Ausa Life Insurance Company, Bankers United Life Assurance Company, Crown Life Insurance Company, General Services Life Insurance Company, Life Investors Insurance Company of America, Modern Woodmen of America, Monumental Life Insurance Company, the Mutual Life Insurance Company of New York, and the Prudential Insurance Company of America v. Ernst and Young

Plaintiffs-appellants AUSA Life Insurance Company, Bankers United Life Assurance Company, Crown Life Insurance Company, General Services Life Insurance Company, Life Investors Insurance Company of America, Modern Woodmen of America, Monumental Life Insurance Company, The Mutual Life Insurance Company of New York, and The Prudential Life Insurance Company of America (collectively, "insurance companies" or "investors") appeal from the dismissal of their Securities Act and other claims against Ernst & Young ("E&Y") after a bench trial in the United States District Court for the Southern District of New York (William C. Conner, Judge).

The appellants are insurance companies that invested in the securities of JWP, Inc., a company which ultimately went belly-up, causing the appellants to lose most of their investments.1 The appellee is the accounting firm that served as the independent auditor for JWP from 1985 through 1992, the period during which the appellants invested in JWP and the period during which the allegedly fraudulent activity was occurring.

The appellants made their initial purchases of JWP's notes in November of 1988. Through March 1992, they purchased additional JWP notes, the investments totaling $149 million. The notes were purchased in accordance with agreements ("Note Agreements") which included, among other things, the financial representations made by JWP at the time of the notes' issuances, future procedures to which JWP agreed to adhere for certifying JWP's maintained financial viability, procedures to be followed in the event of a default on the notes, and the like.

In purchasing the notes, appellants relied on JWP's past financial statements, including annual reports certified by E&Y. These financial statements were required, under the Note Agreements, to be kept in accordance with generally accepted accounting principles ("GAAP"). Also, at the time of each annual audit by E&Y, E&Y was required under the Note Agreements to furnish to JWP a letter for JWP to transmit to noteholders,2 referred to as a "no-default certificate" or a "negative assurance letter," which stated that E&Y had audited JWP's financial statements and that JWP was in compliance with the financial covenants in the Note Agreements.

In this instance and consistently, E&Y's statements about JWP's financial health were less than accurate and were not always in accordance with GAAP or GAAS ("generally accepted auditing standards"). However, E&Y did not fail to notice that often JWP's financial representations about itself were not in accordance with GAAP; rather, E&Y consistently noticed, protested, and then acquiesced in these misrepresentations:

E&Y's failure lay in the seeming spinelessness of John LaBarca [the partner in charge of the JWP audit] and the other E&Y accountants in their dealings with JWP, and particularly with its CEO, Ernest Grendi . . . . Grendi almost invariably succeeded in either persuading or bullying them to agree that JWP's books required no adjustment. Part of the problem was undoubtedly the close personal relationship between Grendi and LaBarca. Grendi had been a partner of LaBarca in E&Y's predecessor firm and they continued to be good friends, regularly jogging together in preparation for the New York City Marathon.

AUSA, 991 F. Supp. at 248. "It became a well-worn inside joke to refer to the lax accounting standards at JWP as "EGAAP," an acronym for Ernest Grendi's Accepted Accounting Practices." Id. at 253.

JWP rapidly expanded between 1984 and 1992 with many aggressive acquisitions. The expansion was mainly financed by private placements of debt securities, which put JWP in an increasingly leveraged position. JWP's final, fatal acquisition was that of Businessland, Inc., in 1991. Businessland was a retailer of computers and a supplier of software. It had lost an average of ten million dollars a month over the ten months prior to the acquisition, and its auditors had issued a "going concern" qualification on its most recent audited financial statement, which indicated that the auditors doubted the company could survive.

Notwithstanding the gloomy financial picture, JWP executives saw potential. They believed that Businessland's structure could be converted into that of a "value-added" systems integrator; they thought that Businessland could be meshed into JWP's existing business which was heavily involved in installing wiring for computer networks; and they intended to capitalize on Businessland's trained sales force and existing clientele.

Unfortunately, this ambitious business venture did not evolve as envisioned. Upon JWP's acquisition of Businessland, JWP was forced to advance money to Businessland to meet the latter's operating expenditures. As well, the planned closure of most of Businessland's retail stores took longer than was initially anticipated. During the same general time period (the early 1990s), the retail computer market was the battleground for the "PC price wars," periods of intense competition, on bases including price. To nail the coffin shut, there was a downward trend in office construction which negatively impacted the electrical construction division of JWP.

In early 1992, David Sokol, JWP's new President and Chief Operating Officer, took note of what appeared to be serious accounting irregularities in JWP's records and statements. In August of 1992, JWP retained Deloitte & Touche ("D&T"), another major accounting firm, to review thoroughly JWP's books and E&Y's audits.

D&T concluded that JWP's annual reports for 1990-1992 should be restated to reduce the 1990 after-tax net income by 15% (from $59 million to $50 million), that the 1991 after-tax income should be reduced by 52% from $60 million to $29 million, and that 1992 loss of $612 million with a corresponding net worth of negative $176 million should be reflected. E&Y concurred.

JWP was able to continue paying the interest due on its notes through 1992, and JWP made partial payments through April 1993. However, JWP ultimately defaulted and was placed in involuntary bankruptcy in December 1993. Some appellants sold their notes at a huge loss in 1993 and 1994, and some appellants partially exchanged some of their notes for cash and securities of a lesser total value than the original notes. At the end of the day, appellants sustained at least a loss of approximately $100 million in lost principal and unpaid interest.

Over twenty lawsuits were filed as a result of JWP's demise. A consolidated suit, comprised of plaintiffs who had purchased JWP common stock in the open market between May 1, 1991, and October 2, 1992, was settled, as was a suit comprised of those who had sold their businesses to JWP in exchange for JWP common stock. Two actions remained: the instant one and AUSA Life Ins. Co. v. Andrew T. Dwyer, 94 Civ. 2201 (WCC). The latter suit appears to be closed, having been settled or otherwise disposed of. SeeCivil Docket for Case #: 94-CV-2201 (S.D.N.Y. Docket as of March 15, 2000). This case remains.

In the district court, plaintiffs made essentially three categories of claims against E&Y: federal securities law claims, New York common law claims for fraud, and negligent misrepresentation claims. A bench trial was conducted over eleven weeks, and, at the conclusion of the trial, after post-trial briefs and proposed findings and conclusions were submitted by the parties, the district court issued an Opinion and Order detailing its findings and dismissing the plaintiffs' claims. See AUSA, 991 F. Supp. 234. At the same time, the court issued extensive Findings of Fact. See Findings of Fact, Joint Appendix at 2466, AUSA, 991 F. Supp. 234 (S.D.N.Y. Dec. 5, 1997) (94 Civ. 3116 (WCC)).

The court found the following: From 1988 to 1991, E&Y was aware of serious accounting irregularities with respect to the small tool inventories which increased JWP's net income, but E&Y did not insist on the correction of the irregularities. See AUSA, 991 F. Supp. at 242. E&Y knew that JWP was recording anticipated future tax benefits of net operating loss (NOL) carryforwards in clear violation of GAAP (presumably for the "purpose of dressing up its year-end consolidated balance sheet"), yet E&Y saw "nothing wrong" with this practice. Id. After discovering more accounting abuses as to NOLs which also seemed to inflate current net operating income, E&Y again "issued unqualified audit reports for the years in question," those years including the late 1980s. Id. at 243. E&Y was also aware of and acquiesced in numerous other accounting abuses in claims and receivables which inflated JWP's earnings and assets at least from 1989 forward. See id. at 243-46. In sum, "[t]he annual no-default letters issued by E&Y were . . . false in that they certified that JWP's books had been kept in accordance with GAAP, which E&Y knew was untrue." Id. at 246.

The court determined that the plaintiffs established the materiality and reliance elements of federal securities law violations. Seeid. at 246-47. The court determined that it was questionable whether the plaintiffs established the scienter element of both the federal claims and the state claims. Seeid. at 247-248, 252. The court found definitively that the plaintiffs did not prove the causation element of both the federal and state law claims because the plaintiffs were not able to show loss causation -- the plaintiffs could not establish that E&Y's egregious accounting idiosyncracies caused plaintiffs' losses because JWP ultimately imploded due to Businessland's operations and the uncontrollable effects of the PC price wars. See id. at 248-50, 252. The court found that the financial devastation of JWP was a "result of unforeseeable and independent post-audit events and not because of fiscal infirmities which were concealed by JWP's misleading financial statements." Id. at 250. With respect to the negligent misrepresentation claims, the court further found both that privity and causation were lacking. See id. at 252-53. This appeal followed.

Appellants based their claims on Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78j(b); the rules and regulations promulgated thereunder, including SEC Rule 10b-5; and the common law.

It shall be unlawful for any person, directly or indirectly, . .

. .

(b) To use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

15 U.S.C. 78j(b). To prove a violation of 10(b), a plaintiff must prove (1) damage to the plaintiff, (2) which was caused by reliance on the defendant's misrepresentations or omissions of material facts, (3) which were made with scienter -- intent to deceive, manipulate, or defraud, or reckless disregard for the resultant deception, (4) which were made in connection with the purchase or sale of securities, and (5) which were furthered through the defendant's use of the mails or a national securities exchange. See Citibank, N.A. v. K-H Corp., 968 F.2d 1489, 1494 (2d Cir. 1992).

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

17 C.F.R. 240.10b-5. To establish a violation of Rule 10b-5, the plaintiff must prove that:

in connection with the purchase or sale of securities, the defendant, acting with scienter, made a false material misrepresentation or omitted to disclose material information and that plaintiff's reliance on defendant's action caused [plaintiff] injury.

Press v. Chem. Invest. Servs. Corp., 166 F.3d 529, 534 (2d Cir. 1999) (internal quotations and citation omitted).

With respect to the common law claims, plaintiffs made both common law fraud and deceit claims and common law claims for negligent misrepresentations and omissions. In New York state, to prove a fraud claim, a plaintiff must prove "a misrepresentation or a material omission of fact which was false and known to be false by defendant, made for the purpose of inducing the other party to rely upon it, justifiable reliance of the other party on the misrepresentation or material omission, and injury." Lama Holding Co. v. Smith Barney Inc., 88 N.Y.2d 413, 421, 668 N.E.2d 1370, 1373, 646 N.Y.S.2d 76, 80 (1996). With respect to negligent misrepresentation, the Court of Appeals of New York has stated that

[A] negligent statement may be the basis for recovery of damages, where there is carelessness in imparting words upon which others were expected to rely and upon which they did act or failed to act to their damage, but such information is not actionable unless expressed directly, with knowledge or notice that it will be acted upon, to one to whom the author is bound by some relation of duty, arising out of contract or otherwise, to act with care if he acts at all.

White v. Guarente, 43 N.Y.2d 356, 363-64, 372 N.E.2d 315, 319, 401, 401 N.Y.S.2d 474, 478 (1977) (internal citation omitted).

The appellants appeal on five bases, some of which pertain to the federal claims, some of which pertain to the state claims, and some of which pertain to both. These bases boil down to three arguments with the district court's determinations: (1) the district court's refusal to find causation between E&Y's actions or inactions and the appellants' losses; (2) the district court's standards for assessing the transaction causation and scienter elements of the appellants' federal securities claims and the appellants' common law fraud claims; and (3) the district court's finding that there was not a near-privity relationship between the investors and E&Y.

We hold that transaction causation was established. We vacate and remand the loss causation determination. We hold that scienter was established. We reverse the privity determination.

As above stated, this case was tried without a jury before United States District Court Judge Conner. In such a posture, the court's determinations of fact will not be disturbed unless they are "clearly erroneous." See Scribner v. Summers, 84 F.3d 554, 557 (2d Cir. 1996). Questions of law are reviewed de novo, as are mixed questions of law and fact. See id. at 557.

We agree with the district court that E&Y did not perform the most efficacious accounting in this situation. See AUSA, 991 F. Supp. at 253-254 ("John LaBarca [senior E&Y accountant] and his associates apparently lacked the backbone to stand up to the intransigent and intimidating Ernest Grendi and insist upon the changes necessary for compliance with GAAP"). However, we part company with the district court on its determination that it was "unforeseeable post-audit developments [that] caused JWP's insolvency and default even if its financial condition had been fully as healthy as was represented in those reports." Id. at 254.

Causation in this context has two elements: transaction causation and loss causation. See Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380-381 (2d Cir. 1974). Loss causation is causation in the traditional "proximate cause" sense -- the allegedly unlawful conduct caused the economic harm. Seeid. at 380. Transaction causation means that "the violations in question caused the appellant to engage in the transaction in question." See id. at 380. Transaction causation has been analogized to reliance. See Currie v. Cayman Resources Corp., 835 F.2d 780, 785 (11th Cir. 1988).

The district court determined that "It is by no means clear that plaintiffs have proven even transaction causation . . . . However, this Court need not resolve the issue of transaction causation because the evidence definitively fails to establish the necessary loss causation." AUSA, 991 F. Supp. at 249-50.

There is ample evidence in the record that the appellants relied on E&Y's certifications of the financial soundness of JWP both in making their note purchases and in continuing to hold the notes. This was not a situation where the notes were marketed en masse, and E&Y had a barely tangential role in the transaction. Rather, the purchasers of these private placement notes specifically required the audits of E&Y before purchasing the notes and as a condition of their purchase. The district court stated as much in the findings of fact: "If the plaintiffs had known the lack of quality of JWP's notes at the time of the offerings, they likely would not and in some cases could not have bought them." See 447, Findings of Fact, Joint Appendix at 2606, AUSA, 991 F. Supp. 234 (S.D.N.Y. Dec. 5, 1997) (WCC)).3

Applying to these facts the legal definition of transaction causation, we find that transaction causation was established.4 Cf. Manufacturers Hanover Trust Co. v. Drysdale Secs. Corp., 801 F.2d 13, 20 (2d Cir. 1986) (describing accountant's misrepresentations which led financial institutions to do business with a financially unsound company).

Addressing loss causation is a more difficult endeavor. How far back should the line be drawn in the causal chain, before which, "because of convenience, of public policy, of a rough sense of justice," proximate cause cannot be found? Palsgraf v. Long Island R. Co., 248 N.Y. 339, 352, 162 N.E. 99, 103 (1928). In the vernacular, where does the buck stop?

We agree with most of the district court's factual determinations, set out both in the opinion -- AUSA, 991 F. Supp. 234 -- and in the court's "Findings of Fact," Joint Appendix at 2466, AUSA, 991 F. Supp. 234 (S.D.N.Y. Dec. 5, 1997) (94 Civ. 3116 (WCC)). Those with which we do not agree are not clearly erroneous. However, given the true nature of the "loss causation" determination, as fully discussed below, the district court did not make all of the specific findings of fact required. We therefore vacate the court's determination and remand for reconsideration and more pertinent factual findings in light of this opinion.

a. The District Court's Factual Determinations

In the section of the "Findings of Fact" labeled "Loss Causation," the district court made findings focusing on whether the misrepresentations on the financial statements available to the investors prior to their note purchases pertained to JWP's cash flow, which "is the source of interest and principal payments to lenders." 453, Findings of Fact, Joint Appendix at 2606, AUSA, 991 F. Supp. 234 (S.D.N.Y. Dec. 5, 1997) (94 Civ. 3116 (WCC)); see 451-62, id. at 2607-2611. However, given the legal definition of loss causation, these factual determinations are not the most relevant. Since loss causation is causation in the traditional "proximate cause" sense, an examination by the district court of different facts relevant to whether the allegedly unlawful conduct caused the economic harm would have been more appropriate.

The following piecemeal factual determinations made by the district court are relevant: JWP was in default on its notes because it was in violation of the financial covenants in the Note Agreements. See 440, id. at 2607. E&Y knew of these violations, but assisted in concealing them. See 506, id. at 2625. This default could have allowed the plaintiffs to accelerate the due date on the notes. See 471, id. at 2613. Accurate accounting, auditing, and reporting would have at least made the plaintiffs aware of the default and precarious financial position of JWP, though, at oral argument, the appellee maintained that JWP would have had thirty days to cure the default before the plaintiffs could accelerate the notes. At oral argument, the appellee also contended that, had the investors been made aware of the default, they would have waived it, and it would have become a non-issue. We need not speculate on that here. Suffice it to say that the factual findings establish that JWP was in default on its notes prior to its acquisition of Businessland, and the investors would have known of such had E&Y correctly performed their duties.

True, the district court found that "JWP would not have defaulted on its debt obligations but for its acquisition of Businessland, which turned out to be a veritable sinkhole for cash." AUSA, 991 F. Supp. at 250. But, as discussed above, had JWP's financial situation been accurately represented by E&Y, and had E&Y revealed the undisputed GAAP violations, JWP would have been in default on its notes prior to its acquisition of Businessland. Therefore, the acquisition of Businessland could not have taken place without a cure of the default or the investors' waivers of the default.

b. The District Court's Application of Law to Fact

The appellee maintains -- and the district court agreed -- that the events leading to the demise of JWP and the loss of appellants' investments were due to external events for which appellee cannot be held accountable, and therefore loss causation was not established. The district court said specifically that

JWP's insolvency and resulting default on its note obligations were caused not by the differences between its actual financial condition and that reflected in its audited annual reports, but by much more significant factors, including JWP's disastrous acquisition of the failing Businessland, in combination with the downturn in commercial construction and fierce competition in the PC market.

Id. at 250. We disagree, however, with this conclusion of the district court to the extent that the district court did not fully consider the legal definition of "loss causation" and the requisite factual points in determining whether loss causation was established.

A good starting point for our analysis of this case is Marbury Management, Inc. v. Kohn, 629 F.2d 705 (2d Cir. 1980). In Marbury Management, the plaintiffs were purchasers of stock who sued the brokerage house (Wood, Walker) and the brokerage employee (Alfred Kohn) from whom they purchased the stock. Kohn, who induced the plaintiffs to purchase the stock and to continue to hold it, was not a licensed, registered representative broker as he had represented to the purchasers. Instead, he was a trainee. See id. at 707. The stock lost value, and the plaintiffs, upon discovering that the selling employee was not a "security analyst," as his business card portrayed, sued for the money lost on the securities. See id. The district court dismissed the plaintiffs' claims as to the brokerage firm, holding that the plaintiffs failed to prove scienter vis-a-vis either conscious wrongful participation or negligence in supervision. See id. With respect to Kohn, the district court held him liable under 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78j(b). See id.

Kohn and the plaintiffs cross-appealed, and this court reversed the judgment in favor of Wood, Walker, and affirmed the judgment against Kohn. See id. A dissent, see id. at 716-723, argued that the majority ignored the fact that

the injury averred must proceed directly from the wrong alleged and must not be attributable to some supervening cause. This elementary rule precludes recovery in the case at bar since Kohn's misrepresentations as to his qualifications as a broker in no way caused the decline in the market value of the stocks he promoted.

Id. at 717. The majority, however, held that this was simply a matter of imposing liability for losses resulting from fraudulent representations that "induce[d] the retention of securities as an investment" and resulted in "damages flowing from retention." Id. at 709. The majority focused on both the fact that the unlicensed seller caused the plaintiffs to purchase securities that they otherwise might not have purchased and that the seller also encouraged the plaintiffs to hold the securities past a point at which they might have otherwise sold the securities. See id. at 709-10.

Manufacturers Hanover Trust Co., 801 F.2d 13, relied upon Marbury. We there defined our task as the quantification of "the role of the accountant, and the scope of his liability, in presenting to the financial community information about a financial institution seeking to attract or maintain business in transactions involving agreements to repurchase (or resell) government securities." Id. at 18. We noted that the requirement of loss causation "derives from the common law tort concept of 'proximate causation.'" Id. at 20 (internal citation omitted). Going further, we relied on the language in Marbury, 629 F.2d at 708, which provided that loss causation "'in effect requires that the damage complained of be one of the foreseeable consequences of the misrepresentation.'" Manufacturers Hanover Trust, 801 F.2d at 21 (internal citations omitted).

Returning, then, to Marbury, while the complained of "fraud," as it were, in Marbury was factually different from that here -- an unlicensed seller falsely purporting to be registered versus the auditor falsely certifying financial health -- the analysis in Marbury is broad enough to apply to our situation. We were concerned in Marbury with the facts that the fraud both induced the investors to make the investment and induced the investors not to abandon it. See Marbury, 629 F.2d at 709-10. The relatively tangential feel to the fact that the fraud causation was traced to a career misrepresentation disappeared once the court considered the context of the fact and its import in the causal chain. The same can be said here.

The majority in Marbury analyzed cases -- including David v. Belmont, 291 Mass. 450, 197 N.E. 83 (1935); Rothmiller v. Stein, 143 N.Y. 581, 38 N.E. 718 (1894); and Continental Ins. Co. v. Mercadante, 222 A.D. 181, 225 N.Y.S. 488 (1st Dept. 1927) -- which found liability premised on assurances by a broker or seller which induced continued retention of a stock which ultimately plummeted in value, regardless of the cause of the final plunge in price. Id. at 709. These cases are equally applicable here.

The careful analysis in Continental Insurance Co., while certainly not binding, is worth noting. In that case, the plaintiff insurance companies sued the defendants (apparently stock brokers or company officers) for both inducing the plaintiffs to buy and inducing the plaintiffs to continue to hold securities that later became worthless. See Continental Ins. Co., 222 A.D. at 182, 225 N.Y.S. at 489-90. The defendants induced the plaintiffs to buy and retain the securities by conveying false financial information as to the earnings and solvency of the underlying obligor on the securities. See id. The court considered whether the defendants could be held liable for the plaintiffs' decision not to sell the securities prior to the underlying obligor's default when the plaintiffs presented no proof that they intended to sell the securities until the defendants told them not to sell. See Id. at 184, 225 N.Y.S. at 491-92 ("We come, then, to the more difficult question of whether this inaction can be said to have been caused by the false representations, in view of the circumstances that the plaintiffs had not previously determined upon action.").

In resolving the issue, the court quoted Smith v. Kay, 7 H.L.C. 750, 770 (Lord Cranworth) (1859)

It does not lie in the mouths of these persons to say what he would have done if they had not concocted the fraud, and if there had never been any deception at all practiced. That is not the question. The question rather is what this young man would have done, if he had known all that had really taken place.

Continental Ins. Co., 222 A.D. at 185, 225 N.Y.S. at 492. Moreover, the court noted that