The Domino Principle(1977)

(1) Overstated the current assets of Kinderhill in the amount of $11 million in accounts receivable due from the Limited Partnerships. Complaint at 35. Because these were the product of a ponzi scheme, it was highly improbable that any accounts receivable from the Limited Partnerships would be properly repaid. Id. at 61(a). Moreover, E & Y had been warned by its predecessor Peat, Marwick that should the general partner fail, the limited partnerships might fail also because they were so highly leveraged (the "domino effect statement"). Id. at 61(c). The plaintiffs allege that E & Y failed to include the domino effect statement in the notes to the audited balance sheet.

The Domino Principle(1977)

The plaintiffs base their claim of E & Y's knowledge of the Ponzi scheme on the Peat, Marwick's "domino" statement, on the disclaimer that the Limited Partnerships might have to sell off assets ahead of schedule, id. at 52, and on E & Y's knowledge of the frequency of the transactions between the limited partnerships at above-market rates. Id. at 45.

Even when taken together, these statements do not reveal scienter of the fraud. The domino statement can be explained simply in terms of the highly leveraged nature of the partnerships, which all parties knew about, and which was due to the partnerships' use as tax shelters. Id. at 45(b). The fact that the partnerships, at various points, had had to sell bloodstock ahead of schedule does not inherently imply a ponzi scheme. Even the admission that the partnerships engaged in numerous interpartnership transactions is not inherently *1102 suspicious, when even the plaintiffs admit that Kinderhill gave the impression that these were necessary for enabling the actual business of the partnerships horseraising to function properly. "Each of the partnerships enter into transactions (for stallion services, boarding and maintenance, bloodstock purchase/sale, advancing of funds, etc.) with the General Partner and other partnerships." Complaint at 45(c). Although plaintiffs allege that these interpartnership transactions inflated the assets, they simply allege that "all" the accounts were worthless ("The accounts receivable were in fact of no value because they were generated as part of the ponzi scheme described above." Id. at 61). The only factual allegations to support this are statistics to show that while assets may have been overvalued (e.g., "actual proceeds of 1984 sales were only at 75% of appraised value," id. at 42(c))) they were not valueless. The Second Amended Complaint still fails to allege adequately the amount of the purported overstatement. Quantum Overseas, N.V. v. Touche Ross & Co., 663 F. Supp. 658, 667 (S.D.N.Y.1987); Seiden v. Butcher, 458 F. Supp. 81, 83 (S.D.N.Y.1978) (plaintiff must specify what is overvalued, the amount of the overvaluation and facts underlying allegation that assets were "knowingly" overvalued).

The new factual claim that the plaintiffs make to support their allegations is that E & Y was aware that Kinderhill had guaranteed payment of the investor notes which the sureties had bonded for the various limited partnerships. The plaintiffs maintain this was a material fact since, in effect, it increased the liabilities of the general partner. Since a failure on the part of the highly-leveraged general partner would have the triggered the "domino effect," the plaintiffs seem to reason that any debts or obligations incurred by the general partner were therefore material. Although the conversations by which the auditors learned of this with Martin and other Kinderhill employees remain undated and unspecified, and therefore insufficiently particular, the plaintiffs state that E & Y must have learned of this extra potential liability since it reviewed the surety bonds securing the collection of the investor notes. Complaint at 82. Again this fails to allege scienter on the part of E & Y. Plaintiffs allege that "the financial well being of Martin and Kinderhill was necessary for the viability of the limited partnerships and Select," (at 81(h)) but this does not establish that Kinderhill would cease to be financially viable. Plaintiffs have cited no accounting principle which requires all security interests and pledges, of whatever kind, to be included on the annual balance sheet.[4]*1104 The omission of this contingent liability, without more, raises no inference of fraud and suggests only negligence. 041b061a72