The opinion of the court was delivered by: EUGENE H. NICKERSON
NICKERSON, District Judge:
This civil litigation arises from the allegedly fraudulent and negligent conduct of Eddie Antar and his relatives and the officers, directors, auditors, underwriters, employees, and vendors of the consumer electronics retailer Crazy Eddie, Inc. ("Crazy Eddie") (now in bankruptcy).
The various complaints in the case have alleged, in summary, that from 1980 through 1987, Eddie Antar, founder of Crazy Eddie, together with numerous relatives and associates, engaged in a series of spectacularly bold schemes designed falsely to portray Crazy Eddie as a thriving commercial enterprise so that investors would buy shares in it and those shares would sell at an inflated price. According to the proposed amendment to the class action complaint in In re Crazy Eddie Sec. Litig. (the "Class Complaint"), Eddie Antar realized cash proceeds of $ 72,245,649, his father Sam M. Antar realized $ 16,857,332, and other family members and associates realized lesser amounts. In this opinion the court refers to this series of schemes collectively as the "Crazy Eddie Fraud."
The court addresses three motions. The class plaintiffs move to amend their complaint. Their proposed complaint, styled as the "Fourth Supplemental Amended and Consolidated Complaint," newly alleges that defendants Peat Marwick Main & Co. and KMG Main Hurdman (now merged and referred to collectively as "Peat Marwick") violated sections 1962(c) and 1962(d) of the Racketeer Influenced and Corrupt Organizations Act ("RICO"), 18 U.S.C. §§ 1961 et seq., and makes additional changes to reflect previous rulings of this court.
Plaintiffs Entertainment Marketing, Inc. and Elias Zinn move to amend their complaint (the "EMI/Zinn Complaint"). The proposed complaint (i) adds a RICO claim against Peat Marwick and other individual defendants, (ii) broadens the previously asserted claim of common law fraud to encompass Peat Marwick and adds a demand for punitive damages, (iii) broadens the negligence claims to encompass certain individual defendants, (iv) eliminates one claim, and (v) drops certain defendants from other claims.
Peat Marwick cross-moves for summary judgment on the negligence and negligent misrepresentation claim alleged in the EMI/Zinn Complaint.
Numerous memoranda and orders of this court have recounted the facts of this litigation. The court assumes familiarity with its previous published memoranda and orders dated December 30, 1988, Bernstein v. Crazy Eddie, Inc., 702 F. Supp. 962 (E.D.N.Y. 1988); June 16, 1989, In re Crazy Eddie Sec. Litig., 714 F. Supp. 1285 (E.D.N.Y. 1989); June 19, 1990, In re Crazy Eddie Sec. Litig., 740 F. Supp. 149 (E.D.N.Y. 1990); September 19, 1990, In re Crazy Eddie Sec. Litig., 747 F. Supp. 850 (E.D.N.Y. 1990); March 6, 1991, In re Crazy Eddie Sec. Litig., 135 F.R.D. 39 (E.D.N.Y. 1991); May 1, 1992, In re Crazy Eddie Sec. Litig., 792 F. Supp. 197 (E.D.N.Y. 1992) (the "May 1992 Order"); and September 4, 1992, In re Crazy Eddie Sec. Litig., 802 F. Supp. 804 (E.D.N.Y. 1992) (the "September 1992 Order").
RICO Claims Against Peat Marwick
The court considers together the motions of the class plaintiffs and the EMI/Zinn plaintiffs to add RICO claims against Peat Marwick.
The substance of these claims is that Alphonse Ferrara, the former Peat Marwick partner who supervised or substantially participated in that firm's audit of Crazy Eddie financial statements for the years ending 1985, 1986 and 1987, knew about or deliberately disregarded obvious evidence of material misrepresentations in Crazy Eddie financial statements and intentionally concealed fraud from its directors, underwriters, and investors.
1. Allegations common to both complaints
The two complaints allege, in substance, the following.
(a) Failure to investigate discovered inventory fraud in 1985. In the course of Ferrara's first annual audit in 1985, he learned that Crazy Eddie inventory tickets and count sheets at three separate stores were physically altered, inflating the company's inventory by more than $ 1 million. He spoke to Eddie Antar who explained that the alterations must have been made by a disgruntled employee and not by management. Ferrara accepted this explanation, adjusted the inventory to reverse the effect of the known alterations, and took no further steps to ascertain whether the fraud was wider than the known alterations.
Ferrara failed to broaden the scope of Peat Marwick's inventory audit in 1986, despite his discovery of attempted fraud the year before. As a result, according to the EMI/Zinn Complaint, Ferrara overlooked a scheme devised by Eddie Antar to overstate Company inventory by $ 12 to $ 14 million.
(b) Active concealment of the Zazy scheme in 1986. On March 5, 1987 Crazy Eddie's counsel, James Purcell of Paul Weiss Rifkind Wharton & Garrison, was informed by individuals at Salomon Brothers Inc that an anonymous telephone caller had told them of "theft at the highest levels of Crazy Eddie management" involving the three members of Crazy Eddie's "Office of the President" and Zazy International ("Zazy"). Plaintiffs would later learn of a variety of fraudulent transactions, including theft of Company inventory, perpetrated by Crazy Eddie and Zazy.
Purcell asked Ferrara and James H. Scott, Jr., a Columbia Business School professor who then headed the Crazy Eddie Audit Committee, thoroughly to investigate the Zazy transactions. Purcell memorialized these conversations in a contemporaneous "Office Memorandum" discovered shortly before the EMI/Zinn plaintiffs sought leave of the court to amend their complaint.
Peat Marwick had not yet started its 1987 audit and could easily have designed the audit to examine the Zazy transactions. It did not.
According to minutes of a meeting of the Crazy Eddie Audit Committee on June 8, 1987, appended to the EMI/Zinn Complaint, "representatives" of Peat Marwick, alleged to include Ferrara, reported that Peat Marwick had investigated allegations of "irregularities with respect to sales by the Company to Zazy's" and that it had "no reason to believe that any irregularities had occurred." Ferrara later said that he was never asked to investigate the Zazy transactions and, in fact, never conducted such investigation.
Ferrara refused to investigate the Zazy transactions because, he explained to Sam E. Antar, he was afraid such investigation might force him to resign from the Crazy Eddie account.
The debit memo fraud allegedly worked in the following manner. Crazy Eddie, like other retailers, would periodically return goods to suppliers. After returning goods the supplier would provide Crazy Eddie with a debit memo, commonly called a "reep," entitling Crazy Eddie to reduce the amount it owed on its next payment to the supplier. In fiscal 1986 and before, Crazy Eddie reportedly did not "recognize" these purchase discounts and trade allowances for accounting purposes until they were deducted from checks written by Crazy Eddie to the supplier.
Beginning in fiscal 1987, Crazy Eddie recognized these purchase discounts and trade allowances when it received a debit memo from the supplier. This change in accounting principle allowed Crazy Eddie insiders to create $ 20 million in fictitious debit memos, thereby reducing (by causing debits to be posted to) accounts payable. Neither complaint states which account received an offsetting credit for $ 20 million.
The complaints allege that Ferrara knew that the amount of debit memos in 1987 vastly exceeded purchase discount and trade allowance debit memos in 1986, yet he failed to examine them. Moreover, Peat Marwick failed to indicate that the accounts payable in 1987 were not reported in a manner consistent with the reporting of accounts payable in 1986, in violation of generally accepted accounting principles.
The complaints suggest that any trained accountant would have discovered the debit memo fraud, given the size of the scheme and the inherent risk of fraud posed by the immediate recognition of debit memos, and that Ferrara willfully ignored unmistakable evidence of such fraud.
2. Allegations contained in the Class Complaint
The Class Complaint alleges, in substance, the following additional instances of misconduct.
(a) Misrepresentations to underwriters. Ferrara intentionally misled underwriters in the course of their due diligence inquiries in three or more instances.
First, he lied about a table that was included in prospectuses distributed in connection with two public offerings of securities in March and again in June of 1986. The table, which provided a breakdown of Crazy Eddie product sales by product category, had been created by Sam E. Antar based on his "seat-of-the-pants" guess. When Sam E. Antar was pressed by the underwriters to provide back-up documentation to support his numbers, which both he and Ferrara knew he could not provide, Ferrara provided a "comfort letter" to the underwriters. Ferrara allegedly issued this letter so that the underwriters would not discover that Sam E. Antar had fabricated some of the information in the prospectus.
Second, Ferrara falsely informed defendants Salomon Brothers Inc, Bear Stearns & Co., Inc., and Wertheim Schroder & Co., Inc. that the Crazy Eddie's Management Information System was functioning when he knew it was essentially non-functional.
Finally, he further misled various underwriters about the nature of Crazy Eddie's internal management and financial controls, and he failed to inform them of non-arms-length transactions between the Company and various Antar family members.
(b) Reckless conduct. In addition, Ferrara engaged in instances of reckless accounting practices too numerous to recount here. For example, even after Ferrara learned that Crazy Eddie employees had physically tampered with Peat Marwick's audit work papers, he failed to safeguard the work papers. This allowed Crazy Eddie employees to continually rework Peat Marwick's numbers during evenings after Peat Marwick auditors had gone home.
The EMI/Zinn Complaint alleges, in substance, the following additional acts of deliberate misconduct.
(a) Destroying documents after November 6, 1987. After new management took control of the Company on November 6, 1987 and discovered an apparent $ 45 million inventory short-fall, Ferrara, who was asked to assist in the ensuing investigation, destroyed documents to conceal fraudulent transactions with Zazy prior to the end of fiscal 1987.
(b) Phony adjustments to inventory in 1986 and 1987. While preparing the financial statement for fiscal 1986, Ferrara made fictitious adjustments, having no basis in fact, in order to reduce the year-end inventory total. Ferrara and possibly others at Peat Marwick made similarly fictitious adjustments during the following year. He allegedly made these adjustments in order to conceal the fraudulent overstatement of Company inventory.
(c) Financial anomalies. Much as the Class Complaint alleges numerous specific instances of reckless conduct, the EMI/Zinn Complaint alleges numerous instances of implausible financial trends. For example, as a combined result of the debit memo and inventory frauds during fiscal 1987, the Company's reported inventory increased from $ 60 million to $ 109 million during 1987 whereas reported accounts payable declined from $ 52 million to $ 50 million. Such disparate trends, the complaint alleges, must have alerted Ferrara to fraud.
Peat Marwick opposes both motions to amend. It contends, first, that the motions should be denied because (a) both proposed complaints (i) fail to allege with particularity the predicate acts of mail fraud, wire fraud, or, in the case of the EMI/Zinn Complaint, "fraud in the sale of securities," and (ii) fail to state a violation under 18 U.S.C. § 1962; and, (b) the EMI/Zinn Complaint fails to allege causation with particularity.
Peat Marwick contends, second, that it would be unduly prejudiced in both instances if the court grants leave to amend.
The court rejected the contention that Peat Marwick would be unfairly prejudiced by the addition of a RICO claim, stating in its May 1992 Order that:
Peat Marwick had notice of the facts that give rise to this alleged RICO claim because it relates to the fraud and other claims set forth in the Second Complaint. The only new fact is that Ferrara, a Peat Marwick partner, "actually knew" of the fraud committed . . . .
Although Peat Marwick will have to investigate the new fact of knowledge, it will not be unduly prejudiced by the addition of the RICO claim.
In re Crazy Eddie Sec. Litig., 792 F. Supp. at 205.
Peat Marwick contends, in its opposition to the motion to amend the EMI/Zinn Complaint, that it will be prejudiced because that complaint makes many allegations "on information and belief." Since discovery is now complete, it says it either will have to go to trial on an amended pleading without adequate discovery on the new factual allegations, or will be "forced to endure yet further delay necessitated by the taking of additional discovery."
The EMI/Zinn plaintiffs have submitted, in reply, documents and deposition testimony already available to Peat Marwick which appear to support most of the allegations of fact and many of the inferences made upon information and belief.
If after reviewing the reply submission, Peat Marwick wishes to apply to Magistrate Judge Carter for additional discovery, it is free to do so.
To state a claim under the RICO Act, plaintiffs must meet two pleading burdens. First, they must allege that each defendant violated section 1962. Plaintiffs must allege seven constituent elements: "(1) that the defendant (2) through the commission of two or more acts (3) constituting a 'pattern' (4) of 'racketeering activity' (5) directly or indirectly invests in, or maintains an interest in, or participates in (6) an 'enterprise' (7) the activities of which affect interstate or foreign commerce. 18 U.S.C. § 1962(a)-(c) (1976)." Moss v. Morgan Stanley Inc., 719 F.2d 5, 17 (2d Cir. 1983) aff'd sub nom Moss v. Newman, 465 U.S. 1025, 79 L. Ed. 2d 684, 104 S. Ct. 1280 (1984). Or plaintiffs must allege that the defendant conspired to engage in such a pattern of racketeering activity. 18 U.S.C. § 1962(d).
"Racketeering activity" is defined to include, among other crimes, (i) any act which is indictable under 18 U.S.C. § 1341 (relating to mail fraud), 18 U.S.C. § 1342 (relating to wire fraud), and (ii) "any offense involving . . . fraud in the sale of securities . . . punishable under any law of the United States."
Second, plaintiffs must allege they were injured in their business or property "by reason of a violation of section 1962." 18 U.S.C. § 1964(c).
Whether Peat Marwick violated section 1962
(1) "Racketeering activity"
The Class Complaint alleges that Peat Marwick violated the mail and wire fraud statutes. The EMI/Zinn Complaint alleges that Peat Marwick engaged in mail fraud and "fraud in the sale of securities."
Peat Marwick contends that the proposed complaints fail to state the required elements of any of these offenses with the particularity required by Rule 9(b) of the Federal Rules of Civil Procedure. That rule imposes a heightened pleading burden whenever fraud is alleged in order to provide defendants with fair notice of the claims, to protect them from harm to reputation or goodwill due to unfounded allegations, and to reduce the number of strike suits. See Bernstein v. Crazy Eddie, Inc., 702 F. Supp. at 976. A complaint should specify the time, place, speaker, and content of alleged misrepresentations. Luce v. Edelstein, 802 F.2d 49, 54 (2d Cir. 1986).
To state a claim for mail fraud, under 18 U.S.C. § 1341, or for wire fraud, under 18 U.S.C. § 1343, the complaint must allege (1) the existence of a scheme to defraud, (2) defendant's knowing or intentional participation in the scheme, and (3) the use of interstate mails or wire communications in furtherance of the scheme. See Griffin v. McNiff, 744 F. Supp. 1237, 1255 (S.D.N.Y. 1990) (mail fraud).
(1) Existence of a scheme
Beyond any question, the two complaints allege the existence of a scheme to defraud with sufficient particularity. The EMI/Zinn Complaint is replete with specific allegations of fraudulent schemes in 1985 to 1987 materially to overstate inventory and understate accounts payable, to engage in sham transactions, and to conceal such fraudulent misrepresentations contained in Crazy Eddie's annual, quarterly and periodic financial disclosures. The Class Complaint is even more richly ornamented with details of the alleged Crazy Eddie Fraud, beginning in 1980.
The court need not dwell on these details, as Peat Marwick does not deny in its responsive papers the existence of a scheme among at least some of the defendants to defraud investors.
(2) Participation in the scheme with intent
Again beyond question, the complaint alleges that Peat Marwick participated in the Crazy Eddie Fraud in numerous ways by certifying the various fraudulent financial statements and by representing to the Crazy Eddie directors and the investment community that such statements fairly stated the financial condition of the Company.
To show intent to defraud, plaintiffs must allege that Peat Marwick acted knowingly to deceive contemplating causing financial loss to another. United States v. Starr, 816 F.2d 94, 98 (2d Cir. 1987). "Such knowledge is established if a person is aware of a high probability of its existence, unless he actually believes that it does not exist." United States v. Cano, 702 F.2d 370, 371 (2d Cir. 1983) (per curiam).
Plaintiffs assume, and Peat Marwick does not contest, that intentional participation by its partner, Ferrara, constitutes intentional participation by Peat Marwick. Thus, plaintiffs may show that Peat Marwick participated with intent to defraud by showing that Ferrara acted with deliberate disregard of the Crazy Eddie Fraud, or that he acted with a conscious purpose to avoid learning the truth.
Rule 9(b) imposes additional specific pleading requirements to show intent. Although the rule provides that "intent . . . and other condition of mind . . . may be averred generally," plaintiffs must plead factual allegations giving rise to a "strong inference" that defendants possessed the requisite fraudulent intent. Beck v. Manufacturers Hanover Trust Co., 820 F.2d 46, 49 (2d Cir. 1987), cert. denied, 484 U.S. 1005, 98 L. Ed. 2d 650, 108 S. Ct. 698 (1988).
A complaint can meet this burden in two ways. Either it can allege facts showing that a defendant had a clear motive and opportunity for participating in the fraud. Id. Or it can identify "circumstances indicating conscious behavior by the defendant, though the strength of the circumstantial allegations must be correspondingly greater." Id. (citations omitted).
The EMI/Zinn Complaint makes some allegations going to opportunity and motive. Ferrara had the opportunity to misstate financial statements and conceal fraud. The complaint suggests he was driven to retain his lucrative relationship with Crazy Eddie. Indeed, he had allegedly negotiated a pay raise from Peat Marwick in the spring of 1984 after accepting a generous offer by Crazy Eddie to serve as Chief Financial Officer. Later Ferrara allegedly negotiated a $ 1 million a year consulting agreement on behalf of Peat Marwick with Crazy Eddie.
But a jury could also infer, to the contrary, that Ferrara would be highly motivated to pursue evidence of widespread fraud, given that his conscious avoidance would be likely to result eventually in substantial financial and reputational costs to him and his firm. Thus, if this complaint's allegation of intent to deceive rested solely on Ferrara's opportunity and motive, it would fail. See, e.g., Securities & Exch. Comm'n v. Price Waterhouse, 797 F. Supp. 1217, 1242 (S.D.N.Y. 1992) (finding that lucrative fees alone do not suggest an adequate motive to commit fraud).
The two complaints also allege a pattern of conduct by Ferrara that strongly suggests, at a minimum, that he willfully avoided discovering, and deliberately ...