The opinion of the court was delivered by: BONSAL
These two actions, which were tried together by the court without a jury, arise out of the merger of Hathaway Instruments, Inc., into The Lionel Corporation, which merger became effective on November 6, 1961. Plaintiff in 66 Civ. 1523, Republic Technology Fund, Inc. ("Republic"), was incorporated under the laws of Delaware and has its principal place of business in California. Plaintiff in 66 Civ. 1992, The New England Industries, Inc. ("NEI"), was incorporated under the laws of Connecticut and has its principal place of business in New York. Both plaintiffs are investment funds. The defendant in both actions, The Lionel Corporation ("Lionel"),
was incorporated under the laws of New York and has its principal place of business in New Jersey. Plaintiffs are former shareholders of Hathaway, and as a result of the merger of Hathaway into Lionel, received shares of Lionel convertible preferred stock in exchange for their shares of unregistered Hathaway common stock.
The gravamen of plaintiffs' complaints is that Lionel's unaudited Financial Statements for the six-month period ending June 30, 1961, contained in the Hathaway proxy statement on which they relied in exchanging their shares, were materially false and misleading in that they understated Lionel's losses for this period. Plaintiffs sue under Section 17 of the Securities Act of 1933, 15 U.S.C. § 77q, Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) and Rule 10b-5 promulgated thereunder, and Section 14 (15 U.S.C. § 78n) and Rule 14a-9 promulgated thereunder. Jurisdiction is based on Section 22(a) of the Securities Act of 1933, 15 U.S.C. § 77v, and Section 27 of the Securities Exchange Act of 1934, 15 U.S.C. § 78aa.
By way of pendent jurisdiction in both actions and diversity of citizenship in the Republic action, plaintiffs allege that Lionel breached its contractual obligation to register under the Securities Act of 1933 the shares of Lionel preferred stock which they received in exchange for their unregistered shares of Hathaway common stock.
On July 8, 1960, Republic purchased 25,000 shares of the unregistered Hathaway common stock, and on March 15, 1961 purchased 25,000 additional shares. On March 15, 1961, NEI purchased 15,000 shares of unregistered Hathaway common stock.
In June of 1961, Lionel and Hathaway entered into merger negotiations culminating in a merger agreement. The merger became effective on November 6, 1961.
The Agreement of Merger, which was attached to the Hathaway proxy statement as Exhibit A, provided for the "conversion" of the 1,022,727 shares of Hathaway common stock into Lionel 3 3/4 non-cumulative convertible preferred stock at the rate of one share of Lionel preferred for each three shares of Hathaway common. In accordance with the Agreement of Merger, Republic exchanged 50,000 shares of Hathaway common for 16,667 of Lionel preferred, and NEI exchanged 15,000 shares of Hathaway common for 5,000 shares of Lionel preferred.
The Hathaway proxy statement included Financial Statements for both companies as well as pro forma Financial Statements for the merged company. Lionel's Financial Statements included audited financial figures for the five-year period ending December 31, 1960, and unaudited financial figures for the six-month periods ending June 30, 1960, and June 30, 1961. Lionel's unaudited Consolidated Statement of Income for the six-month period ending June 30, 1961, showed a net loss of $107,996 ($.18 per share) as compared with a profit of $655,011 ($.48 per share) for the corresponding period in 1960. The pro forma net income statement for the merged company for the six-month period ending June 30, 1961, showed a net income of $245,311 ($.08 per share).
The loss shown by Lionel for this period was the beginning of a long period of financial adversity. Lionel showed a loss for the year 1961 of $2,532,277; for the year 1962, of $4,871,209; and for the year 1963, of $6,537,525. For the year 1960, Lionel showed a net income of $862,897.
An action was instituted on April 2, 1963, in the New York Supreme Court, which included the plaintiffs and which was a purported class action seeking substantially the same relief here sought. The New York action was dismissed on May 11, 1966, for lack of prosecution. The instant actions were instituted as purported class actions on May 25, 1966 (Republic) and July 6, 1966 (NEI). On November 7, 1966, Judge Weinfeld denied plaintiffs class action status without prejudice. At trial, plaintiffs made no attempt to have the case treated as a class action.
In view of the deteriorating financial condition of Lionel, it is understandable that plaintiffs should seek some way to recoup their loss. Indeed, it may be that Lionel's mounting losses resulted, in part, by mismanagement. However, only Lionel is named as a defendant, so that any recovery from Lionel will be paid out of its assets at the expense of its other stockholders. This makes it essential that the plaintiffs prove their contentions by a fair preponderance of the evidence.
At trial, plaintiffs relied on the expert testimony of Irving L. Duchan,
a certified public accountant. Mr. Duchan is a partner in J.H. Cohen and Company, an accounting firm which audits publicly held corporations. Mr. Duchan taught accounting at the School of Business of the City College of New York and has testified on numerous occasions as an accounting expert.
At trial, Lionel relied on the testimony of Kermit Easton, a certified public accountant and a partner of S.D. Leidesdorf & Co. ("Leidesdorf"). Leidesdorf was Lionel's auditor from the early 1940's when Lionel became a publicly held corporation, until the mid 1960's. Mr. Easton is a member of the faculty of the Northeastern University Center for Management Development, where he teaches corporate financial reporting, has appeared on Practicing Law Institute Panels, and has lectured before the American Management Association. In 1960 Mr. Easton was a managing accountant on the Lionel audit. In 1961 he became the senior managing accountant, and he subsequently became a partner of the firm. Mr. Easton testified both as to his participation in the preparation of the Financial Statements and as an accounting expert.
Plaintiffs contend that Lionel's unaudited financial figures for the six-month period ending June 30, 1961, were false and misleading in that Lionel failed to make necessary adjustments in the following items:
(2) Sales returns and allowances
(3) Reserve for bad debts
(5) Research and development
(6) Selling, advertising and ...