Petition — Meers v. Sundstrand Corp.
Supreme Court brief1977
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In the
Supreme Court of the United States
OctoneR Term, 1977
77-383 «@
Petitioner,
vs.
SUNDSTRAND CORPORATION,
Respondent.
PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE SEVENTH CIRCUIT
ALBERT E. JENNER, JR.
DONALD R. HARRIS
LYNNE E. McNOWN
One IBM Plaza
Chicago, Illinois 60611
(312) 222-9350
Attorneys for Petitioner
Henry W. MEERs
Of Counsel:
JENNER & BLOCK
UNITED STATES LAW PRINTING CO., CHICAGO, ILLINOIS 60618 (312) 525-6581
TABLE OF CONTENTS
PAGE
I ik a eS adiseabiaaban 1
EL Ee SNe ORO aa om oe ae 2
I a asieeecannians Sana 2
| a ee 2
I a i cllanemeenens 3
OI TN noice ia enlaces indaibilllananlaneibon 4
I a oa i 4
The Aborted Sundstrand-SKI Merger Negotiations 4
The Side Deal—Sundstrand’s Aequisition of
Huarisa’s Option ................ Solissheiineniialodetitdiiediniistiaes 7
The Burke Report and Ernst & Ernst Letter ........ y
I a a hessltnsesouresboninil 11
Rf a ae Ee Oe 12
Reasens for Granting the Writ. ................................. 13
I, The Culpability Standard Adopted By The Seventh
Cireuit Conflicts With A Controlling Decision Of
TE chciaceicichtinnniaietieaithemniinsshdaipcitsinmabiiatiipshdsaretapipien 13
A. Ernst é Ernst Requires An Intent To Deceive,
Manipulate Or Defraud ............................cccess--0 13
B. If Recklessness Can Ever Trigger Section
10(b) Liability, It Should Be Applied Only In
Cases Involving Affirmative Misrepresenta-
tion—Not Nondisclosure Cases _ ...................... 15
C. However Phrased, The Seventh Circuit In-
correctly Applied The Ernst & Ernst Test To
Se Ey ee. RINE TID eenesintincerterncntnscnersentetinns 17
ii
PAGE
II. If Recklessness By The Defendant Is Sufficient
For Liability, Recklessness By The Plaintiff
ee 21
COI acces venesssintnniinrensene cence 23
Appendix
Section 10(b) of the Securities Exchange Act
Tiina psn vninnsssentcniennsinpnainianaiianiaiiamiaaial App. 1
Biethe WES) nccsenescesineensicsscetempteninaaee App. 1
ee Re a re App. 2
District Court’s Judgment Order .......................- App. 71
Seventh Circuit Opinion .....................-.-cosee-eeseoees App. 72
Seventh Circuit’s Judgment .......022.....-.---eeeee App. 108
Seventh Cireuit’s Order Denying Petition for
TROOUTI oceiainssiniiniinniciaiindiiniiaee App. 109
TABLE OF AUTHORITIES
Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), re-
versing, 503 F.2d 1100 (7th Cir. 1974) _.......... 2, 13, 14, 15,
16,17, 21
Section 10(b) of the Securities Exchange Act of
DE, cncssmcesevisiinictticeaiciantinteiiimiamaiaal 2, 3, 4, 13, 14, 15
BD IG nisecniettinccstccitie ee 2, 3, 13, 14, 21, 23
In the
Supreme Court of the United States
Ocrosper TERM, 1977
No.
HENRY W. MEERS,
Petitioner,
vs.
SUNDSTRAND CORPORATION,
Respondent.
PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE SEVENTH CIRCUIT
Henry W. Meers hereby petitions that a writ of certio-
rari be issued to review the judgment of the United States
Court of Appeals for the Seventh Circuit entered on Feb-
ruary 23, 1977.
OPINIONS BELOW
The opinion of the United States Court of Appeals for
the Seventh Circuit is reported officially at 553 F.2d 1033
and unofficially at [1976-1977] CCH Fed. See. L. Rep.
2
795,887 and is printed in the Appendix at page 72. The
opinion of the United States District Court of the Northern
District of Illinois, Eastern Division, is not reported and
is printed in the Appendix at page 2.
JURISDICTION
The Seventh Cireuit’s judgment was entered on Feb-
ruary 23, 1977. (App. 108.) Petitioner’s timely petition for
rehearing was denied on April 18, 1977. (App. 109.) The
jurisdiction of this Court is invoked under 28 U.S.C.
§1254(1).
QUESTIONS PRESENTED
1. Is the Seventh Circuit’s new standard for liability
in a civil damage suit under Rule 10b-5 inconsistent with
this Court’s decision in Ernst € Ernst v. Hochfelder, 425
U.S. 185 (1976), since it imposes liability for omissions
deemed ‘‘reckless’’, with intent determined by an ‘‘objec-
tive’’ standard, even though the defendant acted in good
faith and without any actual intent to deceive, manipulate
or defraud?
2. Ina civil damage suit where liability is imposed, not
for any intent to deceive, manipulate or defraud, but only
for recklessness, is it a defense to liability that the plain-
tiff acted with equal or greater recklessness?
STATUTE AND RULE INVOLVED
The statute and rule involved in this case are §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 there-
under. The text of these provisions is reproduced in the
Appendix at page 1.
3
STATEMENT OF THE CASE
This action was brought in 1969 by Sundstrand Corpora-
tion against Standard Kollsman Industries, Inc. (‘‘SKI’’),
a publicly-owned corporation, John B. Huarisa, who was
president, a director and a major shareholder of SKI, and
Henry W. Meers, who was a partner in the investment
banking firm of White, Weld & Co. and an outside director
of SKIL.* Sundstrand claimed that defendants violated
§10(b) of the Securities Exchange Act of 1934 and Rule
10b-5 in conneciion with its acauisition of 223,190 shares
of SKI stock.
At the first trial (non-jury), this suit was dismissed at
the close of plaintiff’s case. Sundstrand appealed and ob-
tained a reversal on the ground that certain evidence had
been excluded. 488 F.2d 807 (1973). At the second trial,
the District Court entered judgment against all defendants,
jointly and severally, in the amount of $4,434,786 plus in-
terest. (App. 71.) The defendants appealed, and the
Seventh Circuit affirmed the judgment of liability but re-
duced the award of damages to $334,785 plus interest.
(App. 107-08.)
*In 1972, SKI was merged into Sun Chemical Corporation and
Sun Chemical was substituted as a defendant. Huarisa died in 1975,
and the executors of his estate were substituted as defendants.
STATEMENT OF FACTS
Ixtroduction
In the period from November, 1968 into January,
1969, SKI and Sundstrand were carrying on negotiations,
in which Meers was peripherally involved, for a possible
merger. In the midst of the negotiations, a block of SKI
stock, upon which Huarisa had an option, became avail-
able. In early January, 1969, after Meers’ role in the
merger was completed, Huarisa sold his option to Sund-
strand for $334,785 in a side deal with which Meers had
no involvement.
The Seventh Circuit applied an ‘‘objective’’ test to con-
clude that Meers was ‘‘reckless’’ in failing to call Sund-
strand before it purchased the option and advise that a
dissident SKI director had raised questions in the middle
of 1968 about certain SKI accounting policies, questions
which Meers believed to be without merit and to have been
resolved many months earlier. Meers was held to be per-
sonally liable for the $334,785 which Sundstrand paid to
Huarisa, even though there was no finding that he had
any intent to deceive or defraud Sundstrand or that he
had not acted in good faith. The Seventh Circuit deter-
mined that a defendant is liable under Section 10(b) for
omissions which the Court ‘‘objectively’’ determined to be
‘*reckless’’, even if the defendant ‘‘subjectively’’ lacked any
intent to deceive, manipulate or defraud.
The following is a brief statement of facts as found by
the courts below.
The Aborted Sundstrand-SKI Merger Negotiations
In the mid to late 1960’s, Sundstrand was an aggressive,
acquisition-minded company, which regularly reviewed
5
possible acquisition candidates. Between late 1967 and
October, 1968, Sundstrand considered the possibility of
acquiring SKI on three separate occasions. The initiative
for Sundstrand’s interest came from its wholly-owned sub-
sidiary, United Controls, which manufactured aircraft in-
struments as did Kollsman Instrument Corporation, one
of SKI’s subsidiaries. In the fall of 1968, an officer of
United Controls discussed its interest in acquiring SKI
with a White, Weld partner, who immediately reported the
conversation to Meers.
Negotiations for the possible merger of Sundstrand and
SKI began in November, 1968. Meers arranged an initial
meeting between executives of the two companies,* but he
did not attend that meeting or participate in the extensive
negotiations that took place up to the afternoon of Decem-
ber 26, 1968. Those negotiations were conducted by officers
of Sundstrand and Huarisa. On December 23, 1968, Sund-
strand decided to make an offer to acquire SKI at a price
equivalent to $32.75 per share for SKI stock. Sundstrand
made that decision without consulting with or advising
Meers. The $32.75 offer was presented to Huarisa at a
meeting at Sundstrand’s offices on the morning of Decem-
ber 26, 1968. Huarisa rejected the offer as being too low
and asked the Sundstrand officials to negotiate the price
with Meers. A meeting was immediately arranged for that
afternoon.
Meers (acting for SKI) and the Sundstrand officials met
during the afternoon of December 26.** Sundstrand reit-
*In his telephone call to arrange the initial meeting, Meers told
Sundstrand to get any information it wanted about SKI from SKI.
** This was the first contact Meers had had with Sundstrand
since his telephone call in November to arrange the first meeting
between the companies.
6
erated the $32.75 proposal and twice increased its offer.
Meers consulted by telephone with Huarisa as to each offer,
and, after rejecting the first two, Huarisa agreed to rec-
ommend Sundstrand’s ‘‘final’’ proposal of $38.25 per share
to SKI’s board of directors." The $38.25 proposal was
merely a preliminary proposal subject to approval by the
board of directors of each company, agreement by the
parties upon a definitive contract, and a detailed survey
to be made by Sundstrand of the facilities and books of
SKI and its subsidiaries.
Between December 26 and January 20, 1969 (when Sund-
stand terminated merger discussions), Meers had only two
contacts with Sundstrand: on December 27, Sundstrand
delivered a letter setting forth the terms of its offer to
Meers’ office, and on January 2, Sundstrand’s president
called Meers to ask if Meers knew how news of the merger,
which was still not public, had ‘‘leaked’’.** There was no
substantive discussion about the potential merger on either
occasion.
On January 7, 1969, Sundstrand commenced an exhaus-
tive investigation of SKI’s financial condition. Its survey
was conducted by fifteen Sundstrand officials and consumed
at least seven days. Meers was not consulted about the
investigation, nor was he advised of its progress. On Janu-
ary 20, Sundstrand called off the merger discussions be-
cause its investigative team had concluded that the merger
* The parties agreed that, if a merger were consummated, White,
Weld & Co. would be paid a fee of $150,000 for investment bank-
ing services to be performed in connection with the merger.
** It ultimately developed that Sundstrand’s officers began pur-
chasing SKI stock for their own accounts in late December, 1968,
before the public announcement on January 2, 1969 of the tentative
proposal, at prices substantially below the $38.25 price.
7
would not be in Sundstrand’s best interest.* One of the
principal reasons that Sundstrand decided against the
merger was its conclusion that SKI would be unable to
amortize all of the $4,700,000 of preproduction costs which
SKI was carrying on its books as assets.**
The Side Deal — Sundstrand’s Acquisition of
Huarisa’s Option
Although the merger never took place, Meers was held
liable for Sundstrand’s losses in a ‘‘side deal’’ with which
he had no connection.
On December 7, 1968, during the preliminary merger
discussions between Sundstrand and SKI, Sun Chemical
Corporation offered to purchase 223,190 shares of stock
owned by the Burke family and upon which Huarisa had
a right of first refusal at $30 per share. Sun Chemical’s
offer to buy the stock and Huarisa’s option rights were
widely reported in the Wall Street Journal and the Chi-
cago papers. Meers assumed that Huarisa would exercise
his option, and Huarisa, in fact, intended to do so.
But in early January, 1969, Huarisa was told by his
lawyers that he would have securities law and tax prob-
* The Sundstrand officers who had purchased SKI stock in De-
cember, 1968, before news of the merger negotiations was made
public, sold their SKI stock, at a substantial profit, in mid-January,
1969 before news that the merger was off was made public.
** Before making its proposals in December, 1968, Sundstrand
knew that SKI had substantial deferred preproduction costs. That
fact was disclosed in SKI’s 1967 annual report and was discussed
by Huarisa at a meeting with Sundstrand officers in November,
1968. The magnitude of these deferred costs caused Sundstrand’s
president to personally instruct the survey team to investigate this
matter thoroughly.
8
lems if he bought the Burke stock and then sold it to Sund-
strand in the proposed merger. Therefore, on January 4,
1969, Huarisa called Sundstrand’s president, advised him
of the problem, and arranged a meeting for January 6,
which Sundstrand’s and SKI’s counsel aiso attended. At
this meeting, Sundstrand agreed to acquire Huarisa’s
option. On January 9, a written agreement providing for
the acquisition of the option was executed by Sundstrand
and Huarisa. The price was $334,785.* Thus, all discus-
sions relating to Sundstand’s acquisition of the option
took place between January 4 and 9, with the only nego-
tiating meeting being the one on January 6.
Meers did not know of the January 6 meeting or that
Sundstrand was going to or might acquire the option
until after the meeting had occurred. A few days after
January 6, Huarisa or SKI’s attorney called Meers and
told him that Sundstrand had agreed to purchase the Burke
stock. The earliest date upon which the call might have
been made was January 8. Meers was not given any details
of the transaction. He was not told that Sundstrand’s
agreement was still executory, or that the contract was to
be signed the next day. Sundstrand made the decision
to buy the option on January 6 and executed the agreec-
ment on January 9 without advising or consulting with
Meers.
* Under the option, the total purchase price for the 223,190 shares
was $6,695,700. To exercise the option, a 59% initial payment
($334,785) was required. The remainder of the purchase price was
to be made in two installments. After making the 5% payment, the
option holder was not obligated to make any further payments.
In agreeing to pay $334,785 for the option, Sundstrand was reim-
bursing Huarisa for the amount he had spent to exercise the option.
Sundstrand, which had only acquired Huarisa’s option to facilitate
the proposed merger, bought the 223,190 shares on February 6, after
it had terminated merger negotiations with SKI.
9
The Burke Report and Ernst & Ernst Letter
Both the District Court and the Seventh Circuit found
Meers liable for failing to disclose a document referred to
as the ‘‘Burke report’’ and a letter to Burke from an
accountant at Ernst & Ernst.
James W. Burke, author of the Burke report, was a
dissident member of SKI’s board of directors and had
been an officer of SKI. His father had been the founder of
SKI. When his father died, Burke was passed over for the
job of president, and Huarisa was brought in for that
position. Huarisa demoted Burke for incompetence.
In mid-1968, after SKI’s annual report for 1967 was
released, Burke raised questions about the earnings re
ported therein. Burke expressed the opinion that those
earnings were overstated, and he questioned a number of
SKI’s accounting practices, in particular, the practice of
carrying preproduction costs as assets to be amortized
over future contracts, rather than expensing those costs
as they were incurred. Burke’s questions were considered
at a series of meetings held by the SKI board of directors
and were rebutted by detailed written analyses prepared
by SKI’s management.
Then Burke employed an accountant from Ernst
& Ernst, who did not conduct an audit but made only a
brief review of some of SKI’s financial data, and then
wrote a letter posing questions similar to Burke’s. At
Meers’ request, Price Waterhouse, the accountants who
had certified SKI’s 1967 financial statements, responded
to the questions, and further meetings were held among
the directors, the accountant from Ernst & Ernst, the
accountants from Price Waterhouse, and SKI manage-
ment. Price Waterhouse and SKI management firmly and
consistently maintained that the company’s accounting
practices were proper in all respects and that the ques-
10
tions raised by Burke and the accountant from Ernst &
Ernst were without substance.
Ultimately, in August, 1968, the Price Waterhouse part-
ner in charge of the SKI account and SKI’s financial vice-
president met with a member of the staff of the Securities
and Exchange Commission (‘‘SEC’’) in Washington, D.C.
and reviewed the various accounting questions. Meers had
suggested such a meeting. The SEC did not find anything
wrong with SKI’s accounting, and in fact ‘‘concluded
that the 1967 annual report [the report questioned by
Burke] did not reflect improper accounting practices.’’
(App. 96.) Meers was so advised.*
As a result of the consideration given to this matter in
the summer of 1968, the SKI board decided that Burke’s
criticisms were without merit. Meers, who had attended
a substantial number of the meetings, also concluded that
Burke’s objections were not valid, and that SKI’s account-
ing practices were proper. In reaching that determination,
Meers relied upon his analysis of the accounting questions
from the meetings he had attended and the documents he
had reviewed, the unequivocal positions taken and expla-
nations given by management and Price Waterhouse, the
fact that the questions posed by the accountant from Ernst
& Ernst were admittedly raised without the benefit of a
detailed examination of SKI’s records, and the position
taken by the SEC.
The Seventh Circuit held Meers liable solely for failing
to disclose the Burke report and the Ernst & Ernst letter
to Sundstrand prior to the purchase of Huarisa’s option
* Although the Seventh Circuit thought that “1968 accounting
practices were not passed on in the SEC meeting” (App. 97), the
SEC’s acceptance of the practices employed in the 1967 annual re-
port amounted to approval of the practices being employed by SKI’s
accountants in August, 1968, since the same accounting principles
were being applied. That was what Burke was complaining about.
11
on January 9, 1969. Liability was imposed even though
Meers testified that he had put this matter out of his mind
after the August, 1968 meeting with the SEC was reported
to him and he had decided that Burke was wrong. The
basis for liability turns on the events of the January 2, 1969
SKI board meeting at which the Sundstrand merger
proposal was considered. Burke_testified that, at this
meeting, he asked Huarisa whether Sundstrand had been
advised of the questions he and the Ernst & Ernst ae-
ecountant had raised. Burke further testified that Huarisa
replied in the negative, and that SKI’s attorney stated that
those materials did not have to be given to Sundstrand.*
SKI’s 1968 Earnings
In late January and February, 1969, as part of its
regular audit for the year ended December 31, 1968, Price
Waterhouse changed its position on some of the matters
which had been discussed in mid-1968, and raised with
SKI management some of the questions earlier raised by
Burke. These questions were resolved in March, 1969 at
meetings between Price Waterhouse and SKI financial
people by having SKI write off substantial amounts of
deferred preproduction costs which had previously been
carried as assets. This resulted in reducing SKI’s earn-
ings from the 86 cents per share reported for the first three
quarters of 1968 to a loss of 15 cents per share for the
entire year.
In this period, Meers was not informed that Price Water-
house had changed its approach to some of the questions
considered in mid-1968, nor was he even aware that discus-
* Meers testified that Burke did not raise any such question at the
January 2 meeting. Huarisa, who had died prior to the trial, testi-
fied in full about the January 2 meeting at a deposition without
mentioning any such discussion by Burke. Burke, who voted to
approve the Sundstrand merger proposal, did not advise Sundstrand
of his mid-1968 questions, nor did any other SKI director.
12
sions of this nature were taking place. He did not know
that SKI would report a loss for 1968 until that fact was
announced to the public at the end of March, 1969, aimost:
three months after Sundstrand had purchased the option.
He was surprised and immediately called SKI’s financial
vice-president for an explanation.
The Judgment Below
The Seventh Circuit held Meers personally liable for
$334,785 for ‘‘reckless nondisclosure’’ because he did not
call Sundstrand prior to January 9, 1969 and tell it about
Burke’s mid-1968 accounting objections.
The District Court found that SKI and Huarisa
acted intentionally or recklessly to deceive Sundstrand,
but premised Meers’ liability solely upon negligence,
making no finding that Meers had any intent to deceive
or defraud Sundstrand, and making no finding that he had
engaged in any intentional misconduct, or even that he
had acted recklessly. Likewise, the Seventh Circuit did
not find that Meers had any intent to deceive or defraud
Sundstrand or that he lacked good faith. Instead, the
Seventh Circuit applied an ‘‘objective’’ test and found
Meers’ conduct ‘‘reckless’’ as a matter of law.* The result
was to find Meers liable for not advising Sundstrand of
objections to accounting procedures which the Seventh Cir-
cuit in hindsight regarded as important, but which Meers
in January, 1969, honestly and in good faith regarded
as being without merit. According to the Seventh Circuit’s
new standard, Meers’ lack of intent to defraud or deceive
is irrelevant as a matter of law.
* The only consideration given to Meers’ actual or “subjective”
state of mind by the Seventh Circuit was whether he had forgotten
the Burke matter. Once the Seventh Circuit found that Meers had
been reminded of Burke’s objections at the January 2 board meet-
ing, liability was “objectively” determined without regard to actual
intent or good faith.
13
REASONS FOR GRANTING THE WRIT
I,
THE CULPABILITY STANDARD ADOPTED BY THE
SEVENTH CIRCUIT CONFLICTS WITH A CONTROL-
LING DECISION OF THIS COURT.
This Court should grant certiorari in this case to reit-
erate the holding of Ernst & Ernst v. Hochfelder, 425 US.
185 (1976), that Rule 10b-5 requires an intent to deceive,
manipulate or defraud, and to reject the Seventh Circuit’s
new standard which imposes liability for negligence under
the guise of an ‘‘objective’’ test of recklessness.
A. Ernst & Ernst Requires An Intent To Deceive,
Manipulate Or Defraud.
In Ernst & Ernst, the Seventh Circuit held negligence
sufficient for the imposition of liability under Rule 10b-5.
903 F.2d 1100 (7th Cir. 1974). This Court granted cer-
tiorari for the explicit purpose of deciding whether scienter
—an intent to deceive, manipulate, or defraud—was neces-
sary for liability or whether negligence was enough. The
decision held squarely that scienter is required. 425 U.S.
at 193 and 194 n.12.
In reaching its conclusion, the Court carefully exam-
ined the language and legislative history of §10(b) of the
Securities Exchange Act of 1934 and the language and
administrative history of Rule 10b-5. In all of these
sources, it found that the focus was upon proscribing inten-
tional, deceptive misconduct. Section 10(b) speaks of pro-
hibiting ‘‘any manipulative or deceptive device or contriv-
14
ance’’, words which ‘‘strongly suggest that §10(b) was
intended to proscribe knowing or intentional misconduct.’’
425 U.S. at 197. From the legislative history of §10(b),
the Court concluded that ‘‘[t]here is no indication ...
that §10(b) was intended to proscribe conduct not involv-
ing scienter.’’ 425 U.S. at 202. Similarly, Rule 10b-5 was
promulgated to cover situations involving scienter and not
something less than that. 425 U.S. at 212. Furthermore,
the Court noted that ‘‘[t]here is no indication that Con-
gress intended anyone to be made liable for [manipulative
or deceptive] practices unless he acted other than in good
faith.’’ 425 U.S. at 206.
The Court recognized in a footnote 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 act’’, and left open the issue of whether reckless
behavior could ‘‘in some cirecumstances’’ be a basis for
liability under Rule 10b-5. 425 U.S. at 194, n.12. (Emphasis
added.) But from the quoted language, it is obvious that
recklessness can be a basis for Rule 10b-5 liability only
where it is the equivalent of intentional misconduct, i.e.,
an intent to deceive, manipulate or defraud.
The Seventh Circuit has seized upon the open issue of
reckless conduct, 425 U.S. at 194 n.12, to fasten liability
upon Meers. However, the Court did not require proof
of bad faith or an intent to deceive, manipulate or defraud.
Indeed, the District Court had distinguished between
Meers and the other defendants by omitting any finding
that Meers had engaged in intentional or reckless conduct.
The Seventh Circuit admitted that a remand would be
required if intent were critical.
However, the Seventh Circuit concluded that the con-
duct which the District Court had found to be negligent
was ‘‘reckless’’ as a matter of law. Regardless of Meers’
15
good faith and lack of intent to defraud, the Seventh
Cireuit concluded that ‘‘recklessness’’ and liability are
established solely by the Court’s ‘‘objective’’ conclusion
that the matters not disclosed to Sundstrand (7.e., Burke’s
opinions about SKI’s accounting) were very important in
the transaction.
This Court in Ernst d Ernst squarely held that §10(b)
liability requires lack of good faith and an intent to
deceive, manipulate or defraud. The Seventh Circuit holds
just as squarely that liability may be based on an ‘‘objec-
tive’’ determination of the materiality of the undisclosed
matter—and that good faith and lack of an intent to defraud
is no defense. It is difficult to imagine a more direct con-
flict with the standard enunciated by this Court. If Ernst
é Ernst is not to be eroded, this Court must reject the new
Seventh Circuit standard.
B. If Recklessness Can Ever Trigger Section 10(b) Lia-
bility, It Should Be Applied Only In Cases Involving
Affirmative Misrepresentation— Not Nondisclosure
Cases.
In the instant case, liability was not imposed for any
affirmative misrepresentations by Meers, but rather for
his failure to disclose. Liability should not be imposed for
nondisclosure, as it was here, when there is no evidence
of an intent to conceal, deceive or defraud. While the con-
cept of ‘‘recklessness’’ may fit misrepresentation cases, it
makes no sense as applied to nondisclosure.*
Recklessness can have independent meaning and may
be a separate basis for liability for affirmative misrepre-
sentations. Where a false representation is made, the
*In its discussion of reckless conduct in footnote 12 of Ernst &
Ernst, this Court spoke only of “reckless disregard for the truth.”
The opinion does not discuss recklessness in terms of omissions.
16
speaker may misstate intentionally, recklessly, or negli-
gently. An intentional misrepresentation is one which the
speaker knows to be false. A negligent misrepresentation
has some basis but the basis is insufficient to make the
representation reasonable. A reckless misrepresentation is
one which the speaker has no factual basis for making—
a statement made with such a flagrant disregard for the
truth that the conduct may be deemed equivalent to an
intent to deceive. In any event, it is clear that the speaker
did not act in good faith. For example, if a seller of stock
misstates the age of the company’s manufacturing plant
as 10 years rather than 25 years, he may act intentionally
(knowing the correct age of the plant), recklessly (guess-
ing the age ‘‘off the top of his head’’ without any effort
to check the accuracy of his statement) or negligently
(after making an unreasonably inadequate attempt to
check the facts).
In contrast, there are not three degrees of conduct re-
garding omissions; there are no ‘‘reckless’’ omissions. If
an omission does not occur for the purpose of defrauding
or deceiving, the conduct is not equivalent to the inten-
tional misconduct required by Ernst @ Ernst. Anything
less is a negligent omission, even if disguised by adjectives
such as ‘‘recklessness’’ or ‘‘gross negligence’’. The
Seventh Circuit’s formulation that recklessness exists
where the danger of misleading buyers through the omis-
sion was ‘‘so obvious that any reasonable man would be
legally bound as knowing [the danger]’’ is merely another
way of stating a ‘‘negligence’’ or ‘‘gross negligence” test.
Absent a purpose to deceive or defraud, omissions which
are labeled ‘‘reckless’’ are in reality only negligent and
are not a proper basis for Rule 10b-5 liability. In omission
17
cases, the focus must be on whether there was a scheme
or intent to deceive or defraud.*
The only ‘‘subjective’’ aspect of the Seventh Circuit’s
test is whether the defendant remembered the undisclosed
facts. (App. 93, n.20.) If he remembered the facts, and the
Court finds the facts to be material**, the Seventh Circuit
will impose liability, regardless of his actual good faith
and lack of purpose to defraud. Thus, even if the District
Court had entered explicit findings (1) that Meers had no
intent to deceive Sundstrand and (2) that Meers in good
faith thought the Burke matter was unimportant and with-
out merit, the Seventh Circuit would still find Meers liable.
Clearly, this test is not equivalent to the Ernst & Ernst
test, which requires intentional or wilful conduct to deceive,
manipulate or defraud and which allows the defense of
good faith. Instead, it is a negligence test dressed up with
additional adjectives.
C. However Phrased, The Seventh Circuit Incorrectly
Applied The Ernst & Ernst Test To The Facts Of
This Case.
The manifest impropriety of the Seventh Circuit’s test
can be seen from its application to this case. On any of
* Intentional wrongdoers will not be immunized for fraudulent
failures to disclose by refusing to impose liability for “reckless”
omissions. Mere denials of any bad faith will not preclude liability.
It is common to infer an intent to deceive from circumstantial evi-
dence of the defendant’s conduct.
** Materiality, an objective test, is already in the Rule 10b-5 li-
ability equation as an element separate and distinct from scienter,
which focuses on the subjective mental state of the defendant. By
making the culpability test depend upon materiality, the Seventh
Circuit has, in effect, eliminated the scienter requirement.
18
the three key dates (December 26, January 2 and January
8), Meers’ failure to advise Sundstrand of Burke’s criti-
cisms of SKI’s accounting was at most negligence, and was
never the result of any purpose to defraud or deceive
Sundstrand.*
On December 26, 1968, Meers met with Sundstrand offi-
cials for a couple hours to negotiate the price of the pro-
posed merger. The testimony is uncontroverted that, on
that day, Meers had in fact forgotten about the Burke
questions, which he thought had been resolved several
months earlier when the SEC did not question SKI’s
accounting policies. Moreover, on December 26, the only
transaction under consideration was Sundstrand’s possible
merger with SKI. Sundstrand had advised Meers that it
was going to conduct a full seale, in-depth investigation
of SKI before preparing a definitive agreement and
proceeding with a merger, dealing directly with SKI
to obtain desired information. Meers expected Sund-
strand to do just that before it took any action, and
* The court below incorrectly found (App. 88-89) that Meers
was a “quasi-fiduciary” with an affirmative duty to disclose. The
record is clear, based upon the events of late 1968 and January, 1969,
that no such relationship or duty existed or was even contemplated
by either Sundstrand or Meers. Throughout the merger negoti-
ations, Sundstrand always looked to Huarisa and SKI for dis-
closure, never to Meers. It was clear that Meers was acting on be-
half of SKI, not Sundstrand, in the very limited price negotiations
which he carried on as a telephonic intermediary on December 26.
At no time during the entire negotiations respecting the proposed
merger did Sundstrand ever ask Meers for advice regarding either
the merger or the purchase of the Burke option, nor did he give
any advice. Sundstrand did not advise him in advance of its inten-
tions to buy the Burke option. The only investment banking rela-
tionship which ever existed between Sundstrand and Meers’ firm
terminated in the spring of 1968, long before the merger negotiations
with SKI began.
19
he never undertook a disclosure role, nor did Sundstrand
expect him to. Sundstrand never consulted with him or
requested information from him.
On January 2, at the SKI board meeting, Burke claims
to have asked whether Sundstrand had been told of his
questions, to which Huarisa said ‘‘no’’. Thus, the Seventh
Circuit concluded that from January 2, Meers no longer
had forgotten the Burke matter. Even if Meers’ denial
of that testimony is discounted, the evidence shows that
Meers’ failure to disclose was not due to bad faith or an
intent to deceive. Burke testified that SKI’s counsel ad-
vised the board (including Meers) that the Burke questions
did not have to be disclosed to Sundstrand. The only pos-
sible transaction of which Meers knew on January 2 was the
potential merger, and Sundstrand was to conduct its
thorough on-site investigation before concluding any defini-
tive merger agreement.* As of January 2, Meers did not
know that Sundstrand was going to buy or even consider
buying Huarisa’s option. He thought Huarisa was going to
* There is no evidence that Meers thought that the facts relating
to deferred preproduction costs and other items questioned by Burke
would not be disclosed to Sundstrand during the upcoming investi-
gation. Sundstrand already knew that SKI had large amounts of
deferred preproduction costs on its books, and Sundstrand’s presi-
dent instructed the survey team to investigate this item thoroughly.
In fact, Sundstrand did learn the facts relating to SKI's deferral
of preproduction costs during its investigation and concluded that it
would not go ahead with the merger because, in part, of concern
about those costs.
‘ Indeed, it is doubtful that the Burke matter was even material,
since the only fact which Sundstrand did not know was that, in
spite of assurances by management and Price Waterhouse, Burke
did not agree with the policy of deferring these costs. Sundstrand’s
original complaint did not even complain of the omission to disclose
the Burke report, but rather relied upon misrepresentations allegedly
made by the defendants.
20
exercise the option himself. Finally, Meers honestly
thought, as a result of the extensive meetings and consid-
eration given to the Burke matter in mid-1968 (including
consultation with Price Waterhouse and the SEC, an
agency not reticent in taking action regarding disputed
issues of accounting and financial reporting) that Burke
and the Ernst & Ernst accountant were wrong and that
management and Price Waterhouse were correct. There
was nothing that Meers thought was wrong with SKI’s
accounting, and consequently, he had no reason to perceive
any need for disclosure.”
Meers learned that Sundstrand had agreed to buy the
Burke stock at the earliest on January 8. He was not in-
volved in that transaction at all.** He was not told that
the contract had not yet been signed or that it was to be
signed the next day. Sundstrand did not even tell him
of the transaction, much less consult with him about it or
ask for any information. Nothing had changed his honest
opinion that Burke was wrong and that SKI’s accounting,
vouched for by management and Price Waterhouse, and
unquestioned by the SEC, was proper. SKI’s attorney,
who had said that disclosure of the Burke matter was not
necessary, had not changed his advice. Thus, any failure
to disclose in the 24-hour period prior to Sundstrand’s
execution of the agreement on January 9 was not the result
*In mid-1968, Meers reasonably and diligently did all that can
be expected of an outside director on an accounting dispute such
as the one here. The Seventh Circuit's standard which requires dis-
closure of things which Meers actually believed to be incorrect is
untenable and improper.
** Meers was not a purchaser or seller, nor did he get any com-
mission for Sundstrand’s acquisition of the option or the Burke
stock. Thus, there was no financial gain of any kind to improperly
motivate any nondisclosure by him.
21
ra
of any conscious decision not to disclose in order to deceive
Sundstrand; nor was it the result of bad faith.
By ignoring Meers’ good faith, and by imposing liability
for failing to disclose facts which Meers honestly did not
think had merit or were important, but which the Seventh
Circuit now thinks an objective, reasonable man would
have regarded as important, the Seventh Circuit has elim-
inated the scienter requirement in nondisclosure cases
under Rule 10b-5 and predicated liability upon negligence.
Furthermore, Meers has been the victim of an injustice.
He has been involved in this litigation for eight years. On
the first trial he was exonerated. After the second trial,
he was found liable for negligence on a very dubious basis.
Then on appeal, this supposed negligence has been escalated
to ‘‘recklessness’’—the ‘‘legally functional equivalent for
intent’’. (App. 93.) Since it is well known that this Court
in Ernst & Ernst interpreted Rule 10b-5 to require an
intent to deceive, manipulate or defraud, the Seventh Cir-
cuit’s decision that this standard was met tars Meers with
intentional wrongdoing—something no Court has ever
found. The Seventh Circuit’s new standard is bad in con-
ception and its vices are manifest in the instant case. It
should be rejected by this Court.
II.
IF RECKLESSNESS BY THE DEFENDANT IS SUFFI-
CIENT FOR LIABILITY, RECKLESSNESS BY THE
PLAINTIFF SHOULD BE A DEFENSE.
In the instant case, the Seventh Circuit imposed liability
upon Meers for ‘‘reckless’’ conduct, 7.e., a failure to exer-
cise sufficient care. At the same time, it rejected Meers’
defense that Sundstrand was at least equally reckless in
its acquisition of the Burke option. Indeed, Sundstrand was
more careless tian Meers.
22
On January 8 (at the earliest), Meers learned that Sund-
strand had agreed to buy the Burke stock. He did not, how-
ever, know that the agreement had not yet been signed
and would be signed the next day, January 9. Meers is held
liable for failing to realize that Sundstrand needed to be
informed of the Burke report (which Meers honestly did
not consider to be meritorious) and failing to call Sund-
strand within a matter of hours before it signed the agree-
ment on January 9.
But compare Sundstrand’s conduct. Sundstrand knew
from SKI1’s 1967 annual report that SKI had substantial
deferred preproduction costs on its books, and had dis-
cussed the matter with Huarisa in November, 1968. The
Sundstrand investigation team had been directed by Sund-
strand’s president to investigate that matter thoroughly.
The team was actually at SKI’s east coast facilities that
very week conducting the investigation, two full days of
which were completed on January 7 and 8, before the con-
tract was signed on January 9. Sundstrand’s officers could
have called the team on January 6 or 7, told them to look
into the preproduction cost item on a priority basis, and
to report back before the contract was signed. Or the
signing of the contract obligating the payment of $334,785
could have been delayed a day or two to permit consulta-
tion with the team, or could have been made subject
to an audit. Sundstrand took none of those actions.
Sundstrand’s officers could even have called Meers, told
him that a contract was to be signed on January 9, and
asked him if there was to his knowledge any matter which
they should consider before going ahead. Instead, Sund-
strand deliberately acted to keep Meers in ignorance of this
transaction. Meers should not be held liable for Sund-
strand’s failure to take sufficient time to consider the facts
available to it, or for Sundstrand’s failure to complete
the investigation that it told Meers it was going to make
23
prior to taking any action. Sundstrand’s hasty action in
purchasing the option was nuch more reckless than any
inaction by Meers.
It is totally inappropriate to impose liability upon a
defendant when the plaintiff’s conduct was more reckless,
a greater failure to exercise proper care. Under such cir-
cumstances, it is the plaintiff’s own conduct rather than the
defendant’s which causes its injury.
Consequently, it should be a defense in a Rule 10b-5
case, that the plaintiff’s conduct was either equally at fault
or more at fault in causing the plaintiff to be injured. It
does not serve any useful purpose to allow plaintiffs to
recover from defendants whose conduct is not more cul-
“pable. Indeed, plaintiffs should be required to exercise due
care to protect themselves in securities transactions. The
result of allowing the due care defense will be to promote
prudent conduct by everyone.
CONCLUSION
For the foregoing reasons, it is respectfully submitted
that this Court should grant the Petition for a Writ of
Certiorari to review the decision of the United States
Court of Appeals for the Seventh Circuit.
Respectfully submitted,
Avert E. JENNER, JR
DonaLp R. Harris
Lynne E. McNown
One IBM Plaza
Chicago, Illinois 60611
Attorneys for Petitioner
Henry W. MEERs
Of Counsel:
JENNER & BLocK
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APPENDIX
APPENDIX
Section 10(b) of the Securities Exchange Act of 1934
15 U.S.C. § 78j(b)
It shall be unlawful for any person, directly or indirect-
ly, by the use of any means of instrumentality of inter-
state commerce or of the mails, or of any facility of any
national securities exchange—
(b) To use or employ, in connection with the purchase
or sale of any security registered on a national securities
exchange or any security not so registered, any manipula-
tive or deceptive device or contrivance in contravention of
such rules and regulations as the Commission may prescribe
as necessary or appropriate in the public interest or for the
protection of investors.
Rule 10b-5
17 C.F.R. § 240.10b-5
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, or of any facility of any national
securities exchange,
(1) to employ any device, scheme or artifice to de-
fraud,
(2) to make any untrue statement of a material
fact or to omit to state material fact necessary in
order to make the statements made, in the light of the
circumstances under which they were made, not mis-
leading, or
(3) to 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.
App. 2
IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF ILLINOIS
EASTERN DIVISION
SUNDSTRAND CORPORATION,
Plaintiff,
Vs.
SUN CHEMICAL CORPORATION, et al.,
Defendants.
NO. 69 C 1660
MEMORANDUM OPINION
January 23, 1977
I.
This long-contested action was filed on August 9, 1969,
by Sundstrand Corporation (‘‘Sundstrand’’) against Stan-
dard Kollsman Industries, Ine. (‘‘SKI’’), John B. Huarisa
and Henry W. Meers, alleging violations by the defendants
of Section 10(b) of the Securities Exchange Act of 1934,
15 U.S.C. §78j(b), and Rule 10b-5 promulgated thereunder
by the Securities and Exchange Commission, 17 CFR
240.10b-5. Jurisdiction of this court is based on Section
27 of the Act, 15 U.S.C. §78aa.
1 Rule 10b-5 provides:
“Tt shall be unlawful for any person, directly or indirectly,
by the use of any means or instrumentality of interstate com-
merce, or of the mails or of any facility of any national securities
exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) 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 the light of the circumstances under which
they were made, not misleading, or
(c) To 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.”
App. 3 .
The transactions in dispute occurred on January 9,
1969, when Sunstrand, in connection with merger negotia-
tions which were then taking place between Sundstrand
and SKI, transferred to Huarisa 5,685 shares of Sund-
strand common stock, in exchange for the right to acquire
a block of 223,190 shares of SKI common stock owned by
the Burke family on which Huarisa had a right of first re-
fusal; and on February 6, 1969, when Sundstrand paid
$6,360,915 for that stock. The gravamen of Sundstrand’s
complaint is that Huarisa, Meers and SKI conspired to
violate and did violate Rule 10b-5 by misrepresenting ma-
terial facts and failing to disclose material facts about the
performance and financial condition of SKI during the
merger negotiations which resulted in Sundstrand’s pur-
chase of the SKI stock. Huarisa has filed a counterclaim
alleging that Sundstrand is obligated to repurchase from
him the 5,685 shares of Sundstrand stock transferred to him.
This case was originally tried by another judge of this
court from September 21 to December 8, 1971. At the close
of Sundstrand’s case, the trial judge granted defendants’
motions to dismiss under F.R.Civ. P. ii(b). The Court
of Appeals reversed, principally on the ground that the
trial judge had unduly limited the scope of Sundstrand’s
proof, and remanded for a new trial. 488 F.2d 807 (1973).
The case was tried in this court without a jury from Sep-
tember 16 to October 8, 1975. The following constitutes the
findings of fact and conclusions of law as required by F.R.
Civ P. 52.
The Parties
Sundstrand is a Delaware corporation, with its principal
place of business in Rockford, Illinois.
Sun Chemical is a Delaware corporation. On December
31, 1972, SKI was merged into Sun Chemical. Sundstrand
subsequently filed an amended complaint, and Sun Chemi-
cal was substituted as a defendant for SKI. While Sun
App. 4
Chemica! is a defendant in this action, it has been on the
other side of the question of the validity of SKI’s public
earnings statements. As a purchaser of a substantial block
of SKI stock, it was a party-plaintiff in a case filed in the
Southern District of New York, 69 Civ. 4374, against SKI,
Price Waterhouse, Raymond Ryan and others alleging,
inter alia, that the nine-months’ earnings report issued by
SKI in September, 1968, contained misrepresentations of
material facts and failed to disclose material facts in vio-
lation of Rule 10b-5. That case has been settled.
Prior to the Sun Chemical merger, SKI was an Illinois
corporation with places of business in Melrose Park, Illi-
nois, and other locations within the United States. SKI
was publicly owned, and its common stock was traded on
the New York Stock Exchange. At all relevant times SKI
had approximately 2,380,000 shares of common stock out-
standing. In making financial reports to its stockholders
and the public, SKI generally consolidated the financial in-
formation for itself, Kollsman Instrument Corporation
(‘*KIC’’) and its other subsidiaries.
KIC was the principal subsidiary of SKI. In 1967 and
1968, about two-thirds of the consolidated sales of SKI
and its subsidiaries were attributable to KIC, and the fi-
nancial results of KIC were the principal determinant of
SKI’s profit or loss position. During the relevant time
period, all the members of the SKI Board were also direc-
tors of KIC and at least four persons, including Huarisa
and Ryan, were officers of both SKI and KIC. KIC con-
ducted its business through several divisions, one of which
was the Avionics Division. The Avionics Division manufac-
tured commercial and military aircraft instrumentation.
At all relevant times John B. Huarisa was Chairman of
the Foard and President of SKI. He owned 172,000 shares
? Huarisa resigned as President of SKI on about March 5, 1969.
He continued to serve as Chairman of the Board until December
29, 1972.
App. 5
of SKI stock which he had acquired as part of the arrange-
ments made in connection with his becoming the chief
executive officer, at an average cost of $8.75 per share.
Huarisa also held a right of first refusal on additional
shares of SKI common stock owned by the Burke family
interests, pursuant to a Pooling Agreement dated Feb-
ruary 25, 1967.* It was this stock which Sundstrand paid
for on February 6, 1969. In May, 1975, Huarisa died, and
Thomas B. Hart and Raymond F. Ryan, as co-executors of
Huarisa’s estate, were subsequently substituted as defen-
dants for Huarisa.
Defendant Raymond F. Ryan was Vice President and
Treasurer of SKI from 1965 until 1969 and was responsi-
ble for the issuance of the financial statements of SKI and
subsidiaries. Although Ryan left SKI in July, 1971, and
went into business as a consultant, when the first trial of
this case commenced in September, 1971, his only client
was SKI which was paying him $4,100 per month. There-
after, in early 1973, he joined a company known as Stan-
comp, Inc., as its president. That corporation was formed
to purchase the assets of the Tuner Division of SKI. Until
his death Huarisa was Chairman of the Board of Stan-
comp, Inc., and Ryan’s superior. Huarisa and Ryan were
the only stockholders in Stancomp, Ine.
Defendant Thomas B. Hart, Jr., is a partner in the law
firm of Pope, Ballard, Shepard & Fowle, attorneys herein
for Sun Chemical and for Ryan and Hart as co-executors
of Huarisa’s estate.
Henry W. Meers was a director and stockholder of SKI
from May, 1967, untii May, 1970. In 1968 he received
$7,500 from SKI as director fees. Meers was a broker en-
3 See infra p. 14.
App. 6
gaged in the sale of securities and a managing partner in
the Chicago office of White, Weld & Company (‘‘ White,
Weld’’). White, Weld is a partnership which is a regis-
tered broker-dealer whose business includes acting as an
underwriter of securities and as a business broker for
corporations seeking to acquire or be acquired by other
corporations. In early 1968, White, Weld served as a co-
managing underwriter of a public offering by Sundstrand
of its securities. As a managing partner of White, Weld,
Meers personally performed services on behalf of Sund-
strand in connection with the offering and thereby became
acquainted with James W. Ethington, then president of
Sundstrand, and certain of its other officers. Farwell
Smith, a partner in White, Weld, worked under Meers in
connection with the underwriting of Sundstrand securities
and thereafter, up to March, 1969, made regular business
calls on Sundstrand in Rockford.
The Merger Negotiations
The purchase and sale of securities out of which this
case arises took place in the context of merger negotiations
between Sundstrand and SKI. In the late summer of 1968,
Huarisa and SKI were searching for a company suitable
for a merger with SKI. Meers and Huarisa had first dis-
cussed the subject as early as the spring or early summer
of 1968. Meers had, at that time, recommended several
companies, including Sundstrand, to Huarisa as good merg-
er prospects.
At the same time that SKI was looking for prospective
merger partners, other companies were considering acqui-
sition of SKI. In September, 1968, Riker Video Industries,
Inc., announced its intention to make a tender offer to SKI
stockholders to acquire all of SKI’s outstanding shares.
App. 7
The Riker Video proposal! was discussed at the SKI board
meeting on October 21, 1968. It was concluded that Riker
Video should not be given serious consideration as a pos-
sible merger candidate.
By November, 1968, Wubbenhorst, an officer of KIC,
had specifically been assigned the job of investigating var-
ious merger candidates and was writing a series of memo-
randa on the subject. He and Ryan concluded that Sund-
strand was a good candidate.
In early or mid-November, 1968, Huarisa, after dis-
cussing the possibility of a merger with Sundstrard with
Meers several times, directed Meers to get in touch with
Sundstrand and see if they were interested in a merger
with SKI. Meers telephoned James Ethington, president
of Sundstrand, and inquired as to his interest in a merger
and informed him of SKI’s 1967 earnings ($1.30 per share)
and its published earnings up to that time. Ethington,
after conferring with Louis Schuette, vice chairman of the
Sundstrand board and chairman of the Sundstrand execu-
tive committee, told Meers that Sundstrand would be in-
terested ir having further discussions.
Following this call, Ethington, Louis H. Schuette, Carl
L. Sadler, Jr., executive vice president of Sundstrand, and
other representatives of Sundstrand met with Huarisa in
a series of meetings in Illinois, New York and Connecticut,
to learn more about each other’s companies and to consider
the feasibility of a merger. These meetings occurred on
November 19 and December 3, 17-19 and 26, 1968. During
these meetings Huarisa confirmed to officers of Sundstrand
that SKI’s earnings for the first three quarters of 1968
were 86 cents per share, as reported in the published nine-
months’ earnings statement.
App. 8
On November 19, 1968, Ethington, Huarisa, Schuette and
Farwell Smith, a partner of Meers at White, Weld, met at
the Chicago Club in Chicago to discuss a possible merger
of Sundstrand and SKI. Smith substituted for Meers, who
was out of town. At that meeting Huarisa said that SKI
was looking for a merger partner in view of the attempt
by Riker Video Industries, Inc. to take over SKI and
merger proposals by a number of other companies; that
merger negotiations would have to be based upon SKI’s
projected earnings and that SKI was preparing projections
for 1969; and that SKI earnings for the first quarter of
1969 would be substantially better than SKI’s past history.
Huarisa also stated that SKI’s poor results for the fourth
quarter of 1967 were the result of some problems they had
had; that the Avionics Division had lost money, but that
he now had Avionics turned around and he expected SKI
to make more money in 1968 than it did in 1967. Also at
that meeting, Schuette asked Huarisa to prepare a projec-
tion of SKI earnings for 1968 and 1969.
A second meeting was arranged for the morning of De-
cember 3, 1968, at the Sundstrand corporate offices in Rock-
ford, Illinois. Huarisa met at various times that day with
Ethington, Sadler, Schuette, Bruce Olson, chairman of
the Sundstrand board, and Burnell Gustafson, a vice presi-
dent of Sundstrand. At one or more of these meetings,
Huarisa said that he would prefer to wait to negotiate the
merger until SKI’s financial results for the first quarter of
1969 were available, but that he was concerned about a
possible take-over of SKI by another corporation and there
was a need to proceed rapidly if Sundstrand was interested
in a merger.
At one of the meetings on December 3, 1968, Huarisa in-
formed Ethington and Schuette that SKI’s net income for
1968 would be between $2,600,000 and $2,900,000, that
App. 9
SKI’s 1968 earnings per share would be about $1.16, and
that earnings for the year 1969 would be about $2.41 or
even $2.50 per share. He said that the 1969 projection
should be the basis for negotiations.
Although Huarisa denied that he advised Sundstrand of
SKI’s expected 1968 earnings on December 3, 1968, the
consistent testimony of Ethington and Schuette that such
information was furnished, as well as Ethington’s con-
temporaneous notes of the meeting, support the conclusion
that he made this estimate of earnings. It is implausible
that the parties would discuss a proposed acquisition of
SKI in December of 1968 without considering SKI’s 1968
earnings. Huarisa stated in the SKI board meeting of
January 2, 1969, that he had told Sundstrand that SKI
would earn about $1.14 per share. The foregoing finding is
further supported by the testimony of Krinsly, an officer
of Sun Chemical, that Huarisa told him less than two weeks
after that SKI’s 1968 earnings would be $1.15 per share.
On December 17 through 19, 1968, Evans Erikson, vice
president of Sundstrand’s aerospace group, and Sadler,
together with Huarisa, visited SKI’s manufacturing and
executive facilities in Elmhurst and Syosset, New York
(KIC) and in Bridgeport, Connecticut (Casco Products
Corporation). On December 18, 1968, during a ride from
Syosset to New York City, Huarisa told Sadler and Erik-
son that Sundstrand would have to give SKI a positive
indication of interest in a merger before a divisional break-
down of SKI’s 1969 earnings projection of $2.41 per share
and other underlying SKI financial information would be
divulged. Huarisa also told Erikson and Sadler that such
a proposal by Sundstrand would have to be made before
January 1, 1969, because of the pressure from other com-
panies interested in taking over SKI. During this time
App. 10
Huarisa also said that other companies were anxious to
acquire SKI and that Sundstrand would have to pay sig-
nificantly more than $30 per SKI share in order to acquire
SKIL.
During the period from mid-November through Decem-
ber 26, 1968, Meers had several conversations with Huarisa
concerning the possible acquisition of SKI by Sundstrand
in which they discussed Huarisa’s meetings with Sund-
strand.
On the morning of December 26, 1968, Huarisa met with
Ethington, Olson, Sadler and Schuette in the Sundstrand
corporate offices in Rockford. At this meeting Huarisa
gave Sundstrand representatives an additional written
projection which showed 1969 earnings of $2.13 per share,
stating that it was very conservative and that SKI should
earn $2.41 or even $2.50 per share in 1969. Huarisa indicat-
ed that the 1968 earnings, as reported, were $.86 a share
and that in no case would there be adjustments which
would affect what had already been reported. Huarisa
also said that a Sundstrand offer of $32.75 for each share
of SKI stock was probably too low because he had offers
as high as $45 a share. (In fact, SKI had received no acqui-
sition or merger offers at the time such statement was
made, except for one which Huarisa deemed frivolous.)
Huarisa said Sundstrand should negotiate a price with
Meers.
Huarisa called Meers after he left Rockford on Decem-
ber 26 and had lunch with Meers. They discussed the ne-
gotiations with Sundstrand, and Meers agreed to handle
the merger negotiations for Huarisa. They agreed that
they would try to get the best deal they could. Huarisa told
Meers that he thought SKI’s 1969 earnings would be be-
App. 11
tween $2.00 and $2.50 per share. Meers considered Huarisa
a client of his firm and told him that there would be a fee
involved if the merger was consummated.
Ethington and Schuette then met with Meers for three
hours on the afternoon of December 26, 1968, to negotiate a
price for Sundstrand’s proposed acquisition of SKI. Meers
testified at trial that he was acting as an agent for Huarisa
during this meeting. During the meeting Meers periodical-
ly called Huarisa to get his comments on the successive
proposals made by Sundstrand. Meers first called and
transmitted an offer equivalent to $32.75 per share.
Huarisa told Meers that he (Meers) knew what SKI’s
earnings were and said that SKI had had discussions with
other companies at much higher prices and that $32.75
was not enough. Ethington and Schuette made further cal-
culations and offered $36 per share which Meers relayed
to Huarisa and which Huarisa also rejected as too low.
During the meeting Meers told Ethington and Schuette
that Sundstrand had had discussions with other companies
at prices as high as $45 per share. Ethington told Meers
that he was basing his offers on SKI earnings of $1.16 per
share in 1968 and $2.00 per share in 1969, even though
Huarisa had projected $2.13 to $2.41 per share for 1969.
Meers replied that Ethington’s earnings figures were rea-
sonable. Ethington and Schuette made a third and final
offer equivalent to $38.25 per share of SKI stock. Huarisa
agreed to submit that proposal to the board of directors
and the stockholders.
After Huarisa’s acceptance of the offer, it was agreed
that Ethington and Schuette would return to Rockford to
type up the proposal in final form. It was also agreed that
Meers’ firm, White, Weld, would receive a $150,000 fee if
the merger was consummated. There was no discussion of
App. 12
anything further that White, Weld would have to do to
earn this fee.
Meers’ testimony that he did not discuss SKI earnings
on the afternoon of December 26 is not plausible. Meers
admitted that Huarisa mentioned the 1969 projection of $2
to $2.50 per share at lunch that day and again mentioned
earnings projections during at least one of their phone
calls that afternoon. The subject of the negotiations was
how much Sundstrand would offer for each SKI share.
Ethington testified that he was concerned that a merger
not result in a dilution of Sundstrand’s earnings per share
and that Sundstrand’s offers were based on SKI’s earnings.
The conclusion is irresistible that SKI’s earnings must
have been a central part of those negotiations. Finally,
defendants’ effort to impeach the testimony of Ethington
in this regard failed. Ethington’s testimony at the first
trial of this case was virtually identical, and his deposi-
tion testimony on the point is not inconsistent, with his
testimony at trial.
As agreed at the meeting, Sundstrand drafted a proposal
that, subject to its conducting a survey of the business of
SKI and certain other conditions, Sundstrand would ac-
quire the assets of SKI subject to its liabilities, in exchange
for Sundstrand common stock at a market value approxi-
mately equivalent to $38.25 for each outstanding share of
SKI stock. Ethington delivered the written proposal to
Meers on December 27, 1968, and Meers delivered it to
Huarisa at his home on December 28, 1968. Under the
Sundstrand proposal, taking into account the 172,000
shares of SKI stock he owned, Huarisa stood to profit per-
sonally by about $5,200,000.
App. 13
On January 2, 1969, the SKI Board of Directors con-
sidered Sundstrand’s proposal. At that meeting Huarisa
informed the Board, including Meers, that he had told
Sundstrand that SKI earnings for 1968 would be about
$1.14 per share and that its 1969 earnings would be between
$2.00 and $2.50 per share. He further acknowledged, in
answer to a question by James W. Burke, Jr., one of the
directors, that he had not advised Sundstrand of the
‘*Burke Report.’’* The Board authorized Huarisa to
proceed on the basis of Sundstrand’s proposal. On the
same date the proposal was made public.
Meers contradicted Burke’s testimony that at the Jan-
uary 2 Board meeting Burke asked questions of Huarisa
and Meers as to whether Sundstrand had been advised of
SKI’s projected earnings and Burke’s raising accounting
questions. To the extent that there is a conflict in the evi-
dence, the court finds that, based on all the evidence,
Burke’s testimony in this regard is more credible.
Sundstrand’s Purchase of the SKI Stock
On January 4, 1969, Huarisa called Ethington and said
that he had a problem with a block of stock on which he
had to exercise an option by January 9, 1969. On January
6, 1969, Ethington, Huarisa, W. McNeil Kennedy, an at-
torney for Huarisa and also a SKI director, Charles E.
Pitt, Jr., a partner in the law firm representing Sund-
strand, and others met in Kennedy’s office in Chicago. At
this meeting, Huarisa and his attorneys informed Sund-
strand that Huarisa had received from the Burke family
an offer to sell to him at $30 per share 223,190 shares of
SKI stock covered by his right of first refusal in the Pool-
ing Agreement dated February 23, 1967. This offer to sell
by the Burke family had been communicated to Huarisa
on December 10, 1968.
4 See infra at 27. [App. 25-26.]
App. 14
Under the terms of the pooling agreement, Huarisa had
a right of first refusal on a large block of stock held by or
in trust for members of the Burke family.® In order to
exercise this right, Huarisa had to make a payment of 5%
of the price of the stock within 30 days of being notified of
an offer to purchase the stock by another party and an
intent by the Burkes to sell. A further payment of 20%
had to be made within 60 days and the entire amount had
to be paid within 120 days. If any payment was not made
according to the terms of the agreement, all restrictions on
the sale of the stock lapsed and any prior payments made
were forfeited.
Because Huarisa had received the Burkes’ offer to sell
on December 10, 1968, the thirty days within which Huarisa
had to make the first 5% payment would end on January
9, 1969, at which time Sun Chemical, which had made the
offer to the Burkes, would have an unconditional right to
purchase the stock. Huarisa said that if Sun Chemical got
this stock, Sundstrand and SKI could forget about the
proposed merger. Huarisa and his counsel told Sundstrand
that certain legal obstacles made uneconomic,® and thereby
prevented, Huarisa’s purchase and retention of that stock
if SKI and Sundstrand were to merge. At that meeting
Ethington stated that Sundstrand would be interested in
buying the stock only if it thought the proposed merger
5 The Burkes are the family of the founder of Standard Kollsman,
James O. Burke.
®* Huarisa was advised by his counsel that he faced possible sub-
stantial liabilities under Section 16(b) of the Securities Exchange
Act of 1934, 15 U.S.C. §78p(b), and Section 356 of the Internal
Revenue Code, 26 U.S.C. §356, if he purchased the stock himself
and the merger went through.
- App. 15
was going to take place. In response to Ethington’s ques-
tion, Huarisa said that SKI’s 1968 and 1969 earnings pro-
jections still looked good. Ethington, on behalf of Sund-
strand, orally agreed to purchase the 223,190 shares of
SKI stock from Huarisa at $30 per share. Because of con-
cern that Sun Chemical would attempt to upset the trans-
action if it learned of Huarisa’s sale of the Burke stock
to Sundstrand, it was agreed not to disclose the sale pub-
licly.
Meers was not present at, nor was he consulted by Sund-
strand in connection with, this meeting. However, he had
been aware that Huarisa hdd a right of first refusal on the
Burke stock since before he became a director of SKI and
had known of Sun Chemical’s offer for the Burke stock
since early December, 1968. At that time Meers received
a telephone call from Gus Levy, senior partner of Goldman
Sachs, who stated that his client, Alexander of Sun Chem-
ical, had almost 20% of SKI’s stock and would appreciate
Meers’ cooperation. Meers then called Huarisa who said
that was not true since he still had a right of first refusal
on the Burke stock. Meers then called Levy and advised
him of Huarisa’s right of first refusal. A day or two after
Huarisa’s January 6, 1969, meeting with Ethington, Meers
discussed with Huarisa Sundstrand’s prospective pur-
chase of the Burke stock.
On January 8, 1969, Huarisa took the first step toward
exercising his right of first refusal by delivering to the
Burke family his written election to purchase and five
percent of the purchase price, $334,785. On January 9,
Sundstrand and Huarisa entered into a stock purchase
agreement which provided, in relevant part, that:
‘‘1, Huarisa hereby sells, transfers and conveys
to Sundstrand the 223,190 shares of common stock of
Standard Kollsman Industries Inc. (‘‘SKI Shares’’)
App. 16
referred to in the Offer to Sell and related Pooling
Agreement, subject to payment by Sundstrand of the
unpaid balance of $6,360,915.00 due under the terms
of the Offer to Sell. ...[U]pon such payment of the
unpaid balance by Sundstrand, Sundstrand shall have
valid title to the SKI shares. ...
‘*2. Sundstrand hereby sells, transfers and conveys
to Huarisa 5,686 shares of common stock of Sund-
strand. sare
‘<3.
‘*4. (a) Sundstrand agrees that at any time or
times within two (2) years from the date hereof it will
purchase from Huarisa all or any part of the Sund-
strand Shares described in paragraph 2 hereof for the
eash price of $58.875 per share (which is the closing
price of the Sundstrand common shares on the New
York Stock Exchange on January 8, 1969) within fif-
teen (15) days after receipt by Sundstrand of written
notice from Huarisa that he exercises his right to sell
as provided in this paragraph 4(a)....’’
This agreement was entered into in contemplation of
and in connection with the proposed merger. On January
9, 1969, Sundstrand’s information with respect to the earn-
ings and financial condition of SKI consisted solely of that
obtained from published sources and the statements of the
defendants. Public information and statements of the de-
fendants which were particularly relied upon by Sund-
strand in entering into this agreement were the reported
earnings of 86 cents per share for the first nine months of
1968, the statements that SKI’s earnings would be about
$1.16 per share for the entire year 1968, the statements
App. 17
that the Avionics Division had been turned around and the
earnings projections for 1969 of at least $2.13 per share
in 1969.
There is no question that, by entering into the agreement
of January 9 Sundstrand obligated itself to convey to
Huarisa 5,686 shares of Sundstrand stock to compensate
him for his payment of $334,785 under the terms of the
Pooling Agreement. Thus, the defendants’ liability for
misrepresentations and omissions made in connection with
Sundstrand‘s transfer of these shares to Huarisa depends
on what was said, or not said, and what Sundstrand knew,
or did not know, as of January 9, 1969.
The parties dispute strenuously the question of whether
or not, by signing the agreement, Sundstrand also pur-
chased, at least for the purposes of Rule 10b-5, the entire
block of Burke stock at that time. Sundstrand argues
that it acquired the Burke stock on January 9, 1969, and
that the payment of $6,360,190 made on February 6 was
simply the final payment for an already consummated
deal. Under this interpretation, the defendants’ liability
with respect to the Burke stock is to be judged by condi-
tions as they existed on January 9. Defendants assert that
the purchase of the Burke stock occurred on February 6.
As a consequence of this interpretation, they argue that
the question of liability must be approached in terms not
only of what the defendants said, or did not say, but also
in terms of what Sundstrand found out for itself in its
survey of SKI conducted during January, 1969. This in-
vestigation, defendants claim, made Sundstrand aware of
all relevant information about SKI’s financia! prospects
and rendered harmless any misrepresentations which may
have been made. (Defendants do not, of course, admit that
any misrepresentations were made.)
App. 18
The court finds that the purchase of the Burke SKI
stock occurred on February 6, 1969. Under the terms of
the January 9 agreement, Sundstrand was under no legal
obligation to make any further payments toward the pur-
chase of the Burke stock, and Huarisa was only obligated
to make the transfer of the stock to Huarisa ‘‘subject to
payment by Sundstrand of the unpaid balance of $6,360,915
due under the terms of the Offer to Sell.’’ The only rele-
vant obligation * imposed on Sundstrand by the agreement
was to indemnify Huarisa for his 5% initial payment made
to keep the Burke stock out of the hands of Sun Chemical
for another thirty days. By the agreement, Sundstrand
secured an option to purchase the Burke stock by making
further payments according to the terms of the Pooling
Agreement. Sundstrand’s position was the same as Hua-
risa’s under the Pooling Agreement. It could make the
further payments and get the stock, or it could decline
to go through with the deal and forfeit the payment al-
ready made.
This is both the most reasonable reading of the terms
of the agreement and the most reasonable sort of agree-
ment for the parties to have entered into at that point.
Sundstrand’s reason for making the agreement was to
prevent Sun Chemical from acquiring a block of SKI stock
large enough to frustrate the Sundstrand-SKI merger
before Sundstrand could complete the investigation needed
to decide whether to go through with the merger. In order
to do this, it needed only to block Sun Chemical’s aequisi-
tion of the stock long enough to complete its investiga-
tion.®
7 Other obligations imposed by the agreement are of no conse-
quence to this issue.
8 This interpretation of the January 9 agreement is in accord with
that of the Court of Appeals, 488 F.2d 807, 810 (7th Cir. 1973).
App. 19
Continued Merger Negotiations After
January 9, 1969
Having thus preserved the possibility of a merger,
Sundstrand began a survey of various aspects of the oper-
ation of SKI to determine whether or not the merger
should be consummated. On January 9 and 10, 1969, offi-
cers and employees of Sundstrand, who were part of the
survey team, met with Ryan, Werle, Katz, and other finan-
cial personnel of KIC at the SKI facilities in Elmhurst
and Syosset, New York. On January 13 and 14, 1969,
Donald Miller, Sundstrand’s Controller, and his assistant
visited Ryan at the SKI offices in Melrose Park, Illinois.
On January 16, 1969, Miller and Ross met with Ryan and
Werle at the offices of SKI in Melrose Park, Illinois. In
one or more of such meetings, SKI representatives made
the following representations of material fact:
(a) That each quarter KIC reviewed the status of
each long-term contract and the estimated cost to com-
plete it and that, if the review disclosed that losses would
be incurred on the contract, KIC’s practice was to write
off immediately the total amount of such losses.
(b) That as a result of the last such review, $600,000
had been written off against Avionics Division income for
the month of November, 1968, and that, except for that
write-off, KIC would have made a profit in November.
(c) That by the fourth quarter of 1968, general and
administrative expenses of KIC had been reduced from
¢8,000,000 to $6,000,000 on an annualized basis, and that
the Avionics Division was profitable in the fourth quarter
of 1968 as a result of the profit improvement program.
App. 20
(d) That SKI’s earnings for the then completed year
1968 would be about $1.15 to $1.20 per share and that SKI
earnings for the year 1969 would be a little over $2 per
share.
(e) That SKI’s earnings for the eleven months ended
November 30, 1968, were $.84 per share.
(f) That the SKI financial results for December, 1968
would be very good and that, despite the results through
November 30, 1968, SKI would meet its 1968 earnings
projection.
(g) That the maximum amount of preproduction costs
which would be written off by KIC for 1968 was $902,000,
consisting of $151,000 of such costs on the KS-200, $72,000
on the AAU-19, $526,000 on the CPU-46, $96,000 on the
4201 airspeed indicator, and $57,000 on products to be
used on the Boeing 747. (Sundstrand was also shown a
document reflecting these figures as the ‘‘Amount of
Write-Off—1968,’’ and the same amounts were recorded
by Ross in his notes.
(h) That SKI expected to write off less than $902,000
of deferred preproduction costs for 1968 after discussions
with its auditors.
(i) That the only portion of the $902,000 which SKI
was definitely going to write off in 1968 was the $96,000
of deferred preproduction costs on the 4201.
(j) That KIC evaluated its inventory for obsolescence,
that a physical inventory in KIC had been taken at mid-
year 1968, that the inventories on KIC’s books were good
and that the reserve for obsolescence in the amount of
$183,000 at November 30, 1968, would be more than ade-
quate to cover any obsolescent inventory.
App. 21
At trial, Ryan denied that statements were made as to
a $600,000 November write-off in the Avionics Division,
or as to the level of earnings of SKI for December or for
all of 1968. The court finds that Ryan’s testimony is not
credible and is against the weight of the evidence. Ryan
is strongly identified with the defendants’ interests in
this litigation. As Ryan himself admitted, Werle did most
of the talking at their meetings with Sundstrand, and de-
fendants did not offer any testimony of Werle in that
regard. Both Ross and Miller testified as to statements
made with regard to the $600,000 November write-off.
Further support is provided by Ross’ handwritten notes.
Ryan’s testimony that he gave no projections of 1968 earn-
ings to Miller is likewise not credible. Miller appeared
pursuant to subpoena and testified as an independent wit-
ness, not having been associated with Sundstrand since
1971.
Though defendants Sun Chemical and Huarisa claim
that Sundstrand had full access to all relevant sources of
information during the survey, such was not the case,
particularly with respect to financial information. While
KIC personnel were instructed generally to make request-
ed information available to the Sundstrand team, this di-
rective explicitly excluded financial information. All re-
quests for financial information were to be referred to
Ryan and Werle. Ryan and Werle, who reported directly
to Huarisa, determined what financial information Sund-
strand would receive. In addition, on the day that the
survey began, Ross was told that the Sundstrand team
would not be seeing David B. Nichinson, the chief execu-
tive officer of KIC, SKI’s most important subsidiary, be
cause he had resigned. In fact, Nichinson had not resigned,
but had been summarily removed from his position by
App. 22
Huarisa. This action was prompted, at least in part, by
Nichinson’s disagreement with Huarisa over how much
earnings KIC would be able to report in 1968 and 1969.°
On January 17, 1969, Werle furnished to Miller by
phone, and confirmed by letter, further information re-
garding preproduction costs. He stated that $30,000 of
preproduction costs on the CPU-46 were ‘‘covered,’’ and
$876,000 of preproduction costs on the AAU-19 were
‘‘covered’’. Implicit in these statements was the repre-
sentation that the contracts would be profitable, since an
unprofitable contract would produce no gross profit to
‘‘cover’’ any preproduction costs.
Except for the write-offs of preproduction costs of
$902,000 or less, at no time prior to February 6, 1969, was
Sundstrand advised of any write-offs or adjustments
which were under consideration for the year-end 1968.
Upon returning to Rockford, Sundstrand personnel
evaluated the information provided them by the SKI rep-
resentatives. They concluded on January 20 that certain
aspects of the SKI operation, including an increase in
labor costs which a merger would cause, undesirable SKI
labor practices, and lack of the expected compatibility of
®In August, 1968, Huarisa told the president of KIC, David B.
Nichinson, that he “had to have a couple of million dollars more”
of KIC income in 1968. When Nichinson told Huarisa that it was
not possible for KIC to earn more in 1968 than had previously been
estimated, Huarisa responded that if Nichinson couldn’t give it to
him he “knew where he could find it.” Thereafter, Huarisa reor-
ganized the top management of KIC, announcing that George J.
Werle, Vice President-Controller of KIC, would be responsible for
all KIC financial affairs, that Mordecai D. Katz would be respon-
sible for management of the Avionics Division and that both Werle
and Katz would report directly to Huarisa rather than to Nichinson.
App. 23
SKI’s and Sundstrand’s products, made the acquisition
unattractive. The opinion was also expressed that SKI’s
earnings projections were somewhat optimistic. The
Sundstrand personnel estimated, based on the information
supplied, that SKI would earn about $.80 to $1.00 for 1968
and $1.45 to $1.50 and up for 1969. A decision was then
made to cancel the negotiations.
The conclusion to cancel the negotiations was discussed
on the evening of January 20, 1969, when Ethington and
Schuette met with Huarisa and Meers at a hotel near
O’Hare Airport. After Ethington and Schuette outlined
the reasons the proposal was being cancelled, namely, in-
creased labor costs which a merger would cause, lack of
product compatibility and Sundstrand’s reduced estimate
of SKI earnings, Huarisa replied that SKI could prove
that SKI would meet its earnings projections and that he
wanted to meet again to demonstrate the validity of his
position. At Meers’ request, Sundstrand agreed to defer
announcing termination of the merger proposal until they
met again with Huarisa.
On January 22, 1969, Ethington, Schuette, Erikson,
Miller, Huarisa, Meers and Ryan met at the Chicago Club.
The Sundstrand people expressed their doubts about
SKI’s earnings projections. These doubts were founded
in part on questions about SKI’s deferral of preproduc-
tion costs on certain contracts and about the profitability
of some contracts on which SKI was expecting a profit.
Both Huarisa and Ryan said that SKI would be able to
amortize these deferred preproduction costs in 1969 and
thereafter. Huarisa assured Sundstrand that no more
than $600,000 of preproduction costs would have to be
expensed in 1968, and that even if that maximum write-off
were made, earnings would not fall below the already
reported $.86 per share.
App. 24
With respect to the CPU-46, Ryan said that SKI would
get orders for 3,500 units, that the total market was about
8,000 units, that SKI would pass certain tests and be
placed on the government’s Qualified Products List ‘‘any
day,’’ which would enable it to receive follow-on orders,
and that it would in fact receive such orders. With respect
to the AAU-19, Ryan said SKI had started delivery in
1968, anticipated a delivery rate of 150 to 250 units per
month, that the total market potential was 30,000 units of
which SKI would get at least 15,000 and that since SKI’s
only competition was Aerosonic Corporation, which was
having delivery problems, SKI should get more than half
of the market for the AAU-19. Ryan also said that the
AAU-19 was probably one of the best programs that SKI
had as far as future potential was concerned. With re-
spect to the KS-200, Ryan said that despite declines in
sales of the Boeing 727 and 737 aircraft, SKI’s estimate
of 500 units was stil! accurate. He also said that the total
market for the KS-200 was over 1100 units and SKI was
the sole source for the product.
Despite these assurances, Sundstrand adhered to its de-
cision to call off the merger negotiations. At the close of
the meeting, Ethington said that Sundstrand appreciated
the efforts that SKI had made to supply them with infor-
mation. He also said that Sundstrand was going to honor
‘‘its commitment’’ with respect to the Burke shares. On
January 23, Sundstrand and SKI announced to the public
that plans for the merger had been dropped.
On February 6, 1969, in accord with the terms of the
January 6 agreement, Sundstrand made its payment for
the Burkes’ 223,190 shares of SKI common stock. The
transaction was accomplished by Sundstrand’s delivering
to Huarisa’s agents, who delivered to the National Boule-
App. 25
vard Bank of Chicago as escrowee a cashier’s check for
$6,360,915.00, and the Burkes’ delivering certificates for
223,190 shares of SKI common stock to the escrowee, who
delivered them to Huarisa’s agents, who delivered them
to Sundstrand.
Although Sundstrand was under no legal obligation to
make this payment, there is no doubt that Sundstrand, in
completing this purchase, had a right to rely on and was
in fact relying on what it had learned prior to the termina-
tion of the merger negotiations.
Subsequent Events
After completing its purchase, Sundstrand became
aware of material misrepresentations and omissions on
the part of the defendants.
On March 21, 1969, SKI published its 1968 Annual Re-
port which reported a net loss after taxes equivalent to
$.15 per share. A large part of the discrepancy between
this year end loss and the reported earnings of $.86 per
share for the first nine months of 1968 was attributable
to large write-offs of deferred preproduction costs and
the recognition of losses on several major contracts, in-
eluding the CPU-46, the AAU-19 and the KS-200.
About March 21, 1969, Norman Alexander, president of
Sun Chemical, telephoned Ethington and said that he had
copies of reports on SKI by James Burke,” a director of
SKI, and Ernst & Ernst, a firm of certified public ac-
countants, and asked if Ethington knew of their existence.
Ethington said that he had never heard of either report.
When Alexander offered to let Ethington read them,
10 James Burke was a member of the family which owned the
“Burke stock”.
App. 26
Ethington and Ross took a flight the next day to New York
City, where they met with Alexander and Stuart Krinsley,
vice president and general counsel for Sun Chemical. The
reports questioned, as of May, 1968, the propriety of the
continued deferral of preproduction costs and the failure
to recognize losses on some of the contracts which resulted
in the loss reported at year end 1968.
On March 27, 1969, Ethington called Meers who was
vacationing in the Bahamas and told Meers that he had
just gotten a copy of the Burke and Ernst & Ernst reports
and that he was very upset that he had not been previously
advised of these matters. Upon Meers’ return, Ethington
and Ross met with Meers. Ethington told Meers that he
was very upset that he had not been advised that one of
the SKI directors had questioned SKI’s earnings and that
ke had not received the Burke and Ernst & Ernst reports.
At trial, Meers acknowledged that he had not provided
such information to Sundstrand and had not advised
Sundstrand that Burke felt compelled to go to the SEC
with his complaints.
After Sundstrand learned of SKI’s financial results for
1968 and of the Burke and Ernst & Ernst reports, it un-
successfully sought to dispose of its SKI stock. Unable
to dispose of the stock, Sundstrand, through its counsel,
wrote to SKI, Huarisa and Meers in July, 1969, demand-
ing that the stock purchase be rescinded. Recission was
refused, and this action was filed on August 9, 1969.
Il.
It is apparent from the foregoing findings that the
plaintiff became involved in the purchase of the Burke
stock as a prelude to an anticipated merger. A merger is
a purchase or sale of securities within the meaning of
App. 27
Rule 10b-5. Dasho v. Susquehanna Corp., 380 F.2d 262
(7th Cir.), cert. denied, 389 U.S. 977 (1967). The fact that
Sundstrand, for reasons of its own, was unwilling to com-
plete the merger does not deprive it of its rights as an
investor. Thus, the various misrepresentations au@ omis-
sions made by Huarisa, Meers and SKI in their mereer
negotiations with Sundstrand were in connection with the
purchase of the stock by Sundstrand just as much as they
were in connection with the proposed merger.
The liability of the defendants under Rule 10b-5 is not
affected by the question whether the Burke family or
Huarisa was the immediate seller of the stock purchased
by Sundstrand. The rule in such cases is that persons
other than the immediate seller who engage in conduct
violative of Rule 10b-5 which causes the plaintiffs damage
in connection with the purchase may be held liable." See
generally Bromberg, Securities Laws: Fraud, See. 8.5
(500), et seg. (1974); Eason v. General Motors Acceptance
Corp., 490 F.2d 654 (7th Cir. 1973), cert. denied, 416 U.S.
960 (1974); G & M, Inc. v. Newbern, 488 F.2d 742, 745 (9th
Cir. 1973); Freed v. Szabo Food Service, CCH Fed. Sec.
L.Rep. 791,317 (N.D.Ill. 1964) [1961-64 Transfer Binder] ;
Cf. Sundstrand Corp. v. Standard Kollsman Industries,
Inc., 488 F.2d 807 (7th Cir. 1973).
11 Rule 10b-5, adopted in 1942, has a broad remedial purpose,
viz. to afford those engaging in securities transactions the protection
of full disclosure by those with whom they deal. Rule 10b-5 “greatly
expands the protection frequently so hemmed in by the traditional
concepts of common law misrepresentation and deceit.” Hooper v.
Mountain States Sec. Corp., 282 F.2d 195, 201 (5th Cir. 1960),
cert. denied, 365 U.S. 814 (1961), and should be construed “ ‘not
technically and restrictively, but flexibly to effectuate its remedial
purposes’.” Affiliated Ute Citizens of Utah v. United States, supra,
at 151, quoting SEC v. Capital Gains Research Bureau, 375 U.S.
180, 195 (1963).
App. 28
Material Misrepresentations and Omissions
To be actionable under Rule 10b-5, the statements of
defendants must have contained material misrepresenta-
tions or defendants must have omitted to state material
facts. With respect to omissions, such as the failure to
disclose the Burke and Ernst & Ernst reports and the
Price Waterhouse memorandum of January 27, 1969,
‘*All that is necessary is that the facts withheld be
material in the sense that a reasonable investor might
have considered them important in making this deci-
sion [to sell certain stock]. (Emphasis added.) Affili-
ated Ute Citizens of Utah v. United States, 406 U.S.
128, 153-54 (1972).
See also Northway, Inc. v. TSC Industries, Inc., 512 F.2d
324, 331 n.13 (7th Cir. 1975). A misrepresented fact will
be deemed material if ‘‘ ‘a reasonable man would attach
importance [to the fact misrepresented] in determining
his choice of action in the transaction in question.’ ’’ List
v. Fashion Park, Inc., 340 F.2d 457, 462 (2d Cir. 1965). All
of the misrepresentations and omissions discussed below
were material.
A. Misrepresentations and Omissions Prior to January
9, 1969.
1. Earnings Projections
The earnings figures of $2,600,000 or $2,900,000 and
$1.16 per share for all of 1968 which Huarisa represented
to Sundstrand were grossly inflated. In 1968 SKI reported
a loss of $367,803, equivalent to $.15 per share.
The projections of $2.50 and $2.41 per share earnings
in 1969 and even the ‘‘conservative’’ projection of $2.13
were similarly overstated. The actual SKI 1969 earnings
were only $.35 per share, and this low figure was in spite
App. 29
of the fact that 1968, not 1969, bore the brunt of the write-
off of preproduction costs. These 1968 write-offs, as pub-
licly stated by SKI and Huarisa in late March, 1969, were
‘to insure that the company’s earnings in 1969 and the
years beyond are not compromised by past problems
. .”’? Ryan testified that he told Sundstrand that the
SKI projections for 1968 were based on the assumption
that $900,000 of deferred preproduction costs would be
written off in 1968. In fact, more than $2,400,000 of such
costs were written off as of year-end 1968. Though write-
offs of such magnitude should have increased the likeli-
hood that SKI would realize its 1969 earnings projections,
the earnings turned out to be only 16% of the ‘‘conserva-
tive’’ projection.
These representations as to the earnings for the entire
year 1968 and the earnings for the year 1969 were clearly
material. The SEC has said that ‘‘management’s assess-
ment of a company’s future performance is information
of significant importance to the investor. .. .’’ SEC Rel.
No. 34-9984, 17 CFR 241.9984, CCH Sec.L.Rep. 23,508.
See also Marz v. Computer Sciences Corp., 507 F.2d 4835,
489 (9th Cir. 1974). It is true that an earnings projection
is not actionable simply because it turns out to have been
too optimistic. Securities and Exchange Commission v. R.
A, Holman €& Co., 366 F.2d 456 (2d Cir. 1966). However,
an earnings projection will be found to be a ‘‘misstate-
ment’’ unless it is ‘‘a reasonable and justified statement
of opinion . . . with a sound factual or historical basis.’’
G & M, Inc. v. Newbern, supra, at 745-46. See also Marx
v. Computer Sciences Corp., supra, at 490-91; Beecher v.
Able, 374 F.Supp. 341, 347-48 (S.D.N.Y. 1974); Green v.
Jonhop, Inc., 358 F.Supp. 413 (D.Ore. 1973).
App. 30
The 1968 earnings projections made by Huarisa and
SKI do not meet this standard. There is no evidence that
these projections were reasonable statements or that they
had any sound foundation. The evidence does show that
Huarisa and SKI knew, or were reckless in not knowing,
that the earnings reported for the first nine months of
1968, which were the foundation for the projection of the
whole year’s earnings, were grossly overstated and that
nothing had occurred during the last quarter of 1968 which
would even make up for that overstatement. The projec-
tion of 1969 earnings was also a misstatement. Huarisa,
as chief executive officer of SKI, worked closely with
Ryan, the chief financial officer, and was familiar with
SKI’s production and financial difficulties. Despite this
knowledge, Huarisa told Sundstrand that he projected
1969 earnings to be between $2.50 and a ‘‘conservative’’
$2.13 per share. Defendants Sun Chemical and Huarisa
presented no evidence to support this optimistic forecast.
In fact, 1969 earnings were only $.35 per share, even
though SKI wrote off more than $3,000,000 more than
Huarisa said was the maximum possible write-off at year
end 1968. These write-offs enhanced SKI’s 1969 earnings.
The inference is inescapable that Huarisa and SKI knew,
or were reckless in not knowing, that the projected 1969
earnings given to Sundstrand were grossly inflated and
without sound and reasonable basis and were, therefore,
‘‘misstatements of material fact’’ for the purposes of
Rule 10b-5.
2. Failure to Disclose the Burke and Ernst & Ernst
Reports
The defendants failed to disclose to Sundstrand that
James W. Burke, a director, officer and large shareholder
of SKI had, in May, 1968, formally submitted to the board
of directors of SKI questions as to the propriety of cer-
App. 31
tain SKI accounting practices, including that of continu-
ing to defer certain preproduction costs on the CPU-46
and other programs. The questions related principally to
accounting practices as revealed in the 1967 annual report.
Burke supported his questions in June with a report from
Ernst & Ernst, an independent firm of certified public ac-
countants which Burke had asked to consider the propriety
of the practices he challenged. Ernst & Ernst, though de-
clining to render a formal! opinion because it had not con-
ducted an examination in conformity with generally ac-
cepted auditing procedures, concluded that the practices
addressed in the Burke Report seemed questionable.
These reports were considered serious enough by the
SKI board of directors to be discussed at at least twenty-
five board meetings during the spring and summer of
1968. The board directed the officers of SKI to prepare
responses to Burke’s questions, and at Meers’ request,
representatives of Price Waterhouse, the firm of certified
public accountants which prepared the SKI 1967 annual
report, appeared at several of these meetings to diseuss
Burke’s questions. The board eventually decided that
Burke’s criticisms were without merit. However, as a
result of Burke’s questions, the board began, in April,
1968, to receive monthly financial reports. These reports
revealed the continual increase of deferred preproduction
costs on the CPU-46 and other programs throughout 1968.
Meers was concerned enough to ask about the progress
of each of the contracts on which costs were deferred, in-
cluding the CPU-46, at every board meeting and asked
particularly whether the CPU-46 had been qualified with
the government—a step which was essential to producing
an acceptable product and obtaining follow-on contracts.
In each such meeting he learned that no such qualification
had been obtained. (In fact, qualification was not obtained
until September, 1969.)
App. 32
Dissatisfied with the board’s action, Burke complained
to the SEC. Ryan, Hart, acting as attorney for SKI, and
H. Dudley Murphy, a partner of Price Waterhouse, met
in Washington with Curtis A. Davies of the SEC to dis-
cuss Burke’s charges. At that meeting it was concluded
that the 1967 annual report did not reflect improper ac-
counting practices. With respect to preproduction costs
on the CPU-46, Murphy assured Davies that Price Water-
house would re-evaluate the situation when they prepared
the 1968 annual report. This assurance was reiterated in
a letter from Murphy to Davies. Both Ryan and Meers
saw copies of that letter. None of this was disclosed to
Sundstrand.
Neither was it disclosed that, because of questions about
the propriety of SKI’s 1967 financial statements, two di-
rectors of SKI, Burke and Perry Addleman, refused to
sign a registration statement filed by SKI with the Securi-
ties and Exchange Commission in March, 1968. Meers
later suggested that the registration statement be with-
drawn, which was done in August, 1968. In addition, de-
fendants failed to disclose to Sundstrand that Addleman
also raised questions about the financial accounting of
SKI.
Defendants argue that, for a number of reasons, there
was no actionable failure to disclose in connection with
the Burke and Ernst & Ernst reports. They argue first
that the existence of the reports was in fact disclosed by
Neil Kennedy, a partner in the law firm representing
Huarisa and SKI, at the January 6, 1969, meeting in his
office at which the problem of the Sun Chemical offer for
the Burke stock and Huarisa’s inability to exercise his
option were discussed. This assertion, supported by the
deposition testimony of Huarisa and Howard B. Sweig,
another attorney in the law firm representing Huarisa and
App. 33
SKI, is contradicted by the trial testimony of Ethington
and is belied by the conduct of Ethington and Ross in rush-
ing to New York after receiving the call from Alexander
and then immediately confronting Meers with the failure
to disclose the Burke and Ernst & Ernst reports.
It is not, however, necessary for this court to resolve
the conflict between the testimony of Ethington and of
Huarisa and Sweig, because even accepting Huarisa’s and
Sweig’s version of the January 6 meeting, defendants’
disclosure was inadequate. According to Sweig, at the
end of an extensive discussion in which Kennedy belittled
Burke’s business judgment and his personal qualities,
Kennedy stated, as a further example of Burke’s irra-
tional behavior, that Burke had retained some accountants
and had complained to the SEC about SKI’s financial
affairs. According to defendants’ version, when Ethington
asked what happened at the SEC, Kennedy replied, ‘‘the
SEC kicked them out of the office.’’ This last statement
does not reflect what happened, and any statement to that
effect is misleading. The SEC had not kicked Burke out,
but had, rather, accepted Price Waterhouse’s explanation
of the 1967 annual report and their assurance that they
would review the propriety of continued deferrals of the
CPU-46 at year end 1968, indicating, at least, that one
matter was still open. Thus, even if defendants’ witnesses
are believed, any disclosure of the Burke and Ernst &
Ernst reports on January 6, 1969, was made in a false and
misleading manner and did not inform Sundstrand of the
material facts.
Defendants also assert that the Burke and Ernst &
Ernst reports did not need to be disclosed because the
SKI board of directors and, more importantly, the SEC
had considered Burke’s complaints and found them
groundless. As discussed above, that was not the result
App. 34
of the meeting with Davies of the SEC. Moreover, all the
defendants knew from the monthly financial statements
that the deferred preproduction costs on the CPU-46 and
other programs kept increasing after the meetings with
the SEC. They also knew, from the answers to Meers’
questions at board meetings, that the CPU-46 had still not
qualified and was, therefore, not a candidate for any of
the follow-on business necessary to amortize the mounting
preproduction costs.
With these important issues not resolved, the materi-
ality of the Burke and Ernst & Ernst reports is not open
to serious question. The fact that a director of SKI and
a national accounting firm had raised these questions was
itself a material fact which should have been disclosed to
Sundstrand. The significance of these questions was rec-
ognized by Meers and the other directors of SKI, who at-
tended numerous meetings at which officers of SKI and
representatives of Price Waterhouse took part in dis-
cussions of the issues raised by the reports. The impor-
tance of the reports is confirmed by subsequent events.
In preparing the 1968 annual report, Price Waterhouse
determined that the continued deferral of preproduction
costs on the CPU-46 and other programs was improper,
and that the losses on the CPU-46 should be written off.
These matters, raised in the Burke and Ernst & Ernst re-
ports, resulted in write-offs of several million dollars.
3. Nine-Month Earnings Report of November 4, 1968
SKI’s quarterly report to shareholders for the nine
months ended September 30, 1968, prepared on or about
November 4, 1968, was false and misleading. This report,
which was not audited or examined by SKI’s independent
certified public accountants, Price Waterhouse & Co., was
not prepared in accordance with generally accepted ac-
counting principles, nor with its own accounting policies.
App. 35
Instead, the accounting policies followed in the prepara-
tion of the audited financial statements for year-end 1967
and 1968, which were reflected in SKI’s annual reports
for those years, were largely ignored in the preparation
of the results for the nine months ended September 30,
1968.
The reported nine-month earnings of SKI and its sub-
sidiaries included grossly inflated amounts for KIC. The
report overstated earnings because of a failure to make
various adjustments which would have reduced KIC’s in-
come, and because of certain ‘‘management adjustments’’
which increased income, and which were improper in whole
or in part.
The adjustments which should have been made by KIC
were in several categories: recognition of anticipated
losses on contracts (cost overruns), amortization of pre-
production costs, write-off of ‘‘preproduction’’ costs in-
curred where there was no related contract, write-off of
improperly deferred purported ‘‘start-up’’ costs, and er-
rors in costing between SKI and KIC. Had these adjust-
ments been made, SKI would have reported 30 cents as
earnings per share for the nine months ended September
30, 1968, rather than 86 cents per share. As early as July,
1968, Werle submitted a memorandum to Nichinson re-
vealing his knowledge that a number of these adjustments
were required to be made.
The particular adjustments which should have been
made, and their effect on the financial results which were
actually reported, are summarized in Table A at page [37].
Gerald W. Hepp, a certified public accountant, testified
as an expert witness for Sundstrand on certain accounting
matters, particularly with respect to the SKI report of
September 30, 1968. Hepp was qualified to testify as an
App. 36
expert on such matters. The opinions he expressed were
based on generally accepted accounting principles, the ac-
counting policies of KIC applicable to the preparation of
SKI consolidated financial reports as reflected in SKI and
KIC published reports, ‘‘representation letters’’ to Price
Waterhouse, and other documents, rules of the Securities
and Exchange Commission and New York Stock Exchange,
and accounting records of SKI and KIC. Hepp examined
original accounting records of KIC produced by Sun
Chemical. He also considered other accounting records
and working papers produced by the corporate defendant
and by Price Waterhouse & Co. As a basis for his opin-
ions, Hepp considered and relied upon the available evi-
dence from the records of the corporate defendant as well
as other evidence, and the sources he relied upon were of
a type reasonably relied upon by accountants in forming
opinions on accounting matters.
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TABLE A—SUMMARY OF ADJUSTMENTS WHICH SHOULD
OF STANDARD KOLLSMAN INDUSTRIES, INC.
REFERENCE a NATURE OF ADJUSTMENT
CPU-46 319 Recognition of anticipated loss on c
CPU~-46 320 Amortization of preproduction costs
AAU-19 321 Recognition of anticipated loss on cx
AAU-19 322 Amortization of preproduction costs
4201 323 Write-off costs incurred because of r
related contract
SWING 324 Reccgnition of anticipated loss on cc
Ordinance 325 Write-off of improperly deferred cost
VVI 326 Recognition of anticipated loss on cc
M125 327 Error in costing between SKI and KIC
KS200 328 Reversal of profit improperly recorde
906262 330 Pecognition of anticipated loss on cc
908152 331 Recognition of anticipated loss on cc
906322 332 Recognition of anticipated loss on cc
TOTAL ADJUSTMENTS
Reported in Statements
Total Adjustments (See above)
Adjusted Amounts
This table is substantially taken from Plaintifi's Trial Ex!
PTX316 included an adjustment of $261,816 as amortization oi
that the evidence does not support plaintiff's assertion thi
App. 37
HAVE BEEN REFLECTED IN FINANCIAL STATEMENTS
ND SUBSIDIARIES AT SEPTEMBER 30, 1968
AMOUNT OF INCOME TAX NET PER-SHARZ
ADJUSTMENT EFFECT ADJUSTMENT _ EFFECT
tract $ 324,445 $ 170,983 $ 153,462 $ .064
369,889 194,932 174,957 .073
tract 596,381 314,293 282,088 -118
294,978 155,453. 139,525 .059
| 70,766 37,294 33,472 .014
‘tract 162,000 85,374 76,626 -032
521,917 275,050 246,867 -104
tract 188,227 $9,195 89,032 .037-
147,770 77,875 69,895 -029
| 44,000 23,188 20,812 -009
tract 26,396 13,911 12,485 .005
tract 14,114 7,439 6,675 .003
tract 35,490 12,656 16,744 .007
2,796,283. __1473.643_ 1,322,640 _ wg58
Income Tax Net Net
“Earnings” Effect Earnings Eamings
$4,350,039 $2,293,626 $2,056,413 $ .86
2,796,283 1,473,643 1,322,640 . 56
$14553.253§ $812,283 $..233.223 3.2230
bit 316 (PTX 316).
preproduction costs on the K5-2Z00. The court finds
; this adjustment should have been made.
App. 38
The opinions expressed by Hepp as to the adjustments
which should have been made are supported by the weight
of the evidence. Hepp’s opinions were predicated on docu-
ments and other evidence showing facts known to the cor-
porate defendant prior to the preparation of the nine-
month report, on or about November 4, 1968. Further,
these opinions are consistent with and corroborated by
(a) the deposition testimony of Donald B. Chandler, the
Price Waterhouse partner-in-charge of the KIC phase of
the audits for year-end 1967 and 1968, (b) the trial testi-
mony of Howard D. Murphy, the Price Waterhouse part-
ner-in-charge of the overall audit of SKI and subsidiaries
for those years, (c) memoranda prepared by Price Water-
house in which judgments and opinions on many of the
same matters were expressed, (d) documentary evidence
of adjustments later made by the corporate defendant with
respect to the same costs, including both year-end adjust-
ments and the monthly amortization of preproduction
costs which finally commenced in 1969, and (e) portions
cf the testimony of the defendant Ryan.
Other portions of Ryan’s testimony were contrary to
portions of Hepp’s testimony. To the extent there is a
conflict, the court accepts the testimony of Hepp and dis-
counts the contrary testimony of Ryan because Ryan’s
contrary testimony is against the weight of the evidence,
both documentary and testimonial, as will be discussed
hereafter, and because Ryan is strongly identified with
the interests of the defendants.
Defendants challenged the testimony of Hepp in two
principal areas: first, the required date of commencement
of amortization of preproduction costs on products known
as the CPU-46 (a military air data computer), AAU-19
(an altimeter for use on military aircraft) and KS-200 (an
air data computer for use on commercial aircraft), and
second, the proper manner of determining the existence
of cost overruns on contracts.
App. 39
Preproduction costs are costs, consisting primarily of
engineering labor and related overhead, which are in-
curred in the development of a product. Under generally
accepted accounting principles, costs of this nature may,
in some circumstances,” be deferred, rather than expensed
as incurred, to some future time when, it is hoped, the
product will be in production and earning profits which
will ‘‘cover’’ the preproduction expenses. Where the pro-
gram does not produce the expected profits, deferred costs
must be amortized over a set period of time. By year-end
1967, KIC had deferred substantial preproduction costs
in connection with the CPU-46, the AAU-19 and the KS-
200 programs. (‘‘Program’’ refers to a situation in which
KIC had a contract for a particular product, and also
had the expectation of additional follow-on contracts.)
The amount of these costs was of such a magnitude that
it was felt a formal policy for dealing with them should
be adopted. SKI and KIC, in consultation with Price
Waterhouse, formalized a policy which provided that,
where appropriate, preproduction costs could be deferred
until the first delivery date under the initial contract of
the program. Beginning on that date, all deferred costs
would be amortized as ‘‘covered’’ in equal amounts over
a three-year period. Price Waterhouse emphasized that,
in order to maintain accounting consistency, the date on
which amortization was to begin, once set, could not be
changed.
With respect to the CPU-46, the AAU-19 and the KS-
200, on which some $2,500,000 of preproduction costs had
been deferred by the end of 1967, the date for the first
12Qnly a program which represents the development of a new
product or a new technology and which has potential for substan-
tial follow-on business warrants deferral of preproduction costs. -
App. 40
deliveries under the initial contracts on those programs
had all passed by December 31, 1967. Consequently, the
starting date for the three-year period of amortization of
preproduction costs on those programs was set as of Janu-
ary 1, 1968. This policy was referred to in the SKI annual
report for 1967 and was implemented by the manner in
which uncovered preproduction costs were carried as as-
sets in the balance sheet contained in that report. While
two-thirds of such costs were separately shown in the bal-
ance sheet as deferred preproduction costs, the other one-
third was included in ‘‘Current Assets’’. The amount in-
cluded in ‘‘Current Assets’’ was to be either amortized
or ‘‘covered’’ by follow-on contracts during 1968. It was
also referred to in the 1968 KIC ‘‘representation letter’’
sent to Price Waterhouse in connection with the year-end
audit. Ryan testified that in 1968 he understood amortiza-
tion was to commence on the date of first actual delivery
of the product, and that he did not know until February
of 1969 that the amortization of preproduction costs on
these three programs was to commence January 1, 1968.
The distinction is critical because, due to late performance
by SKI and changes in contract specifications, delivery of
the first CPU-46 was not scheduled until some time in
1969, and delivery of the AAU-19 had not commenced until
the spring of 1968. The court finds that Ryan’s lack of
knowledge of the proper starting date for amortization
stemmed from willful and wanton negligence or a reckless
disregard for the truth. Moreover, a memorandum from
Werle to Nichinson in July, 1968, shows that Werle knew
that January 1, 1968, was the proper starting date. After
he was promoted by Huarisa in August, 1968, however,
he changed his position and sought to defer the starting
date to the date of first delivery of the product involved.
App. 41
Hepp testified, and this court finds, that, had SKI fol-
lowed the correct principles of accounting for its prepro-
duction costs, the nine months’ earnings report would have
reflected the amortization of preproduction costs on the
CPU-46 in the amount of $369,889 and the amortization
of $294,978 of such costs on the AAU-19. In fact, there
was no amortization of these costs.
Another program on which preproduction costs should
have been written off as of September 30, 1968, was the
4201 airspeed indicator. According to the SKI policy on
preproduction costs, deferral was proper only where there
was at least one contract in hand for the product being
developed. The only exception to this was where a con-
tract was being negotiated and was virtually certain to be
signed. As of the end of September, 1968, KIC had de-
ferred $70,766 in preproduction costs on the 4201, but had
no contract in hand. In August, 1968 Boeing had can-
celled the only outstanding order for the 4201. No other
orders were being negotiated. All of these costs should
have been written off.
The accounting policy of SKI and KIC as set forth in
the SKI annual reports for 1967 and 1968, and in the
‘representation letters’’ from KIC to Price Waterhouse
in connection with the audits for those years, provides
that the determination of whether a contract is in a cost
overrun position is made on the basis of an evaluation of
the contract or contracts in house, as distinguished from
follow-on contracts expected or hoped to be received as
a part of a program. As stated in the annual reports for
those years,
‘“‘Tf estimates of total contract cost indicate a loss,
provision is made currently for the total loss antici-
pated on the contract.’’
App. 42
There is evidence that from August, 1968, through Janu-
ary, 1969, i.e., after Werle was promoted to report directly
to Huarisa, KIC made computations of total contract costs
on the CPU-46 and AAU-19 on a program basis, that is,
on the assumption that additional follow-on contracts
would be received and production costs per unit would
thereby be lowered. By using this program basis rather
than a contract-in-house basis, cost overruns were pur-
portedly eliminated. These computations were inconsis-
tent with the accounting policies of KIC, and to the extent
they may have been used as a basis for not recognizing
cost overruns or not amortizing preproduction * costs as
of September 30, 1968, the accounting policies of KIC were
simply ignored. The amount of losses on these two con-
tracts which should have been, put were not, written off
at the end of the third quarter of 1968 was $324,445 on the
CPU-46 and $596,381 on the AAU-19.
A number of other losses should have been, but were
not, recognized as of September 30, 1968. KIC internal
accounting papers show that losses aggregating $75,910
on three contracts numbered 906,262, 908,152 and 906,322
were known prior to the release of the nine months’ earn-
ings report. The losses on these contracts were not writ-
ten off. Similarly, losses on the VVi (Vertical Velocity
Indicator) are shown by KIC internal documents and in-
terrogatory answers of Sun Chemical and Huarisa to have
been known prior to the preparation of the nine months’
report but were not written off at that time. Hepp testified
that the amount of loss which should have been recognized
as of September 30 was $188,227. Though the amount
13 To the extent that a contract is calculated to be profitable, pre-
production costs which would otherwise have to be amortized are
considered “covered”.
App. 43
which was written off on the VVI as of year-end 1968 was
only $139,304, defendants Sun Chemical and Huarisa of-
fered no evidence to contradict Hepp’s testimony, and,
consequently, the court finds that in light of facts as they
then existed, $188,227 should have been written off on the
VVI contract as of September 30, 1968. Finally, SKI
should have recognized a loss of $162,000 on the SWING
contract. SKI had sustained a loss of $337,000 on this
secret government program but had submitted a claim to
the government to cover the loss and had, accordingly, not
written off the loss. By July, 1968, at the latest, however,
Werle recognized that, because of a limitation of claim
agreed to by SKI, the maximum amount recoverable under
the claim was $175,000, and that $162,000 would have to
be written off.
Three other adjustments to the KIC books should have
been made in connection with the three quarters’ report.
On September 30, KIC carried on its books a profit of $44,-
000 on the KS-200. This was improper because there were
at that time uncovered, unamortized preproduction costs
in that program, and according to the policy on prepro-
duction costs, no profit could be recorded until all prepro-
duction costs had been covered. Second, $521,917 had been
deferred as ‘‘start-up costs’’ of the ordnance division of
KIC. This di sion was formed by combining parts of
other divisions of KIC which had ordnance-type contracts
into a new ordnance-only division. Hepp testified that
these ‘‘start-up’’ costs were simply the normal overhead
and administrative expenses of an established, though
expanding, line of business and not properly deferrable.
Deferral of start-up costs is allowable, if at all, only when
incurred in the commencement of a new line of endeavor.
Hepp’s opinion of the propriety of the deferral of these
costs was supported by Price Waterhouse’s evaluation of
~~
App. 44
these costs and their insistance that they be written off at
year end. Finally, the nine months’ report reflected an im-
properly recorded profit of $147,770 attributable to an
error in costing between KIC and SKI on the M125 fuse
contract. The fuses for this contract were manufactured
in SKI facilities, and sold to KIC, which sold them to the
government. The SKI-KIC transaction was intended to
be at the same price as the KIC-government sale. The re-
sult of this would be that KIC would show zero profit or
loss. By the end of August, however, a number of fuses
had been sold to the government at a price higher than
that which SKI had charged KIC, resulting in profit of
$147,770 being wrongfully recorded at KIC. This was
known by Werle and Nichinson at least as early as Sep-
tember 26, 1968, but no adjustment was made on the con-
solidated SKI books prior to the publication of the nine
months’ report on November 4, 1968.
In 1975, almost four years after the first trial of this
ease, Sun Chemical produced underlying general ledger
records of KIC. In examining these records, Hepp de-
termined that they reveal pre-tax profit of KIC for the
first nine months of 1968 in an amount $2,445,000 less than
the KIC figure included in the consolidated financial re-
sults of SKI’s September 30, 1968, quarterly report. In
response to Hepp’s request for further information, Sun
Chemical produced a document which indicates that the
pre-tax profit of KIC for that nine-month period was de-
liberately increased by $2,445,000 over the amount re-
flected in the general ledger accounts of KIC. Subsequent
discovery revealed only one handwritten document, labeled
‘KIC Summary of Management Adjustments to P & L
1968’ (Summary of Adjustments), which purports to
support the $214 million increase in income. Each of the
App. 45
adjustments in the various items set forth in this docu-
ment had the effect of increasing income. If this $24 mil-
lion write-up had not been made, and the other adjust-
ments referred to, supra, had been made, SKI’s results for
September 30, 1968, would have been reported as a loss
of $1,153,000 before taxes, or a loss of 18 cents per share
after taxes, rather than the $4,350,000 or 86 cents per share
in earnings which were actually reported.
Hepp did not go so far as to render an opinion that
these ‘‘management adjustments’’ were improper. He
testified on cross-examination that adjustments of this gen-
eral nature are sometimes made by business firms during
the course of a year on the basis of accountants’ working
papers and are not recorded in the general ledger accounts
until year-end. In addition, defendants Sun Chemical and
Huarisa offered a group of exhibits which they contend
show year-end 1968 entries in accounts referred to on the
Summary of Adjustments, in support of their contention
that the management adjustments at September 30, 1968,
were proper. Some of these exhibits were identified and
explained during the cross-examination of Hepp, but
others have not been identified or explained by any wit-
ness. Indeed, defendants presented no testimony whatso-
ever with respect to these ‘‘management adjustments’’. In
an interrogatory answer purporting to explain the adjust-
ments shown on the Summary, Sun Chemical and Huarisa
stated that the $2,445,000 management adjustments were
later reduced and ‘‘resulted in a year-end book entry on
the KIC general ledgers of $1,525,075.”’
Based upon all the evidence, the court finds that even
if the ‘‘management adjustments’’ included in the Sep-
tember 30, 1968, KIC financial statement were in part
proper, at least the difference between the amount booked
at year-end and the amount as of September 30, 1968, ap-
App. 46
proximately $920,000, had ‘no proper purpose and was
made in a deliberate effort to increase the reported earn-
ings of SKI and its subsidiaries for the nine-month period
ending September 30, 1968. This finding is supported by
the following facts: (a) The Summary of Adjustments
contains no detail for the management adjustments to in-
dividual accounts for the month of September, 1968, al-
though such detail is provided for August and earlier
months; (b) the very existence of the management adjust-
ments was revealed only after years of the persistent dis-
covery efforts of plaintiff, and the more recent thorough
investigation by Hepp; and (c) Werle, the man specially
promoted by Huarisa in August, 1968 to find ‘‘r couple of
million dollars more of KIC income” in 1968, was respon-
sible for the KIC financial statement in question. (d)
Neither Werle nor anyone else presented any testimony as
to the reasons for these adjustments, all of which resulted
in reporting higher SKI earnings. In the context of the
other misrepresentations in the nine months’ report and
the negotiations with Sundstrand, these factors compel
the conclusion that these adjustments were deliberately
overstated.
If management adjustments in the amount of $920,000
had not been made as of September 30, 1968, SKI’s re-
ported earnings per share would have been reduced by 18
cents. Thus, taking into account the downward adjust-
ments which should have been made, and the management
inflated adjustments which should not have been made,
the court finds that SKI should have reported earnings of
approximately 12 cents per share for the nine months
ended September 30, 1968, rather than 86 cents per share.
The court further finds that Ryan and Werle knew of the
falsity of the earnings reported by SKI for the nine months
ended September 30, 1968.
App. 47
In August 1969, Sun Chemical, then a stockholder of
SKI, filed suit against SKI, Huarisa, Ryan and others,
charging the defendants with violation of Rule 10b-5 on
the ground, among others, that SKI’s September 30, 1968,
quarterly report to its shareholders was false and mis-
leading. In April 1970, Sun Chemical, still a SKI share-
holder, joined as an additional named plaintiff in a class
action that had been initiated by another SKI stockholder
against SKI and Price Waterhouse, likewise charging de-
fendants with violation of Rule 10b-5. The complaint joined
in by Sun Chemical not only alleged that SKI’s September
30, 1968, quarterly report to its shareholders was false
and misleading, but also that members of the plaintiff
class—which included Sundstrand—had suffered substan-
tial injury as a result of the wrongs complained of. At the
same time that Sun Chemical joined the class action, its
individual suit was voluntarily dismissed, and Huarisa
and Ryan were thereby dropped as defendants. At about
the same time, Alexander, president of Sun Chemical,
joined the SKI board. Although Sun Chemical remained
a plaintiff in the class litigation, as successor to SKI, it
paid $250,000 in final settlement of the case in May 1975,
long after its December 1972 merger with SKI.
Unaudited interim statements of earnings reported to
investors are required by the federal securities laws to
meet the same standards of truthfulness and adequate dis-
closure as are required for audited annual reports, Kaiser-
Frazer Corp. v. Otis & Co., 195 F.2d 838 (2d Cir. 1952),
cert. denied, 344 U.S. 856 (1952); SEC v. Keller Indus.,
Inc., 342 F.Supp. 654 (S.D. N.Y. 1972). A reasonable in-
vestor undoubtedly might attach importance to such re-
ports in making an investment decision.
App. 48
It was on these misrepresentations and nondisclosures
made during the preliminary negotiations and in the nine
months’ earnings report that Sundstrand relied when it
entered into the January 9, 1968, agreement and trans-
ferred to Huarisa the 5,686 shares of Sundstrand common
stock. Between January 9 and the purchase of the 223,190
shares of SKI stock by Sundstrand on February 6, Sund-
strand conducted an investigation of SKI, described above.
This investigation, however, did not cure the previous
misrepresentations and omissions. In fact, defendants’ pre-
vious misrepresentations were reiterated and their state-
ments were amplified by further material false representa-
tions and omissions.
B. Material Misrepresentations and Omissions Between
January » and February 6, 1969
1. Price Waterhouse & Co. Audit
During January, 1969, SKI personnel were conferring
with Price Waterhouse & Co., SKI’s independent public
accountants, with reference to adjustments which would
have to be made on the books of SKI.** Adjustments in
the magnitude of several million dollars were then being
considered. On January 15, 1969, John Martin, Werle’s
staff assistant, informed Nichinson, then president and a
director of KIC and vice president of SKI, that, in the
14 The assessment of Price Waterhouse was of utmost importance
in determining the true state of the financial condition of SKI.
SKI was required by regulations of the Securities and Exchange
Commission to obtain a certificate from independent public ac-
countants with respect to its year-end financial statements (see
SEC Regulation S-X, 17 CFR 210 as in effect at the time relevant
to this case), and the financial statements in the SKI annual reports
to shareholders had regularly been audited and certified by Price
Waterhouse for a number of years.
App. 49
course of the Price Waterhouse year-end audit, write-offs
of certain costs on the books of KIC were being considered.
These write-offs were far in excess of the amount stated
to Sundstrand by Ryan and Werle as the ‘‘maximum’’
write-off of preproduction costs and involved other types
of substantial costs. On January 20, 1969, Nichinson had
a phone conversation with Donald Chandler, the Price
Waterhouse partner-in-charge of the KIC phase of the
SKI audit. Chandler discussed the areas of adjustment
being considered and acknowledged that KIC write-offs
on the order of perhaps $2,000,000 to $2,500,000 were un-
der consideration.
Several days prior to Sundstrand’s cash payment of
$6,360,915 for the SKI stock on February 6, 1969, Ryan
and Werle received a memorandum from Price Water-
house stating its preliminary assessment that write-offs
in the range of $3,000,000 to $4,500,000 would have to be
made on the books of KIC as of year-end 1968. Write-offs
of such magnitude would have had the effect of reducing
SKI’s after tax earnings by about $.60 to $.90 per share—
compared to per share earnings of $.86 reported for the
first nine months and compared to the $1.16 figure for the
full year which had been given to Sundstrand. Huarisa
knew of this assessment before February 6.
Price Waterhouse prepared its memorandum between
January 20 and 27, 1969. The consideration of many of
these write-offs had commenced long before—as early as
October, 1968, when Price Waterhouse started its annual
audit work for SKI and its subsidiaries. The evidence
establishes that Huarisa, Ryan, Werle, SKI and KIC knew
or should have known of Price Waterhouse’s views at least
by the time of the survey meetings with Sundstrand earlier
in January. This finding is further supported by the fol-
App. 50
lowing: (a) Nichinson was able to obtain such informa-
tion even though his position as president of KIC was be-
clouded by the earlier announcement of his purported
‘‘resignation’’; (b) the Price Waterhouse audit team had
been working in the KIC offices and consulting with KIC
management for some four months prior to the prepara-
tion of the memorandum; and (c) the need for many of
these write-offs had been evident by the time of the publi-
cation of the report for the first nine months of 1968.
The assessment in the memorandum was a material fact
which should have been disclosed to Sundstrand prior to
its payment of $6,360,915 in cash for the SKI stock on
February 6, 1969. Defendants had a duty, prior to the
time Sundstrand made its payment on February 6, 1969,
for the SKI stock, to advise Sundstrand of any facts they
learned which tended to show that statements they pre-
viously made were not true when made or were no longer
true. Fisher v. Kletz, 266 F.Supp. 180 (S.D. N.Y. 1967);
Butler Aviation Inter. Inc. v. Comprehensive Designers,
Inc, 307 F. Supp. 910, 913 (S.D.N.Y. 1969), aff’d, 425 F.2d
842 (2d Cir. 1970); SEC v. Shattuck Denn Mining Corp.,
297 F.Supp. 470, 476 (S.D.N.Y. 1968); Restatement of
Torts, $441(2); Prosser, Law of Torts, §106, pp. 696-97
(4th ed. 1971).
The fact that the memorandum contained preliminary
assessments rather than final conclusions did not vitiate
this duty of disclosure. The memorandum concerned a
number of issues, such as the treatment of preproduction
costs on the CPU-46, the AAU-19 and the KS-200, the
profitability of these and other long-term contracts and
the value of certain inventories, about which Sundstrand
had asked particular questions and SKI had made specific
representations, most of which were contradicted by the
App. 51
Price Waterhouse memorandum. In these circumstances,
the preliminary nature of the memorandum did not affect
its materiality or the duty to disclose it. This duty was
not met. Sundstrand first learned of this assessment in
pretrial discovery in this case when it was produced by
Price Waterhouse. The document was never produced by
SKI.
Significantly, the Price Waterhouse assessment was an
accurate evaluation of the amount of write-offs actually re-
quired. Adjustments, including ‘‘start-up’’ costs and cost
overruns as well as deferred preproduction costs, of more
than $4,600,000—five times the ‘‘maximum’’ stated by
SKI to Sundstrand—were charged on the books of KIC
as of year-end 1968 and were the principal reason for the
disastrous financial results ultimately reported for 1968.
When Ryan explained these results to the SKI board of
directors in March, 1969, he discussed the major items
written off. Each of these items had been mentioned as a
candidate for write-off in the Price Waterhouse assess-
ment. Nearly half of this amount consisted of write-offs
of items other than preproduction costs, which items had
not been mentioned at all during the January meetings
with Sundstrand.
2. Other Misrepresentations
In addition to the failure to disclose the Price Water-
house evaluation and the continued false and misleading
statements as to SKI’s 1968 and 1969 earnings and the
profitability of the Avionics Division, other statements
made by Huarisa and SKI during the period from Sund-
strand’s purchase of the SKI stock, January 9, 1969, to
its cash payment therefor, February 6, 1969, were false
App. 52
and misleading in numerous respects. These misrepresen-
tations and omissions, described below, pertained to write-
offs which were in fact made at year-end 1968, in the total
amount of more than $4,625,000, or 92 cents per share after
taxes. All of these misrepresentations and omissions were
material.
CPU-46
As of year-end 1968, KIC wrote cff $2,015,000 of prepro-
duction and production costs in connection with the CPU-
46. This sum was the total of the following costs:
Preproduction costs incurred
through December 31, 1968 $1,540,911
Estimated preproduction costs to
be incurred thereafter 214,000
Anticipated loss on production contract 260,089
Total $2,015,000
The CPU-46 write-off was taken for the following rea-
sons:
(a) Despite the long period since the initial contract
was made, KIC had still not completed the tests required
by the government to demonstrate acceptability of the
product, and the time for such completion continued to be
unknown. Successful completion of these tests was re-
quired before deliveries could be made under the contract,
and also before KIC could attain status on the govern-
ment’s Qualified Products List (‘‘QPL’’), which was con-
sidered a prerequisite to KIC’s ability to obtain any fol-
low-on business.
(b) KIC’s estimates of the market potential for
this product, even if it should obtain follow-on business,
were inflated out of all relation to the government’s real
needs.
App. 53
(c) Without even considering preproduction costs,
KIC could not produce the CPU-46 at a cost which would
yield a profit on the contract-in-house. There was no evi-
dence that units covered by subsequent follow-on contracts
—even if such contracts could be obtained—could be pro-
duced at a profit.
Defendants contend that the ‘‘decision” to write off the
CPU-46 costs was made in March, 1969. During the period
January 9 to February 6, 1969, however, defendants had
knowledge of all the facts on which the ‘‘decision’’ was
ultimately based. In fact, the reasons given for this ‘‘de-
cision’’ were essentially the same ones expressed by Burke
and Ernst & Ernst in the spring and summer of 1968 in
questioning the CPU 46 accounting treatment.
During that period of time, defendants made the follow-
ing material misrepresentations and omissions to Sund-
strand with respect co the CPU-46:
(a) Representation that final government approval on
the CPU-46 was imminent and would be obtained almost
any day. Defendants knew or should have known that
such approval could not be obtained before the summer of
1969. Such approval was not, in faet, fortheoming until
September, 1969. 25
(b) Representation that the total market potential for
the CPU-46 was at least 8,000 units. In fact, the govern-
ment’s total program requirement—the total number of
units expected by the government to be ultimately procured
and not yet contracted for—was 2,619 units. Katz obtained
this information from the government officer in charge of
CPU-46 procurement in November, 1968, and relayed it at
that time to Werle and other KIC personnel.
App. 54
(c) Representations that the maximum amount of pre-
production costs KIC could possibly have to write off on
the CPU-46 at year-end 1968 was $526,000 and that the
contract-in-house was profitable. In fact, at year-end 1968
KIC wrote off $1,755,000 of preproduction costs and $260,-
000 as a cost over-run on the CPU-46.
Preproduction Costs on the AAU-19
As of year-end 1968, KIC wrote off one-third of the pre-
production costs incurred in connection with the AAU-19,
in the sum of $408,000. |
Although Ryan and Werle knew that KIC’s accounting
policy required such write-offs, they did not disclose this
fact to Sundstrand. To the contrary, Ryan and Werle false-
ly stated to Sundstrand on January 16, 1969, that the
maximum amount of such costs KIC could possibly have to
write off on the AAU-19 was $72,000.
Obselescent Inventory
As of year-end 1968, KIC wrote off against income $379,-
168 to provide an adequate reserve for obsolete inventory
in the Avionics Division; $362,758 of this amount was at-
tributable to a write-off of obsolescent guidance spare
parts inventory, otherwise known as ‘‘cost center 855’’.
Price Waterhouse, during December, 1968 and January,
1969, was specifically questioning, with KIC, the propriety
of carrying this virtually dead inventory on KIC’s books.
Nevertheless, on January 9 and January 16, 1969, Ryan
and Werle falsely stated to Sundstrand that the inventory
reserve of about $180,000 was adequate and would be suffi-
cient to cover any obsolescence of inventory.
App. 55
Ordnance Start-up Costs
As of year-end 1968, KIC wrote off the so-called ord-
nance ‘‘start-up’’ costs, in the sum of $522,000, which
should have been written off as of September 30, 1968. No
mention of these costs had been made te Sundstrand.
Losses Determined from Review of Status of Contracts,
Including Estimated Cost to Complete
KIC wrote off a total of $1,298,239 in excess production
costs on contracts, reflecting losses incurred and/or antici-
pated under some nine long-term contracts. The contracts
and amounts of these costs are as follows:
CPU-46 $ 260,089"
SWING 224,083
VVI 221,067
AAU-19 181,000
KS-208 112,000
L.L.L. TV 94,000**
SPARS 86,000
IRU 70,000
SPERRY 50,000
Total $1,298,239
As a result of contract status reports prepared month-
ly in some KIC divisions and quarterly in others, SKI
knew during and even long before January, 1969 that the
production cost on at least seven of these contracts, CPU-
46, SWING, VVI, AAU-19, KS-208, L.L.L. TV and IRU,
15 Also referred to under the heading CPU-46, supra.
16In this instance KIC reversed this amount of previously record-
ed estimated profits, due to a revaluation indicating break-even at
completion of the contract.
App. 56
was in excess of the contract recovery by approximately
the amounts written off at year-end, but did not advise
Sundstrand of any of these excess costs. In fact, Werle
falsely informed Sundstrand that the AAU-19 contract
or contracts were profitable.
Further the representations regarding quarterly KIC
reviews of long-term contracts, the write-off of losses dis-
closed by such reviews, and $600,000 written off for the
month of November, 1968 were false and misleading. Al-
though Contract Status Reports were prepared by division-
al personnel at KIC on a monthly or quarterly basis, the
corporate accounting personnel of KIC ignored cost over-
runs shown by these Contract Status Reports and did not
write off any of these losses during 1968. Where estimates
to complete made during 1968 showed a contract loss, KIC
did not write off the loss but instead continued to carry the
excess costs on its books. Neither $600,000 nor any other
sum was written off in November, 1968 as the result of
any contract review.
Defendants argue that even if there were misrepresenta-
tions made of facts not disclosed to Sundstrand prior to
January 9, which they deny, there can be no liability be-
eause Sundstrand was given free access to all relevant
data during its survey of SKI and should have discovered
the true facts of SKI’s financial condition. This assertion
is without merit. Its principal flaw is that with respect to
financial information, the type of information most impor-
tant to this lawsuit, Sundstrand did not, in fact, have un-
fettered access to information about SKI. In fact, rather
than provide Sundstrand with access to the truth about
SKI’s financial condition, SKI and Huarisa used the sur-
vey to make the further misrepresentations discussed
above.
App. 57
Further, even if Huarisa and SKI had allowed Sund-
strand free access to SKI’s records, they would have no
valid defense. With respect to omissions, the duty to
‘*state all material facts necessary to make other state-
ments not misleading . . . is not discharged merely by giv-
ing the purchaser access to company records and letting
him piece together the material facts if he can.’’ Metro-
Goldwyn-Mayer, Inc. v. Ross, 509 F.2d 930, 933 (2d Cir.
1975). Moreover, the duty is no different where the in-
vestor is supposedly sophisticated. Stier v. Smith, 473 F.
2d 1205, 1207 (Sth Cir. 1973). With respect te misrepre-
sentations, the Seventh Circuit has recently held that, ‘‘[it
is not] material, short of a showing of actual knowledge
of the fraud, what knowledge any plaintiff had about [the
defendant].’’ Sanders v. John Nuveen & Co., Inc., 524 F.
2d 1064, 1073 (7th Cir. 1975). There is no evidence what-
soever that Sundstrand had actual knowledge of the fraud
being perpetrated upon it.
Causation
In order to prevail in an action under Rule 10b-5, plain-
tiff must show not only that the defendant engaged in
wrongful conduct, but also that the conduct caused him
injury. This is generally done by establishing reliance up-
on the misrepresentations or omissions of defendant.
Where the misconduct alleged is a failure to disclose,
‘*. . . positive proof of reliance is not a prerequisite
to recovery. All that is necessary is that the facts
withheld be material in the sense that a reasonable
investor might have considered them important in
the making of this decision. [Citations omitted.] This
obligation to disclose and this withholding of a ma-
terial fact establish the requisite element of causation
in fact.’’ Affiliated Ute Citizens of Utah v. United
States, supra, at 153-54.
App. 58
See also Northway, Inc. v. TSC Industries, Inc., 512 F.2d
324, 331 (7th Cir.), cert. granted 14 U.S.L.W. 3180 (Oct. 6,
1975). Where misrepresentations are alleged, the test of
reliance is whether ‘‘ ‘the misrepresentation is a substan-
tial factor in determining the course of conduct which re-
sults in [the recipient’s] loss’ ’’, List v. Fashion Park, Inc.,
supra, at 462.*7
The court finds that Sundstrand’s proof clearly estab-
lishes that it relied on all of the misrepresentations and
omissions discussed above. The Burke and Ernst & Ernst
reports and the Price Waterhouse memorandum were ma-
terial, and no other reliance need be shown. The affirma-
tive misrepresentations concerned matters crucial to the
determination of terms of any merger—present and future
earnings—and about which Sundstrand had shown con-
cern from the beginning of the negotiations. Bihington
gave direct testimony at trial that Sundstrand relied on
SKI’s and Huarisa’s representations about SKI’s earn-
ings in the purchase of the stock. The court finds further
that Sundstrand’s reliance was entirely reasonable.”
Standard of Duty
The final element of plaintiff’s case is a showing that
the defendants acted, or failed to act, with a mental state
for which liability can be imposed. It has been held by this
Circuit that a 10b-5 plaintiff need not prove the scienter
17 Some courts have questioned whether even this much need be
shown where the facts misrepresented are material. See e.g., Jani-
gan v. Taylor, 344 F.2d 781 (1st Cir.), cert. denied 382 U.S. 879
(1965); Reeder v. Mastercraft Blectronics Corp.. 363 F.Supp. 574
(S.D.N.Y. 1973).
8 From Sanders v. Nuveen, supra, it appears that reasonableness
need not be shown, as long as plaintiff did not actually know of the
fraud.
. .«. 2a
App. 59
required for a common law action for fraud based on
intent or recklessness. In Tomera v. Galt, 511 F.2d 504,
508 (7th Cir. 1975), the court said ‘‘Rule 10b-5 claimants
need not plead nor prove scienter.’’ That is, a plaintiff
can recover for negligent, as well as intentional or reckless,
misrepresentations or omissions. See also Parrent v. Mid-
west Rug Mills, Inc., 455 F.2d 123 (7th Cir. 1972), Vander-
boom v. Sexton, 422 F.2d 1233 (8th Cir. 1970), and Ellis
v. Carter, 291 F.2d 270 (9th Cir. 1961). But see Lanza v.
Drexel & Co., 479 F.2d 1277 (2d Cir. 1973). Subsequent to
Tomera the Court of Appeals for the Seventh Circuit has
indicated that rather than a single standard, there may be
a flexible standard of duty to disclose and investigate the
truth of representations which depends upon the details
of the particular business relationship. Sanders v. John
Nuveen & Co., Inc., supra, at 1069, n. 13-15. See also
Kohler v. Kohler Co., 319 F.2d 634, 637-38 (7th Cir. 1963).
A flexible duty standard under Rule 10b-5 has been em-
braced by the Ninth Cireuit in White v. Abrams, 495 F.
2d 724 (9th Cir. 1974), and by several commentators. 2 A.
Bromberg, Securities Laws: Fraud, §8.4 (513) at 204.115
(1971), Bucklo, Scienter and Rule 10b-5, 67 Nw.U.L.Rev.
562, 595, n. 179. A flexible standard is a recognition of the
fact that securities transactions come in so manv varied
contexts, and the participants in those transactions have
so many and such widely varying relationships to each
other, that no single standard can accomplish the purposes
of Rule 10b-5 in all cases.
‘‘Instead of perpetuating the practice of discussing
scienter and negligence as absolutes which are capable
of being objectively applied, more is gained by recog-
nizing that there is a sliding scale which determines
what constitutes sufficiently diligent conduct to avoid
App. 60
10b-5 liability, and that 10b-5 liability is determinable
only within the context of the vagaries of the specific
facts presented. Mann, Rule 10b-5: Evolution of a
Continuum of Conduct to Replace the Catch Phrases
of Negligence and Scienter, 45 N.Y.U.L.Rev. 1206,
1209 (1970).
In light of Nuveen, supra, and because the relationship of
defendant Meers to the other parties in this lawsuit is
rather unusual, this court concludes that a flexible duty
standard is appropriate in this case. Thus, the duty ques-
tion, and the ultimate question of liability, must be con-
sidered separately for each defendant.
Liability of the Defendants
A. Liability of Huarisa
Huarisa, because of his position as a director and as
chief executive officer of SKI, and because of the enormous
profit which he stood to make if the merger between Sund-
strand and SKI was consummated, was under a strict
duty to investigate the truth of the representations which
he and other officers of SKI made to Sundstrand and to in-
sure that no material facts were not disclosed. However,
it is not necessary to consider at length the precise nature
of Huarisa’s duty, because it is the conclusion of the court
that he deliberately, or, at best, recklessly, misrepresented
SKI’s nine months’ earnings, SKI’s earnings for 1968 and
for 1969, the interest of other companies in acquiring SKI
at a price of $45 and the amount of potential write-offs of
deferred preproduction costs for 1968. Huarisa also de-
liberately, or recklessly, failed to disclose the existence of
the Burke and Ernst & Ernst reports, the Price Water-
house memorandum of January 27, 1969, and the need for
write-offs because of losses on contracts at year-end 1968.
a eee ee Ce ee See tee emer oT a oar ae er Ty ee WR Ase 2p werd
ah ine) ie —_
App. 61
The court also finds that Huarisa was in a conspiracy
with SKI in making these misrepresentations. Huarisa
and other officers of SKI, Ryan and Werle in particular,
acted in concert to prevent Sundstrand from discovering
the true financial condition of the corporation. Thus,
Huarisa is also responsible, as a co-conspirator, for the
misrepresentations already discussed made by Ryan,
Werle and other SKI personnel during the Sundstrand
survey of SKI and the meeting on January 22. These
misrepresentations were also made intentionally or reck-
lessly. Huarisa is also responsible for these statements of
SKI personnel by virtue of the fact that he was a control-
ling person of SKI for the purposes of Section 20(a) of
the 1934 Act, 15 U.S.C. §78t(a),’® and as such is liable for
the actions of SKI. SEC v. First Securities Co. of Chgo.,
463 F.2d 981 (7th Cir.), cert. denied 409 U.S. 880 (1972) ;
Dyer v. Eastern Trust and Banking Co., 336 F.Supp. 890,
915 (D.Me. 1971). SKI, of course, can act only through its
personnel, and the actions of such personnel on behalf of
SKI are taken to be the actions of SKI. Affiliated Ute
Citizens of Utah v. United States, supra, at 154.
In sum, because Huarisa, and others for whose conduct
he is liable, intentionally or recklessly made material mis-
representations and failed to disclose material facts in con-
nection with Sundstrand’s purchase of the Burkes’ 223,190
shares of SKI common stock, Huarisa is liable to Sund-
strand for the damages which it suffered as a consequence
of that transaction.
B. Liability of Sun Chemical
Sun Chemical is the successor to the liability of SKI.
As such it is liable for the misrepresentations and omis-
sions of Huarisa. It is also liable because SKI individual-
19 See supra at pp. 70.
App. 62
ly violated Rule 10b-5 through the acts of Huarisa, Ryan,
Werle and other SKI personnel on its behalf. Affiliated
Ute Citizens, supra, at 154.
C. Inability of Meers
The determination of Meers’ liability requires an exami-
nation of his relationship to the other parties in this suit
and to the transaction at issue. To begin with, Meers was
a director of SKI. As such he was privy to information
not available to the public or to Sundstrand and was able,
if he wished, to make inquiries into areas about which he
had questions. He and his fellow directors were also, of
course, ultimately responsible for the conduct of SKI’s
affairs. Meers was also acting as an investment banker
for SKI and Huarisa in this transaction. He set up the
initial contact between Sundstrand and SKI, arranged fur-
ther meetings and conducted the negotiations which led
to Sundstrand’s offer. It was understood by both Meers
and SKI that these services were not those of a director
and that he and his firm would receive a substantial fee if
the merger were completed. Finally, Meers and his firm
had a continuing business relationship with Sundstrand.
White, Weld had performed investment banking services
for Sundstrand in the recent past and the firms maintained
business contacts until the decline in the value of SKI stock
and.the revelation of the Burke and Ernst & Ernst reports
understandably soured the relationship. As investment
banker to Sundstrand, Meers had the confidence of Sund-
strand. Sundstrand also understood that Meers and White,
Weld were to receive a fee if the merger went through.
In effect, Meers was on both sides and in the middle of
the transaction. He had a position of influence in, and had
aecess to information from SKI, he had the confidence of
Sundstrand, and he had a pecuniary interest, as the man
n° tert we 0
os Dn ced save’ ae ee
App. 63
who set up the deal, in making certain that the merger
would go through. Each of these positions imposed a duty
of disclosure on Meers. The combination of these some-
what conflicting relationships created a strong duty not
only to disclose the facts which he knew, but to make a
reasonably diligent investigation to determine that the
representations which he and others were making were
true and that no material facts remained undisclosed.
Meers breached this duty by failing to disclose the exis-
tence of the Burke and Ernst & Ernst reports and the
questions that they raised about SKI’s treatment of pre-
production costs in general and their treatment of those
costs in connection with the CPU-46 in particular. Meers’
argument that the reports did not need to be disclosed is
without merit. Without question, the discussions at board
meetings and with the SEC clearly pointed out the impor-
tance of proper future treatment of preproduction costs.
From the information which he received as a director,
Meers knew that the deferral of costs on the CPU-46 and
other programs was continuing and that, despite repeated
assurances that qualification for government contracts was
imminent, the CPU-46 had not in fact been qualified. Thus,
Meers was on notice that one of the principal problems
raised in the Burke and Ernst & Ernst reports was not re-
solved and was, in fact, becoming more severe. Given this
knowledge, and the knowledge that Sundstrand had not
been apprised of the Burke and Ernst & Ernst reports,
Meers was under a duty to discl. se to Sundstrand the exis-
tence of the reports and the persistence of the problem
and to investigate the propriety of continued deferral of
preproduction costs, particularly when such an investiga-
tion would have revealed that several million dollars of
preproduction costs were being deferred in violation of
SKI’s policy for the treatment of such costs.
App. 64
Meers failed to disclose these material facts which he
was under a duty to disclose, and because of this, he is
liable to Sundstrand for the damages suffered in connec-
tion with its purchase of the Burke stock.
Meers is also liable as an aider and abettor of Huarisa
and SKI. A person is liable as an aider and abettor of a
violation of the securities laws where he,
‘¢. .. had knowledge of or, but for a breach of duty of
inquiry, should have had knowledge of the fraud, and
. . . possessing such knowledge the party failed to act
due to an improper motive or breach of a duty of dis-
closure.’’ (Emphasis supplied.) Hochfelder v. Mid-
west Stock Exchange, 503 F.2d 364, 374 (7th Cir. 1974).
As discussed above, Meers had a duty of inquiry which he
breached. Had he inquired into the propriety of SKI’s
treatment of preproduction costs, he would have discovered
that they were being carried on the books without the
amortization required by the accounting policy stated in
the 1967 annual reports and in the 1967 KIC representa-
tion letter. He would also have discovered that if these
costs had been properly accounted for, SKI’s nine months’
earnings for 1968 and the projections for all of 1968 would
have been drastically lower. Had he discovered these
things, he would have had a duty to disclose them.
Finally, Meers is liable for the wrongdoing of SKI as
a ‘‘controlling person’’ of that corporation. Section 20(a)
of the 1934 Act, 15 U.S.C. §78t(a), provides:
‘*(a) Every person who, directly or indirectly, con-
trols any person liable under any provision of this
chapter or of any rule or regulation thereunder shall
also be liable jointly and severally with and to the
same extent as such controlled person to any person
tee te ne ee
App. 65
to whom suck controlled person is liable, unless the
controlling person acted in good faith and did not di-
rectly or indirectly induce the act or acts constituting
the violation or cause of action.’’
A number of cases have held that a person ‘‘controls’’ a
corporation simply by being an active director. Moerman
v. Zipco, Inc., 302 F.Supp. 439, 447 (E.D.N.Y. 1969) ; Dyer
v. Eastern Trust & Banking Co., 336 F.Supp. 890, 915 (D.
Me. 1971). Other cases have required a showing that the
person allegedly in control in fact exercised some control
and was, to some extent, involved in the transaction at
issue. Mader v. Armel, 461 F.2d 1123, 1125 (6th Cir. 1972) ;
cf. Strong v. France, 474 F.2d 747, 752 (9th Cir. 1973);
Sennott v. Rodman & Renshaw, 474 F.2d 32 (7th Cir. 1973).
The court finds that under either standard, Meers was a
controlling person of SKI with respect to this transaction.
Meers was not just one of many co-equal directors. SKI
had only six directors, and two of them, Burke and Perry
Addleman, were in disagreement with Huarisa and the
rest of the board. Moreover, Meers took an active part in
the merger negotiations and in the board’s consideration
of the proposal. Meers consulted with Huarisa about what
merger terms would be acceptable to the board and nego-
tiated the terms of the proposal as Huarisa’s agent. When
the Sundstrand proposal was submitted to the board,
Meers took part in a discussion of its terms and in a dis-
cussion of what representations had been made to Sund-
strand.
As a controlling person, Meers is liable for the acts of
SKI unless he can show that he ‘‘acted in good faith and
did not directly or indirectly induce the act or acts con-
stituting the violation or cause of action.’’ He did not
make this showing. The Seventh Circuit has said that
App. 66
‘* . . ‘to satisfy the requirement of good faith [in
order for a controlling person to avoid liability there-
by] it is necessary for the [controlling person] to
show that some precautionary steps were taken to
prevent the injury suffered,’ Lorenz v. Watson, 258
F.Supp. 724, 732...’’ SEC v. First Securities Co. of
Chicago, 463 F.2d 981, 987 (7th Cir.), cert. denied 409
U.S. 880 (1972) ;
and that
‘¢ ‘failure of the controlling person to maintain and
diligently enforce a proper system of internal super-
vision and control constitutes pa
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