The opinion of the court was delivered by: WEINFELD
This action arises from the 1982 sale of a controlling interest in the American Plan Corporation ("American Plan" or the "Company"), a New York corporation engaged through its subsidiaries in the property and casualty insurance business. Defendants Ronald, Thelma, and Beatrice Hart and Barbara Bergen, individually and in representative capacities, collectively controlled 520,691 shares, approximately thirty-five percent of the outstanding stock of American Plan. On June 25, 1982, plaintiff A.P.N. Holdings Corp. and defendants executed a stock purchase agreement (the "Agreement") whereby plaintiff agreed to purchase defendants' interest at a price of $10 per share, which totalled $5,206,910. Plaintiff paid defendants $520,000 when the Agreement was executed; an additional $1,230,000 when the transaction closed on October 5, 1982; and executed a promissory note for the balance of $3,456,910, which is unpaid and now past due.
The Agreement was negotiated by Abe Lieber, plaintiff's principal shareholder, president, and chairman of the board, and Ronald Hart, then a director and paid consultant of American Plan and formerly its president and chairman of the board, who acted on behalf of all defendants. Plaintiff claims that Lieber and Hart agreed upon a purchase price of $10 per share with the understanding that such price was approximately twice the book value per share of American Plan stock as reflected in the Company's then most recent financial statements filed with the Securities and Exchange Commission ("SEC"); that Hart denied plaintiff access to the Company's books and records prior to the closing date but assured it that the SEC filings fairly and accurately represented the Company's financial condition and, indeed, so warranted in the Agreement; and that after the closing date when plaintiff gained access to the company's books and records it discovered that the true book value of American Plan prior to the closing date was $0.51 per share, more than five dollars less than that reflected in the Company's most recent financial statements. In short, plaintiff charges that in assessing the Company's book value, which the parties allegedly understood was the basis of the $10 per share purchase price, it had no choice but to rely entirely upon the Company's publicly filed financial statements and that these statements were inaccurate and incomplete and far overstated the book value of American Plan.
Plaintiff seeks to recover damages of $4,675,805, the difference between the purchase price of $10 per share of American Plan stock and the alleged true value of that stock. In the alternative, plaintiff seeks reformation of the Agreement to reflect a purchase price of $1.02 per share, or twice the Company's alleged true book value of $0.51 per share, and restitution in the amount of $1,218,895, the difference between the purchase price as reformed and the amount plaintiff previously paid defendants as of the closing date. Defendants, in addition to a general denial of plaintiff's claims, emphasize that under paragraph 3.1(c) of the Agreement plaintiff disclaimed reliance upon any representation or warranty by defendants concerning the financial condition of American Plan other than a limited warranty that, to the best of defendants' knowledge, no material adverse change had occurred after the first quarterly report was filed in 1982. Defendants also assert a counterclaim to recover $3,456,910, the balance of the agreed purchase price, from plaintiff under its promissory note and a third party claim against Abe Lieber, his wife, and various affiliates who executed a guaranty of payment by plaintiff (the "Guarantors").
The complaint alleges federal claims under section 10(b) and 20(a) of the Securities Exchange Act of 1934
and section 17(a) of the Securities Act of 1933
and state claims for breach of contract, breach of warranty, mistake of fact, common law fraud, negligent misrepresentation, and violation of section 352-c of the New York General Business Law.
These claims involve different standards of culpability. For example, defendants may not be held liable under section 10(b) of the Securities Exchange Act of 1934 without proof of "Scienter,"
whereas they may be held liable for damages caused by a breach of warranty upon proof that the warranted facts did not exist.
Yet, despite these differences, all these claims essentially rest upon the factual charge that the Company's publicly filed financial statements, upon which plaintiff allegedly relied in agreeing to pay defendants $10 per share for their interest in American Plan, contained errors that misrepresented the Company's book value. Thus, to recover upon any of the asserted grounds, plaintiff must establish by a preponderance of the evidence that the financial statements at issue in fact contained the errors as charged.
Plaintiff's claims in large measure center about the application of of accounting principles in the insurance industry and alleged errors in American Plan's financial filings, which served as the basis for restating those statements in subsequent filings. The specific financial statements in issue are those contained in the Company's Form 10K for 1981 ("1981 10K") and Forms 10Q for the first three quarters of 1982 ("1982 10Q's"). All parties acknowledge that annual and quarterly financial statements filed with the SEC must be prepared in accordance with generally accepted accounting principles ("GAAP"). Plaintiff contends that after it took control of the Company, new management and outside auditors discovered, during two successive audits, that these financial statements contained errors under GAAP. First, in conducting the 1982 annual audit, new management and the accounting firm of Alexander Grant & Company ("Alexander Grant") allegedly found in 1982 10Q's in error with respect to the adequacy of the Company's loss and loss adjustment expense reserves and to bad debts owed the Company by two of its agents. Thereafter, in conducting the 1983 annual audit, new management and Peat, Marwick, Mitchell & Company ("Peat, Marwick"), retained a place of Alexander grant, allegedly found errors in the 1981 10K and additional errors in the 1982 10Q's. These alleged errors concerned reinsurance recoverable by the Company, contingent commissions owed to a leading agent, and the way the Company accounted for two surplus relief treaties, discussed hereafter.
Plaintiff further contends that all of these discoveries were based upon information that was available to old management when it prepared the 1981 10K and 1982 10Q's and that therefore, under GAAP, they constituted "errors" and warranted restatements of the financial statements contained in those filings. As a result of these restatements, which new management included in the Company's Form 10K for 1982 and Form 10K for 1983, the book value of American Plan for the nine months ended September 30, 1982 -- the last statement date before the closing -- allegedly dropped more than $5 per share to $0.51 per share.
An observation is warranted at the outset. After the occurrence of events in issue, Abe Lieber called in one "expert" after another who scrutinized the Company's financial statements and whose efforts, one is justified in concluding, were directed to turning up some "error" that would sustain plaintiff's claim that the book value of American Plan had been overstated. Many of the views of these experts who testified were highly conceptualized and were based upon their opinions as accountants. Against this testimony was that of American Plan's officers, who had been active in the day to day management of the Company's affairs and were familiar with the Company's insurance experience record, accounting practices and requirements. The fact that plaintiff's experts opined as to what they believed were errors in the Company's various financial projections and assignments of debits and credits does not entitle their views to greater consideration than that to be accorded lay persons who demonstrated a thorough understanding of the basic facts in issue.
Their credibility as witnesses is subject to appraisal by the same standards as those applied to ordinary witnesses. The Court accepts in substance the judgment of the Company's officers who had the experience of many years in evaluating the various financial matters to which the plaintiff's attack is directed. They were the day to day workers in the vineyard.
Based upon the Court's trial notes, which include its contemporaneous appraisal of each witness, a word reading of the stenographic transcript of the trial, the demeanor of the witnesses, and evaluation of their credibility -- which in this case played a critical role -- and the reasonable inferences to be drawn from established facts and surrounding circumstances, the Court concludes that plaintiff has failed to discharge its burden of proof on the central factual charge in the complaint. It has not established that the old management of American Plan -- and thus defendants -- acted without justification in preparing the financial statements under attack or that these statements contained the errors charged. As to defendants' counterclaim, and third party claim, there is not dispute that plaintiff has defaulted on two installments of its promissory note. Its only defense -- and that of the Guarantors -- is the central charge set forth in the complaint, that the 1981 10K and 1982 10Q's contained errors under GAAP that misrepresented the book value of American Plan. Plaintiff's failure to sustain this charge is therefore dispositive of all claims, counterclaims and third party claims.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
After the closing, Richard Pluschau, a certified public accountant who has served as the Company's outside auditor for over ten years and had considerable experience in the field of insurance, was engaged by new management of American Plan as chief financial officer. He conducted a statistical analysis of the Company's historical claim activity for several prior years in order to determine whether the Company's reserves for unpaid losses and loss adjustment expenses were adequate. Pluschau concluded that as of December 31, 1982 the reserves were inadequate and should be increased by between $2 million and $2.5 million. Thereafter, at Pluschau's suggestion, Huggins & Co., Inc. ("Huggins"), an actuarial firm, was retained by the Company to conduct an independent review of the reserves and it issued an opinion certifying the adequacy of the reserves as revised upward by Pluschau. The question then arose whether this revision should be reflected solely in the fourth quarter of 1982 or also in the first three quarters of that year, as to which the financial statements had already been filed. Pluschau specifically requested Alexander Grant, retained to conduct the 1982 annual audit, to determine whether the Company's financial statements in the 1982 10Q's filed previously should be restated in view of the revision of reserves. Alexander Grant concluded that the financial statements for the first two quarters of 1982 should be restated to reflect an increase in reserves of $774,108 and $132,130, respectively.
Plaintiff contends that the restatements were warranted under GAAP because the inadequacy of the reserves could have been discovered by old management when it prepared the 1982 10Q's. Pluschau so concluded because he found no evidence that old management had conducted an analysis of the company's "formula" reserves during the 1982 quarterly financial statement periods. Formula reserves, as distinct from case reserves, which are based upon individual claims already filed with the Company, are estimates of losses incurred but not yet reported to the Company ("IBNR's"), the cost of seetling claims ("loss adjustment expense"), and the inflationary impact upon the case reserves. Unlike the case reserves, which are set on a case by case basis as claims are filed with the Company, formula reserves are determined by applying certain formulae to historical claim data; they require an empirical judgement about the likelihood that past loss experience will be repeated. In Pluschau's view, had old management reviewed the formula reserves as of September 30, 1982, it would have found them inadequate. Dominic Esposito, the Alexander Grant partner in charge of the 1982 annual audit, also found no evidence that old management had conducted an overall review of the formula reserves during 1982 and concurred in Pluschau's decision to restate the 1982 10Q's, although he also would have concurred in confining the revision to the final quarter of 1982.
The conclusion of Pluschau, Huggins, and Alexander Grant that the 1982 loss and loss adjustment expense reserves were inadequate was disputed by Murray Lemonik, who was president, chief executive officer, and chairman of the board of American Plan prior to the closing and had been in the service of the Company for fifteen years. While Lemonik did not participate in the reserves review conducted by new management, he opposed the decision to increase the 1982 reserves for two reasons. First, the New York State Department of Insurance had only recently, in mid-1980, completed its triennial examination of the Company and reported that the reserves were adequate, as Lemonik put it, "very close" to being "on the button."
Since there had been no change in the Company's personnel who analyzed the case and formula reserves, no change in the instructions given them, and no change in the Company's operations, Lemonik saw no reason to believe that a reserve adjustment was necessary.
Second, new management did not conduct a review of "stale" claims in 1983. Stale claims are reported claims as to which the Company has set reserves but which are no longer active and may be closed out. In Lemonik's view, had new management conducted a case by case review of reported claims in order to identify stale claims, as had been done routinely by old management and as he urged new management to do in 1983, a large number of case reserves would have been reduced or eliminated. Lemonik asserted that his belief had been borne out when new management finally conducted a stale claim review in 1984 and found that case reserves should be reduced by approximately $3.5 million. Based upon prior Company experience, Lemonik stated, some sixty-five to seventy-five percent of that reduction would have related back to claims filed in ...