Lattanzio v. Deloitte & Touche Llp

• Citation: 476 F.3d 147
• Decision Date: 31 January 2007
• Docket Number: Docket No. 05-5805-cv.
• Parties: John LATTANZIO, Herbert Black, Peter C. Kornman, Mary Cheasty Kornman, Harold G. Gove, Harold Levinson, on behalf of themselves and all others similarly situated, R.M.F. Global, Inc., on behalf of itself and all others similarly situated, Consolidated-Plaintiffs-Appellants, v. DELOITTE & TOUCHE LLP, Defendant-Appellee, Warnaco Group Inc., Linda Wachner, William S. Finkelstein, Stanley P. Silverstein, Defendants.
• Court: United States Courts of Appeals. United States Court of Appeals (2nd Circuit)

476 F.3d 147

John LATTANZIO, Herbert Black, Peter C. Kornman, Mary Cheasty Kornman, Harold G. Gove, Harold Levinson, on behalf of themselves and all others

similarly situated, R.M.F. Global, Inc., on behalf of itself and all others similarly situated, Consolidated-Plaintiffs-Appellants, v. DELOITTE & TOUCHE LLP, Defendant-Appellee Warnaco Group Inc., Linda Wachner, William S. Finkelstein, Stanley P. Silverstein, Defendants.

Docket No. 05-5805-cv.

United States Court of Appeals, Second Circuit.

Argued: October 11, 2006.

Decided: January 31, 2007.

Frederick W. Gerkens, III, Lovell Stewart Halebian LLP, New York, N.Y. (Christopher Lovell, on the brief), for Plaintiffs-Appellants.

Daniel F. Kolb, Davis Polk & Wardwell, New York, N.Y. (Amelia T.R. Starr, on the brief), for Defendant-Appellee.

Before JACOBS, Chief Judge, WALKER, Circuit Judge, O'CONNOR, Associate Justice Retired.^*

JACOBS, Chief Judge.

Plaintiffs, representing a putative class of persons that purchased the stock of Warnaco Group, Inc. ("Warnaco"), appeal from the judgment of the United States District Court for the Southern District of New York (Cedarbaum, J.) dismissing their securities fraud claim against Warnaco's outside accountant, Deloitte & Touche LLP ("Deloitte"), under Fed. R.Civ.P. 12(b)(6). (Defendant Warnaco has settled.) Plaintiffs allege that Deloitte made numerous misstatements regarding Warnaco's financial condition and failed to correct previous misstatements; that the risk of Warnaco's financial collapse was thereby concealed; and that plaintiffs lost the value of their shares when Warnaco filed for bankruptcy on June 11, 2001.

In a thorough and well-reasoned opinion, the district court concluded that:

[i] Deloitte was not liable for Warnaco's quarterly statements, which it did not audit;

[ii] Deloitte had no duty during the class period to correct statements or misstatements made by Deloitte prior to the class period; and

[iii] Plaintiffs inadequately alleged loss causation in connection with the statements that Deloitte made during the class period.

For the following reasons, we reach the same conclusions as the district court.

I

In the months leading up to its June 11, 2001 bankruptcy filing, Warnaco had defaulted on its credit agreements, had failed to obtain waivers from its creditors, and had seen its stock price plunge to "almost zero." (Am. Class Action Compl. ¶ 5 [hereinafter "Compl."].) Plaintiffs represent a putative class of persons that purchased Warnaco common stock between August 15, 2000 and June 8, 2001 (the "Class Period"). Throughout the Class Period, Deloitte served as Warnaco's outside accountant, a role it had filled since November 1999.

In reviewing a dismissal pursuant to Fed.R.Civ.P. 12(b)(6), we assume plaintiffs' allegations to be true. Lentell v. Merrill Lynch & Co., 396 F.3d 161, 165 (2d Cir. 2005). We therefore recount the allegations of Deloitte's misstatements (and failures to correct) contained in plaintiffs' complaint.

The Allegations as to the 1999 Form 10-K

Warnaco's initial Form 10-K for the year 1999 was filed on March 31, 2000. Amended forms were filed on April 3, 2000 and May 16, 2000 (collectively, the "1999 10-K"). Each of these filings contained Deloitte's statement that it had "audited the accompanying consolidated balance sheet of [Warnaco] . . . in accordance with auditing standards generally accepted . . . . In our opinion, [the] consolidated financial statements present fairly, in all material respects, the financial position of [Warnaco] as of January 1, 2000." (Compl.¶ 80.)

The allegation as to the 1999 10-K is that total shareholder equity ("TSE") was stated as $563 million instead of $533 million. Of the $30 million overstatement, $26 million was attributed to Warnaco's failure to properly account for charge-backs resulting from the return of goods by retailers in the period from 1997 to 1999. Deloitte allegedly became aware of the improper charge-back accounting in February 2000, but did not correct Warnaco's financial statements until March 2001 (the "Charge-back Restatement").

The remaining $4 million net overstatement was attributed to erroneous inter-company accounting between Warnaco and its wholly-owned subsidiary Designer Holdings (including an understatement of accounts payable by $18 million, which presumably was offset somehow in arriving at the $4 million net overstatement). According to plaintiffs, these misstatements "occurred when Samuel Batraki, Deloitte's senior auditor of Warnaco, became employed by Warnaco . . . as a controller of Designer Holdings" in May 2000 (id. ¶¶ 2(c), 11)—although it appears that the 1999 10-K was filed before Batraki joined Warnaco. Deloitte allegedly became aware of the errors in the inter-company Designer Holdings accounting sometime in fall 2000, but did not correct Warnaco's financial statements until August 22, 2001, after Warnaco was already in bankruptcy ("Designer Holdings Restatement").

The Allegations as to Quarterly Statements

Warnaco filed three quarterly statements during the Class Period: the August 15, 2000 Form 10-Q ("August 10-Q"); the November 16, 2000 Form 10-Q ("November 10-Q"); and the May 26, 2001 Form 10-Q ("May 10-Q").

The allegation as to the August 10-Q is that TSE was stated as $480 million instead of $334 million—a $146 million error. As in the 1999 10-K, $26 million of this overstatement was attributed to the errors that were later corrected in the Charge-back Restatement. Another $17 million was attributed to the inter-company accounting errors later corrected in the Designer Holdings Restatement. Additionally, plaintiffs estimate that $103 million of inventory claimed by Warnaco in the August 10-Q was actually worthless and unsaleable. Warnaco subsequently conceded a $13 million inventory overvaluation in an amended Form 10-Q*A (the "April 2001 Restatement"); the remaining $90 million has not been conceded by Warnaco or been the subject of restatement. It is alleged that Deloitte knew of the errors reflected in the April 2001 Restatement by (at least) November 3, 2000—after the filing of the August 10-Q but before the filing of the November 10-Q, discussed below.

The first allegation as to the November 10-Q is that TSE was stated as $348 million instead of $198 million—a $150 million error. As with the August 10-Q, $26 million was attributed to the Charge-back Restatement and $103 million was attributed to worthless inventory, which included $13 million attributed to the April 2001 Restatement. The Designer Holdings Restatement accounted for the remaining $20 million discrepancy.

The second allegation as to the November 10-Q is that the figures for Warnaco's long-term debt and cash were misstated to fake compliance with Warnaco's debt covenants. Two weeks before the November 10-Q was filed, Warnaco issued a press release stating that its long-term debt was $1.79 billion and its TSE was $348 million (including $227 million cash). According to plaintiffs, this debt-to-equity ratio of over five-to-one violated Warnaco's debt covenants. However, in the November 10-Q, Warnaco's cash and debt figures were each reduced by $190 million, leaving the difference unaltered, but changing the ratio to an acceptable 4.6-to-one, thus concealing Warnaco's non-compliance with its covenants. Plaintiffs allege that Deloitte was aware of the correct debt and equity information in advance of Warnaco's November 2 press release, and therefore knew that the information in the November 10-Q was false.

The allegation as to the May 10-Q is that TSE was stated as $35 million instead of $16 million in the red—a $51 million error. The entire discrepancy was attributed to the inter-company accounting that was later corrected in the Designer Holdings Restatement.

These quarterly statements (unlike the 1999 10-K) were not audited by Deloitte, and were not accompanied by an audit opinion. However, federal securities regulations required that Deloitte "review" the statements, see 17 C.F.R. § 210.10-01(d), and plaintiffs allege that Deloitte did.

The Allegations as to the 2000 Form 10-K

On April 17, 2001, Warnaco filed its Form 10-K for the year 2000 (the "2000 10-K"). The 2000 10-K stated TSE as $77 million instead of $27 million—a $50 million net discrepancy attributed to the inter-company accounting corrected by the Designer Holdings Restatement, which later conceded that the 2000 10-K understated accounts payable and liabilities by $97 million and overstated inventories by $1.2 million. The 2000 10-K (like the 1999 10-K) contained Deloitte's statement that it had "audited the accompanying consolidated balance sheet of [Warnaco] . . . in accordance with auditing standards generally accepted . . . . In our opinion, [the] consolidated financial statements present fairly in all material respects, the financial position of [Warnaco] as of December 30, 2000." (Compl. ¶ 166.)

This audit opinion also delivered a "going concern" warning that Warnaco "was not in compliance with certain covenants of its long-term debt agreements as of December 30, 2000 as a result of losses in 2000, and [Warnaco] has a working capital deficiency as of December 30, 2000. These matters raise substantial doubt about its ability to continue as a going concern."

II

We review a district court's grant of a motion to dismiss de novo. Allaire Corp. v. Okumus, 433 F.3d 248, 249-50 (2d Cir. 2006). Plaintiffs assert two claims against Deloitte: [i] violation of § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, and [ii] breach of common law fiduciary duty.

To state a claim under § 10(b) and Rule 10b-5, plaintiffs must allege that Deloitte "(1) made misstatements or omissions of material fact; (2) with scienter; (3) in connection with the purchase or sale of securities; (4) upon which plaintiffs relied; and (5) that plaintiffs' reliance was the proximate cause of their injury." In re...