EBC I, Inc. v. Goldman, Sachs & Co.

Read, J.

(dissenting in part). The majority today holds that the lead managing underwriter in a firm commitment underwriting owes a fiduciary duty to the issuer to disclose conflicts of interest in connection with the pricing of securities. This new fiduciary obligation wars against our precedent and potentially conflicts with a highly complex regulatory framework designed to safeguard investors. I therefore respectfully dissent.

“Unless statutory language or public policy dictates otherwise, the terms of a written agreement define the rights and obligations of the parties” (Abiele Contr. v New York City School Constr. Auth., 91 NY2d 1, 9 [1997]). We have faithfully—that is, until today—declined to second-guess or interpolate unbargained-for provisions into contracts that are “the product of an arms-length transaction between sophisticated businessmen, ably represented” (JMD Holding Corp. v Congress Fin. Corp., 4 NY3d 373, 382 [2005]; see also South Rd. Assoc., LLC v International Bus. Machs. Corp., 4 NY3d 272, 277 [2005] [the “instrument was negotiated between sophisticated, counseled business people negotiating at arm’s length” (quoting Matter of Wallace v 600 Partners Co., 86 NY2d 543, 548 [1995] and Vermont Teddy Bear Co. v 538 Madison Realty Co., 1 NY3d 470, 475 [2004])]; Fiore v Oakwood Plaza Shopping Ctr., 78 NY2d 572, 581 [1991] [“Defendants were sophisticated parties involved in an arm’s length commercial transaction .... The purchase price of the land alone was well in excess of $1 million, indicating the magnitude of the project. Furthermore, the parties were represented by counsel in negotiating the terms of the agreement”]; Chimart Assoc. v Paul, 66 NY2d 570, 574 [1986] [“the contract at issue is part of a multimillion dollar transaction involving sophisticated, counseled parties dealing at arm’s length”]).

More particularly, we have—again, until today—refrained from injecting fiduciary obligations into sophisticated, counseled parties’ arm’s length commercial dealings. In refusing to fashion a “newly-notched fiduciary-like duty” for finders in Northeast Gen. Corp. v Wellington Adv. (82 NY2d 158, 161 [1993]), we remarked that “[i]f the parties find themselves or place themselves in the milieu of the ‘workaday’ mundane marketplace, and if they do not create their own relationship of higher trust, courts should not ordinarily transport them to the higher realm of relationship and fashion the stricter duty for them.” (Id. at 162.)

Plaintiff, the committee of unsecured creditors of the bankrupt eToys, Inc., claims that Goldman, Sachs & Co., the lead managing underwriter of eToys’ initial public offering (IPO),¹ duped eToys into underpricing its stock at $20 a share.² Goldman allegedly carried out this deception so that it might profit from secret side deals with preferred customers who “were obligated to kick back to Goldman a portion of any profits that they made on after[ ]market sales of eToys [’] securities allocated to them at the IPO.”³ While the pleading does not spell out exactly how underpricing worked in Goldman’s favor, plaintiffs theory has to be that Goldman, whose underwriting compensation was a percentage (6.75%) of aggregate offering proceeds, stood to make more money on kickbacks from these secret side deals than it would have earned on its increased compensation from selling shares at some higher, theoretically “correct” price. Plaintiff further alleges that “[b]ased on communications with Goldman, it was eToys’ understanding that the offering price for eToys’ common shares was to be set primarily by reference to then current market conditions and the anticipated demand for eToys’ shares.”

In allowing plaintiffs claim for breach of fiduciary duty to go forward, the majority disregards that eToys was a sophisticated, well-counseled business entity. eToys’ major stockholders included important venture-capital and corporate investors; its largest single stockholder, Idealab, styles itself as an incubator for successful technology companies (see chttp:// www.idealab.com>, cached at <http://www.courts.state.ny.us/ reporter/webdocs/idealab.htm>). eToys was represented by the Venture Law Group, EC., which “specializes in representing high potential technology companies from before their creation through their public offering or acquisition and beyond,” and which in 1999 handled “the fourth largest number of initial public offerings for technology companies in the country” (<http://www.venlaw.com/About>, cached at <http:// www.courts.state.ny.us/reporter/webdocs/ Venture_Law_Group.htm>).

Further, the offering price was a key term in the underwriting agreement, a purchase contract between eToys, the issuer/ seller, and Goldman, the underwriter/buyer, who represented all the underwriters in the syndicate.⁴ How may a buyer ever owe a duty of the highest trust and confidence to a seller regarding a negotiated purchase price? The interests of a buyer and seller are inevitably not the same. Indeed, it is a longstanding principle of contract law that a buyer may make a binding contract to buy something that it knows its seller undervalues (Laidlaw v Organ, 2 Wheat [15 US] 178 [1817]).

Here, eToys’ prospectus acknowledged that the “initial public offering price for the common stock has been negotiated among eToys and the representatives of the underwriters” (emphasis added). Contrary to plaintiffs allegation, eToys also represented in the prospectus that the offering price was not driven by anticipated demand alone. The other factors that came into play were “eToys’ historical performance, estimates of eToys’ business potential and earnings prospects, an assessment of eToys’ management and the consideration of the above factors in relation to market valuation of companies in related businesses.” Further, eToys’ prospectus identified four “principal purposes” for the IPO: to increase working capital, create a public market for its stock, facilitate future access to the public capital markets, and increase visibility in the retail marketplace. By selling only 8.2% of its outstanding common stock at $20 a share, eToys raised the capital called for by its business plan.

In short, the offering price was not “set” by Goldman, it was negotiated by sophisticated, represented parties—the issuer/ seller and the underwriter/buyer; the offering price was negotiated with reference to more than “then current market conditions” and “anticipated demand”; and eToys did not seek to negotiate an offering price solely to maximize the proceeds raised in the offering. Documentary evidence in the record confirms all these points, and the nature of the contractual relationship between an issuer and an underwriter is long-established and well-understood (see United States v Morgan, 118 F Supp 621, 635-655 [SD NY 1953]). While plaintiffs may have alleged “an advisory relationship that was independent of the underwriting agreement” (majority op at 20), conclusory allegations are insufficient to survive a motion to dismiss (see e.g. Caniglia v Chicago Tribune-N.Y. News Syndicate, 204 AD2d 233, 233-234 [1st Dept 1994] [on motion to dismiss, facts pleaded are presumed to be true and accorded every favorable inference, but “allegations consisting of bare legal conclusions, as well as factual claims inherently incredible or flatly contradicted by documentary evidence are not entitled to such consideration”]).

Finally, I am less sanguine than the majority about the consequences of recognizing “a fiduciary duty . . . requiring disclosure of [a lead underwriter’s] compensation arrangements with its customers” (majority op at 20). The excesses of the market in the days of the Internet high-tech mania did not go unnoticed by regulators. In addition to a flurry of enforcement actions at the state and federal levels, the Securities and Exchange Commission (SEC) in 2002 asked the two major self-regulatory organizations (SROs),⁵ the New York Stock Exchange, Inc. (NYSE) and the National Association of Securities Dealers, Inc. (NASD), to convene a high-level group of business and academic leaders to review the IPO process in light of the experience of the 1990’s, and to recommend ways to cure the problems exposed during that period and to improve the underwriting process going forward. This group produced a report in May 2003 (see NYSE/NASD IPO Advisory Committee, Report and Recommendations of a committee convened by the New York Stock Exchange, Inc. and NASD at the request of the US Securities and Exchange Commission [May 2003], published on the Internet at <http://www.nasd.com/web/groups/rules_regs/ documents/rules_regs/nasdw_010373.pdf>, cached at <http:// www.courts.state.ny.us/reporter/webdocs/nasdw_010373.pdf>), directly leading, among other things, to pending proposed NYSE rule 470 and NASD rule 2712 {see 69 Fed Reg 77,804 [Dec. 28, 2004]; see also 70 Fed Reg 19,672 [Apr. 13, 2005]). These rather complicated proposed rules govern allocations and distributions of shares in IPOs.⁶ How our new fiduciary duty for underwriters may fit into or conflict with the developing regulatory scheme is impossible to predict. We have, however, at the very least introduced uncertainty into a complex subject of enormous importance to investors. This subject is, in my view, better dealt with by specialized regulators than by the evolving common law.

Chief Judge Kaye and Judges G.B. Smith, Rosenblatt, Graffeo and R.S. Smith concur with Judge Ciparick; Judge Read dissents in part in a separate opinion.

Order modified, etc.

1 . An IPO is the first public issuance of a stock from a company that has not previously been traded publicly. In a “hot” IPO, like eToys’, the stock immediately trades at a premium in the aftermarket, the trading that takes place after termination of the price and trading restrictions governing the offering.

2 . “Underpricing” refers to the difference between the price at which stock is sold to the public in an IPO and the price in the aftermarket. That IPOs are underpriced is “as shocking a surprise as Claude Rains’ discovery in ‘Casablanca’ that gambling was in progress at Rick’s Café,” since the “systematic underpricing of IPO shares is probably the most thoroughly documented empirical fact about IPOs” (Coffee, Corporate Securities, The IPO Allocation Probe: Who Is the Victim?, NYLJ, Jan. 18, 2001, at 5, col 1; see generally Ritter, The Long-Run Performance of Initial Public Offerings, 46 J Fin 3 [1991] [citing studies showing that IPOs produce 16.4% average positive initial return as measured from the offering price to the market price at the end of the first day of trading, and that extent of underpricing is highly cyclical, with much higher positive initial returns evident during “hot issue” markets; and, using a sample of 1,526 IPOs that went public in the United States in the 1975-1984 period, documenting third “anomaly,” which is that in the long run IPOs appear to be overpriced]; see also Griffith, Spinning and Underpricing: Legal and Economic Analysis of the Preferential Allocation of Shares in Initial Public Offerings, 69 Brook L Rev 583, 590-630 [Winter 2004] [examining various theories to explain underpricing]). During the heyday of the Internet stock bubble, when eToys’ public offering took place, very large “pops” in first-day IPO prices were commonplace, reaching a zenith (or nadir, depending upon your point of view) with the IPO of VA Linux Systems in December 1999. VA Linux—which, like eToys is now bankrupt—was priced at $30 a share, opened at $300 a share and closed at $242.375 a share, thus soaring 698% in opening day Nasdaq trading (see Fisher, A Tiny Company Without Profits Goes Public With a Bang, New York Times, Dec. 10, 1999; see also Baker, Who Wants to Be a Millionaire? Law Firms Investing in Hot High-Tech IPOs Are Making a Fortune, But Some Critics Worry the Stock Craze is Clouding Ethics Matters, 86 Feb ABA J 36 [“The fact that VA Linux hadn’t turned a dime in profits and had no expectation of doing so did little to deter trading. Investors pushed the price upward on a gamble that the public would see the fledgling company . . . as a rival to Microsoft”]).

3 . The practices alleged in the complaint are commonly referred to as “spinning” and “flipping.” Spinning refers to the preferential allocation of the right to buy shares in an IPO, often to company managers or venture capitalists, who may quickly resell or “flip” these shares in the aftermarket for large profits.

4 . The syndicate was the ad hoc group of underwriters who banded together to underwrite—that is, purchase—from eToys, the issuer/seller, at a fixed price less the discount (6.75%) and to distribute eToys’ new securities.

5 . SROs are quasi-governmental entities with, “a duty to promulgate and enforce rules governing the conduct of [their] members” (Barbara v New York Stock Exch., Inc., 99 F3d 49, 51 [2d Cir 1996]; see 15 USC § 78c [a] [26]; § 78f [b]; § 78s [g]). The SEC must approve or reject any rule, practice, policy or interpretation proposed by an SRO (see 15 USC § 78s [b]; Barbara, 99 F3d at 51 [describing the role of SROs in enforcement of federal securities laws and SRO rules or regulations]).

6 . Specifically, the proposed rules would (1) prohibit IPO allocations as a consideration or inducement for the receipt of compensation that is excessive in relation to the services provided by the member or member organization (so-called “quid pro quo” allocations); (2) prohibit the awarding of IPO shares to executive officers and directors and their household members of issuers that have, or will have, an investment banking relationship with the member or member organization on the condition that such officers and directors, on behalf of the issuer, direct future investment banking business to the member or member organization (i.e., spinning); (3) prohibit the imposition of a flipping penalty (a “penalty bid”) on associated persons whose customers flipped IPO shares unless such penalty is imposed on the entire underwriting syndicate; and (4) require the book-running lead manager, who is responsible for assembling pre-price indications of interest in an underwritten transaction, to provide the issuer’s pricing committee (or, if the issuer has no pricing committee, its board of directors) with (a) a regular report of indications of interest, including the names of interested institutional investors and the number of shares indicated by each, and a report of aggregate demand from retail investors (which the SROs characterized as conforming the rules to existing practices); and (b) a report on final allocations within a reasonable time after the IPO’s settlement date. These proposed rules would also extend lock-up agreements (i.e., formal restrictions on resale of securities) to officers’ and directors’ issuer-directed shares (e.g., so-called “friends and family” programs) and require the book-running lead manager to notify the issuer and the public (through a major news service) at least two days prior to the release or waiver of any lock-up or other restriction on the transfer of the issuer’s shares; specify how the book-running lead manager and other syndicate members must deal with returned shares; and prohibit members from accepting market orders to purchase IPO shares in the aftermarket for one trading day following an IPO (see also 69 Fed Reg, at 77,813-77,814 [discussing three possible new approaches for regulating unseasoned issuers, whose stocks experienced dramatic run-ups and declines in price during the late 1990’s and 2000, and the factors, both objective and subjective, that bear upon establishing an offering price]).