Appeal from a judgment entered in the United States District Court for the Southern District of New York, Richard Owen, Judge, in favor of plaintiff for $17 million plus interest and costs after a jury trial in an action seeking to recover damages claimed as a result of alleged false representations by an accounting firm made on behalf of a government securities dealer. Judgment affirmed in part. Award of pre-judgment interest vacated and remanded.
Before: PIERCE, MINER and ALTIMARI, Circuit Judges.
The defendant accounting firm appeals from a judgment entered in the United States District Court for the Southern District of New York, Richard Owen, Judge, after a jury returned a verdict against it. The jury awarded plaintiff $17 million, to which the district judge added pre-judgment interest, post-judgment interest and costs, in a civil action seeking damages for losses that Manufacturers Hanover Trust Company ("Manufacturers" or "MHT") claimed to have suffered as a result of certain alleged misrepresentations that Arthur Andersen & Co. ("Andersen") made on behalf of Andersen's client, Drysdale Securities Corporation ("DSC") and its successor, Drysdale Government Securities, Inc. ("DGSI"). The district judge submitted seven separate theories of liability to the jury: misrepresentation or material omission "in connection with" the purchase or sale of securities, in violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder; misrepresentation or material omission "in" the purchase or sale of securities, in violation of section 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q(a)(2); misrepresentation or material omission in a "prospectus" or "oral communication," in violation of section 12(2) of the Securities Act of 1933, 15 U.S.C. § 77l(2); conspiracy to violate the above federal securities laws; aiding and abetting in the violation of the above federal securities laws; common law negligence; and common law fraud. The jury returned a general verdict, following which the judge requested that the jury state the cause or causes of action on which the verdict was premised, which it did.
On appeal, Andersen argues principally that the district court lacked federal subject matter jurisdiction; that the requisite loss causation standard for liability for securities fraud was not met; that plaintiff MHT caused its loss by its own recklessness; that it was error for the district judge to submit a negligence theory to the jury; that in selecting and instructing the jury the district judge deprived Andersen of a fundamentally fair trial; and that reversal of any of MHT's claims requires reversal of the entire verdict. MHT cross-appeals for a mini-trial exclusively on the issue of punitive damages. We affirm the judgment in favor of plaintiff in the amount of $17 million and deny the relief requested on cross-appeal. We also remand for further proceedings on the issue of pre-judgment interest only.
In this civil action MHT sought damages against the Andersen accounting firm, which it asserts made misrepresentations as to the financial status of DGSI, a company created by DSC to transact business through trading in repurchase agreements ("repos") or resale agreements ("reverse repos") involving government securities.*fn1 DSC, a brokerage house sine 1889, engaged in a scheme to purchase and sell government securities through repos and reverse repos beginning in May 1980 and ending in May 1982, just three months after DSC had transferred the repo business to a separate, newly capitalized, corporation called DGSI. The appellees presented evidence to the jury that Warren Essner, a senior Andersen audit partner, misrepresented DGSI's net worth as $20.8 million when it actually was negative $190 million.
DSC had transferred the repo business to DGSI in February 1982 for two related reasons. First, it wanted to satisfy banks that had been serving as DSC agents (acting for an undisclosed principal) and that had begun to demand that DSC provide adequate assurances of sufficient capital to absorb the risk of insolvency in the repo market. Evidence was introduced showing that beginning in December 1981, DSC received requests for an audited financial statement from Chase Manhattan Bank, Chemical Bank, U.S. Trust Co., and MHT. Second, DSC wanted to avoid a New York Stock Exchange audit of DSC repo capitalization. The concerns for DSC's financial stability developed as DSC began to lose money because of financial losses in its securities trading and alleged misappropriation of monies by DSC Chairman Joseph Ossorio and DSC trader David Heuwetter.*fn2
The mechanics of DGSI's repo business are not disputed. Ossorio and Heuwetter created a so-called "Ponzi" scheme that profited from the use of coupon interest on securities sold. The essence of the scheme was DGSI's exploitation of an important difference between government securities transactions in (1) the "securities" or "cash" market, in which securities are straightforwardly purchased and sold at market prices, and (2) the "repo market," in which government securities are purchased and sold pursuant to repo or reverse repo transactions. In the securities market, the price of a government security, such as a United States Treasury note, includes the market price of a particular issue and the accrued "coupon interest" on the security (i.e., the value of government payments due on the security at the time of the sale). In the repo market, the accrued coupon interest is paid only on the repurchase (or resale) transaction; the initial "loan" of the security is made at a price that includes only the market value of the security. Before the security is repurchased, its price will be "marked to market" periodically to reflect changed value. By borrowing increasing volumes of government bonds through reverse repos, selling them in the cash market and utilizing the cash and temporarily obtained accrued coupon interest to meet obligations on previously borrowed bonds and to conduct other trades, DGSI managed to stay solvent between February 1, 1982 (when DGSI was created, with the liabilities it had inherited from DSC) and May 17, 1982, when DGSI's ultimate collapse occurred and investors lost some $300 million.
Unlike Ossorio and Heuwetter, Warren Essner, a partner at Andersen, and Andersen itself, were not principals in this scheme. There is no evidence that they profited from it, or that they stood to gain anything from DGSI's precarious situation. Rather, Essner and Andersen had a limited role relating to the creation of DGSI. The fundamental issue in this case involves the scope of liability that flowed from this limited role.
Andersen had audited DSC in 1977 and 1978, but had no business relationship with it again until January 8, 1982. On that date, Ossorio contacted Essner at the Andersen firm regarding tax and accounting concerns in the contemplated creation of DGSI. Essner and Ossorio drafted a January 31, 1982 letter announcing DGSI's information and discussing its capitalization. The letter was intended for the benefit of potential DGSI clients and indicated that DSC would transfer $5 million net assets and liabilities to DGSI. (These assets and liabilities constituted repo and reverse repo positions in DSC's portfolio.) In addition, it stated that Heuwetter would invest $12.8 million and Ossorio $2.7 million, bringing the total capitalization to almost $21 million.
There was evidence that during a meeting on January 31, Heuwetter had cautioned Essner about an $11 billion "matched book"*fn3 of repos and reverse repos that DSC controller Dennis Ruppert (who later pleaded guilty to state securities fraud charges) had fictitiously manufactured to create in part the purported $5 million transfer of DSC positions to DGSI. The true positions concealed by this false "matched book," Heuwetter testified, could not be disclosed, for fear that "if the dealer community found out the size of the positions that I was playing with . . . we would be out of business the next day . . . "
On the evening of January 31, 1982, Essner prepared a "Statement of Subordinated Debt and Equity" to support the January 31 letter. This document did not disclose the size of the government securities positions transferred from DSC to DGSI. It reflected a purported capitalization of $20.8 million ($5 million net assets and liabilities transferred from DSC plus $15.8 million cash). There was evidence that Essner prepared the statement without consulting DSC's books and records, which, in any event, allegedly had been in incomprehensible disarray.
On and after February 1, Heuwetter delivered copies of the letter and statement to financial institutions including MHT. However, Chase and MHT pressed for an audited financial statement prepared by an independent accounting firm, even though both had been doing business with DGSI since its inception on February 1.
The parties dispute whether Ossorio asked Essner to prepare an audited statement by January 31 or during the week of February 8. In either event, on behalf of Arthur Andersen, Essner prepared a "report on specified elements of a financial statement," which purported to constitute an unqualified opinion prepared in accordance with Generally Accepted Auditing Standards ("GAAS"). There is disputed evidence, however, that Essner never had conducted an audit, and that Essner later manufactured work papers in an apparent effort to legitimize his previous reports. MHT presented evidence at trial that Essner's and Andersen's work violated several procedures required by GAAS*fn4 as well as many of Andersen's own Audit Objectives and Procedures ("AOP").*fn5 For preparing the letter, statement and report, Andersen billed and received from DSC $14,400. There is no evidence of any other payment to Essner or Andersen.
Andersen introduced evidence that at no time did MHT request a DGSI balance sheet as of February 1, 1982, or a DGSI balance sheet or income statement as of any later date. Andersen also introduced evidence that MHT inadequately monitored DGSI's creditworthiness and MHT's own risk exposure, in contrast to other financial institutions, several of which extricated themselves from business dealings with DGSI in time to avoid the kind of loss that MHT ultimately suffered. MHT countered with evidence that its internal controls over relevant economic risks associated with its business with DGSI was reasonable when viewed in light of prevailing industry practice.
The judge instructed the jury on seven causes of action: the three substantive securities laws, conspiracy and aiding and abetting in the violation thereof, and common law fraud and negligence. He further instructed the jury to find "either in favor of the plaintiff or the defendant." After deliberation, the jury foreman announced that "we find for Manufacturers Hanover." The judge polled the jury, and then asked "which cause of action or causes of action you base this award on." Andersen did not object to this procedure. After returning to the jury room, and after some further instruction from the judge, the jury announced that "10B5 [sic], Section 12(2), 17 A [sic] and the two state statutes" had been violated. The jury was then discharged without another poll or further requests.
This case requires us to consider the role of the accountant, and the scope of his liability, in presenting to the financial community information about a financial institution seeking to attract or maintain business in transactions involving agreements to repurchase (or resell) government securities. In an SEC enforcement action arising from many of the same facts herein, we earlier held that the allegation that DSC and three of its officers, and Andersen and Essner, violated section 10(b) of the 1934 Act and Rule 10b-5 thereunder and section 17(a) of the 1933 Act stated a valid federal cause of action. SEC v. Drysdale Securities Corp., 785 F.2d 38 (2d Cir.), cert. denied, 476 U.S. 1171, 106 S. Ct. 2894, 90 L. Ed. 2d 981 (1986). In this case, we are called upon to review jurisdictional, substantive and procedural issues arising from MHT's private action against Andersen for allegedly misrepresenting DGSI's financial status.
I. Federal Subject Matter Jurisdiction.
Andersen argues that repos are not securities, and hence that the district court lacked federal subject matter jurisdiction over this case. Whether or not repos are securities, it is clear that the district court had jurisdiction as to the claims under section 10(b) of the 1934 Act and section 17(a) of the 1933 Act. In the related litigation of SEC v. Drysdale, we assumed that repos and reverse repos are not securities, but held that it would suffice if the alleged fraud by DSC and Andersen were "in connection with the purchase or sale" of securities under section 10(b) and "in the offer or sale" of securities under section 17(a). 785 F.2d at 40-42 & n.2.
Of course, Judge Winter's reasoning in Drysdale may not apply to MHT's claim under section 12(2) of the 1933 ACT, since the underlying government securities are exempt from the proscriptions of the section. See 15 U.S.C. § 77c(a)(2) (exempting securities "issued or guaranteed by the United States"); id § 77 l (2) (expressly exempting securities defined in subsection 77c(a)(2)). Thus, MHT's claim under section 12(2) may be cognizable only if the repos themselves are securities. However, since we need not decide whether repos are securities to affirm as we do on the ...