Opinion
Case No. 01-1027 SIPA Liquidation, Adversary Case No. 02-1179.
November 23, 2004
MEMORANDUM OF DECISION ON ORDER GRANTING MOTION FOR SUMMARY JUDGMENT
Plaintiffs, the Securities Investor Protection Corporation ("SIPC") and Douglas L. Lutz, trustee for the debtors' estate ("Trustee"), seek monetary relief in the amount of $6,000,000 from an accounting firm and one of its principals for alleged negligence and negligent misrepresentations related to various audits of the now defunct Donahue Securities, Inc. ("DSI"), a securities broker-dealer firm formerly doing business in Cincinnati, Ohio. On July 21, 2003, the Court entered an order (Doc. 17) granting, in part, a Fed.R.Civ.P. 12(b)(6) motion to dismiss filed by the Defendants, Munninghoff, Lange Co. and Douglas B. Lange (hereinafter referred to collectively as "Munninghoff Lange" or the "Defendants"). The Court dismissed all claims except the claim of SIPC, on its own behalf, for negligent misrepresentation. Thereafter, the Defendants filed their answer (Doc. 22) to the remaining cause of action and the parties entered into a Joint Stipulation (Doc. 27). Presently before the Court is a summary judgment motion ("Motion") (Doc. 31) filed by the Defendants. By their Motion, the Defendants contend that SIPC cannot satisfy the reliance element of its negligent misrepresentation claim upon SIPC's stipulation that "SIPC never received the DSI audited financial statements that [Munninghoff Lange], on behalf of DSI, provided to the SEC and the NASD." See Doc. 27 at ¶ 9.
FACTS
Munninghoff Lange served as the independent auditor for DSI for fiscal years 1991 through 2000, and in that capacity, rendered unqualified opinions on DSI's financial statements for each of those years. (Joint Stipulation at ¶ 1.) In its capacity as the independent auditor for DSI, Munninghoff Lange was required to furnish to the Securities and Exchange Commission ("SEC") and the National Association of Securities Dealers, Inc. ("NASD") DSI's audited financial statements and comments relative to any material inadequacies found to exist in DSI's accounting system, internal accounting control and procedures for safeguarding securities and to indicate any corrective action taken or proposed. (Joint Stipulation at ¶ 2.) If the SEC or the NASD learned that material inadequacies existed in DSI's accounting system, internal accounting control or the procedures for safeguarding securities such that they believed that DSI was in or approaching financial difficulty, the SEC and the NASD were required to notify SIPC pursuant to 15 U.S.C. § 78eee(a)(1). (Joint Stipulation at ¶ 7.)
For each fiscal year during which Munninghoff Lange acted as DSI's independent auditor, Munninghoff Lange provided the SEC and the NASD with DSI's audited financial statements and a report on DSI's internal control. (Joint Stipulation at ¶ 8.) SIPC never received the DSI audited financial statements that Munninghoff Lange, on behalf of DSI, provided to the SEC and the NASD. (Joint Stipulation at ¶ 9.) The DSI audited financial statements prepared by DSI and the audit reports relevant thereto issued by Munninghoff Lange on behalf of DSI did not contain comments relative to any material inadequacies found to exist in DSI's accounting system, internal accounting control and procedures for safeguarding securities and did not indicate any corrective action taken or proposed. (Joint Stipulation at ¶ 10.)
During the week of February 12-16, 2001, examiners from the SEC's Office of Broker-Dealer Inspections and Examinations commenced an examination of DSI. (Joint Stipulation at ¶ 13.) On February 20, 2001, Stephen G. Donahue, through counsel, admitted that he had misappropriated customer funds through the use of non-existent investment vehicles. (Joint Stipulation at ¶ 14.) Following its determination that DSI was in or approaching financial difficulty, the SEC immediately notified SIPC. (Joint Stipulation at ¶ 15.)
ISSUE
The Defendants argue that SIPC could not possibly have relied upon the Defendants' audit reports submitted to the SEC and the NASD when SIPC admits that it never received the reports. SIPC raises four arguments in response: (1) Ohio law does not require direct reliance to sustain a claim of negligent misrepresentation; (2) SIPC must have relied on the audit reports because reliance by SIPC is the intended effect of the federal regulatory system; (3) SIPC is entitled to a presumption of reliance where a fraud on the regulatory process is committed; and (4) SIPC did rely on the Munninghoff Lange audit reports given that the SEC and NASD were required to notify SIPC immediately of any material inadequacies disclosed in the reports.
ANALYSIS
I. Actual reliance is an essential element of a negligent misrepresentation claim under Ohio law
As a threshold matter, SIPC contends that Ohio law does not require direct reliance to sustain a claim of negligent misrepresentation. The Court disagrees.
Ohio law requires a two-step analysis for a negligent misrepresentation claim against an accountant. The first step concerns the privity issue, which limits the field of third parties to whom the accountant owes a duty. Under Ohio law, third parties cannot pursue such an action unless "a member of a limited class whose reliance on the accountant's representation is specifically foreseen." Haddon View Investment Co. v. Coopers Lybrand, 70 Ohio St. 2d 154 (1982). If a third party is a member of such a limited class, then the second step looks to the elements of the claim itself. According to the Supreme Court of Ohio:
The elements of negligent misrepresentation are as follows: "One who, in the course of his business, profession or employment, or in any other transaction in which he has a pecuniary interest, supplies false information for the guidance of others in their business transactions, is subject to liability for pecuniary loss caused to them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating the information."
Delman v. City of Cleveland Heights, 41 Ohio St. 3d 1, 4 (1989) (quoting 3 Restatement of the Law 2d, Torts (1965) 126-127, Section 552(1)) (emphasis added). Consequently, Ohio law requires that a plaintiff show actual proof of justifiable reliance in order to prevail on a claim of negligent misrepresentation.
SIPC appears to have confused these two steps of a negligent misrepresentation claim. SIPC seems to believe that the reliance issue is subsumed within the privity issue, particularly an element of privity under New York law (linking conduct) that does not exist under Ohio law. In response to the Defendants' contention that SIPC's stipulation places this case squarely within the holding of Securities Investor Protection Corp. v. BDO Seidman, LLP, 245 F.3d 174 (2d Cir. 2001), SIPC argues that this case is distinguishable in that Ohio law does not contain the additional privity requirement of linking conduct.
BDO Seidman was a SIPA action against the debtor's accountant for fraudulent misrepresentation and negligent misrepresentation. The action was brought by the SIPA trustee and SIPC on behalf of customers and SIPC itself.
Although this argument is somewhat cryptic in SIPC's brief (Doc. 35), it was articulated with greater clarity at the August 31, 2004 pretrial conference.
Counsel for SIPC: The idea that there must be some direct reliance by SIPC, I think, mischaracterizes and overstates, really, the Ohio law. The direct reliance argument is akin to what New York requires, which is strict privity. But, in the Haddon View case, and therefore under Ohio law, the Court moves away from that requirement and says that is at odds with the law of Ohio. . . . And that's what Ohio law requires, as we see it, under Haddon View. A lesser standard than this direct reliance and this direct privity requirement.
The Court agrees with SIPC that Ohio law does not recognize the stricter privity standard applied under New York law (i.e. linking conduct). Nonetheless, the fact that Ohio does not require linking conduct to establish the privity necessary to assert a negligent misrepresentation claim does not mean that Ohio has completely abandoned the reliance element of the underlying claim itself. Reliance remains an indispensable element of a negligent misrepresentation claim that is separate from the privity analysis. This is illustrated in Foster Wheeler Enviresponse, Inc. v. Franklin County Convention Facilities Authority, 78 Ohio St. 3d 353 (1997).
In Foster Wheeler, an environmental hazards remediation contractor ("Enviresponse") was hired to remove hazardous waste from a construction site. Enviresponse filed a negligent misrepresentation claim against an environmental consulting firm ("Lawhon") hired to provide consulting services at the construction site. Enviresponse alleged that Lawhon negligently misrepresented the amount of hazardous waste at the site. The trial court granted summary judgment in favor of Lawhon and the appellate court affirmed. On appeal to the Supreme Court of Ohio, Enviresponse's argument was primarily devoted to the issue of whether there was privity between the parties. The Court did not deem it necessary to delve into this issue if there was no proof of one of the elements of the underlying claim. Explaining the relationship between the privity issue and the elements of the underlying claim, the Court stated:
Privity, or its substitute, is not a tort; it serves only to identify an interest or establish a relationship necessary to allow for the bringing of a tort action for purely economic damages. Regardless of whether the threshold requirement for privity is met, or even justified, there can be no recovery where a necessary element to the tort itself is found to be missing.
Id. at 365-66. The Supreme Court affirmed the appellate court decision after it concluded that Enviresponse had not satisfied its burden of proof as to one of the underlying elements. Significant to the instant case, it was the element of justifiable reliance that was not established. Consequently, Foster Wheeler confirms the two-step analysis set forth above and clearly requires proof of justifiable reliance under step two, which is wholly separate from the privity analysis of step one. Accord Gutter v. Dow Jones, Inc., 22 Ohio St. 3d 286 (1986) (affirming dismissal of negligent misrepresentation action where plaintiff was not member of limited class (i.e. no privity) and, in the alternative, justifiability of plaintiff's reliance was questionable at best).
II. The intended effect of the federal regulatory scheme is immaterial to the issue of whether SIPC actually relied on the Munninghoff Lange audit reports under the common law of Ohio
The vast majority of SIPC's brief is devoted to the proposition that SIPC must have relied on the audit reports because that is the intent behind the very structure of the regulatory system itself. In support thereof, SIPC makes the following statements:
The express language of SIPA, federal case law . . . and the regulatory structure governing the audit undertaken by the Defendants, compel a finding by this Court that SIPC did indeed rely on the reports. (Doc. 35 at 2.)
[T]he Supreme Court has held that the efficacy of this regulatory scheme depends on the ability of SIPC to rely upon the reports issued by auditors of broker-dealers. Touche Ross Co. v. Redington, 442 U.S. 560 (1979). (Doc. 35 at 3.)
Contrary to SIPC's characterization, Redington "held" that there is no private cause of action under § 17(a) of the Securities Exchange Act of 1934, which requires broker-dealers to maintain records and file reports as the Securities and Exchange Commission may prescribe.
The regulations adopted under § 17(a) of the Exchange Act contemplate SIPC's reliance upon Defendants' audit. (Doc. 35 at 14.)
[A]pplicable law, rules, and regulations make clear that SIPC, in conjunction with regulatory authorities, must rely on the independent auditors[.] (Doc. 35 at 15.)
The Court is not persuaded by these arguments. SIPC has asserted an action for negligent misrepresentation under Ohio common law. Such an action is governed by Ohio law. The intended effect of a federal regulatory scheme is completely irrelevant to the issue of whether a party to that scheme can sustain its burden of proof on the reliance element of a state law action.
Under Ohio law, the reliance element of a negligent misrepresentation claim presents a question of fact and "requires inquiry into the relationship of the parties." Crown Property Development, Inc. v. Omega Oil Co., 113 Ohio App. 3d 647, 657 (1996). None of the foregoing arguments raised by SIPC take this approach. Instead of looking to the facts surrounding the relationship of the parties, SIPC directs the Court's attention to the purported intent behind various federal laws, rules and regulations. Such intent may or may not be relevant to some federal action. However, SIPC chose not to proceed under federal law but instead to pursue a claim under Ohio law. Consequently, the Court rejects SIPC's argument that it must have relied on the audit reports because of the intended effect of the federal regulatory system.
III. A presumption of reliance does not arise under a state law claim for negligent misrepresentation where a fraud on the regulatory process is committed
The SEC filed an amicus brief (Doc. 37) in which it argues "that the reliance requirement can be satisfied by SIPC's reliance on the integrity of the regulatory process." Similar to the concept of "fraud on the market" that creates a presumption of reliance in federal securities cases, the SEC argues that a presumption of reliance should arise in this proceeding because the Defendants committed "fraud on the regulatory process." In support, both the SEC and SIPC cite Mishkin v. Peat, Marwick, Mitchell Co., 658 F. Supp. 271 (S.D.N.Y. 1987).
Although SIPC cites Mishkin in its brief, it appears to have retreated from this position. At the August 31, 2004 pretrial conference, counsel for SIPC said:
We don't go as far, however, to characterize it and put this gloss on it of well this is a fraud on the regulatory process. This is not necessarily a fraud on the regulatory process case.
In Mishkin, a SIPA trustee sued the debtor's accountant for aiding and abetting federal securities law violations as a result of the accountant's failure to discover and disclose the debtor's fraud. The accountant moved to dismiss under Fed.R.Civ.P. 12(b)(6). The ultimate issue before the court was whether the complaint alleged the element of scienter on the part of the accountant. The court noted that recklessness was sufficient to establish scienter where the plaintiff's reliance upon the accountant's audit was reasonably foreseeable. Consequently, the issue of reliance became a focal point. Denying the motion, the court stated:
It is common sense that an accountant engaged in such activities can reasonably foresee that not only the regulatory agency but also the purchasing public will rely upon the audit. The fact that the complaint fails to allege direct reliance by customers of [the debtor] on the company's financial statements or [the accountant's] certification of those statements is irrelevant. An analogy can be drawn to the doctrine of "fraud on the market" which is premised upon the notion that deception of the marketplace itself amounts to actionable fraud. The theory presumes reliance, even if the individual victim did not see the offending statement.
. . . .
. . . [T]he reliance alleged by plaintiff is not reliance on the integrity of the market, but rather on the integrity or operation of the regulatory process which is designed to insure the solvency and legitimate operation of broker-dealers in order to protect the public in transacting business with them. An investor does and should be able to rely on the regulatory process' regulation of a broker-dealer to assure the broker-dealer's solvency and legitimacy[.]
Id. at 275-76. Mishkin, however, is distinguishable on the basis that it did not concern a claim for negligent misrepresentation under state law but a claim for aiding and abetting under federal securities law.
This very distinction was made by the Second Circuit in BDO Seidman I. See SIPC v. BDO Seidman, LLP, 222 F.3d 63 (2d Cir. 2000). In support of their fraud claim on behalf of customers, the plaintiffs argued that reliance should be presumed because of "fraud on the regulatory process." Distinguishing Mishkin, the court reasoned as follows:
Whatever the merits of the "fraud on the regulatory process" theory . . . it does not assist the plaintiffs in this case. To the extent that the federal courts have adopted this concept, it has applied only in the context of the federal securities laws. As the district court recognized, common-law fraud claims require a different analysis than those brought under the federal securities regulation scheme. Relying on this distinction, federal courts repeatedly have refused to apply the fraud on the market theory to state common law cases despite its wide acceptance in the federal securities fraud context. New York courts have also recognized this difference.
Given that New York has not adopted even the well-recognized fraud on the market theory to allow a presumption of reliance in common-law fraud cases, we see no basis for applying the fraud on the regulatory process theory to achieve that end in this state-law case.
BDO Seidman I, 222 F.3d at 72-73 (citations omitted). Similar to the law of New York, this Court is not aware of any Ohio authority applying either theory within the context of a common law action. However, the Supreme Court of Ohio has not addressed this issue. If it did, this Court is persuaded that it would require proof of direct reliance so characteristic of suits predicated upon common law fraud and reject the presumption of reliance arising under the "fraud on the market" and "fraud on the regulatory process" theories. See Murphy v. Sofamor Danke Group, Inc., 123 F. 3d 394, 403-04 (6th Cir. 1997) (predicting that Supreme Court of Tennessee would reject "fraud on the market" theory of reliance in support of negligent misrepresentation claim where Tennessee follows the Restatement (Second) of Torts § 552 and majority rule under the Restatement requires actual reliance); Haddon View Investment Co. v. Coopers Lybrand, 70 Ohio St. 2d 154 (1982) (adopting the Restatement (Second) of Torts § 552).
IV. SIPC did not rely on the Munninghoff Lange audit reports even though the SEC and NASD are required to immediately notify SIPC of any material inadequacies disclosed in the reports
Lastly, SIPC argues that it relied on the Munninghoff Lange audit reports because the SEC and NASD were required to notify SIPC immediately of any material inadequacies disclosed in the reports. This argument boils down to a third party communication of an alleged misrepresentation through the third party's silence and whether the same is actionable as a negligent misrepresentation. Under this theory SIPC contends that the SEC and NASD, by the fact that they did not alert SIPC to any problems concerning DSI, relayed to SIPC the substance of the Defendants' audit reports — being that no material inadequacies were found to exist in DSI's accounting system — and that SIPC relied on the same.
This very same argument was raised by SIPC in BDO Seidman and ultimately rejected by New York's highest court. BDO Seidman deserves careful consideration because it is the only decision that this Court is aware of that addresses this unique argument that would appear to arise only within the context of the regulatory scheme established by the Securities Investor Protection Act of 1970.
SIPC argues that this very issue was resolved in its favor in a SIPA liquidation currently pending in Texas. In the Texas liquidation, the SIPA trustee and SIPC filed an action against the debtor's accountant for, among other things, negligent misrepresentation. Footnote 29 of SIPC's brief states:
Further, in SIPC v. Cheshier Fuller, after the close of lengthy discovery, the defendant accountants filed a motion for summary judgment, arguing that SIPC could not prove, as a matter of law, that it relied on the accountants' audit report. The accountants' arguments were rejected when, on March 31, 2004, the bankruptcy court entered an Order Denying Defendants' Motion for Summary Judgment Against All Claims of the Securities Investor Protection Corporation. See SIPC v. Cheshier Fuller, Adversary No. 00-6068 (Bankr. E.D. Tex.).
SIPC did not attach a copy of the order referred to. In reply, however, the Defendants did attach a copy of the order. The order reflects that the summary judgment motion was denied because of a factual dispute — not because SIPC was found to have relied as a matter of law. Accordingly, the Cheshier Fuller decision does not offer any guidance on the legal issue presently before this court.
The BDO Seidman court explained this "no news is good news" theory of reliance as follows:
the SIPC argues that it relied nonetheless on the information contained in Seidman's reports because, under the SIPA regulatory scheme, it relies on the SEC and the NASD to alert it regarding any impending financial difficulties a broker-dealer may be facing. Thus, the SIPC maintains, by remaining silent about a particular broker-dealer's financial condition, the SEC and the NASD essentially transmit the audit report's message that the government has no cause for concern.
Securities Investor Protection Corp. v. BDO Seidman, LLP, 222 F.3d 63, 77 (2d Cir. 2000). The court went on to explain that this was a novel question under New York law.
In BDO Seidman, SIPC asserted claims for negligent misrepresentation and fraud against the accountant of a failed broker-dealer. Both actions require proof of justifiable reliance. Consequently, although the court discussed the reliance issue within the context of the fraud claim, the same analysis applied to the negligent misrepresentation claim. The court simply incorporated the analysis by reference when it discussed the negligent misrepresentation claim later in the opinion.
Although New York law is fairly clear that a plaintiff may establish reliance on misrepresentations it receives from a third party in a repackaged form, such as a credit rating or a financial report, New York courts have not extended this rule to cover a third party's failure to convey information at all. As the district court correctly noted, the SIPC's theory of reliance "rests on the absence of any activity by [the SEC and the NASD], . . . rather than on any subsequent communication of Seidman's misrepresentation." Seidman, 49 F. Supp.2d at 656. . . .
Whether fraud liability encompasses reliance on the absence of communication, rather than on communication itself, is thus currently unclear under New York law. Resolving this issue will involve a detailed analysis of the policy concerns underlying New York's fraud rules, including the sometimes difficult balance between deterring fraud in accounting transactions and protecting accountants against "far-flung liability for inchoate or unintended injuries." Union Carbide Corp. v. Montell N.V., 9 F. Supp. 2d 405, 412 (S.D.N.Y. 1998).
Id. at 78. Accordingly, the court certified the issue to the New York Court of Appeals. Id.
The New York Court of Appeals ruled that SIPC did not rely on the accountant's misrepresentations but on the SEC and the NASD.
Like the Second Circuit, the New York Court of Appeals addressed the reliance issue within the context of SIPC's fraud claim. Nonetheless, the analysis is equally applicable given that both claims require proof of justifiable reliance. The New York Court of Appeals did not get to the reliance issue on the negligent misrepresentation claim because it concluded that there was no privity between SIPC and the accountants.
We conclude, however, that "no news is good news" is an insufficient basis for SIPC's fraud claim here.
. . . . Plaintiff cannot sustain a cause of action for fraud if defendant's misrepresentation did not form the basis of reliance. As conceded in the complaint, SIPC relied to its detriment on the implication of the NASD's silence, not on representations from BDO.
. . . .
. . . . The inescapable conclusion from the complaint's reference to the reporting rules and the regulatory "early warning system" is that the NASD had a significant role in choosing what information it wanted to receive and, in addition, what it deemed worthy of communicating. In such a situation SIPC's reliance on silence from the NASD cannot be equated with its reliance on any affirmative misrepresentation or concealment of material fact by BDO.
. . . .
SIPC's complaint assumes that silence from the regulators can mean only one thing. In this case, however, the absence of communication from the NASD to SIPC could have meant any number of things, among them that the regulators were not carefully reading defendant's audits. The vagaries inherent in SIPC's theory of liability convince us that no information at all is simply too little information on which to base a claim for fraudulent misrepresentation here. Where BDO's reports were filtered through the NASD's own process of evaluation, SIPC cannot claim justifiable reliance on the filtered statements, or the absence thereof, as representing either the sum or substance of BDO's representations. The regulatory framework involved in this case thus creates an insurmountable disconnect between BDO's representations and SIPC's purported reliance on those representations.
Securities Investor Protection Corp. v. BDO Seidman, L.L.P., 746 N.E. 2d 1042, 1047-48 (N.Y. 2001) (emphasis added).
The decision of the New York Court of Appeals is thorough and wellreasoned. Under the existing regulatory scheme SIPC relies on the SEC and NASD, not on the audit reports submitted to those entities.
Perhaps without even realizing it, SIPC admitted as much in its brief.
SIPA's legislative history further demonstrates Congress's intent that SIPC rely on other parties' receipt and review of information regarding the financial health of member broker-dealer firms. (Doc. 35 at 8.)
If the Ohio Supreme Court had to address this issue, this Court is persuaded that it would follow the decision of the New York Court of Appeals. Accordingly, this Court concludes that SIPC did not rely upon the Munninghoff Lange audit reports.
This Court is not aware of any decision from the Supreme Court of Ohio addressing the "no news is good news" theory of reliance.
This is not to say that the Defendants have no culpability in relation to their audits of DSI. It may be that some other theory of liability would enable SIPC to recoup its losses. Even in the absence thereof, it is clear that the Defendants, at the very least, face the possibility of administrative/regulatory action, as outlined by counsel for the SEC at the August 31, 2004 pretrial conference.
The Court is cognizant of the sense of injustice in its ruling. At the pretrial conference, counsel for SIPC repeatedly asserted SIPC's belief that a ruling in its favor is simply a "common sense approach" as to how the regulatory system should work. Although this may be, the regulatory system is not structured in such a way as to permit SIPC to prevail on any legal theory that requires proof of reliance on the audit reports. If that is the intended effect of the regulatory scheme, then it is up to the legislature, not the courts, to bring this to pass. See Touche Ross Co. v. Redington, 442 U.S. 560, 579 (1979) ("SIPC and the Trustee contend that the result we reach sanctions injustice. But even if that were the case, the argument is made in the wrong forum, for we are not at liberty to legislate. If there is to be a federal damages remedy under these circumstances, Congress must provide it.").
CONCLUSION
For the foregoing reasons, the Motion will be GRANTED. An order to this effect will be entered.