## Facts

- Chadbourn, Inc. agreed to acquire Standard Knitting Mills, Inc. through a stock-for-stock exchange requiring approval by Standard’s shareholders via proxy solicitation.
- The proxy statement described the exchange as offering Standard shareholders a package of Chadbourn securities, including Chadbourn preferred stock touted as attractive for dividend return and liquidity.
- Chadbourn was subject to bank loan covenants restricting dividend payments on both common and preferred stock.
- The proxy materials disclosed restrictions on common dividends but did not clearly disclose that the same loan covenants also restricted dividends on the preferred stock offered to Standard shareholders.
- Peat, Marwick, Mitchell & Co., Chadbourn’s outside auditor, participated in preparing/reviewing financial information included in the proxy statement.
- After the merger, Chadbourn’s financial condition deteriorated substantially; a later reorganization/settlement shifted control of the combined company to the former Standard shareholders.
- Shareholders brought a class action alleging materially misleading proxy materials, asserting claims under § 10(b) and Rule 10b-5 and under § 14(a) and Rule 14a-9; most defendants settled, but Peat proceeded to trial.
- The district court found the omission material and found Peat’s conduct negligent, entered judgment against Peat for damages, prejudgment interest, and attorneys’ fees, but expressly did not find scienter.

## Issues

1. Whether private plaintiffs seeking damages under § 10(b) and Rule 10b-5 must prove scienter (intent to deceive or at least recklessness), rather than mere negligence, against an outside accounting firm involved in proxy-related disclosures.
2. Whether private plaintiffs seeking damages under § 14(a) and Rule 14a-9 must prove scienter, rather than negligence, for an accountant’s participation in preparing an allegedly misleading proxy statement.

## Decision

- The Sixth Circuit reversed the judgment against Peat.
- The court held that scienter is required for private damages claims under § 10(b) and Rule 10b-5 and that the record supported, at most, negligence.
- The court also held that scienter is required for private damages claims under § 14(a) and Rule 14a-9, at least as applied to an independent accounting firm participating in proxy statement preparation.
- Because the trial court found no scienter, Peat could not be held liable; the damages, prejudgment interest, and attorneys’ fee award were reversed.

## Legal Principles

- In a private action for damages under § 10(b) and Rule 10b-5, plaintiffs must prove scienter; negligence is insufficient.
- Scienter includes intentional misconduct and may include reckless disregard for the truth; a merely careless failure to disclose does not satisfy the requirement.
- In a private action for damages under § 14(a) and Rule 14a-9, scienter is required at least for primary liability of an outside accounting firm involved in proxy solicitation materials.
- When the factfinder expressly determines that an omission was not the result of scienter, liability for damages under Rule 10b-5 and Rule 14a-9 cannot stand.

## Conclusion

The Sixth Circuit set aside liability and monetary awards against an outside auditor because private damages claims for misleading omissions in merger-related proxy materials required proof of scienter under both Rule 10b-5 and Rule 14a-9, and the findings established only negligence.


Adams v. Standard Knitting Mills, Inc., 623 F.2d 422 (6th Cir. 1980)