Finkel v. Docutel/Olivetti Corp.

• Decision Date: 27 May 1987
• Docket Number: No. 86-1680,86-1680
• Citation: 817 F.2d 356
• Parties: , Fed. Sec. L. Rep. P 93,281 Hannah FINKEL, Plaintiff-Appellant, v. DOCUTEL/OLIVETTI CORPORATION, et al, Defendants-Appellees.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 356

817 F.2d 356

55 USLW 2692, Fed. Sec. L. Rep. P 93,281

Hannah FINKEL, Plaintiff-Appellant, v. DOCUTEL/OLIVETTI CORPORATION, et al, Defendants-Appellees.

No. 86-1680.

United States Court of Appeals Fifth Circuit.

May 27, 1987.

Jules Brody, Stull, Stull & Brody, New York City, W.D. Masterson, Kilgore & Kilgore, Inc., Dallas, Tex., for plaintiff-appellant.

Steven M. Woghin, Robert F. Henderson, Dallas, Tex., for Docutel/Olivetti, DeMoss, & Meredith.

George M. Newcombe, David E. Massengill, New York City, for Ing. Olivetti & C., DeBenedetti, Fubini & Piol.

Appeal from the United States District Court for the Northern District of Texas.

Before JOLLY and DAVIS, Circuit Judges and FELDMAN, ^* District Judge.

FELDMAN, District Judge:

This appeal asks whether the fraud on the market theory applies in 10b-5 securities fraud suits when the securities at issue were purchased in the open market. In the limited context of this opinion, we hold that the answer is yes and, therefore, proof of reliance on specific misconduct in the purchase or sale of a security in the open market is not a requisite key to recovery. Thus, we affirm in part and reverse in part, and remand to the district court for proceedings consistent with the parameters set here.

I. BACKGROUND

Plaintiff, Hannah Finkel, brought this action on behalf of herself and other purchasers of the stock of Docutel/Olivetti Corporation alleging violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 of the Securities and Exchange Commission. In the complaint, plaintiff pleaded the fraud on the market theory to satisfy the reliance element of her claim. She alleged that Docutel's inventories were materially overstated, that defendants failed to disclose the true value of Docutel's inventories (which artificially inflated the market price of Docutel), and that she suffered damages because she relied on the integrity of the market price when she purchased Docutel's stock. The stock was purchased in the open market.

Docutel is a Delaware corporation that was formed to produce automatic teller machines. In 1982, Docutel, by merging with Olivetti Corporation of America, ¹ expanded its product line to include typewriters, personal computers, and related equipment. Olivetti Corporation is the United States subsidiary of defendant Ing. C. Olivetti & C., S.p.A., an Italian corporation. Defendants B.J. Meredith and Emmet R. DeMoss were officers of Docutel during the period at issue. Defendants Carlo DeBenedetti and Simone Fubini were officers of Olivetti and directors of Docutel. And defendant Elserino M. Piol was a director of both corporations.

Docutel's stock trades in the over-the-counter market (a reporting network in which transactions in securities are reported to the National Association of Securities Dealers for publication). It is a publicly owned and traded corporation. As of October 1, 1983, Docutel had issued and outstanding 6.8 million shares of common stock held by approximately 3,200 public shareholders. On December 5, 1983, plaintiff purchased 300 shares of Docutel at $14- 5/8 per share for a total price of $4,474.75. On February 16, 1984, just months later, Docutel announced a projected net loss of $14,000,000 for 1983. This projection proved to be low, and Docutel's form 10-K for 1983 reported a loss of $18,263,000, including $10,900,000 of inventory write-downs. On April 6, 1984, Docutel's stock price closed at $7- 1/4, significantly below its 1983 high of $38- 7/8.

Plaintiff claims that Olivetti, by virtue of its 46% interest in Docutel, controlled Docutel and used that control to hide its losses in Olivetti of America. Her central complaint is that throughout 1983 Docutel purchased Olivetti Corporation of America's inventories at inflated prices, ² but that Docutel concealed this fact until early 1984 when the year-end audit forced it to take large inventory write-downs. The inventory write-downs totalled $10,900,000 of which approximately $10,100,000 was recorded in the fourth quarter. ³ The essential thrust of her charge is that the delay in taking the write-downs defrauded purchasers of Docutel stock who bought it between the release of Docutel's form 10-Q for the first quarter of 1983 and the subsequent statements projecting losses for 1983, by causing them to buy at an inflated price. ⁴

Defendants moved to dismiss the complaint under Fed.R.Civ.P. 12(b)(6) because plaintiff failed to plead reliance on any specific misleading statement, and under Fed.R.Civ.P. 9(b) for failure to plead fraud with particularity. Discovery and class certification were deferred pending a ruling on the motion to dismiss. ⁵ On August 20, 1983, the district court dismissed the complaint on the ground of failure to plead individual reliance. The court held that, under Shores v. Sklar, 647 F.2d 462 (5th Cir.1981) (en banc), cert. denied, 459 U.S. 1102, 103 S.Ct. 722, 74 L.Ed.2d 949 (1983), the fraud on the market theory applies only to the special example of unmarketable securities. Since the plaintiff claimed only that "the price was too high when she bought it", rather than that Docutel's stock was unmarketable at any price, the court held that her failure to plead individual reliance was fatal and the case was dismissed. We hold the court read Shores v. Sklar too narrowly.

II. DEVELOPMENT OF THE FRAUD ON THE MARKET THEORY

Reliance is one of the cornerstones of a Rule 10b-5 claim. Dupuy v. Dupuy 551 F.2d 1005, 1014 (5th Cir.), cert. denied, 434 U.S. 911, 98 S.Ct. 312, 54 L.Ed.2d 197 (1977). The Rule 10b-5 cause of action is rooted in the ancient common law tort of deceit, which required proof of reliance on the defendant's specific misrepresentation. Huddleston v. Herman & MacLean, 640 F.2d 534, 547 (5th Cir.1981), affirmed in part and reversed in part, 459 U.S. 375, 102 S.Ct. 683, 74 L.Ed.2d 548 (1983). Proof of reliance establishes that the damaged party was induced to act by the defendant's conduct; it defines the causal link between defendant's misconduct and the plaintiff's decision to buy or sell securities. Id.; Dupuy, supra, at 1016. It is the generally applied bond between bad conduct and damages. It confirms the rather universal notion that one damaged ought not be rewarded for one's own deficient conduct.

The issue presented here, however, is not whether reliance is an element of Rule 10b-5, but how it may be proved, and who must prove it.

Two doctrines have evolved which assert how a plaintiff may satisfy the reliance element without specially proving that he or she relied directly on some active misrepresentation: the Affiliated Ute presumption, and the "fraud on the market" theory. They interact.

A. The Affiliated Ute Presumption

In Affiliated Ute Citizens v. United States, 406 U.S. 128, 92 S.Ct. 1456, 31 L.Ed.2d 741 (1972), the Supreme Court held that the 10b-5 plaintiff does not have to present positive proof of reliance in all securities fraud settings. Two of the defendants in Affiliated Ute bought stock from the plaintiffs without disclosing to them the existence of a secondary market in which the securities could be sold at a higher price. The defendants were not only aware of the secondary market, but had developed it themselves. The Court explained why positive proof of reliance was not required:

"It is no answer to urge that, as to some of the petitioners, these defendants may have made no positive representation or recommendation....

Under the circumstances of this case, involving primarily a failure to disclose, positive proof of reliance is not a prerequisite to recovery. All that is necessary is that the facts withheld be material in the sense that a reasonable investor might have considered them important in the making of this decision."

Id., 406 U.S. at 153-54, 92 S.Ct. at 1472 (citations omitted).

Courts applying Affiliated Ute have doctrinally invoked a rebuttable presumption of reliance based on proof of materiality in cases alleging deception by non-disclosure of information. ⁶ In Rifkin v. Crow, 574 F.2d 256 (5th Cir.1978), this Court summarized the pattern that emerged after Affiliated Ute:

"Where a 10b-5 action alleges defendant made positive misrepresentations of material information, proof of reliance by the plaintiff upon the misrepresentation is required. Upon an absence of proof on the issue, plaintiff loses. On the other hand, where a plaintiff alleges deception by defendant's nondisclosure of material information, the Ute presumption obviates the need for plaintiff to prove actual reliance on the omitted information. Upon a failure of proof on the issue, defendant loses. But this presumption of reliance is not conclusive. If defendant can prove that plaintiff did not rely, that is, that plaintiff's decision would not have been affected even if defendant had disclosed the omitted facts, the plaintiff's recovery is barred."

574 F.2d at 262 (footnotes omitted).

A court must, therefore, analytically characterize a 10b-5 action as either primarily a nondisclosure case (which would make the presumption applicable), or a positive misrepresentation case. Actually, the division of 10b-5 actions into these two categories is justified by the Rule itself. ⁷ Cases involving primarily a failure to disclose implicate the first and third subsections of Rule 10b-5; cases involving primarily a misstatement or failure to state a fact necessary to make statements made not misleading implicate the second subsection (which is the only subsection of the Rule that specifically mentions the active misrepresentation concept of prohibited conduct). Huddleston v. Herman & MacLean, 640 F.2d at 548.

B. The Fraud on the Market Theory

We turn briefly from judicial literature to economic doctrine.

The fraud on the market theory is premised on the hypothesis that the market price of a security, in an open market environment as opposed to a private transaction between seller and buyer, accurately...