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AUSA LIFE INS. CO. v. ERNST & YOUNG

December 5, 1997

AUSA LIFE INSURANCE COMPANY, et al., Plaintiffs, against ERNST & YOUNG, Defendant.


The opinion of the court was delivered by: CONNER

 CONNER, Senior D. J.:

 This is one of a group of 22 actions brought by investors in the securities of JWP, Inc. in an attempt to recoup their losses on such investments. Nineteen separate actions brought by those who purchased the common stock of JWP were consolidated into a single action captioned In re JWP, Inc. Securities Litigation, 928 F. Supp. 1239, 1246. The plaintiffs in the consolidated action filed a joint class action complaint and the Court certified a plaintiff class consisting of all those who purchased JWP common stock in the open market between May 1, 1991 and October 2, 1992. After extensive discovery and lengthy negotiations, the class action was settled, along with a twentieth action, Melvin S. Aronoff, et al. v. Andrew Dwyer, et al., 928 F. Supp. 1239, *1261, brought by the owners of a business which they sold to JWP in exchange, inter alia, for JWP common stock. The two remaining actions were brought by a group of nine U.S. and Canadian insurance companies who had purchased long-term notes of JWP in a series of private placements. One of these two actions, AUSA Life Insurance Company, et al. v. Andrew T. Dwyer, et al., 928 F. Supp. 1239, *1266, 94 Civ. 2201 (WCC), was brought against the officers and directors of JWP who allegedly manipulated the financial statements of the company to grossly overstate its net worth and earnings and create a false picture of financial strength and earnings prospects. That action is awaiting trial.

 The present action, the last of the group of 22, was brought against Ernst & Young ("E&Y"), the "Big 6" accounting firm which served as independent auditor for JWP from 1985 through the completion of its audit of JWP's consolidated annual report for 1992, spanning the entire period of the alleged fraudulent activity. Plaintiffs assert claims against E&Y under Section 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. Sec. 78j(b), and for common law fraud and negligent misrepresentation, alleging that E&Y either conspired with JWP's executives in the perpetration of the fraud or, having discovered it, deliberately suppressed the information, or were reckless in the conduct of their audits and thereby failed to discover accounting irregularities that would have been discovered in audits conducted in accordance with generally accepted auditing standards ("GAAS"). The action was tried without a jury over an eleven-week period from April to July, 1997 and post-trial briefs and proposed findings and conclusions were submitted thereafter by the parties. This Opinion will briefly summarize the Court's decision, which is more fully detailed in the separate Findings of Fact which follow.

 BACKGROUND

 In the early 1980's, JWP was a relatively small company whose business consisted primarily of operating a regulated water utility on Long Island, New York. Between 1984 and 1992, JWP expanded aggressively and rapidly by acquiring some 100 companies, mostly in the fields of mechanical and electrical engineering and construction, energy and environmental systems and computer sales and services. These acquisitions increased the company's revenues to roughly 100 times their early 1980's levels. They were financed primarily by private placements of debt securities, which placed JWP in a highly leveraged and recession-sensitive financial position.

 The nine insurance companies who are plaintiffs in this action purchased a total of $ 149 million of JWP's notes between November 15, 1988 and March 6, 1992. These purchases were made in reliance on JWP's past financial statements, including its annual reports certified by E&Y, and involved Note Agreements which required that JWP's books be kept in accordance with generally accepted accounting principles ("GAAP") and that at the time of each annual audit JWP's independent auditors (E&Y) furnish to JWP for transmittal to the noteholders a letter (which plaintiffs call a "no-default certificate," while defendant prefers the term "negative assurance letter") stating that it has audited JWP's financial statements according to GAAS and that "nothing has come to our attention that caused us believe that the company has failed to comply with the terms * * * of the Note Agreement."

 JWP's final acquisition was by far its largest (in terms of revenues) and riskiest. In late 1991, it purchased Businessland, Inc. ("Businessland"), a retailer of computers and supplier of software and related services. Businessland was in serious financial trouble, having lost an average of ten million dollars a month over the previous ten months, and its auditors (not E&Y) had issued a "going concern" qualification on Businessland's most recent audited financial statements, indicating their doubt as to the company's ability to survive. However, JWP's executives believed they could turn the company around by converting it from a "box pusher" reselling computer hardware into a higher-margin "value-added" systems integrator supplying to large corporate clients their full computer needs, including networking setups, tailor-made software, instruction and servicing. They saw in Businessland's existing clientele of Fortune 1000 companies and trained sales force the nucleus of a potentially dynamic and profitable organization which would mesh well with their successful electrical contracting business, already heavily involved in the installation of wiring for complex corporate computer networks.

 Although JWP's annual report for 1991, audited and certified by E&Y, showed revenue of $ 3.6 billion, after-tax profit of $ 60.3 million and net worth of $ 496 million, after the Businessland acquisition there was reason to question the company's financial health and prospects. In early 1992, David Sokol was brought in as JWP's President and Chief Operating Officer. He soon discovered what appeared to be a number of serious accounting irregularities. In August 1992, at Sokol's direction, JWP retained another "Big Six" accounting firm, Deloitte & Touche, to conduct a thorough review of the company's books and E&Y's audits. They concluded, and E&Y concurred, that JWP's annual reports for 1990-1992 should be restated to reduce 1990 after-tax net income by 15% (from $ 59 to $ 50 million) and 1991 after-tax net income by 52% (from $ 60 to $ 29 million) and to reflect a 1992 loss of $ 612 million and net worth of minus $ 176 million.

 JWP continued to pay all of the interest due on its notes through 1992, and made partial payments through April 1993, but ultimately defaulted and was placed in involuntary bankruptcy on December 21, 1993. All of the plaintiffs except Prudential sold all of their notes at deep discounts in 1993 and 1994. Prudential sold part of its notes at a loss and in the bankruptcy reorganization exchanged the remainder for cash and securities of substantially lesser total value than the face amount of the notes. In principal and unpaid interest, plaintiffs thus lost a total of approximately $ 100 million.

 PLAINTIFFS' CLAIMS

 Plaintiffs contend that although E&Y issued clean audit reports certifying the year-end financial statements of JWP as well as the annual no-default letters, on all of which plaintiffs relied in purchasing JWP's notes, E&Y's audits fell far short of the requirements of GAAS and were negligent to the point of recklessness, particularly in failing to report its discoveries that JWP's accounting had overstated net income through many violations of GAAP, including:

 1. In accounting for its its corporate acquisitions, JWP used the "purchase" method, but repeatedly violated GAAP rules relating thereto by capitalizing as "goodwill" operating expenses improperly classified as acquisition costs, including costs incurred after the acquisition and beyond the one-year "window" allowed by GAAP.

 2. JWP arbitrarily wrote up the inventory of small tools of several of its acquired subsidiaries, offsetting this entry by creating "negative goodwill" which was amortized into net income and by creating a "general reserve" which was used to offset operating losses.

 3. JWP set up in a "negative goodwill" account the anticipated tax benefits of the net operating loss ("NOL") carryforwards of its acquired companies, without satisfying GAAP and SEC requirements concerning such treatment, and amortized this account to increase reported net income.

 4. JWP improperly capitalized the costs of unproven software for internal use.

 5. JWP concealed construction contract losses by recording baseless claims.

 6. JWP failed to establish reserves for receivables of dubious collectibility.

 E&Y's DEFENSES

 In addition to contending that plaintiffs have not proven the necessary elements of their claims of fraud and negligent misrepresentation, E&Y asserts a number of affirmative or special defenses:

 (1) that the claims under Section 10(b) are barred by the Statute of Limitations;

 (3) that JWP's insolvency and plaintiffs' resulting losses were caused not by falsity in JWP's financial statements but by the downturn in commercial construction, by JWP's catastrophic acquisition of the failing Businessland and the ensuing PC price wars.

 DISCUSSION

 It is only natural for one who has suffered an injury or financial loss to seek legal redress from those who caused it and, if those primarily responsible have insufficient resources for full restitution, to pursue others less directly involved to make up the deficiency. In the present case, the insurance company lenders lost roughly $ 100 million on their purchases of JWP's notes. These purchases were made in reliance upon JWP's annual reports audited by E&Y and on E&Y's no-default letters for the preceding years. Following their review, Deloitte & Touche concluded, and E&Y conceded, that the annual reports were incorrect in many significant respects.

 During settlement discussions, it became apparent that the officers of JWP responsible for the improper accounting practices, even if they are proven guilty of fraud, are substantially judgment-proof, with reachable assets sufficient to cover only a tiny fraction of plaintiffs' losses, even without considering the hundreds of millions of dollars in claims filed by those who purchased JWP's common stock in reliance on JWP's misleading financial statements. JWP had three layers of directors and officers ("D&O") liability insurance covering claims against these officials (excepting claims for intentional deception) up to a total of $ 50 million. But these policies covered defense costs as well as damages, and each of these individual defendants had his own separate attorney so that almost half of the total D&O coverage was consumed by defense costs during the extensive discovery and motion proceedings. Settlement of the stockholders' actions consumed much of the remainder of the D&O coverage. Thus the insurance companies who purchased JWP's notes are left with the prospect of recovering no more than a small fraction of their losses in their action against the directors and officers, an action which will almost surely be settled, for otherwise the defense costs could be expected to eat up virtually all of the remaining D&O coverage. The present action against the presumed "deep pocket" accounting firm which audited and certified JWP's annual reports and issued the accompanying "no default" letters is thus the insurance company plaintiffs' main chance for reimbursement of their substantial losses.

 PLAINTIFFS' SECTION 10(b) CLAIMS

 To recover against E&Y on their claims under Section 10(b), plaintiffs must prove (1) that JWP's annual reports and/or E&Y's annual no-default letters were false in material respects; (2) that in certifying the annual reports and/or in issuing the no-default letters E&Y acted with scienter--that is, with actual knowledge of their material falsity and an intent to deceive investors or with such recklessness that an intent to deceive may be inferred; (3) that plaintiffs relied on the annual reports and/or the no-default letters in deciding to purchase JWP's notes; and (4) that defendants suffered losses as a result of such reliance. Bloor v. Carro, Spanbock, Londin, Rodman & Fass, 754 F.2d 57, 61 (2d Cir. 1985).

 Falsity

 The evidence clearly showed that JWP's audited annual reports for each of the years 1987 through 1992 contained material errors and that E&Y's annual no-default letters falsely attested that E&Y had discovered no violation of the Note Agreements, which required that JWP's books be kept in accordance with GAAP.

 Acquisition accounting abuses. Among the errors which were found were a number of violations of GAAP rules for treating the acquisition of subsidiaries. When the acquiring company pays more than the book value or appraised value of the net worth of the acquired company, the excess is considered as a payment for the "goodwill" of the acquired company, and is written up as an asset which is amortized as a reduction of net income of the acquiring company over a 40-year period. When the purchase price is less than the book value or appraised value, the difference is treated as "negative goodwill" and is amortized to increase net income over a "reasonable"--but much shorter--period, usually five to seven years.

 JWP used the "purchase accounting" method of recording its acquisitions of subsidiaries, but repeatedly failed to follow the GAAP standards applicable thereto. When JWP acquired Forest Electric in 1986, it was forced to sell another subsidiary, Lehr Construction Co. in order to avoid a conflict of interest between the executives of Forest and Lehr. Lehr was sold at a substantial loss, but JWP decided that the loss should not be taken as a reduction of current net income but considered part of Forest's acquisition cost, capitalized as "goodwill" of Forest, and amortized over 40 years. E&Y deemed this treatment "reasonable." But in 1988, when JWP paid $ 875,000 to Lehr, JWP also treated this as an additional acquisition cost, although it was beyond the one-year "window" to which GAAP limits the recognition of acquisition costs. Thus it would be amortized over 40 years instead of being taken as a reduction of 1988 income. E&Y objected to this violation, but ultimately decided it was "immaterial" and issued a clean 1988 audit report. When JWP acquired Kerby-Saunders-Warkol ("KSW") in 1987, E&Y found that KSW had failed to disclose certain contingent liabilities and thereby concealed $ 1.25 million in losses. JWP looked to the former owners for reimbursement and treated this amount as a "contingent receivable." Because GAAP expressly prohibits the recognition of contingent assets, JWP falsely recorded it as a "note receivable." E&Y discovered this violation, but John LaBarca, its partner in charge of the JWP audit, approved it on the dubious ground that "there is no P&L effect" and because, if the "note" is uncollectible, the net worth of KSW would be reduced by $ 1.25 million, which could be capitalized as goodwill and amortized over 40 years.

 In its audit of JWP's 1988 annual report, E&Y discovered that in three other acquisitions, JWP had incurred costs totaling $ 1.275 million outside GAAP's one-year window, but had nevertheless capitalized them as goodwill. E&Y included these items in its 1988 Summary of Audit Differences and suggested to JWP that the costs must be taken to reduce 1988 net income. This was not done but again E&Y decided the errors were not so substantial as to require an exception to its 1988 audit report.

 In its 1989 acquisition of Drake & Scull, a UK construction company, JWP wrote off $ 4.2 million which Olympia & York, a major Drake & Scull customer, owed to JWP's subsidiary Forest Electric, and which was of questionable collectibility. Of course if the debt was uncollectible, the write-off should have been taken as a reduction of net income in 1989, rather than being capitalized as part of the acquisition cost. E&Y's John LaBarca questioned JWP's Chief Financial Officer, Ernest Grendi, about the matter and they reached an agreement to treat $ 2 million of the debt as collectible and thus part of the acquisition cost. During E&Y's 1989 audit, it decided that this agreement violated the GAAP rule against treating the disposition of assets of the acquiring company as a cost of acquisition. LaBarca accordingly proposed to Ernest Grendi that the still uncollected entire amount of $ 4 million be taken to reduce 1989 net income. Grendi declined to make such an adjustment. E&Y included this item in its 1989 Summary of Audit Differences, but relented and did not make it an exception to its 1989 audit report.

 In its 1989 acquisition of Drake & Scull, JWP gave a former executive of the acquired company a consulting agreement which cost JWP $ 645,000 for services performed subsequent to the acquisition. Rather than treating this as a current expense, JWP capitalized it as a cost of acquisition. E&Y disapproved this treatment and included it in its 1989 Summary of Audit Differences. JWP refused to make the change, but E&Y nevertheless issued an unqualified 1989 audit report.

 In March 1990, an unjustified bookkeeping entry was made at JWP's subsidiary Enviro-Gro, debiting the Patents asset account in the arbitrary amount of $ 678,000 and crediting the Income account in the same amount. When questioned about it, JWP's Joseph Grendi admitted the entry was "baseless," adding that it was his time to be ...


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