524 F.2d 1064 (7th Cir. 1975), 74-2047, Sanders v. John Nuveen & Co., Inc.
|Docket Nº:||74-2047, 75-1260.|
|Citation:||524 F.2d 1064|
|Party Name:||Henry T. SANDERS, Plaintiff-Appellee, v. JOHN NUVEEN & CO., INC., et al., Defendants-Appellants.|
|Case Date:||October 30, 1975|
|Court:||United States Courts of Appeals, Court of Appeals for the Seventh Circuit|
Argued June 13, 1975.
[Copyrighted Material Omitted]
Milton H. Cohen, Allan Horwich, Chicago, Ill., for defendants-appellants.
Richard Orlikoff, Salvatore A. Barbatano, Chicago, Ill., for plaintiff-appellee.
Before CLARK, Associate Justice (Retired), [*] FAIRCHILD, Chief Judge, and STEVENS, Circuit Judge.
STEVENS, Circuit Judge.
The principal question presented is whether an underwriter of short term commercial paper, who acted in the mistaken but honest belief that financial statements prepared by certified public accountants correctly represented the condition of the issuer is liable to its customers for losses sustained as a result of the issuer's default. The district court held the underwriter liable on the theory that it breached a duty to make reasonable inquiries that would have led to the discovery of the issuer's fraud. We affirm.
The plaintiff class consists of 42 purchasers of short term notes issued by Winter & Hirsch, Inc. ("WH"), a finance company that defaulted on its obligations on February 25, 1970. All of the plaintiffs' notes, totaling $1,612,500 in face value, were purchased from the defendant, John Nuveen & Co., Inc. ("Nuveen") during the period between June 30, 1969, and February 10, 1970.
Nuveen, whose primary business for many years had been the sale of tax exempt securities, entered the commercial paper business in September of 1968
by acquiring the assets of a commercial paper broker headquartered in Chicago. WH had been one of approximately 40 issuers represented by that broker. Without first making an investigation of the corporate affairs, business, or financial condition of WH, Nuveen began to underwrite and to sell commercial paper issued by WH.
Nuveen operated 17 branch offices located throughout the United States. Its entire sales force, including 172 registered representatives, was authorized to sell commercial paper. The paper which it sold, including the WH notes, was rated "Desirable" by a subsidiary by National Credit Office in a system in which "Prime" was the highest rating and "Desirable" was the second category. The head of Nuveen's commercial paper department testified that the paper handled by Nuveen was sold on the basis "that there should be no question but what the paper will be paid at maturity."
Nuveen customarily prepared a credit report on the issues of commercial paper which it sold; such reports on WH were given to Nuveen's customers. At least some of the reports stated that they contained information derived from a "detailed audit" of WH.
The district court found that Nuveen was an underwriter of WH commercial paper. During the period between September 1968 and February 1970, Nuveen purchased and resold substantially all of WH's short term discount notes. 1 The amount of outstanding indebtedness evidenced by such notes varied from about $1,500,000 to $4,000,000. 2 Nuveen sold WH paper to banks, insurance companies, individuals and firms throughout the United States. They were frequently "rolled over" at maturity; that is, new notes were accepted in payment of outstanding notes when they became due. The conclusion that Nuveen was an underwriter for WH is not challenged.
Nuveen made some investigation of the affairs of WH. It analyzed semiannual financial statements prepared by the certified public accounting firm of Lieber, Bleiweis & Company. Nuveen ascertained that a number of large banks had been extending millions of dollars of credit to WH for many years. 3 In March of 1969 a credit analyst employed by Nuveen spent a day at the offices of WH; he examined records relating to WH's accounts receivable and its collection procedures.
In September of 1969, Investors Diversified Services ("IDS"), through its wholly owned subsidiary, Investors Syndicate of America, Inc., acquired all the stock of Nuveen. The senior vice-president of IDS then became a director of Nuveen and a member of its Executive Committee, with special responsibility for the commercial paper operation. Thereafter, the head of Nuveen's commercial paper department had lunch with the president of WH, noticed that he appeared ill, and decided to conduct a check of WH. Accordingly, Nuveen personnel again reviewed
the most recent Lieber, Bleiweis statements, and in mid-January of 1970, letters of inquiry were sent to 10 banks. The responses were either neutral or favorable.
Nuveen never made any request to examine WH's tax returns, its corporate minutes, or its contracts. Nuveen did not meet with any representative of Lieber, Bleiweis and made no request to see any working papers used in the preparation of its semiannual statements.
In January of 1970, two lenders who had heard rumors about the Lieber, Bleiweis audits of WH, insisted that WH retain a new accounting firm to conduct an audit as of January 31, 1970. The new accounting firm was retained on January 12, 1970. Those accountants promptly discovered that no federal income tax return had been filed for the fiscal year ended August 31, 1969; that Lieber, Bleiweis work papers were either not in existence or not available; and that the general ledger of WH could not be reconciled with the August 31, 1969, statement of net worth in the Lieber, Bleiweis audit. In due course, the accountants discovered a $14,000,000 deficiency in the accounts receivable and unrecorded indebtedness of $1,750,000. WH was hopelessly insolvent a fact which had been concealed by the falsification of records by WH and Lieber, Bleiweis for a period of at least 10 years. 4
On February 10, 1970, Nuveen first heard the rumors about WH and, as a result of inquiries, also learned that a fresh audit of WH was being made. Nuveen immediately ceased the sale of WH commercial paper and sold none thereafter. The WH notes then outstanding were not paid.
On March 12, 1970, plaintiff Henry T. Sanders filed this class action against Nuveen, the corporations directly and indirectly in control of Nuveen, 5 and nine individuals. 6 The complaint as amended principally alleged that the defendant Nuveen violated the federal securities laws by selling WH commercial paper without first making an investigation of WH sufficient to satisfy Nuveen's duty as an underwriter, 7 and the Rules of Fair Practice of the National Association of Securities Dealers, Inc., by failing to establish written procedures for the sale of commercial paper and failing properly to train and supervise its salesmen. The other defendants are alleged to be liable as "controlling persons" of Nuveen.
The district court denied defendants' motion to strike certain critical allegations and then certified to this court the question whether the WH commercial paper was a "security" within the meaning of the Securities Exchange Act of 1934. We answered that question in the affirmative 8 and remanded the case for trial.
After trial the district court made detailed findings of fact and entered judgment for plaintiffs. The court concluded that Nuveen had a duty as an underwriter to make a reasonable investigation of WH and that, in the circumstances of this case, such an investigation would have revealed the fraud. Defendants appeal, primarily contending that Nuveen acted reasonably and did not violate any statutory duty to its customers.
Appeal No. 74-2047
We think appellants are correct in arguing that Nuveen's liability in this case must rest on Rule 10b-5. 9 Section 11 of the Securities Act of 1933 is inapplicable because no registration statement was filed, 10 and we do not rely on § 12(2) of that Act because the district court did not find any violation of that section. 11 We also agree with appellants that the evidence does not indicate that all members of the class relied on express recommendations by Nuveen. Moreover, for purposes of decision we accept appellants' argument that the Lieber, Bleiweis audit was appropriately certified and nothing in the audits themselves gave Nuveen any special reason to question their accuracy. 12 Finally, we deliberately avoid any extended discussion of the broad question whether there is a generally applicable standard of culpability in Rule 10b-5 cases lying somewhere between the extremes of common law fraud on the one hand 13 and mere negligence on the other. 14 We assume the standard may be phrased differently in different circumstances. 15
In this case, the result is controlled by a few critical facts. Defendant Nuveen was an underwriter of WH commercial paper. Although Nuveen was unaware of the fraud perpetrated by WH and Lieber, Bleiweis, a request to examine federal income tax returns, corporate minute books and accounting work papers or indeed any one of these sources of information would have revealed the fraud or at the very least would have revealed deficiencies that would have mandated further inquiry.
Nuveen's status as an underwriter is significant for two reasons. An
underwriter's relationship with the issuer gives the underwriter access to facts that are not equally available to members of the public who must rely on published information. And the relationship between the underwriter and its customers implicitly involves a favorable recommendation of the issued security. Because the public relies on the integrity, 16 independence and expertise of the underwriter, the underwriter's participation significantly enhances the marketability of the security. 17 And since the underwriter is unquestionably aware of the nature of the public's reliance on his...
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