Date: 05-02-2007

Case Style: The Robert N. Clemens Trust, et al. v. Morgan Stanley DW, Inc.

Case Number: 06-5525

Judge: R. Guy Cole, Jr.

Court: United States Court of Appeals for the Sixth Circuit on appeal from the Western District of Tennessee (Shelby County)

Plaintiff's Attorney:

H. Naill Falls, FALLS & VEACH, Nashville, Tennessee, for Appellants.

Defendant's Attorney:

Richard Rosen, PAUL, WEISS, RIFKIND, WHARTON & GARRISON, New York, New York, for Appellee.

Description:

The Robert N. Clemens Trust, Automobile Consumer Service Corporation, John D. Brandon, Jr., Pat F. Wakefield, and Marty D. Jackson (collectively the "Plaintiffs") brought this class-action suit against Morgan Stanley DW, Inc. ("Morgan Stanley"). Plaintiffs allege that Morgan Stanley's brokers recommended to Plaintiffs the purchase of unsuitable securities in violation of Section 10(b) of the Securities and Exchange Act of 1934, codified at 15 U.S.C. § 78j, and Rule 10b-5, codified at 17 C.F.R. § 240.10b-5. The Plaintiffs also brought statelaw claims against Morgan Stanley under Tenn. Code Ann. § 48-2-121(a), which parallels the language in Rule 10b-5, and Ala. Code § 8-6-19. The district court granted Morgan Stanley's motion, under Rule 12(b)(6), to dismiss Plaintiffs' complaint. For the following reasons, we AFFIRM the district court's dismissal of Plaintiffs' suit.

I. BACKGROUND

Plaintiffs brought this class-action suit on behalf of individuals and entities who, at the recommendation of a Morgan Stanley broker, purchased $50,000 or more of Class B shares in one or more of Morgan Stanley's mutual funds.1 For purposes of reviewing the district court's grant of Morgan Stanley's motion to dismiss under Federal Rule of Civil Procedure 12(b)(6), we accept as true the Plaintiffs' allegations. Therefore, the following facts are taken from the complaint:

Morgan Stanley, and its affiliates, market[] more than sixty mutual equity and bond mutual funds to investors throughout the United States. Compl. 15. The Morgan Stanley Funds, which invest in stocks, bonds, and other classes of assets and offer a wide range of investment strategies, are marketed to the public as a "family of mutual funds." Id. 19. The great majority of Morgan Stanley Fund shares are marketed and sold to investors who have brokerage accounts with Morgan Stanley. Id. 24.

Morgan Stanley Funds are offered in different share classes, designated as A, B, C and other share classes. Id. 25. The share classes for a given fund represent claims on the same underlying portfolio of investments, but differ in their expense structures. Id. Expenses for the share classes are differentiated with respect to the amount and timing of one-time charges, referred to as "loads," and annual fees for asset management, marketing, sales ("distribution"), and other services. Id. 26.

For Class A shares in equity funds, Morgan Stanley typically charges what is referred to as a "front-end load" in the amount of 5.25% for investments of less than $25,000, which is paid at the time of the initial investment. Id. 27. In addition, Class A shares are charged an annual distribution fee of 0.25% as well as other fees and expenses. Id. The front-end load is reduced incrementally for investments of $25,000 or more. Id. For example, the front-end load for an investment of $25,000 to $49,999 is reduced to 4.75% of the investment. Id. The front-end load is further reduced at investment levels of $50,000, $100,000, $250,000, and $500[,000]. Id. The front-end load for Class A shares is eliminated altogether for investments of $1 million and over. Id.

The reduced sales charge is applicable to purchases of Class A shares in a single transaction. Id. 28. The reduced sales charge is also available (1) for combined purchases of Class A shares in different Morgan Stanley Funds, (2) under rights of accumulation, (3) when the investor enters into a Letter of Intent, and (4) under a number of other different scenarios relating to retirement planning. Id. 29.

Morgan Stanley offers Class B shares with no initial sales charge, but the Class B shares are subject to a contingent deferred sales charge (CDSC), also known as back-end load, ranging from 5% in the first year the shares are held to 1% in the sixth year. Id. 30. There is no CDSC for Class B shares held more than six years. Id. Morgan Stanley states that it normally charges Class B shareholders of equity funds an annual distribution fee of 1%, which is .75% more than Class A shares, as well as the same other fees and expenses charged to Class A funds. Id. 31.

In order to determine which share class is best for a particular investment strategy or investment amount, one must examine the fees and expenses associated with each share class during the period of time the investor may hold the investment. Id. 33. As [Morgan Stanley] knows, such an analysis is beyond the ability of the vast majority of mutual fund investors. Id.

With a $50,000 investment in Class A, investors pay a smaller front-end load than with smaller investments. Id. 34. With respect to almost any possible holding period, an investor is better off investing $50,000 or more in Class A shares rather than Class B shares. Id. Because of the greater reduction in the Class A front-end load for investors [who invest between $100,000 and $249,000], a Class A investment is even more clearly superior to a Class B investment. Id. 35.

Defendant recommends and sells Class B shares to individuals and entities investing $50,000 or more in Morgan Stanley funds, even though defendant knows that Class B investors will pay more fees and earn less profit than if they had chosen Class A shares. Id. 37. A stockbroker who recommends an investment to a client has a legal obligation to recommend only suitable investments. Id. 38. [Morgan Stanley] and its agents have consistently violated this duty in recommending the purchase of Morgan Stanley mutual funds in amounts of $50,000 or more. Id. In addition, by recommending that [Plaintiffs] purchase Class B shares in such amounts, [Morgan Stanley] and its agents impliedly represented to [Plaintiffs] that such an investment was suitable for them. Id. This representation was false. Id.

(JA 9-28.) Morgan Stanley's bond funds perform in the same manner as the equity funds discussed above. Plaintiffs invested in both equity and bond funds.

On March 8, 2006, the district court granted Morgan Stanley's motion to dismiss Plaintiffs' federal-law claims because Plaintiffs failed to state a cause of action under the heightened pleading requirement for Section 10(b) and Rule 10b-5. Robert N. Clemens Trust v. Morgan Stanley DW, Inc., No. 04-2384, slip op. (W.D. Tenn. Mar. 8, 2006). In granting Morgan Stanley's motion to dismiss, the district court reached the following conclusions: (1) Plaintiffs failed to state specific factual allegations that Morgan Stanley "or its agents knew or were reckless in not knowing that Class B was inferior to Class A shares"; (2) Plaintiffs failed to state sufficient facts to "allow the Court to draw an inference that [Morgan Stanley] knew that Class B was inferior to Class A" shares and thus the "most likely inference is that Morgan Stanley sought to offer diverse funds to its clients"; and (3) Plaintiffs failed to state specific facts to establish that Morgan Stanley's brokers "knew that Class B was unsuitable for investors." Clemens Trust, slip op. at 6-7. The district court also declined to exercise supplemental jurisdiction over Plaintiffs' state-law claims. Plaintiffs timely appealed.

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Section 10(b) of the Securities and Exchange Act of 1934 (the "Act") and Rule 10b-5 "prohibit fraudulent, material misstatements or omissions in connection with the sale or purchase of a security." PR Diamonds, Inc. v. Chandler, 364 F.3d 671, 680-81 (6th Cir. 2004) (quoting Morse v. McWhorter, 290 F.3d 795, 798 (6th Cir. 2002)). Section 10(b) provides, in relevant part, as follows:

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 exchange 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.

15 U.S.C. § 78j (2000). Further, Rule 10b-5, promulgated by the Securities and Exchange Commission ("SEC") under Section 10(b), provides, in relevant part, as follows:

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,

(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.

17 C.F.R. § 240.10b-5. A valid claim under Section 10(b) of the Act and Rule 10b-5 "must allege, in connection with the purchase or sale of securities, the misstatement or omission of a material fact, made with scienter, upon which the plaintiff justifiably relied and which proximately caused the plaintiff's injury." In re Comshare, 183 F.3d at 548; PR Diamonds, 364 F.3d at 681.

Prior to 1995, a plaintiff bringing a fraud action had to plead fraud "with particularity" as required by Federal Rule of Civil Procedure 9(b). In 1995, Congress amended the Act through the passage of the Private Securities Litigation Reform Act (the "PSLRA"), codified at 15 U.S.C. §§ 78u–4 & –5 (1998). The PSLRA heightened the standard for pleading scienter in a securitiesfraud case:

In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

15 U.S.C. § 78u–4(b)(2) (1998) (emphasis added).

The Seventh Circuit explained that the purpose for the heightened pleading requirement in fraud cases was "to force the plaintiff to do more than the usual investigation before filing his complaint." Ackerman v. Nw. Mut. Life Ins. Co., 172 F.3d 467, 469 (7th Cir. 1999). The Ackerman court noted that "[g]reater precomplaint investigation is warranted in fraud cases because public charges of fraud can do great harm to the reputation of a business firm or other enterprise (or individual)." Id. Therefore, the added pre-complaint investigation assures the court "that the charge of fraud is responsible and supported, rather than defamatory and extortionate." Id. at 469-70. The PSLRA, however, did not alter the scienter standard. See In re Comshare, 183 F.3d at 548-49 ("The PSLRA did not change the scienter that a plaintiff must prove to prevail in a securities fraud case but instead changed what a plaintiff must plead in his complaint in order to survive a motion to dismiss."). Thus, "[t]o establish a defendant's liability under § 10(b), a plaintiff must, as a threshold matter, allege in his complaint that the defendant acted with sufficient scienter." Id. at 548.

In Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976), the Supreme Court defined scienter as "a mental state embracing intent to deceive, manipulate, or defraud." The Court in Ernst did not address "whether, in some circumstances, reckless behavior is sufficient for civil liability under Section 10(b) and Rule 10b-5." Id. Nonetheless, we have "long premised liability on at least reckless behavior." Helwig v. Vencor, Inc., 251 F.3d 540, 548 (6th Cir. 2001) (en banc) (quoting Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1025 (6th Cir. 1979)). In Mansbach, we defined recklessness as "highly unreasonable conduct which is an extreme departure from the standards of ordinary care. While the danger need not be known, it must at least be so obvious that any reasonable man would have known of it." 598 F.2d at 1025. We explained that recklessness, as a mental state, "falls somewhere between intent and negligence." Id. at 1025 n.36 (citing Sanders v. John Nuveen & Co., Inc., 554 F.2d 790, 793 (7th Cir. 1977)).

* * *

Outcome: For the foregoing reasons, we AFFIRM the district court’s grant of Morgan Stanley’s motion to dismiss Plaintiffs’ complaint.

Plaintiff's Experts: Unknown

Defendant's Experts: Unknown

Comments: None