McGann v. Ernst & Young

• Decision Date: 04 December 1996
• Docket Number: Nos. 95-55925,s. 95-55925
• Citation: 102 F.3d 390
• Parties: 96 Cal. Daily Op. Serv. 8744, 96 Daily Journal D.A.R. 14,455 Dollard McGANN; Barry A. Bragger; Peter Gershon; Steven G. Cooperman, M.D.; William S. Atherton; Irving Scher; Michael Patitucci, Jr.; J. Floyd Johnson; Schulman, Rogers, Gandal, Pordy & Becker, et al., Plaintiffs-Appellants, v. ERNST & YOUNG, Defendant-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 390

102 F.3d 390

96 Cal. Daily Op. Serv. 8744, 96 Daily Journal

D.A.R. 14,455

Dollard McGANN; Barry A. Bragger; Peter Gershon; Steven

G. Cooperman, M.D.; William S. Atherton; Irving Scher;

Michael Patitucci, Jr.; J. Floyd Johnson; Schulman, Rogers, Gandal, Pordy & Becker, et al., Plaintiffs-Appellants, v. ERNST & YOUNG, Defendant-Appellee.

Nos. 95-55925.

United States Court of Appeals,

Ninth Circuit.

Argued and Submitted Aug. 7, 1996.

Decided Sept. 9, 1996.

As Amended on Denial of Rehearing

and Rehearing En Banc Dec. 4, 1996. ^*

Leonard B. Simon, Milberg, Weiss, Bershad, Hynes & Lerach, San Diego, CA, for plaintiffs-appellants.

Miles N. Ruthberg, Latham & Watkins, Los Angeles, CA, for defendant-appellee.

Richard H. Walker, Securities and Exchange Commission, Washington, DC, for amicus curiae.

Appeal from the United States District Court for the Central District of California, Alicemarie H. Stotler, District Judge, Presiding. D.C. No. CV-93-00814-AHS.

Before: FLETCHER and TASHIMA, Circuit Judges, and RESTANI, ^** Judge, United States Court of International Trade.

FLETCHER, Circuit Judge:

Plaintiff securities investors appeal the grant of judgment on the pleadings for defendant Ernst & Young ("E&Y"), an independent accounting firm. Plaintiffs alleged that E&Y incurred primary liability under § 10(b) of the Securities Exchange Act of 1934 (the "Act") by preparing a fraudulent audit report that it knew would be included by its client in a Form 10-K. This case requires us to decide whether the Supreme Court's recent decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 114 S.Ct. 1439, 128 L.Ed.2d 119 (1994), overturned the traditional interpretation of § 10(b) first set forth in SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2nd Cir.1968) (en banc), cert. denied sub nom. Coates v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969). We have jurisdiction, 28 U.S.C. § 1291, and we reverse.

I. FACTS AND PRIOR PROCEEDINGS

At all relevant times, E&Y was the outside auditor for the Community Psychiatric Centers ("CPC"), a publicly traded corporation. Plaintiffs alleged the following facts: E&Y issued a false and misleading audit opinion regarding CPC's financial statements for the fiscal year ending in November 1990. Specifically, E&Y failed to disclose the fact that CPC had a major accounts receivable problem. E&Y knew that CPC would include this audit opinion in its annual Form 10-K filed with the Securities and Exchange Commission ("SEC"). The suppression of this information caused the artificial inflation of the price of CPC's stock. In September and November 1991, when CPC announced a major drop in earnings due to $37 million in uncollectible debts, the value of CPC's stock declined precipitously.

In June 1993, plaintiffs filed this action against E&Y. ¹ Plaintiffs are a class of persons who purchased CPC stock between the time of the publication of E&Y's audit opinion and the time of CPC's announcement regarding bad debts. Plaintiffs alleged that by producing a fraudulent audit report with the knowledge that its client would disseminate the statements therein to the securities market, E&Y committed fraudulent acts "in connection with" the trading of securities, 15 U.S.C. § 78j(b), and thus violated § 10(b). Plaintiffs claimed that E&Y was both a primary violator of § 10(b), and a secondary violator as a conspirator with and an aider and abettor to CPC.

In May 1995, the district court granted E&Y's motion for judgment on the pleadings. See Fed.R.Civ.P. 12(c). The court held that the Supreme Court's recent decision in Central Bank squarely rejected aider and abettor liability under § 10(b). The court also held that Central Bank implicitly rejected conspirator liability. ² The plaintiffs appeal neither of these holdings.

The district court then dismissed the plaintiffs' primary liability claim, holding that an independent accounting firm does not act "in connection with" securities trading when it produces a fraudulent audit report that it knows its client will include in a Form 10-K. The court noted the contrary authority of the Second Circuit's Texas Gulf and the Ninth Circuit's Wessel v. Buhler, 437 F.2d 279 (9th Cir.1971), but concluded that the these decisions were inconsistent with Central Bank. Specifically, the court reasoned that while Central Bank rested on the text of § 10(b), Texas Gulf and Wessel improperly rested on underlying congressional goals. The plaintiffs appeal the district court's primary liability holding.

II. DISCUSSION

This case presents two overlapping questions: First, did Central Bank undermine Texas Gulf and its progeny? Second, is an accounting firm subject to primary liability under § 10(b) when it prepares a fraudulent audit report that it knows its client will include in a Form 10-K? We answer the first question in the negative, and the second question in the affirmative.

A. STANDARD OF REVIEW

We review de novo a judgment on the pleadings pursuant to Rule 12(c). Merchants Home Delivery Service, Inc. v. Hall & Co., 50 F.3d 1486, 1488 (9th Cir.) (citation omitted), cert. denied sub nom. Prometheus Funding Corp. v. Merchants Home Delivery Services, Inc., --- U.S. ----, 116 S.Ct. 418, 133 L.Ed.2d 335 (1995). A judgment on the pleadings is properly granted when, taking all allegations in the pleading as true, the moving party is entitled to judgment as a matter of law. Id. We also review questions of law de novo. Twenty-Three Nineteen Creekside, Inc. v. Commissioner, 59 F.3d 130, 131 (9th Cir.1995).

B. THE TRADITIONAL VIEW: TEXAS GULF

The Securities Exchange Act of 1934 regulates the post-distribution trading of securities. See 15 U.S.C. § 78a et seq. The " 'fundamental purpose' " of the Act was " 'to substitute a philosophy of full disclosure for the philosophy of caveat emptor.' " Central Bank, 511 U.S. at ----, 114 S.Ct. at 1445 (quoting Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 151, 92 S.Ct. 1456, 1471, 31 L.Ed.2d 741 (1972)). Section 10(b) of the Act prohibits fraudulent activities "in connection with" the purchase or sale of securities, ³ as does SEC Rule 10b-5. ⁴

In Texas Gulf, the Second Circuit held that false and misleading assertions are made "in connection with" securities trading "whenever [such] assertions are made ... in a manner reasonably calculated to influence the investing public...." 401 F.2d at 862. Specifically, the court held that company officers violated Rule 10b-5 by issuing a misleading press release regarding the company's successful oil exploration activities. The court further held that the prohibition of Rule 10b-5 applies whether or not "the makers of a misleading statement also participated in pertinent securities transactions in connection therewith...." Id. at 860. See also Heit v. Weitzen, 402 F.2d 909 (2nd Cir.1968) (applying Texas Gulf to fraudulent annual reports, "as well as documents filed by the individual defendants with the SEC"), cert. denied, 395 U.S. 903, 89 S.Ct. 1740, 23 L.Ed.2d 217 (1969).

The Ninth Circuit adopted the Second Circuit's formulation. In Wessel, the Ninth Circuit held that " 'Rule 10b-5 is violated whenever assertions are made ... in a manner reasonably calculated to influence the investing public....' " 437 F.2d at 282 (quoting Texas Gulf, 401 F.2d at 862). The court then held that an outside accountant does not violate this standard by preparing documents that were never publicly disseminated. Id. In SEC v. Rana Research, Inc., 8 F.3d 1358 (9th Cir.1993), the Ninth Circuit again relied on the Texas Gulf formulation, holding that a financial consultant violated Rule 10b-5 by issuing a misleading press release regarding the stock value of a publicly traded company. Id. at 1362.

Several other circuits have also adopted Texas Gulf 's interpretation of the "in connection with" language of § 10(b). Gottlieb v. Sandia American Corp., 452 F.2d 510, 516 (3rd Cir.), cert. denied sub nom. Wechsler v. Gottlieb, 404 U.S. 938, 92 S.Ct. 274, 30 L.Ed.2d 250 (1971); Akin v. Q-L Investments, Inc., 959 F.2d 521, 528 (5th Cir.1992); Mitchell v. Texas Gulf Sulphur Co., 446 F.2d 90, 100-01 (10th Cir.), cert. denied, 404 U.S. 1004, 92 S.Ct. 564, 30 L.Ed.2d 558 (1971); SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1171 (D.C.Cir.1978), cert. denied sub nom. Zimmerman v. SEC, 440 U.S. 913, 99 S.Ct. 1227, 59 L.Ed.2d 462 (1979).

The Supreme Court has never squarely addressed the validity of the Texas Gulf test. See Superintendent of Ins. of the State of New York v. Bankers Life & Cas. Co., 404 U.S. 6, 12-13, 92 S.Ct. 165, 168-70, 30 L.Ed.2d 128 (1971) (describing the issue as whether deceptive practices "touch[ ]" the sale of securities). However, in a discussion of the materiality of merger discussions for the purposes of § 10(b), the Court favorably quoted Texas Gulf 's interpretation of the "in connection with" language. Basic Inc. v. Levinson, 485 U.S. 224, 235 n. 13, 108 S.Ct. 978, 985 n. 13, 99 L.Ed.2d 194 (1988).

C. THE CONTINUED VITALITY OF TEXAS GULF

The district court held and the defendant argues on appeal that Central Bank fatally undermined Texas Gulf and its progeny. Specifically, it is claimed that while the former requires an analysis of the text and structure of § 10(b), the latter improperly rest exclusively on policy considerations. The defendants further argue that under a proper reading of "in connection with," only those who actually trade securities are subject to primary liability under § 10(b). Accountants who simply make misrepresentations that they know will be included in Forms 10-K would not be included.

These reports of Texas Gulf 's demise are greatly exaggerated. There is no tension between the holding of Central Bank and the holding of Texas Gulf: the former forbids § 10(b) actions against aiders and abettors, 511 U.S. at ----, 114 S.Ct. at 1455, while the latter allows § 10(b) actions against primary violators " ...