Merrill Lynch & Co. Inc. v. Allegheny Energy, Inc.

Decision Date31 August 2007
Docket NumberDocket No. 05-5129-cv.
Citation500 F.3d 171
PartiesMERRILL LYNCH & CO. INC., Merrill Lynch & Capital Services, Inc., ML IBK Positions, Inc., Plaintiffs-Counter-Defendants-Appellees, v. ALLEGHENY ENERGY, INC., Allegheny Energy Supply Company, LLC, Defendants-Counterclaimant-Appellants.
CourtU.S. Court of Appeals — Second Circuit

Before: CARDAMONE, WALKER, and RAGGI, Circuit Judges.

CARDAMONE, Circuit Judge:

Allegheny Energy, Inc. (Allegheny, defendant or appellant) and its wholly-owned subsidiary Allegheny Energy Supply Company, LLC (Supply) appeal from a judgment of the United States District Court for the Southern District of New York (Baer, J.) entered August 26, 2005 awarding Merrill Lynch & Co. Inc., Merrill Lynch & Capital Services, Inc., and ML IBK Positions, Inc. (collectively Merrill Lynch or plaintiff) $158 million on its contract claim against Allegheny and dismissing Allegheny's counterclaims.

The case arises out of Allegheny's acquisition of Global Energy Markets (GEM), an energy commodities trading business owned by Merrill Lynch, for the sum of $490 million plus a two percent interest in Supply. Market conditions spiraled downwards after the fall of Enron in 2001. In 2002 when Allegheny failed to perform its contractual commitment to contribute certain assets to Supply, Merrill Lynch exercised its right to sell back its interest in Supply at an agreed price of $115 million. Litigation ensued when Allegheny questioned the accuracy of Merrill Lynch's representations to it with respect to GEM, and refused to honor Merrill Lynch's right to sell its interest in Supply back to Allegheny.

Some facts critical to the sale of GEM were peculiarly within the knowledge of Merrill Lynch and not disclosed by it to Allegheny. The lack of that information may have played a part in defendant's decision to purchase GEM. But, not knowing the undisclosed facts means Allegheny could not accurately assess its decision. As Alexander Pope succinctly said "What can we reason, but from what we know?" Alexander Pope, An Essay on Man: Epistle I — Of the Nature and State of Man with Respect to the Universe, in 40 The Harvard Classics, 418 (Charles W. Eliot ed., 1910). For that reason this judgment must be reversed in part.


This litigation involves two business entities that have a significant presence in the American economy. Allegheny is a Pennsylvania-based energy company with more than 5,000 employees. Merrill Lynch is a leading financial management company with offices in 36 countries. Allegheny sought in 2000 to expand Supply, its wholly-owned subsidiary, through the acquisition of an energy commodities trading company. Merrill Lynch, which had until that time acted as Allegheny's financial advisor, offered Allegheny one of its trading desks, Global Energy Markets. Serious negotiations concerning the acquisition of GEM by Allegheny began in September 2000. When Merrill Lynch withdrew as Allegheny's financial advisor, Allegheny retained a new team of sophisticated advisors.

A. Financial Data on GEM

Merrill Lynch prepared and delivered to Allegheny financial data on GEM's performance and profitability. These financial summaries covered September, October 2000, and January 2001, and included profit and loss calculations on GEM's largest trading asset, the Williams contract. The September and October financial summaries were flawed in two notable respects: The data reflected substantially higher revenues and net income for GEM than was reflected on Merrill Lynch's books and records, and the reports were not prepared by Merrill Lynch's finance department as required by its own internal regulations.

GEM had a contract with Williams Energy Marketing & Trading, a Southern California energy provider, giving GEM options to buy electricity over a period of years. The October financials recognized additional revenues of $32 million attributed to the Williams contract. When defendant discovered an earlier estimate of David Chung, an expert hired by Merrill Lynch to value the Williams contract, that reflected a $10.5 million loss on the contract, defendant challenged the integrity of the process by which Merrill Lynch arrived at the $32 million figure. Nonetheless, the district court credited Merrill Lynch's explanation that Chung's lower valuation was rejected because his methodology was improper under generally accepted accounting principles.

In early January 2001, within days of the scheduled signing, Merrill Lynch realized that the September and October summaries contained significantly different numbers than those reflected on Merrill Lynch's own books. On January 5, 2001 plaintiff corrected at least some of the inaccuracies in the earlier reports, but overstated earnings generated by operations other than the Williams contract. It appears that the non-Williams component of GEM was only of peripheral concern to the parties.

The January financials did not reflect $28 million in losses incurred on the Williams contract. Merrill Lynch explained the omission by reference to a company policy under which such losses are reflected at the management level so that traders will not be penalized for unpredictable fluctuations in assets like the Williams contract. The district court found these losses were disclosed to Allegheny in valuation spreadsheets prepared by Chung. When plaintiff's negotiating team delivered the January data it informed Allegheny that the updated report should be substituted for the September and October summaries. Merrill Lynch's partial explanation for the different figures was that the January version reflected certain overhead costs that were disregarded earlier. Allegheny asserts it rejected the new financials and insisted that the deal proceed on the basis of the September and October reports.

It is a significant factor in this litigation that Dan Gordon, GEM's chief executive officer, played a large role in Merrill Lynch's alleged fraud. Gordon has since admitted to knowingly providing Allegheny with inaccurate information in the September and October financials. After the closing of the GEM deal it was learned that Gordon had embezzled $43 million dollars from Merrill Lynch by rigging a fraudulent contract for outage insurance on the Williams contract with a sham company he owned called Falcon Energy Holdings (Falcon). He was later convicted and jailed for his criminal conduct.

Although there is no direct evidence that other officers at Merrill Lynch knew of Gordon's embezzlement prior to the closing, the record reveals some of plaintiff's officials were aware Gordon had evaded its internal credit controls to set up the Falcon deal and had lied about the evasion. Plaintiff also knew that Gordon had prepared the flawed September and October financials, but seems to have believed that the inaccuracies were the product of disapproved accounting methods, rather than dishonesty. Merrill Lynch failed to disclose any of these facts to Allegheny.

B. The Purchase Agreement

After four months of due diligence the parties signed an Asset Contribution and Purchase Agreement (Purchase Agreement or Agreement) on January 8, 2001. Under the Agreement Allegheny acquired GEM paying Merrill Lynch $490 million in cash and giving it a two percent membership interest in Supply. Section 5.15 of the Purchase Agreement provided that if Allegheny failed to contribute certain assets to Supply by September 16, 2002 Merrill Lynch could require Allegheny to repurchase its interest in Supply for $115 million.

Merrill Lynch agreed to several warranties in the Agreement relating to the quality and nature of the information it had provided Allegheny. Section 3.12(b) stated that the Business Selected Data has been prepared in good faith by the management of the business based upon the financial records of the business. The district court found the provision referenced the January financial data exclusively. In § 3.12(c), which the district court found applicable to all of the disputed financial data, Merrill Lynch represented the "books of account and other financial records of [GEM] (i) are in all material respects true, complete and correct, and do not contain or reflect any material inaccuracies or discrepancies and (ii) have been maintained in accordance with [plaintiff's] business and accounting practices." Plaintiff agreed in § 3.16 that the information it provided to Allegheny "in the aggregate, includes all information known to the Sellers which, in their reasonable judgment exercised in good faith, is appropriate for the Purchasers to evaluate [GEM's] trading positions and trading operations." The parties waived "any and all right to trial by jury in any legal proceeding arising out of or related to" the Purchase Agreement.

C. Prior Proceedings

In early September 2002 Allegheny reported that it would be unable to contribute to Supply the assets contemplated in the Agreement and Merrill Lynch gave prompt notice of its intention to exercise its put right pursuant to § 5.15. On September 24, 2002 Merrill Lynch filed the instant action against Allegheny in district court, contending Allegheny breached the Agreement by failing to honor Merrill Lynch's put right.

Defendant brought an action against plaintiff in state court the following day and moved to stay the federal proceedings plaintiff had instituted arguing that Supply's presence in the federal litigation would defeat complete...

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