686 F.2d 449 (7th Cir. 1982), 81-2126, Cenco Inc. v. Seidman & Seidman

Docket Nº:81-2126, 81-2264.
Citation:686 F.2d 449
Party Name:CENCO INCORPORATED, Cross-Claimant-Appellant, Cross-Defendant-Appellee, v. SEIDMAN & SEIDMAN, Cross-Defendant-Appellee, Cross-Claimant-Appellant.
Case Date:March 26, 1982
Court:United States Courts of Appeals, Court of Appeals for the Seventh Circuit

Page 449

686 F.2d 449 (7th Cir. 1982)

CENCO INCORPORATED, Cross-Claimant-Appellant, Cross-Defendant-Appellee,


SEIDMAN & SEIDMAN, Cross-Defendant-Appellee, Cross-Claimant-Appellant.

Nos. 81-2126, 81-2264.

United States Court of Appeals, Seventh Circuit

March 26, 1982

Argued Feb. 22, 1982.

Certiorari Denied Oct. 4, 1982.

See 103 S.Ct. 177.

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Fred H. Bartlit, Jr., Kirkland & Ellis, Chicago, Ill., for Cenco Inc.

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Samuel Weisbard, McDermott, Will & Emergy, Chicago, Ill., for Seidman & Seidman.

Before BAUER, WOOD and POSNER, Circuit Judges.

POSNER, Circuit Judge.

We consider in this case the standards under the common law of Illinois governing the liability of independent auditors for failing to detect fraud by the management of the company audited; the standing of auditors under the RICO statute (Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. §§ 1961 et seq.) to sue such a company for damages; and-sua sponte, as we are obliged to do-questions of federal subject-matter jurisdiction.

Between 1970 and 1975, managerial employees of Cenco Incorporated engaged in a massive fraud. The fraud began in Cenco's Medical/Health Division but eventually spread to the top management of Cenco, and by the time it was unmasked the chairman and president of Cenco plus a number of vice-presidents and other top managers were deeply involved. Not all the managers of Cenco were corrupt, however. Seven of the nine members of the board of directors were not in on the fraud, although there is evidence that they were negligent in allowing it to flourish undetected beneath their noses. The fraud was eventually discovered by a newly hired financial officer at Cenco who reported his suspicions to the Securities and Exchange Commission. Cenco's independent auditor throughout the period of the fraud, the accounting partnership of Seidman & Seidman, either never discovered the fraud or if it did failed to report it.

The fraud primarily involved the inflating of inventories in the Medical/Health Division far above their actual value. This increased the apparent worth of Cenco and greatly increased the market price of its stock (when the fraud was unmasked, the market price plummeted by more than 75 percent). The inflated stock was used to buy up other companies on the cheap. Cenco further benefited from the fraud by being able to borrow money at lower rates than if its inventories had been honestly stated and by getting its insurers to pay inflated claims for inventory lost or destroyed, since Cenco's insurance claims were based on inflated rather than actual inventory values. Thus, those involved in the fraud were not stealing from the company, as in the usual corporate fraud case, but were instead aggrandizing the company (and themselves) at the expense of outsiders, such as the owners of the companies that Cenco bought with its inflated stock, the banks that loaned Cenco money, and the insurance companies that insured its inventories.

The unmasking of the fraud led to the filing of a class action in federal district court against Cenco, its corrupt managers, and Seidman & Seidman. The class was composed of purchasers of Cenco stock during the period of the fraud, when the stock price was inflated. The suit charged the defendants with having violated various federal securities laws and SEC rules, notably Rule 10b-5, and common law strictures against fraud and related misconduct. Cenco-now under clean management-filed a cross-claim under Rule 13(g) of the Federal Rules of Civil Procedure against its codefendant Seidman & Seidman, alleging that Seidman was liable to Cenco under both federal and state common law for having failed to prevent the fraud by Cenco's managers. Seidman filed its own Rule 13(g) cross-claim against Cenco, alleging that Seidman had been one of the victims of Cenco's fraud and was thus entitled to damages from Cenco under the RICO statute, state common law, and principles of indemnity.

Cenco's and Seidman's cross-claims against each other were set for trial together. The trial began on May 8, 1980, one day before the last settlement in the class action, which happened to be the settlement with Seidman (for $3.5 million), was submitted to the district judge for his approval. The trial was separated into liability and damages phases; liability, of course, was tried first. At the close of all the evidence but before submitting the case to the jury, the judge granted a directed verdict in favor

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of Cenco dismissing Seidman's cross-claim and a directed verdict in favor of Seidman on those counts in Cenco's cross-claim that alleged that Seidman had aided and abetted the fraud of Cenco's managers and had actually joined their conspiracy to defraud.

The case went to the jury on the three remaining counts in Cenco's cross-claim, alleging respectively breach of contract, professional malpractice (negligence), and fraud. Cenco's evidence tended to show that in the early stages of the fraud Seidman had been careless in checking Cenco's inventory figures and its carelessness had prevented the fraud from being nipped in the bud; that as the fraud expanded, Seidman's auditors became suspicious, but, perhaps to protect the very high fees that Seidman was getting from Cenco (about $1 million a year, which was 70 percent of Seidman's total billings), concealed their suspicions and kept giving Cenco a clean bill of health at their audit reports; that one partner in Seidman, asked by Cenco's general counsel (who was not in on the fraud) whether Seidman suspected anything, answered: "No one suspects fraud. Dismiss that." Seidman's evidence tended to show, to the contrary, that Seidman had diligently attempted to follow up all signs of fraud but had been thwarted by the efforts of the large group of managers at all levels at Cenco who were in on the fraud to prevent Seidman from learning about it.

The jury found for Seidman on all three counts. Cenco appeals both from the dismissal of its aiding and abetting and conspiracy counts and from the judgment entered against it on the jury's verdict, which it contends was based on erroneous instructions. Seidman appeals from the dismissal of the RICO and common law counts in its cross-claim. Several other rulings by the district judge are also before us on these cross-appeals.

We begin our analysis with the directed verdict in favor of Seidman on Cenco's aiding and abetting and conspiracy counts. Like the rest of Cenco's cross-claim these counts are based solely on Illinois law. Although the cross-claim purports to base federal jurisdiction on 28 U.S.C. § 1331, the general federal-question jurisdictional statute, and on section 27 of the Securities Exchange Act of 1934, 15 U.S.C. § 78aa, a general conferral of federal jurisdiction over cases arising under the federal securities laws, these statutes are not pertinent to Cenco's cross-claim since Cenco does not allege any violation of a federal statute or rule. One sentence in Cenco's reply brief in this court, citing an interstate pollution case, asks us to create a rule of federal common law to govern auditors' liabilities, but we decline so casual an invitation to so ambitious an exercise of judicial creativity.

The only basis for federal jurisdiction over Cenco's cross-claim is the concept of ancillary jurisdiction, which allows state-law claims to be litigated in federal court in some circumstances even if the requirements of diversity jurisdiction are not met (as they are not here). A Rule 13(g) cross-claim is within the ancillary jurisdiction of the federal courts if the main claim is within their jurisdiction, as the claim of the class plaintiffs was; and the dismissal of the main claim does not require the dismissal of the cross-claim, at least if the main claim is not dismissed before the trial of the cross-claim. See Federman v. Empire Fire & Marine Ins. Co., 597 F.2d 798, 811 (2d Cir. 1979). Since the class action settlement was not approved by the district court until June 30, 1980, which was after the start of the trial on the cross-claims, and did not become final until upheld by this court a year later sub nom. Helfand v. Fromkin, 645 F.2d 76 (7th Cir. 1981) (mem), the district court had jurisdiction to adjudicate Cenco's cross-claim against Seidman even though it was based purely on state law and Cenco and Seidman are not citizens of different states.

Coming to the merits, we can easily dispose of the charge that Seidman aided and abetted the fraud by Cenco's managers. There is no tort of aiding and abetting under Illinois law or, so far as we know, the law of any other state; all the cases that Cenco has cited with regard to this count are criminal cases. This is not a gap in tort

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law. Anyone who would be guilty in a criminal proceeding of aiding and abetting a fraud would be liable under tort law as a participant in the fraud, since aider-abettor liability requires participation in the criminal venture. E.g., United States v. Beck, 615 F.2d 441, 448-49 (7th Cir. 1980). The only utility of a separate tort of aiding and abetting in the commission of a tort would be to give plaintiffs' lawyers one more charge to fling at the jury in the hope that if enough charges are made the jury may accept at least one. In any event, creating a new Illinois tort is something for the Illinois courts or legislature to do rather than the federal courts.

We have much the same reaction to the conspiracy count, though the fact that Seidman does not argue that there is no tort of conspiracy makes us diffident about disposing of it on this ground. Tort law, unlike criminal law, does not punish "inchoate," which is to say purely preparatory, conduct; for wrongdoing to be actionable as a tort there must be an injury, see, e.g., Town of Thornton v. Winterhoff, 406 Ill. 113, 119, 92 N.E.2d 163, 166 (1950), as Cenco itself argues in defending the...

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