The opinion of the court was delivered by: TYLER
In October, 1966, plaintiffs in this class action
moved against defendant Peat, Marwick, Mitchell & Co. ("PMM") for further discovery under Rule 34, F.R. Civ. P., based in part upon the allegations set forth in paragraphs 25 through 25.3 of the second consolidated amended complaint (hereinafter "the complaint"). PMM opposed this motion, and, in addition, cross-moved against the plaintiffs, pursuant to Rule 12(b) (1) and/or 12(b) (6), F.R. Civ. P., for an order by this court dismissing paragraphs 25-25.3 of the complaint on the grounds that the court has no jurisdiction over the subject matter contained therein and/or that the allegations of these paragraphs fail to state a claim upon which relief can be granted. Plaintiffs and the Securities and Exchange Commission ("SEC"), which has filed an amicus curiae brief, strenuously oppose the cross-motion.
The discovery motion was disposed of by this court in a memorandum opinion, dated November 1, 1966; this opinion will deal with PMM's cross-motion to dismiss paragraphs 25-25.3 of the complaint.
For the purposes of this motion, the parties agree in principle that the facts urged upon the court by the plaintiffs must be accepted as true and that the challenged portions of the complaint must be upheld if they are supported by any viable rule of law. There follows a summarization of the facts which reasonably can be read from the formal complaint allegations, particularly those under fire in this motion.
Sometime early in 1964, PMM, acting as an independent public accountant, undertook the job of auditing the financial statements that Yale Express System, Inc. ("Yale"), a national transportation concern, intended to include in the annual report to its stockholders for the year ending December 31, 1963. On March 31, 1964, PMM certified the figures contained in these statements. On or about April 9, the annual report containing the certification was issued to the stockholders of Yale. Subsequently, on or about June 29, 1964, a Form 10-K Report, containing the same financial statements as the annual report, was filed with the SEC as required by that agency's rules and regulations.
At an unspecified date "early in 1964", probably shortly after the completion of the audit, Yale engaged PMM to conduct so-called "special studies" of Yale's past and current income and expenses. In the course of this special assignment, sometime presumably before the end of 1964,
PMM discovered that the figures in the annual report were substantially false and misleading.
Not until May 5, 1965, however, when the results of the special studies were released, did PMM disclose this finding to the exchanges on which Yale securities were traded, to the SEC or to the public at large.
Furthermore, during the course of PMM's special studies, Yale periodically announced to PMM an intention to issue several interim statements and reports to show the company's 1964 financial performance. In at least two instances, Yale was told by PMM that figures derived from the special studies could not be used as a basis for these interim statements; in addition, PMM recommended that the figures developed by Yale through its internal accounting procedures be used in the reports.
Yale thereupon issued several interim statements containing figures which were not compiled, audited or certified by PMM. As in the case of the annual and SEC reports, later developments revealed that the figures contained in these interim statements were materially false and misleading.
Plaintiffs allege that, from the compilation of figures for 1964 and its knowledge of the contents of the interim reports, PMM knew that the figures contained in those statements were grossly inaccurate. No disclosure of this finding has yet been made to the exchanges, the SEC or the public.
Within this alleged factual context, the plaintiffs assert that PMM is liable in damages for its failure to disclose not only that the certified financial statements in the 1963 annual report contained false and misleading figures but also that the interim statements issued by Yale were inaccurate. Because the bases for such claimed liability are grounded on distinctly different legal theories, the issues unique to each area will be discussed and analyzed separately.
Plaintiffs attack PMM for its silence and inaction after its employees discovered, during the special studies, that the audited and certified figures in the financial statements reflecting Yale's 1963 performance were grossly inaccurate. They contend that inasmuch as PMM knew that its audit and certificate would be relied upon by the investing public,
The accounting firm had a duty to alert the public in some way that the audited and certified statements were materially false and inaccurate. PMM counters that there is no common law or statutory basis for imposing such a duty on it as a public accounting firm retained by the officers and directors of Yale.
Strict analysis leads to the conclusion that PMM is attacked in the complaint because it wore two hats in conducting its business relations with Yale during the period in question. PMM audited and certified the financial statements in the 1963 annual report and Form 10-K as a statutory "independent public accountant"
"is not only to the client who pays his fee, but also to investors, creditors and others who may rely on the financial statements which he certifies. . . . The public accountant must report fairly on the facts as he finds them whether favorable or unfavorable to his client. His duty is to safeguard the public interest, not that of his client. (In the Matter of Touche, Niven, Bailey & Smart, 37 S.E.C. 629, 670-671 (1957))
Following the certification, PMM switched its role to that of an accountant employed by Yale to undertake special studies which were necessitated by business demands rather than by statutory or regulatory requirements. In this sense, it can be seen that during the special studies PMM was a "dependent public accountant" whose primary obligations, under normal circumstances, were to its client and not the public.
It was, of course, during the conduct of the special studies that the inaccuracies in the audited and certified statements were discovered. The time of this discovery makes the questions here involved difficult and unique. On the basis of the Commission's Touche, Niven opinion, an accountant has a duty to the investing public to certify only those statements which he deems accurate. This duty is not directly involved here, however, for the inaccuracies were discovered after the certification had been made and the 1963 annual report had been released. PMM maintains, therefore, that any duty to the investing public terminated once it certified the relevant financial statements. Plaintiffs, of course, contend to the contrary. Thus, the serious question arises as to whether or not an obligation correlative to but conceptually different from the duty to audit and to certify with reasonable care and professional competence
arose as a result of the circumstance that PMM knew that investors were relying upon its certification of the financial statements in Yale's annual report.
Plaintiffs' claim is grounded in the common law action of deceit, albeit an unusual type in that most cases of deceit involve an affirmative misrepresentation by the defendant.
Here, however, plaintiffs attack PMM's nondisclosure or silence.
It is Dean Prosser's view that, in contrast with the issues raised when an affirmative misrepresentation is involved, "a much more difficult problem arises as to whether mere silence, or a passive failure to disclose facts of which the defendant has knowledge, can serve as the foundation of a deceit action." Prosser, Torts 533 (2d ed. 1955). The law in this area is in a state of flux due to the inroads being made into the old doctrine of caveat emptor. Although the prevailing rule still seems to be that there is no liability for tacit nondisclosure, Dean Prosser adds the following important qualification: "to this general rule, if such it be, the courts have developed a number of exceptions, some of which are as yet very ill-defined, and have no very definite boundaries." Id. at 534. One of these exceptions is that
"one who has made a statement and subsequently acquires new information which makes it untrue or misleading, must disclose such information to any one whom he knows to be still acting on the basis of the original statement . . . ." (Ibid.)
Section 551 of the First Restatement of Torts, which is couched in the specific terms of "a business transaction", is in substantial agreement with Dean Prosser. The Restatement position in Section 551(1) is that
"one who fails to disclose to another a thing which he knows may justifiably induce the other to act or refrain from acting in a business transaction is subject to the same liability to the other as though he had represented the nonexistence of the matter which he has failed to disclose, if, but only if, he is under a duty to the other to exercise reasonable care to disclose the matter in question."
Section 551(2) lists the instances when the requisite duty to disclose arises. For present purposes, the following portion from that subsection is important:
"One party to a business transaction is under a duty to exercise reasonable care to disclose to the other before the transaction is consummated . . . (b) any subsequently acquired information which he recognizes as making untrue or misleading a previous representation which when made was true or believed to be so."
Although an exhaustive discussion of the cases supporting Dean Prosser and the Restatement is not necessary, an analysis of several typical authorities will illustrate the practical effects of the operation of the principles described above.
In Loewer v. Harris, 57 Fed. 368 (2d Cir. 1893), plaintiff buyer and defendant seller were negotiating the possible transfer of a brewery. In early January, 1891, the buyer made inquiries about the brewery's output and average profits, stressing the importance of the answers to his decision whether or not to purchase. The seller commented favorably on the operations inquired about. Later, on April 28, 1891, a purchase contract was executed.
During the period between the time of the representations and the time of the signing of the contract, the output and profits of the brewery declined. The seller never communicated these downturns to the buyer. When the buyer subsequently discovered the declines, he brought suit against the seller for failure to disclose them. The court held that nondisclosure under these circumstances was a proper basis for liability on the rationale that
"when one of the parties, pending negotiations for a contract has held out to the other the existence of a certain state of facts, material to the subject of the contract, and knows that the other is acting upon the inducement of their existence, and, while they are pending, knows that a change has occurred, of which the other party is ignorant, good faith and common honesty require him to correct the misapprehension which he has created. It becomes his duty to make disclosure of the changed state of facts, because he has put the other party off his guard." (57 Fed. at 373)
It should be noted that, in Loewer, the information contained in one representation was made untrue as a result of a change in the performance of the brewery; while, in the instant case, the representation was rendered false not by a change in conditions but by a discovery that the information on which the representation was based was itself false and misleading. This distinction would not seem crucial, however, for the impact upon the person who relies on the representation is the same: he is induced to act in reliance upon a representation which the representer knows has become false. In short, the manner in which the representation is transformed into a misrepresentation should not determine the right of a plaintiff to maintain an action for nondisclosure.
In Fitzgerald v. McFadden, 88 F.2d 639 (2d Cir. 1937), one defendant, an attorney acting as an agent for his client, represented to the plaintiff that an invention of the client was patentable. The attorney subsequently learned that another person had filed for a patent involving a similar process but failed to convey this discovery to the plaintiff. An action was brought for damages suffered as a result of payments made by plaintiff to finance enterprises utilizing the allegedly patentable invention. Plaintiff's recovery against the defendant attorney was upheld by the Second Circuit on the ground that defendant allowed plaintiff to act on the basis of a statement made by the defendant which the latter knew had become false. Implicit in such a holding, of course, is the principle that the defendant was under a duty to notify plaintiff that he had learned that the invention involved might not be patentable.
Generally speaking, I can see no reason why this duty to disclose should not be imposed upon an accounting firm which makes a representation it knows will be relied upon by investors. To be sure, certification of a financial statement does not create a formal business relationship between the accountant who certifies and the individual who relies upon the certificate for investment purposes. The act of certification, however, is similar in its effect to a representation made in a business transaction: both supply information which is naturally and justifiably relied upon by individuals for decisional purposes. Viewed in this context of the impact of nondisclosure on the injured party, it is difficult to conceive that a distinction between accountants and parties to a business transaction is warranted. The elements of "good faith and common honesty" which govern the businessman presumably should also apply to the statutory "independent public accountant".
PMM, of course, disputes the imposition of a duty to disclose and, for its purposes, properly emphasizes that the Restatement speaks in terms of "a business transaction" to which the alleged tortfeasor is a party and in which he has a definite pecuniary interest. Indeed, the cases discussed and cited heretofore involve instances where both plaintiff and defendant are economically affected by the defendant's nondisclosure.
PMM contends that the duty imposed on a party to a business transaction to disclose that a prior representation is false and misleading is "in no way pertinent to the standard of responsibility applicable to the independent auditor" (PMM's Reply Brief, p. 8) and that the obligation to disclose is contingent upon the presence of the opportunity for the accrual of personal gain to the nondisclosure party as a result of the nondisclosure.
The parties and the SEC have not supplied, nor has the court found, any cases which analyze the issue raised by this contention within a factual framework involving nondisclosure of information which makes a prior representation false. As the ensuing discussion will show, however, this does not mean that plaintiffs' cause of action for deceit must be dismissed at this stage of this litigation, nor does it preclude a rational analysis of the issue raised by defendant.
In cases involving affirmative misrepresentations, it is now the settled rule that a misrepresenter can be held liable, regardless of ...