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FRANKEL v. ICD HOLDINGS S.A.

UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK


June 10, 1996

ALFRED M. FRANKEL, et ano., Plaintiffs, against ICD HOLDINGS S.A., et al., Defendants.

The opinion of the court was delivered by: KAPLAN

OPINION

 LEWIS A. KAPLAN, District Judge.

 In January 1994, plaintiffs, then the owners ICD Group, Inc. ("ICD"), one of the largest international dealers in petrochemical based commodities, sold all of their ICD stock to ICD Holdings S.A. ("Holdings"), an entity formed by two of their key employees, Dirk de Geus and Peter Loeffelhardt, for the purpose of acquiring ICD in a management buyout. Part of the consideration for plaintiffs' stock was subordinated notes of Holdings in the aggregate principal amount of $ 5 million (the "Notes"). The Notes were secured by absolute and unconditional guarantees executed by ICD Group B.V. ("B.V."), *fn1" de Geus and Loeffelhardt (the "Guarantees").

 As sometimes occurs in acquisitions in which, like this one, the ultimate purchase price is to be determined by reference to a balance sheet to be prepared after the closing, the Buyers *fn2" in time claimed that the closing balance sheet was fraudulent and refused to pay the Notes. The sellers thereupon commenced this action in New York Supreme Court by moving for summary judgment on the Notes and Guarantees in lieu of complaint. See N.Y. CPLR § 3213 (McKinney 1992). Defendants removed to this Court and resist summary judgment, principally on the ground that the alleged fraud is a defense to the Notes and Guarantees. *fn3"

 Facts

 Background

 Prior to the events at issue here, ICD traded in over one hundred products and had holdings around the world. It was the ultimate parent entity of B.V., and all of its common stock was owned by plaintiffs Alfred M. Frankel and Jacques Leviant.

 In 1993, Messrs. de Geus and Loeffelhardt were managing directors of, and were part of the management team that controlled, the commercial aspects of ICD's European and Russian operations. (de Geus Aff. P 5) Indeed, they were its most senior officials and ran the day to day operations of B.V. (Frankel Decl. P 9) Anxious to obtain a greater share in the profits of those operations, they discussed with plaintiffs a number of options to accomplish that goal. (de Geus Aff. P 6) According to defendants, plaintiffs were interested in selling because they were concerned about the economic environment in Europe and Russia. (Id. P 7)

 The Buyout Transaction

 The parties agreed on a buyout transaction in late 1993 or the first days of 1994. (Id. PP 6, 14, 15 & Ex. D) De Geus and Loeffelhardt caused Holdings to be organized to serve as the acquisition vehicle, and the transaction was structured as a purchase by Holdings of all of the common stock of ICD. (See id. P 7)

 The Purchase Agreement

 The Purchase Agreement provided that the purchase price would be:

 

"determined as an amount equal to the Book Value (as defined in Section 1.04) less $ 900,000 (subject to final adjustment as agreed by the parties ...), plus an additional contingent Purchase Price set forth in Section 6.03 below." (Id. Ex. D § 1.03(a))

 "Book Value" was to be determined from a special purpose consolidated statement of net assets as of September 30, 1993, as adjusted (the "Balance Sheet"). (Id. Ex. D § 1.04)) The parties agreed that Book Value would be determined by Richard A. Eisner & Co., ICD's certified public accountants. (Id).

 As is typical, the transaction contemplated the preparation of a preliminary balance sheet, which would provide the basis for the closing, with the price subject to subsequent adjustment upon the preparation of the definitive Balance Sheet later on. Section 1.05(a) of the Purchase Agreement provided in pertinent part that the accountants would:

 

"deliver the Balance Sheet (which shall be binding on the parties absent manifest error) (or if Eisner has not completed the Balance Sheet, a preliminary Balance Sheet reflecting Eisner's then current good faith estimate of Book Value (the 'Preliminary Balance Sheet') ... as well as a calculation, based upon the Balance Sheet (or the Preliminary Balance Sheet) ... of the Purchase Price and the portion thereof payable in cash at the Closing (the 'Estimated Cash Purchase Price')." (Id. Ex. D § 1.05(a))

 In the event the transaction closed on a Preliminary Balance Sheet, plaintiffs were obligated to deliver the Closing Balance Sheet and a determination of the Final Cash Purchase Price within thirty days thereafter. (Id. Ex. D § 1.05(b)) If the Closing Balance Sheet indicated that the Buyers had overpaid, Holdings was entitled to return of the overpayment. (Id. Ex. D § 1.05(c))

 The Purchase Price was to be paid in cash plus two Notes aggregating $ 5 million. (Id. Ex. D § 1.03(c)) Significantly, the agreement provided that the amount of any post-closing adjustment in the price would be paid promptly (id. Ex. D § 1.05(c)); there is no suggestion in the Agreement or the Notes that the Buyers would be paid (or accept) the return of any overpayment in the form of a reduction in the principal amount of the Notes.

 It was a condition to the obligation of each side to go forward with the transaction that the Estimated Cash Purchase Price be within ten percent of $ 67.8 million. (Id. Ex. D §§ 7.05, 8.04) De Geus claims that the sellers knew that the Buyers would not proceed with the transaction if the Estimated Cash Purchase Price was less than ninety percent of the $ 67.8 million figure. (Id. P 11)

 The "Open Items"

 As indicated above, part of the purchase price was described in the Purchase Agreement as "additional contingent Purchase Price set forth in Section 6.03" of the Agreement. (Id. Ex. D § 1.03(a)) Section 6.03 provided in relevant part that the sellers would be entitled, as additional contingent Purchase Price, to a percentage of the Closing Date Profits of Holdings and certain subsidiaries for each fiscal quarter, beginning with the quarter ending December 31, 1993. Insofar as is relevant here, "Closing Date Profits" for any quarter was defined as "the net cash profit (or loss) realized in such quarter from any contract or other item of value not reflected on the Balance Sheet which arose before October 1, 1993 (certain of which are set forth in Exhibit 6.03(4)), including, without limitation, arising from the relationship with V.O. Soyuzchim Export ..." (Id. Ex. D § 6.03(a)(4)) Exhibit 6.03(4) to the agreement listed sixteen "open items" and stated that all adjustments that would result therefrom would be split between the sellers and the Buyers in the ratio of 70/30 "and excluded from the contingent purchase price calculation." (Id. Ex. E) In a number of cases listed, the Exhibit makes clear that the parties did not have September 30, 1993 financial results at the time the transaction was negotiated and closed. (E.g., id. Ex. E PP 2, 8)

 The Notes and Guarantees

 The form of the Notes was specified in the Purchase Agreement. They are not simple IOUs. Rather, they are fourteen page, single spaced instruments containing extensive specifications of events of default, subordination provisions, definitions, and tax and other provisions specifically designed for this transaction. Section 15 of each Note provides:

 

"Obligations Absolute. The payment obligations of the Company [Holdings] under this Note shall be unconditional and irrevocable and shall be paid strictly in accordance with the terms of this Note under all circumstances, including, without limitation, the following circumstances:

 

"(i) the existence of any claim, set-off defense or other right which the Company or any other person may have at any time against the Holder or any other holder whether in connection with this Note, the Acquisition Agreement, the transactions contemplated herein or therein, or any unrelated transaction; or

 

"(ii) any other circumstances or happening whatsoever, whether or not similar to any of the foregoing." (Id. Ex. F § 15)

 The form of the Guarantees also was specified in the Purchase Agreement. They provide:

 

"Each of the undersigned stockholders of ICD Holdings S.A. (the 'Company'), a Luxembourg corporation, and ICD Group, B.V., hereby jointly and severally irrevocably and unconditionally guarantees to the Holders of this Note that the Company will pay and perform as required therein the Company's obligations under this Note.

 

"This Guaranty is an absolute, unconditional, present and continuing guaranty of payment and not of collectibility and is in no way conditioned or contingent upon any attempt to collect from the Company or upon any other condition or contingency.

 

"This Guaranty shall be governed by and construed and enforced in accordance with the laws of the State of New York, without giving effect to the principles of conflicts of laws thereof." (Id. Ex. G)

 The Closing

 On March 28, 1994, Eisner delivered a Preliminary Balance Sheet, a statement of the Estimated Cash Purchase Price and the list of open items contemplated by the Purchase Agreement. (Id. P 14 & Ex. H, I and E) The Estimated Cash Purchase Price was $ 64,933,450, which satisfied the condition that the price fall within ten percent of $ 67.8 million. (Id. P 14) The total estimated purchase price, taking account of the Notes, therefore was just under $ 70 million. (Id.) At the Closing, which occurred on March 30, 1994, the Buyers transferred $ 64,933,450 in cash to the sellers and signed and delivered the Notes and Guarantees. (Id. P 15 & Ex. D)

 In May 1994, plaintiff Frankel advised de Geus that Eisner had made a $ 1.5 million arithmetic error in computing the price, and plaintiffs immediately wired the overpayment to the Buyers. (Id. P 18; Frankel Decl. P 22)

 The Dispute Arises

 The Closing Balance Sheet is dated May 31, 1994. (de Geus Aff. Ex. L) The parties disagree, however, as to when it was provided to defendants. According to Frankel, it was turned over on or about the date of the report. (Frankel Decl. P 23) De Geus claims it was not produced until December 1995. (de Geus Aff. P 23). The Court therefore assumes the latter date for purposes of this motion.

 By the summer of 1995, the Buyers were looking for an adjustment of the purchase price in their favor. In a July 21, 1995 letter, de Geus took the position that there had been an overpayment of at least $ 2 million, although he professed an inability to determine the amount precisely. He suggested that the sellers make an interim payment in that amount. (de Geus Aff. P 20 & Ex. J)

 The November 1995 Moret Ernst & Young Report

 In November 1995, the Buyers retained Moret Ernst & Young ("Moret") to review the "open items," including the status of ICD's Russian subsidiaries. De Geus claims that Moret's November 1995 report "uncovered that the Balance Sheet failed to account for the 'open items' and thus was materially overstated or otherwise unsubstantiated by approximately $ 4.7 million." (de Geus Aff. P 21) De Geus' characterization, however, mischaracterizes the Moret report, a copy of which is attached to de Geus' affidavit. (Id. Ex. K)

 The face of the Moret report explicitly contradicts de Geus' broad assertion that Moret examined Eisner's treatment of the "open items" and concluded that Eisner had failed to account for them. The procedures Moret carried out were "limited to the items 8 (AOZT Versus) and 12 (Hisparus) of exhibit 6.03(4)." *fn4" (de Geus Aff. Ex. K, at 3) Nor did Moret reach any conclusions as to Eisner's treatment of those two items. The report begins by stating that Moret had not, as of November 14, 1995, completed the audit for the fifteen month period ending September 30, 1994 because, among other things, it had not yet received audited financial statements and audit clearance for Hisparus and AOZT Versus for the relevant period. (Id. at 1) Indeed, it goes on to say that it was "informed by Ernst & Young Moscow that it would be a great problem, if not impossible, to prepare the audited financial statements as per September 30, 1993." (Id. at 2)

 In the absence of any audited financial data for these two Russian subsidiaries, the Buyers provided Moret with their own calculation of their dollar equity value as of September 30, 1993. While Moret reviewed the Buyers' calculation, they did nothing more than check the arithmetic and exchange rates and verify that the Buyers' treatment of Russian value added tax was consistent with prior financial statements. They disclaimed any meaningful opinion:

 

"In our opinion, the methodology used to arrive at the approximate dollar net equity value as at September 30, 1993, given the circumstances, is acceptable. Because the above procedures do not constitute an audit in accordance with generally accepted auditing standards, we do not express an opinion. We make no representation regarding the sufficiency of the foregoing procedures for your purpose." (Emphasis supplied)

 Thus, by its own admission, Moret was in no position, and did not purport, to determine the financial results or the equity value of those subsidiaries.

 The January 1, 1996 Interest Payment

 Pursuant to the terms of the Notes, interest payments of approximately $ 113,000 were due on January 1, 1993. (de Geus Aff. P 25) By letter dated December 28, 1995, the Buyers' counsel took the position that the Buyers had overpaid by at least $ 4.7 million and probably as much as $ 7 to $ 8 million. They purported to direct that approximately $ 113,000 of the alleged overpayment be applied to the interest payments and the balance in reduction in the principal amount of the Notes. (Id. Ex. N)

 The 1996 Moret Report

 After the commencement of this litigation, Moret rendered a second report to Holdings, this one for the purpose of commenting on the treatment of the "open items" in an "attached draft settlement." (Id. Ex. O) Unfortunately, defendants have not seen fit to submit the attachment to the Moret report, so it is not entirely clear what "draft settlement" the report was talking about, although the text of the report indicates that it probably was a draft of the Buyers' calculation of the Book Value. Nevertheless, it is plain from the materials submitted, as well as the comments of counsel at oral argument, that the two principal bones of contention are AOZT Versus and Hisparus, which the Buyers claim had negative equity values of $ 827,090 and $ 3,844,370 at September 30, 1993, respectively. The suggestion by defendants is that the Balance Sheet improperly failed to reflect these sums, which would have reduced the purchase price. Perhaps so. *fn5" Moret, however, does not say that. What is most striking about the 1996 Moret report is the basis for the conclusion that these two entities have the indicated negative equity values.

 Moret's report begins with the statement that the procedures it performed:

 

"were designed to be responsive to management's [i.e., Holdings'] objectives and were approved by management prior to their performance. Because the adequacy of the procedures for management's purposes is dependent upon a number of subjective factors, we have no opinion as to whether or not these procedures are adequate for such purposes. Had we performed additional procedures, other matters might have come to our attention that would have been reported to you.

 

"Our findings and observations are a result of the Company's staff representations and the Company's accounting records. The procedures performed were not sufficient to obtain an opinion with respect to the completeness and correctness of these records and therefore we cannot and will not express an opinion on the completeness and correctness of the calculation underlying the draft settlement." (Id.) (Emphasis supplied)

 1. AOZT Versus. The report then proceeds, as far as is relevant here, to consideration of the $ 827,090 negative equity value assigned to AOZT Versus. It indicates that Holdings advised Moret that, at the end of November 1995, ICD's books showed a receivable from AOZT Versus that was $ 8 million less than the amount that the Buyers claimed was due. The Buyers advised Moret that the receivable was uncollectible and that, in the Buyers' opinion, $ 3.4 million of the shortfall was allocable to the period June 30, 1993 through September 30, 1993, i.e., before the closing. This of course appears to be the source of the allegation that there was a negative equity value at September 30, 1993. Moret, however, refused to express any opinion on the subject, commenting that "the position taken [by the Buyers] is one which includes a number of subjective factors, and we cannot and will not express an opinion on this part of the draft settlement." (Id. Ex. O at 5-6)

 2. Hisparus. Moret's comments regarding Hisparus and its alleged negative equity of $ 3,844,370 at September 30, 1993 are simply a repetition of the statements contained in the November 1995 letter.

 It should be noted that defendants have submitted an affidavit of a partner of Moret which states that "it appears that the open items were not accounted for in [Eisner's determination of] the Final Cash Purchase Price." (Goedkoop Aff. P 3) The affidavit does not explain the basis for this statement and simply refers the reader to Moret's two reports. (Id. P 4)

 Discussion

 Personal Jurisdiction

 De Geus and Loeffelhardt are subjects of the Netherlands and Spain, respectively. Both were served by registered mail. Accordingly, before proceeding to the merits of this dispute, the Court must consider their cross-motion to dismiss the action as against them on the ground that they are not subject to the personal jurisdiction of this Court.

 Section 10.11 of the Purchase Agreement provides in relevant part:

 

"Each of the parties (including the Shareholders) hereto hereby irrevocably and unconditionally consents to submit to the exclusive jurisdiction of the courts of the State of New York and of the United States of America, in each case located in the County of New York, for any Litigation arising out of or relating to this Agreement and the transactions contemplated hereby ... and further agrees that service of any process, summons, notice or document by US. registered mail to its respective address set forth in Section 10.10 shall be effective service of process for any Litigation brought against it in any such court." (de Geus Aff. Ex. D § 10.11) (Emphasis supplied)

 De Geus and Loeffelhardt were served in accordance with the terms of the Agreement. *fn6" Accordingly, they have no proper objection to personal jurisdiction. E.g., Burger King Corp. v. Rudzewicz, 471 U.S. 462, 473 n.14, 85 L. Ed. 2d 528, 105 S. Ct. 2174 (1985); National Equipment Rental, Ltd. v. Szukhent, 375 U.S. 311, 315-16, 11 L. Ed. 2d 354, 84 S. Ct. 411 (1964); Reed & Martin, Inc. v. Westinghouse Electric Corp., 439 F.2d 1268, 1276 (2d Cir. 1971). Their cross-motion to dismiss is frivolous and is denied.

 The Notes

 Default

 Defendants' next line of defense is to assert that there is a genuine issue of fact as to whether any default occurred. They contend that they are not in default because they instructed plaintiffs to apply toward payment on the Notes part of the amount they claim they overpaid for the purchase of the ICD stock. In substance, defendants seek to set off their unresolved claim of overpayment against the payments expressly called for by the Notes.

 The question of which side will retain or, indeed, recover money or property pending resolution of a dispute as to ownership often is of great practical importance. It can affect a party's cash flow or solvency pendente lite, and possession may significantly alter the combatants' relative bargaining positions while the dispute goes on. In consequence, sophisticated parties to commercial transactions may contract that one party or the other shall be entitled to hold or, indeed, be paid disputed sums pending final resolution of a controversy. *fn7"

 The Notes provide that the payment obligations thereunder are "unconditional and irrevocable ... under all circumstances, including, without limitation, ... the existence of any claim, set-off defense or other right which the Company ... may have ... against the Holder ..." *fn8" (de Geus Aff. Ex. F, at 13) Since the waiver of "any ... set-off defense" is more than sufficiently specific to satisfy New York law, a subject discussed in much greater detail below in another connection, the Buyers had no right to set off against payments due on the Notes any amount they claim they are owed by reason of the alleged overpayment.

 Defendants contend that their position is supported by Section 1.05(c) of the Purchase Agreement, which provides in relevant part:

 

"If the Final Cash Purchase Price is greater than the Estimated Cash Purchase Price, Buyer shall promptly pay to (or as directed by) Sellers the amount of the difference. If the Final Cash Purchase Price is less than the Estimated Cash Purchase Price, Sellers shall promptly pay to (or as directed by) Buyer the amount of the difference." (de Geus Aff. Ex. D § 1.05(c))

 The argument is that since the purchase price computed in accordance with the Purchase Agreement, in the defendants' view, was smaller than the "Estimated Cash Purchase Price," defendants were entitled to have the plaintiffs pay the alleged overpayment "as directed by" the defendants. The argument is unavailing.

 Section 1.05(c) must be read in a manner consistent with the other terms of the Agreement. The Notes made the obligations they represented unconditional and irrevocable, irrespective of any set-off defense or other claim. In all the circumstances, it is perfectly clear that defendants bargained away any right they may have had to set off any claimed overpayment against their obligations on the Notes. To read Section 1.05(c) as permitting the Buyers to direct the plaintiffs to pay a disputed amount as instructed would be inconsistent with that view and do violence to the expressed intention of the parties. In consequence, defendants' failure to make the interest payments concededly due on January 1, 1996 constituted an Event of Default under each of the Notes. (de Geus Aff. Ex. F § 5)

 Availability of the Alleged Fraud Defense

 Defendants next contend that their claim of fraud in the inducement precludes the entry of summary judgment against them on the Notes and the Guarantees. They rely on Danann Realty Corp. v. Harris, 5 N.Y.2d 317, 184 N.Y.S.2d 599, 157 N.E.2d 597 (1959), and its progeny for the proposition that a Note or Guarantee is subject to a fraudulent inducement defense, even if it is "absolute and unconditional" by its terms, unless there is a specific disclaimer of that defense. They contend that there is none in these instruments.

 Danann was an action by the purchaser of a lease which claimed that it had contracted to buy the lease in reliance on fraudulent misrepresentations by the seller as to the operating expenses and profits of the building. The contract of sale provided that all prior agreements and understandings were merged in the contract, that neither party relied upon any statements not set forth therein, and that the seller had not made any representations as to the expenses or operation of the premises. The New York Court of Appeals held that these specific disclaimers of representations of the sort upon which the plaintiff allegedly relied precluded assertion of the fraud claim, although it observed that a general and vague merger clause would not have done so. 5 N.Y.2d at 320-21, 184 N.Y.S.2d at 602.

 In Citibank, N.A. v. Plapinger, 66 N.Y.2d 90, 495 N.Y.S.2d 309, 485 N.E.2d 974 (1985), the Court of Appeals considered the application of Danann to a negotiated guarantee by sophisticated corporate officers of a multimillion dollar debt of the corporation. The guarantee recited that it was "absolute and unconditional" notwithstanding "(i) any lack of validity ... of the ... [guaranteed] Loan Agreement ... or any other agreement or instrument relating thereto" or "(vii) any other circumstances which might otherwise constitute a defense" to the guarantee. 66 N.Y.2d at 94, 495 N.Y.S.2d at 312. Noting that Danann had been sharply criticized and that Plapinger did not involve "generalized boilerplate," the Court of Appeals held that the fraud defense had been waived:

 

"Though not the explicit disclaimer present in Danann, the substance of defendants' guarantee forecloses their reliance on the claim that they were fraudulently inducted to sign the guarantee by the banks' oral promise of an additional line of credit. To permit that would in effect condone defendants' own fraud in 'deliberately misrepresenting [their] true intention' ( Danann Realty Corp. v. Harris, 5 N.Y.2d at p 323, 184 N.Y.S.2d 599, 157 N.E.2d 597) when putting their signatures to their 'absolute and unconditional' guarantee." 66 N.Y.2d at 94, 495 N.Y.S.2d at 312.

 The pertinent language of the Notes in this case is quite similar to that of the guarantee held to have waived the fraudulent inducement defense in Plapinger:

 

[balance of page intentionally left blank]

  The Notes in this Case The Plapinger Guarantee "The payment oblications of the Guarantee "absolute and Company ... unconditional . . . shall be unconditional and irrespective of irrevocable and shall be paid strictly in accordance with the terms of this Note under all circumstances, including, without limitation, the following circumstances: "(i) the existence of any claim, "(i) any lack of validity ... of set off defense the ... Restated or other right which the Company or Loan Agreement ... or any other any other agreement or person may have at any time against instrument relating thereto", or the Holder ..., or * * * "(ii) any other circumstances or "(vii) any other circumstances happening which might whatsoever, whether or not similar otherwise constitute a defense to any of the ..." foregoing."

19960610

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