University Hill Foundation v. Goldman, Sachs & Co.

• Citation: 422 F. Supp. 879
• Decision Date: 27 October 1976
• Docket Number: No. 71 Civ. 1166.,71 Civ. 1166.
• Parties: UNIVERSITY HILL FOUNDATION, Plaintiff, v. GOLDMAN, SACHS & CO., Defendant.
• Court: United States District Courts. 2nd Circuit. United States District Courts. 2nd Circuit. Southern District of New York

422 F. Supp. 879

UNIVERSITY HILL FOUNDATION, Plaintiff, v. GOLDMAN, SACHS & CO., Defendant.

No. 71 Civ. 1166.

United States District Court, S. D. New York.

October 27, 1976.

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Regan, Goldfarb, Heller, Wetzler & Quinn, New York City, for plaintiff; Howard Breindel, Jan D. Atlas, Robert Aronson, New York City, of counsel.

Sullivan & Cromwell, New York City, for defendant; Michael M. Maney, Philip L. Graham, Jr., Charles E. Dorkey III, New York City, of counsel.

LASKER, District Judge.

This suit raises important questions regarding the application of federal securities laws to the sale of commercial paper. It is one of a number of actions by persons who in the Spring of 1970 bought commercial paper issued by the Penn Central Transportation Company (Penn Central, or the Company) from the defendant, Goldman, Sachs & Co., which was the exclusive dealer in the securities.¹

The plaintiff, University Hill Foundation (University Hill or the Foundation), purchased two notes in the aggregate face amount of $600,000. which were to mature on September 25, 1970. At maturity the notes were duly presented, but payment was refused for, as is well known, on June 21st the Company had filed a petition in bankruptcy. The Foundation alleges that in the sale of the paper Goldman, Sachs violated § 12(2) of the Securities Act of 1933, 15 U.S.C. § 77l(2), § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) and Rule 10b-5 promulgated thereunder, and a variety of state statutes and the common law.² It is claimed that Goldman, Sachs falsely represented both that Penn Central was creditworthy and that Goldman, Sachs had performed an adequate credit investigation, and, further, that Goldman, Sachs omitted to disclose at least six items of information necessary to render the statements made not misleading. Specifically, Goldman, Sachs is charged with failing to disclose:

1) That one month before the sale, upon receipt of a negative financial report from Penn Central, the defendant reduced its inventory of this paper by $10,000,000. by selling it back to the Company;

2) That the "Prime" rating of Penn Central paper by the National Credit Office (NCO) was not based upon NCO's independent evaluation of the paper but upon Goldman, Sachs' decision to continue selling it;

3) That for seven months prior to the sale Goldman, Sachs had unsuccessfully attempted to get Penn Central to increase its bank line coverage for its commercial paper from 50% to 100%;

4) That prior to the sale a major banking institution had removed Penn Central from its list of approved issuers;

5) That Penn Central was in a very tight cash position, lacked working capital and was experiencing increasing losses; and

6) That Penn Central was using the proceeds from the sale of commercial paper to finance non-current transactions.

Finally, the Foundation asserts that in order to prevent the collapse of the commercial paper market, Goldman, Sachs engaged in a fraudulent scheme or course of conduct to withhold negative information about Penn Central until the Company should become financially sound. The Foundation seeks to rescind the sale.

Goldman, Sachs vigorously denies the allegations. According to it, the only representation it made was that at the time of the sale to the Foundation Goldman, Sachs reasonably believed Penn Central to be creditworthy, and it steadfastly continues to maintain that this statement was true. Conceding that the $10 million buy-back of its Penn Central commercial paper inventory could, when isolated from the business context, be interpreted to reflect negatively on its motives, Goldman, Sachs insists that there were sound business reasons for this transaction which had nothing to do with a loss of faith in the Company's paper. With regard to the NCO "Prime" rating, Goldman, Sachs argues that it had no reason to believe that the rating was not based on NCO's independent evaluation of the paper. As for the other alleged omissions, the defendant maintains that they were for a variety of reasons not material in the circumstances of this transaction.

The action was tried to the court without a jury. In addition to six full days of testimony the parties submitted numerous depositions and portions of the testimony in one of the related cases, Franklin Savings Bank v. Levy, et al., 406 F.Supp. 40 (S.D. N.Y.1975). (Hereinafter F.S.B. v. Levy.) In order properly to evaluate the respective contentions of the parties it is necessary, in addition to discussing the facts of the sale here in issue, to describe the workings of the commercial paper market, Goldman, Sachs' role in that market as an exclusive dealer, and the interaction between Penn Central and Goldman, Sachs in the months preceding the sale.

I.

A. The Parties

The Foundation is a California non-profit corporation based in Los Angeles, primarily engaged in raising funds for Loyola University. In March, 1970, and for about two years prior to that time, Howard B. Fitzpatrick, an industrial paint contractor, served as the Foundation's President. He donated ten hours a week to the Foundation, where he had sole responsibility for its daily affairs and for its investments. The Foundation's only employee was a part-time secretary.

From time to time Fitzpatrick decided to purchase commercial paper for the Foundation. These investments were made through one of the Foundation's several banks. When contemplating such a transaction, it was his practice to contact the investment department of at least two banks, find out what paper was available and select the item which best fitted the Foundation's requirements in terms of safety, rate of return and maturity. (106) (Unless otherwise indicated, numbers appearing in parentheses refer to pages of the trial transcript.) He then communicated this decision to one of the banks, which handled the actual purchase of the paper. One of the institutions so employed by Fitzpatrick was the Union Bank of Los Angeles. The official there with whom he dealt was Noel G. LeMay, Vice President in charge of the short-term money market operations of the bank's investment division.

Goldman, Sachs is a partnership in the business of investment banking, underwriting, securities brokerage and related financial activities. Its principal office is in New York City and it maintains offices in Los Angeles as well as other major cities. Since its inception in 1869 Goldman, Sachs has been a dealer in commercial paper. At the time of the transaction in issue, Goldman, Sachs was the largest of six such dealers.³ The partner in charge of the Commercial Paper Department was Robert G. Wilson. Wilson was responsible both for the daily buying and selling operations and for the decision to accept or terminate corporate clients who wished to issue commercial paper. This decision hinged in large part on Wilson's assessment of the financial condition of the issuer, or its creditworthiness, a term dealt with extensively below. In making an evaluation of creditworthiness Wilson placed heavy reliance on Jack A. Vogel, the Manager of the Credit Department, a sub-unit of the Commercial Paper Department. Vogel supervised the work of five credit analysts whose function was to assist in the initial investigation of prospective issuers, to monitor the financial condition of the issuers whose paper Goldman, Sachs sold and to put together information of credit significance for periodic distribution to commercial paper purchasers.

B. The Commercial Paper Market and the Sale to the Foundation

The commercial paper market facilitates the flow of cash from lenders with temporary surpluses to borrowers with temporary deficits. Commercial paper consists of unsecured promissory notes usually having a maturity which does not exceed nine months. Corporations of sufficient size and reputation to attract purchasers of these general obligations can normally sell their paper at rates which enable them to meet their short-term borrowing requirements for less than they would have to pay for bank loans. The notes are sold on a discount basis and offer attractive short-term investment for corporations and others with substantial temporary cash excesses. The excesses must be substantial because paper is available only in large dollar units. (The average transaction involves $1 million (237), and in Penn Central's case, a $100,000. note was a small sale. (See Defendant's Exhibit CU.))

Because of the large amounts involved buyers understandably desire to complete the transaction on the date of the sale to avoid losing a day's interest, (260-61) and since the actual mechanics of delivering the notes to the buyer's bank are somewhat cumbersome, the selling day is compressed into a two-and-a-half to three hour period from roughly 9:30 A.M. to 12:00 or 12:15 P.M. During this period the sales force at Goldman, Sachs alone puts together four to five hundred transactions, (274) virtually all of which are completed in a series of brief telephone conversations between the purchaser, the purchaser's agent, if he has one, a commercial paper salesman and a commercial paper buyer.

The transaction involved in this case was typical. (274) Fitzpatrick knew that the Foundation had a $600,000. investment about to mature in an account at Union Bank. He called LeMay to inquire what commercial paper was available with a maturity of approximately six months as a successor investment. LeMay, in turn, called several commercial paper dealers, including the salesmen at Goldman, Sachs' Los Angeles office, to ask what paper was for sale. (14-15) The Goldman, Sachs salesman mentioned three or four issues which met Fitzpatrick's requirements, called a commercial paper buyer in his department to verify that the notes were still on hand and then confirmed to LeMay that the paper was in fact available for sale. (253-55, 274) LeMay at that point...