11%, from $ 93 million to $ 83 million. As previously noted, the testimony of plaintiffs' expert that the reduction should have been considerably greater was less than convincing. To a potential purchaser of JWP's common stock, such a difference might be meaningful because it might significantly diminish the expectation of future dividends and price appreciation. But plaintiffs were purchasing debt securities, and their main concern was JWP's cash flow and its ability to pay interest and principal. To such investors, a fractional difference in net income may be inconsequential. See Norwood Venture Corp. v. Converse Inc., 959 F. Supp. 205, 209-10 (S.D.N.Y. 1997).
However this Court need not resolve the issue of transaction causation, because the evidence definitely fails to establish the necessary loss causation. JWP's insolvency and resulting default on its note obligations were caused not by the differences between its actual financial condition and that reflected in its audited annual reports, but by much more significant factors, including JWP's disastrous acquisition of the failing Businessland, in combination with the downturn in commercial construction and fierce competition in the PC market.
It is important to note that virtually every one of the errors found in JWP's books (the abuses of purchase accounting for corporate acquisitions, the arbitrary write-up of small-tool inventories, the improper accounting for NOL carryforwards, the write-up of spurious claims for extras, and the failure to establish reserves for receivables of doubtful collectibility) involved non-cash items which did not affect JWP's cash balances or its actual cash flow. As previously stated, these errors did increase reported net income. They thus increased apparent cash flow, which is computed by a simple formula popularly known by the mnemonic acronym EBITDA (earnings before interest, taxes, depreciation and amortization). However, they had no effect on actual cash flow or on JWP's ability to discharge the obligations for principal and interest on its debt. Indeed, JWP continued to pay all of the interest due through 1992.
There is ample reason to believe the testimony of JWP's former Chief Executive Officer, Andrew Dwyer, that JWP would not have defaulted on its debt obligations but for its acquisition of Businessland, which turned out to be a veritable sinkhole for cash. Even after restatement of its annual reports, JWP continued to show substantial profits and increasing cash flows through 1991. In 1992, largely because of the mountainous restructuring charges incurred in the integration of Businessland into its I/S Division, JWP suffered a net loss of $ 612 million and a negative cash flow of $ 49.6 million, losses which continued through 1993. There was simply insufficient cash remaining to pay plaintiffs and the other creditors who threw the company into involuntary bankruptcy in December 1993. It is immaterial that most of the restructuring charges were nonrecurring and that Businessland became profitable after it was sold to others because the charges were of sufficient size and duration to cause JWP's default and bankruptcy; Businessland's ultimate profitability in the hands of other owners could not undo the past.
Plaintiffs' contention that JWP's default in 1993 was not caused by its loss of $ 735 million in 1992 and 1993 but by the fact that its earnings back in the years 1987 to 1990 were less than reported (although still substantial) stretches advocacy beyond rationality.
It would be manifestly unfair, as well as contrary to law, to hold E&Y jointly and severally liable to reimburse in full losses that JWP's noteholders sustained as a result of unforeseeable and independent post-audit events and not because of fiscal infirmities which were concealed by JWP's misleading financial statements. See Revak v. SEC Realty Co., 18 F.3d 81, 89-90 (2d Cir. 1994).
In Lampf, Pleva, Lipkind & Petigrow v. Gilbertson, 501 U.S. 350, 364, 115 L. Ed. 2d 321, 111 S. Ct. 2773 (1991), the Supreme Court ruled that private actions under Section 10(b) must be commenced within one year after discovery of the facts constituting the violation and within three years after the violation occurred. The Second Circuit has held that "'discovery' . . . includes constructive or inquiry notice, as well as actual notice." Menowitz v. Brown, 991 F.2d 36, 41 (2d Cir. 1993). The standard is an objective one:
A plaintiff in a federal securities case will be deemed to have discovered fraud . . . when a reasonable investor of ordinary intelligence would have discovered the existence of the fraud. . . . Moreover, when the circumstances suggest to an investor of ordinary intelligence that she has been defrauded, a duty of inquiry arises, and knowledge will be imputed to the investor who does not make such an inquiry. Such circumstances are often analogized to "storm warnings."
Dodds v. Cigna Securities, Inc., 12 F.3d 346, 350 (2d Cir. 1993)(internal citations omitted). However, the circumstances must be "such as to suggest to a person of ordinary intelligence the probability that he has been defrauded by defendant." Armstrong v. McAlpin, 699 F.2d 79, 88 (2d Cir. 1983) (emphasis added). If a plaintiff who has been put on inquiry notice is reasonably diligent in investigating to determine whether fraud has been perpetrated, the running of the limitations period is tolled during such investigation. See Westinghouse Elec. Corp. v. 21 Int'l Holdings, Inc., 821 F. Supp. 212, 222 (S.D.N.Y. 1993).
In September 1993, the plaintiffs in this action entered into a tolling agreement with E&Y under which the action is deemed to have been filed on September 23, 1993. Therefore if plaintiffs were on inquiry notice as to the fraud charged before September 23, 1992 and did not diligently pursue an inquiry at least until that date, all their Section 10(b) claims are barred. Plaintiffs have asserted no Section 10(b) claims based on their purchases of notes before September 23, 1990 because such claims are barred by the three-year prong of the limitation.
In our May 22, 1996 decision on defendants' motions for summary judgment, 928 F. Supp. 1239, 1250, we stated that plaintiffs were placed on inquiry notice by August 14, 1992, when JWP issued a press release announcing that as a result of a review by outside auditors it was restating its consolidated financial statement for the first quarter of 1992 and revising its earnings results from the second quarter of 1992 to reflect net after-tax charges totaling $ 64.5 million. The press release also disclosed that a total of thirteen shareholder class-action suits had been filed, charging that JWP and its management had violated Section 10(b) by making false and misleading statements in various public documents including JWP's annual reports and that, in one of those suits, E&Y had also been named as a defendant.
However that ruling of May 22, 1996 was made in the context of the consolidated action, which included claims by the noteholder plaintiffs not only against E&Y but also against JWP's officers and directors. Moreover it was made before the Court had ruled that because JWP's audited annual report for 1991, as well as all later financial statements, were not published until after plaintiffs made their last purchases of JWP's notes, that report and the later statements were irrelevant except to the extent that they tended to show errors in JWP's earlier statements. The Court did not rule that JWP's press release of August 14, 1992, which referred only to restatement of JWP's financials for the first quarter of 1992 and to revision of the results for the second quarter of 1992, was sufficient to alert plaintiffs to the likelihood that JWP's audited annual reports for 1990 and earlier were materially false or misleading. Much less did the Court find that the press release alerted plaintiffs to the likelihood that E&Y, in certifying the earlier statements and issuing its annual no-default letters, had either knowingly concealed the errors in the statements and JWP's failure to follow GAAP in preparing them, or had failed to discover the errors because of the reckless conduct of its audits.
The fact that a number of shareholder class-action suits had been filed against JWP's officers and directors, even though one of the actions also named E&Y as a defendant, was not enough to alert the noteholder plaintiffs of the likelihood that they had a viable Section 10(b) claim against E&Y. The earliest starting date of the class period alleged in any of the actions was August 5, 1991, long after publication of E&Y's audited annual report for 1990, so the actions did not alert plaintiffs to the probability of errors in E&Y's annual reports for 1990 and earlier years--the only reports relevant here. In addition, the shareholders were suing on the basis of the precipitous drop in the market price of their shares, a triggering event which did not directly affect the holders of JWP's debt securities. They were still being paid the full interest due to them, and might never suffer any loss, so long as JWP's cash flow was sufficient to fund the payments of interest and principal, regardless of what might happen to the price of JWP's stock. Thus the Second Circuit Court in In re Ames Department Stores, Inc. Note Litigation, 991 F.2d 953 (2d Cir. 1993) ruled that the filing of a shareholder class-action suit did not as a matter of law put the noteholders on inquiry notice that they may also have fraud claims because
holders of equity securities often, perhaps usually, have different concerns from those of holders of debt securities. What primarily matters to the latter is that the company meet its obligations on the debt instrument when due. In contrast, investors in equity securities generally are concerned with a company's earnings prospects since equity securities usually trade, to a greater extent, on a company's earnings outlook.