Howard Rosen v. Cascade International, Inc.

Citations: 256 F.3d 1194; 50 Fed. R. Serv. 3d 335; 2001 U.S. App. LEXIS 15529; 2001 WL 776765Docket: 99-14681

Court: Court of Appeals for the Eleventh Circuit; July 11, 2001; Federal Appellate Court

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Plaintiffs James Ziemba and Patricia MacDougle, along with others, filed a securities class action in 1992 against Cascade International, Inc. and its officers, including President Victor G. Incendy, and independent auditor Bernard H. Levy, among others. They alleged violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. The district court dismissed several defendants, including the law firm Gunster, Yoakley, Stewart, P.A. (GY&S), on December 16, 1993. While the court denied a motion to dismiss against the auditing firm Coopers, Lybrand, it later dismissed the claims against Coopers in 1995, citing the Supreme Court's ruling in Central Bank of Denver, which stated that private plaintiffs cannot pursue aiding and abetting claims under 10(b). The plaintiffs' attempts to amend their complaint were denied, and a final judgment was entered on September 30, 1999. They subsequently appealed the dismissal of their claims against Coopers and GY&S and the denial of their amendment motion. The court confirmed its jurisdiction over the appeal due to the finality of the September 30 order, which allowed for the review of prior non-final orders. Cascade, a public company since 1985, reported significant growth and profits in its filings with the NASDAQ from 1989 to 1991, focusing on women’s apparel, cosmetics, and fragrances through various subsidiaries.

Cascade's independent auditor, Bernard Levy, confirmed that audits were conducted per generally accepted standards in its 10-K reports. On August 20, 1991, the SEC notified Cascade's President and CEO, Incendy, of an ongoing review of Cascade's transactions, requesting extensive documentation, including a list of its stores and cosmetic counters. By September 1991, rumors about the legitimacy of Cascade's profits emerged, and on October 1, 1991, the Overpriced Stock Service warned of potential troubles for the company. Following this, several class action lawsuits were filed, which Cascade dismissed as meritless, asserting there were no operational negative developments and threatened legal action against analysts questioning its financials. However, on November 20, 1991, Cascade revealed potential inaccuracies in its financial statements and reported difficulties in locating Incendy. Subsequently, trading in Cascade stock was suspended by the National Association of Securities Dealers until accurate financial disclosures were made. On December 13, 1991, interim chair Aaron Karp announced the board's authorization for a Chapter 11 bankruptcy filing, and in January 1992, Karp informed shareholders of significant misrepresentations of Cascade's assets and unauthorized stock issuance. An amended class action lawsuit was filed on July 7, 1992, on behalf of Cascade common stock purchasers from August 1989 to November 1991. 

The appeal addresses whether the district court erred in dismissing claims against GY&S and C&L under Rule 10(b) and in denying the motion to amend the complaint. Dismissal was reviewed de novo, while the denial of amendment was reviewed for abuse of discretion, with a de novo legal analysis on the futility of the amendment. The court affirmed the dismissal. The allegations against GY&S include its representation of Cascade on legal matters from 1989 through Incendy's disappearance, advising on the accuracy of financial disclosures, and involvement in public communications related to a deal with Oleg Cassini, without prompting corrections to previous press releases.

On October 2, 1991, the OSS published an article questioning Cascade, prompting GY&S to prepare a memorandum for Incendy on October 7, 1991, suggesting public statements in response to the OSS Report and Cascade's stock decline. GY&S allegedly failed to verify the factual accuracy of these statements. Subsequently, Cascade issued a public document based on GY&S's recommendations. On the same day, GY&S provided Incendy with an opinion letter stating Conston was in bankruptcy, despite knowing its Plan of Reorganization had been confirmed earlier. This letter allowed Incendy to justify not consolidating Conston's financial statements with Cascade's.

In October 1991, GY&S attorney Michael Platner engaged with stock analysts spreading negative rumors about Cascade, urging them to cease their inquiries. On October 30, Cascade announced it would sue the OSS for trade defamation, linking the OSS Report to orchestrated short-selling by brokerage analysts. GY&S reviewed this press release, although it was drafted by another law firm, and was aware of the significant challenges a trade defamation suit would face and that no connection between short-sellers and the OSS Report had been established. On November 7, Platner wrote to The Miami Review criticizing an upcoming article about Cascade for being incomplete and uninvestigated.

Separately, C&L audited Fran's Fashions and issued an unqualified audit opinion, which plaintiffs claim was false due to violations of auditing standards, including lack of independence and insufficient evidence. C&L also audited Conston, issuing an unqualified report despite knowing both subsidiaries were suffering significant losses and requiring urgent funding from Cascade. Plaintiffs allege that C&L ignored "red flags" indicating Cascade's inability to provide necessary capital and assert that proper audits would have resulted in "going concern" qualifications for both subsidiaries.

In fall 1990, Cascade solicited C&L's opinion on whether Conston's financial statements should be consolidated with Cascade's. C&L concluded that consolidation was unnecessary, citing Financial Accounting Standard No. 94, which Plaintiffs argue C&L interpreted too narrowly. This opinion allegedly facilitated Cascade's fraudulent omission of Conston's poor financial performance. Following the filing of Cascade's 1991 10-K on September 27, 1991, C&L became aware that Conston's financials were still not consolidated, despite the report indicating 126 Fran's Fashions stores, while Plaintiffs claim only 70-80 existed. C&L did not retract its audit opinion on Conston's financial statements from March and June 1991 until November 29, 1991, and the audit report for Fran's Fashions consolidated financials was not withdrawn until December 3, 1991.

Plaintiffs allege violations of Section 10(b) of the Securities Exchange Act and Rule 10b-5, which prohibit fraudulent activities in securities transactions. To establish a claim under these provisions, a plaintiff must demonstrate a misstatement or omission of a material fact made with scienter, reliance on that misstatement, and that it caused their injury. Severe recklessness can satisfy the scienter requirement, defined as an extreme departure from ordinary care that presents a danger of misleading investors. Additionally, under Federal Rule of Civil Procedure 9(b), claims of fraud must specify the circumstances of the fraud with particularity, though intent and knowledge can be stated more generally.

The particularity rule in fraud actions is designed to inform defendants of the specific misconduct alleged against them, thereby safeguarding against baseless accusations of fraud. According to Rule 9(b), a complaint must detail: 1) the specific statements made or omitted, 2) the time and place of these statements and the individuals responsible, 3) the misleading nature of the statements, and 4) the benefits obtained by the defendants due to the fraud. In the case at hand, the district court dismissed the Plaintiffs' 10(b) claim against GY&S, determining that GY&S was not obligated to disclose negative information about its client, Cascade. The Plaintiffs contended that GY&S had a duty to disclose once misleading statements were made, despite no direct statements being made to them. They asserted GY&S's primary liability stemmed from its involvement in creating allegedly fraudulent communications.

The district court also dismissed the Plaintiffs' claims against C&L, ruling that the Plaintiffs failed to demonstrate any material misrepresentations in C&L's audit reports or any public assurances regarding Cascade's financial statements. C&L's only potential liability was its failure to disclose inaccuracies in Cascade's 1991 10-K, but the court found no duty existed to disclose Cascade’s fraud since C&L did not publicly position itself as Cascade's auditor.

On appeal, the Plaintiffs argued C&L was primarily liable under 10(b) due to misadvising Cascade about financial consolidations and failing to incorporate 'going concern' qualifications in its reports. However, GY&S and C&L contended they were not primarily liable, referencing the Supreme Court's Central Bank decision, which eliminated aiding and abetting liability under 10(b), and asserting they owed no duty to disclose fraud since they did not make public statements about Cascade. The district court's dismissal of the claims was deemed appropriate, and the decision to deny the motion for leave to amend was upheld. The Supreme Court's Central Bank case was pivotal to the analysis of the Plaintiffs' claims.

The Colorado Springs-Stetson Hills Public Building Authority issued $26 million in bonds to support public improvements at the Stetson Hills development, secured by landowner assessment liens. Bond covenants mandated that the land securing the bonds must equal at least 160% of the outstanding principal and interest, with annual appraisals from the developer, AmWest, to verify compliance. An appraisal provided in 1988 indicated stable land values, suggesting the 160% requirement was met. However, concerns arose from a senior underwriter about declining property values and the appraisal's age. Central Bank, as indenture trustee, sought an independent appraisal but postponed this review until after the closing of the 1988 bond issue. The Authority defaulted on the bonds before the independent appraisal occurred.

Subsequently, plaintiffs attempted to hold Central Bank liable under Rule 10(b), claiming it aided and abetted a 10(b) violation. The district court ruled in favor of Central Bank, but the Tenth Circuit reversed, indicating a genuine issue of material fact regarding Central Bank's recklessness and substantial assistance through the appraisal delay. The Supreme Court granted certiorari to determine whether aiding and abetting liability exists under 10(b). It concluded that private plaintiffs cannot pursue aiding and abetting claims under 10(b), rejecting the interpretation that the statute's language includes such liability. The Court emphasized that allowing recovery for aiding and abetting would undermine the necessity for a plaintiff to demonstrate reliance on a misstatement or omission, a critical element for 10b-5 recovery.

Allowing the proposed aiding and abetting action could result in the defendant facing liability without demonstrating that the plaintiff relied on the aider and abettor's actions or statements. This stance aligns with the precedent set in *Chiarella v. United States*, which requires a specific relationship to establish a duty to disclose for omissions to be actionable. Circumventing the reliance requirement would undermine established limits on recovery under Rule 10b-5. Although the Supreme Court determined that private plaintiffs cannot maintain aiding and abetting suits under 10(b), it acknowledged that secondary actors in securities markets are not entirely free from liability. Any individual or entity that employs manipulative devices or makes material misstatements, which a purchaser or seller relies on, may be held primarily liable if all primary liability conditions under Rule 10b-5 are satisfied.

Following *Central Bank*, federal courts have diverged on the criteria for establishing primary liability for secondary actors like lawyers or accountants under 10(b). Some courts, such as in *In re Software Toolworks*, have ruled that accountants can be primarily liable if they significantly influenced the statements made by others. Conversely, other cases like *Anixter v. Home-Stake Prod. Co.* suggest secondary actors must themselves make false statements to incur liability. The consensus indicates that for a secondary actor to be primarily liable under 10(b), plaintiffs must demonstrate reliance on the defendant's misstatement or omission, which must be publicly attributed to the defendant at the time of the investment decision. This conclusion is consistent with the principles established in *Central Bank* and *Basic Inc. v. Levinson*. The analysis will first address the allegations against GY&S and then those against C&L.

Plaintiffs allege that GY&S played a significant role in drafting or editing fraudulent communications but admit to no reliance on misstatements made by GY&S. This claim is insufficient under the precedent established in Central Bank, which emphasizes the necessity of reliance for recovery under Rule 10b-5. The court asserts that allowing such claims would effectively reinstate aiding and abetting liability, contrary to the Supreme Court's ruling. Furthermore, regarding omissions, GY&S is not liable for failing to disclose material facts because it did not have a duty to disclose—no attorney-client relationship existed between GY&S and the Plaintiffs, which is essential for establishing such a duty. The court cites various factors that contribute to determining the existence of a duty to disclose, concluding that GY&S's lack of fiduciary obligation towards the Plaintiffs negates any liability for omissions related to its client, Cascade.

In *Schatz v. Rosenberg*, the Fourth Circuit established that a lawyer does not have a duty to disclose information to a third party unless a relationship of "trust and confidence" exists. GY&S, due to its fiduciary obligations to its client Cascade, was entitled to privileges protecting it from disclosure of Cascade's information. It was noted that neither lawyers nor accountants are mandated to report client information unless a disclosure duty exists. Furthermore, GY&S did not make any statements to the plaintiffs, meaning the plaintiffs could not claim reliance on GY&S for their investment decisions. The court contrasted this with *Rudolph v. Arthur Andersen Co.*, where an auditor could potentially have a duty to disclose based on their involvement in the company's disclosures. The court concluded that GY&S had no obligation to disclose any fraud related to Cascade to the plaintiffs.

Regarding C&L, the plaintiffs made three allegations: misadvising Cascade about consolidating financial results with Conston, failing to include "going concern" qualifications in audits, and not disclosing fraud suggested by Cascade's 1991 10-K. The court found that the claim against C&L regarding non-consolidation advice failed due to a lack of reliance since the audit reports cited by the plaintiffs were not prepared by C&L. The court reasoned that allowing liability without attribution would undermine the reliance requirement of Rule 10(b). Therefore, since GY&S was not primarily liable for misstatements and the plaintiffs did not meet pleading standards under Fed. R. Civ. P. 9(b), the claims against both GY&S and C&L were dismissed. Additionally, FAS No. 94 supported C&L's advice that consolidating returns were unnecessary, particularly given Conston's bankruptcy status.

Plaintiffs allege that C&L failed to include "going concern" qualifications in its audit reports for Fran's Fashions and Conston, arguing this omission violated auditing standards. They assert that C&L knew both subsidiaries were in severe financial distress and required substantial funding from Cascade to continue operations. The plaintiffs claim that had C&L conducted proper audits, it would have issued "going concern" opinions, which would have necessitated similar disclosures in Cascade's financial statements. C&L's audits, conducted in accordance with Generally Accepted Auditing Standards (GAAS), included unqualified opinions for both subsidiaries, which plaintiffs argue were misleading due to C&L's alleged failures to maintain independence, exercise due care, obtain sufficient evidence, and provide adequate disclosures. Although violations of AICPA standards can indicate violations of antifraud rules under Section 10(b) of the 1934 Act, the plaintiffs' allegations do not meet the particularity requirement set forth in Federal Rule of Civil Procedure 9(b).

Allegations of violations of GAAP or SEC regulations alone, without evidence of fraudulent intent, do not suffice to establish a securities fraud claim. The Ninth Circuit emphasizes that mere inaccuracies in accounting or noncompliance with GAAP do not demonstrate scienter, as seen in In re Software Toolworks Inc. The Fifth Circuit also notes that generic claims about accounting standard violations fail to support fraud in Melder v. Morris, while the Second Circuit in Decker v. Massey-Ferguson specifies that general accounting principle violations do not meet Rule 9(b) standards for fraud pleading. Severe recklessness, necessary for a fraud claim, requires extreme deviations from ordinary care, not just negligence. 

To adequately plead fraud under Rule 9(b), plaintiffs must present more than mere auditing standard violations. In this case, plaintiffs attempt to provide additional evidence by citing "red flags" that C&L allegedly overlooked during audits of Fran's Fashions and Conston. These include concerns about the lack of workpapers during an audit of a subsidiary, doubts about the independence of the auditor, and unusual retractions of audit requests. Other points highlight the questionable representations made by Cascade's management, financial losses of Fran's Fashions, overdue accounts payable, and issues regarding the CFO's role.

Despite these allegations, the plaintiffs have not met the pleading requirements of Rule 9(b). While some courts have accepted that violations of GAAP or GAAS, along with ignored "red flags," could sustain a fraud claim, the current plaintiffs fail to establish this connection adequately.

Plaintiffs in this case argue that an accounting firm, C&L, acted fraudulently by failing to recognize signs of fraud related to its audits of Fran's Fashions and Conston. However, the court finds that the plaintiffs have not sufficiently demonstrated that C&L was aware of any fraud or that it acted with severe recklessness. The plaintiffs' claims rely on the existence of "red flags," including documents that allegedly indicated a need for going concern qualifications in C&L's audit reports. However, the court states that these claims only suggest gross negligence rather than fraud.

To support their claims, the plaintiffs would need to establish a series of inferences: that both Fran's Fashions and Conston required capital from Cascade, C&L had a duty to investigate Cascade, and that such an investigation would have revealed significant issues. The court deems this chain of inferences too weak to indicate a severe departure from ordinary care standards.

Regarding the plaintiffs' assertion of a duty under AU Section 341, which discusses auditors’ responsibilities concerning an entity's ability to continue as a going concern, the court clarifies that the section does not impose specific duties on auditors of subsidiaries to investigate their parent companies. The language of AU Section 341 allows for discretion, indicating there are no clear obligations outlined for the auditors in this context.

Plaintiffs have not sufficiently alleged a violation of AU Section 341, particularly failing to demonstrate a highly unreasonable misrepresentation or omission that constitutes a significant deviation from ordinary care standards. The lack of detail in the allegations, especially regarding the circumstances of an omitted duty and how the statements or omissions were misleading, weakens their claims. Actual disclosures made by C&L, including negative financial positions for Fran's Fashions and Conston's bankruptcy status prior to April 1991, undermine any implication of fraud. Allegations of "red flags" concerning C&L's awareness of losses and overdue accounts payable only suggest negligence, not fraud. While there may be scenarios where a shareholder can establish a 10(b) violation regarding misleading statements about a subsidiary, Plaintiffs' claims related to C&L’s audits of Fran's Fashions and Conston do not meet Rule 9(b) pleading requirements.

Regarding the alleged material omissions concerning Cascade's 1991 10-K, Plaintiffs argue C&L should have identified errors in the financial statements and the number of Fran's Fashions stores. However, Plaintiffs fail to allege fraud with the necessary specificity and do not present evidence of any affirmative misrepresentations in Cascade's 1991 10-K. Notably, C&L did withdraw its audit reports for Conston and Fran's Fashions shortly after Cascade's announcement of potential inaccuracies in its financial statements.

C&L was not Cascade's independent auditor; Levy, who prepared the auditor's report for Cascade's 1991 10-K, held that role. Consequently, the Plaintiffs relied on Levy for the report's accuracy, not C&L. The alleged errors in the 10-K did not invalidate C&L's prior audit reports for Fran's Fashions and Conston, nor was there an explanation provided by the Plaintiffs to suggest otherwise. Furthermore, C&L's private advice to Cascade in November 1990 regarding the non-necessity of consolidating Conston's financial statements due to its bankruptcy status was not publicly disclosed, meaning investors did not rely on it.

The Plaintiffs appeared to assume that auditors have a continuing duty to monitor not only their client’s public filings but also those of the client’s parent. However, no accounting principle or case law was cited to support this alleged duty. Additionally, the Plaintiffs did not establish that C&L initiated the trading of Cascade securities or benefited from such trades. They argued C&L should be liable under Rule 10(b) for not withdrawing its audit reports immediately after the 10-K filing, delaying until late November and early December 1991. Despite doubts regarding C&L's duty to disclose errors in the 10-K, the court did not make a definitive ruling on this duty or the potential ongoing duty to monitor public filings.

The court referenced Rudolph's general principle that accountants are not expected to keep investors informed of adverse developments after a report's certification. The Plaintiffs failed to specify the nature of any alleged duty breached by C&L or to meet the particularity requirements of Rule 9(b) regarding their claims. Lastly, the Plaintiffs contended that the district court erred in denying them leave to amend their complaint to include more details about C&L’s conduct.

The district court rejected Plaintiffs' motion to amend their complaint, determining that the proposed additional allegations would not establish a claim under §10(b). The court cited precedent indicating that a plaintiff should be allowed to amend their complaint if it could potentially state a viable claim; however, if an amended complaint would not succeed in stating a claim, dismissal with prejudice is appropriate. Plaintiffs presented eleven new allegations intended to show C&L's "scienter" and a duty to disclose. Upon review, the court concluded that the district court acted within its discretion in denying the motion to amend, affirming that the amended complaint did not adequately state a claim against GY&S and C&L for primary liability under §10(b). Consequently, the district court's judgment was upheld, and the court chose not to consider scenarios where an auditor of a subsidiary might have a disclosure duty relevant to a parent's shareholders under §10(b).