United States District Court, Southern District of New York
June 4, 1990
AXEL JOHNSON, INC., PLAINTIFF,
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
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.
Specifically, Andersen points to paragraph 28 of the Complaint which
[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
II. THE COMMON LAW CLAIMS
Andersen moves to dismiss the pendent common law claims on the grounds
that they are barred by the applicable statutes of limitations.*fn2
A. Johnsonh Pre-Acquisition Malpractice and Negligence Claim
Because Johnson is a resident of New York, its direct claims (as
distinct from its Assignee claims) are governed by the relevant New York
statutes of limitations.
N.Y.Civ.Prac. L. & R. § 202 (McKinney 1990). Section 214(6) of
N.Y.Civ.Prac. L. & R. (McKinney's 1990) provides that non-medically based
actions for malpractice must be commenced within three years of
completion of the defendant's work. Credit Alliance Corp. v. Arthur
Andersen & Co., 101 A.D.2d 231, 236, 476 N.Y.2d 539, 542-43 (1st Dept.
1984) rev'd on other grounds, 65 N.Y.2d 536, 493 N.Y.S.2d 435,
483 N.E.2d 110 (1985).
With respect to Johnson's claims arising out of events preceding its
acquisition of ITI (the "pre-acquisition claims"), Andersen argues that
because no contract or implied contract existed between Johnson and
Andersen, the three-year period of limitations for malpractice and
negligence claims applies and the claims are time-barred. In Credit
Alliance Corp. v. Arthur Andersen, 122 Misc.2d 1045, 471 N.Y.S.2d 938,
939 (1983), aff'd, 101 A.D.2d 231, 236, 476 N.Y.2d 539, 542-43 (1st
Dept. 1984) rev'd on other grounds, 65 N.Y.2d 536, 493 N Y So.2d 435,
483 N.E.2d 110 (1985), the court held that an action brought by a party
not in privity with the defendant accountant "but whose reliance on the
accountant's work was foreseeable and within the accountant's
contemplation is essentially an action for negligence [which is]
governed, therefore, by a three-year statute of limitations."
Johnson contends that the complaint, paragraphs 34-35, sufficiently
alleges that, in connection with Johnson's effort to acquire ITI, Johnson
and ITI worked so closely together that they were virtually in
contractual privity. However, the complaint alleges only that Andersen
owed a duty of care to users of the financial statements it prepared for
ITI and that Andersen knew Johnson would rely on such statements in
connection with its purchase of ITI stock. Even if true, such allegations
are not sufficient to create privity between Andersen and ITI.
Because the pre-acquisition claims of Johnson against ITI do not arise
out of a contractual relationship, the six-year statute of limitations
for contracts does not apply. The three-year statute of limitations for
negligence and malpractice applies and, accordingly, the claims are
B. Johnson's Post-Acquisition Malpractice and Negligence Claim
Andersen asserts that those claims for negligence and malpractice
asserted by Johnson which arise out of services performed by Andersen for
Johnson after Johnson's takeover of ITI on December 22, 1982 (the
"post-acquisition claims") are time barred because Andersen did no work
for Johnson after September 20, 1985, when Johnson terminated Andersen's
services, and this action was brought more than three years after that
However, as Johnson points out, a recent line of cases have held that
New York's six-year period of limitations for contracts applies to
malpractice and negligence actions which assert damages to property or
pecuniary interests and are based on the defendant's failure to exercise
due care in the performance of a contract. Video Corp. of America v.
Frederick Flatto Assoc., Inc., 58 N.Y.2d 1026, 462 N.Y.S.2d 439,
448 N.E.2d 1350 (1983). See also Bernstein v. Crazy Eddie, Inc.,
702 F. Supp. 962, 985 (E.D.N.Y. 1988) (recognizing claim of failure to
exercise due care against accountant as sounding in contract, not tort,
under Video Corp.); Sinopoli v. Cocozza, 105 A.D.2d 743, 481 N.Y.S.2d 177,
178 (2d Dept. 1984) (six year statute of limitations applies to claim of
failure to exercise due care by attorney). In Cohen v. Goodfriend,
665 F. Supp. 152, 159 (E.D.N.Y. 1987), the court stated:
[U]nder New York law, a plaintiff may sue a
professional, such as an attorney, for negligence and
breach of contract based on the failure to use due
care, within New York's six year statute of
limitations for contract actions as long as the
liability asserted "had its genesis in the contractual
relationship of the parties." Baratta v. Kozloweki,
94 A.D.2d 454, 461, 464 N.Y.S.2d 803, 808 (2d Dep't
1983) (quoting Sears, Roebuck & Co. v. Enco
Associates, 43 N.Y.2d 389, 396, 401 N.Y.S.2d 767,
771, 372 N.E.2d 555, 558 (1977)). To avail himself of
period it is not necessary that a plaintiff plead a
contractual theory of liability or that there be an
express agreement between the parties for the
professional to use due care in the performance of
Johnson's post-acquisition claims clearly have their "genesis in the
contractual relationship of the parties," because Johnson was a client of
Andersen's for three years following Johnson's acquisition of ITI. For
this reason, and because Johnson seeks pecuniary damages for those
post-acquisition claims, New York's six year limitations period applies
and the claims are not timebarred.
C. The Assignee Claim of Negligence and Malpractice
Andersen argues that all of the Assignee claims asserted by Johnson are
barred by the applicable Michigan statute of limitations.*fn3
Johnson concedes that the relevant statutes of limitations for its
Assignee claims based on negligence and professional malpractice,
Mich.Comp.Laws.Ann. §§ 600.5838, 600.5805(4), require that an action
be instituted within two years of the date on which the defendant ceased
to provide services or six months from the date on which plaintiff
discovered or should have discovered the claim, whichever is later.
Andersen argues that because it ceased to provide services to ITI on
September 20, 1985, when Johnson advised Andersen that ITI was switching
to another auditing firm, the limitations period expired on September
20, 1987 and, accordingly, Johnson's action is time-barred because it was
filed in 1989.
Johnson responds that it did not and could not have discovered its
damages until June 1989, when Johnson and ITI settled the action brought
on behalf of the United States — relating to defective pricing by
ITI — pursuant to which they paid the government more than fourteen
million dollars. The complaint in this action was filed on September,
29, 1989, less than six months later. Accordingly, Johnson asserts that
the claims are timely filed. Andersen contends that Johnson knew that it
had suffered some damages as early as November, 1985, when it was charged
by the government with defective pricing practices.
Under Michigan law:
[A] malpractice claim accrues only when all the
necessary elements of a cause of action have
occurred, including damages. Luick v. Rademacher,
129 Mich. App. 803, 342 N.W.2d 617 (1983). It is the
fact of identifiable and appreciable loss, and not the
finality of monetary damages, that gives birth to the
cause of action. Id.
Dowker v. Peacock, 152 Mich. App. 669, 394 N.W.2d 65, 66 (Mich.App.
1986). In Dowker plaintiff filed a complaint on August 9, 1984 against
his attorney for malpractice arising out of a lawsuit which the attorney
had filed on plaintiff's behalf against Wayne Harding and a claim of lien
on Harding's property in February 1980. The lien proved to be defective
and the attorney withdrew it in April 1980. Plaintiff dismissed the
attorney on March 1, 1982, and hired another attorney. The plaintiff's
case against Harding went to trial in June 1984 but on June 15, 1984
Harding filed for bankruptcy and listed plaintiff as a creditor.
The Dowker court held that only on the date of bankruptcy, when the
plaintiff lost his opportunity to secure a judgment against Harding, did
the plaintiff suffer any "identifiable and appreciable loss" resulting
from the first attorney's failure to file a proper construction lien in
1980. Accordingly, the court held that plaintiff's action against the
attorney, filed less than six months after the date of the Harding
bankruptcy, was timely. The court stated:
If plaintiff had prevailed in the lawsuit against
Wayne Harding, he would have no claim of malpractice
against defendants for the defective lien, having
suffered no injury. But when Harding's
bankruptcy aborted the lawsuit, the defective lien
became decisive. Indeed, until the outcome of the
circuit court action was known, it could not be
ascertained whether plaintiff had suffered any harm by
defendants' negligence regarding the construction
lien. Had plaintiffs filed a malpractice action
against defendants while the lawsuit against Wayne
Harding was still in progress, it would have been
dismissed as premature.
394 N.W.2d at 67 (citations omitted). Similarly, in this case, until the
outcome of the government's investigation was known — the
settlement agreement between Johnson, ITI and the government — it
could not be said that, within the meaning of Michigan caselaw, Johnson
had suffered any "identifiable and appreciable loss" as a result of the
alleged malpractice by Andersen. Andersen's argument that Johnson knew it
had suffered an appreciable loss in November 1985 — when the
government initiated its investigation — is unpersuasive. Had the
government later dropped its investigation there would have been no
appreciable loss. Andersen's argument that Johnson could have determined
its losses at any point during the investigation to determine its damages
is undercut by Dowker.
Moreover, although the legal rationale of Dowker appears to be
controlling and persuasive, the result is not unfair to Andersen. Under
Andersen's view, in order to file its action timely, Johnson would have
had to do so before Johnson's settlement with the Government. However,
this would have been to Andersen's disadvantage because it could well
have been deemed by the Government as an indication of Johnson's
liability, thereby greatly reducing any chance that the Government would
have dropped or dismissed the charges and increasing the chances that
Johnson would have to pay damages to the government and pursue its action
against Andersen to recover such damages. In sum, the rule urged by
Andersen would require plaintiffs to file a malpractice action when
damages are merely speculative and might increase the chances of such
damages accruing, to the very detriment of defendants such as Andersen.
Accordingly, the Fourth Claim, the Assignee claim relating to
negligence and malpractice, is not time barred.
D. The Assignee Claim of Breach of Contract
Andersen asserts that the Assignee claim based on breach of contract is
time barred. It argues that, under Michigan caselaw, Michigan's two year
statute of limitations period for malpractice claims applies to a breach
of contract claim when the claim is against a professional for failure to
exercise due care, as it is in this case. Because this action was
instituted more than two years after the date on which Johnson terminated
its contract with Andersen, September 20, 1985, Andersen argues that the
period of limitations has expired. Johnson contends that the applicable
statute of limitations is Mich.Comp. Laws Ann. § 600.5807(8), which
carries a six year limitations period for breach of contract claims.
Under Michigan law, in determining which of two different statutes of
limitation applies, "[t]he applicable period of limitations depends upon
the theory actually pled when the same set of facts can support either of
two distinct causes of action." Barnard v. Dilley, 134 Mich. App. 375,
350 N.W.2d 887, 888 (1984). In Barnard the court set forth the standard
by which to determine the "theory actually pled" for deciding whether
Michigan's two-year period of limitations for contracts or the six-year
malpractice limitations period applies:
In her first amended complaint, plaintiff alleged only
that a contract to represent her in a specific action
was made between her and defendant Dilley. This
contract was not a "special agreement" as that term
was used in Stewart v. Rudner, 349 Mich. 459, 468,
84 N.W.2d 816 (1957). It was not a contract to perform
a specific act, but one to exercise appropriate legal
skill in providing representation in a lawsuit. Her
claim is that damages flowed not from his failure to
represent her, but from his failure to represent her
adequately. This is a
claim grounded on malpractice and malpractice
350 N.W.2d at 888. In Penner v. Seaway Hosp.,
169 Mich. App. 502, 427 N.W.2d 584 (1988) the court,
following the analysis of Barnard, concluded that a
complaint which charged "that defendant breached the
alleged agreement by failing to properly diagnose the
decedent's ailments and render appropriate medical care"
was a malpractice action and not a contract action. Id.
at 587. The Penner court relied on the lack of "an
agreement to perform any specific act." Id. See also
Stroud v. Ward, 169 Mich. App. 1, 425 N.W.2d 490, 494
(1988) (because plaintiff's damages resulted from
inadequate representation by defendant, claim is based
on malpractice rather than breach of contract for
statute of limitations purposes).
Johnson's argument that the complaint alleges facts
adequate to support the existence of the "special
agreement" referred to in Barnard v. Dilley and Stewart
v. Rudner, 349 Mich. 459, 468, 84 N.W.2d 816, 823
(1957), is not persuasive. In Stewart v. Rudner the
court held that an action was better characterized as a
contract claim, rather than a malpractice claim, where
the complaint alleged a "special agreement" between
plaintiff and her obstetrician to perform a caesarean
section; the defendant had not simply agreed to deliver
plaintiff's child according to general professional
standards of care. The court stated:
"The two causes of action are dissimilar as to
theory, proof and damages recoverable. Malpractice is
predicated upon the failure to exercise requisite
medical skill and is tortious in nature. The action in
contract is based upon a failure to perform a special
agreement. Negligence, the basis of the one, is
foreign to the other."
Id. 84 N.W.2d at 823 (quoting Colvin v. Smith, 276 A.D. 9, 92 N.Y.S.2d 794,
Johnson does not state which facts in the complaint indicate the
existence of a special agreement to perform a specific act. In deed, the
complaint's fifth claim, alleging breaches of contract, states only
[Between 1979 and 1985] ITI and [Andersen] had a
contractual relationship with respect to the services
agreed to be performed by [Andersen] for ITI.
As part of the contract, [Andersen] agreed to
perform its services according to the highest
professional standards of due care, and to observe
GAAS, GAAP, and the doctrine of fair reporting.
[Andersen's] violations of GAAS, GAAP, and the
doctrine of fair reporting . . . constituted breaches
The relevant portion of the complaint, cited above, alleges merely that
the contract between Andersen and ITI was for performance of audit and
review services in compliance with the relevant professional standards.
There is not any indication of a "special agreement," of the type
described in Barnard. Accordingly, Michigan's two year limitations period
for malpractice applies to Johnson's fifth claim and it is barred because
the action was brought more than two years after the termination of
Andersen's services by Johnson on September 20, 1985.
In sum, Andersen's motion to dismiss is granted with respect to the
Assignee claim of breach of contract and the pre-acquisition claim of
negligence and malpractice but is denied with respect to all other
claims. Accordingly, the Second claim of the complaint and that portion
of the Fifth claim which states Johnson's Assignee contract claim are
dismissed. Discovery shall be limited, in the first instance, to the
issue of whether Andersen's conduct constituted gross negligence or
recklessness and shall be completed by July 2.
It is so ordered.