*1 FUND, INC., REPUBLIC TECHNOLOGY Plaintiff-Appellant,
v. CORPORATION,
The LIONEL Defendant-Appellee. INDUSTRIES,
The NEW ENGLAND INC., Plaintiff-Appellant,
v. CORPORATION,
The LIONEL Defendant-Appellee. 529, 530, 72-1901,
Nos. Dockets 72-1902. Appeals,
United States Court of
Second Circuit.
Argued March 1973. July 17,
Decided *2 family claiming the bride’s
groom failed disclose a number of lia- negotiations bilities at time of leading up nuptials. appeal judgment absolving appel- is from a liability lee from under either contrac- tual or securities law connection with *3 (six months’) an interim financial state- proxy ment, used in materials and in a registration statement, prepared relative merger Hathaway Instruments, (“Hathaway”), Inc. into The Lionel Cor- (“Lionel”). poration Appellants were Hathaway. prin- stockholders Their cipal in- claim below and here is that (and terim statement hence the registration statement) materials artificially it in- earnings flated because it did not reflect $2,221,000 adjustments year’s that at ultimately required end were and also because it contained no write-off of subsidiary losing will of a mon- that was ey essentially at the time. The in- case therefore, volves, scope corpora- of a duty tion’s to make its interim financial accurately reflect the real prior merger, state of fiscal affairs to a or, put way, another the extent to which adjustments in an interim statement year’s that are or should end be made at anticipated. must be I. FACTUAL BACKGROUND AND PROCEEDINGS BELOW. Appellants are both investment funds. Orans, Elsen, Pol- Elsen & Sheldon H. Appellant Republic Technology July, City (Lewis Shapiro stein, York New 1960, purchased 25,000 shares com- City, Lupert, York and Leslie A. New Hathaway. mon stock in stock This brief), plaintiffs-appellants. for registered agreed Hathaway had Connelly, Tolan, Olwine, E. James to use its best efforts it to cause Weyher, York Chase, New registered request Republic O’Donnell from City, City (Judith Kaye, York New Technology. Appellants S. between them defendant-appellee. brief), purchased on the 40,000 later another shares Hathaway March, stock in 1961.1 In re- HAYS, MULLIGAN Before turn, Hathaway agreed that it would Judges. OAKES, Circuit prepare Regis- and file with SEC a Judge: OAKES, Circuit tration for the on or Statement stock be- May 15, 1961, fore use would unhappy aftermath This case is the reg- marriage gone sour, corporate with its best efforts the end that such Hathaway-Lionel merger 1,022,727 Hatha on November 1. There shares way date of as of the stock effective ef- would and remain nel filed its istration become period of not than 24 the for a less SEC. fective thereof. from the effective date months Meanwhile, however, unaudited finan- register request required un- No peri- cial the six statements for months’ 1961,purchase. March, der ending pre- 20, 1961, od had been pared Hathaway for Lionel and and a toy and the well-known Lionel was pro period combined had forma that, some after manufacturer train figures prepared. also been These operations, years entered of successful showed a six months’ loss for Lionel of corporate acquisitions, program of into a per $84,000 or share a com- $.06 Electron- Anton-Imco of which was one pro profit $245,000 or bined forma Corp., Intercon- in turn owned ics It share. omission $.08 Manufacturing Co., Inc., and tinental adjust- Lionel statement to show certain Inc. Electronics Laboratories Anton into ments made at end or to take (Anton-Imco its two subsidiaries adjustment way account to Anton- collectively referred sometimes are *4 good subsidiary’s Imco will that losses or “electron- as the “Anton-Imco” herein controversy that is the of here. crux Lionel.) to Further of ics division” complicate little, Anton a The interim used in matters statements were corporate agreement merg- Inc. connection with Electronics Laboratories changed September 15, in March of er dated name 1961. Under its was agreed Inc. Laboratories Lionel Lionel terms to file on or before to Electronic Labs”), 15, registration re- (hereinafter 1961, “Lionel October a state- covering acquired a subsidi- Intercontinental ment Hathaway all stock mained made ary by pre- Lionel Labs of Anton-Imco. stockholders which measuring agreement de- Hathaway legally and “radiation detection vious was obligated register. agreed and electro-me- to vices” “electronic Lionel also Hathaway’s obligations manu- devices.” Intercontinental to undertake chanical components. missile factured aircraft and effectuate and maintain the effective- together provided, appar- registration ness of a These last two statement. “glamor” corporate figures ently, some same six in months’ were used acquisitions proxy in- package. Lionel Other materials submitted to Hatha- concern, fishing Airex, way tackle cluded a and Lionel stockholders to obtain components” Telerad, approval merger, ap- “microwave their Hathaway Up proval 25, 1961, the ultimate ensued concern. on October effec- November, merger 1961, 6, They the stock tive on November 1961. also selling registration statement, at to four Lionel had been two used were despite S-l, Sep- its book the fact times value Form filed with 1961, 28, 30, 1961, by interim state- Lionel. June tember Pursuant even losing merger dispute exchanged appellants here Lionel their ment money was during 65,000 Hathaway the first six months shares of common for 21,667 pre- 1961. shares of convertible 3%'% ferred stock of Lionel. merger, appellant Prior the Lionel adjustments There Technology option were a number of Republic its exercised Hathaway 31, 1961, recorded as of December as request registration of its year-end result of the of events May 7, audit or and on or about shares occurring during registration quarter the fourth Hathaway statement. filed a these, appellants merger 1961. Of the ones most Lionel discussions with When insistently however, re- claim should been have commenced flected in the June 30 interim statement Hathaway permission requested from registration are: this the SEC withdraw permission Inventory was In Lio-
statement. This write-downs: toy granted September Lio- $262,830 until when nel’s and train late division inventory government obsolescence was written down and one contracts item quarter $51,369. in the fourth or written off as $140,000 31; at December was a write- Appellants point $30,000 out that each price variance,” off- as “raw material adjustments prof- would reduced $77,946 was a write-down lower of shown materials market; cost or and the rather remarka- per one cent $256,000 ble sum of off written as (of merged company). share In- “unlocated difference between December year-end deed, adjustments after physical inventory.” 1961 book and actually made, were without even count- $100,000 In Lionel’s Telerad division ing any write-down of Anton-Imco inventory off in was written the fourth will, profit expected the consolidated quarter $440,000 required to be be shown interim statement be- year’s off at written end. In Lionel $1,898,609, came a loss in the sum of in in- Labs was written down and when added to this ventory year’s end. The total of special charges, the overall loss totaled yras $1,476,776. these write-offs over million or share.2 $2.5 $1.71 2. Sales returns A allowances: sitting court, The district without provided total of jury, appel- took' from both end for sales returns allowances accounting Duchan, expert, lants’ Mr. toy and train division and Airex Easton, manag- and from Mr. the senior division. ing accountant D. Leidesdorf & S. development: 3. Research Re- independent (“Leidesdorf”), Co. certi- *5 totaling development search and costs public accountants, fied worked who $226,983 toy in the and train division Lionel in Mr. audits 1960 and 1961. $163,000 and Labs Lionel were writ- preparation Easton testified both to his year’s ten off at end. question of the financial statements advertising selling, 4. Deferred accounting expert. may and as an It expense: service Lionel off wrote surprise not come as a that while Mr. toy expenses these opinion Duchan testified in his year’s train division at end. June 30 should reflected statement have adjustments portion adjustments The total of the above a substantial of the actually year’s end, were made at end is that were made at $2,221,659. ef- Mr. Easton’s was to the fect the interim ac- statement was Appellants also claim that the interim (in being curate addition to in accord- statement: generally accepted ance with the same 5. Should have reflected a write-off accounting principles used Lionel’s An- will attributable to Lionel’s prior finan- statements and its division, ton-Imco at which was carried statements). cial $998,000, despite loss for the opinion print- The in an district court 1961; first six months of (S.D.N.Y.1972) F.Supp. ed at 345 656 greater 6. Should have reflected a plaintiffs (appellants) had held that debts, for bad returns and reserve sales preponderance “not a fair established allowances; Finan- of the evidence that the June 30 materially false or not cial were 7. Should included two Statements any (one to state material credit items returns that Lionel omitted sales coop- necessary fact to make statements allowances and one for misleading.” F.Supp. advertising expense $19,234) not or 345 erative false accounting charges” “special apparently did contractual penses; uniform ex- objected might the hidden not appellants one call them relate the items consolidation, expenses merger. moving,
545
sought
distinguish Kai
It
II. SECURITIES LAW CLAIMS.
at 662.
Corp.
Co., 195
v. Otis
F.2d
ser-Frazer
and Rule
A. Section
Har-9.
H
Cir.),
(2d
denied,
U.S.
cert.
344
838
by agreeing
We
the dis-
commence
(1952), on the
97
664
73
L.Ed.
S.Ct.
judge
respect
treatment of
trict
his
manage
ground that the Kaiser-Frazer
Exchange
Act
claim under Securities
figures in its interim state
ment used
14
The claimed viola-
and Rule 14a-9.
§
they
while
to be untrue
ment that
knew
proxy
tion of the
proxies
rules must fail because
the Lionel
there
no evidence that
respect
“in
not solicited
management
similarly.
345 F.
acted
any
registered pur-
security
.
.
Supp.
found no
at 663. It
violations
of the Act. Securi-
suant
section 12”
1933, 15
17
the Securities Act of
§
Exchange
1934, 14(a), 15
ties
ofAct
§
77q,
10(b) of the Secu
or of
U.S.C. §
§
78n(a);
14a-2,
Rule
17
U.S.C.
§
Exchange
15
rities
Act
U.S.C. §
Loss,
240.14a-2. See L.
Secu-
C.F.R.
5
§
10b-5,
78j(b),
C.F.R.
and Rule
17
§
Regulation
(1969). Thus,
2835-36
rities
240.10b-5,
promulgated
thereunder.
requirement in re-
whatever
spect
scienter
holding
Hathaway proxy
While
damages
private action for
to a
subject
14 of the
was not
statement
§
violation,
Rule
redress a
14a-9
§
78n(a),
Act, 15
and Rule
U.S.C. §
Gamble-Skogmo, Inc.,
see
v.
Gerstle
(since
14a-9,
17 C.F.R.
240.14a-9
§
Cir., May 9,
(2d
at 1299-1301
F.2d 1281
registered),
Hathaway common was not
simply
1973),
liability in
no
plaintiffs
also
had
court
held
proxy-rule
respect to
here.
violations
that the
state
failed to establish
Ob-5,
materially misleading
B.
and Lionel’s
or that
Rule
17§
ment was
Accounting.
necessary
Under
Rule
omitted material facts
Interim
both
had
misleading. 345
of the Securities Act of
10b-5 and
1933,
make it not false
§
however,
77q(a),
respect
F.Supp.
it is
663 n.6.
15 U.S.C.
With
necessary
Lionel
claims,
to determine whether
the court found that
contractual
“any
statement of mate
the interim
were made
untrue
financial statements
materially misleading,
omission “to state a ma
that the
rial fact” or an
pro
necessary
in order to make
fact
Lionel
terial
light
made,
spectus
within a
did
effective
become
*6
they
Further,
the court
which
circumstances under
reasonable time.
misleading.
discharged
made,
.”
.
Were
its obli
held
gation
Lionel had
that
and the
Hathaway’s
to use
the
financial statement
successor
interim
as
registration
initial
statement and
keep the
best efforts to
the interim
which utilized
statement
effective,
prospectus
be
statement and
“misleading”
of “the
in view
statement
unwillingness
the au
of
cause it was the
underlying the transac
circumstances”
necessary
certify
financial
ditor to
the
answering
question we
this
In
?3
action
accumulating
statements due to Lionel’s
weight
give
must,
full
course,
of
regis
delay
largely
led to
losses that
fact,
even
of
the district court’s
tration and the ineffectiveness
ap
are free to look
the
while we
registration.
complaint
The
was accord
plication
law
of
securities
the
ingly
will discuss the se
We
dismissed.
Industries,
found. See Chris-Craft
facts
separately from the
curities law claims
Corp.,
Piper
480 F.2d
Aircraft
Inc. v.
claims, and in that or
(2d
1973), (opinion
contractual law
of
Cir.,
341 at 364
J.). Taking
Timbers,
evidence
der.
the
(1967).
977,
480,
549
inventory adjustment
require
Airex
in the
ment that
sold
second half
interim
gone
por-
year,
that Airex
out
the likelihood that a substantial
and
had
and
fishing
altogether
purchase price
tackle business
tion of the raw material
again
before
Here
known to Lionel
March
1961.
Easton
variance was
adjustment
no
These
seem
us
testified that
June
June
facts
30.
going
great
place
required
for-
burden of
was
because the
bulk
on Lionel the
right
ad-
that no
returns and allowances occurred
show
ward with evidence
justment
made; here there
The trial court
Christmas sales.
needed to
after
accepted
finding
testimony
every
suppose
sub-
that a
and its
was
reason
“clearly
portion
occurred
not
variance
erroneous.”
stantial
prior
date of the issuance
Development.
and
4. Research
merger purposes.
Cf.
D)
development (R
Research and
&
Rohr,
Bourdon, Inc. v.
Bowman
toy
totaling $226,983
and
in the
costs
per
(D.Mass.),
cu-
Supp.
aff’d
F.
$163,000 in
train
and
Lionel
division
(1st
1960) ;
riam,
T.
between June 30
reserve
agree.
against
$72,000
constrained to
ful
ac-
Accounts” of
$3,312,000 or 2.1
counts
receivable
Summary.
summary, then,
7.
In
we
per
(a
cent)
year’s
end
reserve
misrepresenta-
believe that there was a
$315,000
Accounts,
for
Dis-
“Doubtful
good
respect
$998,000
tion in
to the
will
against
counts, Returns and Allowances”
item,
price
$140,000
raw material
$3,649,000 of accounts receivable or 8.5
$226,983
variance and the
R & D costs
per
testimony essentially
cent). That
toy
division,
in the
and train
pointed
year’s
at
out that
the reserve
on the basis of the
evidence adduced
discounts,
end included a reserve for
re-
interim statement should have disclosed
allowances,
turns and
items not included uncertainty regarding the first
Appellants’ response
as of June 30.
adjustment
respect
made some
to the
to the extent that the understate-
proof
other two. Absent further
we
ment in June
sales returns and
involved
may
adjustment
assume that the
should
argu-
duplicates appellants’
allowances it
equaled
per
have
adjustments
50
cent of the last two
adjustment
ment that a June 30
actually
that were
made at
Again, however,
needed for those items.
year end,
re-
it must
Lion-
be remembered that
spectively, sums which we find substan-
el’s business was Christmas seasonal.
enough
tial
to warrant
consideration
Over-reporting
expenses
of deferred
ear-
remand.
ly
year might
pro-
well not have
Materiality,
C.
Scienter and Reli-
picture
compa-
vided an accurate
of the
ance. The district court
did
consid-
ny’s
Appellants
condition.
failed to
separately
er
materiality
the issues of
present
evidence
re-
deceptiveness
the one hand and
of the
serves were overstated in
to the
relation
representations
in the interim state-
full
For all we
sales.
know
Rather,
ments on the other hand.
as we
entire
difference of almost
cent
indicated,
were basical-
between the ratio of reserve to accounts
ly
alleged
to the effect that each of the
year-
in the interim and the
receivable
“misrepre-
omissions did not involve a
may
explained by
end
sentation.” Since
found,
we have
how-
at the
addition
apparently
a reserve
end
ever,
respects
that in certain
there were
selling year
bad
of 1961
misrepresentations, we must remand un-
sales returns and allowances.
say
less we can
that under no construc-
tion of the evidence could the district
Miscellaneous Items. The
6.
misrepresentations
court find that
regarding
three
items
miscellaneous
were material or that there was estab-
price adjustment
govern-
contract
on a
necessary
lished the
culpability on the
contract,
ment
credit
balance
sales
part
by
of Lionel.10 We
no means can
cooper-
returns and a credit
in a
balance
say so.
advertising expense
ative
account
to-
gether
amount
about
upon
We have touched
the issue
materiality
were treated
court below as hav-
in reference to the An-
haps this item should have been written off
1961.” Since there is no indication that
September 30,
projections
as of
confusion
sales fell off
before June
however,
probe
is not
mysteries
aided
the somewhat arcane ac-
we need not
jargon describing
countant’s
this:
“[de-
of this item.
selling, advertising
ferred
and service ex-
9. The court also said there was “no show-
penses
September 30, 1961,
deferred as at
any
them
involved a material
expensed
which should have been
misrepresentation.”
F.Supp.
at 662.
September 30, 1961,
budgeted
if the
sales
expense
September 30,
solely
alleged
used in the
10. All of this relates
1961, computation
of the deferral were
securities
law violations.
The contract
expense
year
actual
separately.
sales and
claim will be dealt with
Industries,
Piper
Inc. v.
Chris-Craft
Where a
will
issue.
ton-Imco
merger
earnings
supra,
pic
Corp.,
Aircraft
F.2d
prospect, the
inis
*11
(footnote omitted).11
corporation
to
acquiring
has
the
ture of
significance to the stockhold
of real
be
never
The
district
court
proposed
ac
corporation
to be
ers of the
question
culpability.
On
reached
earnings
quired,
the most current
so, bearing in mind
remand it should do
Kai
highest importance. See
are of the
large
to a
extent the accountants
supra.
Otis,
Corp.
Accord
v.
ser-Frazer
figures
rely
preparing the interim
earnings
convey
ingly,
these
failure to
ing
management
upon
information
discrepancy
accurately,
is at all
if the
applied
to
is
The test
be
advice.
substantial,
material
has to be
application.
terms,
As
clear
explicated
if not
being
in this
person
The test
misled.
opinions
recently
most
as set
is the same
17 case
10b-5
§
Judge
Judge
Mansfield
Timbers and
Judge
by
14(e) case)
(albeit in a
forth
supra,
Inc.,
Industries,
in Chris-Craft
Timbers:
J.)
(Timbers,
slip op.
and at 396
at 362
materiality focuses
concept
(Mansfield,
something
spe
J.),
The
short oi
weightiness
or
misstated
require'd
on the
defraud is
cific intent to
negligence;
investor’s
something
in á reasonable
omitted fact
more than “mere”
buy
articulat
certainly, knowledge
or
We
sell.
that the
decision
of the fact
materiality
in List
figures
v.
picture
standard
ed the
is
created a false
457,
Inc.,
Park,
F.2d
462 enough,
part
sophisticated
340
Fashion
on the
811,
disregard
(2 Cir.),
denied,
86
managers
382 U.S.
corporate
cert.
reckless
(1965), to
23,
be
L.Ed.2d 60
15
v.
S.Ct.
of’the truth is
See Lanza
sufficient.
at
man would
35794,
‘a reasonable
“whether
Co.,
F.2d 1277
Drexel &
No.
479
misrepre
importance
banc);
(en
the fact
(2d
Apr. 26, 1973),
tach
Cir.,
[to
1306
determining
choice of
Co.,
his
Shearson,
sented]
v.
Hammill &
Shemtob
”
question.’
1971)
442,
(2d
(dic
transaction
action in the
F.2d
Cir.
448
tum) ;
445
only
materiality
Service,
test is concerned
Globus v. Law Research
prototype reason
Inc.,
1276,
(2d
whether
with
Cir.
418 F.2d
1290-1291
913,
relied. See
denied,
1969),
able investor would
cert.
90
397 U.S.
909,
Weitzen,
912-
(1970);
F.2d
913,
v.
402
Heit
Heit