Opinion ID: 359617
Heading Depth: 2
Heading Rank: 4

Heading: The Acquisition by Combustion

Text: 32 Bateson and Bronson met with Kiamie and Kelly, another officer of Combustion, on January 7, 1970, as had been previously arranged. Bronson showed Kiamie the accrual statements for the first three quarters of 1969, and they discussed the terms of the agreement reached with the estate. During the meeting, Kelly stated that Combustion would offer Bronson and Bateson in the vicinity of $6,000,000 worth of stock for the corporation and partnership. A tentative agreement was reduced to writing on January 12, 1970. Exhibit 49. On January 9, 1970, Bronson wrote to the President of Barry Wright to explain his and Bateson's decision to join Combustion. The letter said: We could not discuss anything until after January 6, 1970, and we were not able to gauge the seriousness of indication on their (Combustion's) part until we had a meeting with them. Exhibit 43. 33 On February 2, 1970, Picard delivered to Radoccia two pages to be substituted for the first two pages of the Corporate Purchase Agreement between Maguire and the estate of January 6, 1970. The substituted pages provided that the entire $581,603.62 which the corporation agreed to pay the estate was in consideration for the 350 shares of common stock rather than reflecting the $577,150 which had been loaned to the corporation by Holmes and the estate as specified in the first agreement. Exhibit 4. Although the record provides no explanation for the substitution, the effect is a capitalization of the money loaned by Holmes and the estate to the partnership. This coincides with the capitalization of the money loaned by Bateson and Bronson. A fair inference is that this was done to facilitate Combustion's acquisition of Maguire. There is no evidence in the record that Mrs. Holmes ever agreed to the substitution. 34 Bronson and Picard met with Kiamie on February 17, 1970, at which time the corporate acquisition was revised, and the partnership acquisition eliminated from the agreement. On February 20, 1970, Radoccia wrote to Bronson requesting that quarterly financial statements be sent to him since the estate was now a creditor of the business. Exhibit RR. In response, Bronson sent an Estimated Statement of Net Worth and Income Statements as of December 31, 1969, combined and also broken down between the partnership and the corporation and prepared on both a cash basis and an accrual basis. Exhibit SS. The material showed gross corporate income, on an accrual basis, of $7,800,000 and a net profit, again on an accrual basis, of $908,809 before taxes. 9 35 The tentative acquisition agreement was amended on March 3, 1970, to provide that Combustion would transfer to Bateson and Bronson, in exchange for their Maguire stock, a total of 24,240 shares of Combustion's common stock as an initial payment and 24,000 shares on a contingent, earn out basis. A final agreement to this effect was executed on April 29, 1970. Exhibit 17. At the same time, Bateson and Bronson entered into employment agreements with Combustion. Maguire was to retain in its treasury the 350 shares of stock formerly belonging to the estate. 36 In August of 1970, the noninterest bearing note from the corporation in the sum of $581,603.62, representing the balance due the estate, was cancelled by the immediate payment of $417,000. Bronson initiated the transaction by a letter to Coffey, with a copy to Radoccia, stating that $417,000, in Combustion's judgment, was the present value of the seven $83,086 annual payments that Maguire was obligated to make. The estate accepted this offer, and, on August 6, 1970, Mrs. Holmes, Radoccia, and the Maguire corporation executed an agreement stating that the executors accepted the $417,000 in full satisfaction of the corporation's note. Exhibit A. 10 37 Coffey first learned of the impending sale to Combustion in January or February of 1970. The only action he took with regard to the sale was to certify the corporation's by-laws. Coffey testified that, as late as 1971, Bateson said that he got little out of the transaction with Combustion and that the real money would come from the earnout. Bronson and Bateson informed the bank of the sale on March 6, 1970, and the bank's trust committee chairman wrote a congratulatory letter to Combustion aimed towards soliciting continued business. LIABILITY AS TO BATESON AND BRONSON 38  Section 10(b) of the 1934 (Securities Exchange) Act and Rule 10b-5 prohibit the use of any manipulative or deceptive device or contrivance in the sale of securities. Cook v. Avien, Inc., 573 F.2d 685, 692 (1st Cir. 1978). The traditional elements of a 10b-5 action are scienter, 11 material omissions and/or misrepresentations, reliance, and due care by the plaintiff. The Supreme Court in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976), eliminated negligence as a cause of action in a 10b-5 securities case, but left open the question of whether reckless conduct would suffice to ground a claim. 39 The district court found that this case was primarily one of nondisclosure and that the defendants had failed to reveal to the estate accrual figures reflecting the true value of the business and the details of the negotiations for the acquisition of the business by Barry Wright, Science Management, and Combustion. Although the court concluded that all of the above omissions were material, it clearly placed greatest emphasis on the failure to reveal the merger information. In addition to the omission of material facts, and as a secondary basis for liability, the court found that defendants had made deliberate misrepresentations to the estate as to the condition of the business. Finally, the court held that plaintiffs had established sufficient scienter on the part of defendants and reliance and due care on their own part to succeed in their suit. 40 Appellants do not appear to question any of the legal standards applied by the district court in arriving at its holding. But they rigorously contest the district court's finding of scienter, materiality, affirmative misrepresentation and reliance. We shall discuss each in turn. The court's finding of due care on the part of plaintiffs is not discussed in appellants' brief and, therefore, that issue is before us only tangentially. Scienter 41 There is no dispute that, if the district court was correct in finding that the evidence . . . demonstrates a pattern of intentional deception on the part of the individual defendants, 434 F.Supp. 1382 the Supreme Court's scienter requirement as set out in Ernst & Ernst v. Hochfelder, supra, would be satisfied. However, appellants argue that the court seriously misinterpreted and mischaracterized the evidence, which, they contend, if viewed in its correct light, would not sustain a finding of intent to deceive. Thus the issues as to scienter 12 are basically questions of fact and must be resolved in favor of affirming the district court's findings, unless shown to be clearly erroneous. United States v. United States Gypsum,333 U.S. 364, 68 S.Ct. 525, 92 L.Ed. 746 (1947). Fed.R.Civ.P. 52(a). A factual finding is clearly erroneous when it is against the clear weight of the evidence. Barbe v. Drummond, 507 F.2d 794, 797 (1st Cir. 1974). This is so whether the evidence reviewed is primarily documentary or comprised of testimony subject to the court's findings of credibility and reliability. Local Union 1219 v. United Bro. Corporation, 493 F.2d 93, 96 (1st Cir. 1974). A finding will be found erroneous and require reversal only if we are  'left with the definitive and firm conviction that a mistake has been committed.'  Evans v. United States, 319 F.2d 751, 753 (1st Cir. 1963). A. The Accrual Information 42 Appellants claim that the accrual information was divulged to the estate representatives because it was carried on the face of the Revised Estimated Net Worth of the Partnership and the Corporation of March 31, 1969. Exhibit 15. Bateson and Bronson contend that, by reading the December 31, 1968, partnership statement, Exhibit 17, in conjunction with the March 31, 1969, combined partnership and corporation statements, one can determine the cash basis partnership profit for the three months ending March 31, 1969. They argue that the accrual basis profits for the corporation, the partnership cash basis profit, and the corporation cash basis loss can all be found in these statements. 13 43 If one possesses a high decree of accounting skill and is thoroughly familiar with the structure of the partnership and the corporation, the accrual figures can, after effort, be determined from the statement, but we cannot say that the statements display the accrual profit of the corporation in any readily understandable fashion. The March 31, 1969, statement is misleading, to say the least, in the light of the very large cash basis loss and the absence of any explanatory note. Bronson testified that, on September 24, 1969, the date when this information was delivered to the estate representatives, he did not know that it contained accrual information. If Bronson did disclose the accrual information, then he did so unknowingly, and the impact of this disclosure on the court's finding of scienter would be minimal. If Bronson did not know from reading the statement that it contained the accrual information, which he now contends that it does, the estate certainly could not be faulted for failing to dig deep enough to uncover it. 44 Appellants contend that the financial statements delivered to the estate at the time of closing showed that the corporate cash basis loss of $1,330,000 was exceeded by the partnership cash basis profit of $1,831,175 for the year, with a net profit of $501,175. Exhibit 16. Appellees do not quarrel with this submission, and it is true as far as it goes. The problem is not in the information itself, but in the inferences and values which appellants assign to the net profit of $501,175. 45 First, appellants contend that this information shows clearly that the corporate cash loss should not have been construed as evidence of serious financial troubles as the district court found. Second, they argue that the district court could only have found that the cash loss was evidence of financial trouble because it failed to understand the relationship between the partnership and the corporation and that the combined net profit of the two was more important than the corporate cash loss. They further contend that their reading and interpretation of the financial statements would be evident to any reader and that no sophisticated analysis of financial statements is required. 46 We do not think that the district court was unable to comprehend the relationship between the partnership and the corporation. An indication of a loss, on either a cash or accrual basis, is evidence, at least at first blush, more of financial trouble than of a profitable operation. While the combined figures do show a profit, it was only $500,000, before taxes; accrual data would have shown a far greater profit with earnings in the vicinity of a million dollars, so that the cash basis figures are misleading and incomplete. 47 It is of even more importance that the figures revealing a cash basis profit would be of little significance to a sophisticated appraiser. More pertinent indications of value would have been the work in progress, the contracts still to be fulfilled, and the amounts to be billed and collected for this work. These so-called unrecorded assets and liabilities are of far greater importance in predicting a corporation's performance in the future than a cash basis profit figure. 14 An accurate accrual statement would have portrayed a rosy future for the corporation. But without any accrual figures and without any knowledge of the acquisition activity, the future of the business could reasonably have been interpreted to be bleak. Such a forecast would be reinforced by the indications of extreme cash flow problems of which Bronson complained. 48 Appellants next contend that the district court erred in finding that Bronson concealed the nine month accrual statement because it had, in fact, been delivered to Tingley. Tingley was not an estate representative; he was a loan officer of the bank and was not necessarily aware of the specific factors that had to be evaluated by the estate. The obligation of the corporation was to report to the estate's representatives. The disclosure to Tingley was not made to furnish the estate with information about the business but because of the bank's independent concern as a creditor of the corporation. 15 49 Appellants' contention that they effectively disclosed this information to Coffey, as a representative of the estate, has more merit, but it still falls short of what was required. Coffey was sent a copy of the letter to Tingley which stated that the accrual report was ready. The letter does not state whether the copy was sent to Coffey in his capacity as estate representative or as the corporation's counsel. Because it concerned dealing with the bank as a creditor, we can only assume that the letter was sent to him in his capacity as corporate counsel, particularly since Coffey was not an executor, but only estate counsel, and since all other communications by Bronson and Bateson to the estate were made to Radoccia. We are constrained to add that Coffey's representation of both the corporation and the estate, despite his attempt to isolate estate matters from corporate matters, did not show good judgment. See ABA Canons of Professional Ethics, No. 5. Because both parties to this suit were aware of his dual representation and retained him not only despite it, but because of it, we only comment that an independent attorney's reliance on Bateson's and Bronson's honesty might well have been more tempered. In any event, when the corporation chose to communicate with the estate, it directed those communications to Mrs. Holmes as well as Radoccia and Coffey, not to Tingley and Coffey. 50 The nine month accrual statements which were given to Tingley on December 15, 1969, and the supplemental statements sent to him on December 18, contain income and expense statements and balance sheets on both a cash and an accrual basis. They completely and accurately show the company's performance and disclose the financial data which an intelligent investor-stockholder would need in order to determine the value and potential of the business. No reason is given for appellants' failure to disclose this information directly to the estate, which they had available and obviously considered important. 51 Bronson's testimony indicated a recognition of the separation between the trust and commercial departments of the bank. He testified that the accrual statements had been prepared for the commercial section of the Industrial National Bank, and when asked whether there was any accrual information supplied to the estate in addition to the March 31, 1969, statement, he replied: Not to my knowledge. When asked whether he had supplied a copy of the accrual statement to any estate representatives prior to January 6, 1970 . . ., he replied in the negative. Bronson further testified that he never told anyone representing the estate that the corporation was enjoying a profitable operation if measured on an accrual basis. In light of this testimony and the other evidence, the district court's findings of selective disclosure and material omissions were not clearly erroneous. 52 B. The Price Paid the Estate for Maguire's Stock 53 Appellants' second contention with respect to the underlying facts is that the district court's finding that the estate sold all of its stock in the Maguire corporation for $4,453 is clearly erroneous and that the finding so obscured the court's view of the other evidence that this one error prejudiced all of the other factual findings. Appellants argue that the estate sold all of its interest in the Maguire business for $815,000, and that the figure cannot be broken down into separate parts. 54 Based as it was on the characterization of payments made by the parties in the settlement contract, before pages were substituted without Mrs. Holmes' knowledge, we cannot say that the finding is clearly erroneous. In fact, it appears to be clearly correct. Holmes and the estate advanced $577,150 to the Maguire corporation as working capital in the form of a loan. This figure was in proportion to Holmes's share of the stock and was matched by loans from Bateson and Bronson of $412,250 each in proportion to their shares of stock. When the $815,000 which the business owed the estate was apportioned between the partnership and the corporation, the corporation's share was $581,603.62. The balance was due from the partnership and was based on the contemporary cash value of the partnership. Of the $581,603.62, $577,150 was money loaned to the corporation. The balance of $4,453 was what was paid for the stock. Even after the pages of the agreement were changed to provide that the loaned money would be capitalized as a contribution to capital, the estate received the same amount of money; $577,150 represented the amount advanced to the company as working capital, and the only sum received by the estate for the Maguire corporation as a going business was $4,453.62. By comparison, Combustion's payment to Bronson and Bateson was made with full knowledge of the corporate debt and reflected the value put on the business over and above whatever had been paid to the estate. In reviewing damages, however, we are aware that uniform treatment must be given to the loans, or paid in equity, made by the three owners. We discuss this Infra. C. The Misrepresentations 55 We turn now to the question of whether the district court was clearly erroneous in its finding that Bronson painted a black picture and made negative remarks and that they contributed to the estate's misapprehension of Maguire's true financial condition. Mrs. Holmes testified in cross-examination: Mr. Bronson did speak at that meeting about the situation of the company; that it was in very poor shape; they were having a difficult time; and went on at great length that the Company was in the pits so to speak. I mean it was not doing well. 16 Appellants argue that the actual remarks were addressed only to a cash flow situation, and stress that the only testimony with regard to Bronson's remarks was that of Mrs. Holmes, who admittedly did not know much about the financial affairs of the company. The determination of the weight and credibility of the evidence is entirely up to the district court. Moreover, we point out that Coffey also testified that he was sure that Maguire was in extreme financial difficulty. He stated that the close working conditions between himself and the principals of Maguire left him certain that they were making all necessary disclosures and that he was sure of their accuracy. Yet, Coffey was never made aware of the offer of Barry Wright or of the serious negotiations between Maguire and other firms concerning acquisition or merger and he testified that he was not involved in the financial affairs of the company. The district court gave great weight to Coffey's testimony, which, of course, was entirely within its province. 56 The evidence which appellants adduced to show that Maguire was in a cash bind, but not in any financial danger, does nothing to disprove the finding that a black picture was presented. On the contrary, it could be interpreted to demonstrate how appellants created the illusion of serious financial difficulties while actually enjoying remarkable success. 57 D. The Partnership Agreement and Oral Understanding 58 In addition to the evidence as to accrual omissions and misrepresentations as to the corporation condition, there remains the most damaging evidence of all, defendants' failure to disclose their ongoing merger negotiations which revealed to them that the business in its corporate form was far more valuable than the estate's buy out price would indicate. No disclosure of merger information occurred even after his own attorney, Robert Picard, advised Bronson of securities law requirements in this area. 17 To explain these omissions, appellants argue that they acted in good faith reliance on their understanding that the partnership agreement's survivorship  buy out provisions carried over to the new corporate form. 59 There is no doubt that the three owners of the business had an oral understanding, after forming the corporation, that, if anything happened to any one of them before a written agreement was executed providing for a method of determining the value of the stock of the new corporation, the determination of the deceased's interest in the business could be computed according to the buy out provisions of the partnership agreement. The oral understanding was not reduced to writing and appellants agree that it did not constitute a binding agreement as the court below ruled. 18 It is Bateson's and Bronson's position, however, that they acted in good faith, in accord with the partnership agreement, even if mistaken as to its effect, and, therefore, had no intention to deceive. The state of mind of appellants, of course, goes to the core of the issue of scienter, but claimed good faith reliance on the partnership agreement is only one indication of scienter. The entire course of conduct of Bateson and Bronson was properly scrutinized by the district court. We point out that if the partnership agreement controlled, as Bateson and Bronson claim they thought, there would have been no reason for only a partial disclosure of the financial situation and silence as to the merger activities. Furthermore, under the partnership buy out provisions, the parties could arrive at any other arrangement that was considered fair. 19 So, even if the partnership agreement were in effect, there was no hard and fast formula as to the deceased partner's share. We also observe that the 20 percent discount applied to the estate's share of the business was not a provision of the partnership buy out agreement. 60 The exact intent of the parties in agreeing on a survivorship arrangement must remain obscure. It is difficult to believe that partners who have just incorporated their business, among other reasons, to promote its merger or acquisition potential, would at the same time agree to an absolute and inflexible survivorship agreement which completely ignored the market value of their corporate stock. The district court was not clearly erroneous in inferring that the existence of this nonbinding agreement could not satisfactorily explain the policy of secrecy and omission perpetrated by the defendants. 61 There are two securities fraud cases in which the question and effect of an agreement is the central issue, Rochez Brothers, Inc. v. Rhoades, 491 F.2d 402 (3d Cir. 1973), and Saint Louis Union Trust Company v. Merrill Lynch, Etc., 562 F.2d 1040 (8th Cir. 1977). Appellants contend that our case falls between Rochez Bros. and Saint Louis Union which implicitly suggests that Rochez Bros. is distinguishable. We find it on point in important respects. In Rochez Bros., two stockholders who owned all of the outstanding stock of a corporation between them had both business and personal difficulties. Rochez made an offer to sell his stock to Rhoades. Rochez knew that Rhoades had valued a one-half interest in the corporation to an outsider at 1.75 million dollars and considered the valuation too high; Rochez initiated the transaction between himself and Rhoades and set out very specific terms and a timetable. When he set the price, he stated that he did not care where Rhoades got the money and assumed that Rhoades had outside investors waiting in the wings. The sale price set by Rochez was $598,000. Rhoades, shortly after acquiring the company, sold it for $4,250,000, plus stock in the acquiring company, based on negotiations begun before Rochez had sold out. The material information which it was found that Rhoades failed to disclose prior to the sale was that he had hired a finder to look for and arrange for an acquisition, and that negotiations were under way. Id. at 406-409. 62 In the present case, it is arguable that the disclosure that a finder was retained was made to Coffey. But Coffey also could be found to have been under the impression that the reason for searching for an acquiring corporation was that Maguire was in trouble. Appellants point out that in Rochez, there was no prior and continuing understanding between the parties. While it is true that the Rochez agreement was not of long standing, it was definitely binding. The offer to sell was made with full knowledge of the corporation's financial situation, except for the extent of acquisition negotiations already underway; otherwise, the facts are strikingly similar to the case at bar. There was no binding agreement in this case and, to the extent that there was an understanding, it was followed by the estate representatives because they operated under a misconception of the actual state of financial affairs as did Rochez. 63 Saint Louis Union is a different situation. In that case, there was a valid written agreement made at the time of the stock acquisition for repurchase upon death. The sale was triggered by this agreement and was in no way based upon any knowledge or misconception of the plaintiffs. In the instant case, there was no agreement in effect at the time the corporation was formed and the subsequent understanding to use the partnership as a basis for determining value was made without knowledge of material facts and under the misapprehension that the corporation was in desperate straits.