The opinion of the court was delivered by: CONNER
This action is before the Court on objections filed by defendants Peat, Marwick, Mitchell & Co. and Jerome Lowengrub, a partner in Peat, Marwick, Mitchell & Co. purportedly named as representative of a defendant class of all Peat Marwick partners (collectively "PMM"), pursuant to 28 U.S.C. § 636(b) (1), to the Recommended Decision of Magistrate Harold J. Raby, Report No. 19 submitted April 20, 1979, on PMM's motion for partial judgment of dismissal on the pleadings or for partial summary judgment.
Plaintiff James Bloor ("Trustee"), Chapter X Trustee for Investors Funding Corporation of New York ("IFC"), has instituted this suit against a multitude of defendants alleging fraud in connection with the insolvency of IFC. The complaint alleges that PMM was retained by IFC to audit certain of its books and report upon its financial statements for the years 1968-1971, and asserts the following claims against PMM which are at issue in this motion:
"(a) violations of Sections 10(b), 20, 18 and 14 of the Securities Exchange Act of 1934 (the "1934 Act") (15 U.S.C. §§ 78j(b); 78t; 78r; and 78n) (fourth through sixth claims);
"(b) state law claims for violations of Sections 352-c and 339-a of the New York General Business Law (seventh and eighth claims);
"(c) a state law claim of aiding and abetting common law fraud (third claim);
"(d) a state law claim for breach of contract in performing accounting services (nineteenth claim);
"(e) state law claims for negligence in performing such services (twentieth and twenty-second claims); and
"(f) a bankruptcy claim for fraudulent transfer (twenty-seventh claim)."
In his Report 19 ("Report"), Magistrate Raby recommends the granting of PMM's motion as to the Trustee's Sixth Claim against PMM, alleging violation of Section 14 of the 1934 Act. The Trustee has not objected to this recommendation. This portion of the Report is accordingly approved.
The Report also recommends denial of PMM's motion as to the Trustee's Third, Fourth, Fifth, Seventh, Eighth, Nineteenth, Twentieth, Twenty-Second and Twenty-Seventh Claims. PMM has objected to these recommendations, and accordingly the Court must make a de novo determination as to these issues, 28 U.S.C. § 636(b).
The principal actors in the drama described in the Trustee's complaint are Jerome, Norman and Raphael Dansker ("Danskers"), "the principal officers, controlling directors, controlling stockholders and the dominant force of IFC until some time prior to October 21, 1974" (105.)
IFC allegedly suffered massive damages at the direction of the Danskers, in part as a result of certain management decisions and in part as a result of transactions by which the Danskers misappropriated IFC funds for the personal benefit of themselves and others (103 et passim. ). Characterizing these actions by the Danskers as "the Fraud" (100), the Trustee asserts that "(as) the Fraud progressed, larger and larger amounts of money were required and were obtained in order (i) to cover up past fraudulent activities, management malfeasance, and business reverses, (ii) to give IFC the false and misleading appearance of legitimacy and success and (iii) to continue the Fraud" (104). Consequently the Fraud is said to have included multiple secret and sham transactions resulting in artificial profits and concealed losses (101). On the basis of this false image of financial health, the Danskers were allegedly able to obtain for IFC huge quantities of funds from creditors, debenture holders, stockholders and other sources (102), monies purportedly utilized in perpetuating and concealing "the Fraud."
The alleged role of PMM in this scenario consisted of its certification of IFC financial statements which, according to the Trustee, materially overstated the income and assets of IFC while materially understating its losses and liabilities (223). PMM is alleged to have breached its contractual obligation to render accounting services in a "thorough, skillful and diligent manner" (228); to have failed "to employ generally accepted auditing standards" (228); to have performed "in reckless disregard of the facts, and in a reckless, careless, unskilled and grossly negligent manner" (229); and to have failed to discover IFC's true financial condition and adequately to prepare and examine IFC's financial statements (229). The complaint concludes that since such inaccurate financial statements were necessary to the continued ability of IFC to obtain funds, and further, since the acquisition of funds by IFC was necessary to the continued vitality of "the Fraud," but for PMM's failure to perform properly its accounting services "the Fraud" would not have continued throughout PMM's tenure as IFC's independent auditor (230). The complaint contains specific allegations that inaccurate financial statements certified by PMM were included in prospectuses and other SEC filings in connection with the issuance and sale of securities (236), and that such sales "were an integral part of the Fraud since they generated the money which was necessary to perpetrate and maintain the Fraud" (234).
Among the many arguments advanced by PMM in support of its motion, two legal issues have repeating significance, and will accordingly be addressed here preliminarily to a discussion of the Trustee's nine specific claims for relief. These two general issues are (a) whether IFC suffered damages in connection with the purchase or sale of securities and, if so, whether the alleged conduct of PMM proximately caused such damages, and (b) whether the conduct and knowledge of the Danskers and other IFC management may be imputed to IFC.
A. The "In Connection With" and Causation Requirements
The thrust of the Trustee's allegations regarding securities transactions is that the Danskers, as a result of IFC's artificial appearance of financial health, were able to induce investors to purchase IFC's securities at prices in excess of their true value. If this is so, argues PMM, then IFC received more than fair value in its securities transactions. Any damage suffered by IFC,
PMM's argument continues, resulted from subsequent misappropriations or investment misjudgments as to the proceeds from such securities transactions, and such damages were thus not suffered in connection with the purchase or sale of a security, the requisite element of a private action for damages under Sections 10(b) and 18, see Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S. Ct. 1917, 44 L. Ed. 2d 539 (1975); Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir.), cert. denied, 343 U.S. 956, 72 S. Ct. 1051, 96 L. Ed. 1356 (1952).
The Trustee in response has relied upon the decision of the Supreme Court in Supt. of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 92 S. Ct. 165, 30 L. Ed. 2d 128 (1971). In Bankers Life, the plaintiff brought suit under Section 17(a) of the Securities Act of 1933 (the "1933 Act") and Section 10(b) of the 1934 Act on behalf of Manhattan Casualty Co. Manhattan was caused by one of its officers to sell its United States Treasury bonds and to deposit the proceeds from such sale in an account at Irving Trust, against which account the officer and his outside collaborators had fraudulently drawn a check for their personal use in purchasing stock of Manhattan. Despite the fact that "the full market price was paid for those bonds," id. at 9, 92 S. Ct. at 167, the Court concluded that fraud was committed in connection with the sale of these Treasury bonds because "the seller was duped into believing that it, the seller, would receive the proceeds." Id. The Court concluded:
"The crux of the present case is that Manhattan suffered an injury as a result of deceptive practices touching its sale of securities as an investor."
Id. at 12-13, 92 S. Ct. at 169.
The Trustee contends that Bankers Life broadly establishes that transactions "touching" the purchase or sale of securities fall within the ambit of the federal securities laws. Specifically, the Trustee construes Bankers Life as holding that damages suffered by a corporation as a result of the misappropriation or misuse of its funds can be the basis for a securities laws claim if: (1) the funds had been acquired by the corporation in exchange for securities, and (2) the sale of the securities by the corporation and the misdirection of the receipts therefor were both accomplished as parts of an integral scheme to defraud the corporation.
PMM has offered an alternative construction of Bankers Life. According to PMM, the Court found the claim in Bankers Life to be cognizable under the federal securities laws because the sale of the Treasury bonds was a necessary and inseparable element of the arrangement by which Manhattan was defrauded, i. e., the deposit of the proceeds in an account against which defendants had that same day drawn a check in the same amount. Critical to PMM's interpretation of Bankers Life is the Court's statement that Manhattan "was duped into believing that it ... would receive the proceeds." 404 U.S. at 9, 92 S. Ct. at 167. PMM argues that Bankers Life is not applicable to a situation where the securities transaction and the misdirection of the proceeds are conceptually separate, i. e., where the corporation does receive the proceeds from the sale of securities but is subsequently defrauded of the benefits of such consideration. Otherwise, suggests PMM, every state law action for mismanagement or theft of corporate funds will be converted into a federal securities laws claim if the funds were originally obtained in a prior securities transaction.
In support of its position, PMM relies principally upon Rochelle v. Marine Midland Grace Trust Co., 535 F.2d 523 (9th Cir. 1976). In Rochelle, the Ninth Circuit held that a bankruptcy trustee could not maintain a Section 10(b) action against the bankrupt corporation's former officers and its independent accountants where plaintiff admitted that full value was received by the bankrupt on the issuance of its debentures, but complained that the proceeds were "frittered away" by expenditures on losing real estate ventures, as part of a scheme to create "a facade of corporate health." Id. at 528-29. The court distinguished Bankers Life on the ground that "(t)he nexus between the securities transaction and the alleged losses due to mismanagement is too attenuated in this case to use as a predicate for Section 10(b) liability." Id. at 529.
In reply, the Trustee's position is that his allegations are not merely of corporate mismanagement of the proceeds from securities sales, but are rather of a continuing fraud with the objective, at least in part, of looting IFC of such funds, and thus that the instant case is more akin to Bankers Life than to Rochelle. Alternatively, the Trustee argues that the cases are inconsistent and that the superior authority of Bankers Life must control.
Without adopting PMM's closely circumscribed reading of Bankers Life, the Court is persuaded that Rochelle is both correct and consistent with Bankers Life, and that for the reasons stated in Rochelle a portion of the damage claim alleged by the Trustee does not state a claim against PMM under the federal securities laws because the damages were not incurred in connection with the purchase or sale of a security. Specifically, any damage suffered by IFC as a result of mismanagement of the proceeds of sales of securities cannot be the basis of a federal securities laws claim against PMM.
Since IFC, by the Trustee's own allegations, received more than fair value in exchange for its debentures and other securities, it was not damaged until the proceeds from such sales were subsequently misused. Such damages to IFC occurred either because (1) the Danskers looted IFC of such monies, or (2) such monies were poured into imprudent ventures in order to maintain the facade of IFC's financial well-being. The latter category is precisely the basis of the claim advanced and rejected in Rochelle, and this Court agrees with the ruling in that case that such a claim is essentially a state law claim of corporate mismanagement and breach of fiduciary obligations, and that the connection to a securities transaction is too tenuous to form the basis for a claim under the federal securities laws.
This rationale is in no way inconsistent with Bankers Life. As I read Bankers Life, it at most establishes the principle that a federal securities laws claim is stated by a complaint which alleges that defendants caused plaintiff to sell securities and fraudulently misappropriated the proceeds of that sale. It does not lay the groundwork for the recovery of funds imprudently invested and managed on behalf of the corporate plaintiff with the design of preventing the revelation of the corporation's disastrous financial condition.
As to the former category the claim for damages resulting from the looting by the Danskers PMM, as noted, suggests that Bankers Life is also inapplicable to this portion of the Trustee's claim, based upon its reading of Bankers Life as being restricted to a situation where the securities sale and the looting are so nearly contemporaneous that the seller cannot be said to have ever received the proceeds from the sale. The Court finds it unnecessary either to adopt or reject this construction of Bankers Life, for I am convinced that PMM must be sustained on the alternative ground advanced in support of its position: i. e., that assuming that the damages suffered by IFC as a result of the looting by the Danskers does form the basis of a claim cognizable under the securities laws pursuant to Bankers Life, no such claim may be asserted against PMM because, as a matter of law, the conduct of PMM was not a proximate cause of such damages.
In order for a claim to be actionable under the federal securities laws, the injury must have been a proximate result of the misleading statements or omissions. Marbury Management, Inc. v. Kohn, 629 F.2d 705, CCH Fed.Sec.L.Rep. P 97,357 at 97,399 (2d Cir. 1980). In accordance with traditional tort definitions, the requirement of proximate cause is satisfied if "the damage was either a direct result or a reasonably foreseeable result of the misleading statement." Globus v. Law Research Service, Inc., 418 F.2d 1276, 1291 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S. Ct. 913, 25 L. Ed. 2d 93 (1970).
In the instant case, the Trustee has attempted to satisfy this requirement by a series of "but for" connections linking the financial statements to the injury to IFC. Specifically, the Trustee's position is that but for the inaccurate financial statements, IFC would not have been able to sell its securities (or at least that IFC would not have been able to sell them for so high a price); that but for the sale of IFC securities, IFC would not have been in possession of any proceeds from such sales (or at least that IFC would not have been in possession of such a quantity of funds); and that but for the existence of such monies, the Danskers would not have been able to utilize a portion of these for the personal benefit of themselves and others.
The Court is in agreement with PMM that such a "but for" chain does not establish that the looting was either a direct or a reasonably foreseeable result of the allegedly misleading financial statements. It is arguably foreseeable, as a result of financial statements overstating the financial condition of a corporation, that securities issued and sold by that corporation will command a price higher than their true value, that purchasers will be injured as a result and that the corporation will receive excessive funds in consideration for the securities. However, it is certainly not a direct or reasonably foreseeable result of such financial statements that inside management will embezzle such surplus funds for their personal use.
The Trustee's claim is merely that but for the allegedly misleading financial statements, the Danskers would not have been in a position to loot IFC, i. e., there would not have been IFC funds available both to use for their personal benefit and to continue to mask IFC's financial debility. Several courts which have addressed structurally similar claims have found the requisite proximate causal connection lacking.
For example, in Hoover v. Allen, 241 F. Supp. 213 (S.D.N.Y.1965), the plaintiffs, stockholders of the subject corporation, alleged that, by means of false and misleading financial statements, other stockholders of the corporation were induced by the defendants to sell their stock back to the corporation, thereby giving the defendants control of the corporation. The plaintiffs sought damages for certain acts of corporate waste committed by the defendants, which, the plaintiffs contended, would not have occurred but for the opportunity available to defendants resulting from their control of the corporation. The court dismissed the claim under Section 10(b), in part because of the absence of any proximate causal relationship:
"While it is logically true that "but for' corporate control the alleged acts of corporate waste could not have been committed, the "but for' test of causation has been fully discredited as a basis for imposing liability, particularly when, as here, such a test would also be the sole justification for federal ...