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McLean v. Alexander

decided: May 18, 1979.

MALCOLM P. MCLEAN, INDIVIDUALLY
v.
JACK ALEXANDER; DANIEL D. FRIEL; BERNARD HESSLER, JR., TRUSTEE; HELEN JUNE FRIEL, TRUSTEE; FREDERIC A. LANG; ROBERT R. WALSH; FRANK B. FRANCIS; BERNARD HESSLER, JR.; MARTIN A. APOSTOLICO; MERLE R. AIKEN; SHELLEY P. JONES; THOMAS F. BAKER; SHIELDS & COMPANY, INCORPORATED; AND CASHMAN & SCHIAVI MALCOLM P. MCLEAN, APPELLANT IN NO. 78-2029 CASHMAN & SCHIAVI, APPELLANT IN NO. 78-2030 (D.C. CIVIL NO. 3972)



ON APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF DELAWARE

Before Gibbons and Hunter, Circuit Judges and Meanor,*fn* District Judge.

Author: Gibbons

Opinion OF THE COURT

Cashman & Schiavi (C & S) a firm of certified public accountants, appeal from a final judgment awarding Malcolm P. McLean damages in his suit under Section 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, and under the Delaware common law of fraud. McLean cross-appeals from the same judgment, contending that the court erred in calculating the credit C & S should receive an account of payments made by settling joint tortfeasors and in denying prejudgment interest. The case was tried to the court without a jury. We conclude that the judgment against C & S must be reversed. Since we reverse that judgment we do not reach the issues tendered in McLean's cross-appeal.

I. BACKGROUND FACTS*fn1

On January 28, 1970 McLean purchased from its shareholders all the outstanding stock of Technidyne, Inc. (Technidyne), a Delaware corporation with its principal place of business in Wilmington, Delaware. Technidyne was a small company specializing in the manufacture of laser-beam devices for use in the construction industry. Prior to the sale it had developed as its principal product the Model V Technitool, a laser device intended to simplify the process of aligning sewer pipe in a trench. In late 1969, faced with a severe cash shortage, the managing shareholders of Technidyne began to explore the possibility of a private placement to obtain capital. They spoke to Shields & Co., a New York investment advisory firm, which circulated a report on Technidyne to prospective private investors. The report, for which the managing shareholders supplied the information, stressed that Technidyne had had success in marketing the Model V Technitool. It disclosed that Technidyne had designated American Vitrified Products (AMVIT), a sewer pipe manufacturer, as its exclusive distributor for Technitools during 1967 and 1968, and had sold 96 Technitools to AMVIT in that period. The report also disclosed that the exclusive distributorship was now terminated, but that direct selling efforts had produced 16 sales of Technitools in less than three months. The Shields report stated that it was based on information furnished by Technidyne management, and that Shields did not guarantee the truth of its contents.

McLean, a sophisticated investor with a large personal fortune and a history of successful investment in high technology businesses, learned of Technidyne later in 1969 when a business colleague sent him copy of the Shields & Co. report. After reading it, he dispatched an employee, Harry Jeter, to Wilmington to make further inquiries. On January 6, 1970, Jeter met with Daniel Friel, a substantial Technidyne stockholder, and with Jack Alexander, Robert R. Walsh, and Shelley P. Jones, President, General Manager, and Vice President for Sales, respectively, of Technidyne. Jones and Friel informed Jeter that the sixteen direct sales mentioned in the Shields report had increased to 41 sales. During the meeting Technidyne management also relied upon two written "projections." One of the projections referred to the 41 "sales" as orders, but the district court found that these orders were consistently orally represented to be sales. A second projection stated that AMVIT had sold 114 Technitool units in 2 1/2 years with a very limited sales effort. Friel and Walsh also told Jeter that the exclusive distributorship with AMVIT had been terminated because of AMVIT's economic problems. The district court found that Jeter and McLean saw the two projections and relied on them in acquiring the Technidyne stock. On January 7, 1970, Jeter was given a Certified Report of Examination of Technidyne, prepared by C & S, for the eleven month period ending November 30, 1969. More particular reference will be made to that report hereafter. McLean read the C & S Report while he was considering the purchase of Technidyne.

Following Jeter's visit, McLean also visited the Technidyne plant, meeting with Jones, Friel, Alexander and Walsh. McLean again was told that the AMVIT distributorship was terminated because of AMVIT's poor performance. At a second meeting with McLean, Friel relied heavily on the sales projections referred to above in promoting the sale of the company.

On January 28, 1970, a stock purchase agreement was executed by Jeter as agent for McLean and Friel as agent for all the Technidyne stockholders. McLean agreed to pay $1,950,000.00 for 535 shares of Technidyne stock, as follows: $399,998.10 at Closing; $1,300,001.85 in non-interest bearing promissory notes; and $250,000.00 to satisfy an outstanding Technidyne debt. The C & S Report of Examination showed assets of only $188,419, and negative earnings. Thus it is clear that the purchase price reflected McLean's interest in future sales rather than in present assets or past earnings.

After consummation of the stock purchase McLean gradually learned that the shareholders' representations regarding the pre-closing sales of the Model V Technitool and the relationship of Technidyne with AMVIT had been false. Although AMVIT had purchased a hundred-odd units, it had succeeded in selling only 35, retaining approximately seventy in its inventory. Moreover, the AMVIT distributorship agreement had been terminated not because of AMVIT's poor performance, but because the poor quality of the Technidyne units had resulted in frequent product breakdowns. The 41 sales represented as having occurred after termination of the AMVIT relationship turned out to be either mere orders, sales conditioned on resale, or consignments. By June or July of 1970 McLean realized he had been defrauded. Meanwhile he made substantial advances to Technidyne, eventually totalling $564,751, first in an effort to keep it afloat, and then to assist in the orderly winding up of the business. Finally in October, 1970, the company closed its doors.

McLean sued the selling shareholders, Shields & Co., and C & S. C & S cross-claimed against the other defendants for contribution. During the course of a lengthy trial McLean settled his claims against Shields & Co. and the individual stockholders.*fn2 In the settlement agreement McLean agreed to indemnify the settling defendants (except Jones) against any liability on the cross-claim by C & S. The case against C & S went forward, resulting ultimately in a determination that McLean had suffered $2,514,751 in damages, for which C & S was liable as a joint tortfeasor. Applying relative fault principles, however, the court concluded that C & S was only 10% Responsible for the plaintiff's injury, and was therefore entitled to a 90% Contribution from the defendants. Since the selling shareholders were indemnified by their settlement with McLean for any contribution recovery by C & S, that recovery was offset directly against McLean's award, thereby reducing C & S's direct liability to $199,105.87. The court denied prejudgment interest, and entered judgment in that amount. This appeal and cross-appeal followed.

II. C & S's LIABILITY

From what has been said above, it is evident that McLean was induced to purchase the stock of Technidyne by representations concerning past sales, and future sales potential, of the Model V Technitool, and that those representations were false. Specifically, the representation that AMVIT had sold 114 Technitool units in 2 1/2 years was false, as was the representation that 41 more units had been sold after the termination of the AMVIT distributorship. This fraud was substantial and pervasive.

The claim against C & S, however, is a much narrower one. C & S was not at any time privy to the negotiations between the stockholders and McLean, nor did it have any knowledge of the broad representations made during those meetings. So far as appears, the only contact between C & S and McLean was McLean's receipt, through Technidyne's management, of a copy of the November 30, 1969 Certified Report of Examination prepared by C & S, which contained an audited balance sheet dated November 30, 1969, the full text of which is set out in the margin.*fn3 Only one item on this balance sheet the statement of $73,733 in accounts receivable was found at trial to be false or misleading. The report accurately showed a deficit in retained earnings of $91,647 and negative stockholders' equity of $66,331. It showed total assets of $188,419, and this figure is also substantially accurate, since if the accounts receivable were overstated the inventory of $66,111 was correspondingly understated.

McLean, however, was paying many times the total value of the assets shown on the balance sheet, and was primarily interested in sales potential. The district court found that McLean viewed the $73,733 figure "as representing almost entirely the accounts due and owing as a result of the 16 recent sales referred to in the Shields Report. . . ."*fn4 It further found that

McLean and Jeter, relying upon the independence of the outside auditors, viewed the audit as confirming what they had previously been told and seen regarding the marketability of Technidyne's pipe-laying tool.*fn5

It therefore stated the issue for trial as follows:

In light of a settlement between the purchaser plaintiff and both the shareholders and investment banker, the primary issue before the Court is whether the accountant proceeded in a deliberate, knowing or reckless manner in the preparation of his audit such that the plaintiff, relying on material information provided or omitted by defendant, incurred a loss protected by section 10(b) of the Securities Exchange Act of 1934.

The gravamen of McLean's complaint is that Schiavi knowingly or recklessly represented to McLean as a member of the investing public, that Technidyne had "hard" sales whereas in fact the underlying transactions were merely consignments or guaranteed sales.*fn6

The court then proceeded to determine that the audited statement of accounts receivable, as evidence of sixteen actual sales, was material to McLean's investment decision, that he relied upon that information, and that in purchasing the stock he acted with due diligence.*fn7 At this ...


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