Frymire-Brinati v. KPMG Peat Marwick

Decision Date29 July 1993
Docket NumberFRYMIRE-BRINATI and M,No. 92-1083,92-1083
Citation2 F.3d 183
Parties, Fed. Sec. L. Rep. P 97,737, 37 Fed. R. Evid. Serv. 1352 Kathleenichael Brinati, Plaintiffs-Appellees, v. KPMG PEAT MARWICK, Defendant-Appellant.
CourtU.S. Court of Appeals — Seventh Circuit

Anthony C. Valiulis, Stewart M. Weltman, Deborah Schmitt Bussert, Michael J. Freed (argued), Christopher J. Stuart, Michael R. Shelist, Much, Shelist, Freed, Denenberg & Ament, Chicago, IL, Roger B. Greenberg, Richie & Greenberg, Houston, TX, Jack Dawson, Miller, Dollarhide, Dawson & Shaw, Oklahoma City, OK, for plaintiffs-appellees.

Jeffrey R. Tone (argued), Linton Jeffries Childs, Robert R. Watson, Frank B. Vanker, Robert D. McLean, Sidley & Austin, Chicago, IL, for defendant-appellant.

Before BAUER, Chief Judge, and POSNER and EASTERBROOK, Circuit Judges.

EASTERBROOK, Circuit Judge.

Patrick E. Powers developed real estate in Norman, Oklahoma. He organized the business through a central corporation, Pepco, Incorporated, that was the general partner in a series of limited partnerships investing in particular properties. Each partnership raised outside money from limited partners. Richard A. Frymire and his daughter Kathleen Frymire-Brinati invested in some of these partnerships and owned some common stock of Pepco itself. In 1982 Frymire-Brinati was elected to Pepco's board as an "advisory" director.

In December 1984 Powers asked Frymire for assistance. Powers told Frymire that he was hoping to arrange a merger but that to look attractive Pepco would need to show greater liquidity on its books. Powers asked Frymire to invest $1 million in preferred stock paying 12% per annum, with the understanding--not written down, lest it spoil the impression--that Pepco would redeem the stock on Frymire's request. Frymire informed his daughter and her husband Michael Brinati. Daughter and son-in-law decided to oblige Powers and purchased the preferred stock on December 31, 1984. But this did not fool the auditor. Peat, Marwick, Mitchell & Co., now called KPMG Peat Marwick, smelled a rat and resigned without completing the audit of the 1984 financial statement. Only the Frymires and Brinatis were fooled. Pepco and its empire of partnerships collapsed, a receiver was appointed in October 1985, and Powers signed an administrative consent order. Powers denied that he had bilked any investors and promised not to do it again. Oklahoma prosecuted Powers for fraud, embezzlement, and the sale of unregistered securities; in 1988 Powers was acquitted of the former two charges and convicted of the latter. He served no time in jail but was suspended for one year from the practice of law. Oklahoma ex rel. Oklahoma Bar Association v. Powers, 781 P.2d 832 (Okla.1989).

Out one million dollars in addition to their earlier investments, Frymire-Brinati and her husband filed this suit against the only solvent party: Peat Marwick. According to the complaint, Peat Marwick committed securities fraud in certifying Pepco's 1983 financial statements, on which, the plaintiffs said, they had relied in making their investment. Pepco's principal assets were its stakes in the partnerships, which Peat Marwick certified were carried at the lesser of cost or market. Each of these investments was shown at cost, even though, according to plaintiffs, Peat Marwick knew (or was reckless in failing to discover) that they were worth far less. Plaintiffs also observed that Powers had pulled a similar stunt at the end of 1983, obtaining a short-term infusion of cash to make the books look good--but in early 1984 Powers repaid this money, a step he did not complete with plaintiffs. Peat Marwick failed to discern this earlier financial flim-flam. Judge Moran removed from the case all claims except those under Sec. 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78j(b), the SEC's Rule 10b-5, 17 C.F.R. Sec. 240.10b-5, and state law. 657 F.Supp. 889 (N.D.Ill.1987). The case was assigned to Judge Lindberg for trial, which lasted six weeks in 1991. A jury returned a verdict for plaintiffs on all claims, awarding them $1 million in compensatory and $2 million in punitive damages. The district judge denied Peat Marwick's motion for a new trial, remarking that "[t]he evidence was rich and provided a deep reservoir of bases to support a jury verdict for either party on each and every count." "The testimony of witness Hassett, without more, was adequate to satisfy [the required] standards." 1991 WL 268047, 1991 U.S.Dist.LEXIS 17909.

William Hassett, manager of the Chicago accounting firm of Altschuler, Melvoin & Glasser, was the plaintiffs' star witness, and the only one the judge mentioned. Hassett testified that in conducting the audit of Pepco's 1983 financial statements (which we call the "1983 audit" even though it occurred in 1984) Peat Marwick violated seven of the ten Generally Accepted Auditing Standards (GAAS). The standard to which the parties have devoted most attention is that auditors certify that the accounts have been stated according to Generally Accepted Accounting Principles (GAAP). Peat Marwick so certified, but this was false, Hassett testified, because Pepco's investments in the partnerships were not worth what they were represented as being worth. GAAP calls for the use of the lesser of cost or market value. Hassett concentrated on the latter, testifying that as a first approximation the investments were worthless. Why worthless? Hassett used a discounted cash flow analysis, valuing the partnerships' projects at ten times their annual cash flow. Many of these projects had low or negative net cash flows; Hassett accordingly assigned them a value of zero.

Needless to say, this led to great controversy at trial. Hassett's method implies that raw land is worthless and that a large office building in the final stages of construction also has no value even though it is fully leased out and could be sold for a hundred million dollars. Eventually Hassett conceded that his valuations were not "market values" at all but were "a fairly simple pass at what the magnitude of the problem was". To determine a market value using a discounted cash flow analysis, one must consider potential cash flows (for example, what the office building will produce after occupancy) and not simply historical cash flows. Richard A. Brealey & Stewart C. Myers, Principles of Corporate Finance 62-66, 191-96 (3d ed. 1988). See Lucian Arye Bebchuk & Marcel Kahan, Fairness Opinions: How Fair Are They and What Can Be Done About It?, 1989 Duke L.J. 27, 35-37, for a description of the requirements of discounted cash flow analysis and the difficulty of doing it well.

Admitting Hassett's "fairly simple pass" into evidence just because he is an expert in accounting is problematic, for Hassett conceded that he did not employ the methodology that experts in valuation find essential. A "trial judge must ensure that any and all [expert] testimony or evidence admitted is not only relevant, but reliable." Daubert v. Merrell Dow Pharmaceuticals, Inc., --- U.S. ----, 113 S.Ct. 2786, 125 L.Ed.2d 469 (1993). The Federal Rules of Evidence require a judge to undertake "a preliminary assessment of whether the reasoning or methodology underlying the testimony is scientifically valid and of whether that reasoning or methodology properly can be applied to the facts in issue." Id. at ----, 113 S.Ct. at 2790. See also Mid-State Fertilizer Co. v. Exchange National Bank, 877 F.2d 1333, 1339-40 (7th Cir.1989); Deltak, Inc. v. Advanced Systems, Inc., 574 F.Supp. 400, 405-06 (N.D.Ill.1983), vacated on other grounds, 767 F.2d 357 (7th Cir.1985). The trial judge did not conduct such a "preliminary assessment" before permitting Hassett to testify about his method. Although district judges possess considerable discretion in dealing with expert testimony, Carroll v. Otis Elevator Co., 896 F.2d 210, 212 (7th Cir.1990), on this record the court could not properly have admitted Hassett's valuation. Fed.R.Evid. 702.

After Hassett was done, Peat Marwick tried to put things in a better light with experts of its own. Richard Behrens, chairman of the Real Estate Committee of the American Institute of Certified Public Accountants, testified that Hassett had bungled by using historical rather than projected future income in his cash flow analysis. In an effort to move from theory to concrete valuation, Peat Marwick offered James Hoyt, a real estate appraiser with 28 years' experience in the Oklahoma market, to testify about the accuracy of the property values in the financial statements. The district judge prevented Hoyt from testifying, ruling that Hoyt had not laid a proper foundation for his testimony during the deposition taken three months before trial. Peat Marwick wanted to use Hoyt to respond to Hassett, and Hassett himself did not disclose the nature of his proposed testimony until shortly before trial, after Hoyt's deposition. It is difficult to see how Hoyt could have laid out details of the response before learning what he was responding to. After preventing Hoyt from testifying, the trial judge severely limited the testimony of Abbie Smith, a professor of accounting at the University of Chicago's Graduate School of Business. Professor Smith would have testified that financial statements dated December 31, 1983, would not have been material to a reasonable investor asked to make an investment a year later--especially one serving on the issuer's board. Again the trial judge ruled that the witness had not disclosed this opinion sufficiently far in advance of trial, even though he permitted Hassett and two other witnesses for the plaintiffs (Carl Pojezny and Dennis Maley) to give extensive testimony that had not been disclosed until the last minute.

Similarly one-sided rulings on evidentiary matters occurred throughout the trial. In response to discovery requests and pretrial motions, Peat...

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