Opinion ID: 476327
Heading Depth: 3
Heading Rank: 2

Heading: Causation and Andersen's Recklessness Defense.

Text: 25 As for the alleged violation of section 10(b), for which accountants may be held primarily liable, see, e.g., Herman & MacLean v. Huddleston, 459 U.S. 375, 103 S.Ct. 683, 74 L.Ed.2d 548 (1983); Competitive Associates, Inc. v. Laventhol, Krekstein, Horwath & Horwath, 516 F.2d 811, 815 (2d Cir.1975); Fund of Funds, Ltd. v. Arthur Andersen & Co., 545 F.Supp. 1314, 1351-53 (S.D.N.Y.1982), Andersen argues principally that MHT failed to demonstrate loss causation, and that the jury was not properly instructed on this element of the section 10(b) theory. The standard for liability in a civil action under section 10(b) is causation not merely in inducing the plaintiff to enter into a transaction or series of transactions, but causation of the actual loss suffered. Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 943 & n. 23 (2d Cir.) (Friendly, J.), cert. denied, 469 U.S. 884, 105 S.Ct. 253, 83 L.Ed.2d 190 (1984); Marbury Management, Inc. v. Kohn, 629 F.2d 705 (2d Cir.), cert. denied, 449 U.S. 1011, 101 S.Ct. 566, 66 L.Ed.2d 469 (1980); Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir.1974), cert. denied, 421 U.S. 976, 95 S.Ct. 1976, 44 L.Ed.2d 467 (1975). It is clear that on the record evidence a fact-finder could conclude that Andersen's misrepresentations as to DGSI's solvency induced MHT (and other financial institutions) to do business with the newly-formed DGSI. There was evidence that the financial community, including MHT, sought assurance of adequate capitalization of DSC amidst growing concerns of insufficient funding; that Andersen materially misstated DGSI's capitalization in its audited financial statement; and that copies of the Andersen statement were distributed in Andersen envelopes with Andersen's knowledge to various financial institutions including MHT. There was evidence that MHT Senior Vice President Stephen Goodhue, head of MHT's Wall Street Department, relied primarily, though not exclusively, on the Andersen statement in approving DGSI for its government securities business. In light of this evidence, Andersen challenges the adequacy of the charge and the sufficiency of the evidence not as to transaction causation but only as to loss causation. 26 The requirement of loss causation derives from the common law tort concept of proximate causation. See Marbury Management, 629 F.2d at 708 (citing Restatement (Second) of Torts Sec. 548A (1977)). In addition to this requirement as to the significance of the misrepresentation in the chain of causation, loss causation in effect requires that the damage complained of be one of the foreseeable consequences of the misrepresentation. Id. (citing Oleck v. Fischer, [1979 Transfer Binder] Fed.Sec.L.Rep. (CCH) p 96,898, at 95,702-03 (S.D.N.Y.1979), aff'd, 623 F.2d 791 (2d Cir.1980)). 27 We find Andersen's argument that the district court failed to instruct the jury properly on loss causation to be without merit. The district judge clearly defined proximate causation and used that term throughout his charge. In defining the term, the judge specifically noted the requirement that the damage was either a direct result of the misleading statement or one which could reasonably have been foreseen. Further, the judge charged that the jury must determine whether any of MHT's loss was due to its own business shortcomings; whether the bank caused its own losses, and if so, to return a verdict for Andersen even if Andersen acted improperly; whether Andersen caused part and MHT caused part of MHT's loss and, if so, to determine how much loss is attributable to Andersen; whether MHT had satisfied its burden of demonstrating that its loss was not caused by its own recklessness or negligence, and if MHT's recklessness caused any or all of its damage, then Andersen is not liable for such damage; and whether any of MHT's loss was caused not by Andersen's conduct but by MHT's own recklessness or the conduct of third parties, and if so, then MHT is not entitled to recover for such loss. Indeed, we note that the court's proximate cause charge was virtually identical to the charge requested by Andersen. 28 When it comes to evaluating the evidence of loss causation, we cannot accept Andersen's argument, premised in part on Bennett v. United States Trust Co., 770 F.2d 308 (2d Cir.1985), cert. denied, --- U.S. ----, 106 S.Ct. 800, 88 L.Ed.2d 776 (1986) that there is simply no direct or proximate relationship between the loss and the misrepresentation. Id. at 314. In Bennett, plaintiffs borrowed funds from the U.S. Trust Co. to purchase utility stocks which were then deposited with U.S. Trust as collateral. The stock declined in value, and ultimately U.S. Trust liquidated plaintiffs' account. Plaintiffs not only lost their equity in the stock, but also became liable to U.S. Trust for $1.2 million in unpaid interest and principal on their loan. Plaintiffs sued U.S. Trust, claiming that in making the loan, U.S. Trust knowingly or recklessly misrepresented to them that the Federal Reserve margin requirements do not apply to public utility stock deposited with a bank as collateral. Plaintiffs did not and could not allege, however, that U.S. Trust in any way recommended that they purchase public utility stock in general, or any particular public utility stock. Rather, [t]he Bennetts, and the Bennetts alone, decided to invest in public utility stock. Id. at 313-14. The same cannot necessarily be said of MHT. There was certainly evidence upon which a rational trier of fact could find, as the jury apparently found, that Andersen, by its misrepresentations, induced MHT to enter into repurchase agreements with DGSI involving the particular underlying government securities. The financial community had come to mistrust DSC's solvency before the Andersen report was issued. In this context, the Andersen report portrayed a new, highly capitalized company on whose promises to repurchase or resell particular government securities, an institution such as MHT could reasonably rely. Andersen was aware that its report was intended to be and actually was circulated to institutions including MHT for the purpose of inducing them to participate in government securities repurchase agreements. 29 This case is thus distinguishable from Bennett and more similar to Marbury Management, supra. In the latter case, a trainee in a brokerage firm misrepresented his expertise by claiming that he was a stockbroker and a portfolio management specialist. That misrepresentation induced the plaintiffs to purchase and retain specific securities that the trainee recommended, despite their misgivings about the stock. Similarly, by misrepresenting DGSI's financial status, Andersen may reasonably have been found to have induced MHT to enter into repurchase agreements involving DGSI government securities, despite MHT's (and the financial community's) earlier misgivings about the financial risk associated with entering into precisely these agreements with DGSI. Further, although the misrepresentation in Marbury Management did not go to the intrinsic investment characteristics of the stock, it did go to the investment quality of the stock purchases because, had the plaintiffs known that their broker was an inexperienced trainee, they asserted they would not have accepted his recommendations, especially given their initial reservations. Similarly, although the misrepresentation in the present case did not go to the investment characteristics of the underlying government securities--and, under our holding in Drysdale, this was not required--it did go to the investment quality of the repos since, presumably, MHT would not have contracted with DGSI to purchase and sell government securities had MHT known of the misrepresentation regarding DGSI's finances, particularly given that the Andersen statements were in part a response to the financial community's concern regarding DSC's stability. 30 Andersen also relies heavily on Edwards & Hanly v. Wells Fargo Securities Clearance Corp., 602 F.2d 478 (2d Cir.1979), cert. denied, 444 U.S. 1045, 100 S.Ct. 734, 62 L.Ed.2d 731 (1980), and argues that MHT's alleged recklessness caused its own loss, and that the verdict in the district court therefore contravenes the established principle that  '[t]he securities laws were not enacted to protect sophisticated businessmen from their own errors of judgment.'  Id. at 486 (quoting Hirsch v. du Pont, 553 F.2d 750, 763 (2d Cir.1977)). In our view, Andersen misapplies this principle in seeking to resurrect imperfections in MHT's internal operations as a bar to recovering for losses caused by Andersen's misrepresentations. Cf. Faller Group, Inc. v. Jaffe, 564 F.Supp. 1177, 1181 (S.D.N.Y.1983) (failure to initiate certain investigative checks does not bar action for fraud) (citing Mallis v. Bankers Trust Co., 615 F.2d 68 (2d Cir.1980) (Friendly, J.), cert. denied, 449 U.S. 1123, 101 S.Ct. 938, 67 L.Ed.2d 109 (1981); Dupuy v. Dupuy, 551 F.2d 1005 (5th Cir.) (Wisdom, J.), cert. denied, 434 U.S. 911, 98 S.Ct. 312, 54 L.Ed.2d 197 (1977)). 31 We note the applicable legal standard regarding plaintiff's conduct. Plaintiff's burden of persuasion is simply to negate recklessness when defendant puts that in issue, not to establish due care. Mallis, 615 F.2d at 79 (footnote omitted). Thus, although Edwards & Hanly had expressly approach[ed] the issue of [plaintiff's] conduct from the standpoint of ... due diligence, 602 F.2d at 485, the applicable standard is recklessness. We note, however, that Judge Friendly asserted in dicta that [t]he facts in Edwards & Hanly would have led to dismissal under the Dupuy [recklessness] standard. Mallis, 615 F.2d at 79 n. 9. 7 32 In our view, the evidence adduced at trial demonstrates that Andersen's reliance on Edwards & Hanly is misplaced, and its arguments of recklessness on MHT's part unpersuasive. We note that plaintiff Edwards & Hanly, a brokerage house, was denied recovery because, in that case, [t]he primary cause of E & H's loss was its failure to comply with Regulation T, ... [promulgated] pursuant to Sec. 7 of the Exchange Act, 15 U.S.C. Sec. 78g. 602 F.2d at 486. Regulation T expressly requires broker-dealers, such as E & H, to ensure that a security purchased in a cash account is held in the account or that the creditor accepts in good faith the customer's statement that the security is owned by the customer or the customer's principal, and that it will be promptly deposited in the account. See 12 C.F.R. Sec. 220.8(a)(2). In the present case, however, Andersen has not alleged any particular regulatory violation by MHT, which, in any event, was acting not as a broker purchasing or selling securities for its customer, but as fiscal agent for an undisclosed principal, providing for its customers short-term repo and reverse repo positions in government securities, and assuming responsibility to its customers for DGSI's obligations. Of course, MHT may be denied recovery on the basis of adequate proof of common law recklessness as assessed in light of industry practice. We do not wish to suggest that a defendant must show a violation of some statutory or regulatory proscription to show recklessness. But the lack herein of an established statutory or regulatory cognate to Regulation T, violation of which was central to our holding in Edwards & Hanly, forces us to inquire as to what, if anything, in this case stands as similarly compelling proof of recklessness. 33 Andersen's arguments on this critical issue rest principally on its comparisons of various aspects of MHT's DGSI transactions with those of other financial institutions that managed to escape the DGSI collapse either unscathed or considerably less harmed than was MHT. We find these arguments ultimately unpersuasive. For example, Andersen argues that MHT recklessly failed adequately to control its own volume and other risks. Volume risks relate to the amount of money that MHT invested in repo and reverse repo positions with DGSI at any one time. Although some financial institutions, such as Merrill Lynch, Dean Witter Reynolds, Salomon Brothers, First Boston, Citibank and Prudential-Bache, determined that they would transact from zero to $50 million worth of repo business with DGSI, based principally on its cash reserves, there was also evidence that other reputable firms, notably U.S. Trust Company and Chase Manhattan Bank, transacted some $2 to $2.5 billion in repo business with DGSI, as did MHT. Thus, industry practice as to volume risk was not nearly as uniform as Andersen would suggest. Further, volume risk is but one element in total risk exposure, and its significance in the calculus of total risk exposure may be diluted to the extent that the primary government securities dealer, here, DGSI, maintains matched books of repos and reverse repos, a practice that DGSI fraudulently purported to maintain. There was evidence regarding the government securities business of other primary dealers, W.E. Pollack, Prudential-Bache, and Dean Witter, suggesting that the volume of business transacted by DGSI generally and with a particular customer, such as MHT, might have comported with the practices of those firms had matched books in fact been sustained. 34 As to non-volume risk controls, Andersen introduced evidence that MHT failed adequately to monitor the following: the market risk that the cash and bonds which it received from DGSI might be worth less than the cash and bonds delivered to DGSI; the coupon interest risk that DGSI might fail to pay accrued coupon interest when due or to return borrowed bonds; and the repo interest risk that DGSI might fail to pay repo interest owed. But there was also evidence--certainly enough to allow a jury to find the claim of recklessness negated--that MHT monitored these risks reasonably when measured by prevailing industry practice. As to market risk, there was evidence that MHT followed the common industry practice of marking to market at 100% of the stated par value of the securities. U.S. Trust, the only other intermediary bank that testified as to risk controls, apparently marked to market in the same way as MHT: the intermediary bank would not initiate marks, but would process the marks requested by the principals to the transactions. There was also evidence that MHT periodically checked to ensure that the DGSI transactions were being marked to market. In our view, the evidence of these internal controls by MHT was sufficient to justify a jury's negating the charge of recklessness as to market risk, whether or not MHT could have or should have actually initiated, as opposed to merely processed and periodically monitored, markings to market. Cf. Faller Group, Inc., 564 F.Supp. at 1181 (failure to initiate further investigative checks did not bar action for fraud) (citing Mallis, supra; Dupuy, supra ). 35 As to coupon interest risk, there was evidence that MHT's handwritten records were transcribed from computerized risk assessments that were substantially similar to Andersen's own computer assessments of accrued coupon risk, except that MHT's program entailed a one-day lag in calculation and did not account for DGSI fails in tendering cash or securities due by the time the Fed wire closes at the end of a business day under reverse repos until MHT employee D'Amore corrected by hand the computer assessment each day to account for such fails. There was also evidence that MHT controlled coupon risk by demanding that DGSI process more repos than reverse repos through MHT, thereby reducing risk since, with repos, the borrower was obligated to remit coupon interest to DGSI, while with reverse repos, DGSI was obligated to remit coupon interest to the lender. Further, there was evidence that in monitoring coupon risk, MHT set up a collateral account into which DGSI was to deposit cash and securities to cover MHT's coupon interest exposure. Andersen's own expert on repo procedures, Robert Bird, conceded that prior to DGSI's collapse, it was not the industry practice to collateralize accrued coupon interest, and that MHT's coupon risk controls, including its collateral account, constituted a fair effort to attempt to control the coupon exposure. Certainly these internal controls render MHT considerably more conscientious than E & H, which often failed even to mark the defendant's sales long--a failure which alone might not even be a breach of duty. Edwards & Hanly, 602 F.2d at 486 (citing Naftalin & Co. v. Merrill Lynch, Pierce, Fenner & Smith, 469 F.2d 1166, 1175 (8th Cir.1972)). Also, even assuming, arguendo, that Andersen is correct that MHT often failed to enforce this collateral control procedure when DGSI ignored requests for additional collateral, the mere institution and partial enforcement of the collateral control procedure appears to have rendered MHT ahead of, not behind, then-prevailing industry practice in monitoring coupon interest risk. 36 As to repo interest risk, there was evidence only that at least two other firms had developed computer programs to monitor this risk, the importance of which must not be overstated in the total calculus of risk, and that MHT was beginning to develop its own program when the collapse occurred. 37 In short, applying the overall standards of industry practice, the jury reasonably could conclude that MHT endeavored to control risk sufficiently to negate Andersen's claim of MHT's recklessness. 38 Andersen also argues that MHT recklessly failed to heed warning signs of DGSI's impending collapse. In our view, Andersen relies improperly on Edwards & Hanly and thereby mischaracterizes MHT's immediate response to warning signals as a longer-term organizational policy of conscious avoidance. During the approximately one month preceding DGSI's collapse, DGSI often failed to return securities due. As Andersen points out, in April 1982 fails lasting three or more days occurred on 58 percent of DGSI's scheduled returns. But the countervailing evidence was sufficient to allow a finding that the charge of recklessness had been negated: MHT officers Martello, D'Amore and Zinns apparently worked with DGSI in April and May in an effort to reduce exposure risks; and, in May 1982, MHT was in daily communication with DGSI regarding the former's exposure. Further, there was evidence that in MHT's experience, DGSI consistently cured fails, and that, in any event, only fails that occurred in the week prior to the collapse of DGSI were still open on May 17, 1982. This contrasts with Edwards & Hanly, where, in response to fails of up to several months for securities due within several days, repeatedly over a period of approximately one year, plaintiff E & H made only sporadic inquiries and even then apparently contented itself with evasive answers. Edwards & Hanly, 602 F.2d at 486-87. Finally, we must recognize the sheer speed of events herein in contrast to Edwards & Hanly. While E & H had approximately one year during which it could have protected itself from ongoing fails, here MHT had at most one-quarter to one-third that duration from the time of the circulation of the Andersen statement in February 1982 until the ultimate collapse of DGSI in May 1982. Indeed, the duration must be considered shorter still when measured from the time when fails became a legitimate source of concern. In sum, as to the brief period of MHT's interaction with DGSI, the evidence supports the conclusion that MHT endeavored to protect its investments, and negated the charge of recklessness. 39