Opinion ID: 387913
Heading Depth: 2
Heading Rank: 1

Heading: The Failure to Disclose the Post-Merger Conversion Terms Set Out in the Indenture

Text: 141 In his first federal claim, Broad essentially alleges that at the time the Debentures were issued in 1967, and thereafter up until the time of the merger in the fall of 1973, the defendants 28 omitted to disclose a material fact with regard to the contractual terms under which the Debentures operated specifically, that under the terms of the Indenture, the right to convert into Collins Common Stock could, in the event of a merger, be replaced with the right to convert into only that which the holders of Collins Common Stock received in the merger. 29 Broad argues that this constituted a knowing, intentional, and reckless failure to disclose a material fact. The language of Section 4.11, of course, was available to anyone who cared to look at the Indenture, so Broad's claim can only be that the defendants should have made specific reference in the prospectus and other materials to that provision of the Indenture. His claim can alternately be read as a misrepresentation claim i. e., that various statements on the face of the Debentures, in the press releases and advertisements, and in the prospectus (all to the effect that the Debentures were convertible into Collins Common Stock at any time up until 1987) were misleading. 142 It is a familiar proposition since the Supreme Court's decision in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976), that as part of his case a plaintiff must allege and prove that the defendants acted with scienter a mental state embracing an intent to deceive, manipulate, or defraud. Id. at 193-94 n.12, 96 S.Ct. at 1381 n.12. The holding of that case was that mere negligence is insufficient to support liability in a private suit for damages under Rule 10b-5. The Court specifically left open, however, the question of whether recklessness could satisfy the scienter requirement. Id. See also Aaron v. SEC, 446 U.S. 680, 686 n.5, 100 S.Ct. 1945, 1950 n.5, 64 L.Ed.2d 611 (1980) (adopting definition of scienter as a mental state embracing intent to deceive, manipulate, defraud in the context of SEC enforcement proceedings, but leaving open the question of whether scienter may also include reckless behavior). 143 Several other circuits that have considered the question have held that recklessness could satisfy the scienter requirement. E. g., Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1023 (6th Cir. 1979); Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 44 (2d Cir.), cert. denied, 439 U.S. 1039, 99 S.Ct. 642, 58 L.Ed.2d 698 (1978); Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977); Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1039-40 (7th Cir.), cert. denied, 434 U.S. 875, 98 S.Ct. 224, 54 L.Ed.2d 155 (1977). The recklessness described by the Seventh Circuit in Sanders and Sundstrand is limited to 144 a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it. 145 Sundstrand, 553 F.2d at 1045. The Seventh Circuit characterized that sort of recklessness as equivalent to willful fraud. Id. 146 The panel opinion in this case agreed with our sister circuits that recklessness, properly defined and adequately distinguished from mere negligence, could satisfy the scienter requirement. The panel adopted the definition of recklessness that was articulated by the Seventh Circuit in Sundstrand and Sanders. 614 F.2d at 439-40. During the period that this case was pending before the en banc court, several other panels also addressed the topic in varying degrees. 30 In particular, while noting that the en banc court had not yet spoken on this question, a panel of this court explicitly held in G. A. Thompson & Co. v. Partridge, 636 F.2d 945, 961-62 & nn. 32-34 (5th Cir. 1981), that severe recklessness was sufficient to satisfy the scienter requirement. Accordingly, we hold that in the context of a private action for money damages brought under section 10(b) and Rule 10b-5, the requirement that the plaintiff prove scienter i. e., a mental state embracing intent to deceive, manipulate, or defraud is satisfied by proof that the defendants acted with severe recklessness. 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. 147 Applying this standard to the case at bar, we note that there is precious little testimony in the record concerning the events at the time the Debentures were issued. The creators of and original parties to the Indenture were Collins on the one hand, and a team of underwriters on the other. The underwriters were managed by Kidder, Peabody & Co. Incorporated and White, Weld & Co. Both sides were represented by counsel: Collins by Lynch, Dallas, Smith & Harman of Cedar Rapids, Iowa, and the underwriters by Sullivan & Cromwell of New York. C. J. Lynch of the Lynch, Dallas firm testified by deposition that the basic form of the Indenture was lifted from indentures that Collins and these underwriters had used in prior convertible debenture offerings by Collins; those indentures from the prior offerings had been drafted in the first instance by Kidder, Peabody's counsel, Sullivan & Cromwell. 148 The Indenture that emerged for the 1967 offering was only partially the result of actual negotiation between the parties. In the normal course of events, the issuer and the lead underwriter actively negotiate the business portions of an indenture, which deal with such provisions as the aggregate principal amount of the debentures, their maturity date, the interest rate they bear, the subordination of the debt they represent to any senior indebtedness, the rate at which they may be converted into common stock, the redemption prices and dates, and so forth. The remainder of the indenture is invariably made up of boilerplate provisions that typically are not discussed at all by either the representatives of the issuer or those of the lead underwriter; indeed, most of those provisions are not even discussed by counsel for the respective parties, and many of them are required by federal law to be inserted into the indenture verbatim. Mr. Lynch's testimony in this case indicates that the drafting of the Indenture for the 1967 Collins Debenture issue was absolutely typical of industry practice: the boilerplate provisions, including those upon which this lawsuit turns, were never specifically discussed. 149 Such testimony as there is indicates that no party specifically considered at that time the possibility that Section 4.11 of the Indenture would be called into play at some future date, although Mr. Lynch testified that he had at some point reviewed the language of that section on Collins' behalf and found it satisfactory. There is no indication in the record that anyone acting for either Collins or the underwriters considered the inclusion in the prospectus and other sales materials of a detailed description of the operation of Section 4.11. Indeed, the testimony in the record overwhelmingly indicates that the parties thought themselves to be under no legal duty to disclose in detailed fashion in the prospectus and other sales materials any of the Indenture's provisions for more remote future contingencies. Neither is there evidence to raise a jury question on whether the defendants engaged in a continuing course of conduct to deceive subsequent purchasers after the Debentures were issued. Counsel for Broad even conceded, in arguing against the defendants' motions for a directed verdict in the trial court, that there was insufficient evidence to raise a jury question of scienter on this count. 150 Given all of this, we conclude that Broad's evidence on this count could support no more than a finding of simple negligence by the defendants in failing to disclose the workings of Section 4.11 in the prospectus and other sales materials. Accordingly, we affirm the judgment of the district court with regard to this claim under Rule 10b-5. 151 B. The Scheme to Deprive the Holders of Debentures of Their Right to Convert into Common Stock 152 In his second claim under Rule 10b-5, Broad alleges that the defendants collectively schemed to defraud the holders of Debentures of their right to convert the Debentures into common stock, substituting therefor a right to convert into cash. The panel opinion affirmed the district court's directed verdict on this claim on the ground that there had been no purchase or sale of the Debentures at the time of the merger because the supplemental indenture did not so substantially change the underlying security as to fall within the forced or constructive sale doctrine. 614 F.2d at 435-39. 153 We agree that the directed verdict on this count was proper as a matter of law, but we base our decision on a different ground. 31 We have concluded in part II of this opinion, supra, that as a matter of law, the holders of Debentures received in the supplemental indenture all to which they were contractually entitled under the Indenture. There is no doubt but that there was concerted, intentional conduct by the defendants to bring about that result. But as a matter of law, there was no violation of section 10(b) or Rule 10b-5 because there was no fraud. Section 10(b) is aptly described as a catch-all provision, but what it catches must be fraud. Chiarella v. United States, 445 U.S. 222, 234-35, 100 S.Ct. 1108, 1118, 63 L.Ed.2d 348 (1980) (criminal prosecution under section 10(b) and Rule 10b-5). It is elementary that section 10(b) and Rule 10b-5 reach only conduct involving manipulation or deception. E. g., Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 97 S.Ct. 54, 50 L.Ed.2d 74 (1977); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976). The defendants' conduct involved neither; they merely carried out their contractual obligations. As a conceptual matter, they could not have fraudulently schemed to deprive the holders of Debentures of a right that those holders did not in fact have. Accordingly, we affirm the judgment of the district court with regard to this claim under Rule 10b-5. 32