Escott v. BarChris Construction Corp

Brief Fact Summary. Having implemented due diligence when formulating a registration statement on behalf of BarChris (Defendant), the multiple principals and professionals involved argued that they were relieved from liability for the mistakes in that statement.

Synopsis of Rule of Law. Those accountable for an inaccurate registration statement may be relieved of liability if they implemented due diligence in its formulation.

Facts. Bowling alley construction business, BarChris Construction Corp., had multiple financing agreements that they used in the sale of alleys to purchasers. Triangular sales and sale-leaseback agreements were regularly used. Continuous replacement of working capital became a need for BarChris due to the nature of the sales. In 1961, BarChris issued 15 year debentures to increase capital. Following the law, a registration statement was created, containingBarChris’ assets for 1960 and the first quarter of 1961, this statement, however, includingabundant mistakes. It utterlyexaggeratedsales, net income, and earnings per share while not revealing particular unpaid debts, customers’ misbehaviors, and specific operative facets of BarChris. BarChris ultimately filed for bankruptcy after going broke. A class of the debentures buyers filed a suit seeking recessionary damages under § 11 of the Securities Act, with several defendants moving to dismiss. [The Court looked into every defendant very thoroughly, with a summation as follows: Kircher was the treasurer and CFO for BarChris, he was aware that a part of the 1960 auditing numbers were wrong; that there was a customer misbehavior problem, among many other items of note, he was cognizant of the pertinent facts. Birnbaum was house counsel and assistant secretary, whom signed amendments to the statement. He depended on Kircher for the nonaudited segments of the statement but with no privateunderstanding of the books or monetary transactions. Auslander was a nonofficer-director who signed amendments to the statement without first reading them, depending on theaffirmations of Kircher that they were accurate. The director and outside attorney for BarChris, Grant, drafted the registration statement, relying on numbers from an audit by Peat, Marwick. In regards to nonaudited numbers, he depended on the word of multiple BarChris officers as to the authenticity.  He never began an investigation of the books or contracts. Drexel & Co was the main underwriter; Coleman was director of BarChris and partner of Drexel & Co; and Ballard, a Drexel attorney, all were dependent on Kircher’s affirmations as to the truth of the nonaudited portions of the statement, without making an independent inquiry. Peat, Marwick was the auditor of the 1960s figures. It failed to observe its own internal standards or even regularly recognized auditing standards. It did not realize that one venture had not been purchased, and thus that sales had been exaggerated and liabilities minimized.]

Issue. If due diligence was implemented in the formulation of the inaccurate registration statement, may those accountable be relieved of liability?

Held. (McLean, J.) Yes. If due diligence was implemented in the formulation of the inaccurate registration statement, those accountable may be relieved of liability. § 11(b) of the Securities Act excuses from liability if the person can demonstrate, having sections of a registration statement drafted by an expert, that he had no plausible foundation for trusting it included mistakes or missing information sections outside his proficiency.  If he led a judicious investigation and had no grounds for trusting the statement to have been a mistake, he may cite the subsection. In establishing if any defendant met the criterion of § 11(b), each defendant must be independently evaluated. Kircher’s inability to depend on § 11(b) was obvious; he knew all the pertinent facts and that both the expertised and non-expertised portions of the statements were erroneous but Birnbaum did not know that expertised portion was incorrect and so can evoke § 11(b). Regarding the nonexpertised portion, he did not make a reasonable investigation; he merely depended on Kircher’s assertions. § 11(b) was not available for use due to the aforementioned failing to constitute due diligence. Birnbarn and Auslander had the same positions in that while they could depend on § 11(b) with regard to expertise sections but due to failure to make a reasonable investigation could not depend on the nonexpertised sections. As the main preparer of the statement, Grant had a greater duty to lead a reasonable investigation, he depended on Peat, Marwick’s audit of the numbers in 1960 and was unaware that they were wrong, which meant that he could apply § 11(b) with these sections. In regard to nonexpertised sections, he was under an affirmative duty to examine BarChris’ books to determine the accuracy of the figures BarChris officers had provided him, he failed to do so and as a result could not apply § 11(b). As underwriters, Drexel & Co. had a duty to conduct a reasonable investigation, and because of failing to do so, could not apply § 11(b). Finally, the same goes for the Drexel associated individual defendants, Coleman and Ballard, while Peat, Marwick failed to conduct an audit in accordance with usually recognized auditing principles, as instructed, so lost protection under § 11(b). In conclusion, S§ 11(b) protection is not afforded to any of the parties trying to obtain it due to them lacking ample diligence. Motions denied.

Discussion. Section 11 is a lengthy, complex stipulation and is most coherent when examined from the point of view of individual defendants. Generally, when a violation of § 11 occurs, the issuer will be experiencing financial troubles and because of this a plaintiff will try to join more financially sound defendants, like in this case. Aside from the issuer, the defendants were categorized as nonexperts or experts. An expert may be met with the affirmative defense of due diligence and/or reliance. Meeting the onus of truth needed for these defenses vary on both the expert and nonexpert label of the defendant and the location of the fabricated statement in an expertised or nonexpertised section of the registration statement. As showcased here, deciding where the expertised portions are and what an expert is. Usually, those sections of the registration created upon the authority of an expert are visibly prefaced, however, whether self-proclaiming acts like this hold up in court has yet to be tested. A significant feature of this case is the omission of the attorney’s work product from the expertised sections, seeing as even though attorney’s who inform the legality of the specific security is providing a sort of expertise, Grant’s contribution was determined nonexpert. This categorization in BarChris caused the loss of a due diligence defense for all the defendants who were dependent upon counsel for advice. In this case, the underwriters could not form a due diligence defense because they were lacking in their investigation with the court mentioning that the underwriter’s reputation is frequently an influential feature to investors and so cannot uphold an inactive role in the distribution. It is not out of the ordinary that an underwriter is required to assume some type of policing duties since they occupy an indispensable role. The underwriter would usually hold a “due diligence†meeting just prior to the effective date when they would ask relevant questions to the directors and officers. BarChris makes it apparent that this is not a reasonable investigation. Since this case, underwriters have been trying to contractually push liability back to the issuer’s officers and counsel. The honesty of the registration statements is affirmed by the written opinions of the directors and counsel as required by the underwriter. Accountants and other experts are most susceptible to § 11 liability because they make complex and extensive investigations of the issuer’s finances. As evidenced here, an issuer may try to hide financial troubles and therefore cannot be depended upon. An attorney is also a director in BarChris, however it is becoming more common that while an issuer is in registration, an attorney may reject a directorship even though with cross-claims for malpractice it is unlikely that they will elude liability. S 11 makes no difference between inside and outside directors, even though Auslander was outside and new, BarChris held him liable. It is apparent that the more enmeshed a director is the more that is required to sustain his due diligence defense.