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October 11, 2000


The opinion of the court was delivered by: William C. Conner, Senior District Judge.


This securities fraud action was remanded to this Court by the United States Court of Appeals for the Second Circuit for additional findings of fact on the issue of loss causation. 206 F.3d 202. Counsel for the parties agreed that no additional evidence was required or desired and that, after briefing of the issue by the parties, the Court should make the necessary supplemental findings on the basis of the existing record. Those briefs having been received and considered and the record having been reviewed in light of the views expressed in the several opinions of the Court of Appeals, this Court files herewith its Supplemental Findings of Fact, which will be summarized and explained in this Opinion.


As more fully delineated in this Court's prior Opinion, reported at 991 F. Supp. 234, this action is one of 22 lawsuits brought by investors in the securities of JWP, Inc. ("JWP"). All 20 of the actions brought by those who lost money on their acquisitions of JWP's common stock have been settled. This and the one other remaining action were brought by a group of insurance companies who purchased JWP's notes. The other action, which is still pending, was brought against certain officers and directors of JWP who allegedly perpetrated fraud in overstating the company's assets and earnings during the years prior to plaintiffs' purchases of the notes. Because the defendants in that action are substantially judgment-proof and because the company's directors and officers ("D & O") liability insurance coverage has been substantially exhausted by the settlement of the stock purchasers' actions and by defense costs, that action will undoubtedly be settled for a small fraction of the claims. Thus, the only hope of the note purchasers for substantial recoupment of their losses is the present action against Ernst & Young ("E & Y"), the accounting firm that served as JWP's auditor from 1985 through completion of the audit of JWP's consolidated annual report for 1992, encompassing the entire period of the alleged fraud.

The Issues in this Case and the Prior Proceedings in this Court

In this action, plaintiffs charge that E & Y, having discovered substantial errors in JWP's accounts, and knowing that they had not been kept in accordance with generally accepted accounting principles ("GAAP"), nevertheless certified as accurate JWP's financial reports for the years 1987 through 1991, and issued to the noteholders the annual "no-default" letters required by their Note Agreements with JWP, certifying that their audits had uncovered no breaches of any obligations under the Note Agreements which included, inter alia, the requirement that JWP's books be kept in accordance with GAAP. Plaintiffs further claim that, in reliance on these certified financial statements and no-default letters, they purchased a total of $149 million in face value of JWP's notes in private placements between November 1988 and March 1992 and, after JWP defaulted on interest payments due on the notes and was thrown into involuntary bankruptcy, settled for a net loss of slightly more than $100 million in principal and unpaid interest. Plaintiffs asserted claims under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j (b), and for common law fraud and negligent misrepresentation.

After an 11-week trial, this Court filed extensive Findings of Fact and Conclusions of Law, with an accompanying Opinion and Order in which:

(a) The Section 10(b) claim was dismissed because, although E & Y had knowingly made material false representations which induced plaintiffs to invest in JWP's notes (so that there was "transaction causation"), there was not "loss causation" because "JWP's insolvency and resulting default on the notes 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." 991 F. Supp. at 250. At the time the notes were purchased, even after correction of all the accounting errors which were found or proven, JWP actually had more than ample cash flow to discharge all its obligations on the notes when due, and did in fact pay interest in full through the end of 1992. Id. "JWP would not have defaulted on its debt obligations but for its acquisition of Businessland, . . . a veritable sinkhole for cash." Id. Thus, plaintiffs' "losses were not caused by the fiscal infirmities concealed by JWP's annual reports but by unforeseeable post-audit developments which would have caused JWP's insolvency and default even if its financial condition had been fully as healthy as was represented in those reports." Id. at 254.
(b) The common law fraud claim was dismissed for the same reason — lack of proximate cause. Id. at 252.
(c) The negligent misrepresentation claim was dismissed for lack of proximate cause and because there was no relationship approaching privity between plaintiffs and E & Y since at the time it certified JWP's finanacial statements and issued the no-default letters, E & Y did not even know whether JWP would be issuing additional notes, much less who the purchasers of those notes would be, so that there was no satisfaction of the second requirement of the three-prong test of Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536, 483 N.E.2d 110, 493 N.Y.S.2d 435 (1985), namely that "the defendant must have intended that a known party or parties would rely [on its representations]." Id. at 252-53 (emphasis added).

The Court of Appeals Opinions

Plaintiffs' appeal from this Court's judgment was argued December 7, 1998. However, the Court of Appeals did not issue an opinion in the case until March 17, 2000, more than 15 months later. The reason for this unusual delay became apparent when each of the three judges on the panel handed down a separate opinion, advocating a resolution of the issue of loss causation differing from that advanced by the other two members of the panel. Apparently, for over a year, each of the judges had firmly held out for his own views on this issue and refused to concur in the views of either of his brothers. The impasse was finally broken when Judge Jacobs graciously yielded, explaining, "In order to allow the Court to issue a mandate, I have shifted my vote on the issue of loss causation — from affirmance to vacatur with a remand for further findings." 206 F.3d at 225. However, Judge Jacobs indicated that he believed the remand unnecessary, adding, "If, as I think, the district court has implicitly decided the fact question that is now being remanded for consideration, the district court's adoption of those findings of fact will under this mandate result in the same judgment that the district court has entered and that I would affirm on the present record and findings." Id.

None of the three judges on the panel indicated that he would reverse any of the findings of fact made by this Court. Judge Jacobs specifically stated that he would affirm all of them. Id. at 225. Judge Oakes stated that he agreed with "most of" them and that, "[t]hose with which we do not agree are not clearly erroneous." Id. at 210. Chief Judge Winter did not express disagreement with any of the findings, and relied upon them in concluding that "the facts found by the district court demonstrate loss causation as a matter of law." Id. at 228.

Chief Judge Winter reasoned that plaintiffs were misled not only as to JWP's financial condition but also as to "(i) the quality of the firm's management and auditor; and (ii) the firm's current incentives with regard to risk aversion." Id. at 230. He concluded that the pattern of JWP's accounting deceptions and the financial weakness they concealed tempted its management "to seek salvation in a risky deal" and increase the company's profitability before disclosure of the fraud, so that "the collapse of JWP as a result of the Businessland venture was well within the zone of risk concealed by the misrepresentations." Id. at 237-38. Neither of the other members of the panel shared this expansive view of foreseeability.

All three opinions did agree that, in the context of securities fraud, the causation required for liability comprises both transaction causation and loss causation. Id. at 209, 225, 233. All three also agreed that the touchstone of loss causation is foreseeability. Id. at 211-15, 226, 233. Judge Oakes' opinion, which became the prevailing opinion of the Court when Judge Jacobs, with expressed reluctance, concurred in it, framed that issue in these terms:

The foreseeability query is whether E & Y could have reasonably foreseen that their certification of false financial information could lead to the demise of JWP, by enabling JWP to make an acquisition that otherwise would have been subjected to higher scrutiny, which led to harm to the investors.

Id. at 217. Remarking that this Court "did not make factual findings as to foreseeability specifically," the Court of Appeals remanded the case for "more factual findings" with instructions to "reconsider proximate cause in the context of its factual determinations on foreseeability." Id. The majority opinion then offered "a tow rope to assist the district court through this Serbonian Bog" by counseling:

A foreseeability finding turns on fairness, policy, and, as before, "a rough sense of justice." . . . "A `reasonably foreseeable act' might well be regarded as an act that a reasonable person who knew everything that the defendant knew at the time would have been able to know in advance with a fair degree of probability." . . . Where foreseeability is less than immediately obvious, it is appropriate to make a judgment based on "some social idea of justice or policy." . . . These considerations should be coupled with the recognition that proximate cause is a common law concept, and such concepts evolve in a manner that reflects "economic, social and political developments." . . . "Therefore it is appropriate to examine the underlying policy of the securities law involved and the climate of securities regulation as it has evolved and as it currently exists."

Id. at 217-18 (citations omitted).

Judge Oakes' opinion proceeded to review the history and underlying purposes of the securities laws, with particular emphasis on the objectives of (a) encouraging issuers of corporate securities to disclose financial information voluntarily, and (b) encouraging losing investors to pursue valid claims and encouraging defendants to fight abusive claims. He concluded that these considerations weigh in favor of finding loss causation in the present case. Id. at 218-19. However, he stopped short of making such a finding and remitted the issue to this Court with further guidance quoted from the Comment to Section 548a of the Restatement (Second) of Torts (1977), including the following:

Id. at 219. Gripping this "tow rope" as firmly as possible, and hopefully also grasping its full import, we have attempted to answer the question of foreseeability by making the accompanying Supplemental Findings of Fact, based upon our evaluation of the evidence adduced at the trial.

With respect to plaintiffs' claim for negligent misrepresentation, the Court of Appeals found that there was a relationship approaching privity between E & Y and plaintiffs, so that E & Y owed plaintiffs a duty which was breached by E & Y's misrepresentations and remanded "so that the district court can determine whether the other elements of common law fraud are established." Id. at 222-23. As with a claim under Section 10(b) of the federal securities law, a claim for securities fraud under New York common law requires proof not only that the defendant's misrepresentation induced the plaintiff to enter into the transaction but also caused the plaintiff's loss thereon. In one of the shareholders' actions against E & Y likewise arising out of its certification of JWP's 1990 annual report, the Supreme Court of New York County stated:

To prevail on their fraud claim, plaintiffs must show both that that they reasonably relied upon the misrepresentations contained in the financial statements and that such misrepresentations caused their losses. . . . Plaintiffs argue that for purposes of demonstrating loss causation, it is sufficient to demonstrate that the misrepresentations were a substantial factor in inducing [plaintiffs] ...

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