In re Leslie Fay Companies, Inc. Securities Lit.

• Citation: 835 F. Supp. 167
• Decision Date: 27 October 1993
• Docket Number: No. 92 Civ. 8036 (WCC).,92 Civ. 8036 (WCC).
• 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

835 F. Supp. 167

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.

October 22, 1993.

As Corrected Nunc Pro Tunc October 27, 1993.

COPYRIGHT MATERIAL OMITTED

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, for plaintiffs.

Shea & Gould, New York City, Leon P. Gold, Arthur D. Felsenfeld, Jonathan Young, of counsel, for defendant BDO Seidman.

OPINION AND ORDER

WILLIAM C. CONNER, District Judge.

This class action is brought by plaintiffs on behalf of all individuals who purchased common stock of The Leslie Fay Co., Inc. ("Leslie Fay" or "the Company") between February 4, 1992 and April 5, 1993. The complaint alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and asserts claims for aiding and abetting securities fraud against a number of Leslie Fay's officers and directors and BDO Seidman ("BDO"), the Company's outside auditor. The action is currently before the Court on BDO's motion to dismiss pursuant to Rules 9(b) and 12(b)(6), Fed.R.Civ.P. The motion is denied.

BACKGROUND

In early 1992, Leslie Fay, a well-known manufacturer of women's apparel, made a number of statements which touted the firm's 1991 performance and made positive prognostications as to its anticipated 1992 results. Compl. ¶¶ 27-30. These representations, at least as to the 1991 results, were supported by the firm's SEC filings. On March 27, 1992, Leslie Fay filed its 1991 10-K Form in which it formally reported net income of $29.4 million on net sales of $836.6 million, or $1.55 net income per share, which compared favorably with 1990's net income of $29 million on net sales of $859 million, or $1.53 net income per share. The 10-K filing included BDO's February 7, 1992 opinion letter which represented that Leslie Fay's operation results and cash flows for 1991 had been computed in conformity with generally accepted accounting principles ("GAAP") and that BDO's audit was performed in accordance with generally accepted accounting standards ("GAAS"). Compl. ¶ 33.

Reports of Leslie Fay's positive performance continued through the first half of 1992. On April 22, 1992, the Company's first quarter Form 10-Q filing reported earnings of $0.56 per share, up 2 cents per share compared with the first quarter of 1991. Compl. ¶ 35. At the annual meeting on April 29, 1992, the Company's CEO touted its future prospects, Compl. ¶ 36, and on June 5, 1992, Leslie Fay announced its intention to repurchase one million of its common shares over the next year. Compl. ¶ 37. On July 14, 1992, the Company announced that second quarter earnings, like those of the prior quarter, would be record breaking. Earnings of $1,636,000, or $0.09 per share, were reported which showed a remarkable improvement over the $70,000, or less than $0.01 per share, which had been earned in the second quarter of 1991. Compl. ¶ 38. In his September 9, 1992 retirement announcement, defendant Alan Golub, president and COO of the Company, stated that Leslie Fay was positioned for excellence in the 1990's despite the difficult economic climate. Compl. ¶ 43.

The tone of Leslie Fay's public statements began to change in mid-September of 1992. On September 14, 1992, the Company announced that, as a result of the weak economy, it would earn only about $0.60 per share in the third quarter of 1992 and that the Company now projected that earnings for 1992 as a whole would approximate those of the prior year. Compl. ¶ 44. In response, Leslie Fay stock fell $3.00 to a close of $12.25 on the day after this announcement. Id. Nonetheless, the Company maintained that it was in a good position to weather this cyclical economic storm. Compl. ¶¶ 44, 45. The third quarter earnings, announced on October 20, 1992, were consistent with the September 14 forecast. Compl. ¶ 46.

In February of 1993 the house of cards that was Leslie Fay began to crumble. On February 1, 1993, the Company announced that it had requested that the board of directors' audit committee commence an investigation into "accounting irregularities" which might cause Leslie Fay to restate previously reported earnings for 1991 and to eliminate any profit for 1992. Compl. ¶ 47. The Company suspended Corporate Controller Donald Kenia pending the outcome of the investigation, but Leslie Fay's CEO, John Pomerantz, insisted, in a widely distributed press release, that the financial viability of the Company was not in jeopardy. Id. On the same day Leslie Fay's General Counsel, Herman Gordon, announced that the audit committee would investigate inaccurate entries involving an overstatement of inventory and a reduction of the cost of goods sold. Gordon explained:

The people responsible for giving (outside) auditors the company balance sheet, schedules and back-up data were not able to produce them because of these entries.

Compl. ¶ 49. As a result of this announcement, trading in Leslie Fay stock was suspended and at the end of the trading day the stock had fallen to $7 3/8 per share from its close of $12 per share on the previous day. Compl. ¶ 48. On February 2, 1993, it was reported that Kenia had admitted that he and 15 other employees of the Company's Wilkes-Barre, Pennsylvania offices had been falsifying invoices for over one year, and the Company announced that the false entries began in the last quarter of 1991 and continued through all of 1992. Compl. ¶¶ 55,50. Upon announcing his fraud, Kenia stated that he was coming forward because the discrepancies caused by the falsifications had become too large to hide. Compl. ¶ 55. On February 16, 1993, Leslie Fay announced that it had commenced an investigation into possible false SEC filings made by the Company, and on March 26, 1993, it was announced that Leslie Fay was the subject of a Commission investigation as well. Compl. ¶ 58,62. On February 26, 1993, Leslie Fay announced the preliminary financial results of the Audit Committee. The $29 million, or $1.55 per share, originally reported as earnings for 1991 was revised to $17 million, or $0.91 per share. In addition, a loss of $13.7 million, or $0.72 per share was estimated for 1992. The Company also announced that BDO had withdrawn its opinion of the Company's 1991 financial statement. Compl. ¶ 60. On March 22, 1993, Paul Polishan, CFO of the Company, took a leave of absence pending the final outcome of the Audit Committee report. Compl. ¶ 61. Finally, on April 5, 1993, Leslie Fay filed a voluntary bankruptcy petition under Chapter 11 of the Federal Bankruptcy Code, and in response, its common stock price fell to $2.75 per share. Compl. ¶¶ 64,63.

For the purposes of this motion, it is important to note that the only false statements which are attributed to BDO are those made in the Company's 1991 10-K statement. BDO admits that these statements were false when they were made; indeed this was the rationale for BDO's withdrawal of its opinion. BDO argues only that the complaint fails to allege sufficiently that it made these statements with scienter.

The complaint makes three factual allegations in support of its claim that BDO acted with the requisite mental state. First, plaintiffs point out that the accounting firm had a long and profitable relationship with Leslie Fay. Compl. ¶ 67. Second, the complaint claims that BDO either intentionally or recklessly failed to audit Leslie Fay in accordance with GAAS. Compl. ¶¶ 67,70. Finally, it is alleged that BDO either intentionally or recklessly failed to discover that the Company had not prepared its books in accordance with GAAP. Compl. ¶ 69. In support of this allegation the complaint notes that BDO failed to discover that the Company was violating an accounting rule requiring that inventory be valued at the lower of cost or market so that there will be a proper matching of costs against revenue and requiring that unrealized profits not be credited to income. Compl. ¶ 69(d) & (e).

DISCUSSION

Motions, like the one at bar, which attack Rule 10b-5 pleadings for their failure to allege a factual basis supporting scienter are particularly troublesome because it is unclear what type of recklessness is considered sufficient to establish scienter. BDO contends that Rule 10b-5 requires a showing of recklessness which is tantamount to intentional or deliberate conduct, while plaintiffs claim that the Second Circuit has not qualified its holding that reckless behavior is sufficient to support scienter. As discussed in "Part I" below, we tend towards the former position although we believe that a fact finder may infer intent from extremely reckless behavior.

Our discussion of what plaintiffs must prove to satisfy the scienter requirement is relevant here only to the extent that it sheds light on what must be pled to sustain a claim under Rule 10b-5. On a motion to dismiss we accept all allegations in the complaint as true, and dismiss only if, after drawing all inferences in plaintiffs' favor, it is clear that they are not entitled to relief. Cosmas v. Hassett, 886 F.2d 8, 11 (2d Cir. 1989); see Conley v. Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 102, 2 L.Ed.2d 80 (1957). BDO brings this motion under Rule 9(b), Fed.R.Civ.P., which requires that averments of fraud state the circumstances constituting fraud with particularity. However, Rule 9(b) must be read in the context of Rule 8(a) which calls only for a short plain statement of the claim for relief. DiVittorio v. Equidyne Extractive Indus., Inc., 822 F.2d 1242, 1247 (2d Cir.1987). Further, Rule 9(b) does not require that mental conditions such as intent or knowledge be averred with particularity although plaintiffs must...