Stransky v. Cummins Engine Co., Inc.

• Decision Date: 07 April 1995
• Docket Number: No. 94-1964,94-1964
• Citation: 51 F.3d 1329
• Parties: , Fed. Sec. L. Rep. P 98,668 Alan J. STRANSKY, Plaintiff-Appellant, v. CUMMINS ENGINE COMPANY, INC., Henry B. Schacht, James A. Henderson, J. Irwin Miller, William I. Miller, George W. Newlin, William D. Schwab, Harold Brown, Robert J. Darnall, Hanna H. Gray, Henry L. Hillman, Paul L. Miller, Donald S. Perkins, William D. Ruckelshaus, and Franklin A. Thomas, Defendants-Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1329

51 F.3d 1329

63 USLW 2656, Fed. Sec. L. Rep. P 98,668

Alan J. STRANSKY, Plaintiff-Appellant, v. CUMMINS ENGINE COMPANY, INC., Henry B. Schacht, James A.

Henderson, J. Irwin Miller, William I. Miller, George W.

Newlin, William D. Schwab, Harold Brown, Robert J. Darnall,

Hanna H. Gray, Henry L. Hillman, Paul L. Miller, Donald S.

Perkins, William D. Ruckelshaus, and Franklin A. Thomas,

Defendants-Appellees.

No. 94-1964.

United States Court of Appeals,

Seventh Circuit.

Argued Oct. 4, 1994.

Decided April 4, 1995.

As Amended April 7, 1995.

Richard N. Bell, Irwin B. Levin, David J. Cutshaw (argued), Cohen & Malad, Indianapolis, IN, Gene Mesh, Robert Michael Phebus, Mesh & Associates, Cincinnati, OH, for Alan J. Stransky.

Francis P. Barron, Cravath, Swaine & Moore, New York City, Robert K. Stanley (argued), Kevin M. Toner, Michael R. Maine, Baker & Daniels, Indianapolis, IN, for Cummins Engine Co., Inc., Henry B. Schacht, James A. Henderson, Franklin A. Thomas, George W. Newlin, William D. Schwab, Harold Brown, Robert J. Darnall, Hanna H. Gray, Henry L. Hillman, Jr., Paul L. Miller, Donald S. Perkins and William D. Ruckelshaus.

David C. Campbell, Bingham, Summers, Welsh & Spilman, Indianapolis, IN, for William I. Miller and Irwin J. Miller.

Before BAUER, KANNE, and ROVNER, Circuit Judges. ^*

KANNE, Circuit Judge.

The predicate for this case is a familiar one: a company makes optimistic predictions about future performance, the predictions turn out to be less than prophetic, and shareholders cry foul, or more specifically, fraud. Alan Stransky and Raphael Warkel filed a class action suit against Cummins Engine Company, Inc. (Cummins), alleging securities fraud. The district court dismissed with prejudice, pursuant to Federal Rule of Civil Procedure (FRCP) 12(b)(6), Stransky's claim under the First Amended Complaint (FAC). The court denied, in part, Cummins' motion to dismiss as it related to Warkel. Pursuant to FRCP 54(b), the dismissal of Stransky's claim is final and ready for review. On appeal, we must accept well-pled facts as true and make all reasonable inferences in favor of the non-movant. Propst v. Bitzer, 39 F.3d 148, 154 (7th Cir.1994). We review the district court's decision to dismiss the complaint de novo. Wade v. Hopper, 993 F.2d 1246, 1250 (7th Cir.1993).

Cummins is a leading designer and manufacturer of in-line and v-type diesel engines. Because of new emissions standards promulgated by the U.S. Environmental Protection Agency, in 1988 Cummins began producing redesigned engines. Stransky claims that "in internal technical memoranda, Cummins admitted that it had 'rushed' its design and production to comply with the new standards, that there was insufficient time for evaluation of the engines, and that the technical division had relied too much on the testing of prototype hardware rather than on the testing of the final production product." Cummins typically warranted its engines for two years or 100,000 miles, whichever came first.

Stransky alleges that beginning in the fall of 1988 and extending through the spring of 1989, Cummins' board of directors was informed that the newly designed engines were experiencing problems due to faulty design and that costs associated with fixing the engines (warranty costs) were rising. Specifically, Stransky alleges the following:

20. Warranty claims on these newly designed engines began to come in to the Company fast and furious in late 1988 and early 1989. From January to April of 1989, warranty claims and costs regarding [the newly designed engines] were hundreds of thousands of dollars higher than predicted, higher than planned, and higher than the targets.

* * * * * *

22. Graphs generated by Cummins' technical personnel reflected dramatic increases in warranty and product costs of the [new engines] as of April 1989.... The warranty claims paid in each of the months of January, February, March and April of 1989 were more than 50% higher than payments made in the same months in 1987 and 1988.

23. During the February 12th, 13th, 1989 Board meeting, ... the Director Defendants discussed [the warranty problems] at the meeting as being the biggest problem in the engine business segment of the Company. The Director Defendants also discussed at that February 1989 Board meeting that the Company needed "to reverse the recent trend of rising quality problems."

24. On April 3, 1989, or on April 4, 1989, Mr. Schacht reported to the Director Defendants at the April Board meeting that the Company's major concern was with its warranty costs.

Of course, to state a securities fraud claim, Stransky must allege fraud. To this end, Stransky alleges that during the fall of 1988, the directors of Cummins became concerned that the Hanson Group (USA) Ltd. (Hanson), a known corporate takeover company, was preparing a hostile takeover. To thwart this effort, the directors conceived a plan known among the directors as "Project Diesel." By March 1989, the directors' research into Hanson indicated that it typically took over companies whose stock was undervalued. As is true in many hostile takeovers, Hanson would fire the company's management and replace them with its own group. Thus, Stransky alleges that in order to entrench themselves against the takeover, the directors plotted to increase the value of Cummins' stock by suppressing the news of the redesigned engines' problems.

Mere silence about even material information is not fraudulent absent a duty to speak. Chiarella v. United States, 445 U.S. 222, 235, 100 S.Ct. 1108, 1118, 63 L.Ed.2d 348 (1980). Stransky alleges that Cummins' silence about the rising warranty costs violated SEC Rule 10b-5 because a duty to disclose the warranty problems arose when Cummins made public statements that related to warranty costs and were misleading because of the withheld information about the problems. If one speaks, he must speak the whole truth. Ackerman v. Schwartz, 947 F.2d 841, 848 (7th Cir.1991).

In general, to prevail on a Rule 10b-5 claim, a plaintiff must prove that the defendant: 1) made a misstatement or omission, 2) of material fact, 3) with scienter, 4) in connection with the purchase or sale of securities, 5) upon which the plaintiff relied, and 6) that reliance proximately caused the plaintiff's injury. In re Phillips Petroleum Securities Litigation, 881 F.2d 1236, 1244 (3rd Cir.1989); see also Schlifke v. Seafirst Corp., 866 F.2d 935, 943 (7th Cir.1989). The avenues of proving a false or misleading statement or omission are still uncertain. The most common and obvious method is by demonstrating that the defendant fraudulently made a statement of material fact or omitted a fact necessary to prevent a statement from being misleading. Two other avenues have been kicked around by courts, litigants and academics alike: a "duty to correct" and a "duty to update." ¹ Litigants often fail to distinguish between these theories (as did Stransky in this case) and to delineate their exact parameters. The former applies when a company makes a historical statement that, at the time made, the company believed to be true, but as revealed by subsequently discovered information actually was not. The company then must correct the prior statement within a reasonable time. See, e.g., Backman v. Polaroid Corp., 910 F.2d 10, 16-17 (1st Cir.1990). ²

Some have argued that a duty to update arises when a company makes a forward-looking ³ statement--a projection ⁴--that because of subsequent events becomes untrue. See, e.g., Backman, 910 F.2d at 17; see also Robert H. Rosenblum, An Issuer's Duty Under Rule 10b-5 to Correct and Update Materially Misleading Statements, 40 CATH.U.L.REV. 289 (1991). This court has never embraced such a theory, and we decline to do so now.

Of course, examining the wording of Rule 10b-5 sheds light on the interpretation to be given it. As it relates to this case, Rule 10b-5 states:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any national securities exchange, ...

(b) To make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. (Emphasis added).

The rule implicitly precludes basing liability on circumstances that arise after the speaker makes the statement. In addition, the securities laws typically do not act as a Monday Morning Quarterback. "The securities laws approach matters from an ex ante perspective: just as a statement true when made does not become fraudulent because things unexpectedly go wrong, so a statement materially false when made does not become acceptable because it happens to come true." Pommer v. Medtest Corp., 961 F.2d 620, 623 (7th Cir.1992). These considerations give us serious pause in imposing a duty to update. ⁵

Courts differ on how they examine forward-looking statements. One method, adopted by the Fourth Circuit, has focused on the requirement that the misleading statement be material. A misleading statement is material for purposes of Rule 10b-5 if there is " 'a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available.' " Basic Inc. v. Levinson, 485 U.S. 224, 231-32, 108 S.Ct. 978, 983, 99 L.Ed.2d 194 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 96 S.Ct. 2126, 48 L.Ed.2d 757 (1976)). In Howard v. Haddad, 962 F.2d 328 (4th Cir.1992), Howard claimed that Haddad induced him, through misrepresentations, to buy stock in a bank that subsequently went under. The alleged misrepresentations were statements by Haddad "that it was a growing bank, and that it was [a] good investment." Id. at 329. The Fourth Circuit held that such "puffery" could not lead to liability because it "lacks...