements in presenting such a defense. Comfort letters do not “expertise any portion of the registration statement that is otherwise non-expertised.” William F. Alderman, Potential Liabilities in Initial Public Offerings, in How To Prepare an Initial Public Offering 2004 405-06 (2004); see also Committee on Federal Regulation of Securities, Report of Task Force on Sellers’ Due Diligence and Similar Defenses Under the Federal Securities Laws, 48 Bus. Law. 1185, 1210 (1993) (“Task Force Report” ) (underwriters “remain responsible” for unaudited interim financial information as in the case of other non-expertised information).

D. Integrated Disclosure, Shelf Registration, and Rule 176 Beginning in the late 1960s, the SEC embarked on a “program to integrate the *667 disclosure requirements of the Securities Act and the Securities Exchange Act of 1934.” See Circumstances Affecting the Determination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief Under Section 11 of the Securities Act, SEC Release No.


6335, 1981 WL 31062, at *1 (Aug. 6, 1981) (“SEC Rel. 6335”). The chief purpose of the integrated disclosure system was to furnish investors with “meaningful, nonduplicative information both periodically and when securities distributions are made to the public,” while decreasing “costs of compliance for public companies.” Reproposal of Comprehensive Revision to System for Registration of Securities Offerings, SEC Release No. 6331, 1981 WL 30765, at *2 (Aug. 6, 1981) (“SEC Rel. 6331”). Although earlier steps toward integration had been taken, the SEC aimed in the early 1980s to integrate the two acts, “primarily by incorporating by reference Exchange Act reports into Securities Act registration statements.” SEC Rel. 6335, 1981 WL 31062, at *3. The push to incorporate by reference was motivated by the growing recognition that “for companies in the top tier, there is a steady stream of high quality corporate information continually furnished to the market and broadly digested, synthesized and disseminated.” Shelf Registration, SEC Release No. 6499, 1983 WL 408321, at *2 (Nov. 17, 1983) (“SEC Rel. 6499”). The SEC reasoned that top-tier companies should be able to incorporate their Exchange Act filing by reference, since these disclosures, along with “other communications by the registrant, such as press releases, ha [ve] already been disseminated and accounted for by the market place.” SEC Rel. 6331, 1981 WL 30765, at *4. Those eligible include issuers who, among other things, either have substantial equity “floats” or rated debt securities. Incorporation by reference was implemented by introducing a new, shortened registration form-Form S-3-for use by “companies which are widely followed by professional analysts.” Id. In a Form S-3 registration, the registrant’s Form 10-K from the most recently concluded fiscal year and all subsequent periodic Exchange Act filings between the end of that fiscal year and the termination of the offering are required to be incorporated by reference. Given the reduced length of the form, the process of filing a Form S-3 is known as short-form registration. Short-form registration was accompanied by related changes in shelf registration, the process by which securities are registered to be offered or sold on a delayed or continuous basis. The purpose of shelf registration is to allow a single registration statement to be filed for a series of offerings. SEC Rel. 6499, 1983 WL 408321, at *4. Shelf registration aims to afford the issuer the “procedural flexibility” to vary “the structure and terms of securities on short notice” and “time its offering to avail itself of the most advantageous market conditions.” Id. More concretely, shelf registration enables

an issuer that wishes to sell some or all of the registered securities at any point during the two year period to contact the several managing underwriters named in the registration statement, determine which underwriter will give it the best terms, and offer the security to the market through that underwriter in a matter of hours.

Merritt B. Fox, Shelf Registration, Integrated Disclosure, and Underwriter Due Diligence: An Economic Analysis, 70 Va. L.Rev. 1005, 1005 n. 4 (1984). Although shelf registration had been available prior to the introduction of integrated disclosure, integrated disclosure mandated a reexamination of which securities *668 could be offered on a continuous or delayed basis. Under Rule 415, which was finalized in 1983, all


registrants eligible to use Form S-3 may engage in shelf registration “in an amount ... reasonably expected to be offered and sold within two years from the initial effective date of the registration.”45 17 C.F.R. §§ 230.415(a)(1)(x), (a)(2). As amended in 1992, Rule 415 allows registration of shelf offerings without requiring registrants to allocate the total amount to specific classes of securities. As a result, issuers can “decide as late as the point of sale which of its securities to use.” SEC Rel. 7606A, 63 Fed.Reg. at 67179. Together, the mechanism of incorporation by reference and the expansion of shelf registration significantly reduced the time and expense necessary to prepare public offerings, thus enabling more “rapid access to today’s capital markets.” SEC Rel. 6335, 1981 WL 31062, at *4. As the SEC recognized, these changes affected the time in which underwriters could perform their investigations of an issuer. Underwriters had weeks to perform due diligence for traditional registration statements. By contrast, under a short-form registration regime, “[p]reparation time is reduced sharply” thanks to the ability to incorporate by reference prior disclosures. Id. at *5. These two innovations triggered concern among underwriters. Members of the financial community worried about their ability “to undertake a reasonable investigation with respect to the adequacy of the information incorporated by reference from periodic reports filed under the Exchange Act into the short form registration statements utilized in an integrated disclosure system.” Id. at *1. Specifically, underwriters expressed concern that

this reduction in preparation time, together with competitive pressures, will restrict the ability of responsible underwriters to conduct what would be deemed to be a reasonable investigation, pursuant to Section 11, of the contents of the registration statement.... [I]ssuers may be reluctant to wait for responsible underwriters to finish their inquiry, and may be receptive to offers from underwriters willing to do less.

Id. at *5. Because an underwriter could select among competing underwriters when offering securities through a shelf registration, some questioned whether an underwriter could “afford to devote the time and expense necessary to conduct a due diligence review before knowing whether it will handle an offering and that there may not be sufficient time to do so once it is selected.” SEC Rel. 6499, 1983 WL 408321, at *5. Others doubted whether they would have the chance “to apply their independent scrutiny and judgment to documents prepared by registrants many months before an offering.” Id. *669 Because of concerns like those described here, the SEC introduced Rule 176 in 1981 “to make explicit what circumstances may bear upon the determination of what constitutes a reasonable investigation and reasonable ground for belief as these terms are used in Section 11(b).” SEC Rel. 6335, 1981 WL 31062, at *1. Rather than give underwriters a “safe harbor from liability for statements made in incorporated Exchange Act reports,”46 id. at *7, as some suggested should happen, the SEC turned to the American Law Institute’s proposed Federal Securities Code for guidance. Rule 176, which largely mirrors Section 1704(g) of the Code, provides in relevant part:


In determining whether or not the conduct of a person constitutes a reasonable investigation or a reasonable ground for belief meeting the standard set forth in section 11(c), relevant circumstances include, with respect to a person other than the issuer. [sic]

(a) The type of issuer;

(b) The type of security;

(c) The type of person;

....

(f) Reasonable reliance on officers, employees, and others whose duties should have given them knowledge of the particular facts (in the light of the functions and responsibilities of the particular person with respect to the issuer and the filing);

(g) When the person is an underwriter, the type of underwriting arrangement, the role of the particular person as an underwriter and the availability of information with respect to the registrant; and

(h) Whether, with respect to a fact or document incorporated by reference, the particular person had any responsibility for the fact or document at the time of the filing from which it was incorporated.

17 C.F.R. § 230.176. Although “[n]o court has ever been called upon to interpret Rule 176,” the SEC’s own commentary on the rule makes clear that Rule 176 did not alter the fundamental nature of underwriters’ due diligence obligations. Langevoort, 63 Law & Contemp. Probs. at 65; Task Force Report, 48 Bus. Law. at 1210. At the time Rule 176 was finalized, the SEC took care to explain that integrated disclosure was intended to “simplify disclosure and reduce unnecessary repetition and redelivery of information,” not to “modify the responsibility of underwriters and others to make a reasonable investigation.” SEC Rel. 6335, 1981 WL 31062, at *10. Instead, emphasizing that “nothing in the Commission’s integrated disclosure system precludes conducting adequate due diligence,” the SEC advised underwriters concerned about the time pressures created by integrated disclosure to “arrange [their] due diligence procedures over time for the purpose of avoiding last minute delays in an offering environment characterized by rapid market changes.” Id. It also reminded them that an underwriter is “never compelled to proceed with an offering until he has accomplished his due diligence.” Id. (emphasis supplied). And the SEC warned underwriters that the verification “required by the case law and contemplated by the statute” would still be required in appropriate circumstances. *670 Id. at *10-11. As recently as December 1998, the SEC recalled that it “expressly rejected the consideration of competitive timing and pressures when evaluating the reasonableness of an underwriter’s investigation.” 63 Fed.Reg. at 67231. The SEC’s intent to maintain high standards for underwriter due diligence is confirmed by its many discussions of appropriate due diligence techniques in the integrated disclosure system. In proposing Rule 176, the SEC acknowledged that different investigatory methods would be needed “in view of the compressed preparation time and the volatile nature of the capital markets.” SEC Rel. 6335, 1981 WL 31062, at *11. Nonetheless, it emphasized that such


techniques must be “equally thorough.” Id. (emphasis supplied). Among the strategies recommended by the SEC were the development of a “reservoir of knowledge about the companies that may select the underwriter to distribute their securities registered on short form registration statements” through a “careful review of [periodic Exchange Act] filings on an ongoing basis,” consultation of analysts’ reports, and active participation in the issuer’s investor relations program, especially analysts and brokers meetings. Id. at *11-12. At the time the SEC finalized the shelf registration rule two years later, it again recognized that “the techniques of conducting due diligence investigations of registrants qualified to use short form registration ... would differ from due diligence investigations under other circumstances.” SEC Rel. 6499, 1983 WL 408321, at *6. Nonetheless, it stressed the use of “anticipatory and continuous due diligence programs” to augment underwriters’ fulfillment of their due diligence obligations. Id. Among other practices, the SEC approvingly noted the increased designation of one law firm to act as underwriters’ counsel, which “facilitates continuous due diligence by ensuring on-going access to the registrant on the underwriters’ behalf”; the holding of “Exchange Act report ‘drafting sessions,’ ” which allow underwriters “to participate in the drafting and review of periodic disclosure documents before they are filed”; and “periodic due diligence sessions,” such as meetings between prospective underwriters, their counsel, and management shortly after the release of quarterly earnings. Id. In 1998, the SEC proposed expanding Rule 176 to “identify six due diligence practices that the Commission believes would enhance an underwriter’s due diligence investigation when conducting an expedited offering.” SEC Rel. 7606A, 63 Fed.Reg. at 67231. Among these six practices were the underwriter’s receipt of a SAS 72 comfort letter. Yet the SEC emphasized that “these practices in no way constitute an exclusive list or serve as a substitute for a court’s analysis of all relevant circumstances.” Id. The 1998 proposal has never been finalized. Even if the proposed changes had been enacted, however, the SEC cautioned that “only a court can make the determination of whether a defendant’s conduct was reasonable under all the circumstances of a particular offering.” SEC Rel. 6335, 1981 WL 31062, at *13. It must be noted that academics and practitioners alike have asserted that the current regime for underwriter liability under Section 11 no longer makes sense. Professor Coffee, for one, has observed that “it is not clear that the underwriter today still performs the classic gatekeeping function.... Many argue that serious due diligence efforts are simply not feasible within the time constraints of shelf registration. Given these constraints, they claim that the solution lies in downsizing *671 the threat under section 11.” John C. Coffee, Jr., Brave New World?: The Impact(s) of the Internet on Modern Securities Regulation, 52 Bus. Law. 1195, 1211 (1997). Another professor has remarked that “there is a strong practical case to be made for absolving underwriters of all inquiry obligations short of recklessness.... As underwriter involvement diminishes in significance relative to the deal as a whole, it becomes that much more problematic to apply a negligence-based standard in the first place.” Langevoort, 63 Law & Contemp. Probs. at 67. A third asserts that in today’s capital markets, “it is reasonable to question whether the underwriter’s ‘due diligence’ role is justified at all.... [F]or shelf registrations, disinterested advance due diligence is the exception not the rule.” Frank Partnoy, Barbarians at the Gatekeepers?: A Proposal for a Modified Strict Liability Regime,


79 Wash. U.L.Q. 491, 522 (2001) (citation omitted) (“Barbarians at the Gatekeepers” ). In a related vein, a Task Force of experienced counsel to underwriters concludes that the “ ‘integrated disclosure system’ and the expansion of shelf registration statements have called into question whether underwriters any longer ‘sponsor’ an issue in a meaningful way, as opposed to delivering advice and distribution services.” Task Force Report, 48 Bus. Law. at 1239. Similarly, the ABA Committee on Federal Regulation on Securities has complained to the SEC that

[t]he benefits of ‘on demand’ financing ... are undermined by continuing to impose on financial intermediaries and other ‘gatekeepers’ the responsibility to take the time necessary to do a sufficient due diligence investigation to assure quality disclosure without recognizing and making allowances for their difficulty or even inability to do so. It is not possible for underwriters and others to meet this standard in the current financing environment.

Letter from ABA Committee on Federal Regulation on Securities, Business Law Section, to David B.H. Martin, Director, Division of Corporation Finance, SEC, Aug. 22, 2001. Thus, academics and practitioners have called for a reexamination of underwriters’ liability under Sections 11 and 12(a)(2) on the grounds that “Congress’s assumptions in 1933 and 1934 about registrants working with individual underwriters in a relatively leisurely atmosphere are at odds with today’s competition by multiple underwriters for high-speed transactions.” Id. Implicit in these calls for a legislative change is the recognition that current law continues to place a burden upon an underwriter to conduct a reasonable investigation of non-expertised statements in a registration statement, including an issuer’s interim financial statements.

E. Case Law: Reliance Defense Over thirty-five years ago, the Honorable Edward C. McLean of this District observed that “there is little or no judicial authority” on how a defendant can successfully establish his affirmative defenses under Section 11. Escott v. BarChris Constr. Corp., 283 F.Supp. 643, 683 (S.D.N.Y.1968). This remains true today. Neither the Supreme Court nor the Second Circuit has explored this area of law in any significant way. Justice Powell, however, reflected on the reliance defense in his dissent from the Court’s denial of certiorari in John Nuveen & Co. v. Sanders, 450 U.S. at 1005, 101 S.Ct. 1719, a case addressed to the requirements of Section 12(a)(2)’s reasonable care defense. According to Justice Powell, Section 11

explicitly absolve[s] [an underwriter] of the duty to investigate with respect to “any part of the registration statement purporting to be made on the authority *672 of an expert” such as a certified accountant if “he had no reasonable ground to believe and did not believe” that the information therein was misleading. This provision is in the Act because, almost by definition, it is reasonable to rely on financial statements certified by public accountants.


Id. at 1010, 101 S.Ct. 1719 (emphasis supplied) (citation omitted). Justice Powell further explained that underwriters’ reliance on certified financial statements is not only reasonable but also, in his view, “essential to the proper functioning of securities marketing, to the trading in securities, to the lending of money by banks and financial institutions, and to the reliance by stockholders on the reports of their corporations.” Id. n. 4, 101 S.Ct. 1719. He observed that “where breaches by accountants occur, it is the accountants themselves-not those who rely in good faith on their professional expertise-who are at fault and who should be held responsible.” Id.; see also Worlds of Wonder, 35 F.3d at 1421, Software Toolworks, 50 F.3d at 623; Griffin v. PaineWebber, Inc., 84 F.Supp.2d 508, 512-13 (S.D.N.Y.2000). [17] Nevertheless, underwriters’ reliance on audited financial statements may not be blind. Rather, where “red flags” regarding the reliability of an audited financial statement emerge, mere reliance on an audit will not be sufficient to ward off liability. The concept of red flags primarily appears in cases arising under Section 10(b) of the Exchange Act. See, e.g., LC Capital Partners, LP v. Frontier Ins. Group, Inc., 318 F.3d 148, 154 (2d Cir.2003); Chill v. Gen. Elec. Co., 101 F.3d 263, 269 (2d Cir.1996); In re Ames Dep’t Stores, Inc. Note Litig., 991 F.2d 968, 981 (2d Cir.1993); Mosesian v. Peat, Marwick, Mitchell & Co., 727 F.2d 873, 877 (9th Cir.1984); In re Philip Servs. Corp. Sec. Litig., No. 98 Civ. 0835(MBM), 2004 WL 1152501, at *9-10 (S.D.N.Y. May 24, 2004); In re Global Crossing, Ltd. Sec. Litig., 322 F.Supp.2d 319, 347 (S.D.N.Y.2004); In re WorldCom Sec. Litig., No. 02 Civ. 3288(DLC), 2003 WL 21488087, at *9 (S.D.N.Y. June 25, 2003); In re Complete Mgmt. Inc. Sec. Litig., 153 F.Supp.2d 314, 334 (S.D.N.Y.2001). In these cases, the phrase “red flags” can be used to describe two different concepts. First, red flags can be those facts which come to a defendant’s attention that would place a reasonable party in defendant’s position “on notice that the audited company was engaged in wrongdoing to the detriment of its investors.” In re Sunterra Corp. Sec. Litig., 199 F.Supp.2d 1308, 1333 (M.D.Fl.2002). In contrast to Section 11 and Section 12(a)(2) claims, which do not require a showing of scienter, in a Section 10(b) case, the plaintiff must sufficiently plead that the defendant acted with “an intent to deceive, manipulate or defraud.” Kalnit v. Eichler, 264 F.3d 131, 138 (2d Cir.2001) (citation omitted). One way of meeting this standard is to allege facts showing that the defendant’s conduct was “highly unreasonable, representing an extreme departure from the standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.” Rothman v. Gregor, 220 F.3d 81, 90 (2d Cir.2000) (citation omitted). Therefore, in an attempt to demonstrate recklessness, plaintiffs in Section 10(b) cases often assert that a defendant ignored “red warning flags” of another actor’s wrongdoing. Chill, 101 F.3d at 269. See also Philip Servs., 2004 WL 1152501, at *9; Complete Mgmt., 153 F.Supp.2d at 334. The phrase “red flags,” or “storm warnings,” may also describe facts or circumstances *673 that “would suggest to an investor of ordinary intelligence the probability that she has been defrauded.” Frontier Ins., 318 F.3d at 154 (citation omitted); see also Ames Dep’t Stores, 991 F.2d at 981, Complete Mgmt., 153 F.Supp.2d at 337. The Second Circuit, for example, has found that a company’s taking three substantial reserve charges over four years should have “alert[ed] any reasonable investor that something is seriously wrong.” Frontier Ins., 318 F.3d


at 155. Where such red flags arise, a duty of inquiry arises and knowledge of the fraud is imputed to the investor with consequences as to whether or not a claim has been filed within the statute of limitations. Id. at 154; see also 15 U.S.C. § 78i(e). While the existence of red flags is principally discussed in the Section 10(b) context, courts have also used this concept to inform their analysis of Section 11 claims. In Software Toolworks, 50 F.3d 615, for example, the plaintiffs asserted that the underwriter defendants were not entitled to “blindly rely” on the audited financial statements in light of “red flags” suggesting that the recognition of revenue for certain sales was improper. Id. at 623. Among other assertions, the plaintiffs alleged that the underwriter defendants’ discovery of a memorandum that revealed the backdating of a sales contract so that Toolworks could recognize revenue in a particular fiscal year constituted a “red flag” that should have deprived the defendants of their reliance defense. Id. at 624. Finding that the underwriters demanded an explanation from the auditor about its accounting, insisted on written confirmations of particular contracts, and confirmed the auditor’s accounting method with other accounting firms, the Ninth Circuit upheld the district court’s holding that the underwriters’ “investigation ... was reasonable” as a matter of law. Id. Nevertheless, it noted that “[i]f the Underwriters had done nothing more” than simply discover the red flag, the plaintiffs’ contention that the underwriter could no longer rely on the audit would be correct. Id. [18] [19] Given the difference between the contexts in which the term “red flag” is used, a particular fact that is deemed to constitute a red flag in a Section 10(b) claim may not be a red flag in a Section 11 inquiry, and vice versa. An example from Mosesian, 727 F.2d 873, may be instructive here. At trial, to support its argument that a Section 10(b) claim was time-barred, the auditor identified seven “red flag” events that it contended should have “alert[ed] a reasonably prudent investor of wrongdoing on [its] part.” Id. at 877. The court rejected the auditor’s argument, finding that a company’s “[f]inancial problems ... do not necessarily suggest accounting fraud.” Id. at 878. The court’s conclusion in Mosesian does not mean, however, that financial problems cannot constitute red flags in Section 11 cases. Rather, as outlined above, in order to be entitled to the reliance defense under Section 11, a defendant must show that he had “no reasonable ground to believe and did not believe” that the statements within the registration statement that were made on an expert’s authority were untrue. 15 U.S.C. 77k(b)(3)(C). Any information that strips a defendant of his confidence in the accuracy of those portions of a registration statement premised on audited financial statements is a red flag, whether or not it relates to accounting fraud or an audit failure. What is at stake under Section 11 is not an auditor’s scienter, but the accuracy and completeness of the statements in the registration statement. It is equally important to note that what constitutes a red flag depends on the facts and context of a particular case. For instance, this Circuit asserted in a recent *674 Section 10(b) case that its determination of whether storm warnings exist would “depend in large part on how significant the company’s disclosed problems are, how likely they are of a recurring nature, and how substantial are the ‘reassuring’ steps announced to avoid their recurrence.” Frontier Ins., 318 F.3d at 155. In a similar vein, “[t]he question of what a reasonably prudent [man] should have known is particularly suited to a jury determination.” Mosesian, 727 F.2d


at 879.

F. Case Law: Due Diligence Defense [20] Just as there is little judicial elaboration of the reliance defense, so too there is “little judicial gloss” on the due diligence defense afforded to underwriters for non-expertised portions of a registration statement. Feit, 332 F.Supp. at 576. See also Glassman v. Computervision Corp., 90 F.3d 617, 628 (1st Cir.1996) (“The law on due diligence is sparse....”); John C. Coffee, Jr., A Statutory and Case Law Primer on Due Diligence Under the Securities Law, 886 P.L.I./Corp 11, 17 (1995) (“Few decisions have wrestled with the concepts in §§ 11(b) and 11(c).”); Joseph McLaughlin, Some Challenges to Underwriters and Their Counsel in the Modern Capital Markets Environment, 28 Wake Forest L.Rev. 61, 67 (1993) (noting “relative paucity of judicial interpretations of the underwriters’ ‘due diligence’ defense”); Partnoy, Barbarians at the Gatekeepers, 79 Wash. U.L.Q. at 514 (2001) (Section 11 due diligence defense has generated “little case law.”). While there is a paucity of caselaw, “two early cases,” Escott v. BarChris Construction Corp., 283 F.Supp. at 643, and Feit v. Leasco Data Processing Equipment Corp., 332 F.Supp. at 544, “remain the major polestars” in defining what constitutes a reasonable investigation. Coffee, 886 P.L.I./Corp. at 17 (citation omitted). Faced with “no judicial decision defining the degree of diligence which underwriters must exercise to establish their defense under Section 11,” in 1968, the BarChris court contemplated whether “it is sufficient [for an underwriter] to ask questions, to obtain answers which, if true, would be thought satisfactory, and to let it go at that, without seeking to ascertain from the records whether the answers in fact are true and complete.” BarChris, 283 F.Supp. at 696. The lead underwriter or its counsel read annual reports and prospectuses of other companies within the industry; perused the issuer’s prior prospectuses, annual reports, and most recent unaudited interim financial statements, as well as its minutes from the previous five years and its major contracts; and attended several meetings with the issuer at which underwriter and underwriters’ counsel asked “pertinent questions and received answers which satisfied them” and in which “extensive, successive proofs of the prospectus were considered and revised.” Id. at 693-95. Rendering his opinion following a bench trial, Judge McLean noted the impossibility of establishing “a rigid rule suitable for every case defining the extent to which such verification must go. It is a question of degree, a matter of judgment in each case.” Id. at 697 (emphasis supplied). Nonetheless, he held the underwriters had not conducted a “reasonable investigation of the truth of those portions of the prospectus which were not made on the authority of [the auditor] as an expert” because they made “almost no attempt to verify management’s representations.” Id. at 697 (emphasis supplied). In determining that an underwriter’s due diligence obligations include efforts to verify information supplied by the issuer, the BarChris court relied heavily on the purpose of Section 11 and underwriters’ role within *675 the statutory scheme. As Judge McLean observed,

The purpose of Section 11 is to protect investors. To that end the underwriters are made responsible for the truth of the prospectus. If they


may escape that responsibility by taking at face value representations made to them by the company’s management, then the inclusion of underwriters among those liable under Section 11 affords the investors no additional protection. To effectuate the statute’s purpose, the phrase “reasonable investigation” must be construed to require more effort on the part of the underwriters than the mere accurate reporting in the prospectus of “data presented” to them by the company. It should make no difference that this data is elicited by questions addressed to the company officers by the underwriters, or that the underwriters at the time believe that the company’s officers are truthful and reliable. In order to make the underwriters’ participation in this enterprise of any value to the investors, the underwriters must make some reasonable attempt to verify the data submitted to them. They may not rely solely on the company’s officers or on the company’s counsel. A prudent man in the management of his own property would not rely on them.

Id.

Three years later, the Honorable Jack B. Weinstein further expounded on the due diligence defense in Feit, 332 F.Supp. at 544. Like the BarChris opinion before it, which refused to set forth a “rigid rule” for reasonable investigation, Feit insists that “[w]hat constitutes ‘reasonable investigation’ and a ‘reasonable ground to believe’ will vary with the degree of involvement of the individual, his expertise, and his access to the pertinent information and data.” Id. at 577. Yet Feit places great emphasis on the underwriters’ role in a securities offering, observing that “the underwriter is the only participant in the registration process who, as to matters not certified by the accountant, is able to make the kind of investigation which will protect the purchasing public.” Id. at 581 (citation omitted). Given the underwriter’s independence from the issuer, Judge Weinstein affirmed that while an underwriter is not “expected to possess the intimate knowledge of corporate affairs of inside directors,” his obligation is to conduct a meaningful investigation, “not merely ... listen[ ] to management’s explanations of the company’s affairs.” Id. at 581-82 (citation omitted). “Tacit reliance on management assertions is unacceptable; the underwriters must play devil’s advocate.” Id. at 582 (citation omitted). Rendering his decision following a bench trial, Judge Weinstein found that the Feit underwriters had “just barely” satisfied this standard by completing a “thorough review of all available financial data,” including an examination of the issuer’s audit, “searching inquiries” of the issuer’s major bank, and a study of the issuer’s corporate minutes, records, and major agreements; attending due diligence meetings at which the proposed registration statement was reviewed “line by line”; reviewing correspondence pertinent to the omission at issue; and remaining in “constant contact” with the issuer. Id. at 582-83. The years following BarChris and Feit have been marked by considerable change in the regulatory framework governing securities registration. Specifically, short-form registration, the expansion of shelf registration, and Rule 176 were each introduced well after these two cases were decided. Recent Section 11 case law, however, shows no signs of abandoning the early courts’ demand that underwriters employ *676 “a high degree of care in investigation


and independent verification of the company’s representations.” Feit, 332 F.Supp. at 582. The most prominent recent discussion of an underwriter’s due diligence obligation appears in Software Toolworks, 50 F.3d at 615. In Software Toolworks, the Ninth Circuit partially affirmed a decision granting summary judgment to the underwriter defendants on the basis of their due diligence defense, specifically, that they had sufficiently investigated the issuer’s business with Nintendo. In conducting that investigation, the underwriters obtained written representations from the auditor and issuer as to the prospectus’s accuracy, confirmed the issuer’s return policy with its customers, and surveyed retailers regarding pricing and other relevant details. Software Toolworks, 50 F.3d at 622-23. The Software Toolworks court reversed the district court’s grant of summary judgment with respect to other aspects of the underwriters’ due diligence efforts. Notably, it found that there were questions of fact as to whether underwriters performed adequate due diligence on the issuer’s post-prospectus entry of $7 million in large consignment sales, which were later reversed in the final financial statements for the quarter. Id. at 626. Rather than play’s “devil’s advocate,” as Feit requires an underwriter to do, the Software Toolworks underwriters “did little more than rely on Toolworks’ assurances that the transactions were legitimate,” making summary judgment in their favor inappropriate. Id. The Honorable Robert W. Sweet of this District, citing Feit, asserted in 1993 that “reasonably due diligence will normally involve a careful review of the issuer’s financial statements and important contracts.” Ades v. Deloitte & Touche, Nos. 90 Civ. 4959(RWS), 90 Civ. 5056(RWS), 1993 WL 362364, at *19 (S.D.N.Y. Sep. 17, 1993) (emphasis supplied). The court denied summary judgment for the underwriter defendant, which had argued that it was entitled to rely upon the interim financial statements despite having not performed “line-by-line scrutiny” of the same. Id. at *21. While acknowledging that a “private placement agent need not duplicate accounting procedures in evaluating a firm,” the court found that the underwriter’s inquiries as to certain major contracts and its reliance on the interim financial statements presented factual issues as to the adequacy and reasonableness of its due diligence investigation. Id. Where district courts have granted summary judgment for underwriters in recent years, the underwriters have demonstrated extensive due diligence efforts. As one court recounted in granting summary judgment,

The underwriters had over twenty meetings with various management personnel, covering all aspects of the company’s business. Company personnel were specifically questioned about the development and scheduled availability of products, related operating systems and applications software. The underwriters also contacted many of [the issuer’s] suppliers, customers, and distributors, who were asked extensive questions about the company’s operations. The underwriters reviewed company documents including operating plans, product literature, corporate records, financial statements, contacts, and lists of distributors and customers. They examined trade journals and other industry-related publications to ascertain industry trends, market trends and competitive information.... When any negative or questionable information was


developed as a result of their investigation, the underwriters discussed it with the appropriate *677 persons and arrived at informed decisions and opinions.

Weinberger v. Jackson, No. C-89-2301-CAL, 1990 WL 260676, at *3 (N.D.Cal. Oct.11, 1990), 1999 U.S. Dist. LEXIS 18394, at *7-8 (emphasis supplied). Another court granted summary judgment for the underwriter defendant only after establishing that the underwriters conducted an “unquestionably extensive” investigation. In re Int’l Rectifier Sec. Litig., No. CV91-3357-RMT(BQRX), 1997 WL 529600, at *3 (C.D.Cal.1997), 1997 U.S. Dist. LEXIS 23966, at *7. Among other things, their diligence included a review of the issuer’s “internal financial forecasts, contracts, and other important documents”; interviews of the issuer’s major customers, outside quality consultants, attorneys, auditor, and nearly a dozen of the issuer’s managers; “written verification from [the issuer’s] management that the information in the prospectus was correct”; and “a ‘cold comfort’ letter from [the issuer’s] outside accountants indicating that there had been no material changes in [the issuer’s] financial position since its last audit.” Id. at *8, 1997 U.S. Dist. LEXIS 23966, at *20-21. Similarly, the court in Phillips v. Kidder, Peabody & Co., 933 F.Supp. 303 (S.D.N.Y.1996), aff’d, 108 F.3d 1370, 1997 WL 138814 (2d Cir.1997), found that the underwriter defendant had conducted extensive due diligence, which included “reviewing the [issuer’s] financial statements, forecasts, budgets, and accounting controls, including discussions and/or meetings with management, outside directors, accountants, suppliers, and lending banks.” Phillips, 933 F.Supp. at 318. Moreover, although the underwriters “relied in large part on the cold comfort letters provided by Arthur Andersen,” those comfort letters did not concern unaudited interim financial information. Id. at 323. Rather, the detailed comfort letter in Phillips recited specific steps taken to confirm the adequacy of the issuer’s internal inventory and accounting controls in the wake of a major supplier’s reduction of prices on certain products, and was only one part of the underwriters’ due diligence on the issue of inventory shrinkage. Id. at 319 n. 11. [21] Thus, courts have continued to insist that underwriters demonstrate that they have conducted a meaningful investigation before granting summary judgment. That includes a reasonable investigation of unaudited financial information. See Glassman, 90 F.3d at 629 (“[A] failure by the underwriters either to verify a company’s statements as to its financial state or to consider new information up to the effective date of an offering would almost certainly constitute a lack of due diligence.”). In addition, an underwriter conducting a due diligence investigation must “look deeper and question more” where confronted with red flags. Enron, 235 F.Supp.2d at 707; see also Univ. Hill Found. v. Goldman, Sachs & Co., 422 F.Supp. 879, 900 (S.D.N.Y.1976) (whether or not underwriter conducted “reasonable investigation” depends on “the presence or absence of ‘warning signals’ to [underwriter] that something more might be in order.”) (citation omitted). While none of these courts have employed principles of statutory construction to reach their holdings, our role here, as always, is “to interpret the language of the statute enacted by Congress.” Barnhart v. Sigmon Coal Co., Inc., 534 U.S. 438, 461, 122 S.Ct. 941, 151 L.Ed.2d 908 (2002). Such statutory interpretation must “begin with the language employed by Congress and the assumption that the ordinary meaning of that language accurately


expresses the legislative purpose.” *678 Engine Mfrs. Ass’n v. S. Coast Air Quality Mgmt. Dist., 541 U.S. 246, 124 S.Ct. 1756, 1761, 158 L.Ed.2d 529 (2004) (citation omitted). In the Section 11 context, this presumption is heightened by the fact that “in the securities Acts Congress has used its words with precision.” Nuveen, 450 U.S. at 1009, 101 S.Ct. 1719 (Powell, J., dissenting from denial of cert.). Section 11(b) plainly commands that underwriters conduct an investigation as to portions of a registration statement not made on the authority of an expert. “When a word is not defined by statute, we normally construe it in accord with its ordinary or natural meaning.” Smith v. United States, 508 U.S. 223, 228, 113 S.Ct. 2050, 124 L.Ed.2d 138 (1993). Today, as in 1933 when Section 11 became law, the word “investigation” connotes a “thorough” or “searching inquiry.” Compare Webster’s New International Dictionary of the English Language 1306 (2d ed. 1934) (“Webster’s 1934”) with Webster’s Third New International Dictionary of the English Language 1189 (1993) (“Webster’s 1993”). Then and now, it can also mean the process of investigating. See Webster’s 1934 at 1306; Webster’s 1993 at 1189. Under this latter definition, an investigation is no less demanding, as the word “investigate” is defined as “to inquire and examine into with systematic attention to detail and relationship.” Webster’s 1934 at 1306; see also Webster’s 1993 at 1189 (“to inquire into systematically.”)

G. The Application of the Law to This Motion The Underwriter Defendants have moved for summary judgment on each of the alleged misstatements in the 2000 and 2001 Registration Statements. The Underwriter Defendants analyze each of the misstatements (as opposed to the omissions) that the Lead Plaintiff has alleged as quintessentially matters of accounting. Most of the misstatements are financial figures from WorldCom’s Exchange Act reports that were incorporated by reference into the Registration Statements. Additional misstatements include management’s comparison of financial figures from one period to the next, statements by WorldCom’s management describing accounting policies and future expectations, and the use of proceeds. The Underwriter Defendants contend that they are entitled to summary judgment on their affirmative defenses of reliance and due diligence because they were entitled to rely on Andersen’s audits and comfort letters. The analysis that follows distinguishes between the expertised and non-expertised statements which are the subject of this motion.

1. Audited Financial Statements The Underwriter Defendants contend that they were entitled to rely on Andersen’s unqualified “clean” audit opinions for WorldCom’s 1999 and 2000 Form 10-Ks as expertised statements under Section 11(b)(3)(C). Their motion for summary judgment on their reliance defense is denied.

a. 2000 Registration Statement The Lead Plaintiff points to one issue that it contends gave the Underwriter Defendants a


reasonable ground to question the reliability of WorldCom’s 1999 Form 10-K. According to the computations presented by the Lead Plaintiff, WorldCom’s reported E/R ratio was significantly lower than that of the equivalent numbers of its two closest competitors, Sprint and AT & T.47 The Lead Plaintiff argues that, in the extremely competitive market in which WorldCom operated, that discrepancy triggered *679 a duty to investigate such a crucial measurement of the company’s health. The Lead Plaintiff has shown that there are issues of fact as to whether the Underwriter Defendants had reasonable grounds to believe that the 1999 Form 10-K was inaccurate in the lines related to the E/R ratio reflected in that filing. The Underwriter Defendants argue that the difference in the E/R ratios was insufficient as a matter of law to put the Underwriter Defendants on notice of any accounting irregularity. In support of this, they point to the fact that this difference was publicly available information and no one else announced a belief that it suggested the existence of an accounting fraud at WorldCom. The fact that the difference was publicly available information does not absolve the Underwriter Defendants of their duty to bring their expertise to bear on the issue. The Underwriter Defendants do not dispute that they were required to be familiar with the Exchange Act filings that were incorporated by reference into the Registration Statement. If a “prudent man in the management of his own property,” 15 U.S.C. § 77k(c), upon reading the 1999 Form 10-K and being familiar with the other relevant information about the issuer’s competitors would have questioned the accuracy of the figures, then those figures constituted a red flag and imposed a duty of investigation on the Underwriter Defendants. A jury would be entitled to find that this difference was of sufficient importance to have triggered a duty to investigate the reliability of the figures on which the ratio was based even though the figures had been audited. The Underwriter Defendants contend that an audited figure can never constitute a red flag and impose a duty of investigation. This argument mischaracterizes the Lead Plaintiff’s position. The Lead Plaintiff has pointed to facts extraneous to WorldCom’s audited figures to argue that a reasonable person would have inquired further about the discrepancy between the audited figures and the comparable information from competitors.48 As discussed above, the existence of red flags can create a duty to investigate even audited financial statements. The Underwriter Defendants argue that the standard that should apply is whether they had “clear and direct notice” of an “accounting” problem. They argue that case law establishes that “ordinary business events” do not constitute red flags. They are wrong. There is no basis in law to find a requirement that a red flag arises only when there is “clear and direct” notice of an accounting issue. The standard under Section 11 is whether a defendant has proven that it had “no reasonable ground to believe and did not believe” that a registration statement contained material misstatements, a standard given meaning by what a “prudent man” would do in the management of his own property. Nor is the bar lowered because there is an expert’s opinion on which an underwriter is entitled to rely. The “prudent man” standard applies to Section 11(b)(3)(C). Finally, what constitutes an ordinary business event and what constitutes a red flag is an issue of fact. These are exquisitely fact intensive inquiries that depend on the circumstances surrounding a particular issuer and the alleged misstatement.


There *680 is no category of information which can always be ignored by an underwriter on the ground that it constitutes an ordinary business event. What is ordinary in one context may be sufficiently unusual in another to create a duty of investigation by a “prudent man.” In their analysis of the E/R ratio discrepancy itself, the Underwriter Defendants contend that a difference in ratios is not necessarily suspicious in a competitive industry and that the Lead Plaintiff’s expert has incorrectly calculated the comparable ratios for AT & T and Sprint.49 Each of these arguments raises questions of fact that must be resolved at trial.

b. 2001 Registration Statement The Lead Plaintiff points to three issues that it contends imposed upon the Underwriter Defendants a duty to investigate the reliability of WorldCom’s 2000 Form 10-K. They are the discrepancy between WorldCom’s E/R ratio and that of its competitors; the deterioration in the MCI long-distance business, which the Lead Plaintiff alleges should have caused them to question the accuracy of WorldCom’s reported assets;50 and Ebbers’ personal financial situation, which gave him both the motive and opportunity to inflate WorldCom’s stock price through manipulation. The Underwriter Defendants’ general arguments about the nature of the reliance defense insofar as it concerns audited information have already been addressed. The arguments that are particular to the individual red flags identified by the Lead Plaintiff are addressed below. The Underwriter Defendants have shown that they are entitled to summary judgment on the issue of whether Ebbers’ financial situation constituted a red flag that imposed upon them the duty of inquiry.

i. Goodwill and Asset Impairment The Underwriter Defendants make several arguments concerning the issue of goodwill and asset impairment. They contend that it was public knowledge that AT & T and Sprint took asset impairment charges to their core networks in 2000 while WorldCom did not, that the telecommunications sector was in decline, and that analysts had described the equity value of the MCI tracking stock as close to zero. To the extent that these arguments are meant to suggest that bondholders cannot show that they relied on any misstatement in the WorldCom financials, there is no requirement of such a showing under either Section 11 or Section 12(a)(2). Furthermore, the issue in connection with the reliance defense is not whether the red flag information was well known, but whether the red flags existed and imposed a duty upon the Underwriter Defendants under the “prudent man” standard to inquire of WorldCom and/or Andersen about the reporting of WorldCom’s assets because the Underwriter Defendants had a reasonable ground to believe that the reporting of assets may have been inaccurate. *681 The Underwriter Defendants next contend that WorldCom’s treatment of the accounting issue was defensible.51 The Underwriter Defendants may be able to establish at trial that there was no misrepresentation of WorldCom’s assets, but they have not moved for


summary judgment on that ground. Instead, they have moved for summary judgment on their reliance defense by arguing that they had no duty to make any inquiry regarding the accuracy of WorldCom’s statement of its assets. The Lead Plaintiff has shown that there are issues of fact regarding WorldCom’s statement of its assets that a jury may find raised a red flag and imposed upon the Underwriter Defendants the obligation to inquire.

ii. Ebbers’ Personal Finances [22] The Underwriter Defendants are entitled to summary judgment on the issue of whether Ebbers’ personal financial situation, and in particular the extent to which his wealth was dependent on WorldCom’s stock price, imposed upon them an obligation to inquire. The Lead Plaintiff has shown that the Underwriter Defendants were well aware of the complexity of Ebbers’ personal finances and the extraordinary extent to which those finances were dependent on the movement in WorldCom’s stock price. They had access to information which painted a much starker picture in this regard than the public record. The Lead Plaintiff has also shown that the Underwriter Defendants should have understood that Ebbers was in a position to affect the integrity of WorldCom’s financial reporting. What the Lead Plaintiff has not shown is that the Underwriter Defendants had any reason to believe that Ebbers would use his access and power to commit fraud. The “motive and opportunity” cases that arise in the context of Section 10(b) of the Exchange Act have limited relevance here. The issue under Section 10(b) is whether a plaintiff has adequately pleaded an officer’s motive and opportunity to engage in fraud such that the defendant’s scienter has been adequately alleged. See, e.g., Acito v. IMCERA Group, 47 F.3d 47, 54 (2d Cir.1995). The issue here is whether the Underwriter Defendants’ knowledge of Ebbers, including his financial circumstances, gave them reason to believe the WorldCom audited financial statements were inaccurate. Without some evidence that the Underwriter Defendants had reason to believe that Ebbers was untrustworthy, his dependence on WorldCom’s financial health, even though extraordinary, is insufficient to constitute a red flag that he may have caused a manipulation of WorldCom’s financial statements.

iii. E/R Ratio The Underwriter Defendants rely on many of the arguments that they made regarding the E/R ratio in connection with the 2000 Registration Statement. The Lead Plaintiff has shown that there are issues of fact as to whether the discrepancy in the WorldCom E/R ratio, when compared to comparable companies’ E/R ratios, was sufficient to cause a prudent man to make an inquiry regarding the accuracy of the 2000 Form 10-K.

2. Interim Financial Statements [23] The Underwriter Defendants contend that, pursuant to Sections 11(b)(3)(A) and 12(a)(2), they were entitled to rely on Andersen’s comfort letters for WorldCom’s *682 unaudited interim financial statements for the first quarter of 2000 and 2001 so long as the Lead


Plaintiff is unable to show that the Underwriter Defendants were on notice of any accounting red flags. They argue that this statement of the due diligence defense is particularly appropriate because WorldCom was a seasoned issuer and the Registration Statements were part of the integrated disclosure system that allowed the Exchange Act periodic reports to be incorporated by reference. The Underwriter Defendants contend that “Form S-3 issuers” like WorldCom are only required to include transaction-related information in a Form S-3 prospectus and that the information contained in the Exchange Act filings which are incorporated by reference do not need to be repeated. They argue that in the context of integrated disclosure for shelf registrations, and as a result of SEC Rule 176, the focus is on an underwriter’s continuous learning about an “industry” and reasonable reliance on other professionals, such as an issuer’s auditor. As a consequence, they contend that there is no difference from the point of view of the underwriter between audited and unaudited financial statements so long as the underwriter receives an auditor’s comfort letter. According to the Underwriter Defendants, so long as there are no red flags that bring the auditor’s assessment into question, the receipt of a comfort letter “goes a long way to establish” due diligence with respect to all matters of accounting. They ask for a legal ruling that “an underwriter’s investigation of accounting issues is reasonable when it rests on the independent auditor’s SAS 71 review for interim financial statements,” at least in the context of seasoned issuers engaged in a shelf registration. Finally, they argue that it is material that no amount of reasonable diligence could have uncovered the capitalization of line costs since the WorldCom management deliberately concealed it from Andersen and every other outsider and would never have given them any documents or information that would have revealed the fraud. Andersen issued a May 19 comfort letter and May 23 bringdown comfort letter for the 2000 Offering. Andersen issued comfort letters on May 9 and 16 for the 2001 Offering. These comfort letters addressed the only interim financial statements that were incorporated by reference in the Registration Statements. In connection with the latter Offering, the Underwriter Defendants emphasize that J.P. Morgan and SSB had recently had occasion to work closely with WorldCom on other projects. The two firms had participated in the two tracking stock realignment of WorldCom announced in November 2000, and J.P. Morgan had acted as a lead manager and sole book-runner for WorldCom’s $2 billion private placement in December 2000. They point to these activities as part of their continuous due diligence for WorldCom. To prevail on their due diligence defense at trial, the Underwriter Defendants must show that they conducted a reasonable investigation and that after such an investigation that they had reasonable ground to believe that the statements in the Registration Statements, including the information in the unaudited interim financial statements, were true. See 15 U.S.C. § 77k(b)(3)(A). In judging that investigation, a jury will have to consider the non-exclusive list of factors enumerated in Rule 176. Insofar as Rule 176 is concerned, there does not appear to be any dispute that WorldCom was a “well-established” issuer, that the notes at issue were investment-grade debt securities, that SSB and J.P. Morgan assigned experienced personnel to the due diligence teams, that they spoke to the issuer’s CFO and in 2001 also spoke to Andersen, that the underwriting *683 was a firm commitment underwriting, that the underwriting was through a shelf registration, that many analysts and credit reporting


agencies followed and reported on WorldCom, that the issuer and not the Underwriter Defendants had responsibility for preparing the interim financial statements, and that Andersen and not the Underwriter Defendants had responsibility for reviewing the interim financial statements. The Lead Plaintiff has shown that there are questions of fact, however, as to whether the Underwriter Defendants conducted a reasonable investigation in either 2000 or 2001. It points to what it contends is evidence of the limited number of conversations with the issuer or its auditor, the cursory nature of the inquiries, the failure to go behind any of the almost formulaic answers given to questions, and the failure to inquire into issues of particular prominence in the Underwriter Defendants’ own internal evaluations of the financial condition of the issuer or in the financial press. It argues in particular with respect to 2001, that having internally downgraded WorldCom’s credit rating and having taken steps to limit their exposure as WorldCom creditors, the Underwriter Defendants were well aware that WorldCom was in a deteriorating financial position in a troubled industry, and that a reasonable investigation would have entailed a more searching inquiry than that undertaken by the Underwriter Defendants. Given the enormity of these two bond offerings, and the general deterioration in WorldCom’s financial situation, at least as of the time of the 2001 Offering, they argue that a particularly probing inquiry by a prudent underwriter was warranted. These issues of fact require a jury trial.52 The Underwriter Defendants have framed their summary judgment motion in a way that is incompatible with their burden of proving their due diligence defense under Section 11. They seek to restrict the inquiry on their due diligence solely to the work undertaken with respect to the interim financial statements and therefore to restrict it to a determination of whether any red flags existed that would put them on notice of a duty to make an inquiry of the interim financial statements. This formulation converts the due diligence defense into the reliance defense and balkanizes the task of due diligence. In order to succeed with a due diligence defense, the Underwriter Defendants will have to show that they conducted a reasonable investigation of the non-expertised portions of the Registration Statements and thereafter had reasonable ground to believe that the interim financial statements were true. In assessing the reasonableness of the investigation, their receipt of the comfort letters will be important evidence, but it is insufficient by itself to establish the defense. It is important to note that even if no reasonable investigation would have uncovered a fraud, an underwriter will prevail on its defense if can show it did conduct a reasonable investigation. Conversely, an underwriter must conduct a reasonable investigation to prevail on the due diligence defense, even if it appears that such an investigation would have proven futile in uncovering the fraud. Without a reasonable *684 investigation, of course, it can never be known what would have been uncovered or what additional disclosures would have been demanded. The Underwriter Defendants argue that if they are not entitled to rely on a comfort letter, the costs of capital formation in the United States will be substantially increased since


underwriters will have to hire their own accounting firms to rehash the work of the issuer’s auditor. Nothing in this Opinion should be read as imposing that obligation on underwriters or the underwriting process. The term “reasonable investigation” encompasses many modes of inquiry between obtaining comfort letters from an auditor and doing little more, on one hand, and having to re-audit a company’s books on the other. Nonetheless, if aggressive or unusual accounting strategies regarding significant issues come to light in the course of a reasonable investigation, a prudent underwriter may choose to consult with accounting experts to confirm that the accounting treatment is appropriate and that additional disclosure is unnecessary. See Software Toolworks, 50 F.3d at 624. Underwriters perform a different function from auditors. They have special access to information about an issuer at a critical time in the issuer’s corporate life, at a time it is seeking to raise capital. The public relies on the underwriter to obtain and verify relevant information and then make sure that essential facts are disclosed.53 Acting with the degree of diligence that applies to a prudent man when managing his own property, underwriters should ask those questions and seek those answers that are appropriate in the circumstances. They are not being asked to duplicate the work of auditors, but to conduct a reasonable investigation. If their initial investigation leads them to question the accuracy of financial reporting, then the existence of an audit or a comfort letter will not excuse the failure to follow through with a subsequent investigation of the matter. If red flags arise from a reasonable investigation, underwriters will have to make sufficient inquiry to satisfy themselves as to the accuracy of the financial statements, and if unsatisfied, they must demand disclosure, withdraw from the underwriting process, or bear the risk of liability. An underwriter should, and the Underwriter Defendants here certainly did, have the “business and financial expertise to identify the weak points in an issuer’s business and financial condition and to assess the adequacy of an issuer’s disclosure in this regard.” Task Force Report, 48 Bus. Law. at 1222. It is in part because underwriters have taken their responsibilities seriously in this regard that, from the perspective of over seventy years, the Securities Act has been an effective instrument of regulation. The question the jury will have to decide here is whether the Underwriter Defendants have fulfilled that obligation in the context of the two WorldCom Offerings. The Underwriter Defendants contend that they will be able to show at trial that the continuous due diligence that they performed with respect to WorldCom amounted to a reasonable investigation for both Offerings. This Opinion does not address the likelihood of that showing because the Underwriter Defendants have not moved for summary judgement on that ground. For that reason, it is also unnecessary to *685 address their arguments about the difficulty of meeting the traditional standard for due diligence in the context of integrated disclosure and shelf registrations. In any event, the Underwriter Defendants have not shown that the prudent man standard in Section 11 has been diluted by any regulatory changes. The processes through which and the timing in which due diligence is performed have changed, but the ultimate test of reasonable conduct in the specific circumstances of an offering remains unchanged.


IV. The Underwriter Defendants’ Motion for Summary Judgment: Omissions The Underwriter Defendants have also moved for summary judgment on each of the omissions from the Registration Statements that underlie the Securities Act claims. The alleged omissions are numerous. The Lead Plaintiff has identified twenty omissions from the 2000 Registration Statement, and forty-two from the 2001 Registration Statement.54 The Underwriter Defendants have shown that they are entitled to summary judgment on some of these alleged omissions.

A. 2000 Registration Statement The identified omissions from the 2000 Registration Statement are that it: 1. Failed to disclose WorldCom’s lack of a strategic plan if the Sprint merger failed, leaving the Company without a wireless business. 2. Failed to disclose WorldCom’s serious problems with obtaining the requisite regulatory approvals for the Sprint merger, including the fact that on May 18, 2000, a committee of the Department of Justice recommended that the Department block the merger. 3. Failed to disclose adequately that WorldCom was experiencing continued difficulty with its MCI long-distance business segment. 4. Failed to disclose adequately that the proliferation of new competitors in the voice long-distance business was having a negative impact on WorldCom’s revenue and cash generation. 5. Failed to disclose adequately that the WorldCom Group’s stated plan of focusing on high-growth data and Internet segments was almost entirely dependent on the Company’s ability to stabilize cash flows in its long-distance business. 6. Failed to disclose the extent to which consumer and wholesale long-distance revenue was declining and was expected to decline. 7. Failed to disclose adequately that, while the Company intended to increase revenues by focusing on providing data services, this segment of WorldCom’s business required large infusions of capital. 8. Failed to disclose adequately that WorldCom’s future performance was contingent upon the success of its data and IP [Internet portal] initiatives. 9. Failed to disclose that certain of the Underwriter Defendants suffered from conflicts of interest that affected their ability to conduct a reasonable due diligence investigation in connection with the May 2000 Offering, including the following: a. The fact that WorldCom selected the Underwriter Defendants for the May 2000 Offering based, at least in part, on the amount of credit that the Underwriter *686 Defendants’


commercial banking affiliates agreed to extend to WorldCom, rather than on the basis of merit; b. The fact that WorldCom selected the Underwriter Defendants for the May 2000 Offering based, at least in part, on the ratings that the Underwriter Defendants’ research analysts had provided WorldCom; c. The fact that certain of the Underwriter Defendants, and their corporate affiliates, extended millions of dollars in loans to WorldCom’s CEO Bernie Ebbers in exchange for WorldCom’s investment banking business; and d. The fact that Salomon Smith Barney allocated numerous shares of initial public offering[s] to WorldCom officers and directors-enabling them to make millions of dollars in risk-free profits-in exchange for WorldCom’s investment banking business. 10. Failed to include a risk factor section, despite the fact that WorldCom’s business was facing a number of significant risks. 11. Failed to disclose that Ebbers was encumbered with a staggering amount of personal debt-much of which was extended by certain of the Underwriter Defendants and their affiliates and much of which was guaranteed by Ebbers’ WorldCom shares-such that he faced personal financial ruin if the price of WorldCom stock dropped. 12. Failed to disclose the numerous outside business ventures in which Ebbers was involved, in addition to what was supposed to be his full-time job as WorldCom’s CEO, and that he undoubtedly was distracted by the demands of those other businesses. 13. Failed to disclose the lack of any meaningful internal accounting controls at WorldCom. 14. Failed to disclose the lack of Board oversight at WorldCom, including the Board’s failure to carefully consider large corporate transactions and its abdication of authority to Ebbers and Sullivan. 15. Failed to disclose that personnel assigned by the Underwriter Defendants to conduct due diligence on the Company were not able to form a view about what events or conditions were material to WorldCom. 16. Failed to disclose that the Underwriter Defendants had failed to conduct a reasonable investigation to determine whether WorldCom had the ability to service the debt it was assuming in the May 2000 Offering. 17. Failed to disclose that the audit committee of WorldCom’s Board of Directors was not actively involved in discharging its duty to oversee the auditing of the Company’s financial statements. 18. Failed to disclose that WorldCom provided significantly less financial information


regarding its business segments to the public than its competitors. 19. Failed to disclose the lack of meaningful debt planning by the Company or its advisors, including the lack of analysis to assess whether the Company could maintain the debt it incurred. 20. Failed to disclose that WorldCom’s acquisition of SkyTel Communications (“SkyTel”) had not been properly considered by WorldCom’s Board and that it was not a sound business decision. The Underwriter Defendants seek summary judgment on all of these purported material omissions. The Lead Plaintiff opposes summary judgment with respect to three groups of the listed omissions from the 2000 Registration Statement: the Sprint merger, the conflicts of interest, and risk factors. The last category encompasses *687 several of the separately listed omissions. Because the Lead Plaintiff has not addressed the Underwriter Defendants’ arguments in support of summary judgment on omission items 12-18, and 20, summary judgment is granted with respect to them. Summary judgment is denied on the items related to the remaining three issues.

1. Sprint Merger The 2000 Registration Statement did not discuss the May 18 decision by officials in the antitrust division of the Department of Justice to recommend against approval of the merger or the impact that a failure to merge would have on WorldCom. The 2000 Registration Statement did disclose that “the merger is subject to the receipt of consents and approvals from various government entities, which may jeopardize or delay completion of the merger.” The Underwriter Defendants argue that they had no duty to handicap the chances that the merger would be approved, and that many articles on May 18 discussed the antitrust decision and the likelihood that it would be reversed or upheld. [24] A duty to disclose exists “when disclosure is necessary to make prior statements not misleading.” In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 268 (2d Cir.1993) (citation omitted). Once a potential merger is disclosed by an issuer, there is a duty to “update opinions and projections ... if the original opinions or projections have become misleading as the result of intervening events.” Id. at 267. [25] [26] Moreover, cautionary language within a registration statement indicating that a merger is subject to certain conditions does not necessarily mean that an underwriter has satisfied its disclosure duties. A defendant may not be liable for misrepresentations in a registration statement if they were “sufficiently balanced by cautionary language within the same prospectus such that no reasonable investor would be misled about the nature and risk of the offered security.” P. Stolz Family P’ship, L.P. v. Daum, 355 F.3d 92, 96 (2d Cir.2004); see also Halperin, 295 F.3d at 357. Yet “the misrepresentation of present or historical facts cannot be cured by cautionary language.” Daum, 355 F.3d at 96-97. The type of cautionary language that gives shelter to Section 11 and 12(a)(2) defendants is that


aimed at warning investors that bad things may come to pass-in dealing with the contingent or unforeseen future. Historical or present fact-knowledge within the grasp of the offeror-is a different matter. Such facts exist and are known; they are not unforeseen or contingent. It would be perverse indeed if an offeror could knowingly misrepresent historical facts but at the same time disclaim those misrepresented facts with cautionary language.

Id. at 97. “When objectively verifiable factors cause a significant change in a party’s attitude toward a merger ... the securities laws may require that previously disclosed intentions be corrected.” In re Gulf Oil/Cities Serv. Tender Offer Litig., 725 F.Supp. 712, 748 (S.D.N.Y.1989). [27] An underwriter can be relieved of a duty to disclose when certain developments affecting a corporation become “matters of general public knowledge.” Seibert v. Sperry Rand Corp., 586 F.2d 949, 952 (2d Cir.1978). As the Second Circuit stated in Seibert, “there is no duty to disclose information to one who reasonably should already be aware of it”; rather, “where information is equally available to both parties, a defendant should not be held liable to the plaintiff under the securities laws for failure to disclose.” Id. (citation omitted). In Seibert, for instance, *688 the Second Circuit granted summary judgment for the defendants, who were accused of violating Section 14(a) of the Exchange Act, on the grounds that “any reasonable shareholder who was not already familiar with [the allegedly omitted information] had this information readily available to him” in the form of a nationwide consumer boycott accompanied by “massive media advertising,” pervasive press coverage, congressional debate, and administrative and judicial opinions. Id. Nonetheless, the Second Circuit has more recently found that there are “serious limitations” on a Section 11 defendant’s ability to “charge its stockholders with knowledge of information omitted from a ... prospectus on the basis that the information is public knowledge and otherwise available to them.” Kronfeld, 832 F.2d at 736. Moreover, sporadic press reports or reports published in other contexts may “not be considered to be part of the information that was reasonably available” to investors. United Paperworkers Int’l Union v. Int’l Paper Co., 985 F.2d 1190, 1199 (2d Cir.1993). [28] The Sprint merger was a principal focus of the 2000 Registration Statement, in particular the May 19 Prospectus Supplement,55 which contained a pro forma consolidated financial statement for the post-merger company. Given that the announcement of the antitrust division posed a serious obstacle to obtaining the requisite regulatory approvals for the Sprint Merger, Lead Plaintiff may be able to show that the failure to describe those problems and their impact on WorldCom was a material omission and that the boilerplate language in the Registration Statement warning investors that the merger was subject to regulatory approval was inadequate. While the May 18 decision may have been a matter of wide public knowledge, there is an issue of fact as to whether WorldCom’s own failure to describe those problems and their impact on WorldCom was material.


2. Conflicts of Interest The Underwriter Defendants contend that the amalgam of conflict of interest allegations omitted from the 2000 Registration Statement should be dismissed principally because there was no duty to disclose these facts. They point out that it is not illegal for banks to lend money, to underwrite bonds, to issue research reports, or to make a profit from doing each of these activities. They urge that it is a matter of opinion rather than fact as to whether their agreement to lend money to WorldCom or to Ebbers, their issuance of favorable analyst reports about WorldCom, or their decision to give WorldCom officers IPO shares56 was behind their selection as underwriters. The Underwriter Defendants also point out that many of these industry practices were the subject of press reports. The primary function of a registration statement is to disclose information about the issuer, not its underwriters. Indeed, the regulations governing the form and content of registration statements do not require many underwriter-specific disclosures. *689 Regulation S-K, for example, simply “requires an issuer to identify each underwriter with a material relationship with the issuer and the nature of the relationship, the underwriter’s obligation to take securities, the underwriter’s compensation, the existence of any underwriter’s representatives on the issuer’s board of directors, and any indemnity provided to the underwriter.” Degulis v. LXR Biotech., Inc., 928 F.Supp. 1301, 1314 (S.D.N.Y.1996); see also 17 C.F.R. § 229.508(a), (e), (f), (g). It is also worth noting that although Item 508(a) of Regulation S-K requires each underwriter with a material relationship with a “registrant” to “state the nature of the relationship,” 17 C.F.R. § 229.508(a), the term “registrant” refers only to an issuer of securities and not to its employees, officers, or directors. See, e.g., 17 C.F.R. § 230.100(a)(4) (“[a]s used in the rules and regulations prescribed in this part by the Securities and Exchange Commission pursuant to the Securities Act of 1933,” registrant means the “issuer of securities for which a registration statement is filed” unless context requires otherwise). While Regulation S-K requires disclosure of limited underwriter-related information, “no authority suggests that Regulation S-K is preemptive of the materiality requirement.” Degulis, 928 F.Supp. at 1314. As stated previously, the regulations accompanying Section 11 include a catch-all provision, Rule 408, that requires registration statements to contain, “in addition to the information expressly required to be included in a registration statement ... such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading.” 17 C.F.R. § 230.408. [29] Information regarding relationships that undermine the independence of an underwriter’s judgment about the quality of the investment can be material to an investor. As a consequence, non-disclosure of an underwriter or issuer’s conflicts of interest can constitute material omissions, even where no regulation expressly compels the disclosure of such conflicts. SEC v. Softpoint, Inc., 958 F.Supp. 846, 863 (S.D.N.Y.1997) (corporation paid money to brokerage firms in exchange for their cooperation in illegally liquidating unregistered stock); SEC v. Scott, 565 F.Supp. 1513, 1527 (S.D.N.Y.1983) (kickback agreement between the issuer and the underwriter), aff’d sub nom, SEC v. Cayman Islands Reins. Corp., 734 F.2d 118 (2d Cir.1984). See also Jenny v. Shearson, Hammill, & Co., No. 74 Civ. 3526, 1981 WL 1611, at *5 (S.D.N.Y. Mar.20, 1981) (brokerage’s failure to disclose


investment banking relationship with issuers). [30] The Lead Plaintiff has presented sufficient information to raise questions of fact as to the adequacy of the disclosures in the 2000 Registration Statement concerning the relationship between certain of the underwriters, including the co-lead underwriters, and WorldCom. The jury will have to determine whether press reports about such topics as the spinning of IPO shares and bankers’ dual roles as analysts and underwriters were sufficient to make it unnecessary to provide further disclosure within the Registration Statement. The jury will also have to determine whether the relationships between Ebbers and the bankers were so significant, given Ebbers’ prominent position within the registrant and his power to affect their selection as underwriters for a bond offering, that a description of that relationship was material and required to be disclosed by *690 Rule 408.57

3. Risk Factors [31] The Lead Plaintiff contends that the 2000 Registration Statement was required by Item 503(c) of Regulation S-K to include a risk factors section that discussed WorldCom’s ability to sustain its debt load, its reliance on borrowed money to fund its operations, its problems placing its commercial paper, its lack of positive cash-flow, and its underperforming stock.58 The Underwriter Defendants contend that as an investment grade company, WorldCom only had to describe in a risk factors section those “special circumstances” that had arisen since its last public filing and that the 2000 Registration Statement did so in its detailed discussion of the Sprint merger. They also assert that each of the risk factors identified by the Lead Plaintiff was in any event adequately disclosed, albeit not in a section denominated for risk factors. Item 503(c) of Regulation S-K requires that a registration statement “must” include “where appropriate ... a discussion of the most significant factors that make the offering speculative or risky.” 17 C.F.R. § 229.508(c). With respect to the form and scope of a risk factors section, Item 503 directs that the risk factors discussion “be concise and organized logically. Do not present risks that could apply to any issuer or any offering. Explain how the risk affects the issuer or the securities being offered. Set forth each risk factor under a subcaption that adequately describes the risk.” Id. In addition, Item 503 provides some guidance as to the issues that merit discussion in a risk factors section, explaining that

The risk factors may include, among other things, the following:

(1) Your lack of an operating history;

(2) Your lack of profitable operations in recent periods;

(3) Your financial position;

(4) Your business or proposed business;

(5) The lack of a market for your common equity securities or securities convertible into or exercisable for common equity securities.


Id. (emphasis supplied.) SEC guidance surrounding the content of Item 503 has been limited. For instance, in proposed rules released last month, the SEC briefly stated that a risk factors discussion under Item 503 is intended to “describe the most significant factors that may adversely affect the issuer’s business, operations, industry or financial position, or its future financial performance.” Securities Offering Reform, SEC Release No. 8501, 2004 WL 2610458, at *86 (Nov. 3, 2004). Similarly, in providing guidance to *691 issuers as to what they should disclose regarding their readiness for Y2K issues, the SEC advised in 1998 that a discussion of risk factors must be “specific to the particular company and its operations, and should explain how the risk affects the company and its operations, and should explain how the risk affects the company and/or the securities being offered. Generic or boilerplate discussions do not tell the investors how the risk may affect their investment.” Statement of the Commission Regarding Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisers, Investment Companies, and Municipal Securities Issuers, SEC Release No. 7558, 1998 WL 425894, at *14 (July 29, 1998). When and if a prospectus must include a risk factor disclosure pursuant to Item 503 does not appear to have been discussed within the case law. Securities law commentators have noted that “even though the inclusion of a risk factors section in a prospectus filed under the 1933 Act is technically voluntary under Item 503(c) of Regulation S-K ... this inclusion has become widely accepted as a sound and prudent defensive measure in an era marked by class action lawsuits.” 2 Alan R. Bromberg & Lewis D. Lowenfels, Bromberg & Lowenfels on Securities Fraud and Commodities Fraud § 5:280 (2d ed.2001). The SEC itself, however, has issued conflicting statements. While stating in 1983 that the disclosure of risk factors is “optional, at the discretion of the registrant,” Registration Form Used by Open-End Management Investment Companies; Guidelines, SEC Release No. 6479, 1983 WL 35814, at *5 (Aug. 12, 1983), the SEC has suggested more recently that a risk factor discussion may be a necessity. Specifically, in 1998, the SEC proposed requiring risk factor disclosure in annual and quarterly reports filed pursuant to the Exchange Act and allowing reporting companies to incorporate risk factor disclosure into Securities Act registration statements. SEC Rel. 7606A, 63 Fed.Reg. at 67239. In so doing, it noted that

[m]ost Securities Act registration statements currently require an analysis of the risks associated with an investment in a company’s securities. Item 503 of Regulation S-K describes that required disclosure as a “discussion of the most significant factors that make the offering speculative or risky.” The Commission promulgated this requirement because it assists investors in comprehending more fully whether the securities present an appropriate level of risk for them as an investment.

Id. (emphasis supplied); see also Form S-3, Registration Statement Under the Securities Act of 1933, Item 3 (“Furnish the information required by Item 503 of Regulation S-K.”). The Lead Plaintiff has identified a constellation of material omissions from the 2000 Registration Statement that concern the profitability of WorldCom’s long-distance voice business and the impact that decreasing profit margins in that part of its business were having and would have on WorldCom’s ability to compete, in particular on its ability to pour capital


into its data services and Internet portal initiatives. While the Registration Statement discusses repeatedly and in many contexts the intense competition that WorldCom was facing, the Lead Plaintiff has shown that there is a question of fact as to whether it adequately disclosed even to a careful reader the alleged precarious state of WorldCom’s profit margins in a major component of its business-the long-distance voice business-and the impact of that problem on its business as a whole, *692 including its ability to service its debt.59 It has shown that similar questions of fact exist at least as to WorldCom’s disclosures regarding the burden of its debt load.60 The Underwriter Defendants contend that public reports from rating agencies described the competition that WorldCom faced from other carriers in the long-distance market and that WorldCom’s revenue from that line of business was declining. The Lead Plaintiff has shown that the issue of the condition of WorldCom’s long-distance business was of sufficient importance to the overall economic health of WorldCom that a fact-finder could determine that it was appropriate under Item 503, as well as material to investors, to have a more complete description from WorldCom itself of the state of that business.

B. 2001 Registration Statement The Lead Plaintiff has identified forty-two purported material omissions from the 2001 Registration Statement. They are, that the document: 1. Failed to disclose that WorldCom was improperly capitalizing line costs in violation of GAAP. 2. Failed to disclose that WorldCom had fraudulently under-reported its line costs in 2000 and the first quarter of 2001 by billions of dollars through the improper release of reserves. 3. Failed to disclose that WorldCom’s business plan, in light of its failure to acquire Sprint, lacked a wireless strategy needed to compete effectively. 4. Failed to disclose adequately that the proliferation of new competitors in the voice long-distance business was having a negative impact on WorldCom’s revenue and cash generation. 5. Failed to disclose that the WorldCom Group’s stated plan of focusing on high-growth data and Internet segments was almost entirely dependent on the Company’s ability to stabilize cash flows through the MCI Group. 6. Failed to disclose adequately that WorldCom was experiencing continued difficulty with its MCI long-distance business segment. 7. Failed to disclose the extent to which consumer and wholesale long-distance revenue was declining and was expected to decline. 8. Failed to disclose adequately that certain of the proceeds of the offering would be used to


fund the Company’s negative free cash flow. 9. Failed to disclose that certain of the Underwriter Defendants extended credit *693 to WorldCom based on the promise of significant investment banking fees, planning immediately to reduce this exposure through transactions hidden from the Company and the investing public. 10. Failed to disclose that, while the Company intended to increase revenues by focusing on providing data services, this segment of WorldCom’s business required large infusions of capital. 11. Failed to disclose that WorldCom’s future performance was contingent upon the success of its data and IP initiatives. 12. Failed to disclose adequately the rapid rate at which WorldCom’s debt leverage was rising and the effect this would have on the Company’s liquidity. 13. Failed to disclose adequately the effect that the lack of a wireless component was having on WorldCom’s business. 14. Failed to disclose adequately the liquidity threat from continuing pricing pressures in long-haul transport, consumer long distance and other business segments. 15. Failed to disclose adequately that the slowdown in corporate telecom spending due to a weakening global economy was adversely affecting WorldCom’s financial health. 16. Failed to disclose that WorldCom provided significantly less financial information regarding its business segments to the public than its competitors. 17. Failed to disclose that WorldCom had not had a permanent Treasurer for many months and that the newly appointed Treasurer lack relevant experience. 18. Failed to disclose that personnel assigned by the Underwriter Defendants to conduct due diligence on the Company were not able to form a view about what events or conditions were material to WorldCom. 19. Failed to disclose there were concerns among certain of the Underwriter Defendants that the Company would be downgraded by Moody’s. 20. Failed to disclose concerns among certain of the Underwriter Defendants that WorldCom would be unable to maintain its credit ratings after assuming the debt from the May 2001 Offering as well as the debt from the acquisition of Intermedia. 21. Failed to disclose that certain of the Underwriter Defendants suffered from conflicts of interest that affected their ability to conduct a reasonable due diligence investigation....


22. Failed to disclose that several of the Underwriter Defendants had, in the months immediately preceding the May 2001 Offering, internally downgraded the Company’s credit rating in recognition of WorldCom’s deteriorating financial condition, and other Underwriter Defendants had expressed significant concerns about the Company’s creditworthiness. 23. Failed to disclose that WorldCom would be required to fund Digex’s significant operating losses, which would have a material adverse effect on WorldCom’s financial condition. 24. Failed to disclose that Intermedia was subject to a going concern letter from its auditor Ernst & Young. 25. Failed to disclose that the Company would need to expend significant amounts of cash to fund Intermedia as a going concern, despite the absence of any meaningful return on this investment of cash. 26. Failed to disclose that there was no sound business reason for WorldCom to acquire Digex. 27. Failed to disclose that the Intermedia acquisition was not properly considered *694 by WorldCom’s Board of Directors prior to committing the Company to a purchase agreement. 28. Failed to disclose that WorldCom did inadequate due diligence on Intermedia before agreeing to purchase the company. 29. Failed to disclose the likelihood that the Company would not be able to sell the non-Digex assets of Intermedia, as required by the Department of Justice, for any material amount. 30. Failed to include a risk factor section, despite the fact that WorldCom’s business was facing a number of significant risks. 31. Failed to disclose certain of the Underwriter Defendants’ belief that WorldCom’s institution of tracker stocks served no legitimate business purpose, and was done merely to attempt to disguise the deterioration in the business of WorldCom, Inc. 32. Failed to disclose the lack of any meaningful internal accounting controls at WorldCom. 33. Failed to disclose the lack of Board oversight at WorldCom, including the Board’s failure to carefully consider large corporate transactions and its abdication of authority to Ebbers and Sullivan. 34. Failed to disclose the lack of meaningful debt planning by the Company or its advisors, including the lack of analysis to assess whether the Company could maintain the debt it incurred.


35. Failed to disclose that WorldCom’s acquisition of SkyTel Communications had not been properly considered by WorldCom’s Board and that it was not a sound business decision. 36. Failed to disclose that WorldCom’s commercial paper credit rating prevented it from using commercial paper to fund its business plan and service its debt in the future. 37. Failed to disclose adequately the significant risk that WorldCom did not have the ability to service the debt it was assuming in the May 2001 Offering. 38. Failed to disclose that Ebbers was encumbered with a staggering amount of personal debt-much of which was extended by certain of the Underwriter Defendants and their affiliates and much of which was guaranteed by Ebbers’ WorldCom shares-such that he faced personal financial ruin if the price of WorldCom stock dropped. 39. Failed to disclose the numerous outside business ventures in which Ebbers was involved, in addition to what was supposed to be his full-time job as WorldCom’s CEO, and that he would undoubtedly be distracted by the demands of running these businesses. 40. Failed to disclose that certain Underwriter Defendants were concerned about Ebbers’ long-term objectives and the depth of senior management on WorldCom’s future financial health. 41. Failed to disclose that the Underwriter Defendants did not conduct an adequate investigation into Ebbers’ ability to repay his personal loans, much of which was guaranteed by WorldCom. 42. Failed to disclose that the audit committee of WorldCom’s Board of Directors was not actively involved in discharging its duty to oversee the auditing of the Company’s financial statements. The Underwriter Defendants have moved for summary judgment with respect to each of these alleged omissions. The Lead Plaintiff argues in response that the 2001 Registration Statement should have included discussions of the Underwriter Defendants’ conflicted relationship with *695 WorldCom and Ebbers, their decision to downgrade WorldCom as a credit risk and to hedge their own financial exposure to WorldCom, WorldCom’s intent to use the proceeds of the offering to fund negative cash flow, and WorldCom’s cash flow needs and ability to service its debt, as well as a risk factor section.61 For reasons similar to those discussed in connection with the 2000 Registration Statement, the motion for summary judgment on the claims based on the conflicts of interest, and WorldCom’s cash flow and debt problems are denied. Because the Lead Plaintiff has not responded sufficiently to the arguments made by the Underwriter Defendants, or for the reasons explained herein, the Underwriter Defendants’ motion is granted for listed omissions 8, 16-20, 22-29, 31-33, 35, and 39-42. The motion is granted as to the omission of any disclosure that the Underwriter Defendants had internally downgraded WorldCom as a credit risk, and the omission from the use of proceeds section of the Registration Statement.


1. Downgrading WorldCom as a Credit Risk [32] In February 2001, several of the Underwriter Defendants internally downgraded their credit ratings for WorldCom and some of them took steps to minimize or hedge their own exposure stemming from their participation in WorldCom credit facilities. While the Underwriter Defendants did not publicly disclose their ratings during this same period S & P publicly downgraded its credit rating for WorldCom. The SEC regulations do not include, in their lengthy and detailed description of facts to be disclosed in a registration statement, any requirement to disclose an underwriter’s internal credit ratings for the issuer or an underwriter’s management of its own exposure on loans to an issuer. See Schedule A to Section 7(a) of the Securities Act, 15 U.S.C. §§ 77g(a), 77aa, and Reg. S-K, 17 C.F.R. § 229.10, et seq. The limited disclosures that the regulations do require regarding an underwriter have already been described. Regulation S-K permits the disclosure of an issuer’s credit ratings but does not compel it. The SEC initially discouraged the disclosure of credit ratings publicly reported by credit agencies since the “rating represents the subjective opinion of the rating organization that cannot be verified or even explained by the issuer of the securities.” Disclosure of Security Ratings in Registration Statements, SEC Release No. 6336, 1981 WL 30768, at *3 (Aug. 6, 1981) (“SEC Rel. 6336”). In 1981, however, the SEC revised its policy to “permit[ ] registrants to disclose, on a voluntary basis, ratings assigned by rating organizations to classes of debt securities ... in registration statements and periodic reports.” 17 C.F.R. § 229.10(c) (emphasis supplied). In so doing, the SEC noted the “significance and usefulness” of ratings to investors, market professionals, and regulatory *696 bodies alike. SEC Rel. 6336, 1981 WL 30768, at *3. The SEC further emphasized that by enabling registrants to include security ratings assigned to a class of debt securities in a registration statement, it was not imposing “a mandatory rule in this area nor ... indicating that issuers should disclose security ratings.” Id. at *4. The Underwriter Defendants had no obligation to disclose in the WorldCom Registration Statement information about their own internal credit ratings for WorldCom or their own hedging strategies for WorldCom debt that they held. These facts were unknown to WorldCom, and the Lead Plaintiff has not shown that the registration process requires disclosure of such facts. This does not mean, however, that the Underwriter Defendants’ internal credit ratings and hedging strategies are irrelevant to the issues to be tried. An underwriter’s perception of the nature of the risks faced by a WorldCom creditor is some evidence of the existence of such risks, and thus reflects on the quality of disclosures that an underwriter was required to ensure were made through a registration statement.62 Even if these internal downgrades and hedging activities need not be disclosed, the Lead Plaintiff has shown that they help to raise material issues of fact as to whether the 2001 Registration Statement adequately described the risk of investing in WorldCom.


2. Use of Proceeds [33] The Lead Plaintiff contends that it was a material omission not to disclose, in the “use of proceeds” section of the 2001 Registration Statement, that the proceeds would be used to fund WorldCom’s “negative cash flow.” The Prospectus Supplement disclosed that the proceeds would be used for general corporate purposes, including “to repay commercial paper, which was used for general corporate purposes.” Item 504 of Regulation S-K requires a registration statement to disclose the “principal purposes for which the net proceeds to the registrant from the securities to be offered are intended to be used and the approximate amount intended to be used for each such purpose.” 17 C.F.R. § 229.504 (emphasis supplied). While “[d]etails of proposed expenditures need not be given,” the Instructions to Item 504 direct a registrant to consider “the need to include a discussion of certain matters addressed in the discussion and analysis of [the] registrant’s financial condition.” Id. Moreover, the Instructions explain that a registrant “may reserve the right to change the use of proceeds, provided that such reservation is due to certain contingencies that are discussed specifically and the alternatives to such use in that event are indicated.” Id. Last year, the Second Circuit affirmed the dismissal of a claim that a prospectus that stated that the proceeds would primarily be used as working capital for business expansion, including for “general corporate purposes,” was false and misleading. DeMaria, 153 F.Supp.2d at 313. The issuer’s “alleged use of the proceeds in part to repay [ ] losses does not constitute a misstatement because a function of working capital is to fund operations.” *697 DeMaria, 153 F.Supp.2d at 313. In contrast, an issuer’s declaration in a prospectus that a portion of the proceeds from a debt offering would be used to repay in full certain short-term bank borrowings was actionable when substantially all of the proceeds were used for this purpose. Beecher v. Able, 374 F.Supp. 341, 355 (S.D.N.Y.1974). The disclosure that the proceeds would be used for “general corporate purposes” was broad enough to include the funding of negative cash flow. There is no misrepresentation about the use of proceeds, and Item 504 does not require disclosure of details. Whether the Registration Statement otherwise adequately disclosed material information about WorldCom’s cash flow is more appropriately addressed in the context of its omission of a risk factors section.

3. Risk Factors The Lead Plaintiff asserts that Item 503(c) of Regulation S-K required the 2001 Registration Statement to include a risk factors section that discussed WorldCom’s ability to satisfy its debt burden and its lack of planning in that regard, the fact that it was not cash-flow positive, the problems it was experiencing placing its commercial paper, WorldCom’s renegotiation of its credit facilities, and the fall in WorldCom’s stock price.63 The Underwriter Defendants rely on their argument that it is unnecessary to include a risk factors section in the Registration Statement unless there are “special circumstances” and that none existed here.


[34] This prong of the Lead Plaintiff’s case rests on its overarching argument that the 2001 Registration Statement did not adequately describe critical financial information about WorldCom that any reasonable investor would have wanted to have and that should have been included in the Registration Statement in a complete and accessible manner. Whether, when read as a whole, the 2001 Registration Statement adequately described WorldCom’s financial position and the risks attendant to a purchase of WorldCom bonds is a question for the jury. In the event that the 2001 Registration Statement did adequately describe the risks, albeit not in a section labeled “risk factors,” that description would ameliorate if not eliminate any argument that the failure to include the description a section labeled “risk factors” was material. The Lead Plaintiff has shown that there are questions of fact as to whether material information regarding WorldCom’s financial condition was omitted from the 2001 Registration Statement, and as to whether that omitted information was of the kind that should have been highlighted by including it in a section labeled “risk factors.”

Conclusion

The motion by the Securities Industry Association and the Bond Market Association to appear as amici curiae is granted. For the reasons stated herein, the parties’ motions for summary judgment are each granted in part and denied in part. The Lead Plaintiff’s motion is granted as to WorldCom’s 2001 Registration Statement insofar as it reported line costs *698 in WorldCom’s first quarter financial statement for 2001. The Underwriter Defendants’ motion is granted as to listed omissions 12-18 and 20 for the 2000 Registration Statement, and 8, 16-20, 22-29, 31-33, 35, and 39-42 for the 2001 Registration Statement.

SO ORDERED:

Parallel Citations

Fed. Sec. L. Rep. P 93,057, Fed. Sec. L. Rep. P 93,062

Footnotes 1

Line costs, which are transmission costs, are described below. They were the single largest operating expense incurred by WorldCom.

2

The MDL Panel also transferred all litigation concerning WorldCom raising issues under the Employment Retirement Income Security Act, 29 U.S.C. § 1001 et seq., to this district. It has been consolidated and is referred to as the ERISA Litigation.


3

Fact discovery of the plaintiffs in the Individual Actions remains to be done.

4

The underwriters consist of Salomon Smith Barney, Inc., now d/b/a/ Citigroup Global Markets Inc. and Salomon Brothers International Limited (collectively “SSB”); J.P. Morgan Chase & Co., J.P. Morgan Securities, Ltd., & J.P. Morgan Securities, Inc. (collectively “J.P. Morgan”); Banc of America Securities LLC; Chase Securities Inc.; Lehman Brothers Inc., Blaylock & Partners, L.P.; Credit Suisse First Boston Corp.; Deutsche Bank Alex. Brown, Inc., now known as Deutsche Bank Securities, Inc.; Goldman, Sachs & Co.; UBS Warburg LLC; ABN/AMNRO Inc.; Utendahl Capital; Tokyo-Mitsubishi International plc; Westdeutsche Landesbank Girozentrale; BNP Paribas Securities Corp.; Caboto Holding SIM S.p.A.; Fleet Securities Inc.; and Mizuho International plc. Some of the Underwriter Defendants participated in only one of the two Offerings. For purposes of this Opinion, it is unnecessary to distinguish among them. As used in this Opinion, the term “Underwriter Defendants” refers to all underwriters except for SSB.

5

With one exception, all of the material misstatements in the 2000 and 2001 offerings outlined by Lead Plaintiff in its responses to the Underwriter Defendants’ second set of interrogatories are grounded in WorldCom’s financial statements. The sole exception relates to statements in the May 2001 Registration Statement as to how proceeds from the offering would be used. This alleged misstatement is similar to an alleged omission in the registration statement, and the Underwriter Defendants have presented arguments in their briefs that address either characterization.

6

Bandwidth is used to mean the rate of data transmission and refers to the maximum amount of information that can be sent along a particular communications circuit per second.

7

A November 21, 2000 SSB memorandum explains that the SSB private banking group held approximately $50 million of margin loans to Ebbers and certain of his companies which were secured by WorldCom stock. At the then current price of WorldCom stock, this gave Citigroup an unsecured exposure of $5 million. The memorandum explained, “[o]n the strength of the corporate finance relationship between SSB and [WorldCom], SSB effectively guaranteed the Private Bank’s exposure, and has elected not to enforce the margin call provisions or the demand feature of our loan documents. We are, however, in the process of taking liens on the client’s vacation condo and his yacht which reportedly have aggregate value sufficient to cover our clean exposure.”

8

On July 9, 2004, the Underwriter Defendants refused, when responding to the Lead Plaintiff’s Requests for Admission, to admit that any of WorldCom’s financial disclosures contained misstatements. The Underwriter Defendants maintained this position during a telephone conference with the Court and other parties on August 18, 2004, noting that Andersen had taken an identical stance. Two days later, however, the Underwriter Defendants filed their motion for summary judgment, in which they represent that they are reviewing their responses to Lead Plaintiff’s Requests for


Admission “to determine the extent to which amendment of any denial is required by the fact that WorldCom improperly accounted for $771 million in line costs in the first quarter of 2001.”

9

A reserve was created when WorldCom received a bill that was smaller than the bill it had estimated it would receive. The statute of limitations on submitting a corrected bill, or “backbilling,” was understood to be 24 months.

10

On November 1, 2000, WorldCom announced a plan to separate its businesses and create two publicly traded tracking stocks: WorldCom, which would reflect the performance of WorldCom’s “core high-growth data,” Internet, hosting and international businesses; and MCI, which would reflect the performance of its high cash flow consumer, small business, wholesale long-distance voice and dial-up Internet access operations.

11

A Form 8-K is the SEC form used for companies’ current reports pursuant to Sections 13 and 15(d) of the Exchange Act, 15 U.S.C. §§ 78m(a)(2), 78o(d). A Form 8-K must be filed upon the occurrence of certain significant corporate events as defined by the SEC and may be filed with respect to any other matter the company considers of material importance.

12

The Underwriter Defendants argue that these documents have never been authenticated.

13

The 2001 Line Cost Budget reads in this connection: “YOY change in E/R largely impacted by: Increase in submitted E/R in domestic voice/data: ... Depletion of reserve liabilities ....” (emphasis supplied).

14

The Underwriter Defendants contend that the Lead Plaintiff has focused on the wrong page of the document and should focus on the last page “which shows actual capital expenditures of less than what WorldCom actually reported.” It is the Lead Plaintiff’s contention, however, that the Capital Expenditure Report does in fact reflect “actual capital expenditures of less than what WorldCom actually reported.” It would appear, therefore, that the parties are reading the document in a similar way.

15

Morse testified that without that software tool and without access to the general ledger (which the internal audit department did not have), it would have taken him weeks of digging to uncover the fraud. In his opinion, someone with access to the general ledger or someone who asked those who made the questionable entries for the documentation to support the entries, could also have uncovered the fraud.

16

A Form 10-K is an SEC form used to file a company’s annual report pursuant to Sections 13(a)(2) and 15(d) of the Exchange Act, 15 U.S.C. §§ 78m(a)(2), 78o(d).

17

“An unqualified opinion, the most favorable report an auditor may give, represents the auditor’s finding that the company’s financial statements fairly present the financial position of the company, the results of its operations, and the changes in its financial


position for the period under audit, in conformity with consistently applied generally accepted accounting principles.” United States v. Arthur Young & Co., 465 U.S. 805, 818 n. 13, 104 S.Ct. 1495, 79 L.Ed.2d 826 (1984).

18

A Form 10-Q is the SEC form used for quarterly reports under Sections 13(a)(2) and 15(d) of the Exchange Act, 15 U.S.C §§ 78m(a)(2), 78o(d).

19

A book runner is responsible for pricing the offering and allocating shares to institutional and retail investors. A lead manager determines the amount of shares reserved for its own sales efforts and the amount of the offering for other members of the syndicate.

20

As described below, a registration statement is composed of two documents: a prospectus, and other information the SEC regulations require an issuer to disclose.

21

The draft document noted, for instance, that the development of the business of WorldCom required “significant capital expenditures” and that it planned to “access” the debt market to meet its needs to the extent that its cash flow, credit facilities, and commercial paper program were insufficient. It warned that the “effect of technological changes, including changes relating to emerging wireline and wireless transmission and switching technologies, on the businesses of MCI WorldCom cannot be predicted.” It described legislation and court rulings that were affecting its business. On the issue of competition, the draft document noted over the course of a several page detailed discussion that WorldCom expected that competition would intensify, including competition “due to the development of new technologies.”

22

WorldCom explained that it “no longer disclose[d]” risk factors related to the business of WorldCom in its SEC filings. Insofar as the regulatory environment was concerned, it noted that it updated its regulatory information each quarter in its “34 Act filings.” WorldCom did, however, want to consider whether risks associated with the Sprint merger should be included.

23

The memorandum indicated that due diligence for WorldCom for the period prior to August 17, 1999 was contained in a document of that date.

24

The memorandum does not identify who participated in the conversation with Sullivan.

25

By February 21, 2001, a J.P. Morgan banker described the burden of carrying the debt associated with the Intermedia business as “a serious risk factor” for WorldCom.

26

The Underwriter Defendants contend that at this point in time the author no longer had the responsibility for assigning a credit rating to WorldCom.

27

According to a March 28, 2001 Bank of America memorandum, “[b]ecause WCOM needs to refinance its existing Bank Facilities in a tough bank environment, the Company has stated that it will tie the bank refinance with its new $10 billion bond


deal. Specifically, the Company stated it plans to only ask a few players (including BAS) to hold $800 million in the new Bank Facilities for Joint Book Running Manager on the bonds.”

28

This Opinion does not discuss similar evidence regarding SSB, on this and other points, since it has settled with the Lead Plaintiff. That evidence will be admissible at trial, however, to the extent that SSB’s due diligence is at issue.

29

A credit default swap enables a lender to hedge its exposure to a borrower. The lender enters into a swap contract and pays a premium for credit default protection to the swap seller. In the event of a failure to pay, the swap seller agrees to pay the lender the value of the loan. If there is no failure to pay, the lender has lost only the premium.

30

The Bank of America communication reflecting this plan reads: “we will get down in this facility to $500MM (through syndication, secondary sales or 364 day credit default swaps) ... we are telling the company $800MM hold though.” A February 2 Bank of America memorandum put the problem succinctly: “If we try (and successfully win) Joint Books this quarter of a potential ... Bond deal and then try and exit the Securitization (we are one of the Leads) or significantly lower commitment as the Lead in one of the larger Bank deals out there at $10.25BN ... WCOM should go nuts.” (Emphasis supplied.)

31

The memorandum lists the date as April 19, 2000. It is assumed that it should be April 19, 2001.

32

The memorandum indicates that the due diligence for WorldCom for the period from August 16, 1999 to May 23, 2000 is contained in a memorandum of May 26, 2000.

33

The Lead Plaintiff contends that the lead investment banker for Bank of America was aware that her bank’s credit experts had downgraded WorldCom, and that she testified that that knowledge did not influence her due diligence and that she did not advise any other Underwriter Defendant or Cravath that her bank had downgraded WorldCom. The Lead Plaintiff has not included with its summary judgment papers the deposition pages that would confirm that description.

34

EBITDA stands for earnings before interest, taxes, depreciation, and amortization.

35

In working on the draft of this document, a Cravath attorney had opined that this description was “too broad” and needed to be revised to add more detail of WorldCom’s intentions.

36

Section 11 states in pertinent part: In case any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security (unless it is proved that at the time


of such acquisition he knew of such untruth or omission) may ... sue- (1) every person who signed the registration statement; (2) every person who was a director of ... the issuer ...; .... (4) every accountant ... who has with his consent been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report or valuation which is used in connection with the registration statement ...; (5) every underwriter with respect to such security.

If such person acquired the security after the issuer has made generally available to its security holders an earning statement covering a period of at least twelve months beginning after the effective date of the registration statement, then the right of recovery under this subsection shall be conditioned on proof that such person acquired the security relying upon such untrue statement in the registration statement or relying upon the registration statement and not knowing of such omission, but such reliance may be established without proof of the reading of the registration statement by such person.

15 U.S.C. § 77k(a).

37

Regulations S-X and S-K, which were developed as parts of the “integrated disclosure system,” which is described below, also address the form and content of disclosure under the Exchange Act. See, e.g., 2 Louis Loss & Joel Seligman, Securities Regulation 607 (3d ed.1999).

38

The standard for materiality under Sections 11 and 12 of the Securities Act is “identical to that under Section 10(b)” of the Exchange Act. Rombach v. Chang, 355 F.3d 164, 178 n. 11 (2d Cir.2004).

39

Although fact discovery closed on July 9, 2004, the parties in the Securities Litigation were permitted to reserve time to depose ten witnesses that the Government deems critical to its prosecution of Ebbers following their testimony in Ebbers’ criminal trial. Ebbers’ trial is scheduled to begin on January 17, 2005.

40

As described below, the Underwriter Defendants are entitled to rely on the due diligence defense whether or not it would have uncovered the fraud. Conversely, they must shoulder the burden of establishing their due diligence even if that due diligence would not have revealed the existence of fraudulent conduct. The parties have not addressed whether the Underwriter Defendants’ argument in this regard would be more persuasive under Section 12(a)(2). Compare 5 Arnold S. Jacobs, Disclosure and Remedies Under the Securities Laws § 3:158 (West 2004) (contending that a defendant could successfully establish a reasonable care defense under Section 12(a)(2) “if he does not exercise reasonable care but would have been unable to ascertain the falsity even if he had used reasonable care”) with 3B Harold S. Bloomenthal & Samuel Wolff, Securities & Federal Corporate Law § 12:6 (2d ed. 1998) (“Given the role of an underwriter, in order to avoid Section 12(a)(2) liability it must make a reasonable investigation in order to establish that it used reasonable care.”).


In Demarco v. Edens, 390 F.2d 836 (2d Cir.1968), the Court of Appeals affirmed a judgment following trial that an issuer had used “reasonable care” in selecting an underwriter and did not know that the underwriter would not remit the proceeds of the sale of securities. Id. at 842. The court observed both that the issuer had taken the steps necessary to show its reasonable care but also that it did not need to “probe[ ] more deeply into the background and affairs” of the underwriter as “[f]urther inquiry ... would have disclosed nothing.” Id. at 843.

41

Section 11 also provides a defense to an expert as concerns “any part of the registration statement purporting to be made upon his authority as an expert.” The expert must prove that

he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading.

15 U.S.C. § 77k(b)(3)(B) (emphasis supplied).

42

Financial statements are generally understood to include a balance sheet, an income statement, a statement of changes in stockholders’ equity, a statement of cash flow, and related note disclosures.

43

SAS 71 states that an accountant’s “report accompanying interim financial information that he or she has reviewed should consist of” the five components of the Rule 436 definition as well as three additional requirements, such as a statement that the financial information is the responsibility of the company’s management. Statement on Auditing Standards 71, Codification of Auditing Standards and Procedures, “Interim Financial Information” (AICPA, Professional Standards, vol. 1, AU § 722).

44

At the time that Rule 436 was implemented, SAS 24 was the governing standard for auditors’ reviews of unaudited interim financial statements. In 1992, it was superceded by SAS 71, which was in effect during the events at issue here. See John J. Huber et al., An Underwriter’s Due Diligence in the Permitted Absence of an Expert’s Consent, Insights, Aug. 2002, at 2 n. 23.

45

Although Rule 415 was not finalized until 1983, it was proposed concurrently with the development of Form S-3 and Rule 176, which is discussed below. See generally SEC Rel. 6335, 1981 WL 31062, at *2 (listing a “three tier system for the registration of securities, Forms S-1, S-2 and S-3” and “a new rule governing registration of securities to be sold in a continuous or delayed offering” among several rulemaking proposals announced on the same day as Rule 176).

Rule 415 does not limit shelf registration to those issuers eligible to use Form S-3, but also permits shelf registration for “traditional primary and secondary shelf offerings,” including “those where securities are sold to employees, customers or existing shareholders; those involving interests in limited partnerships; those related to acquisitions and other business combinations; and those of securities underlying


options, warrants, rights or conversions.” SEC Rel. 6499, 1983 WL 408321, at *7; see generally 17 C.F.R. § 230.415.

46

Academic assessments of Rule 176 have often observed that Rule 176 does not provide a safe harbor. See, e.g., Donald C. Langevoort, Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment, 63 Law & Contemp. Probs. 45, 63 (2000) (Rule 176 does not furnish a “true safe harbor, providing immunity to underwriters who follow its guidelines.”).

47

WorldCom’s E/R ratio was 43%. The expert for the Lead Plaintiff calculates that AT & T’s equivalent ratio was 46.8% and Sprint’s was 53.2%.

48

The Underwriter Defendants assert that they were extremely knowledgeable about the telecommunications industry and had a sophisticated understanding of it and WorldCom’s place within that industry due to their continuous due diligence over the years. They do not deny that they were, and were required to be, in a position to understand and analyze the significance of a variation in E/R ratios.

49

The Underwriter Defendants contend that the Lead Plaintiff’s expert has included costs AT & T and Sprint incurred to operate their own lines, while WorldCom’s E/R ratio is based solely on the amount it pays to others for access to lines. In their reply brief, the Underwriter Defendants represent that Lead Plaintiff’s expert calculates that the line costs for 1999 were understated by $60 million, which would have had a minimal effect on the E/R ratio. They argue that this discrepancy was not material. Arguments made for the first time in reply will not be considered.

50

When WorldCom acquired MCI for $47 billion, $29 billion of that purchase price was attributed to goodwill, which is treated as an intangible asset.

51

The Underwriter Defendants principally rely on a reading of correspondence between WorldCom and the SEC regarding WorldCom’s use of a forty-year useful life depreciation curve for goodwill and industry practice.

52

To the extent that the Lead Plaintiff seeks to find an issue of fact from the differences between the comfort letters provided in 2000 and 2001, that argument does not seem particularly strong. The 2001 Registration Statement incorporated WorldCom’s Form 8-K for the first quarter of 2001, while the 2000 Registration Statement incorporated Worldcom’s Form 10-Q for the first quarter. The Underwriter Defendants appear to have shown that in 2001 Andersen gave the appropriate form of comfort letter for a Form 8-K.

53

Reflecting on underwriters’ role as the procurer and verifier of critical issuer-specific information, some academic commentators describe them as “reputational intermediaries” or “gatekeepers.” See, e.g., John Coffee, Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L.Rev. 301, 302 n. 1, 308 nn. 13-14 (2004).


54

This list is taken from the June 4, 2004 Response by the Lead Plaintiff to the Underwriter Defendants’ Second Set of Interrogatories. On June 14, 2004, the Lead Plaintiff supplemented that response. The June 14 document principally adds detail for some of the items in the June 4 document.

55

The Underwriter Defendants contend that the Prospectus Supplement was filed on May 12 and not May 19. They are wrong. There is a Prospectus that is dated May 12, 2000. This document is attached to the Prospectus Supplement dated May 19, 2000. On its first and last pages, the Prospectus Supplement indicates that its date of filing is May 19, and that it includes the May 12 Prospectus.

56

The parties dispute whether the “spinning” of IPO shares to Ebbers and other WorldCom executives was publicly disclosed during the class period.

57

The Underwriter Defendants contend that any ruling that it is for the jury to decide whether it was a material omission to fail to disclose their economic entanglements with Ebbers will require disclosure in every underwriting of home mortgages, student loans, and checking and savings accounts. This very list underscores the difference between ordinary arrangements between employees and banks and the extraordinary financial relationships between the Underwriter Defendants and Ebbers. The Lead Plaintiff has presented sufficient evidence for a fact finder to conclude that Ebbers’ arrangements with the Underwriter Defendants were of a magnitude and complexity to be both extraordinary and material to investors. Should the jury agree, such a decision should not be read as indicating that there is a duty to disclose an executive’s ordinary banking arrangements and relationships.

58

This list is taken from the Lead Plaintiff’s June 14, 2004 Supplemental Responses to Underwriter-Related Defendants’ Second Set of Interrogatories. The list omits those items where the Lead Plaintiff did not respond to the arguments made by the Underwriter Defendants.

59

Among the passages in the 1999 Form 10-K and first quarter 2000 Form 10-Q on which the Underwriter Defendants rely as evidence of the adequacy of the disclosures in the 2000 Registration Statements are descriptions of increases in “voice revenues” that were partially offset by declines in “wholesale traffic” and federally mandated access charge reductions. They also point to descriptions in the 1999 Form 10-K of a number of factors that could impact WorldCom’s ability to compete successfully in its data and Internet portal business and the statement that “[t]he success of MCI WorldCom will depend heavily upon its ability to provide high quality data communications services, including Internet connectivity and value-added Internet services at competitive prices.” The Form 10-K added that “the Company’s pursuit of necessary technological advances may require substantial time and expense,” and devoted an entire paragraph to an explanation of the necessity for significant capital expenditures to develop a competitive business.


60

Because the parties addressed so many issues in their papers, they did not address the remaining risk factor issues in sufficient detail to allow a reasonable assessment to be made as to them.

61

Although the Lead Plaintiff also refers to the problems that plagued the Intermedia acquisition, it does not respond to the detailed arguments made by the Underwriter Defendants outlining the disclosures about those problems in, inter alia, Intermedia’s and WorldCom’s public filings, including WorldCom’s May 9, 2001 Form S-4 filed in connection with that merger. Similarly, although the Lead Plaintiff refers to the fact that the creation of the tracker stocks had no legitimate business purpose, it does not respond to the Underwriter Defendants’ recitation of the extensive disclosures about these stocks and WorldCom’s concomitant realignment of its business units. The Underwriter Defendants have shown that, given the extensive disclosures by WorldCom, they are entitled to summary judgment on the omissions relating to Intermedia and the tracker stocks.

62

The Underwriter Defendants’ internal credit ratings for WorldCom and their hedging activities are also relevant to the due diligence defense that the Underwriter Defendants intend to proffer at trial. While the Underwriter Defendants argue that it is always prudent to hedge one’s investments, it will be a question of fact for the jury whether the hedging activity undertaken here was in the ordinary course or because of special concern over WorldCom’s economic health.

63

This list of omitted risk factors is taken from the Lead Plaintiff’s Supplemental Responses to the Underwriter-Related Defendants’ Second Set of Interrogatories. The list omits certain items which are not discussed in the Lead Plaintiff’s opposition to summary judgment. It also omits the fact that several of the senior underwriters had recently lowered their internal credit ratings for WorldCom. For reasons already discussed, there was no duty to disclose this last fact.


Documents

CHAPTER TWO - RESOURCE MATERIALS - cadds-edu.org