The opinion of the court was delivered by: STEWART
Plaintiffs brought suit for defendants' alleged violations of the federal securities laws, common law fraud and breach of contract. All of these claims arise out of plaintiffs' investments in natural resource interests (the "overcharge" claims more fully described at pp. 1328-1335 infra) and the sale of a portion of a particular investment in the Canadian Arctic used to calculate unrealized appreciation on the remainder of plaintiffs' interest (the "revaluation" claim, see pp. 1335-1343 infra). The defendants as plaintiffs' accountants and auditors were charged with primary violations of section 17(a) of the Securities Act of 1933 ("1933 Act"), 15 U.S.C. § 77q(a) (1976), and section 10(b) of the Securities Exchange Act of 1934 ("1934 Act"), 15 U.S.C. § 78j(b) (1976), and aiding and abetting violations of those provisions. Subject matter jurisdiction is based upon section 22 of the 1933 Act, 15 U.S.C. § 77v (1976), section 27 of the 1934 Act, 15 U.S.C. § 78aa (1976), diversity of citizenship and pendent jurisdiction.
The case was tried to a jury beginning July 13, 1981. After some 55 trial days and over two weeks of jury deliberation, defendants were held liable for: aiding and abetting violations of section 10(b) of the 1934 Act, and sections 17(a)(1), 17(a)(2), and 17(a)(3) of the 1933 Act regarding the "overcharge" claims; primary violations of section 10(b) and section 17(a)(3) regarding the "revaluation" claims; aiding and abetting violations of section 10(b) and sections 17(a)(1), 17(a)(2), and 17(a)(3) regarding the revaluation claims; and common law fraud and breach of contract regarding both the overcharge and revaluation claims. The jury found that AA was not liable for primary violations of sections 10(b), 17(a)(1), and 17(a)(3) regarding the overcharge claims and that AA was not liable for a primary violation of section 17(a)(1) concerning the revaluation claim.
The jury assessed damages for each recoverable overcharge claim at $47,966,079 and for each recoverable revaluation claim at $32,751,763. Following submission of proposed forms of judgment and memoranda, we issued a Memorandum Decision reducing the verdict by the allocable amounts of several prior settlements and awarding prejudgment interest. The Memorandum Decision and judgment entered thereon were sealed because the amount one of prior settlement included in the calculations was previously sealed.
Defendants timely moved for a new trial and for judgment notwithstanding the verdict. The standards for deciding these motions are exacting, but not identical. Hubbard v. Faros Fisheries, Inc., 626 F.2d 196, 199-200 (1st Cir. 1980); Lang v. Birch Shipping Co., 523 F. Supp. 1112, 1114 (S.D.N.Y. 1981). On a motion for judgment n.o.v., we are commanded not to weigh the evidence or determine the credibility of the witnesses. Simblest v. Maynard, 427 F.2d 1, 4 (2d Cir. 1970). We decide whether the evidence could only lead reasonable persons to a conclusion contrary to the verdict. Sirota v. Solitron, 673 F.2d 566, slip op. at 1368 (2d Cir. 1982); Hubbard v. Faros Fisheries, Inc., 626 F.2d at 199; Simblest v. Maynard, 427 F.2d at 4. All reasonable inferences must be made in favor of the party receiving the verdict. Id. Thus, we must affirm the verdict if we find sufficient evidence to support the jury's reasonable findings of fact although a different conclusion is also plausible. See Hubbard v. Faros Fishing, Inc., 626 F.2d at 200; O'Connor v. Pennsylvania R.R., 308 F.2d 911, 914-15 (2d Cir. 1962). See also Planters Mfg. Co. v. Protection Mutual Ins. Co., 380 F.2d 869, 874 (5th Cir. 1967), cert. denied, 389 U.S. 930, 19 L. Ed. 2d 282, 88 S. Ct. 293 (1968). We may grant a new trial in the interests of justice where judgment n.o.v. would not be appropriate. Id. at 881, cert. denied, 389 U.S. 930, 19 L. Ed. 2d 282, 88 S. Ct. 293; Isley v. Motown Record Corp., 69 F.R.D. 12, 16 (S.D.N.Y. 1975). We may weigh the evidence on a motion for a new trial "and [we] need not view it in the light most favorable to the verdict winner". Bevevino v. Saydjari, 574 F.2d 676, 684 (2d Cir. 1978). Our object in deciding a motion for a new trial is to prevent a miscarriage of justice or an erroneous verdict. Id. We begin, however, with a statement of facts which a jury reasonably could find in support of the verdict.
Investors Overseas Services, Limited ("IOS, Ltd."), one of the high-flying financial investment vehicles of the 1960's, sponsored and managed mutual funds, among other diversified financial services. IOS, Ltd. was a Canadian company headquartered in Switzerland. Plaintiffs Fund of Funds, Ltd. ("FOF") and IOS Growth Fund, Ltd. ("IOS Growth") were open-ended "off-shore" mutual funds controlled and managed by IOS, Ltd. FOF was also a Canadian company, although operations of FOF were directed from Switzerland and corporate records were maintained in Ferney-Voltaire, France. IOS Growth was a clone of FOF, spun-off in December 1969 in response to a change in German law to permit German investors to continue to invest in IOS's mutual funds. IOS Growth received an interest in FOF's assets proportionate to the interest of the German shareholders in FOF before the spin-off -- about 4% of FOF's assets. As FOF and IOS Growth have identical interests, claims and positions with respect to the transactions at issue, we shall include IOS Growth in our references to FOF, except where expressly indicated to the contrary.
FOF initially invested in American mutual funds, hence its name. Due to SEC objections, FOF was forced to change its investment strategy in 1967.
FOF incorporated FOF Proprietary Funds, Ltd. ("FOF Prop") as an umbrella for specialized discretionary investment accounts managed by individual investment advisors. FOF Prop's investments were largely concentrated in American securities. The subaccount advisors were compensated according to both the realized and unrealized (paper) appreciation of their portfolios.
After all the transactions pertinent to this suit,
FOF, FOF Prop and IOS Growth were placed in liquidation under Canadian law, and John Orr was appointed permanent liquidator.
Defendants are Arthur Andersen & Co. ("AA") and Arthur Andersen & Co. (Switzerland), one of the "Big Eight" accounting firms. AA was employed as the auditor for IOS, Ltd. "and consolidated subsidiaries and affiliated funds". See Px-59. The Zurich office was officially responsible for a separate report as to FOF. The pertinent part of the engagement letter for 1968 is as follows:
Our audit work on companies for which we are responsible will consist of examination of the respective balance sheets and statements of net assets and investments as of December 31, 1968, and the related statements of income, surplus and changes in net assets for the year then ending in order to enable us to express an opinion on the financial position of the respective entities and the results of their operations. These examinations will be made in accordance with generally accepted auditing standards and will include all auditing procedures which we consider necessary in the circumstances. These procedures will include, among other things, review and tests of the accounting procedures and internal controls, tests of documentary evidence supporting the transactions recorded in the accounts and direct confirmation of certain assets and liabilities by correspondence with selected customers, creditors, legal counsel, banks, etc. While certain types of defalcations and similar irregularities may be disclosed by this kind of an examination, it is not designed for that purpose and will not involve the audit of a sufficiently large portion of the total transactions to afford assurance that any defalcations and irregularities will be uncovered. Generally, primary reliance for such disclosure is placed on a company's system of internal control and effective supervision of its accounts and procedures. Of course, any irregularities coming to our attention would be reported to you immediately.
Px-59 (emphasis added). The engagement letter for 1969 is identical in this respect. Px-165.
2. Investments in Natural Resource Interests
In late 1967 and early 1968, FOF decided to establish the Natural Resources Fund Account ("NRFA") as a subaccount of FOF Prop. The object of FOF in investing in natural resource assets was to avoid a potential stock market downturn. At this time, IOS and FOF officers first contacted John M. King ("King"), a Denver oil, gas and mineral investor and developer. In February 1968, a formal investment advisory contract was circulated between Edward M. Cowett ("Cowett"), the Chief Operating Officer of IOS and FOF, and counsel for King Resources Corporation ("KRC"), Timothy Lowry ("Lowry"), designating Regency Products, Ltd. a KRC subsidiary, as investment advisor to FOF Prop. The agreement with Regency was not finalized. No written investment advisory agreement was ever entered into by FOF or FOF Prop.
The establishment of the NRFA was also discussed at a meeting of the FOF Board of Directors in Acapulco, Mexico on April 5, 1968. The minutes of this meeting form a cornerstone of FOF's securities law claims and are reproduced below:
Messrs. John King, Rowland Boucher and James Fredrickson of King Resources Company, Denver, Colorado, were thereupon invited to join the meeting, and to make a presentation to the Directors concerning the advisability of investments by the Company in oil, gas, mineral and other natural resource properties. Mr. King, assisted by Mr. Boucher and Dr. Fredrickson, explained to the Directors the various types of properties that might be suitable for investment. He indicated that such properties were available both within and without the United States, that the return which might be expected from any property increased with the degree of risk involved (so that pure exploration properties would yield the highest return, assuming discovery, and recovery drillings on proven properties would yield the lowest return), and that a proprietary account with an initial allocation of $10 million should be invested in a minimum of 40 properties (so as to spread risk and insure sufficient diversification of projects). He cited the past record of King Resources Company and of Imperial American and Royal (two publicly offered limited partnerships managed by a King Resources affiliate) to demonstrate that wholly independent of tax considerations (write-off of intangibles, as well as depletion allowance) diversified investment in oil, gas, mineral and natural resource properties could be extremely profitable. He indicated that the role of King Resources with respect to the contemplated Natural Resources Proprietary Account would be that of a vendor or properties to the proprietary account, with such properties to be sold on an arms-length basis at prices no less favorable to the proprietary account than the prices charged by King to its 200-odd industrial and other purchasers.
A general discussion ensued concerning the contemplated Natural Resources Account, during the course of which: (i) Mr. Cowett indicated that tax counsel had approved a procedure whereby the Company could utilize intangible writeoffs and depletion allowances of the Natural Resources Account to eliminate all or a substantial portion of the 30% withholding on dividends paid to the Company by registered investment companies and (ii) an investment in diversified natural resources properties was approved by the Directors on an experimental basis, with the initial $10 million allocation to be increased only upon satisfactory performance having been achieved.
It was then suggested that, as the number of proprietary accounts grew, it was advisable for each of such accounts to be assigned for liason [sic] purposes to a particular Director of the Company. After a general discussion, this suggestion was adopted, as well as a further suggestion that the Board of Directors of F.O.F. Proprietary Funds Ltd. be expanded so as to include "outside" Directors (particularly those "outside" Directors previously on the Board of the original Proprietary Funds which were registered investment companies), with the expanded Board of Directors of F.O.F. Proprietary Funds Ltd. to serve as a source of advisory boards for each of the Proprietary Fund Accounts. Pending the enlargement of the Board of Directors of F.O.F. Proprietary Funds Ltd., the following Directors of the Company were assigned to perform liason [sic] functions with respect to the following proprietary fund accounts:
Edmund G. Brown Carr Fund
C. Henry Buhl, III Hedge and York Funds
Allan F. Conwill Computer Directions and
Edward M. Cowett Groo and Real Estate Growth
Pierre A. Rinfret Meid and Technology Funds
Eric D. Scott Natural Resources Fund
Wilson W. Wyatt Alger Fund
Mr. Cowett was instructed to advise the portfolio managers of each of the proprietary fund accounts of the above assignment.
Px-32, pp. 9-11, 13. FOF authorized formation of the NRFA, initially capitalized at $10 million, and a wholly-owned subsidiary of FOF Prop, Natural Resources Corporation ("NRC"), a Maryland corporation, to invest in oil, gas and mineral properties and interests. NRC had no offices or employees. TR 2981-82, 8861-62. As NRC had no business which would supply funds for its various purchases, funds for investments were supplied from FOF's account at the Bank of New York. TR 2982-83.
a. King's Relationship with FOF
There was considerable evidence that John King, KRC and other related corporate entities controlled and managed the NRFA in the same manner as other subaccount advisors. See TR 979-80, 1921, 2992, 6356, 6982, 8308-09, 10,061, 10,067; Px-83; Px-121; Px-392. But see TR 1919-20; Dx-A-12. The King group frequently characterized itself as an investment advisor to FOF. Px-56; Px-80; Px-87. However, investments in natural resource interests were fundamentally different from other FOF Prop investments in one important particular: in each and every natural resource transaction, the interest purchased was a portion of an interest previously or contemporaneously owned by a member of the King group. E.g., TR 9834-36. AA auditors characterized this arrangement as unusual. TR 2415, 3453.
FOF's investments in natural resource interests were made as follows: (1) the interests would be identified by the King group either in their "inventory" of properties or purchased for resale to FOF;
(2) the King group would "ascertain the potential productivity and [make] the determination of the worth of the property" (TR 9868); (3) a representative of KRC telephoned Cowett in Geneva to recommend the interest and to tell FOF the price (TR 9864); (4) Cowett would agree (although he may have had the "power" to turn down an investment, there is no specific evidence that he ever did so and the jury could infer from the evidence that he never did exercise a veto, e.g., TR 9865; but see, TR 9296-97); (5) KRC would send a bill to FOF, with copies to Scott, the liaison director between FOF and the King group, and Arthur Lipper Corporation (to value FOF shares initially at the cost of the assets purchased, TR 9865); (6) FOF also received a prospect summary outlining the nature and scope of the acquisition (e.g., Px-613).
The pricing policy followed by the King group was the subject of considerable testimony, most of it interpreting the phrases used in the minutes of FOF's Acapulco meeting at which King represented that "the role of King Resources with respect to the Natural Resources Proprietary Account would be that of a vendor of properties to the proprietary account, with such properties to be sold on an arm's-length basis at prices no less favorable to the proprietary account than the prices charged by King to its 200-odd industrial or other purchasers ". Px-32 (emphasis added). Cowett's general understanding of the pricing policy was stated in a memorandum written on April 19, 1968: KRC would offer properties to NRC "from time to time and on a more or less continuous basis", the terms of sale to be "no less favorable than those offered by [KRC] to other non-affiliated purchasers [and] all transactions will be arms-length in nature". Dx-A-12. Cowett also stated his understanding of the relationship and pricing policy in a letter dated November 11, 1970:
It was my express understanding (and, I believe, the express understanding of each of the FOF Directors) that:
a. Without specific approval, no investment was to be made by the Prop Fund in any resource property, unless KR or affiliated companies had a meaningful investment in the same properties. This was generally understood to be a 50/50 relationship. (However, it was recognized that there would be instances where the Prop Fund had less than a 50% interest, as well as instances where KR, by reason of the limitation of its own resources, would hold less than a 50% interest. In no event was the Prop Fund to have more than a 50% interest.)
b. KR was to have a 12-1/2% "net operating profits" interest in respect of any property acquired by the Prop Fund. (I must confess my own naivete was such that I did not understand the true significance between a "net operating profits" interest and a "profit sharing management" fee.)
c. The prices to be paid by the Prop Fund were to be no higher than what would be paid by knowledgable industry purchasers on a negotiated arms-length basis. (While I understood that KR might vend properties out of its inventory to the Prop Fund at a mark-up, I viewed the standard set forth in the previous sentence as protecting the Prop Fund; and, when I visualized sales from "inventory", I was thinking in terms of properties held by KR for a meaningful period of time prior to vending, during which period the values of the properties had presumably appreciated by virtue of intervening events.)
I understood that KR and affiliated companies would, of course, in setting a price to be paid by the Prop Fund for a resource property, add to the direct cost of the property a reasonable amount to cover investigative and administrative costs incurred as a result of the property acquisition program.
I also understood that KR or affiliated companies might perform drilling, coring or other services in connection with property exploration and development; I was specifically advised by John King and/or Rowland Boucher that amounts billed for such work would generally be calculated on a cost plus 7% or 8% profit basis.
I might add that in the last few months I have been advised by IOS personnel that in several instances properties were acquired by KR or affiliated companies one day and vended (either that same day or almost immediately thereafter) to the Prop Fund at a 10 times or 20 times mark-up. Such a practice was clearly contrary to the understandings motivating IOS/FOF to enter into and to continue the relationship with KR.
a. If KR could buy property at $ x, this was a clear indication of the value of such property to knowledgable industry purchasers.
b. If a tract of acreage was purchased by KR for $1 an acre, with a "turn-about" vending to the Prop Fund at a price of $10 an acre for 50% of the position, such transaction would fly directly in the face of the underlying concept of KR having a meaningful investment in properties along with FOF. (It was never intended that FOF have a partner in resource properties who would have a "free ride". We never intended to play a "heads you win, tails I lose" game.)
Px-538. Cowett's understanding of arm's-length pricing thus relies upon market value, including KRC's cost, with appreciation over KRC's cost plus a reasonable profit dependent upon the passage of time and intervening events. The price was not necessarily dependent upon there actually being sales to KRC's 200-odd customers. Testimony was elicited on cross-examination of Conwill that supports Cowett's understanding of the pricing policy, the importance of proportionate investment by the King group in interests sold to FOF and the specific treatment of interests acquired by KRC and TCC for substantially contemporaneous resale to FOF. TR 10,076-95.
Conwill testified that natural resource interests held in inventory might be priced differently than interests bought specifically for resale to FOF. TR 10,080-83. Cornfeld also testified that, as to interests purchased for FOF, KRC's cost would reflect the market value. TR 6333-34.
Beginning immediately after the Acapulco meeting FOF began to purchase oil, gas and mineral interests from KRC. King reported to the FOF Board of Directors on August 2, 1968 that $3,000,000 of the initial authorization of $10,000,000 was committed, with great success to date. Px-44.
In connection with the year end 1968 audit of FOF by AA, the Denver office prepared a "Summary of 1968 Sales to IAMC, Royal and IOS" as of December 31, 1968. Px-95. This document was one of a series of comparisons of prices charged by the King group to FOF, King affiliates and other knowledgeable industry purchasers. E.g., Px-69, Px-143, Px-160; Dx-K-11. The "Summary of 1968 Sales" (Px-95) shows the following with respect to sales to the King affiliates:
Current Current Profit As A
Current Sales Cost [to KRC] Profit % of Sales
Sales to IAMC $9,876,271 $8,220,324 $1,655,947 16.8%
Sales to Royal 6,566,491 4,085,544 2,480,947 37.8%
Sales to IOS 11,325,386 4,307,583 7,017,803 62.0%
In the same document, AA also computed the comparative profits for KRC excluding interests sold to Royal and to IOS (really FOF) which carried exceptionally high markups. AA subtracted the Midbar deal from Royal's calculations, which represented almost 50% of gross sales by KRC to Royal in 1968 and returned a 54.6% profit as a percentage of sales, resulting in a net 22.1% profit margin. Five different transactions were omitted in reaching a net profit figure on KRC's sales to FOF. Individually, these transactions showed profits of 98.6%, 98.7%, 56.7%, 58%, and 85.6%. After subtracting these individual sales, however, KRC's profit as a percentage of sales was over 33%. Thus, AA knew in early 1969 that KRC's sales to FOF were made at significantly higher percentage profits than 1968 sales to King affiliates Royal or IAMC.
KRC's "Consolidated Sales to Industry", dated September 30, 1969, illustrates that KRC's profits on sales to FOF were 68.2%, as compared with average profits on all sales of nearly 36%. Px-143. The comparison is especially stark when we examine only the seven industry customers which purchased over $1 million of interests from KRC. The next highest profit/sales ratio earned by KRC on sales to such customers (after FOF at 68.2%) was 24.4%; the lowest profit/sales ratio was 5%. KRC earned much higher profits on sales to FOF than on sales to its other non-affiliated customers.
In 1968, KRC sold $11,829,236 worth of interests to FOF, which KRC purchased for $4,855,001; total 1968 sales to other entities by KRC amounted to $34,040,665, and the purchase price of such interests to KRC was $22,673,406.
Px-740. In 1969, KRC did $41,259,314 worth of business with FOF, selling interests to FOF which directly cost KRC $13,220,440; sales to other entities of interests purchased by KRC for $48,848,654 totaled $63,379,281. Id. In 1970, KRC sold interests which it had purchased for $5,053,363 to FOF for $14,855,839; sales to other entities amounted to $13,597,575 on interests purchased by KRC for $9,235,812. Id.
FOF also purchased natural resource interests from KRC's sister company, The Colorado Corporation ("TCC"). TCC had 1969 gross sales to other entities besides FOF of $39,239,060 of interests which it purchased for $26,048,157. Px-745. In 1969, FOF purchased interests from TCC for $13,228,449 which TCC purchased for $3,670,844. In 1970, TCC grossed considerably more on sales to FOF than to other entities: only $238,686 was received from other entities for interests which were purchased by TCC for $91,186, while interests obtained by TCC for $1,522,270 were sold to FOF for $4,202,038.
These calculations were derived from AA's workpapers. Moreover, there is evidence that the King entities built up a "special inventory" of natural resource interests for resale to FOF, Px-519, and that was known to AA.
c. AA's Knowledge of the King-FOF Relationship
In addition to auditing FOF, AA audited the King group, including KRC, TCC and John M. King personally. AA's Denver office performed the King audits and did substantial work on the NRFA audit for FOF. TR 1971, 3632-33, 5260-62, 8764. The partner in charge and the manager of the KRC audit held the same positions with respect to the NRFA audit. TR 2883-85, 4629. The NRFA audit was performed by using the records of KRC, TR 1702, 8935, and sometimes AA staffers would work on KRC and NRFA audits contemporaneously. TR 1701-02, 1784. Thus, AA's understanding of the ongoing business relationship between FOF and the King group can be determined from documents found in the AA files for KRC or NRFA and from testimony regarding the actual conduct of the audits. The Denver office did have notice of the investment advisory relationship between KRC and FOF, as described in KRC submissions to the SEC. Px-50, Px-80, Px-87. AA also possessed minutes of an IOS Board of Directors meeting describing the NRFA as "essentially a discretionary account managed by King Resources Corporation". Px-392. During the relevant time period, AA itself noted KRC's "carte blanche authority to buy oil and gas properties for [NRC]", Px-121, see also Px-83, and "quasi-fiduciary" duty to FOF, Px-530. AA also had access to information detailing the King group's costs and profits with respect to FOF. TR 4697-98; Px-66, Px-67.
Additionally, AA was aware of the lack of a written contract evidencing the terms of the relationship between KRC and FOF. TR 8816-17. The Denver office sought confirmation of the nature of any KRC-FOF agreement from KRC for a KRC audit, but did not seek any such information from FOF with respect to the NRFA audit. Although AA's Swiss office received a copy of the Acapulco minutes, see Dx-E-8, it is quite significant that AA's Denver office did not see the minutes, TR 1849, 8535-36, as the Denver personnel were responsible for determining adherence to the pricing agreement.
d. AA's Knowledge of the Purchases
By AA's calculation, "the earliest date when anyone employed by Andersen would have become aware of KRC's 1968 sales to FOF was in early 1969", AA Brief at 297, prior to the March 24, 1969 date on Px-95. March 24, 1969 was three weeks before AA's audit report for KRC for 1968 was filed. Px-585. However, it is reasonable to find that AA knew what FOF paid for the interests purchased in 1968, that AA knew what KRC paid for them, and that AA knew KRC's profits, prior to February 5, 1969, when the FOF audit report as of December 31, 1968 was filed. Philip Carr testified that Denver first did some "information gathering" on the NRFA at the request of the New York office for the FOF Prop audit as of December 31, 1968. TR 2884, 3433. Some FOF-KRC transactions were reviewed for the 1968 year end audit by Carr in the Denver office of AA before January 28, 1969. Px-157. Nicholas Constantakis testified that New York and Denver were responsible for NRFA matters for the year end 1968 audit. TR 2286, 2385. Graydon Hubbard testified that the Denver office was first asked to provide some sales documents relating to the year end 1968 FOF audit and that it obtained such documents from KRC. TR 4624, 4627. There is no evidence that the NRFA was audited by AA as of June 30, 1968 -- although FOF was audited twice yearly -- or what such audit showed.
AA viewed King and his companies as a difficult client, posing difficult issues and some risks to AA itself, prior to the year end 1968 KRC audit and as early as 1966. TR 2271, 3415, 3424, 4742.
AA also viewed FOF as presenting difficult problems. TR 2303-05. However, the year end 1968 audit is the first instance of AA's actual knowledge of King's sales and profits. See Px-69; Px-95. The Denver office of AA had primary responsibility for audits of the NRFA occurring after year end 1968. This involved scrutiny of the "back-up documents" on NRFA. TR 2142. For the FOF audit as of June 30, 1969, AA's Denver office determined the cost value of NRFA purchases by reference to the KRC books. TR 3438-39. AA did not determine the market value of the NRFA interests for the FOF audit as of June 30, 1969, but did review the valuation as being in accordance with FOF's guidelines, which basically referred the matter of valuations to Rowland Boucher of KRC. TR 3447-53. The FOF financial statements for the periods as of June 30, 1968, December 31, 1968, and June 30, 1969 were unqualified.
As an open-ended mutual fund, FOF was required to value its investment portfolio on a daily basis. The daily share value was determined by dividing the net asset value of FOF's entire portfolio by the number of outstanding shares. Dx-A-1. FOF redeemed shares on the basis of its daily share value -- a value that was too low would undercompensate redeeming shareholders, and one that was too high would overcompensate them. Natural resource interests posed sensitive problems of valuation, due to their speculative nature and the lack of a market for determining current realizable value.
In late 1968, John King arranged with Robert Raff, president of a Seattle brokerage firm, to sell 10% of a certain natural resource interest owned by FOF to provide a basis for revaluation of FOF's remaining 90% interest. The purchase priced totaled $440,000, with an $88,000 down payment required. However, Raff and his company did not have the money to make the down payment. TR 1311. King advanced Raff the money to make the down payment, TR 1938-39, and assured Raff that no further financial commitment was necessary. TR 1266, 1269-72; Px-499. Without knowing that the Fox-Raff sale was not an "arm's-length" transaction, AA auditors questioned the objective basis for a write-up based upon the short holding period for the interest, the lack of any strikes or new geological information on the area, and doubted whether the 10% sale was sufficient to establish the value of the whole parcel. TR 1916. On the basis of these doubts, AA resolved to "write a letter to the Board of Directors of FOF Prop and FOF pointing out lack of adequate objective basis for unrealized appreciation, lack of disclosure in prospectus, and fact that our passing this unrealized appreciation on the basis of immaterial [sic] doesn't set a precedent for future". Px-77. No such letter was ever sent to the FOF Prop or FOF Boards, or to anyone else.
It was also thought by AA to be desirable to have an independent appraisal of the interests. TR 1984. Discussions within the AA ranks concerning Fox-Raff extended to the very highest partnership level. The AA partner working on the year end 1968 FOF Prop audit, John Robinson, was notified in January 1969 by Phil Carr of the Denver office of the fact that the sale to Fox-Raff was not at arm's length because King had advanced the down payment to Raff in the form of a non-interest bearing loan. TR 1928, 1950. Robinson recorded the conversation with Carr as follows:
Phil Carr telephoned to say that the $88,000 cash paid to National Resources Corp. at 12/30/68 (20% of contract amount was advanced (non-interest bearing) by King Resources Corp. for a of the purchasers because their corporation had not yet been formed. On 1/30/69 (today) allegedly the $88,000 is being paid to King Resources by either the purchaser or the parent of the purchaser (Fox, Raff).
The significance of the above appears to be that the original seller (King Resources), who are now in one or more joint ventures with Natural Resources Corp., advanced on 12/30/68 money (at no interest) for account of new purchaser to old purchaser so old purchaser could within his calendar year (1968) pick up unrealized appreciation and thus increase the earnings and N.A. [net asset] value of the stock of an offshore mutual fund by approximately 4 cents to 5 cents per share.
PX-79. AA never told any representatives of FOF, FOF Prop or IOS that the sale was not bona fide. However, AA determined to treat the transaction as not material to FOF's financial statement, despite its non-arm's length character.
TR 1984. The Fox-Raff transaction resulted in a write-up of unrealized appreciation in certain natural resource interests of $820,000 or about 2-1/2 cents per share, and was reflected in the year end 1968 financial statement of FOF with a footnote to the effect that such a gain was determined by the Board of Directors of FOF. Dx-A-24.
Fox-Raff was also audited by AA. Both Raff and AA workpapers confirm AA's knowledge that the investment would be sold within six months, so that Raff would never have to meet the remaining financial obligations to FOF. TR 1297-98; Px-65, Px-107.
When FOF pressed for payment, Raff sought and obtained the means to pay FOF from Boucher at KRC. TR 1360-61, 1365-67, 1385-87; Px-139. AA/Denver knew of the prepaid commission chosen by Boucher to provide Raff with the means to pay FOF. Px-209; Px-290.
b. Development of Guidelines
In connection with a proposed mid-1969 revaluation, FOF informed KRC that AA's Denver office would have "full audit responsibility for the investment account both as to cost and market value" and expected AA/Denver to confirm to AA/New York and AA/Geneva "that they have satisfied themselves as to the cost and market valuation of the investments of NRC as of June 30, 1969." Px-112. Although the prospect of opining on the market values of FOF's investments troubled Phil Carr of AA's Denver office, Px-116, he was informed by the Geneva office that it would not be sufficient merely to disclose the method of valuation if that "does not fairly present the facts." Px-119. It was understood that KRC was establishing values for FOF's natural resource interests. TR 3452-53; 4827; Px-158. Carr did meet with KRC to review the mid-1969 revaluations made by KRC at the end of July 1969. The mid-1969 revaluation totalling $18,884,976, was made by Boucher and supported by an appraisal by J. C. Sproule and Associates, independent Canadian geological and engineering consultants. This fixed the per acre value at approximately $2.00.
In the fall of 1969, AA was asked by Boucher of KRC what kind of sale or documentation was required to support a revaluation of FOF's Arctic interests. TR 8658-59. After this inquiry, AA sought to establish guidelines or "general ground rules" for revaluations based upon unrealized appreciation to provide "substantive independent evidence for reviewing the reasonableness of the client's valuations." A November 7, 1969 memorandum authored by Phil Carr set out AA's proposal:
Any significant increase in the value of natural resource properties over original cost to FOF must, for audit purposes, be supported by either:
(1) An appraisal report rendered by a competent, independent expert, or
(2) an arms-length [sic] sale of a sufficiently large enough portion of a property to establish a proportionate value for the portion retained.
Item (2) above is where we currently are not in clear agreement with the client. King Resources Company (Rowland Boucher) has been informed by FOF (purportedly Ed Cowett, Executive Vice President) that sale of a 10% interest in a property would be sufficient for FOF's purposes in ascribing a proportionate value to the 90% retained. This procedure was first used at December 31, 1968, when King Resources Company arranged, on behalf of FOF, for the sale of a 10% interest in an oil and gas drilling prospect and certain uranium claims and leases to Fox-Roff, [sic] Inc., a Seattle brokerage firm affiliate . . . .
Since our responsibilities here in Denver with respect to the December 31, 1968, FOF audit consisted only of determining the basis on which King Resources Company determined the valuations (not auditing such values), we discussed this transaction with John Robinson and Nick Constantakis in New York but left any final audit decision up to them. It is our understanding that the King Resources Company valuations determined by the 10% sale were allowed to stand in the final FOF audit report.
On the question of what constitutes adequate sales data for valuation purposes (i.e., the 10% question), we have proposed the following to King Resources Company:
(1) No unrealized appreciation would be allowed on sales of relatively small percentages of properties to private investors or others who do not have the necessary expertise to determine a realistic fair market value. By "relatively small", we envision approximately 50% as being a minimum level in this type of sale to establish proportionate values for the remaining interests. This would preclude any unrealized appreciation on sales such as the December, 1968, sales to Fox-Roff, [sic] Inc. since it could not be reasonably sustained that a brokerage firm has the expertise necessary to evaluate primarily undeveloped resource interests.
(2) Appreciation would be allowed if supported by arms-length [sic] sales to knowledgeable outside parties. For example, if King Resources Company sold a 25% interest in the Arctic permits to Texaco or another major oil company, we believe it would be appropriate to ascribe proportionate value to the 75% retained. Just where to draw the line on the percentage has not been clearly established. We feel 10% would be a bare minimum and would like to see a higher number.
It appears that we will be faced with a valuation problem along the above lines relatively soon since King Resources Company in September, 1969, has apparently made a sale somewhere in the neighborhood of 10-15% of FOF's interest in a South African diamond property. The buyer is purportedly a Canadian mining company of unknown quality, but probably is not the type buyer in this situation that Texaco would be to an oil and gas property. King Resources Company is proposing to use this sale as the basis for a $3.5 million write-up in FOF's remaining interest, which write-up would be included in their September 30, 1969, valuation reported to FOF.
Both Dee Hubbard and Cal Bennett have been heavily involved in our work to date and will continue to participate rather closely in our future responsibilities for this client. We would certainly appreciate your thoughts on our valuation approach problems, John, after you have had a chance to review the enclosed material.
Px-158. This memorandum was circulated to AA partners March in Chicago (the senior AA partner responsible for audit practices), Evenson in Los Angeles (the regional audit practice director), Robinson in New York, and Tenz in Geneva. A copy was given to Cowett. John March suggested a sale of a "25-30% minimum", a more conservative figure (TR 5512), and stated that it "must be a cash deal with no take-out option".
Px-164. The guideline finally adopted by FOF in the spring of 1970 for inclusion in the 1969 Annual Report was slightly different:
The following sets forth the present guidelines established by the Boards of Directors of the fund and Proprietary with respect to the valuation of natural resource properties. Such guidelines have been consistently followed.
(a) Such properties are carried at cost, until an event of such obvious and compelling significance occurs as to require a change in that value. Discovery of a mineral interest, determination of the property being unproductive through testing or other geological evaluation, or a sale of all or a portion of the property held would be among the factors which would constitute such an event.
(b) A partial sale may be used as a basis for evaluation of unrealized appreciation on the remaining holdings when such sale is at arm's length, and when a sufficient percentage of Proprietary's holding is sold.
(c) Outside appraisals are used only in those cases where the Boards of Directors are satisfied that there is appropriate substance to recognition of unrealized appreciation on the basis of appraisal. However, where significant unrealized appreciation is involved, independent appraisals may not be considered sufficient and demonstration of the current realizability of such appreciation through a consummated sale may be required.
Dx-B-2. FOF's guideline does not specify a fixed percentage which must be sold and does not refer to the identity or attributes of a buyer.
With AA's guidelines in mind, KRC tried to find a major oil company to purchase a significant interest in the Canadian Arctic. KRC was unsuccessful in attempting to sell a 25% interest in the Canadian Arctic to Standard Oil of Indiana in late 1969. TR 4564-65. A subsequent proposal was for FOF Prop to sell 25% of their Arctic interest to an independent group of investors for $50 million cash, resulting in unrealized appreciation of the remainder of FOF's interest of $150 million. Px-170. Finally, King arranged a sale of 9.375% of his group's Arctic interest to third parties in late December 1969 and FOF in essence reimbursed King by selling an identical interest in its Arctic holdings to the King group in January 1970 on the same terms as King's original sale. The 1970 FOF Annual Report details the transaction as consummated:
In January, 1970, Proprietary concluded a sale for its subsidiaries of 10 per cent of their interests in the Arctic permits. This sale was made to the operator of the permit interests on the same bases and terms as a December, 1969, sale by such operator of a 9.375% interest to outside third parties. Sales proceeds consisted of $779,300 cash down-payment and $7,570,000 payable in six semi-annual installments beginning in 1973 and bearing interest at 6% per annum. The sales agreement also relieves the sellers of 80% of the first $10,436,500 of their commitment for exploration costs. The purchasers have thereby assumed an obligation for exploration costs which is $7,305,500 in excess of such costs applicable to their interests in the permits.
Based on the terms of the sale outlined above, and as approved by the Boards of Directors of the Fund and Proprietary, Proprietary has valued its subsidiary's interest in the Arctic permits at $119,000,000. Such value represents a gross valuation of $156,000,000 less, (a) discounting to provide an effective 8-1/2% interest rate on permit payments and an effective 10% interest rate on excess work obligation payments ($20,000,000) and, (b) the 12-1/2% net operating profits interest ($17,000,000). The portion of that valuation applicable to Proprietary is $114,240,000, equal to $10.60 per net acre. After deduction of management fees and income taxes, the Fund's value per net acre is $8.01.
Dx-B-2. The cash portion of the sale amounted to approximately 4% of the purchase price.
This sale of FOF's 9.375% interest in the Canadian Arctic to John Mecom and Consolidated Oil & Gas ("COG") was the basis for the $119 million upward revaluation of the remainder of FOF's Arctic interest. Although John King (personally) and Lakeshore Associates (a King affiliate) also purchased some of FOF's interest at the same time, they were not considered by AA in evaluating the transaction.
Mecom, a wealthy Texan who owned U.S. Oil of Louisiana, Inc. was experiencing severe cash flow problems as of December 1969. Mecom lost $11,458,000 for the year ending September 30, 1969, Px-147, and even after he refinanced several loans that were in default in 1968, TR 4262-63, Px-39, faced debts of over $132,000,000. AA audited Mecom from its Houston office, TR 4146, and knew of his cash bind, TR 4149-51, 4272. In February 1968, Leonard Spacek, AA's managing partner, met with King and Mecom to discuss integration of the King and Mecom organizations, TR 4265-66, Px-29. Spacek also discussed a role for KRC in refinancing Mecom's debts in May 1968 and in December 1968 Spacek discussed the possibility of a King-Mecom joint venture with the Houston office of AA. TR 4272; Px-36; Px-51; Px-61. In late 1969, King was casting about for a purchaser for a portion of FOF's Arctic interest to justify a revaluation. King approached Mecom with a deal that was remarkably similar to the one offered Raff a year earlier. A King employee asked Mecom to purchase an interest in the Arctic. King would provide the $266,000 down payment, TR 3975, and subsequent $10 million in payments would be provided by King's use of Mecom-owned oil and drilling equipment. TR 3969. The King-Mecom deal was consummated on December 24, 1969 and a written side agreement enabling Mecom to make the Arctic purchase was executed:
This is to confirm my agreement with you in connection with your purchase from King Resources Company of approximately 347,883 net acres of oil and gas exploration permits in the Canadian Arctic Islands for $7.50 per acre plus $7.50 per acre in work obligations under the terms of an agreement with King Resources Company dated December 24, 1969.
I have agreed to provide sufficient net cash receipts to be paid to you to enable you to make all payments on your said contract with King Resources Company through payments due in October, 1971.
At any time after October 1971 up to December 31, 1971, I have also agreed that if you so request and assign to me your interest to said permits, I will assume and pay and hold you harmless from all obligation to pay all amounts due King Resources under said contract subsequent to October, 1971. Provided that if, prior to October 1971, you are afforded an opportunity to sell your interests at a price in excess of your costs, my further obligations hereunder shall cease.
This letter will be held for our mutual account by Timothy G. Lowery [sic] of Peterson, Lowry, Rall Barger & Ross of Chicago, Illinois.
Px-193. The final side agreement was different from King's original proposal, but it was a necessary prerequisite to Mecom's participation in the transaction. TR 3959-60; 3968.
COG was a Denver-based oil and gas concern headed by a friend of King. TR 4328, 4522. COG was not a major oil company. TR 4523, 4585-86, 4826-27, 9045. To AA's knowledge, the King entities and COG had previously joined in business transactions. TR 9101-02; Px-385. King arranged a $600,000 loan for COG with a Tulsa, Oklahoma bank, TR 4405, 4474, without which COG would not have entered into the transaction. TR 4375-76. There is conflicting evidence whether COG had a side agreement with King whereby COG "could turn the acreage back to King Resources today if it wished, cancelling all further payments". Px-412. In February 1970 KRC purchased one-half of COG's interest in certain Alaskan property for $15 per acre. Since KRC had rejected such a transaction four months earlier and COG was apparently willing to accept $3 per acre, Px-146, this deal may also support a conclusion that KRC and COG had a side agreement concerning the December 1969 purchase by COG from FOF.
There was considerable discussion within the AA ranks concerning possible qualification of the FOF financials when the magnitude of the proposed revaluation became clear in mid-December 1969. The Denver office did not believe that AA could give an unqualified opinion "on the overall market value of [FOF's] investments at December 31, 1969." Px-172; Px-179. The Denver office, charged with the responsibility of checking the values of FOF's purchases, "tried to emphasize that [their] work  is not necessarily authority for rendering unqualified opinion when natural resources fund becomes [a] material part of FOF." Px-179. Los Angeles-based regional audit practice director Evenson concurred in Denver's assessment. Id. The Denver office stressed that it was a policy decision to be made by March, at AA's home office in Chicago, "whether [the] firm can give [an] unqualified opinion on fund when [a] material part of [FOF's] portfolio is invested in assets which are not valued by an active daily market of sellers selling and buyers buying." Id. March's initial reaction was that revaluation of the whole parcel on the basis of a proposed sale of a one-eighth interest for $21,000,000 seemed like "a great deal of maneuvering of values based on very little cash received at the present time." Px-175. Alan Brodd of AA's Geneva office, however, noted that FOF's response to a qualification would be "an explosion" since FOF would follow "the creteria [sic] we have laid down." Px-178. Brodd asked: "What is different now compared to 6.30.69 when amounts were material?" Id. It is quite clear that FOF did not want anything in the auditor's opinion which could be interpreted as a negative statement with respect to the revaluation. TR 3040-42, 5529. In response to Brodd, March said that he did not foresee qualification in the usual sense. Px-181. After consultation with various AA partners, the decision was made by March to add the following sentences to the "scope paragraph" of the auditor's report: "Certain investments, in the absence of quoted market prices, have been valued by the Board of Directors as indicated in note . These valuations have been ...