Emerald Investments v. Allmerica Finan Life

In the
United States Court of Appeals
For the Seventh Circuit
____________
Nos. 07-1597, 07-1501
EMERALD INVESTMENTS LIMITED PARTNERSHIP, et al.,
Plaintiffs-Appellees/Cross-Appellants,
v.
ALLMERICA FINANCIAL LIFE INSURANCE AND ANNUITY CO.,
Defendant-Appellant/Cross-Appellee.
____________
Appeals from the United States District Court
for the Northern District of Illinois, Eastern Division.
No. 02 C 05251—John F. Grady, Judge.
____________
ARGUED NOVEMBER 1, 2007—DECIDED FEBRUARY 20, 2008
____________
Before POSNER, WOOD, and SYKES, Circuit Judges.
POSNER, Circuit Judge. Emerald, the plaintiff in this
diversity suit (governed by Illinois law) for breach of
contract, obtained a verdict and judgment for $1.1 million
against the defendant, Allmerica. Allmerica contends
that Emerald should not have been awarded any damages
apart from the cost of a $150,000 surrender fee discussed
later in this opinion. Emerald, cross-appealing, wants
greater damages than the jury awarded; but on the view
we take of the case, the cross-appeal is academic.
2 Nos. 07-1597, 07-1501
Allmerica sells variable annuities both directly to annu-
itants and to intermediaries who resell to annuitants. An
annuity is in effect a reverse life-insurance contract:
you pay a lump sum to the insurance company in ex-
change for a promise to pay you an income for life; the
longer you live, and also the higher the return from
investing the lump-sum purchase price (that investment
generates the variable component in a variable annuity),
the better you do. Allmerica allows the purchaser to
place the purchase price in any one of a number of mutual
funds with which the company has an arrangement. One
of these is the Scudder International Fund.
Emerald, which one might have thought an intermedi-
ary customer, in March 1999 bought $5 million worth
of variable annuities from Allmerica and later increased
its investment to hundreds of millions of dollars. Emerald
was not interested in reselling its variable annuities to
prospective retirees, however. It wanted to engage in
arbitrage. An arbitrage opportunity arises when the
same thing is being sold at two different prices and the
difference is due to some oversight or other error, or
to price discrimination (charging different prices for the
same good or service on the basis of different intensities
of consumer demand for it), rather than to costs of trans-
portation or other circumstances that might place the
good in different markets and thus prevent uniform
pricing. The arbitrageur spots the artificial price differ-
ence, buys at the lower price, and resells at the higher
price. The effect is to bring about price uniformity,
which terminates the arbitrage opportunity. Arbitrage is
a socially useful activity because if the same good or
service, costing the same and traded or tradable in the
same market, is selling at different prices, one of those
Nos. 07-1597, 07-1501 3
prices is too high (excluding the case in which one of the
goods is selling below cost, in which event the price is
too low) from the standpoint of an efficient allocation
of resources.
Emerald had noticed that identical securities were
selling at different prices in mutual fund accounts offered
to the purchasers of Allmerica’s variable annuities. The
mutual funds set the prices that they charge for shares
in their funds at 4 p.m. New York time, which is when
the New York Stock Exchange closes. Those prices are a
composite of the prices of the shares (in publicly held
companies) owned by the fund. (On the pricing of mutual
fund shares, see generally SEC, “Disclosure Regarding
Market Timing and Selective Disclosure of Portfolio
Holdings: Proposed Rule,” 68 Fed. Reg. 70,401 (Dec. 17,
2003); DH2, Inc. v. SEC, 422 F.3d 591, 592-93 (7th Cir.
2005).) In the case of shares traded on foreign exchanges
and therefore included in the Scudder International
Fund, as the name implies, the price of a mutual fund
share was, during the period relevant to this suit,
a composite of the closing prices of the company shares
(the shares owned by the fund) in the principal foreign
exchange on which they were traded. Suppose the ex-
change had closed at 11 a.m. New York time (4 p.m. in
London). In that event the share prices that the mutual
fund would use to compute the price of its own shares at
4 p.m. New York time would be five hours old. During
that interval, the prices of the foreign-traded shares
may have risen or fallen in aftermarket trading or in
trading on an exchange that was still open. Suppose
those prices had risen. The mutual fund shares, since
their prices are a function of the prices of the shares owned
by the fund, would be underpriced.
4 Nos. 07-1597, 07-1501
To take advantage of the discrepancy between the
composite price and the prices of the fund’s constituent
assets, Emerald would buy shares in the mutual funds
minutes before it was 4 p.m. in New York (so as not to
attract imitators, who would bid up the price of the shares
in their eagerness to buy them) and sell them the next day,
or within a few days, once the price of the foreign-
traded shares was reflected in the price of the mutual fund
shares. See also Kircher v. Putnam Funds Trust, 403 F.3d
478, 480-81 (7th Cir. 2005), vacated for want of jurisdiction,
547 U.S. 633 (2006).
Emerald financed its purchases of shares in the Scudder
International Fund by transferring money from the
Allmerica money-market fund in which it parked its
investment in annuity contracts when it was not engaged
in arbitrage. When the contract with Emerald had been
made, Allmerica had allowed buyers of its annuities to
transfer their investments to any other mutual fund with
which Allmerica had an arrangement. But Emerald’s
frequent transfers between the money-market fund and
the Scudder International Fund were a pain to both
Allmerica and Scudder. The transfers were large—as much
as $111 million. Scudder had to keep a large amount of
cash on hand, which it would have preferred to invest, in
order to redeem shares in its fund when Emerald, having
bought the shares because it believed them underpriced,
decided soon afterward to return to its money-market
fund. Scudder’s other investors suffered and so therefore
did Allmerica, since its variable-annuity contracts lost
value.
Had Allmerica known that Emerald was buying vari-
able annuities in order to engage in international time-
zone arbitrage, it would not have sold to Emerald, at
Nos. 07-1597, 07-1501 5
least in the quantity it did; other sellers of variable
annuities had stopped dealing with Emerald. In Decem-
ber 2001, Allmerica limited the number of transfers that
its customers could make from the Scudder Interna-
tional Fund to another account to one per month. That
action precipitated this suit. To add insult to injury,
when Emerald later withdrew its money from All-
merica, Allmerica charged a $150,000 surrender fee,
which Emerald had to pay to get its money out. The dis-
trict judge ruled that the imposition of the limit was a
breach of contract, and Allmerica does not contest the
ruling.
In July 2004, after this suit was brought, Allmerica,
perhaps anticipating the district judge’s ruling on the
transfer limitation, closed the Scudder International
Fund (and other international funds in which market
timing was likely to occur) to new investments. With the
international funds closed, no longer could Emerald
transfer money into them from the money-market fund.
The district judge ruled that this method of stopping
market timing was not a breach of Allmerica’s contract
with Emerald—which makes us wonder whether any
damages should have been awarded for the acknowl-
edged breach of contract noted in the preceding para-
graph. A breach of contract to be actionable has to
cause the plaintiff’s injury. Had Allmerica not broken its
contract, it almost certainly would have done what it did
when it was sued for breach—closed the fund to new
investments—so that Emerald’s loss of profits from
arbitraging would have been the same.
Allmerica doesn’t make that simple argument, however.
Instead it argues that the damages awarded by the jury
were unforeseeable, and alternatively that they were
6 Nos. 07-1597, 07-1501
hopelessly speculative. The first argument relies on the
venerable precedent of Hadley v. Baxendale, 9 Ex. 341,
156 Eng. Rep. 145 (1854), which, as we noted in EVRA
Corp. v. Swiss Bank Corp., 673 F.2d 951, 955-56 (7th Cir.
1982), has been received into Illinois’s common law.
Allmerica argues that Hadley and the cases in Illinois and
elsewhere that follow it stand for the proposition that
damages for breach of contract are limited to those that
are “foreseeable” when the contract is made, and that
the trading profits that Emerald claims to have lost as a
result of the breach were not foreseeable to Allmerica
in March 1999 because Emerald did not tell Allmerica
that it was buying variable annuities in order to engage
in arbitrage, and on a large scale.
Allmerica overreads Hadley and the cases following it.
They are cases about special handling. The Hadleys
owned a flour mill. The millshaft broke, and the Hadleys
hired Baxendale to transport the broken millshaft to a
shop that, using the broken millshaft as a model,
would make a new one. Because the Hadleys had no
spare, the mill was shut down until the new millshaft
arrived, and they incurred substantial losses. The receipt
of the new shaft was delayed as a result of a breach by
Baxendale of its contract of carriage. The court held that
the Hadleys could not recover the profits they had lost be-
cause of the delay. Had they wanted Baxendale to take
special care to get the new millshaft to them by the con-
tractually specified deadline, they should have negotiated
for that care, that special handling; undoubtedly Baxen-
dale would have demanded a higher price.
An Illinois case illustrates this point. The plaintiff in
Siegel v. Western Union Telegraph Co., 37 N.E.2d 868 (Ill.
App. 1941), had delivered $200 to Western Union with
Nos. 07-1597, 07-1501 7
instructions to transmit it to a friend of the plaintiff’s. The
money was to be bet (legally) on a horse, but this was not
disclosed in the instructions to Western Union, which
misdirected the money order; as a result it did not
reach the friend until after the race was over—in which
the horse that the plaintiff had intended to bet on won
and would have paid $1650. The plaintiff sued Western
Union for the $1450 in lost profit (which was conceded—
there was no question that he would have bet on the horse
that won), and failed on the authority of Hadley v.
Baxendale. 37 N.E.2d at 871. Or imagine a professional
photographer who after spending months in the Himalayas
taking pictures to be used in advertising mountain-climb-
ing gear drops off his roll of film at the nearest Walgreens
when he returns to the United States and Walgreen loses
it, and he sues Walgreen for his lost profits. He would
lose. Had he wanted Walgreen to guarantee that the
film would be properly developed and returned to him,
he should have negotiated for such a guaranty; failing
that, he should have taken an extra roll of film with him
on his expedition or had the film developed by a firm
catering to professional photographers.
This case isn’t like Hadley or Siegel or our hypothetical
photographer’s case. It is not that Allmerica failed to take
special care to fulfill its contractual obligations because
Emerald had failed to negotiate for special care. This is
a routine case in which the victim of a breach of contract
is suing for the profits that he thinks he would have
made had the breach not occurred. A buyer is not re-
quired to disclose the profit he anticipates from dealing
with the seller; such a requirement would kill the incen-
tive to seek out profit opportunities. There would be no
incentive to engage in arbitrage if the arbitrageur had to
8 Nos. 07-1597, 07-1501
disclose to the person from whom he was buying an
underpriced good that it was underpriced because it
could be resold in another market at a higher price. For
then the would-be seller would resell it in that market
himself, bypassing the arbitrageur and pocketing the
arbitrageur’s anticipated profit.
The old but still good case that governs here is Laidlaw v.
Organ, 15 U.S. (2 Wheat.) 178 (1817). A merchant in
New Orleans learned of the Treaty of Ghent, which
ended the War of 1812, before the news became public. He
quickly bought a large quantity of tobacco, since he
knew that, with the British blockade of New Orleans
about to end and the export of tobacco therefore about
to resume, the price of tobacco would rise, as it did. The
seller was indignant, sued, and lost. Had he won, business-
men’s incentives to obtain commercially valuable infor-
mation, and by doing so speed the adjustment of prices
to new conditions of supply and demand, would be
impaired. See Teamsters Local 282 Pension Trust Fund v.
Angelos, 762 F.2d 522, 528 (7th Cir. 1985) (Illinois law);
United States v. Dial, 757 F.2d 163, 168 (7th Cir. 1985) (ditto).
In support of its second ground for attacking the
judgment—that the damages awarded, though modest in
relation to what Emerald had sought, were speculative,
or in other words not proved—Allmerica finally reaches
solid ground. Emerald presented just two types of damages
evidence. One, excluded by the district judge, consisted
of two reports by a finance professor, Steven Buser. The
other consisted of testimony by a principal of Emerald
about trades that he would have made had Allmerica
not pulled the plug in December 2001.
Buser’s initial report proposed that if permitted by
Allmerica to continue its market-timing trading, Emerald
Nos. 07-1597, 07-1501 9
would have earned an annual rate of return on its invest-
ment of 34 percent for 20 years, for a discounted present
value of $150 million. That was a preposterous estimate,
properly excluded by the district judge under Fed. R.
Evid. 702. The essence of an arbitrage opportunity is that
it is transient. It is the exploitation of an economic
anomaly, and the process of exploiting the anomaly
eliminates it (that is the social function of arbitrage). If a
pharmaceutical company sells drugs at a lower price to
hospitals than to drugstores, then the hospitals, unless
restricted, will order more drugs and sell the excess to
drugstores at a price intermediate between what they
pay the pharmaceutical company and what the drug-
stores pay. As the company’s revenues from selling to
drugstores decline, it will have to reduce its price to them
until it is charging them the same prices it charges the
hospitals; otherwise it would have no more sales to drug-
stores. So eventually there will be just one price. Like-
wise in this case: by the time of trial the process of eliminat-
ing the arbitrage opportunity that Emerald had exploited
was well under way. This was due in part to a rule pro-
posed by the SEC, “Disclosure Regarding Market Timing
and Selective Disclosure of Portfolio Holdings,” supra,
that flagged the type of arbitrage Emerald was engaged
in, and that when adopted (as it was on April 23, 2004,
69 Fed. Reg. 22,300) eliminated the arbitrage opportunity
by requiring funds to use a different method of pricing
their shares; and in part to the refusal of more and more
mutual funds to do business with market timers. See
generally Investment Company Institute, “Questions and
Answers About the Mutual Fund Investigations” (Nov.
2003), www.ici.org/issues/timing/arc-reg/faqs_timing.
html (visited Jan. 30, 2008). Buser’s choice of a 34 percent
annual rate of return was a blind extrapolation from
10 Nos. 07-1597, 07-1501
Emerald’s history. It ignored the changed circumstances
that we have mentioned, even though they had already
caused a decline in the company’s rate of return from
trading in the annuities it had bought from Allmerica
from 40 percent to 14 percent in the year of the breach
of contract (2001); the rate of return actually turned nega-
tive before trial. And the 40 percent rate had doubtless
reflected not just Emerald’s trading strategy but also the
stock market boom of the 1990s, which ended in 2000.
Buser’s first report was so irresponsible as to justify
the judge’s decision to exclude the second report sum-
marily. Buser had demonstrated a willingness to abandon
the norms of his profession in the interest of his client.
Such a person cannot be trusted to continue as an expert
witness in the case in which he has demonstrated that
willingness, and perhaps not in other cases either.
This leaves the testimony of the Emerald principal.
With the benefit of hindsight, he picked days on which he
said he would have traded during the damages period
(which the judge had cut off at July 2004) had it not been
for the breach of contract, which prevented him from do-
ing so. His testimony was as worthless as Siegel’s
would have been had Siegel picked the horse to bet on
after the race had been run. Once the price of shares,
traded on a foreign stock exchange, at the opening of the
New York Stock Exchange is known, one knows with
certainty whether buying shares in a mutual fund that
owned those foreign-traded shares at 3:59 p.m. New York
time the previous day would have been profitable. That
is no evidence that one would have traded then, for there
is no way in which such testimony could be tested. It
would be different had Emerald based its market-timing
trading on a formula that determined when and in what
Nos. 07-1597, 07-1501 11
dollar amount to transfer money into the Scudder Inter-
national Fund and when to transfer back out of it into
the money-market fund. But it did not use a formula. It
traded on hunch.
Emerald did present some evidence of trades it made
during the damages period involving international mutual
funds not offered by Allmerica, but whether it would have
upped the ante by trading in the Scudder International
Fund as well was unproven. Before it was frozen out,
Emerald often had traded in other funds without also
trading on the same day in the Scudder fund.
What we have said is enough to require that the award
of damages be reversed. But for completeness we re-
spond to two further arguments pressed by Emerald. The
first is that Allmerica, having broken the contract with it
in December 2001, could not later invoke the contractual
provision entitling it to close its accounts to new money,
which truncated its liability at July 2004. In defense,
Allmerica invokes the doctrine of “partial breach.” Like
many legal doctrines it is badly named. There is no
such thing as a partial breach. There is a breach of con-
tract, and there are alterations and terminations that are
not breaches. The doctrine is really an aspect of election
of remedies. If a party to a contract breaks it, the other
party can abandon the contract (unless the breach is very
minor, Circle Security Agency, Inc. v. Ross, 437 N.E.2d 667,
672 (Ill. App. 1982); Sahadi v. Continental Illinois National
Bank & Trust Co., 706 F.2d 193, 196-97 (7th Cir. 1983)
(Illinois law)) and sue for damages, or it can continue
with the contract and sue for damages. William W. Bierce,
Ltd. v. Hutchins, 205 U.S. 340, 346 (1907) (Holmes, J.); South
Beloit Electric Co. v. Lar Gar Enterprises, Inc., 224 N.E.2d 306,
310-11 (Ill. App. 1967). But if it makes the latter election,
12 Nos. 07-1597, 07-1501
it is bound to the obligations that the contract imposes on
it. Wollenberger v. Hoover, 179 N.E. 42, 57 (Ill. 1931); Newton
v. Aitken, 633 N.E.2d 213, 216-17 (Ill. App. 1994); Con-
tinental Sand & Gravel, Inc. v. K & K Sand & Gravel, Inc., 755
F.2d 87, 93 (7th Cir. 1985) (Illinois law). When Allmerica
in December 2001 broke its contract with Emerald by
refusing to permit it more than one transfer a month,
Emerald could have terminated the contract. But it did not,
and so Allmerica was entitled to enforce the obligations
that the contract put on Emerald.
Emerald argues that what Scudder might have done
to terminate Emerald’s trading in its international fund
is irrelevant or, at best, an affirmative defense to be
pleaded and proved by Allmerica. Neither argument is
correct. Damages for breach of contract are intended to
give the plaintiff the difference between where he
would have been financially had the contract not been
broken, and where he is in fact. All sorts of actions by
nonparties to a contract might prevent the victim from
profiting from the contract even if it the defendant had
not broken it, and if that is proved then the plaintiff is
simply out of luck. If, as the evidence strongly suggests,
Scudder would have terminated its relations with
Allmerica, as it was legally entitled to do, had Emerald
kept trading in the Scudder International Fund, Emerald
could not have profited from that trading. As Emerald had
the burden of proving its damages, Allmerica was not
obliged to plead or prove that Scudder would have cut
off Allmerica and hence Emerald.
The judgment is affirmed with respect to liability but
reversed with respect to damages. The district court is
directed to enter a judgment that Allmerica broke its
contract with Emerald in December 2001 but (since nomi-
Nos. 07-1597, 07-1501 13
nal damages are not sought) that Emerald is entitled to
no damages or other relief beyond the $150,000 surrender
fee, plus appropriate interest.
A true Copy:
Teste:
_____________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—2-20-08