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IN RE PHAR-MOR, INC. SECS. LITIG. v. COOPERS & LYB

June 20, 1995

IN RE PHAR-MOR, INC. SECURITIES LITIGATION; GIANT EAGLE OF DELAWARE, INC.; GERALD E. CHAIT; STANLEY MORAVITZ; IRWIN PORTER; FARRELL RUBENSTEIN; DAVID S. SHAPIRA; NORMAN WEIZENBAUM; and GIANT EAGLE, INC., Plaintiffs,
v.
COOPERS & LYBRAND and EUGENE M. FREEDMAN, WILLIAM K. O'BRIEN, LARRY S. SCHUMER, JOHN HENRY CYNKAR, ROBERT SCOTT WILLIAMS, RICHARD L. BAIRD, JOHN E. EASTON, PHILIP H. REED, JR., V. M. O'REILLY, JOHN J. ROBERTS, STEVEN L. SKALAK, ROBERT T. CARUSO, BJORN HANSON, WILLIAM F. BUETTNER, JR., GREGORY S. FINERTY and RICHARD E. SHERMAN, on behalf of themselves and as representatives of a class of partners and principals of Coopers & Lybrand, Defendants.



The opinion of the court was delivered by: DONALD E. ZIEGLER

 ZIEGLER, Chief Judge

 Pending before the court is the motion of defendant, Coopers & Lybrand ("Coopers"), for summary judgement with respect to the claims asserted by plaintiffs, Giant Eagle of Delaware, Inc. ("GE Delaware"), Giant Eagle, Inc. ("Giant Eagle"), and six members of the Board of Directors of Phar-Mor, Inc. ("Phar-Mor"), namely, Gerald E. Chait, Stanley Moravitz, Irwin Porter, David S. Shapira, Farrell Rubenstein and Norman Weizenbaum (collectively referred to as "the PM Directors"). *fn1"

 This action stems from the financial fraud that was perpetrated by certain officers of Phar-Mor during the late 1980's and early 1990's. It is one of over forty actions which have been consolidated in this court as part of the multidistrict litigation styled In re Phar-Mor, Inc. Securities Litigation, MDL No. 959. The fraud at Phar-Mor, a deep discount drugstore chain, was allegedly masterminded by Michael I. Monus, its former Chief Operating Officer, and Patrick B. Finn, its former Chief Financial Officer. *fn2" As a result of the fraud, Phar-Mor's financial statements falsely reflected a profitable business when, in fact, Phar-Mor was operating at a substantial loss. *fn3" Shortly after the fraud was revealed in August of 1992, Phar-Mor filed a petition for relief under Chapter 11 of the Bankruptcy Code.

 Giant Eagle, a Pennsylvania corporation with its principal place of business in Pittsburgh, Pennsylvania, is a privately-held company that operates a chain of supermarkets in Pennsylvania, West Virginia and Ohio. GE Delaware, a Delaware corporation with its principal place of business in Wilmington, Delaware, is a wholly-owned subsidiary of Giant Eagle. Each of the PM Directors are residents of Pennsylvania with the exception of Norman Weizenbaum, who is a resident of Florida.

 Coopers, a partnership established under the laws of New York, is an international public accounting firm. Coopers served as Phar-Mor's outside auditor from 1984 until August 1992. Coopers also served as the outside auditor for Giant Eagle for approximately twenty years until its services were terminated in August 1992. The audits of both Phar-Mor and Giant Eagle were performed by auditors working out of Coopers' offices located in Pittsburgh, Pennsylvania. All of the auditors that worked on the particular audits at issue here, namely, the audits of Phar-Mor and Giant Eagle for the fiscal years 1989, 1990 and 1991, were licensed by the Commonwealth of Pennsylvania. *fn4"

 GE Delaware and the PM Directors are purchasers of over $ 100 million of Phar-Mor stock. We have separated the purchases into four categories. The first category ("Pre-fraud Purchases") consists of purchases made "pre-fraud," or those purchases made prior to fiscal year 1989. *fn5" The second category ("1989 PPM Purchases") consists of those purchases made in Phar-Mor's private placement stock offering of November 1989. In the November 1989 offering, 460,000 shares were offered at $ 175.00 per share for a total offering price of $ 80,500,000.00. The offer was made by way of a November 1, 1989, private placement memorandum ("PPM") which, with Coopers' authorization, contained a copy of Coopers' fiscal 1989 Phar-Mor audit report. The third category ("1990 PPM Purchases") consists of those purchases made in Phar-Mor's private placement stock offering of September 1990. In the September 1990 offering, 4,000,000 shares were offered at $ 20.00 per share for a total offering price of $ 80,000,000.00. The offer was made by way of a September 13, 1990 PPM, which contained a copy of Coopers' fiscal 1990 Phar-Mor audit report. The fourth category ("FY 89-91 Purchases") consists of purchases which were made during fiscal years 1989 through 1991 that were not purchased as part of a private placement offering. These include the exercise of stock options. The following chart summarizes the purchases of GE Delaware and the PM Directors: *fn6" 1. Gerald E. Chait: Pre-fraud Purchases $ 520,000.00 1989 PPM Purchases --NONE-- 1990 PPM Purchases --NONE-- FY 89-91 Purchases 144,500.00 TOTAL PURCHASES $ 664,500.00 2. GE Delaware: Pre-fraud Purchases $ 26,456,240.00 1989 PPM Purchases 25,535,475.00 1990 PPM Purchases 25,000,000.00 FY 89-91 Purchases 19,999,980.00 TOTAL PURCHASES $ 96,991,695.00 3. Stanley Moravitz: Pre-fraud Purchases $ 150,000.00 1989 PPM Purchases 35,000.00 1990 PPM Purchases 220,000.00 FY 89-91 Purchases 152,170.00 TOTAL PURCHASES $ 557,170.00 4. Stanley & Flo Moravitz: Pre-fraud Purchases $ 62,000.00 1989 PPM Purchases --NONE-- 1990 PPM Purchases 20,000.00 FY 89-91 Purchases 27,000.00 TOTAL PURCHASES $ 109,000.00 5. Irwin Porter: Pre-fraud Purchases $ 136,380.00 1989 PPM Purchases 70,000.00 PPM Purchases --NONE-- FY 89-91 Purchases 197,080.00 TOTAL PURCHASES $ 403,460.00 6. Farrell Rubenstein: Pre-fraud Purchases $ --NONE-- 1989 PPM Purchases --NONE-- 1990 PPM Purchases 100,000.00 FY 89-91 Purchases --NONE-- TOTAL PURCHASES $ 100,000.00 7. David S. Shapira and Karen A Shapira: Pre-fraud Purchases $ 2,900,000.00 1989 PPM Purchases 49,875.00 1990 PPM Purchases --NONE-- FY 89-91 Purchases 152,170.00 TOTAL PURCHASES $ 3,102,045.00 8. Norman Weizenbaum: Pre-fraud Purchases $ 286,940.00 1989 PPM Purchases --NONE-- 1990 PPM Purchases --NONE-- FY 89-91 Purchases 259,580.00 TOTAL PURCHASES $ 546,520.00 9. Norman Weizenbaum trustee for L. Weizenbaum: Pre-fraud Purchases $ 77,470.00 1989 PPM Purchases --NONE-- 1990 PPM Purchases --NONE-- FY 89-91 Purchases --NONE-- TOTAL PURCHASES $ 77,470.00

 Plaintiffs contend that, had Coopers not recklessly and improperly performed its audits of Phar-Mor during the fiscal years 1989 through 1991, it would have uncovered the fraud and plaintiffs would not have purchased shares of Phar-Mor stock during 1989 and 1990, or alternatively, would have purchased the shares at a considerably lower price. In addition, plaintiffs contend that Coopers' reckless audits precluded them from protecting their investments in Phar-Mor. Finally, Giant Eagle contends that if Coopers had uncovered the fraud, it would not have entered into the significant and ill-fated business transactions with Phar-Mor.

 Summary judgment is appropriate when there are no genuine issues of material fact and the moving party is entitled to judgment as a matter of law. Fed.R.Civ.P. 56; Celotex Corp. v. Catrett, 477 U.S. 317, 322, 91 L. Ed. 2d 265, 106 S. Ct. 2548 (1986). In considering a motion for summary judgment, we must examine the evidence in the light most favorable to the non-moving party and draw all reasonable inferences in favor of that party. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 255, 91 L. Ed. 2d 202, 106 S. Ct. 2505 (1986).

 The parties agree that Pennsylvania law controls the instant action. Pennsylvania has adopted the "most significant relationship test" set forth in section 145 of the Restatement (Second) of Conflict of Laws (1971). See, e.g., Griffith v. United Air Lines, Inc., 416 Pa. 1, 203 A.2d 796 (Pa. 1964). Under this test, a court should apply the law of the state with the most significant contacts to the action and the strongest interest in the application of its law. In the case at bar, Pennsylvania has the most significant contacts, including (1) all of the plaintiffs, with the exception of GE Delaware and Norman Weizenbaum are residents of Pennsylvania; (2) Giant Eagle and Phar-Mor are incorporated under the laws of Pennsylvania and Giant Eagle has its principal place of business here; (3) the stock purchased by plaintiffs was issued and sold in Pennsylvania; (4) the Coopers auditors who worked on the Phar-Mor and Giant Eagle audits are licensed by the Commonwealth of Pennsylvania and these auditors worked out of Coopers' Pittsburgh office; (5) the relationship between the parties was centered in Pennsylvania; and (6) the audit reports were prepared at and disseminated from Cooper's Pittsburgh office. No other state has such significant contacts to the instant action and we will apply Pennsylvania law to plaintiffs' state law claims. *fn7"

 Coopers' initially argues that the claims of Giant Eagle and GE Delaware are defective because the fraud perpetrated at Phar-Mor is attributable to both corporations under the general rule that "the fraud of an officer of a corporation is imputed to the corporation when the officer's fraudulent conduct was (1) in the course of his employment, and (2) for the benefit of the corporation." Rochez Bros., Inc. v. Rhoades, 527 F.2d 880, 884 (3d Cir. 1975, cert. denied, 425 U.S. 993, 48 L. Ed. 2d 817, 96 S. Ct. 2205 (1976). Under the imputation defense, a "participant in the fraud cannot also be a victim entitled to recover damages." Cenco Inc. v. Seidman & Seidman, 686 F.2d 449, 454 (7th Cir. 1992), cert. denied, 459 U.S. 880, 74 L. Ed. 2d 145, 103 S. Ct. 177 (1982).

 Coopers contends that Monus was a servant of Giant Eagle, subject to its direction and control and, therefore, his fraudulent actions must be imputed to the Giant Eagle corporations. Coopers points to the fact that Monus had a written employment agreement with Giant Eagle pursuant to which he served as Phar-Mor's President through the end of 1991. The agreement stated that Monus would "report to and be subject to the direction of the Chief Executive Officer of [Giant Eagle]." Further, the agreement provided that Giant Eagle would pay Monus' annual salary and bonus. Coopers submits that these factors establish as a matter of law that Giant Eagle remained in a master-servant relationship with Monus and did not relinquish its rights to control him.

 Regardless of whether Coopers' argument respecting Monus' employment status is meritorious, we reject Coopers' imputation defense for the same reason that we rejected, on summary judgment, the defense with respect to the claims asserted against Coopers by Phar-Mor, namely, the existence of genuine issues of material fact as to whether Monus, Finn and others were acting adversely to corporate interests. See, e.g., F.D.I.C. v. O'Melveny & Myers, 969 F.2d 744 (9th Cir. 1992) rev'd. on other grounds, 129 L. Ed. 2d 67, U.S. , 114 S. Ct. 2048 (1994). The factors establishing the existence of a jury question on the "adverse interest" exception are set forth in our opinion denying Coopers' summary judgment motion in Phar-Mor, Inc. v. Coopers, Civil Action No. 92-2108 (Opinion, June 1, 1995), and will not be restated here. We note, however, that the imputation defense is even less conducive to a summary dismissal with respect to the Giant Eagle plaintiffs because Monus, unlike Finn and the other alleged perpetrators, invoked his fifth amendment privilege and has not testified whether he intended, by his fraudulent acts, to benefit either Phar-Mor or the Giant Eagle corporations.

 Coopers next argues that the claims of GE Delaware and the PM Directors under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 must be dismissed because (1) plaintiffs can offer no facts from which a jury could reasonably conclude that Coopers acted with scienter, and (2) it is partially untimely.

 One of the requisite elements of a claim under section 10(b) of the 1934 Act and Rule 10b-5 is proof that the defendant acted with scienter. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976). In Ernst, the Supreme Court noted that:

 
the term "scienter" refers to a mental state, embracing intent to deceive, manipulate, or defraud. In certain areas of the law recklessness is considered to be a form of intentional conduct for purposes of imposing liability for some act. We need not address here the question whether, in some circumstances, reckless behavior is sufficient for civil liability under § 10(b) and Rule 10b-5.

 Id. at 194, n. 12.

 Three years after Ernst was decided, the Court of Appeals, following the leading case of Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033 (7th Cir. 1977), cert. denied, 434 U.S. 875, 54 L. Ed. 2d 155, 98 S. Ct. 224, 98 S. Ct. 225 (1977), held that proof of reckless conduct could satisfy the scienter requirement. McLean v. Alexander, 599 F.2d 1190, 1197-98 (3d Cir. 1979); see also, Coleco Industries, Inc. v. Berman, 567 F.2d 569 (3d Cir. 1977), cert. denied, 439 U.S. 830, 58 L. Ed. 2d 124, 99 S. Ct. 106 (1978). The Court of Appeals approved the formulation for recklessness set forth in Sundstrand, where "reckless conduct," as a minimum threshold for liability under section 10(b), was defined as:

 
highly unreasonable [conduct], involving not merely inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.

 McLean at 1197 (brackets in original) (quoting Sundstrand at 1045).

 The Court of Appeals further explained that, while "negligence -- whether gross, grave or inexcusable -- cannot serve as a substitute for scienter," a plaintiff can satisfy the scienter requirement by proving "that the defendant lacked a genuine belief that the information disclosed was accurate and complete in all material respects." Id. 599 F.2d at 1198. The Court then stressed that:

 
to prove scienter the plaintiff need not produce direct evidence of the defendant's state of mind. Circumstantial evidence may often be the principal, if not only, means of proving bad faith. A showing of shoddy accounting practices amounting at best to a pretended audit, or of grounds supporting a representation so flimsy as to lead to the conclusion that there was no genuine belief back of it have traditionally supported a finding of liability in the face of repeated assertions of good faith, and continue to do so. In such cases, the factfinder may justifiably conclude that despite those assertions the danger of misleading . . . [was] so obvious that the actor must have been aware of it.

 Id. at 1198 (internal citations and quotations omitted).

 The Court of Appeals has, on a number of occasions, reaffirmed its holding that proof of recklessness suffices to state a federal cause of action under section 10(b). In Eisenberg v. Gagnon, 766 F.2d 770, 776 (3d Cir. 1985), cert. denied, 474 U.S. 946, 88 L. Ed. 2d 290, 106 S. Ct. 342 (1985), the court stated that an "opinion [of an accountant] that has been issued without a genuine belief or reasonable basis is an 'untrue' statement which, if made knowingly or recklessly, is culpable conduct under § 10(b) and Rule 10b-5." See also, Kline v. First Western Government Securities, Inc., 24 F.3d 480, 486 (3d Cir. 1994), cert. denied, U.S. , 115 S. Ct. 613, 30 L. Ed. 2d 522 (1994) (same); In re Phillips Petroleum Securities Litigation, 881 F.2d 1236, 1244 (3d Cir. 1989) (recklessness on the part of a defendant meets the scienter requirement of Section 10(b) and Rule 10b-5); Sharp v. Coopers & Lybrand, 649 F.2d 175, 193 (3d Cir. 1981), cert. denied, 455 U.S. 938, 71 L. Ed. 2d 648, 102 S. Ct. 1427 (1982) (the standard for scienter includes recklessness); Healey v. Catalyst Recovery of Pennsylvania, Inc., 616 F.2d 641, 649 (3d Cir. 1980) (same).

 Coopers argues that the above-cited authorities no longer provide an accurate statement of the law in view of the recent opinion of the Supreme Court in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., U.S. , 114 S. Ct. 1439, 128 L. Ed. 119 (1994). In that case, the Court held that civil liability under section 10(b) does not extend to parties who merely aid and abet the manipulative or deceptive practices. In reaching its holding, the Court relied on the fact that the statute did not expressly provide for aiding and abetting liability. The Court stated that: "if . . . Congress intended to impose aiding and abetting liability [under section 10(b)], we presume it would have used the words 'aid' and 'abet' in the statutory text. But it did not." Id., 114 S. Ct. at 1448.

 Coopers argues that under the holding in Central Bank, judicial extension of the statute to reach reckless conduct is unwarranted. In short, defendant contends that had Congress intended to make reckless conduct unlawful under section 10(b), it would have used the term "reckless" in the statute. *fn8"

 Coopers has not cited any authority which supports the proposition that it espouses and the only case that we have found which addresses the issue, In re Leslie Fay Companies, Inc., 871 F. Supp. 686 (S.D.N.Y. 1995), rejected the auditor's contention that Central Bank overruled the Second Circuit's recklessness standard under section 10(b). Moreover, even if we were to conclude that Coopers' argument had merit, we would still be bound to apply the recklessness standard in the face of the Court of Appeals' decision in Kline, supra. In that case, which was decided shortly after the Supreme Court rendered its opinion in Central Bank, the Court of Appeals reaffirmed that its interpretation of the Supreme Court's "scienter" requirement included reckless conduct. Kline at 486.

 Coopers' suggestion that Kline is not dispositive of the issue because it was argued fifteen months before Central Bank was decided is belied by the fact that the Court of Appeals noted in Kline that, while Central Bank would appear to bar the plaintiffs' aiding and abetting claims against the defendant law firm, "we do not believe [Central Bank] affects our analysis with respect to whether [defendant] may be held liable for material misrepresentations or omissions as a primary violator [under section 10(b)] . . . ." Id. at 485, n. 4 (brackets supplied). The Court then applied the recklessness standard to plaintiffs' claims. Thus, Kline is binding precedent on this court and we hold that reckless conduct remains a substitute to the scienter requirement under section 10(b).

 Viewing the facts in the light most favorable to plaintiffs, as we must, we hold that plaintiffs have adduced sufficient evidence from which a jury could conclude that Coopers' audits of Phar-Mor during the fiscal years 1989 through 1991 were "so flimsy as to lead to the conclusion that there was no genuine belief" to back Coopers' opinion in its 1989, 1990 and 1991 audit reports that the financial statements "present fairly, in all material respects, the financial position of Phar-Mor, Inc. . . . in conformity with generally accepted accounting principles."

 We will not detail the evidence that plaintiffs contend establishes the existence of a jury question as to whether Coopers' alleged audit deficiencies arose to the level of reckless conduct. We find that plaintiffs' submission of the report of their expert, Professor George J. Benston, which concludes that Coopers was reckless in conducting its audits of Phar-Mor, is sufficient to avoid summary judgment. See, Paton v. LaPrade, 524 F.2d 862, 871 (3d Cir. 1975). It is significant that, in reaching his conclusion, Professor Benston placed particular emphasis on the fact that Coopers "ignored results of their own audit tests that indicated that the amounts recorded to end-of-year inventory could not be determined to an extent that would allow them to opine that Phar-Mor's financial statements . . . were not materially misstated." Thus, in Professor Benston's opinion, Coopers had no grounds to support a genuine belief that the Phar-Mor's financial statements accurately reflected its financial condition. Our review of the voluminous documents of record confirms that sufficient evidence exists from which a jury could reasonably reach the same conclusion with respect to Coopers' audits of inventory. *fn9"

 We next address Coopers' argument that plaintiffs' section 10(b) claims are partially untimely. Specifically, Coopers contends that the claims arising from plaintiffs' purchases of shares of Phar-Mor stock on November 22, 1989 are barred by the statute of limitations. In purchasing these shares, plaintiffs allegedly relied on the November 1, 1989 prospectus, which included Coopers' ...


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