Ballan v. Wilfred American Educational Corp.

• Decision Date: 30 August 1989
• Docket Number: No. 88 C 3921.,88 C 3921.
• Citation: 720 F. Supp. 241
• Parties: Eli BALLAN, Plaintiff, v. WILFRED AMERICAN EDUCATIONAL CORPORATION, Albert H. Brodkin, Philip E. Jakeway, Jr., Francis C. Rooney, Jr., Dominick A. Albano, Anthony B. Colletti, Lloyd Frank, Philip E. Jakeway III, Ann D. Lovatt, and James W. Moore, Defendants.
• Court: U.S. District Court — Eastern District of New York

720 F. Supp. 241

Eli BALLAN, Plaintiff, v. WILFRED AMERICAN EDUCATIONAL CORPORATION, Albert H. Brodkin, Philip E. Jakeway, Jr., Francis C. Rooney, Jr., Dominick A. Albano, Anthony B. Colletti, Lloyd Frank, Philip E. Jakeway III, Ann D. Lovatt, and James W. Moore, Defendants.

No. 88 C 3921.

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

August 30, 1989.

COPYRIGHT MATERIAL OMITTED

Rabin & Sirota (Zachary Alan Starr, of counsel), New York City, for plaintiff.

Parker Chapin Flattau & Klimpl (Stephen G. Rinehart, of counsel), New York City, for defendant Wilfred American Educational Corp.

Herbert L. Scharf, Woodmere, N.Y., for defendants Brodkin and Frank.

Scheffler Karlinsky & Stein (Robert P. Stein, Ronald D. Lefton, and Lori A. Friedman, of counsel, New York City, for defendants Jakeway, Jr., Jakeway III, Colletti, and Lovatt.

Debevoise & Plimpton (Asa Rountree, John G. Koeltl, and Edwin G. Schallert, of counsel), New York City, for defendants Rooney and Albano.

MEMORANDUM AND ORDER

NICKERSON, District Judge.

Plaintiff brought this action under §§ 10(b) and 20(a) of the Securities Exchange Act (the Act), 15 U.S.C. §§ 78j(b), 78t(a) (1982), Rule 10b-5 promulgated under § 10(b), 17 C.F.R. § 240.10b-5 (1988), and common law. The complaint alleges that defendants did not disclose their failure to comply with government regulations and the potential consequences of government investigations into that failure. Defendants move to dismiss on the grounds that the complaint does not state a claim upon which relief can be granted or plead fraud with particularity, and that there is no subject matter jurisdiction over the pendent state law claim.

I.

For the purposes of the motion, the court assumes the truth of the facts alleged.

Defendant Wilfred American Educational Corporation (Wilfred) owns and operates many "career" schools throughout the United States. They teach vocational subjects ranging from hairdressing to automotive training. Wilfred is a publicly traded company with over nine million shares of common stock (the Stock) issued and outstanding.

The other defendants (the individual defendants) are directors of Wilfred. Defendant Philip E. Jakeway, Jr. (Jakeway), is Chairman of the Board and President, and his son, defendant Philip E. Jakeway III, is Executive Vice President. Defendants Colletti and Lovatt were at one time Wilfred officers but had retired by 1987.

Plaintiff purchased fifty shares of the Stock on May 12, 1987. He seeks to represent a class of all persons who bought Wilfred securities on the open market (the Class) from October 10, 1984 through December 12, 1988 (the Class Period), excluding defendants and their affiliates, successors, and families.

The claims concern Wilfred's participation in financial aid programs administered by the United States Department of Education (the Education Department). About 95% of Wilfred's students receive some form of government-sponsored financial aid. Between 85% and 90% of Wilfred's revenues come from such aid, much of it from loan programs administered by the Education Department.

Participation in government loan programs subjects Wilfred to extensive regulation and to audit and compliance reviews by administering agencies. An institution failing to comply with the regulations risks suspension, limitation, or termination of its participation in the programs as well as fines, penalties, and damages.

Beginning before October 1984, defendants "flagrantly" violated those regulations by encouraging students to submit false aid applications. They also "fostered an environment" conducive to regulatory violations by, among other things, failing to supervise Wilfred employees so as to ensure that they complied with the regulations.

In October 1984 Wilfred completed an initial public offering of the Stock. The registration statement and prospectus through which the shares were sold did not disclose that Wilfred had not complied with the student aid regulations, that Wilfred's hiring practices and internal controls were inadequate to insure full compliance, that Wilfred's "corporate environment ... was such as to actually encourage noncompliance," and that it was reasonably likely that noncompliance would result in Wilfred's suspension from participation in government aid programs.

Around January 1985 both the Education Department and the United States Department of Justice (the Justice Department) began inquiry into the administration of financial aid programs at some Wilfred schools. Defendants did not reveal those investigations in Wilfred's 1984 Annual Report to shareholders or in its 1984 Annual Report on Form 10-K, filed with the Securities and Exchange Commission (SEC) on April 1, 1985.

On April 2, 1985 an article in the St. Petersburg Times exposed the existence of the investigations. On April 5, 1989 Wilfred filed with the SEC a Form 8 acknowledging the investigations. Defendants did not, however, disclose the investigations in any document likely to be received by shareholders or the investing public.

Instead, defendants launched a scheme to conceal the investigations and to mislead shareholders and the investing public into believing that Wilfred's financial condition would not be jeopardized by the investigations or by Wilfred's financial aid procedures. To that end, on about February 27, 1985 Wilfred announced record revenues and net income for the fiscal year ended December 31, 1984. The announcement did not state that the revenues and net income were the result of Wilfred's failure to comply with government aid regulations and that investigations into that failure were pending.

Similarly misleading were Wilfred's announcements issued about May 8, 1985 and August 8, 1985 relating to first and second quarter earnings. Wilfred's quarterly reports on Form 10-Q for quarters ended March 30, 1985, June 30, 1985, September 30, 1985, and March 31, 1986 and its Annual Report to shareholders for the fiscal year ended December 31, 1985 also failed to reveal the pendency of the investigations.

In its quarterly report on Form 10-Q for the quarter ended June 30, 1986, filed with the SEC on August 12, 1986, Wilfred disclosed the existence of the investigations and added: "No actions have been instituted against the Company as a result of these inquiries, the earliest of which was initiated approximately 1½ years ago." Wilfred omitted to state, although it knew, that (1) the investigations related to serious charges that Wilfred admissions representatives had counseled students to submit false applications for financial aid and (2) the investigations were nearly complete and actions against Wilfred and some of its employees were imminent.

On October 21, 1986 a federal grand jury in the District of Massachusetts indicted seven former admissions representatives at two Wilfred schools on charges of aiding, abetting, and counseling students to submit false applications for federal grants.

In its quarterly report to shareholders on Form 10-Q for the quarter ended September 30, 1986, filed with the SEC on November 14, 1986, Wilfred disclosed those indictments, but did not state that action by the Justice Department against Wilfred itself and a subsidiary was "imminent" and that the Education Department had served administrative subpoenas on both Wilfred and nine Wilfred schools.

In its Annual Report to shareholders for the fiscal year ended December 31, 1986, filed with the SEC on May 4, 1987, Wilfred further sought to mislead the investing public about its compliance with the regulations. The Chairman of the Board's letter to shareholders in that report, dated March 13, 1987, stated:

The Company's administration of student financial aid is being investigated. As a result, our auditors have made reference to this in their report. The Company's policy, of course, has always been to comply with all applicable laws and regulations. To further ensure that federal and state funding is used in a responsible way, we added additional, elaborate compliance and control steps which we believe are the best procedures in the industry.

The letter went on to discuss Wilfred's financial outlook "in a highly positive manner."

These statements in the letter to shareholders falsely suggested that any failure to comply with government regulations was not widespread, prior "compliance and control steps" had been adequate, and Wilfred's management had not been involved in any wrongdoing. The statements did not explain the nature, seriousness, and impact of the government investigations.

"Tucked away" in a note to Wilfred's consolidated financial statements at the back of the 1986 Annual Report was a more detailed description of the investigations. The report added:

Were an action to be instituted, and were an adverse decision to be rendered against the Company, fines, penalties and damages could result and the Company could be subject to suspension, limitation or termination from participation in government financial aid programs.

The Company believes that its policies are in compliance with applicable regulations and, if any employees violated any government regulations, those employees were acting against Company policy.

Wilfred's quarterly reports on Form 10-Q for the quarters ended March 31, 1987, June 30, 1987, and September 30, 1987 contained the same information as the Annual Report. They made no mention of the Justice Department's expansion of its investigation, of the issuance of a grand jury subpoena in the District of Columbia, of the indictment on charges of perjury of an admissions representative at one of Wilfred's schools in Massachusetts, or that many former and current Wilfred employees were targets of the investigations.

Throughout the Class Period Wilfred failed to reveal how it administered student financial aid during the period under investigation. Nor did it disclose the likelihood that Wilfred and some of its employees would be indicted, that...