Barry ESCOTT

v.
BARCHRIS CONSTRUCTION CORP.
283 F.Supp. 643.
United States District Court, Southern District of New York.
March 29, 1968.

LEGAL & HISTORICAL SIGNIFICANCE

• This decision is the most complete and authoritative word on the scope of liability
under Section 11 of the Securities Act of 1933.

• The officers of BarChris Construction Corporation loaned money to the firm and
also arranged for corporate bank loans. To raise still more money, BarChris sold
bonds (certificates that evidence corporate debt). When BarChris did not repay
the bonds, Barry Escott and others who had bought them filed a suit in federal dis-
trict court. They alleged that the bonds’ registration statement (a document
that must be filed with the Securities and Exchange Commission in regard to se-
curities—which include stocks and bonds—disclosing information of interest to
potential investors) contained material false statements and omissions. The defen-
dants included BarChris’s officers and directors. Most of the misstatements
related to loans that BarChris had taken out, loans that BarChris had made, and
defaults on both. The defendants filed motions to dismiss the suit.

• The most significant issue for the court to address was the standard of care to
apply to the defendants.

CASE EXCERPTS
McLEAN, District Judge.

* * * *
Section 11(b) of the [Securities] Act [of 1933] provides that:

“ * * * no person, other than the issuer, shall be liable * * * who shall sus-
tain the burden of proof [the duty of proving a fact in dispute]—
* * * *
(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 investiga-
tion, reasonable ground to believe and did believe, at the time such part of the reg-
istration statement became effective, that the statements therein were true and
17
18 HANDBOOK OF LANDMARK CASES AND STATUTES, REVISED EDITION

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 * * * has pleaded these affirmative defenses [a response that

does not deny the facts but attacks the legal right to bring the suit]. Each claims that (1)
as to the part of the registration statement purporting to be made on the authority of an
expert * * * , 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 regis-
tration statement, he made a reasonable investigation, as a result of which he had rea-
sonable 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.
* * * *
I turn now to the question of whether defendants have proved their due diligence
[a reasonable investigation on which a party bases his or her belief about the truth of a
statement] defenses. The position of each defendant will be separately considered.

RUSSO
Russo was, to all intents and purposes, the chief executive officer of BarChris. He
was a member of the executive committee. He was familiar with all aspects of the
business. * * * He acted on BarChris’s behalf in making * * * financing agreements
* * * . He talked with customers about their delinquencies [failures to make payments
when due].
* * * He knew the status of [BarChris’s projects]. * * *
It was Russo who arranged for the temporary increase in BarChris’s cash in banks
* * * , a transaction which borders on the fraudulent. He was thoroughly aware of
BarChris’s stringent financial condition * * * . He had personally advanced large sums
to BarChris of which $175,000 remained unpaid * * * .
 ESCOTT v. BARCHRIS CONSTRUCTION CORP. 19

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 responsibil-
ity 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. [Emphasis added.]
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 * * * . They knew of their own large ad-
vances 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 pre-
sent purposes, from Russo’s. They could not have believed that the registration state-
ment 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.
[The court discussed the other defendants’ circumstances separately, applying the
highest standard of care to the insiders who, like Russo, Vitolo, and Pugliese, were
principal officers that are required to sign a registration statement. The court also took
into consideration each signer’s expertise, such as a legal or accounting background.]
* * * *
Defendants’ motions to dismiss this action * * * are denied.

FOR CRITICAL ANALYSIS

1. Should the court have allowed the officers of the corporation to avoid liability on the
ground that they relied on their attorneys and accountants to draft the statement properly?

2. Is it fair to hold someone liable on the basis of a document that they sign without
reading? Why or why not?
20 HANDBOOK OF LANDMARK CASES AND STATUTES, REVISED EDITION

CASE GLOSSARY
Affirmative defense A response that does not deny the facts of a plaintiff’s claim but
attacks the plaintiff’s legal right to bring the suit.
Bonds Certificates that evidence corporate debt.
Burden of proof The duty of proving a fact in dispute.
Due diligence A reasonable investigation on which a party bases his or her belief about
the truth of a statement.
Registration statement A document that must be filed with the Securities and Ex-
change Commission in regard to securities, disclosing information of interest to
potential investors.