Sullivan & Long, Inc. v. Scattered Corp.

• Citation: 47 F.3d 857
• Decision Date: 13 March 1995
• Docket Number: No. 94-2015,94-2015
• Parties: Fed. Sec. L. Rep. P 98,617 SULLIVAN & LONG, INCORPORATED, et al., Plaintiffs-Appellants, v. SCATTERED CORPORATION, Defendant-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

Page 857

47 F.3d 857

Fed. Sec. L. Rep. P 98,617

SULLIVAN & LONG, INCORPORATED, et al., Plaintiffs-Appellants, v. SCATTERED CORPORATION, Defendant-Appellee.

No. 94-2015.

United States Court of Appeals, Seventh Circuit.

Argued Nov. 1, 1994.

Decided Feb. 8, 1995.

Rehearing and Suggestion for Rehearing

En Banc Denied March 13, 1995. ^*

Jay A. Canel (argued), Peter M. King, Stephen D. Davis, Canel, Davis & King, Chicago, IL, Milo W. Lundblad, Flossmoor, IL, for plaintiffs-appellants Sullivan & Long, Inc., Joseph D. Lapota, Jr.

Michael B. Hyman, Carol V. Gilden, Much, Shelist, Freed, Denenberg & Ament, Clinton A. Krislov, Jonathan Nachsin, Krislov & Associates, Chicago, IL, for plaintiff-appellant Carole Bland.

Robert D. Allison, Chicago, IL, Jules Brody, Stull, Stull & Brody, New York City, for plaintiff-appellant James Hamburger.

Michael B. Hyman, Carol V. Gilden, Much, Shelist, Freed, Denenberg & Ament, Chicago, IL, Jules Brody, Stull, Stull & Brody, New York City, Clinton A. Krislov, Jonathan Nachsin, Krislov & Associates, Chicago, IL, Milo W. Lundblad, Flossmoor, IL, Perry J. Shwachman, Cin, Schwachman & Wagner, Chicago, IL, for plaintiffs-appellants Mark V. Harkins, Samuel Hooker, Charles Hawker, Audrey Hewitt, Anthony Hewitt, John Eckensten, Ronald J. Moran, Lesley R. Moran, Timothy J. Moran, Leon D. Ardelean, Jeffrey J. Sims, Sheffield Wolk, A.J. Blythe, Dorothy B. Nussdorf, Dan Chlipala.

Elizabeth D. Sharp, Paul A. Hybel, Thomas Kottler, LeLand W. Hutchinson, Jr. (argued), Freeborn & Peters, Chicago, IL, for defendant-appellee Scattered Corp., an Ill. Corp.

Before POSNER, Chief Judge, and COFFEY and MANION, Circuit Judges.

POSNER, Chief Judge.

This is an appeal from the dismissal, for failure to state a claim, of a suit that charges violations of the securities laws growing out of a notorious, or at least newsworthy, episode of short selling of common stock of LTV Corporation. In re Scattered Corporation Securities Litigation, 844 F.Supp. 416 (N.D.Ill.1994); see, e.g., Kurt Eichenwald, "Stock Strategy under Scrutiny," N.Y. Times, Aug. 26, 1993, p. D1; Alexandra Peers & Jeffrey Taylor, "Chicago Broker Faces Inquiry over LTV Short Sales," Wall St. J., Aug. 27, 1993, p. C1. The plaintiffs allege a "market manipulation" on an awesome scale that jeopardized the solvency of the Chicago (formerly Midwest) Stock Exchange. But like the district judge we have difficulty understanding what right of the plaintiffs the "manipulation" violated or how they were harmed.

LTV, a large steel producer, entered bankruptcy in 1986. In February of 1993 it announced a proposed plan of reorganization under which existing stock in the company would be replaced by new stock most of which would be issued to the bondholders and other creditors of LTV. Existing stockholders would receive warrants entitling them to purchase some of the new stock. The plan contained an estimate that the new shares would be worth only 3 or 4 cents. When the plan was announced, the old shares were trading for more than 30 cents. There were 122 million old shares outstanding.

The plan was confirmed by the bankruptcy court on May 27, 1993, and the court fixed June 29 as the last day on which the old shares would be tradable. Beginning before the confirmation date, but greatly accelerating on that date, the principal defendant, a Chicago Stock Exchange market maker (a dealer willing both to buy and sell a particular stock or other security for his account on a regular basis, 15 U.S.C. Sec. 78c(a)(38)) with the alarming name of Scattered Corporation, sold short huge quantities of the old LTV shares. It sold short, in fact, tens of millions of such shares a week, for a total, when trading ended on June 29, of 170 million shares, far more than the 122 million old LTV shares outstanding. The excess of shares sold short over total shares outstanding is the focus of the plaintiffs' complaint.

A short sale is a sale at a price fixed now for delivery later. A trader sells stock short when he thinks the price of the stock is going to fall, so that when the time for delivery arrives he can buy it at a lower price and pocket the difference. If, for example, he sells the stock short at 50 cents a share, and the price falls to 40 cents before he delivers the stock, he can buy the stock for 40 cents a share, deliver it to the buyer, and have made a profit of 10 cents. Under the rules of the Chicago Stock Exchange, the buyer in a short-sale situation is entitled to delivery within five working days of the sale. If the seller fails to make delivery (maybe he doesn't have the stock), the rules entitle the buyer to "buy in" the stock, that is, to go out and purchase it on the open market and charge the price to the short seller. See United States v. Naftalin, 441 U.S. 768, 771 n. 2, 99 S.Ct. 2077, 2080, 60 L.Ed.2d 624 (1979). If in our example the price had risen by the end of five working days to 65 cents and the seller did not deliver, the buyer would go into the market, buy the stock at 65 cents, and charge the price back to the short seller. After the completion of the transaction, the buyer would have stock worth 65 cents that he had obtained at a net cost of 50 cents (50cents + 65cents - 65cents). Notice that a short seller's potential loss is unlimited, since it is simply the difference between the sale price and the market price--which could be anything.

The plaintiffs in this case were buyers on the other side of Scattered's short sales. They thought the price of the old shares would rise before plunging to 3 or 4 cents by June 29. (An old share would be worth that, rather than, as one might imagine, zero, because the holder of 100 shares was entitled to turn his shares in and receive 1.08 warrants to buy new shares at the rate of one warrant per share. The warrants, being worth approximately 100 times the old shares, were selling for between $3.125 and $4.125.) Why they thought this is a puzzle. Since on May 27 it was certain, or virtually so (nothing is really certain), that shares of common stock in LTV would be worth no more than 4 cents in just a month, it is unclear why the stock did not plunge immediately to that level. In fact it remained in the two-digit range for quite some time, and on the very last day of trading was trading at 7.8 cents even though it was within hours of plunging to half that.

Scattered's counsel told us that the only reason the stock did not plunge immediately is that many brokers and investors do not read a plan of reorganization carefully--it is a long, complex, and jargon-ridden document--and hence many of them did not at first, or perhaps even at last, realize that the old stock in LTV would indeed be worth only 3 or 4 cents after the reorganization was completed. The problem may be endemic with reorganizations. Eichenwald's article suggests that many investors misunderstand the significance of news that a company is reorganizing. They see that the price of the stock is "low," and think that they are getting in on the ground floor rather than climbing aboard a sinking ship. See also Kurt Eichenwald "Being Nearly Worthless, Wang Shares, Of Course, Sell Briskly," N.Y. Times, Sept. 16, 1993, p. D8. Maybe the stock exchanges or the SEC should do something about these gullibles, since competition, which usually protects the uninformed purchaser, seems not to be working. Scattered, however, disclaims any legal responsibility for educating its buyers, and indeed has none, not being a fiduciary of the people it trades with. Chiarella v. United States, 445 U.S. 222, 233, 100 S.Ct. 1108, 1117, 63 L.Ed.2d 348 (1980). Its counsel acknowledged that his client hoped to take advantage of these people by selling them stock short. That is what short sellers do: they bet on a declining market, trusting that they have better information or better instincts than other traders, those who will buy from them. There is nothing unlawful about trading on an information advantage, provided that it is not based on inside information, id. at 233, 235, 100 S.Ct. at 1117, 1118; Dirks v. SEC, 463 U.S. 646, 654-55, 103 S.Ct. 3255, 3261-62, 77 L.Ed.2d 911 (1983); Barker v. Henderson, Franklin, Starnes & Holt, 797 F.2d 490, 495-96 (7th Cir.1986), which is not alleged. Scattered merely had a better understanding of the information about the reorganization than the investors with whom it traded. It was not even a matter of its having nonpublic information, though the cases we have just cited make clear that trading on nonpublic information is lawful unless it is inside information. It was a matter of a superior interpretation of public information, the information contained in the plan of reorganization.

The effect of trading on an information advantage is to dispel, by penalizing, ignorance and to bring market values into closer, quicker conformity with economic reality. The profit that such trading brings at the expense of less knowledgeable traders provides the incentive for a private, for-profit firm, such as Scattered, to provide this economic service.

Darwinian this process may appear to be, and yet how many (if any) of the plaintiffs resemble the proverbial widow and orphan, or other harmless prey? Sullivan & Long is the first-listed plaintiff. According to a magazine article that the plaintiffs cited in their complaint, "Mr. Sullivan, who is a member of the CSE's [Chicago Stock Exchange's] board of governors and is an owner of CSE member firm Sullivan & Long Inc., tried to use an arbitration strategy similar to Scattered's to profit from the difference in price between LTV's stock and warrants. But in late June, Mr. Sullivan, who was effectively betting that LTV's stock price would decline, became concerned that the price might rise when he discovered how large a short position Scattered had. He bought LTV shares to cover his own short position, and his firm incurred modest losses. In July, Sullivan & Long filed suit against Scattered...."...