Ausa Life Insurance Co. v. Ernst & Young

• Decision Date: 05 December 1997
• Docket Number: 94 Civ. 3116(WCC).
• Citation: 991 F.Supp. 234
• Parties: AUSA LIFE INSURANCE COMPANY, et al., Plaintiffs, v. ERNST & YOUNG, Defendant.
• Court: U.S. District Court — Southern District of New York

Page 234

991 F.Supp. 234

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

94 Civ. 3116(WCC).

United States District Court, S.D. New York.

December 5, 1997.

As Amended December 19, 1997 nunc pro tunc December 5, 1997.

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Cadwalader, Wickersham & Taft, New York City (Debra Brown Steinberg, Edwin David Robertson, of counsel), for Plaintiffs.

Mayer, Brown & Platt, Chicago, IL (Alan N. Salpeter, Howard J. Roin, Caryn Jacobs, Bradley J. Andreozzi, Brian Massengill, Linda T. Coberly, of counsel), Schulte Roth & Zabel L.L.P., New York City (Howard O. Godnick, of counsel), Ernst & Young L.L.P., General Counsel's Office New York City (Patricia A. Connell, of counsel), for Defendant.

OPINION AND ORDER

WILLIAM C. CONNER, Senior District Judge.

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, 92 Civ. 5815(WCC). 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., 94 Civ. 2201(WCC), 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., 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.

Businessland was a massive bite for JWP to swallow, its 1990 revenues of $1.3 billion increasing JWP's total revenues by 45%. And JWP was immediately faced with the burden of advancing funds to Businessland to meet its operating expenses. The planned closure of most of Businessland's retail stores took longer and cost more than anticipated. Moreover, the acquisition coincided with a period of intense competition in computer sales, commonly referred to as the "PC price wars." This factor, in combination with a downward trend in office construction adversely affecting the electrical construction divisions of JWP, resulted in substantial losses.

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 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.

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