Warren v. Reserve Fund, Inc.

• Decision Date: 02 April 1984
• Docket Number: No. 82-1697,82-1697
• Citation: 728 F.2d 741
• Parties: Fed. Sec. L. Rep. P 91,409 Henry Lee WARREN, Plaintiff-Appellant Cross-Appellee, v. The RESERVE FUND, INC., Reserve Management Corporation, Harry B.R. Brown and Bruce R. Bent, Defendants-Appellees Cross-Appellants.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 741

728 F.2d 741

Fed. Sec. L. Rep. P 91,409

Henry Lee WARREN, Plaintiff-Appellant Cross-Appellee, v. The RESERVE FUND, INC., Reserve Management Corporation Harry B.R. Brown and Bruce R. Bent Defendants-Appellees Cross-Appellants.

No. 82-1697.

United States Court of Appeals Fifth Circuit.

April 2, 1984.

Steven A. Sinkin, San Antonio, Tex., Susman & McGowan, Terrell W. Oxford, James Thomas McCartt, Houston, Tex., Herbert B. Newberg, Philadelphia, Pa., for plaintiff-appellant cross-appellee.

Salmanson, Smith & Mouer, Thomas M. Booker, Robert O. Smith, Austin, Tex., Grutman & Schafrann, Vito C. Casoni, Donn A. Randall, New York City, for Reserve Fund.

Oppenheimer, Rosenberg, Kelleher & Wheatley, Seagal V. Wheatley, Edward M. Lavin, San Antonio, Tex., for Reserve Mngt., Brown & Bent.

Appeals from the United States District Court for the Western District of Texas.

Before BROWN, REAVLEY and WILLIAMS, Circuit Judges.

JERRE S. WILLIAMS, Circuit Judge.

Plaintiff Henry Lee Warren, an investor in The Reserve Fund, Inc., a mutual fund headquartered in New York City, appeals from the district court's denial of class certification and its order of dismissal in an action alleging securities misrepresentation by the mutual fund. In his complaint, Warren claimed that prerecorded WATS line telephone messages that stated the Fund's "current yield" misrepresented the Fund's actual daily dividend to investors. The relief sought is based on Sec. 10(b) of the Securities Exchange Act of 1934. We affirm both the denial of certification and the order of dismissal.

I. FACTS

On June 26, 1979, plaintiff Henry Lee Warren consulted his broker about investing some cash that plaintiff had received from the sale of stock. The broker suggested investing in The Reserve Fund, Inc., a no-load open-end mutual fund, ¹ and gave Warren a WATS number to call for more information about the fund's performance.

Each day, the Reserve Fund prepared a recorded message based on the following format:

The Reserve Fund's current yield on ______ is ______%. We paid ______% for the last ______ days. We earned ______% for the last quarter. Our assets exceed $____________ and our average portfolio life is ____________ days. For further information, please call (212) 977-9880 or write us at 811 Seventh Avenue, N.Y., N.Y. 10019. Thank you for calling.

On June 26, the Fund reported on the WATS message that the "current yield" was 9.88%. Mr. Warren invested $7,827.79 with the Fund that same day. ²

On October 22, 1979, Warren instituted this action against The Reserve Fund ³ under Rule 10b-5, 17 C.F.R. Sec. 240.10-5 (1980), promulgated by the Securities and Exchange Commission under Sec. 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78j(b) (1976). ⁴ Warren's sole claim is based on one line from the Fund's pre-recorded WATS line telephone message. Warren contends that the first sentence of the message, which reported the Fund's "current yield," constituted a scheme to defraud the investing public since the figure quoted as the "current yield" was not the actual rate that funds placed with defendant earned on that date ⁵ and since a reasonable investor would assume that "current yield" represented actual dividends paid. Warren claims that the Fund either should have included the true daily yield in the recording or alternatively, that the Fund should not have stated the "current yield" at all, since stated alone this information misled the public. ⁶

On October 29, 1979, Warren moved for class certification on behalf of all persons, numbering approximately 80,000, who purchased shares of The Reserve Fund during the three year period from October, 1976 through October, 1979. The Fund made a motion for summary judgment claiming that plaintiff suffered no out-of-pocket damages and therefore had no compensable loss. The summary judgment motion was denied without an opinion by Judge Roberts on August 18, 1980. The case was then reassigned to Judge Bunton who denied Warren's motion for class certification. ⁷ The case was then transferred again to Judge Garcia who dismissed the case on November 9, 1982 after reconsideration of the damages issue.

Six months after filing the action, in April, 1980, Warren redeemed his investment and received $8,571.00, representing a gain of $743.21 and a yield of 12.15%.

II. DISMISSAL

A. District court ruling

Plaintiff's sole claim is founded on an alleged violation of Rule 10b-5. In order to state a claim for relief under 10b-5, the plaintiff must establish (1) a misrepresentation or omission or other fraudulent device; (2) a purchase or sale of securities in connection with the fraudulent device; (3) scienter by defendant in making the misrepresentation or omission; (4) materiality of the misrepresentation or omission; (5) justifiable reliance on the fraudulent device by plaintiff (or due diligence against it); and (6) damages resulting from the fraudulent device. Cameron v. Outdoor Resorts of America, Inc., 608 F.2d 187, 193 (5th Cir.1979), affirmed in part, vacated and remanded in part on rehearing, 611 F.2d 105 (5th Cir.1980); see also Huddleston v. Herman & MacLean, 640 F.2d 534, 543 (5th Cir.1981), cert. granted, 456 U.S. 914, 102 S.Ct. 1766, 72 L.Ed.2d 173 (1982), aff'd in relevant part, --- U.S. ----, 103 S.Ct. 683, 74 L.Ed.2d 548 (1983). Plaintiff can succeed in stating a claim only if a genuine issue of material fact is established with respect to each of these elements.

The district court dismissed the case based on its conclusion that plaintiff had not made a threshold showing of out-of-pocket loss, which the Court considered to be the proper measure of damages in a 10b-5 action. The district court noted that plaintiff purchased stock in the Fund with an original investment of $7,827.79. He sold the shares in April, 1980, for $8,571.00, earning a dividend of greater than 12%. Since plaintiff recovered his investment and gained an additional $743.21, the court found no compensable loss.

Plaintiff contends that the district court erred in concluding that he did not suffer out-of-pocket loss, ⁸ and that in any event out-of-pocket loss is not the only measure of injury in a 10b-5 action. ⁹ We find it unnecessary to analyze the legal effect of any damages that may have resulted in this case. Whether or not plaintiff suffered damages compensable under Rule 10b-5, the dismissal of this action was not an abuse of discretion because plaintiff could not establish the presence of scienter, another necessary prerequisite to recovery under Rule 10b-5. For this reason, we decline consideration of the various damages theories presented by plaintiffs in their briefs, and focus instead upon scienter. ¹⁰

B. Scienter

It is now well established that in order to state a cause of action under 10b-5, the plaintiff must allege and prove that the defendant acted with scienter. In the seminal case, Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976), the Supreme Court defined scienter as "a mental state embracing intent to deceive, manipulate, or defraud." Id. at 193 n. 12, 96 S.Ct. at 1381 n. 12.

Since the Ernst & Ernst case, this Court has held that in the context of a private action for money damages under Rule 10b-5, scienter is satisfied by proof that defendants acted with severe recklessness. ¹¹ Broad v. Rockwell International Corporation, 642 F.2d 929, 961 (5th Cir.) (en banc), cert. denied, 454 U.S. 965, 102 S.Ct. 506, 70 L.Ed.2d 380 (1981). Our definition of scienter is precise. "Severe recklessness is limited to those highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and that present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it." Id. at 961-62 (emphasis added). ¹²

Plaintiff's basic contention is that he was confused by the current yield message because he thought current yield meant daily dividend. Scienter, however, cannot be established by a mere assertion of plaintiff's confused state of mind. On the contrary, analysis of scienter requires an examination of defendant's conduct.

In concluding that defendant's conduct did not rise to the level of scienter, we rely on several factors. First, the defendants introduced evidence indicating that the Fund's method of calculating and reporting yields fully complied with then existing SEC recommendations. At the district court hearing, the defendant referred to studies conducted by the SEC which were designed to determine what type financial information the funds should supply to the public. ¹³ In an effort to provide meaningful data that would enable potential investors to compare the various funds, the Commission proposed that money funds publish two types of yields--one reflecting present earning rate and a second reflecting the rate shareholders were paid in the past. The "present earning rate" represented what the assets in the fund were currently earning, net of fund expenses, and was to be valued by whatever method the fund consistently used. The Commission suggested that funds disclose past yields through use of average portfolio maturity quotas as well as some form of historical yields. These particular figures were chosen because they reflect both present and past performance and could aid investors in formulating an overall picture of various funds.

The Reserve Fund followed these recommendations in composing their prerecorded WATS message. The Fund presented the "present earning rate" as "current yield." As suggested by the SEC, this figure represented what the Fund's assets were earning, net of operating expenses. ¹⁴ In addition to a current yield quotation, the Fund also provided information reflecting its performance in the past. The WATS message included historical yield quotations for the...