Pegasus Fund, Inc. v. Laraneta
| Decision Date | 14 February 1980 |
| Docket Number | No. 77-3450,77-3450 |
| Citation | 617 F.2d 1335 |
| Parties | Fed. Sec. L. Rep. P 97,281 The PEGASUS FUND, INC., Vanderbilt Mutual Fund, Inc., and Pegasus Income & Capital Fund, Inc., Plaintiffs-Appellants, v. Ronald J. LARANETA et al., and Federated Investors, Inc., et al., Defendants, and Arthur Young & Company, Defendant-Appellee. |
| Court | U.S. Court of Appeals — Ninth Circuit |
Arthur N. Greenberg, Greenberg & Glusker, Los Angeles, Cal., for plaintiffs-appellants.
Carl D. Liggio, Arthur Young & Co., New York City (argued), for defendant-appellee; Mitchell L. Lathrop, MacDonald, Halsted & Laybourne, Los Angeles, Cal., on brief.
Appeal from the United States District Court for the Central District of California.
Before SNEED and TANG, Circuit Judges, and JAMESON *, District Judge.
The plaintiffs-appellants are three mutual funds that charge the defendant-appellee, an accounting firm, with recklessly performing an audit of the funds' financial statements in violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and rule 10b-5, 17 C.F.R. § 240.10b-5. This appeal is taken from summary judgment on pleadings that alleged only a rule 10b-5 violation, although a memorandum submitted in opposition to the motion for summary judgment alluded to the possibility of a private claim under section 34(b) of the Investment Company Act of 1940, 15 U.S.C. § 80a-33(b). The appellee has moved this court to dismiss a portion of the appeal that challenges the allegedly implicit summary judgment on the section 34(b) claim and to strike the corresponding part of the plaintiffs-appellants' brief. By previous order of this court the motion is to be considered with the merits of the appeal. Our jurisdiction rests on 28 U.S.C. § 1291. We grant the appellee's motion to dismiss the section 34(b) portion of the appeal and affirm the summary judgment.
The appellants are investment companies, or mutual funds, registered in accordance with the Investment Company Act of 1940, 15 U.S.C. § 80a-1 et seq. As a result of several transactions during 1973, each mutual fund bought a restricted debenture of Burreson & Co., Inc., secured by deeds of trust on realty whose value exceeded the face value of the debentures. One of the appellants, Pegasus Income & Capital Fund, Inc. (PIC), also purchased an Oh Boy! Industries, Inc. restricted debenture and a block of its convertible preferred stock. Since none of the securities were traded on any exchange and all were restricted, the directors of the funds had a duty, under 15 U.S.C. § 80a-2(a)(41) and 17 C.F.R. § 270.2a-4(a)(1), to value them. Each board met and valued the debentures at cost, which was also the face value of the securities. PIC valued its Oh Boy! Industries preferred stock at 95% of face value in view of the acknowledged weakness of the issuer.
As required by 15 U.S.C. § 80a-29(e), the directors of the mutual funds made arrangements for an audit of their financial statements. The appellee Arthur Young was the accounting firm chosen for the task. The mutual funds gave Arthur Young copies of various documents from their files, including:
(a) the Burreson & Co. and Oh Boy! Industries securities, the latter of which showed on its face an interest rate of 111/2%;
(b) a preliminary draft of a Burreson & Co. financial statement as of June 30, 1973 as to which the company's auditor had disclaimed any opinion;
(c) an audited financial statement of Oh Boy! Industries as of May 31, 1973 as to which the auditor had expressed an unqualified opinion;
(d) security agreements underlying the Burreson & Co. debentures, listing trust deed collateral.
Arthur Young certified the appellants' financial statements without qualification, stating in part: By that date, however, the appellants allege that the Burreson and Oh Boy! securities were practically worthless.
After receiving the audit opinion, the mutual funds bought, on the recommendation of their investment advisors, securities issued by Commercial Petro-Gas, Inc. (CPG) and North American Credit Corp. (NACC), described in the mutual funds' pleadings as Burreson & Co. affiliates. Arthur Young has made the uncontroverted allegation that it was unaware of any connection between CPG, NACC and Burreson & Co. Interlocking directorates permitted some of the mutual funds' directors to defraud the funds by channeling the investment capital of the funds into corporations the directors owned or controlled. The mutual funds do not contend that Arthur Young was a participant in or beneficiary of these schemes.
An alleged basic flaw in the audit, which the mutual funds assert was recklessly done, was Arthur Young's failure to advise the mutual funds that the debenture collateral consisted not of first deeds of trust but of "all-inclusive" deeds of trust, which the funds say represent junior security interests. Arthur Young maintains that all-inclusive deeds of trust can represent first or second mortgages. The partner of Arthur Young responsible for the audit testified in related SEC proceedings that he did "know what (first deeds of trust) are." While the accounting firm inspected the restricted securities in the custody of California Bankers Trust Co. (CBT), the custodian of the mutual funds' assets, it accepted CBT's written and oral assertions that the related collateral documents were first deeds of trust.
The mutual funds note several other warning details that they allege a proper audit would have revealed. Some of these concern the Burreson debentures, and others concern the Oh Boy! debentures and convertible preferred shares. The following allegations belong to the first group:
Arthur Young's work papers for the audit disclosed that Burreson & Co. had an accumulated net worth deficit of over six million dollars and was delinquent in interest and principal payments on certain trust deed notes in the amount of $370,000 as of April 30, 1973. These notes were secured by the same realty that secured the plaintiffs' debentures, and represented a superior claim to that collateral. The work papers reflect that Burreson had been and was still running at a loss as of the date of the audit opinion. Financial statements included in the work papers revealed that Burreson had been a party charged in cease and desist orders and consent decrees in five securities violation actions brought in 1972 and 1973 by federal and California regulatory agencies. The work papers show that the face value of the trust deed notes securing appellant Vanderbilt Mutual Fund's Burreson debenture was less than the outstanding principal balance of the debenture. By December 31, 1973 Burreson had sold more than one-third of the trust deed note collateral to another defendant in this case, Sackman-Gilliland Corp., without the mutual funds' consent. Arthur Young, it is argued, would have discovered the wrongful sale of the missing notes if it had attempted to inspect them instead of relying on the word of the mutual funds' custodian.
The allegations relating to the Oh Boy! Industries' securities are these:
Arthur Young's work papers show that it knew Oh Boy! Industries had an operating deficit of about $500,000 and a retained earnings deficit of almost $1,257,000 for 1973. The Oh Boy! debenture fixed a usurious interest rate under California law 111/2%, which it bore on its face. The president of Oh Boy! Industries was also a director of each of the funds. The funds contend that these facts should have caused Arthur Young to qualify its opinion with regard to the Pegasus Income & Capital Investment Fund, Inc. financial statements, refuse certification, or seek a written opinion of counsel as to the legality of the purchase of the debenture.
The persons responsible for the fraudulent scheme were officer-directors of the mutual funds. Several have been convicted of conspiracy and violations of the federal securities laws. At least one disinterested director on the boards of all three mutual funds professes that he relied on the audit in approving the continued use of investment managers controlled by directors involved in the fraud.
Notwithstanding these allegations and assertions by the mutual funds, the district court on the basis of the record before it found that the following facts, inter alia, were not in genuine dispute:
11. Arthur Young did not make any statement to the plaintiffs, either in its audit opinion respecting each Fund or during the course of the respective audits, regarding the legality of PIC Fund's purchase of Oh Boy! securities.
12. Arthur Young did not make any statement to plaintiffs, at any time herein, either in its audit opinion with respect to each Fund or during the course of each audit, that the value of the Burreson debentures as of December 31, 1973 were equal to their face value.
13. Arthur Young did not make any statement to the plaintiffs at any time herein, either in the audit opinions respecting each Fund or in the course of each respective audit, that the value of the Oh Boy! securities as of December 31, 1973 was equal to $872,500.
14. At no time during the course of its audit of the financial statements of each of the respective Funds did Arthur Young know that the Funds were considering the purchase of securities issued by either North American Credit Corporation ("NACC") or Commercial Petro-Gas ("CPG"). Arthur Young only learned of such purchases after the Funds had consummated the acquisitions.
15. At no time during the course of its audit of each of the respective...
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