Escott v. Barchris Construction Corp.

United States District Court for the Southern District of New York, 1968.

283 F. Supp. 643.

This is an action by purchasers of 5 1/2 per cent convertible subordinated fifteen year debentures of BarChris Construction Corporation (BarChris). Plaintiffs purport to sue on their own behalf and "on behalf of all other and present and former holders" of the debentures. . . .

The action is brought under Section 11 of the Securities Act of 1933 (15 U.S.C. ยง 77k). Plaintiffs allege that the registration statement with respect to these debentures filed with the Securities and Exchange Commission, which became effective on May 16, 1961, contained material false statements and material omissions.

Defendants fall into three categories: (1) the persons who signed the registration statement; (2) the underwriters, consisting of eight investment banking firms, led by Drexel & Co. (Drexel); and (3) BarChris's auditors, Peat, Marwick, Mitchell & Co. (Peat, Marwick).

. . .

. . . On the main issue of liability, the questions to be decided are (1) did the registration statement contain false statements of fact, or did it omit to state facts which should have been stated in order to prevent it from being misleading; (2) if so, were the facts which were falsely stated or omitted "material" within the meaning of the Act; (3) if so, have defendants established their affirmative defenses?

Before discussing these questions, some background facts should be mentioned. At the time relevant here, BarChris was engaged primarily in the construction of bowling alleys, somewhat euphemistically referred to as "bowling centers." These were rather elaborate affairs. They contained not only a number of alleys or "lanes," but also, in most cases, bar and restaurant facilities.

. . .

BarChris's sales increased dramatically from 1956 to 1960. According to the prospectus, net sales, in round figures, in 1956 were some $800,000, in 1957 $1,300,000, in 1958 $1,700,000. In 1959 they increased to over $3,300,000, and by 1960 they had leaped to over $9,165,000.

. . .

In general, BarChris's method of operation was to enter into a contract with a customer, receive from him at that time a comparatively small down payment on the purchase price, and proceed to construct and equip the bowling alley. When the work was finished and the building delivered, the customer paid the balance of the contract price in notes, payable in installments over a period of years. BarChris discounted these notes with a factor and received part of their face amount in cash. The factor held back part as a reserve.

In 1960 BarChris began a practice which has been referred to throughout this case as the "alternative method of financing." In substance this was a sale and leaseback arrangement. It involved a distinction between the "interior" of a building and the building itself, i.e., the outer shell. In instances in which this method applied, BarChris would build and install what it referred to as the "interior package." Actually this amounted to constructing and installing the equipment in a building. When it was completed, it would sell the interior to a factor, James Talcott Inc. (Talcott), who would pay BarChris the full contract price therefor. The factor then proceeded to lease the interior either directly to BarChris's customer or back to a subsidiary of BarChris. In the latter case, the subsidiary in turn would lease it to the customer.

Under either financing method, BarChris was compelled to expend considerable sums in defraying the cost of construction before it received reimbursement. As a consequence, BarChris was in constant need of cash to finance its operations, a need which grew more pressing as operations expanded.

In December 1959, BarChris sold 560,000 shares of common stock to the public at $3.00 per share. This issue was underwritten by Peter Morgan & Company, one of the present defendants.

By early 1961, BarChris needed additional working capital. The proceeds of the sale of the debentures involved in this action were to be devoted, in part at least, to fill that need.

The registration statement of the debentures, in preliminary form, was filed with the Securities and Exchange Commission on March 30, 1961. A first amendment was filed on May 11 and a second on May 16. The registration statement became effective on May 16. The closing of the financing took place on May 24. On that day BarChris received the net proceeds of the financing.

By that time BarChris was experiencing difficulties in collecting amounts due from some of its customers. Some of them were in arrears in payments due to factors on their discounted notes. As time went on those difficulties increased. Although BarChris continued to build alleys in 1961 and 1962, it became increasingly apparent that the industry was overbuilt. Operators of alleys, often inadequately financed, began to fail. Precisely when the tide turned is a matter of dispute, but at any rate, it was painfully apparent in 1962.

In May of that year BarChris made an abortive attempt to raise more money by the sale of common stock. It filed with the Securities and Exchange Commission a registration statement for the stock issue which it later withdrew. In October 1962 BarChris came to the end of the road. On October 29, 1962, it filed in this court a petition for an arrangement under Chapter XI of the Bankruptcy Act. BarChris defaulted in the payment of the interest due on November 1, 1962 on the debentures.

The Debenture Registration Statement

In preparing the registration statement for the debentures, Grant acted for BarChris. He had previously represented BarChris in preparing the registration statement for the common stock issue. In connection with the sale of common stock, BarChris had issued purchase warrants. In January 1961 a second registration statement was filed in order to update the information pertaining to these warrants. Grant had prepared that statement as well.

Some of the basic information needed for the debenture registration statement was contained in the registration statements previously filed with respect to the common stock and warrants. Grant used these old registration statements as a model in preparing the new one, making the changes which he considered necessary in order to meet the new situation.

The underwriters were represented by the Philadelphia law firm of Drinker, Biddle & Reath. John A. Ballard, a member of that firm, was in charge of that work, assisted by a young associate named Stanton.

Peat, Marwick, BarChris's auditors, who had previously audited BarChris's annual balance sheet and earnings figures for 1958 and 1959, did the same for 1960. These figures were set forth in the registration statement. In addition, Peat, Marwick undertook a so-called "S-1 review," the proper scope of which is one of the matters debated here.

The registration statement in its final form contained a prospectus as well as other information. Plaintiffs' claims of falsities and omissions pertain solely to the prospectus, not to the additional data.

The prospectus contained, among other things, a description of BarChris's business, a description of its real property, some material pertaining to certain of its subsidiaries, and remarks about various other aspects of its affairs. It also contained financial information. It included a consolidated balance sheet as of December 31, 1960, with elaborate explanatory notes. These figures had been audited by Peat, Marwick. It also contained unaudited figures as to net sales, gross profit and net earnings for the first quarter ended March 31, 1961, as compared with the similar quarter for 1960. In addition, it set forth figures as to the company's backlog of unfilled orders as of March 31, 1961, as compared with March 31, 1960, and figures as to BarChris's contingent liability, as of April 30, 1961, on customers' notes discounted and its contingent liability under the so-called alternative method of financing.

Plaintiffs challenge the accuracy of a number of these figures. They also charge that the text of the prospectus, apart from the figures, was false in a number of respects, and that material information was omitted. Each of these contentions, after eliminating duplications, will be separately considered.

. . .


For convenience, the various falsities and omissions which I have discussed in the preceding pages are recapitulated here. They were as follows:


1960 Earnings




(a) Sales


  As per prospectus



  Correct figure




$ 653,900





(b) Net Operating Income



  As per prospectus



  Correct figure




$ 246,605





(c) Earnings per Share



  As per prospectus

    $ .75


  Correct figure




    $ .10





1960 Balance Sheet






Current Assets



As per prospectus



Correct figure




$ 609,689





Contingent Liabilities as of De-



 cember 31, 1960 on Alternative



 Method of Financing






As per prospectus

$ 750,000


Correct figure




$ 375,795


Capitol Lanes should have been



shown as a direct liability

$ 325,000





Contingent Liabilities as of April



30, 1961






As per prospectus

$ 825,000


Correct figure




$ 618,853


Capitol Lanes should have been



shown as a direct liability

$ 314,166





Earnings Figures for Quarter end-



ing March 31, 1961






(a) Sales



  As per prospectus



  Correct figure




$ 519,810





(b) Gross Profit



  As per prospectus

$ 483,121


  Correct figure




$ 230,755





Backlog as of March 31, 1961



As per prospectus



Correct figure









Failure to Disclose Officers' Loans



Outstanding and Unpaid on May



16, 1961

$ 386,615





Failure to Disclose Use of Proceeds



in Manner not Revealed in Pro-












Failure to Disclose Customers' De-



linquencies in May 1961 and Bar-



Chris's Potential Liability with Re-



spect Thereto









Failure to Disclose the Fact



that BarChris was Already Engaged,



and was about to be More Heavily



Engaged, in the Operation of Bowl-



ing Alleys



It is a prerequisite to liability under Section 11 of the Act that the fact which is falsely stated in a registration statement, or the fact that is omitted when it should have been stated to avoid misleading, be "material." . . .

. . .

Judged by this test, there is no doubt that many of the misstatements and omissions in this prospectus were material. This is true of all of them which relate to the state of affairs in 1961, i.e., the overstatement of sales and gross profit for the first quarter, the understatement of contingent liabilities as of April 30, the overstatement of orders on hand and the failure to disclose the true facts with respect to officers' loans, customers' delinquencies, application of proceeds and the prospective operation of several alleys.

The misstatements and omissions pertaining to BarChris's status as of December 31, 1960, however, present a much closer question. . . .

. . .

Since there was an abundance of material misstatements pertaining to 1961 affairs, whether or not the errors in the 1960 figures were material does not affect the outcome of this case except to the extent that it bears upon the liability of Peat, Marwick. That subject will be discussed hereinafter.

The "Due Diligence" Defenses

Section 11(b) of the Act provides that:

" . . . no person, other than the issuer, shall be liable . . . who shall sustain the burden of proof --


* * *


(3) that (A) as regards any part of the registration statement not purporting to be made on the authority of an expert . . . he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading; . . . and (C) as regards any part of the registration statement purporting to be made on the authority of an expert (other than himself) . . . he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became effective, that the statements therein were untrue or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading . . . ."


Section 11(c) defines "reasonable investigation" as follows:

"In determining, for the purpose of paragraph (3) of subsection (b) of this section, what constitutes reasonable investigation and reasonable ground for belief, the standard of reasonableness shall be that required of a prudent man in the management of his own property."


Every defendant, except BarChris itself, to whom, as the issuer, these defenses are not available, and except Peat, Marwick, whose position rests on a different statutory provision, has pleaded these affirmative defenses. Each claims that (1) as to the part of the registration statement purporting to be made on the authority of an expert (which, for convenience, I shall refer to as the "expertised portion"), he had no reasonable ground to believe and did not believe that there were any untrue statements or material omissions, and (2) as to the other parts of the registration statement, he made a reasonable investigation, as a result of which he had reasonable ground to believe and did believe that the registration statement was true and that no material fact was omitted. As to each defendant, the question is whether he has sustained the burden of proving these defenses. Surprising enough, there is little or no judicial authority on this question. No decisions directly in point under Section 11 have been found.

. . .

. . . The only expert, in the statutory sense, was Peat, Marwick, and the only parts of the registration statement which purported to be made upon the authority of an expert were the portions which purported to be made on Peat, Marwick's authority.

. . .

I turn now to the question of whether defendants have proved their due diligence defenses. The position of each defendant will be separately considered.


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 was personally in charge of dealings with the factors. He acted on BarChris's behalf in making the financing agreements with Talcott and he handled the negotiations with Talcott in the spring of 1961. He talked with customers about their delinquencies.

Russo prepared the list of jobs which went into the backlog figure. He knew the status of those jobs. In addition to being chief executive officer of BarChris, he was a director of T-Bowl International, Inc., and the principals in St. Ann's were his friends.

It was Russo who arranged for the temporary increase in BarChris's cash in banks on December 31, 1960, a transaction which borders on the fraudulent. He was thoroughly aware of BarChris's stringent financial condition in May 1961. He had personally advanced large sums to BarChris of which $175,000 remained unpaid as of May 16.

In short, Russo 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 of the business who stuck with it to the end. Vitolo was president and Pugliese was vice president. Despite their titles, their field of responsibility in the administration of BarChris's affairs during the period in question seems to have been less all-embracing than Russo's. Pugliese in particular appears to have limited his activities to supervising the actual construction work.

Vitolo and Pugliese 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 whether it was or not is irrelevant. 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. At meetings of that committee BarChris's affairs were discussed at length. They must have known what was going on. Certainly they knew of the inadequacy of cash in 1961. 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, the position of Vitolo and Pugliese is not significantly different, for present purposes, from Russo's. They could not have believed that the registration statement was wholly true and that no material facts had been omitted. And in any case, there is nothing to show that they made any investigation of anything which they may not have known about or understood. They have not proved their due diligence defenses.


Kircher was treasurer of BarChris and its chief financial officer. He is a certified public accountant and an intelligent man. He was thoroughly familiar with BarChris's financial affairs. He knew the terms of BarChris's agreements with Talcott. He knew of the customers' delinquency problem. He participated actively with Russo in May 1961 in the successful effort to hold Talcott off until the financing proceeds came in. He knew how the financing proceeds were to be applied and he saw to it that they were so applied. He arranged the officers' loans and he knew all the facts concerning them.

. . .

Kircher's contention is that he had never before dealt with a registration statement, that he did not know what it should contain, and that he relied wholly on Grant, Ballard and Peat, Marwick to guide him. He claims that it was their fault, not his, if there was anything wrong with it. He says that all the facts were recorded in BarChris's books where these "experts" could have seen them if they had looked. He says that he truthfully answered all their questions. In effect, he says that if they did not know enough to ask the right questions and to give him the proper instructions, that is not his responsibility.

There is an issue of credibility here. In fact, Kircher was not frank in dealing with Grant and Ballard. He withheld information from them. But even if he had told them all the facts, this would not have constituted the due diligence contemplated by the statute. Knowing the facts, Kircher had reason to believe that the expertised portion of the prospectus, i.e., the 1960 figures, was in part incorrect. He could not shut his eyes to the facts and rely on Peat, Marwick for that portion.

As to the rest of the prospectus, knowing the facts, he did not have a reasonable ground to believe it to be true. On the contrary, he must have known that in part it was untrue. Under these circumstances, he was not entitled to sit back and place the blame on the lawyers for not advising him about it.

Kircher has not proved his due diligence defenses.


Trilling's position is somewhat different from Kircher's. He was BarChris's controller. He signed the registration statement in that capacity, although he was not a director.

Trilling entered BarChris's employ in October 1960. He was Kircher's subordinate. When Kircher asked him for information, he furnished it. On at least one occasion he got it wrong.

. . .

Trilling may well have been unaware of several of the inaccuracies in the prospectus. But he must have known of some of them. . . . In the light of these facts, 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 did not prove that as to the parts of the prospectus expertised by Peat, Marwick he had no reasonable ground to believe that it was untrue. He also failed to prove, as to the parts of the prospectus not expertised by Peat, Marwick, 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. He did what was asked of him and assumed that others would properly take care of supplying accurate data as to the other aspects of the company's business. This would have been well enough but for the fact that he signed the registration statement. As a signer, he could not avoid responsibility by leaving it up to others to make it accurate. Trilling did not sustain the burden of proving his due diligence defenses.


Birnbaum was a young lawyer, admitted to the bar in 1957, who, after brief periods of employment by two different law firms and an equally brief period of practicing in his own firm, was employed by BarChris as house counsel and assistant secretary in October 1960. Unfortunately for him, he became secretary and a director of BarChris on April 17, 1961, after the first version of the registration statement had been filed with the Securities and Exchange Commission. He signed the later amendments, thereby becoming responsible for the accuracy of the prospectus in its final form.

Although the prospectus, in its description of "management," lists Birnbaum among the "executive officers" and devotes several sentences to a recital of his career, the fact seems to be that he was not an executive officer in any real sense. He did not participate in the management of the company. As house counsel, he attended to legal matters of a routine nature. Among other things, he incorporated subsidiaries, with which BarChris was plentifully supplied. Among the subsidiaries which he incorporated were Capitol Lanes, Inc. which operated Capitol, Yonkers Lanes, Inc. which eventually operated Yonkers, and Parkway Lanes, Inc. which eventually operated Bridge. He was thus aware of that aspect of the business.

Birnbaum examined contracts. In that connection he advised BarChris that the T-Bowl contracts were not legally enforceable. He was thus aware of that fact.

One of Birnbaum's more important duties, first as assistant secretary and later as full-fledged secretary, was to keep the corporate minutes of BarChris and its subsidiaries. This necessarily informed him to a considerable extent about the company's affairs. Birnbaum was not initially a member of the executive committee, however, and did not keep its minutes at the outset. According to the minutes, the first meeting which he attended, "upon invitation of the Committee," was on March 22, 1961. He became a member shortly thereafter and kept the minutes beginning with the meeting of April 24, 1961.

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 and relied on the others to get it right. Unlike Trilling, he was entitled to rely upon Peat, Marwick for the 1960 figures, for as far as appears, he had no personal knowledge of the company's books of account or financial transactions. But he was not entitled to rely upon Kircher, Grant and Ballard for the other portions of the prospectus. As a lawyer, he should have known his obligations under the statute. He should have known that he was required to make a reasonable investigation of the truth of all the statements in the unexpertised portion of the document which he signed. 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 was an "outside" director, i.e., one who was not an officer of BarChris. He was chairman of the board of Valley Stream National Bank in Valley Stream, Long Island. In February 1961 Vitolo asked him to become a director of BarChris. Vitolo gave him an enthusiastic account of BarChris's progress and prospects. As an inducement, Vitolo said that when BarChris received the proceeds of a forthcoming issue of securities, it would deposit $1,000,000 in Auslander's bank.

In February and early March 1961, before accepting Vitolo's invitation, Auslander made some investigation of BarChris. He obtained Dun & Bradstreet reports which contained sales and earnings figures for periods earlier than December 31, 1960. He caused inquiry to be made of certain of BarChris's banks and was advised that they regarded BarChris favorably. He was informed that inquiry of Talcott had also produced a favorable response.

On March 3, 1961, Auslander indicated his willingness to accept a place on the board. Shortly thereafter, on March 14, Kircher sent him a copy of BarChris's annual report for 1960. Auslander observed that BarChris's auditors were Peat, Marwick. They were also the auditors for the Valley Stream National Bank. He thought well of them.

Auslander was elected a director on April 17, 1961. The registration statement in its original form had already been filed, of course without his signature. On May 10, 1961, he signed a signature page for the first amendment to the registration statement which was filed on May 11, 1961. This was a separate sheet without any document attached. Auslander did not know that it was a signature page for a registration statement. He vaguely understood that it was something "for the SEC."

Auslander attended a meeting of BarChris's directors on May 15, 1961. At that meeting he, along with the other directors, signed the signature sheet for the second amendment which constituted the registration statement in its final form. Again, this was only a separate sheet without any document attached. Auslander never saw a copy of the registration statement in its final form.

At the May 15 directors' meeting, however, Auslander did realize that what he was signing was a signature sheet to a registration statement. This was the first time that he had appreciated that fact. A copy of the registration statement in its earlier form as amended on May 11, 1961 was passed around at the meeting. Auslander glanced at it briefly. He did not read it thoroughly.

At the May 15 meeting, Russo and Vitolo stated that everything was in order and that the prospectus was correct. Auslander believed this statement.

In considering Auslander's due diligence defenses, a distinction is to be drawn between the expertised and non-expertised portions of the prospectus. As to the former, Auslander knew that Peat, Marwick had audited the 1960 figures. He believed them to be correct because he had confidence in Peat, Marwick. He had no reasonable ground to believe otherwise.

As to the non-expertised portions, however, Auslander is in a different position. He seems to have been under the impression that Peat, Marwick was responsible for all the figures. This impression was not correct, as he would have realized if he had read the prospectus carefully. Auslander made no investigation of the accuracy of the prospectus. He relied on the assurance of Vitolo and Russo, and upon the information he had received in answer to his inquiries back in February and early March. These inquiries were general ones, in the nature of a credit check. The information which he received in answer to them was also general, without specific reference to the statements in the prospectus, which was not prepared until some time thereafter.

It is true that Auslander became a director on the eve of the financing. He had little opportunity to familiarize himself with the company's affairs. The question is whether, under such circumstances, Auslander did enough to establish his due diligence defense with respect to the non-expertised portions of the prospectus.

. . .

Section 11 imposes liability in the first instance upon a director, no matter how new he is. He is presumed to know his responsibility when he becomes a director. He can escape liability only by using that reasonable care to investigate the facts which a prudent man would employ in the management of his own property. In my opinion, a prudent man would not act in an important matter without any knowledge of the relevant facts, in sole reliance upon representations of persons who are comparative strangers and upon general information which does not purport to cover the particular case. To say that such minimal conduct measures up to the statutory standard would, to all intents and purposes, absolve new directors from responsibility merely because they are new. This is not a sensible construction of Section 11, when one bears in mind its fundamental purpose of requiring full and truthful disclosure for the protection of investors.

I find and conclude that Auslander has not established his due diligence defense with respect to the misstatements and omissions in those portions of the prospectus other than the audited 1960 figures.


Rose, another "outside" director, is in a position comparable to Auslander's. . . .

. . .

What has been said with respect to Auslander applies equally to Rose. He has not sustained the burden of proving his due diligence defense as to the portions of the registration statement other than the audited 1960 figures.


Grant became a director of BarChris in October 1960. His law firm was counsel to BarChris in matters pertaining to the registration of securities. Grant drafted the registration statement for the stock issue in 1959 and for the warrants in January 1961. He also drafted the registration statement for the debentures. In the preliminary division of work between him and Ballard, the underwriters' counsel, Grant took initial responsibility for preparing the registration statement, while Ballard devoted his efforts in the first instance to preparing the indenture.

 Grant is sued as a director and as a signer of the registration statement. This is not an action against him for malpractice in his capacity as a lawyer. Nevertheless, in considering Grant's due diligence defenses, the unique position which he occupied cannot be disregarded. As the director most directly concerned with writing the registration statement and assuring its accuracy, more was required of him in the way of reasonable investigation than could fairly be expected of a director who had no connection with this work.

There is no valid basis for plaintiffs' accusation that Grant knew that the prospectus was false in some respects and incomplete and misleading in others. Having seen him testify at length, I am satisfied as to his integrity. I find that Grant honestly believed that the registration statement was true and that no material facts had been omitted from it.

In this belief he was mistaken, and the fact is that for all his work, he never discovered any of the errors or omissions which have been recounted at length in this opinion, with the single exception of Capitol Lanes. He knew that BarChris had not sold this alley and intended to operate it, but he appears to have been under the erroneous impression that Peat, Marwick had knowingly sanctioned its inclusion in sales because of the allegedly temporary nature of the operation.

Grant contends that a finding that he did not make a reasonable investigation would be equivalent to a holding that a lawyer for an issuing company, in order to show due diligence, must make an independent audit of the figures supplied to him by his client. I do not consider this to be a realistic statement of the issue. There were errors and omissions here which could have been detected without an audit. The question is whether, despite his failure to detect them, Grant made a reasonable effort to that end.

Much of this registration statement is a scissors and paste-pot job. Grant lifted large portions from the earlier prospectuses, modifying them in some instances to the extent that he considered necessary. But BarChris's affairs had changed for the worse by May 1961. Statements that were accurate in January were no longer accurate in May. Grant never discovered this. He accepted the assurances of Kircher and Russo that any change which might have occurred had been for the better, rather than the contrary.

It is claimed that a lawyer is entitled to rely on the statements of his client and that to require him to verify their accuracy would set an unreasonably high standard. This is too broad a generalization. It is all a matter of degree. To require an audit would obviously be unreasonable. On the other hand, to require a check of matters easily verifiable is not unreasonable. Even honest clients can make mistakes. The statute imposes liability for untrue statements regardless of whether they are intentionally untrue. The way to prevent mistakes is to test oral information by examining the original written record.

There were things which Grant could readily have checked which he did not check. For example, he was unaware of the provisions of the agreements between BarChris and Talcott. He never read them. Thus, he did not know, although he readily could have ascertained, that BarChris's contingent liability on Type B leaseback arrangements was 100 per cent, not 25 per cent. He did not appreciate that if BarChris defaulted in repurchasing delinquent customers' notes upon Talcott's demand, Talcott could accelerate all the customer paper in its hands, which amounted to over $3,000,000.

. . .

Grant was unaware of the fact that BarChris was about to operate Bridge and Yonkers. He did not read the minutes of those subsidiaries which would have revealed that fact to him. On the subject of minutes, Grant knew that minutes of certain meetings of the BarChris executive committee held in 1961 had not been written up. Kircher, who had acted as secretary at those meetings, had complete notes of them. Kircher told Grant that there was no point in writing up the minutes because the matters discussed at those meetings were purely routine. Grant did not insist that the minutes be written up, nor did he look at Kircher's notes. If he had, he would have learned that on February 27, 1961 there was an extended discussion in the executive committee meeting about customers' delinquencies, that on March 8, 1961 the committee had discussed the pros and cons of alley operation by BarChris, that on March 18, 1961 the committee was informed that BarChris was constructing or about to begin constructing twelve alleys for which it had no contracts, and that on May 13, 1961 Dreyfuss, one of the worst delinquents, had filed a petition in Chapter X.

Grant knew that there had been loans from officers to BarChris in the past because that subject had been mentioned in the 1959 and January 1961 prospectuses. In March Grant prepared a questionnaire to be answered by officers and directors for the purpose of obtaining information to be used in the prospectus. The questionnaire did not inquire expressly about the existence of officers' loans. At approximately the same time, Grant prepared another questionnaire in order to obtain information on proxy statements for the annual stockholders' meeting. This questionnaire asked each officer to state whether he was indebted to BarChris, but it did not ask whether BarChris was indebted to him.

Despite the inadequacy of these written questionnaires, Grant did, on March 16, 1961, orally inquire as to whether any officers' loans were outstanding. He was assured by Russo, Vitolo and Pugliese that all such loans had been repaid. Grant did not ask again. He was unaware of the new loans in April. He did know, however, that, at Kircher's request, a provision was inserted in the indenture which gave loans from individuals priority over the debentures. Kircher's insistence on this clause did not arouse his suspicions.

It is only fair to say that Grant was given to understand by Kircher that there were no new officers' loans and that there would not be any before May 16. It is still a close question, however, whether, under all the circumstances, Grant should have investigated further, perhaps by asking Peat, Marwick, in the course of its S-1 review, to look at the books on this particular point. I believe that a careful man would have checked.

There is more to the subject of due diligence than this, particularly with respect to the application of proceeds and customers' delinquencies.

The application of proceeds language in the prospectus was drafted by Kircher back in January. It may well have expressed his intent at that time, but his intent, and that of the other principal officers of BarChris, was very different in May. Grant did not appreciate that the earlier language was no longer appropriate. He never learned of the situation which the company faced in May. He knew that BarChris was short of cash, but he had no idea how short. He did not know that BarChris was withholding delivery of checks already drawn and signed because there was not enough money in the bank to pay them. He did not know that the officers of the company intended to use immediately approximately one-third of the financing proceeds in a manner not disclosed in the prospectus, including approximately $1,000,000 in paying old debts.

In this connection, mention should be made of a fact which has previously been referred to only in passing. The "negative cash balance" in BarChris's Lafayette National Bank account in May 1961 included a check dated April 10, 1961 to the order of Grant's firm, Perkins, Daniels, McCormack & Collins, in the amount of $8,711. This check was not deposited by Perkins, Daniels until June 1, after the financing proceeds had been received by BarChris. Of course, if Grant had knowingly withheld deposit of this check until that time, he would be in a position similar to Russo, Vitolo and Pugliese. I do not believe, however, that that was the case. I find that the check was not delivered by BarChris to Perkins, Daniels until shortly before June 1.

This incident is worthy of mention, however, for another reason. The prospectus stated on page 10 that Perkins, Daniels had "received fees aggregating $13,000" from BarChris. This check for $8,711 was one of those fees. It had not been received by Perkins, Daniels prior to May 16. Grant was unaware of this. In approving this erroneous statement in the prospectus, he did not consult his own bookkeeper to ascertain whether it was correct. Kircher told him that the bill had been paid and Grant took his word for it. If he had inquired and had found that this representation was untrue, this discovery might well have led him to a realization of the true state of BarChris's finances in May 1961.

As far as customers' delinquencies is concerned, although Grant discussed this with Kircher, he again accepted the assurances of Kircher and Russo that no serious problem existed. He did not examine the records as to delinquencies, although BarChris maintained such a record. Any inquiry on his part of Talcott or an examination of BarChris's correspondence with Talcott in April and May 1961 would have apprised him of the true facts. It would have led him to appreciate that the statement in this prospectus, carried over from earlier prospectuses, to the effect that since 1955 BarChris had been required to repurchase less than one-half of one per cent of discounted customers' notes could no longer properly be made without further explanation.

Grant was entitled to rely on Peat, Marwick for the 1960 figures. He had no reasonable ground to believe them to be inaccurate. But the matters which I have mentioned were not within the expertised portion of the prospectus. As to this, Grant was obliged to make a reasonable investigation. I am forced to find that he did not make one. After making all due allowances for the fact that BarChris's officers misled him, there are too many instances in which Grant failed to make an inquiry which he could easily have made which, if pursued, would have put him on his guard. In my opinion, this finding on the evidence in this case does not establish an unreasonably high standard in other cases for company counsel who are also directors. Each case must rest on its own facts. I conclude that Grant has not established his due diligence defenses except as to the audited 1960 figures.

The Underwriters and Coleman

The underwriters other than Drexel made no investigation of the accuracy of the prospectus. One of them, Peter Morgan, had underwritten the 1959 stock issue and had been a director of BarChris. He thus had some general familiarity with its affairs, but he knew no more than the other underwriters about the debenture prospectus. They all relied upon Drexel as the "lead" underwriter.

Drexel did make an investigation. The work was in charge of Coleman, a partner of the firm, assisted by Casperson, an associate. Drexel's attorneys acted as attorneys for the entire group of underwriters. Ballard did the work, assisted by Stanton.

. . .

By mid-March, Coleman was in a position to make more specific inquiries. By that time Grant had prepared a first draft of the prospectus, consisting of a marked-up copy of the January 1961 warrant prospectus. Coleman attended the meetings to discuss the prospectus with BarChris's representatives. The meetings were held at Perkins, Daniels' office on March 20, March 23 and March 24, 1961. Those present included Grant or his partner McCormack and Kircher for the company, and Coleman, Casperson and Ballard for the underwriters. Logan, Peat, Marwick's manager of the 1960 audit, was present at one of the meetings.

. . .

Coleman and Ballard asked pertinent questions and received answers which satisfied them. Among other things, the following transpired.

. . .

The alternative method of financing was explained. Kircher said that BarChris's contingent liability was only 25 per cent.

There was talk about operating alleys. Kircher said that BarChris did not operate any. Coleman and Ballard inquired whether BarChris built alleys on speculation, i.e., without any customer's contract for them. Kircher said BarChris did not.

There was discussion of officers' loans. Kircher said that the $155,000 had been repaid and that no further officers' loans were contemplated. Coleman said that this was wise, for loans from officers "indicated financial instability of the company."

. . .

After Coleman was elected a director on April 17, 1961, he made no further independent investigation of the accuracy of the prospectus. He assumed that Ballard was taking care of this on his behalf as well as on behalf of the underwriters.

In April 1961 Ballard instructed Stanton to examine BarChris's minutes for the past five years and also to look at "the major contracts of the company."23 Stanton went to BarChris's office for that purpose on April 24. He asked Birnbaum for the minute books. He read the minutes of the board of directors and discovered interleaved in them a few minutes of executive committee meetings in 1960. He asked Kircher if there were any others. Kircher said that there had been other executive committee meetings but that the minutes had not been written up.

Stanton read the minutes of a few BarChris subsidiaries. His testimony was vague as to which ones. He had no recollection of seeing the minutes of Capitol Lanes, Inc. or Biel or Parkway Lanes, Inc. He did not discover that BarChris was operating Capitol or that it planned to operate Bridge and Yonkers.

As to the "major contracts," all that Stanton could remember seeing was an insurance policy. Birnbaum told him that there was no file of major contracts. Stanton did not examine the agreements with Talcott. He did not examine the contracts with customers. He did not look to see what contracts comprised the backlog figure. Stanton examined no accounting records of BarChris. His visit, which lasted one day, was devoted primarily to reading the directors' minutes.

On April 25 Ballard wrote to Grant about certain matters which Stanton had noted on his visit to BarChris the day before, none of which Ballard considered "very earth shaking." As far as relevant here, these were (1) Russo's remark as recorded in the executive committee minutes of November 3, 1960 to the effect that because of customers' defaults, BarChris might find itself in the business of operating alleys; (2) the fact that the minutes of Sanpark Realty Corporation were incomplete; and (3) the fact that minutes of the executive committee were missing.

On May 9, 1961, Ballard came to New York and conferred with Grant and Kircher. They discussed the Securities and Exchange Commission's deficiency letter of May 4, 1961 which required the inclusion in the prospectus of certain additional information, notably net sales, gross profits and net earnings figures for the first quarter of 1961. They also discussed the points raised in Ballard's letter to Grant of April 25. As to the latter, most of the conversation related to what Russo had meant by his remark on November 3, 1960. Kircher said that the delinquency problem was less severe now than it had been back in November 1960, that no alleys had been repossessed, and that although he was "worried about one alley in Harlem" (Dreyfuss), that was a "special situation." Grant reported that Russo had told him that his statement on November 3, 1960 was "merely hypothetical." On the strength of this conversation, Ballard was satisfied that the one-half of one per cent figure in the prospectus did not need qualification or elaboration.

. . .

Like Grant, Ballard, without checking, relied on the information which he got from Kircher. He also relied on Grant who, as company counsel, presumably was familiar with its affairs.

The formal opinion which Ballard's firm rendered to the underwriters at the closing on May 24, 1961 made clear that this is what he had done. The opinion stated:

"In the course of the preparation of the Registration Statement and Prospectus by the Company, we have had numerous conferences with representatives of and counsel for the Company and with its auditors and we have raised many questions regarding the business of the Company. Satisfactory answers to such questions were in each case given us, and all other information and documents we requested have been supplied. We are of the opinion that the data presented to us are accurately reflected in the Registration Statement and Prospectus and that there has been omitted from the Registration Statement no material facts included in such data. Although we have not otherwise verified the completeness or accuracy of the information furnished to us, on the basis of the foregoing and with the exception of the financial statements and schedules (which this opinion does not pass upon), we have no reason to believe that the Registration Statement or Prospectus contains any untrue statement of any material fact or omits to state a material fact required to be stated therein or necessary in order to make the statements therein not misleading."


Coleman testified that Drexel had an understanding with its attorneys that "we expect them to inspect on our behalf the corporate records of the company including, but not limited to, the minutes of the corporation, the stockholders and the committees of the board authorized to act for the board." Ballard manifested his awareness of this understanding by sending Stanton to read the minutes and the major contracts. It is difficult to square this understanding with the formal opinion of Ballard's firm which expressly disclaimed any attempt to verify information supplied by the company and its counsel.

In any event, it is clear that no effectual attempt at verification was made. The question is whether due diligence required that it be made. Stated another way, is it sufficient to ask questions, to obtain answers which, if true, would be thought satisfactory, and to let it go at that, without seeking to ascertain from the records whether the answers in fact are true and complete?

I have already held that this procedure is not sufficient in Grant's case. Are underwriters in a different position, as far as due diligence is concerned?

The underwriters say that the prospectus is the company's prospectus, not theirs. Doubtless this is the way they customarily regard it. But the Securities Act makes no such distinction. The underwriters are just as responsible as the company if the prospectus is false. And prospective investors rely upon the reputation of the underwriters in deciding whether to purchase the securities.

. . .

The purpose of Section 11 is to protect investors. To that end the underwriters are made responsible for the truth of the prospectus. If they may escape that responsibility by taking at face value representations made to them by the company's management, then the inclusion of underwriters among those liable under Section 11 affords the investors no additional protection. To effectuate the statute's purpose, the phrase "reasonable investigation" must be construed to require more effort on the part of the underwriters than the mere accurate reporting in the prospectus of "data presented" to them by the company. It should make no difference that this data is elicited by questions addressed to the company officers by the underwriters, or that the underwriters at the time believe that the company's officers are truthful and reliable. In order to make the underwriters' participation in this enterprise of any value to the investors, the underwriters must make some reasonable attempt to verify the data submitted to them. They may not rely solely on the company's officers or on the company's counsel. A prudent man in the management of his own property would not rely on them.

It is impossible to lay down a rigid rule suitable for every case defining the extent to which such verification must go. It is a question of degree, a matter of judgment in each case. In the present case, the underwriters' counsel made almost no attempt to verify management's representations. I hold that that was insufficient.

On the evidence in this case, I find that the underwriters' counsel did not make a reasonable investigation of the truth of those portions of the prospectus which were not made on the authority of Peat, Marwick as an expert. Drexel is bound by their failure. It is not a matter of relying upon counsel for legal advice. Here the attorneys were dealing with matters of fact. Drexel delegated to them, as its agent, the business of examining the corporate minutes and contracts. It must bear the consequences of their failure to make an adequate examination.

The other underwriters, who did nothing and relied solely on Drexel and on the lawyers, are also bound by it. It follows that although Drexel and the other underwriters believed that those portions of the prospectus were true, they had no reasonable ground for that belief, within the meaning of the statute. Hence, they have not established their due diligence defense, except as to the 1960 audited figures.

The same conclusions must apply to Coleman. Although he participated quite actively in the earlier stages of the preparation of the prospectus, and contributed questions and warnings of his own, in addition to the questions of counsel, the fact is that he stopped his participation toward the end of March 1961. He made no investigation after he became a director. When it came to verification, he relied upon his counsel to do it for him. Since counsel failed to do it, Coleman is bound by that failure. Consequently, in his case also, he has not established his due diligence defense except as to the audited 1960 figures.

Peat, Marwick

Section 11(b) provides:

"Notwithstanding the provisions of subsection (a) no person . . . shall be liable as provided therein who shall sustain the burden of proof --

* * *

"(3) that . . . (B) as regards any part of the registration statement purporting to be made upon his authority as an expert . . . (i) he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading . . . ."

This defines the due diligence defense for an expert. Peat, Marwick has pleaded it.

The part of the registration statement purporting to be made upon the authority of Peat, Marwick as an expert was, as we have seen, the 1960 figures. But because the statute requires the court to determine Peat, Marwick's belief, and the grounds thereof, "at the time such part of the registration statement became effective," for the purposes of this affirmative defense, the matter must be viewed as of May 16, 1961, and the question is whether at that time Peat, Marwick, after reasonable investigation, had reasonable ground to believe and did believe that the 1960 figures were true and that no material fact had been omitted from the registration statement which should have been included in order to make the 1960 figures not misleading. In deciding this issue, the court must consider not only what Peat, Marwick did in its 1960 audit, but also what it did in its subsequent "S-1 review." The proper scope of that review must also be determined.

It may be noted that we are concerned at this point only with the question of Peat, Marwick's liability to plaintiffs. At the closing on May 24, 1961, Peat, Marwick delivered a so-called "comfort letter" to the underwriters. This letter stated:

"It is understood that this letter is for the information of the underwriters and is not to be quoted or referred to, in whole or in part, in the Registration Statement or Prospectus or in any literature used in connection with the sale of securities."


Plaintiffs may not take advantage of any undertakings or representations in this letter. If they exceeded the normal scope of an S-1 review (a question which I do not now decide) that is a matter which relates only to the cross claims which defendants have asserted against each other and which I have postponed for determination at a later date.

The 1960 Audit

Peat, Marwick's work was in general charge of a member of the firm, Cummings, and more immediately in charge of Peat, Marwick's manager, Logan. Most of the actual work was performed by a senior accountant, Berardi, who had junior assistants, one of whom was Kennedy.

Berardi was then about thirty years old. He was not yet a C.P.A. He had had no previous experience with the bowling industry. This was his first job as a senior accountant. He could hardly have been given a more difficult assignment.

. . .

In substance, what Berardi did is similar to what Grant and Ballard did. He asked questions, he got answers which he considered satisfactory, and he did nothing to verify them. . . .

. . .

Accountants should not be held to a standard higher than that recognized in their profession. I do not do so here. Berardi's review did not come up to that standard. He did not take some of the steps which Peat, Marwick's written program prescribed. He did not spend an adequate amount of time on a task of this magnitude. Most important of all, he was too easily satisfied with glib answers to his inquiries.

This is not to say that he should have made a complete audit. But there 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.

. . .

23. Stanton was a very junior associate. He had been admitted to the bar in January 1961, some three months before. This was the first registration statement he had ever worked on.