Spectrum Financial Companies v. Marconsult, Inc.

608 F.2d 377

• Court: Court of Appeals for the Ninth Circuit
• Decided: November 14, 1979
• Docket: Nos. 76-2546, 76-2651
• Status: Published

Opinions

EUGENE A. WRIGHT, Circuit Judge:

Spectrum Financial Companies, the general partner of two limited partnerships, sued under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j (1976), and § 17(a) of the Securities Exchange Act of 1933,15 U.S.C. § 77q (1976), alleging that Marconsult, Inc. and its accounting firm, Harris, Kerr, Forster and Company (HKF), made false and misleading statements regarding the value of Marconsult stock which Spectrum’s limited partners received in exchange for oil and gas leases. Several limited partners intervened.

The district court refused to certify as a class Spectrum and its limited partners and granted HKF’s motion for summary judgment.

We affirm the denial of class certification and reverse the grant of summary judgment. The case is remanded for reconsideration in light of Nelson v. Serwold, 576 F.2d 1332 (9th Cir.), cert. denied, 439 U.S. 970, 99 S.Ct. 464, 58 L.Ed.2d 431 (1978).

FACTS

In January, 1972, Spectrum entered into an agreement with Marconsult. The limited partners agreed to exchange their interests in oil and gas wells for common stock and debentures of Marconsult. The agreement was conditioned upon qualification of the securities with the California Commissioner of Corporations and upon approval of the exchange by 75% of the limited partners.

In March, 1972, Marconsult applied to the Commissioner for a permit to issue its common stock and convertible notes to Spectrum. Two days later, Marconsult hired HKF to audit its financial condition and render an opinion for the 1971 calendar year.

On May 8, HKF delivered to Marconsult draft copies of a financial statement for the calendar year 1971, together with its audit report dated April 24, 1972. The 12-month statement was unfavorable, disclosing that Marconsult had but $57,000 in sales and had suffered a loss of almost $250,000 during the year.

The Commissioner’s hearing took place on May 16. Marconsult did not distribute the financial statement to Spectrum and the limited partners or submit it for the consideration of the Department. Following the hearing, the Deputy Commissioner indicated that the application stood submitted pending the filing of additional financial data. HKF delivered to Marconsult its opening letter, with financial statements, on May 24.

The report was furnished to no one outside Marconsult. Instead, the company requested HKF to prepare and certify new financial statements covering a 16-month period from August 31, 1970 to the end of 1971.

Meanwhile, despite the fact that no additional financial data were submitted to the Department, the permit to issue securities was granted on June 22. It contained a legend severely restricting the transfer of the securities in the limited partners’ hands.

HKF delivered the 16-month financial statement to Marconsult in early July. It incorporated more than $200,000 of business conducted during the four months before the beginning of the 1971 calendar year. As a result, it was considerably more favorable than the 12-month report. HKF’s new opinion letter followed on July 18.

Spectrum received the requisite 75% approval on July 10. None of the accepting limited partners had seen any of Marcon-sult’s financial statements, and the 16-month report had not been disseminated outside Marconsult as of that date. On August 17, nevertheless, Marconsult applied to the Commissioner for an order removing the restriction on transfer, and the 16-month statement was submitted as part of the application. The Commissioner removed the restriction.

The exchange took place in October 1972. In July 1973, it was apparent that Marcon-sult had fallen drastically short of its income projections and was virtually insolvent.

Spectrum filed suit, alleging that Mar-consult and HKF violated federal securities laws by failing to disclose the shaky foundation of Marconsult’s stock. Spectrum’s limited partners moved for an order certifying them as a class. The motion was denied as was a motion for interlocutory appeal. Fifty-six of the 92 nonparty limited partners then filed a new action, and the two actions were consolidated for trial.

HKF moved unsuccessfully for summary judgment in December 1975. In March 1976, the Supreme Court decided Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976). HKF renewed its motion on the basis of the scienter requirement of that case and this time summary judgment was granted.

SUMMARY JUDGMENT

Summary judgment is appropriate only where there is no genuine issue as to any material fact. Fed.R.Civ.Proc. 56; Lane Bryant v. Maternity Lane, 173 F.2d 559, 565 (9th Cir. 1949). All inferences that can be drawn from the depositions, admissions, and affidavits on file must be viewed in a light most favorable to the party opposing summary judgment. United States v. Diebold, Inc., 369 U.S. 654, 82 S.Ct. 993, 8 L.Ed.2d 176 (1962).

A genuine issue must be predicated on a viable legal theory. McGuire v. Columbia Broadcasting System, Inc., 399 F.2d 902, 905 (9th Cir. 1968). In this circuit, prior to Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976), scienter was not a necessary predicate for liability under § 10(b) and Rule 10b-5. See, e. g., White v. Abrams, 495 F.2d 724, 734-35 (9th Cir. 1974). We applied a “flexible duty” standard incorporating many factors to determine whether the defendants had a duty to disclose information relevant to the purchase or sale of securities. Id.

The district court denied summary judgment under the applicable Ninth Circuit standard, but granted it after Hochfelder clearly established that scienter is an element of Rule 10b-5 violations. Because this change in the applicable legal standard was the only event intervening between the denial and grant of summary judgment, we must assume that the trial court believed there were genuine issues of material fact under the old standard but that appellants failed to establish a genuine issue with respect to scienter.

Scienter

Appellants argue that the trial court erred in interpreting too strictly the scien-ter requirement. They contend that the element of scienter may be established by proof of reckless behavior, and that the pleadings and depositions on file raise a genuine issue of material fact as to whether HKF acted recklessly in supplying Marcon-sult with the 16-month statement.

In Hochfelder, the Court reserved the question whether “reckless behavior is sufficient for civil liability under § 10(b) and Rule 10b-5.” 425 U.S. at 193-94 n.12, 96 S.Ct. 1375,1381, 47 L.Ed.2d 668. This court answered the question affirmatively in Nelson v. Serwold, 576 F.2d 1332 (9th Cir.), cert. denied, 439 U.S. 970, 99 S.Ct. 464, 58 L.Ed.2d 431 (1978).

Nelson contains a thorough discussion of the scienter requirement and the effect of Hochfelder. We concluded that “recklessness, or some degree of intent not sufficiently aggravated to be characterized as ‘deliberate and cold-blooded’ ” would support liability under § 10(b) and Rule 10b-5. Nelson v. Serwold, 576 F.2d at 1338. Our holding is in accord with those of other circuits. See, e. g., Edward J. Mawod & Co. v. Securities & Exch. Com’n, 591 F.2d 588, 596 (10th Cir. 1979); Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 46 (2d Cir. 1978); Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir.), cert. denied, 434 U.S. 875, 98 S.Ct. 224, 54 L.Ed.2d 155 (1977).

The district judge did not have the benefit of our decision in Nelson when he granted summary judgment. He did not indicate whether he examined the depositions in light of a recklessness standard or required some stricter showing of intent. We believe that he should have the opportunity to determine, in the first instance, whether appellants have raised a genuine issue of material fact with respect to whether HKF acted recklessly. We must reverse the grant of summary judgment and remand for reexamination in light of Nelson v. Serwold.

Duty to Disclose

Beyond the issue of whether or not appel-lees were “reckless” is the question of whether they had any duty to disclose material information to appellants. In White v. Abrams, 495 F.2d 724, 735-6 (9th Cir. 1974), this court delimited the duty owed by a given defendant to a given plaintiff. Our recent decision in Zweig v. Hearst Corp., 594 F.2d 1261 (9th Cir. 1979), restated the White “flexible duty standard”:

[these] factors are relevant in determining the scope of the duty to disclose material facts under Rule 10b-5: (1) the relationship of defendant to plaintiff; (2) defendant’s access to the information as compared to that of plaintiff; (3) defendant’s benefit derived from the relationship; (4) defendant’s awareness of whether plaintiff was relying on their relationship in making his or her investment decisions; and (5) defendant’s activity in initiating the transaction in question.

Id. at 1268.

A brief application of the present facts to this standard reveals that there was at least a triable issue of fact as to whether appel-lees owed appellants any duty.

1. Relationship of Plaintiff to Defendant.

While the relationship was indirect, it surely existed. HKF knew that a buyer had been found for what was essentially worthless stock. It also knew that without a buyer for its stock, Marconsult would not be in a position to pay HKF’s fee. HKF’s strong incentive to make Marconsult “look good” on paper created a relationship with any potential buyer not unlike the relationship in Zweig, where a financial columnist had a strong incentive to make a particular merger appear attractive to his readers. We there held that the columnist owed a duty to disclose to his readers his interest in the merger.

2. Defendant’s Access to Information.

It goes without saying that an accountant has greater access to a company’s financial data than a potential purchaser. Appellees note that the limited partners could have obtained any needed information by utilizing the subpoena power of the Commissioner of Corporations. Even if they had done so, however, they would not have obtained the data as easily as could HKF, nor would they be as skilled in interpreting the raw data.

3. Benefit to Defendant.

As noted above, in light of Marconsult’s bleak financial picture, it seems clear that HKF’s fees might not have been paid had a buyer not been found.

4. Defendant’s Awareness of Plaintiff’s Reliance.

In initially approving the exchange, the Commissioner severely restricted the transferability of the stock. After he read the 16-month financial statement prepared by HKF, he removed the restriction. This gave rise to a triable issue of fact as to the impact of the financial statement both on the Commissioner and on appellants. As noted earlier, the entire transaction was conditioned on the Commissioner’s approval, as HKF well knew. If appellants relied on HKF’s statement, it is logical to conclude that appellants relied on HKF, and that HKF knew of this reliance.

5. Defendant’s Initiation of the Transaction.

This factor is clearly not relevant here, as HKF was consulted only after the transaction was under way. Nevertheless, enough of the factors comprising the “flexible duty standard” are present to conclude that there is a triable issue of fact as to whether or not HKF owed a duty to appellants. Summary judgment was therefore inappropriate.

CLASS CERTIFICATION

Appellants also protest the district court’s denial of class certification.

Rule 23(a) of the Federal Rules of Civil Procedure sets forth these prerequisites to a class action:

(1) the class must be so numerous that joinder of all members is impracticable,

(2) there must be questions of law or fact common to the class,

(3) the claims or defenses of the representative parties must be typical of the claims or defenses of the class, and

(4) the representative parties must fairly and adequately protect the interests of the class.

The determination whether a class should be certified should not be overturned on review unless it is shown that the district court abused its discretion. Hornreich v. Plant Industries, Inc., 535 F.2d 550, 552 (9th Cir. 1976).

Appellants have asserted that joinder of the limited partners is impracticable. Following denial of class status, however, Spectrum was able to reach all 92 limited partners, 56 of whom joined in the second lawsuit that was later consolidated with the original action. This indicates that joinder was not impracticable. Moreover, it may indicate that several potential members of the class did not wish to pursue their claims, despite the fact that it would cost them nothing.

Appellants also contend that all questions of law or fact in the case are common to the limited partners. There is evidence in the pleadings that the several intervenors relied on different communications when they decided to approve the exchange. Some of the representations made to them were by Spectrum, and there may have been reason for the trial judge to believe that the interests of these parties would be in conflict if the case went to trial. Although it appears that most of the issues are common to all potential members of the class, the judge did not abuse his discretion in denying certification.¹

We affirm in part, reverse in part and remand the case to the district court for proceedings in accordance herewith.

1 . HKF claims that because all 92 of Spectrum’s limited partners received notice of the second lawsuit, and because 56 of them elected to join it, the class action question is moot now that the two cases have been consolidated. Thirty-six potential members of the class are not parties to the lawsuit. The issue is not moot unless all potential members of the class are parties.