Court Opinion

ID: 6985231
Source: CourtListenerOpinion
Date Created: 2022-07-24 02:57:47.583951+00
Date Added: 2024-06-11T16:09:24.893915
License: Public Domain

WINTER, Chief Judge,
dissenting:
I agree with the conclusions reached by Judge Oakes’s opinion as to transaction causation and scienter. With regard to loss causation, I would hold that the facts found by the district court demonstrate loss causation as a matter of law. Limiting my discussion of applicable law to appellants’ single federal claim, brought under Section 10(b) of the ’34 Act, 15 U.S.C. § 78j(b), I respectfully dissent.
I
Before turning to a detailed discussion of loss causation under Section 10(b), I briefly summarize my reasoning. The issues that are principally contested are: (i) transaction causation, or whether the *229fraud here was a but-for cause of appellants’ losses; (ii) E&Y’s knowledge of the fraud and its intent, or “scienter” in the jargon of securities law; and (iii) loss causation, or whether the fraud was the “proximate cause” of appellants’ losses.
Transaction causation was clearly established by the district court’s findings regarding the materiality of the false statements and appellants’ reliance upon those statements. See AUSA Life Ins. Co. v. Ernst & Young, 991 F.Supp 234, 246-47 (S.D.N.Y.1997). Indeed, the district court specifically found that, had appellants known the truth as to the value of the JWP notes, “they likely would not and in some cases could not have bought them.” ¶ 447, Joint appendix at 2606 (S.D.N.Y. Dec. 5, 1997) [hereinafter cited as “Findings ¶-, at-”].
In my view, scienter was also clearly established. As the district court expressly found, E&Y knew that the year-end financial statements and no-fault letters contained false and misleading information. See id. ¶ 369, at 2581; see also 991 F.Supp at 247-48. E&Y timely informed JWP’s management of that very fact with regard to many of the misstatements recited in the district court’s opinion, but, when rebuffed, acquiesced in the fraud. See 991 F.Supp at 241-46. Moreover, E&Y knew that appellants would rely upon the false statements. See Findings ¶ 438, at 2602. Indeed, that was the purpose of the provisions of the notes requiring “no-fault” letters prepared by E&Y. See id ¶¶ 431-31, at 2598-99. No more is needed to establish scienter as a matter of law. See Cosmas v. Hassett, 886 F.2d 8, 13 (2d Cir.1989) (to prove scienter, plaintiff in Section 10(b) case must “adequately identify] circumstances indicating conscious behavior by the defendants”).
The main battleground is over Section 10(b)’s element of loss causation. This is an issue of mixed fact and law, the factual components of which are reviewed only for clear error, while the legal conclusions drawn therefrom are reviewed de novo. See Lopresti v. Terwilliger, 126 F.3d 34, 39 (2d Cir.1997) (“A district court’s findings of fact following a bench trial will be set aside on appeal only if those findings are clearly erroneous. ... However, the district court’s application of the facts to draw conclusions of law, including a finding of liability, is subject to de novo review. So called mixed questions of law and fact are also reviewed de novo.” (some internal punctuation and all citations omitted)).
Both the district court and my colleagues view the loss causation issue more narrowly than I do. The district court’s reasoning went more or less as follows. Because of the misleading financial statements and no-fault letters, appellants had a view of JWP’s financial condition that was more rosy than the truth. However, the true financial condition of JWP was not so different from the rosy view that a fully informed reasonable investor would have apprehended a significantly greater risk of defeault. Rather, in the court’s view, because the collapse was largely caused by the risky and mistaken business decision to acquire Businessland, it was not sufficiently connected to the misrepresentations to be deemed a foreseeable consequence of them.
Judge Oakes’s opinion, in discussing Restatement (Second) of Torts, appears to take the same view of the issue. See Majority Opinion at 218-220. However, he would remand for more findings on whether, given the true financial picture, JWP’s collapse was foreseeable.1
*230I view the issue rather differently. I would ask the following question: Would a reasonable investor — knowing in 1990 (i) that a firm’s financial statements have deliberately and systematically misstated its condition over at least a two-year period, (ii) that the firm’s auditor has supinely acquiesced in those statements, and (iii) that the auditor had also issued fraudulent no-fault letters on outstanding notes — reasonably apprehend a new and significant danger that business decisions involving volatile risks might be made and that one such decision might lead to financial collapse without the investor having a timely opportunity to make an informed decision as to the exercise of contractual rights that might cap its losses? I would answer the question in the affirmative.
The core of my disagreement with my colleagues goes to the scope of the matters on which appellants were misled by what the district court aptly described as E&Y’s “lap dog” approach to the auditing of JWP and to the preparation of the no-fault letters. See 991 F.Supp. at 248. To be sure, appellants were misled as to JWP’s financial condition. But they were also misled as to two other matters; (i) the quality of the firm’s management and auditor; and (ii) the firm’s current incentives with regard to risk aversion.
First, the various financial statements and no-default letters misstated the firm’s financial condition and compliance with the terms of the notes, not only for the current year but also for prior years. By 1990, therefore, when the first purchase of notes at issue occurred, what was concealed was not simply the true financial condition of JWP but also the critical facts of (at least) two-years of false financial statements and no-default letters. If aware of those facts, a reasonable lender would have inferred that JWP had a management quite willing to lie systematically to investors and an auditor willing to certify the lies. A reasonable lender would then have discounted JWP’s creditworthiness not only because of its less favorable financial condition but also, far more devastatingly, because of the questionable quality of its management and auditor. Reasonable investors surely view firms with an untrustworthy management and auditor far more negatively than they view financially identical firms with honest management and a watch-dog auditor. Moreover, a reasonable lender informed of the truth would also have known that outstanding notes held by the investor were actually in default. Such defaults would have prompted serious consideration of the exercise of contractual remedies. Indeed, had the defaults been known, the Businessland acquisition could not have occurred without either a cure by JWP detailing the years of fraud or a waiver by appellants.
Second, the concealed information about JWP’s management and E & Y’s performance as an auditor would have alerted a reasonable lender to JWP’s incentives to make risky decisions such as the Business-land acquisition. When the management of a firm and its auditor knowingly issue a series of certified annual financial statements that depict a financial condition more favorable than the truth, a dilemma is created. Both know that the truth will ultimately emerge. All things being equal, the value of the firm’s outstanding securities will then decline, and fresh capital will be more costly or simply unavailable without installing a new management and auditor. Only a deal so profitable as to improve the firm’s financial condition sufficiently to offset both the financial implications of the false statements and the decline in confidence in management will preserve the firm’s standing in capital markets. The “huge-deal” solution to the firm’s dilemma, however, puts lenders at risk. Unknown to them, the firm is far less risk averse than would be expected from the publicly available financial statements, and the chances of a default resulting from a deal with high volatility risk— like the Businessland acquisition — are much greater. The collapse here was therefore a foreseeable risk resulting from *231the series of false financial statements, and loss causation has been shown. I now set out my views in somewhat more detail.
II
Although I find no fault in Judge Oakes’s presentation of the facts, there are certain facts that I emphasize because they demonstrate the nature of the fraud at issue and are particularly relevant to-loss causation.
Between 1984 and 1992, JWP, previously a small regulated water utility in Queens, engaged in an aggressive path of expansion by acquisition, primarily financed through private placements of debt securities that were illiquid and had maturities of ten or fifteen years. See AUSA, 991 F.Supp. at 238; Findings ¶ 419, at 2594. Beginning in 1988, appellants purchased some $149 million of JWP notes. Because of the limitations period applicable to Section 10(b) claims and that Section’s limitation to a “purchase or sale,” see Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 731-49, 95 S.Ct. 1917, 44 L.Ed.2d 539 (1975), the present federal action concerns appellants’ purchase of $85 million of JWP notes between 1990 and 1992, well after the pattern of fraudulent JWP annual reports certified by E & Y and fraudulent no-default letters issued by E & Y had begun. See AUSA 991 F.Supp. at 251; Findings ¶¶5, 8, 10, at 2468-70. Appellants contracted for various financial covenants in the Note Agreements. Those covenants required, inter alia, that JWP’s books be kept in accordance with GAAP and that E & Y annually furnish to JWP for transmittal to appellants a no-default letter stating that nothing in its audit caused it to believe that JWP had failed to comply with the terms of the particular Note Agreement. See Findings ¶¶ 436-37, at 2601-02. If JWP violated the financial covenants, appellants had the right, inter alia, to accelerate the due-date on the notes. See id. ¶471, at 2613.
JWP’s audited financial statements, certified by E & Y as accurate, portrayed the company “as a success story” of steady growth, increasing profits, and substantial net worth. Id. ¶ 60, at 2484. “But the reality of JWP’s financial condition was very different from the picture of financial health painted by JWP’s audited financial statements.” Id. Between 1987 and 1991, during which E & Y served as JWP’s independent auditor, JWP routinely violated GAAP and the financial covenants in the Note Agreements. See id. ¶ 440, at 2603. JWP’s disregard for GAAP rules was so flagrant that “[i]t was a frequently repeated inside joke at JWP to refer to ... ‘EGAAP,’ an acronym for [JWP Chief Financial Officer] Ernest Grendi’s Accepted Accounting Principles.” Id. ¶ 325, at 2568. The district court specifically found that E & Y knew of this inside joke. See id. at 2568-69.
Among other things, JWP improperly capitalized operating expenses as acquisition costs, improperly capitalized software development costs, illegitimately capitalized anticipated-net-operating-loss-carry-forwards as “negative goodwill,” arbitrarily wrote up small-tool inventories and offset them against an illegitimate “negative goodwill” account, concealed construction contract losses, and failed to set up adequate accounts receivable reserves. See AUSA 991 F.Supp. at 240-46.
Several of JWP’s accounting abuses served primarily to inflate reported net income, id. at 246, which would be relevant to purchasers and holders of equity securities interested in earnings per share and price/earnings ratios, but which would be less relevant to sophisticated purchasers of privately-placed debt securities. However, other accounting abuses were of great relevance' to lenders. For example, JWP’s illegitimate negative goodwill entries “changed the ratio of tangible to intangible assets,” Findings ¶ 129, at 2506, suggesting to debtholders an inflated level of tangible asset coverage for JWP’s debt. Also, the district court found that the im*232proper entries increased JWP’s earnings before interest, taxes, depreciation and amortization (“EBITDA”). See AUSA, 991 F.Supp. at 250. Thus, JWP directly represented to debtholders a lower than actual Debt/EBITDA ratio, i.e., depicted a higher than actual cash flow available to satisfy its debt obligations. Finally, JWP’s failure to account adequately for anticipated losses on outstanding contracts and accounts receivable inflated the ratio of current assets to current liabilities, suggesting to lenders a heightened level of solvency. See generally Findings ¶ 445, at 2605 (“In connection with their purchases of JWP’s debt securities, [appellants’] financial analysts compared JWP’s financial statements over a period of five or more years by means of ratio analysis.”). The relevance of these misrepresentations to debt investors in general, and to these debt investors in particular, is acutely demonstrated by the fact that the Note Agreements contain specific covenant provisions limiting JWP’s activities based on each of these accounting items. See, e.g., 1992 Note Agreement, PL’s Exh. 139B, ¶ 6A(vii), at 13 (restricting JWP’s assumption of additional debt absent JWP’s meeting target ratios of debt to total capitalization and debt to earnings before interest and taxes (“EBIT”)); id. ¶ 6F, at 23 (requiring JWP to maintain ratio of current assets to current liabilities of not less than 1.25).2
E & Y was aware of, and complicit in, JWP’s accounting abuses: “[E & Y] knew about the accounting irregularities that were pervasive at JWP.... In the face of this knowledge, [E & Y] abandoned its ‘watchdog’ obligations to bark an alarm. Instead, [E & Y] issued clean audit opinions and no-default certificates, thereby lending the considerable prestige of [E & Y’s] imprimatur to JWP’s erroneous financial statements.” Findings ¶ 359, at 2581. E & Y was also well aware of JWP’s violations of the loan covenants. See id. ¶ 440, at 2603. “Time and again, [E & Y] found the fraudulent accounting at JWP, but managed to ‘get comfortable’ with it.” Id. ¶ 348i at 2577. Indeed, E & Y’s “work-papers evidence that the Summary of Audit Differences was deliberately manipulated.” Id. ¶ 353, at 2579. “Part of the problem was undoubtedly the close personal relationship” between Grendi and his •former partner John LaBarca, the lead E & Y auditor covering JWP. AUSA, 991 F.Supp. at 248. “[T]he record suggests that ... LaBarca and his associates exhibited a level of tolerance and timidity inappropriate for an independent auditor. The ‘watch dog’ behaved more like a lap dog.” Id.
In mid-1991, after roughly four years of systematic accounting misstatements, JWP made its largest and riskiest acquisition— the purchase of Businessland, a computer reseller. See id. at 238. It was a “massive bite for JWP to swallow.” Id. at 239. At the time of this acquisition, JWP was in default on all of the notes held by appellants, and it is conceded that, had the defaults been known, the acquisition could not have taken place absent either a cure by JWP or a waiver by appellants.
Businessland’s cash flow had been steadily deteriorating, and its auditors had issued a report reflecting substantial doubts about Businessland’s future prospects as a going concern. See Findings ¶ 35, at 2475. Despite this prognosis,. JWP was convinced it could turn the company around. However, the floundering Businessland became an enormous cash drain on JWP. See id. ¶44, at 2478. In 1992, the computer industry began to slash the prices of personal computers in what became known as the “PC price wars.” Id. ¶48, at 2479. Finally, JWP’s mechanical and engineering business was in a slump due to the oversupply of commercial real estate. See id. *233¶ 54, at 2482. Although Businessland became profitable in the hands of its next owners, JWP had insufficient capital to stay the course. See AUSA, 991 F.Supp. at 250.
In 1992, JWP experienced a liquidity crisis and net losses of $612 million. See Findings ¶¶ 65, 67, at 2485-86. By year end, JWP stopped making full interest payments on the notes. See id. ¶ 69, at 2486. In April 1993, JWP stopped making payments altogether. See id. On December 21,1993, a number of creditors filed an involuntary Chapter 11 bankruptcy petition against JWP, to which JWP consented on February 14, 1994. See id. ¶ 77, at 2489.
Between October 27, 1993 and February 18, 1994, appellants sold their notes for fair market value, at a substantial loss. See id. ¶ 423, at 2595-96. They lost not only their unpaid principal but also their contractual right to receive interest income payable under the notes up to the dates of sale. See id. ¶ 425, at 2596. The parties have stipulated to the amount of lost principal and unpaid interest under the Note Agreements. See id. ¶ 427, at 2596.
Ill
We have stated that “loss causation” under Section 10(b) “correspond^ ... with [the] common law notionf ] of ... proximate causation.” Litton Indus., Inc. v. Lehman Bros. Kuhn Loeb Inc., 967 F.2d 742, 747 (2d Cir.1992); accord Manufacturers Hanover Trust Co. v. Drysdale Sec. Corp., 801 F.2d 13, 20 (2d Cir.1986) (“The requirement of ‘loss causation’ derives from the common law tort concept of ‘proximate causation.’ ” (citing Marbury Mgmt. Inc. v. Kohn, 629 F.2d 705, 708 (2d Cir.1980))). Indeed, courts interpreting Section 10(b) and Rule 10b-5 have often resorted to considering analogous tort law rules, see, e.g., Blue Chip Stamps, 421 U.S. at 744, 95 S.Ct. 1917; see also VII Louis Loss & Joel Seligman, Securities Regulation 3421-22 (3d ed.1989) (“hornbook elements of ‘deceit’ .... in large measure carry over to” fraud concepts under SEC statutes), perhaps because prior to the Private Securities Litigation Reform Act of 1995, Pub.L. No. 104-67, 109 Stat. 737, “[n]o language in either [Section 10(b) or Rule 10b-5 spoke] at all to the contours of a private cause of action for the[se] [provisions’] violation,” Blue Chip Stamps, 421 U.S. at 749, 95 S.Ct. 1917.
Nevertheless, “[i]n a ‘suit on a statute’ ” liability “does [not] depend on whether there is proximate causation as that term is used at common law.” Abrahams v. Young & Rubicam Inc., 79 F.3d 234, 237 (2d Cir.1996). “With statutory claims, the issue is, instead, one of statutory in-tent_” Id.; see also Moore v. Paine-Webber, Inc., 189 F.3d 165, 178 (2d Cir.1999) (Calabresi, J., concurring) (“[T]he pertinent requirements of proximate cause in a [statutory] case are those intended by the legislature that passed the statute, and not those of the common law.”). This is an important point to keep in mind lest we overwork the analogy between proximate cause in common law negligence and proximate cause in federal securities law violations.
For example, Judge Oakes correctly notes that “foreseeability” is the touchstone of loss causation. See Marbury Mgmt., 629 F.2d at 708 (loss causation “requires that the damage complained of be one of the foreseeable consequences of the misrepresentation”). However, the concept of foreseeability may vary according to legal context. For example, use of the term “foreseeable” occurs, inter alia, in common law negligence cases, see Stagl v. Delta Airlines, Inc., 52 F.3d 463, 473 (2d Cir.1995), per se negligence cases involving duties created by statute, see De Haen v. Rockwood Sprinkler Co., 258 N.Y. 350, 179 N.E. 764, 765-66 (1932) (finding negligence in failure to comply with statute requiring elevator shafts be fenced when object fell down unfenced shaft and killed man below because “the hazards to be avoided [by the statutory rule] ... [were] the hazards that ensued”), and cases involving liability un*234der federal law for material misrepresentations or omissions in securities transactions, see Manufacturers Hanover, 801 F.2d at 20-22. “Foreseeability” in each of these categories of cases is not an identical concept; rather, it is a term verbalizing the parameters of liability under particular legal rules both as to classes of persons intended to be protected by those rules and the classes of injuries intended to be compensated. See Moore, 189 F.3d at 178 (“Whether a statute’s causation requirements are broader, narrower, or the same as those of the common law depends on what harms the statute is intended to address.”).
Of course, forseeability in common law negligence cases has largely to do only with reasonably apprehending a particular kind of injury to a particular category of plaintiff. In the case of per se negligence claims where the defendant is under a statutory duty to behave in a specified fashion, “foreseeability” is determined by reference to whether that statute was intended to protect the particular category of plaintiffs and to avoid the particular kind of injury. See W. Page Keeton et al., Prosser & Keeton on the Law of Torts § 36, at 224-27 (5th ed.1984) (to maintain action based on particular statute, plaintiff must bring himself within class of individuals legislature intended to protect, and harm must be one that statute was intended to prevent). While the distinction between proximate cause in negligence claims based on common law or on violation of a statute may not affect the outcome in many cases, the underlying analysis is nonetheless quite different.
In the case of securities fraud, the limits of “foreseeability” must be derived from the purposes of the federal securities laws. See Moore, 189 F.3d at 179-80 (“Where the defendant’s behavior is made actionable by a statute, ... the extent of his liability .... [is governed by] the statute and its purpose .... ” (footnote omitted)). Those laws, as pertinent to the instant matter, impose a duty on firms to provide investors with truthful information relevant to the value of certain investments. “The purpose of [Section] 10(b) and Rule 10b-5 is to protect persons who are deceived in securities transactions — to make sure that buyers of securities get what they think they are getting....” Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 943 (2d Cir.1984) (Friendly, J.). The securities laws are, of course, not an insurance policy against all losses by investors, and the concept of proximate cause limits recovery to plaintiffs and to losses for which the intent of the laws is served by recovery and denies recovery when that intent is not served.
If the meaning of proximate cause in the present context is to be derived from the statutory purpose of making sure that firms provide the truthful information necessary to allow investors to “get what they think they are getting,” then much of the requisite analysis must come from the definition of materiality under federal securities law, which governs the scope and content of the information that the firm is under a duty to provide. The test of materiality is whether a reasonable investor would consider the particular information significant or, put another way, whether the information would affect the “total mix” of information available to the investor. See TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449, 96 S.Ct. 2126, 48 L.Ed.2d 757 (1976). The “foreseeability” of a loss in this context, therefore, turns upon the significance of the misrepresentations or omissions to the total mix of information available to the investor. Of course, in the context of common law negligence, it is generally foreseeability from the defendant’s point of view that is at stake. In securities law, however, the critical issue is what a reasonable investor would have considered significant, and foreseeability is generally from the plaintiffs point of view because, once reliance and scienter are proven, the defendant is *235presumed to anticipate the apprehensions of a reasonable investor.3
Loss causation in the context of federal securities law thus requires consideration of the significance to a reasonable investor of the truth compared to the content of the misrepresentations or omissions. If the significance of the truth is such as to cause a reasonable investor to consider seriously a zone of risk that would be perceived as remote or highly unlikely by one believing the fraud, and the loss ultimately suffered is within that zone, then a misrepresentation or omission as to that information may be deemed a foreseeable or proximate cause of the loss. This is all that is meant by our rule “that the damage complained of be one of the foreseeable consequences of the misrepresentation.” Manufacturers Hanover, 801 F.2d at 21 (citing Marbury Mgmt, 629 F.2d at 708).
A major source of confusion in this regard is the use of causation language. The issue is not whether a misstatement “caused” a loss. Rather, the issues are: (i) whether a reasonable investor would find the total mix of information so significantly altered by the truth as to apprehend a zone of risk that would seem remote to an investor still under the spell of misstatements, and (ii) whether the ultimate loss falls within that zone of risk. For example, losses due to insolvency, much less insolvency itself, are not “caused” by misrepresentations. Currently insolvent firms may (often do) survive and ultimately prosper if skillfully managed. But if a firm is not so fortunate after an investor has been misled as to solvency, the investor should not be denied recovery on the ground that it was management’s lack of skill rather than the false assurances of solvency that “caused” the loss.
Our cases are quite consistent with this analysis, notwithstanding language in some that takes a more cramped view of loss causation. See, e.g., Bennett v. United States Trust Co., 770 F.2d 308, 313-14 (2d Cir.1985) (failing to find loss causation when “the misrepresentation neither induced the purchase nor [was] related to the [security’s] value”). For example, in Manufacturers Hanover, an auditor overstated the solvency of a firm causing the plaintiff banks to enter into repurchase agreements (“repo’s”) involving government securities with the firm. See 801 F.2d at 21-22. We affirmed a jury’s loss causation finding, even though the misrepresentations involved the value of neither the underlying securities being traded nor any investment in the firm. See id. at 22. We reasoned that because the repo’s were “in connection with the purchase or sales of securities,” 15 U.S.C. § 78j(b), and the misinformation concealed the risk that the firm could not complete the transactions, there was loss causation. See Manufacturers Hanover, 801 F.2d at 20, 22.
Moreover, in Marbury Management, we found loss causation where a defendant falsely represented to the plaintiffs who purchased securities on his recommendation that he was a “security analyst” and “portfolio management specialist.” 629 F.2d at 707. We acknowledged that the securities did not “lose value because [the defendant] was not a registered representative” but rather because the market for these securities collapsed apparently as a result of ordinary business losses. Id. at 708. When the plaintiffs inquired about the poor performance of the securities, they were advised by the same defendant that their prices would go up. See id. at 708 n. 2. We held that, as a result, the misrepresentations induced not only the purchase of the securities by the plaintiffs but then' retention as well. See id. at 708, 710. Explaining that a defendant’s false representation of a fact like his expertise must be analyzed in the same way as a fraudulent representation about the intrin*236sic worth of a security, we held that the defendant had proximately caused the plaintiffs loss. See id. at 708-10.
In Marbury Management, investors were deprived of a bargained-for-risk-profile, ie., a portfolio selected by a trained specialist. Instead, they got a portfolio with a significantly greater risk of poor performance because of the lack of the advertised skill, experience, and expertise in selecting it. To be sure, recovery would have to be denied if the ultimate losses were related to a different risk, such as an uninsurable natural disaster. Nevertheless, no purpose of the securities laws would be served by denying recovery because the concealed zone of risk was the heightened likelihood of failure of different firms in the portfolio, albeit due to business-related causes unique to each firm.
IV
I turn now to the application of these principles to the present case. I address the situation as it existed in 1990, when appellants made their first purchase of JWP notes within the limitations period.
Finance is about risk probabilities — ie., risk allocation, diversification, and minimization. Every lender, when deciding whether and on what terms to make a loan, must evaluate the probability of default. See Daniel R. Fischel, The Economics of Lender Liability, 99 Yale L.J. 131, 134 (1989). When appellants invested in JWP, they bargained for a certain risk profile that governed the decision to lend and matters such as maturity and interest rate. They also bargained for E & Y to monitor JWP’s compliance with GAAP and for contractual rights, including acceleration, that might cap their losses should JWP default. E & Y’s conduct deprived them of all these bargains and subjected them to concealed risks that resulted in losses.
It appears to have been the district court’s view that E & Y misrepresented only particular financial information. It found that JWP’s misrepresentations as to its financial condition had a calculable effect on the solvency of the firm so marginal that the risk of a default was not significantly understated by the misrepresentations. See AUSA, 991 F.Supp. at 249-50. The court concluded that the risky and mistaken acquisition of Busi-nessland was therefore not within the risks related to those misrepresentations. See id. at 250. If the only material information misrepresented were the treatment of certain financial matters, I would agree. E & Y’s conduct, however, misrepresented far more.
In each successive JWP financial statement, E & Y incorporated by reference prior fraudulent statements. For example, the 10-K prepared for the year ending December 31, 1990 included backward-looking balance sheet and income statement data for the previous five years. See Pl.’s Ex. 17, Part II, Item 6 at 22. The 10-K explicitly incorporated prior financial statements, including the prior year’s balance sheet information and the 1988 and 1989 statements of income, cash flows, and stockholders’ equity. See id. Part IV, Item 14(a), at 47. E & Y specifically represented:
In our opinion, based on our audits, and for 1988 the report of other auditors, the[se] financial statements ... present fairly, in all material respects, the consolidated financial position of JWP ... at December 31, 1990 and 1989, and the consolidated results of operations and cash flows for each of the three years in the period ended December 31, 1990 in conformity with [GAAP],
Id. at 43.
The note purchases at issue here began in 1990. The fraud had been ongoing since 1987, and, by the time of the 1990 purchases, some of the appellants already owned millions of dollars of JWP notes.4 *237A reasonable investor receiving the financial statements (and in two cases no-default letters) would have concluded that: (i) the risk profile established by prior financial statements was accurate and stable; (ii) E & Y was monitoring JWP’s compliance with GAAP in its financial statements, and no default on the outstanding notes had occurred; and (iii) the ongoing monitoring by E & Y might afford some opportunity for appellants to cap their losses should JWP encounter unexpected difficulties. None of these conclusions would have been correct.
If the true facts had become known in 1990, the inferences that a reasonable investor would have drawn would not have been limited to adjusting the estimated risk of default by discounting the dollar value involved in the misrepresentations. Obviously, the total mix of information relevant to such an investor would have been radically altered. A reasonable investor would have concluded that JWP had a management quite willing to misrepresent systematically its financial condition and an auditor willing to certify the misrepresentations.5 The note provisions requiring the auditor to certify the lack of a default annually would have been deemed worthless. Absent an auditor willing to do its duty, such an investor would attribute no value to contractual rights to take certain action in the event of default because a fully-informed exercise would not be possible. The purchase of yet more JWP notes would have been out of the question in light of the true information. Indeed, in discussing the “investment grade” rating assigned to JWP’s securities, the district court found that “[i]f 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.” Findings ¶447, at 2606. A reasonable noteholder would also have seriously contemplated the wisdom of retaining its present JWP notes and the need to invoke its powers under those notes, including acceleration.
The pattern of such misrepresentations itself created another risk to appellants that a reasonable investor would take into account. The management of a firm like JWP would have apprehended that, while such misstatements would reduce borrowing costs for a time, in all likelihood corrections in statements for prior years would eventually have to be made. The true financial condition of the firm would then be exposed, as would the misdeeds of JWP’s management and E & Y. Investors’ and analysts’ evaluation of JWP would reflect both facts. Moreover, JWP’s management and auditor would know that the corrections would reveal defaults on outstanding notes and perhaps trigger the exercise of the noteholders’ contractual rights, including acceleration. (Indeed, the Businessland acquisition could not have proceeded if the default on the notes had been known, absent a cure by JWP— admission of years of fraud — or waiver by appellants.)
For a management facing such circumstances, the temptation to seek salvation in a risky deal is greatly heightened. Only a very profitable new venture could offset the effect of revelations of past financial misstatements and systematic fraud by existing management and the firm’s auditor. *238To be sure, such a deal would also have a vast downside, but even the prospect of a financial collapse might not seem to management all that different from the circumstances that would prevail if profitability were not substantially increased before disclosure of the fraud.6
In short, when appellants began in 1990 to purchase the notes at issue, they were investing in a firm with compelling incentives that rendered it far less risk averse than the information certified by E & Y suggested. The chance that a highly risky venture would.be undertaken that might lead to a default was far greater than could have been reasonably inferred from the false financial statements and no-default letters, and the contractual rights that might have minimized such a loss were in reality worthless.
Taking this view of the case, I have little difficulty in concluding that loss causation was amply shown. The essentials of appellants’ bargain were a particular risk profile and contractual rights to monitor the debtor. The risk profile was false in that relevant financial information was misstated and the diminished risk averseness of the firm concealed. The contractual rights were rendered valueless because misstatements concealing existing and future defaults would forestall their exercise. In my view, therefore, the collapse of JWP as a result of the Businessland venture was well within the zone of risk concealed by the misrepresentations.
We would not stretch or strain our precedents in so holding. The nexus between the information concealed and the ultimate loss in the instant case is far stronger than it was in Marbury Management. There, the reason for the decline in the value of the securities was the simple failure of the firms to prosper, and liability rested on the false risk profile of expertise in portfolio selection alone. See 629 F.2d at 707-08. Here, the fraudulent scheme itself secretly altered the firm’s risk averseness, concealed existing defaults, and denied the investors an opportunity to make an informed exercise of their contractual rights. In Marbury Management, the plaintiffs retained the securities after receiving assurances from the defendant that their poor performance would improve. See id. at 708 n. 2. Here, appellants retained the notes after the assurances contained in the no-default letters and financial statements.
Moreover, in Manufacturers Hanover, we found loss causation where the defendant accountant overstated the capitalization of a firm, causing the plaintiff bank to enter into repo’s with the firm. See 801 F.2d at 16. Although Manufacturers Hanover involved no misrepresentation as to the value of the government securities traded or as to any investment in the firm, we upheld a liability verdict challenged on loss causation grounds. See id. at 21-22. In the instant matter, the misrepresentations concerned the financial condition, risk incentives, and quality of management and auditor of a firm in which investments were made.
I add three thoughts. First, the view of loss causation advanced by E & Y is entirely counterproductive — indeed ranging from perverse to bizarre — so far as the purposes of the securities laws are con*239cerned. Had E & Y come forward just before the Businessland acquisition and admitted the truth, it would have been exposed to substantial liability — namely, the difference between the price paid for the notes and their very diminished value resulting from the disclosure of a less favorable financial condition and of the years of fraud by management and E & Y. By concealing the truth until the final collapse, E & Y (and JWP if it were solvent) entirely escapes any liability. Under E & Y’s theory, therefore, firms and auditors like JWP and E & Y have every incentive both to continue the fraud and to make riskier gambles in the hope of salvation. If the risks pay off, then equityholders rather than debtholders reap the rewards of the unbargained-for risks; if not, management and the independent auditor escape liability for the fraud altogether. In other words, all the excess risk caused by the auditor’s ongoing fraud is shifted to the victims of the fraud. E & Y’s view of loss causation is thus a rule that encourages the continuance — even escalation — of fraud at the price of increasing the potential loss to lenders.
Second, this is not a weak case for liability. In a significant number of securities cases that federal courts see, the harmful nature of the misrepresentation or omission is far more doubtful, and little actual recovery on the part of investors is expected. See, e.g., Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements in Securities Class Actions, 43 Stan. L.Rev. 497, 505-23, 528, 547-48 (1991); Jonathan R. Macey & Geoffrey P. Miller, The Plaintiffs Attorney’s Role in Class Action and Derivative Regulation: Economic Analysis and Recommendations for Reform, 58 U. Chi. L.Rev. 1, 3 (1991) (“[The private action] regulatory structure is poorly designed in a number of respects, particularly when applied to ‘large-scale, small-claim’ litigation in which the overall liability is large but the individual interests of the class members orcor-porate shareholders are small.”); cf. A.C. Pritchard, Markets as Monitors: A Proposal to Replace Class Actions With Exchanges as Securities Fraud Enforcers, 85 Va. L.Rev. 925, 928 (1999) (“In the typical [fraud on the market] case, the corporation has neither bought nor sold its securities, and, accordingly, has not benefited from the fraud.”).
It is an atypical proxy case, for example, in which anyone really thinks that the actual shareholders’ vote might have been different if the particular information had been restated or included. And the main financial beneficiaries of class action litigation involving allegations of misleading proxies are generally counsel for the plaintiff class and for the defense. See Alexander, 43 Stan. L.Rev. at 597 (“[E]vidence seems to show that derivative actions tend to be resolved ... with no tangible economic benefit to the corporation, plus large attorney’s fees.”). In the instant matter, however, the systematic fraud was directed by E & Y specifically at appellants, who have each lost millions of dollars.
Finally, my view of loss causation is not a limitless theory imposing liability for every act of aggressive accounting. The district court found that the fraud began at least with the annual report for 1987. The notes at issue were purchased in 1990 or later. The misrepresentations at issue had thus gone on for more than two years when the notes were purchased and for almost four years at the time of the Busi-nessland acquisition. That pattern of auditor acquiescence in management fraud is sufficiently longstanding to create the greatly diminished risk averseness discussed in this opinion. In cases where fraudulent accounting acts are isolated and short-run, my view of loss causation would be altered accordingly.7
I therefore respectfully dissent.

. In my view, the district court clearly found a lack of forseeability at several places in its opinion. I really don’t understand what the district court can add to statements such as the "losses that JWP’s noteholders sustained [were] as a result of unforseeable and independent post-auditevents, and not because of fiscal infirmities ... concealed by JWP's misleading financial statements.” 991 F.Supp at 250. I need not dwell on this issue, however, because I disagree with the district court.

. The Note Agreement’s definition of total capitalization specifically subtracts intangible assets from JWP's total net worth. See id. ¶ 10B, at 48-49. The misrepresentations at issue would have even greater effect on JWP’s Debt/EBIT ratio than its Debt/EBITDA ratio, because the misleading amortization items would not be backed out of EBIT figures.

. I recognize of course that a different test might — or might not — be appropriate in a common law fraud claim.

. Two appellants in the federal claim, AUSA and Prudential, had outstanding notes at the *237time of their 1990 purchase. See Findings ¶¶ 1, 10, at 2467, 2469-70. Appellant Monumental Life first purchased notes in 1990, see id. ¶ 5, at 2468, and appellant Modern Woodmen first purchased notes in 1992, see id. 8, at 2469; thus, these appellants relied on fraudulent past financial statements but not no-default letters in purchasing the securities.

. Judge Jacobs speculates that E & Y could have issued a corrected statement of accounts for several years but would not have had to disclose that management had corruptly insisted on the earlier false statements. Even if that is so — and I am not sure that it is — such an extensive correcting of earlier years’ books without any explanation would likely have had the same consequences as a full explanation for their need. Of course, any explanation that omitted a reference to management’s role would have been yet another fraudulent misstatement.

. JWP’s diminished risk aversion is no more than a variation on the familiar principle that highly leveraged firms are less risk averse than similar firms with less debt. "The existence of debt creates an incentive for borrowers to invest in riskier projects. This incentive arises because the lender bears the downside risk if the project turns out poorly, but he does not share in the upside potential if the project turns out well." Daniel R. Fischel, The Economics of Lender Liability, 99 Yale L.J. 131, 134 (1989). "This incentive to invest in risky projects is a direct function of the amount the borrower has at risk.... In the extreme case ... the firm has nothing to lose and everything to gain by adopting a ‘shoot the moon' investment strategy.” Id. JWP was in effect more highly leveraged than its debt investors had been led to believe. The equity base was less than advertised. Moreover, disclosure of the fraud would have driven down equity prices and dried up access to equity capital.

. In light of the majority’s decision, I need not address the measure of damages to be *240derived from my theory of loss causation.