ON APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OF PENNSYLVANIA C.A. No. 73-2790.
Adams and Garth, Circuit Judges, and Layton, District Judge.*fn*
This factually-complex case arises out of the 1973 acquisition of Royal All-Aluminum Swimming Pool Corp. by a 100% stock purchase on the part of Coleco Industries, Inc. Royal's shareholders were Abe Berman, Joseph Rubin, and Irvin, Lewis and Frederick Cohen. Berman acted as president and sales manager, Rubin functioned as vice president, design engineer and production manager, while the Cohens provided financial support to Royal. Berman, Rubin and the Cohens, along with Zelnick, Sobelman and Co., Royal's accountants, were the defendants in the $1.3 million securities fraud action which forms the nucleus of the complaint in this case.
The trial court's extensive opinion, reported at 423 F. Supp. 275-324 (E.D. Pa. 1976), sets forth the circumstances of this case in detail. We therefore present only a capsule review of the events giving rise to the lawsuit.
In 1971, Berman, Rubin and the Cohens incorporated Royal, with the objective of using Berman and Rubin's expertise in manufacturing and marketing above-ground aluminum swimming pools. Royal had a moderately successful year in 1972, making inroads on other pool suppliers' markets, but sold 600 instead of an expected 900 pools, sustaining a net loss of $172,000.*fn1
The combination of a potentially-successful product and a financial squeeze caused by under-capitalization attracted the attention of Coleco, a Connecticut corporation active in the swimming pool field. After initial inquiries in January of 1973, negotiations commenced regarding the purchase of Royal by Coleco. While the original proposition discussed was a $1 million acquisition, the Coleco principals wished to defer consummating the arrangement in order to await the performance of a certified audit of Royal. The Royal officials pressed for an immediate purchase, contending that Royal's current financial situation was so fragile that an immediate infusion of new capital was necessary.
The difference was resolved by a purchase agreement which provided for a firm $500,000 to be paid in four installments, and $500,000 of the purchase price to be made contingent upon the profitability of Royal in succeeding years. In addition, the Royal principals warranted the correctness of Royal's financial statement for the first quarter of 1973 (April 30 statement). Rubin and Berman were to be retained to manage the company at specified salaries. The agreement of sale was signed on June 4, 1973. It is conceded that the April 30th statement underestimated the total inventory set forth by Royal by at least $49,922.
By November 1973, Rubin had quit, Berman had been fired, Coleco had expended - by its estimates - $1.3 million on Royal, Royal had barely broken even, and Coleco was in the process of transferring what was left of Royal to its subsidiary ABCO.
Coleco filed suit on December 4, 1973. The proceeding began as a jury trial, but halfway through the jury was dismissed. After the evidence was closed, Judge Huyett made extensive findings of fact and conclusions of law which are set forth in the course of his opinion.
The interpretation of how matters advanced through each of the various stages is, of course, hotly contested. The first dispute centers on the representations which were made to Coleco before the sale. Coleco claims it was misled as to the profitability of Royal. It points out that on April 18, 1973 Rubin told a Coleco principal that Royal was realizing a gross profit of $500 per pool, and that the April 30, 1973 first quarter report showed a gross profit of $200,000 on the sale of 400 pools.
All parties agree that the April 30 statement was in error, underestimating the cost of the pools manufactured by $49,922, as a result of accounting errors. In addition, Coleco claims that by comparing the April 30 figures with the figures derived from a June, 1973, audit, the cost of the 400 pools was understated by an additional $80,272.*fn2
Berman, Rubin and the Cohens (hereinafter the "Royal defendants") respond that the April 18 representation regarding the gross profit per pool was made in good faith. The trial court agreed, finding that the representation was that Rubin "believed" that he was making $500 per pool, and that such was in fact the state of Rubin's belief (423 F. Supp. at 285, 289). Moreover, the Royal defendants challenge the plaintiff's accounting methods, admitting only the $49,922 discrepancy, and argue that they were misled as much as the plaintiff by the errors of Zelnick, their accountant. The trial court did not pass on this contention explicitly, although it found Zelnick liable to the defendants for the $49,922 error, on the basis of Zelnick's "obvious and mechanical" mistakes (423 F. Supp. at 308-310, 310 n.59).
The major factual disagreement between the parties regarding the various events following the purchase concerns the cause of the business difficulties experienced by Royal. All admit that by the end of the summer, Royal was unable to meet the orders for which it had contracted, and that its operation was beginning to fall apart despite overtime work on the part of Rubin.
Coleco claims that the operation was doomed from the start, given the underestimated profit margin. The Royal defendants contend that the root of the problems was mismanagement by Coleco. While the trial court found that Rubin had informed Coleco that successful operation on the scale it contemplated would require immediate infusions of capital, along with personnel and material from Coleco, in fact the expenditures of money by Coleco on the Royal operation were delayed, and the men and materials never arrived. Moreover, Coleco's management antagonized both Rubin and Berman, the lynchpins of the operation, to the point where one left and the other had to be discharged.
The trial court supported the Royal defendants, finding that "Royal failed, we find it much more probable than not, because Coleco mismanaged it after the acquisition."*fn3
Berman and Rubin both assert that they were driven out - Berman that he was fired without cause, and Rubin that he was forced to resign by intolerable working conditions and lack of cooperation. Both seek to recover the salaries promised them under the contract. Coleco responds that Berman had been derelict in his duty, and that under New Jersey law Rubin's resignation bars recovery on an employment contract. The trial court found for Rubin and against Berman.
By the time this case reached trial, each of the parties, except Zelnick, had invoked a plethora of remedies. Zelnick, however, had settled with Coleco for $350,000 and had become a third-party defendant. In broad overview, the holdings of the trial court were as follows:
(1) Coleco had no valid claim under 15 U.S.C. § 78j(b) and SEC Rule 10b-5. Whatever misrepresentations occurred were made in the belief of their truth or were not "studied." Thus the scienter necessary for a securities violation was lacking.
(2) Coleco had no valid common-law fraud claim. The scienter necessary for a 10b-5 violation is identical to that essential for fraud. Since the former ...