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ZUCKER v. SASAKI

May 6, 1997

VERONICA ZUCKER, on Behalf of Herself and All Others Similarly Situated, Plaintiff, against CHIKARA SASAKI, BERNARD M. MANUEL, IRVING BENSON, COLIN C. FENN, TREVOR J. WRIGHT, ROY E. GREEN, GARY C. SMITH, SUSAN P. JOHNSON, PAUL D. BAIOCCHI, JAMES G. GRONINGER, PAUL JACOBS, STUART B. KATZ, CYGNE DESIGNS, INC., PAINEWEBBER INC., PAINEWEBBER INTERNATIONAL (U.K.) LTD., FURMAN SELZ INC., SMITH BARNEY INC., DAVID FRANKEL, BARRY ROTHBERG, FAYE LANDES and ERNST & YOUNG, L.L.P., Defendants.


The opinion of the court was delivered by: KRAM

 SHIRLEY WOHL KRAM, U.S.D.J.

 In this class action asserting securities fraud, defendant Ernst & Young, L.L.P. ("Ernst & Young") moves to dismiss the amended complaint of plaintiff Veronica Zucker ("Zucker"), pursuant to Federal Rules of Civil Procedure 9(b) and 12(b)(6). For the reasons set forth below, Ernst & Young's motion is granted. *fn1"

 BACKGROUND2

 I. The Fraudulent Scheme

 Cygne Designs, Inc. ("Cygne") designs and manufactures clothing for retailers. Amended Complaint ("Compl.") P 2. On September 28, 1993, Cygne announced its acquisition of Fenn, Wright & Mason ("FWM"), another manufacturer, for 2,000,000 shares of Cygne stock. Compl. P 60. In various public statements and documents, Cygne represented that the acquisition of FWM would increase its earnings and profitability. The acquisition closed on April 6, 1994, and the amount of goodwill was ultimately adjusted to approximately $ 47 million.

 In June 1994, Cygne undertook a secondary stock offering of $ 73.4 million (the "Secondary Offering"), in which it sold 2,300,000 shares. Zucker alleges that as a result of the Secondary Offering, certain insiders and controlling shareholders of Cygne sold 1,725,000 shares at $ 18 1/4 per share. Compl. PP 4, 74. Moreover, according to Zucker, Cygne falsely reported that the proceeds of the Secondary Offering, together with Cygne's internally generated cash flow, would provide Cygne with sufficient resources and liquidity to operate its business and pursue its expansion plans. Compl. PP 81, 83, 94.

 During this period, Zucker claims that defendants also represented to the investing public that Cygne would achieve strong earnings growth in 1994 and 1995. Compl. PP 73, 75, 80, 90, 92. Likewise, Zucker asserts that Cygne made numerous false representations regarding the ability and success of its business, internal organization, merchandizing and relationships with new customers. Compl. PP 65, 67, 73, 78, 91-93.

 On August 4, 1994, Cygne announced an agreement to acquire another manufacturer, GJM International Ltd. ("GJM"), for $ 1.3 million and 650,000 shares of Cygne stock. As with its acquisition of FWM, Cygne represented to the investing public that GJM would be a strong addition to the company. Compl. PP 86, 92, 95. Cygne recorded approximately $ 27.7 million of goodwill in connection with this acquisition. Compl. P 6.

 On October 24, 1994, Cygne revealed that due to poor retail sales and product returns, its third quarter 1994 earnings would be much lower than originally forecast. Compl. P 96. After this announcement, Cygne stock fell from $ 20 per share to $ 12 1/2 per share. Zucker alleges, however, that the stock continued to trade at artificially high prices due to various misrepresentations by Cygne, including that the third quarter decline was a one-time occurrence which had been corrected, Compl. P 97, that the FWM acquisition was successful, Compl. P 97, 114, that the GJM acquisition would improve Cygne's earnings, Compl. P 105, 106, that Cygne would achieve earnings growth in 1994 and 1995 due to new customers, Compl. PP 105, 107, 109-11, and that Cygne had sufficient financial resources and liquidity to operate its business and pursue its expansion plans, Compl. PP 100, 103, 108.

 On April 28, 1995, Cygne filed its annual report with the Securities and Exchange Commission ("SEC"). At the same time, Cygne issued a public statement indicating that it would suffer a substantial loss in the first quarter of 1995 due to various factors, including poor performance of FWM's Hong Kong product sourcing operation, weak sales, quality control problems, and a $ 1.1 million write-off of uncollectible accounts receivable from a new customer. As a result of this announcement, Cygne stock fell to $ 6 1/4 per share. Compl. P 119.

 On September 11, 1995, Cygne announced an even larger loss for the second quarter of 1995 of approximately $ 5.1 million. Compl. P 129. Thereafter, on November 21, 1995, Cygne revealed a third quarter loss of over $ 43 million -- almost $ 3.50 per share. This loss was attributable, in significant part, to the write-off of almost all of the goodwill recorded one year earlier in connection with Cygne's acquisition of FWM. Cygne also revealed other significant problems, such as extreme liquidity shortages and discontinued customers. Compl. P 131.

 Given the aforementioned circumstances, Zucker alleges that from September 28, 1993 through April 28, 1995 (the "Class Period"), Cygne's financial statements were fraudulently manipulated to artificially inflate revenues and earnings. Zucker further asserts that the defendants knew or recklessly disregarded facts relating to this alleged fraud. Specifically, Zucker claims that despite their assurances that the FWM acquisition would increase Cygne's earnings, defendants knew that the acquisition would, in fact, adversely affect Cygne's earnings. In addition, Zucker alleges that defendants knew that Cygne's business was in trouble and that Cygne had been engaging in numerous business activities that threatened the success of the company, but continued to make public statements to the contrary. Finally, Zucker claims that throughout the Class Period, Cygne utilized the help of a variety of professionals -- including its independent accounting firm, Ernst & Young -- to ensure the success of its scheme to defraud the public.

 II. Allegations Against Ernst & Young

 Zucker's Section 10(b) and Rule 10b-5 claims against Ernst & Young are based solely on Cygne's financial statements for the fiscal years ending January 29, 1994 ("Fiscal 1993") and January 28, 1995 ("Fiscal 1994"). Zucker contends that Ernst & Young fraudulently issued "clean" audit opinions of these statements despite knowledge of facts that revealed the falsity of these statements.

 Zucker asserts that in order to overstate revenues, earnings, and stockholders equity, Cygne engaged in numerous accounting practices in violation of Generally Accepted Accounting Principles ("GAAP"). Such practices, according to Zucker, included improperly reporting the value of Cygne's investments in FWM and GJM, improperly recognizing revenues and goodwill, failing to timely write down accounts receivable of doubtful collectibility, and improperly reporting a gain on the disposition of part of FWM's assets in the first quarter of 1995. In particular, Zucker asserts that Ernst & Young knowingly disclosed false information relating to the FWM acquisition in footnote 14 of its audit report for Fiscal 1993. Footnote 14 of the report, labeled "Subsequent Event," states that "On April 6, 1994, Cygne [purchased] FWM, and FWM became a wholly-owned subsidiary of Cygne. The excess of the purchase price over the fair value of the net assets ...


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