Opinion ID: 344913
Heading Depth: 1
Heading Rank: 2

Heading: Liability of Meers

Text: 31 Finally, we must consider whether Meers is also liable under Rule 10b-5 for the injury suffered by Sundstrand. The district court held him liable for three independent reasons: (1) failure to disclose the Burke and Ernst & Ernst reports even though he had a duty to do so; (2) as an aider and abettor of Huarisa and SKI; and (3) as a controlling person of SKI under Section 20(a) of the Securities Exchange Act of 1934 (15 U.S.C. § 78t(a)). We reach only the first ground. 32 Nondisclosure of the Burke and Ernst & Ernst Reports
33 As the district court phrased it. Meers was on both sides and in the middle of the transaction (mem. op. at 68). Meers was an SKI director and was also acting as a merger broker for SKI and Huarisa with respect to Sundstrand. His firm was to receive a $150,000 fee if the merger with Sundstrand was completed. In the past, his firm had performed investment banking services for Sundstrand and its officials had confidence in him. 12 34 Thus, although he was acting in a nominally adversary relationship vis-a-vis Sundstrand as SKI's merger broker, Sundstrand could properly rely on its preexisting and contemporaneous banker-client relationship with Meers for fair disclosure. In this posture as a quasi-fiduciary with respect to Sundstrand, Meers had an affirmative common law duty to disclose material facts relating to the proposed merger. 13 Haimoff, Holmes Looks at Hochfelder and 10b-5, 32 Bus.Law 147, 164-173 (1976) (hereinafter cited as Haimoff) and authorities cited therein. The district court therefore properly held that Meers had a duty to disclose the Burke and Ernst & Ernst reports during his pre-January 9 discussions with Sundstrand. See Carr v. New York Stock Exchange, 414 F.Supp. 1292, 1299-1300 (N.D.Calif.1976); cf. Jennings, Insider Trading in Corporate Securities, 62 Nw.U.L.Rev. 809, 818 (1968). 35
36 After Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668, a merely negligent breach of a duty defendant owes plaintiff is not sufficient to trigger liability under Section 10(b) of the Securities Exchange Act of 1934 as implemented by Rule 10b-5. The opinion below, authored without the benefit of Hochfelder, did not make a finding on whether Meers acted with scienter or recklessly in failing to disclose the Burke and Ernst & Ernst reports because under pre-Hochfelder law in this Circuit the breach of an affirmative duty was actionable without more. Hochfelder v. Midwest Stock Exchange, 503 F.2d 364, 368 (7th Cir. 1974), certiorari denied, 419 U.S. 875, 95 S.Ct. 137, 42 L.Ed.2d 114. Under a negligence Rule 10b-5 standard, a description of the character of the conscious attention the defendant gave his breach of duty was wholly unnecessary. Therefore, unless we can conclude that the level of conscious attention Meers gave to the breach of his duty meets as a matter of law the scienter requirement of Hochfelder, or the reckless requirement of other cases, we would have to remand for a factual finding on this issue. 14 Since we find recklessness present, there is no need for a remand. 37 As noted above in our discussion of Huarisa's and Sun Chemical's liability, Bailey v. Meister Brau, Inc., 535 F.2d 982 (7th Cir. 1976), resolved for this Circuit the ambiguity in footnote 12 of Hochfelder in favor of including reckless behavior in the definition of what behavior is necessary to maintain a Rule 10b-5 action. However, Meers' conduct comprised reckless nondisclosure rather than disclosing information with a reckless disregard for the truth of the material asserted. Thus a more extended analysis of the reckless behavior standard is required in our discussion of Meers' liability. 15 38 At common law reckless behavior was sufficient to support causes of action sounding in fraud or deceit. Since there is no hint in Hochfelder that the Court intended a radical departure from accepted Rule 10b-5 principles, 16 it would be highly inappropriate to construe the Rule 10b-5 remedy to be more restrictive in substantive scope than its common law analogs. 17 McLean v. Alexander, 420 F.Supp. 1057, 1080-1082 (D.Del.1976). See generally, Haimoff, supra, at 154-156. Therefore, we hold that a reckless omission of material facts upon which the plaintiff put justifiable reliance in connection with a sale or purchase of securities is actionable under Section 10(b) as fleshed out by Rule 10b-5. See Coleco Industries, Inc. v. Berman, 423 F.Supp. 275 (E.D.Penn.1976); SEC v. Bausch & Lomb, Inc., 420 F.Supp. 1226, 1242-1244 n. 4 (S.D.N.Y.1976). 39 Apparently the only post-Hochfelder reported definition of recklessness in the context of omissions appears in Franke v. Midwestern Oklahoma Development Authority, 428 F.Supp. 719 (W.D.Okl.1976): 40 reckless conduct may be defined as a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it. 41 As the Supreme Court conceded in Hochfelder: 42 In certain areas of the law recklessness is considered to be a form of intentional conduct for purposes of imposing liability for some act. 425 U.S. at 193-194 n. 12, 96 S.Ct. at 1381. 43 The Franke definition of recklessness is the kind of recklessness that is equivalent to wilful fraud. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 868 (2d Cir. 1968) (Friendly, J., concurring) (en banc ), certiorari denied sub nom. Coates v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756. 18 44 Indeed, the Franke definition of recklessness should be viewed as the functional equivalent of intent. Cf. Bucklo Scienter and Rule 10b-5, 67 Nw.U.L.Rev. 562, 570-571 (1972). Under this definition, the danger of misleading buyers must be actually known or so obvious that any reasonable man would be legally bound as knowing, 19 and the omission must derive from something more egregious than even white heart/empty head good faith. 20 While this definition might not be the conceptual equivalent of intent as a matter of general philosophy, it does serve as a proper legally functional equivalent for intent, because it measures conduct against an external standard which, under the circumstances of a given case, results in the conclusion that the reckless man should bear the risk of his omission. 21 See O. Holmes, The Common Law 130-163; Haimoff, supra, passim; Ruder, Texas Gulf Sulphur The Second Round: Privity and State of Mind in Rule 10b-5 Purchase and Sale Cases, 63 Nw.U.L.Rev. 423, 436-437, 441-442, 444 n. 107 (1968). See also Lanza v. Drexel & Co., 479 F.2d 1277, 1306 n. 98 (2d Cir. 1973) (en banc ); Rochez Bros., Inc. v. Rhoades, 491 F.2d 402, 407-408 (3d Cir. 1974). When measured against this external standard, it may be said that such a reckless man has use(d) or employ(ed) (a) deceptive device within Section 10(b). 22 45 Application of the Recklessness Standard to Meers' Conduct
46 At the December 26 merger negotiation meeting, Meers agreed with Ethington that Ethington's earnings estimates for SKI of $1.16 per share in 1968 and $2.00 23 per share in 1969 were reasonable. Although there is conflicting evidence on whether Meers confirmed these earnings figures as reasonable, we cannot say that the trial court's credibility determination in Ethington's favor was clearly erroneous. 24 Since Sundstrand was primarily concerned that the proposed merger not result in an earnings dilution, the reliability of SKI's earnings projections was, of course, most important to Sundstrand and, as the district court realized (mem. op. 12), it stretches credulity to believe that SKI's earnings were not discussed. Given the importance of the earnings projection, the danger of misleading Sundstrand (as of December 26, 1968) was high when information the Burke and Ernst & Ernst reports that the earnings estimates might be significantly overstated due to accounting gimmickry was kept from Sunstrand's officers. 47 Meers denies actual knowledge of the danger, and the trial court made no determination that Meers possessed actual knowledge. However, a finding on the objective obviousness of the danger was made (mem. op. 32-34), which is sufficient for liability even absent an actual appreciation by Meers of the significance of the omitted material to Sundstrand. 48 The factual findings of the district court relevant to the obviousness of the danger, which upon our independent examination of the record we find amply supported, are most succinctly stated in the trial court's own words (mem. op. 32-34): 49 (Meers) failed to disclose to Sunstrand that James W. Burke, a director, officer and large shareholder of SKI had, in May, 1968, formally submitted to the board of directors of SKI questions as to the propriety of certain SKI accounting practices, including that of continuing to defer certain preproduction costs on the CPU-46 and other programs. The questions related principally to accounting practices as revealed in the 1967 annual report. Burke supported his questions in June with a report from Ernst & Ernst, an independent firm of certified public accountants which Burke had asked to consider the propriety of the practices he challenged. Ernst & Ernst, though declining to render a formal opinion because it had not conducted an examination in conformity with generally accepted auditing procedures, concluded that the practices addressed in the Burke Report seemed questionable. 50 These reports were considered serious enough by the SKI board of directors to be discussed at at least twenty-five board meetings during the spring and summer of 1968. The board directed the officers of SKI to prepare responses to Burke's questions, and at Meers' request, representatives of Price Waterhouse, the firm of certified public accountants which prepared the SKI 1967 annual report, appeared at several of these meetings to discuss Burke's questions. The board eventually decided that Burke's criticisms were without merit. However, as a result of Burke's questions, the board began, in April, 1968, to receive monthly financial reports. These reports revealed the continual increase of deferred preproduction costs on the CPU-46 and other programs throughout 1968. Meers was concerned enough to ask about the progress of each of the contracts on which costs were deferred, including the CPU-46, at every board meeting and asked particularly whether the CPU-46 had been qualified with the government a step which was essential to producing an acceptable product and obtaining follow-on contracts. In each such meeting he learned that no such qualification had been obtained. (In fact, qualification was not obtained until September, 1969.) 51 Dissatisfied with the board's action, Burke complained to the SEC. Ryan, Hart, acting as attorney for SKI, and H. Dudley Murphy, a partner of Price Waterhouse, met in Washington with Curtis A. Davies of the SEC to discuss Burke's charges. At that meeting it was concluded that the 1967 annual report did not reflect improper accounting practices. With respect to preproduction costs on the CPU-46, Murphy assured Davies that Price Waterhouse would re-evaluate the situation when they prepared the 1968 annual report. This assurance was reiterated in a letter from Murphy to Davies. Both Ryan and Meers saw copies of that letter. None of this was disclosed to Sundstrand. 52 Neither was it disclosed that, because of questions about the propriety of SKI's 1967 financial statements, two directors of SKI, Burke and Perry Addleman, refused to sign a registration statement filed by SKI with the Securities and Exchange Commission in March, 1968. Meers later suggested that the registration statement be withdrawn, which was done in August, 1968. In addition, defendants failed to disclose to Sundstrand that Addleman also raised questions about the financial accounting of SKI. 53 The trial court concluded that the materiality of the Burke and Ernst & Ernst reports is not open to serious question (mem. op. 36). 54 Meers places heavy reliance on the SEC meeting of August 1968 as dispelling the doubts the Burke and Ernst & Ernst reports had raised in his mind. However, the 1968 accounting practices were not passed on in the SEC meeting. The monthly financial reports which Meers requested as a result of Burke's initial complaints continued to show an increase in deferred preproduction costs. At every board meeting Meers asked about the preproduction costs. Indeed, Meers found out that the computer unit CPU-46 had still not been qualified with the government, a condition precedent for additional government contracts for that product. Thus the principal expected source of revenue against which to amortize the mounting preproduction costs remained indefinite and unreliable. Under these circumstances, any reasonable man would be bound to know that the danger posed to Sundstrand by the serious conflict on SKI's accounting policy among its board members and two public accounting firms as to deferred preproduction costs had not been vitiated by the inconclusive August 1968 SEC meeting.
55 Yet even if constructive knowledge of the danger to Sundstrand of omitting certain facts is imputed to Meers, an omission caused because Meers genuinely forgot about these facts would not be actionable, even if such an omission derived from inexcusable neglect. Cf. SEC v. Bausch & Lomb, 420 F.Supp. 1226, 1241-1244, nn. 3 & 4 (S.D.N.Y.1976). But we need not remand for a factual determination here since a subsequent pre-January 9 event removed Meers' omission from the putative realm of mere inexcusable neglect. At the January 2, 1969, board meeting to approve the Sundstrand merger proposal, in Meers' presence Burke asked if Sundstrand had been told of the Burke and Ernst & Ernst reports and Huarisa replied that it had not. Therefore, rather than putting the question out of his mind, Meers must have consciously decided not to disclose (and did not disclose) 25 the substance of the reports to Sundstrand. 26 Thus recklessness is established as a matter of law by the facts found by the trial court. Bailey v. Meister Brau, Inc., 535 F.2d 982, 993-994 (7th Cir. 1976). 56
57 Since the omitted facts pass the stringent objective element of the recklessness test, the district court's determination of the materiality of the Burke and Ernst & Ernst reports that there is a substantial likelihood they would be considered important by a reasonable investor is not open to argument, especially since materiality assessments are peculiarly for the trial court as fact-finder. 27 TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 448, 96 S.Ct. 2126, 2132, 48 L.Ed.2d 757. 28 With materiality established, reliance in an omissions case is presumed. Affiliated Utes Citizens v. United States, 406 U.S. 128, 92 S.Ct. 1456, 31 L.Ed.2d 741. 29 58 Of course, Sundstrand would be open to a defense of non-reliance on the omissions if Meers could meet the burden of proof running against him to establish such an affirmative defense. McLean v. Alexander, 420 F.Supp. 1057, 1077-1079 (D.Del.1976). Note, The Reliance Requirement in Private Actions Under SEC Rule 10b-5, 88 Harv.L.Rev. 584, 606 (1975); Wheeler, Plaintiff's Duty of Due Care Under Rule 10b-5: An Implied Defense to an Implied Remedy, 70 Nw.U.L.Rev. 561 (1975); Note, Reliance Under Rule 10b-5: Is the Reasonable Investor Reasonable?, 72 Colum.L.Rev. 562, 567 (1972). In a nondisclosure case, reliance is vitiated if the plaintiff is chargeable with the omitted information. Under a negligence standard of liability, plaintiff could not justifiably claim reliance if he had not exercised due diligence. Wheeler, supra. But under a reckless or Hochfelder scienter standard, (i)f contributory fault of plaintiff is to cancel out wanton or intentional fraud, it ought to be gross conduct somewhat comparable to that of defendant. Holdsworth v. Strong, 545 F.2d 687, 693 (10th Cir. 1976); cf. McLean v. Alexander, 420 F.Supp. 1057, 1078 (D.Del.1976). 59 We find nothing in the record that remotely suggests that Sundstrand was recklessly remiss in not ferreting out on its own the information contained in the Burke and Ernst & Ernst reports before its down payment to Huarisa on January 9, 1969 (mem. op. at 60-61). Rather, the record clearly suggests that if Meers had disclosed the reports, Sundstrand would not have executed the January 9 stock option transfer agreement with Huarisa which compelled it to transfer 5,686 of its shares to Huarisa in return for receiving his option to buy the Burke shares. 30 60 Nor can Meers insulate himself from this liability by urging that he was only involved in the SKI-Sundstrand merger, for it is clear that the January 9 agreement was an integral part in any such merger by preventing Sun Chemical from purchasing the Burke shares for another thirty days (mem. op. 17-18), i.e., until February 9. Since Meers' conduct was partly responsible for Sundstrand's signing the stock option transfer agreement, 31 his nondisclosure was sufficiently in connection with the purchase or sale of any security, as required by Rule 10b-5. Eason v. General Motors Acceptance Corp., 490 F.2d 654 (7th Cir. 1973), certiorari denied, 416 U.S. 960, 94 S.Ct. 1979, 40 L.Ed.2d 312; Heit v. Weitzen, 402 F.2d 909, 912 (2d Cir. 1968), certiorari denied, 395 U.S. 903, 89 S.Ct. 1740, 23 L.Ed.2d 217. 61 It follows that Meers must share in the Huarisa estate's and Sun Chemical's liability on a material omission Rule 10b-5 theory. Therefore, we need not decide whether Meers would also be liable as an aider and abettor 32 or as a controlling person of SKI under 15 U.S.C. § 78t(a) the alternative grounds purportedly establishing Meers' liability in the opinion below. 62