Seventh Circuit Court of Appeals Commentary : In Their Opinion : Lawyer & Attorney Michael E. Rigney : Kelley Drye & Warren Law Firm

On June 16, 2011, the Court granted a petition for panel rehearing and vacated this opinion and judgment.

COSTELLO v. GRUNDON (October 18, 2010)

Several senior Comdisco, Inc. employees participated in the company’s shared investment plan (SIP) program. Under the program: a) participants purchased Comdisco stock, b) the purchase was funded exclusively by personal loans, c) the participants executed promissory notes in their personal capacities, d) Comdisco guaranteed the loans, e) the lenders remitted the loan proceeds directly to Comdisco, f) Comdisco held the shares, g) there were several restrictions on the ability to sell the stock, and h) participants delivered a blank stock power to Comdisco. Within two years, the stock price had risen from $34.50 to $53.00. Many participants sold their shares and made a nice profit. Others, however, did not and were still holding the stock when Comdisco went into bankruptcy. The lenders settled with Comdisco on the guaranty obligation. As part of the settlement, the lenders assigned their rights under the notes to the Comdisco Litigation Trustee. The Trustee brought individual actions against the participants. He moved for summary judgment against two of the participants. The court granted the Trustee’s motion, holding that the Trustee made a prima facie case and rejecting several defenses: a) the alleged misrepresentations were expressions of legal opinion and could not support a fraud finding, b) defendants had not shown reliance, c) defendants could not assert a violation of Regulation U as a defense, and d) a negligent misrepresentation defense was not available against the Trustee. The Trustee subsequently moved for summary judgment against the remaining defendants on the same papers. Defendants raised new defenses. Judge Gettleman (N.D. Ill.) granted the Trustee’s motion, rejecting the additional defenses. The defendants appeal.

In their opinion, Judges Kanne, Rovner, and Tinder affirmed in part and vacated in part. The Court addressed each of the many arguments on appeal in turn. Regulations G and U Violations Defense: Although the Court discussed at length and questioned the district court’s treatment of Comdisco’s or the lenders’ violation of Regulation U or G, it ultimately concluded that it did not need to decide the issue. It concurred with the district court that, even if a violation existed, it did not provide an illegality defense. Relying on Bassler, Blair, and Shearson, the Court noted that the regulations were not meant to protect individual investors and a violation does not make the underlying contract illegal. Section 10(b) Illegality Defense: The Court did disagree with the district court’s treatment of defendants’ defense under § 10(b) of the Securities Exchange Act of 1934. Although the Trustee moved for summary judgment based only on the absence of a false statement, the district court granted it on the absence of scienter, raised only in the reply brief. The Court stated that the Trustee had the initial burden of identifying the basis of his request for relief – the defendants were not required to respond to other grounds, even if later raised in the reply. Although the defendants could have responded to the Trustee’s arguments or sought further discovery, they were not required to do so. Furthermore, the Court found that the district court’s requirement of a heightened “strong inference” of scienter was improper. Finally, the Court declined to itself affirm on the alternative grounds raised by the Trustee in its reply below. Section 17(a) Defense: The district court’s ruling with respect to defendants’ defense under § 17(a) of the Securities Act of 1933 was erroneous for the same reason as the ruling on § 10(b). The court improperly ruled that defendants failed to present evidence of scienter when they were under no obligation to do so at this stage of the proceedings. Fraud and Negligent Misrepresentation Set-Off Defenses: With respect to the fraud and negligent misrepresentation set-off defenses, the district court adopted the ruling and reasoning of it decision on the first summary judgment motion. There is nothing wrong with that, said the Court, except here the defendants presented a new legal argument on the fraud defense and additional evidence with respect on the negligent misrepresentation defense that the court did not consider. The Court concluded that summary judgment in the Trustee’s favor on both was error. Excuse of Non-Performance Defense: Lastly, the Court held that it was error to grant summary judgment on the excuse of non-performance defense. The defendants argued that the lenders’ non-compliance with § 17(a), § 10(b), and Regulation U amounted to a breach of contract and thus excused their performance. The Court concluded that the district court erred in granting summary judgment with respect to the §§ 17(a) and 10(b) claims – given that the Court had just vacated the summary judgments on the underlying defenses. With respect to Regulation U, however, the Court agreed that a violation would not excuse performance since the participants were not in the “zone of interest.” The Court remanded for further proceedings.

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BECK v. DOMBROWSKI (March 20, 2009)

Philip Beck (and the class he represents) was a shareholder of Equity Office Property Trust ("EO"), a real estate investment trust. In late 2006, after EO agreed to be acquired by Blackstone Group, a bidding war ensued between Blackstone and Vornado. Offers and counter offers were each followed by a new proxy solicitation from EO's board. Eventually, EO accepted Blackstone's last bid. Beck brought suit under the Securities Exchange Act and SEC Rule 14a-9, as well as under state law. He alleged misrepresentations and omissions in the proxy solicitation. The district court dismissed the federal claims for a failure to plead the required state of mind with particularity. The court dismissed the state law claim under the doctrine of abstention. Beck appeals.

In their opinion, Judges Posner, Wood and Tinder affirmed. The Court first identified the erroneous basis on which the district court had dismissed the action. Rule 14a-9 does not require a state of mind for a violation -- only a misrepresentation or omission. Notwithstanding the district court's error, the Court still concluded that the complaint should be dismissed. Citing the principle of Bell Atlantic that a defendant should not have to incur the expense of discovery unless the complaint is a substantial one, the Court found that the plaintiffs’ theories were too speculative to survive. The Court also affirmed the lower court's dismissal of the state law claim under Colorado River abstention.

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STARK TRADING v. FALCONBRIDGE LIMITED (January 5, 2009)

Brascan Asset Management (“Brascan”) owned 41% of the common stock of Noranda, Inc. (“Noranda”). Noranda owned, in turn, 59% of Falconbridge, Inc. (“Falconbridge”). Noranda and Falconbridge were both large Canadian mining companies. In March 2005, Noranda offered the minority shareholders in Falconbridge 1.77 shares of Noranda stock for each share of Falconbridge. The offer was conditioned on being accepted by holders of more than half of Falconbridge’s shares. The plaintiffs (two hedge funds) bought Falconbridge shares in the months leading up to the tender-offer expiration date in May. The plaintiffs believed that Falconbridge was grossly undervalued. Before the expiration of the tender-offer, the plaintiffs learned of many problems in the transaction. They expressed their concerns to the Canadian regulators. They exposed a conflict of interest at the investment bank that did the valuation of Falconbridge and in the internal Falconbridge committee that considered the valuation. They also warned that Noranda overstated the value of its own shares. The plaintiffs tendered their shares and the tender-offer succeeded. A few months later, Noranda and Falconbridge merged. Shortly thereafter, another mining company offered to buy the merged company for a price substantially above the tender-offer price. The plaintiffs brought this action against both the merged company and Brascan. The suit was based on the SEC’s Rule 10b-5 and section 11 of the Securities Exchange Act. The district court dismissed the suit for failure to state a claim. Plaintiffs appeal.

In their opinion, Judges Posner, Kanne and Tinder affirmed. The Court first addressed the Rule 10b-5 fraud claims. A claim of fraud cannot be maintained without proof that the plaintiffs relied on the misleading misrepresentations or omissions of the defendant. The Court concluded that plaintiffs were not deceived. They knew Falconbridge was undervalued, they knew the offer was too low, and they knew that Noranda engaged in fraud. They did not try, however, to influence other minority shareholders or even to publicly disclose the information. What they had wanted was a higher offer. Not getting it and worried about the lack of minority shareholder protection under Canadian law, they tendered their shares. Other investors may have been deceived but the plaintiffs actually saw through the fraud. The Court agreed that they could not maintain a 10b-5 action. With respect to the §11 claim, the Court noted that it does not require reliance. A person may bring an action under §11 if the registration statement of the security contains an untrue statement or material omission. The plaintiffs fare no better under §11, however, than they did under 10b-5. The measure of damages is the difference between the purchase price paid by the plaintiff and the share price when it was sold or at the time of the suit, if still owned. Here, the value of the plaintiffs’ investment was higher at the time of the suit than when they purchased the shares.

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