In re eToys, Inc. Sec. Litig., 16 Misc.3d 22 (N.Y. App. Div. 2007)
A lead managing underwriter in a firm commitment underwriting owes a fiduciary duty to the issuer to disclose conflicts of interest in connection with the pricing of securities.
Summary
This case addresses whether a lead managing underwriter owes a fiduciary duty to the issuer regarding the pricing of an initial public offering (IPO), specifically concerning potential conflicts of interest. The New York Appellate Division held that such a duty exists, requiring the underwriter to disclose compensation arrangements with its customers that could influence the IPO’s pricing. This decision hinged on the underwriter’s advisory role extending beyond the underwriting agreement itself. The dissent argued against imposing a fiduciary duty in an arm’s-length transaction between sophisticated parties, suggesting the matter is better addressed by regulatory bodies.
Facts
eToys, Inc., now bankrupt, claimed that Goldman Sachs & Co., the lead managing underwriter for its IPO, underpriced its stock at $20 per share. This allegedly allowed Goldman to profit from secret side deals with preferred customers. These customers were allegedly obligated to kick back a portion of any profits they made on aftermarket sales of eToys’ securities allocated to them at the IPO. eToys asserted that it understood the offering price would be set primarily by reference to then current market conditions and the anticipated demand for eToys’ shares.
Procedural History
The committee of unsecured creditors of eToys, Inc., brought a claim against Goldman Sachs. The lower court initially dismissed the claim. The New York Appellate Division reversed the lower court’s decision, allowing the breach of fiduciary duty claim to proceed.
Issue(s)
Whether a lead managing underwriter of an IPO owes a fiduciary duty to the issuer to disclose potential conflicts of interest related to the pricing of securities, specifically concerning compensation arrangements with the underwriter’s preferred customers.
Holding
Yes, because based on communications with Goldman, it was eToys’ understanding that the offering price for eToys’ common shares was to be set primarily by reference to then current market conditions and the anticipated demand for eToys’ shares, establishing an advisory relationship independent of the underwriting agreement.
Court’s Reasoning
The court reasoned that a fiduciary duty could arise from an advisory relationship that was independent of the underwriting agreement. It found that the lead underwriter’s role extended beyond merely fulfilling the underwriting agreement, potentially creating a relationship of trust and confidence with the issuer. The court emphasized the importance of transparency and disclosure in financial transactions, particularly in the context of IPOs. The court stated that documentary evidence didn’t negate the claim that an advisory relationship existed. The court imposed “a fiduciary duty… requiring disclosure of [a lead underwriter’s] compensation arrangements with its customers.”
The dissenting judge argued that eToys was a sophisticated, well-counseled business entity, making a fiduciary duty inappropriate in this arm’s-length transaction. The dissent also highlighted that the offering price was a negotiated term in the underwriting agreement, a purchase contract between eToys and Goldman Sachs. The dissent cautioned against injecting uncertainty into a complex subject already under regulatory scrutiny by the SEC and SROs, suggesting that specialized regulators are better equipped to address these issues.