In re Leslie Fay Companies, Inc., 92 Civ. 8036 (WCC).

• Decision Date: 03 January 1995
• Docket Number: No. 92 Civ. 8036 (WCC).,92 Civ. 8036 (WCC).
• Citation: 871 F. Supp. 686
• Parties: In re the LESLIE FAY COMPANIES, INC. Securities Litigation. This Document Relates To: All Actions.
• Court: U.S. District Court — Southern District of New York

871 F. Supp. 686

In re the LESLIE FAY COMPANIES, INC. Securities Litigation This Document Relates To: All Actions.

No. 92 Civ. 8036 (WCC).

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

January 3, 1995.

Abbey & Ellis, Chairman of Plaintiffs' Executive Committee, New York City (Arthur N. Abbey, Mark C. Gardy, Stephen J. Fearon, Jr., of counsel).

Milberg Weiss Bershad Hynes & Lerach, Member of Plaintiffs' Executive Committee, New York City (Barry A. Weprin, Jeffrey S. Abraham, of counsel).

Spector & Roseman, P.C., Member of Plaintiffs' Executive Committee, Philadelphia, PA (Robert M. Roseman, of counsel).

Bernstein Litowitz Berger & Grossmann Member of Plaintiffs' Executive Committee, New York City (Daniel Berger, Robert S. Gans, of counsel).

Wolf Popper Ross Wolf & Jones, Member of Plaintiffs' Executive Committee, New York City (Marian P. Rosner, of counsel).

Proskauer Rose Goetz & Mendelsohn, New York City (Leon P. Gold, Mark E. Davidson, David A. Picon, Howard S. Koh, of counsel), for defendant BDO Seidman.

OPINION AND ORDER

WILLIAM C. CONNER, Senior District Judge:

Plaintiffs bring this action on behalf of all individuals who purchased common stock of The Leslie Fay Co., Inc. ("Leslie Fay") between March 28, 1991 and April 5, 1993 (the "Class Period"). The amended complaint alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Before the Court is the motion of defendant BDO Seidman ("BDO") to dismiss pursuant to Rules 9(b) and 12(b)(6), Fed.R.Civ.Pro. Although not moving for reconsideration of our previous disposition of an identical motion, BDO submits this motion asking us to reevaluate our prior decision in light of the Supreme Court's subsequent pronouncement in Central Bank of Denver, N.A. v. First Interstate of Denver, N.A., ___ U.S. ____, 114 S.Ct. 1439, 128 L.Ed.2d 119 (1994), and in light of inadequacies in the plaintiffs' fourth amended complaint. For the reasons stated below, we deny BDO's motion.

I.

Although the facts of this case are thoroughly articulated in our prior opinion, see In re The Leslie Fay Companies, Inc. Securities Litigation, 835 F.Supp. 167 (S.D.N.Y. 1993) hereinafter Leslie Fay I, plaintiffs have since amended their complaint to reflect the findings of a detailed investigation by Leslie Fay's Audit Committee. In light of these new factual allegations, we will briefly summarize the amended complaint to reflect the relevant additions.

Plaintiffs allege that from 1990 through 1992, the officers and directors (the "Individual Defendants") of Leslie Fay, a well-known manufacturer of women's apparel, engaged in a fraudulent scheme designed to deceive the investing public as to its financial viability. Of particular relevance to BDO's participation in the scheme, plaintiffs further allege that to support its public misrepresentations, Leslie Fay altered company financial records in two ways. First, the Company manipulated its books, chiefly the general ledger, to overstate assets and understate liabilities. Leslie Fay utilized these misstatements to conceal shortfalls from divisional budgeted results. Second, Leslie Fay further altered its books and records by, among other things, manipulating inventory counts, classifications and costs; accounts payable; and expenses to substantiate these accounting irregularities. In all, the fraud involved several hundred journal entries, made in more than one hundred different general ledger accounts, occurring over an extended period of time, and involving at least 15 Leslie Fay employees.

The overall scheme led to an overstatement of Leslie Fay's pretax income in the fourth quarter of 1990 through 1992 by a total of over $75 million. Similarly, gross profits were overstated by $3 million (1.1%), $12.4 million (5.1%), and $35.8 million (18.9%), and per-share earnings by $0.15 (10.9%), $0.48 (44.9%), and $1.84 (347.2%) in 1990, 1991, and 1992, respectively.

Leslie Fay retained defendant BDO to provide independent auditing services for the years ending December 29, 1990 and December 28, 1991. BDO issued an unqualified opinion for each of those years (the "Opinions"), which were included in Leslie Fay's 1990 and 1991 Form 10-K reports and 1990 and 1991 Annual Reports to Shareholders, respectively, attesting to the accuracy of Leslie Fay's financial statement schedules and their conformity with Generally Accepted Accounting Principles ("GAAP"). In addition, BDO certified that it performed its audits in accordance with Generally Accepted Auditing Standards ("GAAS"). Based on the pervasiveness of the manipulation described above, plaintiffs allege that BDO either knew or was reckless in not knowing that its unqualified opinions were wholly unfounded. They claim that BDO knew of Leslie Fay's weaknesses in its internal reporting functions, that the company lacked documented accounting and financial policies and procedures, and that it employed practices that were inconsistent with GAAP. Despite bringing several of these deficiencies to Leslie Fay's attention, BDO did not insist that the company implement any reporting changes, submitting that the proposed adjustments were immaterial to the accuracy of the financial statements. Plaintiffs allege that in reality these deficiencies directly led to and involved the ledger manipulations and rendered BDO's '91 and '92 opinions materially untrue.

On February 1, 1993, Leslie Fay informed the investing public of certain "accounting irregularities" and announced that the Board of Directors' Audit Committee would investigate. This disclosure sent the price of Leslie Fay's common stock spiraling from $12.00 to $7.375 per share. Corporate Controller Donald Kenia admitted that he and 15 other employees had been falsifying invoices. He later claimed that he had come forward because the discrepancies caused by the falsification had become too large to hide. By April 5, 1993, following the Company's disclosure that the SEC was investigating the alleged fraud and the Company's petition for bankruptcy under Chapter 11, the stock had fallen to $2.75 per share. After the overstatements were revealed by the Audit Committee on February 26, 1993, BDO withdrew its 1991 opinion. This suit followed.

II.

Defendant BDO moves to dismiss plaintiffs' amended complaint against it on three grounds. First, BDO argues that the Supreme Court's literal interpretation of § 10(b) of the Securities Exchange Act of 1934 (the "1934 Act") in Central Bank of Denver, N.A. v. First Interstate Bank, N.A., ___ U.S. ___, 114 S.Ct. 1439, 128 L.Ed.2d 119 (1994), which foreclosed an aiding and abetting cause of action under that section, also barred reliance on mere reckless behavior in satisfying the scienter requirement of a direct liability cause of action under that section. Second, BDO asserts that even apart from Central Bank, the fourth amended complaint fails to meet the strictures of Fed.R.Civ.Pro. 9(b), which requires pleading fraud with particularity, by omitting allegations that BDO acted with the requisite intent. Finally, BDO contends that under Central Bank's literal statutory, construction, BDO's alleged misstatements, which it contends that Leslie Fay included only in SEC filings not otherwise provided to the investing public, were not promulgated "in connection with the sale or purchase of any security" as required by the statute. Grouping BDO's first and third arguments, we will first consider the impact of Central Bank on the direct liability scienter and "in connection with" aspects of a § 10(b) private cause of action. Second, we will address BDO's argument that even apart from Central Bank we misapplied the scienter standard in Leslie Fay I in holding that the complaint satisfied the constraints of Fed.R.Civ.Pro. 9(b).

A. The Central Bank Case

In March, 1994, the Supreme Court held in a landmark decision that the language of § 10(b) of the 1934 Act, codified at 15 U.S.C. § 78j (1988),¹ did not support a cause of action for aiding and abetting securities fraud prohibited by that section and Rule 10b-5 promulgated thereunder. Central Bank, ___ U.S. at ___, 114 S.Ct. at 1448. This decision effectively abrogated 25 years of recognition of the aiding and abetting doctrine, not to mention overruling the prior holdings of all eleven courts of appeals that have considered such a claim. See Cleary v. Perfectune, Inc., 700 F.2d 774, 777 (1st Cir. 1983); IIT, As International Investment Trust v. Cornfeld, 619 F.2d 909, 922 (2d Cir.1980); Monsen v. Consolidated Dressed Beef Co., 579 F.2d 793, 799, 800 (3d Cir.), cert. denied, 439 U.S. 930, 99 S.Ct. 318, 58 L.Ed.2d 323 (1978); Schatz v. Rosenberg, 943 F.2d 485, 495-96 (4th Cir.1991), cert. denied, ___ U.S. ___, 112 S.Ct. 1475, 117 L.Ed.2d 619 (1992); Fine v. American Solar King Corp., 919 F.2d 290, 300 (5th Cir.1990), cert. dismissed, 502 U.S. 976, 112 S.Ct. 576, 116 L.Ed.2d 601 (1991); Moore v. Fenex, Inc., 809 F.2d 297, 303 (6th Cir.), cert. denied, 483 U.S. 1006, 107 S.Ct. 3231, 97 L.Ed.2d 737 (1987); Schlifke v. Seafirst Corp., 866 F.2d 935, 946-47 (7th Cir.1989); K & S Partnership v. Continental Bank, N.A., 952 F.2d 971, 977 (8th Cir.1991), cert. denied, ___ U.S. ___, 112 S.Ct. 2993, 120 L.Ed.2d 870 (1992); Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1483 (9th Cir.1991); Farlow v. Peat, Marwick, Mitchell & Co., 956 F.2d 982, 986 (10th Cir.1992); Schneberger v. Wheeler, 859 F.2d 1477, 1480 (11th Cir.1988), cert. denied, 490 U.S. 1091, 109 S.Ct. 2433, 104 L.Ed.2d 989 (1989). Although commentators had questioned its viability after the Supreme Court narrowed the scope of prohibited conduct in Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 97 S.Ct. 1292, 51 L.Ed.2d 480 (1977), and Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976), see Donald R. Fischel, Secondary Liability Under Section 10(b) of the Securities Act of 1934, 69 Calif.L.Rev. 80, 82 (1981), the bulk of...