Fine v. American Solar King Corp.

• Decision Date: 04 December 1990
• Docket Number: 89-1290,Nos. 89-1218,s. 89-1218
• Citation: 919 F.2d 290
• Parties: Howard FINE, Oakhill South Corporation, Eugene Vanderford, Dr. Charles Yates, and John V. Yates, Plaintiffs-Appellants, v. AMERICAN SOLAR KING CORP., et al., Defendants, Main Hurdman, Defendant-Appellee. James RANDALL, Plaintiff-Appellant, v. Brian D. PARDO, et al., Defendants, Main Hurdman, Defendant-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 290

919 F.2d 290

Howard FINE, Oakhill South Corporation, Eugene Vanderford, Dr. Charles Yates, and John V. Yates, Plaintiffs-Appellants, v. AMERICAN SOLAR KING CORP., et al., Defendants, Main Hurdman, Defendant-Appellee.

James RANDALL, Plaintiff-Appellant, v. Brian D. PARDO, et al., Defendants, Main Hurdman, Defendant-Appellee.

Nos. 89-1218, 89-1290.

United States Court of Appeals Fifth Circuit.

Dec. 4, 1990.

Terrell W. Oxford, Susman, Godfrey & McGowan, Dallas, Tex., Daniel L. Berger, Bernstein, Litowitz, Berger & Grossmann, New York City, for plaintiffs-appellants in 89-1218.

Stephen Rackow Kaye, James F. Parver, Steven Altman, John W. Ritchie, New York City, Marvin S. Sloman, Dallas, Tex., for Hurdman.

Roger W. Kirby, Lubna M. Farugi, Kaufman, Malchman, Kaufmann & Kirby, New York City, Daniel J. Sheehan, Jr., Sheehan, Young, Smith & Culp, Terrell W. Oxford, Susman, Godfrey & McGowan, Dallas, Tex., for plaintiff-appellant in 89-1290.

Appeals from the United States District Court for the Western District of Texas.

Before KING, JOHNSON and WILLIAMS, Circuit Judges.

KING, Circuit Judge:

Plaintiffs-appellants (Plaintiffs) allege that the accounting firm of Main Hurdman violated Sec. 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder by issuing a materially false and misleading qualified report on American Solar King's (ASK) financial statement for fiscal year 1982. The district court found that the Plaintiffs failed to raise a genuine issue of material fact on the elements of scienter and reliance and granted summary judgment in favor of Main Hurdman. We reverse.

I. BACKGROUND

ASK manufactured collectors for the solar heating of water, and sold groups of such collectors, with associated circulatory equipment and control devices, through a network of distributors for use in the residential solar energy market. In fiscal year 1982, ASK entered the industrial solar energy market, which involved the sale of larger arrays of the same kind of solar collectors to apartment complexes and other industrial users. Under ASK's industrial sales program, the user did not actually buy the system but guaranteed to pay for energy used, up to a maximum of eighty percent of prior fuel costs. The system was sold to a tax-shelter, limited partnership. The first sale was to S.E.P. No. 1 for use by a Wisconsin meat packer (Provimi) and had a sale price of $1,750,000. The partnership paid for the system with $20,000 cash, a short-term note for $905,000, and a long-term, ten-year note at ten percent interest. ASK entered the transaction the day prior to the end of its 1982 fiscal year.

In order to secure the Provimi sale in fiscal year 1982, ASK's own officers and directors purchased about thirty-five percent of S.E.P. No. 1's partnership interests. As a result of the Provimi sale, ASK recognized $1,239,000 of revenue and $964,000 of profits from the Provimi transaction in its 1982 financial statements. With this sale, ASK reported a profit for its fourth quarter and only a small loss for the year as a whole; without this sale, they would have reported a highly unprofitable year.

The Plaintiffs allege that ASK engaged in a fraudulent scheme to overstate its financial statements for fiscal year 1982, and that the Plaintiffs purchased ASK's common stock at artificially inflated prices as a result. Specifically, the Plaintiffs allege that ASK's financial statement for fiscal year 1982 was false and misleading because it:

(1) Improperly recognized revenue from the Provimi sale;

(2) Failed to discount a below market-rate note received in payment for the Provimi system;

(3) Failed to reserve sufficient funds for uncollectible accounts; and

(4) Improperly recognized revenue from sales to Solar Heating, Inc. (Solar Heating), a company under ASK's control.

Main Hurdman violated Sec. 10(b) and Rule 10b-5, the Plaintiffs allege, by issuing a materially false auditor's opinion on ASK's inflated 1982 financial statements. They claim that Main Hurdman's opinion was materially false because:

(1) Main Hurdman incorrectly represented, subject to qualification, that ASK's 1982 financial statements were prepared in conformity with Generally Accepted Accounting Principles (GAAP);

(2) Main Hurdman falsely qualified its opinion by stating that it was "unable to determine the adequacy of the provision for uncollectible accounts," when it knew that the provision for uncollectible accounts was inadequate by at least $200,000 to $300,000; and

(3) Main Hurdman falsely stated that it conducted its audit in accordance with Generally Accepted Auditing Standards (GAAS).

This appeal combines class action suits by purchasers of ASK's common stock during 1982 and 1983. The plaintiffs in Fine v. American Solar King (Fine Plaintiffs), No. 89-1218, consist of purchasers of ASK's common stock from October 28, 1982 (the date on which ASK filed its 1982 Form 10-K containing the allegedly false financial statements) through October 27 1983 (the date ASK announced that it was changing its accounting policies). The plaintiffs in Randall v. American Solar King (Randall Plaintiffs), No. 89-1290, purchased stock from July 8, 1982 to December 29, 1983.

The Fine and Randall Plaintiffs both allege similar violations against ASK; ASK's president, Brian Pardo; ASK's former vice-president for finance, David Redding; and ASK's former accountants, Main Hurdman. These defendants, they assert, violated Rule 10b-5, both as primary violators and as aiders and abetters. The Plaintiffs also assert pendent state law claims of fraud and negligent misrepresentation. The Plaintiffs base their allegations against Main Hurdman largely on Main Hurdman's qualified report on ASK's financial statements for fiscal year 1982. The Randall Plaintiffs also allege that Main Hurdman aided and abetted violations committed by ASK with respect to certain unaudited financial reports and other announcements issued by ASK in fiscal year 1983.

In order to prove a violation under Rule 10b-5, a plaintiff must show:

(1) a misrepresentation or omission or other fraudulent device; (2) a purchase or sale of securities in connection with the fraudulent device; (3) scienter by defendant in making the misrepresentation or omission; (4) materiality of the misrepresentation or omission; (5) justifiable reliance on the fraudulent device by plaintiff (or due diligence against it); and (6) damages resulting from the fraudulent device.

Warren v. Reserve Fund Inc., 728 F.2d 741, 744 (5th Cir.1984). Summary judgment in favor of Main Hurdman was proper if the Plaintiffs' summary judgment evidence failed to raise a genuine issue of material fact on any of these elements.

The district court concluded that the Plaintiffs failed to raise a genuine issue of material fact on the elements of scienter and reliance and granted summary judgment in favor of Main Hurdman, dismissed the pendent state law claims without prejudice, and administratively closed both cases because the defendants, other than Main Hurdman, were in bankruptcy. The Plaintiffs appeal from the district court's grants of summary judgment in favor of Main Hurdman and its orders administratively closing the cases against the other defendants. We reverse the district court's grants of summary judgment and vacate and remand the district court's orders administratively closing the cases.

II. MAIN HURDMAN'S LIABILITY AS A PRIMARY VIOLATOR

A. Scienter

The Plaintiffs allege that Main Hurdman acted with intent to deceive, or severe recklessness, when it issued its qualified auditor's report on ASK's financial statements for fiscal year 1982. Main Hurdman, they argue, knew that ASK improperly recognized revenue from the Provimi sale and from sales to Solar Heating, a company that ASK controlled. They allege that Main Hurdman approved the accounting for these sales in order to benefit certain of Main Hurdman's clients who invested in S.E.P. No. 1 and in order to keep ASK as a client. The Plaintiffs also argue that Main Hurdman knew that its qualification of its report, which stated that Main Hurdman could not determine the adequacy of ASK's reserve for uncollectible accounts, was false because ASK knew that the reserve was inadequate by at least $200,000 to $300,000.

The Plaintiffs observe that Main Hurdman examined the Provimi transaction both before and during their audit. A Main Hurdman planning memo stated:

This transaction must be looked at closely to determine if it was indeed a sale, if the notes carried by ASK are at fair values or if any related parties are involved.... Due to small anticipated net income per books we need to be concerned that the client has done anything possible to record income.

The Plaintiffs argue that, despite these reservations, Main Hurdman approved ASK's accounting for the Provimi sale and that Main Hurdman knew, or should have known, that ASK's accounting for the Provimi sale violated GAAP.

The Plaintiffs' expert testified that revenue may be recognized under GAAP only when the earnings process is virtually complete and an exchange has taken place. At the end of ASK's fiscal year, however, the Provimi system had not yet been constructed or shipped to the buyer and ASK retained material maintenance and warranty obligations. GAAP also provides that revenue should not be recognized when the seller retains material obligations, or if uncertainties exist with respect to the sale. Significant uncertainties existed, the Plaintiffs' expert opined, concerning whether ASK could install the system by the end of the year as required by their contract.

GAAP also provides that the profit on a sale should not be recognized if collection of the sale price is not reasonably assured. The Plaintiffs argue that Main Hurdman knew that the transaction required completion of a working system, and also knew that the solar panels themselves had not been shipped by ASK to S.E.P. No. 1 or Provimi at year end....