This is an action by purchasers of 5 percent convertible subordinated fifteen year debentures of BarChris Construction

This is an action by purchasers of 5½ percent convertible subordinated fifteen year debentures of BarChris Construction Corporation (BarChris). * * *

The action is brought under Section 11 of the Securities Act of 1933. 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).

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Defendants, in addition to denying that the registration statement was false, have pleaded the defense open to them under Section 11 of the Act, * * *.

* * * 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?

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In December 1959, BarChris sold 560,000 shares of common stock to the public at $3.00 per share. This 950 Part 9 Regulation of Business 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 [bowling] 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.

[The court found that the registration statement contained material false statements.]

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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—

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(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 follow:

In determining, for the purposes 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. * * *

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

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Kircher 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. * * *

Moreover, as a member of the executive committee, Kircher was kept informed as to those branches of the business of which he did not have direct charge.

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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. * * *

Kircher has not proved his due diligence defenses. 

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Birnbaum 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.

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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. * * *

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 * * *. 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 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. * * *

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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. * * *

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.

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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 disclosures for the protection of investors.

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The Underwriters The underwriters other than Drexel made no investigation of the accuracy of the 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.

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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.

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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.