AUSA Life Ins. v. Ernst and Young

• Decision Date: 01 August 1998
• Docket Number: Docket No. 98-7162
• Parties: (2nd Cir. 2000) AUSA Life Insurance Company, Bankers United Life Assurance Company, Crown Life Insurance Company, General Services Life Insurance Company, Life Investors Insurance Company of America, Modern Woodmen of America, Monumental Life Insurance Company, The Mutual Life Insurance Company of New York, and The Prudential Insurance Company of America, Plaintiffs-Appellants, v. Ernst and Young, Defendant-Appellee
• Court: U.S. Court of Appeals — Second Circuit

Page 202

206 F.3d 202 (2nd Cir. 2000)

AUSA Life Insurance Company, Bankers United Life Assurance Company, Crown Life Insurance Company, General Services Life Insurance Company, Life Investors Insurance Company of America, Modern Woodmen of America, Monumental Life Insurance Company, The Mutual Life Insurance Company of New York, and The Prudential Insurance Company of America, Plaintiffs-Appellants, v. Ernst and Young, Defendant-Appellee.

Docket No. 98-7162

August Term, 1998

UNITED STATES COURT OF APPEALS

SECOND CIRCUIT

Argued: Dec. 7, 1998

Decided: March 17, 2000

Appeal from dismissal by the United States District Court for the Southern District of New York (William C. Conner, Judge) of the plaintiffs-appellants' Securities Act and other claims against the defendant-appellee after a bench trial, in a holding that loss causation had not been proven.

The district court's judgment is vacated and remanded in part, and reversed in part.

Judge Jacobs concurs in the mandate of the opinion for the court in a separate opinion.

Chief Judge Winter dissents in a separate opinion. [Copyrighted Material Omitted] Peter Buscemi, Washington, DC (Morgan, Lewis & Bockius, LLP; Debra Brown Steinberg, Cadwalader, Wickersham & Taft, New York, NY, of counsel), for Plaintiffs-Appellants.

Kenneth S. Geller, Washington, DC (Mayer, Brown & Platt; Alan N. Salpeter, Michele Odorizzi, Howard J. Roin, Caryn Jacobs, Bradley J. Andreozzi, Linda T. Coberly, Mayer, Brown & Platt, Chicago, IL; Kathryn A. Oberly, Patricia A. Connell of Ernst & Young LLP, New York, NY, of counsel), for Defendant-Appellee.

(Alan I. Horowitz, Gerald Goldman, Jeffrey J. Swart, Miller & Chevalier, Chartered; Phillip E. Stano, Senior Counsel, Litigation, American Council of Life Insurance, Washington, DC, of counsel), for American Council of Life Insurance as Amicus Curiae in support of Plaintiffs-Appellants.

Before: WINTER, Chief Judge, OAKES and JACOBS, Circuit Judges.

Judge JACOBS concurs in the mandate of the opinion for the court in a separate opinion. Chief Judge WINTER dissents in a separate opinion.

OAKES, Senior Circuit Judge:

I. Introduction

Plaintiffs-appellants AUSA Life Insurance Company, Bankers United Life Assurance Company, Crown Life Insurance Company, General Services Life Insurance Company, Life Investors Insurance Company of America, Modern Woodmen of America, Monumental Life Insurance Company, The Mutual Life Insurance Company of New York, and The Prudential Life Insurance Company of America (collectively, "insurance companies" or "investors") appeal from the dismissal of their Securities Act and other claims against Ernst & Young ("E&Y") after a bench trial in the United States District Court for the Southern District of New York (William C. Conner, Judge).

II. Facts

The appellants are insurance companies that invested in the securities of JWP, Inc., a company which ultimately went belly-up, causing the appellants to lose most of their investments.¹ The appellee is the accounting firm that served as the independent auditor for JWP from 1985 through 1992, the period during which the appellants invested in JWP and the period during which the allegedly fraudulent activity was occurring.

The appellants made their initial purchases of JWP's notes in November of 1988. Through March 1992, they purchased additional JWP notes, the investments totaling $149 million. The notes were purchased in accordance with agreements ("Note Agreements") which included, among other things, the financial representations made by JWP at the time of the notes' issuances, future procedures to which JWP agreed to adhere for certifying JWP's maintained financial viability, procedures to be followed in the event of a default on the notes, and the like.

In purchasing the notes, appellants relied on JWP's past financial statements, including annual reports certified by E&Y. These financial statements were required, under the Note Agreements, to be kept in accordance with generally accepted accounting principles ("GAAP"). Also, at the time of each annual audit by E&Y, E&Y was required under the Note Agreements to furnish to JWP a letter for JWP to transmit to noteholders,² referred to as a "no-default certificate" or a "negative assurance letter," which stated that E&Y had audited JWP's financial statements and that JWP was in compliance with the financial covenants in the Note Agreements.

In this instance and consistently, E&Y's statements about JWP's financial health were less than accurate and were not always in accordance with GAAP or GAAS ("generally accepted auditing standards"). However, E&Y did not fail to notice that often JWP's financial representations about itself were not in accordance with GAAP; rather, E&Y consistently noticed, protested, and then acquiesced in these misrepresentations:

E&Y's failure lay in the seeming spinelessness of John LaBarca [the partner in charge of the JWP audit] and the other E&Y accountants in their dealings with JWP, and particularly with its CEO, Ernest Grendi . . . . Grendi almost invariably succeeded in either persuading or bullying them to agree that JWP's books required no adjustment. Part of the problem was undoubtedly the close personal relationship between Grendi and LaBarca. Grendi had been a partner of LaBarca in E&Y's predecessor firm and they continued to be good friends, regularly jogging together in preparation for the New York City Marathon.

AUSA, 991 F. Supp. at 248. "It became a well-worn inside joke to refer to the lax accounting standards at JWP as "EGAAP," an acronym for Ernest Grendi's Accepted Accounting Practices." Id. at 253.

JWP rapidly expanded between 1984 and 1992 with many aggressive acquisitions. The expansion was mainly financed by private placements of debt securities, which put JWP in an increasingly leveraged position. JWP's final, fatal acquisition was that of Businessland, Inc., in 1991. Businessland was a retailer of computers and a supplier of software. It had lost an average of ten million dollars a month over the ten months prior to the acquisition, and its auditors had issued a "going concern" qualification on its most recent audited financial statement, which indicated that the auditors doubted the company could survive.

Notwithstanding the gloomy financial picture, JWP executives saw potential. They believed that Businessland's structure could be converted into that of a "value-added" systems integrator; they thought that Businessland could be meshed into JWP's existing business which was heavily involved in installing wiring for computer networks; and they intended to capitalize on Businessland's trained sales force and existing clientele.

Unfortunately, this ambitious business venture did not evolve as envisioned. Upon JWP's acquisition of Businessland, JWP was forced to advance money to Businessland to meet the latter's operating expenditures. As well, the planned closure of most of Businessland's retail stores took longer than was initially anticipated. During the same general time period (the early 1990s), the retail computer market was the battleground for the "PC price wars," periods of intense competition, on bases including price. To nail the coffin shut, there was a downward trend in office construction which negatively impacted the electrical construction division of JWP.

In early 1992, David Sokol, JWP's new President and Chief Operating Officer, took note of what appeared to be serious accounting irregularities in JWP's records and statements. In August of 1992, JWP retained Deloitte & Touche ("D&T"), another major accounting firm, to review thoroughly JWP's books and E&Y's audits.

D&T concluded that JWP's annual reports for 1990-1992 should be restated to reduce the 1990 after-tax net income by 15% (from $59 million to $50 million), that the 1991 after-tax income should be reduced by 52% from $60 million to $29 million, and that 1992 loss of $612 million with a corresponding net worth of negative $176 million should be reflected. E&Y concurred.

JWP was able to continue paying the interest due on its notes through 1992, and JWP made partial payments through April 1993. However, JWP ultimately defaulted and was placed in involuntary bankruptcy in December 1993. Some appellants sold their notes at a huge loss in 1993 and 1994, and some appellants partially exchanged some of their notes for cash and securities of a lesser total value than the original notes. At the end of the day, appellants sustained at least a loss of approximately $100 million in lost principal and unpaid interest.

Over twenty lawsuits were filed as a result of JWP's demise. A consolidated suit, comprised of plaintiffs who had purchased JWP common stock in the open market between May 1, 1991, and October 2, 1992, was settled, as was a suit comprised of those who had sold their businesses to JWP in exchange for JWP common stock. Two actions remained: the instant one and AUSA Life Ins. Co. v. Andrew T. Dwyer, 94 Civ. 2201 (WCC). The latter suit appears to be closed, having been settled or otherwise disposed of. SeeCivil Docket for Case #: 94-CV-2201 (S.D.N.Y. Docket as of March 15, 2000). This case remains.

In the district court, plaintiffs made essentially three categories of claims against E&Y: federal securities law claims, New York common law claims for fraud, and negligent misrepresentation claims. A bench trial was conducted over eleven weeks, and, at the conclusion of the trial after post-trial briefs and proposed findings and conclusions were submitted by the parties, the district court issued an Opinion and Order detailing its findings and dismissing the plaintiffs' claims. See AUSA, 991 F. Supp. 234. At the same time, the court issued extensive Findings of Fact. See Findings of Fact, Joint Appendix at 2466, AUSA, 991 F. Supp. 234 (S.D.N.Y. Dec. 5, 1997) (94 Civ. 3116 (WCC)).

The court found the following: From 1988 to 1991, E&Y was aware of serious accounting...