RI Hosp. Tr. Nat. Bk. v. Swartz, Bresenoff, Yavner & Jacobs

• Decision Date: 04 February 1972
• Docket Number: No. 71-1284.,71-1284.
• Citation: 455 F.2d 847
• Parties: RHODE ISLAND HOSPITAL TRUST NATIONAL BANK, Appellant, v. SWARTZ, BRESENOFF, YAVNER & JACOBS, a Virginia partnership, et al., Appellees.
• Court: U.S. Court of Appeals — Fourth Circuit

455 F.2d 847 (1972)

RHODE ISLAND HOSPITAL TRUST NATIONAL BANK, Appellant, v. SWARTZ, BRESENOFF, YAVNER & JACOBS, a Virginia partnership, et al., Appellees.

No. 71-1284.

United States Court of Appeals, Fourth Circuit.

Argued October 7, 1971.

Decided February 4, 1972.

William C. Worthington, Norfolk, Va. (Allan M. Shine, and Winograd, Shine & Zacks, Providence, R. I., Gerard P. Rowe, Richmond, Va., and Williams, Worrell, Kelly & Worthington, Norfolk, Va., on brief), for appellant.

William B. Eley, Norfolk, Va. (Rixey & Rixey, Norfolk, Va., on brief), for appellees.

Before WINTER and BUTZNER, Circuit Judges, and DUPREE, District Judge.

WINTER, Circuit Judge:

Rhode Island Hospital Trust National Bank ("Bank") sued Swartz, Bresenoff, Yavner & Jacobs, a firm of certified public accountants ("Accountants"), each of the partners of the firm and the estate of a deceased partner, alleging, inter alia, that Accountants had negligently audited the financial statements of International Trading Corporation and related companies ("Borrower") in consequence of which Bank had made loans to Borrower which was unable to repay them and Bank sustained a loss in excess of $100,000.00. The district court, sitting nonjury, concluded that the evidence failed to establish "fraud or collusion on the part of Accountants, any lack of good faith, misrepresentation, breach of duty, negligence, or failure to use reasonable care in the preparation and issuance of the financial statements," and it dismissed the complaint. We disagree with the district court's conclusions with regard to negligence. We, therefore, reverse and remand for further proceedings.

I

Borrower, an importer of cement, became a customer of Bank in 1962 when it expanded its operations to New England and opened leased pier facilities at Fall River, Massachusetts, and at Providence, Rhode Island. Borrower obtained a line of credit from Bank, to be secured by a pledge of inventories and accounts receivable, in the amount of 75% of collateral but not to exceed $200,000.00. At approximately the same time, Borrower undertook to change its method of loading and unloading cement imports from handling in bags to handling in bulk.

This change in method necessitated a modification of facilities and the expenditure of considerable sums for leasehold improvements. In 1962 in excess of $155,000.00 was spent to improve Borrower's facilities, principally at Fort Lauderdale, Florida; and, since long-term financing was not sought, this tended to deplete working capital.

In 1963 Borrower sought long-term financing of leasehold improvements from Bank, but Bank was unwilling to lend on this basis. Bank, however, did accede to Borrower's request that the maximum amount of its line of credit be exceeded upon Borrower's assurance that economies from savings on labor costs expected to result from bulk handling would enable Borrower to operate more profitably and to meet greater loan obligations.

In June 1964 Borrower represented to Bank that during 1963 it had expended $212,000.00 for leasehold improvements to its facilities at Palm Beach, Florida, Brunswick, Georgia, and Providence, Rhode Island. The work was purportedly done by Borrower, using its own labor and materials. In fact, the claimed 1963 leasehold improvements were totally fictitious. The labor expenses claimed to have been incurred were incurred as operating expenses of handling and storing cement. No materials were purchased. An inspection in 1964 of all three of the facilities disclosed that they were in the same condition as they were at the end of 1962.

In accordance with the loan agreement establishing the line of credit, Borrower was obligated to furnish Bank with financial statements for each year, ending December 31; and, beginning March 27, 1964, Bank pressed to obtain the statements for the year 1963. They were not forthcoming until June 24, 1964. The income statement showed that total operating expenses, amounting to $609,956.42, were reduced by $212,000.00, designated "Estimated Expenses Contained in Operating Expenses Representing Cost of Leasehold Improvements," with the net effect that Borrower had a net profit after taxes of $9,257.60. The balance sheet similarly capitalized this sum on the asset side, together with other leasehold improvements, and showed a net worth of $339,427.48. If the $212,000.00 had not been capitalized, the income statement would have shown a substantial loss from operations and the balance sheet would have shown a substantial depletion of net worth (both of approximately $200,000.00).

When Accountants transmitted the financial statements to their client they wrote a covering letter expressing certain reservations about the "fairness of the accompanying statements." They stated that they had reviewed the balance sheet and profit and loss statement of Borrower and "our examination included a general review of accounting procedures and such tests of accounting records as we were permitted to make." Next, they stated that cash in banks had been verified by direct confirmations and reconciled, but that only 80.98% of the total trade accounts receivable had been confirmed. Physical inventories had been taken in Georgia, Florida and Rhode Island by correspondent accountants and various items of inventory valuation examined, with the result that the inventory as priced by management and the total of inventories as shown on the statements appeared to be correct.

The letter then discussed the crucial item concerned in this litigation—the leasehold improvements—and set forth the following:

Additions to fixed assets in 1963 were found to include principally warehouse improvements and installation of machinery and equipment in Providence, Rhode Island, Brunswick, Georgia, and Palm Beach, Florida. Practically all of this work was done by company employees and materials and overhead was borne by the International Trading Corporation and its affiliates. Unfortunately, fully complete detailed cost records were not kept of these capital improvements and no exact determination could be made as to the actual cost of said improvements. (emphasis added)

The total amount capitalized for leasehold improvements is as follows:

                       International Trading Corporation of Florida       $253,465.75
                       International Trading Corporation of Georgia        105,181.06
                       International Trading Corporation of New England     79,685.16
                                                                          ___________
                                                                          $438,331.97
                

Management has obtained appraisals from the following companies, which support the amounts set up for leasehold improvements in the warehouses:

Kendall Construction Company West Palm Beach, Florida A. H. Leeming and Sons of Rhode Island, Inc. 109 Waterman Street Providence 6, Rhode Island

Copies of their appraisals are attached hereto and are part of this report.¹ (emphasis added)

With reference to the appraisal from A. H. Leeming and Sons of Rhode Island, Inc., this report did not include engineering services, electrical service, crane service and concrete installation forms and drilling. Management was able to identify these items from invoices recorded on its books and are submitted herewith in conjunction with said appraisal. This work was done in Providence, Rhode Island. (emphasis added)

Next, the letter discussed amounts invested in machinery and equipment, trade accounts payable, certain drafts payable, disputed as to amount and unconfirmed, and concluded:

Because of the limitations upon our examination expressed in the preceding paragraphs and the material nature of the items not confirmed directly by us, we are unable to express an opinion as to the fairness of the accompanying statements.

Because of the death of the partner of Accountants who made the examination of Borrower's accounts the proof was not complete as to what examination and what inquiries had been made. The deceased partner's work papers were produced and they showed that the deceased had attempted to segregate the cost of labor, which Borrower had recorded as operating expenses, attributable to the purported leasehold improvements, but the work papers showed that no item of building material cost had been recorded.

While there is uncertainty as to precisely what Accountants did in the preparation of the statements, what the Bank did after copies, together with the Accountants' letter, were delivered to it appears from a memorandum, made on the day the financial statements were received by the Bank's loan officer servicing the account, that the statements "show continued effect of the cost-cutting automation expenses initiated . . . in 1962 and completed shortly before the end of 1963." It called attention to the fact that $400,000.00 had been invested in new equipment and leasehold improvements and this investment had enabled Borrower drastically to "reduce the cost of handling cement both in unloading it from the ships and loading it into the tank trucks." The statements were referred to the analysis department of the Bank for closer study. The analysis department reported critically on the statements on September 24, 1964.

As of the date of receipt of its copies of the financial statements, Bank had lent Borrower $220,000.00. There was testimony, not disputed, that if it had known on the date that $212,000.00 of leasehold improvements were fictitious, it would have refused further loans and immediately begun efforts to effect collection of the amount outstanding. Since Bank...