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AXEL JOHNSON, INC. v. ARTHUR ANDERSEN

April 30, 1991

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



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

Axel Johnson Inc. ("Johnson") alleges that Arthur Andersen & Co. ("Andersen") in 1982 knowingly or recklessly conducted an inadequate audit of a company known as Industrial Tectonics, Inc. ("ITI"), and that Johnson detrimentally relied on that audit when it acquired ITI in that year. Johnson contends that Andersen's conduct violated Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (1988), as well as various provisions of state law.

Andersen moves to dismiss the 10b-5 claim for failure to plead fraud with the particularity required by Fed.R.Civ.P. 9(b), and to dismiss the state law claims for lack of federal jurisdiction in the absence of the 10b-5 claim. Andersen also asserts that the 10b-5 claim is time barred.

The motions are denied.

I.

Johnson acquired ITI in 1982, with Andersen's being the most recent pre-acquisition audit. Following the acquisition, challenges to ITI's pricing of government contracts including two major negotiated orders whose proceeds were reflected in the 1982 audit resulted in payment of a $14.2 million litigation settlement by Johnson as ITI's successor. Johnson's suit alleges that Andersen's pre-acquisition audit of ITI knowingly or recklessly failed to reveal the company's potential liability on these claims in violation of Rule 10b-5.

In a previous motion, Andersen challenged the adequacy, pursuant to Fed.R.Civ.P. 9(b),*fn1 of Johnson's pleading of the scienter element of its 10b-5 claim. That motion was denied in an opinion dated June 4, 1990 on condition that further discovery be conducted solely as to whether Andersen's conduct amounted to gross negligence or recklessness, after which Johnson would be permitted to move again for summary judgment or to dismiss for failure to state a claim under Rule 10b-5. 738 F. Supp. 772.

Andersen's present motion follows that discovery. While styled as another Rule 9(b) motion, it is also effectively a motion to dismiss under Fed.R.Civ.P. 12(b)(6) by virtue of arguments presented by each party as to the adequacy of Johnson's allegations. Accordingly, Andersen's motion as to the complaint's scienter pleadings cannot prevail if Johnson has alleged conduct which as a matter of law may amount to recklessness under Rule 10b-5 and is sufficiently particularized to meet the requirements of Fed.R.Civ.P. 9(b). Because the characterization of conduct as reasonable or negligent or reckless is essentially factual, the issue raised by the motion is whether a reasonable juror could conclude that the conduct alleged in Johnson's complaint and detailed in an additional statement amplifying its scienter allegations amounted to recklessness under Rule 10b-5. We cannot say that no juror could reach such a conclusion.

In Section 10(b) cases, Fed.R.Civ.P. 9(b) requires the allegation of "facts which give rise to a strong inference that the defendants possessed the requisite fraudulent intent." Cosmas v. Hassett, 886 F.2d 8, 12-13 (2d Cir. 1989).

Under Rule 10b-5 "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, 273 (S.D.N.Y. 1987). It has been held that "[a]n 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." Goldman v. McMahan, Brafman, Morgan & Co., 706 F. Supp. 256, 259 (S.D.N.Y. 1989). 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").

Johnson's complaint contains only the following allegation of scienter:

  23 [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.

Following the decision on Andersen's earlier motion in this case, Johnson prepared a "statement in amplification of scienter allegations" to provide a more thorough account of the factual basis for its allegations of scienter than had been made at the time of the previous 9(b) motion. This opinion's factual discussion is drawn from the allegations in Johnson's complaint and additional statement.

ITI derived a substantial portion of its income from bellcrank bearings sold under negotiated government subcontracts. Those contracts were subject to a federal statute and regulations known as "defective pricing" laws,*fn2 which require suppliers to submit accurate, complete and current cost and pricing data in connection with their "contract pricing proposals." Defective pricing laws allow the government an adjustment in the negotiated price should the information submitted be found to be inaccurate, incomplete or noncurrent. 10 U.S.C. § 2306a, 48 C.F.R. §§ 15.804, 215.804. Johnson's liability resulted from ITI's pricing practices.

Andersen's 1982 audit reflected an increase in ITI's claimed profits from $3.5 million in fiscal year 1981 to $5.2 million in fiscal year 1982. Johnson alleges that this increase in profits combined with Andersen's knowledge that ITI was up for sale should have put it on notice to look even more closely than usual for suspect profit claims, and that the logical place to look was in the negotiated contracts which were a principal source of ITI's income. Johnson claims that had Andersen inspected the underlying contracts and cost information from ITI's bellcrank bearings line, it would have discovered reported profits of 75% to 89%, on bellcrank work orders ...


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