New Jersey and, Div. Of Invest. v. Sprint

• Decision Date: 23 April 2004
• Docket Number: No. 03-2071-JWL.,03-2071-JWL.
• Citation: 314 F.Supp.2d 1119
• Parties: State of NEW JERSEY AND ITS DIVISION OF INVESTMENT et al., Plaintiffs, v. SPRINT CORPORATION; William T. Esrey; Ronald T. LeMay; Harold S. Hook; Charles E. Rice; Louis W. Smith; Linda Koch Lorimer; Stewart Turley; DuBose Ausley; Warren L. Batts; Irvine O. Hockaday, Jr.; Arthur Krause; J.P. Meyer; and Ernst & Young LLP, Defendants.
• Court: U.S. District Court — District of Kansas

314 F.Supp.2d 1119

State of NEW JERSEY AND ITS DIVISION OF INVESTMENT et al., Plaintiffs, v. SPRINT CORPORATION; William T. Esrey; Ronald T. LeMay; Harold S. Hook; Charles E. Rice; Louis W. Smith; Linda Koch Lorimer; Stewart Turley; DuBose Ausley; Warren L. Batts; Irvine O. Hockaday, Jr.; Arthur Krause; J.P. Meyer; and Ernst & Young LLP, Defendants.

No. 03-2071-JWL.

United States District Court, D. Kansas.

April 23, 2004.

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COPYRIGHT MATERIAL OMITTED

Allyn Z. Lite, Bruce D. Greenberg, Joseph J. DePalma, Mary Jean Pizza, Lite, DePalma, Greenberg & Rivas LLC, Newark, NJ, Christopher L. Nelson, Jacob A. Goldberg, Richard S. Schiffrin, Schiffrin & Barroway LLC, Bala Cynwyd, PA, Linda C. McFee, Thomas R. Buchanan, McDowell, Rice, Smith & Gaar, PC, Kansas City, MO, for Plaintiffs.

James M. Webster, III, Mark C. Hansen, Kellogg, Huber, Hansen, Todd & Evans Washington, DC, Charles W. German, David J. Rempel, Rouse Hendricks German May PC, Clayton L. Barker, Mark A. Thornhill, Spencer Fane Britt & Browne, Kansas City, MO, David N. Greenwald, Francis P. Barron, Michael A. Paskin, Ronald S. Rolfe, Cravath, Swaine & Moore LLP, New York, NY, for Defendants.

MEMORANDUM & ORDER

LUNGSTRUM, District Judge.

Plaintiffs filed this proposed class action suit on behalf of persons who purchased Sprint securities between October 17, 2000 and February 5, 2003 (the "class period") and on behalf of persons who purchased Sprint "equity units" traceable to an August 7, 2001 registration statement during the class period. In their first amended complaint, plaintiffs allege violations of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and the SEC's Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5 (fraud in connection with the sale of securities) violations of Section 14(a) of the Securities Exchange Act of 1934, 15 U.S.C. § 78n(a), and the SEC's Rule 14a-9 promulgated thereunder, 17 C.F.R. § 240.14a-9 (proxy statement misrepresentations); and violations of Section 11 of the Securities Act of 1933, 15 U.S.C. § 77k (sale of securities through misleading registration statement). Plaintiffs also assert against the individual defendants claims under Section 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. § 78t(a), and Section 15 of the Securities Act of 1933, 15 U.S.C. § 77o, which impose secondary liability upon persons who control persons primarily liable for violations of Section 10(b) and Rule 10b-5, and Section 11, respectively.

This matter is presently before the court on defendant Sprint Corporation and the individual defendants' motion to dismiss pursuant to Federal Rule of Civil Procedure 12(b)(6) (doc. # 68) and defendant Ernst & Young LLP's motion to dismiss pursuant to Federal Rule of Civil Procedure 12(b)(6) (doc. # 70). Oral arguments were heard on the motions on April 1, 2004. After a thorough review of the written submissions by the parties and careful consideration of the arguments made by all parties during oral argument as well as the relevant legal authorities, the court grants in part and denies in part the Sprint defendants' motion to dismiss and grants Ernst & Young's motion to dismiss in its entirety.

I. Background

The following facts are taken from plaintiffs' first amended complaint and, for purposes of analyzing defendants' motions to dismiss, the court assumes the truth of these facts. See infra part II.¹ Defendant Sprint Corporation is a global communications company that provides local, long distance and wireless services. During the Class Period, Sprint's common stock was actively traded on the New York Stock Exchange. As a public company, Sprint regularly files financial reports with the SEC, including annual and quarterly reports, registration statements and proxy statements. During the Class Period, all financial statements included in these reports were audited by defendant Ernst & Young LLP. Moreover, during the Class Period, defendant William T. Esrey was Sprint's Chairman and Chief Executive Officer; defendant Ronald T. LeMay was its President and Chief Operating Officer; defendant Arthur Krause was Sprint's Executive Vice President and Chief Financial Officer; and defendant J.P. Meyer was Sprint's Senior Vice President and Controller. The remaining individual defendants served on Sprint's Board of Directors during the Class Period.

Like many other publicly traded companies, Sprint paid its executives and certain employees, including Mssrs. Esrey and LeMay, a portion of their compensation in the form of Sprint common stock options. This case arises out of events that occurred after Mssrs. Esrey and LeMay exercised certain options during 1999 and 2000. According to plaintiffs, Mssrs. Esrey and LeMay each exercised options during 1999 and 2000 with a taxable gain of $149 million and $138 million, respectively. As a result of Mssrs. Esrey's and LeMay's option exercises, Sprint derived significant tax benefits in the form of deductions from its taxable income. Plaintiffs do not suggest that the options were improperly granted or exercised or that Sprint acted improperly in taking the resulting tax deductions.

Because the exercise of options results in tax liability on the gain realized thereby, the options exercised by Mssrs. Esrey and LeMay subjected them to significant personal tax liability. According to plaintiffs, Mssrs. Esrey and LeMay would have needed more than $100 million in cash, collectively, to pay the taxes associated with their option exercises. While individuals typically fund such tax liabilities through the sale of some shares, the first amended complaint alleges that Mssrs. Esrey and LeMay elected not to sell any Sprint shares for fear that such an action (by Sprint's top two executives) would misleadingly signal a lack of confidence in the company and thereby cause a decline in stock price. As an alternative to selling shares, defendant Ernst & Young developed and offered to Mssrs. Esrey and LeMay certain "tax shelters" which either eliminated or greatly reduced Mssrs. Esrey's and LeMay's tax obligations with respect to the gains realized through the option exercises.² According to plaintiffs, Sprint mandated that its senior executives use Ernst & Young to prepare their personal tax returns and these executives were reimbursed by Sprint for the cost of the work performed by Ernst & Young. Plaintiffs do not allege, however, that Sprint had any knowledge concerning the substance of any advice that Ernst & Young provided to Mssrs. Esrey and LeMay and plaintiffs do not allege that Sprint had any knowledge that Mssrs. Esrey and LeMay had entered into the transactions offered by Ernst & Young, at least at the time they entered into the transactions.

In September 2000, after Mssrs. Esrey and LeMay had entered into the transactions constituting the tax shelters, the IRS issued Cumulative Bulletin Notice 2000-36, which contained Notice 2000-44. That Notice, in turn, outlined the IRS's position that tax shelters similar to the ones that Ernst & Young sold to Mssrs. Esrey and LeMay were invalid and subject to challenge.³ The Notice further stated that participants in such transactions may be subjected to appropriate penalties. According to plaintiffs, Mssrs. Esrey and LeMay, at this point, knew that there was a high probability that the tax liability they had avoided would become due and the taxes that they owed-more than $100 million collectively-would force them into personal financial ruin.

In late 2000, Mssrs. Esrey and LeMay advised Sprint's Board of Directors about the nature of the transactions they had entered into as well as the IRS's subsequent notice suggesting that the transactions were invalid. Mssrs. Esrey and LeMay asked the Board to consider "unwinding" or rescinding the option exercises, thereby nullifying Mssrs. Esrey's and LeMay's tax liability. After seeking guidance from the SEC regarding whether Sprint could rescind the option exercises, Sprint ultimately rejected the idea because it would have caused Sprint to lose the tax deductions it had taken upon Mssrs. Esrey's and LeMay's option exercises and, thus, would have required Sprint to restate its earnings and refile its tax returns to pay back taxes. The Board of Directors also rejected a request from Mr. Esrey for additional compensation to cover his potential tax liability.

By the end of 2001, Mssrs. Esrey and LeMay had applied for and received tax amnesty from the IRS and thus were immune from any penalties the IRS might have levied if it ultimately concluded that the tax shelters utilized by Mssrs. Esrey and LeMay were invalid. Mssrs. Esrey and LeMay, however, were still liable for any unpaid taxes on the gains realized as a result of their option exercises (again, assuming the IRS ultimately concluded that the shelters were invalid). By this time, however, Mssrs. Esrey and LeMay could not sell their shares to cover their potential tax liability because Sprint's common stock price had declined dramatically such that Mssrs. Esrey's and LeMay's potential tax liability far exceeded the total value of their Sprint holdings.

During 2002, Sprint's Board of Directors held over twenty meetings dedicated to discussing the tax problems faced by Mssrs. Esrey and LeMay, the potential conflicts those problems created, whether to retain Mssrs. Esrey and LeMay as its two most senior executives and whether to retain Ernst & Young as Sprint's independent auditor. Moreover, in June 2002, the Board learned that the IRS had begun formally investigating Mssrs. Esrey and LeMay in connection with the specific tax shelters utilized by them.⁴ At that time, the Board hired the law firm of Davis Polk & Wardwell to assess what action Sprint should take. According to plaintiffs, the Board was worried about the tension between its independent auditor, Ernst & Young, and its top two executives, as well as the prospect that personal financial ruin for Mssrs. Esrey and...