The opinion of the court was delivered by: WEINFELD
The defendant Seidman and Seidman ("Seidman") moves to dismiss various claims of amended complaints in five related actions
upon the ground that they either fail to state a claim upon which relief may be granted, pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure, or fail to plead fraud with particularity as required by Rule 9(b), or are redundant.
These five actions (as well as five other actions not now before the court) were spawned by the 1971 failure of Axelrod & Co. ("Axelrod"), a securities broker-dealer and a former member of the New York Stock Exchange ("NYSE"). Seidman is an accounting firm that conducted "surprise audits" of Axelrod in 1970 and 1971, pursuant to NYSE Rule 418.
The five plaintiffs are limited partners or subordinated lenders of Axelrod or both. Each claims in substance that Seidman improperly conducted its 1970 and 1971 audits of Axelrod by failing to analyze certain books and records and by ignoring substantial evidence of irregularities or fraud committed by Axelrod's managing partners. Plaintiffs allege that they suffered loss as a result of Seidman's issuance and certification of materially false financial statements and its failure to disclose the fraud committed by the managing partners or Axelrod's resultant perilous financial condition. Seidman denies these allegations of professional dereliction and claims that the plaintiffs were de facto general partners and participated in the same fraudulent conduct that they charge Seidman should have discovered.
Each plaintiff filed an amended complaint following this court's grant on June 10, 1975 of partial summary judgment to defendant on plaintiffs' claims with respect to the 1971 audit. The motion was granted since it was undisputed that all five plaintiffs had invested in Axelrod prior to Seidman's September 1971 issuance of reports based on its 1971 audit. Further, plaintiffs were bound not to withdraw their investments in Axelrod after its liquidation began in September 1971 until after all firm customers and general creditors had been satisfied. Thus, Seidman's reports could not in any way have caused plaintiffs' losses and plaintiffs had made no purchase or sale "in connection with" Seidman's alleged conduct, and therefore they lacked standing to sue under Rule 10b-5.
Plaintiffs were given leave to serve amended complaints and now reassert their claims as to the 1971 audit upon a different theory, as well as add other claims.
THE MOTION TO DISMISS THE FIRST CLAIM OF BARSCHI AND JOEL ROTHSTEIN
The first claim of all of the plaintiffs is brought under Rule 10b-5 and charges that Seidman made various fraudulent misstatements and omissions in connection with its 1970 audit of Axelrod upon which plaintiffs relied in acquiring and continuing their limited partnership interests in Axelrod. The misstatements and omissions are alleged to be reflected in Seidman's 1970 audit documents, which were certified on December 11, 1970. Seidman contends that, since the complaints of Barschi and Joel Rothstein allege that they acquired these interests in Axelrod in November and October 1970, respectively, prior to the issuance of the 1970 audit documents, they could not have relied upon those documents in making such investments.
Hence, the misstatements and omissions allegedly contained therein were not made "in connection with" plaintiffs' purchase or sale of any security and plaintiffs lack standing under the Birnbaum rule.
However, Rothstein and Barschi urge that they satisfy the Birnbaum requirement because in March 1971, relying upon the 1970 financial statements certified by Seidman, they signed an agreement permitting their loans to remain outstanding and thereby "reinvested" in Axelrod; that this transaction was a repurchase of their interests. Further, they contend that in July 1971 they again continued their status as limited partners by signing amendments to the partnership agreement that were necessitated, at least in part, by a change in the membership of the partnership. Plaintiffs contend that both situations were "purchases" or "sales" of securities, and that defendant committed fraud in connection therewith.
Irrespective of the merits of this "reinvestment" theory it has not been properly pleaded. The amended complaints of Joel Rothstein and Barschi refer merely to their having become investors in Axelrod since October and November 1970, and there is no mention of the March or July 1971 transactions beyond the vague allegation that the plaintiffs "loaned money to Axelrod and permitted such loan to remain outstanding."
In any event, plaintiffs' reliance upon those transactions is without substance. The March 1971 agreement to which Barschi and Joel Rothstein were parties identifies them as limited partners of Axelrod and recites that "the parties have been and are doing business as a Limited Partnership under the firm name of Axelrod & Co . . . . and propose to continue business under that name . . . . The parties shall continue their Limited Partnership . . . ." The agreement on its face, insofar as Barschi and Joel Rothstein are concerned, represents nothing more than a continuation of the status quo. Similarly, the July 1971 agreement refers simply to the withdrawal of certain general and limited partners and the addition of two new general partners. Neither the character nor the amount of Barschi and Joel Rothstein's interests in Axelrod were changed in any way by this reaffirmation of the continuance of the partnership. Although the terms "purchase" and "sale" are broadly construed under the Securities Exchange Act of 1934,
here there has been no alteration of the nature and terms of plaintiffs' status in Axelrod or their respective investments.
Rothstein and Barschi were in exactly the same position prior to the March and July agreements as they were after them.
Their participation in the agreements therefore did not constitute "purchases" or "sales," and the Birnbaum rule bars their cause. Accordingly, the motion to dismiss the first claim of Barschi and Joel Rothstein is granted.
THE MOTION TO DISMISS THE SECOND CLAIM OF ALL PLAINTIFFS
The second claim of each of the five amended complaints once again attempts to base liability on the 1971 audit. Plaintiffs allege that in the course of the audit Seidman uncovered "substantial evidence" of "gross fraud" by the managing partners of Axelrod and learned that the firm was in a highly unstable financial condition but failed to report these derelictions to interested parties. Specifically, plaintiffs charge that two managing partners and one subordinated lender withdrew $1,090,000 from Axelrod in certified checks on August 2, 1971, while the audit was taking place; that Axelrod issued false and fraudulent profit and loss statements between January 1, 1971 and July 30, 1971; and that various other sums were improperly diverted by Axelrod's managing partners. It is alleged that each of these derelictions was "determinable from a review of the firm's books and records" and that defendant's failure to make immediate disclosure of these matters denied to plaintiffs and other investors the opportunity to take timely "corrective action" which would have prevented further dissipation of the firm's assets and otherwise to protect their interests.
Plaintiffs seek to impose liability upon Seidman on the theory that it was under a duty to notify "someone at Axelrod, if not the New York Stock Exchange" immediately upon its discovery of the alleged irregularities and even prior to the rendering of its report.
Plaintiffs would ground the duty of an auditor to make disclosures during the progress of an audit on section 6 of the Securities Exchange Act of 1934
and on a Special Instruction accompanying New York Stock Exchange Rule 417. Section 6 of the Act, together with section 19,
creates a system of self-regulation whereby registered national securities exchanges may adopt and enforce rules consistent with the Act and designed, in general, to protect investors and the public interest. NYSE Special Instruction 417.11, appearing in the Supplementary Material accompanying NYSE Rule 417, provides:
"Any condition disclosed by the audit that would cause the capital or net worth of the member or member organization to be less than that prescribed by the Board of Directors shall be reported to the Exchange by the member or member organization immediately upon the ascertainment of such ...