Zlotnick v. TIE Communications
| Decision Date | 14 January 1988 |
| Docket Number | No. 87-1370,87-1370 |
| Citation | 836 F.2d 818 |
| Court | U.S. Court of Appeals — Third Circuit |
| Parties | Fed. Sec. L. Rep. P 93,575, RICO Bus.Disp.Guide 6838 ZLOTNICK, Albert M., individually and on behalf of all others similarly situated, Appellant, v. TIE COMMUNICATIONS & L.W. Kifer. |
Donald B. Lewis (argued), Philadelphia, Pa., for appellant.
Edward J. Yodowitz (argued), Skadden, Arps, Slate, Meagher & Flom, New York City, and David H. Pittinsky, Dilworth, Paxson, Kalish & Kauffman, Philadelphia, Pa., for appellees.
Before GREENBERG, SCIRICA, and HUNTER, Circuit Judges.
Appellant Albert Zlotnick filed this class action against Appellees TIE Communications,
Inc. ("TIE") and L.W. Kifer, alleging violations of Secs. 9 and 10(b) of the Securities Exchange Act of 1934 and of the RICO Act. Zlotnick claims that appellees' misrepresentations artificially inflated the price of a stock which he had sold short, causing him to lose money when he made the purchase necessary to cover the short sale. The District Court dismissed for failure to state a claim, 665 F.Supp. 397. Zlotnick now seeks a reversal and the reinstatement of his complaint.
In reviewing a dismissal under Fed.R.Civ.P. 12(b)(6), the court must accept as true both the factual allegations contained in the complaint and all the reasonable inferences that can be drawn from those allegations. Wisniewski v. Johns-Manville Corp., 759 F.2d 271, 273 (3d Cir.1985). We therefore accept the facts as presented in Zlotnick's allegations.
In 1981, appellees TIE and Kifer formed Technicom International, Inc. ("Technicom"), a manufacturer of systems to monitor and control the moisture level of communication cables. At all relevant times in this case, TIE was the parent of Technicom and owned a majority of its stock, and Kifer was the Chairman and CEO of Technicom and held a significant equity interest in the company. In March, 1982, TIE and Technicom entered into a "distribution agreement" whereby each would distribute the products of the other. Shortly thereafter, Technicom made a public offering of its common stock, selling approximately 625,000 shares at a price of $9.75 per share. The price of Technicom stock rose steadily throughout 1982, selling at six times its offering price by the end of the year.
On January 6, 1983, Zlotnick sold short 1,000 shares of Technicom at $16.875 per share. Five days later he sold short another 1,000 shares at an average price of $19.30. Zlotnick sold the stock short because he concluded that the stock was overvalued. He based this conclusion in part on his analysis of the company's earnings and prospects, finding that the stock was then selling at a ratio of approximately 50 times current annualized earnings. Zlotnick also based his conclusion on his belief that Technicom faced increasing competition that would diminish its profit margins and depress future earnings. At the time of his short sale Zlotnick was unaware of any wrongdoing or misrepresentations by appellees; and he did not base his decision to sell short on a belief that appellees were deceiving investors.
In early 1983, subsequent to Zlotnick's short sales, appellees undertook to inflate artificially the price of Technicom stock. Specifically, TIE and Kifer caused Technicom to issue several press releases which misrepresented the company's sales agreements and earnings prospects. They also caused Technicom to engage in illusory sales to TIE. Both misrepresentations falsely inflated the company's reported sales and earnings for the fourth quarter and entire fiscal year of 1982 to record levels. By March 14, 1983, the price of Technicom stock had risen to approximately $33.00 per share. Zlotnick, unaware of any deceptive practices by appellees, decided to cut his losses by making the purchases necessary to cover his short position; ultimately, he realized a loss of about $35,000.
The price of Technicom stock did not begin to fall until the summer of 1983. Thereafter, due in part to more realistic statements by Technicom, the value of the stock dropped sharply. On June 30, 1984, the stock was trading at $4.12 per share. Following further reported losses, Technicom merged with its parent TIE via a transaction in which Technicom stockholders received .29 shares of TIE stock for every share of Technicom; the value to shareholders of this transaction was approximately $2.50 per share of Technicom. This represented a drop in value of approximately 90% from the high of the previous year. 1
Zlotnick instituted this action on March 13, 1985 by filing a complaint on behalf of himself and all similarly situated investors. The complaint was amended on June 6, 1985. Appellees moved for dismissal on September 16, 1985; and after requesting further briefing on the fraud-on-the-market theory, the District Court dismissed the amended complaint on June 23, 1987. In the meantime, this court had explicitly adopted the fraud-on-the-market theory in Peil v. Speiser, 806 F.2d 1154 (3d Cir.1986). The District Court, accepting this court's decision in Peil, nonetheless held that Zlotnick had not sufficiently alleged reliance on appellees' deception, and therefore had not stated a claim upon which relief could be granted. Zlotnick filed a notice of appeal on June 26, 1987.
Because this case turns to some extent on the nature of short selling as an investment strategy, we set out here our understanding of that process. Where the traditional investor seeks to profit by trading a stock the value of which he expects to rise, the short seller seeks to profit by trading stocks which he expects to decline in value. A typical short seller expects decline because, based on his view of the underlying strengths and weaknesses of a business, he concludes that the market overvalues the business' stock. As demonstrated by the allegations, these underlying facts can concern the present--such as the fact that a stock trades at fifty times its earnings--or they can concern the future--such as the fact that a business will face increased competition. 2
Short selling is accomplished by selling stock which the investor does not yet own; normally this is done by borrowing shares from a broker at an agreed upon fee or rate of interest. At this point the investor's commitment to the buyer of the stock is complete; the buyer has his shares and the short seller his purchase price. The short seller is obligated, however, to buy an equivalent number of shares in order to return the borrowed shares. In theory, the short seller makes this covering purchase using the funds he received from selling the borrowed stock. Herein lies the short seller's potential for profit: if the price of the stock declines after the short sale, he does not need all the funds to make his covering purchase; the short seller then pockets the difference. On the other hand, there is no limit to the short seller's potential loss: if the price of the stock rises, so too does the short seller's loss, and since there is no cap to a stock's price, there is no limitation on the short seller's risk. There is no time limit on this obligation to cover.
Appellees challenge Zlotnick's standing to bring suit under the securities laws. They claim that since Zlotnick, in effect, sold his stock before he purchased it, he never owned any Technicom stock. Therefore, they argue, he has no standing under the Supreme Court's ruling in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S.Ct. 1917, 44 L.Ed.2d 539 (1975). Appellees also seek to distinguish the short seller from the traditional investor, arguing that while the traditional investor hopes to profit from the company's good fortune, the short seller gains his profit from the company's decline. In effect, the short seller "bets against" the company, and so should not be treated as an investor in it. Appellees also analogize the short seller to the options trader, whom several courts have found unprotected by the anti-fraud provisions of the securities acts. See, e.g., Starkman v. Warner Communications, Inc., 671 F.Supp. 297 (S.D.N.Y.1987).
Appellees' standing arguments are without merit. In Blue Chip Stamps, the Supreme Court limited the class of potential plaintiffs under Sec. 10(b) to those who actually purchased or sold securities. Here, Zlotnick did both: he sold shares short, and he purchased shares later to cover that short sale. Therefore, he meets the technical standing requirements of the securities laws. The Court in Blue Chip Stamps noted that requiring a plaintiff to have actually purchased or sold stock to have standing may result in arbitrary distinctions. 421 U.S. at 738-39, 95 S.Ct. at 1926-27. Moreover, any similarity between the investment strategies of a short seller and an options trader is irrelevant where the difference between the two investors is that the former actually purchases securities while the latter does not....
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