In re Worldcom, Inc. Securities Litigation

346 F.Supp.2d 628

In re WORLDCOM, INC. SECURITIES LITIGATION This Document Relates to: All Actions

No. 02 Civ. 3288(DLC).

United States District Court, S.D. New York.

December 15, 2004.

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Max W. Berger, John P. Coffey, Steven B. Singer, Chad Johnson, Beata Gocyk-Farber, John C. Browne, Jennifer L. Edlind, David R. Hassel, Bernstein Litowitz Berger & Grossman LLP, New York, NY, Leonard Barrack, Gerald J. Rodos, Jeffrey W. Golan, Mark R. Rosen, Jeffrey A. Barrack, Pearlette V. Toussant, Barrack, Rodos & Bacine, Philadelphia, PA, for Lead Plaintiff in the Securities Litigation.

Jay B. Kasner, Susan L. Saltzstein, Cyrus Amir-Mokri, Steven J. Kolleeny, Skadden, Arps, Slate, Meagher & Flom LLP, New York, NY, Thomas J. Nolan, Jason D. Russell, Los Angeles, CA, for Underwriter Defendants.

George R. Kramer, Securities Industry Association, Washington, D.C., Marjorie E. Gross, The Bond Market Association, New York, NY, Davis Polk & Wardwell, New York, NY, for amici curiae the Securities Industry Association and The Bond Market Association.

OPINION AND ORDER

COTE, District Judge.

TABLE OF CONTENTS
Introduction ..................................................................634
Background ....................................................................635
     Procedural History .......................................................635
     WorldCom and its Role in the Telecommunications Industry .................637
     Ebbers' Dependence on WorldCom Stock .....................................639
     WorldCom's Accounting Strategies .........................................640
     Andersen and the 1999 Form 10-K ..........................................643
     2000 Offering ............................................................645
     Late 2000 Investment Banking Transactions ................................649
     The Underwriter Defendants' Credit Assessment of WorldCom as of Early
       2001 ...................................................................649
     2000 Form 10-K ...........................................................652
     2001 Offering ............................................................652
Discussion ....................................................................655
        I. Legal Framework ....................................................656
           A. Section 11 ......................................................656
           B. Section 12 ......................................................659

       II. Lead Plaintiff's Motion for Partial Summary Judgment ...............660
      III. The Underwriter Defendants' Motion for Summary Judgment: The
             Financial Statements .............................................661
           A.  Role of the Underwriter ........................................662
           B.  The "Due Diligence" Defenses ...................................662
           C.  Accountants as Experts .........................................664
           D.  Integrated Disclosure, Shelf Registration, and Rule 176 ........666
           E.  Case Law: Reliance Defense .....................................671
           F.  Case Law: Due Diligence Defense ................................674
           G.  The Application of the Law to This Motion ......................678
               1. Audited Financial Statements ................................678
                  a. 2000 Registration Statement ..............................678
                  b. 2001 Registration Statement ..............................680
                       i. Goodwill and Asset Impairment .......................680
                      ii. Ebbers' Personal Finances ...........................681
                     iii. E/R Ratio ...........................................681
               2. Interim Financial Statements ................................681
       IV. The Underwriter Defendants' Motion for Summary Judgment
             Omissions ........................................................685
           A. 2000 Registration Statement .....................................685
              1. Sprint Merger ................................................687
              2. Conflicts of Interest ........................................688
              3. Risk Factors .................................................690
           B. 2001 Registration Statement .....................................692
              1. Downgrading WorldCom as a Credit Risk ........................695
              2. Use of Proceeds ..............................................696
              3. Risk Factors .................................................697
Conclusion ....................................................................697

This Opinion addresses issues related to an underwriter's due diligence obligations. Following the conclusion of fact discovery, several of the parties in this consolidated securities class action arising from the collapse of WorldCom, Inc. ("WorldCom") have filed for summary judgment. This Opinion resolves the motions for summary judgment filed by Lead Plaintiff for the class, who seeks a declaration that certain of the WorldCom financials incorporated in the registration statements for two WorldCom bond offerings contained material misstatements; and by the underwriters for those same bond offerings, who seek a declaration that they have no liability for any false statements in the WorldCom financials that accompanied the registration statements or for the alleged omissions from those registration statements.

It is undisputed that at least as of early 2001 WorldCom executives engaged in a secretive scheme to manipulate WorldCom's public filings concerning WorldCom's financial condition. Because those public filings were incorporated into the registration statements for the two bond offerings, the underwriters are liable for those false statements unless they can show that they were sufficiently diligent in their investigation of WorldCom in connection with the bond offerings. Through these motions, the Lead Plaintiff emphasizes that the underwriters did almost no investigation of WorldCom in connection with their underwriting of the bond offerings for the company, and because they did essentially no investigation, will be unable to succeed with their defense that they were diligent. The Lead Plaintiff contends moreover that there were "red flags" that should have led the underwriters to question even the audited financials filed by WorldCom.

For their part, the underwriters emphasize that WorldCom management concealed the fraud from almost everyone within WorldCom, from WorldCom's outside auditor, and from the underwriters themselves. They assert that they were entitled to rely on WorldCom's audited financial statements as accurately describing the company's financial condition, and also on the comfort letters that WorldCom's outside auditor provided for the unaudited financial statements. While they have not moved for summary judgment on the adequacy of their due diligence efforts per se, they do argue that those efforts should not be measured solely by the work that they undertook in connection with the bond offerings themselves, but should be assessed against a background of their long term familiarity and work with the company. They also argue that much of the information that was allegedly omitted from the bond registration statements was already known to the public.

For the following reasons, the Lead Plaintiff's motion is granted in part. The underwriters' motion is also granted in part.

Background

These summary judgment motions require, in varying amounts of detail, an understanding of the industry in which WorldCom operated, some of the accounting issues that affected the reliability of the WorldCom financial statements, and the due diligence work performed by the underwriters in connection with the two bond offerings. The facts recited here are either undisputed or as shown by the party resisting summary judgment, unless otherwise identified. A brief description of the history of this litigation and the context for the summary judgment motions precedes the factual recitation.

Procedural History

WorldCom announced a massive restatement of its financials on June 25, 2002. It reported its intention to restate its financial statements for 2001 and the first quarter of 2002. According to that announcement, "[a]s a result of an internal audit of the company's capital expenditure accounting, it was determined that certain transfers from line cost expenses¹ to capital accounts during this period were not made in accordance with generally accepted accounting principles (GAAP)." The amount of transfers was then estimated to be over $3.8 billion. Without the improper transfers, the company estimated that it would have reported a net loss for 2001 and the first quarter of 2002. On July 21, it filed for bankruptcy. A restatement of WorldCom's financials was issued in 2004 in connection with WorldCom's emergence from bankruptcy. WorldCom restated its financial information for the years ending 2000 and 2001. The restatement included approximately $76 billion in adjustments, which reduced WorldCom's net equity from approximately $50 billion to approximately minus $20 billion.

Securities litigation addressing the accuracy of WorldCom's financial statements commenced in the Spring of 2002. Those class actions filed in this district were consolidated on August 15, 2002. The Judicial Panel on Multi-District Litigation ("MDL Panel") transferred the securities litigation pending in federal courts to this district and all of the actions, both individual ("Individual Actions") and class actions, were consolidated for pre-trial purposes on December 23, 2002. In re WorldCom, Inc. Sec....