Fed. Sec. L. Rep. P 95,475 David B. Kusner v. First Pennsylvania Corporation, 531 F.2d 1234, 1st Cir. (1976)
Fed. Sec. L. Rep. P 95,475 David B. Kusner v. First Pennsylvania Corporation, 531 F.2d 1234, 1st Cir. (1976)
Fed. Sec. L. Rep. P 95,475 David B. Kusner v. First Pennsylvania Corporation, 531 F.2d 1234, 1st Cir. (1976)
2d 1234
The district court held that Counts I--III should be dismissed because plaintiff
was a creditor of the Trust and as such, under Rule 23.1 and our holding in
Kauffman v. Dreyfus Fund, Inc., 434 F.2d 727 (2d Cir. 1970), cert. denied, 401
U.S. 974, 91 S.Ct. 1190, 28 L.Ed.2d 323 (1971), could not pursue a derivative
claim; because the Investment Advisers Act did not afford creditors standing to
prosecute derivative suits for the benefit of the Trust; and because the
complaint did not allege compliance with the requirement of Rule 23.1 that a
demand for action be made on the independent trustees prior to suit. No appeal
has been taken from the dismissal of Counts I--III, and thus the correctness of
those rulings is not before us. The district court also dismissed Count IV,
holding that the plaintiff, a mere creditor, lacked individual standing to sue.3
This appeal is from that ruling. We reverse.
* Although Count IV is premised upon many of the same facts alleged in the
derivative counts, it is a direct suit by a purchaser of securities, based on 11
and 17(a) of the Securities Act, 15 U.S.C. 77k and 77q(a), and on 10(b)
and 18 of the Securities Exchange Act, 15 U.S.C. 78j(b) and 78r. The district
court concluded that the injury complained of in Count IV was not to the
individual debenture holders, but to the Trust, and thus derivative. Invoking the
rule of Kauffman v. Dreyfus Fund, Inc., supra, that a security holder may
maintain a personal action only where he has suffered individual injury, the
district court concluded that all the wrongs complained of were to the Trust,
and dismissed Count IV of Kusner's complaint for lack of the requisite personal
interest.
4
There is no question, then, that he meets the standing test of the Blue ChipBirnbaum rule. The only remaining question is whether, on any state of facts
which he might prove under the allegations of Count IV, he could show injury.
Defendants argue that as long as the debentures are not in default, Kusner has
not exercised his conversion privilege and he has not purchased stock pursuant
to the warrants, he has not been injured by any misrepresentations that might
have occurred. This argument overlooks the significant difference between
debentures having no stock purchase or conversion features and debentures
sold with such privileges. Because an appreciation of this difference is vital to
this appeal, our analysis will begin by way of illustration.
To start with the simplest variety, let us hypothesize a $1000 bond with an 8%
interest rate and no warrants or conversion features. The market price of that
bond, assuming the issuer is solvent, will be primarily a function of the market
interest rate. A prospectus containing representations about earnings potential
which might be of material interest to a stockholder would, in all likelihood, be
of no interest to the bondholder. This is because the bondholder will be paid his
principal and interest regardless, and the market price of his security will be
determined by factors external to the corporation's earnings.
If, however, that same bond is sold with a warrant to purchase one share of the
corporation's common stock at any time within a fixed time at a fixed price,
then representations which are material to a purchaser of stock become material
to the purchaser of the bond. When the issuer decided to issue a bond with a
warrant attached it probably did so in the expectation that the potential earnings
of the corporation would make the warrant attractive, and thereby produce a
lower interest rate on the bond. The extent to which the market interest rate
exceeded the interest rate to which bond purchasers agreed correlated with the
expectation that the corporation's stock would advance in price above the
warrant price. See Fleischer & Cary, The Taxation of Convertible Bonds and
Stock, 74 Harv.L.Rev. 473, 474 (1961). If that interest differential was the
result of misstatements in the prospectus, a purchaser of the bond and warrant
who relied on the prospectus may well be able to prove causative injury. If the
facts were such that had they been revealed there could have been no
expectation that the market price of the corporation's stock would ever rise
above the warrant price, then the warrant was actually worthless, and any
interest differential on the bond was obtained by fraud.
10
In discussing the derivative counts of the complaint the district court reasoned
that
enterprise on behalf of which he seeks to bring suit.' 395 F.Supp. at 282 (footnote
omitted).
12
Since no appeal has been taken from the dismissal of the derivative counts, we
have no occasion to consider whether the quoted discussion is a proper
limitation on the derivative remedy.5 But whatever may be said for the district
court's reasoning in the derivative suit context, it is totally inapplicable to direct
actions under 10(b). Options and conversion features are securities for which
purchasers give and issuers receive separate consideration. If the purchasers can
prove that they parted with that consideration as a result of material
misrepresentations in a prospectus, they may recover in a direct action whether
or not their interest in the corporation would support a derivative suit.
II
13
The defendants urge, however, that the 10(b) action is barred for another
reason. They point to Section 8.7 of the Indenture under which the securities
were issued which prohibits suits
14 the execution of any trust or power hereof, or for the enforcement of any other
'for
remedy under or upon this Indenture'
15
16
17
The order dismissing Count IV will be reversed and the case remanded for
19
I agree with the majority that we must reverse the dismissal of Count IV of
Kusner's complaint. I believe, however, that his cause of action rests not only
on section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78j(b)
(1971), discussed in Part I of the majority opinion, but at least on one other
section of the federal securities laws.
20
21 In case any part of the registration statement, when such part became effective,
(a)
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 . . . may . . . sue-(1) every person who signed the registration statement;
22
23 every person who was a director of . . . or partner in the issuer at the time of the
(2)
filing of the part of the registration statement with respect to which his liability is
asserted . . ..
24
Kusner directed his complaint at the allegedly false and misleading statements
in the prospectus incorporated into the registration statement. Section 11 is
more precisely tailored to this set of facts than is section 10(b), the general
fraud section of the 1934 Act.
25
Moreover, under section 11 Kusner need only show that he acquired securities
covered by the prospectus and that the false statements or omissions were
material.1 Neither reliance nor a causal connection between the drop in value of
the security and the false or misleading registration statement is an element of a
section 11 action. See 3 L. Loss, Securities Regulation at 1721--1735 (2d ed.
1961). Nor is a section 11 plaintiff required to prove fraud. Rather, as the
Second Circuit has stated:
26 liability under section 11 and similar provisions was designed not so much to
Civil
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.
27
Globus v. Law Research Service, Inc., 418 F.2d 1276, 1288 (2d Cir. 1969), cert.
denied, 397 U.S. 913, 90 S.Ct. 913, 25 L.Ed.2d 93 (1970). Thus, holders of
convertible debentures who simply alleged material false statements and
material omissions in a registration statement under which they purchased the
bonds were held to have stated a sufficient cause of action under section 11 in
Escott v. Barchris Construction Co., 283 F.Supp. 643 (S.D.N.Y.1968).
28
On the other hand, while liability may be established more readily under
section 11 of the 1933 Act, the scope of liability may be more limited than
under section 10(b) of the 1934 Act. Liability under section 11 may not be
imposed upon those defendants which did not sign the prospectus or perform
directorial functions for the Trust.2 Moreover, if Kusner proceeds under section
11, he may need to consider whether he will be precluded from proceeding
under section 10(b) as well. Montague v. Electronic Corp. of America, 76
F.Supp. 933, 936 (S.D.N.Y.1948).3
29
As to the defendants' contention that Kusner is barred from suit by section 8.7
of the Indenture, I join with Judge Gibbons in rejecting that argument for the
reasons stated in part II of the majority opinion.
For a more extensive analysis of the differences obetween bonds with warrants
and bonds with conversion privileges, see Klein, The Convertible Bond, A
Peculiar Package, 123 U.Pa.L.Rev. 547 (1975)
Convertible bonds have been described as deferred equity financing, resorted to
by issuers whose common stock price is low, but is expected to rise. See
Fleischer & Cary, The Taxation of Convertible Bonds and Stock, 74
Harv.L.Rev. 473, 474 (1961), quoting C. Pilcher, Raising Capital with
Convertible Securities 138 (1955). Arguably, they should for most purposes be
treated similarly to stock. Since in this case we deal with a dismissal for failure
to state a claim upon which relief may be granted, and we have identified one
possible ground upon which relief might be granted, we need not here explore
all possible legal ramifications of the device.
But cf. Feit v. Leasco Data Processing Equipment Corp., 332 F.Supp. 544, 563
(E.D.N.Y.1971); Rosenberg v. Globe Aircraft Corp., 80 F.Supp. 123, 124
(E.D.Pa.1948)