Petition — Franklin Life Insurance v. Commonwealth Edison Co.

“Bupreme Gout, Uh . |

FILED 1

|

AUG 24 Tg |

IN THE

Supreme Court of the United States

OCTOBER TERM, 1979

no...4269-2 42

THE FRANKLIN LIFE INSURANCE COMPANY, a corporation, individually

| and representatively on behalf of all holders of the 9.44% Cumulative

| Prior Preferred Stock of Commonwealth Edison Company, a corporation,

7 Petitioners,

V

COMMONWEALTH EDISON COMPANY, a corporation,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE SEVENTH CIRCUIT

FREDERICK H. STONE

Franklin Square

Springfield, Illinois 62713

GEORGE B. GILLESPIE

GILLESPIE, CADIGAN & GILLESPIE

217 South Seventh Street

Springfield, Illinois 62701

Attorneys for Petitioners

Of Counsel:

ALAN R. BROMBERG

3315 Daniels

Dalla8, Texas 75275

A ANREP TRAN RAI AAMRMINEMC SN SERENE MEI RAS A SR ARIAS

St. Louis Law Printing Co.. Inc.. 812 Olive Stree: 63101 314-231-4477

=

INDEX

Page

awe bn des ccc keke sess l

EE EE a 2

Ee 2

Statutes and Rule Involved ....................0000- 3

ee ee se cae k sce se ss saccesess 3

Reasons for Granting the Writ .................05:. 12

I eres cece sss esesvceseeces 14

a ae oie ada tous wenscesees 16

1. Edison Violated the Disclosure Requirements of the

Federal Securities Laws in the 9.44% Preferred

a 16

2. The Redemption of the 9.44% Stock was “Through

Refunding, Directly or Indirectly, by or in An-

ticipation of Debt” at a Lower Interest Cost to Edi-

son than the 9.44% Annual Dividend Cost on the

9.44% Stock and the Redemption Breached the

Contract with the Owners of the Stock .......... 28

3. Edison Breached its Contract with the New York

Stock Exchange which was for the Benefit of the

EE Ee 34

4. Edison Violated the Fraud Provisions of the Federal

Securities Laws when it Redeemed the 9.44% Stock 39

eek be pe bab biedadeccsccsece 41

Appendix A—Opinion of the Court of Appeals ........ A-l

Appendix B—Judgment of the Court of Appeals ........ A-3

Appendix C—Order on Petition for Rehearing

Appendix D—Memorandum Order of the District Court .. A-6

Appendix E—Statutes and Rule Involved

TABLE OF AUTHORITIES

Cases:

Affiliated Ute Citizens v. United States, 406 U.S. 128, 151 16

Allen v. Penn Central Co., 350 F.Supp. 697, 702 (E.D. Pa.

1972)

Bailey v. Meister Brau, Inc., 535 F.2d 982, 993-994 (7th

eee tee ia wea uae cra 6 tone 25, 26, 41

Drachman v. Harvey, 453 F.2d 722, 736-738 (2nd Cir. en

EE ce hig eeey ee Ce 39

Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195 (1976) . .18, 24

Feit v. Leasco Data Processing Equipment Corp., 332 F.

Supp. 544, 564-565 (E.D. N.Y. 1971) .............. 23

Gerstle v. Gamble-Skogmo, Inc., 298 F.Supp. 66, 95

(E.D. N.Y. 1969) 478 F.2d 1281 (2nd Cir. 1973) . .24, 33

Gould v. American Hawaiian Steamship Co., 331 F.Supp.

981, 995-996 (D. Del. 1971), 535 F.2d 761 (3d Cir.

ca MO ee eee a eee 37

Indiana National Bank v. Mobil Oil Corp., 578 F.2d 180,

187, n. 15

Kohn v. American Metal Climax, Inc., 322 F.Supp. 1331,

1362 (E.D. Pa. 1971); affirmed 458 F.2d 255, 265, (3rd

Cir. 1972); cert. denied 409 U.S. 874 (1972) ........ 37

Levine v. Seilon, 439 F.2d 328, 332 (2nd Cir. 1971) .... 39

iil

Marx v. Computer Sciences Corp., 507 F.2d 485, 491

8 ewer rer aes ee Pree 21

Robinson v. Penn Central Co., 336 F.Supp. 655, 657 (E.D.

Peer reer rer Teer ee eee oe Tee ey Cree 37

Sanders v. John Nuveen & Co., 554 F.2d 790, 792-793

OE sx ny d 0c boos EGE Res CL abe O RSS Ree; 25

Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 477-478

UNE occa e ksh hGd Ue ER AMM MASS BARRE RD TOR OS 18

SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 863, cert.

re BE i re ere ere ee ee 21

SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77 (S.D.

N.Y. 1970); affirmed 446 F.2d 1301, 1304; cert. de-

nied 404 U.S. 1005 (1971) ....... cece eee eee eee 22

Speed v. Transamerica Corp., 99 F.Supp. 808, 843-849

(D.Del. 1951); 135 F.Supp. 176 (D.Del. 1955); affirmed

235 F.2d 369 (3rd Cir. 1956) .......-. ee ee eee eee 39

Standard Oil of California v. Perkins, 347 F.2d 379, 383

Ae) eee er ee ee ee 32

Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033,

1039-1040, 1043-1045 (7th Cir. 1977); cert. denied

Poe BT og: re eer ee eo 25

TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449

ae eerr ly ere kre Tree eee ee 21

Van Gemert v. Boeing Co., 520 F.2d 1373, 1379 (2nd

Cir. 1975); 553 F.2d 812 (2d Cir. 1977); 573 F.2d

733 (2d Cir. 1978); 590 F.2d 433 (2d Cir. en banc

1978); cert. granted May 14, 1979 (DKT. 78-

RO oi bios cc sobebes bicscdvesnesceses 22, 33, 34, 39

Wright v. Heizer Corp., 560 F.2d 236, 246-248 (7th Cir.

1977) cert. denied 434 U.S. 1066 (1978) ...... 25, 27, 41

iv

Statutes and Rules:

Securities Act of 1933

S20 89 CSL. FRED oi cco oe 39

S88 85 WOE. PE. ..kcs cca 3, 26

SiMe 95 GSE. - Fie .ucs....cche ee 3, 4, 20

Securities Exchange Act of 1934

$ 10@) 15 UBC. § TOW .4..6555.05-. 3,4, 17

SEC Rule 10b-5, 17 C.F.R., Sec. 240.10b-5 ...... 3, 4, 17, 20

SEC Form S-1, Item 13(a)(6), 2 CCH Fed. Sec. L.

mp. § PER ow... os cunn ene 19

SEC Form S-7, Item 7(a)(6), 2 CCH Fed. Sec. L. Rep.

SG TRO * . os 5s «5060 we ile en 19

SEC Sec. Act Rule 408, 17 C.F.R. § 230.408 .......... 19

Other Authorities:

3 Corbin, Contract Sec. 559 (1960) ..............00.. 31

Kessler, Contracts on Adhesion—Some Thoughts About

Freedom of Contract, 43 Colum. L. Rev. 629 (1943)... 31

Note, 54 Cornell L.Q. 271, 272-278 (1969) .......... 31

ress

IN THE

Supreme Court of the United States

OCTOBER TERM, 1979

BN ee cn

THE FRANKLIN LIFE INSURANCE COMPANY, a corporation, individually

and representatively on behalf of all holders of the 9.44% Cumulative

Prior Preferred Stock of Commonwealth Edison Company, a corporation,

Petitioners,

V

COMMONWEALTH EDISON COMPANY, a corporation,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE SEVENTH CIRCUIT

Petitioner, The Franklin Life Insurance Company, et al.,

prays that a Writ of Certiorari be issued to review the judg-

ment of the United States Court of Appeals for the Seventh

Circuit entered on May 22, 1979.

OPINIONS BELOW

The Opinion of the Court of Appeals affirming the decision

of the District Court and adopting its Memorandum Order as

the opinion of the Court of Appeals, with an exception not

here germane, is reported at 598 F.2d 1109 and is reprinted as

a, pon

Appendix A hereto (App. p. A-1, infra). The Memoraacum

Order of the District Court is reported at 451 F.Supp. 602

(S. D. Ill. 1978) and is reprinted as Appendix D hereto (App.

p. A-6-A-32, infra).

JURISDICTION

The judgment of the Court of Appeals was entered on May

22, 1979 (Appendix B, p. A-3, infra). A timely Petition for

Rehearing was denied on June 22, 1979 and a corrected order

of denial was entered June 27, 1979 (Appendix C, p. A-5,

infra). The jurisdiction of this Court is invoked pursuant to 28

U.S.C. § 1254(1).

QUESTIONS PRESENTED

(1) When the issuer of a high yield security (9.44% Pre-

ferred Stock) states in its prospectus that the security may not

be “redeemed through refunding, directly or indirectly, by or

in anticipation of the incurring of any debt” at an interest cost

below 9.44%, is it liable (under the Federal Securities Laws)

to buyers for failing to disclose in the prospectus:

(a) It believed it could redeem the security from the

proceeds of common stock even though it may be bor-

rowing heavily, before and after the redemption, at rates

far below 9.44%, and

(b) Its plans and considerations with respect to early

redemption?

(2) When the prospectus and the terms of a high yield se-

curity (9.44% Preferred Stock) prohibit redemption “through

refunding, directly or indirectly, by or in anticipation of the

incurring of any debt” at an interest cost below 9.44%, does

the issuer breach its contract with the holders of the security

an on

by redeeming the security from the proceeds of an issue of

common stock sandwiched between the incurring of hundreds

of millions of dollars of debt at interest costs far below 9.44%?

(3) Is the issuer of securities listed on the New York Stock

Exchange required to comply strictly with the requirements for

giving notice of the taking of corporate action looking toward

the redemption of securities?

(4) Is the redemption of securities in violation of the terms

of the prospectus offering the securities and in violation of the

contractual responsibilities of the issuer-seller respecting the

securities also a violation of the fraud provisions of the Federal

Securities Laws?

STATUTES AND RULE INVOLVED

Sections 11(a) and 17(a) of the Securities Act of 1933

(“1933 Act”), 15 U.S.C. §77k and 77q, Section 10(b) of the

Securities Exchange Act of 1934 (“1934 Act”), 15 U.S.C. §§

78j(b) and Rule 10b-5, 17 C.F.R., Section 240. 10b-5 are

set forth as Appendix E hereto (App. p. A-33, infra).

STATEMENT OF THE CASE

Petitioner, The Franklin Life Insurance Company, filed this

action individually and as representative of the class of persons

holding shares of 9.44% Cumulative Prior Preferred Stock

(“STOCK”) issued by Commonwealth Edison Co. (“EDI-

SON”). Other class members, including Teachers Retirement

System of Texas (“Texas Teachers”) were granted leave to

intervene or entered their appearance through various counsel.

The action was certified as a class action under Federal Rules

of Civil Procedure 23(b)(3). Petitioners alleged violation of

§§ 11 and 17 of the Securities Act of 1933, 15 U.S.C. § 77k,

—_ -o

and 15 U.S.C. § 77q respectively, as well as Section 10(b) of

the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) and

Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder.

The Stock Issuance

On June 24, 1970 Commonwealth Edison Company, Re-

spondent, through underwriters, publicly sold one million shares

of its 9.44% Cumulative Prior Preferred Stock (“STOCK”) at

a price of $100 per share pursuant to a registration statement

filed with the Securities and Exchange Commission (“SEC”) ef-

fective June 24, 1970. At the time the STOCK was issued

investment funds were in short supply and as a result preferred

stock issues bore an uncharacteristically high rate of return.

Although EDISON would have preferred to issue the STOCK

with a dividend rate of 9.25% and a five year redemption re-

striction, it was convinced by its underwriters, primarily the

First Boston Corporation, that a dividend rate of 9.44% and a

ten year redemption restriction were required for a successful

stock issue (App. p. A-8, infra). The Petitioner and an interven-

ing plaintiff, Texas Teachers, invested $2.5 million and $3 mil-

lion (respectively) in the STOCK as a long term investment.

The STOCK was redeemed March 20, 1972 at $110 a share

when interest rates had dropped below 7.5%. Before the re-

demption announcement, the STOCK was trading on the New

York Stock Exchange at prices around $120 a share.

A prospectus was filed with the SEC and distributed to in-

vestors for the original sale of the STOCK. The prospectus

stated on page 1 that the STOCK was:

“(n)ot redeemable, directly or indirectly, prior to August

1, 1980, through certain refunding operations (See page 2).”

On page 2 of the prospectus, the text of the redemption pro-

vision provided:

—_

“(p)rior to August 1, 1980, none of the shares of the

9.44% Prior Preferred Stock may be redeemed through re-

funding, directly or indirectly, by or in anticipation of the

incurring of any debt or the issuance of any shares of the

Prior Preferred Stock or any other stock ranking on a parity

with the Prior Preferred Stock, if such debt has an interest

cost to the Company (as defined), or such shares have a

dividend cost to the Company (as defined), less than the

dividend cost to the Company of the 9.44% Prior Preferred

Stock. Subject to the foregoing, the 9.44% Prior Preferred

Stock will be redeemable at the option of the Company as a

whole at any time or in part from time to time at the follow-

ing per share redemption prices: $110 if redeemed before

August 1, 1980; $107 if redeemed on or after August 1,

1980, but before August 1, 1983; $104 if redeemed on or

after August 1, 1983, but before August 1, 1986; and $101

if redeemed on or after August 1, 1986; in each case plus

accrued and unpaid dividends, if any. (Italics added. )

The prospectus also contained a section entitled “Purpose of

Issue and Construction Program” on pages 4 and 5. This section

stated that the proceeds from the sale of the STOCK would be

added to working capital for application partly toward payment

of commercial short term paper and partly for interim financing

of the construction program. The section described the con-

struction program for the next five year period, 1970-1974, “as

now forecast, calls for electric plant expenditures of approxi-

mately $2,250,000,000.” Of that amount it was estimated

that $1,150,000,000 would have to be raised through the sale

of additional securities. (App. p. A-9 infra)

Consistent with this construction program, EDISON’s long

term debt increased from $1.849 Billion at the end of 1971

to an amount in excess of $3 Billion at the time of the trial of

the issues in 1977. Each issue of long term debt made by EDI-

smssiicad

SON subsequent to 1971 was at an interest cost to EDISON of

less than 9.44%. During 1972 EDISON also incurred debt

through the issuance of short term promissory notes. Its short

term debt on January 1, 1972 was $140,000,000 and at the

end of 1972 it was $258,000,000. All of the short term debt

was at an interest rate of less than 9.44% (App. p. A-9, infra).

At the time the STOCK was offered to the public on June 24,

1970, EDISON considered redemption of the STOCK when

market conditions were feasible to do so and it was advantageous

to its other stockholders as a viable alternative to the payment

of the high dividend rate. EDISON also believed that it could

redeem the STOCK at any time from the proceeds of common

stock and warrants and its belief was not affected by the fact

that it needed more than $1 Billion of outside financing the five

year period next after the issuance of the STOCK. This informa-

tion was not disclosed in the prospectus although EDISON knew

it would have influenced the judgment of investors if it had

been disclosed (Tr. 385-387, App. 123-125).

The Petitioner read and relied on the prospectus as a whole in

making its decision to purchase the STOCK and believed from

the prospectus that EDISON would be a net borrower . . . to

meet its construction needs . . . for at least five years after the

issuance of the STOCK . . . EDISON would be increasing the

amount of its debt each year and Petitioner was led to believe the

STOCK could not be redeemed while EDISON was anticipating

borrowing at a lesser interest cost than 9.44%. Had Petitioner

believed otherwise it would not have purchased the STOCK as

its investment philosophy called for long term investments

to honor obligations to its policyholders, annuitants and retirees

which would continually mature over long periods of time.

Analysts and brokers had a similar belief and would not, had

they believed otherwise, recommended that their clients or cus-

tomers purchase the STOCK. Other individual investors relying

te en ee .

cae eine

upon the prospectus, summaries contained in Standard & Poor’s

and stock brokers’ understanding of the redemption provisions,

purchased the STOCK with the common understanding they

would be able to own the STOCK until August 1, 1980 (PI.

Exs. 92-95, 97-121).

Had EDISON inserted in its prospectus its belief that it could

redeem the STOCK at any time from the proceeds of an issue

of common stock and planned to do so when market conditions

made it feasible, neither Petitioner nor intervening plaintiff,

Texas Teachers, would have purchased the STOCK.

From the time of the issuance of the STOCK in June 1970

until its redemption was announced on January 4, 1972, the

STOCK traded on the New York, Midwest and Pacific Stock Ex-

changes. Throughout 1971 it traded above $110 per share (the

redemption price) and was trading at $119.6875 per share on

January 4, 1972, the date EDISON announced its proposed

redemption of the STOCK. The following day the price of the

STOCK fell to $111.375 per share for an overnight loss of

$8.3125 per share . . . a total market loss of $8,312,500.

The Trial Court found that the omissions charged against

EDISON were material and that reliance is to be presumed as

the testimony established that had plaintiffs known either of an

intent to redeem when market conditions made it feasible or of

EDISON’s belief that redemption could be accomplished out of

the issuance of common stock prior to August 1, 1980 without

regard to borrowings at a lesser interest cost than the 9.44%

dividend rate on the STOCK, they would not have purchaséd

(App. p. A-15, infra). The Trial Court observed that the ma-

terial facts assertedly omitted are not objective but are subjective.

The Trial Court observed that the Plaintiffs would require state-

ments of EDISON’s intent and of EDISON’s belief concerning

the proper interpretation of the redemption provisions of the

prospectus. The Trial Court stated that whether the securities

—

laws are broad enough to require disclosure of such facts is open

to serious question. Whether the prospectus adequately dis-

closed these facts is another question on which the Trial Court

expresses no opinion (App. p. A-16, infra). The Trial Court in

ruling against the Petitioner did so upon the basis of a failure to

show scienter on the part of EDISON.

From the time of the issuance of the STOCK in June 1970

until its redemption was announced on January 4, 1972 and

completed on March 20, 1972, the STOCK traded on the New

York, Midwest and Pacific Stock Exchanges. The agreement for

listing the STOCK on the New York Stock Exchange required

the publication of any action taken by EDISON with respect to

rights or benefits pertaining to the ownership of the STOCK, and

Section Al0 of the New York Stock Exchange Manual defines

publicity in the listing agreement in respect of redemption action

and requires a news release to be made as soon as possible after

corporation action which will lead to or looks toward redemption.

The agreement provides that to insure coverage the news should

be released to one or more newspapers of general circulation

in New York City which regularly publish financial news or to

one or more wire services.

The Stock Redemption

By proxy statement dated February 25, 1971 for EDISON’s

annual meeting to be held on April 2, 1971, EDISON an-

nounced a proposed amendment to its Articles of Incorporation

to increase the number of shares of authorized common stock and

stated that it anticipated that new preference or additional com-

mon stock may be sold to redeem or otherwise be used to retire

all or part of the STOCK but that EDISON had no definitive

plans. At the annual meeting on April 2, 1971, when the stock-

holders approved the increase and authorization of stock of

EDISON, thereby making it possible for EDISON to issue

common stock for more than enough money to retire the entire

~

—

issue of STOCK, EDISON announced that it was disappointed

in the 9.44% dividend rate on the STOCK and that it expected

to refund it when market conditions made it feasible to do so.

EDISON did not comply with its agreement with the New York

Stock Exchange. It did make a wide distribution of the proxy

statement with information respecting the redemption set forth

in five lines on page 6 of a 28-page proxy statement. It dis-

tributed to the press and brokerage firms Notes to its Annual

Meeting held on April 2, and reference to the redemption was

set forth in three lines on page 5 of a 15-page summary of the

meeting. EDISON was well aware that the investment com-

munity was not alerted to the possibility of redemption as it

monitored the trading on the New York Stock Exchange as re-

ported daily in the Wall Street Journal. From the annual meet-

ing date on April 2, 1971 until the redemption was announced by

a news release appearing in the Wall Street Journal on January

5, 1972, 147,300 shares of the STOCK were traded on the

New York Stock Exchange for an average of $7.18 per share

above the $110 redemption price.

Following the announcement of the proposed redemption on

January 5, 1972, EDISON received numerous protests from its

shareholders and complaints that it had no right to make such

redemption but redeemed despite protesting delegations from

leading utilities analysts. In the prospectus dated February 22,

1972 for the units of common stock with warrants used for the

redemption, and prior to the redemption, EDISON acknowledged

receipt of communications from shareholders protesting redemp-

tion, claiming the prospectus for the STOCK did not clearly

indicate there could be a redemption prior to August 1, 1980

and claiming that Edison could not redeem because it was con-

tinuing to use debt as part of a continuing program to finance

construction which might have a lower cost than the 9.44%

dividend on the STOCK. Despite these protests and claims of

rights, EDISON proceeded with redemption thereby depriving

the owners of the STOCK of their rights of ownership.

—

In addition to the actions based on the violation of the Federal

Securities Laws and the New York Stock Exchange agreements,

Petitioners claim a breach of contract as the terms of the STOCK

and the provisions in EDISON’s Articles of Incorporation re-

specting the same constituted a contract between the stockhold-

ers and EDISON. The Petitioners asserted that the contract

did not permit redemption at the time EDISON was in the proc-

ess of borrowing money at an interest cost less than the 9.44%

dividend on the STOCK. The District Court in deciding against

Petitioners on this issue stated in its Memorandum Order:

“The actions of EDISON as shown by the evidence, could

be characterized as redemption in anticipation of debt since

it well knew its financing needs and that in the current

market those needs could be met at a cost of less than

9.44%. If the redemption clause requires an examination

of the entire borrowing activities of EDISON then plaintiffs

should prevail.

“However, I believe that the clause forbidding redemption

through refunding by or in anticipation of debt, requires an

examination of only the source of the funds actually used to

achieve the redemption. Were the proceeds of the issue of

common stock and warrants in anticipation of debt at an

interest cost of less than 9.44%? The answer must be no.

Common stock cannot be refunded.” (App. p. A-27,

infra)

The trial Court concluded:

“Although I believe EDISON could have avoided this entire

matter by making its right express, I cannot say that EDI-

SON’s drafting, which stated expressly the methods by

which redemption was prohibited and impliedly reserved

to itself all other methods, violated the Federal Securities

—

Laws or violated plaintiffs’ vested contract rights. The de-

cision here has not been quick nor easy. Drafting could

have alleviated not only the time and effort spent here but

the unrewarded expectations of plaintiffs.” (App. p. A-

32, infra)

The Trial Court gave judgment for EDISCN. The Court of Ap-

peals affirmed per curiam, adopting the Trial Court's Mem-

orandum Order (with an exception not relevant here).

—_ sn

REASONS FOR GRANTING THE WRIT

The reasons for granting the writ are legal and economic. The

legal reasons are detailed below. The economic reasons, al-

though vastly important, will not be elaborated. In brief, they

are that billions of dollars of redeemable securities play a critical

role in financing business on the one hand and providing invest-

ment opportunities on the other. During 1978 there were public

and private offerings of approximately $50 Billion of bonds

and preferred stocks and many of these issues of securities have

redemption terms similar to the redemption terms at issue in

this action. In excess of $12 Billion of these securities were issued

by public utilities. The yields on 1978 public offerings of these

securities range from an approximate 10.25% to 8.40%. With

stable interest rates apparently a thing of the past, redemption

provisions assume overpowering importance. For redemption

has the ability to let issuers refinance their high interest obliga-

tions more cheaply when rates decline and, at the same time,

deprive investors of their high rate of return. Issuers and in-

vestors alike are entitled to clarification of what disclosure must

be made about redemption terms, what the boilerplate redemp-

tion language means, and how redemption may be carried out.

The issues are particularly timely since we appear to be moving

into another decline of interest rates from a very high level. . .

precisely the situation which led to the redemption in this case.

Moreover, the decision in this case may possibly affect the rights

of issuers and holders of billions of dollars of securities owned

by the investing public.

Turning to the legal reasons, the Court of Appeals (by adopt-

ing the District Court Memorandum Order) has decided im-

portant issues of Federal Securities Law which have not been

but should be settled by this Court. These center on (1) the dis-

closure obligations in a 1933 Act prospectus and the use there

of misleading language (which is defended on the ground that

PE RE i A

SOLE i + mes ne om

— ae

it is boilerplate but which was never used for redemption by

anyone except EDISON), (2) the proper standard of scienter

when a 1934 Act Rule 10b-5 claim is based on a 1933 Act

registration statement, and (3) the application of the antifraud

provisions to a redemption of securities.

The District Court, in its Memorandum Order, recites a find-

ing of undisputed testimony that the omissions charged were ma-

terial and that reliance is to be presumed and that had plaintiffs

known either of EDISON’s intent to redeem when market

conditions made it feasible to do so or of EDISON’s belief that

redemption could be accomplished out of an issue of common

stock prior to August 1, 1980 without regard to the debt being

incurred it would not have purchased the STOCK. The District

Court declared that the material facts assertedly omitted are

not objective but are subjective and declined to rule on whether

the securities laws are broad enough to require the disclosure

of subjective facts and, moreover, expressed no opinion on

whether the prospectus adequately disclosed these facts. (App.

p. A-16, infra) The Court of Appeals, in adopting the Memo-

randum Order, similarly expresses no opinion on this most sig-

nificant issue, which not only relates to the claims of the plain-

tiffs but to the problems to be faced by investors when interest

rates decline in the future. The decision undermines the intent

or recklessness standard earlier created.

1.

—_— pn

SUMMARY OF ARGUMENT

EDISON violated the disclosure requirements of the Federal

Securities Laws in the 9.44% Preferred Stock Prospectus

1.1 The Securities Laws are intended to obtain full disclosure

to and fair treatment of investors.

1.2 EDISON did not adequately disclose the redemption

terms of the STOCK, and the statements it made were

materially misleading

1.3 EDISON’s misrepresentations and omissions were with

scienter

(A) The standard is recklessness

(B) Great care is required in a $100 Million stock of-

fering

(C) Great care is required when there is a conflict of in-

terest

(D) Great care was taken in preparing the construction

and financing forecast, and no less care is required

in the closely related redemption terms

(E) EDISON acted recklessly in writing the redemption

terms of the prospectus

EDISON’s redemption of the 9.44% STOCK was “through

refunding directly or indirectly, by or in anticipation of any

debt” at a lower interest cost to EDISON than the $9,440,-

000 annual dividend cost to EDISON on the 9.44% STOCK

and the redemption breached the contract with owners of the

STOCK

2.1 The meaning of the redemption contract (and the conse-

quent breach) are established as a matter of law and also

by the evidence

oo Noe

am 15 —-

(A) The evidence shows breach

(B) The redemption language does not support the Trial

Court’s holding that there was no breach

2.2 If there is any doubt about the meaning of the contract,

it should be construed strictly against EDISON on the

principles of adhesion and contra proferentum

. EDISON breached its contract with the New York Stock

Exchange which was for the benefit of the holders of the

STOCK

. EDISON violated the fraud provisions of the Federal Se-

curities Laws when it redeemed the STOCK

=

ARGUMENT

1. EDISON Violated the Disclosure Requirements of the Fed-

eral Securities Laws in the 9.44% Preferred Stock Pros-

pectus.

1.1 The securities laws are intended to obtain full disclosure

to and fair treatment of investors.

The need for buyer information is at the heart of the Securi-

ties Act of 1933, which is often called the “Truth in Securities”

Act. The thrust of the 1933 Act, particularly the registration

and prospectus provisions, was emphasized very succinctly by the

President when he sent the proposed Bill to Congress: “This pro-

posal adds to the ancient rule of caveat emptor the further

doctrine ‘let the seller also beware.’ It puts the burden of telling

the whole truth on the seller.” (Letter from President Franklin

D. Roosevelt to Congress, Mar. 29, 1933.)

The broad purpose of the Federal! Securities Laws has been

Stated time and again by the judiciary at all levels. In Affiliated

Ute Citizens v. U. S., 406 U.S. 128, 151 (1972), Mr. Justice

Blackmun said it once more in speaking for a unanimous

Supreme Court:

“The Court has said that the 1934 Act and its companion

legislative enactments (including the 1933 Act) embrace a

‘fundamental purpose . . . to substitute a philosophy of full

disclosure for the philosophy of caveat emptor and thus to

achieve a high standard of business ethics in the securities

industry.’ SEC v. Capital Gains Research Bureau, 375 U.S.

180, 186, 11 L.Ed.2d 237, 243, 84 S.Ct. 275 (1963). In

the case just cited the Court noted that Congress intended

securities legislation enacted for the purpose of avoiding

frauds to be construed ‘not technically and restrictively, bust

flexibly to effectuate its remedial purposes’. Id., at 195,

a ieetenmnaetinmaetie eden aeieeteeatio time

—

11 L.Ed.2d at 248. This was recently said once again in

Superintendent of Insurance v. Bankers Life & Casualty

Co., 404 U.S. 6, 12, 30 L.Ed.2d 128, 134, 92 S.Ct. 165

(1971).” (italics supplied.)

Rule 10b-5, promulgated by the Securities and Exchange

Commission under authority granted in 1934 Act §10(b), 15

U.S.C. §78j(b), is an important implementation of the full dis-

closure-fair treatment system. It provides:

“(I]t shall be unlawful for any person, directly or indirectly,

by the use of any means or instrumentality of interstate

commerce, or of the mails or of any facility of a national

securities exchange,

(a) To employ any device, scheme or artifice to de-

fraud,

(b) To make any untrue statement of a material fact

or to omit a material fact necessary in order to

make the statements made, in the light of the cir-

cumstances under which they were made, not mis-

leading or

(c) To engage in any act, practice, or course of busi-

ness which operates or would operate as a fraud

or deceit upon any person,

in connection with the sale or purchase of any security.”

17 CFR §240.10b-S.

Even when construing §10(b) and Rule 10b-5 narrowly, this

Court has recognized that disclosure is the overriding purpose:

“. . . [T]he Court repeatedly has described the ‘funda-

mental purpose’ of the Act as implementing a ‘philosophy

of full disclosure’; once full and fair disclosure has oc-

curred, the fairness of the terms of the transaction is at

most a tangential concern of the statute.”

—si

Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 477-478

(1977) (by Mr. Justice White).

“The Securities Act of 1933... was Gesigned to provide

investors with full disclosure of material information con-

cerning public offerings of securities . . .”

Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195 (1976) (by

Mr. Justice Powell).

1.2 EDISON did not adequately disclose the redemption

terms of the STOCK, and the statements it made were

materially misleading.

In purported compliance with the full disclosure require-

ments of the 1933 and 1934 Acts EDISON’s prospectus promi-

nently stated (on page 2, cross referenced on the cover page)

that the STOCK could not be “redeemed through refunding,

directly or indirectly, by or in anticipation of the incurring of

any debt” at an interest cost below 9.44%.

Placed as it was, and coming at a time of high interest rates,

that language could only be construed as an assurance to in-

vestors that they would not be deprived of their high dividends

by a redemption when interest rates dropped if EDISON was

then in anticipation of borrowing. The meaning of the redemp-

tion language is discussed further in Part 2 below at p. 28.

The prospectus did not disclose—did not even hint at—the

following interpretations and information, all of which EDI-

SON concedes it held at the time the STOCK was sold:

(1) EDISON believed it could redeem the STOCK at any

time from the proceeds of common stock and warrants (Tr. 429,

430; Stip. 7).

(2) Its belief was not affected by the fact that it had an-

nounced that it needed more than $1 Billion of outside financ-

ing in the next five years (Stip. 8) . . . in other words, it saw

a

aw {9 ...

no connection between (a) its construction and outside financ-

ing forecast and (b) the “anticipation” language in the re-

demption terms or, as an inevitable sequel, the “anticipation”

language was meaningless in EDISON’s interpretation.

(3) EDISON considered redemption of the STOCK when

market conditions made it feasible as a strong possibility (Tr.

385).

(4) It considered redemption of the STOCK when market

conditions made it advantageous to the EDISON common

shareholders as a strong possibility (Tr. 386).

(5) It considered redemption of the STOCK when market

conditions made it feasible and when it was good for the EDI-

SON common shareholders as a viable alternative open to

EDISON (Tr. 385).

This information was not disclosed although EDISON’s Vice

Chairman and Chief Financial Officer, Corey, conceded that it

would have influenced the judgment of investors if it had been

disclosed.

The Trial Court’s characterization of the information con-

cealed in the prospectus as not objective but subjective is beside

the point when the information is required to be disclosed by

Federal law, as redemption terms are. See SEC Form S-1, Item

13(a)(6), 2 CCH Fed. Sec. L. Rep. § 7123; SEC Form S-7,

Item 7(a)(6), CCH 4 7192; and accompanying Instruction 1 to

these Items: “a brief summary of the (redemption) provisions

which are pertinent from an investment standpoint.” See also

SEC Sec. Act. Rule 408, 17 C.F.R. § 230.408, which . . . with

reference to registration statements (of which a prospectus is the

main part) . . . echoes 10b-5: “In addition to the information

expressly required to be included in a registration statement,

there shall be added such further material information, if any,

as may be necessary to make the required statements, in the

—_— —

light of the circumstances under which they are made, not mis-

leading.” The redemption provision in the prospectus (quoted

on page 5 above) was materially misleading in failing to say

that redemption was permitted from the proceeds of common

stock even though in anticipation of borrowing below 9.44%.

This was particularly true in light of EDISON’s undisclosed in-

tents, beliefs and interpretations as to the redemption language it

used. The redemption provision was also materially misleading

in using the word “refunding” without explaining the very

peculiar meaning that EDISON now assigns the word (and per-

suaded the trial Court to adopt). See page 29 below in Part

2.1(B).

Whether omissions from statements are violations of the anti-

fraud provisions is determined “in the light of the circumstances

under which they were made.” 1933 Act § 17(a)(2); Rule

10b-5(2). The circumstances in this case included not only an

elaborate 1933 Act prospectus but the prominent mention in

that prospectus of a 5-year construction forecast of $2,250,-

000,000 of which $1,150,000,000 would be financed by the sale

of securities. The preponderance of senior securities (debt and

preferred stock) in the description of the construction program,

in the capitalization table on p. 6 (57.3% long term debt, 8.7%

preferred stock), and in the balance sheet on p. 19 made it clear

that EDISON was anticipating selling much debt or preferred

securities. In this context of steady anticipation of future financ-

ing by senior securities, and of the historically high 9.44%

dividend rate on the STOCK, it was essential for EDISON to

disclose exactly what it meant by the redemption language of

the STOCK, and exactly what it had in mind as to redemption

of the STOCK.

The trial Court stated: “The prospectus does not purport to

link the construction program with the redemption terms.”

This ignores the “circumstances” just described and purpose of a

eo te as =

se ene ee

~~

prospectus which is to be “read as a whole by a reasonable

shareholder.” Allen v. Penn Central Co., 350 F.Supp. 697, 702

(E.D. Pa. 1972). The reasonable investor test of whether a

statement is misleading is widely recognized. See, e.g., SEC v.

Texas Gulf Sulphur Co., 401 F.2d 833, 863 (2d Cir. in banc

1968), cert. denied 394 U.S. 976 (1969), test applied on re-

mand, 312 F.Supp. 77, 83-84 (S.D. N.Y. 1970), affirmed 446

F.2d 1301, 1304-05 (2d Cir. 1971), cert. denied 404 USS.

1005 (1971); Marx v. Computer Sciences Corp., 507 F.2d 485,

491 (9th Cir. 1974). This Court has used the same standards

under the closely related antifraud provision of the 1934 Act

proxy rules, referring to the reasonable shareholder and the “total

mix” of information made available. TSC Industries Inc. v.

Northway, Inc., 426 U.S. 438, 449 (1976).

A reasonable investor is supposed to read and consider the

entire prospectus. That is precisely what the Plaintiffs did. It

would be wholly inconsistent with the requirements and pur-

poses of the securities laws to hold that a prospectus reader

is to ignore page 4 (showing that EDISON, for years to come,

will be in anticipation of issuing debt) when he interprets page

2 (saying that there will be no redemption in anticipation of

debt below 9.44%). It would be equally inconsistent to let

an issuer say that its disclosure obligations on page 2 have noth-

ing te do with what it says on page 4.

If the redemption language used by EDISON was historically

intended to permit redemption from common stock proceeds

(as the trial Court suggests, App. p. A-17, infra), EDISON

was in an unusually good position to know and disclose this in

the prospectus. For the witness who testified to the history

was an executive of the firm that acted as lead underwriter for

EDISON ’s sale of the STOCK (Tr. 689).

EDISON has argued, and the trial Court seems to believe,

(App. p. A-17) that EDISON is protected from liability be-

=

cause its redemption language was similar to that of other utili-

ties. The main fallacy in this argument s that no other utility used

it to redeem from the proceeds of common stock (Tr. 714). But

there is another important thing to be noted: some companies

were much more explicit, either expressly authorizing redemp-

tion from the proceeds of common stock (Detroit Edison, Tr.

322, 323) or expressly prohibiting it (Pacific Gas & Electric,

Tr. 561, 598). Yet EDISON did neither. So it did not write

just like everyone else, and it was unique in redeeming.

Additional evidence of the insufficiency and misleading qual-

ity of EDISON’s disclosure of the redemption terms . . . if

more is needed . . . can be found in the market history of the

STOCK. As interest rates fell, the STOCK rose, and traded

steadily and continuously above the $110 redemption price for

all of 1971 (Pl. Ex. 23). This is irrefutable evidence that in-

vestors were misled on a grand scale, since no reasonable in-

vestor would pay more than $110 for a stock that he under-

stood could be redeemed at will by the issuer for $110. The

conclusiveness of market evidence of investor understanding is

shown in SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 at

866 (2d Cir. in banc 1968) (concurring opinion of Judge

Friendly), cert. denied 394 U.S. 976 (1969). Closer to our

facts is the reference in Van Gemert v. Boeing Co., 520 F.2d

1373, 1379 (2d Cir. 1972) to market action and collective

investor behavior as proof that the redemption notices for a

convertible debenture were insufficient. To the same effect, re-

garding a notice that a tender offer had been oversubscribed,

is Indiana National Bank v. Mobil Oil Corp., 578 F.2d 180,

187 n. 15 (7th Cir. 1978): “This sharp drop in price was cer-

tainly an indication to an unsophisticated investor that a sig-

nificant event had occurred.”

The District Court’s rejection of market evidence (App. p.

A-18) on the ground investors might have thought EDISON

incapable of issuing the common stock with which it was en-

—

titled to redeem . . . is sheer conjecture. It ignores the col-

lective price-setting effect of investor belief in the market, rec-

ognized in the cases just cited. It assumes the point in issue:

that EDISON adequately conveyed that the STOCK could be

redeemed from common. It ignores the extensive testimony of

investors, brokers and analysts. And it ignores the fundamental

purpose of the securities laws, to protect investor through full

disclosure.

EDISON’s narrow view of disclosure is precisely the kind

held inadequate in Feit v. Leasco Data Processing Equipment

Corp., 332 F. Supp. 544, 564-565 (E.D. N.Y. 1971) (emphasis

added):

“The entire legislative scheme (of disclosure) can be frus-

trated by technical compliance. . . in the absence of any real

intent to communicate * ° *

In at least some instances, what has developed in lieu of the

open disclosure envisioned by the Congress is a literary art

form calculated to communicate as little of the essential

information as possible while exuding the air of total candor.

Masters of this medium utilize turgid prose to enshroud the

occasional critical revelation in a morass of dull, and—to

all but the sophisticates—useless financial and historical

data. In the face of such obfuscatory tactics the common or

even the moderately well informed investor is almost as

much at the mercy of the issuer as was his pre-SEC parent.

He cannot by reading the prospectus discern the merit of

the offering.”

In Feit the Court concluded:

“Using a statement to obscure, rather than reveal, in plain

English, the critical elements of a proposed business deal

cannot be countenanced under the securities regulation

acts * * * The prospective purchaser of a new issue is

en

entitled to know what the deal is all about.” (332 F.Supp.

549)

Under the anti-fraud provisions of the Federal Securities

Acts, stockholders must be fully and completely informed.

Under these provisions there is no room for technical explana-

tions and tight-lipped announcements, and all doubt arising from

ambiguous statements must be resolved in favor of the stock-

holders. (Gerstle v. Gamble-Skogmo, Inc., 298 F.Supp. 66, 95

(E.D. N.Y. 1969), affirmed (except as to computation of in-

terest), 478 F.2d 1281 (2d Cir. 1973).

These principles further demonstrate the inadequacy of EDI-

SON’s disclosure about the redemption. The use of “stock

language” which did not “provide meaningful disclosure” of or

“reveal in plain English” the critical effect of the redemption

language . . . as construed by EDISON .. . on investors. Clearly

EDISON lacked “any rea! intent to communicate” on this subject

and this “cannot be countenanced under the securities regulation

acts”. There is no room here for “technical explanations and

tight-lipped announcements” of the kind EDISON made. Clearly

this material information . . . this intent and interpretation of

EDISON which would deprive the investors of their securities,

just when the language seemed to assure they could continue to

hold them . . . should have been made known to the investors.

1.3 EDISON’s misrepresentations and omissions were with

scienter.

(A) The Standard Is Recklessness.

It is now settled that negligence does not violate 10b-5. Ernst

& Ernst v. Hochfelder, 425 U. S. 185 (1976). This Court ex-

pressly declined to rule whether recklessness will violate. 425

U.S. 194 n. 12 (penultimate paragraph). A ruling on that point

is now timely.

——

The 7th Circuit, where this case arose, has consistently held

that recklessness suffices for a 10b-5 violation. Bailey v. Meister

Brau, Inc., 535 F.2d 982, 993-994 (7th Cir. 1976) (as con-

strued in Sundstrand, below) ; Sundstrand Corp. v. Sun Chemical

Corp., 553 F.2d 1033, 1039-1040, 1043-1045 (7th Cir. 1977)

cert. denied 434 U.S. 875 (1977); Sanders v. John Nuveen &

Co., 554 F.2d 790, 792-793 (7th Cir. 1977); Wright v. Heizer

Corp., 560 F.2d 236, 246-248 (7th Cir. 1977) cert. denied 434

U.S. 1008 (1978).

Moreover, the recklessness test applies equally to misrepresen-

tation (Bailey, above), to nondisclosure (Sundstrand, above;

Sanders, above), and to schemes to defraud with elements of both

misrepresentation and nondisclosure (Wright, above).

The test adopted by the Seventh Circuit is:

“reckless conduct may be defined as 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 mislead-

ing buyers or sellers that is either known to the defendant

or is so obvious that the actor must have been aware of

it.” (Sundstrand, 553 F.2d 1045)

Recklessness cannot be measured by a needle on a meter. It

must be inferred from the circumstances. The undisputed cir-

cumstances here include the supreme materiality of the infor-

mation involved . . . the redemption terms of a fixed divi-

dend stock issued at the height of a tight money period. The

circumstances also include the kind of document EDISON was

issuing . . . a statutory prospectus for a big offering and the

sharp conflict of interest between EDISON and the holders of

the STOCK as well as the careful financing forecast which

EDISON did.

—_—

(B) Great Care Is Required in a $100 Million Offering.

EDISON must be judged on the writing of a prospectus for

a $100 Million stock issue registered with the SEC . . . the

largest preferred stock issue ever marketed (Tr. 732, 733). The

potential for investor injury in so large an issue is itself large.

The resources, time and skill available to write the prospectus

correctly are also large. The standard of care required in such

a prospectus is very high. See Securities Act of 1933, §11(a),

15 U.S.C.A. §§774(a).

(C) Great Care Is Required When There Is a Conflict of

Interest.

There was a conflict of interest between EDISON and the

holders of the STOCK, centering on the high dividend (not

deductible for EDISON’s taxes) which EDISON would want

to stop as soon as possible and which the holders would want

to keep as long as possible.

Such a conflict of interest intensifies the duty to disclose and

the method of disclosure. This is the teaching of Bailey v.

Meister Brau, Inc., 535 F.2d 982 (7th Cir. 1976) where a

controlling shareholder (Continental) violated 10b-5 by sell-

ing the corporation’s assets for Meister Brau stock and selling

its stock in the corporation to Meister Brau for cash, all in

disregard of the minority shareholders’ first refusal right to buy

the controlling shares and without adequate disclosure to him.

The Court noted that:

“There was a clear conflict of interest between Continen-

tal’s fiduciary duty as controlling shareholder to the Black

Company and its minority shareholder Bailey and its ob-

jective of effecting the sale of the Black estate shares to

Meister Brau.

. . . Continental . . . blinded by conflict of interest, wan-

tonly ignore(d) evidence of the unfairness of (the) se-

— yn

curities transaction to the corporation and therefore fail(ed)

to disclose this evidence to those shareholders whose inter-

ests lie with the corporation” (535 F.2d 993).

The same combination of conflict of interest and reckless-

ness was found in Wright v. Heizer Corp., 560 F.2d 236, 247,

248 (7th Cir. 1977), cert. denied 434 U.S. 1008 (1978).

(D) Great Care Was Taken in Preparing the Construction and

Financing Forecast, and No Less Care Is Required in the Closely

Related Redemption Terms.

We have already noted in Part 1.2 above, the intimate con-

nection between EDISON’s construction and financing forecasts

(which determine its anticipation of debt) and the redemption

terms of the STOCK (no redemption in anticipation of lower

cost debt). EDISON’s forecasts are elaborate and it represented

to the Illinois Commerce Commission that its forecasts are made

“with great care” and take into account, among other factors,

“estimate(d) interest expense, based on current commitments and

anticipated debt financing” (P1. Ex. 80). What is reckless for a

company to omit or misstate is surely related to the information

it so carefully compiles on the same subject.

(E) EDISON Acted Recklessly in Writing the Redemption

Terms of the Prospectus.

To sum up, EDISON was writing a solemn, detailed, Congres-

sionally mandated disclosure document for a very large securi-

ties offering. The redemption language was a critically important

part. Every dollar EDISON would save by redemption of the

STOCK if interest rates declined would be at the expense of the

STOCK holders. It was accustomed to detailed and careful

financial forecasting. Yet all it chose to tell investors in the

STOCK prospectus was:

“(N)one of the . . . (STOCK) may be redeemed through

refunding, directly or indirectly, by or in anticipation of

en

the incurring of any debt or the issuance of any shares of

the (STOCK) or of any other stock ranking prior to or

on a parity with the (STOCK), if such debt has an interest

cost to the Company (as defined), or such shares have a

dividend cost to the Company (as defined), less than the

dividend cost to the Company of the (STOCK).”

Surely it was reckless . . . as a matter of law and on the over-

whelming preponderance of the evidence . . . for EDISON to

say this without saying what it concededly knew, believed and

intended:, i.e. the five facts detailed in Part 1.2 above at page

18-19.

2. EDISON’s Redemption of the 9.44% Stock Was “Through

Refunding Directly or Indirectly, by or in Anticipation of

Any Debt” at a Lower Interest Cost to EDISON than the

$9,440,000 Annual Dividend Cost to EDISON on the

9.44% STOCK and the Redemption Breached the Contract

With Owners of the STOCK. |

2.1 The meaning of the redemption contract (and the conse-

quent breach) are established as a matter of law and also

by the evidence.

(A) The Evidence Shows Breach.

The prospectus for the STOCK provided that none of the

STOCK may be redeemed through refunding directly or in-

directly, by or in anticipation of incurring any debt or the issu-

ance of any other shares of prior preferred stock with an interest

or dividend cost less than the 9.44% required to be paid on this

STOCK.

The Trial Court correctly noted that it is unquestioned that

the redemption terms of preferred stock issues create a contract

between the corporation and its stockholders (App. p. A-24,

infra)

mis

The Trial Court further found that there was no dispute

surrounding the relevant facts and that EDISON redeemed the

STOCK in March 1972 directly out of an issue of common

stock and warrants at a time when its need for financing to

continue the construction program was apparent. It is undis-

puted that the needed funds were available at interest costs

less than 9.44%. It is undisputed that at the time of the re-

demption EDISON anticipated outside financing of over $2.3

Billion and at that time anticipated borrowing money at far

less than 9.44% interest (Tr. 580). The Trial Court found:

“Consistent with this construction forecast, Edison’s long

term debt increased from $1.849 billion at the end of

1971 to an amount in excess of $3 billion at the time of

trial. Each issue of long term debt made by Edison, sub-

sequent to the year 1971, was at an interest cost to Edi-

son of less than 9.44%. During 1972, Edison also in-

curred debt through the issuance of short-term promissory

notes. Edison’s short-term debt on January 1, 1972, was

$140 million, while at the end of 1972, it was $258 mil-

lion. All the short-term commercial paper was issued at

an interest rate of less than 9.44%.” (App. p. A-9, infra)

These facts alone establish that the redemption was in breach

of the contract because it was in anticipation of incurring debt

below 9.44%.

(B) The Redemption Language Does Not Support the Lower

Court’s Holding That There Was No Breach.

The Trial Court wrestled earnestly with the redemption lan-

guage and recognized its inadequacy. It acknowledged that:

“The actions of Edison as shown by the evidence, could

be characterized as redemption in anticipation of debt

since it well knew its financing needs and that in the cur-

rent market those needs could be met at a cost of less

than 9.44%. If the redemption clause requires an exam-

== 30 —

ination of the entire borrowing activities of Edison then

plaintiffs should prevail.” (App. p. A-27, infra)

The Trial Court took the view that the clause forbidding re-

demption through refunding by or in anticipation of debt re-

quires an examination only of the source of funds actually

used to achieve the redemption and that the question is whether

the proceeds of the issue of common stock and warrants were

in anticipation of debt at an interest cost of less than 9.44%.

The Court answers this in the negative because common stock

cannot be refunded. It is true common stock cannot be re-

funded, only repurchased, but that is irrelevant. Even if this

reasoning can be followed, it cannot be sustained by the re-

demption language. The latter deals with redemption or re-

funding in anticipation of lower cost financing, not with whether

the source of funds was in such anticipation and not with

whether the securities providing the funds could themselves be

refunded.

There is no way the language of the redemption terms can

Support the Trial Court’s reasoning. If “directly or indirectly,

by or in anticipation” modifies only “redeemed”, the redemption

was plainly in anticipation of borrowing below 9.44%, as the

Trial Court concedes. (App. p. A-27, infra) If the language

modifies only “refunding” (construed as the sale of the common

stock for money to pay for the redemption), the result is the

same. The sale of common stock, occurring just before the re-

demption, was equally in anticipation of borrowing below

9.44%. If the language modifies only “refunding” (construed

as giving the money back for the STOCK, i.e., redeeming it),

the result is the same. We think the language modifies both “re-

deemed” and “refunding” (however construed) because of its

placement, buttressed by “directly or indirectly” to indicate the

broadest possible applicability. In this event, the result is again

the same, but reinforced. (No one disputes that the redemp-

tion was through refunding of some sort). This is exactly the

~~

word used by EDISON’s Vice Chairman Corey in his inade-

quately disclosed statement of April 2, 1971: “* * * we

expect to refund it when market conditions make it feasible to

do so * * *.” (Pl. Ex. 129; Def. Ex. 7).

>

The words “directly or indirectly” and ‘in anticipation of” are

everyday words and have no particular technical meaning in the

investment community. The word “redeem” has the dictionary

meaning “to buy back or to pay off.” The word “refund” has

the dictionary meaning of “giving back or to restore, to make

repayment or to reimburse” or the more technical meaning “to

pay off or redeem one security with the proceeds of sale of

another security.”

It follows that the contract with the STOCK holders was

breached by redeeming or refunding in anticipation of borrow-

ing below 9.44%. This is true as a matter of law (interpretation

of the contract by the Court). It is equally true as a matter of

fact (interpretation of the contract by buyers, brokers, analysts

and the market as a whole, as detailed earlier).

2.2 If there is any doubt about the meaning of the contract,

it should be construed strictly against EDISON on the

principles of adhesion and contra proferentum.

If the redemption terms were somehow unclear or ambiguous

they should be construed strictly against EDISON on well known

principles of adhesion and Contra Proferentum.

The contract here was certainly one of adhesion. EDISON

wrote the redemption terms, put them in the prospectus and of-

fered them on a take-it-or-leave it basis to thousands or millions

of investors, more than 4,000 of whom accepted (PI. Ex. 5). See

3 Corbin, Contract Sec. 559 (1960); Kessler, Contracts of Ad-

hesion—Some Thoughts About Freedom of Contract, 43 Colum.

L. Rev. 629 (1943); Note, 54 Cornell L.Q. 271, 272-78 (1969)

and authorities cited below.

—_ po

While the Trial Court declined to apply adhesion rules, it did

find the fact situation appropriate for the application of Contra

Proferentum. This is a rule of contract interpretation which

provides that when words of a contract have been chosen by one

party and another merely assents to these words, that fact alone

may tip the balance against the contracting party. The Trial

Court found the doctrine of Contra Proferentum to be used to

ascertain meaning where ambiguities remain but concluded there

is no ambiguity to be construed against EDISON. With this we

take issue. If the redemption language means what the Court

says it does, this was not apparent to the readers to whom it

was addressed . . . prospective buyers of the STOCK.

Construing an adhesion contract strictly against the writer is

particularly appropriate when the presentation to the public is in

a prospectus required by securities laws to make full disclosure

and achieve fair treatment for investors, and when the extreme

importance of the language is reflected by its prominence in the

prospectus (page 2, the first text page) cross referenced by the

very first line on the cover page following the designation of the

STOCK. We are not here seeking construction of a pure com-

mercial contract but a contract that is part of a prospectus for

$100 million registered offering of securities to the public. We

are not here solely for the construction of a contract as it may

apply to sophisticated investors such as Petitioner and Texas

Teachers who were misled, but for other institutional investors

and the 3,771 individual investors owning an average of 61

shares each. Many of these have expressed their reliance upon

the terms of the prospectus and other writings relating to the

STOCK, such as Standard & Poor’s, to mean that they could

enjoy ownership of the STOCK until August 1, 1980. Their

belief rested on a straightforward, common sense reading of the

redemption terms, as we have shown in Part 2.1 above. This is

precisely what was called for in Standard Oil of California v.

Perkins, 347 F.2d 379, 383 (9th Cir. 1965), deciaring that an

a

adhesion contract should be construed in accordance with its

understanding by the “layman unversed in the law.”

In Gerstle v. Gamble-Skogmo, Inc., 298 F.Supp. 66, 95 (E.D.

N.Y. 1969), affirmed (except as to computation of interest), 478

F.2d 1281 (2nd Cir. 1973) . . . Judge Bartels declared:

“Under the anti-fraud provisions of the Federal Securities

Acts, stockholders must be fully and completely informed.

Under these provisions there is no room for technical ex-

planations and tight-lipped announcements, and all doubt

arising from ambiguous statements must be resolved in

favor of the stockholders.”

His statement applies adhesion principles to securities law dis-

closure documents (proxy statements) much like the prospectus

we have here.

Also supporting the adhesion doctrine in application to pub-

licly held securities is Van Gemert v. Boeing Co., 520 F.2d

1373, 1383 (2d Cir. 1975), on damages 553 F.2d 812 (2d

Cir. 1977), on counsel fees 573 F.2d 733 (2d Cir. 1978), 590

F.2d 433 (2d Cir. en banc 1978) cert. granted May 14, 1979

(Dkt. 78-1327). The first opinion held, apparently as a matter

of state law, that the notice given for redemption of debentures

was “simply insufficient to give fair and reasonable notice” even

though “it may have conformed to the requirements of the In-

denture.”

There should be no room in this case for technical explana-

tions and tight-lipped announcements; all doubts arising from

ambiguous statements should be resolved in favor of the stock-

holders.

The circumstances that called for strict interpretation against

EDISON are highlighted in the Trial Court’s final words:

—

“Although I believe Edison could have avoided this en-

tire matter by making its right express, I cannot say that

Edison’s drafting, which stated expressly the methods by

which redemption was prohibited and impliedly reserved

to itself all other methods, violated the Federal Securities

Laws or violated plaintiffs’ vested contract rights. The de-

cision here has not been quick nor easy. Drafting could

have alleviated not only the time and effort spent here but

the unrewarded expectations of plaintiffs.” (App. p. A-32,

infra)

The Court below found that EDISON could have avoided

the entire matter by making its right express. This is true. EDI-

SON knew on June 24, 1970 (when the STOCK was issued) that

EDISON had the intent to redeem this STOCK when market

conditions made it feasible to do so and it was advantageous

to common stockholders, and interpreted the redemption terms

as giving it the right to do so. This was unknown to the in-

vestors and it was material information which, if known to the

investors, would have led them to invest their funds elsewhere.

3. Edison Breached Its Contract With the New York Stock Ex-

change Which Was for the Benefit of the Holders of the

Stock.

The STOCK was listed on the New York Stock Exchange

(NYSE) and EDISON, like all other companies whose securities

are listed on the NYSE, had a listing agreement with the NY

SE (Tr. 416). Although notified by the Plaintiff to produce its

listing agreement, EDISON failed to do so, but stipulated in

open Court that the redemption provisions of EDISON’s listing

agreement were the same as quoted in Van Gemert v. Boeing

Co., 520 F.2d 1373, 1376 (2d Cir. 1975) (Van Gemert I),

on damages, 553 F.2d 812 (2d Cir. 1977), on counsel fees,

573 F.2d 733 (2d Cir. 1978), 590 F.2d 433 (2d Cir. en banc

satan MM es

1978), cert. granted May 14, 1979 (Dkt. 78-1327). The list-

ing agreement in Van Gemert I reads in relevant part:

“The Corporation will publish immediately to the holders

of any of its securities listed on the Exchange any action

taken by the Corporation with respect to * * * any rights

or benefits pertaining to the ownership of its securities

***” (520 F.2d 1376).

“Section Al0 of the NYSE ‘Company Manual’ specifically de-

fines what is meant by publicity in the Listing Agreement:

‘Publicity: The term “publicity” as used * * * in the

listing agreement in respect of a redemption action, refers

to a general news release, and not to the formal notice of

advertisement of redemption sometimes required by provi-

sions of an indenture or charter.

‘Such news release shall be made as soon as possible

after corporate action which will lead to, or which looks

toward, redemption is taken * * * and shall be made by

the fastest available means, i.e., telephone, telegraph or

hand-delivery.

‘To insure coverage which will adequately inform the

public, the news should be released to at least one or more

newspapers of general circulation in New York City, which

regularly publish financial news, or to one or more of the

national news-wire services (Associated Press, United

Press International), in addition to such other release as

the company may elect to make.’” (520 F.2d 1376-1377.)

(Emphasis supplied. )

Under Van Gemert I, holders of redeemable securities are

third party beneficiaries of the listing contract with the NYSE;

Defendant’s liability arose out of a failure to provide fair and

reasonable notice of redemption. The redemption notice re-

quired in the listing agreement is obviously for the benefit of

the holders of the STOCK and potential holders . . . buyers

—

in the open market after the happening of the event which re-

quires the notice.

The District Court, without reaching related issues, found

adequate release of the redempiion plans to satisfy the NYSE

requirements (/.pp. p. A-24, infra). The release was by (1) a

proxy statement dated February 25, 1971 for an annual meet-

ing to be held on April 2, 1971, stating that new preference or

common stock may be sold to retire all or part of the STOCK

although the company has no definitive plans (Def. Ex. 6), and

(2) a report of annual meeting held on April 2, 1971, stating

“In the future, we expect to take advantage of changes in the

money market as they occur * * *” and “We were disappointed

in the 9.44% dividend rate on the prior preferred stock we

sold last August, but we expect to refund it when market con-

ditions make it feasible to do so.” (Pl. Ex. 129, Def. Ex. 7).

EDISON’s Vice Chairman Corey, who was chief financial

officer of EDISON at all times relevant to the issue, claims that

EDISON intended to tell of these plans to the investment com-

munity on April 2, 1971 (Tr. 480), but concedes that EDI-

SON’s efforts to tell the investment community about its inten-

tion to redeem the STOCK when market conditions were

favorable were not as successful as EDISON might have hoped

(Tr. 477). The following is the significant sequence in his testi-

mony appearing on Tr. 481:

Q. Well, it says here, “To insure coverage which will ade-

quately inform the public, the news should be released to

at least one or more newspapers of general circulation in

New York City, which regularly publish its financial news.”

You didn’t do that, did you?

A. We didn’t do it because——

Q. You didn’t do it, did you?

A. That’s correct.

_— oo

Although EDISON was called upon to produce a record of

its publication of action taken at the stockholders meeting on

April 2, 1971, this was not produced (Tr. 765). It did produce

a witness who testified to mailing a proxy statement and report

of the annual meeting to 190,000 shareholders, to 1,134 ana-

lysts and brokers and to 260 newspapers including the Wall

Street Journal, New York Times and Associated Wire Press.

This information relating to redemption “when market con-

ditions made it feasible to do so” was buried within the proxy

statement and within the report of annua! meeting so no publi-

cation was made for the benefit of the investing public. In

the proxy statement, the information occupies five lines on

page 6 of a 28-page document (Def. Ex. 6). The reference

to the annual meeting on April 2, 1971 is contained in three

lines on page 5 of a 15-page summary of the meeting (Def.

Ex. 7). Such buried facts are not adequate disclosure. Kohn

v. American Metal Climax, Inc., 322 F.Supp. 1331, 1362

(E.D. Pa. 1971), affirmed on this point, 458 F.2d 255, 265

(3rd Cir. 1972), cert. denied 409 U.S. 874 (1972); Gould v.

American Hawaiian Steamship Co., 331 F.Supp. 981, 995-96

(D. Del. 1971), vacated on other grounds 535 F.2d 761, 773-

74 (3d Cir. 1976); Robinson v. Penn Central Co., 336 F.Supp.

655, 657 (E.D. Pa. 1971). We submit that this is not the

publicity required by the listing agreement of the NYSE. What

financial reporter or newspaper editor is going to wade through

all these pages in hopes of finding something to print? The

material was not printed. No wonder some people paid $119

per share in the market a few days before the redemption was

finally announced as required by the Rules. The law and the

NYSE require a greater and much more specific notice than

EDISON gave.

There is ample proof that EDISON failed to inform the mar-

ket. The market wholly failed to react; see Part 1.2, pp. 22-23

above. Stock broker Schoettler, who was recommending . . . and

whose customers were buying . . . the STOCK in the secondary

— a

market, believed that it would not be possible for EDISON to

redeem the STOCK before 1980 (Tr. 244-247). So did the

investors who bought the STOCK in the secondary market and

wrote unhappily to EDISON (PI. Ex. 92-121). Plaintiffs’ Ex-

hibit 102 (Rubach: purchased in good faith at $117 in March

1971); Plaintiffs’ Exhibit 112 (Pizza Food Products: 3,000

shares at prices from $119 to $120; our investment was made

at a substantial premium over par only after a careful review

of the prospectus); Plaintiffs’ Exhibit 115 (Hendricks: 23 shares

at $117.50 on August 26, 1971 and 6 shares at $120.75 on

September 15, 1971; Standard & Poor’s showed redemption

restricted to 8-1-80); Plaintiffs’ Exhibit 118 (Brusenbach: senior

citizens trying to better our income by buying 200 shares at

$119.50 on November 12, 1971; “we were not given to under-

stand that you could redeem at your will”); Plaintiffs’ Exhibit

131 (Salomon Bros. price list for marketable securities showing

the STOCK NR80, meaning non-redeemable before 1980).

EDISON’s replies to these shareholders conceded that it had

not adequately informed the market. Its Corporate Secretary

Kavanagh wrote Lloyd Hendricks on Feb. 25, 1972 (Pl. Ex.

115) saying EDISON had tried to disclose, but admitting: “How-

ever, it is plain that much of the investment community ap-

parently was not already alerted to this possibility.” On Feb.

24 he wrote another shareholder (PI. Ex. 101): “Evidently

our warnings about the redemption were widely disregarded in

the investment community, because the price of the Stock instead

of staying near the redemption price of $110 rose with interest

rates” (emphasis supplied).

When EDISON did finally comply with the NYSE publication

requirements on Jan. 5, 1972, the market for the STOCK

dropped more than $8 a share, to the redemption price ($110)

plus accrued dividends. Vice Chairman Corey said this was

a normal reaction to a pinpointed announcement of redemption

(Tr. 414). The Trial Court agreed that it was a normal re-

action (App. p. A-11, infra).

— wn

Had EDISON complied with the NYSE requirements in Apr.

1971 the market would have topped out around $110. Instead,

we have a class of buyers of at least 147,300 shares after Apr. 2,

1971 at prices up to $10 above the redemption price (average

$7.18 above the redemption price) who suffered an out of pocket

loss of more than $1 million. These person are the third party

beneficiaries of the NYSE publication requirements in the listing

agreement and were grievously injured by EDISON’s breach of

the agreement.

4. EDISON Violated the Fraud Provisions of the Federal Se-

curities Laws When It Redeemed the 9.44% Stock.

The redemption before this Court was a purchase and a sale.

In a redemption, a shareholder gives up his shares and receives

cash. Thus he makes a “disposition of a security . . . for value,”

within the meaning of “sale” in 1933 Act § 2(3), 15 U.S.C.A.

§ 77b(3). Correspondingly, the redemption is a “purchase”

by the redeeming company. Drachman v. Harvey, 453 F.2d 722,

737 (2d Cir. in banc 1972).

It is well settled that a scheme to defraud in connection with a

redemption is a violation of the securities laws (Drachman v.

Harvey, 453 F.2d 722, 736-38 (2d Cir. in banc 1972); Levine

v. Seilon, 439 F.2d 328, 332 (2d Cir. 1971); Speed v. Trans-

america Corp., 99 F.Supp. 808, 843-49 (D. Del. 1951), 135

F.Supp. 176 (D. Del. 1955), affirmed 235 F.2d 369 (3d Cir.

1956); see Van Gemert v. Boeing, 520 F.2d 1373 (2d Cir.

1975), on damages, 553 F.2d 812 (2d Cir. 1977).), on coun-

sel fees 573 F.2d 733 (2d Cir. 1978), 590 F.2d 433 (2d Cir.

en banc 1978), cert. granted May 14, 1979 (Dkt. 78-1327).

The redemption here was more than reckless; it was inten-

tional. It was a conscious deliberate act taken by EDISON with

full corporate formality to obtain benefits including cash savings

by termination of the high dividends on the 9.44% STOCK. Vice

—

Chairman Corey and Chairman Ward declared the redemption

is being made to increase cash flow (Pl. Ex. 92 and 94, re-

spectively) and at this time EDISON knew that the investment

community was not alerted to the possibility of redemption (Tr.

438) and that its communication efforts were not as successful

as it “might have hoped” (Tr. 479).

The only possible conclusion is that the market did not under-

stand the redemption terms as EDISON did and that EDISON

was brazenly indifferent to the plight of investors like Mr. and

Mrs. Frank Brusenbach who bought 200 shares of the STOCK

on November 12, 1971 at $119.50 per share and would sustain

an out-of-pocket loss of $1,900 by the time the redemption was

completed three months later (Pl. Ex. 118). This loss was,

to paraphrase the Court, below, “the market’s normal reaction to

EDISON’s plans to redeem the STOCK.” (App. p. A-11, infra)

EDISON was in direct conflict of interest with the holders of the

STOCK since they would lose and it would gain by the redemp-

tion. EDISON went relentlessly ahead and destroyed more than

$8 Million of market value of the STOCK. EDISON brought this

loss upon the investors at a time it had forecast more than $1.5

Billion of outside financing and anticipated financing at a net

interest cost of less than 9.44%. This redemption was in an-

ticipation of lower cost debt financing, and in violation of the

redemption language. The redemption was in utter disregard of

the rights of the holders of the STOCK. The redemption was

carried out after EDISON received numerous protests and com-

plaints that it had no right to redeem. Plaintiffs’ Exhibit 11, the

prospectus dated February 22, 1972 for units of common stock

with warrants, sets forth on page 6 that EDISON, prior to the

redemption, acknowledges receipt of communications from

shareholders protesting redemption and claiming the prospectus

did not clearly indicate there could be a redemption prior to

gust 1, 1980 and claiming that EDISON indicated it could

ot redeem because it would continue to use debt as a part of a

nl nite

continuing program to finance construction which might have a

lower cost than the 9.44% dividend.

It would be hard to find a better description of EDISON’s

redemption than the language the Seventh Circuit has twice

used recently to describe sufficient scienter for a 10b-5 violation:

“Blinded by a conflict of interest, (Defendant) wantonly ig-

nore(d) evidence of the unfairness of the securities transac-

tion * * *” Bailey v. Meister Brau, Inc., 535 F.2d 982, 993

(7th Cir. 1976); Wright v. Heizer Corp., 560 F.2d 236 (7th

Cir. 1977) cert. denied 434 U.S. 1066 (1978).

CONCLUSION

For the reasons stated, this Petition for Writ of Certiorari

should be granted.

Respectfully submitted,

FREDERICK H. STONE

Franklin Square

Springfield, Illinois 62713

GEORGE B. GILLESPIE

GILLESPIE, CADIGAN & GILLESPIE

217 South Seventh Street

Springfield, Illinois 62701

Attorneys for Petitioners

Of Counsel:

ALAN R. BROMBERG

3315 Daniels

Dallas, Texas 75275

APPENDIX.

Mit 6 cate m~

— *

APPENDIX A

Opinion of the Court of Appeals

In the United States Court of Appeals

for the Seventh Circuit

No. 78-1896

The Franklin Life Insurance Company, et al.,

Plaintiffs-Appellants,

v.

Commonwealth Edison Company,

Defendant-Appellee.

Appeal from the United States District Court for the

Southern District of Illinois, Southern Division.

No. S-Civ-72-37—J. Waldo Ackerman, Judge.

Argued February 21, 1979—Decided May 22, 1979,

Before PELL and BAUER, Circuit Judges, and NOLAND, *

PER CURIAM. This action arose out of the issuance and

subsequent redemption of one million shares of 9.44% Cumu-

lative Prior Preferred Stock at a par value of $100 per share

by the defendant. The plaintiffs alleged violations of §§ 11 and

17 of the Securities Act of 1933, 15 U.S.C. §§ 77k and 77q, and

§ 10(b) of the Securities Act of 1934, 15 U.S.C. § 78j(b) and

* District Judge James E. Noland of the Southern District of

Indiana is sitting by designation.

District Judge.

— "on

Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder.

They also alleged a breach of contract claim based on the re-

demption terms in the prospectus and in the defendant’s Articles

of Incorporation, and a third party beneficiary claim based on

the defendant's alleged violation of its listing agreement with the

New York Stock Exchange.

After trial, the district court entered judgment for the de-

fendant on all counts and issued a thorough and well-reasoned

memorandum order addressing each issue. 451 F.Supp. 602

(S.D. Ill. 1978). The issues on appeal are virtually identical

to those before the district court. Because we are of the opinion

that the district court reached the correct result for the proper

reasons, we adopt as our own that court’s opinion except for

the last paragraph on page 615 and the first paragraph on page

616. These two paragraphs are not essential to the result, and

accordingly we do not deem it appropriate to reach the issue

there addressed.

The judgment of the district court is Affirmed.

Se | ee

an are

— ne

APPENDIX B

Judgment of the Court of Appeals

Per Curiam Opinion

United States Court of Appeals

for the Seventh Circuit

Chicago, Illinois 60604

May 22, 1979

Before

Hon. Wilbur F. Pell, Jr., Circuit Judge

Hon. William J. Bauer, Circuit Judge

Hon. James E. Noland, District Judge*

®,

Franklin Life Insurance Company, a,

Corporation, Individually and Rep-| Appeal from the

resentatively on Behalf of All Hold- United States Dis-

ers of the 9.44% Cumulative Prior trict Court for the

Preferred Stock of Commonwealth Southern District of

Edison Company, a Corporation, Illinois, Springfield

Plaintiffs-Appellants, Division

VS. No. S-Civ-72-37

Commonwealth Edison Company, a| J. Waldo Ackerman,

Corporation, Judge

Defendant-Appellee. |

This cause came on to be heard on the transcript of the record

from the United States District Court for the Southern District

of Illinois, Springfield Division, and was argued by counsel.

* Honorable James E. Noland, Judge, United States District Court

for the Southern District of Indiana, sitting by designation.

No. 78-1896

om

On consideration whereof, it is ordered and adjudged by this

court that the judgment of the said District Court in this cause

appealed from be, and the same is hereby, Affirmed, with costs,

in accordance with the opinion of this court filed this date.

MoM). lata ee olan

Seid Mitt italy ett” "2 inline tt on oe

hae nai anh ABR AT N a et b

ee ee ee eT ee

—_

APPENDIX C

Order on Petition for Rehearing

United States Court of Appeals

For the Seventh Circuit

Chicago, Illinois 60604

June 27, 1979

Before

Hon. Wilbur F. Pell, Jr., Circuit Judge

Hon. William J. Bauer, Circuit Judge

Hon. James E. Noland, Circuit Judge*

The Franklin Life Insurance a | Appeal from the

et al., United States Dis-

ae trict Court for the

. [llinois, Southern Di-

No. 78-1896 vs.

vision.

No. S-Civ-72-37

J. Waldo Ackerman,

Defendant-Appellee. Judge

Commonwealth Edison Company,

On consideration of the petition for rehearing and suggestion

for rehearing en banc filed in the above-entitled cause by plain-

tiffs-appellants, The Franklin Life Insurance Company, et al.,

no judge in active service has requested a vote thereon** and

all of the judges on the original panel have voted to deny a re-

hearing. Accordingly,

IT IS ORDERED that the aforesaid petition for rehearing be,

and the same is hereby, DENIED.

* The Honorable James E. Noland, District Judge for the Southern

District of Indiana, Indianapolis Division, sitting by designation.

** Judges Tone and Wood disqualified themselves from considera-

tion of the petition for rehearing en banc filed in the above case.

=

APPENDIX D

Memorandum Order of the District Court

This action arises out of the issuance and subsequent redemp-

tion of one million shares of 9.44% Cumulative Prior Preferred

Stock at a par value of $100 per share, by defendant Common-

wealth Edison Company. Trial on the issue of liability has

been had before the Court sitting without a jury and the points

presented have been ably briefed and argued by the parties.

This Memorandum Order shall incorporate within its text the

Court's findings of fact and conclusions of law, pursuant to

F.R.Civ.P. 52(a).

Plaintiff, Franklin Life Insurance Company, filed this action

individually and as representative of the class of persons holding

the stock on or after January 4, 1972. Subsequently, other class

members including the Teacher Retirement System of Texas,

were either granted leave to intervene or entered their appear-

ance in this action through various counsel.

The action was certified as a class action under F.R.Civ.P.

23(b)(3). The class consisted of 5,828 shareholders of the

Edison Stock as of January 4, 1972, and thereafter. Pursuant

to the notice required, 1,317 shareholders filed a written election

to be excluded from tie class leaving 4,511 members of the

plaintiff class. The Court’s certifying order, consistent with

F.R.Civ.P 23(c)(1), was conditional, thus allowing the class

to be modified or altered prior to a decision on the merits.

The claims of plaintiffs can be basically divided into two

categories, those based on alleged violations of the Federal

Securities Acts and those based on breach of contract theories.

The real crux of the matter is whether the redemption provisions

contained in the prospectus and the actions taken by defendant

thereunder, can be said to have either breached defendant’s con-

9 Nl i hs hike A AOA SRE i AEE AA 0 be Iw ae PL WE

ey, oe

tractual obligations or materially misled plaintiffs in violation

of the Federal Securities Laws.

Plaintiffs, on the securities claims, allege violations of §§ 11

and 17 of the Securities Act of 1933, 15 U.S.C. § 77k and 15

U.S.C. § 77q respectively, as well as Section 10b of the Securi-

ties Exchange Act of 1934, 15 U.S.C. § 78j(b) and Rule 10b-5,

17 CFR § 240.10b-5, promulgated thereunder. On the contract

claims, plaintiffs assert first that defendant redeemed in viola-

tion of the redemption terms as set out in the prospectus and in

Edison’s Articles of Incorporation and since those terms con-

stitute an agreement between Edison and each of its share-

holders, Edison must respond in damages for breach of contract.

Further, plaintiffs claim that defendant failed to sufficiently

publicize actions taken which looked toward the redemption

of the Stock in violation of its listing agreement with the New

York Stock Exchange, which plaintiffs assert, gives rise to a

third party beneficiary action on that contract.

While each of these claims will be examined in more detail,

for the reasons stated below and on the evidence presented, I

find judgment must be for defendant on all counts.

I

In general, the facts surrounding this litigation are not in

dispute. On June 24, 1970, defendant sold through its under-

writers, one million shares of its 9.44% Cumulative Prior Pre-

ferred STOCK (hereinafter STOCK) at the offering price of

$100 per share. Plaintiff, Franklin Life Insurance Company

(hereinafter Franklin), purchased 25,000 shares of the STOCK

at the asking price on or about June 24, 1970. Intervenors, the

Teachers Retirement System of Texas (hereinafter Texas Teach-

ers), purchased 30,000 shares at the asking price and took de-

livery, under a delayed delivery agreement on May 4, 1971.

Both Franklin and Texas Teachers examined the prospectus

aS

issued by defendant in conjunction with its stock issue and

relied on that prospectus when purchasing the STOCK.

At the time the STOCK was issued, investment funds were

in short supply and as a result preferred stock issues bore an

uncharacteristically high rate of return. Because of this high

rate of return and because of the STOCK’s redemption provi-

sions, both Franklin and Texas Teachers purchased the STOCK

as a long-term investment.

Although defendant preferred to issue the STOCK with a

9.25% dividend rate and a five year redemption restriction

period, defendant was convinced through negotiations with its

underwriters, primarily the First Boston Corporation, that a

dividend rate of 9.44% and a ten year redemption restriction

period were required for a successful stock issue. These terms

were incorporated in the prospectus issued in connection with

the sale of the STOCK and in EDISON’S Articles of Incorpora-

tion.

The prospectus provided on page 1 that the STOCK was:

[nJot redeemable, directly or indirectly, prior to August

1, 1980, through certain refunding operations (See page 2).

On page 2 of the prospectus, the text of the redemption

provision provided:

[p]rior to August 1, 1980, none of the shares of the 9.44%

Prior Preferred STOCK may be redeemed through re-

funding, directly or indirectly, by or in anticipation of the

incurring of any debt or the issuance of any shares of the

Prior Preferred STOCK or any other stock ranking

prior to or on a parity with the Prior Preferred STOCK,

if such debt has an interest cost to the Company (as de-

fined), or such shares have a dividend cost to the Com-

pany (as defined), less than the dividend cost to the

br ee

asa «20

BE Be ee. aes Oe lathe BO

Ft tg i ek ANT Nines STE Da PR Mh okie Oy itd am pe

a Soo

Company of the 9.44% Prior Preferred Stock. Subject

to the foregoing, the 9.44% Prior Preferred STOCK will

be redeemable at the option of the Company as a whole

at any time or in part from time to time at the following

per share redemption prices: $110 if redeemed before Au-

gust 1, 1980; $107 if redeemed on or after August 1,

1980, but before August 1, 1983; $104 if redeemed on

or after August 1, 1983, but before August 1, 1986; and

$101 if redeemed on or after August 1, 1986; in each

case plus accrued and unpaid dividends, if any. (Empha-

sis added.)

The prospectus also contained a section entitled “Purpose

of Issue and Construction Program” on pages 4 and 5. That

section stated that the net proceeds from the sale of the STOCK

would be added to working capital for application in part toward

repayment of short-term commercial paper and primarily for

interim financing of the construction program. This section of

the prospectus then described the construction program and

stated that the program for the next five year period, 1970-74,

“as now forecast, calls for electric plant expenditures of ap-

proximately $2,250,000,000.” Of that amount, it was estimated

that $1,150,000,000 would have to be raised through the sale

of additional securities of the company.

Consistent with this construction forecast, EDISON’S long

term debt increased from $1,849 billion at the end of 1971 to

an amount in excess of $3 billion at the time of trial. Each

issue of long term debt made by EDISON, subsequent to the

year 1971, was at an interest cost to EDISON of less than

9.44%. During 1972, EDISON also incurred debt through the

issuance of short-term promissory notes. EDISON’S short-term

debt on January 1, 1972, was $140 million, while at the end of

1972, it was $258 million. All the short-term commercial paper

was issued at an interest rate of less than 9.44%.

— A-10 —

The mails and instrumentalities of interstate commerce were

used in the sale of the STOCK and the STOCK was listed and

traded on the New York, Midwest and Pacific Stock Exchanges

after August 13, 1970, and until the redemption of the STOCK.

At the time the STOCK was issued, defendant believed that

in accordance with the redemption terms, it could redeem the

STOCK from the proceeds of common stock or other junior

security offerings without regard to its borrowing activities.

On February 2, 1971, EDISON issued its proxy statement

for the 1971 annual meeting. The shareholders at that annual

meeting were requested to vote on two proposals pertinent here.

The first was an amendment to EDISON’S Articles of Incorpora-

tion increasing the number of authorized shares of common

stock from 60 million to 75 million shares, and the second

sought to authorize the creation of a new class of preferred

stock. At page 6 of the proxy statement defendant stated:

Also, it is anticipated that the new Preference Stock or

additional Common Stock, or shares of both such classes,

may in the future be sold to redeem or otherwise used to

retire all or part of the 9.44% Series of Prior Preferred

Stock. However, the Company has no definitive plans at

the date of this proxy statement for issuance of additional

equity securities.

At EDISON’S annual meeting on April 2, 1971, defendant’s

Vice-Chairman Gordon Corey was quoted in the report of the

annual meeting as saying:

We were disappointed in the 9.44% dividend rate on the

prior preferred stock we sold last August, but we expect

to refund it when market conditions make it feasible to

do so.

The report of the annual meeting also contained a statement of

defendant’s Chairman J. Harris Ward in response to a question

ee ee ee eee ae

— A-11l —

from a stockholder, that EDISON did not intend to issue com-

mon stock in the near future.

Throughout 1971 and until January 5, 1972, when the an-

nouncement of EDISON’s intent to redeem the stock ap-

peared in the Wall Street Journal, the STOCK was traded on

the exchanges at prices continually above the $110 redemption

price. EDISON monitored the trading of the STOCK on the

exchanges and was aware of this fact. On January 4, 1972, the

STOCK was trading at $119.6875 per share. On January 5,

1972, after the announcement had appeared in the Wall Street

Journal, the price of the STOCK fell to $111.375, a value ap-

proximating the $110 redemption price plus accrued dividends.

Those holding the STOCK on January 4, 1972, suffered a loss

of $8.3125 per share in the course of the market’s normal reac-

tion to EDISON’s plans to redeem the STOCK.

On February 2, 1972, EDISON, pursuant to the terms of a

prospectus, offered common stock and warrants to the common

stock holders of EDISON. That offer was fully subscribed.

EDISON segregated the proceeds of the common stock and

warrants offering and redeemed the STOCK out of those pro-

ceeds on or about March 20, 1972, at the redemption price of

$110 per share plus accrued interest.

II

Plaintiffs assert that both the original sale of the STOCK

and its subsequent redemption violated the cited securities laws.

At the heart of plaintiffs’ various claims is the assertion that the

prospectus when read as a whole, and particularly the redemp-

tion provision, when read in conjunction with the construction

forecast, led plaintiffs to believe that the STOCK could not be

redeemed for ten years, that is, prior to August 1, 1980. The

key to this interpretation of the prospectus, is the language in

— A-12 —

the redemption provisions which stated that prior to August 1,

1980, none of the shares of the STOCK might be redeemed

“through refunding, directly or indirectly, by or in anticipation

of the incurring of any debt . . .”

The bulk of plaintiffs’ arguments on the securities law counts

have been concerned with the alleged violation of Rule 10b-5.

Since the elements of a claim under both §§ 11 and 17 of the

1933 Act have been interpreted to be either more restrictive

or coterminous with the elements required under Rule 10b-5,!

this opinion will be limited to the 10b-5 claim and the § 11 and

§ 17 claims governed by the result under 10b-5.

Rule 10b-5, promulgated by the Securities and Exchange

Commission under authority granted in 15 U.S.C. § 76j(),

provides:

1 Section 11 of the 1933 Act, 15 U.S.C. § 77k, provides civil lia-

bility for false registration statements. Section 11 however, has been

interpreted generally as being limited to damages for —— at

the original offering, thus excluding those members of the plaintiff

class who purchased in a secondary market. See, In Re Equity Fund-

ing Corp. of America Securities Litigation, 416 F.Supp. 161, 186-88

(C.D.Calif. 1976). Further, at least the Securities and Exchange

Commission believes that damages under Section 11 are not recover-

able where plaintiff disposed of the security at a price in excess of

the offering price. See, SEC Release No. 45, 11 Fed.Reg. 10947

(Sept. 22, 1933).

Section 17 of the 1933 Act, 15 U.S.C. § 77q, provides that it shall

be unlawful for any person in the offer or sale of any security to use

any of the means or instrumentalities of interstate commerce to con-

summate a fraudulent transaction. This section is often pled in con-

junction with claims under Rule 10b-5. Liability under Section 17

has been considered coterminous with liability under Rule 10b-5.

SEC v. Texas Gulf Sulphur, 401 F.2d 833 at 867 (2nd Cir. 1968)

(concurring opinion of Friendly, J.), and said to require a finding of

scienter as in 10b-5 cases. Sanders v. Nuveen & Co., Inc., 554 F.2d

790, 795-796. (7th Cir. 1977). Further, Section 17 contains no

express provision for any civil remedy and thus such a remedy must

be judicially implied. In Blue Chip Stamps v. Manor Drug Stores,

421 U.S. 723, 733 n. 6 (1975), the United States Supreme Court

reserved ruling on this precise issue, and I do not feel it necessary

to reach it here.

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— A-13 —

[i]t shall be unlawful for any person, directly or indirectly,

by the use of any means or instrumentality of interstate

commerce, or of the mails or of any facility of a national

securities exchange,

(a) To employ any device, scheme or artifice to defraud,

(b) To make any untrue statement of a material fact or to

omit to state a material fact necessary in order to make

the statements made, in the light of the circumstances

under which they were made, not misleading or

(c) To engage in any act, practice, or course of business

which operates or would operate as a fraud or deceit

upon any person,

in connection with the sale or purchase of any security.

20 CFR § 240.10b-5.

Plaintiffs make two basic claims under Rule 10b-5. First,

it is asserted that defendant omitted a material fact necessary in

order to make statements made, in light of the circumstances

under which they were made, not misleading. More specifically,

plaintiffs assert that defendant’s intent to redeem the stock with

an issue of common stock and warrants when market conditions

made it feasible to do so, and defendant's belief that the redemp-

tion provisions of the prospectus allowed such a redemption with-

out regard to defendant's borrowing transactions, were omissions

of material fact necessary, in order to make statements made,

in light of the circumstances under which they were made, not

misleading. Secondly, the plaintiffs urge that the redemption, in

light of these omissions, must have been a device, scheme, or

artifice to defraud.

A private plaintiff under Rule 10b-5, bears the burden of

proving by a preponderance of the evidence that he was a

purchaser or seller of the security;” that there was a misstatement,

2 Blue Chip Stamps et al. v. Manor Drugstores, 421 U.S. 723

(1975).

— se

nondisclosure, or scheme to defraud;* that the non-disclosure or

misstatement was of a material fact, i.e., a fact that a reasonable

investor might have considered important in making his in-

vestment decision;* that there was reliance, that is, a causal re-

lationship between the violation of the rule and the injury;5

and that defendant acted with a mental state embracing an in-

tent to deceive, manipulate, or defraud,® or alternatively that

defendant recklessly misstated or omitted a material fact.?

* Santa Fe Industries, Inc., et al. v. Green, et al., 430 U.S. 462

(1977).

+ Affiliated Ute Citizens v. U. S., 406 U.S. 128, 153-154 (1972).

5 This element is presumed where a material omission is found.

Affiliated Ute Citizens v. U. S., 406 U.S. 128, 153-154 (1972).

TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 447, n. 9

(1975).

6 Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, n. 12 (1976).

* Sunstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033 (7th

Cir. 1977). In this case the Seventh Circuit defined recklessness for

10b-5 purposes in the following manner:

reckless conduct may be defined as a highly unreasonable omis-

sion, involving not merely simple, or even inexcusable negli-

gence, 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 so obvious that the actor

must have been aware of it. 553 F.2d 1033, 1045.

Further, the Court of Appeals for the Seventh Circuit said of this

definition that “the — of misleading buyers must be actually

known or so obvious that any reasonable man would be legally

bound as knowing,” Sunstrand, supra, at 1045, and that “[t]his is an

objective test although the circumstances must be viewed in their

contemporaneous configuration rather than in the blazing light of

hindsight.” Sunstrand, supra, at 1045. n. 19.

Since Sunstrand, the Seventh Circuit has further defined the scope of

recklessness saying:

We believe “recklessness” in these circumstances comes closer to

being a lesser form of intent than merely a greater degree of

ordinary negligence. We perceive it would be not just a differ-

ence in degree, but also in kind. Sanders v. Nuveen & Co., Inc.,

554 F.2d 790, 793 (7th Cir. 1977).

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— A-15 —

In this case, under either of the transactions asserted as vio-

lations of Rule 10b-5, the issuance or redemption of the stock,

the class of plaintiffs here, by definition, purchased and sold

the stock. Further there was undisputed testimony that the

omissions charged were material, and that being the case, re-

liance is to be presumed.® The crucial questions are whether

there was a non-disclosure or a scheme to defraud and, if so,

did defendant act with a mental state appropriate for the im-

position of liability?

A. STOCK ISSUE

Looking first at the time the STOCK was issued, the “omis-

sions” charged have relevance only in light of plaintiffs’ inter-

pretation of the redemption provision. Plaintiffs interpreted that

portion of the redemption provision reading, “none of the shares

of the 9.44% Prior Preferred Stock may be redeemed through

refunding, directly or indirectly, by or in anticipation of the

incurring of any debt . . .” as prohibiting any refunding so long

as defendant was borrowing money at interest cost of less than

9.44%. Thus, from the time of issuance until August 1, 1980,

plaintiffs believed redemption could not be accomplished so

long as defendant was a “net borrower”, that is, borrowing more

money per year than it repayed. The construction forecast in the

prospectus, when read with plaintiffs’ interpretation of the re-

demption language, rendered the stock uncallable prior to

August 1, 1980. The testimony has established, that had plain-

tiffs known either of defendant’s intent to redeem when market

conditions made it feasible or of defendant’s belief that redemp-

tion could be accomplished out of the issuance of common stock

prior to August 1, 1980, without regard to the debt incurred,

they would not have purchased.

8 See note 5, supra.

— A-16—

In order to establish an omission under Rule 10b-5, plaintiffs

must show that defendant omitted a material fact necessary

in order to make the statements made, in the light of the circum-

stances under which they were made, not misleading. The ma-

terial facts assertedly omitted here are not objective. They are

subjective. What plaintiffs would require are statements of de-

fendant’s intent and of defendant's beliefs concerning the proper

interpretation of the redemption provision. Whether the security

laws are broad enough to require the disclosure of such facts is,

in my mind, open to serious question. Further, whether the

language of the prospectus adequately disclosed these facts is

another question on which I express no opinion.

Assuming, however, that the securities laws require this type

of disclosure and that the prospectus did not adequately disclose

these facts, the question remains whether the non-disclosure was

done intentionally or recklessly or as part of a scheme or artifice

to defraud.

An examination of the prospectus does not reveal any intent

to mislead nor does it reveal any recklessness. The prospectus

does not purport to link the construction forecast with the re-

demption terms. The summary of the redemption terms appear-

ing on page 1 purports to limit defendant’s right to redeem only

through “certain refunding operations.” The redemption pro-

vision, arguably, forebade refunding through the proceeds of a

stock issue, only if that stock ranked prior to or on a parity with

the stock here in question and at an effective cost to the company

of less than 9.44%.

There was no evidence that defendant was aware of any “net

borrower” theory. Nor was there any evidence that redemption

® The thing misrepresented or not disclosed must be material in-

formation, which perhaps includes something more than firm fact,

but does not include opinion or interpretation. Blomberg, Alan R..,

Securities Law, Vol. 3 p. 197 (1977).

eed ee es

— A-17 —

of a preferred stock issue through the proceeds of a common

stock issue had ever been thwarted by language similar to “di-

rectly, indirectly, by or in anticipation of any debt,”—when

coupled with increasing debt.

Defendant’s witness Edward Lebens, a former Vice-President

and Director of the underwriting First Boston Corporation, testi-

fied that the genesis of the “directly, indirectly, by or in antici-

pation of any debt” language grew out of a situation in the

1930’s and 40’s where corporations would issue bonds at a

given rate of interest and within a very short period of time,

refinance that issue with a subsequent issue at a lower rate.

The language, Mr. Lebens testified, was designed to prevent

this type of redemption, but not to prevent the redemption out

of an issue of common stock. Further, the various prospecti

concerning the issue of other utility preferred stock establish

conclusively that although the language in the prospectus here

at issue may be slightly different, it is not aberrational. The

fact that Edison used similar language in a 1957 preferred

stock issue which in turn, was redeemed in 1962, is entitled

to some weight even though the conditions of that redemption

varied greatly from those here under consideration.

Under these circumstances, the evidence fails to support a

finding that defendant either intentionally or recklessly, failed

to disclose a material fact necessary, to make the statements

made not misleading. The evidence fails to support a finding

of scienter. Therefore, there can be no securities law violation

surrounding the issuance of the stock and judgment must be for

defendant.

B. REDEMPTION

Edison’s redemption is asserted to give rise to liability under

Rule 10b-5 in two ways. It is argued first, as the capstone of

an Edison scheme to defraud purchasers of the Stock and second,

—

as a breach of the duty, under Rule 10b-5, to continually inform

the market of material information. Under both theories, the

gravaman of the complaint is defendant’s failure to reveal its

belief in its right to redeem out of common stock and its intent

to do so when market conditions made it feasible.

These omissions are subject to the same questions raised and

reserved in Part I.A. above. Because I held in that section of

the opinion, that no finding of scienter could be made, no

finding of a scheme to defraud existing from issuance through

redemption can be made.

However, another factor is added to that analysis in plaintiff's

argument here. That factor is the assertion that Edison, at

some point, through its monitoring of the market, must have

known that the market did not interpret the redemption provi-

sions as did defendant. The argument is premised on two

points. First, that the current market price is an accurate in-

dicator of the market’s knowledge about the stock, including its

redemption provisions, and secondly, that no reasonable investor

knowing Edison’s belief in its right to redeem and its intent to

do so when market conditions made it feasible, would purchase

at a price in excess of the redemption price.

It would appear to me, however, that there may be a number

of reasons for a reasonable investor purchasing at a cost in excess

of the redemption price knowing full well EDISON’s beliefs and

intent, e.g., the investor might believe EDISON incapable of is-

suing common stock. Be that as it may, if the premise is ac-

cepted, a solid argument for scienter can be constructed since

at some point, EDISON had to know that the market was

unaware of EDISON’s belief in its right to redeem and intent to

do so when feasible.

Once this knowledge was in EDISON’s hands, subsequent pur-

chasers of the STOCK could seek to establish liability based on

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— Al? —

reckless failure to disclose material information. Further, the

original purchasers could benefit from the argument that al-

though scienter was absent at the time of issue, in light of the

subsequently acquired knowledge, nondisclosure might indicate

development of a scheme to defraud.

The answer to both theories is the same. Although the orig-

inal prospectus may have failed to adequately disclose EDISON’s

belief and intentions, a question I expressly reserved earlier,

there are subsequent disclosures here, the February 25, 1971,

proxy statement and the statements made at the annual meeting

and contained in EDISON’s Report of Annual Meeting. If

those statements adequately disclose defendant’s beliefs and in-

tentions, there can be no recovery on either of these theories.'°

As Justice White said:

... the Court repeatedly has described the “fundamental

purpose” of the Act as implementing a “philosophy of full

disclosure”; once full and fair disclosure has occurred, the

fairness of the terms of the transaction is at most a

tangential concern of the statute."?

The pertinent portions of the proxy statement and the report

of the annual meeting have been quoted earlier. See, pp. 6-7,

supra. (App. p. A-10) The statements of EDISON in those docu-

ments clearly reveal EDISON’s belief in its right to redeem and

its intent to do so when market conditions made such a redemp-

10 Plaintiffs emphasize that the redemption was in reckless disre-

gard for the rights of its shareholders. The rights of the shareholders

under the redemption provision to me to be a question of

contract and will be discussed in Part III infra. ae this theory

does not appear to place the charged omissions and the necessary

mental state in the Bm time frame. Suffice to say, if there was ade-

quate disclosure of the omissions asserted, a 10b-5 action premised

on the redemption itself will not lie.

11 Santa Fe Industries, Inc., supra n. 3 at 477-78.

— A-20 —

tion feasible. The only question is the adequacy of the dis-

closure. !2

Defendant’s witness Jerry Quilty testified that all of defend-

ant’s 190,000 shareholders, including both individuals and in-

stitutions, received a copy of the February 25, 1971, proxy state-

ment. Mr. Quilty also testified that each shareholder and 1,134

analysts and brokers received copies of the report of the 1971

annual meeting. Further, Mr. Quilty testified that both the proxy

statement and the report of the annual meeting were circulated

to a media list containing 260 newspapers and other public in-

formation services including the Wall Street Journal, the New

York Times, and the Associated Press Wire Service.

Other testimony from plaintiffs’ own witnesses establishes that

defendant’s belief and intent were broadly disseminated prior to

redemption. Both Mr. Lobb and Mr. Pruitt of Texas Teachers

testified that Texas Teachers had information from the market

place and from the brokerage house of Merrill Lynch, Pearce,

Fenner & Smith, that defendant might redeem the stock. Mr.

Parker, of the Duff & Phelps firm, also testified that he had heard

information in the market place pertaining to the statement con-

tained in defendant's proxy statement and the report of its annual

meeting.

Under these circumstances the evidence establishes that there

was adequate disclosure of defendant’s belief that it could legally

redeem and of its intention to redeem when market conditions

made it feasible through the February 25 proxy statement and

the 1971 report of its annual meeting. Those disclosures thwart

any claims based on a breach on the continuing duty to dis-

close material information, and provide no evidentiary support

for the asserted scheme to defraud.

12 This question recurs in plaintiffs’ third party beneficiary theory

and is discussed again in Part III. A. infra.

Be Bin’ mee Te Re ee

— A-21 —

The evidence fails to support any finding of liability on any

of the claims asserted under Rule 10b-5. Therefore in accord

with the analysis above, judgment must be for defendant and

against plaintiffs on all the federal securities claims.

Il

Along with theories asserting securities law violations, plain-

tiffs have two pendant claims based on breach of contract. Plain-

tiffs’ first theory is that they are third party beneficiaries of a

contract, the New York Stock Exchange listing agreement,

between defendant and the New York Stock Exchange. Plain-

tiffs’ second theory is that the redemption provision constituted

a contract between EDISON and its stockholders and that the

redemption violated that contract since it was “. . . directly,

indirectly, by or in anticipation of debt.” Each of these theories

of liability will be discussed more fully below.

A. NYSE LISTING AGREEMENT

In order for a stock to be listed on the New York Stock

Exchange, the issuer must enter into a “listing agreement” with

the Exchange. Although the agreement in this instance has not

been produced, it must be assumed that such an agreement was

executed since it is undisputed that the STOCK was listed on

the New York Stock Exchange.

The listing agreement is said to be not only for the benefit

of the parties—EDISON and the Exchange—but also specifi-

cally for the benefit of the investing public. Plaintiffs claim

therefore that since the benefits accruing to the investing public

were specifically contemplated by the parties to the agreement,

damages may flow to plaintiffs as third party beneficiaries for

any breach of that agreement. The breach asserted is that the

publication surrounding the 1971 proxy statement and the 1971

annual meeting was insufficient under the listing agreement.

om iE ne

Although the evidence fails to support a finding of any “plan”

to redeem as of April 2, 1977—~as opposed to the clearly estab-

lished intent to redeem “when market conditions made it feas-

ible”—plaintiffs allege that the increase in the number of au-

thorized shares of common stock was corporate action which

“looked toward” redemption. The increase in the number of

authorized shares of common was proposed in the proxy state-

ment of February 25, 1971, and approved at the April 1971

annual meeting.

Plaintiffs argue that under Section A10 of the New York

Stock Exchange Company Manual,'* a general news release’

: Shall be made as soon as possible after corporate

action which will lead to, or which looks toward, redemp-

tion is taken. Van Gemert, supra n. 13 at 1376.

Thus, plaintiffs reason that the increase in the authorized shares

of common stock was a corporate action “looking toward” re-

demption and that defendant failed to issue a general news

release.

In Van Gemert, plaintiffs were a class of debenture holders

who held the right to convert the debentures to common stock

prior to redemption. Members of the class failed to convert

their debentures to common stock assertedly because of inade-

quate notice of the redemption.

a —_ be noted aS ae the NYSE Company Manual

nor the listing agreement which the Manual is purported to interpret

are before the Court. But by stipulation of counsel, the jer ne

provisions of both, as found in Van Gemert v. Boeing, 520 F.2d 1373

_ (2nd Cir. 1975) cert. den. 423 U.S. 947 (1975), on damages 553

F.2d 812 (2nd Cir. 1977), are applicable to the case at bar.

14 Defined as a release to:

One or more newspapers of general circulation in New York

City, which regularly publish financial news, or to one or more

of the national wires services (Associated Press, United Press

International), in addition to such other release as the com

may elect to make. Van Gemert, supra, n. 13, at 1376-1377.

Se ee See

— A-23 —

Plaintiffs here advance two theories which were also asserted

by the plaintiffs in Van Gemert. Plaintiffs assert that they were

third party beneficiaries under the NYSE listing agreement and

that the terms under which the defendants accomplished re-

demption constituted a contract of adhesion which should not

be enforced.'®

Although the author of the Van Gemert opinion, Circuit

Judge Oakes, indicated that he would base his finding of lia-

ibility on the third party beneficiary theory,'® the majority of

the panel found defendant's liability arose from a failure to

provide debenture holders with fair and reasonable notice of

redemption and failure to adequately apprise the debenture

holders of what notice of redemption they could expect.'7 The

majority found that the duty to adequately apprise the deben-

ture holders of the manner in which a notice of redemption

could be expected arose out of the “contract between Boeing

and the debenture holders, pursuant to which Boeing was ex-

ercising its right to redeem the debentures.”?*

While I, like Judge Oakes in Van Gemert, find the listing

agreement theory attractive, there are a number of hurdles which

plaintiffs fail to overcome.

In order to establish EDISON’s liability on this theory, I be-

lieve plaintiffs must establish that: (1) the listing agreement

vests third party beneficiary rights in plaintiffs; (2) that Sec-

tion A10 is incorporated into the listing agreement; (3) that

the “looking toward” language of Section A10 requires a gen-

eral press release in the case of the type of tentative corporate

action taken here; and (4) that such a release was not made.

15 This latter theory is discussed in more detail infra.

16 See, 520 F.2d 1373, 1382 n. 19.

Id. at 1383-1386.

15 Id. at 1383.

1

on fh ow

Although a number of the links in this chain are weak, I be-

lieve that the fourth link—the showing that such a release was

not made—is missing entirely.

The testimony of Mr. Quilty, discussed earlier,!® is uncon-

troverted and establishes that a general news release was made.

The fact that the release contained other corperate data and

was not shown to have actually been published would not appear

to constitute a breach of the requirements of Section A10.

PB. BREACH OF SHAREHOLDERS CONTRACT

The final question presented is the very heart of the litigation.

Plaintiffs argue that EDISON, in violation of its contract with

plaintiffs, “redeemed through refunding, directly or indirectly,

by or in anticipation of the incurring of any debt” at an interest

cost of less than 9.44%.

It is unquestioned that the redemption terms of preferred

stock issues create a contract between the corporation and its

stockholders. See, Tennant v. Epstein, 356 Ill. 26, 33 (1934);

Kern v. Chicago & Eastern RR Co., 6 Ill. App. 3d 247, 250

(1st Dist. 1972); and 11 Fletcher Cyc Corp. (per. ed.), ch. 58,

§§ 5295, 5309 (1971 revised volume). Further, there is no

dispute surrounding the relevant facts. EDISON redeemed the

STOCK directly out of an issue of common stock and warrants

at a time when its need for financing, to continue the construction

program, was apparent. It is undisputed that the needed funds

were available at an interest cost of less than 9.44%.

The question presented is purely one of contract construction.

Does the “directly or indirectly, by or in anticipation” language

permit redemption out of the proceeds of an issue of common

19 See, pages 17-18, supra. (App. p. A-20)

ane D4

— A-25 —

stock and warrants regardless of EDISON’s borrowing pro-

jections?

The first step in the construction of any contract is to examine

and interpret the language. The redemption provision is quoted

in full on pages 4-5, supra. \App. p. A-8) The key provision

provides that prior to August 1, 1980, none of '.e STOCK:

. may be redeemed through refunding, directly or in-

directly, by or in anticipation of the incurring of any debt

or the issuance of any shares of the Prior Preferred Stock or

any other stock ranking prior to or on a parity with the

Prior Preferred Stock, if such debt had an interest cost to

the Company (as defined) or such shares have a dividend

cost to the Company (as defined), less than the dividend

cost to the Company of the 9.44% Prior Preferred Stock.

Each of the parties has presented a number of principles of

contract construction urged as controlling under the circum-

stances. Each will be examined below. But it should be noted that

the general goal of the contract construction—determining the

intent of the parties and giving it effect—is difficult to achieve

here because the contract was not one formed through negotia-

tions between two parties. EDISON drafted the provisions and

offered the stock for sale to the general public. There was no

contact between the parties concerning the terms of the redemp-

tion provision, although there were negotiations between EDI-

SON and its principal underwriter, First Boston Corporation

concerning the redemption provisions.

In any event, the evidence shows that from the beginning,

EDISON believed that the redemption provisions gave it the

right to redeem out of the proceeds of an issue of common

stock at any time. On the other hand, the evidence also

establishes that a number of the members of the plaintiff class

including the class representatives, believed that EDISON had

— A-26 —

no right, under the redemption provision, to redeem in any

manner so long as EDISON could foresee that money would

have to be borrowed at an interest cost of less than 9.44% for

its construction program.

EDISON makes a number of agruments in support of its

position. First, that the clear meaning of the provision allows

the actions taken here. The argument is based on the use of

the word “refunding”. Since the redemption provision provides

that none of the stock:

. may be redeemed through refunding directly, indi-

rectly, by or in anticipation of any debt . . . (Emphasis

added.)

and since common stock is part of the permanent capital of

the corporation and cannot be refunded, refunding through an

issue of common stock is permissible. EDISON argues that

a redemption directly out of an issue of common stock can-

not be indirectly by or in anticipation of debt since the re-

funding operation necessarily must terminate with the issue of

common.

This argument does not take into account the broad reading

of “anticipation” argued for by plaintiffs. They read “anticipa-

tion” as an ordinary word used in its ordinary sense. There is

no technical use in the trade meaning for anticipation, they

assert. The generally accepted meaning of anticipate is the

equivalent of forecast or foresee. Thus plaintiffs argue that the

redemption terms forbid redemption even out of common stock,

at a time when EDISON forecast borrowing money at an inter-

est rate of less than 9.44%, the precise factual situation here.

Were it not for “refunding”, plaintiffs’ argument would be

persuasive. However, there appears to me to be a logical dis-

tinction between redemption in anticipation of debt and re-

demption through refunding in anticipation of debt.

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— A-27 —

The actions of EDISON as shown by the evidence, could be

characterized as redemption in anticipation of debt since it well

knew its financing needs and that in the current market those

needs could be met at a cost of less than 9.44%. If the re-

demption clause requires an examination of the entire borrow-

ing activities of EDISON then plaintiffs should prevail.

However, I believe that the clause forbidding redemption

through refunding by or in anticipation of debt, requires an

examination of only the source of the funds actually used to

achieve the redemption. Were the proceeds of the issue of com-

mon stock and warrants in anticipation of debt at an interest

cost of less than 9.44%? The answer must be no. Common

stock cannot be refunded.

The concepts are illusive but perhaps the interpretations of

plaintiffs and defendant can be contrasted vith a simple exam-

ple. Were a man to borrow $1,000 from the bank in order to

start a small business, the bank might well place a provision

in the loan agreement forbidding the borrower from repaying

the $1,000 from funds derived in any manner out of the funds

borrowed at a lower interest rate.

Plaintiffs would argue that this agreement would preclude

the borrower from taking on a partner for $1,000 and using

that $1,000 to repay the bank loan when the borrower knew that

within a short period of time the borrower and his new partner

were going to borrow $20,000 for expansion of the business.

EDISON on the other hand would contend that so long as the

$1,000 used to repay the bank was in no way derived from

funds borrowed at a lower interest rate the plans of the partner-

ship for expansion are irrelevant. The question would be whether

the agreement controlled the source of the funds used to repay

the loan or the borrowing activities of the borrower entirely.

Certainly the borrower in the example could repay out of the

proceeds of a sale of a % interest in the business and still be

planning to borrow $20,000 to buy himself a yacht.

— A-28 —

In each case the borrower anticipates borrowing funds. But

in neither cas¢ does he anticipate borrowing funds to replace

the capita! advanced by the bank. If he anticipates borrowing

to buy himself a yacht, clearly the $1,000 is in no way affected.

And likewise, although it can be argued that he would have been

wiser to save the $1,000 invested by his new partner and thus

borrow only $19,000 for business expansion, the $1,000 used

to repay the bank has no real connection with his expansion

plans. He did not agree to remain in debt to the bank as long as

he was going to be in debt to anyone. He merely promised to re-

pay the borrowed funds out of capital derived in a manner other

than through new debt.

The question in this case is the same. Does the redemption

provision control the source of the funds used to supply the $110

million necessary for redemption or does it forbid redemption

so long as it could be foreseen that funds would have to be

borrowed to complete EDISON’s construction plans? Unless the

provision seeks to control only the source of the repayment fund,

the word refunding has no meaning.

When the word refunding is given meaning, the question of

borrowing by or in anticipation of debt is narrowed from cor-

porate borrowings in general, to the funds and the methodology

used to replace the $100 million dollars raised by the preferred

stock issue. Thus, whether the corporation as a whole was “in

anticipation of debt” is not the issue. The question is whether

the redemption itself, was in anticipation of debt. Where did the

money used to redeem the preferred stock come from and was

that source in anticipation of debt?

This is the only construction which gives meaning to both

the words, “redeem” and “refunding”. Plaintiffs use redeem and

refund interchangeably. But there is a difference between redemp-

tion by or in anticipation of debt and “redeem through refunding

by or in anticipation of debt”.

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— A-29 —

This interpretation is bolstered by two other provisions of the

prospectus. On page 1 of the prospectus, it is provided that the

STOCK is not redeemable prior to August 1, 1980, directly or

indirectly “through certain refunding operations.” Further, in the

redemption clause itself, $110 ($10 premium over purchase

price) is set as the redemption price if redeemed prior to August

1, 1980.

These provisions can only be interpreted as showing that

EDISON considered redemption a real possibility. They fur-

ther show that the language is intended to restrict the scope of

the “refunding operations” and only by limiting refunding op-

erations, place limits on redemption. The method used to re-

deem cannot be in anticipation of debt but the corporation

itself may be, under the language. Use of the words “refund-

ing operation” points up the difference between “refund” and

“redeem”.

The interpretation plaintiffs seek would allow redemption

prior to 1980 only in two very unlikely circumstances: out of

funds with an interest cost in excess of 9.44% or out of any

fund so long as the construction plans were scrapped and no

funds were to be borrowed. Given economic reality, no cor-

poration is going to redeem out of higher cost debt. Neither

is it likely that a corporation, whose main enterprise is the

production of electric power, will cease proposed construction

and expansion. Given today’s ever increasing demand for elec-

trical power, ever greater construction and expansion can be

expected.

Thus, plaintiffs’ interpretation in effect would render the

stock uncallable prior to August 1, 1980. If this were EDI-

SON’s intent it could have been achieved with a great deal less

words. Further, it is not beyond the realm of speculation that

a stock issued as uncallable for ten years could have been sold

bearing a lesser rate of return than 9.44%.

— A-30 —

In the construction of a contract an interpretation which

gives reasonable meaning to all its terms is preferred to an in-

terpretation which leaves some terms to no effect. See, Thomas

Hoist Co. v. Newman Co., 365 Ill. 160, 166 (1937); Restate-

ment of Contracts, § 236(a); and Williston, Contracts § 619,

p. 731 (3rd Ed. 1971). The interpretation sought by plain-

tiffs would render meager meaning to the price for redemption

prior to August 1, 1980 and no meaning to the word “refund-

ing.” The objection to EDISON’s interpretation is that it does

not give “anticipation” the broadest possible meaning. Under

these circumstances, EDISON’s interpretation must prevail.

Having reached that conclusion the remaining discussion is

perhaps unwarranted but in view of the time and effort ex-

pended by the parties and their counsel and in view of the

length of the opinion at this point, I would feel remiss if some

mention of the other arguments were not made.

EDISON argued further, that in the event the redemption

terms were found ambiguous, trade usage should be used to

interpret those terms. In this regard, EDISON offered the

expert testimony of Mr. Edward Lebens of the First Boston

Corporation, Mr. Sanford Reis of Reis & Chandler, Inc., and

Mr. Fergus McDiarmid of Lincoln National Life Insurance

Company. Mr. Lebens, as discussed earlier, testified that the

language here in question grew out of investor responses to

corporate bond rollovers occurring in the 1930’s and 40’s. All

three of plaintiffs’ witnesses testified that the language here was

never intended to prevent redemption out of common stock and

that since common stock was the company’s permanent capi-

tal it was never issued in anticipation of any further financial

activity.

Although the veracity of these witnesses is undoubted, this

evidence is unpersuasive. The problem with the evidence is

determiuiing what “trade” is familiar with these terms and their

iidititie satis»

— A-31 —

history. None of the plaintiffs who testified, nor any of plaintiffs’

employees, were aware of this trade usage or the history sur-

rounding it. The credentials of many of plaintiffs’ witnesses are

unsurpassed. Apparently one must have been active in the bond

market of the 1930’s and 40’s to be aware of this trade usage.

Further, were the redemption provisions contained in a cor-

porate bond, the expert testimony would be more relevant and

more persuasive. But the issue here is preferred stock. The ex-

hibits establish that similar language is not uncommon in pre-

ferred stock issues. But the evidence fails to establish that the

language had a generally known or well established trade usage

among those commonly dealing with preferred stock issues.

Plaintiffs’ major argument on the contract issue is that the

redemption terms constitute a contract of adhesion and thus

any ambiguities must be construed against the drafter. It is gen-

erally stated that where there is a standardized contract made

between parties of disparate bargaining power, the unconscion-

able features of that contract are unenforceable as a manner of

policy. Van Gemert, supra. n. 13 at 1380. See also, Kessler,

Contracts of Adhesion—Some Thoughts About Freedom of

Contract, 43 Colum. L. Rev. 629 (1943).

Here, there are a number of factors which I believe make the

adhesion contract idea unworkable. Primarily, this is because the

provisions of the redemption terms as interpreted by EDISON,

are not unconscionable. The question here is not whether those

terms are unconscionable but which of two interpretations of the

language is to be given effect.

While the adhesion contract theory is inapplicable, I believe

its corollary—Contra Proferentum—could be appropriate for

application here. Contra Proferentum is a rule of contract inter-

pretation which provides that when the words of a contract have

been chosen by one party and another merely assents to those

— <p

words, that fact alone may tip the balance against the party

drafting the contract. As noted earlier, that fact situation is

present here.

EDISON makes the point, and I believe it well taken, that

the idea of construing a contract against the drafter is not a re-

sult oriented rule but rather a rule which provides an answer

when all other methods of construction and interpretation still

leave the contract ambiguous. Contra Proferentum is to be used

to ascertain meaning where ambiguities remain and not to

achieve a verdict for the nondrafter of the agreement. See, Hurd

v. Illinois Bell Telephone Co., 136 F.Supp. 125 (N.D.Ill. 1955),

affd 234 F.2d 942 (7th Cir. 1956); Bowler v. Metropolitan

Sanitary District of Greater Chicago, 117 Ill.App. 2d 237 (1st

Dist. 1969), and 3 Corbin on Contracts, § 559 (1964).

Here the rule of interpretation which requires all the terms

of the contract to be given meaning establishes the controlling

interpretation to be given the redemption terms. There remains

no ambiguity to be construed against the drafter.

Although I believe EDISON could have avoided this entire

matter by making its right express, I cannot say that EDISON’s

drafting, which stated expressly the methods by which redemp-

tion was prohibited and impliedly reserved to itself all other

methods, violated the Federal Securities Laws or violated plain-

tiffs’ vested contract rights. The decision here has not been

quick nor easy. Drafting could have alleviated not only the time

and effort spent here but the unrewarded expectations of plain-

tiffs.

Judgment for defendant on all Counts.

Enter this 19 day of May, 1978.

J. WALDO ACKERMAN

United States District Judge

oli a CS ee ES Pee ee

— A-33 —

APPENDIX E

Statutes and Rule

The pertinent portions of the Securities Act of 1933 are:

Section 11, 15 U.S.C. § 77k:

“(a) In case any part of the registration statement, when

such part became effective, contained an untrue statement

of a material fact or omitted to state a material fact required

to be stated therein or necessary to make the statements

therein not misleading, any person acquiring such security

(unless it is proved that at the time of such aquisition he

knew of such untruth or omission) may; either at law or in

equity, in any court of competent jurisdiction, sue— * * *”

Section 17, 15 U.S.C. § 77q:

“(a) It shall be unlawful for any person in the offer or sale

of any securities by the use of any means or instruments of

transportation or communication in interstate commerce or

by the use of the mails, directly or indirectly—

(1) to employ any device, scheme, or artifice to de-

fraud, or

(2) to obtain money or property by means of any

untrue statement of a material fact or any omission to

state a material fact necessary in order to make the

statements made, in the light of the circumstances

under which they were made, not misleading, or

(3) to engage in any transaction, practice, or course

of business which operates or would operate as a fraud

or deceit upon the purchaser. * * *”

The pertinent portions of the Securities Exchange Act of 1934

are:

my * von

Section 15 U.S.C., Section 78j(b):

“It shall be unlawful for any person, directly or indirectly,

by the use of any means or instrumentality of interstate

commerce or of the mails, or of any facility of any national

securities exchange— * * *

(b) To use or employ, in connection with the purchase or

sale of any security registered on a national securities ex-

change or any security not so registered, any manipulative

or deceptive device or contrivance in contravention of such

rules and regulations as the Commission may prescribe as

necessary Or appropriate in the public interest or for the

protection of investors.”

Rule 10b-5 of the Securities and Exchange Commission, 17

C.F.R., Section 240 10b5:

“It shall be unlawful for any person, directly or indirectly,

by the use of any means or instrumentality of interstate com-

merce, or of the mails or of any facility of any national se-

curities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to

omit to state a material fact necessary in order to make the

statements made, in the light of the circumstances under

which they were made, not misleading, or

(c) To engage in any act, practice, or course of business

which operates or would operate as a fraud or deceit upon

any person, in connection with the purchase or sale of any

security.”

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