Cammer v. Bloom

• Decision Date: 19 April 1989
• Docket Number: Civ. A. No. 88-2458.
• Citation: 711 F. Supp. 1264
• Parties: Rose CAMMER, et al., Plaintiffs, v. Bruce M. BLOOM, et al., Defendants.
• Court: U.S. District Court — District of New Jersey

711 F. Supp. 1264

Rose CAMMER, et al., Plaintiffs, v. Bruce M. BLOOM, et al., Defendants.

Civ. A. No. 88-2458.

United States District Court, D. New Jersey.

April 19, 1989.

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Peter S. Pearlman, Cohn & Lifland, Saddle Brook, N.J., and David J. Bershad, Milberg, Weiss, Bershad, Specthrie & Lerach, and Stephen T. Rodd, Abbey & Ellis, New York City, for plaintiffs.

Torre, Garman & Amdur, East Rutherford, N.J., for defendant Bruce M. Bloom.

Fischer & Kagan, Clifton, N.J., for Philip I. Kagan.

Clyde A. Szuch, Pitney, Hardin, Kipp & Szuch, Morristown, N.J., and Charles A. Gilman, Cahill, Gordon & Reindel, New York City, for defendant Peat Marwick Main & Co.

James P. Anelli, Kalb, Friedman, Siegelbaum & Moran, Roseland, N.J., and Ronald E. DePetris, Summit, Rovins & Feldesman, New York City, for defendant Michael Weinstein.

Greenberg Margolis, Ziegler, Schwartz, Dratch, Fishman, Franzblau & Falkin, Roseland, N.J., for defendant Richard Bober.

McKenna, Liska & Leone, Red Bank, N.J., for defendant Dennis Lustig.

OPINION AND ORDER

LECHNER, District Judge.

This is an action brought by holders of common stock of Coated Sales, Inc. ("Coated Sales" or the "Company"). The individual defendants include Bruce M. Bloom, Richard Bober, Ernest Glantz, Michael S. Weinstein, Dennis Lustig, and Philip I. Kagan ("Kagan"). These individuals are or were high level officers of Coated Sales and, in the case of Kagan, an outside director and attorney for the Company. Other defendants include Coated Sales, now in bankruptcy proceedings, and Peat Marwick Main & Co. ("PMM"), the former independent auditors for Coated Sales. Separate motions have been filed by PMM and Kagan attacking the sufficiency of plaintiffs' Consolidated Amended Class Action Complaint (the "Amended Complaint").¹

Count I of the Amended Complaint is asserted pursuant to Sections 10(b) and 20(a)² of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. §§ 78j(b) (1982) and 78t(a) (1982), and Rule 10b-5 promulgated under Section 10(b). Count II of the Amended Complaint alleges common law fraud and deceit under the law of the State of New Jersey. Count III of the Amended Complaint asserts a claim of negligent misrepresentation, again based upon New Jersey law.

PMM's motion requests a dismissal of Count I pursuant to Fed.R.Civ.P. 12(b)(6) (for failure to allege necessary elements, or adequate substitutes therefor, of the securities fraud claims) and Fed.R.Civ.P. 9(b) (for failure to allege fraud as to PMM reports with particularity). PMM's motion requests a dismissal of Counts II and III on the grounds that, if Count I is dismissed, there will exist no independent basis for federal jurisdiction, and, as well, pursuant to Fed.R.Civ.P. 9(b); 12(b)(1) and 12(b)(6).³

Kagan's motion requests a dismissal of Counts I, II and III pursuant to Fed.R.Civ. P. 12(b) (for failure to allege facts giving rise to controlling person's liability under the federal securities laws) and Fed.R.Civ. P. 9(b) (for failure to allege specific fraud on the part of Kagan).

Facts⁴

Coated Sales, incorporated under the laws of the State of New Jersey in 1974, develops and sells specially treated fabrics to industry and government. Coated Sales became a public company in 1984 when it offered shares of common stock registered on Form S-1 under the Securities Act of 1933 (the "Securities Act"), 15 U.S.C. § 77a et seq., the Securities and Exchange Commission ("SEC") form which relatively new and unseasoned corporate issuers are required to use for securities offerings.⁵ The Company's publicly held securities are not listed on a national exchange, but instead are traded in the "over-the-counter" market (a reporting network in which transactions in securities are reported to the National Association of Securities Dealers for publication) and listed on the NASDAQ automated national quotation system ("NASDAQ"). According to the Amended Complaint, during the class period⁶ Coated Sales had approximately 19,000,000 shares of stock outstanding which were held by approximately 1200 holders. Amended Complaint ¶ 10. The Amended Complaint contains no other factual allegations indicating the degree to which the Company's stock was traded or followed by investors and analysts; it does not allege in plain words or otherwise the market for Coated Sales stock was efficient or well-developed.

As is sometimes the case with new "growth companies," Coated Sales found itself in a bankruptcy situation (Chapter 11 filing made on June 16, 1988) after learning from PMM that the Company's financial well being had been overstated in the last two years. PMM had been the independent public auditor for Coated Sales until it resigned, as announced by the Board of Directors of the Company on May 23, 1988. Although not overly critical to most aspects of the present motions, a short summary of the Company's troubles is useful.

According to the Amended Complaint, Coated Sales had booked material amounts of revenue in fiscal years 1987 and 1988 pursuant to fictitious "bill and hold" transactions. Under this procedure, the Company would sometimes recognize revenue in advance of shipping goods to customers, an accounting practice which is allegedly acceptable only where there exists a sound business justification, i.e., the customer has yet to instruct the Company as to where and when to ship the goods.⁷ The Amended Complaint indicates this accounting practice was accomplished by the creation of phony invoices which were never sent to the purported customer. The invoices were marked with the instruction "Bill and Hold, Do Not Call". Plaintiffs allege this unusual instruction should have revealed the scheme to falsify revenues.

In addition, the Amended Complaint alleges Company officers perpetrated a significant fraud beginning in the Fall of 1987 in connection with a phony equipment acquisition. These officers stated an equipment manufacturer received $6,000,000 from Coated Sales as a deposit on the machinery; this amount was capitalized and classified on the balance sheet as part of the current assets. It is asserted that on May 6, 1988, PMM learned the $6,000,000 deposit for machinery was a sham transaction and reported this to the Company's Board of Directors at its May 20, 1988 meeting. On May 23, 1988 Coated Sales announced PMM had resigned as the Company's auditors because it was dissatisfied with representations regarding the alleged $6,000,000 payment for machinery in October, 1987 and determined it could not rely on the representations of management.

In response to PMM's resignation, the Board appointed an outside director to investigate the $6,000,000 transaction. As a result of the investigation, Coated Sales conceded on May 31, 1988 that the $6,000,000 "deposit" on machinery reportedly made in October, 1987 and the $6,000,000 "receipt" by the supposed equipment manufacturer in May 1988 of a deposit never took place. The Company conceded the net assets reported as of November 30, 1987 and May 17, 1988 were overstated by $6,000,000. The Company also conceded that "material irregularities in the booking of accounts receivable were discovered" and stated that "many of the individual defendants were being terminated from their senior management positions." Amended Complaint ¶ 34(a).

On May 31, 1988 a press release was issued concerning the foregoing events. Following the announcement on May 31, 1988 the market price of Coated Sales common stock dropped 2 1/8 points per share. During the Class Period, the stock reached a high of $12 per share. Amended Complaint ¶ 35. It is not clear from the Amended Complaint how quickly the 2 1/8 point per share drop occurred. Furthermore, while it appears from this allegation that Coated Sales stock declined during the Class Period, it is not possible to determine from the Amended Complaint to what extent various changes in the price occurred in response to specific information released by the Company during the period.

The vast majority of the allegations contained in the Amended Complaint, and indeed all of the allegations relating to the culpable acts referred to above, are made against individual defendants Weinstein, Bober, Bloom, Glantz and Lustig, the top management of Coated Sales. As to PMM, the Amended Complaint alleges Coated Sales' 1987 fiscal year and financial statements were fraudulent and PMM nonetheless issued its unqualified opinion that the financial statements had been audited by PMM in accordance with generally accepted auditing standards ("GAAS") and fairly represented the financial position of Coated Sales under generally accepted accounting principles ("GAAP").⁸

The Amended Complaint recites in detail what auditing steps should have been taken, and what accounting treatment should have occurred, under GAAS and GAAP and further states how various accounting principles and standards were violated in this case. For example, the Amended Complaint alleges PMM violated GAAP by permitting Coated Sales to book material amounts of revenue in fiscal 1987 from the fictitious "bill and hold" transactions. PMM was allegedly required under GAAS to take greater than usual care in auditing these transactions because GAAP does not allow such revenues to be recorded prior to shipment, absent a compelling business purpose, and because of the unusual legend contained on the invoices: "Do Not Call." In addition, the Amended Complaint alleges PMM delayed unreasonably in bringing the financial irregularities to the attention of the Company's Board of Directors at its regular meeting on May 20, 1988, some two weeks after PMM discovered them.

The financial statements, along with PMM's opinion, were contained in Coated Sales' 1987 Annual Report and 10-K Report.⁹ PMM's present motion centers on the issue of reliance which, as discussed below, is a necessary element...