Argued May 2, 1978.
Decided October 26, 1978.
John P. Birmingham, Jr., Boston, Mass., with whom Mintz, Levin, Cohn, Glovsky Popeo, Boston, Mass., was on brief, for plaintiffs-appellants-appellees.
George C. Caner, Jr., Boston, Mass., with whom R. K. Gad, III, and Ropes Gray, Boston, Mass., were on brief, for Estabrook Co., Inc., defendants-appellees.
Steven M. Brody, Boston, Mass., with whom Fleming Brody, Boston, Mass., was on brief, for defendants-appellees-appellants, James F. Laura and Albert Eng.
Appeal from the United States District Court for the District of Massachusetts.
Before COFFIN, Chief Judge, CAMPBELL and BOWNES, Circuit Judges.
These are appeals from findings and rulings in a nonjury securities fraud case. Plaintiffs, unassociated purchasers of convertible debentures on January 28, 1970, of a new company called Foto-Mem, Inc., brought action against its two principal officers, its directors and the underwriters pursuant to sections 12(2) and 17(a) of the Securities Act of 1933, 15 U.S.C. §§ 77 l(2), 77q(a), and section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 CFR 240.10b-5. At the time the action was instituted, January 28, 1972, the company was in a Chapter XI bankruptcy proceeding.
Some of the plaintiffs had also purchased stock prior to this date.
The defendant officers, James F. Laura and Albert Eng, appeal the findings of liability under section 10(b) and Rule 10b-5. Plaintiffs-appellants appeal the finding of no liability as to the defendant underwriters, Estabrook Co., Inc., under sections 12(2) and 10(b) of their respective Acts. The district court also made a finding of nonliability as to the directors of Foto-Mem, Inc., but this has not been appealed.
The trial and the consequent findings and rulings focused on alleged misrepresentations and omissions as to the production stage of the two main products of the company.
Background and Time Frame
Foto-Mem, Inc., was formed by defendant Laura on May 5, 1967. Laura had conceived an idea for coping with the "information explosion" through the development of a high capacity, high speed photo-optical storing and retrieval system which would interface with contemporary computers. Initial funds of approximately $100,000 were obtained by private investors, mainly through the efforts of Laura. Defendant Eng, who had extensive experience in computer technology and related fields, joined the company in January of 1968. Laura, who described himself as a financial consultant, did have some experience with computers, but it was Eng who had the engineering expertise and knowledge.
On January 8, 1969, the company made a public offering and its stock was traded in a range of from $18 1/2 to $54 a share until the fall of 1969 when Foto-Mem, Inc., concentrated its financial efforts towards the sale of the debentures which led to this law suit. The prospectus prepared for this offering described its products as being in the development stage.
"The Company believes that it has conceived of new systems for storing and retrieving digital, textual and pictorial information photo-optically and is in the process of designing and developing such systems. However, as the Company is still in the design and development stages, and has not produced or sold any of these systems, and has not had the benefit of industry time-tests of any of these systems, there is no assurance that any of these systems can be produced and made operable or, if produced and made operable, that any of them will prove commercially feasible. The Company is presently building a prototype of its digital memory systems, but there is no assurance that it will successfully complete the same.
The Company also has designs for an audio memory system and for an analog and graphic memory system. The Company has a further design for a total information storage and retrieval system which, in effect, would incorporate all of its other memory system, digital, textual, pictorial, audio, graphic and analog. These designs for an audio memory system, for an analog and graphic memory system and for a total information storage and retrieval system are in the drawing-board stage. No prototype of them is being built, and there is no assurance that any such prototype can be built."
Two machines were built and displayed at computer shows in Las Vegas and Boston to demonstrate the new storing and retrieval systems. The FM 390 was intended to store and retrieve digital information (computer readable) and to operate in conjunction with, and as a supplemental memory bank for, a computer. The memory bank consisted of plastic photodata cards on which information was stored and subsequently read by the use of a laser beam. Conventional computer memory banks used magnetic tape or magnetic cards. The advantage of the laser imprinted photodata cards was that each card could contain a great deal more information at far less cost than magnetic tapes or cards.
The Risar, which was an extension of the FM 390, was designed to combine a computer capacity for index and calling up (positioning for transmission of information) the photodata card with television transmission of the information sought so that the cards did not have to be physically removed from the file and so that two or more interrogators could obtain information from the same card simultaneously.
The machines used as demonstrators at the two shows were hand assembled and contained within finished cabinets. The laser beam for the FM 390 was hand adjusted as required and the part of the Risar system used to store and call up the photodata cards was manufactured by another company, Mosler. The Mosler selectriever was capable of storing up to two hundred thousand microfilm cards and calling up any one of them automatically.
In September of 1969, Foto-Mem, Inc., began discussions with Estabrook, which culminated in an underwriting contract. Estabrook was to undertake the private placement of Foto-Mem debentures in return for options to purchase a part of them at a favorable price and was to be reimbursed for expenses, including sales commissions. Estabrook, of course, had the right to review the confidential memorandum which was to be distributed to potential debenture purchasers.
The district court found that the confidential memorandum contained material misrepresentations and omitted material facts. It was drafted mainly by the company lawyers, Stephen Honig and Jerome Gotkin, and Laura and Eng. A lot of time and energy was devoted to this memorandum; seven drafts were drawn up before the offering circular was finalized. Estabrook's representative in direct charge of the offering, John M. Plukas, spent one day a week at the plant. He saw several of the drafts, but there is no evidence that he took part in any of the actual writing and formulation of the memorandum. The final draft was dated October 31, 1969, and circulated to prospective debenture purchasers immediately thereafter. Sale of debentures closed on January 30, 1970. The two other purchasers of debentures, American Suez Company and the Mellon Bank of Pittsburgh, did not receive the memorandum and are not parties to this suit.
With the exception of Eduard F. Catalono, all of the plaintiff who testified stated that they read the confidential memorandum and relied on it.
Shortly after the closing of the debenture sales, Foto-Mem received an order from the New York Times to purchase a Risar which the paper intended to use to replace its "morgue." The company from then on concentrated its efforts and time on meeting this order to the exclusion of further work on the FM 390. Mosler, the owner and producer of the card selection system, which had been used by Foto-Mem in its demonstration model of the Risar, had also been bidding for the Times contract. When it learned that Foto-Mem had been awarded the contract, it refused to sell it a selectriever, Foto-Mem, therefore, had to design and fabricate its own card selection system for the Risar ordered by the Times. There was testimony by Eng that the Mosler selectriever was not adequate anyway because it used different card sizes and that he had determined to build his own system in 1969. A unit with a Foto-Mem built card selectriever was finally delivered to the Times in August of 1970, but it failed to work properly because of the inadequacies of the card selection system. Despite intensive work for several months by Foto-Mem's engineers and technicians, the Risar was never able to meet the Times' requirements.
A collection of reference works and files of reference material.
The photodata cards rested in a cell. The mechanism needed for the Risar to operate properly had to be able to store the cells, pick up and deliver the designated cell to the selector which would select and place the card in position for imprinting (writing) and reading. The chief difficulty with Foto-Mem's Risar was the inability to place single cards in position for imprinting and reading because the cards stuck together. Mosler had used an air current for positioning the cards; Foto-Mem's attempt to do this was not satisfactory.
It became apparent to Laura and Eng, as well as others, in the late spring of 1970 that Foto-Mem was running out of money. A meeting was, therefore, scheduled for July 15 to which all debenture holders were invited in the hope that they would be persuaded to invest additional funds. The hopes for a cash infusion were not realized. Laura left the meeting abruptly when the debenture holders began to ask hard questions about the financial condition of the company. The reason given for the arid cash condition was poor management which, of course, covers a multitude of sins. After failing to meet the second interest installment on the debentures, due January 30, 1971, Chapter XI bankruptcy proceedings were commenced.
I. THE FINDING OF FRAUD
We begin our analysis of the evidence with a statement of the obvious, that the district court's findings of fact must be upheld unless clearly erroneous. The district court found that Laura and Eng had committed fraud in the preparation of the confidential memorandum:
I find actual intent to deceive by Eng and Laura in informing, and not informing, the other defendants, as well as many plaintiffs individually, and I find they knowingly, and intentionally, and as a matter of proximate cause, were responsible for the found material misstatements and omissions in the Memo.
There is a faint suggestion in the brief for Laura and Eng that the district court had ruled as a matter of law that "good faith" was not a defense. Such a ruling would have been manifestly incorrect. In defining "working prototype" the court stated: "I find that the word `working' signified that it does work, not simply feasible in the sense that it can be made to do so. I do, however, accept, indeed, I expressly find, that a prototype with missing parts may still be described as working if the missing parts manifestly would work. But this means would work readily in fact, not merely in the subjective good faith expectation of the speaker. Good faith may be a defense for saying something untrue, but that is a different matter." We do not interpret this as a ruling of law negating a defense based on good faith. It correctly points out that a representation that a thing will work must be based on something more than the mere hope it will.
Rule 10b-5 fleshes out section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b). It provides:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange,
(1) to employ any device, scheme, or artifice to defraud,
(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
The Supreme Court in Ernst Ernst v. Hochfelder, 425 U.S. 185, 194 n. 12, 96 S.Ct. 1375, 1381, 47 L.Ed.2d 668 (1976), defined the scienter necessary, at least absent extraordinary circumstances, for liability under 10b-5 as "a mental state embracing intent to deceive, manipulate or defraud."
It is clear that the district court's finding of fraud came within the ambit of the rule and the Supreme Court's definition. We turn to the evidence to determine whether the district court was clearly erroneous in finding that the statements in the confidential memorandum were intended to deceive putative investors as to the production stage of Foto-Mem's two products. The district court found that the whole thrust of the confidential memorandum was intended to impress investors with the fact that they could expect market production of the FM 390 and the Risar within a reasonably prompt time. It is sales, not research and development, that attracts investors. And the memorandum, the district court found, was deliberately pitched to impressing investors with the fact that production and sales were part of the immediate future.
A. The Use of the Words "Working Prototype"
Much testimony was devoted to what the words working prototype used in the memorandum meant or would mean to the average investor. Despite defendants' position that the trial judge misdefined working prototype and reached into the wild blue yonder for its meaning, we find there was a sound evidentiary basis for the definition used by the trial court.
I find that the word "working" signifies that it does work, not simply feasible in the sense that it can be made to do so. I do, however, accept, indeed, I expressly find, that a prototype with missing parts may still be described as working if the missing parts manifestly would work. But this means would work readily in fact, not merely in the subjective good faith expectation of the speaker.
Leaving aside the self-interested testimony of the plaintiffs, all of whom explained what the word working prototype meant, the testimony of Richardson, Maurais, Mann, or Wemple, standing alone, was sufficient to securely anchor the court's definition; and the court, of course, was free to pick and choose from all the evidence for a definition that would fit the context of the case. We note that Laura, in answer to a question from the court, admitted that there was no working prototype of an automatic retrieval Risar. The one used in the shows was handloaded. But the district court had more than trial testimony on which to based its finding that Laura and Eng deliberately misrepresented the production stage of the FM 390 and the Risar. As noted, supra, the confidential memorandum went through seven drafts before it was deemed satisfactory by the company lawyers. The first four drafts used the word "design" to describe the Risar: "The Company has a design for a Tisar which stores only written records such as business files called a Risar." (emphasis added). Attorney Gotkin testified that Laura and Eng insisted that the company had a working prototype of the Risar and that the word design be changed to working prototype. Moreover, in June of 1970, the company prepared a prospectus for the SEC preparatory to a stock offering that never materialized. In its second amendment to the registration statement, there was the following statement:
However, although the company has completed a "laboratory" prototype of its FM 390 and its first production model of a Risar there is no assurance that either system will withstand industry time tests.
Attorney Honig equated laboratory prototype with working prototype, but the district court could and did find that laboratory prototype meant a lesser advanced stage of development than a working prototype. The first draft of the SEC filing used the words engineering prototype. It was well within the district court's discretion to determine that working prototype meant the most advanced stage of development when compared with laboratory and engineering prototypes.
B. The Laser Problem
The defendants take vehement exception to the district court's finding that the FM 390 had not reached the working prototype stage and was not ready for fabrication of the first production unit because of laser problems. They assert that any difficulty with the laser was of minor significance and that it could be corrected in due course. We note that Leonard Wemple, Director of Engineering for Foto-Mem, testified that the laser required frequent hand adjustment to keep it operating correctly, that the adjustment times were not satisfactory, that these continued to be problems after a new laser was purchased. There was also evidence, although the district court did not focus on it, from which it could be found that pains were taken at the shows to conceal the hand adjustment of the laser. The laser was an integral part of the operation of the FM 390. The use of the microfiche photodata cards depended on a laser that would work rapidly and accurately. It was not error for the district court to conclude that, at the time the confidential memorandum was disseminated, the laser problems contradicted the assertions that there was a working prototype of the FM 390 and that the company was in the process of fabricating the first production unit.
C. Other Misrepresentations
The district court found that the statement that the FM 390 was capable of "a mass (multibillion bit) memory" was misleading because there was no readily available automatic photodata card selector system. Foto-Mem depended on the Mosler mechanism for its show demonstrators. The memorandum stated that the memory bank was the heart of the Risar. This was true. But the investors were not informed that what kept the heart beating was the Mosler selectriever. As the New York Times' experience proved, the Risar could not operate satisfactorily because the photodata card calling up system was defective. The investors should have been told explicitly the important role that the Mosler selectriever played in Foto-Mem's system. It might then have been obvious to some of them that dependence on a competitor for a vital part of the unit made this an extremely hazardous venture.
We think the district court was justified in finding that an explanation of how the money invested was to be used implied that, as far as the FM 390 and the Risar were concerned, research and development was about over and production and sales were just around the corner.
D. Fraudulent Intent
The next issue is whether there is evidence to sustain the district court's finding that Laura and Eng intended to deceive through the statements made in the confidential memorandum and the omissions therefrom. We find this a closer question than did the district court, but our review is restricted. We agree with the district court that "there was a bona fide purpose and a genuine hope of success." The issue is, was the district court clearly erroneous in finding that Laura's and Eng's hopes for success became so overriding as to result in deliberate deception. There is no doubt that both men, at very little personal expense, had acquired stockholdings that would make them millionaires if the company was successful. They both believed that all it would take to hit the jackpot was more time and money. They had the time and presumably the skill and knowhow; potential investors represented the money. We cannot say that the district court committed clear error in finding that Laura and Eng used the confidential memorandum to make material misrepresentations and deliberately omitted therefrom material facts in order to obtain working capital.
II. THE FINDING OF NO. 10b-5 LIABILITY AS TO ESTABROOK
Plaintiffs-appellants claim that the district court erred in finding that Plukas, Estabrook's representative in charge of the Foto-Mem debenture offering, did not act recklessly in approving the confidential memorandum. We assume without deciding that recklessness, as well as fraud, will ground an action under Rule 10b-5.
In Ernst Ernst v. Hochfelder, 425 U.S. 185, 194 n. 12, 96 S.Ct. 1375, 1381, 47 L.Ed.2d 668 (1976), the Supreme Court expressly refrained from deciding "the question whether in some circumstances, reckless behavior is sufficient for civil liability under § 10(b) and Rule 10b-5."
The main thrust of plaintiffs' argument is that the district court "failed to apply the proper standards for recklessness to the facts it found." The trial judge defined recklessness as "carelessness approaching indifference." That the definition is brief, terse and lacks case citations does not make it wrong. We turn first to tort law for a fuller definition. Prosser's definition is as follows:
The usual meaning assigned to "wilful," "wanton" or "reckless," according to taste as to the word used, is that the actor has intentionally done an act of an unreasonable character in disregard of a risk known to him or so obvious that he must be taken to have been aware of it, and so great as to make it highly probable that harm would follow. It usually is accompanied by a conscious indifference to the consequences, amounting almost to willingness that they shall follow; and it has been said that this is indispensable.
W. Prosser, Law of Torts 185 (4th ed. 1971). The Restatement words its definition differently, but it is to the same effect.
§ 500. Reckless Disregard of Safety Defined
The actor's conduct is in reckless disregard of the safety of another if he does an act or intentionally fails to do an act which it is his duty to the other to do, knowing or having reason to know of facts which would lead a reasonable man to realize, not only that his conduct creates an unreasonable risk of physical harm to another, but also that such risk is substantially greater than that which is necessary to make his conduct negligent.
In the context of Rule 10b-5 cases, the Seventh Circuit viewed recklessness as follows:
In view of the Supreme Court's analysis in Hochfelder of the statutory scheme of implied private remedies and express remedies, the definition of "reckless behavior" should not be a liberal one lest any discernible distinction between "scienter" and "negligence" be obliterated for these purposes. We believe "reckless" in these circumstances comes closer to being a lesser form of intent than merely a greater degree of ordinary negligence. We perceive it to be not just a difference in degree, but also in kind. Sanders v. John Nuveen Co., Inc., 554 F.2d 790, 793 (7th Cir. 1977).
We cited with approval the phrase "[reckless conduct] comes closer to being a lesser form of intent than merely a greater degree of ordinary negligence" in Cook v. Avien, Inc., 573 F.2d 685, 692 (1st Cir. 1978).
Plaintiffs' reliance on SEC v. Universal Major Industries Corp., 546 F.2d 1044 (2d Cir. 1976), is badly skewed. In that case, the court held that a prosecution by the SEC for aiding and abetting in the selling of unregistered stock may be based on mere negligence. There was no definition of or discussion of recklessness. The court explicitly stated: "In these same decisions, we also made it clear that in SEC proceedings seeking equitable relief, a cause of action may be predicated upon negligence alone, and scienter is not required." Id. at 1047.
By any semantic standard, the district court's definition of recklessness as "carelessness approaching indifference" is less rigorous and demanding than the one we approved in Cook v. Avien, Inc., supra, 573 F.2d at 692, which connotes some degree of intent rather than mere indifference. Although unusual, brevity can be the soul of a legal definition as well as wit; we find that the district court's definition of recklessness was not legally incorrect.
The question, therefore, becomes not whether the district court applied the proper standard, but whether its finding that Plukas was not reckless is sustainable by the evidence. The district court found that Plukas was negligent. There is a grey area in which negligence merges into recklessness. We analyze the facts and findings to determine if such a merger occurred here.
Plaintiffs, of course, do not quarrel with the district court's characterization of Plukas as "a man of intelligence and some experience," who "had great opportunity to observe." The court found "that his [Plukas'] belief in the accuracy of the Memo reveals considerable lack of care on his part." In his deposition, Plukas admitted knowledge of difficulties with the laser. He testified at trial that he knew that expansion from the FM 390 to the Risar involved engineering as well as mechanical problems and, most importantly, the court found that Plukas "understood that to progress from prototype to marketable unit required `a great deal more work.'" The trial judge did not credit Plukas' testimony that he understood that the expansion equipment could be purchased readily from Mosler. All of this, as the district court found, adds up to a strong negligence case. But there is little, if any, evidence of indifference and none at all that would involve intent. As in the case relied on by plaintiffs, Sanders v. Nuveen Co., Inc., supra, 544 F.2d at 793, there were no facts that would compel a finding that "acts of commission or omissions were reckless, that is, that they were so highly unreasonable and such an extreme departure from the standards of ordinary care as to present a danger of misleading the plaintiff to the extent that the danger was either known to the defendant or so obvious that the defendant must have been award of it."
Plukas, like Laura and Eng, insisted that there were working prototypes of the FM 390 and the Risar, but it was Laura and Eng on whom Plukas relied for this information. While Plukas did receive the drafts of the confidential memorandum for review, they were in completed form when he got them. He was not involved in the wording or composition of the memo. We cannot ignore the fact that Plukas invested money of his own in Foto-Mem; that belies any known or obvious danger. The district court's finding, clearly supportable on the record, that Plukas' failure to scrutinize the memo with scouring scepticism was due in part, at least, to the fact that two experienced investors, Suez American and the Mellon Bank, had conducted a technical investigation by experts and then became subscribers cannot be brushed aside. Plukas' view of Foto-Mem's future was, like that of most of the plaintiffs', dazzled and distorted by the rainbow hues that appeared to be leading directly to the pot of gold. We note also that none of the investors here were babes in the woods. Most of them had investing experience and some of them even had technical background and knowledge. Laura's and Eng's idea was alluring, but only Laura and Eng understood fully what was needed to turn their dream into reality. Under any accepted definition, it was not error for the district court to find that Plukas' conduct did not constitute recklessness.
III. THE OMISSION FROM THE CONFIDENTIAL MEMORANDUM OF LAURA'S CONVICTION AND BANK ROBBERY
The district court's finding that the omission from the memo of Laura's past criminal record was not material was a judgment call and, in our opinion, correct. Laura's character and integrity were not involved; it was his idea that attracted the investors. Calling attention to a youthful misstep, if it was that, would in no way have alerted potential investors to a possibility of material misrepresentations and omissions in the debenture circular. Eng's past connection with a company that had failed might have been some sort of a warning signal, but very faint in the light of his obvious skill, knowledge and experience. The plaintiffs have not questioned the omissions as to Eng's background on appeal and we advert to it only for purposes of comparison.
IV. SECTION 12(2) AND THE STATUTE OF LIMITATIONS
There is no question that Estabrook would be liable under section 12(2) of the Securities Act, 15 U.S.C. § 77 l(2), were it not for the district court's finding that plaintiffs were barred by the time limitations of section 13 of the Act, 15 U.S.C. § 77m, which provides in pertinent part:
"Any person who . . . (2) offers or sells a security (whether or not exempted by the provisions of section 3 [ 15 USCS § 77c], other than paragraph (2), of subsection (a) thereof), by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission, shall be liable to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security."
§ 77m. Limitation of actions
No action shall be maintained to enforce any liability created under section 11[ 15 USCS § 77k] or section 12(2) [15 USCS § 77 l(2)] unless brought within one year after the discovery of the untrue statement or the omission, or after such discovery should have been made by the exercise of reasonable diligence, or, if the action is to enforce a liability created under section 12(1) [15 USCS § 77 l(1)], unless brought within one year after the violation upon which it is based.
We address first plaintiffs' assertion that the district court erred in placing the burden of proof on plaintiffs. This is easily refuted. In Cook v. Avien, Inc., supra, 573 F.2d at 695, we held: "The burden of showing compliance with the § 12(2) statutory period of limitations rests on the plaintiffs."
We also held in Cook v. Avien, Inc., supra, at 697:
Although the question of whether reasonable diligence has been exercised is factually based, we conclude that the actual determination is a sufficiently mixed question of law and fact to permit an appellate court to resolve the issue at least where the action below was tried to the court.
We, therefore, turn to the evidence to determine if the plaintiffs acted with due diligence in pursuing their 12(2) claim. We must consider the nature of the misrepresentations and omissions, the opportunities to uncover them and the subsequent conduct of the parties. Cook v. Avien, Inc., supra, at 696-97. The district court found that plaintiffs were or should have been put on "inquiry notice" by the meeting of July 15, 1970. Since there is no evidence from which it could be found that plaintiffs should have been put on notice earlier, our scrutiny starts with that meeting. The meeting was called because Foto-Mem faced a financial crisis; it was rapidly running out of money. The best account of what transpired at the meeting comes from the testimony of George Robinette and the memo he prepared after the meeting. Hard questions were asked by Robinette, Connors (Mellon Bank), and Glickman (American Suez) as to what had happened to the money already invested, and why the recent sales projections were not fulfilled. In response to these questions Laura stressed the technological capabilities of the company and minimized its financial problems. There is no evidence that any of the plaintiffs asked either Laura or Eng any questions about the production stage of the FM 390 or the Risar, even though some of them knew that the Times' Risar order was already late in delivery. Robinette testified, "I did not question the company's technical ability or question its ability to create a product using the technology which it had. My concerns at that point were primarily about the management, the present finances and the future financial condition of the company and its ability to survive really." With the perspicacity given by hindsight, it is obvious that the questions were directed to the wrong end of the operation.
Robert Goldberg had been told by Laura that they expected to deliver a Risar system to the Times in March.
Plaintiffs argue that the defendants, Laura, Eng, and Estabrook, actively concealed the fraud and, therefore, tolled the running of the limitations period. This was done, plaintiffs assert, by concealing the underlying facts as to the two products and purposely diverting plaintiffs' attention away from this by stressing financial matters. This rather ingenuous argument overlooks the fact that serious financial matters actually triggered the meeting and that no one asked any direct questions about the development stage of the FM 390 or the Risar at the meeting. There was no need to divert plaintiffs' attention to the financial straits of Foto-Mem; that was the avowed purpose of the meeting. Diversionary tactics were unnecessary. Plaintiffs had almost a blind faith in Foto-Mem's technological capabilities. This is best summarized by an excerpt from the final paragraph of Robinette's memo:
The nut of the problem is that the Company is technologically very good, but its day-to-day administration stinks! And it is nearly broke, and its programs are still not bringing any money. But there is still enough here to be hopeful about (though that's all!) and, in any case, the quality of Eng and his products should continue to be very attractive to another company should the merger route be pursued.
It is true that, if Laura or Eng had stated at the meeting that the words working prototype in the confidential memorandum had been poorly chosen, some of the plaintiffs might have pricked up their ears. But failure to recant when not asked to is hardly evidence of active concealment. Laura's and Eng's fraud rested on what was said and left unsaid in the confidential memorandum. Their duty of disclosure was a continuing one. It was not limited to the July 15 meeting. It is also important to remember that the meeting was not instigated by the plaintiffs to obtain information; Laura and Eng called the meeting hoping to raise money from the debenture holders. The meeting was not set up as a smoke screen to divert the attention of the plaintiffs from the production stage of the FM 390 and the Risar. The question is whether, as a result of the meeting, plaintiffs should have begun to "smell a rat." We find it hard to understand why the plaintiffs continued to accept the company's product claims in the face of no sales and no money. "The financial data available to the purchasers provided them with sufficient storm warnings to alert a reasonable person to the possibility that there were either misleading statements or significant omissions involved in the sale of the notes." Cook v. Avien, Inc., supra, at 697-698.
But, even if we accept plaintiffs' claim that the July 15 meeting was not the type of event that would trigger a "due diligence" inquiry, no reason is advanced as to why the failure of the Times Risar to work should not have aroused suspicions. Robinette testified, "I think it began to be apparent in the late fall, the early winter, the winter certainly of 1970, that the test was not working out as well as people had hoped for in the beginning." Goldberg attended a meeting at the New York Times in the fall of 1970. He testified, "Well, it was obvious that the machine was there but it was not functioning." It was not until American Suez filed suit for fraud, based on financial misrepresentation and omissions, that plaintiffs began to take stock of their own situation. The Suez suit cannot be accepted as the starting point for a "due diligence" pursuit of the facts. Due diligence requires something more than passively waiting until suit is brought by another investor where financial storm warnings and operational problems with the main product had been clearly visible for more than a year. Under these circumstances, doing nothing for a year is not exercising due diligence.
The complaint was filed January 28, 1972.
The judgment of the district court is affirmed.