143 F.3d 1140 (8th Cir. 1998), 97-2522, Rodney v. KPMG Peat Marwick

Docket Nº:97-2522MN.
Citation:143 F.3d 1140
Party Name:Richard J. RODNEY, Jr.; Doug Shonka; Carl Patrick Monahan; Jerry Hoehnen; Rosemary Boris; Thomas W. Newcome, III; Delvin D. Junker; Printing Mailing Trade District, affiliated with the Newspaper Drivers' Division of the International Brotherhood of the Teamsters, on behalf of themselves and all others similarly situated; History Theater, Inc., a Mi
Case Date:May 12, 1998
Court:United States Courts of Appeals, Court of Appeals for the Eighth Circuit

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143 F.3d 1140 (8th Cir. 1998)

Richard J. RODNEY, Jr.; Doug Shonka; Carl Patrick Monahan;

Jerry Hoehnen; Rosemary Boris; Thomas W. Newcome, III;

Delvin D. Junker; Printing Mailing Trade District,

affiliated with the Newspaper Drivers' Division of the

International Brotherhood of the Teamsters, on behalf of

themselves and all others similarly situated; History

Theater, Inc., a Minnesota non-profit corporation; Paul

Gold; Bernard Friedman, on behalf of themselves and all

others similarly situated, Appellants,



No. 97-2522MN.

United States Court of Appeals, Eighth Circuit

May 12, 1998

Submitted Feb. 12, 1998.

Rehearing and Suggestion for Rehearing

En Banc Denied July 6, 1998.[*]

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Richard A. Lockridge, Minneapolis, MN, argued (Gregg M. Fishbein, Vernon J. Vander Weide, Marianne E. Durkin, William Weinstein, Mary F. Seymour, Mark Reinhardt, and Gavin S. Wilkinson, on the brief), for Appellants.

Eliot S. Kaplan, Minneapolis, MN, argued (Deborah J. Palmer, Agnes E.C. Brandon, Claudia L. Taft, and John A. Shutkin, on the brief), for Appellee.

Before FAGG, JOHN R. GIBSON, and MURPHY, Circuit Judges.

FAGG, Circuit Judge.

This is a class action securities fraud case against KPMG Peat Marwick (KPMG) as auditor of the Piper Funds Inc. Institutional Government Income Portfolio (the Fund). The members of the plaintiff class (the Investors), approximately 8000 shareholders who invested in the Fund between September 30, 1991 and April 11, 1994 (the class period), appeal from the district court's order granting summary judgment in favor of KPMG. Although the Fund's prospectuses discussed most of the Fund's investments and their risks, the Investors contend the Fund's investments violated three of its own self-imposed investment restrictions, and KPMG failed to meet its duty to disclose these violations. We will call these investment restriction claims the noncompliance claims. The Investors also brought a nondisclosure claim, contending KPMG failed to reveal that the Fund's portfolio had a longer average life, and thus was riskier, than the Fund said it had. Without contesting any of these four claims, KPMG argued anything it omitted to say would not have significantly altered the mix of available information, so the claimed omissions were immaterial as a matter of law. The district court agreed with KPMG, but we do not. We reverse and remand for further proceedings.

Some explanation of the Fund's investments will help orient the reader to this factually complex case. Unless otherwise noted, we rely on the Fund's own prospectuses for our information. During the class period, the Fund invested primarily in mortgage-related securities. The Fund bought mortgage-backed securities familiarly known under names like Fannie Mae and Freddie Mac. These securities are issued by federal entities that assemble pools of mortgage

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loans, and the security entitles its holder to receive a portion of the principal and interest payments on the underlying loans. The Fund also traded heavily in a variety of mortgage-backed derivatives. These included collateralized mortgage obligations (CMOs), which divide up principal and interest flowing into a mortgage pool into shares of various classes or "tranches" with different payment priorities. For a more detailed explanation of CMOs, see Banca Cremi, S.A. v. Alex. Brown & Sons, Inc., 132 F.3d 1017, 1022-23 (4th Cir.1997) (Magill, J.). Some of the Fund's CMOs were floating rate CMOs, with rates subject to periodic readjustment in step with a particular index, like an adjustable-rate mortgage. Others were inverse or reverse floating CMOs, with adjustable rates that move against the index. The Fund also bought interest-only and principal-only stripped mortgage-backed securities (SMBSs). As their names suggest, these securities deliver distributions from either interest or principal payments, but not both. The Fund's derivatives were highly sensitive to interest-rate change. According to the Investors, when the Federal Reserve Board raised interest rates in 1994, the Fund was heavily invested in principal-only SMBSs and inverse floating CMOs, both of which are especially hard hit when interest rates go up.

In addition, the Fund engaged in "forward commitments." In these transactions, a security is bought or sold at a fixed price, but payment is delayed until a future date. Meanwhile, the value of the security may fluctuate, resulting in a gain or loss when payment day arrives. The Fund also entered into repurchase agreements, buying securities subject to the seller's agreement to repurchase them after a stated period of time. Repurchase agreements can be characterized as loans, with the bought-and-resold security functioning as collateral. See 15 U.S.C. § 80a-2(a)(23) (1994) (" 'Lend' includes a purchase coupled with an agreement by the vendor to repurchase; 'borrow' includes a sale coupled with a similar agreement."). All of these various investments and transactions--CMOs, floating and inverse floating CMOs, SMBSs, forward commitments, and repurchase agreements--were disclosed by the Fund, along with their risks.

In a letter to shareholders dated April 12, 1994, the Fund revealed for the first time that it had also engaged in what it called a "sale forward program," which "involve[d] the sale of securities and a simultaneous agreement to repurchase them at a later date." As a result, the letter said, the Fund was "[c]urrently ... 35% leveraged." Based in part on this letter, the Investors contend the Fund was on the borrowing as well as the lending side of repurchase agreements. From the borrowing side, the transaction is called a reverse repurchase agreement. See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10,666, 6 F. Sec. L. Rep. (CCH) p 48,525, at 37,553-4 & n.2 (Apr. 18, 1979). The Investors claim the Fund's reverse repurchase agreements took the form of dollar rolls, which "can be thought of as a collateralized borrowing, where an institution pledges mortgage pass-throughs to a dealer to obtain cash." Steven J. Carlson & John F. Tierney, Collateralized Borrowing via Dollar Rolls, in The Handbook of Mortgage-Backed Securities 1019, 1020 (Frank J. Fabozzi ed., 3d ed.1992). Based on internal KPMG documents, the Investors contend KPMG knew of the Fund's dollar rolls.

We turn now to the Investors' three noncompliance claims. The Fund's prospectuses stated that, among other prohibitions, the Fund could not borrow money, issue senior securities, or invest in securities "which in the opinion of the Fund's investment adviser at the time of such investment are not readily marketable." (This last restriction was later changed to a nonfundamental policy, as disclosed in the Fund's prospectus dated February 1, 1994.) As fundamental investment policies, these three restrictions could be changed only by the shareholders themselves. See 15 U.S.C. § 80a-13(a)(2), (3) (1994).

First, the Investors contend the Fund's undisclosed dollar rolls violated the no-borrowing rule. The Investors claim the Fund's forward commitments also violated the same restriction. Forward commitments generate leverage. See 6 F. Sec. L. Rep. p 48,525, at 37,553-6. Creating leverage, the Investors say, is really the same as borrowing

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because in either case the shareholders achieve a right to return on a capital base that exceeds the sum of...

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