Atari Corp. v. Ernst & Whinney

• Decision Date: 10 December 1992
• Docket Number: Nos. 91-15668,91-15693,s. 91-15668
• Citation: 981 F.2d 1025
• Parties: ATARI CORPORATION, a Nevada corporation, Plaintiff-Appellant, v. ERNST & WHINNEY, a partnership; Goldman Sachs, a partnership; Wilfred Schwartz, Keith Powell; Merrill Lyons; Michael A. Pastore; Hyman Hershow; Marc Laulhere; Jack W. Minor, individuals, Defendants-Appellees. ATARI CORPORATION, a Nevada corporation, Plaintiff-Appellee, v. ERNST & WHINNEY, a partnership; Goldman Sachs, a partnership, Defendants, and Wilfred Schwartz, Keith Powell; Merrill Lyons; Michael A. Pastore; Hyman Hershow; Marc Laulhere; Jack W. Minor, individuals, Defendants-Appellants. Ninth Circuit
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1025

981 F.2d 1025

ATARI CORPORATION, a Nevada corporation, Plaintiff-Appellant, v. ERNST & WHINNEY, a partnership; Goldman Sachs, a

partnership; Wilfred Schwartz, Keith Powell; Merrill

Lyons; Michael A. Pastore; Hyman Hershow; Marc Laulhere;

Jack W. Minor, individuals, Defendants-Appellees.

ATARI CORPORATION, a Nevada corporation, Plaintiff-Appellee, v. ERNST & WHINNEY, a partnership; Goldman Sachs, a

partnership, Defendants,

and

Wilfred Schwartz, Keith Powell; Merrill Lyons; Michael A.

Pastore; Hyman Hershow; Marc Laulhere; Jack W.

Minor, individuals, Defendants-Appellants.

Nos. 91-15668, 91-15693.

United States Court of Appeals,Ninth Circuit.

Argued and Submitted June 10, 1992.

Decided July 22, 1992.

As Amended on Grant of Rehearing Dec. 10, 1992.

Jonathan P. Hayden, Heller, Ehrman, White & McAuliffe, San Francisco, CA, Matthew S. Steinberg, Inman, Weisz & Steinberg, Beverly Hills, CA, and Robert A. Sacks, Sullivan & Cromwell, Los Angeles, CA, for appellees-appellants.

John W. Clark, Clark & Korda, San Jose, CA, for appellant-appellee.

Appeal from the United States District Court for the Northern District of California.

Before: ALARCON, HALL, and KLEINFELD, Circuit Judges.

ORDER

Appellant Atari's petition for rehearing is GRANTED. The opinion filed July 22, 1992, is amended as follows:

Appellant Atari's motion to correct the record to include the transcript of the pretrial conference is GRANTED.

OPINION

CYNTHIA HOLCOMB HALL, Circuit Judge:

Atari Corporation ("Atari") appeals the district court's order granting summary judgment to Appellees Ernst & Whinney, Goldman Sachs, and several officers ("the individual defendants") of the Federated Group, Inc. ("Federated") on Atari's claims of securities fraud under sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 and Rule 10b-5 thereunder, related RICO violations, common law fraud, negligent misrepresentation, and professional malpractice, arising out of a merger agreement between Atari and Federated. The district court had federal question jurisdiction over Atari's federal law claims pursuant to 28 U.S.C. § 1331, and pendent jurisdiction over Atari's state claims. We have jurisdiction over this timely filed appeal pursuant to 28 U.S.C. § 1291 and we affirm.

The individual defendants appeal the district court's order denying their counterclaim for indemnification, which they base on a provision in the Agreement and Plan of Merger ("the Agreement") between Federated and Atari. The district court had ancillary jurisdiction over the individual defendants' compulsory counterclaim. See Baker v. Gold Seal Liquors, Inc., 417 U.S. 467, 469 n. 1, 94 S.Ct. 2504, 2506 n. 1, 41 L.Ed.2d 243 (1974). We have jurisdiction under 28 U.S.C. § 1291 and we reverse.

I FACTS

On April 26, 1987, Atari initiated a plan to acquire Federated. Atari's evaluation of Federated's finances began in earnest on June 30 when Greg Pratt, Atari's chief financial officer, attended a meeting at which he received audited 10-K forms filed by Federated with the SEC for the fiscal years ending March 1, 1986 and 1987, and Pratt also received an unaudited May 31, 1987 10-Q form. Because the 10-K statements had been audited, Pratt assumed the numbers he had before him were basically accurate. He nevertheless retained a healthy skepticism. "I discounted those statements somewhat, simply because I knew Federated was losing money and I assumed that they would take a slightly aggressive stance on accounting issues." Pratt also knew that $2.4 million of goodwill assigned to one Federated store would have to be written off entirely.

In addition to the SEC forms, Pratt reviewed a May 22, 1987 loan agreement between Federated and its banks, Federated's general ledger, and an inventory report. In the course of discussing these items, Federated's chief financial officer Merrill Lyons assured Pratt regarding several problems raised in the Ernst & Whinney audit and told him that information regarding "D" Code (distressed, discontinued, old) inventory was not available. Despite these assurances, Pratt was left with the impression that the value of the company's assets had been "grossly overstated." As discovery proceeded, the picture of Federated's financial condition grew bleaker. Pratt testified that "the longer we investigated, the more dirt we found."

In early August, Pratt asked Earl Charles of Deloitte Haskins & Sells to review Ernst & Whinney's work papers for the fiscal year end March 1, 1987. Charles's review revealed one significant flaw in the audit. Federated's financial statements listed as an asset $8 million in market development funds ("MDF"), which are funds manufacturers make available to retailers to promote products. The Ernst & Whinney audit had not reviewed this asset and Pratt felt the MDF's should not be listed because they had not been collected. In a telephone conversation that took place sometime between August 10 and August 14, Pratt asked Lyons to provide a list of the vendors who owed Federated these MDF's, so he could verify the asset, but Lyons refused.

During this same conversation, Pratt and Lyons discussed several other problems that Pratt perceived in the financial statements among which was the way Federated had depreciated its prerecorded video tape inventory. Pratt asked Lyons for certain information that would enable him to analyze whether Federated's depreciation method was appropriate. He did not receive that information prior to August 23, the date the Agreement was entered.

Two investment bankers from Goldman Sachs took part in this conversation and assured Pratt that the numbers in Federated's financial statements were valid. But Pratt proceeded with his own evaluation, in an effort to estimate the "true" net book value of the company. His analysis led him to conclude that Federated's value should be adjusted downward by $11.6 million. Pratt developed this estimate using Federated's depreciation of the videotape inventory, which he did not trust. Thus from his perspective, the $11.6 million figure was a conservative estimate of the extent to which Federated had been overvalued. When Pratt informed Goldman Sachs about his own valuation of the company, the investment bankers once again insisted that Federated's numbers were accurate and that his adjustments were inappropriate. Pratt remained unconvinced, and up until August 23 he continued to believe that adjustments of between $10 and 15 million were necessary.

By August 23 Pratt had concluded that Federated's balance sheet required between $14 and $20 million in adjustments--a conclusion based in part on a determination that the $8 million MDF account was "bogus." But he realized that a write-down of these assets would trigger the default provisions of Federated's loan agreements with several banks.

Despite Pratt's concerns, Atari and Federated entered into the Agreement and Plan of Merger on August 23. Atari offered to purchase all the shares of Federated stock at a price of $6.25 per share. Although this price was less than that requested by Federated, Pratt believed it was still about $2.15 too high. The deal was made contingent on further due diligence revealing no significant problems with Federated's financial statements.

Due diligence conducted subsequent to August 23 led Atari to conclude that Federated's books had to be adjusted downward by about $30 million. These adjustments, Pratt realized, would place Federated in "instant default" under its loan agreements. By September 27, Pratt had determined that Federated's 10-K and 10-Q reports contained untrue statements and that Atari had been fraudulently induced to enter the Agreement. On that day, Atari sent a letter to Federated's chairman, Wilfred Schwartz, indicating Atari's intention to withdraw from the deal unless Federated permitted Atari to extend its tender offer 45 days so it could audit Federated's books. Federated rejected the proposal and insisted that Atari had an obligation to close the deal. If it did not, Federated would almost surely go into bankruptcy and sue Atari for damages.

At this point, Schwartz proposed the deal that the parties refer to as the "Bet Agreement." The agreement provided for a post-closing audit. If the audit revealed the need for adjustments between $27 and $32 million, Atari would be locked into the $67 million purchase price. But if the audit revealed the need for adjustments greater than $32 million, Schwartz would have to pay Atari one dollar for each dollar in adjustments, up to $37 million. If the adjustments turned out to be less than $27 million, Atari would cancel Schwartz's guarantee to Federated's lenders by one dollar per dollar of adjustments, up to $5 million. In other words, Atari was betting that up to $5 million in additional adjustments would be necessary; if they were, the purchase price would be effectively reduced $5 million to $62 million. It appears that Atari predicted--accurately--that even greater adjustments would be necessary, for it proposed to eliminate the $5 million cap on Schwartz's liability. Schwartz, however, would not enter the bet without the cap.

Though Pratt believed Federated's assets were overstated, without an audit he could not be sure and he therefore felt that Atari had no choice but to proceed with the deal. On October 5, the deal was closed and, as it expected, Atari won the bet. On February 15, 1988, the results of Coopers and Lybrand's audit were released identifying adjustments of $43 million dollars, resulting in a reduction of Federated's net worth by $33 million. Pratt claims that he never believed the adjustments would be as high as that, and if he had, he would not have agreed to going forward with the deal.

Upon the defendants' motions for summary judgment, the district court held discovery limited to the question of whether Atari justifiably relied on any allegedly fraudulent statements by any defendant. The court entered...