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AXEL JOHNSON, INC. v. ARTHUR ANDERSEN & CO.

June 4, 1990

AXEL JOHNSON, INC., PLAINTIFF,
v.
ARTHUR ANDERSEN & CO., DEFENDANT.



The opinion of the court was delivered by: Lasker, District Judge.

Arthur Andersen & Co. ("Andersen") moves to dismiss the securities fraud claim of the complaint for failure to plead fraud with particularity pursuant to Fed.R.Civ.P. 9(b), to dismiss the common law claims on the grounds that they are barred by the applicable statutes of limitations, and for a stay of discovery pending determination of the motion to dismiss.

This action arises out of various audits and financial reviews conducted by Andersen's Michigan office for Industrial Tectonics, Inc. ("ITI"), a Michigan corporation, and Axel Johnson Inc. ("Johnson"), a New York company. Johnson alleges that, in connection with its acquisition of ITI in 1982, it relied on Andersen's financial reports and audits of ITI, which proved to be materially false and deceptive because they failed to disclose that ITI's net income and net sales were overstated by several million dollars as a result of undetected defective pricing. Johnson dismissed Andersen as ITI's auditor on September 18, 1985. On December 18, 1985 a former employee of ITI filed a qui tam action on behalf of the United States against ITI and Johnson which purported to state violations of the False Claims Act resulting from ITI's submission of allegedly defective cost or pricing data in connection with various government military contracts. The United States assumed prosecution of the action and eventually ITI and Johnson paid the government $14,279,524.00 pursuant to a settlement agreement.

The complaint alleges five claims relating to Andersen's alleged failure to perform its audits of ITI in accordance with generally accepted auditing standards ("GAAS") and to discover and disclose ITI's failure to prepare its financial statements according to generally accepted accounting principles ("GAAP"). Johnson brings some of the claims as assignee of ITI (the "Assignee claims").

I. THE 10B-5 CLAIM

The sole basis for federal jurisdiction is the First Claim, which alleges that Andersen violated Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b)(1982), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, by knowingly or recklessly failing to disclose that its audits were not performed in accordance with GAAS, and that Johnson relied upon Andersen's audits and ITI's allegedly false reports in determining the price which Johnson paid for ITI's stock.

Andersen argues that the complaint alleges nothing more than simple negligence, and, accordingly, fails to satisfy the requirements of Fed.R.Civ.P. 9(b), that allegations of fraud be pleaded with particularity.*fn1 According to Andersen, the complaint does not allege any facts giving rise to any inference that Andersen acted with fraudulent intent. See Beck v. Manufacturers Hanover Trust Co., 820 F.2d 46, 50 (2d Cir. 1987) (to satisfy Rule 9(b), "factual allegations must give rise to a `strong inference' that the defendants possessed the requisite fraudulent intent"), cert. denied, 484 U.S. 1005, 108 S.Ct. 698, 98 L.Ed.2d 650 (1988); Ouaknine v. MacFarlane, 897 F.2d 75, 79-80 (2d Cir. 1990).

Specifically, Andersen points to paragraph 28 of the Complaint which states:

  [Andersen's] failures to disclose described in
  paragraphs 21 and 22 above were knowing or reckless.
  The bases for this allegation include subsequent
  review of ITI's books and records and matters
  uncovered during litigation and negotiation of the
  claims asserted in the Butenkoff action.

Andersen asserts that this paragraph is conclusory and alleges no facts from which fraudulent intent could be reasonably inferred.

Johnson contends that the complaint's specific allegations of Andersen's failure to comply with basic provisions of GAAS are sufficient to give rise to an inference of gross negligence or recklessness, and that such recklessness satisfies the scienter requirement of Rule 10b-5.

In Rule 10b-5 cases "recklessness is sufficient to establish scienter where the plaintiffs are third parties whose reliance upon the accountant's audit or opinion letter is reasonably foreseeable." Mishkin v. Peat, Marwick, Mitchell & Co., 658 F. Supp. 271, 278 (S.D.N.Y. 1987). See Goldman v. McMahan, Brafman, Morgan & Co., 706 F. Supp. 256, 259 (S.D.N.Y. 1989). In Goldman the court stated: "An egregious refusal to see the obvious, or to investigate the doubtful, may in some cases give rise to an inference of gross negligence which can be the functional equivalent of recklessness." Id. See also Jordan v. Madison Leasing Co., 596 F. Supp. 707, 710 (S.D.N.Y. 1984) ("negligence, if gross, or blindness, although not equivalent to fraud, is sufficient to sustain an inference of fraud").

In this case the complaint purports to allege gross negligence and recklessness by Andersen in failing to disclose the several alleged violations of the GAAS. On the face of the complaint, it is difficult to determine whether these allegations constitute "[a]n egregious refusal to see the obvious, or to investigate the doubtful," 706 F. Supp. at 259, and are thus sufficiently specific to meet the requirements of Rule 9 (b). See Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 114 (2d Cir. 1982) ("conclusory allegations that defendant's conduct was fraudulent or deceptive" not sufficient under Rule 9(b)). Such a determination necessarily involves some acquaintance with customary professional standards in the auditing business. Moreover, in light of Johnson's right to amend the complaint even if this motion is granted, and the fact that the main purpose of Rule 9(b) — to apprise the defendant of the nature of the claims against which it must defend — appears to have been at least partially achieved in this case, the motion to dismiss is denied with respect to the First Claim on the following conditions: Discovery shall, in the first instance, be limited to the issue of whether Andersen's conduct constituted gross negligence or recklessness and shall be completed by July 2, after which date the defendant may move for summary judgment or to dismiss for failure to state a claim under Rule 10b-5.

II. THE COMMON LAW CLAIMS

Andersen moves to dismiss the pendent common law claims on the grounds that they are barred by the applicable ...


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