Court: Court of Appeals for the Second Circuit; March 16, 2000; Federal Appellate Court
Judge Jacobs concurs with the court's opinion while Chief Judge Winter dissents. The plaintiffs-appellants, a group of insurance companies, appeal the dismissal of their Securities Act claims against Ernst & Young (E.Y.) following a bench trial in the Southern District of New York. The insurance companies invested a total of $149 million in JWP, Inc., a company that ultimately failed, leading to significant financial losses.
E.Y. served as JWP's independent auditor from 1985 to 1992, during which the alleged fraudulent activities occurred. The appellants relied on JWP's financial statements, which were certified by E.Y. and purportedly complied with generally accepted accounting principles (GAAP) as stipulated in the Note Agreements. E.Y. was also responsible for issuing a "no-default certificate" confirming JWP's financial compliance.
Despite frequent indications that JWP's financial representations were inconsistent with GAAP, E.Y. failed to take appropriate action, often yielding to pressures from JWP's CEO, Ernest Grendi. Their close personal relationship contributed to E.Y.'s lack of accountability in auditing JWP's financial statements. This situation became a source of humor within the firm, referred to as "EGAAP" (Ernest Grendi’s Accepted Accounting Practices), highlighting the lax accounting standards observed at JWP during its aggressive expansion leading up to its ultimate failure following the acquisition of Businessland, Inc. in 1991.
Businessland, a computer retailer and software supplier, faced severe financial difficulties, losing an average of ten million dollars monthly for ten months before its acquisition by JWP, which received a "going concern" qualification from its auditors indicating doubts about Businessland's viability. JWP executives saw potential in transforming Businessland into a "value-added" systems integrator, leveraging its existing sales force and clientele, and integrating it with JWP’s network installation business. However, the integration proved problematic, requiring JWP to provide financial support for Businessland's operations and delaying the closure of most retail outlets.
During this period, the retail computer market experienced intense price competition, and a downturn in office construction adversely affected JWP's electrical construction division. In early 1992, JWP's new President, David Sokol, identified significant accounting irregularities, prompting JWP to hire Deloitte & Touche to audit its financial statements. Deloitte’s review led to restatements of JWP's annual reports, significantly reducing reported after-tax incomes for 1990 and 1991 and reflecting a substantial loss in 1992.
Despite managing to service its debts through 1992 and making partial payments into 1993, JWP eventually defaulted and entered involuntary bankruptcy in December 1993. Investors suffered significant losses, with some selling their notes at a substantial loss and others exchanging them for lower-value cash and securities. Overall, appellants incurred losses exceeding $100 million. The fallout resulted in over twenty lawsuits, with a consolidated case settled and two remaining, including the current one and AUSA Life Ins. Co. v. Andrew T. Dwyer. Plaintiffs in the ongoing case made claims against E.Y. for federal securities law violations, New York common law fraud, and negligent misrepresentation. Following an eleven-week bench trial, the district court dismissed the plaintiffs' claims and issued detailed findings of fact.
E.Y. was found to be aware of significant accounting irregularities from 1988 to 1991 involving JWP’s small tool inventories, which inflated net income, yet failed to demand corrections. E.Y. also allowed JWP to record anticipated future tax benefits from net operating loss (NOL) carryforwards in violation of GAAP, dismissing the practice as acceptable. Despite discovering additional abuses related to NOLs that inflated net income, E.Y. issued unqualified audit reports for the late 1980s. From 1989 onward, E.Y. was complicit in other accounting irregularities that inflated JWP’s earnings and assets. The court determined that E.Y.'s annual no-default letters falsely certified JWP’s compliance with GAAP.
While the plaintiffs demonstrated materiality and reliance under federal securities law, they faced challenges proving the scienter element and failed to establish causation for their losses, which were attributed to external factors like Businessland’s operations and the PC price wars, rather than E.Y.'s accounting practices. The court concluded that JWP's financial collapse resulted from unforeseeable events post-audit, not from concealed fiscal issues. Additionally, the court found deficiencies in privity and causation regarding the negligent misrepresentation claims. The plaintiffs' claims were based on Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, which outline the requirements for proving securities fraud.
To prove a violation of Rule 10b-5, a plaintiff must demonstrate that the defendant made a false material misrepresentation or omitted to disclose material information, acted with scienter, and that the plaintiff's reliance on these actions resulted in injury. In New York, a fraud claim requires proof of a false misrepresentation or material omission made with intent to induce reliance, justifiable reliance by the plaintiff, and resulting injury. For negligent misrepresentation, a plaintiff must show carelessness in providing information that was expected to be relied upon, with a duty of care owed to the plaintiff.
The appellants appeal based on five grounds, focusing on three main arguments regarding the district court’s findings: (1) insufficient causation between E.Y.’s actions and the appellants’ losses, (2) standards for assessing causation and scienter in federal securities and state fraud claims, and (3) the absence of a near-privity relationship between the investors and E.Y. The court found transaction causation established but vacated the determination on loss causation, confirmed the establishment of scienter, and reversed the privity finding. The case, tried without a jury, follows a standard of review where factual determinations are upheld unless clearly erroneous, while legal questions, including mixed questions of law and fact, are reviewed de novo.
In terms of causation, the court concurred that E.Y. did not perform adequate accounting but disagreed with the lower court's conclusion that unforeseeable events caused JWP’s insolvency, asserting that both transaction causation (which links violations to the transaction) and loss causation (which connects unlawful conduct to economic harm) need to be established.
Transaction causation was established as the district court acknowledged that plaintiffs relied on E.Y.’s certifications of JWP's financial health when purchasing and holding their notes. The notes were not mass-marketed; instead, purchasers specifically required E.Y.’s audits as a condition for their acquisitions. If the plaintiffs had been aware of the low quality of JWP’s notes, they likely would not have purchased them.
In contrast, loss causation presented greater challenges. The court referenced the need to determine where to draw the line in the causal chain regarding proximate cause. While the district court made various factual determinations related to loss causation, including that JWP defaulted on its notes due to financial covenant violations concealed by E.Y., it did not fully address all necessary factual findings. Notably, the court's focus on whether misrepresentations affected JWP’s cash flow was deemed less relevant than examining how the unlawful conduct led to economic harm. Key findings indicated that accurate accounting and auditing would have alerted investors to JWP's precarious financial status, which could have allowed them to accelerate note repayment. However, speculation about potential investor responses to such information was deemed unnecessary for the current analysis. Ultimately, the court vacated the loss causation determination and remanded the case for further factual findings.
The district court determined that JWP's default on its debt obligations was primarily due to its acquisition of Businessland, which was financially detrimental. However, had E.Y. accurately represented JWP's financial condition and disclosed GAAP violations, JWP would have already been in default before acquiring Businessland. Consequently, the acquisition necessitated either curing the default or obtaining waivers from investors. The court also found that the losses experienced by the appellants were not the result of E.Y.'s misrepresentation but rather due to external factors, including the acquisition and market conditions, leading to a conclusion that loss causation was not established.
The appellants contest this conclusion, arguing that the district court failed to properly apply the legal definition of "loss causation." A relevant case, Marbury Management, Inc. v. Kohn, illustrates this principle. In that case, a stock purchaser sued a brokerage employee who misrepresented his qualifications. The district court initially dismissed claims against the brokerage firm but held Kohn liable under the Securities Exchange Act for his fraudulent representations that induced the purchase and retention of stocks. The appellate court affirmed Kohn's liability, emphasizing that fraudulent misrepresentations can lead to losses even if external market factors contributed to the decline in stock value. This precedent highlights the need to consider both the direct impact of misrepresentations and the causative link to the financial losses incurred by the plaintiffs, which the district court may have overlooked in its analysis.
The requirement of loss causation is rooted in the common law tort principle of proximate causation, necessitating that the damages alleged must be foreseeable consequences of the misrepresentation. The case of Marbury establishes that fraud can induce both investment and retention of that investment. Although the specifics of the fraud differ—unlicensed selling versus false financial certification—the broad analysis from Marbury applies here. The court's review of various precedents shows that liability can arise from false assurances that lead investors to hold onto stocks that later decline in value, regardless of the final cause of that decline.
Continental Insurance Co. is highlighted for its examination of whether defendants could be liable for losses incurred by plaintiffs who did not act to sell securities based on misleading financial information. The court determined that if a defendant's misrepresentation contributed to a plaintiff's inaction, the defendant could be held accountable for the resulting loss. The court articulated that the critical issue is not what the plaintiffs might have done absent the fraud, but rather what they would have done had they been fully informed. The defendants’ intent to induce passive behavior through their misrepresentation establishes a basis for liability. This reasoning is relevant to the current case, where E.Y.’s certified financial statements successfully convinced investors to retain their investment in JWP.
The insurance companies’ lack of evidence regarding their intentions to purchase or unload JWP’s notes does not negate the reasonable probability that the fraud achieved its intended result. The district court's reliance on cases such as Citibank, N.A. v. K-H Corp. and First Nationwide Bank v. Gelt Funding Corp. to determine that loss causation was not proved is scrutinized, revealing that these cases do not necessitate the court's conclusion. In Citibank, the plaintiff alleged that the defendants concealed a $7 million loan, which led to Citibank's inability to recover its loan after GAIL defaulted. The district court dismissed Citibank's claim due to a lack of alleged proximate causation between the default and the undisclosed loan, a conclusion subsequently affirmed by the Second Circuit. The court clarified that establishing loss causation requires demonstrating that the misrepresentation caused the actual loss. In contrast, the current complaint does allege proximate causation, asserting that E.Y. violated GAAP and concealed accounting abuses, which resulted in actual losses by hindering the plaintiffs' rights under the note purchase agreements and enabling JWP to continue its financing activities.
The plaintiffs in Citibank did not make allegations parallel to those in First Nationwide Bank v. Gelt Funding Corp. In that case, First Nationwide Bank (FNB) engaged Gelt Funding Corp. as a mortgage broker for approximately $900 million in nonrecourse loans. FNB filed a lawsuit against Gelt and its principals, Gross and Herzka, alleging a RICO conspiracy based on misrepresentations regarding the value of collateral properties, which induced FNB to make loans it otherwise would not have issued. The district court dismissed the case under Rule 12(b)(6), ruling that the alleged misrepresentations did not proximately cause the injuries claimed by FNB.
On appeal, the Second Circuit affirmed this dismissal, agreeing that FNB failed to sufficiently plead injury and proximate cause. The court utilized a three-part test to evaluate proximate cause: (1) the misrepresented property value was significantly above its actual value, (2) the injury occurred shortly after the misrepresentation, and (3) no external factors contributed to the injury. The court noted that while these factors were not exhaustive, they provided a framework for assessing the allegations.
The court found FNB's methodology for evaluating the defendants' misrepresentations flawed and the conclusions illogical. It also determined that the timing of the injury was too distant from the misrepresentations to establish a causal link. Notably, the real estate market collapse during the defaults served as an intervening factor, suggesting that the losses were more likely attributable to broader market conditions rather than the alleged fraud. The court acknowledged that while its ruling in First Nationwide was based on the specific facts of that case, it did not preclude a different outcome in future cases where evidence of proximate cause could be adequately established post-market collapse.
Proximate cause and foreseeability are crucial concepts highlighted in the First Nationwide Bank case, where "proximate cause" was used interchangeably with "loss causation." The plaintiff must demonstrate that misstatements caused the transaction to result in a loss. The purpose of establishing proximate cause is to limit legal responsibility for wrongful acts, ensuring liability only extends to those whose injuries were a substantial factor in the causal sequence and were reasonably foreseeable as a natural consequence. Factors influencing proximate cause include the foreseeability of the injury, the presence of independent causes, and the directness of the causal connection.
The district court referenced Revak v. SEC Realty Corp. to argue against holding E. Y jointly liable for losses incurred by JWP’s noteholders due to unforeseeable post-audit events rather than concealed fiscal issues. While agreeing with Revak's legal principles, there was disagreement regarding its application in this case. In Revak, plaintiffs only claimed they faced onerous default terms without identifying a loss directly caused by those changes. Conversely, in this case, the GAAP violations and E. Y's concealment of JWP's financial condition were significant issues that became apparent and directly affected investors by obscuring JWP's true status, thus distinguishing it from Revak's situation.
The appellants referenced several cases, including Bloor v. Carro and DiLeo v. Ernst Young, but none compelled a different outcome. Bloor involved a bankruptcy trustee seeking to hold corporate counsel liable for the company's demise, which was deemed not a foreseeable result of the counsel's actions. DiLeo involved purchasers suing an accountant after a company's financial collapse, but the facts were distinguishable from the current case. Overall, the reliance on Revak by the district court was deemed inappropriate given the different nature of the misrepresentations involved.
The Seventh Circuit Court of Appeals upheld the district court's dismissal of the plaintiffs' claims, emphasizing that the complaint failed to specify any financial issues that the accountant should have identified. The court ruled that the fraud claim was inadequately pled, highlighting the familiar pattern in securities litigation where a firm's initially positive portrayal later contrasts with a less favorable reality. The plaintiffs' assertion that this disparity must be due to fraud was deemed insufficient, lacking supporting facts.
The court clarified that loss causation is distinct from transaction causation, with the former requiring that the damages claimed be foreseeable consequences of the misrepresentation. Citing legal precedents, the court acknowledged that foreseeability should not be addressed until causation is established, acting as a limit on liability. It maintained that it would continue to treat loss causation as intertwined with proximate causation, embodying notions of foreseeability. The district court's findings indicated that reliance on JWP's audited reports did not proximately cause the plaintiffs' losses, noting that proximate cause often involves factual determinations where foreseeability of intervening acts varies.
Foreseeability is a factual question determined by the finder of fact, as established in case law. The “reasonable foreseeability” standard must be applied to the specific circumstances of each case. While applying this legal standard to facts is typically a legal issue, the district court failed to make specific factual findings related to the foreseeability aspect of proximate cause. The central question of foreseeability is whether E.Y. could have reasonably anticipated that certifying false financial information would lead to JWP's downfall, affecting investors. Due to the lack of factual findings on foreseeability, the court is remanded to make these findings and subsequently reassess proximate cause based on them.
A finding of foreseeability is influenced by considerations of fairness, policy, and justice. The determination of a “reasonably foreseeable act” involves assessing what a reasonable person, aware of the same information as the defendant, would likely foresee. When foreseeability is not clear-cut, it can be judged through societal views on justice and policy. Proximate cause also incorporates policy considerations and evolves with societal changes.
The historical context of securities laws is relevant, particularly the enactment of the 1933 and 1934 Securities Acts during the Great Depression, aimed at restoring investor confidence and fostering economic growth. The 1934 Act established regular reporting requirements for publicly traded companies, as highlighted in case law.
Congress enacted a comprehensive federal regulatory scheme in the early 1930s to ensure that investors had access to accurate information about companies. Concerns arose over meritless securities lawsuits, often filed by "professional" plaintiffs seeking quick settlements, potentially raising capital costs and deterring corporate disclosure. In response, Congress passed the Private Securities Litigation Reform Act of 1995, aimed at encouraging corporate information disclosure, empowering investors to control litigation, and motivating plaintiffs' lawyers to pursue valid claims while enabling defendants to contest abusive claims.
The Act’s first purpose emphasizes ongoing congressional concern for disclosure, while the third acknowledges that not all claims are valid and encourages plaintiffs to assert legitimate claims. These elements support establishing loss causation in the current case, particularly as the auditor hindered disclosure. Concerns regarding an increase in abusive claims if loss causation is found are dismissed, as this determination will not lead to an influx of meritless lawsuits.
The Restatement (Second) of Torts provides guidance on foreseeability and causation, asserting that a fraudulent misrepresentation is a legal cause of pecuniary loss if such loss can reasonably be expected from reliance on it. Causation is contingent on the recipient's actual reliance on the misrepresentation. Not all resulting losses are legally caused; only those within the foreseeable risk created by the misrepresentation fall under the maker's liability.
Misrepresentations must be evaluated based on their potential to cause losses and the likelihood of such losses occurring. When a financial condition is misrepresented, it remains relevant even if subsequent insolvency is influenced by external factors, such as industry-wide downturns. For instance, if a corporation misrepresented its financial health and subsequently fails due to industry conditions, it could still be liable for losses if it is determined that a sound financial status would have allowed the corporation to survive.
An illustration provided in the legal text describes a scenario where A, an investor, purchases bonds from B, who falsely represents the financial status of X Oil Corporation. When the oil industry suffers and the corporation becomes insolvent, A incurs greater losses than if the industry downturn had occurred independently. In this case, B is liable for the additional losses resulting from the insolvency.
In a similar context, E.Y. did not directly offer the investment notes to the insurance companies but was aware of their investment intentions and certified misleading financial conditions necessary for their purchase. E.Y. also concealed the fact that JWP was not in default and continued to endorse the misrepresentations in JWP's financial reports, making E.Y. liable for the misrepresentations.
The court in David emphasized that if a defendant fraudulently induces a plaintiff to refrain from selling stock, they are responsible for any resulting losses from the stock's value decrease, regardless of the causes being external or beyond the control of either party. The court acknowledged that this might broaden the definition of actionable deceit.
The extension of legal principles is justified by a commitment to commercial morality and the objective of the law to provide remedies against fraud. The district court was found to lack adequate factual findings on the foreseeability of loss causation, leading to a decision to vacate and remand the case. The court also did not sufficiently address the scienter issue, as it had already resolved the case on loss causation grounds. The court noted the difficulty in determining whether the accounting justifications provided by Grendi for JWP were unreasonable enough to imply E. Y's intent to deceive investors.
In an interest of judicial efficiency, the appellate court chose to resolve the scienter issue directly, confirming that the appellants had proven the requisite intent to deceive as required under Section 10(b) of the Securities Exchange Act of 1934. Although establishing intent can be challenging, particularly for corporations, the court recognized that intent could be presumed under certain conditions. It noted that when a scheme is likely to result in harm, and a corporation acts with knowledge of potential consequences, it can be treated as if it desired those outcomes.
In this case, E. Y’s financial certifications suggested that JWP was not on the verge of collapse; rather, it appeared capable of enduring temporary losses and potentially attracting new capital. The investors had assumed certain risks based on the information provided, but they were not informed of the higher likelihood of collapse due to JWP's precarious financial situation. The court emphasized that had E. Y’s accountants considered the implications of their accounting practices, they would have recognized that their actions could impose an undisclosed risk on investors, ultimately leading to harm.
E. Y exhibited the intent to deceive or manipulate, as demonstrated by its agreement to JWP's accounting abuses despite knowing that manipulated financial reports would be relied upon by insurance companies and other parties. The district court expressed concern over E. Y's motivation for committing fraud, suggesting that the potential risk to its reputation and the relatively small fee from auditing JWP made deliberate fraud unlikely. However, this perspective misinterprets the scienter issue, which should focus on the foreseeability of the consequences of E. Y's actions rather than its intentions. The court emphasized that E. Y, as a professional accounting firm, understood the significance of its financial certifications and the weight they carried with investors.
Regarding the negligent misrepresentation claims, the district court found a lack of privity between the investors and E. Y, failing to satisfy the second prong of New York's "near-privity" test. This decision was contested, and the court referenced the New York State Court of Appeals ruling in Credit Alliance Corp. v. Arthur Andersen & Co., which established that accountants can be held liable for negligence to noncontractual parties if three conditions are met: awareness of the financial reports' intended use, knowledge of the party's reliance, and conduct linking accountants to the relying party. The Credit Alliance case included two actions with differing outcomes based on the nature of the relationship, ultimately indicating that privity can exist under specific circumstances.
In *Credit Alliance Corp. v. Arthur Andersen Co.*, the auditors for L.B. Smith Co. prepared financial statements that allegedly overstated Smith's financial health, which were then relied upon by Credit Alliance Corp. for financing decisions. The Court of Appeals ruled that Credit Alliance failed to establish a privity or approaching privity relationship with the accountants due to inadequate allegations regarding the purpose of the financial reports and the accountants' conduct.
In *European American Bank and Trust Co. v. Strauhs Kaye*, the plaintiff bank claimed substantial loans were made to Majestic Industries based on misleading financial reports from the accounting firm, which purportedly complied with GAAP but did not. Following a default by a Majestic subsidiary, the bank sued for damages, asserting Strauhs Kaye's negligence, which was bolstered by direct communications between the bank and the accountants regarding reliance on the financial evaluations. The Court of Appeals found sufficient allegations of negligence due to the established direct nexus between the parties.
The current case resembles *European American* more than *Credit Alliance*. The district court determined that Ernst & Young (E.Y.) was aware that insurance companies, as investors, existed and were relying on their no-default certificates, which named the insurance company noteholders. However, the court concluded that E.Y. did not know that its audit reports would be relied upon by these plaintiffs for purchasing decisions regarding JWP's notes. E.Y.'s no-default letters were intended for forwarding to noteholders, indicating awareness of potential reliance, but the firm could not predict future sales of notes or which recipients would act on the letters.
The second requirement of the Credit Alliance test was not met, as there was no relationship of near-privity between E. Y and future purchasers. The court disagreed with the district court's conclusion regarding this requirement, which necessitates that the accountant be aware that their report would be used for a specific investor purpose. E. Y was aware that the "no-default" letters were meant to inform investors that their notes were not in default, thus satisfying the second prong of the Credit Alliance test. The appellate court reversed the district court's finding of no privity and remanded the case to consider whether other elements of common law fraud were established.
The district court had not addressed damages due to its finding of no loss causation; hence, this issue will also be reconsidered on remand. Furthermore, the opinion emphasizes the importance of accurate information in the financial market, which is crucial for maintaining investor confidence and ensuring proper market function. The appellate court partially reversed and vacated the district court's decisions and remanded for additional consideration based on these findings. The facts recounted stem from the district court's findings, which the appellate court found acceptable. Discrepancies in the district court's findings regarding the plaintiffs' concerns about repayment were clarified, confirming that they were not contradictory.
Paragraph 447 indicates that plaintiffs "likely would not and in some cases could not have bought" the notes, which is a significant point. The court opts to resolve the matter directly rather than remanding it to the district court for reconsideration, prioritizing judicial efficiency. The discussion highlights the importance of drawing parallels between loss causation in securities law and its common law counterparts, suggesting that losses referred to as "harm" involve risks that investors did not intend to take or could not have been aware of. The text emphasizes the evolving nature of proximate cause in tort law, noting its flexibility in legal contexts. It also points out the contentious nature of foreseeability within tort law. Additionally, it references the Securities Act of 1933 and the Private Securities Litigation Reform Act of 1995, underlining that "harm" specifically refers to losses from concealed risks. The district court's analysis of scienter required plaintiffs to demonstrate "motive and opportunity" to infer fraud, but the court does not feel constrained by this terminology, focusing instead on the sufficiency of evidence in the context of a bench trial.
