Associated Randall Bank v. Griffin, Kubik, Stephens & Thompson, Inc., 92-2684

• Citation: 3 F.3d 208
• Decision Date: 19 August 1993
• Docket Number: No. 92-2684,92-2684
• Parties: ASSOCIATED RANDALL BANK, Plaintiff-Appellant, v. GRIFFIN, KUBIK, STEPHENS & THOMPSON, INC., Defendant-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

Page 208

3 F.3d 208

ASSOCIATED RANDALL BANK, Plaintiff-Appellant, v. GRIFFIN, KUBIK, STEPHENS & THOMPSON, INC., Defendant-Appellee.

No. 92-2684.

United States Court of Appeals Seventh Circuit.

Argued Jan. 12, 1993.

Decided Aug. 19, 1993.

Donald K. Schott, Erica M. Eisinger (argued), Quarles & Brady, Madison, WI, for plaintiff-appellant.

Linda M. Zech, DeWitt, Porter, Huggett, Schumacher & Morgan, Madison, WI, Ronald P. Kane (argued), Michael A. Kraft, Diane C. Fischer, Siegan, Barbakoff & Gomberg, Chicago, IL, for defendant-appellee.

Before EASTERBROOK and ROVNER, Circuit Judges, and ESCHBACH, Senior Circuit Judge.

EASTERBROOK, Circuit Judge.

Associated Randall Bank, a financial institution chartered by Wisconsin, frequently invested in bonds issued by state and local governments. Between the mid 1970s and 1987 it relied on advice furnished by James Kubik. Since 1980 Kubik has been a principal of Griffin, Kubik, Stephens & Thompson, Inc., a broker-dealer specializing in municipal securities. Although James Fiore, the Bank's president, retained ultimate authority over investment decisions, he accepted most of Kubik's recommendations. Late in 1986 Kubik recommended, and the Bank purchased, securities nominally issued by Memphis and Louisiana. Since 1991 these bonds have been in default, and the Bank wants Griffin Kubik to make good the investment. Suing under the diversity jurisdiction, the Bank has invoked the common law of Wisconsin. (The federal securities laws do not apply to most governmental securities. 15 U.S.C. Secs. 77c(a)(2), 78c(a)(12)(A)(i), (ii), (29), (42).) The posture of the case leads us to state the facts and inferences favorably to the Bank, with the usual caution that a trial may put things in a different light.

Kubik recommended both the Memphis and Louisiana bonds. Kubik told Fiore that the Memphis bonds were "not unlike" municipal bonds the Bank had purchased before. "Not unlike" can mean almost anything; although the listener may cancel the negatives to obtain "like," the author may want to convey some difference between "like" and "not unlike." Speakers and writers alike would do well to heed the advice: "Beware the unappealing trick of not un____, a kind of litotes that convolutes lawyers' language. Swear off using it by saying to yourself, 'A not unblack dog was chasing a not unsmall rabbit across a not ungreen field.' " Bryan A. Garner, The Elements of Legal Style 155 (1991), quoting from George Orwell, Politics and the English Language, in 4 Collected Essays, Journalism and Letters of George Orwell 127, 138 (1968). Kubik had not brushed up on his Orwell and may have to pay dearly.

The Bank had been purchasing bonds that would be repaid from the income of housing (a common place for banks to reinvest depositors' capital), and Fiore was willing to buy more. Fiore understood Kubik to say that the proceeds of the Memphis bonds were designed to finance investment in low and moderate income housing. Kubik concedes that this is what he meant, which makes it a statement of "fact" for purposes of Wisconsin's law so long as it is understood as a representation about the documents in existence rather than a prediction about how things would turn out. Compare Radford v. J.J.B. Enterprises, Ltd., 163 Wis.2d 534, 544, 472 N.W.2d 790, 794 (App.1991), with Consolidated Papers, Inc. v. Dorr-Oliver, Inc., 153 Wis.2d 589, 594, 451 N.W.2d 456, 459 (App.1989). The only caution Kubik offered was that income from the Memphis bonds would be taxable. The Bank bought $250,000 of the Memphis bonds and an equal amount of the Louisiana bonds, which Kubik said were "similar" to the Memphis instruments. According to the Bank, the statement that proceeds of the Memphis and Louisiana bonds would be invested in housing (or agricultural projects, in Louisiana's case) was a negligent misrepresentation. See Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Boeck, 127 Wis.2d 127, 377 N.W.2d 605 (1985); Whipp v. Iverson, 43 Wis.2d 166, 169-70, 168 N.W.2d 201, 203-04 (1969). The proceeds were invested not in housing or agriculture but indirectly in a portfolio of convertible subordinated corporate debentures--high-yield, high-risk instruments commonly known as "junk bonds." When the risks came to pass, owners of the Memphis and Louisiana bonds were left holding the bag.

The Memphis and Louisiana securities were among eight similar packages underwritten by Drexel Burnham Lambert Incorporated and guaranteed by Executive Life Insurance Company. The proceeds of the offering ($400 million for the Memphis bonds, $150 million for the Louisiana bonds) were sent to Executive Life, which issued "guaranteed investment contracts" to the public authorities. Executive Life then reinvested the proceeds in a portfolio of high-yield instruments offered by Drexel Burnham. It used the income from these instruments to pay the interest on its obligations to the eight state and local governments. Executive Life pledged its capital surplus, about $184 million, to guarantee its commitments. This arrangement was safe so long as the portfolio of "junk bonds" performed well. Standard & Poor's gave the Memphis and Louisiana bonds an AAA rating and held Executive Life in the same high regard. But a downturn in the economy or hostility from governmental regulators could hurt this market in volatile instruments. In the event, the portfolio was affected by both a downturn and public hostility. Standard & Poor's downgraded the bonds to A in February 1990 and to BBB in April 1990. Executive Life failed and was placed in conservatorship in April 1991. State regulators have taken the position that the guaranteed investment contracts are not insurance and so come behind policyholders' claims in priority. The Memphis and Louisiana bonds accordingly are in default.

What then of the stated uses of the bonds' proceeds--housing for Memphis, agriculture for Louisiana? None of the indentures specified that the state or municipal officials had to invest all, or even any, of the proceeds in public projects, and there was no time limit for making such investments. To finance any of their projects, the state and local officials had to borrow against the guaranteed investment contracts. The amount that could be borrowed in any year was limited, the rate of interest charged was high, the agency had to pay a fee for each advance, and the loans had to be well secured with re-purchase obligations. These terms induced the public agencies to leave all of the funds with Executive Life. A trade publication ran a series of articles in the fall of 1986 pointing out these unusual features of the securities, relaying criticism of S & P's AAA rating (Moody's had given the bonds a lower rating), and observing that the terms on which the public authorities could obtain any of the proceeds implied that "the bonds [have been] sold only to earn arbitrage and not to perform a public purpose, such as making loans for multifamily housing and agriculture and industrial development." George Yacik, "S & P to Uphold AAA Rating of Executive Life Claims Paying," The Bond Buyer (Oct. 29, 1986). In other words, junk bonds were paying rates of interest in excess of state and local governments' cost of capital. Public authorities therefore could raise money to invest in junk bonds, earning a profit on the difference in interest rates. To the extent investors saw what was going on, the public authorities had to pay higher interest rates, so the arbitrage profit was limited. A headline in The Bond Buyer of November 6, 1986, ran: "Taxable Munis Backed by AAA-Rated GICs Trade at Yields Equal to BBB Corporates." The article added that the bonds "are currently trading at yields anywhere between 140 and 165 basis points above the yield on 10-year Treasury notes--about the same spreads on corporate bonds rated BBB." So the market was not fooled, although perhaps the initial purchasers paid too much, only to see the price fall in the secondary market to assure these higher yields.

Kubik held himself out as an expert in municipal bonds, and his firm once informed the Bank that it was dealing in securities "with the greatest degree of complexity and credit nuance amongst fixed income vehicles, mandating expert guidance in the field." Although Griffin Kubik subscribed to The Bond Buyer and similar publications, Kubik does not recall reading in them any suggestion that the Memphis and Louisiana bonds were unusual. He recommended them to Fiore largely on the strength of the AAA rating and their high yields. Fiore bought them on the same basis. The Bank received the offering circular for the Memphis bonds after agreeing to buy them but before settlement; it received the offering circular for the Louisiana bonds after settlement. In each case the Bank gave the circular a cursory review and salted the bonds away. In 1987 the Bank began receiving investment advice exclusively from a subsidiary of an affiliated bank; satisfied with the AAA rating, the new investment adviser did not suggest selling the bonds. The Bank was still holding them when the default occurred--although Kubik had informed the Bank about the downgradings to A and BBB in 1990.

The district court dismissed under Fed.R.Civ.P. 12(b)(6) the Bank's argument that Griffin Kubik could be liable for selling securities that were "unsuitable" to the Bank's investment objectives. Later it granted summary judgment on the claims of negligent misrepresentation. (There were two flavors: negligence and strict responsibility for misrepresentation. For current purposes these torts have the same elements, so we refer only to negligence.) Griffin Kubik prevailed because the key "not unlike" statement was true: the Memphis bonds were for the purpose of housing loans. So the offering circular said. For the district court, that was that. Hindsight (the fact that no housing loans were ever made) cannot produce retroactive misrepresentation; Griffin Kubik...