Frymire v. Peat, Marwick, Mitchell & Co.

• Decision Date: 26 March 1987
• Docket Number: No. 85 C 10460.,85 C 10460.
• Citation: 657 F. Supp. 889
• Court: U.S. District Court — Northern District of Illinois
• Parties: Richard A. FRYMIRE, Kathleen Frymire-Brinati, and Michael Brinati, Plaintiffs, v. PEAT, MARWICK, MITCHELL & CO., Defendant.

657 F. Supp. 889

Richard A. FRYMIRE, Kathleen Frymire-Brinati, and Michael Brinati, Plaintiffs, v. PEAT, MARWICK, MITCHELL & CO., Defendant.

No. 85 C 10460.

United States District Court, N.D. Illinois, E.D.

March 26, 1987.

COPYRIGHT MATERIAL OMITTED

Michael J. Freed, Anthony C. Valiulis, Stewart M. Weltman, Much Shelist Freed Denenberg Ament & Eiger, P.C., Chicago, Ill., for plaintiffs.

Robert D. McLean, Michael J. Sweeney, Frank B. Vanker, Sidley & Austin, Chicago, Ill., for defendant.

MEMORANDUM AND ORDER

MORAN, District Judge.

The facts and parties in this case broadly resemble those of Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976). In Ernst, the plaintiffs invested in an allegedly fraudulent scheme. The perpetrator of the fraud was unavailable for suit (having committed suicide after bankrupting his company), and so the investors sued the auditors for securities fraud on the theory that the investors had been misled by financial statements the auditors had approved. 425 U.S. at 189, 96 S.Ct. at 1378. Here the three plaintiffs, apparently related by blood or marriage, are stockholders in Pepco, Inc., an Oklahoma corporation, which apparently was in the business of selling interests in limited partnerships in real estate to persons seeking tax shelters. Both Pepco and its former president, Patrick Powers, are in bankruptcy and therefore are unavailable for suit. Plaintiffs thus bring this complaint against Pepco's auditors, defendant Peat, Marwick, Mitchell & Co. (PMM). PMM moves to dismiss under Federal Rule of Civil Procedure 12(b)(6) for failure to state a claim, and Federal Rule of Civil Procedure 9(b) for failure to plead fraud and conspiracy to defraud with particularity.

The 42-page complaint consists of six counts. Count I is under § 12(2) of the Securities Act of 1933, 15 U.S.C. § 77l(2); count II under § 17(a) of the same Act, 15 U.S.C. § 77q(a); count III under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Securities Exchange Commission (SEC) Rule 10b-5, 17 C.F.R. § 240.10b-5; count IV, a claim for treble damages under the Racketeer Influenced and Corrupt Organizations Act (RICO), 18 U.S.C. § 1961 et seq. Counts V and VI are pendent Illinois law claims for common law fraud and negligent misrepresentation, respectively.

I.

PMM moves to dismiss count I because it is not a proper defendant to a § 12(2) action. That section, it contends, imposes liability only on sellers of securities, a liability which runs only to persons who purchased the security from them. Sanders v. John Nuveen & Co., 619 F.2d 1222, 1226 (7th Cir.1980), cert. denied, 450 U.S. 1005, 101 S.Ct. 1719, 68 L.Ed.2d 210 (1981); Collins v. Signetics Corp., 605 F.2d 110, 113 (3d Cir.1979). Plaintiffs counter by arguing that experts such as auditors hired to perform services and to express opinions can be liable under § 12(2) for "aiding and abetting" the perpetrator of the fraud.

This circuit simply does not recognize such liability for § 12(2). The existence of aiding and abetting liability is in some doubt even for the far more well established Rule 10b-5 action. Herman & MacLean v. Huddleston, 459 U.S. 375, 379 n. 5, 103 S.Ct. 683, 685 n. 5, 74 L.Ed.2d 548 (1983); Congregation of the Passion, Holy Cross Province v. Kidder Peabody & Co., 800 F.2d 177, 183 (7th Cir.1986). The Holy Cross court, 800 F.2d at 183, identified Barker v. Henderson, Franklin, Starnes & Holt, 797 F.2d 490 (7th Cir.1986), as the major recent opinion in this circuit on aiding and abetting. Barker not only does not mention aiding and abetting for § 12(2), but expressly says that to be liable under that section an accounting firm must have been an issuer, director, offeror or seller of securities, or a signatory of a prospectus, or a person with the ability to direct the actions of persons who were. 797 F.2d at 494. Moreover, even those circuits which do impose § 12(2) aiding and abetting liability nevertheless limit it to those who actively participated in a sale, e.g., through solicitations or a role in negotiations. In re Diasonics Securities Litigation, 599 F.Supp. 447, 457 (N.D.Cal.1984). None of those descriptions fit PMM here. Count I is dismissed.

II.

PMM defends against count II first of all by arguing that there is no private right of action under § 17(a), and alternatively that even if there is, only sellers can be defendants under it. Plaintiffs remind this court that we held some time ago that private rights of action exist under all three subsections of § 17(a). Spatz v. Borenstein, 513 F.Supp. 571, 576 (N.D.Ill. 1981). However, that holding rested on our reading of Seventh Circuit precedents at that time, which we thought had squarely concluded in favor of a private right of action under § 17(a). Since then, three different panels of this circuit have stated that the existence of the private action is an open question. Ray v. Karris, 780 F.2d 636, 641 n. 3 (7th Cir.1985); Teamsters Local 282 Pension Trust Fund v. Angelos, 762 F.2d 522, 530 (7th Cir.1985); Peoria Union Stock Yards Company Retirement Plan v. Penn Mutual Life Insurance Co., 698 F.2d 320, 323 (7th Cir.1983). As a result, a division of opinion has emerged within this district. Compare Beck v. Cantor, Fitzgerald & Co., 621 F.Supp. 1547, 1559-1560 (N.D.Ill.1985) with Onesti v. Thomson McKinnon Securities, Inc., 619 F.Supp. 1262, 1266-1267 (N.D.Ill.1985).

This case also presents, as Spatz did not, the question of the appropriate standard of federal securities law liability for providers of services and opinions, such as auditors. In Ernst, the Supreme Court held that securities fraud victims could not recover damages from an auditing firm in a Rule 10b-5 action without proof of scienter. The court concluded that Congress, in passing the securities laws, intended to establish different standards of liability for different types of defendants in different circumstances and, further, that mere providers of services and opinions should ordinarily have less exposure to liability than issuers and sellers of securities. 425 U.S. at 200, 208. For example, under § 11(b)(3) of the Securities Act of 1933, 15 U.S.C. § 77k(b)(3)(B), issuers of securities are strictly liable for misleading errors in a registration statement. Accountants, however, are liable only for their negligence.

For the review of financial statements, even more protection from liability seemed appropriate. An issuer out to perpetrate a fraud could defraud auditors as well as investors. Thus one factor in the court's decision in Ernst was a belief that liability for mere negligence under § 10(b) and Rule 10b-5, which had already been determined to reach providers of services and opinions like auditors, would expose them to far more liability more often than Congress had intended. Id., 425 U.S. at 211-212 n. 31, 214-216 n. 33, 96 S.Ct. at 1389-1390 n. 31, 1391 n. 33. A standard of liability which required proof of intent, knowledge or recklessness was more in keeping with the statutory scheme.

A possible application of § 17(a) to auditors presents the same problem. The Supreme Court has determined in the context of an SEC action that while § 17(a)(1) requires proof of scienter, a negligence standard applies to § 17(a)(2) and § 17(a)(3). Aaron v. SEC, 446 U.S. 680, 697, 100 S.Ct. 1945, 1956, 64 L.Ed.2d 611 (1980). Plaintiffs' count II includes a claim under § 17(a)(3), which provides:

It shall be unlawful for any person in the offer or sale of any securities by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, directly or indirectly, ... to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

The language of the subsection is thus very similar to subsection (c) of Rule 10b-5. If the standard of liability for § 17(a)(3) is negligence, and if a private action exists under it which runs to auditors, then securities fraud plaintiffs will be able, through a different route, to reach nearly the same result which the Ernst court concluded was neither intended by Congress nor within the proper scope of federal securities laws.

The Fifth Circuit has made an extensive analysis of both the statute and its legislative history. Landry v. All American Assurance Co., 688 F.2d 381, 384-391 (5th Cir.1982). That court concluded both that Congress never intended a private right of action under any subsection of § 17(a), and that an action based on mere negligence "would effectively frustrate Congress' carefully laid framework" for securities fraud. Id. at 391; see also Beck, 621 F.Supp. at 1560. The question of using § 17(a)(3) against a provider of services or opinions has not been before the Seventh Circuit. In each case where the Seventh Circuit has appeared to allow a private action under § 17(a), the claim in question actually required proof of scienter, so that it had essentially the same elements as a 10b-5 action and "added nothing to plaintiff's arsenal." Peoria Union, 698 F.2d at 323; see Angelos, 762 F.2d at 530-531. Thus this circuit has never authorized use of § 17(a) to expand federal securities liability. Moreover, the court's treatment of the subject in Angelos suggests that it would not.

If PMM is correct in reading § 17(a) to apply only to sellers, of course, then the problem of a sweeping federal negligence action against auditors does not appear. There is some justification for their position in the statutory language. § 17(a) says "in the offer or sale of any securities," as opposed to § 10(b)'s and Rule 10b-5's mere "in connection with the purchase or sale" (emphasis added). Also, the Aaron court commented that § 17(a) "applies only to sellers." 446 U.S. at 687, 100 S.Ct. at 1950. Although the context of the court's opinion makes it clear that the court was there contrasting § 17(a) with Rule 10b-5's...