influence Sapiens and was a controlling person." (Complaint P49.) The SEC defines a control person as one having "the possession, directly or indirectly, of the power to direct or cause the direction of management and policies of a person, whether through the ownership of voting securities or otherwise." 17 C.F.R. § 240.12b-2 (for 1934 Act); 17 C.F.R. § 230.405 (for 1933 Act).
In order to sustain such a motion at the pleading stage, a plaintiff must plead facts which "support a reasonable inference that they had the potential power to influence and direct the activities of the primary violator." Food and Allied Service Trades Dept., AFL-CIO v. Millfeld Trading Co., 841 F. Supp. 1386, 1391 (S.D.N.Y. 1994); Borden, Inc. v. Spoor Behrins Campbell & Young, Inc., 735 F. Supp. 587, 591 (S.D.N.Y. 1990).
In Lanza v. Drexel & Co., 479 F.2d 1277 (2d Cir. 1973), the court stated that the intent of Section 20 was obviously to impose liability only on those directors who fall within its definition of control and who are in some meaningful sense culpable participants in the fraud perpetrated by controlled persons. Lanza, 479 F.2d at 1299. A number of subsequent opinions led by Marbury Management, Inc. v. Kohn, 629 F.2d 705 cert. denied 449 U.S. 1011, 66 L. Ed. 2d 469, 101 S. Ct. 566 (1980), have since held that neither scienter nor culpable participation is required to state a claim for Section 20 liability. See, e.g., Food & Allied Service Trades Dept., 841 F. Supp. 1386, 1391 (S.D.N.Y. 1994); Borden, Inc., 735 F. Supp. 587 (S.D.N.Y. 1990).
Marbury Management was a case in which liability was premised on a respondeat superior theory which is very similar to an agency theory and held that Section 20(a) did not preclude control liability on that theory. Marbury Management, 629 F.2d at 712-713. In Borden, Inc. control liability was premised on 100% stock ownership. Borden, Inc., 735 F. Supp. at 591. As Lanza points out, liability based on stock ownership or agency existed in the 1933 act prior to the passage of Section 20(a). Lanza, 479 F.2d at 1298 n.63. A review of the precedents leads this Court to conclude that pleading respondeat superior, an agency relationship, substantial stock ownership, or officer/director status from which control can be directly inferred without more, provides a sufficient basis to show control liability. However, if plaintiff seeks to attribute control status to a third party, director, or employee who is not in a control position nor an outside party such as an attorney, auditor or underwriter, then further factual allegations must be made to show that in fact such control can be inferred.
Director status alone does not establish control person liability. In re Par Pharmaceutical, Inc. Securities Litigation, 733 F. Supp. 668 (S.D.N.Y. 1990). "A person's status as an officer, director, or shareholder, absent more, is not enough to trigger liability under § 20." Hemming v. Alfin Fragrances, Inc., 690 F. Supp. 239, 245 (S.D.N.Y. 1988); cf. Gray v. First Winthrop Corp., 776 F. Supp. 504 (N.D. Cal. 1991) (lender's status as major lender or standard terms of loan agreement are insufficient to establish controlling person liability); Barker v. Henderson, Franklin, Starnes & Holt, 797 F.2d 490 (7th Cir. 1986) (neither law firm nor accounting firm which rendered services to corporation which sold bonds and notes in violation of federal securities law had ability to control corporation); Morse v. Weingarten, 777 F. Supp. 312, 318 (S.D.N.Y. 1991) (allegations that underwriter exercised control over corporation's investments fail to state a claim for control person liability absent allegations identifying any position or title that underwriter held at corporation or any meetings which underwriter attended or conversations which he had with any of the corporation's officers).
Accordingly, when a defendant does not clearly occupy control status, the plaintiff must plead facts from which control status can be inferred, e.g., that defendant had power, pursuant to an agreement to control the primary violator or aided the primary violator in performed some culpable conduct linking the defendant to the primary violation for which relief is sought. For instance, in Food and Allied Services Trade Dept., the control person claims as against director defendants other than Peizer were not dismissed. Food and Allied Services Trade Dept., 841 F. Supp. at 1391. The defendants in that case were long time vice-presidents of Sales, Operations, and Finance as well as directors of Millfeld Trading, Inc., the primary violator. Peizer was not an officer, but was a director for eight months. He was also a substantial holder of Millfeld Trading's convertible debentures and divested himself of 90% of his substantial holdings of common stock the day before the public announcement of Millfeld Trading's wrongdoing. Id. Even so, the court held that since Peizer was not alleged 1) to have held a controlling block of stock, 2) to have been involved in Millfeld Trading's day to day operation, or 3) to have had had anything to do with the preparations of Millfeld Trading's public statements during the relevant period, controlling person status was not shown. The court found that it could not infer from the sale of stock that Peizer had long standing knowledge and control of Millfeld Trading as opposed to inside knowledge of the public announcements to be made the next day. The § 20(a) claim against Peizer was dismissed. Food & Allied Service Trades Dept., 841 F. Supp. at 1392.
Here, plaintiffs allege that (1) SB was a founder of Sapiens, (2) SB was a creditor of Sapiens at the time of its formation, (3) SB owned 8% of Sapiens' shares, (4) SB had a Vice President on Sapiens' board of directors, and (5) SB was the underwriter for the Notes offering. (Complaint PP9, 12-15.) The Offering Circular shows that the officers and directors as a group owned 34.5% of the outstanding common stock of Sapiens and that SB was not a controlling stockholder of Sapiens. Accordingly, SB's 8% holding together with the other facts alleged do not meet the standard for control person status on the part of SB. For the purposes of this motion to dismiss, the facts alleged do not "support a reasonable inference that [SB] had the potential power to influence and direct the activities of" Sapiens. Food and Allied Service Trades Dept., 841 F. Supp. at 1391.
For the forgoing reasons, SB's motion to dismiss the control person claims pursuant to Fed. R. Civ. P. 12(b)(6) is granted.
VI. D&T's Motion to Dismiss the Section 10(b) Claim.
Plaintiffs claim that defendant D&T violated § 10(b) and Rule 10b-5 of the 1934 Act. Defendant D&T audited Sapiens' 1992 financial statements contained in the Offering Circular. In order to withstand a motion to dismiss, a plaintiff pleading a § 10(b) and Rule 10b-5 cause of action must allege that, in connection with the offering or sale of a security, the defendant (1) "made a false material representation or omitted to disclose material information" and (2) the defendant "acted with scienter." Acito, 47 F.3d at 52; In re Time Warner, Inc. Securities Litigation, 9 F.3d 259, 264 (2d Cir. 1993). The standard for pleading these elements of a § 10(b) claim is stated in Fed. R. Civ. P. 9(b), where "in all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity." Shields, 25 F.3d at 1127. Under this standard, plaintiffs have failed to allege facts indicating that D&T made a fraudulent statement and have also failed to allege facts indicating that D&T acted with scienter.
With respect to plaintiffs' failure to allege a fraudulent statement made by D&T, the complaint alleges that the financial statements in the Offering Circular "contained untrue statements of material fact and omitted to disclose material facts in various respects." (Complaint P20.)
The only allegations of statements attributed to D&T, however, are stated in paragraphs 19 and 20 of the Complaint. Paragraph 19 alleges, "Among other things, the Offering Circular contained audited financial statements of Sapiens certified by defendant D&T for the fiscal year ended December 31, 1992 (the '1992 financials'), as well as unaudited financial statements for the six month period ending June 30, 1993 (the '1993 Six-Month Financials')." This paragraph alleges mere certification and no wrongdoing by D&T. Paragraph 20 alleges that:
"Said financial statements contained untrue statements of material fact and omitted to disclose material facts in various respects, including but not limited to the certification by defendant Deloitte that its audit of the 1992 financials had been conducted 'in accordance with generally accepted auditing standards' and that the 1992 Financials 'presented fairly, in all material respects, the financial position of [Sapiens] and subsidiaries as of December 31, 1992 and the results of their operations and their cash flows for the year then ended in accordance with generally accepted accounting principles.' In fact, the 1992 Financials falsely inflated the Company's revenues and income in that, among other ways and without limitation, they purported to recognize revenue from license sales under distribution and marketing agreements upon shipment of the software and either execution of a signed contract or acceptance of the invoice, and from license sales to end users upon delivery of the software and acceptance by the end user or a signed contract, despite and without disclosing serious uncertainty concerning (i) the purchasers' ability to pay and their economic substance apart from Sapiens; (ii) whether transactions were real or instead 'sham' transactions involving contingent or non-existent obligations on the part of purchasers, (iii) whether the price to be paid pursuant to transactions was fixed or determinable at the time they were entered into; (iv) whether the risk of loss had passed; and/or (v) despite uncertainty about the adequacy and completeness of contract executions and sales approvals."
Thus, in paragraph 20, plaintiffs' allegations about D&T are that the following statements on its audit opinion were false: (1) that its audit of the 1992 Sapiens financial statements had been conducted in accordance with generally accepted auditing standards ("the Auditing Standards"); and (2) that Sapiens 1992 financial statements "present fairly, in all material respects, the financial position of [Sapiens] as of December 31, 1992 . . and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles" ("the Accounting Principles"). (Hammond Decl., Ex. A at 86.)
With respect to plaintiffs' allegation about Auditing Standards ("allegation (1)"), there is no other allegation in the complaint that D&T violated any specific auditing standard. Thus the first allegation lacks the particularity required by Rule 9(b).
With respect to plaintiffs' allegation about Accounting Principles ("allegation (2)"), paragraph 20 goes on to expand on the general allegation by alleging that the 1992 financials falsely inflated Sapiens' revenues and income by recognizing revenue from license sales without disclosing several types of uncertainties and, in paragraph 22
, alleges that unspecified defendants violated certain Accounting Principles. These allegations do not comply fully with the requirements of Rule 9(b) set forth in Acito, which provide that "the complaint must: (1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent." Acito, 47 F.3d at 51; Mills, 12 F.3d at 1175.
Plaintiffs have specified D&T's statements in the audit opinion which it contends were false, i.e., allegations 1 and 2, thus complying with the first requirement, and by referencing the audit opinion identifies the speaker and the time and place of the statements, thereby satisfying the second and third requirement. Paragraph 22, however, only states what Accounting Principles are alleged to be violated and does not plead facts showing who violated these principles, how they were violated, or why D&T may be charged with fraud for their violation. Additionally, Paragraph 22 alleges violations of Accounting Principles by the "defendants," but does not contain any specific allegation about D&T, which was solely involved as the auditor. Plaintiffs also fail to explain why the alleged violation of Accounting Principles rendered the statements fraudulent and do not meet the fourth requirement.
In making its allegation in Paragraph 20, plaintiffs' complaint quotes from D&T's audit opinion selectively, failing to quote portions of the audit opinion which stated (1) "financial statements are the responsibility of [Sapiens'] management. Our responsibility is to express an opinion on these financial statements based on our audits"; (2) "evidence supporting the amounts and disclosures in the financial statements" were examined "on a test basis"; (3) its audit had been conducted in accordance with the Auditing Standards; and (4) "in our opinion, . . . [the] 1992 and 1991 consolidated financial statements present fairly . . . the financial position of [Sapiens] . . . as of December 31, 1992 . . ., and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles." (Hammond Decl., Ex. A at 86.)
Plaintiffs have failed to allege facts demonstrating that D&T did not follow the Auditing Standards or check Sapiens' application of the Accounting Principles in its Audit.
Plaintiffs contend, however, that because the auditing process is peculiarly within D&T's knowledge, they need not plead facts to demonstrate the noncompliance with the Auditing Standards under Rule 9(b), and cite DiVittorio v. Equidyne Extractive Industries, Inc., 822 F.2d 1242, 1247 in support. (Pls. Mem. at 38.) In DiVittorio, the court states that when fraud allegations are "peculiarly within the opposing party's knowledge," the complaining party must still allege "facts upon which the belief is based." DiVittorio, 822 F.2d at 1247. Plaintiffs, however, have limited their pleading of any violation of the Auditing Standards to a single conclusory allegation in Paragraph 20, and thus fail to meet the standard under Rule 9(b): "In all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity." Fed. R. Civ. P. 9(b).
Scienter may also be pled by alleging facts that "constitute strong circumstantial evidence of conscious misbehavior or recklessness." Acito, 47 F.3d at 52; Shields, 25 F.3d at 1128. Although plaintiffs have not alleged any specific fraudulent violation of the Auditing Standards by D&T, they nevertheless contend that they have alleged scienter because they have alleged that the audited financial statements were not prepared in accordance with the Accounting Principles. They overlook that a violation of an Accounting Principle by the preparer of financials may not be detected by a properly conducted audit.
Plaintiffs, citing CMNY Capital, L.P. v. Deloitte & Touche, 821 F. Supp. 152, 165 (S.D.N.Y. 1993), argue that the complaint alleges conduct "so far outside the boundaries of professional behavior that recklessness may be inferred." CMNY Capital, L.P., 821 F. Supp. at 165.
In CMNY, the complaint specifically alleged facts in support of a theory of reckless disregard of the auditing procedures. CMNY, 821 F. Supp. at 157. After stating that D&T "in its audit of the fiscal year 1988 statement . . . manifested . . . recklessness by failing to perform the following audit procedures," the complaint in CMNY, listed the actual specific audit procedures that D&T allegedly failed to follow and explained why its failure to follow the procedures was significant. CMNY, 821 F. Supp. at 157 (after alleging D&T failed to conduct such a review, the complaint contained the following allegation: "Cut-off procedures for year-end sales should have been reviewed. A physical presence, as well as a review of subsequent shipments to sale dates, would have revealed cut-off problems.") In contrast, the most the plaintiffs allege here are the enumerated violations of the Accounting Principles in paragraph 22. (See, e.g., Complaint P22(a) which states: "[Defendants] violated the principle that revenue be recognized only when a transaction is completed, with appropriate provision for uncollectible accounts.") The allegations in this complaint do not allege facts showing why any violation of Auditing Principles resulted in a material misstatement of fact in the financials, nor do they show that D&T failed to follow proper audit procedures. Acito, 47 F.3d at 52; Shields, 25 F.3d at 1128. Plaintiffs merely allege that Accounting Principles were violated in the preparation of the financials, which D&T made clear in its audit opinion were Sapiens' responsibility. (Hammond Decl., Ex. A at 86.) Therefore, the Complaint's conclusory allegations fail to allege facts sufficient to infer scienter on the part of D&T.
Plaintiffs also contend that the complaint adequately alleged scienter by alleging facts outlining how D&T had the "motive" and "opportunity" to defraud. Ades v. Deloitte & Touche, 799 F. Supp. 1493, 1498 (S.D.N.Y. 1992). Plaintiffs contend that the allegations stating that Sapiens and D&T had a business relationship between 1991 and 1994, and the fees from that relationship would be significant to the specific accountant handling D&T's business, constitute allegations of scienter. (Pls. Mem. 44-45.) There is no legal precedent which supports the contention that such allegations are sufficient. In any event, this theory is spelled out only in plaintiffs' motion papers. The complaint does not allege facts upon which this inference of scienter is based.
Plaintiffs fail to allege significant facts from which to infer scienter, and therefore, do not meet their burden under Rule 9(b). In re Integrated Resources Real Estate Ltd. Partnerships Securities Litigation, 815 F. Supp. 620, 670 (S.D.N.Y. 1993) (plaintiffs failed to allege any reckless behavior on part of auditors and thus failed to demonstrate scienter). For the forgoing reasons, the § 10(b) and Rule 10b-5 claims against defendant D&T are dismissed pursuant to Fed. R. Civ. P. 12(b)(6) and 9(b).
Defendants' motion to dismiss the complaint pursuant to Fed. R. Civ. P. 12(b)(1) for lack of subject matter jurisdiction is DENIED. Defendants' motion to dismiss the complaint as barred by the statute of limitations is DENIED. Defendants Sapiens and SB's motion to dismiss the § 12(2) claim pursuant to Fed. R. Civ. P. 12(b)(6) as foreclosed by Gustafson, 513 U.S. 561, 131 L. Ed. 2d 1, 115 S. Ct. 1061 (1995) is DENIED. Defendant SB's motion to dismiss the § 10(b) claim pursuant to Fed. R. Civ. P. 12(b)(6) and 9(b) is GRANTED. Defendant SB's motion to dismiss the controlling person claims pursuant to Fed. R. Civ. P. 12(b)(6) GRANTED. Defendant D&T's motion to dismiss the § 10(b) claim pursuant to Fed. R. Civ. P. 12(b)(6) and 9(b) is GRANTED.
For the reasons heretofore stated, the plaintiffs' common law claims against D&T and SB set forth in Count IV are also dismissed.
IT IS SO ORDERED
Dated: New York, New York
September 20, 1996
Robert P. Patterson, Jr.