UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK
December 21, 1982
CHEMICAL BANK, Plaintiff,
ARTHUR ANDERSEN & CO., GERALD LEE, MERVYN SILVER, JOSEPH HEILBRUN, and JOHN DOES, Numbered One through Twenty, the latter being fictitious names, Defendants; MANUFACTURERS HANOVER TRUST COMPANY and FIRST PENNSYLVANIA BANK, N.A., Plaintiffs, v. ARTHUR ANDERSEN & CO., GERALD LEE, MERVYN SILVER and JOSEPH HEILBRUN, Defendants; SECURITY PACIFIC NATIONAL BANK, Plaintiff, v. ARTHUR ANDERSEN & CO., GERALD LEE, MERVYN SILVER and JOSEPH HEILBRUN, Defendants
The opinion of the court was delivered by: GOETTEL
This is an action
for violations of section 10(b) and rule 10b-5 of the Securities Exchange Act of 1934 (1934 Act), section 17(a) of the Securities Act of 1933 (1933 Act), and state common law. Before this Court is defendant Arthur Andersen & Co.'s (Andersen) motion to dismiss and for summary judgment.
The plaintiffs in this action are four commercial banks, Manufacturers Hanover Trust Company (MHT), First Pennsylvania Bank, N.A. (First Pennsylvania), Chemical Bank (Chemical), and Security Pacific National Bank (Security Pacific). (They will be referred to collectively as the Banks.)
The principal defendant
is Andersen, a public accounting firm with offices throughout the United States and the world. From 1973 until 1979, Andersen was the independent public accountant for the Frigitemp Corporation (Frigitemp), a New York corporation that is now in bankruptcy.
This lawsuit arises from a series of loans made by the Banks to Frigitemp and one of its wholly owned subsidiaries, Elsters, Inc. (Elsters). During the mid-1970's, Frigitemp, which had earlier embarked upon a course of rapid expension, required large amounts of capital, and it looked to the Banks for financing. The Banks obliged.
The money was advanced and the obligations of the parties defined in three transactions. The first will be called the Secured Credit Transaction. In a contract dated December 31, 1975 (the Secured Credit Agreement), the Banks agreed to provide Frigitemp with a line of credit up to $8 million. Beginning in 1976, the Banks advanced approximately $6.5 million to Frigitemp. These advances were secured by a pledge of Frigitemp's customer notes receivable and were evidenced by Frigitemp's promissory notes.
The second transaction will be called the Unsecured Loan Transaction. In September 1976, the Banks and Frigitemp began discussing the need to restructure Frigitemp's debt. Pending formal restructuring, which was expected to occur in 1977, Frigitemp asked for and received a $5 million short term loan from MHT, Chemical, and Security Pacific. The funding took place in two stages. In September 1976, the Banks advanced $1.5 million to Frigitemp, and Frigitemp gave a one month promissory note to each bank. In October 1976, the three banks advanced $3.5 million to Frigitemp, and Frigitemp gave each bank a three month promissory note that reflected the September 1976 financing and that matured on February 28, 1977. (The maturity of these notes was later extended to April 30, 1977.) In February 1977, Frigitemp received an additional $4 million unsecured loan from all four banks and gave each bank a promissory note that matured on April 30, 1977.
The final transaction occurred in August 1977. From March 1977 until August 1977, Frigitemp's management and members of the Banks' senior management discussed Frigitemp's future financial needs and the terms and conditions of the debt restructuring. The fruit of these negotiations was the August 1977 transaction, in which the Banks restructured Frigitemp's debt and provided $4 million in new financing to Elsters.
There were essentially three parts to this transaction, although the Banks maintain that "all three agreements (plus the Pledge and Guarantee) were structured as, and were intended to be, part of one single, integrated refinancing package." O'Neill Affidavit para. 26. First, the Banks extended the maturity date on the unsecured notes from April 30, 1977 to March 31, 1978. To reflect this change, Frigitemp executed new notes in substitution for the prior indebtedness. (These will be called the Replacement Notes.) Second, the Banks extended the maturity date on the notes issued pursuant to the Secured Credit Agreement from July 1, 1977 to July 1, 1978. See id. P 28. To reflect this change, the notes were amended by endorsements dated August 9, 1977. (These will be called the Note Endorsements.) Finally, the Banks advanced $4 million to Elsters. Elsters gave the Banks promissory notes that matured on March 31, 1978; Frigitemp guaranteed the loan and pledged 100% of Elsters common stock, 750 shares, pursuant to a Pledge and Security Agreement.
Thus, as of August 1977, Frigitemp and Elsters owed the Banks approximately $19.5 million. By the time that Frigitemp filed its bankruptcy petition in 1978, however, only approximately one-third of that amount had been repaid.
The Banks commenced this action in 1979 in what is essentially an attempt to hold Andersen liable for these losses. They allege that they entered into the transactions with Frigitemp and Elsters in reliance on Frigitemp's financial statements audited and certified by Andersen for the years 1973-1976 and that these statements were materially false and misleading.
According to the Banks, Andersen's conduct in preparing and certifying these statements amounted to violations of the securities laws: the first claim is that Andersen violated section 17(a) of the 1933 Act and section 10(b) and rule 10b-5 of the 1934 Act; the fourth claim is that Andersen aided and abetted violations of these provisions.
Andersen filed this motion in 1982, after extensive discovery. It contends that this Court lacks jurisdiction because the alleged fraud was not "in connection with" the purchase or sale of a security and that the complaint fails to state a claim against Andersen as either a primary violator of the securities laws or as an aider and abettor.
For the reasons stated below, Andersen's motion is denied.
I. Jurisdiction Under the Securities Laws
The sine qua non of a federal court's jurisdiction to hear a claim under section 10(b) of the 1934 Act is a misrepresentation "in connection with the purchase or sale of [a security]," 1934 Act § 10(b), 15 U.S.C. § 78j(b) (1976); under section 17(a) of the 1933 Act, it is a misrepresentation "in the offer or sale of [a security]," 1933 Act § 17(a), 15 U.S.C. § 77q(a) (1976). The Banks assert that these requirements are satisfied by virtue of the notes issued in connection with the August 1977 transaction and the pledge of Elsters stock. Andersen, on the other hand, argues that the notes are not securities
and that the alleged fraud was not "in connection with" the pledge of Elsters stock.
A. The Notes As Securities
Three types of notes were issued in connection with the August 1977 transaction. First, there were the Replacement Notes issued by Frigitemp to the Banks in substitution for the prior unsecured indebtedness. These notes were issued on August 9, 1977 and matured on March 31, 1978, a period of approximately eight months. They provided for a definite rate of interest tied to the prime rate of the lending bank, and they were unsecured. Second, there were the Note Endorsements that amended the notes issued pursuant to the Secured Credit Agreement. The endorsements were dated August 9, 1977 and extended the maturity date on the notes to July 1, 1978. The notes, as amended, provided for a definite rate of interest tied to the prime rate of the lending bank, and they were secured by Frigitemp's customer notes receivable. Third, there were the notes issued by Elsters to reflect the $4 million advance. These notes were issued on August 9, 1977 and matured on March 31, 1978, a period of approximately eight months. They provided for a definite rate of interest tied to the prime rate of the lending bank, and they were secured by Frigitemp's pledge of Elsters common stock. Moreover, the underlying loan agreement provided that the proceeds of the loan were to be added to Elsters' working capital for use in the ordinary course of business.
Whether these notes are securities is not an easy question. The 1933 Act provides that, unless the context otherwise requires, "the term 'security' means any note." 1933 Act § 2(1), 15 U.S.C. § 77b(1) (1976). Although "any note . . . which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited," is exempt from the 1933 Act's registration requirements, 1933 Act § 3(a)(3), 15 U.S.C. § 77c(a)(3) (1976), it is clear that this exemption does not apply to the Act's antifraud provisions. Exchange National Bank v. Touche Ross & Co., 544 F.2d 1126, 1131 (2d Cir. 1976) (quoting Zeller v. Bogue Electric Manufacturing Corp., 476 F.2d 795, 799 (2d Cir.), cert. denied, 414 U.S. 908, 94 S. Ct. 217, 38 L. Ed. 2d 146 (1973)); Sonnenschein, Federal Securities Law Coverage of Note Transactions: The Antifraud Provisions, 35 Bus. Law. 1567, 1572, 1574-75 (1980); see 1933 Act § 12(2), 15 U.S.C. § 77l(2) (1976); id. § 17(c), 15 U.S.C. § 77q(c) (1976). The 1934 Act provides that unless the context otherwise requires, "the term security means any note . . . but shall not include any note . . . which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited." 1934 Act § 3(a)(10), 15 U.S.C. § 78c(a) (10) (1976). Thus, a literal reading of the statutes would mean that all notes are securities for purposes of section 17(a) of the 1933 Act and all notes with a maturity of greater than nine months are securities for the purposes of section 10(b) of the 1934 Act.
Despite the broad statutory language, however, not every note is a security. Oliver v. Bostetter, 426 F. Supp. 1082, 1085 (D. Md. 1977); see Exchange National Bank v. Touche Ross & Co., supra, 544 F.2d at 1133-37; Zeller v. Bogue Electric Manufacturing Corp., supra, 476 F.2d at 800. Perceiving that Congress, in passing the securities laws, intended to protect investors, see Tcherepnin v. Knight, 389 U.S. 332, 336, 19 L. Ed. 2d 564, 88 S. Ct. 548 (1967), and not "to regulate commercial loan transactions that would have no impact on the securities markets," American Fletcher Mortgage Co. v. U.S. Steel Credit Corp., 635 F.2d 1247, 1254 (7th Cir. 1980), cert. denied, 451 U.S. 911, 68 L. Ed. 2d 300, 101 S. Ct. 1982 (1981), most courts have held that, regardless of maturity, a note is a security only if it evidences an investment transaction; if it merely reflects a commercial loan transaction, the provisions of the securities laws do not apply. Id. at 1254; National Bank of Commerce v. All American Assurance Co., 583 F.2d 1295, 1301 (5th Cir. 1978); Great Western Bank & Trust v. Kotz, 532 F.2d 1252, 1256 (9th Cir. 1976); C.N.S. Enterprises, Inc. v. G. & G. Enterprises, Inc., 508 F.2d 1354, 1359 (7th Cir.), cert. denied, 423 U.S. 825, 46 L. Ed. 2d 40, 96 S. Ct. 38 (1975); McClure v. First National Bank, 497 F.2d 490, 493-95 (5th Cir. 1974), cert. denied, 420 U.S. 930, 43 L. Ed. 2d 402, 95 S. Ct. 1132 (1975); Briggs v. Sterner, 529 F. Supp. 1155, 1167 (S.D. Iowa 1981); Robbins v. First American Bank, 514 F. Supp. 1183, 1187-88 (N.D. Ill. 1981); see Exchange National Bank v. Touche Ross & Co., supra, 544 F.2d at 1134-37; Sonnenschein, supra, at 1587-89. This is known as the commercial-investment dichotomy. See National Bank of Commerce v. All American Assurance Co., supra, 583 F.2d at 1301; Great Western Bank & Trust v. Kotz, supra, 532 F.2d at 1256; Sonnenschein, supra, at 1588.
Courts utilizing the commercial-investment dichotomy judge a particular note transaction "against the attributes of an 'investment' and [accord antifraud coverage only to those transactions that sufficiently] display those attributes." Sonnenschein, supra, at 1588. The Ninth Circuit, for example, has noted that factors such as the term of the note,
the nature and extent of collateralization,
the form of the obligation,
the circumstances of issuance,
the relationship between the amount borrowed and the size of the borrower's business,
and the contemplated use of the proceeds
can be useful in determining whether a given note transaction represents an investment. Great Western Bank & Trust v. Kotz, supra, 532 F.2d at 1257-58.
If these factors were applied to the present case, a result that the notes did not represent an investment worthy of protection under the securities laws would certainly seem defensible. First, the notes were for a short term: the Replacement Notes and the Elsters notes had a maturity of less than nine months, the Note Endorsements had a maturity of eleven months. Second, the Note Endorsements and the Elsters notes were fully secured: the Note Endorsements by Frigitemp's customer notes receivable, the Elsters notes by 100% of Elsters common stock. Third, the notes were for a fixed amount, had a fixed maturity, and had a stated rate of interest. Thus, repayment did not depend solely upon the profit or productivity of Frigitemp and Elsters. See National Bank of Commerce v. All American Assurance Co., supra, 583 F.2d at 1301. Finally, a large class of investors was not involved. The obligations evidenced by the notes and the underlying agreements resulted from months of negotiations between the parties and were tailored to meet the needs of both Frigitemp and the Banks. In sum, the notes had the essential characteristics of an instrument representing a commercial loan. See generally Great Western Bank & Trust v. Kotz, supra, 532 F.2d at 1260 ("A note given to a bank in the course of a commercial financing transaction is not generally a security within the meaning of the federal securities [laws]."); Sonnenschein, supra, at 1581 ("in most cases in which institutional lenders have made federal antifraud claims, [coverage has been] denied").
Application of the commercial-investment dichotomy, however, is inappropriate in the Second Circuit. Rather, determination of whether a note is a security is governed by the test enunciated by Judge Friendly in Exchange National Bank v. Touche Ross & Co., supra. See Banco Nacional de Costa Rica v. Bremar Holdings Corp., 492 F. Supp. 364, 368 (S.D.N.Y. 1980); SEC v. Garfinkle,  Fed. Sec. L. Rep. (CCH) P 96,465, at 93,700 (S.D.N.Y. 1978); Altman v. Knight, 431 F. Supp. 309, 311-12 (S.D.N.Y. 1977). In that case, Judge Friendly, after reviewing the decisions that applied the commercial-investment dichotomy, concluded that "the efforts to provide meaningful criteria for decision under 'the commercial-investment' dichotomy do not seem to us to carry much promise of success." Id. at 1136.
He therefore adopted what has been termed a literalist of neo-literalist approach to the subject of notes as securities. Union Planters National Bank v. Commercial Credit Business Loans, Inc., 651 F.2d 1174, 1180 n.7 (6th Cir.), cert. denied, 454 U.S. 1124, 71 L. Ed. 2d 111, 102 S. Ct. 972 (1981); Sonnenschein, supra, at 1602; see Exchange National Bank v. Touche Ross & Co., supra, 544 F.2d at 1137 ("the best alternative now available may lie in greater recourse to the statutory language"). In Judge Friendly's words,
[a] party asserting that a note of more than nine months maturity is not within the 1934 Act (or that a note with a maturity of nine months or less is within it) or that any note is not within the anti-fraud provisions of the 1933 Act has the burden of showing that "the context otherwise requires." (Emphasis supplied.) One can readily think of many cases where it does -- the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a "character" loan to a bank customer, short-term notes secured by an assignment of accounts receivable, or a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized). When a note does not bear a strong family resemblance to these examples and has a maturity exceeding nine months, [section] 10(b) of the 1934 Act should generally be held to apply.
Id. at 1137-38 (footnotes omitted).
Applying Judge Friendly's test to this case, the Court finds that the Note Endorsements are not securities. These notes, which were for a short term and which were secured by Frigitemp's customer notes receivable, bear a strong family resemblance to "short-term notes secured by an assignment of accounts receivable." Id. at 1138. The Replacement Notes, on the other hand, bear no resemblance to the examples delineated by Judge Friendly and would presumptively be securities for purposes of section 17(a) of the 1933 Act.
Their status under the 1934 Act, however, is not as clear because the notes had a maturity at the time of issuance of less than nine months.
Judge Friendly offered no guidance for determining "the status under the 1934 Act of a note with a maturity of nine months or less that does not bear such a strong family resemblance." Id. at 1138 n. 19; see also Franklin Savings Bank v. Levy, 551 F.2d 521, 528 n. 11 (2d Cir. 1977). Nevertheless, under the circumstances of this case, the Court concludes that the Replacement Notes are securities. Because the notes do not bear a strong family resemblance to the examples delineated by Judge Friendly, they would presumptively be securities for purposes of section 17(a). The Court can perceive no reason for differentiating between section 17(a) and section 10(b) and holding that the notes are securities under one provision, but not the other.
See Sonnenschein, supra, at 1575;
see also Zeller v. Bogue Electric Manufacturing Corp., supra, 476 F.2d at 799-800.
Moreover, although the Replacement Notes had a maturity of less than nine months when issued on August 9, 1977, their actual effect was to extend the maturity date on the existing unsecured notes from April 30, 1977 until March 31, 1978, a period of eleven months. See Note Replacement Agreement, Ross Affidavit Ex. 9, at 1 (the Replacement Notes were issued "to extend the maturity of the Existing Notes"). This makes the Court especially reluctant to conclude that these notes are excluded from the coverage of section 10(b) solely because of their short term.
Andersen's fallback position is that Exchange National Bank is no longer controlling precedent because the Supreme Court, in Marine Bank v. Weaver, 455 U.S. 551, 102 S. Ct. 1220, 71 L. Ed. 2d 409 (1982),
rejected the literalist approach in favor of one that emphasizes the economic realities of a given transaction. This interpretation has not been accepted in this Circuit. In Golden v. Garafalo, 678 F.2d 1139 (2d Cir. 1982), a case decided after Weaver, the Second Circuit concluded that an economic reality analysis is inappropriate in most situations and essentially affirmed the literalist approach to determining whether an instrument is a security within the meaning of the securities laws.
It noted that
we believe that Congress intended to draft an expansive definition [of the term "security"] and to include with specificity all instruments with characteristics agreed upon in the commercial world, such as "debentures," "stock," "treasury stock" or "voting-trust certificates." Catch-all phrases such as "investment contract," were then included to cover unique instruments not easily classified. If the "economic reality" test were to be the core of the definition, only general catch-all terms would have been used.
* * *
Our prior cases fully support this view. In Movielab, Inc. v. Berkey Photo, Inc., 452 F.2d 662 (2d Cir. 1971), we held that two 8% installment notes, in the amount of $5,250,000 each, given by Movielab to Berkey and payable over 20 years were "securities" because they were "notes." In "economic reality," the transaction was merely a sale of assets on credit and, therefore, of a commercial, rather than investment, nature. We have reaffirmed Movielab in a post- United Housing Foundation, Inc. v. Forman 421 U.S. 837, 95 S. Ct. 2051, 44 L. Ed. 2d 621, decision. Exchange National Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1133 (2d Cir. 1976). Judge Friendly's opinion in that case noted the "dubious value" of the SEC v. W. J. Howey Co. 328 U.S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244 "economic reality" test in the context of determining what kind of "notes" are "securities," id. at 1136, and suggested that even in the light of Forman, "the best alternative . . . may lie in greater recourse to the statutory language." Id. at 1137. We agree fully with Judge Friendly that however great the merits of the Howey test in determining what falls within the catch-all phrase "investment contract," it is of little help in determining the meaning of more specific words which refer to instruments with commonly agreed upon characteristics, such as "stock."
* * *
Congress thus may have had good reason to draft the definition of "security" so as to include all instruments having commonly agreed upon characteristics, such as "stock," leaving "economic reality" to govern only the catch-all phrase "investment contract" in cases involving unusual or unique instruments. The dangers in creating uncertainty as to the scope of the Acts and in generating slippery legal and factual issues going to jurisdiction are substantial. We regard that as having been the legislative judgment, and we give it force.
Id. at 1144-46.
The clear import of Golden is that Exchange National Bank is still the law in this circuit. Thus, although there may well be merit to the commercial-investment dichotomy, the Court is bound to follow Judge Friendly's literalist approach and hold that the Replacement Notes are securities and that there is jurisdiction to hear the Banks' claims under the securities laws.
B. The Pledge of Elsters Stock
Whether the pledge of Elsters stock is sufficient to support the exercise of jurisdiction is also an interesting issue. To resolve it, two questions must be answered: first, whether the pledge of Elsters stock was a sale within the meaning of the securities laws; second, whether the alleged fraud occurred "in connection with" the pledge.
The answer to the first question is clear: a pledge of stock is equivalent to a sale for purposes of section 17(a) of the 1933 Act, Rubin v. United States, 449 U.S. 424, 431, 66 L. Ed. 2d 633, 101 S. Ct. 698 (1981); United States v. Gentile, 530 F.2d 461, 466-67 (2d Cir.), cert. denied, 426 U.S. 936, 49 L. Ed. 2d 388, 96 S. Ct. 2651 (1976), and section 10(b) of the 1934 Act, Mallis v. Federal Deposit Insurance Corp., 568 F.2d 824, 828-30 (2d Cir. 1977), cert. dismissed, 435 U.S. 381, 98 S. Ct. 1117, 55 L. Ed. 2d 357 (1978); see Marine Bank v. Weaver, supra, 102 S. Ct. at 1222 n.2 (Supreme Court implied that its holding in Rubin was applicable to section 10(b)).
The question that has been debated by the parties is whether the alleged fraud occurred "in connection with" the pledge of Elsters stock. Andersen argues that, because there was no misrepresentation or omission concerning the value of Elsters stock or Elsters' financial condition, the pledge of Elsters stock cannot be used to sustain jurisdiction under section 10(b). The Banks argue that, to sustain jurisdiction under section 10(b), the fraud must merely "touch upon" the sale, not relate to the value of the pledged securities. According to the Banks, this requirement has been satisfied. The Court agrees with the Banks.
The seminal case on the "in connection with" requirement is Superintendent of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 30 L. Ed. 2d 128, 92 S. Ct. 165 (1971). The facts of Superintendent of Insurance can be summarized as follows. As part of a scheme to take control of the Manhattan Casualty Company, several defendants induced Manhattan's Board of Directors to sell its United States Treasury Bonds for approximately $5 million. The defendants, however, misappropriated the money and used it to purchase all of Manhattan's stock. Manhattan, through New York's Superintendent of Insurance, sued for violations of section 10(b) and section 17(a). The District Court dismissed the complaint, and the Second Circuit affirmed, holding, inter alia, that there was no fraud "in connection with" the sale of the Treasury Bonds. The Second Circuit noted that
what distinguishes the fraud perpetrated on Manhattan in this case from one cognizable under Rule 10b-5 is that its sole object was to obtain possession of Manhattan's government bonds for the personal use of the perpetrators. No doubt the deception was successful, for had the board known that Sweeny and his associates intended to misappropriate the proceeds for their own use it undoubtedly would not have authorized their sale. But that deception did not infect the subsequent sales transaction. With respect to the terms of the sale itself neither the purchaser nor the seller of the bonds was deceived or defrauded. Indeed, it is no part of the liquidator's claim that the full and fair market price was not paid for those bonds by their purchaser. The fraud which harmed the plaintiff consisted of the failure of Sweeny and his associates to account for the proceeds. There is a structural difference between the sale of the corporation's bonds at a concededly fair price and the subsequent fraudulent misappropriation of the proceeds received.
Superintendent of Insurance v. Bankers Life & Casualty Co., 430 F.2d 355, 360 (2d Cir. 1970) (citations omitted). The Supreme Court reversed, holding that the fraud was "in connection with" the sale of the Treasury Bonds. 404 U.S. at 12. Writing for a unanimous Court, Justice Douglas noted that "section 10(b) must be read flexibly, not technically and restrictively." Id. Because "Manhattan suffered an injury as a result of deceptive practices touching its sale of securities," it had a cause of action under the securities laws. Id. at 12-13.
Superintendent of Insurance and its progeny require a nexus, albeit not a direct or close relationship, between the allegedly fraudulent conduct and the sale of securities. Brown v. Ivie, 661 F.2d 62, 65 (5th Cir. 1981), cert. denied, 455 U.S. 990, 102 S. Ct. 1614, 71 L. Ed. 2d 850 (1982); Ketchum v. Green, 557 F.2d 1022, 1028 (3d Cir.), cert. denied, 434 U.S. 940, 54 L. Ed. 2d 300, 98 S. Ct. 431 (1977). Stated otherwise, the fraudulent conduct must "touch upon" the securities transaction. United States v. Newman, 664 F.2d 12, 18 (2d Cir. 1981); Brown v. Ivie, supra, 661 F.2d at 65; Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1028 (6th Cir. 1979); Competitive Associates, Inc. v. Laventhol, Krekstein, Horwath & Horwath, 516 F.2d 811, 815 (2d Cir. 1975); see Superintendent of Insurance v. Bankers Life & Casualty Co., supra, 404 U.S. at 12-13. This has been called the "'de minimis touch test,'" Mansbach v. Prescott, Ball & Turben, supra, 598 F.2d at 1028 (quoting Note, The Pendulum Swings Farther: The "In Connection With" Requirement and Pretrial Dismissals of Rule 10b-5 Private Claims for Damages, 56 Tex. L. Rev. 62, 66 (1977)), primarily because it does not take much of a "touch" to satisfy the test. See 1 A. Bromberg & L. Lowenfels, Securities Fraud and Commodity Fraud § 4.7(574)(3), at 88.34 (1979) (only a "very tenuous" connection need be shown). Indeed, one commentator has noted that
the "in connection with" clause would ordinarily be fulfilled if a securities transaction is involved in some way, even though the fraud did not occur in the purchase or sale that is attacked (assuming the fraud and securities transaction can be integrated into the same scheme), the deceit did not concern the terms of the securities transaction, the claimant was not a party to the deceptive transaction, the fraud and the loss were merely indirectly connected, the securities transaction was only tangentially related to the fraudulent course of conduct, and the fraud was not aimed at causing a purchase or sale of a security.
5 A. Jacobs, Litigation and Practice Under Rule 10b-5, § 38.01[b], at 2-43 to 2-44 (2d ed. 1981). The practical result of this broad test has been that, since Superintendent of Insurance, few courts have found the relationship between the fraud and the sale to be too attenuated or remote to support a claim under section 10(b). Mansbach v. Prescott, Ball & Turben, supra, 598 F.2d at 1028.
The Second Circuit has consistently adhered to the teachings of Superintendent of Insurance, United States v. Newman, supra, 664 F.2d at 18, and, like other courts, has liberally construed the "in connection with" requirement. Competitive Associates, Inc. v. Laventhol, Krekstein, Horwath & Horwath, supra, is a good example. In that case, the plaintiff lost several million dollars on securities transactions made by one Yamada in his capacity as the plaintiff's investment adviser. To recoup some of its losses, the plaintiff sued the defendant accounting firm under section 10(b), alleging that the firm misrepresented the financial condition of Takara Partners, an investment fund managed by Yamada, to induce the plaintiff to retain Yamada and his company to manage part of its portfolio. There was no allegation that the defendant misstated the financial condition of the companies whose securities were traded. The Second Circuit held that the allegations in the complaint were sufficient to meet the "in connection with" requirement because the "plaintiff . . . alleged a fraudulent scheme the accomplishment of which is directly related to the trading process." Id. at 815; see United States v. Newman, supra, 664 F.2d at 18.
Andersen's argument that the fraud must relate to the value of the securities finds no support in the case law. The argument appears to be premised on language in Rubin and Gentile concerning the identical investment risks taken by a pledgee and a purchaser of stock. See Rubin v. United States, supra, 449 U.S. at 431; United States v. Gentile, supra, 530 F.2d at 467. For example, Andersen points to the Supreme Court's statement that "both [a pledgee and a purchaser of stock] are relying on the value of the securities themselves, and both must be able to depend on the representations made by the transferor of the securities," 449 U.S. at 431; argues that, "when the Supreme Court referred to 'the representations made by the transferor of the securities,' it meant representations as to the securities transferred, and not representations as to the transferor," Memorandum of Law of Defendant Arthur Andersen & Co. in Support of Motion to Dismiss and for Summary Judgment at 30; and concludes that the Supreme Court made clear that the borrower in a pledge transaction (and presumably the seller in an outright sale of a security) can be liable under the securities laws only if he fails to disclose accurate information about the pledged securities. The problem with Andersen's argument, however, is that the passages relied upon have been taken out of context. The discussion in Rubin, and the similar discussion in Gentile, concerned only whether a pledge of stock was a sale. Both courts were simply saying that, because the investment risk taken by a pledgee is identical to the investment risk taken by a purchaser of shares of stock, there is no reason to treat a pledge differently than an outright sale of stock for purposes of the antifraud provisions of the securities laws. If more was intended, it was not indicated.
Perhaps the Supreme Court will, when confronted with the issue, narrow the test for determining whether the "in connection with" requirement has been satisfied since there are undoubtedly many instances in which the liberal interpretation of the requirement allows use of the securities laws in what are merely state law commercial disputes.
Until it does, however, the Court must adhere to Supreme Court and Second Circuit precedent and utilize the broad touch test. See Kaufman and Broad, Inc. v. Belzberg, 522 F. Supp. 35, 41 (S.D.N.Y. 1981) ("This Court has neither the inclination nor the effrontery to ignore or defy the applicable rulings of the Court of Appeals in this Circuit.").
Application of the "touch test" to the facts of this case
leads to the conclusion that the "in connection with" requirement of section 10(b) has been satisfied. The Banks, in their complaint and supporting affidavit, allege that the pledge of Elsters stock was inextricably entwined with the other parts of the August 1977 transaction. More importantly, they allege that, in deciding whether to advance the money to Elsters, Frigitemp's wholly owned subsidiary, and accept Frigitemp's guarantee and pledge of Elsters stock, they relied on the financial statements prepared and certified by Andersen and that, but for the presentation of Frigitemp as a financially healthy company, they would not have accepted Frigitemp's guarantee and pledge of Elsters stock. Unquestionably, the Banks do not allege that there were any misrepresentations concerning the value of Elsters stock. In view of the breadth of the "touch test" and in view of the Banks' allegation that they would not have entered into the transaction if the truth about Frigitemp were known, however, the Court cannot say, as a matter of law, that the alleged fraud did not "touch upon" the pledge of Elsters stock. Thus, the Court holds that the pledge is sufficient to sustain jurisdiction over the transactions at issue.
See Weaver v. Marine Bank, 637 F.2d 157, 163 (3d Cir. 1980) (on analogous facts, the Third Circuit held that the "in connection with" requirement was satisfied), rev'd on other grounds, 455 U.S. 551, 102 S. Ct. 1220, 71 L. Ed. 2d 409 (1982).
II. Legal Sufficiency of the Complaints
The second part of Andersen's motion raises the question whether the Banks' first and fourth claims -- that Andersen violated the securities laws and that it aided and abetted violations of the securities laws -- are legally sufficient.
A. Primary Liability
Andersen makes three arguments concerning primary liability. Initially, it argues that, as a matter of law, an independent outside auditor cannot be liable as a primary violator of section 10(b) of the 1934 Act; according to Andersen, it can at most be charged as an aider and abettor of a securities law violation. Second, Andersen argues that the complaint must be dismissed because it merely tracks the language of section 10(b). Finally, Andersen argues that the allegations of the complaint amount only to a claim of negligence and that, therefore, Andersen's scienter has not been adequately pleaded. None of these arguments warrants dismissal of the complaint.
Andersen's initial argument is incorrect. There is no reason why an accounting firm that engages in allegedly fraudulent conduct in violation of the securities laws cannot be held liable for those violations. As one court explained,
commonly, in securities fraud actions, a distinction has been drawn between primary and secondary defendants. Those persons or entities owing direct duties to the public are classified as primary wrongdoers and those whose liabilities arise because another has violated the law are classified as secondary wrongdoers.
Accountants may be primary wrongdoers when they [prepare and certify financial statements that] contain misrepresentations or omit to state facts necessary to make what is said not misleading [because] financial statements certified by an accountant for presentation to investors give rise to a direct duty to the public.
Seiffer v. Topsy's International, Inc., 487 F. Supp. 653, 667 (D. Kan. 1980) (citation omitted); accord, McLean v. Alexander, 599 F.2d 1190, 1195-99 (3d Cir. 1979) (although the court held that the requisite scienter was not present, it assumed that an accountant could be liable as a primary violator); Herzfeld v. Laventhol, Krekstein, Horwath & Horwath, 540 F.2d 27, 28-38 (2d Cir. 1976) (court upheld judgment against accountants as primary violators of section 10(b)); Competitive Associates, Inc. v. Laventhol, Krekstein, Horwath & Horwath, supra, 516 F.2d at 812-15 (section 10(b) action against accountants for preparing false and misleading financial statements allowed to proceed to trial).
The four cases cited by Andersen do not compel a contrary conclusion. Three cases, Edwards & Hanly v. Wells Fargo Securities Clearance Corp., 602 F.2d 478 (2d Cir. 1979), cert. denied, 444 U.S. 1045, 62 L. Ed. 2d 731, 100 S. Ct. 734 (1980), Lanza v. Drexel & Co., 479 F.2d 1277 (2d Cir. 1973) (en banc), and Savino v. E.F. Hutton & Co., 507 F. Supp. 1225 (S.D.N.Y. 1981), stand only for the proposition that, if one does not engage in "independent fraudulent conduct on which liability could be hinged, [he] may not be held liable as [a] principal." Id. at 1241; see 602 F.2d at 483; 479 F.2d at 1289. In the fourth case, Fischer v. Kletz, 266 F. Supp. 180 (S.D.N.Y. 1967), Judge Tyler merely wrote that defendants in securities fraud cases tend "to fall into four general categories[:] . . . insiders, . . . broker dealers, . . . corporations whose stock is purchased or sold by plaintiffs[,] . . . [and aiders and abettors of] . . . a party who falls into one of the first three [categories]." Id. at 190. Judge Tyler did not say that an accountant could not be liable for fraudulent misrepresentations in a financial statement he prepared and certified.
Andersen's second argument is equally unavailing. Admittedly, the first claim in the complaint does track the language of section 17(a) and section 10(b). The MHT complaint, for example, alleges that Andersen
employed devices, schemes and artifices to defraud; . . . made untrue statements of material facts, in the Statements and elsewhere, or omitted to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; and . . . engaged in acts, practices, and courses of conduct and business which operated or would operate as a fraud or deceit.
MHT Complaint para. 27. If that were all that was alleged, Andersen would be correct in asserting that a claim for primary liability is not stated. See Ross v. A.H. Robins Co., 607 F.2d 545, 557 (2d Cir. 1979) ("It will not do merely to track the language of Rule 10b-5 and rely on such meaningless phrases as 'scheme and conspiracy' or 'plan and scheme and course of conduct to deceive.'"), cert. denied, 446 U.S. 946, 64 L. Ed. 2d 802, 100 S. Ct. 2175 (1980). The first claim, however, also incorporates by reference approximately eleven pages of allegations that state with particularity the basis of Andersen's alleged liability under the securities laws. E.g., MHT Complaint PP 4-25. Inclusion of these allegations in the first claim makes frivolous any argument that the complaint merely tracks the language of section 10(b).
Turning to the scienter argument, the Court notes that Andersen is correct in pointing out that it cannot be liable under section 10(b) for mere negligence. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976); see Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 472, 51 L. Ed. 2d 480, 97 S. Ct. 1292 (1977). "[A] private cause of action for damages will [not] lie under [section 10(b)] in the absence of any allegations of 'scienter,'" Ernst & Ernst v. Hochfelder, supra, 425 U.S. at 193, which, in this circuit, means intent or recklessness.
IIT, An International Investment Trust v. Cornfeld, 619 F.2d 909, 923 (2d Cir. 1980) ("reckless conduct will generally satisfy the scienter requirement"); accord, Sirota v. Solitron Devices, Inc., 673 F.2d 566, 575 (2d Cir. 1982).
Andersen is incorrect, however, in arguing that the allegations of the complaint amount only to a claim of negligence. The complaint alleges that Andersen knew that financial information contained in the financial statements was materially false and misleading or was so reckless in preparing and certifying the statements that its conduct was tantamount to wilfullness. If the Banks prove either of these allegations -- knowledge or recklessness -- at trial,
they will have satisfied the scienter requirement as it has been interpreted in this Circuit.
Thus, they have alleged scienter sufficiently to state a claim against Andersen as a primary violator of section 10(b), and it would be improvident to conclude at this juncture that there is no set of facts that would entitle the Banks to relief under section 10(b). See Conley v. Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957) ("complaint should not be dismissed for failure to state a claim unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief" (footnote omitted)).
B. Aiding and Abetting Liability
Andersen makes two arguments concerning the Banks' allegations of aiding and abetting liability: the first is that there is no aiding and abetting liability under the antifraud provisions of the securities laws; the second is that the complaint does not adequately plead Andersen's scienter. Neither argument has merit.
A cause of action for aiding and abetting a violation of the antifraud provisions of the securities laws has been recognized in the Second Circuit for many years.
See Sirota v. Solitron Devices, Inc., supra, 673 F.2d at 575; IIT, An International Investment Trust v. Cornfeld, supra, 619 F.2d at 922; Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47-48 (2d Cir.), cert. denied, 439 U.S. 1039, 58 L. Ed. 2d 698, 99 S. Ct. 642 (1978). If one knowingly renders substantial assistance "in the achievement of [a] primary violation [of the securities laws]," he can be liable as an aider and abettor. IIT, An International Investment Trust v. Cornfeld, supra, 619 F.2d at 922.
The only issue on this motion, therefore, is whether the scienter element has been pleaded adequately.
Although the degree of scienter necessary to establish a primary violation of section 10(b) is fairly well established in this circuit, see Sirota v. Solitron Devices, Inc., supra, 673 F.2d at 575; IIT, An International Investment Trust v. Cornfeld, supra, 619 F.2d at 923, the degree of scienter necessary to establish aiding and abetting liability is an open question. Actual knowledge, of course, will satisfy the requirement. See id. at 923-24. Moreover, recklessness is sufficient when "the alleged aider and abettor owes a fiduciary duty to the defrauded party." Rolf v. Blyth, Eastman Dillon & Co., supra, 570 F.2d at 44 (footnote omitted); see Sirota v. Solitron Devices, Inc., supra, 673 F.2d at 575; IIT, An International Investment Trust v. Cornfeld, supra, 619 F.2d at 923. Whether recklessness is sufficient in the absence of a fiduciary duty, however, has not been resolved.
Sirota v. Solitron Devices, Inc., supra, 673 F.2d at 575.
Be that as it may, the parameters of the scienter element need not be determined in this case because the Banks allege more than recklessness. In the fourth claim, the Banks allege that "all of the defendants other than Andersen intentionally, wilfully and fraudulently misrepresented to plaintiffs the true and accurate state of the finances of Frigitemp," MHT Complaint para. 36, and that "Andersen, through its gross negligence and reckless disregard for the accuracy of its statements and opinions concerning the finances of Frigitemp, aided and abetted [these] intentional, wilful and fraudulent misrepresentations." Id. P 37. Additionally, the fourth claim, like the first, incorporates by reference approximately eleven pages of allegations that state with particularity the basis of Andersen's alleged liability under the securities laws. Thus, we must read the fourth claim to allege that Andersen, in addition to being reckless, knew or should have known of the misrepresentations in the financial statements and that it knew or should have known that the statements would be relied upon by the Banks.
This is sufficient to survive a motion to dismiss. See IIT, An International Investment Trust v. Cornfeld, supra, 619 F.2d at 923-24 (allegations that the defendants "aided and abetted and joined in the conspiracy by circulating a prospectus which they knew, or should have known, contained material misrepresentations of facts and material omissions" were sufficient as a "matter of pleading."). Whether the Banks can indeed prove such knowledge will have to await trial.
Although the Court believes that the present state of the law in this circuit precludes dismissal of the Banks' claims under the securities laws, it recognizes that there is substantial ground for difference of opinion on the jurisdictional questions -- whether the Replacement Notes are securities and whether the pledge of Elsters stock is sufficient to support jurisdiction over this lawsuit. Because these are controlling legal questions, it appears that an immediate appeal from this decision will materially advance the ultimate termination of this litigation. Consequently, the Court will certify an interlocutory appeal on the jurisdictional questions pursuant to 28 U.S.C. § 1292(b) (1976), and will stay further proceedings pending the outcome of the appeal.