The opinion of the court was delivered by: CONNER
This case is before the court on defendant's motion to vacate the findings of an audit that examines the royalty certification statement defendant submitted pursuant to the parties' 1975 Consent Judgment. The auditor, William Shulman, has concluded that Plaintiff Audiovisual Publishers ("AVP") is entitled to approximately $ 6.7 million in royalty payments and accrued interest from Defendant Cenco, Inc. ("Cenco"). Defendant contends that the assumptions and methodology that Mr. Shulman employed are flawed and that his conclusions should be rejected. In defendant's view, it owes no money to plaintiff. Not surprisingly, plaintiff argues that Mr. Shulman's audit was proper and asks the court to direct defendant to pay the amount Mr. Shulman determined to be due plaintiff.
The convoluted history of the instant litigation, which spans almost a quarter century, is set forth in the court's prior opinions. However, in order to place the most recent iteration of this long-running dispute in context, a brief review of past events is warranted. AVP, a producer of educational film strips and cassettes, initiated this breach of contract action against Cenco in 1972, claiming that Cenco had deprived it of royalties for certain cassettes under an arrangement between the parties.
Defendant submitted its royalty certification statement for the period August 1, 1971 through June 30, 1975, and plaintiff objected. However, the parties discovered that many of defendant's relevant records were missing. Because plaintiff was subsequently unable to locate an auditor willing and able to review defendant's royalty statement, the court directed defendant to obtain an audit. In April 1984, Arthur Andersen & Co. ("Arthur Andersen") completed an audit of defendant's royalty statement. Consistent with the court's directive, Arthur Andersen limited its review to the period from August 1, 1971 to April 30, 1973. Arthur Andersen confirmed the royalty statement's accuracy subject to two significant qualifications.
On December 10, 1986, Magistrate Judge Gershon rejected AVP's challenges to the audit and approved Arthur Andersen's finding that plaintiff was entitled to additional royalties in the amount of $ 200.
This court adopted the magistrate's findings, and the Court of Appeals for the Second Circuit denied plaintiff's subsequent appeal.
After the proceedings related to the Arthur Andersen audit concluded, AVP exercised its right under the Consent Judgment to an audit of defendant's royalty certification statements for the years 1973 to 1975, which were outside the scope of Arthur Andersen's examination. In 1991, AVP nominated the firm of Shulman & Solomon to perform this audit, and defendant eventually consented to plaintiff's choice of auditor. Mr. Shulman then conducted the audit in two parts. In a December 1994 report, Mr. Shulman concluded that defendant owed AVP $ 3,449,928.44 in royalties and interest pursuant to the Consent Judgment's cassette royalty and filmstrip provisions. In a separate report, Mr. Shulman also found that defendant owed plaintiff $ 538,453.27 including interest under the Consent Judgment's "Deryck Waring" provisions.
In response to defendant's objections to the December reports, Mr. Shulman first modified his original reports and then issued a revised report in July 1995 ("Revised Report"). The Revised Report reduced plaintiff's recommended award by $ 184,049.91 before interest to correct for several accounting errors. However, Mr. Shulman also made substantive alterations to his report that resulted in a net increase of $ 532,012 before interest.
Defendant, in several lengthy submissions to the court, forcefully, albeit repetitively, raises numerous challenges to the Shulman audit. Defendant urges first that the audit suffers from methodological defects that render the entire audit invalid. Second, defendant contends that, aside from the audit's systemic flaws, Mr. Shulman's substantive conclusions are incorrect.
A. Mr. Shulman's Methodology
Defendant argues that Mr. Shulman's conclusions deserve no weight because Mr. Shulman did not perform his audit in accordance with Generally Accepted Auditing Standards ("GAAS"). Although the Consent Judgment is silent as to the type of audit required, defendant argues that an audit is an "attest service" that must be conducted pursuant to GAAS or the Statements of Standards for Attestation Engagements. In support of this position, defendant observes that Magistrate Judge Gershon, after denying plaintiff's request for a conference to consider the specific auditing methods and procedures to be followed by Arthur Andersen, expressly directed Arthur Andersen to "conduct the audit under the generally accepted standards and procedures of its profession." Order dated Jan. 27, 1984, at 3. Similarly, Magistrate Judge Sinclair found that "generally accepted auditing standards . . . apply to special purpose audits such as royalty reviews." Order dated July 23, 1981, at 18.
Defendant maintains that plaintiff indicated prior to the audit that Mr. Shulman would adhere to GAAS and that on the basis of plaintiff's representations defendant assented to plaintiff's nomination of Mr. Shulman. Last, defendant argues that in 1986 plaintiff challenged the Arthur Andersen audit on the ground that it deviated from GAAS. Therefore, in defendant's view, it is disingenuous for plaintiff now to claim that Mr. Shulman need not have adhered to GAAS in conducting his audit.
We are unpersuaded by defendant's argument that Mr. Shulman erred by not adhering to GAAS.
The Consent Judgment does not expressly require the application of GAAS testing standards. Moreover, we agree with plaintiff that the absence of a substantial number of relevant records in this case justifies resort to reasonable alternative methods of accounting. As we previously observed with respect to the Arthur Andersen audit, "it is clear that a patchwork of alternative procedures will be required in any attempt to apply generally accepted auditing standards . . . . The need for alternative methods of testing the royalty statements for 1971 and 1972 is occasioned by the state of defendant's documentations." Opinion dated Feb. 23, 1983, at 10.
We note that, contrary to defendant's assertion, plaintiff did not misrepresent to either the court or defendant that Mr. Shulman would conduct a strict GAAS audit. Rather, in the 1991 letter to the court upon which defendant relies, Maxime Ferris, AVP's owner, stated, "I imagine that all other auditing matters could and should be left to the discretion of the accounting firm conducting the audit. . . . I would imagine that the accountant who undertakes this or any other audit would want to do his work as he sees fit within the guidelines of GAAS . . . ." Letter from Ferris to the court dated Apr. 15, 1991, at 2. Mr. Ferris' statements cannot reasonably be read as an assurance that the audit now at issue would be conducted in strict conformity to GAAS. To the contrary, Mr. Ferris' statements are clearly an expression of his view that the auditor would be afforded significant latitude in conducting his examination.
Defendant next attacks Mr. Shulman's report on the ground that Mr. Shulman failed to perform his work with due professional care. In support of this claim, defendant offers numerous examples of what defendant and defendant's expert believe are fatal flaws in Mr. Shulman's conduct of the audit. Defendant's principal criticisms are that Mr. Shulman failed to examine the internal control structure in effect at Eye Gate, Cenco's predecessor in interest, during the audit period; that he failed to cite source material supporting the factual assertions in his report; that he did not consider relevant evidence; and that he lacked impartiality.
We find that defendant overstates the importance of a review of internal controls at Eye Gate. Defendant contends that such a review by Mr. Shulman was necessary in order for Mr. Shulman to "develop an understanding of . . . how various types of books and records (such as invoices, voucher registers and bank statements) supported and complimented [sic] one another. . . ." Cenco Reply Mem. at 25. Had he conducted this review, according to defendant, Mr. Shulman would have performed his missing-check analysis differently. However, we are satisfied that Mr. Shulman had an understanding of defendant's control structure sufficient to allow him to form judgments about the claims in defendant's royalty statement. If, as defendant contends, Mr. Shulman erred in the conduct of his missing-check analysis, it was not because he failed to review Eye Gate's internal controls. Contrary to defendant's assertion, we see little reason why Mr. Shulman would need to embark on a comprehensive study of Eye Gate's control structure in order for him to understand that checks not written during the audit period did not represent a royalty due during that period. Similarly, it is clear that royalties would be unwarranted for any missing checks that bank records show were never negotiated. Moreover, we note that plaintiff's experts have concluded that because Eye Gate is no longer a going concern "the lack of financial records, the inability to observe and discuss accounting procedures, and the twenty-year distance between the current examination and the actual recording of the transactions in question definitively moots the need for assessment of the internal control structure at Eye Gate in the early 1970s." Spinelli & Wynne Aff. of Sept. 21, 1995, at 5.
As to Mr. Shulman's alleged failure to cite specific support for his factual assertions, we find Mr. Shulman's response somewhat unsatisfying. Mr. Shulman simply disregards defendant's criticism that the absence of factual support taints his workpapers. However, rather than invalidate the entire audit on this ground, the court will consider Mr. Shulman's challenged conclusions and reject those that lack adequate substantiation. In addition, it is unfortunate that Mr. Shulman apparently declined to consider fully some potentially relevant evidence offered by defendant and may have engaged in substantive ex parte communications with plaintiff while not affording defendant the same opportunity to articulate its position. Although Mr. Shulman's conduct does not warrant setting aside the audit, it somewhat diminishes the weight to which the audit is entitled, as does the fact that Mr. Shulman issued signed but "imperfect" reports in December 1994 apparently with the expectation that he would subsequently revise them. Shulman Aff. at 28-29.
B. Mr. Shulman's Substantive Conclusions
Defendant challenges virtually every aspect and detail of Mr. Shulman's audit report. However, defendant's criticisms of the audit fall into four general categories. First, defendant argues that, contrary to Mr. Shulman's analysis, it owes no royalties for noncaptioned-filmstrip cassettes produced from the 730 audio masters that Mr. Shulman contends defendant should have designated as royalty-generating audio masters (the "undesignated masters"). Second, defendant asserts that no further royalties are due on cassette purchases stemming from the 637 captioned filmstrips that comprised defendant's original list of royalty-producing audio masters (the "designated masters"). Third, in defendant's view, it owes AVP no payment under the Consent Judgment's filmstrip provisions. Last, defendant states that if any money is due plaintiff, Mr. Shulman's interest calculations are flawed and should be revised.
1. Deryck Waring Masters and Previously Undesignated Audio Masters
Paragraph 2 of the Consent Judgment provides for royalty payments on cassette purchases thus:
Cenco will pay to Audiovisual an amount equal to fifty cents for each cassette or other tape purchased or acquired by it since August 1, 1971, from a supplier other than Audiovisual which used a script created by Audiovisual solely at its own expense.
Defendant maintains, and has maintained from the outset, that AVP scripted and produced 637 original audio masters for captioned filmstrips (those filmstrips originally created without sound but for which defendant subsequently supplied audio narration) and that royalties are due only on cassettes created from these designated masters. These 637 titles comprise the list of royalty masters upon which Arthur Andersen relied in conducting its audit. However, Mr. Shulman has determined that, in addition to the audio masters designated by defendant, there are 730 audio masters corresponding to noncaptioned filmstrips that should be treated as royalty masters.
Of the 730 undesignated masters that Mr. Shulman identifies, 243 are Deryck Waring masters within the meaning of the Consent Judgment.
Revised Report at 12a. As defendant observes, a Deryck Waring master is, by definition, a master produced by AVP using a script "provided or paid for by Cenco." Consent Judgment at P 6. Thus, a master cannot be both a Deryck Waring master under Paragraph 6 and a royalty master scripted solely by AVP under Paragraph 2 of the Consent Judgment. Mr. Shulman's unilateral determination that in 1975 a representative of defendant made misstatements to the court and that as a consequence the Consent Judgment must be modified to eliminate the Deryck Waring provisions is wholly inappropriate and is rejected. Revised Report at 20. Mr. Shulman does not have the discretionary authority to fundamentally alter the terms of the Consent Judgment by treating Deryck Waring masters as royalty masters.
Several earlier decisions in this case squarely addressed the issue of which audio masters are to be included on the list of royalty titles. In her 1986 Order, Magistrate Judge Gershon found that the master list submitted by ...