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

Heading: Liability Standard for Huarisa and Sun Chemical

Text: 13 In considering the liability of Huarisa, the district court concluded that 14 he deliberately, or, at best, recklessly, misrepresented SKI's nine months' earnings, SKI's earnings for 1968 and for 1969, the interest of other companies in acquiring SKI at a price of $45 and the amount of potential write-offs of deferred preproduction costs for 1968. Huarisa also deliberately, or recklessly, failed to disclose the existence of the Burke and Ernst & Ernst reports, the Price Waterhouse memorandum of January 27, 1969, and the need for write-offs because of losses on contracts at year-end 1968. (Mem. op. 65.) 5 15 The court added that Huarisa conspired with SKI and other officers, particularly Messrs. Ryan and Werle, 6 in making these misrepresentations, and that the misrepresentations of SKI personnel made during Sundstrand's January 1969 survey of SKI and during the Sundstrand-SKI meeting on January 22 were also made intentionally or recklessly. Besides being liable as a co-conspirator, Huarisa was held liable because he was a controlling person of SKI within Section 20(a) of the Securities Exchange Act of 1934 (15 U.S.C. § 78t(a) ). His executors do not contest that he was a controlling person (Sundstrand Br. 23, n.  ). 16 In employing the intentional or reckless test with respect to Huarisa's and other SKI employees' conduct, the district court acted correctly. In Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668, the Supreme Court held that a private cause for damages would not lie under Section 10b and Rule 10b-5 in the absence of an intent to deceive or manipulate on the defendant's part. Sundstrand's amended complaint alleged both fraud and deceit, and the intent standard of Hochfelder was employed by the court below in passing on Huarisa's liability. It is true that in Hochfelder the Supreme Court did not decide whether reckless behavior is sufficient for civil liability under Section 10(b) and Rule 10b-5, although it recognized that recklessness is sometimes considered a form of intentional conduct for purposes of imposing liability for some acts. 425 U.S. at 194, n. 12, 96 S.Ct. 1375. Subsequently we held a corporation liable under Rule 10b-5 where, blinded by conflict of interest, it wantonly ignored readily available evidence of the unfairness of a proposed acquisition and therefore failed to disclose certain facts to the other stockholders of the company it controlled and proposed to sell. Bailey v. Meister Brau, Inc., 535 F.2d 982, 993-994 (7th Cir. 1976). This was akin to the alternative reckless standard employed by Judge Decker. See also Lanz v. Drexel & Co., 479 F.2d 1277, 1306 (2d Cir. 1973) (en banc ); cf. Bonner v. Coughlin, 545 F.2d 565, 567-569 (7th Cir. 1976) (en banc ); Kimbrough v. O'Neil, 545 F.2d 1059, 1061 (7th Cir. 1976) (en banc ). Therefore, there was no error in using the reckless alternative in assessing Huarisa's liability as his counsel seems to concede. 17 Sun Chemical does not contest that it is liable as the successor to SKI if Huarisa, Ryan, Werle and other SKI personnel violated Rule 10b-5, as the court found. 18 To escape liability, Huarisa and Sun Chemical assert that Sundstrand is barred from recovery by its failure to exercise due care or diligence. However, that defense is not available in an intentional fraud case. Holdsworth v. Strong, 545 F.2d 687 (10th Cir. 1976) (en banc ) As will be seen, Sundstrand has amply shown reliance on Huarisa's and SKI's misrepresentations and omissions when entering into the January 9 agreement, and that its reliance was then justified. Under Holdsworth, that is sufficient to establish a causal connection between the misrepresentations and omissions and Sundstrand's injury. Therefore, the judgment below is affirmed insofar as it imposes liability on Huarisa and Sun Chemical for causing Sundstrand to enter into the stock option transfer agreement of January 9. 19
20 For Huarisa and Sun Chemical to be liable under Rule 10b-5, their statements must have contained material misrepresentations or they must have omitted to state material facts. The most recent test of materiality under the Securities Exchange Act of 1934 is whether there is a substantial likelihood that a reasonable (investor) would consider (the omitted facts or misrepresentations) important in deciding whether to invest. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449, 96 S.Ct. 2126, 2133, 48 L.Ed.2d 757; S. D. Cohn & Co. v. Woolf, 426 U.S. 944, 96 S.Ct. 3161, 49 L.Ed.2d 1181. Applying this test, we believe the following misrepresentations and omissions were material and that Sundstrand relied thereon. 7 21 As to 1968, Huarisa represented to Sundstrand that SKI would earn $2.6 million or $2.9 million, and $1.16 per share, whereas it lost $367,803, or 15cents per share. Like the court below, we remain unconvinced that these projections were reasonable because Huarisa and Ryan knew of SKI's production and financial difficulties and of the distinct possibility of large write-offs having to be made at the end of that year. 8 22 The projection of $2.13 to $2.50 per share earnings for 1969 was also overstated, for the actual 1969 earnings were only 35cents per share. Defendants have not convinced us that the 1969 projections were reasonable. Again, we agree with the district court that Huarisa and SKI knew, or were reckless in not knowing, that the 1969 earnings were grossly inflated. The pre-merger misrepresentations about SKI's earnings projections for 1968 and 1969 were continued by Huarisa and Ryan at the January 22 meeting when they endeavored to persuade Sundstrand to revoke its decision not to proceed with the merger. However, nothing said by Huarisa and Ryan on January 22 could have influenced Sundstrand to proceed with the February 6 purchase of the Burke shares, for by then Sundstrand had received enough adverse information about SKI to call off the merger and to cause Sundstrand officers to divest themselves of the bulk of their SKI shares. 23 Huarisa and other SKI personnel also failed to disclose to Sundstrand that dissident SKI director James W. Burke filed a May 1968 report with the SKI board of directors questioning its accounting practices for 1967, particularly with respect to continuing to defer certain preproduction costs. Burke filed a supporting report from the accounting firm of Ernst & Ernst. These reports were discussed by the SKI's board at 25 board meetings during 1968, and representatives of Price Waterhouse, SKI's accounting firm, also discussed Burke's questions at several board meetings. Because of Burke's report, commencing in April 1968, the board received monthly financial reports showing the continual increase of deferred preproduction costs on certain SKI programs. In view of Burke's complaints to the SEC, SKI sent a Price Waterhouse partner and one of SKI's lawyers to discuss Burke's charges with the SEC, where it was concluded that the 1967 annual report did not reflect improper accounting practices. However, the Price Waterhouse firm assured the SEC that it would re-evaluate the situation when the 1968 annual report was prepared. The materiality of the nondisclosure of these reports is apparent, for SKI's board and Price Waterhouse representatives devoted major attention to them during 1968, and they certainly were a factor in causing Price Waterhouse to insist that SKI could not continue to defer preproduction costs in 1968. As a reviewing court, we are bound by the district judge's credibility determination that Sundstrand's president Ethington was influenced by the nondisclosure of these critical reports. This was supported by his and Sundstrand's secretary's March 22 flight to New York just after the president of Sun Chemical informed them of the reports. 9 24 On January 27, 1969, Price Waterhouse completed a memorandum stating its preliminary assessment that write-offs ranging from $3 million to.$4.5 million would have to be made on the books of KIC for the year 1968. KIC's vice president-controller Werle admittedly received a copy of this report on January 31, and SKI's financial vice president and treasurer Ryan admittedly received it on February 3. The district court found that Huarisa also must have known of this Price Waterhouse assessment before February 6 when Sundstrand paid the $6,360,915 balance for the 223,190 Burke shares of SKI stock. This memorandum was obviously material, for it resulted in $4.6 million being charged on the KIC books in 1968, causing SKI to lose 15cents per share. The memorandum should have been disclosed to Sundstrand, for it contradicted previous representations made by SKI personnel and certainly would have affected any reasonable investor's decision to proceed with a purchase of the magnitude involved on February 6. 10 But having been prepared so late, it of course could not have influenced Sundstrand to execute or reject the January 9 stock option transfer agreement. Its nondisclosure did not motivate Sundstrand in making its February 6 payment for the Burke shares because we find Sundstrand had sufficient adverse information by then as to SKI. 25 Thus a number of material misstatements and omissions were made by Huarisa and SKI upon which Sundstrand relied. Whether or not this reliance was justified for purposes of damage causation, we defer to a later discussion in this opinion. However, in order to assess damage causation intelligently, it is necessary to study Sundstrand's obligation to purchase the Burke stock in greater detail. 26
27 In the court below, Sundstrand contended that it purchased the Burke family stock on January 9 and was obligated by its written agreement of that date with Huarisa to complete the payment therefor. We agree with the district court that the January 9 agreement between Sundstrand and Huarisa did not obligate Sundstrand to complete the purchase of Burke stock. Paragraph 2 of that agreement did require Sundstrand to convey 5,686 shares of Sundstrand stock to Huarisa to reimburse him for the $334,785 which he had paid the Burkes when he exercised his option to purchase their stock at $30 per share on January 8. In order to determine Sundstrand's liability under the January 9 contract, it is necessary to consider also the December 7, 1968, Burke family's written offer to sell 223,190 common shares of SKI stock to Huarisa at $30 per share and the pooling agreement referred to therein. The pooling agreement between the Burke family and Huarisa was dated February 23, 1967. It and the offer to sell gave John B. Huarisa the right of first refusal to purchase the Burke shares for 30 days after December 10, 1968, 11 by paying the Burkes $334,785 (5 per cent of the complete purchase price) at the time of his election to purchase. This deadline was January 9, and Huarisa satisfied this clause on January 8, 1969. Under the pooling agreement, if he wished to complete the purchase, he had until February 9 to pay an additional 20 per cent and until April 9 to pay the final 75 per cent. The pooling agreement provided that Huarisa would forfeit his right to purchase the 223,190 shares of SKI in the hands of the Burke family if he failed to make any payment when due, with any prior payment being forfeited as liquidated damages. Since the agreement of January 9 between Sundstrand and Huarisa did not bind Sundstrand to pay the unpaid balance of $6,360,915, the agreement remained an offer to sell until Sundstrand should elect to purchase all the shares. Consequently, if Sundstrand did not choose to make additional payments on February 9, it would forfeit only the 5,686 Sundstrand shares that it agreed to convey to Huarisa to reimburse him for his initial payment of $334,785 (which was 5 per cent of the purchase price specified in the offer to sell and the pooling agreement). In Sundstrand I we characterized this transaction as follows: 28 Taking this cue (that otherwise Sun Chemical would purchase the Burke shares and thus impede any SKI-Sundstrand merger), Sundstrand expressed a willingness to purchase Huarisa's rights to the Burke stock and to issue shares in Sundstrand to reimburse Huarisa for his payment of funds due the Burkes within three days. Huarisa accepted this offer. On January 8, he paid the Burkes sufficient funds to hold open his right of first refusal, and executed an agreement with Sundstrand the next day, conveying his purchase rights in return for reimbursement of the ($334,785) monies paid the Burkes. 29 On February 6, 1969, more than two weeks after it had rejected the possibility of merger with SKI, Sundstrand paid the Burkes $6,360,915 and received the stock of SKI which Sun Chemical had earlier offered to purchase. Huarisa was repaid (the $334,785) on March 3, when Sundstrand transferred to him 5,686 shares of its common stock. By its agreement with Huarisa, Sundstrand was to repurchase the shares from him upon fifteen days' notice at any time within two years of the contract date. 488 F.2d at 810. 30 As Sundstrand has explained (Br. 15-16) and as the district court found (mem. op. 19), its reason for entering into the January 9 agreement with Huarisa was to prevent Sun Chemical from acquiring a block of SKI stock large enough to frustrate the proposed Sundstrand-SKI merger before Sundstrand could complete its study of SKI which commenced on January 7 and ended on January 20. Previously Sundstrand had been erroneously told by its counsel that the agreement of January 9 obligated it to buy the 223,190 shares, and accordingly it proceeded with the purchase on February 6. As a result, although Sundstrand's president told Huarisa on January 6 that Sundstrand would only be interested in buying the Burke stock if the proposed merger with SKI were to take place, on January 22, after the merger negotiations terminated, he told Huarisa that Sundstrand would honor its commitment of January 9 with respect to the Burke shares.