The opinion of the court was delivered by: WILLIAM C. CONNER
Plaintiffs bring this action on behalf of all individuals who purchased common stock of The Leslie Fay Co., Inc. ("Leslie Fay") between March 28, 1991 and April 5, 1993 (the "Class Period"). The amended complaint alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Before the Court is the motion of defendant BDO Seidman ("BDO") to dismiss pursuant to Rules 9(b) and 12(b)(6), Fed. R. Civ. Pro. Although not moving for reconsideration of our previous disposition of an identical motion, BDO submits this motion asking us to reevaluate our prior decision in light of the Supreme Court's subsequent pronouncement in Central Bank of Denver, N.A. v. First Interstate of Denver, N.A., 128 L. Ed. 2d 119, 114 S. Ct. 1439 (1994), and in light of inadequacies in the plaintiffs' fourth amended complaint. For the reasons stated below, we deny BDO's motion.
Although the facts of this case are thoroughly articulated in our prior opinion, see In re The Leslie Fay Companies, Inc. Securities Litigation, 835 F. Supp. 167 (S.D.N.Y. 1993) [hereinafter Leslie Fay I], plaintiffs have since amended their complaint to reflect the findings of a detailed investigation by Leslie Fay's Audit Committee. In light of these new factual allegations, we will briefly summarize the amended complaint to reflect the relevant additions.
Plaintiffs allege that from 1990 through 1992, the officers and directors (the "Individual Defendants") of Leslie Fay, a well-known manufacturer of women's apparel, engaged in a fraudulent scheme designed to deceive the investing public as to its financial viability. Of particular relevance to BDO's participation in the scheme, plaintiffs further allege that to support its public misrepresentations, Leslie Fay altered company financial records in two ways. First, the Company manipulated its books, chiefly the general ledger, to overstate assets and understate liabilities. Leslie Fay utilized these misstatements to conceal shortfalls from divisional budgeted results. Second, Leslie Fay further altered its books and records by, among other things, manipulating inventory counts, classifications and costs; accounts payable; and expenses to substantiate these accounting irregularities. In all, the fraud involved several hundred journal entries, made in more than one hundred different general ledger accounts, occurring over an extended period of time, and involving at least 15 Leslie Fay employees.
The overall scheme led to an overstatement of Leslie Fay's pretax income in the fourth quarter of 1990 through 1992 by a total of over $ 75 million. Similarly, gross profits were overstated by $ 3 million (1.1%), $ 12.4 million (5.1%), and $ 35.8 million (18.9%), and per-share earnings by $ 0.15 (10.9%), $ 0.48 (44.9%), and $ 1.84 (347.2%) in 1990, 1991, and 1992, respectively.
Leslie Fay retained defendant BDO to provide independent auditing services for the years ending December 29, 1990 and December 28, 1991. BDO issued an unqualified opinion for each of those years (the "Opinions"), which were included in Leslie Fay's 1990 and 1991 Form 10-K reports and 1990 and 1991 Annual Reports to Shareholders, respectively, attesting to the accuracy of Leslie Fay's financial statement schedules and their conformity with Generally Accepted Accounting Principles ("GAAP"). In addition, BDO certified that it performed its audits in accordance with Generally Accepted Auditing Standards ("GAAS"). Based on the pervasiveness of the manipulation described above, plaintiffs allege that BDO either knew or was reckless in not knowing that its unqualified opinions were wholly unfounded. They claim that BDO knew of Leslie Fay's weaknesses in its internal reporting functions, that the company lacked documented accounting and financial policies and procedures, and that it employed practices that were inconsistent with GAAP. Despite bringing several of these deficiencies to Leslie Fay's attention, BDO did not insist that the company implement any reporting changes, submitting that the proposed adjustments were immaterial to the accuracy of the financial statements. Plaintiffs allege that in reality these deficiencies directly led to and involved the ledger manipulations and rendered BDO's '91 and '92 opinions materially untrue.
On February 1, 1993, Leslie Fay informed the investing public of certain "accounting irregularities" and announced that the Board of Directors' Audit Committee would investigate. This disclosure sent the price of Leslie Fay's common stock spiraling from $ 12.00 to $ 7.375 per share. Corporate Controller Donald Kenia admitted that he and 15 other employees had been falsifying invoices. He later claimed that he had come forward because the discrepancies caused by the falsification had become too large to hide. By April 5, 1993, following the Company's disclosure that the SEC was investigating the alleged fraud and the Company's petition for bankruptcy under Chapter 11, the stock had fallen to $ 2.75 per share. After the overstatements were revealed by the Audit Committee on February 26, 1993, BDO withdrew its 1991 opinion. This suit followed.
Defendant BDO moves to dismiss plaintiffs' amended complaint against it on three grounds. First, BDO argues that the Supreme Court's literal interpretation of § 10(b) of the Securities Exchange Act of 1934 (the "1934 Act") in Central Bank of Denver, N.A. v. First Interstate Bank, N.A., 128 L. Ed. 2d 119, 114 S. Ct. 1439 (1994), which foreclosed an aiding and abetting cause of action under that section, also barred reliance on mere reckless behavior in satisfying the scienter requirement of a direct liability cause of action under that section. Second, BDO asserts that even apart from Central Bank, the fourth amended complaint fails to meet the strictures of Fed. R. Civ. Pro. 9(b), which requires pleading fraud with particularity, by omitting allegations that BDO acted with the requisite intent. Finally, BDO contends that under Central Bank's literal statutory construction, BDO's alleged misstatements, which it contends that Leslie Fay included only in SEC filings not otherwise provided to the investing public, were not promulgated "in connection with the sale or purchase of any security" as required by the statute. Grouping BDO's first and third arguments, we will first consider the impact of Central Bank on the direct liability scienter and "in connection with" aspects of a § 10(b) private cause of action. Second, we will address BDO's argument that even apart from Central Bank we misapplied the scienter standard in Leslie Fay I in holding that the complaint satisfied the constraints of Fed R. Civ. Pro. 9(b).
In March, 1994, the Supreme Court held in a landmark decision that the language of § 10(b) of the 1934 Act, codified at 15 U.S.C. § 78j (1988),
did not support a cause of action for aiding and abetting securities fraud prohibited by that section and Rule 10b-5 promulgated thereunder. Central Bank, 114 S. Ct. at 1448. This decision effectively abrogated 25 years of recognition of the aiding and abetting doctrine, not to mention overruling the prior holdings of all eleven courts of appeals that have considered such a claim. See Cleary v. Perfectune, Inc., 700 F.2d 774, 777 (1st Cir. 1983); IIT, As International Investment Trust v. Cornfeld, 619 F.2d 909, 922 (2d Cir. 1980); Monsen v. Consolidated Dressed Beef Co., 579 F.2d 793, 799, 800 (3d Cir.), cert. denied, 439 U.S. 930 (1978); Schatz v. Rosenberg, 943 F.2d 485, 495-96 (4th Cir. 1991), cert. denied, 112 S. Ct. 1475 (1992); Fine v. American Solar King Corp., 919 F.2d 290, 300 (5th Cir. 1990), cert. dismissed, 112 S. Ct. 576 (1991); Moore v. Fenex, Inc., 809 F.2d 297, 303 (6th Cir.), cert. denied, 483 U.S. 1006 (1987); Schlifke v. Seafirst Corp., 866 F.2d 935, 946-47 (7th Cir. 1989); K & S Partnership v. Continental Bank, N.A., 952 F.2d 971, 977 (8th Cir. 1991), cert. denied, 120 L. Ed. 2d 870, 112 S. Ct. 2993 (1992); Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1483 (9th Cir. 1991); Farlow v. Peat, Marwick, Mitchell & Co., 956 F.2d 982, 986 (10th Cir. 1992); Schneberger v. Wheeler, 859 F.2d 1477, 1480 (11th Cir. 1988), cert. denied, 490 U.S. 1091, 104 L. Ed. 2d 989, 109 S. Ct. 2433 (1989). Although commentators had questioned its viability after the Supreme Court narrowed the scope of prohibited conduct in Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 51 L. Ed. 2d 480, 97 S. Ct. 1292 (1977), and Ernst & Ernst v. Hochfelder, 425 U.S. 185, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976), see Donald R. Fischel, Secondary Liability Under Section 10(b) of the Securities Act of 1934, 69 Calif. L. Rev. 80, 82 (1981), the bulk of the controversy surrounding the aiding and abetting doctrine centered on its scope and not its existence. Indeed in Central Bank itself, the petitioner had merely sought review as to whether the doctrine was applicable to indentured trustees and whether reckless behavior was sufficient to trigger liability under the doctrine. The Supreme court, however, after granting certiorari, specifically requested that the parties address the claim's statutory basis.
In Central Bank, investors brought suit against Colorado Springs Stetson Hills public Building Authority, which issued $ 26 million in bonds in 1986 and 1988 to finance improvements at Stetson Hills; Central Bank of Denver, which served as indenture trustee for the bond issues; the property developer AmWest Development; the 1988 underwriter; and a junior underwriter. The plaintiffs claimed that Central Bank aided and abetted the other defendants in not complying with one of the bonds' covenants, an alleged violation of § 10(b). The district court, finding reckless conduct insufficient to support an aiding and abetting claim, dismissed the complaint against Central Bank. The Tenth Circuit reversed. Sidestepping the scienter issues raised below altogether, the Supreme Court held that § 10(b) does not support a private cause of action for aiding and abetting securities fraud. The Court reasoned that since its prior holdings dictated that the statutory language itself governs the scope of conduct prohibited by § 10(b), and since the language of § 10(b) does not specifically prohibit aiding and abetting securities fraud, plaintiffs could not maintain an action based on that theory. In addition, the Court held that even apart from the language itself, the fact that Congress could have, but did not, provide for an aiding and abetting cause of action in the 1934 Act's express remedies provisions indicated that Congress did not intend to prohibit such conduct, especially not through a judicially implied remedy. Hinting at an alternative possibility, however, the Court did note that an "aider and abettor" might still be liable for primary violations of § 10(b) if its conduct satisfies all of the statute's elements. Central Bank, 114 S. Ct. at 1455.
B. Central Bank and Scienter
At the outset, as BDO implicitly concedes, Central Bank does not expressly hold that recklessness cannot form the basis of primary liability under § 10(b).
Indeed, much to the chagrin of many commentators seeking clarity in securities law, see, e.g., Scott A. Crist, Walking on Thin Ice: The Changing Liability of Attorneys in the Securities Arena, 27 J. Marshall L. Rev. 909, 917 (1994), the Court has again refused to address an issue that it reserved over eighteen years ago in Hochfelder, 425 U.S. at 194 n.12 ("We need not address here the question of whether, in some circumstances, reckless behavior is sufficient for civil liability under § 10(b) and Rule 10b-5."). Unfortunately, therefore, the Supreme Court in Central Bank does little to crystalize the amorphous status of scienter in § 10(b) civil litigation. See Leslie Fay I, 835 F. Supp. at 172 & n.1.
On the other hand, the Second Circuit has specifically addressed the scienter issue. As Judge Wood recounted in In re Fischbach Corporation Securities Litigation, No. 89 Civ. 5826 (KMW), 1992 WL 8715, at *2 (S.D.N.Y. Jan. 15), prior to the Supreme Court's rejection of negligent (as opposed to reckless or intentional) conduct as a basis for securities fraud in Hochfelder, the Second Circuit held that "proof of wilful or reckless disregard for the truth is necessary to establish liability under Rule 10b-5." Lanza v. Drexel & Co., 479 F.2d 1277, 1306 (2d Cir. 1973) (en banc). Then, in Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F.2d 38 (2d Cir.), cert. denied, 439 U.S. 1039, 58 L. Ed. 2d 698, 99 S. Ct. 642 (1978), the court stated that "Hochfelder left intact our rule that recklessness is a form of scienter in appropriate circumstances." Id. at 46. Since that time, the court has repeatedly held that recklessness, at least in some form, may support a claim of fraud under § 10(b). Possibly most important, however, even after Central Bank the court in Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124 (2d Cir. 1994), indicated that allegations of "facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness " may be sufficient to overcome a motion to dismiss. Id. at 1128 (emphasis added).
Notwithstanding Shields ' endorsement of the recklessness standard, at different times since Hochfelder, the Second Circuit has approached § 10(b) scienter in at least three distinct ways.
First, consistent with the Shields holding, the Lanza line of cases indicates that unqualified allegations of recklessness are sufficient to satisfy the scienter requirement of § 10(b) and Rule 10b-5. See, e.g., In re Time Warner Inc. Securities Litigation, 9 F.3d 259, 268-69 (2d Cir. 1993), cert. denied sub nom., Ross v. ZVI Trading Corp., 128 L. Ed. 2d 70, 114 S. Ct. 1397 (1994) ("We have recognized two distinct ways in which a plaintiff may plead scienter without direct knowledge of the defendant's state of mind . . . . The second approach is to allege facts constituting circumstantial evidence of either recklessness or conscious behavior."); Breard v. Sachnoff & Weaver, Ltd., 941 F.2d 142, 144 (2d Cir. 1991) ("'Allegations of scienter are sufficient if supported by facts giving rise to a 'strong inference' of fraudulent intent.' For Rule 10(b)(5) [sic] purposes, scienter includes recklessness." (citations omitted)); Oleck v. Fischer, 623 F.2d 791, 794 (2d Cir. 1980) ("To establish liability after Hochfelder,. . . this court has adhered to the proposition earlier announced in Lanza v. Drexel & Co., 479 F.2d 1277, 1306 (2d Cir. 1973) (en banc) that 'reckless conduct will generally satisfy the scienter requirement.'")
In the Rolf line of cases that developed under the now defunct aiding and abetting theory, the court allowed allegations of recklessness to satisfy the scienter requirement only if the aider and abettor had a fiduciary relationship with the plaintiff. Absent such a relationship, the requisite level of intent was proportional to the remoteness of the actor from the fraudulent transaction. See Sirota v. Solitron Devices, Inc., 673 F.2d 566, 575 (2d Cir. 1982), cert. denied, 459 U.S. 838, 74 L. Ed. 2d 80, 103 S. Ct. 86 (1992) ("This court has held that proof of reckless conduct meets the requirement of scienter in a section 10(b) claim . . . . For the imposition of aider and abettor liability under section 10(b), however, we have held that recklessness satisfies the scienter requirement where 'the alleged aider and abettor owes a fiduciary duty to the defrauded party.' (citations omitted)); Decker v. Massey Ferguson, Ltd., 681 F.2d 111, 120 (2d Cir. 1982) ("Assuming for the argument that recklessness on the part of a non-fiduciary accountant will satisfy Ernst & Ernst's requirement of scienter, such recklessness must be conduct that is 'highly unreasonable,' representing 'an extreme departure from the standards of ordinary care. It must, in fact, approximate an actual intent to aid in the fraud being perpetrated by the audited company." (citations omitted)); IIT, An International Investment Trust v. Cornfeld, 619 F.2d 909, 923 (2d Cir. 1980) ("Reckless conduct will generally satisfy the scienter requirement. However, . . . in applying this general principle to aiders and abettors . . . 'the ...