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SCHICK v. ERNST & YOUNG

December 16, 1992

PETER G. SCHICK, et al., Plaintiffs,
v.
ERNST & YOUNG, Defendant.


SWEET


The opinion of the court was delivered by: ROBERT W. SWEET

Sweet, D. J.

Defendant Ernst & Young ("E&Y") has moved to dismiss the second amended complaint for failure to plead fraud with particularity under Fed. R. Civ. P. 9(b), for failure to state a claim under Fed. R. Civ. P. 12(b)(6), *fn1" for lack of subject matter jurisdiction under Fed. R. Civ. P. 12(b)(1), and for failure to file the securities laws claims within the statute of limitations for actions under 15 U.S.C. § 78j(b) (1988). For the following reasons, the motion is granted.

 The Parties

 Defendant E&Y is a national accounting firm alleged to have provided auditing, accounting, tax and related financial advice and services to the Limited Partnerships, Kinderhill Corporation, Kinderhill Select Bloodstock, Inc., Kinderhill Financial Services, and Kinderhill Investment Company (together, the "Kinderhill Entities") between 1985 and 1988. E&Y was substituted as a successor entity to Ernst and Whinney in the Second Amended Complaint.

 Thomas A. Martin ("Martin") is a citizen of the State of New York who was a general partner of the Limited Partnerships.

 The Kinderhill Corporation ("Kinderhill") is a Delaware corporation that was a general partner of the Limited Partnerships.

 Kinderhill Select Bloodstock, Inc. ("Select") is a Delaware corporation created by the exchange of all of the assets of most of the Limited Partnerships for new common stock in Select in 1987 (the "Select Roll-Up").

 Prior Proceedings

 The Second Amended Complaint asserts claims against E&Y alleging primary liability for securities fraud in violation of § 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, common law fraud, breach of fiduciary duty, and negligence. In an opinion and order of January 18, 1991, Schick I, this court dismissed the original complaint pursuant to Rules 9(b) and 12(b)(6), Fed.R.Civ.P. as against E&Y with leave to replead, and as against defendants Key Bank and Peat Marwick Main & Co. ("Peat Marwick") with prejudice. On April 5, 1991, Schick I was modified to the extent of allowing the Investors to replead a claim against E&Y for primary liability only under § 10(b) and Rule 10b-5. Schick v. Ernst & Whinney, Fed. Sec. L. Rep. (CCH) P 96,089 (S.D.N.Y. 1991).

 The Investors filed an Amended complaint on May 7, 1991. This, too, was dismissed for failure to plead fraud with particularity in this Court's opinion dated January 10, 1992 (Schick II). The Amended Complaint alleged, inter alia, that Ernst and Young knew that the investments in Select were illiquid and that Kinderhill was insolvent in the sense that it would not be able to pay its debts as they became due. This court found that the plaintiffs had not alleged a sufficient factual basis for inferring that E&Y knew that Kinderhill's debts were such that it was insolvent, or that Kinderhill was liable as an indemnitor of various sureties and guarantees of the Partnerships -- a situation which, the plaintiffs allege, rendered the debts due Kinderhill by the Partnerships illusory and so helped to overstate Kinderhill's assets. The Amended Complaint was dismissed with leave to replead on the grounds that the plaintiffs had not alleged sufficient facts to support an inference of scienter.

 The Second Amended Complaint was filed on January 29, 1992. Oral argument was heard on July 1, 1992. Further submissions were received and the motion was considered fully submitted on July 16, 1992.

 The Facts

 The Second Amended Complaint makes essentially the same accusations against E&Y as the Amended Complaint. The plaintiffs allege that between 1980 and mid-1986, Martin and Kinderhill, the general partners of the Limited Partnerships, organized approximately twenty-six limited partnerships in the business of thoroughbred breeding and racing. Through these partnerships, the Investors allege, Martin and Kinderhill perpetrated a fraud against them by means of a "Ponzi scheme." According to the Second Amended Complaint, Martin and Kinderhill continually formed new limited partnerships and caused them to buy and sell assets between each other at unrealistic prices to artificially inflate the Kinderhill entities' asset base, and thus to make them appear successful so as to encourage investment in the new limited partnerships. Sales of interests in the limited partnership were promoted through private placement memoranda (the "Partnership PPMs") and other sales literature that contained allegedly false and misleading representations and omitted to state material facts, and resulted in the presentation of a favorable picture of the financial health of the limited partnerships. Among other things, the Partnership PPMs are alleged to have failed to disclose the large volume of interpartnership transactions (the "related party transactions" or "RPTs") at artificially set prices, Martin's siphoning of funds for his personal use, successive pledging and assignment of promissory notes to banks, and the pyramiding of these notes by using funds from such assignments to acquire assets from existing limited partnerships which assets in turn were pledged to banks for additional financing.

 E&Y's allegedly fraudulent activities relate to an exchange offer consummated in early 1987 whereby Select was formed to acquire all of the assets of the Limited Partnerships in exchange for common stock of Select in a roll-up. According to the Second Amended Complaint, the Investors exchanged their Limited Partnership interests for shares in Select in reliance on a private placement memorandum and its supplements (the "Select Memorandum"), issued on October 10, 1986, and on the audited consolidated balance sheet of the Kinderhill Corporation and its subsidiaries dated June 30, 1986 (the "June 1986 Balance Sheet") which was contained in the Select PPM and which was allegedly prepared by E&Y with knowledge that it would be included in and used by investors reviewing the Select PPM. (Plaintiffs' Amended Complaint P 32).

 The Second Amended Complaint alleges that the Select Memorandum and the June 1986 Balance Sheet contained material misrepresentations and omitted material information upon which the Investors relied in acquiring their interests in Select. Because the only document audited by E&Y on which the plaintiffs could have relied to their detriment was the June 1986 Balance Sheet *fn2" (Plaintiffs' Second Amended Complaint PP 32, 34 [hereinafter designed as Complaint P or solely P]), only those misrepresentations in and omissions from the June 1986 Balance Sheet shall be considered.

 In the June 1986 Balance Sheet, E&Y is again alleged to have:

 (1) Overstated the current assets of Kinderhill in the amount of $ 11 million in accounts receivable due from the Limited Partnerships. Complaint at P 35. Because these were the product of a ponzi scheme, it was highly improbable that any accounts receivable from the Limited Partnerships would be properly repaid. Id. at P 61(a). Moreover, E&Y had been warned by its predecessor Peat, Marwick that should the general partner fail, the limited partnerships might fail also because they were so highly leveraged (the "domino effect statement"). Id. at P 61(c). The plaintiffs allege that E&Y failed to include the domino effect statement in the notes to the audited balance sheet.

 (2) Failed to disclose the routine nature of affiliated transactions through which the Limited Partnerships bought and sold bloodstock, id. at P 63; the percentage of total transactions that these transactions comprised, id. at P 41(b); and the fact that bloodstock in many cases could not bring a comparable price at public auction and that the bloodstock were priced based on appraisals that did not accurately reflect their fair market value at the time of affiliated transactions. Id. at P 41(d).

 (3) Represented that the consolidated balance sheet in the June 1986 Balance Sheet fairly represented the financial position of Kinderhill and related subsidiaries when it in fact did not because it did not include, as it should have according to generally accepted accounting principles (GAAP), "going concern" and "liquidity" qualifications. Id. at P 75. If these had been included, they would have revealed that the Limited Partnerships as rolled-up would be unable to continue profitably in business without engaging in related transactions, that the Limited Partnerships were illiquid and that Kinderhill was at the time or soon would be insolvent and could not continue as a going concern, and that the bloodstock which generated accounts receivable and payable was pledged to Key Bank as security for loans. Id. at P 81.

 (4) Omitted to disclose the amounts of loans extended to the Limited Partnerships for which Kinderhill was liable as general partner, id. at P 68, and failed to disclose Kinderhill's liabilities as indemnitor of the sureties on ...


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