The opinion of the court was delivered by: MACMAHON
MACMAHON, District Judge.
This action was tried to the court, without a jury, on eleven trial days, commencing October 15, 1973 and ending October 29, 1973. Plaintiffs, Gerald L. Herzfeld and General Investors Co., a partnership,
invoking federal question and pendent jurisdiction,
sue the public accounting firm of Laventhol, Krekstein, Horwath & Horwath ("Laventhol") under the anti-fraud provisions of § 10(b) of the Securities Exchange Act of 1934 ("the Act"), 15 U.S.C. § 78j(b); SEC Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5; New York General Business Law § 352-c (McKinney 1968); and the common law.
By leave of court, Laventhol has impleaded third-party defendants Irwin H. Kramer and Allen & Company Incorporated, claiming these defendants should indemnify it for any liability to plaintiffs.
Allen & Company and Allen & Company Incorporated (collectively "Allen") counterclaim against Laventhol seeking damages under § 10(b) of the Act, Rule 10b-5, § 352-c of the New York General Business Law, and the common law.
This action arises out of a private placement of $7.5 million of securities on December 16, 1969 by The Firestone Group, Ltd. ("FGL"), a Delaware corporation engaged in real estate syndication with its principal place of business in California. The securities in question were sold in units consisting of a $250,000 note and 5,000 shares of FGL common stock, at a price of $255,000 each. FGL hired Allen, an investment banking firm, to assist with the private placement and retained Laventhol to perform an audit of FGL's financial statements and to prepare and issue a report and audited financial statements for the eleven-month period ending November 30, 1969. Laventhol knew that its report and audited financial statements would be relied upon by Allen and by prospective investors.
In 1971, FGL petitioned for reorganization under Chapter XI of the federal bankruptcy law. During the bankruptcy proceedings, the $250,000 notes contained in each unit were converted into 25,000 shares of FGL preferred stock, and the 5,000 shares of common stock were reversed split 10 for 1, becoming 500 shares of new common stock. The value of the units, as of October 1, 1971, was estimated at trial to be $27,750 each.
Plaintiffs and Allen contend that the report and financial statements, prepared and issued by Laventhol on December 6, 1969, were materially misleading and that their reliance on the report led to the damages they subsequently suffered.
Essentially, plaintiffs and Allen challenge the accounting treatment accorded by Laventhol to the purported purchase and sale by FGL of certain nursing home properties in November 1969. In the audited report, Laventhol treated these transactions as an acquisition and sale in which FGL first supposedly purchased the nursing homes from Monterey Nursing Inns, Inc. ("Monterey") for $13,362,500 on November 22, 1969 and then, four days later, sold them to Continental Recreation Company, Ltd. ("Continental") for $15,393,000 on November 26, 1969. Moreover, in the report's income statement, Laventhol treated as current income $235,000 and as deferred gross profit $1,795,000 of the projected profit from the transactions.
Plaintiffs and Allen contend that the accounting treatment accorded the Monterey-Continental transactions ("Monterey transactions") was incorrect and not, as Laventhol represented, "in conformity with generally accepted accounting principles" and that the financial statements did not "present fairly the financial position" of FGL as of November 30, 1969. Specifically, they claim that the Monterey transactions were "phony" and intended solely to give support to the private placement and that Laventhol knew or should have known they were "phony," or that the transactions involved nothing more than an option to buy the property at the buyers' discretion and that Laventhol knew or should have known them to be options.
The purchase and sale of the nursing homes was the largest single transaction in the history of FGL. The magnitude and importance of the Monterey transactions can be shown by a comparison of the financial condition of FGL, with and without the Monterey transactions, as in the table below:
Sales $22,132,607 $6,739,607
Total Current Assets 6,290,987 1,300,737
Net Income 66,000 -169,000 (Loss)
Deferred Profit 1,795,000 None
Earnings/Share 10 cents -25 cents (Loss)
Thus, to the eye of a prospective investor, whether FGL appeared to be a profitable or unprofitable, a healthy or ailing, company depended on the recognition of the Monterey transactions in the company's financial statements. If the Monterey transactions were not included in the audited financial statements, it was likely that the private placement would not take place.
Mindful of the importance of the Monterey transactions and their treatment in the Laventhol report, we turn to a consideration of the auditing steps taken by Laventhol with regard to these transactions.
Richard Firestone, president of FGL, called Arnold Lipkin, a Laventhol partner, in mid-November 1969 and told him that an audit of the financial statements of FGL, as of November 30, 1969, would be necessary. Laventhol then proceeded with the audit under the direction of Lipkin, as partner in charge, and Morris Schwalb, as manager of the audit. Schwalb discussed the audit with Chester Wadley, controller of FGL, on November 17, and thereafter Schwalb met with Lipkin periodically to discuss the mechanics of the audit.
A few days after November 26, when the FGL contract with Continental was reputedly signed, the existence of the FGL-Monterey and FGL-Continental contracts came to Schwalb's attention. In early December, Schwalb sought Lipkin's advice as to the proper way to report the transactions. Lipkin requested copies of the contracts and, after reading them, met with a Laventhol partner named Leonard, an expert in the hospital field, to discuss the reasonableness of the consideration in the contracts.
Schwalb and Jerome Gottlieb, a Laventhol partner, met with Martin Scott, vice-president and director of FGL, in late November or early December. Scott informed them that Richard Firestone had initiated both agreements and that Scott was dealing with a Mr. Abramowitz, President of Monterey, in order to assemble the documentation necessary to fulfill the contract terms.
Lipkin met with Firestone on December 2 and asked him about the details of the Monterey transactions. Firestone told Lipkin that the agreements were legitimate, arms-length contracts, made in the normal course of FGL's business. Firestone also provided Lipkin with a memorandum containing references respecting Max Ruderian, president and controlling stockholder of Continental. The memorandum stated that Ruderian had been engaged in real estate syndication for fifteen years and was:
"[The] dean of the syndicators and has tutored almost all of the large syndication firms now operating. . . . We've known him for the last four years or so. He is very well known in Southern California and enjoys probably the top reputation in the field. His operations run into multi-millions of dollars annually."
The memorandum calculated Continental's net worth as "over $100,000," consisting of miniature golf courses and other assets. Ruderian's business practice was to "buy and resell prior to final payment on his sales contracts." Firestone concluded:
"Arnold, this man and his companies are very valued contacts . . . . so if you speak to him please handle him with kid gloves we don't want to lose him for future transactions."
Lipkin, an attorney and a member of the bar of Illinois (he had only practiced law for one year, in 1955), examined the Monterey contracts to determine the proper accounting treatment and concluded that they were legally enforceable. The Monterey-FGL agreement provided for payment of $5,000 on execution of the contract, $25,000 on December 20, 1969, and $3,970,000 on or before January 30, 1970. The amount of $5,822,283.09 was payable "in favor of various institutional lenders," and $3,540,216.91 was payable in equal monthly installments, at 9 1/4% interest, over twenty-five years. The contract also stated, in Exhibit B:
"Buyer reserves the right at any time after 1/30/70 or upon payment of the $3,970,000 cash down payment as required herein to convert this contract of sale to a conventional sale at which time Title shall pass to Buyer, subject to the existing mortgages of record and the balance of this contractual obligation shall be converted to a mortgage and note. Seller shall execute his grant deed in favor of buyer and buyer shall execute his note and mortgage in favor of seller."
The FGL-Continental contract contains identical language to that just quoted, with the substitution of the figure $4,965,250 for $3,970,000. That agreement provided for cash payments of $25,000 on execution of the agreement, $25,000 on or before January 2, 1970, and $4,965,250 on or before January 30, 1970. The amount of $9,363,500 was to be paid "in favor of various lenders," and $1,015,250 was payable in equal monthly installments, at 8 l/2% interest, over ten years. The Continental agreement also provided that:
"Buyer shall pay to the Seller in addition to those amounts already paid the sum of $185,000. in the event of failure to comply. Said additional $185,000. shall be liquidated damages."
After studying the contracts, Lipkin consulted Eli Boyer, a Laventhol partner, about Ruderian. Boyer knew Ruderian through various charitable endeavors as a man of substance and means and was familiar with Ruderian's reputation as a leading land syndicator. Boyer knew of one occasion in 1969 when Ruderian and his partner, Albert Spiegel, gave $50,000 in land and trust deeds to charity. Boyer told Lipkin all that he knew about Ruderian and early in December telephoned Ruderian, in Lipkin's presence, and spoke to him over a speaker phone about the Monterey transactions. Ruderian told Boyer that:
"I [Boyer] should have no concern about their interest in this deal, their ability to complete it and the financial backing they had with respect to its final conclusion."
Ruderian also told Boyer that he had executed the FGL-Continental contract, regarded it as binding on Continental, and intended to comply with its terms.
After the telephone call to Ruderian, Lipkin called three bankers given as references for Ruderian in Firestone's memorandum and discussed Ruderian's reputation and credit with them. Each replied that Ruderian was "a very legitimate, outstanding, substantial business person."
Lipkin then discussed the proper accounting treatment to be accorded the Monterey transactions with Charles Chazen, Laventhol's national partner for auditing and accounting.
In the course of several conversations, Chazen told Lipkin that the proper way to reflect the transactions in the financial statements was to take into current income the two $25,000 cash payments and the $185,000 in liquidated damages payable under the Continental contract. Chazen also instructed Lipkin that Laventhol could not give a "clean" or "unqualified" opinion because the down payments were too small to give the buyer more than a thin equity in the property and the buyer had no recourse against the seller because a purchase money mortgage was involved. As Chazen testified, "conservative accounting dictated a qualification with respect to the collectability of the receivable resulting from the transactions."
Due to the magnitude of the transactions, Chazen felt it wise to verify the accounting treatment and the enforceability of the contracts with someone more experienced in real estate matters. Chazen, therefore, consulted a Laventhol partner named Zeman, who suggested that an attorney be called. With Lipkin and Zeman present, Chazen telephoned Julius Borah, a Los Angeles attorney. In a short conversation, Chazen told Borah that the contract provided for the sale of interests in land and described selected parts of the contracts to Borah, such as, the amounts involved and the fact that the agreement provided for a non-recourse note and the liquidated damage clause in the Continental contract. Chazen then asked Borah if the contract were legally enforceable, "within its terms." Borah replied that the contract was valid. Borah did not ask to see the documents, nor were the contracts read or shown to him, despite the fact that his office was only a half-hour's drive away from Laventhol's office. Chazen did not inquire of Borah whether title to the properties had passed to FGL "because I knew title hadn't passed."
Lipkin testified that the conversation with Borah confirmed his opinion that the contracts were valid and enforceable.
On December 4, Chazen and Lipkin met with Firestone, Scott and Alan Scharf, Firestone's investment advisor, at Firestone's office. The Laventhol partners told Firestone that only a portion of the $2,030,000 profit from the Monterey transactions would be reported as current income for the period ending November 30. Firestone disagreed strongly, arguing that the entire profit should be recorded as current income. Scharf agreed with Firestone and threatened Laventhol with a lawsuit if the private placement fell through. The Laventhol people remained adamant, however, and refused to alter their treatment of the profit on the Monterey transactions.
Thus, when the report was issued on December 6, the Monterey transactions were recorded as a purchase from Monterey and a sale to Continental, the profit being divided into $1,795,000 of deferred income and $235,000 of current income.
At some time during the audit, Schwalb discovered that the Monterey transactions were not recorded on the books of FGL. It was, therefore, decided that an adjusting entry was necessary and such an entry was prepared. Schwalb instructed Wadley to make the adjusting entry on FGL's books by letter on December 19, 1969.
Laventhol also decided to issue the report as a "qualified" opinion. Thus, on December 7 or 8, Schwalb called Wadley and told him to return all copies of the report to Laventhol immediately, saying, "there will be hell to pay if we don't get them back, and don't send them by mail, send them by messenger." Wadley returned the copies of the report and Laventhol substituted a new report which stated that it fairly reflected FGL's financial condition "subject to the collectibility of the balance receivable on the contract of sale (see Note 4 of Notes to Financial Statements)." This addition was the only change in the report, and it was this "qualified" opinion which was seen by the investors, including Herzfeld.
Chazen explained the meaning of the qualification:
"What the qualification means is that it was the auditor's concern that because of the circumstances surrounding the transaction, including the amounts required to be paid initially and the fact that it was a non-recourse note and the fact that it was a purchase money mortgage, that all of these considerations led the auditors to believe that they were in no position to give an opinion on the financial statements, including this receivable because of the possibility of its failure to be collected."
The qualification, however, was not intended by Laventhol to cast doubt on the transaction as a bona fide sale.
Neither the purchase from Monterey nor the sale to Continental was ever consummated. FGL never received the second $25,000 down payment or the liquidated damages, or any other additional sum of money from Continental on this transaction.
The essential facts which plaintiffs must prove here in order to establish a civil claim for relief under § 10(b) of the Act and Rule 10b-5 are that (1) Laventhol's report was materially misleading, (2) Laventhol knew that the report was misleading (scienter), (3) plaintiffs relied upon the report, and (4) plaintiffs suffered damages as a result of such reliance.
1. WAS THE LAVENTHOL REPORT MATERIALLY MISLEADING?
We must first determine whether the audited report and financial statement issued by Laventhol was misleading in a material way. As we have discussed previously, the answer to this question turns on whether the Monterey transactions were properly reported by Laventhol.
Much has been said by the parties about generally accepted accounting principles and the proper way for an accountant to report real estate transactions. We think this misses the point. Our inquiry is properly focused not on whether Laventhol's report satisfies esoteric accounting norms, comprehensible only to the initiate, but whether the report fairly presents the true financial position of Firestone, as of November 30, 1969, to the untutored eye of an ordinary investor.
A major congressional policy underlying the anti-fraud provisions of the securities laws is the protection of investors who rely on the accuracy and completeness of information made available to them in connection with the purchase or sale of securities. Accordingly, those having greater access to information about which the investor is presumably uninformed, or those having a special relationship to investors, have an affirmative duty of disclosure.
A knowing failure to discharge this obligation will justify an award of damages under Rule 10b-5.
There can be no doubt that Laventhol knew that its audited report was required for the FGL private placement and that investors would be relying on the financial statements. Thus, Laventhol had a special duty to issue a truthful report, because it had access to information concerning FGL which was not available to investors and because it knew investors were depending on Laventhol, as a public accounting firm, to reveal the truth about FGL's financial condition.
Traditionally, the accounting profession and the courts have recognized that an auditor or public accountant owes a duty to the public to be independent of his client and to report fairly on the facts before him. Thus, the SEC has said: "[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."
The full disclosure by insiders, which is mandated by the securities laws, coincides with and reinforces the accountant's professional duty to investors who read his reports. This duty cannot be fulfilled merely by following generally accepted accounting principles. Thus:
"Compliance with generally accepted accounting principles is not necessarily sufficient for an accountant to discharge his public obligation. Fair presentation is the touchstone for determining the adequacy of disclosure in financial statements. While adherence to generally accepted accounting principles is a tool to help achieve that end, it is not necessarily a guarantee of fairness."
Indeed, compliance with generally accepted accounting principles will not insulate an accountant from criminal culpability for fraud.
"[Too] much attention to the question whether the financial statements formally complied with principles, practices and conventions accepted at the time should not be permitted to blind us to the basic question whether the financial statements performed the function of enlightenment, which is their only reason for ...