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.
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
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
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