The opinion of the court was delivered by: GRIESA
This is an action under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) and S.E.C. Rule 10b-5.
Plaintiff Competitive Associates, Inc. was formerly a publicly held mutual fund. In October 1970 Competitive retained Akiyoshi Yamada and his company, Takara Asset Management Corporation, to manage a portion of Competitive's portfolio. It was later revealed that Yamada was heavily involved in stock manipulation schemes. Competitive asserts in this action that it was defrauded into hiring Yamada and that Yamada caused several million dollars in losses to Competitive during the time of Yamada's employment.
The case has gone to trial against four defendants the accounting firm of Laventhol Krekstein Horwath & Horwath ("LKH"), and three accountants formerly associated with that firm Morton Dear, Robert E. Bier, and Thomas Martino, Jr.
LKH audited the financial statement of an entity called Takara Partners for the period July 16, 1969 through December 31, 1969. Takara Partners was a small private investment fund, managed by Yamada and his associate John Peter Galanis. The complaint in this action alleges that the financial statement of Takara Partners was false and misleading and that Competitive received and relied upon this false financial statement in hiring Yamada.
At an earlier stage of this litigation the action was dismissed as to LKH and the three individual accountants on a motion for summary judgment, because the submissions on the motion showed conclusively that Competitive neither received nor relied upon the 1969 financial statement of Takara Partners. Competitive appealed, and asserted a new theory on appeal, that, even if Competitive may not have received the Takara Partners financial statement, nevertheless the accounting defendants were liable, because they deliberately participated with Yamada in a scheme to inflate his reputation as a successful investment adviser so that he could obtain "dumping grounds" such as Competitive for his manipulated securities. The Court of Appeals reversed the summary judgment. Competitive Associates, Inc. v. Laventhol Krekstein Horwath & Horwath, 516 F.2d 811 (2d Cir. 1975). The Court of Appeals characterized the triable claim of Competitive as follows (p. 815):
". . . plaintiff's allegations that the very purpose of defendants' certification of Takara's financial statement was to aid in placing Yamada in a position where he could manipulate securities prices and sell these securities to investors attracted by Yamada's reputation and performance."
The case against the accounting defendants has been tried to the Court without a jury. This opinion constitutes the Court's findings of fact and conclusions of law.
Takara Partners commenced operations July 16, 1969. It was a limited partnership, with 25 limited partners, who made investments of $ 100,000 or more each. The list of limited partners included a number of persons prominent in the financial community. The total capital contributed was about $ 2.8 million. The fund was managed by Akiyoshi Yamada and John Peter Galanis, who were the general partners. Both Yamada and Galanis had acquired reputations as talented money managers. Yamada had been with Kuhn Loeb & Co. from 1965 to 1969 and had risen rapidly in that firm. Galanis had been with Merrill Lynch Pierce Fenner & Smith and had also been associated with mutual funds thought to be highly successful.
Unknown to the Takara Partners investors and obviously unknown to the investment community in general, Yamada and Galanis were deeply involved in stock manipulation schemes. Their handling of Takara Partners was disastrous. Among other things, substantial funds were invested in manipulated stocks.
During the first months of the existence of Takara Partners, Yamada and Galanis gave assurances to the limited partners that the assets were growing. The opposite was true. When the end of the year 1969 was approaching, Yamada and Galanis were faced with the necessity of having an audited financial statement prepared. Obviously they desired to conceal the facts. They set out to retain accountants who would be as cooperative as possible, and they determined upon a course of deceiving the accountants, while at the same time gaining their good will by means of stock tips on new issues and help in obtaining additional accounting clients.
Upon the recommendation of Galanis, LKH was retained by Takara Partners in December 1969. Dear was the partner in LKH in charge of the audit. Bier and Martino were employees of the firm. Bier was the senior accountant working under Dear. Martino was a staff accountant under Bier. A second staff accountant Michael J. Weiner worked on the audit, but is not a defendant in the action.
LKH certified the 1969 financial statement of Takara Partners under date of March 23, 1970. The statement showed that the $ 2,817,641 partners' equity contributed had grown to $ 3,269,984 as of December 31, 1969. The value of the marketable and restricted securities was shown as $ 3,287,544, compared with their cost, shown as $ 3,029,036. Another major item in the balance sheet was "Put Options Available" shown as having a value of $ 410,375.
For reasons which will be described subsequently, the 1969 financial statement of Takara Partners was prepared in both a long form and a short form. The long form included a section entitled "Accountants' Report on Supplementary Information." This supplementary information contained lists of the marketable securities and restricted securities, as well as the securities involved in the put options. The short form statement did not include the supplementary information and thus did not include the lists of the specific securities in the Takara Partners portfolio.
It is conceded that the financial statement was materially false. The falsity lay in the drastic overvaluation of restricted securities (I. e., securities not publicly traded) and in the fact that the put options were entirely fictitious.
By way of background, it should be noted that the marketable securities were comprised of 28 common stocks and 2 convertible debentures, which had a cost of $ 1,560,536, and which had a market value on December 31, 1969 of $ 1,194,525. Thus there was an unrealized loss in the marketable securities of $ 366,011. There is no contention that the information regarding the marketable securities was false. Of course, it was this unrealized loss in the marketable securities which made Yamada and Galanis feel the necessity for falsification regarding the restricted securities and the put options in order to create an appearance of growth in the assets of Takara Partners.
Takara Partners owned restricted securities in seven companies as follows:
Academic Development Corporation
Devon International, Inc.
International Computer Products
Science Systems and Technology
In the case of Delanair, Takara Partners owned both stock and warrants. In the case of the other six companies, Takara owned stock.
The long form financial statement listed the total cost for the restricted securities as $ 1,468,500 and listed the "Appraisal Value" of these securities as of December 31, 1969 as $ 2,093,019, producing an unrealized appreciation of $ 624,519. In the case of two of the restricted securities, Academic Development and Science Systems the appraisal value was the same as the cost. In the case of Delanair common stock, the appraisal value was less than the cost. In the case of all other restricted securities, gains were shown. The most spectacular reported gain related to Devon from a cost of $ 13,500 to an appraisal value of $ 371,250.
The Takara Partners partnership agreement required that restricted securities be appraised by an investment banker at the time of the annual audit, and Yamada and Galanis obtained what purported to be such appraisals for the 1969 audit. However, it is conceded that the appraisal values were largely fabricated. In the case of Science Systems the appraisal was forged, and in the case of International Computer Products the appraisal was procured by a bribe. The appraisals for Academic Development, Computer Tools, Medequip, and Devon were procured from persons collaborating with Yamada and Galanis in their illegal enterprises. Only the Delanair appraisal appears to have been bona fide. The value of the restricted securities as of December 31, 1969 was far less than the reported $ 2,193,019.
The fictitious put options arose because Yamada and Galanis felt the need for an additional fraudulent device for inflating the 1969 figures for Takara Partners. Also, one Morton Kaplan had loaned $ 240,000 to Takara Partners in the fall of 1969, and Yamada and Galanis desired to conceal this loan. Galanis devised the idea of creating fictional put options, in which Takara Partners appeared to have the right to put certain stocks to Kaplan's company, Micro Thermal Applications. The fictional option prices were high enough to create a substantial value in the options, and the $ 240,000 could be explained as a down payment against Micro Thermal's obligation under the option agreements.
The long form financial statement listed put options for three companies Brilund Mines, Computer Studies, and Planet Oil and Mineral. The information about the options, as given in the financial statement, was as follows:
The "Market Value of Security" was as of December 31, 1969.
Documents purporting to be put option agreements had been signed by Galanis on behalf of Takara Partners and by Kaplan on behalf of Micro Thermal. The dates of the purported option agreements were:
Brilund Mines 9/15/69 Computer Studies 9/10/69 Planet Oil and Mineral 9/10/69
However, the option agreements were entirely fictitious. Kaplan was an accomplice in the fraud of Galanis and Yamada.
It is now necessary to set forth the facts on the question of what the accountants did and did not do in the Takara Partners audit particularly in reference to the restricted securities and the put options.
Amendment No. 1 to the Limited Partnership Agreement of Takara Partners provided as follows:
"FIRST : VALUATION OF INVESTMENT LETTER SECURITIES. All investment letter securities shall be appraised annually as of the end of each fiscal year of the partnership for the purposes of determining the value of such investment letter securities. The appraisal of investment letter securities shall be made by an independent investment banker selected by the General Partner and the determination of the value of such investment letter securities by the independent investment banker so selected shall be final and conclusive."
The LKH Audit Program for the Takara Partners audit, prepared by senior accountant Bier, provided in part as follows:
"Securities in position gains & losses
From broker confirmations, compare position
Examine securities held & private ...