Ebc I, Inc. v. Goldman Sachs & Co.

• Citation: 832 N.E.2d 26,5 N.Y.3d 11
• Parties: EBC I, INC., Formerly Known as eToys, Inc., by the Official Committee of Unsecured Creditors of EBC I, Inc., Respondent, v. GOLDMAN, SACHS & CO., Appellant.
• Decision Date: 07 June 2005
• Court: New York Court of Appeals

832 N.E.2d 26

5 N.Y.3d 11

EBC I, INC., Formerly Known as eToys, Inc., by the Official Committee of Unsecured Creditors of EBC I, Inc., Respondent, v. GOLDMAN, SACHS & CO., Appellant.

Court of Appeals of New York.

June 7, 2005.

COPYRIGHT MATERIAL OMITTED

Sullivan & Cromwell LLP, New York City (John L. Warden, Penny Shane, David M.J. Rein, Jeremy C. Bates and Matthew D. Dunn of counsel), for appellant.

Pomerantz Haudek Block Grossman & Gross LLP, New York City (Stanley M. Grossman, Shaheen Rushd and Murielle J. Steven of counsel), Wachtel & Masyr LLP (William B. Wachtel of counsel) and Traub, Bonacquist & Fox LLP (Paul Traub, Michael S. Fox and Susan F. Balaschak of counsel) for respondent.

Cleary, Gottlieb, Steen & Hamilton, New York City (Mitchell A. Lowenthal, Lewis J. Liman, David H. Herrington, Nancy I. Ruskin, Stuart N. Mast and Amy Chung of counsel), for Securities Industry Association, amicus curiae.

OPINION OF THE COURT

CIPARICK, J.

Plaintiff, the Official Committee of Unsecured Creditors of EBC I, Inc., formerly known as eToys, Inc., brought this action against defendant Goldman, Sachs & Co., the lead managing underwriter of its initial public stock offering, alleging five causes of action related to the underwriting agreement: breach of fiduciary duty, breach of contract, fraud, professional malpractice and unjust enrichment. We hold that plaintiff's complaint fails to state claims for breach of contract, professional malpractice and unjust enrichment. We therefore modify the Appellate Division order to dismiss these claims and, as modified, affirm to allow the fiduciary duty cause of action to proceed. Leave to replead the fraud cause of action was correctly granted; plaintiff has filed an amended complaint, but the sufficiency of that pleading is not before us on this appeal.

I.

This case involves the underwriting process by which investment banks help take securities to the market in an initial public offering (IPO). Companies may decide to make such an offering for several reasons, including a desire to raise new capital and to create a public market for their shares (see 1 Thomas Lee Hazen, Securities Regulation § 3.1[2] [5th ed.]; see also Larry D. Soderquist, Understanding the Securities Law § 2:2 et seq. [Practising Law Institute 4th ed.]). A "firm commitment underwriting," at issue here, typically involves an agreement whereby the "issuer" — or company seeking to issue the security (see Securities Act of 1933 [48 U.S. Stat. 74, as amended] § 2 [codified at 15 USC § 77b (a)(4)]) — sells an entire allotment of shares to an investment firm who purchases the shares with a view to sell them to the public (see Securities Act of 1933 § 2 [15 USC § 77b (a)(11)] [defining an "underwriter"]; see also 1 Hazen, Securities Regulation § 2.1[2][B]; Louis Loss and Joel Seligman, Fundamentals of Securities Regulation ch. 2A [3d ed.]).

As underwriter, the functions of the investment firm include negotiating an initial public offering price for the securities with the issuer, purchasing the securities from the issuer at a discount and reselling them on the market at the public offering price. The difference or "spread" between the amount the underwriter pays for the securities and the price at which the securities are sold to the public makes up the underwriter's compensation for its services. Because in a firm commitment underwriting the underwriter owns, and is obligated to pay the issuer for the securities regardless of whether it can resell them, it may assemble a group of underwriters, known as a syndicate, to help absorb the risk.¹

As stated in plaintiff's complaint, in the late 1990's, eToys, Inc., an Internet retailer specializing in the sale of products for children, sought to go public in order to obtain financing necessary to further implement its business plan. In January 1999, eToys retained Goldman Sachs as lead managing underwriter of its initial public offering.²

Within the context of its engagement, Goldman Sachs met with potential investors, responded to inquiries about eToys' business and gauged investors' indications of interest in eToys' shares. On April 19, 1999, eToys and Goldman Sachs finalized the underwriting agreement. eToys agreed to sell 8,320,000 shares of its stock to Goldman Sachs and the other underwriters for $18.65 per share with the option to buy an additional 1,248,000 shares at the same price to cover overallotments. The agreement also provided that Goldman Sachs would offer the shares for public sale upon the terms and conditions set forth in the prospectus, which fixed the initial offering price at $20 per share. Thus, Goldman Sachs' potential profit was $1.35 per share or 6.75% of the offering proceeds. Goldman Sachs was to receive a total of at most $12,916,800 from the sale.

On May 20, 1999, the first day of trading, the stock opened at $79 per share rose as high as $85 per share and closed at $76.56. By the end of the year, however, the stock closed at $25. Soon thereafter, it fell below $20 and never rose above the initial offering price. Eventually, in March 2001, eToys filed a voluntary petition for reorganization under chapter 11 of the United States Bankruptcy Code in the District of Delaware. The Bankruptcy Court appointed the Official Committee of Unsecured Creditors and authorized the committee to bring this action on behalf of eToys, now known as EBC I, Inc.

The complaint alleges that eToys relied on Goldman Sachs for its expertise as to pricing the IPO, and that Goldman Sachs gave advice to eToys without disclosing that it had a conflict of interest. Specifically, the complaint alleges that Goldman Sachs entered into arrangements "where-by its customers were obligated to kick back to Goldman a portion of any profits that they made" from the sale of eToys securities subsequent to the initial public offering. Because a lower IPO price would result in a higher profit to these clients upon the resale of the securities and thus a higher payment to Goldman Sachs for the allotment, plaintiff alleges Goldman Sachs had an incentive to advise eToys to underprice its stock. As a result of this undisclosed scheme, Goldman Sachs was allegedly paid 20% to 40% of the clients' profits from trading the eToys securities.

Relying on these allegations, plaintiff brought five causes of action against Goldman Sachs: breach of fiduciary duty (first), breach of contract (second), fraud (third), professional malpractice (fourth) and unjust enrichment (fifth).³ In response, Goldman Sachs moved to dismiss the complaint in its entirety for failure to state any cause of action.

Supreme Court in two orders (one denominated judgment) granted the motion to the extent of dismissing the second, third (with leave to replead), fourth and fifth causes of action. The court denied that part of the motion seeking to dismiss the first cause of action for breach of fiduciary duty, finding that "[a]lthough the contract did not establish a formal fiduciary relationship ... the pleading sufficiently raises an issue as [to] the existence of an informal one," and noting that Goldman Sachs had also advised eToys in connection with a preferred stock offering.

The Appellate Division modified the initial order of Supreme Court, opining that the breach of fiduciary duty claim was correctly sustained upon allegations showing a preexisting relationship between eToys, Inc. and Goldman Sachs that justified eToys' alleged trust in pricing the shares. The Court further held that the trial court properly dismissed the fraud cause of action with leave to replead, reasoning that plaintiff did not allege with sufficient particularity who made the purported misrepresentations to eToys, Inc. The Appellate Division, however, disagreed with the Supreme Court as to the breach of contract, professional malpractice and unjust enrichment causes of action, reinstating all three.

Goldman Sachs appeals by leave of the Appellate Division on a certified question. We now modify the order of the Appellate Division by dismissing the second, fourth and fifth causes of action. We agree with the trial court and Appellate Division that the pleading of the fiduciary duty claim is sufficient and that leave to replead the fraud claim was proper.

II.

In the context of a motion to dismiss pursuant to CPLR 3211, the court must afford the pleadings a liberal construction, take the allegations of the complaint as true and provide plaintiff the benefit of every possible inference (see Goshen v. Mutual Life Ins. Co. of N.Y., 98 N.Y.2d 314, 326, 746 N.Y.S.2d 858 [2002]). Whether a plaintiff can ultimately establish its allegations is not part of the calculus in determining a motion to dismiss. Applying this standard, we conclude that plaintiff's allegations of breach of fiduciary duty survive Goldman Sachs' motion to dismiss.

A fiduciary relationship "exists between two persons when one of them is under a duty to act for or to give advice for the benefit of another upon matters within the scope of the relation" (Restatement [Second] of Torts § 874, Comment a). Such a relationship, necessarily fact-specific, is grounded in a higher level of trust than normally present in the marketplace between those involved in arm's length business transactions (see Northeast Gen. Corp. v. Wellington Adv., 82 N.Y.2d 158, 162, 604 N.Y.S.2d 1, 624 N.E.2d 129 [1993]). Generally, where parties have entered into a contract, courts look to that agreement "to discover ... the nexus of [the parties'] relationship and the particular contractual expression establishing the parties' interdependency" (see id. at 160, 604 N.Y.S.2d 1, 624 N.E.2d 129). "If the parties . . . do not create their own relationship of higher trust, courts should not ordinarily transport them to the higher realm of relationship and fashion the stricter duty for them" (id. at 162, 604 N.Y.S.2d 1, 624 N.E.2d 129). However, it is fundamental that fiduciary "liability is not...