United States District Court, Northern District of New York
August 27, 1990
ALBERT M. KLEIN, BLANCHE TAVE AND DANIEL SLANE, PLAINTIFFS,
HARRY E. GOETZMANN, JR., JOHN L. BARTOLO, LYNN H. SMITH, HENRY A. PANASCI, JR., CHRIS J. WITTING, ALVIN O. BEILING, ROBERT C. HAYMAN, THOMAS J. PRINZING AND JAMES J. MOSHER, DEFENDANTS.
The opinion of the court was delivered by: McCURN, Chief Judge.
MEMORANDUM-DECISION AND ORDER
Plaintiffs, shareholders in Continental Information Systems,
Inc., have brought suit against certain of the corporation's
officers and directors alleging that the defendants made
material misrepresentations and omissions in information
provided to the investing public, in violation of Sections
10(b) and 20(a) of the Securities and Exchange Act of 1934,
15 U.S.C. § 78j(b) and § 78t(a), and Rule 10b-5, 17 C.F.R. §
240.10b-5, promulgated thereunder. The plaintiffs also assert
causes of action based in common law fraud and negligent
misrepresentation. The defendants move to dismiss the
consolidated amended complaint ("complaint") on the grounds
that it fails to state a claim for relief under the federal
securities laws and New York common law, and for failure to
plead fraud with particularity as required by Fed.R.Civ.P.
The plaintiffs, Albert Klein, Blanche Tave, and Daniel Slane,
are representatives of a putative class of purchasers of stock
of Continental Information Services, Inc. ("CIS"), during the
period from April 29, 1987 through November 18, 1988. The
defendants are nine individuals who were officers and/or
directors of CIS during that period. The individual defendants
were signatories to CIS's Securities and Exchange Form 10-K and
the Annual Report to Shareholders for the fiscal year 1988,
issued on or about May 12, 1988.
The factual background pertinent to this motion, as alleged
in the complaint, is as follows:*fn1
CIS's primary business was the leasing of computer equipment.
Prior to the Tax Reform Act of 1986, the bulk of CIS's business
deals involved arrangements with businesses to lease computer
equipment, in which CIS would then sell 90 percent of that
lease agreement to a bank. CIS would sell the remaining 10
percent of the lease agreement to a third party seeking a tax
shelter. Instead of receiving lease payments, the 10 percent
investor would receive the computer equipment's depreciation
tax writeoffs, and half of the equipment's resale value when
the lease expired. CIS would then buy the equipment and deliver
it to the business, earning a commission on the deal. At the
end of the lease, CIS would sell the equipment and split the
residual value with the tax shelter investor.
The Tax Reform Act of 1986, however, eliminated the type of
tax shelters CIS was providing, forcing the company to devise
new strategies to earn its profits. These strategies included
the acquisition of three companies in an attempt to diversify
CIS's business. In August 1987, CIS acquired CMI Corp., a
previous competitor. Also in FY 1988, CIS acquired Aviron
Computer Technologies, Inc., a company which refurbished,
reconfigured and modified computer equipment, and COM-PRO,
another company in the computer field.
The 1988 Annual Report indicated a period of strong growth
for CIS. According to the report, between the years 1986 and
1988, total revenues increased from $221,073,000 to
$547,497,000; earnings before income tax increased from
$18,028,000 to $27,718,000; and net earnings increased from
$10,993,000 to $16,070,000. However, according to the
plaintiffs, CIS improperly recorded the sale of an aircraft on
its books in order to misrepresent its earnings in either FY
1987 or 1988.*fn2
Plaintiffs also include in the complaint several examples of
representations made by the defendants which they allege
indicate defendants' misrepresentations about the true
condition of CIS's business. The representations cited by the
plaintiffs are numerous, but some examples include:
— In the 1987 Annual Report, with respect to CIS's profits
CIS anticipates EVEN more accelerated growth in
the foreseeable future. This optimism is founded
on the Company's remarketing strength in
maximizing the residual value of all assets it
— In the 1987 Annual Report, regarding the effects of the
Tax Reform Act of 1986:
We have said that tax reform would be beneficial
to our industry and continue to believe so . . .
our higher revenues and pre-tax earnings evidence
that our outlook in this respect is correct.
Prospects for the coming year are excellent. We
look forward to continued growth in revenues and
anticipate net income growth of approximately 30%.
— In a May 13, 1988, news release:
We anticipate that the current year will be an
excellent one for the company. As the expanded
sales organization and reorganized administrative
support staff reach full stride, they do so at a
time when the market for pre-owned computer,
telecommunications and aircraft equipment is the
strongest in the history of this business. We
believe that demand for this equipment will
continue at a high level over the foreseeable
future. This demand should be a powerful stimulus
for Continental's continuing growth in both
revenues and earnings.
— In the 1988 Annual Report, regarding $105M in debt to
become due and payable in FY 1989:
The Company is currently negotiating to "term out"
that debt over a 10-year period. Management
believes that some portion of the term loan will
be subordinated debt and some will be senior debt.
Management is confident that this negotiation will
be completed before the end of the second fiscal
quarter of 1989.
On or about July 14, 1988, CIS filed a 10-Q Form with the
Securities and Exchange Commission which stated that the
company had suffered a loss of $7,521,000 for the first quarter
of FY 1989. This statement was made approximately eight weeks
after the statements in the May 13, 1988 news release and 1988
Annual Report. This loss translated into a loss of $.59 per
share, as compared to a profit of $.23 per share for the first
quarter of the previous year.
Following the commencement of this litigation, on or about
January 13, 1989, CIS filed a Chapter 11 petition for
reorganization in the U.S. Bankruptcy Court in the Southern
District of New York. The plaintiffs in their complaint cite an
affidavit filed with the petition by Thomas Prinzing, one of
the defendants in the instant action and senior vice
president-finance and principal financial officer of CIS, in
which Prinzing states, inter alia:
The Debtors' financial difficulties and the
reasons for filing their respective Chapter 11
petitions are principally as follows.
Continental's acquisition of CMI Holding Co. was
originally to be effectuated through both debt and
equity financing. However, due to the "crash"
suffered by the stock market in October 1987,
Continental was unable to complete the
contemplated equity financing. Thus, the
acquisition of CMI Holding Co. was effectuated
solely through debt financing, forcing the Debtors
to incur higher interest expense than originally
contemplated. In addition, although Continental's
acquisition of CMI, Aviron and Com-Pro has
diversified its business and enabled the Debtors
to offer an expanded range of quality service to
their clients, these entities have not as yet been
fully integrated. Excessive operating costs from
lack of economies of
scale and overlapping functions have unfortunately
resulted. . . .
. . . At the same time the Debtors were
experiencing significantly higher operating costs
as a result of the acquisition of CMI Holding Co.,
the Debtors' revenues were declining for the
following reasons. The enactment of the Tax Reform
Act of 1986 greatly reduced the tax advantages
traditionally enjoyed by equipment lessors, causing
the Debtors to re-channel their marketing and sales
efforts. In addition, as a result of operating
losses for the first and second quarters of fiscal
year 1989, accessibility to the investor market and
the ability to use income vehicles to raise outside
capital to support their cash needs were adversely
(Emphasis in original).
The plaintiffs allege that these statements and others
contained in Prinzing's affidavit confirm that the causes of
the sharp downturn in CIS's financial health were existing and
recognized by the management long before their effects were
revealed to the investing public in the summer of 1988. The
plaintiffs further allege that the defendants acted
individually and in concert to conceal adverse material
information about the financial condition and future business
prospects of CIS, in an effort to maintain an artificially high
market price for CIS securities.
The defendants have moved for an order dismissing the
complaint pursuant to Fed.R.Civ.P. 12(b)(6) for failure to
state a claim upon which relief can be granted under the
Securities and Exchange Act of 1934 and New York common law,
and, in the alternative, to dismiss the SEC and common law
fraud claims for failure to plead fraud with particularity as
required by Fed.R.Civ.P. 9(b).
I. Motion to Dismiss
The standards for considering a motion to dismiss pursuant to
Fed.R.Civ.P. 12(b)(6) are well-settled. The motion is addressed
to the face of the complaint, and the court must construe the
complaint's allegations in the light most favorable to the
plaintiffs and accept the well-pleaded factual allegations as
true. Scheuer v. Rhodes, 416 U.S. 232, 236, 94 S.Ct. 1683,
1686, 40 L.Ed.2d 90 (1974). A claim will be dismissed under
Rule 12(b)(6) only if it appears beyond doubt that the
plaintiffs can prove no set of facts supporting their legal
claim which will entitle them to relief. Dahlberg v. Becker,
748 F.2d 85, 88 (2d Cir. 1984), cert. denied, 470 U.S. 1084,
105 S.Ct. 1845, 85 L.Ed.2d 144 (1985).
II. Failure to State a Claim
The defendants maintain that the plaintiffs have failed to
state a claim upon which relief can be granted under Section
10(b) and 20(a) of the Securities and Exchange Act of 1934
("Act") and Rule 10b-5.*fn3 The defendants also argue that the
plaintiffs have not pleaded fraud with the particularity
required by Fed.R.Civ.P. 9(b). More particularly, the
defendants claim that plaintiffs' allegations that the
defendants failed to accurately predict CIS's performance are
not actionable under those sections or under common law fraud.
The Second Circuit has insisted that complaints alleging
fraudulent violations of Section 10(b) and Rule 10b-5 must
satisfy the particularity requirement of Rule 9(b). Decker v.
Massey-Ferguson, Ltd., 681 F.2d 111, 114 (2d Cir. 1982); Ross
v. A.H. Robins Co., 607 F.2d 545, 557-59 (2d Cir. 1979), cert.
denied, 446 U.S. 946, 100 S.Ct. 2175, 64 L.Ed.2d 802 reh'g
denied, 448 U.S. 911, 100 S.Ct. 3057, 65 L.Ed.2d 1140 (1980).
Thus, the court will consider the two prongs of defendants'
motion concomitantly. To state a claim under Section 10(b), the
plaintiffs must allege acts indicating an intent to deceive,
manipulate, or defraud, and Rule 9(b) requires that the
circumstances constituting the fraud be stated with
particularity.*fn4 Decker v. Massey-Ferguson, 681 F.2d at 115.
The factual foundation for the fraud claims must be pleaded.
Stern v. Leucadia Nat'l Corp., 844 F.2d 997, 1003 (2d Cir.),
cert. denied, 488 U.S. 852, 109 S.Ct. 137, 102 L.Ed.2d 109
(1988). Pleadings of fraud may not generally be based upon
information and belief, but, on the other hand, they may be so
pleaded when the facts constituting the fraud allegations are
"peculiarly within the opposing party's knowledge; even then,
however, the allegations must be accompanied by a statement of
the facts upon which the belief is founded." Id. Great
specificity as to knowledge and scienter on the part of the
defendants is not required, since, as Rule 9(b) states,
"[m]alice, intent, knowledge, and other condition of mind of a
person may be averred generally." Goldman v. Belden,
754 F.2d 1059, 1070 (2d Cir. 1985).
Failure to accurately predict future business developments is
generally not actionable under Section 10(b) and Rule 10b-5.
See, e.g., Decker v. Massey-Ferguson, 681 F.2d at 116-18;
Crystal v. Foy, 562 F. Supp. 422, 429 (S.D.N.Y. 1983); Schwartz
v. Novo Industri, A/S, 658 F. Supp. 795, 798-99 (S.D.N.Y. 1987)
("a judgment subsequently found to have been overly optimistic"
is not a basis for a fraud claim under Rule 10b-5); Marbury
Management, Inc. v. Kohn, 470 F. Supp. 509, 512-13 (S.D.N Y
1979) ("the mere fact that the defendant's predictions did not
materialize" does not "indicate that the statements were untrue
at the time of issuance"), aff'd in part, rev'd in part on
other grounds, 629 F.2d 705 (2d Cir.), cert. denied,
449 U.S. 1011, 101 S.Ct. 566, 66 L.Ed.2d 469 (1980).
The basis for plaintiffs' claims, however, is not bad
business judgment. The plaintiffs allege that the defendants
made a series of very positive predictions as to CIS's future
when circumstances suggested that the company's future was, at
best, unclear. The plaintiffs point to, in particular, an
alleged improper accounting practice to misrepresent the
company's earnings, and the statements by Mr. Prinzing in his
affidavit which plaintiffs maintain indicate the company's
awareness of certain business problems which were intentionally
concealed from the investing public. The Second Circuit
considered similar allegations in Goldman v. Belden,
754 F.2d 1059 (2d Cir. 1985), a case cited by the plaintiffs here. The
subject of the complaint in Goldman was the marketing of a
telephone system designed to aid hotels in registering their
guests' long-distance calls. The complaint alleged that,
despite positive predictions about the success of the system
by the corporation's officers and directors in annual reports
and other statements, the corporate officers knew or should
have known of flaws in the marketing program and in the
telephone system which ultimately caused the program to fail.
The alleged flaws in the telephone system were detailed in the
complaint. The complaint further alleged that the positive
predictions about the system's success were made falsely or
with reckless disregard for the truth because of the facts
within the officers' and directors' knowledge. The court held
in Goldman that, given the defendants' positive predictions,
and the plaintiffs' allegations of knowledge of undisclosed
negative factors, the complaint adequately stated a claim under
Section 10(b) and Rule 10b-5. The court stated:
Liability may follow where management
intentionally fosters a mistaken belief concerning
a material fact, such as its evaluation of the
company's progress and earnings prospects in the
Id. at 1069 (quoting Elkind v. Liggett & Myers, Inc.,
635 F.2d 156 (2d Cir. 1980)).
In the instant case, plaintiffs allege that the defendants
made very positive statements about CIS's future when in fact
they knew of circumstances that made the company's prospects
unclear. As in Goldman, defendants' positive statements here
may not be as unqualified as the complaint alleges. However,
the actual effect of the statements on the investing public
goes toward their materiality, which is a mixed question of law
and fact that would be inappropriate to answer as a matter of
law. See Goldman, 754 F.2d at 1068. The allegations of the
positive predictions made by the defendants, coupled with
factual allegations that the defendants knew of and did not
disclose negative factors, adequately state a claim under
Section 10(b) and Rule 10b-5. See id. at 1069. Accordingly, the
defendants' motion to dismiss as to the Section 10(b) and Rule
10b-5 claims is denied.
III. Pendent State Law Claims
The plaintiffs also allege causes of action based in common
law fraud and negligent misrepresentation. The defendants do
not address the common law fraud claim separately from the
Section 10(b) fraud claim. Consequently, for the reasons stated
above, defendants' motion to dismiss the common law fraud claim
is denied as well.
The defendants argue that the negligent misrepresentation
claim should be dismissed because there is no relationship
between plaintiffs and the defendants which would give rise to
a duty on the part of the defendants. The defendants cite in
support of this proposition the New York Court of Appeals
decision in Ossining UFSD v. Anderson, 73 N.Y.2d 417, 541
N YS.2d 335, 539 N.E.2d 91 (1989), in which the court stated
that recovery may be had on a claim for negligent
misrepresentation only where the parties stand in "a
relationship so close as to approach that of privity." Id. at
424, 541 N.Y.S.2d at 338, 539 N.E.2d 91. The rule reaffirmed in
Ossining actually is more accurately stated as follows:
recovery may be had for pecuniary loss arising
from negligent representations where there is
actual privity of contract or a relationship so
close as to approach that of privity.
Id. (emphasis added).
The plaintiffs note that the relationship between shareholders
and a corporation is recognized in New York as a
contractual relationship, and thus actual contractual privity
would exist here. See Application of Stewart Becker, Ltd.,
94 Misc.2d 766, 405 N.Y.S.2d 571, 574 (Sup.Ct. Suffolk County
1978). In addition, the fiduciary obligation of corporate
officers and directors to corporate shareholders is
In the instant case, however, the plaintiffs and the putative
class they represent were not stockholders of CIS until they
purchased stock allegedly relying on negligent
misrepresentations made by the defendants. Thus, the defendants
argue, the negligent misrepresentations complained of here were
made, if at all, to the general investing public. The
plaintiffs do not cite, and the court did not locate, any New
York authority for the proposition that corporate officers
and/or directors owe a duty to the general investing public,
in addition to their fiduciary obligations to the corporation
and its shareholders. The court is persuaded that officers' and
directors' liability for negligent misrepresentations does not
extend that far. As the New York Court of Appeals stated in
Ossining, "[w]e have declined to adopt a rule permitting
recovery by any `foreseeable' plaintiff who relied on the
negligently prepared report, and have rejected even a somewhat
narrower rule that would permit recovery where the reliant
party or class of parties was actually known or foreseen by the
defendants." Ossining, 73 N.Y.2d at 424-25, 541 N.Y.S.2d at
339, 539 N.E.2d at 95. As previously stated, the Court of
Appeals has adopted a more stringent requirement that the
plaintiff show actual privity or a "relationship so close as to
approach that of privity," id. at 424, 541 N.Y.S.2d at 338, 539
N.E.2d at 94, which does not exist here. Thus, the defendants'
motion to dismiss the cause of action based in negligent
misrepresentation is granted.
The motion to dismiss is granted as to plaintiffs' common law
negligent misrepresentation claim, and denied as to the
remainder of plaintiffs' claims.
IT IS SO ORDERED.