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").
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 ...