617 F.2d 1335 (9th Cir. 1980), 77-3450, Pegasus Fund, Inc. v. Laraneta

Docket Nº:77-3450.
Citation:617 F.2d 1335
Party Name:The PEGASUS FUND, INC., Vanderbilt Mutual Fund, Inc., and Pegasus Income & Capital Fund, Inc., Plaintiffs-Appellants, v. Ronald J. LARANETA et al., and Federated Investors, Inc., et al., Defendants, and Arthur Young & Company, Defendant-Appellee.
Case Date:February 14, 1980
Court:United States Courts of Appeals, Court of Appeals for the Ninth Circuit
 
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Page 1335

617 F.2d 1335 (9th Cir. 1980)

The PEGASUS FUND, INC., Vanderbilt Mutual Fund, Inc., and

Pegasus Income & Capital Fund, Inc., Plaintiffs-Appellants,

v.

Ronald J. LARANETA et al., and Federated Investors, Inc., et

al., Defendants,

and

Arthur Young & Company, Defendant-Appellee.

No. 77-3450.

United States Court of Appeals, Ninth Circuit

February 14, 1980

        Rehearing Denied May 20, 1980.

Page 1336

        Arthur N. Greenberg, Greenberg & Glusker, Los Angeles, Cal., for plaintiffs-appellants.

        Carl D. Liggio, Arthur Young & Co., New York City (argued), for defendant-appellee; Mitchell L. Lathrop, MacDonald, Halsted & Laybourne, Los Angeles, Cal., on brief.

        Appeal from the United States District Court for the Central District of California.

        Before SNEED and TANG, Circuit Judges, and JAMESON [*], District Judge.

        SNEED, Circuit Judge:

        The plaintiffs-appellants are three mutual funds that charge the defendant-appellee, an accounting firm, with recklessly performing an audit of the funds' financial statements in violation of section 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. This appeal is taken from summary judgment on pleadings that alleged only a rule 10b-5 violation, although a memorandum submitted in opposition to the motion for summary judgment alluded to the possibility of a private claim under section 34(b) of the Investment Company Act of 1940, 15 U.S.C. § 80a-33(b). The appellee has moved this court to dismiss a portion of the appeal that challenges the allegedly implicit summary judgment on the section 34(b) claim and to strike the corresponding part of the plaintiffs-appellants' brief. By previous order of this court the motion is to be considered with the merits of the appeal. Our jurisdiction rests on 28 U.S.C. § 1291. We grant the appellee's motion to dismiss the section 34(b) portion of the appeal and affirm the summary judgment.

       I.

        FACTUAL SETTING

        The appellants are investment companies, or mutual funds, registered in accordance with the Investment Company Act of 1940, 15 U.S.C. § 80a-1 et seq. As a result of several transactions during 1973, each mutual fund bought a restricted debenture of Burreson & Co., Inc., secured by deeds of trust on realty whose value exceeded the face value of the debentures. One of the appellants, Pegasus Income & Capital Fund, Inc. (PIC), also purchased an Oh Boy! Industries, Inc. restricted debenture and a block of its convertible preferred stock. Since none of the securities were traded on

Page 1337

any exchange and all were restricted, the directors of the funds had a duty, under 15 U.S.C. § 80a-2(a)(41) and 17 C.F.R. § 270.2a-4(a)(1), to value them. Each board met and valued the debentures at cost, which was also the face value of the securities. PIC valued its Oh Boy! Industries preferred stock at 95% of face value in view of the acknowledged weakness of the issuer.

        As required by 15 U.S.C. § 80a-29(e), the directors of the mutual funds made arrangements for an audit of their financial statements. The appellee Arthur Young was the accounting firm chosen for the task. The mutual funds gave Arthur Young copies of various documents from their files, including:

        (a) the Burreson & Co. and Oh Boy! Industries securities, the latter of which showed on its face an interest rate of 111/2%;

        (b) a preliminary draft of a Burreson & Co. financial statement as of June 30, 1973 as to which the company's auditor had disclaimed any opinion;

        (c) an audited financial statement of Oh Boy! Industries as of May 31, 1973 as to which the auditor had expressed an unqualified opinion;

        (d) security agreements underlying the Burreson & Co. debentures, listing trust deed collateral.

        Arthur Young certified the appellants' financial statements without qualification, stating in part: "We have examined the accompanying (financial statements) . . . . Our examination was made in accordance with generally accepted auditing standards . . . (and) . . . the (mutual funds') statements . . . present fairly the net assets of (the mutual funds) at December 31, 1973 . . . in conformity with generally accepted accounting principles applied on a consistent basis." By that date, however, the appellants allege that the Burreson and Oh Boy! securities were practically worthless.

        After receiving the audit opinion, the mutual funds bought, on the recommendation of their investment advisors, securities issued by Commercial Petro-Gas, Inc. (CPG) and North American Credit Corp. (NACC), described in the mutual funds' pleadings as Burreson & Co. affiliates. Arthur Young has made the uncontroverted allegation that it was unaware of any connection between CPG, NACC and Burreson & Co. Interlocking directorates permitted some of the mutual funds' directors to defraud the funds by channeling the investment capital of the funds into corporations the directors owned or controlled. The mutual funds do not contend that Arthur Young was a participant in or beneficiary of these schemes.

        An alleged basic flaw in the audit, which the mutual funds assert was recklessly done, was Arthur Young's failure to advise the mutual funds that the debenture collateral consisted not of first deeds of trust but of "all-inclusive" deeds of trust, which the funds say represent junior security interests. Arthur Young maintains that all-inclusive deeds of trust can represent first or second mortgages. The partner of Arthur Young responsible for the audit testified in related SEC proceedings that he did "know what (first deeds of trust) are." While the accounting firm inspected the restricted securities in the custody of California Bankers Trust Co. (CBT), the custodian of the mutual funds' assets, it accepted CBT's written and oral assertions that the related collateral documents were first deeds of trust.

        The mutual funds note several other warning details that they allege a proper audit would have revealed. Some of these concern the Burreson debentures, and others concern the Oh Boy! debentures...

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