In re Kidder Peabody Securities Litigation, 94 Civ. 3954(BSJ).

• Decision Date: 06 July 1998
• Docket Number: No. 94 Civ. 3954(BSJ).,94 Civ. 3954(BSJ).
• Citation: 10 F.Supp.2d 398
• Parties: In re KIDDER PEABODY SECURITIES LITIGATION.
• Court: U.S. District Court — Southern District of New York

10 F.Supp.2d 398

In re KIDDER PEABODY SECURITIES LITIGATION.

No. 94 Civ. 3954(BSJ).

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

July 6, 1998.

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Richard Bemporad, Jeanne F. D'Esposito, Lowey, Dannenberg, Bemporad & Selinger, P.C., New York City, for Plaintiffs.

Robert F. Wise, Jr., Lawrence J. Portnoy, Laura A. Lopez, Davis, Polk & Wardwell, New York City, for Defendant Kidder Peabody & Co., Inc. and Kidder Peabody Group, Inc.

David M. Brodsky, Daniel J. Kramer, David K. Momborquette, Schulte, Roth & Zabel, New York City, for Defendant Michael A. Carpenter.

Raymond Banoun, Richard A. McGuirk, Cadwalader, Wickersham & Taft, New York City, for Defendant Richard W. O'Donnell.

Henry B. Gutman, Eric S. Kobrick, Simpson, Thacher & Bartlett, New York City, for Defendant Edward A. Cerullo.

Kenneth E. Warner, Lewis S. Fischbein, Coblance & Warner, New York City, for Defendant Orlando Joseph Jett.

MEMORANDUM & ORDER

JONES, District Judge.

This consolidated class action arises from allegations that a trader at defendant Kidder, Peabody & Co., Inc. ("Kidder") engaged in an ongoing scheme from late 1991 until April 1994 to generate false profits through the use of phantom trades. At the time of the alleged scheme, Kidder was a wholly-owned subsidiary of General Electric Company ("GE"). Following disclosure of the scheme, plaintiffs, shareholders of GE who purchased GE common stock between February 26, 1993, and April 15, 1994, commenced this action. Plaintiffs allege that Kidder, its holding company, defendant Kidder, Peabody Group, Inc. ("Kidder Group"), and four employees of Kidder, including the trader directly responsible for generating the false profits, violated the Securities Exchange Act of 1934 by making or causing to be made public statements that incorporated the false profits.¹

Plaintiffs' complaint originally pled twenty-four allegedly false or misleading public statements. Of these, thirteen had been made by GE in public filings, reports and press releases, five had been made by securities analysts, and one had been made by former New York City Mayor David Dinkins. The remaining five statements had been made directly by Kidder or by a Kidder employee.

On October 4, 1995, the Court denied defendants' motions to dismiss the complaint. In re Kidder Peabody Sec. Litig., 1995 WL 590624 (S.D.N.Y. 1995) ("Kidder I"). As part of that decision, however, the Court agreed with defendants that they could not be held liable for statements attributed to GE or to other third parties. Id. at *4. Accordingly, the Court dismissed the claims based on those statements, leaving in the case only the five statements directly attributable to Kidder or Kidder's employees. Id.

Currently pending are defendants' motions for summary judgment, pursuant to Fed. R.Civ.P. 56. Defendants Kidder, Kidder Group, Michael A. Carpenter ("Carpenter"), Richard W. O'Donnell ("O'Donnell"), Edward A. Cerullo ("Cerullo"), and Orlando Joseph Jett ("Jett") join in arguing for summary judgment on the ground that plaintiffs cannot prove, as a matter of law, that any of the allegedly false statements were material. All of the defendants, except for Jett, also argue for summary judgment on the ground that plaintiffs cannot prove, as a matter of law, that they acted with the requisite scienter. In addition, Cerullo argues that he is entitled to summary judgment because plaintiffs cannot prove that he was personally responsible for any of the allegedly false statements or that he owed a duty to GE's shareholders.

Also pending is plaintiffs' application to reinstate the thirteen statements attributed to GE and the five statements attributed to securities analysts, which previously were dismissed by the Court. Plaintiffs argue that defendants should be held liable for these statements because defendants were directly responsible for making them, using GE and the analysts as conduits for materially false information.

BACKGROUND

The following facts are not in dispute unless otherwise noted.

I. Kidder's Organizational Structure and Relationship to GE

At all relevant times, Kidder was a registered securities broker-dealer and full-service investment bank, and a wholly owned subsidiary of Kidder Group, a holding company for several related businesses. Kidder's businesses included securities underwriting, sales and trading of equity and fixed income securities, corporate finance advisory services, and retail brokerage and asset management.

During the class period, Carpenter served as Kidder's Chairman of the Board of Directors and Chief Executive Officer. Below Carpenter was O'Donnell, who served as Kidder's Chief Financial and Administrative Officer. O'Donnell's responsibilities included overseeing Kidder's operations and its audit and credit functions.

Kidder's relationship with GE began in April 1986, when GE purchased Kidder for $602 million. From then until late 1994,² Kidder, through Kidder Group, was a wholly-owned subsidiary of GE Capital Services ("GECS"). GECS, in turn, was a wholly-owned subsidiary of GE, functioning as GE's financial services unit.

GE is engaged in a wide variety of businesses including lighting, appliances, aircraft engines, broadcasting (through NBC), plastics, medical equipment, and power generation. Unlike Kidder, Kidder Group, or GECS, GE is a publicly held company, with its common stock traded on the New York Stock Exchange ("NYSE"). Consistent with its duties as a publicly held company, and pursuant to rules promulgated by the Securities Exchange Commission ("SEC"), GE makes regular public disclosure of its financial statements. During the relevant time period, GE's statements included financial information related to Kidder.

During the class period, Kidder's most dominant business unit was the Fixed Income Division, which was headed by Cerullo.³ According to plaintiffs, this division accounted for the great majority of Kidder's net income and approximately 90% of the book value of Kidder's assets.

The Fixed Income Division consisted of twelve trading desks, including the Government Securities Desk. In July 1991, Jett was hired by Kidder to trade at this desk. It was from this desk that Kidder's false profits originated over the next two and a half years.

II. Trading of Treasury Bonds

Kidder's Government Securities Desk traded in bonds issued by the United States Treasury. As traded on the secondary market, each bond consists of separate components, representing fixed interest and principal payments. Individually, these components are known as "STRIPS," for "Separate Trading of Registered Interest and Principal of Securities." Collectively, these STRIPS constitute a completed bond.

Due to the time value of money, in trading with consumers, a STRIPS security will sell for less than its final payment value. This is because the present value of the right to receive a future payment is less than the value of receiving that payment immediately. Generally, the greater the length of time between purchase date and final payment date, the greater the gap between current price and final value. The converse is also true: As the payment date approaches the price of a STRIPS security will increase, until payment date, when the two values converge.

Purchasers and dealers of STRIPS seek to profit on shifts in interest rates and demand that occur between the sale date of a STRIPS security and its payment date. Dealers also can make profits through "arbitrage," exploiting small, temporary price discrepancies between bonds and the component STRIPS. Thus, if the demand for individual STRIPS on any given day is higher than their current market value as a fully reconstituted bond, a dealer may be able to make a profit by stripping a bond and selling the individual components.

To facilitate the trading of government bonds, the Federal Reserve Board ("Federal Reserve"), acting as agent for the United States Treasury, stands ready at any time to exchange a bond for its individual STRIPS, or vice versa. The exchange of a full set of STRIPS for a bond is known as a "reconstitution" or "recon." The opposite exchange, of a bond for its individual STRIPS, is known as a "strip."

Unlike the sale of STRIPS or bonds to consumers, the exchange of STRIPS for bonds (or bonds for STRIPS) between a broker-dealer and the Federal Reserve has no economic significance. Such an exchange is merely a non-cash trade of economically equivalent securities, much like the exchange of one $100 bill for five $20 bills. Only the Federal Reserve can execute a strip or recon exchange and the Federal Reserve does not arrange, agree to, or confirm such exchanges in advance.

III. Jett Begins to Trade

Although Jett had never traded in government securities, Kidder hired him, according to Jett, to reestablish profitability on the Government Securities Desk. Kidder expected Jett to make profits in part by dealing in STRIPS with customers and through opportunities for arbitrage. According to Melvin Mullin ("Mullin")⁴, Jett's first supervisor at Kidder, when Jett started in 1991 strip and recon arbitrage with customers could result in "profit opportunities in the range of $2000 per million." Such opportunities arose from "doing trades with customers to capture the price differences."

Jett's initial performance at Kidder was "fairly slow," according to Mullin. In August 1991, Jett lost money; the following two months he made only small profits of $229,000 and $275,000. These profits were far less than the $1 million in profits per month that Cerullo and Mullin expected Jett to generate from his trading activities. As a result, at the end of October, Kidder categorized Jett's performance as "Improvement Desirable," giving Jett the second lowest rating on Kidder's five-point performance scale.

Towards the end of 1991, however, Jett's performance appeared to turn around, with reported profits of $500,000 in...