Akin v. Q-L Investments, Inc. ( 1992 )

IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
No. 89-1643
W.O. AKIN, ET AL.,
Plaintiffs-Appellants,
versus
Q-L INVESTMENTS, INC., Etc., ET AL.,
Defendants,
LAVENTHOL & HORWATH,
Defendant-Appellee.
Appeal From the United States District Court
for the Northern District of Texas
(April 15, 1992)
Before KING, JOHNSON, and HIGGINBOTHAM, Circuit Judges.
HIGGINBOTHAM, Circuit Judge:
This is a suit alleging violations of state and federal
securities laws and RICO by accountants who audited financial
statements included in private placement memoranda. Plaintiffs
appeal a summary judgment and a sanction. We reverse.
I.
Plaintiffs are 127 investors who invested in a number of tax-
oriented limited partnerships syndicated between 1973 and 1985 by
a group of companies known as the Quinn-L group. The Quinn-L group
included four companies that served as general partners of these
limited partnerships: Quinn-L Investments, Inc., SML, Inc., Quinn-
L Corporation, and Quinn-L Equities, Inc. The group also included
other companies that performed various functions for the
partnerships such as management and leasing of partnership
properties (Quinn-L Management Corp.), mortgage financing (Quinn-L
Mortgage Co.), lending of working capital funds (Quinn-L Capital
Co.), and construction of improvements on properties, (Braxton
Co.). Virtually all of the companies in the Quinn-L group were
owned entirely by S. Mark Lovell.
The defendant, Laventhol & Horwath, is a national accounting
firm retained by the Quinn-L group in connection with the sale of
thirteen of these limited partnerships in the early 1980's. L & H
furnished reports on financial statements, some of which were
included in the Private Placement Memoranda (PPMs) used in
marketing the partnership investments. L & H prepared reports on
three kinds of financial statements included in the PPMs: (1)
Start-up Balance Sheets, showing initial capitalization of the
partnerships as either $100 or $1,000; (2) Historical Financials,
reporting prior period performance for two of the partnerships
being acquired by the Quinn-L Group; and (3) Corporate Balance
Sheets, reporting financial statements of some of the syndicating
companies. Preparation of these reports was L & H's sole
involvement with the offerings.
The partnerships were primarily involved in real estate--the
construction, ownership, and management of apartment complexes and
office buildings throughout the southeast. There was a common cash
management program among the various entities in the Quinn-L group
2
through which the general partners borrowed money from individual
partnerships for use within the overall structure as needed. The
partnerships were projected to have operating losses for the first
five to eight years of operation, which would generate tax
deductions for the limited partners. Profitable operation would
follow, if all went according to plan. Success depended largely on
the general partners' ability to refinance the partnerships, sell
them for more than their debt, or resyndicate them. With the
passage of the Tax Reform Act of 1986 and the general collapse of
the real estate market in the late 1980s, approximately forty of
the forty-five limited partnerships ultimately went into bankruptcy
or had their properties foreclosed upon.
In 1987 and 1988, plaintiffs filed twenty-six separate
lawsuits alleging violations of federal and state securities laws
and RICO in the sale of the limited partnerships. L & H is a
defendant in thirteen of these suits. The plaintiffs contended
that L & H aided and abetted the Quinn-L partnerships in securities
violations by omitting material facts from the financial reports
they prepared, thereby misleading investors as to the finances of
partnerships in which they were investing. The plaintiffs alleged:
(1) that L & H failed to disclose that the Quinn-L group had to
syndicate additional partnerships in order to survive; (2) that
L & H failed to disclose that the partnerships were "integrated" in
nature--that "affiliate" or "interrelated" transactions among the
individual partnerships were so numerous that the financial success
of each partnership depended on the others; (3) that L & H failed
3
to disclose certain contingent liabilities and the uncollectability
of certain inter-company receivables, thereby distorting the
companies' true net worth; (4) that L & H falsely represented that
it complied with generally accepted accounting principles and
auditing standards; and (5) that L & H materially aided the Quinn-L
Group in the illegal sale of unregistered securities.
The suits were consolidated for discovery and trial. After
nearly two years of discovery, the district court granted L & H's
motions for summary judgment on the state and federal securities
and RICO claims and sanctioned plaintiffs' counsel for bad faith
submission of false and misleading form affidavits.
II.
We ask "if the pleadings, depositions, answers to
interrogatories, and admissions on file, together with the
affidavits, if any, show that there is no genuine issue as to any
material fact and that the moving party is entitled to a judgment
as a matter of law." Fed. R. Civ. P. 56(c). This rule "mandates
the entry of summary judgment, after adequate time for discovery
and upon motion, against a party who fails to make a showing
sufficient to establish the existence of an element essential to
the party's case, and on which the party will bear the burden of
proof at trial." Celotex Corp. v. Catrett, 477 U.S. 317, 322
(1986).
A. Federal Securities Claims
Congress and the SEC have constructed an elaborate regimen for
the securities markets. Its central premise of disclosure finds
4
expression, in part, by defined roles for players in the complex
endeavor of issuing new securities, including underwriters,
lawyers, and accountants. Rule 10b-5 was at its conception a
carefully crafted piece for the disclosure and enforcement
apparatus. Of course that limited assignment changed dramatically
with recognition that Rule 10b-5 was enforceable by a private right
of action. The relevant point is that judicial acceptance of
private enforcement of Rule 10b-5 by an implied right of action
came when the courts were far more hospitable to such ventures.
This implied right brought with it an expansive judicial enterprise
of developing a supporting common law.
The implication of such private rights of enforcement is no
longer favored. Moreover, it is now apparent that open-ended
readings of the duty stated by Rule 10b-5 threaten to rearrange the
congressional scheme. The added layer of liability not for
directly violating Rule 10b-5 but for aiding and abetting such
violation is particularly problematic. Imposing liability upon
traditional participants in the securities markets by resort to
this theory presents greater risks of frustrating the congressional
scheme of securities regulation than direct enforcement of the
rule. There is a powerful argument that these risks are such that
aider and abettor liability should not be enforceable by private
parties pursuing an implied right of action. We must accept the
law of this circuit acquiescing as it does in such suits. There
are formidable arguments, however, against recognizing this cause
of action--arguments that have grown with judicial insistence that
5
Congress legislate; that is, with increasing judicial reluctance to
undertake legislative tasks. We should be exacting in determining
whether aider and abettor liability can be demonstrated.
Plaintiffs argue that L & H aided and abetted violation of
Rule 10b-51 by preparing false and misleading reports on financial
statements. There are three routes by which an accountant may be
held liable under the rule. First, an accountant is directly
liable for intentional or reckless2 misrepresentations if he knows
his statements will be communicated to third parties. See, e.g.,
Fine v. American Solar King Corp., 919 F.2d 290, 298 (5th Cir.
1
"It shall be unlawful for any person, directly or
indirectly, by the use of any means or instrumentality of
interstate commerce, or of the mails, . . . (1) to employ any
device, scheme or artifice to defraud, (2) to make any untrue
statement of a material fact or to omit to state a material fact
necessary in order to make the statements made in light of the
circumstances under which they were made, not misleading, or (3)
engage in any act, practice, or course of business which operates
or would operate as a fraud or deceit upon any person, in
connection with the purchase or sale of any security." 17 C.F.R.
§ 240.10b-5 (1991); 15 U.S.C. § 78j(b).
2
In Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), the
Supreme Court held that scienter was a required element of the
implied cause of action under section 10(b) and Rule 10b-5. The
Court expressly left open the question whether reckless behavior
constitutes intentional conduct sufficient to impose civil
liability, but noted that "[i]n certain areas of the law
recklessness is considered to be a form of intentional conduct
for purposes of imposing liability for some acts." Id. at 193
n.12.
Since Ernst & Ernst, this court has recognized that "severe
recklessness" can satisfy the scienter requirements for a primary
violation under Rule 10(b) in Broad v. Rockwell Int'l Corp., 642
F.2d 929, 961-62 (5th Cir.) (en banc), cert. denied, 454 U.S. 965
(1981); see also Shivangi v. Dean Witter Reynolds, Inc., 825 F.2d
885, 889 (5th Cir. 1987). Although we used the modifier
"severe," our definition of severe recklessness is the same as
that used by other circuits to describe conduct they consider to
be reckless. See Woods v. Barnett Bank, 765 F.2d 1004, 1010 n.9
(11th Cir. 1985).
6
1990); Admiralty Fund v. Hugh Johnson & Co., 677 F.2d 1301, 1312
(9th Cir. 1982); Chemical Bank v. Arthur Andersen & Co., 552 F.
Supp. 439, 454-55 (S.D.N.Y. 1982), rev'd on other grounds, 726 F.2d
930 (2d Cir. 1984). Here the labels "aiding and abetting" and
"secondary liability" are really misnomers, since § 10(b) prohibits
any person from making false or misleading statements "in
connection with" the purchase or sale of a security, even if the
person plays an auxiliary role in the transaction.
Second, an accountant may be held liable for knowingly joining
and substantially assisting in the misrepresentations of another,
regardless of whether he makes any false statements of his own.
Although the Supreme Court has twice reserved decision on liability
for aiding and abetting a violation of Rule 10b-5, see Herman &
MacLean v. Huddleston, 459 U.S. 375, 379 n.5 (1983); Ernst & Ernst
v. Hochfelder, 425 U.S. 185, 191-92 n.7 (1976), this Circuit, in
common with other courts of appeals, has consistently recognized
the validity of this theory. Abell v. Potomac Insurance Co., 858
F.2d 1104, 1115 (5th Cir. 1988), vacated in part on other grounds
sub nom. Abell v. Wright, Lindsey & Jennings, 109 S. Ct. 3242
(1989); Bane v. Sigmundr Exploration Corp., 848 F.2d 579 (5th Cir.
1988); Woodward v. Metro Bank, 522 F.2d 84 (5th Cir. 1975). Like
any conspiracy to defraud, this route generally requires knowledge
of the fraud and intent to join in it.
This court has cleared a third path more circuitous than the
other two. By this route, an accountant may be held liable for
recklessly aiding and abetting a primary violation regardless of
7
whether he has made misrepresentations of his own, when his
assistance in the fraud is particularly substantial and unusual or
when he owes some special duty of disclosure. Woodward, 522 F.2d
at 97; Abell, 858 F.2d at 1127; see also Rolf v. Blyth, Eastman
Dillon & Co., 570 F.2d 38, 44-47 (2d Cir.), cert. denied, 439 U.S.
1039 (1978); Woods v. Barnett Bank, 765 F.2d 1004, 1010, 1011 (11th
Cir. 1985); Cleary v. Perfectune, Inc., 700 F.2d 774, 777 (1st Cir.
1983). This "theory" of liability is mushy and difficult to apply.
Were we writing on a clean slate, it would give us pause. The path
has two serious overlapping problems. First and foremost, the
source and scope of the accountant's duty to disclose is uncertain.
It does not directly rest on any textual provision of the federal
securities laws, but appears to be a specie of federal common law.
Its murky source infects efforts to define its scope. When an
accountant's duty is unfettered from the duty to prevent falsity as
proscribed by Rule 10b-5, it becomes an independent duty to
disclose information "material" to a reasonable investor's decision
akin to the duty owed by a fiduciary. We are not persuaded that
the accountant's duty under 10b-5 is so open-ended. As we see it,
this third path differs from conspiracy and the usual principles of
aiding and abetting insofar as it allows liability for reckless
disregard of facts indicating a client's fraud and the accountant's
assistance in it. Fortunately, only a narrow band of cases can
travel this path--where an accountant has furnished substantial and
non-routine services but is not consciously furthering primary
violations by his client.
8
9
(1) Start-Up Balance Sheets
Six PPMs contained start-up balance sheets indicating the
initial capitalization of the limited partnerships as $100 or
$1,000. The balance sheet of the Timber Ridge--Fort Worth
partnership, for example, stated simply that the assets of the
partnership consisted of $100 cash and that the general partner's
equity investment was $100. L & H reported that this balance sheet
fairly represented the financial position of the partnership at its
inception, in conformity with generally accepted accounting
principles. The start-up balance sheet also included a brief
statement that the partnership intended to acquire a 206-unit
apartment complex and offer 35 limited partnership interests to no
more than 35 limited partners. The district court found that,
given the narrow purpose of such a balance sheet, it had virtually
no potential for misleading investors about the nature of the
partnership. This conclusion, however, rests on L & H's version of
what should have been included in the balance sheets and
accompanying footnotes.
Plaintiffs' experts disagreed with L & H as to what generally
accepted accounting principles required to be disclosed on the
start-up balance sheets and their accompanying footnotes.
According to Bailey, the facial anemia of the balance sheets and
footnotes imposed on L & H the obligation to disclose in its
reports certain material facts omitted from the footnotes. The
balance sheets and footnotes largely omitted discussion of related
party transactions. Had L & H met its professional standards of
10
investigation and disclosure, according to Bailey, it would have
noted the absence of the following from the start-up balance
sheets:
(1) Quinn-L's primary source of financial support came
from continued offerings.
(2) In order to keep the companies and partnerships
solvent, Quinn-L had to continue to offer new deals
and sell projects.
(3) Seldom did any prior syndications ever meet their
optimistic projections.
(4) Quinn-L commingled the funds of each partnership
with the funds of every other partnership. Cash
was used wherever needed, according to Quinn-L's
Cash Control Manager. Thus, funds raised in a new
offering automatically went to support prior losing
ventures.
According to Bailey, L & H knew of the related party relationships,
was aware of the cash management system and commingling of funds,
and should have reported the omission of these material matters
from the balance sheets and footnotes to avoid misleading
investors. A reasonable trier of fact could conclude from this
evidence that L & H was intentionally or recklessly deceiving the
users of these balance sheets by failing to disclose these facts.3
3
I am scribe for the panel but I do not agree that summary
judgment should be reversed with respect to the start-up balance
sheets. In my view, these brief and accurate statements about
the de minimis capitalization of the partnership could not have
misled investors in any way. The amorphous "facts" which
plaintiffs' experts alleged were omitted are a far cry from the
specific distortions alleged in the corporate balance sheets.
Violation of accounting principles is relevant to a determination
of whether an auditor has committed securities fraud, but it does
not reduce plaintiffs' responsibility to show that they were
misled. Rule 10b-5 prohibits the use of manipulative or
deceptive devices, not the violation of accounting principles.
The two are not coextensive. I would affirm with respect to the
start-up balance sheets.
11
(2) Historical Financials
Two PPMs contained historical financials reporting on the
prior period performance of particular limited partnerships that
were being resyndicated. Plaintiffs have not alleged that these
reports misrepresented or omitted any material facts. Hence, they
cannot form the basis of a securities violation.
(3) Corporate Balance Sheets
Five PPMs contained corporate balance sheets reporting on the
financial statements of Quinn-L Investments, Inc. Each corporate
balance sheet included a statement of assets, liabilities, and
shareholders' equity, a statement of revenue, expenses, and
retained earnings, and a statement of source and application of
funds, along with extensive notes. L & H asserted that these
corporate balance sheets were examined in accordance with generally
accepted auditing standards (GAAS) and fairly represented the
financial position of Quinn-L Investments in accordance with
generally accepted accounting principles (GAAP).
Plaintiffs contend that these reports contain several
misrepresentations regarding affiliate transactions--loans, sales
and other business dealings between Quinn-L Investments and other
entities in the Quinn-L Group. For example, plaintiffs' expert
stated that it was improper for L & H to characterize a note
receivable from Braxton Co. for more than $7 million as an asset of
Quinn-L Investments in the 1984 report. Without this related-party
transaction, Quinn-L Investments would have had a minimal or
negative net worth. Plaintiffs' expert asserted that Quinn-L
12
Investments' treatment of the note receivable was a clear violation
of GAAP, since both companies participated in a common cash
management system in which funds were freely transferred between
companies having excess cash and those in need of it. According to
this expert, the transaction was not in substance a sale but part
of a scheme to create inflated and fictitious values. L & H failed
to qualify its report to reflect this violation as required by
GAAS.
Similarly, plaintiffs' expert stated that including another $5
million note receivable as an asset on the 1983 report artificially
inflated the net worth of the company since the receivable was from
an affiliated partnership. Although Quinn-L's previous accountant
had apparently not included this receivable on the 1982 statement,
L & H "reclassified" it in 1983. The expert asserts that this
"reclassification" materially distorted the financial position of
the company. GAAS, he continues, required L & H to discuss any
restatement of accounts with the previous accountant and disclose
the nature of these discussions in its report, so that investors
would know what had taken place. L & H failed to do so.
Plaintiffs' expert observes that Quinn-L Investments obligated
itself to pay affiliated partnerships $37 million in rental
payments for various commercial properties over the course of
several years. The company then assigned its obligations under
these leases to another affiliate, Nashville Feature & Music, Inc.,
but remained obligated. Because Nashville was financially unable
13
to honor this obligation, the expert asserts that GAAS required
L & H to disclose its contingent liability. L & H did not do so.
Although L & H disclosed that Quinn-L Investments was one of
several companies under common control, and therefore was a member
of a common cash management program for the benefit of the group,
plaintiffs' experts provide at least some evidence from which a
jury might infer that L & H intentionally or recklessly misled
investors about the true financial position of Quinn-L Investments.
This is so despite disclosure of the broader relationship between
the partnerships. That disclosure certainly blunted the deceptive
effect of any inflated figures, but it did not eliminate it. The
repeated violation of accounting principles reinforces the evidence
of deception. Fine, 919 F.2d at 297. A reasonable jury could
infer from the evidence in this case that L & H was intentionally
or recklessly deceiving the users of its statements by distorting
the net worth of Quinn-L Investments.
L & H contends that it did not know that its reports would be
included in the various PPMs used in selling the partnerships. An
accountant must know that its statements are to be communicated to
investors before it can violate Rule 10b-5. See SEC v. Texas Gulf
Sulphur, 401 F.2d 833, 862 (2d Cir. 1968) ("Rule 10b-5 is violated
whenever assertions are made, as here, in a manner reasonably
calculated to influence the investing public."); Zoelsch v. Arthur
Andersen & Co., 824 F.2d 27, 34-35 (D.C. Cir. 1987); Mendelsohn v.
Capital Underwriters, Inc., 490 F. Supp. 1069, 1085 (N.D. Cal.
1979). Otherwise, it cannot be said that the statements are made
14
"in connection with" the purchase or sale of securities. See
Zoelsch, 824 F.2d at 35.
In support of its contention, L & H filed an affidavit of
Christopher Mayzner, the L & H partner in charge of the Quinn-L
audit, stating that L & H was ignorant of the intended use of most
of its reports, and had no reason to believe that they would be
used in the PPMs. However, in its memorandum in support of its
partial summary judgment motion, L & H admitted that it was aware
that some of its reports would be included in the PPMs.4 Further,
the value of Mayzner's testimony is limited by the fact that he did
not consult with anyone else at L & H in formulating his opinion
regarding L & H's knowledge. Finally, plaintiffs have also
introduced evidence contradicting Mayzner. Plaintiffs filed an
affidavit from Lovell, swearing that L & H knew that its reports
would appear in the PPMs. Plaintiffs also offered the expert
testimony of Edmund W. Bailey, a certified public accountant, who
stated that L & H must have known that financial statements it
audited would be included in the PPMs. Another expert, Daniel L.
Jackson, a certified public accountant, opined with regard to "The
Woodlands -1983 Limited Partnership," that L & H must have known
that its reports would be included in that PPM.5 This evidence is
4
L & H stated as follows: "In some instances, L & H was
aware that these reports were intended for use in PPMs. In other
instances L & H was not."
5
As evidence of L & H's knowledge, Jackson cites L&H's
engagement letters for the audit of "The Woodlands - 1983 Limited
Partnership," which stated as follows: "You have agreed to
provide us [L&H], prior to filing, proofs of the entire offering
circular and all other accompanying materials within which such
15
sufficient to create a genuine issue of material fact with respect
to L & H's knowledge that its reports would be used in connection
with the sale of securities.
L & H also argues that plaintiffs failed to prove that they
relied on L & H's reports. While materiality can be established
for all the plaintiffs as a group, reliance is a matter of
individual proof. Abell, 858 F.2d at 1118 (citing Huddleston v.
Herman & MacLean, 640 F.2d 534, 549 (5th Cir. Unit A Mar. 1981),
rev'd in part on other grounds, 459 U.S. 375 (1983)). Plaintiffs
argue first that they were not required to show reliance. They
contend that they are entitled to the presumption established by
the Supreme Court in Affiliated Ute Citizens v. United States, 406
U.S. 128 (1972), presuming reliance of plaintiffs who base their
10b-5 claims on omissions.
The Ute presumption, however, operates only in omissions
cases, not where plaintiffs assert positive misrepresentations of
material information. Finkel v. Docutel/Olivetti Corp., 817 F.2d
356, 359 (5th Cir. 1987). The distinction between the two is not
always clear. In each case, a court must decide whether plaintiffs
are claiming that defendants omitted information or misrepresented
it. It is not enough that a claim has aspects of omission--at a
sufficiently high level of generality, they all do. Ute itself
involved "primarily a failure to disclose." 406 U.S. 128, 153
(emphasis supplied). Rather, we remain mindful that the Ute
financial statements are to appear." Jackson also notes that the
audit programs for that limited partnership had signed slips,
indicating that someone at L & H had reviewed the PPM.
16
presumption is a practical solution of the conceptual puzzle of
relying on undisclosed facts.
With respect to the start-up balance sheets, we agree that
plaintiffs are entitled to Ute's presumption of reliance. The
claim here is essentially that L & H failed to disclose material
information that should have been included to present a complete
picture of the financial status of the partnerships. The claims
relating to the corporate balance sheets, however, are claims of
misrepresentation, not omission. L & H disclosed considerable
information about the relationship between Quinn-L Investments and
other entities in the Quinn-L group. Any wrong lies in ignoring
accounting principles and distorting the numbers underlying the net
worth of Quinn-L Investments. This is the stuff of
misrepresentation and does not entitle plaintiffs to the Ute
presumption.6 We make this judgment, which is a legal call for the
judge, by reaching past its peripheral aspects and probing for the
gravamen, the core of the claim.
Plaintiffs offer 127 form affidavits, nearly all of which are
identical, as evidence that they relied on L & H's reports. The
district court struck these affidavits because they failed to
conform with Federal Rule of Civil Procedure 56(e). This rule
provides that when affidavits are used to support or oppose a
summary judgment motion, they "shall be made on personal knowledge,
shall set forth such facts as would be admissible in evidence, and
6
We do not address the fraud-on-the-market theory of
reliance here since it was not raised below.
17
shall show affirmatively that the affiant is competent to testify
as to the matters stated therein." A district court is entitled to
strike affidavits that do not comply with this rule. CMS
Industries, Inc. v. L.P.S. Int'l, Ltd., 643 F.2d 289, 295 (5th Cir.
1981).
The affidavits stated in relevant part
6. Since investing in the Quinn-L partnership(s)
and, in particular, since becoming involved in this
litigation, I have learned, through the investigation of
my counsel, that my partnership(s), and indeed the entire
Quinn-L Group of companies, including Lovell, were not as
represented to me at the time I made my investment
decision. I have learned a number of facts that, had I
known them at the time I was deciding to invest in Quinn-
L, I would not have invested. . . .
10. I also have learned that the true net worth of
the general partner in the Quinn-L partnerships was not
as represented in the offering materials and elsewhere.
For example, I understand that the major asset of Quinn-L
Investments, Inc., general partner, was an unsecured
inter-company receivable that had no real prospects for
payment. Had I known that the true net worth of the
general partner was negative, at the time I made my
investment decision, I would not have invested.
The district court concluded that these statements were not
based on personal knowledge and were inadmissible hearsay. Here,
the statements were offered only to show plaintiffs' reliance on
L & H's misrepresentations, not the truth of the misrepresented
facts. These portions of the affidavits were therefore not
hearsay. Furthermore, certainly as to reliance, plaintiffs'
statements were based on personal knowledge of their individual
investment decisions. Indeed, reliance is an issue about which
only plaintiffs themselves are likely to have personal knowledge.
18
The district court also rejected plaintiffs' affidavits
because they were submitted in bad faith. L & H showed that the
affidavits were replete with false statements and that plaintiffs'
counsel had not undertaken reasonable efforts to ensure their
accuracy. In fact, many plaintiffs admitted that they could not
swear that they had even reviewed a PPM before investing. The
district court's decision to grant summary judgment against these
plaintiffs was entirely appropriate since they will be unable to
show actual reliance on L & H's misrepresentations. Although
plaintiffs are entitled to a presumption of reliance with respect
to the omissions in the start-up balance sheets, this presumption
can be rebutted by a showing that plaintiff's investment decision
would not have been affected even if defendant had disclosed the
omitted facts. Rifkin v. Crow, 574 F.2d 256, 262 (5th Cir. 1978).
Nevertheless, all plaintiffs should not have been dismissed en
masse because many of them admitted to making false statements in
their affidavits. Reliance at this juncture is a matter of
individual proof. Even those plaintiffs who admitted to other
inconsistencies in their affidavits may still be able to show that
they read L & H's reports and would not have invested had they
known the true state of affairs. On a motion for summary judgment,
the district court should disregard only those portions of an
affidavit that are inadequate and consider the rest. Lee v.
National Life Assurance Co., 632 F.2d 524, 529 (5th Cir. 1980).
The district court erred in striking all the affidavits in their
19
entirety. At least some of the affidavits may provide valid
summary judgment evidence of reliance.
With respect to the theory of direct liability, our task is
complete. Although the evidence of fraud is hardly overwhelming,
it is sufficient to create a jury question. We now proceed to
examine plaintiff's theory that L & H aided and abetted a Rule 10b-
5 violation by Quinn-L. Plaintiffs must show that Quinn-L violated
the rule, that L & H had a general awareness of its role in the
violation, and that L & H knowingly rendered substantial assistance
to the violation. Abell, 858 F.2d at 1126.
Defendant has not argued that specific elements of a primary
violation by Quinn-L are lacking. Rather, it asserts that there is
no evidence that any of the allegedly omitted or misrepresented
facts are true. This contention is belied by the affidavits of
Quinn-L employees. Plaintiffs introduced, for example, the
affidavit of Arlan Kent Bishop, a vice president and director of
Quinn-L Corporation and Quinn-L Investments, who stated that the
negative cash flow on particular projects could only be serviced by
the continuing syndication of new projects. Therefore, when some
Quinn-L partnerships began to fail, it was inevitable that they all
fail. The partnerships were all financially dependent on each
other and on continuing syndication. Furthermore, each partnership
was so highly leveraged that it could not be sold, except when
Quinn-L could orchestrate a sale from an earlier limited
partnership to a newer one.
20
Bishop related several material facts about the partnership
investments which were omitted from the PPMs. Had the investors
known of these facts, they may well have decided not to purchase
the limited partnership interests. Although an investor may have
thought he was investing in single, independently viable
partnerships, there is at least some evidence that their money was
going to a shaky network of partnerships that was ultimately bound
to collapse. We think this is sufficient evidence of a primary
rule 10b-5 violation. Despite L & H's arguments that these facts
were simply not true, whether there was a primary violation, and
whether L & H assisted it by preparing misleading reports, are
factual issues for a jury to determine.
Plaintiffs must also prove that L & H had the requisite level
of scienter in assisting Quinn-L. As we have explained, the
standard is conscious intent unless the character and degree of the
assistance is unusual, or unless there is some special duty, in
which case recklessness will suffice. Woodward, 522 F.2d at 97.
The plaintiffs have put forth a great deal of evidence of L & H's
assistance to the Quinn-L entities. The district court found that
these were "financial services . . . and no more." While many,
perhaps most of these services, individually considered, were
routine, a reasonable jury could conclude that the overall level of
involvement by L & H with the Quinn-L entities over a long period
of time constituted particularly substantial or unusual assistance.
If so, a recklessness standard would be appropriate.
21
Furthermore, plaintiffs may be able to establish that L & H
owed a special duty to investors which justifies a recklessness
standard. Courts have held that depending on the circumstances,
accountants may have a duty to disclose information to investors
when they make affirmative statements on which they know the
investors will rely. Compare Arthur Young & Co. v. Reves, 937 F.2d
1310, 1330-31 (8th Cir. 1991); Roberts v. Peat Marwick, Mitchell &
Co., 857 F.2d 646, 653 (9th Cir. 1988); Rudolph v. Arthur Andersen
& Co., 800 F.2d 1040, 1045 (11th Cir. 1986); Sharp v. Coopers &
Lybrand, 649 F.2d 175, 180-84 (3rd Cir. 1981) (circumstances may
support duty of disclosure) with Schatz v. Rosenberg, 943 F.2d 485,
496-97 (4th Cir. 1991); Zoelsch v. Arthur Andersen & Co., 824 F.2d
27, 35-36 (D.C. Cir. 1987); Barker v. Henderson, Franklin, Starnes
& Holt, 797 F.2d 490, 496-97 (7th Cir. 1986); Windon Third Oil &
Gas Drilling Partnership v. FDIC, 805 F.2d 342, 347 (10th Cir.
1986) (circumstances did not support duty of disclosure).
Plaintiffs have produced some evidence that L & H knew that its
reports would be included in the PPMs that were given to investors.
They may be able to prove that L & H owed a duty and that a
recklessness standard for aider and abettor liability is therefore
warranted.
We accordingly reverse the summary judgment granted defendant
on the federal securities claims. We do not foreclose fu2rther
pretrial proceedings calculated to further shape and winnow these
claims or reduce the number of plaintiffs who may go forward. The
district court has the full range of its management powers and we
22
do not intend to limit those in any way. We have also attached
some sample jury instructions on the aider and abettor theory of
liability to assist the district court in formulating its charge.
Our purpose is not to prepare a charge for this able district
court. Rather, we use this means of explaining our ruling. We do
not restrict the district court's wide discretion in submitting any
claim that may ultimately go to a jury.
(4) Unregistered Securities
Plaintiffs contend that L & H violated Rule 10b-5 by aiding
and abetting Quinn-L's violation of § 12 of the Securities Act of
1933, 15 U.S.C. § 77l, and § 33A(1) of the Texas Securities Act,
Tex. Rev. Civ. Stat. Ann. art. 581-33 (Vernon Supp. 1992). The
argument is that L & H should have disclosed that the partnerships
were not registered as securities. Plaintiffs have not, however,
introduced any evidence that the limited partnership interests were
subject to the state or federal registration requirements, and have
therefore failed to prove a primary violation. Moreover, a
"seller" clearly bears the burden of proving an exemption from
registration. See SEC v. Ralston Purina Co., 346 U.S. 119, 126
(1953). The district court has correctly found that L & H was not
a "seller," and there is no authority for imposing on an alleged
aider and abettor the burden of establishing eligibility for an
exemption from registration. Summary judgment as to this issue was
therefore appropriate.
23
B. State Securities Claims
Plaintiffs also assert claims under Section 33(F)(2) of the
Texas Securities Act. Tex. Rev. Civ. Stat. Ann. Article 581-
33(F)(2). This section imposes joint and several liability on
those persons who directly or indirectly, with intent to deceive or
defraud or with reckless disregard for the truth or the law,
materially aid a seller of securities who misrepresents material
facts or omits material facts in connection with the sale. See
Tex. Rev. Civ. Stat. Ann. Article 581-33(A)(2). There are few
Texas decisions construing § 33(F)(2). We take some comfort from
the fact that Texas courts generally look to decisions of the
federal courts to interpret the Texas Securities Act because of
obvious similarities between the state and federal laws. Star
Supply Co. v. Jones, 665 S.W.2d 194,196 (Tex. App. 4 Dist. 1984).
Of course, the language of the Texas provision differs in some
respects from its federal counterpart. We think that they are
sufficiently parallel in relevant ways that, on our facts, the
state securities claims stand or fall with the federal claims.
The Texas Securities Act recognizes on its face, however, that
recklessness satisfies the scienter requirements for aider and
abettor liability. Section 33F(2) holds liable any person, jointly
and severally with the buyer, seller, or issuer, who "materially
aids" with "reckless disregard" a violation of Sections 33A, B, or
C. Tex. Rev. Civ. Stat. Ann. art. 581-33F(2) (Vernon Supp. 1992).
We reverse the summary judgment on the state claims and remand for
further proceedings parallel to the federal claims.
24
C. RICO Claims
Next we consider plaintiffs' arguments that L & H violated the
Racketeering Influenced and Corrupt Organizations Act (RICO), 18
U.S.C. § 1961 et. seq. To establish a RICO violation, plaintiffs
had to establish (1) conduct (2) of an enterprise (3) through a
pattern (4) of racketeering activity. Sedima, S.P.R.L. v. Imrex
Co., 473 U.S. 479 (1985).
Plaintiffs argue that they have shown many acts of
racketeering, that L & H's allegedly fraudulent materials were
repeatedly sent through the federal mails and therefore constituted
mail fraud. 18 U.S.C. § 1341. Plaintiffs' problems of proof with
respect to securities fraud do not necessarily haunt their claim of
mail fraud since reliance is not an element of mail fraud. Abell,
858 F.2d at 1129. Proof of mail fraud requires only a scheme to
defraud which involves the use of the mails for the purpose of
executing the scheme. United States v. McClelland, 868 F.2d 704,
706 (5th Cir. 1989). Each separate use of the mails in furtherance
of the scheme constitutes a separate offense. Id.
We have already determined that there are genuine issues of
material fact regarding the adequacy of the start-up balance sheets
and the corporate balance sheets, including intent to defraud. It
is undisputed that these materials were repeatedly mailed to
facilitate the sale of the limited partnerships. L & H argues that
it did not know that the balance sheets would be included in the
PPMs; plaintiffs have produced contrary evidence. Plaintiffs need
25
only show that it was reasonably foreseeable that the mails would
be used. Id. at 707.
Whether these acts constituted a pattern is a separate issue.
The Supreme Court has recently explained the concept of a pattern
of racketeering activity. H.J. Inc. v. Northwestern Bell Telephone
Co., 492 U.S. 229 (1989). A plaintiff must show two or more
predicate acts of racketeering which are related and which amount
to or pose a threat of continued criminal activity. Id. at 239.
The element of relatedness is satisfied if the criminal conduct
embraces criminal acts "that have the same purposes, results,
participants, victims, or methods of commission, or otherwise are
interrelated by distinguishing characteristics and are not isolated
events." Continuity may be established, inter alia, by a showing
that the predicates "are a regular way of conducting defendant's
ongoing legitimate business, or of conducting or participating in
an ongoing RICO enterprise."
Here, we have little trouble in concluding that the various
acts of mail fraud, if proved, would constitute a pattern of
racketeering activity. PPMs were consistently sent through the
mails in an effort to sell limited partnership interests for which
Quinn-L companies would serve as the general partner. The
provision of the balance sheets was L & H's regular way of
participating in an ongoing and allegedly fraudulent course of
conduct by the Quinn-L group. This is enough to make out a pattern
of racketeering under the RICO statute. See Abell v. Potomac
Insurance Co., Slip Op. No. 90-4737 (5th Cir. Nov. 13, 1991).
26
Finally, we must determine whether there was an enterprise in
which L & H was participating. Plaintiffs assert that the RICO
enterprise here was Quinn-L Corporation.7 Under 18 U.S.C.
§ 1961(4), an "enterprise" can include a corporation or other legal
entity. The enterprise must be an entity separate and apart from
the pattern of activity in which it engages. Manax v. McNamara,
842 F.2d 808, 811 (5th Cir. 1988). Furthermore, before we can
conclude that a defendant participates in the conduct of an
enterprise's affairs, there must be a nexus between the defendant,
the enterprise, and the racketeering activity. In this Circuit,
this nexus is established by proof that the defendant has in fact
committed the racketeering acts alleged, that the defendant's
association with the enterprise facilitated the commission of the
acts, and that the acts had some effect on the enterprise. United
States v. Carlock, 806 F.2d 535, 546 (5th Cir. 1986); United States
v. Cauble, 706 F.2d 1322, 1333 (5th Cir. 1983).8
7
It is unclear to us from the briefs and the record which
partnerships involved Quinn-L Corporation and which ones involved
Quinn-L Investments or other Quinn-L entities. In any event, in
light of our disposition of this case, we think plaintiffs should
be allowed to amend their pleadings on remand to clarify which
Quinn-L entities are targeted as RICO enterprises.
8
We note that Circuit courts have taken different views
regarding "participation in the conduct" of an enterprise. See
Yellow Bus Lines v. Local Union 639, 913 F.2d 948, 952-53 (D.C.
Cir. 1990) (en banc) (discussing the kaleidoscope of views on
this issue). The Supreme Court has recently granted certiorari
to consider an Eighth Circuit case on this topic. See Arthur
Young & Co. v. Reves, 937 F.2d 1310, 1325 (8th Cir. 1991), cert.
granted, __ U.S. __ (1992). Until the Supreme Court speaks, we
continue to apply the standard set forth in Cauble.
27
Quinn-L Corporation meets the definition of an "enterprise."
It was an ongoing corporation that engaged in activities other than
the allegedly fraudulent sales of partnership interests. L & H is
a separate entity employed by Quinn-L Corporation and accused of
participating in its scheme to defraud investors by distorting
financial statements. L & H's association with Quinn-L provided
not only the means of committing the fraud but also the motive.
The effect on the enterprise was to aid in the sale of partnerships
from which it reaped substantial income. Plaintiffs have
established the requisite nexus.
In sum, we are persuaded that the district court erred in
granting summary judgment on plaintiffs' RICO claims. We have
found that the start-up and corporate balance sheets raise a
genuine issue of fact as to whether L & H intended to deceive
plaintiffs about the financial position of the partnerships and the
net worth of Quinn-L Investments. On this record, plaintiffs are
therefore entitled to take their RICO case to a jury.
III.
Finally, plaintiffs and their attorneys object to the Rule 11
sanctions imposed for submitting affidavits not well grounded in
fact and the truth of which the attorneys had not adequately
investigated. Rule 11 provides in relevant part that "[t]he
signature of an attorney or party constitutes a certificate by the
signer that the signer has read the pleading, motion, or other
paper; that to the best of the signer's knowledge, information, and
belief formed after reasonable inquiry it is well grounded in fact.
28
. . . and that it is not interposed for any improper purpose."
F.R.C.P. 11. Violation of Rule 11 justifies the imposition of
sanctions. Robinson v. National Cash Register Co., 808 F.2d 1119,
1130 (5th Cir. 1987). We review the court's award of sanctions for
an abuse of discretion. Thomas v. Capital Security Services, Inc.,
836 F.2d 866, 872 (5th Cir. 1988).
In preparing their response to defendant's motion for summary
judgment, plaintiffs' attorneys mailed 127 form affidavits to their
clients. The plaintiffs read the affidavits, signed them, and
returned them, and their attorneys then filed the affidavits in the
district court with a signed pleading attached. When defendant
questioned plaintiffs about these affidavits in their oral
deposition, many of them admitted that many of the statements
contained in the affidavits were simply not true. Furthermore,
they confessed that they had not spoken with their attorneys about
the affidavits or their contents--they had received the affidavits
in the mail and sent them back, relying on their attorneys to
verify the facts to which they were attesting. On these grounds,
defendant moved to strike the affidavits and requested that
sanctions be imposed on the plaintiffs and their attorneys. While
this motion was pending in the district court, the plaintiffs
resubmitted the affidavits with a later pleading. The district
court concluded that plaintiffs' attorneys had failed to make a
reasonable inquiry as to the truth of the matters asserted in the
affidavits and assessed sanctions in the amount of $31,017.50.
29
We begin by noting that large attorneys' fees awards under
Rule 11 often can be coercive, even debilitating, sanctions. The
sheer size of some awards--tens and even hundreds of thousands of
dollars--can produce "devastating professional and financial
consequences." Cochran, "Rule 11: The Road to Amendment," 61
Miss. L.J. 5, 6 (1991); see also Johnson, Contois & Keeling, "The
Proposed Amendments to Rule 11: Urgent Problems and Suggested
Solutions," 43 Baylor L. Rev. 647, 650 (1991).
It is axiomatic that, in assessing Rule 11 sanctions, the
district court must impose the "least severe sanction adequate" to
accomplish the purposes of Rule 11. Thomas v. Capital Security
Serv., Inc., 836 F.2d 866, 878 (5th Cir. 1988) (en banc). While
the district court has broad discretion to fashion an appropriate
sanction, this court on appeal must ensure that the district court
discharged its duty to impose the least severe sanction adequate.
In cases in which "the sanctions imposed are substantial in amount,
type, or effect," appellate review of the sanctions is particularly
rigorous. Id. In such cases, the district court must enter
specific factual findings to assist the appellate court in its
review of the Rule 11 sanctions.
Despite the substantial size of the Rule 11 sanctions in the
instant case, the district court did not enter specific factual
findings. The court did not indicate in the record the factors it
considered in choosing a $31,017.50 sanction. It did not state in
the record which alternative sanctions, if any, it also considered.
30
Above all, it did not explain why the sanction it imposed was the
least severe sanction adequate to serve the purposes of Rule 11.
The least severe sanction adequate requirement serves a
critical function: it ensures that Rule 11 does not degenerate
into nothing more than a docket control device that the district
courts use to punish unsuccessful litigants who dare to raise their
claims or defenses in federal court. The $31,017.50 sanction in
this case may well be an appropriate Rule 11 sanction. Because of
its substantial size, however, this court may not affirm the
sanction until the district court has entered specific factual
findings determining whether the sanction is the least severe
adequate to serve the purposes of Rule 11.
We vacate the sanction and remand to the district court for
specific factual findings. We reverse the grant of summary
judgment and remand for further proceedings consistent with this
opinion.
31
APPENDIX
Instruction: Aiding and Abetting Liability
under Section 10(b) and Rule 10-b-5
I.
The plaintiff claims that the defendant aided and abetted a
violation of the federal securities law. A person who aids and
abets a violation of Section 10(b) and Rule 10b-5 may be held
liable for the violation.
Plaintiff must prove by a preponderance of the evidence:
1. That someone other than the defendant committed the
securities law violation charged in the complaint.
Answer:________________________________________________
Plaintiff did prove or plaintiff did not prove
If you have answered question 1 plaintiff did prove, then
answer question 2, otherwise do not answer further questions in
this set.
2. That the defendant substantially assisted the securities
violation as found by you in question 1.
Answer:________________________________________________
Plaintiff did prove or plaintiff did not prove
If you have answered question 2 plaintiff did prove, then
answer question 3, otherwise do not answer further questions in
this set.
3. That the defendant intended to assist the securities
violation as found by you in your answer to question 2.9
9
As suggested by Woodward v. Metro Bank of Dallas, 522 F.2d
84, 96 (5th Cir. 1975); Abell v. Potomac Ins. Co., 858 F.2d 1104,
1127 (5th Cir. 1988), vacated in part on other grounds sub nom.
i
Answer:________________________________________________
Plaintiff did prove or plaintiff did not prove
As to the first element, there can be no aiding and abetting
liability unless someone violated the securities laws.
As to the second element, the plaintiff must prove that the
assistance rendered by the defendant was substantial.10 Whether the
assistance was substantial must be considered in light of all the
surrounding circumstances.
As to the third element, the plaintiff must show that the
defendant consciously intended11 to assist the securities violation.
Conscious assistance has two aspects.12 First, the plaintiff must
prove that the defendant had knowledge of the existence of the
securities violation and generally understood how its actions aided
in promoting the success of the securities violation.13 Second, the
plaintiff must prove that the defendant intended to further the
securities violation.14
Fryer v. Abell, 492 U.S. 914 (1989).
10
Abell, 848 F.2d at 1127; Woodward, 522 F.2d at 97 ("In
any case, the assistance must be substantial before liability can
be imposed under 10b-5.").
11
Woodward, 522 F.2d at 97.
12
Abell, 858 F.2d at 1127.
13
Id.
14
Id. ("The second element of scienter -- commitment --
would be met where evidence shows that the abettor acts from a
desire to help the fraud succeed.").
ii
II.
[In cases where a duty to disclose is alleged and proved, or
where the performance of services atypical of the defendants'
business is alleged and proved, or where particularly substantial
assistance is alleged and proved, a fourth question must be
answered. Of course, these may themselves present fact issues for
separate submission to the jury.]
If you have answered question 3 plaintiff did not prove, then
answer question 4, otherwise do not answer further questions in
this set.
4. That the defendant acted in reckless disregard of the
fact that he assisted the securities violation as found
by you in your answer to question 2.
Answer:________________________________________________
Plaintiff did prove or plaintiff did not prove
Reckless disregard as used in question 4 means highly
unreasonable conduct, not merely ordinary mistake or inadvertence.
It is an extreme departure from reasonable conduct. Reckless
assistance has two aspects. First, plaintiff must prove that
defendant acted in reckless disregard of the securities violation
found by you in your answer to question 1. Second, plaintiff must
prove that defendant acted in reckless disregard of the fact of his
assistance.
iii