The opinion of the court was delivered by: D. BROOKS SMITH
III. Discussion of the Complaint
A. Westinghouse Allegations
B. Secondary Defendant Allegations
A. Westinghouse's Alleged Financial Misrepresentations
B. Westinghouse's Alleged Misrepresentations Regarding the Adequacy of its Internal Controls
VI. Counts Two, Three, Four and Five
A. Westinghouse Defendants
A. Westinghouse Defendants
Westinghouse Credit Corporation (WCC) is a subsidiary of Westinghouse Financial Services, Inc. (WFSI), itself a wholly-owned subsidiary of Westinghouse Electric Corporation (Westinghouse). WCC was formed in 1954 to finance consumer sales of Westinghouse products; however, it eventually expanded into new credit markets, including industrial and commercial finance and sophisticated corporate lending. In the early 1980s, WCC hit its stride when it tapped into the booming commercial and residential real estate markets.
Such success, however, was short-lived. WCC's fortunes collapsed along with the real estate market in the late-1980s, and the price of Westinghouse stock tumbled during the class period from a high of $ 39.375/share to a low of $ 15.875/share. Consolidated Amended Class Action Complaint (Docket No. 84) PP 185, 186. Now, like so many lending institutions battered by the late-1980s real estate bust, see Michael Quint, Investors Challenging Banks on Bad Loans, N.Y. Times, January 28, 1991, at D1, Westinghouse, along with its outside accountant and investment bankers, is defending against shareholders who allege that the company made false and misleading statements regarding the health of its financial services units, thereby artificially inflating the price of Westinghouse stock and damaging plaintiffs who purchased that stock at what they claim to have been an artificially high price.
The Purchaser Class Action plaintiffs filed their action on February 28, 1991. Over the course of the next year, the parties skirmished over several discovery motions, until March 18, 1992, when Magistrate Judge Lancaster ordered Westinghouse to make available to plaintiffs, on a continuous basis from April 1, 1992 to April 29, 1992, at WCC's offices, documents relating to 536 accounts designated as "Assets Held for Sale or Restructuring" for inspection and copying. On June 15, 1992, after having reviewed some 3.5 million pages of active investment file documents, plaintiffs filed a Consolidated Amended Class Action Complaint
(Complaint) and an Amended and Supplemental Complaint relating to the derivative action against Westinghouse, Civil Action No. 91-624 (Derivative Complaint) (Docket No. 85). This action is currently before the Court on defendants' motions to dismiss (Docket No. 90, 91, 101, 106).
As noted above, WCC sharply increased its lending activity in the 1980s, expanding into highly leveraged corporate transactions, high-yield securities, and especially, commercial real estate markets. WCC's primary source of funds for these investments was short-term commercial paper debt. When the real estate market softened during the late-1980s and into the early-1990s, many of WCC's real estate receivables began underperforming, and the underlying investment properties lost value. Therefore, on May 8, 1990, in order to protect WCC's standing with the commercial paper ratings agencies, Westinghouse entered into a support agreement with WCC, pursuant to which Westinghouse agreed to maintain for three years, by regular capital infusions if necessary, WCC's total debt-to-equity ratio at a maximum of 6.5 to 1. P 97; Exhibit O to Defendant Westinghouse's Memorandum in Support of Motion to Dismiss Consolidated Amended Class Action Complaint (Westinghouse Memo) at 8.
A - maintain size and likely growth, modest change in mix - acquire Enterprise and United, but stop there
B - maintain size, improve growth outlook by aggressive change in mix - fund aggressive growth in thrifts and mortgage banking by liquidating WCC's current business
C - contract size, maintain mix - accept write down, apply proceeds for sale of written down assets to debt repayment, pursue thrifts and mortgage banking on modest scale
D - pay dividend, contract size and growth - aggressively liquidate assets, distribute cash to parent - abandon thrifts and mortgage banking
Exhibit Y at 15. The report speculated that alternatives B and D were unlikely, and raised the possibility of a fifth alternative, the "missing alternative - focus on selling leasehold residuals and other 'hidden' assets to produce gains for write offs, reduce cost structure (internally generated gains used to write off non-earning assets)." Id. at 17.
The report suggested that Westinghouse continue to "modify and complete the Strategic Plan" and "complete the Lazard study - evaluate exit vs. hold alternatives." Id. at 18. The report concluded, inter alia, that it was "unlikely" that WFSI would continue to operate as a long-term, core business, and that it would eventually exit the real estate markets. The report recommended that WFSI hold its portfolios for exit when the markets recovered, and stated that there was "no need for [a] self-inflicted writedown - unless assets can be liberated." Finally, the report recommended engaging Lazard to [evaluate the costs and benefits of a] near-term exit vs. hold for later exit," and "to assist in internal restructuring effort, and validate Corporate views - also, to assist in communications message." Id. at 20.
Westinghouse did retain Lazard Freres & Co. (Lazard), an investment banking firm, on September 28, 1990. P 115. After interviewing key WCC personnel about WCC's real estate portfolios, Lazard allegedly began preparing Westinghouse's CEO and Chairman of the Board of Directors, Paul Lego, for a meeting with securities analysts scheduled for October 24, 1990. P 125. At the October 24, 1990 meeting, Lego allegedly told the analysts: "We believe our reserves are adequate. We see no major problems there," and, "We do not believe we will have to take any kind of major hit in financial services. We believe our reserves are adequate." P 131.
Lazard subsequently informed Westinghouse that:
Markets do not currently expect any major write-off. They rely on a statement by Westinghouse's management, at the October 24, meeting, that there are no prospects of such write-offs. Several reports quote the statement as the source of their belief. . . . Because it would come as a relative surprise and in contradiction to previous announcements, a large write-off might put the credibility of Westinghouse's management at risk.
On February 27, 1991, Westinghouse and WCC announced that they were taking a $ 975 million pre-tax charge against fourth-quarter 1990 earnings as part of a restructuring plan adopted by Westinghouse for its WFSI and WCC subsidiaries. P 150. Westinghouse also made a cash contribution of $ 525 million to WFSI during the first quarter of 1991 and extended its 1991 support agreement with WCC to June 1994. Exhibit O to Westinghouse Memo at 8.
Concurrent with the February 27, 1991 press release, Westinghouse and WCC filed with the SEC Forms 8-K, pursuant to Sections 13 or 15(d) of the Securities Exchange Act, which require the periodic filing of reports necessary to keep reasonably current the information and documents contained in a registration statement. 15 U.S.C. §§ 78m, 78o(d) (1988). In its February 27, 1991 Form 8-K, WCC disclosed its identification of "$ 139 million in real estate properties owned, $ 653 million in marketable securities, $ 538 million in non-earning receivables and $ 1.3 billion in reduced earning receivables
restructured to earn less than their original contractual rate." Exhibit L to Westinghouse Memo at 2.
On or about March 11, 1991, Westinghouse and WCC filed annual reports, Form 10-K, for the 1990 fiscal year. Exhibits M and N to Westinghouse Memo. On or about April 18, 1991, and again on or about May 6, 1991, Westinghouse filed with the SEC a registration statement, Form S-3, and Prospectus in conjunction with a May 9, 1991 public offering of 19,000 shares of Westinghouse common stock at $ 26.50 per share. Exhibits O, P, and Q to Westinghouse Memo.
On October 7, 1991, Westinghouse filed a Form 8-K that announced that net income was down over the first three quarters of 1991 compared to the same period in 1990, and issued another press release announcing "a major change in strategy to accelerate a broader disposition of assets in its financial services subsidiary, resulting in the recording of a $ 1.68 billion valuation provision during the third quarter." P 179; Exhibit V to Westinghouse Memo at 4. Addressing this second substantial charge against earnings within 9 months, Lego explained: "Because of the prolonged recession, the lack of credit in real estate markets and the nation's oversupply of commercial properties, which have diminished the current value of real estate assets, we have determined to take these decisive actions." P 181; Exhibit V at 10. Lego also stated: "While disappointing, this performance is the result of the comprehensive plan we announced today that is intended to accelerate the recovery of our Financial Services unit and to put the corporation back on the track toward improved operating and financial performance." Id. at 5.
Finally, on or about November 14, 1991, Westinghouse and WCC filed with the SEC their quarterly reports, Form 10-Q, for the third quarter of 1991. Exhibits W and X to Westinghouse Memo. WCC cited "limited progress . . . in liquidating or restructuring real estate and corporate financing assets,"
Exhibit X at 9; Westinghouse disclosed that:
Operating profit for the third quarter and first nine months was down significantly compared with the same periods of 1990. Third quarter operating profit included a $ 1.68 billion valuation provision established to facilitate the previously announced plans to downsize Financial Services. Excluding the $ 1.68 billion valuation provision, operating profit for the quarter and first nine months was sharply lower than the same periods of 1990. The decline in operating profit was due to significant increases in loan loss provisions from continuing business operations.
Exhibit W at 11. Westinghouse also announced that it would enter into a new support agreement with WCC, "stipulating the same financial support with respect to [WCC's 6.5 to 1] debt-to-equity ratio," and providing financial support necessary to guarantee WCC's commercial paper borrowings, and to maintain WCC's debt ratings. Exhibit X at 10.
A. Westinghouse Allegations
Plaintiffs' causes of action against Westinghouse include claims for violations of Sections 10(b) and 20 of the Securities Exchange Act of 1934, as amended (the Exchange Act), 15 U.S.C. §§ 78j(b), 78t (1988), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5 (1992);
Sections 11, 12(2), and 15 of the Securities Act of 1933, as amended (the Securities Act), 15 U.S.C. §§ 77k(a), 771(2), 77o (1988);
and for negligent misrepresentation under principles of Pennsylvania common law.
Plaintiffs allege that as early as 1988, defendants were aware of the serious deterioration of WCC's real estate and highly-leveraged transactions portfolios, but as set forth in more detail in Part V, infra, failed to: (1) fully disclose the extent of the losses in the receivables, attempting to hide those losses; (2) make appropriate valuation provisions to the loan loss reserves established to cover the nonperforming or underperforming receivables; and (3) disclose the effect of the losses upon Westinghouse's and WCC's commercial paper ratings and on Westinghouse in light of Westinghouse's financial obligations to WCC under the support agreement. P 46.
B. The Secondary Defendant Allegations
Plaintiffs also allege causes of action under Section 10(b), Section 11, Section 12(2), and common law negligent misrepresentation against Price Waterhouse, Westinghouse's independent accountant, Lazard, an investment banking firm retained in September 1990 to advise Westinghouse, and several securities underwriters (including Lazard) who underwrote Westinghouse's May 1991 public offering of common stock.
The first substantive mention of the secondary defendants appears at P 48. Price Waterhouse and Lazard are alleged generally to have "aided" Westinghouse, WCC, and the individual defendants in concealing the deteriorating condition of WCC's real estate loans: during the March 28, 1989 through October 22, 1991 period. The factual specifics concerning this aid are distributed among PP 53, 56 and 64: Price Waterhouse and Lazard are alleged to be responsible for WCC's publication of artificially reduced levels of nonearning real estate receivables in WCC's Forms SEC 10-Q and Forms 10-K. Price Waterhouse and Lazard also aided the Westinghouse defendants in some undescribed way in reclassifying nonearning real estate as reduced earning receivables. Price Waterhouse is additionally alleged to have failed to disclose WCC's portfolio of underperforming real estate receivables after auditing WCC's 1988 and 1989 financial statements, and to have authorized Westinghouse's announcement of its 1990 unaudited financial results on January 17, 1991.
Next, in P 77 through P 90, Price Waterhouse is alleged to have audited Westinghouse's and WCC's year-end statements in 1989, 1990 and 1991 and received fees from Westinghouse for doing so. Price Waterhouse is alleged to have assisted Westinghouse and WCC at unspecified times to conceal WCC's losses and risky loans in three ways: (1) by agreeing that WCC's reserve for loan losses would not exceed 2.5% of receivables; (2) by failing to disclose WCC's reclassification of nonearning receivables as reduced earnings receivables, WCC's growing volume of reduced earning receivables, and WCC's in-substance foreclosures; and (3) by misrepresenting that Price Waterhouse's audits were consistent with Generally Accepted Accounting Standards (GAAS) and that Westinghouse and WCC's financial statements were prepared in accordance with Generally Accepted Accounting Principles (GAAP). In 1990, Price Waterhouse is alleged to have informed WCC management of its reluctance to remain at a 2.5% level of reserves, and approved an increase to a 2.8% level of reserves. plaintiff alleges that Price Waterhouse misrepresented this level of reserves as adequate, despite knowing at year-end 1990, facts demonstrating that the level of reserves was deficient by $ 1 billion or more.
Plaintiffs' allegations then turn, in P 103 et seq., to Lazard. Lazard is alleged to have been retained by Westinghouse as a financial adviser in August or September 1990; to have conducted a study of WFSI and WCC; and to have produced a document entitled Westinghouse Credit Corporation -- Discussion Outline. Exhibit B to Underwriter Defendants' Compendium of Exhibits (Compendium).
Lazard partners Felix Rohatyn and Kenrick Wilson allegedly prepared Lego and Warren H. Hollinshead, Westinghouse's Treasurer and CFO, for an October 24, 1990 meeting with securities analysts. Lazard executive Steve Niemczyk is alleged to have written a script containing proposed answers to questions expected from the securities analysts, which script included two statements actually made by Lego at the October 24, 1990 analysts' meeting:
We believe our reserves are adequate. We see no major problems there. . . . We do not believe we will have to take any kind of major hit in financial services. We believe our reserves are adequate.
Compendium, Exhibit A at 7.
Plaintiffs allege that these statements were false and that the Lazard personnel responsible knew or recklessly disregarded facts which demonstrated that the statements were false. P 131.
Lazard allegedly continued to analyze WCC's status in December 1990 and January 1991, and learned of WCC's deteriorated asset values, high levels of nonearning receivables, and the inadequacy of WCC's reserves. Construing an ambiguity in the complaint most favorably to the plaintiffs,
plaintiffs also allege that at the time of the January 16, 1991 earnings report Westinghouse had already planned the charges it later took against 1990 income, P 138, and that Lazard learned of this plan by January 9, 1991. P 136. On January 9, 1991 Lazard allegedly recommended that Westinghouse release fourth-quarter and year-end 1990 earnings results on January 16, 1991 without disclosing any of these facts. Lazard also allegedly recommended a board meeting to discuss a restructuring of WFSI and WCC, a meeting which took place on January 30, 1991.
Plaintiffs allege that Westinghouse personnel met with personnel from Lazard and Shearson Lehman Brothers on February 7, 1991 to discuss the effect on the ratings of Westinghouse commercial paper of an "expected charge to earnings." P 143. In response to Westinghouse's request, Lazard completed a document on February 11, 1991 entitled Model Restructuring and Financial Plan which proposed, inter alia, a $ 1.0 - $ 1.2 billion charge to increase loan 1055 reserves. P 145.
Westinghouse and Lazard allegedly determined to seek the rating agencies' reaction to the proposed charge, P 147, and on February 20, 1991, Lego and other Westinghouse personnel met with: Moody's and Standard and Poor's. The plan submitted by Westinghouse differed in several respects from the Model Plan prepared by Lazard. P 148.
On February 27, 1991, Westinghouse announced its $ 975 million charge against 1990 earnings. Allegedly Lazard and Price Waterhouse knew this "did not provide for adequate reserves," and "chose to conceal the losses" with a "crash effort to sell off the losing real estate loans and properties." P 155. Lazard allegedly also prepared a document for use at the February 27, 1991 board meeting entitled Westinghouse Electric -- Board Meeting Q&A, and which read as follows:
Q: Are the reserves adequate?
A: Given the results of each of these review processes, the charge taken today is clearly reasonable but was at the low end of the range identified by management in conjunction with the strategic review performed by Lazard.
Furthermore, the level of charge taken today is also highly contingent on the implementation of disposition strategies, which continue to be developed, and on market conditions. It is based on an understanding of how management will deal with underperforming assets: An orderly but aggressive liquidation plan.
In this regard, a timely and active monitoring of the ongoing restructuring/disposition plan is crucial. Not a monthly process, but weekly.
Q: When do we need to see "real" results?
A: By the end of the second quarter following the charge, meaningful results should be evident.
A timely reduction in commercial paper through application of cash proceeds raised via asset dispositions;
A progressive reduction in the level of underperforming assets; and
Stable to increasing core earnings and ROE.
Q: What happens in the event there is further deterioration?
A: More draconian steps would be required to preserve credit ratings at a cost to current earnings. But to the extent that WCC's asset disposition strategy, or its ability to term out additional debt, can reduce commercial paper in the near term, there will be less of a risk due to further economic deterioration an/or [sic] a drop in credit ratings. The key is clearly what can be done in the near-term prior to any further deterioration. P 157.
In April and May of 1991, Westinghouse proceeded with another facet of its restructuring plan, a public offering of 19 million shares of common stock. Westinghouse filed a prospectus and registration statement with the SEC in connection with the offering which took place on May 9, 1991. The prospectus stated that the financial statements incorporated by reference in the prospectus were incorporated "in reliance on the report of Price Waterhouse." P 168; Exhibit Q to Westinghouse Memo at 18. The public offering was apparently completed before the fall of 1991. On September 6, 1991, Moody's and Standard & Poor's downgraded Westinghouse's commercial paper. P 178. In response, Westinghouse took an additional $ 1.68 billion charge to add to its reserve for loan losses. P 179.
Plaintiffs allege that as early as October, 1990, Lazard and Price Waterhouse knew that the conditions which Westinghouse gave in October 1991 as reasons for its additional charge existed. P 182. Plaintiffs allege that Lazard and Price Waterhouse also knew facts in February 1991 that should have caused them to conclude that the first charge was grossly inadequate. Id. Lazard and Price Waterhouse nonetheless allegedly aided Westinghouse in taking the $ 975 million charge by representing that it was adequate to cover losses inherent in WCC's portfolio, which resulted in the share prices of the May, 1991 offering not reflecting the true financial weakness of the company. P 183, P 185.
Plaintiffs also allege that in connection with public documents and SEC filings Price Waterhouse made knowing or reckless misrepresentations by falsely stating that Westinghouse and WCC's internal controls were adequate, P 351, P 371*, when in fact Price Waterhouse knew, P 355, that they were not. Allegedly, WCC lacked standards for reporting, inter alia, in-substance foreclosures, P 356, cash-flow projections, P 357, internal valuations, P 358-60, and lending policies. PP 369-73.
Plaintiffs contend that Price Waterhouse also falsely stated that the financial statements accompanying the Annual Reports accurately represented WCC's financial position, P 192, P 347*, and that Price Waterhouse's audits of those statements were conducted in accordance with GAAS. P 192, P 351*, P 365*.
Additionally, Price Waterhouse was retained by Westinghouse in August, 1990 to act as CFO for Brad Cable. WCC provided $ 10 million to effect a leveraged buyout of Brad Cable in September, 1990. Allegedly, Price Waterhouse's inventory of Brad Cable revealed shortfalls which were covered by WCC. PP 297-99. Acting as CFO of Brad Cable at the same time Price Waterhouse was auditing Westinghouse's financial statements allegedly rendered Price Waterhouse unable to conduct an independent audit of Westinghouse, P 405, thereby resulting in Price Waterhouse accepting incorrect information from WCC. PP 374- 403.
The allegations summarized above are the basis for the following causes of action against the secondary defendants:
Count One -- In P 409, Price Waterhouse and Lazard are alleged to have violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder by making "statements, described above [which] were false and misleading when made." The general reference to statements is understood to refer to the specific statements alleged in the body of the complaint, which are again summarized in P 413.
Count Two -- In P 429 and P 430, Price Waterhouse, Lazard and the underwriter defendants are alleged to have violated Section 11 of the Securities Act in connection with the May, 1991 public offering, by participating in the making of false statements in the registration statement, prospectus, and documents incorporated therein. The references to false statements made or true statements not made are understood to refer to the specifics alleged in the body of the complaint, and are summarized in PP 431-433, and in P 434 as to Price Waterhouse only.
Count Three -- Lazard and the underwriter defendants are alleged, in P 442, to have sold Westinghouse common stock in the May 1991 offering through the use of a false or misleading registration statement and prospectus in violation of Section 12(2) of the Securities Act.
Count Four -- Price Waterhouse is alleged to have violated Section 11 of the Securities Act in the same manner alleged in Count Two, towards the persons who purchased Westinghouse common stock directly ...