Petition — Sternbach v. Sirota

Supreme Court of the United States

OCTOBER TERM, 1982

Louis STERNBACH & COMPANY,

Petitioner,

- against -

HOWARD SirOTA, FAMILY RESTORATIONS, A Partnership,

on behalf of themselves and all others similarly situated,

Respondents.

PETITION FOR A WRIT OF CERTIORARI TO THE UNITED

STATES COURT OF APPEALS FOR THE SECOND CIRCUIT

Rosert E. MESHEL

Attorney for Petitioner

Louis Sternbach & Company

70 Pine Street

New York, New York 10270

(212) 269-0927

Of Counsel:

JOHN M. Burns, Ill

E..ior B. Pasik

i

QUESTIONS PRESENTED

1. Whether the common law doctrine of respondeat superior

is an implied remedy available in private Causes of Action com-

meneed under Section 10(b) of the Securities Exchange Act of

1934?

2. Whether the element of scienter can be established as

against an alleged “aider-abettor” of violations of Section 10(b)

of the Securities Exchange Act of 1934 on the basis of reckless

behavior?

3. Whether an accountant’s fraudulent intent can be inferred

under Section 10(b) of the Securities Exchange Act of 1934

solely on the basis of claimed inadequate performance of auditing

procedures and tests?

THE PARTIES

Petitioner Louis Sternbach & Company [“Sternbach”] was

one of the named Defendants in the United States District Court

for the Southern District of New York, and was later a Cross-

Appellee in the appeal to the Second Circuit Court of Appeals.

Solitron Devices, Inc. [“Solitron”], and certain of its individ-

ual officers, including Messrs. Benjamin Friedman, James S. Tra-

ger, and James P. Barry, were Defendants in the District Court,

and Appellants-Cross-Appellees in the Court of Appeals.’

Respondents Howard Sirota and Family Restorations, a Part-

nership, on behalf of themselves and all others similarly situated,

were Plaintiffs in the District Court, and Appellees-Cross-Appel-

lants in the Court of Appeals.

The claims of the class which Plaintiffs Robert J. Berk and

Bruce M. Umlas purported to represent were dismissed by the

District Court, and that dismissal was affirmed by the Second

Circuit Court of Appeals.

1. Solitron and its individual ramet eye dh

hag Fete !'No. io'812367). The for review

: See oe roy my adopted by,

QUESTIONS PRESENTED .........

PARTIES

TABLE OF CONTENTS ...........-00+-+

TABLE OF AUTHORITIES .................

OPINIONS BELOW

JURISDICTION .....

STATUTES AND RULES INVOLVED

STATEMENT OF THE CASE

REASONS FOR GRANTING THE WRIT ...............

1.

:

cownne= 2 Eu. o.

THE COURT OF APPEALS ERRED

WHEN IT HELD THAT THE COMMON

LAW DOCTRINE OF RESPONDEAT SU-

PERIOR IS AN IMPLIED REMEDY

AVAILABLE IN PRIVATE CAUSES OF

ACTION COMMENCED UNDER SEC-

TION 10(B) OF THE SECURITIES EX-

CHANGE ACT OF 1934 8

THE COURT OF APPEALS ERRED

WHEN IT DID NOT REACH THE QUES-

TION OF WHETHER RECKLESS BEHA-

VIOR CAN SATISFY THE ELEMENT OF

SCIENTER IN A SECTION 10(B) “AID-

ING-ABETTING” CLAIM .. 14

THE COURT OF APPEALS ERRED

WHEN IT HELD THAT ACCOUNTANTS’

PERFORMANCE OF AUDITING PRO-

CEDURES AND TESTS CAN, STAND-

ING ALONE, GIVE RISE TO AN INFER-

ENCE OF FRAUDULENT INTENT

UNDER SECTION 10(B) 17

CONCLUSION ...... 19

PAGE

Table of Authorities

Cases:

Aaron v. S.E.C., 446 U.S. 680 (1980) ........cccccecereeeenees 15

Adams v. Standard Knitting Mills, Inc., 623 F.2d 422

(6th Cir. 1980), cert. den. 449 U.S. 1067 (1980) ... 19

Armstrong, Jones & Co. v. S.E.C., 421 F.2d 359 (6th Cir.

1970), cert. den. 398 U.S. 958 (1970) .........cccceeeeeeee 13

Atlantic & Gulf Stevedores, Inc. v. Ellerman Lines, Ltd.,

eee 7

Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723

SITU -sshcenicheresideiensennsniienbnthaahindiltedtiiadigtdsmentesizenteminaayton 9, 11

Christoffel v. E. F. Hutton & Co., 588 F.2d 665 (9th Cir.

SITE? satapeinrastniasiaatalddieniiesnipiiidsicnbinisinotitridinnensorneen 13

Cort v. Ash, 422 U.S. 66 (1975) ..ccccccccseseeseserssveeseesenees 9

Decker v. Massey-Ferguson, Ltd., Slip Opinion dated

June 3, 1982, Docket No. 81-7446 (2d Cir.) ............ 16

Edward J. Mawod & Co. v. S.E.C., 591 F.2d 588 (10th

I SEMI Siccrieshthdi lacrinenissieitindtinaldensbtinasecunmosnieesnenace 16

Edwards & Hanley v. Wells Fargo Securities Clearance

Corp., 602 F.2d 478 (2d Cir. 1979), cert. den. 444 US.

BE TI cicetnialihenccintiendacheegebislibageentedinpracesissibenie’ 15

Ernst & Ernst v. Hochfelder, 425 US. 185

EUIEED * geastetionntictnedstivesntgibiintinmabentiatheapineninmniemans 11, 15, 17-19

Healy v. Catalyst Recovery, Inc., 616 F.2d 641 (3rd Cir.

SITET. dtnrelaiiccipeditaitpiatitinsibinabinsiitimnsigindilticcatantcinnuees 15

LLT. v. Cornfeld, 619 F.2d 909 (2d Cir. 1980) .......... 15

J. 1. Case Co. v. Borak, 377 U.S. 426 (1964) «0.0... 9

Keirnanv. Homeland, Inc., 611 F.2d 785 (9th Cir. 1980) 15

—— om v. Telecheck Int'l, Inc., 482 F.2d 247 (8th Cir.

x : 13

Landy v. Midwestern United Life Ins. Co., 259 F. Supp.

673 (N.D. Ind. 1966) (motion to dismiss denied), 286

F.Supp. 702 (N.D. Ind. 1968) (decision on the merits

after trial), aff'd 417 F.2d 147 (7th Cir. spahes cert.

den. 347 U.S. 989 (1970) 16

Mansbach v. Prescott, Ball & Turben, 598 ‘F.2d 1017

(6th Cir. 1979) 15

Marbury Management v. Kohn, 629 F.2d 705 (2d Cir.

1980), cert den. 449 U.S. 1011 (1981) 13

Vv

Monsen v. Consol. Dressed Beef Co., Inc., 579 F.2d 793

(3rd Cir. 1978), cert. den. 439 U.S. 930 (1979) ..... 16

Myzel v. Fields, 386 F.2d 718 (8th Cir. 1967), cert. den.

390 U.S. 951 (1968) , 13

McLean v. Alexander, 599 F.2d 1190 (3rd Cir. 1979) 18-19

National Railroad Passengers Corp. v. National Associ-

ation of Railroad Passengers, 414 U.S. 453 (1974) 10

Piper v. Chris-Craft Industries, Inc., 430 U.S. 1 (1977) 10

Richardson v. MacArthur, 451 F.2d 35 (10th Cir. 1971) 13

Roches Bros., Inc. (Roches II) v. Rhoades, 527 F.2d 880

3rd Cir. 1975) 13

Rolf v. Blyth, Eastman Dillion & Co., 570 F.2d 38 (2d

Cir. 1978), cert. den. 439 U.S. 1039 (1978) ............ 16

Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977) il

S.E.C. v. Geon Industries, Inc., 531 F.2d 39 (2d Cir.

1976) : 13

S.E.C. v. Management Dynamics, Inc. 515 F.2d 801 (2d

Cir. 1975) ..... ~ 43

Securities Investor Protection Corp. v. Barbour, 421 US.

Be ETE Gstscectsccnntdharcinmnninliiblinniesblitesintedcapess 10

Senott v. Rodman & Renshaw, 474 F.2d 32 (7th Cir.

1973); cert. den. 414 U.S. 926 (1973) .. 13

Sharp v. Coopers & Lybrand, 649 F.2d 175 (3rd Cir.

1981), cert. den. 102 S. Ct. 1427 (1982) ........c.cccce0ee 13

Sunstrand Corp. v. Sun Chem. Corp., 553 F.2d 1032 (7th

Cir. 1977), cert. den. 434 U.S. 875 (1979) ..........0. 15

Texas & P. Ry. Co. v. Rigsby, 241 US. 33 (1916) .... 9

Touche Ross & Co. v. Redington, 442 U.S. 560

(1979) 8-10, 13

Transamerica Mortgage Investors v. Lewis, 444 US. 1

(1979) 10, 13

TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438

(1976) esse 6

Woodward v. Metro Bank of Dallas, 522 F.2d 84 (5

Cir. 1975) 16

Zweig v. Hearst Corp., 521 F.2d 1129 (9th Cir. 1975),

cert. den. 423 US. 1025 (1975) 12, 13

PAGE

Constitution and Statutes:

tee. FG, eee 7

15 U.S.C. §770 [Section 15 of the Securities Act of

ROE whnssctcbecnscnsnpsitbsimescheceaapiiitestitguinmaaneietetitntaneneatins 12

15 U.S.C. § 78j(b) [Section 10(b) of the Securities Ex-

ante FAR GE TENG : secsateniscesevevinnetivinisoressiicapateveienoenees passim

15 U.S.C. § 78q(a) [Section 17(a) of the Securities Ex-

change Act of 1934] ........... 8-10

15 U.S.C. § 78r(a) [Section 18(a) of the Securities Ex-

change Act of 1934] disiihiighanapesenaiinanai 10

15 U.S.C. § 78t(a) [Section 20(a) of the Securities Ex-

CEES FAR GE TOON, etvccsreviintecencicitninincrrminassnsinnsiitn 12-13

15 U.S.C. §§ 80b-1—80b-21 [Investment Advisors Act,

RTI Fe CE GIG ectittibcscensstitnasiinevivenssthieninnnnens 10

Rules:

17 C.F.R. § 240.10b-5 [Rule 10B-5] 00.0... ..ccccccccesceseeeees 2-3

Other Authorities:

Comment, “Implied Rights of Action in Federal Legisla-

tion: Harmonization Within the Statutory Scheme”,

1980 Duke Law Journal 923 .......... 12

Fischel, “Secondary Liability Under Section 10(b) of the

Securities Act of 1934”, 69 California Law Review 80

CRIED Wnibicisiineshddictecpiundeseiapetescctnnatipsenicapainimaneans 8, 12

IN THE

Supreme Court of the United States

OCTOBER TERM, 1982

No.

Louis STERNBACH & COMPANY,

Petitioner,

- against -

HOWARD SiROTA, FAMILY RESTORATIONS, A Partnership, on

behalf of themselves and all others similarly situated,

Respondents.

PETITION FOR A WRIT OF CERTIORARI TO THE UNITED

STATES COURT OF APPEALS FOR THE SECOND CIRCUIT

The opinion of the United States Court of Appeals, rendered

February 19, 1982, is reported at 673 F.2d 566 (2d Cir. 1982),

and is reproduced in the Appendix at A44.". The Court of

Appeals opinion reversed the District Court's granting of Peti-

tioner’s motion for judgment notwithstanding the verdict. The

unreported District Court opinion, rendered March 6, 1981,

granting Petitioner judgment n.o.v., is reproduced in the Appen-

dix at Al.

The Court of Appeals order denying the Petitions for Rehear-

ing is reproduced in the Appendix at A67. The Court of Appeals

order amending its opinion is reproduced in the Appendix at A69.

The Special Interrogatories submitted to and answered affirm-

atively by the jury as part of its verdict in the District Court are

reproduced in the Appendix at A71.

age Page references to the Appendix to this Petition are cited as

2

The judgment of the Court of Appeals was set forth in its

opinion rendered February 19, 1982. (A44) A timely Petition

for Rehearing was filed by the Petitioner, and denied in an order

filed May 13, 1982. (A67) This Court's jurisdiction is invoked

pursuant to 28 U.S.C. § 1254(1).

STATUTES AND RULES INVOLVED

tion 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.

§ 78j(b), which provides as follows:

Ҥ 78}. Manipulative and deceptive devices

It shall be unlawful for any person, directly or indi-

a Sena ae ee ea

state commerce or of the mails, or of any facility of any

national securities exchange—

pe in hy boven pene dh nema

tive or deceptive device or contrivance in contravention of

such rules and regulations as the Commission may pre-

scribe as necessary or appropriate in the public interest or

for the protection of investors.”

The Petition also involves the interpretation and application of

Securities and Exchange Commission Rule 10b-S promulgated

thereunder, 17 C.F.R. § 240.10b-5, which provides as follows:

Ҥ 240.10b-5 E and

. mployment of manipulative and deceptive

It shall be unlawful for any person, directly or indi-

rectly, by the use of any means or instrumentality of inter-

state commerce, or of the mails or of any facility of any

national! securities exchange,

(a) To employ any device, scheme, or artifice to

defraud,

3

(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) Toengage 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 purchaser or sale of any

security.”

In 1975, the Respondents commenced this action alleging that

Solitron, and certain of its officers, including Messrs. Benjamin

Friedman, James S. Trager, and James P. Barry, violated Section

10(b) of the Securities Exchange Act of 1934 and Securities and

Exchange Commission Rule 10b-5 promulgated thereunder.

The Petitioner Sternbach, Solitron’s independent outside

accountants, was alleged to have “aided and abetted” the primary

Section 10(b) violations of Solitron and its officers.

Respondents, later certified as a class of purchasers of the

shares of common stock of Solitron, alleged that Solitron and its

officers, “aided and abetted” by Sternbach, intentionally over-

stated Solitron’s profitability in certain annual Financial State-

ments. Respondents claimed that Solitron’s false and misleading

Financials “polluted” the market, and thereby induced Respon-

dents to purchase Solitron’s stock at an artificially high price.

A jury returned a verdict in Respondents’ favor based upon

Special Interrogatories [A71] submitted to them. The jury

found Solitron and its officers Friedman, Trager and Barry liable

under Section 10(b) for intentionally participating in the publi-

cation and dissemination of false and misleading Financial State-

ments for years 1967, 1968, 1970, and 1972-1974. Sternbach

was also ‘ound liable as a Section 10(b) “aider-abettor” for years

1967, 1968 and 1970 only, and also found liable for the same

years in common law negligence. Sternbach resigned as Soli-

tron’s auditor commencing the 1972 fiscal year, and thus could

not be held responsible for subsequent periods.

4

Respondents’ proof at trial with respect to Sternbach was pri-

marily premised upon claims that Sternbach had constructive,

but not actual, knowledge of Solitron’s overstatements of its

inventory and sales in the years 1967, 1968 and 1970. Respon-

dents’ proof consisted of two reports prepared by the successor

accountants Messrs. Price Waterhouse & Company.

The Price Waterhouse reports were prepared at Solitron’s

behest for use by Solitron in its defense of a claim made by the

Eastern Regional Branch of the United States Renegotiation

Board. In 1972 the Board had determined that Solitron had

earned “excess profits” on its contracts with the federal govern-

ment during the years 1967 and 1968. Solitron was therefore

ordered to disgorge $7,600,000 of “excess profits” to the govern-

ment. The reports submitted to the Renegotiation Board

claimed that Solitron had not been as profitable in the 1967-1970

profits.”*

The motion submitted by Solitron, Friedman, Trager and Barry

5

years 1967, 1968 and 1970. Sternbach’s motion was granted in

its entirety on both the Section 10(b) “aider-abettor” and negli-

gence claims, for years 1967, 1968 and 1970.

With respect to the Section 10(b) claim against Sternbach,

District Court Judge Charles L. Brieant, Jr. found that there was,

“overwhelming uncontroverted evidence in favor of the defendant

Sternbach. There was no evidence from which a reasonable juror

acting reasonably could have concluded that Sternbach aided and

abetted the primary securities law violation with the requisite

scienter.“ [A29-30] The common law negligence claim was

dismissed as a matter of law, and later withdrawn by the Respon-

dents on the appeal to the Second Circuit.

Thereafter, the Second Circuit reversed the granting of judg-

ment n.o.v. to Sternbach, and affirmed-that part of the District

Court decision pertaining to Solitron, Friedman, Trager and

Barry.

The Circuit Court decision that concluded that Sternbach was

liable as an “aider-abettor” of Solitron’s primary Section 10(b)

violations based its reasoning on a “combination” of three “facts”:

Sues

1

lf

i

hal

ali

Sternbach’s claim to have performed various

cedures and tests on Solitron’s 1967-70 inventory, cing pro

might well have concluded that Sternbach knew that its

6

certification of reports overstating inventory was fraudu-

lent. The combination of these facts leads us to the con-

clusion that there was sufficient evidence for the jury to

infer that Sternbach had actual knowledge of fraud in

violation of Rule 10b-5. [A59-60]

The Circuit Court’s “combination” of “facts” analysis was

materially mistaken both in fact’ and law. The Circuit Court's

first so-called “fact”, that Sternbach could be held vicariously

liable based on co-Petitioner James Trager’s “knowledge of the

fraud”, is erroneous. The other erroneous “fact” recited by the

Court was that the jury was permitted to infer that Sternbach

possessed an inteat to defraud by virtue of its performance of

certain audit tests and procedures.

With respect to the first so-called “fact”, Respondents never

alleged that Sternbach’s liability could be vicariously premised on

Trager’s conduct. That is because although James Trager was

employed at Sternbach in 1967, 1968 and early 1969—prior to

described himself as the “lowest fellow on the rung”. [A76-79]

There was no evidence to the contrary. Accordingly, Trager’s

primary 10(b) violations could not have been vicariously imputed

5. While it is axiomatic that this Court reviews questions of law, not

fact, where, as here, a federal Court of Appeals has predicated its

decision upon an egregious and material mistake of fact, as discussed

&

7

7

to Sternbach as a matter of law. The common law doctrine of

respondent superior is not an implied remedy available in private

Section 10(b) Causes of Action.

The Court of Appeals further erred in its first so-called “fact”

when it stated that Sternbach should be regarded as possessing an

intent to defraud because of “the jury’s finding . . . that Trager . . .

had actual knowledge of the fraud” [A60]. The jury did not so

find. Special Interrogatory “3”, submitted to and answered

affirmatively by the jury as part of its verdict, asked whether

Trager “participated in the preparation and dissemination of [the

Financial Statements] to the public with actual knowledge of

their falsity or misleading nature or with a reckless disregard of

their truth or falsity” [Emphasis Addedj* [A72-73]. Thus,

even assuming arguendo that Trager’s scienter could have been

imputed to Sternbach, an actual intent to defraud standard of

scienter could not have been imputed. The jury found that Tra-

ger either intended to defraud, or, acted recklessly. In this cir-

cumstance, the Court of Appeals erred when it decided not to

reach the question of whether acutal intent to defraud or reckless

conduct satisfied the proper standard of scienter as respects an

alleged Section 10(b) “aider-abettor”. [A59] As demon-

strated infra, the Court of Appeals should have determined that

only the standard of actual intent to defraud, not recklessness,

satisfied the scienter requirement of Section 10(b) “aider-abet-

tor” liability, and in the absence of a jury finding that Trager

intended to defraud, Sternbach should not have been found vicar-

iously liable.

The Court of Appeals also erred in the third so-called “fact” of

its “combination” analysis when it held that the jury was allowed

to have “concluded” that Sternbach possessed an actual intent to

defraud because of “Sternbach’s claim to have performed various

costing procedures and tests in Solitron’s 1967-70 inventory”.

[A60] An accountant’s performance of routine and ordinary

auditing tests and procedures cannot, standing alone, permit a

jury to infer an intent to defraud.

REASONS FOR GRANTING THE WRIT

I

THE COURT OF APPEALS ERRED WHEN IT HELD THAT THE

COMMON LAW DOCTRINE OF RESPONDEAT SUPERIOR IS AN

IMPLIED REMEDY IN PRIVATE CAUSES OF ACTION COM-

MENCED UNDER SECTION 10(b) OF THE SECURITIES

EXCHANGE ACT OF 1934.

In holding that the Sternbach partnership was liable under the

federal securities law based on the acts of Trager, the Court of

Appeals applied and extended the common law doctrine of

respondeat superior in a manner never envisioned by either Con-

gress or the Courts." The Second Circuit's decision below irrec-

oncilably conflicted with existing judicial authorities and should

therefore be reversed insofar as it related to the Petitioner

Sternbach.

The Court has never decided the issue of whether the doctrine

of respondeat superior is an implied private remedy available for

imputing Section 10(b) “aiding-abetting” liability. Recent deci-

sions of this Court have severely restricted the availability of

implied remedies under the federal securities law.

In Touche Ross & Co. v. Redington, 442 U.S. 560 (1979), this

Court refused to recognize that Section 17(a) of the Securities

Exchange Act of 1934 [15 U.S.C. § 78q{a)], which requires

broker-dealers and others to prepare and file such records as the

Securities and Exchange Commission may prescribe, created a

private Cause of Action.

10,0 of ite Soares Act of 1934,” 69 California in ban 20

9

This Court charaterized as “entirely misplaced™ arguments

that general tort law principles should justify a Section 17(a)

implied right of action. Rather, this Court stated that the “cen-

tral inquiry” is “whether Congress intended to create, either

expressly or by implication, a private cause of action.” In the

absence of statutory language indicating Congressional intent to

create a Section 17(a) private remedy, none was implied.”

Further reasoning for the Touche Ross decision is found in the

maxim expressio unius est exclusio alterius. The Touche Ross

Court further reasoned that in view of the fact that Section 17(a)

is found amidst other provisions of the Securities Exchange Act

which do expressly grant private Causes of Action, the existence

of these express remedies dictated against implication."

Court observed that a Section 17(a) implied private remedy

would necessarily conflict with the express private remedy of

. ia. 1575. Ine holding that the f fi determining the

at n t the foremost factor in

anne & Sa Slew, this Court ejected is earlier rationale expressed

tion of tort law, this Court its earlier rationale expressed

nS eS v. Rigsby, 241 US. eT Oey In a similar vein,

Noe yh I. Case Co. v. Borak, 377

US. 426 (1964), and Cort v. Ash, 4 US. 66 (197 5). In Borak and

Cort, this Court held that a private right of action could be inferred to

effectuate the remedial intent of a statute even where 20 Congressional

intent to create such a private could be found.

10. The Plaintiffs in Touche ge eyes pote bey atte: wr

to

z

accountants had certified as accurate a false and misleading

statement. The accounting firm of Touche Ross & Co. was

Section 18(a) [15 U.S.C. § 78r(a)], which creates a private

action against persons who make materially misleading state-

ments in reports filed with the S.E.C. The express remedy of

Section 18(a) is limited to persons who, in reliance on the state-

ments, purchased or sold securities at a price influenced by the

statements. However, the Section 17(a) implied right of action

suggested by the Plaintiffs in Touche Ross did not contain the

allegation that Plaintiffs had relied on Touche Ross's certification

when purchasing and selling securities. Hence, this Court

concluded:

“(Where the principal express civil remedy for mis-

statements in reports [Section 18] . . . is by its terms

limited to purchasers and sellers of securities, we are

extremely reluctant to imply a cause of action in § 17(a)

that is significantly broader than the remedy that Con-

gress chose to provide.” 442 U.S. at 574.

In Transamerica Mortgage Advisors v. Lewis, 444 US. |

(1979), this Court again declined to imply a private right of

action out of an existing federal regulatory statute. This Court

adhered to its reasoning in Touche Ross when it held, that in the

absence of express Congressional intent to create a private action

for damages in Section 201 of the Investment Advisers Act of

1940 [15 U.S.C. §§ 80b-1-80b-21], no private action would be

implied. As in Touche Ross, the Transamerica Court based its

decision on the expressio unius rule", the language of the stat-

ute, and the absence of legislative history to the contrary.”

ciation

Craft Industries, Inc., 430 US.1 (1977).

Sn eer ae pea eas

of Railroad US. 453 (1974);

Section 10(b). This Court has emphasized that in determining

whether a Complaint stated a viable Cause of Action under Sec-

tion 10(b), it was necessary to “turn first to the language of

§ 10(b)”, for “[t]}he starting point in every case involving con-

struction of a statute is the language itself.”"

In Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723

(1975), this Court held that an attempt to purchase or sell a

“security” did not satisfy the requirement of the explicit language

of Section 10(b) that the complained-of activity be “in connec-

tion with the purchase or sale of any security.”

In Ernst & Ernst v. Hochfelder, supra, this Court held that

evidence of negligent conduct would not suffice to state a Section

10(b) Cause of Action. This Court focused on the language of

Section 10(b), which prohibits, “any manipulative or deceptive

practice.” These words, said this Court, “make unmistakable a

Congressional intent to proscribe a type of conduct quite different

from negligence.”” A Section 10(b) Cause of Action, held this

Court, required a showing of scienter, defined as, “a mental state

embracing intent to deceive, manipulate, or defraud."“ The

question of whether reckless conduct can constitute scienter was

reserved.

This Court’s emphasis on the statutory language of Section

10(b) was again evident in Santa Fe Industries, Inc. v. Green,

430 U.S. 462 (1977). This Court refused to recognize an action-

able claim under Section 10(b) for alleged breaches of “fiduciary

duty” in connection with a corporate merger. This Court held

that absent manipulation or deception, Section 10(b) did not

reach breaches of “fiduciary duty.”

It is apparent, then, that based on recent decisions of this

Court, an implied private remedy of respondeat superior cannot

be found to exist in Section 10(b).

There is no language in Section 10(b) from which one could

reasonably imply the respondeat superior doctrine. Nor is there

any evidence of Congressional intent suggesting such a reading.

14. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 197 (1976).

1S. Id. at 199.

16. Id. at 193 0.12.

12

To the contrary, the expressio unius rule suggests that Congress

did not intend to confer Section 10(b) with the attributes of

vicarious liability. Section 20(a) of the Securities Exchange Act

of 1934 [15 U.S.C. § 78t(a)], and Section 15 of the Securities

Act of 1933 [15 U.S.C. § 770] each provide that a “controlling

person” may be liable for the securities violations of others. Each

provision also has a “good faith” defense. That is, a person is

protected from liability if he can prove that he exercised reason-

able internal supervision against securities violations. See, e.g.

Zweig v. Hearst Corp., 521 F.2d 1129, 1134-1135 (9th Cir.

1975), cert. den. 423 U.S. 1025 (1975). In light of Sections

20(a) and 15 and the expressio rule, Sternbach submits that it is

fair to conciuae that Congress intended the “controlling person”

provisions of the securities law to be ihe exclusive method of

imposing liability on employers.”

The Circuit Courts are divided on the question of whether

respondeat superior is applicable to Section 10(b) and other

provisions of the securities law, or, whether the statutory “con-

trolling person” provisions are the exclusive means for imposing

vicarious liability. The majority of the Circuit Courts have held

17. See Fischel, “Secondary Lia .", 69 California Law

oe by pid Ty le mp

y as or i i

liability, Piste cast circomrent the * faith” defense available to

" ae ee aa supe-

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13

that the “controlling person” provisions and respondeat superior

can both be utilized to impose vicarious liability.* The Third,

Eighth and Ninth Circuits hold otherwise.”

The Court of Appeals erred when it held Sternbach vicariously

liable based on the acts of Trager, a part-time clerk. Neither

Section 20(a) nor respondent superior can be fairly utilized to

impute Trager’s scienter to Sternbach. Section 20(a) is inappli-

cable because no such claim was pleaded by the Respondents.

The respondeat superior doctrine is inapplicable because based

18. See, seg 4 M v. Kohn, 629 F.2d 705 (2d Cir.

1980), cert. den. 449 US. Of! (1981); S.E.C. v. Geon Industries, Inc.,

(7th Cir. 1973); cert. den. 414 U.S. 926 (1973); Richardson v. MacAr-

thur, 451 F.2d 35 (10th Cir. 1971); Armst Jones & Co. v. S.E.C.,

421 F.2d 359 (6th Cir. 1970), cert. den., 398 U.S. ae oti —_

Fields, 386 F.2d 718 (8th Cir. 1967), cert. den. 390 U.S. 951 {is

19. See, Christoffel v. E.F. Hutton & Co., 588 F.2d 665

1978); Roches Bros., Inc. (Roches | v. Rhoades, 527 F.2d (3rd

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THE COURT OF APPEALS ERRED WHEN IT DID NOT REACH

THE QUESTION OF WHETHER RECKLESS BEHAVIOR CAN

SATISFY THE ELEMENT OF SCIENTER IN A SECTION 10(b)

“AIDING-ABETTING” CLAIM

The Court of Appeals again erred in the first so-called “fact” of

its “combination” analysis with respect to a key factual matter.

The Court erred when it held:

“[T]he [district] court's conclusion that Sternbach lack-

ed actual knowledge [of the fraud] is inconsistent with the

jury's finding . . . that Trager—who was employed by

Sternbach in 1967, 1968, and early 1969—had actual

Pinta of the fraud.” (Emphasis Added]. [A59-

60}.

The jury did not find that co-Petitioner Trager had “actual

knowledge of the fraud” while engaged as a part-time clerk for

Sternbach. In Special Interrogatory “3” [A72-73], the jury

found that for years ending February 28, 1967 and 1968, the

applicable time periods of that Interrogatory during which Tra-

ger was employed at Sternbach, Trager:

eX . participated in the preparation and dissemination

[the financial statements] . . . to the public

«uh ssasat baptist tale tees whaiediaeindion

or with a reckless disregard of their truth or falsity”

[Emphasis Added].

Thus, the Court of Appeals erred when it held that the jury

found that Trager had “actual knowledge of the fraud,” and such

actual knowledge should be vicariously imputed to Sternbach.

The jury found that either Trager participated with actual knowl-

edge of the fraud or acted recklessly. Assuming arguendo that

Trager’s scienter could have been imputed to Sternbach on a

respondeat superior theory, the intent to defraud standard of

scienter could not have been imputed to Sternbach because the

jury did not indicate whether Trager possessed an intent to

defraud the Respondent class members.

15

In light of the jury’s disjunctive finding, that Trager either

intended to defraud or acted recklessly, the Court of Appeals

wrongly decided “not [to] reach the question whether

Sternbach . . . should have been judged under a recklessness

standard [of scienter),” rather than the District Court's standard

of actual intent to defraud [A59]. The Court of Appeals should

have adjudged Sternbach under the standard of actual intent, and

in the absence of a jury finding that Trager acted with actual

intent to defraud, Sternbach should not have been held liable.”

This Court has expressly reserved the question of whether

actual intent to defraud is the sole means for satisfying the Sec-

tion 10(b) requirement of scienter, or, whether reckless behavior

will also suffice. Aaron v. S.E.C., 446 U.S. 680, 686 n.5 (1980);

Ernst & Ernst v. Hochfolder, supra, 425 US. at 193 n.12.

The Circuit Courts have generally held that reckless behavior

will satisfy the element of scienter in a primary Section 10(b)

Cause of Action.”

The Circuit Courts are less settled on the question of whether

recklessness will satisfy the scienter requirement of Section 10(b)

“aiding and abetting” liability.”

The Second Circuit has held that reckless conduct can satisfy

the scienter element of Section 10(b) “aider-abettor” liability

only where a Defendant owed a “fiduciary duty” to the Plaintiff.

Edwards & Hanley v. Wells Fargo Securities Clearance Corp.,

602 F.2d 478, 484-485 (2d Cir. 1979), cert. den. 444 U.S. 1045

(1980); Rolf v. Blyth, Eastman Dillon & Co., supra, 570 F.2d at

44. In the case at bar, the Second Circuit refused to decide

whether Sternbach owed the Respondeuts a “fiduciary duty”, and

whether, accordingly, Sternbach should be adjudged under the

recklessness standard [A59]. The Second Circuit did note that

three New York Southern District Courts were split on the ques-

tion of whether accountants should be adjudicated under an

actual intent or recklessness standard of scienter. [A57-58].

Most recently, in Decker v. Massey-Ferguson, Lid., Slip Opinion

dated June 3, 1982 [Docket No. 81-7446], the Second Circuit

deciined to decide whether corporate directors, alleged to be Sec-

tion 10(b) “aider-abettors,” should be adjudicated under an

actual intent or recklessness standard.

Other Circuit Courts have reached conflicting results when

defining the scienter standard applicable to “aiding-abetting” lia-

bility. The Fifth Circuit in Woodward v. Metro Bank of Dallas,

$22 F.2d 84 (Sth Cir. 1975), held that differing standards of

scienter should be applied, dependent on the alleged “aider-abet-

tor’s” duty of disclosure to the Plaintiff. As stated by Judge

Goldberg of that Court:

“When it is impossible to find any duty of disclosure, an

alleged aider-abettor should be found liable only if scien-

ter of the high ‘conscious intent’ variety can be

ae alas anne aed [/d. at

97}.

On the other hand, the Third, Sixth, Seventh and Tenth Circuit

Courts have held that only actual intent to defraud, or conduct

sufficiently equivalent thereto, will satisfy the scienter element.™

This Court has reserved the question of whether reckless con-

Se a, The Circuit Courts are split on

Edward J. Mawod & Co. v. S.E.C., 591 F.2d 588, 595-596

toh Ce 1979); Mensen v. Consol. Dressed Beef Co., Inc., 579 F.2d

799-800 (3rd fire & ties 30 (1979); v.

Co., 259 F.Supp. 673, 680 (N.D.

denied), 286 F 708 NLD. Ind.

17

the question with respect to “aider-abettor” liability. This Court

is requested to grant certiorari to resoive the conflict among the

Circuit Court decisions as to the nature of the element of scienter

sufficient to establish a Section 10(b) “aiding-abetting” claim.

THE COURT OF APPEALS ERRED WHEN [IT HELD THAT

ACCOUNTANTS’ PERFORMANCE OF AUDITING PROCEDURES

AND TESTS CAN, STANDING ALONE, GIVE RISE TO AN INFER-

ENCE OF FRAUDULENT INTENT UNDER SECTION 10(b) OF

THE SECURITIES EXCHANGE ACT OF 1934

In the third so-called “fact” of its “combination” analysis, the

Court of Appeals predicated its judgment of liability against

Sternbach upon a determination that accountants’ performance

of various auditing procedures and tests can somehow provide a

jury with grounds to infer the accountants’ “fraudulent” intent

under Section 10(b) of the 1934 Act. The Court of Appeals heid

as follows:

“And in light of Sternbach’s claims to have performed

various costing procedures and tests on Solitron’s 1967-

1970 inventory, the jury might well have concluded that

Sternbach knew that its certification of reports overstating

inventory was fraudulent.” [A60]

This holding, extending as limitless the parameters of account-

ants’ liability under the federal securities law, is erroneous, and

conflicts with holdings of this Court, and the Third and Sixth

Circuits.

In Ernst & Ernst v. Hochfelder, supra, a Section 10(b) action

against the accounting firm of Ernst & Ernst was dismissed by

this Court in the absence of the accountants’ fraudulent intent.

This Court defined the requisite showing of fraudulent intent

under Section 10(b) as “a mental state embracing intent to

deceive, manipulate or defraud.” Under this standard, this

Court dismissed the Section 10(b) claim against Ernst & Ernst,

although, as here, the accounting firm was acknowledged to hav:

performed various auditing tests and procedures. The Plaintiffs’

specific factual claim against Ernst & Ernst was that it had failed

to detect management’s fraud, which fraud would have been

In McLean v. Alexander, 599 F.2d 1190 (3rd Cir. 1979),

accountants were alleged to have violated Section 10(b) in view

of their certification of Financial Statements that overstated

accounts receivable. Plaintiffs alleged that the accounts receiva-

ble included certain “consignment” transactions which were

improperly recorded as sales. As in Ernst & Ernst, the account-

ing firm’s defense was that it had performed its audit in accord-

ance with “Generally Accepted Auditing Standards,” and, in any

event, it did not act with scienter. In dismissing the Section

10(b) claim, the Court held that the accountants’ audit, standing

alone, could not sustain a 10(b) claim.”

25. The Court stated: “The [accounting firm's} representation was,

then, an of based i

standards "[ The accoceting fires of] CAS could te bold to have the

expressed the opinion it hed no genuine bole! that it hed the ialbemation

expressed the opinicn it had no genuine that it had the

cunadaiaiamadietekanaina o» te ead LB Smith

Robbins, and Southern Laser established to _atneton el the Coun

that the sixteen transactions were in the nature of consignments. There

was no evidence that Schiavi, the [ firm] partner in of

the audit, had actual of the sales. Thus [the

firm] could be to have the scienter the

it made, and the knowledge it acre

was on

Schiavi's investigation of the four me, Saeee

such an inference was not in this case.” F.2d at 1198-

The Sixth Circuit reached a similar result in Adams v. Stan-

dard Knitting Mills, Inc., 623 F.2d 422 (6th Cir. 1980), cert

den. 449 U.S. 1067 (1980). The Court found that the account-

ing firm of Peat, Marwick, Mitchell & Company had, in its

preparation of audited Financia] Statements, acted negligently

[id. at 426-428]. However, the Court did not find that a negli-

gent audit could, standing alone, give rise to an inference of

scienter and accordingly dismissed the Complaint.

In the instant case, the Court of Appeals holding that an

accountant may be inferred to have acted with fraudulent intent

based merely on the performance of certain auditing tests mani-

festly conflicted with this Court’s holding in Ernst & Ernst, and

the Third and Sixth Circuits’ holdings in McLean and Adams.

CONCLUSION

For the foregoing reasons, the Petition of Louis Sternbach &

Company for a Writ of Certiorari should be granted in all

respects.

Dated: August 10, 1982

Respectfully submitted,

ROBERT E. MESHEL

Attorney for Petitioner

Louis Sternbach & Company

70 Pine Street

New York, New York 10270

(212) 269-0927

Of Counsel:

JOHN M. Burns, III

E.L.ior B. PaAsik