Escott v. BarChris Construction Corp.

United States District Court for the Southern District of New York · 1976 · Corporations

283 F. Supp. 643 (1976)

Updated August 1, 2026

CorporationsSection 11 liabilitydue diligenceSecurities Act of 1933Section 11material misstatementmaterial omissionregistration statement

Facts

BarChris sold debentures under a registration statement that became effective on May 16, 1961. The prospectus overstated or misstated several matters, including 1961 sales and gross profit, backlog, contingent liabilities, officers' loans, the intended use of proceeds, customer delinquencies, and the extent to which BarChris was operating bowling alleys. The defendants included BarChris, directors and officers who signed the registration statement, the underwriters, and BarChris's auditors, Peat, Marwick. Most nonissuer defendants claimed the Section 11 due diligence defense, asserting they reasonably believed the prospectus was accurate.

Issue

Whether the registration statement contained material false statements or omissions under Section 11, and if so, whether the nonissuer defendants established the statutory due diligence defenses. More specifically, the court considered what constitutes a reasonable investigation for directors, underwriters, and accountants, and how expertised and non-expertised portions of the registration statement should be treated.

Rule

Under Section 11, a nonissuer defendant avoids liability only by sustaining the burden of proving that, as to non-expertised portions of the registration statement, after reasonable investigation he had reasonable ground to believe and did believe the statements were true and complete, and as to expertised portions, he had no reasonable ground to believe and did not believe they were false or misleading. Reasonable investigation is measured by the standard of a prudent man in the management of his own property. Materiality turns on whether the misstated or omitted fact is one as to which an average prudent investor ought reasonably to be informed before purchasing, meaning a fact that would have deterred or tended to deter the average prudent investor from buying the security.

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Lakefront Leisure Systems, a Chicago company, sold debentures under a registration statement. The prospectus overstated the issuer’s prior-year sales by 6% and earnings per share by 8%, but still showed dramatic year-over-year growth; it also accurately disclosed that the debentures were speculative and convertible. There were no inaccuracies about current-year operations or liquidity.

Purchasers sue under Section 11 based only on the prior-year sales and earnings errors. Which is the strongest argument for the defendants under the governing materiality standard?

Explanation. Materiality turns on whether the misstated fact is one as to which an average prudent investor ought reasonably to be informed before purchasing—i.e., whether correct disclosure would have deterred or tended to deter the average prudent investor. The opinion treated some inaccuracies in older annual sales and earnings as not material where the company still showed striking growth and the security was speculative. Section 11 does not make every inaccuracy material.