Lucia v. PROSPECT STREET HIGH INCOME PORTFOLIO, Civ. A. No. 90-10781-MA.

• Decision Date: 02 July 1991
• Docket Number: Civ. A. No. 90-10781-MA.
• Citation: 769 F. Supp. 410
• Parties: Robert LUCIA, et al., Plaintiffs, v. PROSPECT STREET HIGH INCOME PORTFOLIO, INC., et al., Defendants.
• Court: U.S. District Court — District of Massachusetts

769 F. Supp. 410

Robert LUCIA, et al., Plaintiffs, v. PROSPECT STREET HIGH INCOME PORTFOLIO, INC., et al., Defendants.

Civ. A. No. 90-10781-MA.

United States District Court, D. Massachusetts.

July 2, 1991.

Nancy Gertner, Silverglate, Gertner, Fine & Good, Boston, Mass., Robert M. Roseman, Rudolph, Seidner, Goldstein, Rochestie & Salmon, P.C., Eugene A. Spector, Eugene A. Spector & Associates, Philadelphia, Pa., for plaintiffs.

Thomas J. Dougherty, Skadden, Arps, Slate, Meagher & Flom, Boston, Mass., for defendants.

MEMORANDUM AND ORDER

MAZZONE, District Judge.

The above-captioned case encompasses four separate actions¹ consolidated by stipulation pursuant to Fed.R.Civ.P. 42(a). The parties agree that the Amended Class Action Complaint filed in the Lucia and Bomireto cases is the operative complaint and that the parties are free to raise statute of limitations defenses based on the dates that individual complaints were filed.

The complaint alleges various violations of federal securities law, fraud, misrepresentation, and violations of the Racketeer Influenced and Corrupt Organizations Act (RICO), against defendant Prospect Street High Income Portfolio, Inc. ("Prospect Street" or "the Portfolio"), its directors, and underwriters. All four cases were originally drawn to Judge Wolf, and the defendants had filed motions to dismiss pursuant to Fed.R.Civ.P. 12(b)(6) and 9(b) when this court issued its opinion in Miller v. New America High Income Fund, 755 F.Supp. 1099 (D.Mass.1991). Noting the similarities between the New America case and the cases before him, Judge Wolf transferred the instant litigation to this court. This memorandum and order decides the pending motions to dismiss.

I. BACKGROUND

To say that the instant case and New America are similar is an understatement. The Lucia complaint repeats the lengthy allegations of the New America complaint nearly verbatim, changing only a few particulars to tailor the complaint to fit the facts of the Prospect Street initial public offering ("IPO"). (In all fairness, it should be noted that the prospectus issued in connection with the Prospect Street IPO borrowed nearly as liberally from the New America prospectus as the present complaint borrows from that filed in New America.)

Defendant Prospect Street is a Maryland corporation with a principal place of business in Boston, organized to invest primarily in "high-yield" fixed securities rated in the lower categories by established rating agencies (i.e., "junk bonds"). Defendant Prospect Street Investment Management Company, Inc. (the "Investment Adviser"), is responsible for the management of Prospect Street's portfolio. The individual defendants Omohundro, Frabotta, Carey, Cote, Meyohas, and Platt are all directors of Prospect Street; Omohundro serves as president of both Prospect Street and the Investment Adviser, and Frabotta is Prospect Street's Vice President, Secretary, and Treasurer. Defendant Thomson McKinnon Securities was, along with the now defunct Drexel Burnham Lambert, Inc., the lead underwriter for Prospect Street's IPO. Thomson McKinnon was also named as representative of the putative defendant class of all underwriters of the IPO. Defendant Milken, throughout the relevant time period, was the head of Drexel's high-yield bond department. The Runda complaint named defendant Prudential-Bache Securities Inc. ("Prudential") as the lead underwriter and as the representative of the defendant class.

Plaintiffs represent a putative class of purchasers of Prospect Street common stock during the period from November 28, 1988, to October 13, 1989, inclusive, and a putative subclass of purchasers of common stock issued in the IPO. In the IPO, pursuant to a prospectus and registration statement dated November 28, 1988, Prospect Street issued 12 million shares of common stock at $10 per share. By the end of April, 1989, more than 13 million shares of common stock were outstanding. The plot thickened when on April 14, 1989, a study headed by Massachusetts Institute of Technology professor Paul Asquith reported that the rate of default of junk bonds was much higher than issuers had been claiming. This study, according to the complaint, signalled the beginning of the demise of the junk bond market in general, and of Drexel Burnham and Milken in particular. Nonetheless, on June 12, 1989, Prospect Street issued its semi-annual report for the period ending April 30, 1989, which continued to maintain a rosy outlook.

During the summer of 1989, bad news about the junk bond market continued to leak out and "the quoted prices at which junk bonds were reportedly selling became severely depressed. However, defendants continued to maintain that Prospect Street because of its investment strategy, still remained a solid investment." Amended Class Action Complaint ¶ 70 hereinafter Complaint. October 31, 1989, saw an historic drop in the stock market and a corresponding collapse in the junk bond market. On November 10, 1989, Prospect Street "slashed" the monthly dividend to 9 cents per share. (On August 9, the directors had declared a 12 cent dividend; in September, the dividend decreased to 11.25 cents.)

Plaintiffs allege that all the named defendants were engaged in a conspiracy "to enable Prospect Street to complete the IPO and to inflate and maintain the price of Prospect Street stock at artificial levels by issuing materially false and misleading information." Complaint ¶ 14(a). The complaint divided the misrepresentations into five categories: statements that minimized the default rate of junk bonds, particularly those used to finance mergers and acquisitions, id. ¶ 76(a); failure to disclose Milken's "inner circle" of purchasers of junk bonds, id. ¶ 76(b); representations that the bonds that Prospect Street intended to purchase would be selected "on the basis of a professional effort to maximize investment potential," when the defendants knew that Prospect Street was an instrument of conspiracy and the "purchaser of last resort" of Drexel's junk bonds, id. ¶ 76(c); misrepresentations of the significant risks of the bonds in Prospect Street's portfolio and of junk bonds in general, id. ¶ 76(d); and failure to disclose that the "bid prices" for junk bonds were artificially inflated. Id. ¶ 76(e). While the plaintiffs paint with a broad brush to describe the nature of the false and misleading statements attributable to defendants, they point only to two specific sources of these statements: the prospectus and the semi-annual report.

In New America, this court dismissed plaintiffs' claims under section 10(b) of the Securities Exchange Act of 1934, as amended, 15 U.S.C. § 78j(b); under SEC Rule 10b-5, 17 C.F.R. § 240.10b-5; as well as the state-law fraud and negligent misrepresentation claims on the basis of plaintiffs' failure to plead "loss causation." New America, 755 F.Supp. at 1106-09. Finding that this failure was not fatal to a cause of action under either section 11 and 12(2) of the Securities Act of 1933, as amended, 15 U.S.C. §§ 77k, 77l(2), I denied the motion to dismiss those claims. As in New America, 755 F.Supp. at 1104, plaintiffs here have alleged three specific misleading statements that could form the basis for section 11 and section 12(2) actions. Taking as true for the moment plaintiffs' allegation that Prospect Street was created as a purchaser of last resort for the least desirable of Drexel's junk bond issues and imputing this knowledge to the defendants,² the use of the DBL Composite, see Complaint ¶ 51, Prospect Street's claim that it would engage in temporary defensive investment strategies, id. ¶ 48, and the prospectus's indication the Prospect Street would invest in "growth-stage" bonds, id. ¶ 50, may have been misleading. As in New America, however, statements in the Prospect Street prospectus with regard to the junk bond market cannot be a basis for any securities law violations, as the prospectus contained multiple warnings about the junk bond market. Likewise, statements in the prospectus that the Portfolio would be managed in accordance with Standard & Poor guidelines were not misleading as to the common stock purchasers because the prospectus made it clear that these guidelines related only to the notes and preferred stock. Finally, any liability based on mismanagement of the Portfolio is not the subject of a federal securities law violation. See 755 F.Supp. at 1103-04 & n. 7.

Defendants in their motions to dismiss before Judge Wolf did not base their argument on "loss causation," although in its reply brief filed with this court, Prudential pointed out that the reasoning in New America is dispositive of the instant securities fraud allegations. Plaintiffs addressed the issue of loss causation in their papers, and I discuss it below.

As the principal ground for their motion to dismiss, defendants argue that the plaintiffs failed to plead fraud with adequate particularity. Fed.R.Civ.P. 9(b). Plaintiffs have briefed this argument, asserting that the complaint satisfies Rule 9(b), and even if it does not, that the rule does not apply to complaints alleging violations of sections 11 and 12(2).

Finally, defendant Prudential argues that, as to it, the sections 11 and 12(2) claims in the Runda complaint are barred by the statute of limitations. I discuss each of these arguments in turn.

II. LOSS CAUSATION

Defendants are correct to assert that the resolution of the section 10(b), fraud, and negligent misrepresentation claims in New America is dispositive of the same claims in the instant litigation. In New America, this court held that the plaintiffs failed to plead a key element of a securities fraud claim — loss causation — in that they did not allege how the misrepresentations of which they complained caused their injury. There, as here, the plaintiffs' viable misrepresentation claims were based on statements that may have led purchasers of common stock to believe that the...