Mishkin v. Peat, Marwick, Mitchell & Co.

• Decision Date: 23 April 1987
• Docket Number: No. 86 Civ. 4301 (EW).,86 Civ. 4301 (EW).
• Citation: 658 F. Supp. 271
• Parties: Edwin B. MISHKIN, as Trustee for the Liquidation of the Business of Parr Securities Corp., Plaintiff, v. PEAT, MARWICK, MITCHELL & CO., Defendant.
• Court: U.S. District Court — Southern District of New York

658 F. Supp. 271

Edwin B. MISHKIN, as Trustee for the Liquidation of the Business of Parr Securities Corp., Plaintiff, v. PEAT, MARWICK, MITCHELL & CO., Defendant.

No. 86 Civ. 4301 (EW).

United States District Court, S.D. New York.

April 23, 1987.

Davis, Markel & Edwards, New York City, for defendant.

Leonard P. Novello, Gen. Counsel, Peat, Marwick, Mitchell & Co., Cleary, Gottlieb, Steen & Hamilton, New York City, for plaintiff; Thomas J. Moloney, Mitchell A. Lowenthal, Martha F. Davis, of counsel.

EDWARD WEINFELD, District Judge.

This action was commenced by Edwin B. Mishkin, trustee for the liquidation of the business of Parr Securities Corp. ("Parr") on behalf of its creditors and also on behalf of customers of Parr and the Securities Investor Protection Corporation ("SIPC"). Parr was a registered broker-dealer until its bankruptcy. The Second Count of the complaint, which is brought on behalf of Parr's customers and SIPC, alleges that as a result of Peat, Marwick, Mitchell & Co.'s ("PMM") reckless conduct in its 1983 audit of Parr, PMM aided and abetted the President of Parr, Gregory F. Herbert, in his violations of section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.

Defendant PMM moves to dismiss the Second Count of the plaintiff's complaint, pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure, for failure to state a claim of aiding and abetting. The Trustee's complaint alleges that PMM was Parr's independent auditor from Parr's incorporation in May 1981 until December 1984; that PMM's last audit and report covered Parr's financial statements for the fiscal year ending October 1983; and that PMM failed to conduct its audit for the period from November 1982 through October 1983 in a competent, professional manner, and, in fact, conducted it with indifference to the consequences of its acts. The Trustee further alleges that had PMM conducted "the most rudimentary elements of an adequate audit," it would have discovered that by October 1983 Parr was insolvent by millions of dollars; that

The appearance of solvency and regularity created by Parr's published financial statements, certified by Peat Marwick, resulted in the continuation of Parr's operations and enabled Herbert to continue to engage in the fraudulent practices described above during the period following completion of the 1983 Audit and through December 1984.

and that by failing to discover such fraudulent practices:

Parr's customers and the Securities Investor Protection Corporation (which has become subrogated to certain claims of such customers) have been damaged from fraudulent transactions involving the purchase and sale of securities during the period following completion of the 1983 Audit and through December 1984 in an amount which plaintiff believes will equal or exceed $6 million.

Essentially, the claim alleges that PMM is liable as an aider and abettor in Herbert's cover-up scheme, in which he hid Parr's loses by raising money through various fraudulent transactions, including the sale of fictitious securities. The damages plaintiff seeks to recover arise only from the fraudulent transactions which occurred "during the period following completion of the 1983 Audit through December 1984."

Discussion

Civil liability for aiding and abetting federal securities fraud under Rule 10b-5 requires proof (1) of a violation by a primary wrongdoer;¹ (2) knowledge of the violation by the person sought to be charged; and (3) that the person sought to be charged "substantially assisted" in the achievement of the primary violation.² "Moreover, the three requirements cannot be considered in isolation from one another."³

It is clear that, with regard to the "knowledge" element of the aiding and abetting test, where a defendant owes a duty to a victim of fraud, recklessness satisfies the scienter requirement.⁴ However, our Court of Appeals has reserved decision on the issue of whether recklessness will be sufficient to satisfy "knowledge" where there is no duty to the victims of the fraud.⁵

This is not to say that the district courts have been left without guidance. Our Court of Appeals has held that where no fiduciary duty is owed to the defrauded party by the defendant, "the `scienter' requirement scales upward — the assistance rendered must be knowing and substantial."<sup>6</sup> Further, that the scienter, "must, in fact, approximate an actual intent to aid in the fraud being perpetrated;"<sup>7</sup> in other words, where there is no fiduciary duty, "... an alleged aider-abettor should be found liable only if scienter of the high `conscious intent' variety can be proved."⁸

In light of this guidance, a number of district courts in our circuit have held that recklessness is sufficient to establish scienter where the plaintiffs are third parties whose reliance upon the accountant's audit or opinion letter is reasonably foreseeable.⁹ While courts do not generally view the accountant-client relationship, and hence the accountant-third-party customer relationship, as a fiduciary one,¹⁰ some support for the holdings of those cases applying a recklessness standard to foreseeable reliance can be found in IIT, International Investment Trust v. Cornfeld.¹¹ In Cornfeld, Judge Friendly wrote that "Accountants do have a duty to take reasonable steps to correct misstatements they have discovered in previous financial statements on which they know the public is relying."¹² One charged with the specific responsibility of a competent professional audit cannot relieve himself of liability by shutting his eyes to what was plainly to be seen.¹³

While the reliance alleged in this case is somewhat more generalized than that alleged in other cases confronting the issue of applying a recklessness standard to an aiding and abetting claim, the existence and nature of the regulatory system under which brokerage firms operate warrants the application of a recklessness standard in this case.

To begin with, among the fraudulent securities transactions contained in plaintiff's allegations is a type of transaction in which the solvency of Parr is directly relevant to a customer's decision to engage in the transaction. The complaint alleges that Herbert was engaging in repurchase transactions. These transactions involve the sale of securities by one party to another party subject to an agreement by the seller that he will repurchase the securities from the buyer at a fixed price at a later date. In Securities & Exchange Commission v. Drysdale Securities Corporation¹⁴ our Court of Appeals held that alleged misrepresentations made with respect to the financial condition of a company selling underlying securities, is fraud in connection with the sale of securities and falls within section 10(b) and Rule 10b-5. The Court based its holding on the idea that such misrepresentations directly involve the consideration for the securities transaction and therefore are closely linked to transfers of the securities. The Court held that part of the consideration offered by the seller was a promise to repurchase and that this promise is rendered worthless by the company's insolvency. In the language of the Court, "Unlike a pledge of securities in a traditional secured financing, in which the financial health of the lender is irrelevant to the value of both the pledged securities and the pledge itself, DGSI's financial strength was essential to the value received by the other party in a securities transaction."¹⁵

Thus, to the extent Herbert was engaging in repurchase transactions involving Parr and its customers, the solvency of Parr is not merely "but for" cause, but rather becomes clear proximate cause in inducing customers to engage in repurchase transactions with Parr.¹⁶ Section 17 of the Securities Exchange Act of 1934 provides the

the principal regulatory tool by which the Commission and the Exchange monitor the financial health of brokerage firms and protect customers from the risks involved in leaving their cash and securities with broker-dealers. The information contained in the sec. 17(a) reports is intended to provide the Commission, the Exchange, and other authorities with sufficiently early warning to enable them to take appropriate action to protect investors before the financial collapse of the particular broker-dealer involved.¹⁷

Thus, since the financial solvency of Parr is of vital importance to investors' decisions to engage in repurchase transactions with Parr, the reliance of the public on PMM's duty to perform a competent audit and insure that any registered broker is solvent is justified. It is legitimate to expect that in conducting an audit and in monitoring the operations and accounting of a broker-dealer as part of the regulation of that broker-dealer, its insolvency would be exposed. In making a decision with regard to transacting a repurchase agreement with a broker-dealer, the very existence of the regulatory system justifies reliance on the performance of duties of those who play a role in the regulatory system's operation. Plaintiff alleges that had PMM competently performed its duty it would have unearthed Parr's insolvency and notified the SEC.

Moreover, plaintiff's Second Count alleges securities fraud violations under section 10(b) and Rule 10b-5 in relation to the purchase and sale of fictitious securities. This aspect of plaintiff's suit seeks damages resulting from "fraudulent transactions involving the purchase and sale of Securities during the period following completion of the 1983 Audit...."¹⁸ and it is alleged that these fraudulent transactions took place because PMM, "by certifying Parr's financial statements for the year ended October 31, 1983, enabled Herbert to continue to engage in such practices and thereby aided and abetted such activity by Herbert."¹⁹

PMM's role in the regulatory process imposed upon it a duty of disclosure to the SEC. PMM, as the auditor of a broker-dealer was required to...