What would you do differently in the future if you were Peat, Marwick?

FACTS Bowling as a leisure activity and sport grew rapidly in the 1950s. BarChris built alleys. Its revenues grew from $800,000 in 1956 to $9,165,000 in 1960. By 1962 overbuilding caused construction to halt. BarChris ran into serious financial problems. It filed a registration statement (effective May 1961) for new bonds to raise cash and the bonds were issued. Circumstances were grave when the registration statement became effective. BarChris filed for bankruptcy in October 1962. BarChris’s financial statements dated December 31, 1960, were included in the prospectus. They were audited by Peat, Marwick (predecessor to KPMG) and contained material errors. Revenues and current assets were overstated and contingent liabilities were understated. The prospectus overstated the demand for alley construction. It misrepresented how the proceeds would be used (a large portion of which would actually go to pay overdue debts and retire loans from officers). It failed to note that, because of defaults, BarChris was now operating several alleys. Escott and other bondholders sued under Section 11 of the 1933 Act, alleging the prospectus was materially misleading. All defendants but BarChris raised the due diligence defense. Judge Mclean turn now to the question of whether defendants have proved their due diligence defenses. The position of each defendant will be separately considered. Russo Russo was, to all intents and purposes, the chief executive officer of BarChris. He was a member of the executive committee. He was familiar with all aspects of the business. . . . [He] knew all the relevant facts. He could not have believed that there were no untrue statements or material omissions in the prospectus. Russo has no due diligence defenses. Vitolo and Pugliese They were the founders. . . . Vitolo was president and Pugliese was vice president. Despite their titles, their [control] over BarChris’s affairs [was far less] than Russo’s. [They are] each men of limited education. It is not hard to believe that for them the prospectus was difficult reading, if indeed they read it at all. But [the] liability of a director who signs a registration statement does not depend upon whether or not he read it or, if he did, whether or not he understood what he was reading. And in any case, Vitolo and Pugliese were not as naive as they claim to be. They were members of BarChris’s executive committee. . . . They must have known what was going on. Certainly they knew of the inadequacy of cash. . . . They knew of their own large advances to the company which remained unpaid. They knew that they had agreed not to deposit their checks until the financing proceeds were received. They knew and intended that part of the proceeds were to be used to pay their own loans. All in all, [their situation] is not significantly different . . . from Russo’s. They could not have believed that the registration statement was wholly true and that no material facts had been omitted. . . . They have not proved their due diligence defenses. Trilling [Trilling was . . . a CPA and former member of Peat, Marwick. He was BarChris’] controller. He signed the registration statement in that capacity, although he was not a director. . . . Trilling may well have been unaware of several of the inaccuracies in the prospectus. But he must have known of some of them. . . . I cannot find that Trilling believed the entire prospectus to be true. But even if he did, he still did not establish his due diligence defenses. He . . . failed to prove, as to the [nonaudited] parts of the prospectus . . ., that he made a reasonable investigation which afforded him a reasonable ground to believe that it was true. As far as appears, he made no investigation. . . . This would have been well enough but for the fact that he signed the registration statement. As a signer, he could not avoid responsibility. . . . [He has not proved] his due diligence defenses. Birnbaum Birnbaum was a young lawyer [employed as in-house counsel. He was] secretary and a director. . . . He signed the later amendments [to the registration statement], thereby becoming responsible for the accuracy of the prospectus. . . . . . . He did not participate in the management of the company. As house counsel, he attended to legal matters of a routine nature. . . . One of Birnbaum’s more important duties . . . was to keep the corporate minutes. . . . This necessarily informed him to a considerable extent about the company’s affairs. . . . It seems probable that Birnbaum did not know of many of the inaccuracies in the prospectus. He must, however, have appreciated some of them. In any case, he made no investigation. . . . [He] was entitled to rely upon Peat, Marwick for the 1960 figures. . . . But he was not entitled to rely upon [anyone else] for the other portions of the prospectus. As a lawyer, he should have known his obligations. . . . Having failed to make such an investigation, he did not have reasonable ground to believe that all these statements were true. Birnbaum has not established his due diligence defenses except as to the audited 1960 figures. Auslander Auslander was an “outside” director. . . . He was chairman . . . of Valley Stream National Bank. [He became a director shortly before the sale of the bonds. He signed the registration statement.] . . . As to the [financial statements], Auslander knew that Peat, Marwick had audited [them, so he] believed them to be correct. . . . He had no reasonable ground to believe otherwise. . . . [T]here were enough danger signals in the materials which he did examine to require some further investigation on his part. Generally accepted accounting standards required such further investigation under these circumstances. It is not always sufficient merely to ask questions. Here again, the burden of proof is on Peat, Marwick. I find that that burden has not been satisfied. I conclude that Peat, Marwick has not established its due diligence defense. Questions 1. a. Why were so many defendants not held responsible for the misleading audited financial statements? b. Which defendants were not successful in claiming the due diligence defense with respect to these financial statements? Why were they denied the defense? 2. Does being “new” make any difference in terms of directorial liability for a signed registration statement? 3. What would you do differently in the future if you were Peat, Marwick?




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