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        Garey & Garey, New York City, for plaintiffs, Wm. Francis Corson, Allan K. Peckel, New York City, of counsel.

        Alex L. Rosen, New York City, for defendant, BarChris Construction Corp.

        Davis, Polk & Wardwell, New York City, for defendants Drexel & Co., and others, Ralph M. Carson, Thomas P. Griesa, New York City, of counsel.

        Milbank, Tweed, Hadley & McCloy, New York City, Attorneys for defendant,

Page 652

Peat, Marwick, Mitchell & Co., A. Donald MacKinnon, Andrew J. Connick, New York City, of counsel.

        Olwine, Connelly, Chase, O'Donnell & Weyher, New York City, for defendant, Grant, John Logan O'Donnell, James E. Tolan, New York City, of counsel.

        Sims & Friedman, New York City, for defendants, Vitolo, Russo and Pugliese, Theodore R. Schreier, New York City, of counsel.

        Emmet, Marvin & Martin, New York City, for defendants, Kircher and Trilling, James J. Higginson, New York City, of counsel.

        Schoengold & Sporn, New York City, for defendant, Birnbaum, Max Schoengold, New York City, of counsel.

        Ferris, Bangs, Davis, Trafford & Syz, New York City, for defendant, Auslander, Lyon Boston, New York City, of counsel.

        Mullane & Moukad, New York City, for defendant, Rose, Joseph E. Moukad, New York City, of counsel.

        McLEAN, District Judge.

        This is an action by purchasers of 5 per cent convertible subordinated fifteen year debentures of BarChris Construction Corporation (BarChris). Plaintiffs purport to sue on their own behalf and "on behalf of all other and present and former holders" of the debentures. When the action was begun on October 25, 1962, there were nine plaintiffs. Others were subsequently permitted to intervene. At the time of the trial, there were over sixty.

        The action is brought under Section 11 of the Securities Act of 1933 (15 U.S.C. § 77k). 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);¹ and (3) BarChris's auditors, Peat, Marwick, Mitchell & Co. (Peat, Marwick).

        The signers, in addition to BarChris itself, were the nine directors of BarChris, plus its controller, defendant Trilling, who was not a director. Of the nine directors, five were officers of BarChris, i. e., defendants Vitolo, president; Russo, executive vice president; Pugliese, vice president; Kircher, treasurer; and Birnbaum, secretary. Of the remaining four, defendant Grant was a member of the firm of Perkins, Daniels, McCormack & Collins, BarChris's attorneys. He became a director in October 1960. Defendant Coleman, a partner in Drexel, became a director on April 17, 1961, as did the other two, Auslander and Rose, who were not otherwise connected with BarChris.

        Defendants, in addition to denying that the registration statement was false, have pleaded the defenses open to them under Section 11 of the Act, plus certain additional defenses, including the statute of limitations. Defendants have also asserted cross-claims against each other, seeking to hold one another liable for any sums for which the respective defendants may be held liable to plaintiffs.

        This opinion will not concern itself with the cross-claims or with issues peculiar to any particular plaintiff. These matters are reserved for later decision. 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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        Before discussing these questions, some background facts should be mentioned. At the time relevant here, BarChris was engaged primarily in the construction of bowling alleys, somewhat euphemistically referred to as "bowling centers." These were rather elaborate affairs. They contained not only a number of alleys or "lanes," but also, in most cases, bar and restaurant facilities.

        BarChris was an outgrowth of a business started as a partnership by Vitolo and Pugliese in 1946. The business was incorporated in New York in 1955 under the name of B & C Bowling Alley Builders, Inc. Its name was subsequently changed to BarChris Construction Corporation.

        The introduction of automatic pin setting machines in 1952 gave a marked stimulus to bowling. It rapidly became a popular sport, with the result that "bowling centers" began to appear throughout the country in rapidly increasing numbers. BarChris benefited from this increased interest in bowling. Its construction operations expanded rapidly. It is estimated that in 1960 BarChris installed approximately three per cent of all lanes built in the United States. It was thus a significant factor in the industry, although two large established companies, American Machine & Foundry Company and Brunswick, were much larger factors. These two companies manufactured bowling equipment, which BarChris did not. They also built most of the bowling alleys, 97 per cent of the total, according to some of the testimony.

        BarChris's sales increased dramatically from 1956 to 1960. According to the prospectus, net sales, in round figures, in 1956 were some $800,000, in 1957 $1,300,000, in 1958 $1,700,000. In 1959 they increased to over $3,300,000, and by 1960 they had leaped to over $9,165,000.²

        For some years the business had exceeded the managerial capacity of its founders. Vitolo and Pugliese are each men of limited education. Vitolo did not get beyond high school. Pugliese ended his schooling in seventh grade. Pugliese devoted his time to supervising the actual construction work. Vitolo was concerned primarily with obtaining new business. Neither was equipped to handle financial matters.

        Rather early in their career they enlisted the aid of Russo, who was trained as an accountant. He first joined them in the days of the partnership, left for a time, and returned as an officer and director of B & C Bowling Alley Builders, Inc. in 1958. He eventually became executive vice president of BarChris. In that capacity he handled many of the transactions which figure in this case.

        In 1959 BarChris hired Kircher, a certified public accountant who had been employed by Peat, Marwick. He started as controller and became treasurer in 1960. In October of that year, another ex-Peat, Marwick employee, Trilling, succeeded Kircher as controller. At approximately the same time Birnbaum, a young attorney, was hired as house counsel. He became secretary on April 17, 1961.³

        In general, BarChris's method of operation was to enter into a contract with a customer, receive from him at that time a comparatively small down payment on the purchase price, and proceed to construct and equip the bowling alley. When the work was finished and the building delivered, the customer paid the balance of the contract price in notes, payable in installments over a period of

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years. BarChris discounted these notes with a factor and received part of their face amount in cash. The factor held back part as a reserve.

        In 1960 BarChris began a practice which has been referred to throughout this case as the "alternative method of financing." In substance this was a sale and leaseback arrangement. It involved a distinction between the "interior" of a building and the building itself, i. e., the outer shell. In instances in which this method applied, BarChris would build and install what it referred to as the "interior package." Actually this amounted to constructing and installing the equipment in a building. When it was completed, it would sell the interior to a factor, James Talcott Inc. (Talcott), who would pay BarChris the full contract price therefor. The factor then proceeded to lease the interior either directly to BarChris's customer or back to a subsidiary of BarChris. In the latter case, the subsidiary in turn would lease it to the customer.

        Under either financing method, BarChris was compelled to expend considerable sums in defraying the cost of construction before it received reimbursement.⁴ As a consequence, BarChris was in constant need of cash to finance its operations, a need which grew more pressing as operations expanded.

        In December 1959, BarChris sold 560,000 shares of common stock to the public at $3.00 per share. This 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 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.⁵ BarChris defaulted in the payment of the interest due on November 1, 1962 on the debentures.

        In preparing the registration statement for the debentures, Grant acted for BarChris. He had previously represented BarChris in preparing the registration statement for the common stock issue. In connection with the sale of common stock, BarChris had issued purchase warrants. In January 1961 a second registration statement was filed in order to

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update the information pertaining to these warrants. Grant had prepared that statement as well.

        Some of the basic information needed for the debenture registration statement was contained in the registration statements previously filed with respect to the common stock and warrants. Grant used these old registration statements as a model in preparing the new one, making the changes which he considered necessary in order to meet the new situation.

        The underwriters were represented by the Philadelphia law firm of Drinker, Biddle & Reath. John A. Ballard, a member of that firm, was in charge of that work, assisted by a young associate named Stanton.

        Peat, Marwick, BarChris's auditors, who had previously audited BarChris's annual balance sheet and earnings figures for 1958 and 1959, did the same for 1960. These figures were set forth in the registration statement. In addition, Peat, Marwick undertook a so-called "S-1 review," the proper scope of which is one of the matters debated here.

        The registration statement in its final form contained a prospectus as well as other information. Plaintiffs' claims of falsities and omissions pertain solely to the prospectus, not to the additional data.

        The prospectus contained, among other things, a description of BarChris's business, a description of its real property, some material pertaining to certain of its subsidiaries, and remarks about various other aspects of its affairs. It also contained financial information. It included a consolidated balance sheet as of December 31, 1960, with elaborate explanatory notes. These figures had been audited by Peat, Marwick. It also contained unaudited figures as to net sales, gross profit and net earnings for the first quarter ended March 31, 1961, as compared with the similar quarter for 1960. In addition, it set forth figures as to the company's backlog of unfilled orders as of March 31, 1961, as compared with March 31, 1960, and figures as to BarChris's contingent liability, as of April 30, 1961, on customers' notes discounted and its contingent liability under the so-called alternative method of financing.

        Plaintiffs challenge the accuracy of a number of these figures. They also charge that the text of the prospectus, apart from the figures, was false in a number of respects, and that material information was omitted. Each of these contentions, after eliminating duplications, will be separately considered.⁶

        The earnings figure set forth at page 4 of the prospectus shows net sales for the calendar year 1960 of $9,165,320. Plaintiffs claim that this figure was overstated by $2,525,350. They assert that it necessarily follows that the figure of $1,742,801 shown in the prospectus as net operating income for 1960, and the figure of earnings per share of $.75, were also incorrect.

        The net sales figure included amounts actually billed by BarChris for alleys completed by it in 1960 and amounts considered billable, although not in fact billed, for alleys not completed but still in process at the end of the year. The latter amounts were computed by using the percentage of completion method. The fact that this method was employed was disclosed in a footnote to the earnings table on page 4 of the prospectus.

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        The greater part of the alleged overstatement of net sales is attributable to the use of the percentage of completion method. It accounts for $2,002,250 out of the total alleged overstatement of $2,525,350. Plaintiffs contend that the percentage of completion method should not have been used at all, i. e., that nothing should have been included in sales for alleys on which construction was still in progress on December 31, 1960. They say further that in any event this method was not properly applied, so that the amount included for such transactions was incorrect, even assuming that it was appropriate to include something for them.

        By and large, I do not accept these contentions. The evidence shows that generally accepted accounting principles sanction the inclusion in sales for one year of part of the consideration ultimately to be received for work in progress which spreads over more than one year. Otherwise the figures would be distorted by reflecting the entire consideration in the sales for the year in which the work was finally completed. The same principle had been followed by BarChris, with Peat, Marwick's knowledge and approval, in 1959. I find that it was proper to employ it also for 1960.

        I also find that, except for two specific instances hereinafter noted, this principle was correctly applied in determining the amount to be included in 1960 sales for these uncompleted jobs.

        BarChris had records of the cost actually expended on each job up to December 31, 1960. The accuracy of these figures is not challenged by plaintiffs. BarChris's engineering department, under Pugliese's supervision, prepared estimates of the costs which were still to be incurred in order to complete each job. The total of the past costs plus estimated future costs constituted the estimated total cost for each job. Comparison of the costs to date with the total estimated cost showed the extent to which each job had been completed by December 31, 1960, i. e., the percentage of completion.

        In the course of its audit of BarChris's records for 1960, Peat, Marwick made an independent check of the accuracy of BarChris's estimate. Berardi, Peat, Marwick's senior accountant engaged in this audit, tabulated BarChris's actual costs on eleven jobs, both large and small, which BarChris had completed. By subtracting the total cost from the contract price, he computed the profit which BarChris had actually made on each job. The percentage of profit to contract price varied from one job to another. The overall average was approximately 25 per cent.

        Proceeding on the assumption, for the purposes of this test check, that the profit on each presently uncompleted job would also be 25 per cent, Berardi deducted this from the contract price of the job. The difference represented the total cost. With two exceptions, these cost figures tallied closely with Pugliese's estimates and produced approximately the same percentage of completion for each job. Having thus satisfied himself of the reasonable accuracy of the percentage, Berardi, except in two instances, applied this percentage to the total contract price of each unfinished job and included in 1960 sales that percentage of the total contract price as having been earned in 1960.

        Plaintiffs quarrel with Berardi's test check. They point out that if he had used a different group of completed jobs in his analysis, he would have come up with a lower average profit figure and hence with a higher total cost and eventually with a lower percentage of completion on the unfinished jobs. This is, of course, true. By the same token, still another group of jobs might have produced a higher profit and hence a lower total cost and a higher percentage of completion. There is no convincing evidence to show that the procedure which Berardi employed was not compatible with good accounting practice. Viewed as of the time of the audit, without regard to

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later events not then known, Berardi's method seems to me to have been reasonable. On the whole, therefore, I find that plaintiffs have failed to prove that the net sales figure was false by reason of the inclusion in it of amounts attributable to unfinished contracts.

        It remains to consider the two exceptions. These jobs were Worcester and Atlas-Bedford. In these instances Berardi's test check yielded a markedly different result from that produced by Pugliese's estimates. Consistent application of Berardi's 25 per cent profit formula would have indicated that these jobs were only 57 per cent and 48 per cent completed, respectively, on December 31, 1960.

        Pugliese's estimate, plus actual costs to date, indicated completion percentages of approximately 78 per cent and 82 per cent respectively. Berardi treated each job as 100 per cent completed. He included in 1960 sales the full contract price of $460,000 for Worcester and $265,000 for Atlas-Bedford.

        Berardi did this on the theory that each job was so nearly finished that for practical purposes it could be considered fully completed. The evidence does not bear this out. A report of an actual inspection of Worcester on January 4, 1961 indicated a 75 per cent completion by that date. No report of any physical inspection of Atlas-Bedford was produced.

        It could be argued that to be consistent, Berardi should have used his own formula with respect to these two alleys. To have done so would have produced sales as to them of only approximately one-half of the amount which he included.

        It is manifest, however, that a strict application of the formula would have been inappropriate, at least in the case of Worcester, for physical inspection of that job showed that in fact it was much nearer completion than 57 per cent. Hence it was proper to reject in this instance the formula based on historical experience with other jobs.

        There was no justification, however, for treating these two jobs as fully finished. The highest percentage of completion which the evidence permits is that indicated by Pugliese's estimates. I find that it would have been correct to use his figures. On that basis, the result is as follows: 78 per cent of the Worcester contract price of $460,000 is $358,800. The difference between that and $460,000 is $101,200. The sales figure for Worcester was therefore overstated by $101,200. 82 per cent of the Atlas-Bedford contract price of $265,000 is $217,300. The difference between that amount and $265,000 is $47,700. The Atlas-Bedford sales figure was thus overstated by $47,700.

        Plaintiffs claim that the inclusion of any sales figure for Worcester and Atlas was incorrect for a wholly different reason. They say that the Worcester contract was cancelled. But actually the cancellation was merely the substitution of a new purchaser for the original one. This substitution occurred in March 1961. There was no reduction in the contract price. The alley was eventually built and the new customer was billed for the full contract price in June 1961. There is thus no merit to plaintiffs' contention.

        As to Atlas-Bedford, plaintiffs point to the fact that the original contract dated August 12, 1960, with a contract price of $265,000, the figure used in computing the 1960 sales, was superseded in 1961 by a new contract containing a reduced contract price of $202,000, a difference of $63,000. They argue that $202,000 should have been the figure used in the 1960 computation. But the testimony is that the superseding contract was made in order to give Atlas the benefit of a $63,000 credit to which it was entitled because BarChris did not furnish certain equipment. The evidence is that this credit was reflected on BarChris's books by reducing sales in the first quarter of 1961, which appears to be the time when the credit arose. I am not persuaded that the 1960 rather than the 1961 sales should have been reduced

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by this credit. Consequently, I do not accept plaintiffs' contention in this respect.

        I turn now to plaintiffs' other criticisms of the 1960 net sales figure.

        Plaintiffs claim that the full contract price of this job was included in 1960 sales in disregard of the fact that the contract price had been reduced by $18,100. I reject this contention. It is true that the contract price was reduced and it is also true that the work papers list the full contract price of $181,000 without specific reference to this reduction. But the work papers also include a lump sum adjustment of $61,056.54 put in to make the figures on the work sheets agree with the sales account in the general ledger. The general ledger account is made up of many plusses and minusses, i. e., increases and reductions of sales. It sufficiently appears that the reduction of $18,100 in the Westover contract price was reflected in this account. Thus, the lump sum adjustment of $61,056.54 brought this reduction into the final computation. It was taken into account despite the fact that the work papers did not specifically mention it.

        Here plaintiffs point out that the work sheets included in sales the sum of $136,000 for this job. Of this sum, $111,000 was the original contract price and $25,000 was labeled "extra work." But BarChris's books of account show the receipt of only $111,000 on the Burke Lanes contract.

        The explanation offered by defendants merely confirms plaintiffs' contention that this $25,000 should not have been included. It was not part of the price of any construction. The testimony is that it was in effect a loan made by BarChris to Burke's landlord, a payment made by BarChris to a third person at the landlord's request for his account. It is impossible to tell whether the landlord ever repaid BarChris the $25,000, except that apparently he did pay $600 in October 1960. In any event, this $25,000 was not a sale and should not have been included in the sales figure.

        We come now to items of more importance, namely, the inclusion in 1960 sales of the contract price of completed alleys which in fact were not sold by BarChris.

        Capitol was also known as Heavenly Lanes.⁷ The premises were located in East Haven, Connecticut.

        Heavenly Lanes was listed in the 1960 computations as a completed contract. The contract price of $330,000 was included in 1960 sales.

        BarChris originally had a contract to construct Heavenly Lanes for an outside customer. Despite all the testimony on this subject, the date of the contract and the name of the customer never emerged. In any event, it is clear that that customer did not go through with the contract.

        On July 29, 1960, BarChris entered into a contract with its wholly-owned subsidiary, BarChris Leasing Corporation, described in the contract as the purchaser, to build this alley. BarChris went ahead and constructed the alley and completed it before December 31, 1960. It never sold it to any outside interest. Purely as a financing mechanism, it sold the alley to Talcott, a factor, who leased it back to Capitol Lanes, Inc., a new corporation organized by BarChris in December 1960, the stock of which was owned by Sanpark Realty Corp., itself a wholly owned subsidiary of BarChris.

        Capitol Lanes, Inc. operated the alley beginning in December 1960. BarChris's minutes show that BarChris contemplated

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its operation as early as November 22, 1960. There is no doubt that nothing should have been included in the 1960 sales figure for this alley. Consequently, the sales figure was inflated by $330,000.

        On January 15, 1960, BarChris entered into a contract with Howard Lanes Company, a Connecticut partnership, to build an alley in Greenwich, Connecticut, for $320,000. It was to contain tenpin lanes. This alley was built and sold and no question is raised as to the propriety of including the $320,000 in 1960 sales.

        Prior to the end of 1960, the purchaser decided that it also wanted an annex to be constructed to house duckpin lanes. The contract price for the annex was $150,000. This sum was also included in the 1960 sales figures.

        BarChris agreed to build the annex and eventually did build it. But it did not sell it to Howard Lanes. Instead, it retained title through a subsidiary and leased the annex to Howard. Although there was some testimony to the effect that Howard had an option to buy the property, this was not established by any documentary evidence, for the lease was never produced. The testimony on the subject is not sufficiently definite to be credible.

        Some of the documents on this subject are dated in the spring of 1961. Thus, on March 1, 1961, BarChris entered into a contract with its wholly owned subsidiary, BarChris Leasing Corporation, for the construction of the annex. This contract apparently was executed as a preliminary to obtaining financing for this project which was secured from a lender known as Credit Industrial Corporation in 1961.

        Although the fact that these documents were executed in March 1961 rather than in 1960 has a bearing upon whether Peat, Marwick should have discovered them in the course of its 1960 audit, that is not the present question. It is clear for present purposes that the $150,000 should not have been included in 1960 sales because the annex was not sold. Consequently, the sales figure was overstated by that amount.

        Bridge Lanes was a job which was in process on December 31, 1960. A portion of the contract price of this job was included in 1960 sales on the percentage of completion method.

        BarChris had a contract to build this alley for a company known as Biel Land & Development Company. In the spring of 1961 BarChris acquired the stock of Biel and thereafter operated the alley through a subsidiary of BarChris, Parkway Lanes, Inc. Although this transaction has a bearing upon the accuracy of the figures for March 31, 1961, a subject to be discussed hereinafter, it seems to have no relevance to the accuracy of the December 31, 1960 sale figure. As of that date, BarChris was performing a contract with an outside purchaser. It was, therefore, proper to include a portion of that contract price in 1960 sales.

        To recapitulate, I find that the 1960 sales figure of $9,165,320, as stated in page 4 of the prospectus, was inaccurate in that it included the following amounts which should not have been included:

Worcester                       $101,200
Atlas-Bedford                     47,700
Burke                             25,000
Capitol                          330,000
Howard Lane Annex                150,000
                               _________
                    Total       $653,900

        The total figure, instead of $9,165,320, should have been $8,511,420.

        It necessarily follows that the figure for net operating income for 1960 appearing on page 4 of the prospectus was also incorrect. The extent to which it was incorrect depends upon the extent to which the incorrect sales figure for the five alleys in question was carried into profits.

Page 660

        In the case of Capitol, an alley completed in 1960, the difference between its contract price and its cost was reflected in profits. This difference was $89,773. Since the alley was not sold, no profit should have been taken on it. Hence, as to this alley, profits were inflated by $89,773.

        The same is true of Howard Lanes Annex. Here the sum incorrectly included in profits was $72,846.

        As to Burke, the entire $25,000 erroneously added to the contract price was carried into profits. Since the $25,000 was not part of the contract price of the job, no part of this sum should have been reflected in profits.

        Worcester and Atlas-Bedford, as we have seen, were incorrectly treated as fully completed in 1960. The difference between their contract price and their total cost, actual and estimated, was treated as profit. This amount, in the case of Worcester, was $197,280, and in the case of Atlas-Bedford, $143,706. The correct profit figure for 1960 was the difference between that portion of the contract price which was properly includible in sales and the cost actually incurred in 1960. This figure in the case of Worcester is approximately $161,000 and in the case of Atlas-Bedford, $121,000. Profits on Worcester were thus inflated by the difference between $197,280 and $161,000 i. e., $36,280, and as to Atlas-Bedford, by the difference between $143,706 and $121,000, i. e., $22,706.

        It follows that profit, and consequently net operating income, was overstated in the following amounts:

Capitol               $ 89,773
Howard Lanes Annex      72,846
Burke                   25,000
Worcester               36,280
Atlas-Bedford           22,706
                      ________
              Total   $246,605

        The net operating income, instead of $1,742,801, should have been $1,496,196.

        Since the net operating income figure was incorrect, it necessarily follows that the ultimate result of the entire table, i. e., the earnings per share figure, was incorrect. The evidence does not permit precise determination of the amount of this error. Since the net operating income figure as restated is approximately 14 per cent less than the figure stated in the prospectus, it would seem to be true, speaking roughly, that the earnings per share figure should be reduced by approximately the same percentage. To do so would produce an earnings per share figure of approximately 65 per share rather than 75.

        The prospectus contained a balance sheet as of December 31, 1960 of BarChris and consolidated subsidiaries. This was audited by Peat, Marwick. Plaintiffs attack its accuracy on a variety of grounds.

        They charge that current assets were grossly overstated because several items were incorrectly classified as current. These are discussed below.

        Cash on hand as of December 31, 1960, as per the balance sheet, amounted to $285,482. This amount actually was on hand on that day. But plaintiffs contend, and I believe correctly, that certain rather peculiar circumstances relating to this cash balance should have been disclosed.

        The evidence is that Talcott held certain reserves in the sum of $147,466.80 as security with respect to customers' notes discounted with Talcott by BarChris Financial Corporation, a wholly owned subsidiary of BarChris. The accounts of BarChris Financial Corporation were not consolidated with those of BarChris in the balance sheet, as the accounts of the other subsidiaries were. BarChris Financial Corporation was covered only by a blind reference to "Investments In (At Equity) And Advances to Non-Consolidated Subsidiary."

        On December 22, 1960, at Russo's request, Talcott released the $147,466.80 to

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BarChris Financial Corporation temporarily, on the latter's agreement to redeposit it with Talcott not later than January 16, 1961, so that Talcott could continue to hold it as security. BarChris Financial Corporation then paid $145,000 of this sum to BarChris, which put it into one of BarChris's bank accounts. It was thus reflected in the cash balance as of December 31, 1960.⁸

        Plaintiffs claim that this transaction was arranged by Russo in order to increase BarChris's cash temporarily, so that its financial condition would look better on December 31, 1960. No other explanation was offered by defendants and I can see none.

        As far as the accuracy of the balance sheet is concerned, the $145,000 undoubtedly was an asset of BarChris Financial Corporation, subject only to Talcott's lien. It would seem that under the circumstances it would have been more accurate to include this amount, not in cash, but in "investment in non-consolidated subsidiary." The latter item is not a current asset, hence to put it there would have reduced current assets by $145,000. In any event, to treat it as cash on hand without some explanation of the temporary character of the deposit was misleading. The incident is important for the light that it sheds upon BarChris's business practices. This has a bearing upon the credibility of some of BarChris's officers and the weight to be given to their testimony in other respects.

        The balance sheet includes in current assets trade accounts receivable in the sum of $1,722,643. Plaintiffs assert that $1,157,973 of this total was improperly classified as current. This is the sum of amounts due from purchasers of seven different alleys. None of these amounts had been due for more than ninety days. The contracts provided that the customers would pay by delivering notes payable over a period of years. Plaintiffs say that only that portion of the receivable which would be represented by notes payable within one year should have been treated as a current asset.

        But it is clear that BarChris's practice was to discount such notes, as soon as it received them, with a factor. Upon discounting them, BarChris would receive at once in cash the full amount of the notes, less such reserve as the factor might retain as security. This practice was disclosed in a footnote to the balance sheet. In view of this fact, I find that these receivables were properly classified as a current asset.

        Plaintiffs also complain about a receivable due from Federal Lanes representing a down payment under its contract for the purchase of an alley. The amount was $125,000. It had been overdue since July 31, 1960. As it turned out, BarChris never did collect this $125,000. Federal eventually went into bankruptcy. Plaintiffs say that the uncollectibility of this debt was so obvious on December 31, 1960 that a full reserve should have been set up against it, thereby reducing current assets accordingly.

        Russo seems to have believed that $100,000 of this $125,000 had been paid by the delivery by Federal and the acceptance by BarChris of 36,400 shares of Federal stock in lieu of cash. Of course, if this were true, $100,000 was not a receivable at all, and the stock

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should have been shown as an asset of BarChris. This was not done.

        The agreement between Federal and BarChris on this subject was not lucidly expressed. However, it is clear that, Russo notwithstanding, BarChris's accounting department did not treat the receipt of this stock as part payment. Instead, they treated it on BarChris's books as security for an account receivable still unpaid in the amount of $125,000. It was because of the existence of this security, which on December 31, 1960 had some value, plus the existence of additional security in the form of a mortgage, that it was decided to treat this $125,000 as fully collectible.

        There are other facts, in addition to the age of this receivable, which cast doubt on the wisdom of this decision. Federal had also delivered notes to BarChris in payment of the balance of the purchase price over and above the down payment. These notes were discounted with Talcott. On December 31, 1960 they were in arrears to the extent of $24,366.66. This was substantially more than the arrearages of any other customer on notes discounted with Talcott as of that date. This was a clear indication, if any were needed, that all was not right with Federal.

        I am well aware that this question of adequate reserves must be determined in the light of the facts as they existed at the time, not as they later developed. Nevertheless, I believe that the prospects for Federal were so bad, even on December 31, 1960, that some reserve should have been set up against the probability that this $125,000 would never be collected. In view of the security in the form of the stock and the mortgage, a reserve of the full $125,000 would not appear to have been necessary. I find that a reserve of at least $50,000 should have been created, and that the current assets should have been reduced in that amount.

        Trade accounts receivable included $150,000 for Howard Lanes Annex. As previously found, this alley was not sold to an outside buyer. At best, this was a receivable due from a consolidated subsidiary of BarChris. It should not have been included in the balance sheet, which purported to eliminate intercompany transactions.

        Among current assets was an item labeled "Financial Institutions on Notes Discounted" $264,689. This was the amount of the reserves withheld by factors on customers' notes discounted with them by BarChris and consolidated subsidiaries. As the notes were paid by the customer to the factors, the reserves were released proportionately by the factors to BarChris. This was explained in a footnote to the balance sheet.

        There is no doubt that this money was an asset of BarChris. There is no attack upon the accuracy of the figure. The claim is that it was not a current asset and should not have been so classified because (1) part of the reserve, in the normal course of events, would not have been released within one year; and (2) some of it might not be released at all, for some of the customers' notes held by the factors were already in arrears. It seems to be true that it could not reasonably be anticipated that all the reserves would be released within one year, as the notes were payable over several years. I believe, therefore, that plaintiffs are correct in their first contention and that this item, in part, at least, should not have been classified as a current asset.

        Next we come to an item under current assets labeled "Charges to customers on contracts in progress (note 2) * * * $1,671,945." Note 2 explained that:

        "Charges to customers on contracts in progress represent the approximate sales value of work completed for the year ended December 31, 1960 determined by applying the estimated percentages

Page 663

of completed work to the total contract values."

        Plaintiffs repeat their contention that the percentage of completion method should not have been employed at all and that nothing should have been included for work in progress. I have already ruled against plaintiffs on this point in discussing the 1960 sales figure.

        In addition, plaintiffs say that in any case this was not a current asset. This contention is answered by what I have already said with respect to the $1,157,973 included in trade accounts receivable. The approximate sales value of the jobs in progress on December 31, 1960 was properly classified as a current asset because it could reasonably be expected that within a year this value would be represented by customers' notes which BarChris could discount and thereby obtain immediate cash.

        Plaintiffs have not established their claim that the BarChris current assets were grossly overstated in the balance sheet. What it boils down to is (1) $145,000 included in cash would more properly have been included in "Investment in Non-consolidated Subsidiary"; (2) current assets should have been reduced by a $50,000 reserve on Federal Lanes; (3) trade accounts receivable were overstated by $150,000 by including Howard Lanes Annex; (4) "Financial institutions on notes discounted $264,689" should have been treated, at least in part, as a noncurrent asset.

        At most, net current assets should have been reduced by the total of these items, $609,689, which would have made them $3,914,332, instead of $4,524,021.

        Footnote 9 to the balance sheet stated:

        "BarChris Construction Corporation in the normal course of its business either accepts customers' installment notes with maturities up to seven years as part payment for products sold and services performed, which notes for the most part are subsequently discounted with financial and other institutions, or sells directly to financial institutions who in turn lease to bowling alley operators (reference is made to the caption `Method of Operation' in this Prospectus).

        "On December 31, 1960 the Company's contingent liability on notes discounted amounted to $3,969,835 (including notes discounted by the finance subsidiary) of which approximately $1,426,756 is due within one year * * *.

        "Under the alternative method of financing the Company is contingently liable as of December 31, 1960 in the amount of approximately $750,000, representing 25% of customers' aggregate unexpired rental payments under leases. This contingent liability will decline during the term of the leases which expire in seven years."

        Plaintiffs challenge the accuracy of the figures contained in this passage. This contention raises the question of the meaning and effect of certain contracts between BarChris, and BarChris Financial, and Talcott, BarChris's most important, although not its only, factor. These contracts relate to both methods of financing, i. e., (1) the discounting by BarChris and BarChris Financial with Talcott of customers' notes receivable, and (2) the sale and leaseback arrangements known in this case as "the alternative method of financing."

        As to the first method, BarChris entered into a written agreement with Talcott, on the latter's printed form, under date of August 20, 1958. This contract was modified in certain respects by a letter agreement between them dated June 23, 1960. BarChris Financial entered into a written agreement with Talcott on the latter's printed form on March 16, 1960. This was modified by a letter agreement between them dated June 23, 1960. There is no significant difference between the BarChris agreements and the BarChris Financial agreements. Consequently, for simplicity's sake, this

Page 664

discussion will be confined to the BarChris agreements. What is said concerning them is equally applicable to the agreements made by BarChris Financial.

        Under the first agreement of August 20, 1958, BarChris agreed to sell to Talcott conditional sales contracts, customers' notes, etc., collectively referred to as "customer paper." Talcott agreed to pay BarChris the face amount of this customer paper less a financing charge. Talcott had the right to retain temporarily a small percentage of the purchase price as a reserve, to be released to BarChris from time to time as the notes were paid down by the customer.

        BarChris warranted that the customer would pay "each item of customer paper transferred to you." BarChris agreed that if the customer defaulted in payment of "any item," BarChris would repurchase "such item" from Talcott upon Talcott's demand.

        The agreement further provided that if BarChris defaulted in performing its obligations under the agreement, then, upon Talcott's demand, BarChris would repurchase "all customer paper then outstanding." If BarChris failed to do so, Talcott had the right to sell the paper at public or private sale.

        The agreement was to continue until terminated by either party on sixty days' written notice, or until the insolvency or bankruptcy of either party.

        The agreement of June 23, 1960 modified the agreement of August 20, 1958 with respect to BarChris's obligation to repurchase those items of customer paper which "are in default solely by reason of the customer's financial inability to pay the same," (defined as "defaulted customer inability items").

        The agreement provided that:

        "Until such time as our said agreement is terminated by either party as therein provided, we shall continue liable to you for the repurchase of defaulted customer inability items to the extent of 50% of the total unpaid balances of all items of customer paper accepted by you and not repurchased by us (`total customer outstandings') without reduction by reason of any prior repurchases by us of defaulted customer inability items or other items."

        The agreement was not terminated at any time relevant here.

        The effect of this amendment was to limit BarChris's contingent liability to repurchase customer paper from Talcott upon Talcott's demand to 50 per cent of the total, as far as "customer inability items" were concerned. As a practical matter, the fact that this amendment applied only to "customer inability items" was immaterial, for in almost every instance, any default on the part of a customer in paying his notes was due to his financial inability to pay.

        BarChris's contingent liability on notes discounted, as set forth in footnote 9 to the prospectus in the sum of $3,969,835, was computed by including in this figure, as to notes discounted with Talcott, only 50 per cent of the unpaid balance as of December 31, 1960. This method of computation was correct. The figure was correct. Plaintiffs' contention to the contrary is without merit.

        I turn now to the alternative method of financing with Talcott. This is complicated by the fact that these sale and leaseback arrangements with Talcott took two forms. BarChris's contingent liability was not the same in each.

        The first form (referred to for convenience as Type A) involved the sale of the "interior" of an alley by BarChris to Talcott and the leasing of the interior by Talcott directly to BarChris's customer. The second (Type B) involved the sale of the interior by BarChris to Talcott, the leasing back of the interior by Talcott to a BarChris subsidiary, BarChris Leasing Corporation, and the lease of the interior by BarChris Leasing Corporation to the customer.

        As to each Type A arrangement, BarChris signed and delivered to Talcott a written guaranty of the customer's, i. e., the lessee's, performance under the lease from Talcott. In each instance, this

Page 665

guaranty contained a limitation of BarChris's liability thereunder to a specified dollar amount. Although the guaranties did not expressly so state, in fact this dollar amount, in each instance, was 25 per cent of the customer's total obligation under the lease.

        In Type B arrangements, BarChris executed and delivered to Talcott a written guaranty of the performance of BarChris Leasing Corporation under its lease from Talcott. The obligation of BarChris under its guaranty was not limited in any way. Thus, BarChris was contingently liable to the extent of 100 per cent for the performance by BarChris Leasing Corporation of its obligation under its lease.

        Footnote 9 to the balance sheet, in stating that BarChris's contingent liability as of December 31, 1960 under the alternative method of financing was approximately $750,000, failed to take account of this difference. The $750,000 figure was computed on the basis of 25 per cent of the lessee's obligation under the lease, regardless of whether the lessee was a customer or was BarChris Leasing Corporation.

        There were three Type B leases included in this computation, those involving Asbury Lanes, Yankee Lanes (Torrington), and Capitol (Heavenly). The obligation of Torrington was $320,627.50 and of Asbury $288,766.68, a total of $609,394.18. This was the amount of BarChris's contingent liability on these two leases, not 25 per cent thereof, or $152,348.54. BarChris's contingent liability was thus understated as to these two leases by $457,045.64.

        The situation as to Capitol (Heavenly) is different and worse. The amount of its lease obligation was $325,000. Capitol was not leased by BarChris Leasing Corporation to an outside customer. It was leased to a BarChris subsidiary. This was an inter-company transaction. Consequently, in this instance BarChris, on a consolidated basis, was directly, not contingently, liable. Hence, instead of including 25 per cent of this $325,000 in contingent liabilities in a footnote, the full $325,000 should have been reflected in the balance sheet as a direct liability of BarChris.⁹

        Apart from the figures, the statement in footnote 9 reading, "This contingent liability will decline during the term of the leases which expire in seven years," was not wholly accurate. As to Type A transactions, inasmuch as BarChris's contingent liability on its guaranty of the customers' leases was expressed in terms of a fixed dollar maximum, there would be no decline in that liability until the customer's obligation was reduced by payments to a sum less than that maximum.

        For convenience, I will refer at this point to two remarks in the text of the prospectus which relate to this subject.

        In describing the alternative method of financing, the prospectus states on page 6:

        "[W]hen the financial institution leases directly to the operator, the Company's contingent liability to the financial institution is limited to 25% of the operator's rental payments for the unexpired period of the lease."

        This statement is literally correct, but it is only part of the story. It describes only BarChris's contingent liability on Type A transactions. There is no mention of the fact that on Type B transactions BarChris's contingent liability is 100 per cent. The omission of this additional explanation makes the prospectus to some extent misleading.

        Also on page 6 the prospectus states:

        "As of December 31, 1960, the Company had completed and sold ten building interiors for an aggregate price of $2,271,000 under this alternative method of financing."

Page 666

        This statement also was not wholly accurate. As of December 31, 1960, BarChris had sold nine building interiors, not ten. Also, one of them, Torrington, was not yet finished as of that date, so that it was not "completed and sold." By May 16, 1961, however, BarChris had sold ten building interiors. In fact, the total was then eleven, if two Cromwell jobs are counted separately. Also by May 16, Torrington had been completed. The inaccuracy in the statement as of December 31, 1960 is de minimis.

             Summary

The net result is as follows:

Add to contingent liabilities:

       3/4ths of liability on
         Asbury and Torrington     $457,045
Deduct Capitol:                      81,250
                                 ___________
       Net understatement of
       contingent liability        $375,795

        Hence, instead of $750,000, the contingent liability figure under the alternative method of financing should have been $1,125,795. Capitol should have been shown as a direct liability in the amount of $325,000.

        Plaintiffs also criticize the reserves, or lack of them, in the balance sheet. First, they claim that the reserve for doubtful accounts receivable in the amount of $54,481 was inadequate.

        "Accounts receivable" in this context means indebtedness of customers which had not as yet been paid by delivery by the customer to BarChris of notes which BarChris could discount with a factor. The $54,481 covered such accounts which were more than ninety days past due on December 31, 1960. Up to that time BarChris's experience had been good, on the whole, in converting accounts receivable into discountable notes.

        The amount of such reserve is a matter of accounting judgment. The evidence does not convince me that the accountant's judgment here was so clearly wrong that the balance sheet can be found to be false or misleading for lack of a higher reserve.

        Plaintiffs also claim that BarChris should have set up a reserve against its contingent liability on customers' notes discounted with factors and on customers' leases guaranteed. Some of these notes were in default on December 31, 1960. The factors however, had not demanded that BarChris repurchase any of them. Talcott contented itself with sending notices to BarChris periodically advising it that certain accounts were in arrears and asking BarChris's "assistance" to "bring these accounts up to date."

        According to Talcott's records, on December 31, 1960 there were eleven customers out of forty who were behind in paying their notes. For the most part, the amounts involved were small. Five were under $5,000. Only three were over $10,000. Of these, only one, Federal, was over $20,000. None of the lessees was behind in his rent.

        Another factor, Henry W. T. Mali & Co., Inc. (Mali), with whom the notes of four customers had been discounted by BarChris Financial, reported that of the four, one, Northford Lanes, was in arrears. BarChris apparently had paid these arrears to Mali for Northford's account.

        I have already discussed Federal, which is a special case. The question is whether, apart from Federal, it was misleading to omit any reserve for all the other contingencies.

        The executive committee minutes show that as early as November 3, 1960, Russo had expressed the opinion that BarChris "would be in the business of operating bowling alleys sometime in the future because of defaults by some of our customers." This remark provoked a discussion which led the executive committee to conclude that if BarChris were forced to take over the operation of a customer's alley, "the least which can be expected is that the notes to BarChris would be met from the operation." In other words, BarChris's officers in November

Page 667

1960 believed that recapture of an alley would not cause a loss to BarChris. They believed that BarChris would be able to meet its obligations to Talcott with respect to such a repossessed alley.

        As events ultimately turned out, BarChris was forced to repossess a number of alleys, and the optimism of its officers in November 1960 as to the effect on BarChris did not prove to be justified. In the light of the subsequent events, it is easy to say that prudence would have dictated the establishment of some reserve as of December 31, 1960. But these matters are always more clearly discerned in retrospect than they are at the time. In my opinion, BarChris's officers were sincere in their belief at the end of 1960 that BarChris was in no real danger of loss from customers' defaults. Apart from Federal, I conclude that their belief, viewed as of that time, was reasonable. The evidence does not establish that the balance sheet as of December 31, 1960 was false or misleading for lack of a reserve against contingent liabilities.

        The prospectus sets forth on page 4 the amount of BarChris's net sales, gross profits and net earnings for the three months ended March 31, 1961, in the amounts of $2,138,455, $483,121, and $125,699, respectively. These figures were unaudited, as the prospectus stated. On page 6 the prospectus set forth $5,101,351 as the amount of BarChris's contingent liability as of April 30, 1961 on customers' notes discounted, and "approximately $825,000" as its contingent liability under the alternative method of financing. Plaintiffs challenge the accuracy of these figures.

        The issue here is essentially the same as that previously discussed with regard to the contingent liability figures as of December 31, 1960. The April 30, 1961 figures were prepared by Trilling. The figure for contingent liability on notes discounted was correctly computed on the basis of 50 per cent of the unpaid balance of notes discounted with Talcott.

        As to the alternative method of financing, Trilling merely took the December 31, 1960 figures and brought them down to date, adding new leases made in the meantime and reflecting intervening payments of rent. The same error was made as to Type B leases, i. e., only 25 per cent of the lessee's obligation was included for Asbury and Torrington, instead of 100 per cent, and 25 per cent was also included for Capitol, an intercompany transaction. In addition, the April 30, 1961 figures included a new lease to BarChris Leasing Corporation dated March 23, 1961 with respect to Olympia Lanes. This was also a Type B transaction. Therefore, the full amount of the lessee's obligation, rather than 25 per cent thereof, should have been included.

        The net result is as follows:

Add:         Asbury          $207,612.51
             Torrington       234,182.64
             Olympia          255,600.00
                             ___________
                 Total       $697,395.15

Deduct:      Capitol          $78,541.67
                             ___________
  Net Understatement of
  Contingent Liability on
  Type B Transactions        $618,853.48

        Instead of $825,000, the contingent liability on the alternative method of financing was at least $1,443,853. Moreover, the liability of $314,166 on Capitol was a direct liability, not a contingent one.¹⁰

Page 668

        Plaintiffs correctly contend that the net sales of $2,138,455 for the three months ended March 31, 1961 were overstated.

        This figure included $269,810 for Bridge Lanes. I have previously noted that the stock of the original customer for this alley, Biel Land & Development Company, was acquired by BarChris in the spring of 1961. The date of acquisition was March 24, 1961. Subsequently, BarChris operated this alley through a subsidiary. Once it began to operate it, it did not sell it at any time thereafter, as far as appears. There is no doubt that by March 31, 1961, this transaction had become an intercompany one. It should not have been included in first quarter 1961 sales.

        Yonkers Lanes is in the same category. The amount included in sales for this alley was $250,000. On May 4, 1961, BarChris organized a subsidiary, Yonkers Lanes, Inc., which eventually operated this alley. Whether BarChris originally had intended to operate it, or whether at the outset it had a customer for it, is not clear from the testimony. However, the minutes of a meeting of BarChris's executive committee held on March 18, 1961 show that as of that date BarChris had no contract with a customer for this alley. It seems clear that by March 31, 1961 this was an intercompany transaction and should not have been included in first quarter sales.

        I do not accept plaintiffs' contention that the contract price of Cromwell Lanes of $91,100 included in the first quarter sales was wrong. Plaintiffs say that the contract price had been reduced by $9,600. I find, however, that the $9,600 shown on BarChris's books as "pre-paid rent," was in effect a down payment on the contract price. The price was not reduced. The amount included in sales for this alley was correct.

        I also find that plaintiffs have not proved that the amounts included in first quarter sales, on the percentage of completion method, for Torrington Lanes and Newington Lanes were improperly computed. Although there is some evidence to the effect that the costs of these jobs eventually turned out to be higher than expected, the evidence is too scanty to prove that this should have been anticipated and allowed for in computing the first quarter figures.

        The net result is that the March 31, 1961 net sales figure was overstated as follows:

Bridge Lanes           $269,810
Yonkers Lanes           250,000
                       ________
               Total   $519,810

        The net sales figure, therefore, should have been $1,618,645, not $2,138,455.

        It necessarily follows that the gross profit figure of $483,121 was wrong to the extent of the gross profit included for Bridge Lanes and Yonkers Lanes. These amounts were:

Bridge Lanes            $125,755
Yonkers                  105,000
                        ________
               Total    $230,755

        The gross profit therefore should have been $252,366, instead of $483,121. Net earnings would necessarily be reduced proportionately. The evidence does not permit calculation of the exact amount of the reduction.

        The prospectus stated on page 5:

        "The Company as of March 31, 1960, had $2,875,000 in unfilled orders on its books. As of March 31, 1961, the comparable amount was approximately $6,905,000. Substantially all of the latter orders are scheduled and are expected to be completed in 1961."

        Plaintiffs contend that the figure of $6,905,000 was erroneous. There is no doubt that it was, to a substantial extent. It is impossible to determine, however, precisely what the figure should have been.

        The difficulty results from the fact that BarChris's books did not contain a

Page 669

record of unfilled orders as of March 31, 1961. Russo testified that he prepared a list of them which was the basis for the figure in the prospectus. The list was never produced. Its absence gave rise to controversy as to what alleys were on the list and what were not. Despite all the testimony and argument on this subject, the matter was never completely settled.

        Out of all this testimony, however, some things clearly emerge. Although it is not possible to specify each and every alley which was included in the total of $6,905,000, there is no dispute about the fact that certain alleys were included. And it is clear that alleys were included for which BarChris, as of March 31, 1961, held no valid enforceable contracts.

        I shall first consider the group of six alleys referred to as the "T-Bowl" group. The principal figure in these transactions was August E. Tumminello. In December 1960 or January 1961, he, at the urging of Vitolo, signed six undated documents on BarChris's printed form of purchase contract. The name of the purchaser at the head of the respective documents was stated as "T-Bowl, Groton," "T-Bowl Milford," "T-Bowl, No. Attleboro," "T-Bowl Baltimore," "T-Bowl Saverna Park," and "T-Bowl Odenton." On five of the six documents the same name appeared after the word "Purchaser" at the bottom, followed by the signature, "August E. Tumminello Pres." On the sixth, that pertaining to North Attleboro, nothing appeared at the bottom after the word "Purchaser" except Tumminello's signature as "Pres."

        In fact, there were no corporations entitled T-Bowl Groton, T-Bowl Milford, etc. These names were merely designations of the geographical area of the proposed alley.

        Each of these "purchase contracts" pported to be for the "interior" of an alley. Each stated that the "purchaser" agreed to purchase "the equipment set forth below." Nothing was set forth below. Each document stated that "specifications are attached." No specifications were attached. Each recited that a specific part of the purchase price had been paid upon the signing of the contract. Nothing was paid at that time.

        Birnbaum, BarChris's secretary and house counsel, advised his fellow officers that these documents were not legally enforceable contracts. The minutes of BarChris's executive committee meeting of March 18, 1961 included each of these alleys in a list of "jobs which are presently being constructed, or will soon be commenced, and on which no contracts with customers have been written."

        On May 2, 1961, a corporation known as T-Bowl International Inc. was organized. Tumminello was its president. Russo was a director. This corporation sold common stock to the public in September 1961. The issue was underwritten by Peter Morgan & Company, one of the underwriting group in the BarChris debenture issue involved here. The T-Bowl prospectus stated:

        "At June 30, 1961, T-Bowl had consolidated negative working capital of $229,058.79 * * *."

        This financing appears to have succeeded. Out of its proceeds T-Bowl International Inc. finally made the down payments to BarChris with respect to the six T-Bowl jobs. Birnbaum caused a line to be drawn through the name of the purchaser on each of the six documents, i. e., T-Bowl Groton, etc., and the words "T-Bowl International Inc." to be written in in ink. The documents were not reexecuted.

        Five of the six alleys were eventually built by BarChris, long after May 16, 1961. One, Severna Park, was never built because its site was condemned for a highway.

        It is undisputed that the total contract price of these six alleys, $2,205,000, was included in the backlog figure. I find that it was inaccurate and misleading to include it.

        I have made due allowance for the fact that BarChris's contract draftsmanship was frequently inartistic. Consequently,

Page 670

I do not regard as determinative the fact that the T-Bowl documents were carelessly drawn and executed. But the difficulty here goes beyond such defects in form. The evidence shows, and I so find, that Tumminello's agreement made in late 1960 or early 1961 to purchase the interior equipment of the six alleys was contingent upon the future organization and successful financing of the corporation which turned out to be T-Bowl International Inc. Whether or not this could ultimately be accomplished was by no means certain on March 31, 1961. Indeed, one may wonder how purchasers were found in September 1961 for the stock of a new corporation starting out in life with a "negative working capital of $229,058.79."

        Doubtless BarChris's officers in the spring of 1961 hoped that this could be accomplished. But the prospectus did not purport to set forth hopes. "Unfilled orders on its books" which are "scheduled" means firm enforceable contracts with purchasers who have made their down payments and who can reasonably be expected to perform their commitments. The six T-Bowl orders did not meet that test. The fact that, as it eventually turned out, five of the six transactions were consummated, does not alter the conclusion that they could not fairly be treated as scheduled orders on BarChris's books as of March 31, 1961.

        It is undisputed that $1,400,000 was included in the backlog figure for this alley. The contract for its construction was not signed until August 9, 1961. BarChris never finished building it.

        As of March 31, 1961, there was no firm commitment with respect to this transaction. There had been negotiations, but agreement had not been reached on financing terms. A BarChris memorandum dated April 24, 1961 and the BarChris executive committee minutes of the same date so indicate. It was inaccurate and misleading to treat this transaction as a scheduled unfilled order on the books as of March 31, 1961.

        It is undisputed that $725,000 was included in the backlog figure for this job. There is testimony that BarChris made a contract in 1960 with a purchaser for this alley and that the purchaser later cancelled the contract. The contract was never produced and the date of cancellation was never specified. The minutes of BarChris's executive committee meeting of March 18, 1961 lists this job as one of those which was then or about to be under construction without a contract.

        BarChris built this alley and operated it itself. At the end of 1961 it was eliminated from 1961 sales because it was an intercompany transaction. I find that it was inaccurate and misleading to include it in the backlog figure.

        It is undisputed that $160,000 was included in the backlog figure for this alley. The contract was not signed until May 11, 1961. The purchaser made a down payment of $8,000 with a postdated check. Later this payment was returned to him and the contract was cancelled. The alley was never built. Whatever BarChris's hopes may have been on March 31, 1961, there was no firm enforceable commitment for this job on that date. I find that it was erroneous and misleading to include it in the backlog figure.

        I have considered plaintiffs' contentions that certain other jobs which it appears were included in the backlog figure should not have been included. These are: Max Block, T-Bowl Middletown, and the buildings for T-Bowl Milford and T-Bowl Groton (which are transactions separate from those involving the interiors of those alleys which I have previously discussed). The evidence on these transactions is conflicting. I shall not review it in detail here. Upon all the evidence I find that plaintiffs have not proved their contention that these alleys were improperly included in

Page 671

the backlog figure, viewing their status as of March 31, 1961.

        I have also considered plaintiffs' contentions with respect to Newport News, Norfolk and Atlas-Bedford. It is clear that these transactions should not have been included in the backlog, but it is not clear that they were. On all the evidence, I find that plaintiffs have not established that any amount for these transactions was in fact included in the backlog.

        By way of summary, I find that the following amounts for the following transactions were erroneously included in the backlog figure:

Six T-Bowl interiors       $2,205,000
Bowl-a-Way                  1,400,000
Woonsocket                    725,000
Atlas-Lincoln                 160,000
                           __________
                   Total   $4,490,000

        In stating that unfilled orders on BarChris's books as of March 31, 1961 were approximately $6,905,000, the prospectus was false. The figure at best should not have been more than $2,415,000. This was less than the amount of unfilled orders on hand at the corresponding date in the previous year, March 31, 1960, which, according to the prospectus, was $2,875,000.

        Up to this point I have considered inaccuracies in the figures set forth in the prospectus, sales and earnings, assets, contingent liabilities, and backlog. Apart from these, plaintiffs contend that there were inaccuracies in certain passages in the text. I will deal with each of the principal contentions on this score.

        The following passage appeared on page 10 of the prospectus:

        "During the three years ending February 28, 1961, the Company from time to time made advances to the officers of the Company, and the officers of the Company from time to time made advances to the Company and its subsidiaries for additional working capital. The maximum amount of such advances by the Company to such officers outstanding at any one time during such period was $87,073, and the corresponding maximum amount of advances by the officers was $155,615. All such advances have been repaid."

        There are three things which could be said to be wrong with this paragraph:

        1. The three-year period referred to should not have been the three years ending on February 28, 1961, but rather the three years ending on March 13, 1961, or, if one prefers, on March 31, 1961.

        2. The $155,615 referred to as the maximum amount of advances made by officers to BarChris during the three-year period had not in fact been repaid.

        3. In any event, as of May 16, 1961, the effective date of the prospectus, there were additional advances by officers which had not been repaid and the existence of which should have been disclosed.

        The evidence shows without substantial contradiction that the first and the third of these points are well taken. The second depends upon questions of credibility. The relevant facts are as follows.

        As of March 12, 1961, BarChris was indebted to three of its officers for loans made by them to BarChris in the following amounts:

Russo                      $ 44,000
Vitolo                       51,615
Pugliese                     60,000
                           ________
                 Total     $155,615

        This is the maximum figure stated in the prospectus.

        On March 13, 1961, BarChris delivered to each of these officers checks in the amount of their respective advances. The checks were drawn on BarChris's account in Lafayette National Bank. Russo deposited his check for $44,000 on April 18, 1961. Vitolo deposited his check for $51,615 on May 31, 1961. Pugliese

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deposited his check for $60,000 on May 26, 1961.

        Thereafter on April 11, 1961, Russo made a new loan to BarChris in the amount of $75,000, and on April 14, 1961 he made another advance in the amount of $100,000, making a total of $175,000. On April 24, 1961 Vitolo loaned BarChris $100,000. Practically simultaneously with the receipt of these advances, BarChris delivered to Russo and Vitolo its checks to their respective orders in the same amounts. Thus BarChris delivered to Russo a check for $75,000 on April 11, 1961, and a check to him for $100,000 on April 17, 1961. BarChris delivered to Vitolo a check to his order for $100,000 on April 24, 1961. These checks were drawn on BarChris's account in Lafayette National Bank. There was not enough money in the account in that bank to pay them.

        When he delivered these checks, Kircher instructed Russo and Vitolo not to deposit them until after BarChris had received additional funds. The proceeds of the debenture issue were received on May 24, 1961. Russo deposited his two checks on May 29. Vitolo deposited his on May 31. By that time enough of the proceeds of the financing had been placed in the Lafayette National Bank account to cover the checks.

        As to the first of the three points previously mentioned, it is obvious from these facts that the date of February 28, 1961 set forth on page 10 of the prospectus was an error. On any theory, the first set of loans totalling $155,615 had not been repaid by that date. Apparently by inadvertence the draftsmen of the prospectus failed to make the date March 13, 1961, or the end of the quarter, March 31, 1961, a date which would have been just as accurate as March 13, or just as inaccurate, depending upon the view one takes of the March 13 transactions. The error in date, however, is not in itself of any great significance.

        Deferring for the moment consideration of the second of the three points, I will pass to consider the third. There is no doubt that the second set of loans made in April, totalling $275,000, had not been repaid by May 16. The delivery of checks to Russo and Vitolo by BarChris under the circumstances recounted above did not constitute repayment at the time of delivery. I find that Russo and Vitolo agreed not to deposit their checks until after the financing proceeds were received. The loans were not repaid until after May 24 when the receipt of the financing proceeds by BarChris made repayment possible.

        It is suggested that, nevertheless, as far as this second set of loans is concerned, the prospectus was not false in stating that "all such advances have been repaid." It is argued that "such advances" referred only to the first set of loans, not to the second. This is a highly literal reading. It can more fairly be said that "such advances" refers to all advances by officers, not merely to certain particular ones, and hence that when the prospectus said that "all such advances" had been repaid, it in effect represented that no loans from officers were outstanding and unpaid as of the effective date, May 16, 1961. So construed, the statement in the prospectus was false. Even if the more literal construction is adopted, so that the prospectus is read as though it had actually said "the $155,615 has been repaid," it is clear that candor and fair disclosure required that the prospectus reveal that although one set of officers' loans had been repaid, there was outstanding another and larger amount of such loans which had not been repaid. The failure to make this disclosure was misleading.

        I return now to the second point. Was it true that at least the $155,615 had been repaid, or was that statement also false? This depends upon whether or not the delivery by BarChris to Russo, Vitolo and Pugliese on March 13 of checks totalling $155,615 was also a conditional delivery. I find that it was. There is testimony to the effect that the delivery on March 13 was not conditional, that no strings were attached to the deposit of these checks. I do not believe it. I do not believe

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that a man like Vitolo or Pugliese would hold a check for some $50,000 or $60,000 approximately two and one-half months without depositing it unless he had agreed to hold it for reasons which he considered sufficient. I do not overlook the fact that Russo deposited his check on April 18. Either Russo made no such agreement, or if he did, he failed to keep it, as Vitolo and Pugliese kept theirs.

        Certain other facts may be noted. The balance in the Lafayette National Bank account fluctuated widely. On March 13, 1961 it was approximately $80,000. Although there were times thereafter when the balance temporarily exceeded $155,615, for the most part it was below that figure, often substantially below it. Moreover, a BarChris work paper contained an entry reading "checks released 5/24/61$399,615.36." This total includes not only the April checks, but also the March 13 checks to Vitolo and Pugliese. If this entry is true (and there is no reason to doubt it), obviously the checks were not "released" on March 13.

        On all the evidence, I find that the Vitolo loan of $51,615 and the Pugliese loan of $60,000 were not repaid prior to May 16, 1961. Of the $155,615, only Russo's loan of $44,000 had been repaid prior to that date. It follows that the statement in the prospectus that officers' loans totalling $155,615 had been repaid was false.

        The prospectus impliedly, if not expressly, represented that there were no loans from officers outstanding as of May 16, 1961. In fact there were then outstanding and unpaid loans from officers in the aggregate amount of $386,615. BarChris paid this amount after May 22, 1961 out of the proceeds of the debenture issue.¹¹

        The prospectus states on page 2:

        "The net proceeds from the sale of the Debentures offered hereby (`the Debentures') will be added initially to the general funds of the Company. Approximately $750,000 has been budgeted for construction of a new plant described under `Property' herein. It is anticipated that approximately $250,000 will be utilized in connection with the development of a new equipment line which includes ball return units, score projection equipment, ball cleaning equipment and related items and approximately $500,000 will be loaned to BarChris Financial Corporation as described under `Subsidiary Companies.' The balance of such net proceeds, or approximately $1,745,000, will be utilized as additional working capital in the expansion of alley construction and installation and supplies and equipment sales. The Company's working capital requirements have risen sharply over the past several years. If this trend continues, the entire balance of such net proceeds will be required for this purpose. Pending such need the Company will be in a position to retain a portion of its customers' paper or to make investments in short term securities."

        Plaintiffs contend that this passage was false. They maintain that BarChris did not intend to use the proceeds of the financing for the purposes stated in this paragraph, and that in fact BarChris did not use them for those purposes. Proper appraisal of this contention requires examination of BarChris's financial condition in May 1961 and of certain events which occurred thereafter.

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        In May 1961 BarChris was very short of cash. This was more or less a chronic state of affairs for BarChris, but it was particularly acute at this moment. It was because of BarChris's urgent need for cash that Russo, Vitolo and Pugliese each lent it substantial sums out of their own funds. In addition to borrowing from its officers, BarChris had also borrowed $242,000 from Manufacturers Trust Company.

        Immediately prior to May 24, 1961, BarChris had four bank accountsin Lafayette National Bank, Meadow Brook National Bank, Chase Manhattan Bank and Manufacturers Trust Company. The Lafayette account was the principal one. According to the bank statement, the balance in that account on May 16, 1961 was $87,049.41 and on May 24, 1961, immediately before BarChris received the proceeds of the financing, it was $21,241.38. But these figures by no means reveal the true situation. According to BarChris's books, there was actually a very substantial "negative cash balance" in this account. This means that if all the checks which BarChris had signed and charged against this account on its books had been presented to the bank, the account would have been overdrawn to the extent of $656,146 on May 16, and $825,736 on May 23.

        A substantial part of this "negative balance" was made up of the checks delivered to Russo, Vitolo and Pugliese which, as we have seen, they agreed to hold without depositing. These aggregated $386,615. There was also the $13,000 check to B.C.L. Realty, which may well have been in the same category. There was a check to Peat, Marwick in the amount of $3,000, and one to Perkins, Daniels, McCormack & Collins, BarChris's attorneys, in the amount of $8,711. These items total $411,326. The difference between this figure and $825,736, i. e., $414,410, was the aggregate amount of certain checks which BarChris had signed and charged against the bank account on its books but had not delivered to the payees. These checks were in payment of bills for materials or services furnished to BarChris by various third persons in the course of BarChris's construction work.¹²

        The amounts on deposit in the other three bank accounts were modest, according to the bank statements. The balances at the date nearest to May 23, 1961 which the bank statements reflected were as follows:

   Meadow Brook            May 4        $   218.71
                           May 31         2,718.71
   Chase Manhattan         May 23        10,108.94
   Manufacturers Trust
    Company                May 15        50,521.37
                          June 1          1,521.37

        The evidence does not indicate whether the same situation obtained with respect to these accounts as with respect to the Lafayette account. It may well be that it did, and that even these small balances, as shown by the banks' records, would have been converted into "negative" ones if checks actually drawn against these accounts, but not delivered to the payees, were taken into account.

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        BarChris received the net proceeds of the financing on May 24, 1961. They amounted to $3,302,298.65. BarChris deposited this sum in a new account in Irving Trust Company. It immediately drew a check for $760,000 against this account and deposited it in Lafayette National Bank on May 24. Further transfers were made shortly thereafter. The transfers totalled $1,379,000.

        Out of the funds so transferred, the entire "negative cash balance" of $825,736 in the Lafayette account was paid. This included the officers' loans. Also, out of these funds BarChris repaid the $242,000 which it had borrowed from Manufacturers Trust Company. Finally, out of these funds, BarChris loaned $120,000 to St. Ann's, Inc., a company with which associates of Tumminello and Russo were connected.¹³

        The total of the officers' loans (not including B.C.L. Realty) and the Manufacturers Trust Company loan was $628,615. It is clear that in the first instance, at least, BarChris used a substantial part of the financing proceeds in a manner not revealed in the prospectus, i. e., to pay its debts. It also used over $400,000 more of the proceeds to pay construction expenses incurred before May 23, 1961. And it used $120,000 of the proceeds to make a loan to Russo's friends. The question is whether or not by reason of these facts the "application of proceeds" paragraph in the prospectus was false or misleading.

        Defendants say that it was not misleading because BarChris later received additional funds from customers which were used for the purposes specified in the prospectus. Their position is that if the financing proceeds are to be considered a fund of "working capital" to be applied in certain specified ways, that fund was later reimbursed, so to speak, by these additional receipts, so that it makes no real difference that initially, a substantial portion of the proceeds was applied in a manner not contemplated by the prospectus.

        It is true that BarChris did continue in business for over a year, it did build alleys and receive payments from customers, and it managed for a time to pay construction costs. It is also true that eventually BarChris did build the new plant mentioned in the prospectus, and it seems to be true that BarChris developed the new equipment line referred to in the prospectus. At least, plaintiffs have not proved the contrary. As