Law School Case Brief
In re WorldCom, Inc. Sec. Litig. - 346 F. Supp. 2d 628 (S.D.N.Y. 2004)
There is no basis in law to find a requirement that a red flag arises only when there is "clear and direct" notice of an accounting issue. The standard under § 11 of the Securities Act of 1933 ("Act"), 15 U.S.C.S. § 77k, is whether a defendant has proven that it had no reasonable ground to believe and did not believe that a registration statement contained material misstatements, a standard given meaning by what a "prudent man" would do in the management of his own property. Nor is the bar lowered because there is an expert's opinion on which an underwriter is entitled to rely. The "prudent man" standard applies to § 11(b)(3)(C) of the Act. Finally, what constitutes an ordinary business event and what constitutes a red flag is an issue of fact. These are exquisitely fact intensive inquiries that depend on the circumstances surrounding a particular issuer and the alleged misstatement. There is no category of information which can always be ignored by an underwriter on the ground that it constitutes an ordinary business event. What is ordinary in one context may be sufficiently unusual in another to create a duty of investigation by a "prudent man."
The executives of WorldCom, Inc. engaged in a secretive scheme to manipulate WorldCom's public filings concerning its financial condition and those public filings were incorporated into the registration statements for two particular bond offerings. Plaintiff investors filed a class action against WorldCom in federal district court alleging, among other things, that defendant underwriters violated §§ 11 and 12(a)(2) of the Securities Act of 1933, 15 U.S.C.S. §§ 77k and 77l by including those false statements in the registration statements. Lead plaintiff and the underwriters filed cross-motions for summary judgment. Lead plaintiff sought a declaration that WorldCom's registration statements for the two bond offerings contained material misstatements. The underwriters sought a declaration that they had no liability for any false statements in or alleged omissions from those registration statements.
Was lead plaintiff able to show that there were issues of fact as to whether the underwriters had reasonable grounds to believe that a form, which reported WorldCom's earnings to revenue ratio, was inaccurate?
The court granted in part each parties' motion for summary judgment. The court held, inter alia, that (1) there was no material issue in dispute regarding the falsity of one of WorldCom's quarterly financial statement or the materiality of that false statement to investors; (2) the underwriters had not established the reliance defense under 15 U.S.C.S. § 77k(b)(3)(C) based on unqualified "clean" audit opinions; (3) lead plaintiff showed that there were issues of fact as to whether the underwriters had reasonable grounds to believe that a form, that reported the company's earnings to revenue ratio, was inaccurate; (4) the underwriters' receipt of comfort letters from WorldCom's auditors was important evidence but insufficient by itself to establish a due diligence defense; and (5) the underwriters established that they were entitled to summary judgment with respect to certain alleged omissions from the registration statements.
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