McMahan & Co. v. Wherehouse Entertainment, Inc.
1990 WL 42295, 900 F.2d 576 (1990)
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Rule of Law:
Statements in securities offering materials that are literally true may nonetheless be materially misleading in violation of federal securities laws if the representations, taken together and in context, would mislead a reasonable investor about the nature of the security.
Facts:
- Wherehouse Entertainment, Inc. issued convertible subordinated debentures to investors.
- The offering materials promoted a key feature: a right for debentureholders to tender their debentures back to Wherehouse upon certain triggering events like a merger.
- This tender right was subject to a waiver if the triggering event was approved by a majority of the company's 'Independent Directors.'
- The materials defined 'Independent Directors' as certain members of the company's existing board of directors.
- Plaintiffs, a group of financial institutions, purchased 34% of these debentures.
- Eighteen months later, Wherehouse executed a leveraged buy-out merger, which was approved by its 'Independent Directors.'
- This merger caused the value of the plaintiffs' debentures to decline to approximately 50% of their face value.
- When plaintiffs attempted to exercise their tender right following the merger, Wherehouse refused, citing the directors' approval and waiver of the right.
Procedural Posture:
- Plaintiffs sued Wherehouse Entertainment, Inc. and other defendants in the United States District Court for the Southern District of New York.
- The complaint alleged violations of §§ 10(b), 11, and 12(2) of the federal securities laws, as well as state-law claims.
- Defendants moved for summary judgment, arguing their disclosures were not misleading.
- The district court granted summary judgment for the defendants, finding no material misstatements or omissions.
- The district court then dismissed the plaintiffs' state-law claims for lack of pendent jurisdiction.
- Plaintiffs (as appellants) appealed the district court's judgment to the United States Court of Appeals for the Second Circuit.
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Issue:
Do representations in debenture offering materials violate federal securities laws when they describe a holder's right to tender as a valuable protection, if that right can be waived by directors whose fiduciary duties to shareholders may render the protection illusory?
Opinions:
Majority - Pratt, J.
Yes. Representations in offering materials can violate federal securities laws if their overall context and presentation would mislead a reasonable investor, even if the individual statements are literally true. The court must assess the 'total mix' of information, not just isolated, technically accurate statements. Here, the materials used language of entitlement ('Holder's Right to Tender', 'option to require') and framed the right as a key 'protection' for debentureholders. A reasonable investor could infer from the term 'Independent Director' that these directors had a special duty to protect debentureholders' interests. However, as ordinary directors, their fiduciary duty is to the shareholders. This inherent conflict could render the debentureholders' right illusory, as directors would almost certainly approve a merger beneficial to shareholders regardless of its impact on debentureholders. This discrepancy between the presented 'protection' and its practical reality creates a triable issue of fact as to whether the offering materials, taken as a whole, were materially misleading.
Dissenting - Sand, J.
No. The offering materials did not violate federal securities laws because the terms of the tender right and the waiver provision were fully and accurately disclosed. The right was not worthless; it served as a deterrent to hostile takeovers that could harm both shareholders and debentureholders, making it a 'special protection,' albeit a limited one. Federal securities laws mandate the disclosure of material facts, not an education on the fundamental principles of corporate governance, such as a director's fiduciary duty to shareholders. The plaintiffs are sophisticated financial institutions that should have understood the implications of the disclosed terms. Any claim regarding the directors' actions in waiving the provision is a matter of state corporate law concerning fiduciary duties, not a federal securities fraud claim.
Analysis:
This decision solidifies the principle that the evaluation of securities disclosures is not a hyper-technical or literal exercise. It confirms that the 'total mix' of information, including the context and 'gloss' placed on facts, is paramount in determining whether a representation is materially misleading. The case serves as a significant warning to issuers that they cannot create a misleadingly positive impression of a security's features through clever wording while relying on the literal truth of a disclaimer buried in the details. It highlights the high disclosure burden on companies when creating rights for one class of stakeholders (e.g., debentureholders) that are controlled by fiduciaries of another (shareholders), requiring clear explanation of the potential conflict of interest.
