Midwest Imports, Ltd. v. Coval

• Citation: 71 F.3d 1311
• Decision Date: 12 December 1995
• Docket Number: No. 95-1184,95-1184
• Parties: MIDWEST IMPORTS, LTD., Plaintiff-Appellant, v. Les COVAL and Joseph Pieciak & Co., P.C., Defendants-Appellees.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

Page 1311

71 F.3d 1311

MIDWEST IMPORTS, LTD., Plaintiff-Appellant, v. Les COVAL and Joseph Pieciak & Co., P.C., Defendants-Appellees.

No. 95-1184.

United States Court of Appeals, Seventh Circuit.

Argued Sept. 14, 1995.

Decided Dec. 12, 1995.

John C. Polales, Chicago, IL, Mark W. Damisch (argued), Daniel J. Arnett, Barclay & Damisch, Chicago, IL, for Midwest Imports Limited, an Illinois corporation.

Michael C. Bruck (argued), D. Kendall Griffith, Thomas Crisham, Michael N. Ripani, Hinshaw & Culbertson, Chicago, IL, for Les Coval, Joseph Pieciak & Company, P.C.

Before CUMMINGS, FLAUM and ROVNER, Circuit Judges.

FLAUM, Circuit Judge.

Plaintiff, Midwest Imports, Ltd. ("Midwest"), filed suit against their former accountant, Les Coval, and his accounting firm, Joseph Pieciak & Co., P.C. (collectively, "Coval and Pieciak"), alleging breach of contract and negligence in connection with the 1989 audit of Midwest's financial statements. Midwest claimed that Coval and Pieciak failed to discover and report an internal control weakness in the accounting department, which enabled a Midwest employee to embezzle $150,000. Coval and Pieciak moved for summary judgment on both counts, and the district court granted their motion. Midwest appeals this decision; we affirm.

I.

Generally, on a motion for summary judgment all material facts and all inferences are construed in the light most favorable to the non-moving party. See Serfecz v. Jewel Food Stores, 67 F.3d 591, 596 (7th Cir.1995). However, in this case, Midwest violated Northern District of Illinois Local Rule 12(N) when it failed to respond to Coval and Pieciak's statement of uncontested facts, which they submitted pursuant to Local Rule 12(M). ¹ Under rule 12(N), a failure to contest the opposing party's 12(M) facts is considered a binding admission of those facts. The district court therefore admitted as true the facts set forth in Coval and Pieciak's 12(M) statement. Midwest does not contest these admissions. Midwest also failed to comply with rule 12(N) by not submitting a separate statement of additional facts that required denial of summary judgment. Midwest simply set forth its additional facts in its memorandum. Due to this deficiency, the district court found the additional facts were not properly before it and should not be considered. As will be discussed infra in section II.A., we find this was an appropriate decision. Accordingly, in reviewing the grant of summary judgment in this case, we "depart from our usual posture of construing all facts in favor of the non-moving party; rather we accept as true all material facts contained in [the moving party's] 12(m) statement." Johnson v. Gudmundsson, 35 F.3d 1104, 1108 (7th Cir.1994). Therefore, the following background is substantially derived from the defendants' statement of uncontested facts and attached exhibits.

In 1989, Midwest, an importer of certain specialty foods, engaged Coval and Pieciak to audit its financial statements for the year ending December 31, 1989. On December 1, 1989, Coval and Pieciak sent a letter to Midwest confirming the details of the engagement. The letter provides in relevant part:

The purpose of our examination is to express our opinion on the fairness of presentation of the aforementioned financial statements taken as a whole and on their conformity with generally accepted accounting principles.

* * * * * *

[The examination] is not specifically designed and cannot be relied upon, to disclose fraud, defalcations or irregularities that may exist.

* * * * * *

In connection with our examination, as part of our services, we will submit to you such suggestions and recommendations for improvements of existing systems of internal control, accounting policies and procedures and other related matters which may come to our attention during the course of our work and which we consider appropriate.

* * * * * *

Our engagement cannot be relied upon to disclose errors, irregularities, or illegal acts, including fraud or defalcations, that exist.

Nana Kendall, the owner of Midwest, acknowledged her understanding of the engagement, as represented in the letter, by signing and returning the engagement letter.

Les Coval performed the audit field work for the Midwest audit in February of 1990. Under generally accepted auditing standard AU 320, ² Coval was required to complete a "preliminary phase" of review of Midwest's internal control system in order to obtain a "general understanding" of that system. ³ See AU 320.53. ⁴ The standard clearly provides that "[t]he purpose of the auditor's study and evaluation of internal control ... is to establish a basis for reliance thereon in determining the nature, extent, and timing of audit tests to be applied in his examination of the financial statements." AU 320.05; see also AU 320.52. ⁵ If the auditor can rely on the company's internal controls, he may reduce the extent of substantive testing necessary to express an opinion on the financial statements. The standard acknowledges that the preliminary review may "provide a basis for constructive suggestions to clients concerning improvements in internal control," and that these suggestions are "desirable"; however, it emphasizes that "the scope of any additional study made to develop such suggestions is not covered by generally accepted auditing standards." AU 320.06; AU 320.07.

As part of his field work, Coval completed several standard forms relating to Midwest's internal control system. Among them was a "Control Environment" form, the explicit purpose of which (according to the form's preface) is "to gain an understanding of the control environment and assess its overall effectiveness to plan the audit...." In completing the "Control Environment" form, Coval answered "yes" in response to more than twenty inquiries regarding Midwest's control system, including: 1) whether accounting personnel understand the duties and procedures applicable to their jobs; 2) whether management established measures to prevent unauthorized access to, or destruction of, documents, records, and assets; and 3) whether management exercises reasonable control over operations so that there is an absence of crisis conditions in operations or accounting, e.g., well-organized work areas, no unusual delays, adequate documentation for all significant transactions, etc. Coval also filled out an "Engagement Acceptance and Continuation Form" and a "Small Business Evaluation" questionnaire. Nowhere on any of these completed forms is there any indication that Coval identified a reportable internal control weakness.

After completing these forms, Coval decided against relying on Midwest's internal control system to evaluate the fair presentation of Midwest's financial statements. Instead, Coval followed the most conservative approach, assessing the internal control risk at 100% and conducting substantive testing of each material account balance. Accounting standards allow auditors to make this choice once the preliminary review has been completed. AU 320.54 states "[o]n completion of the preliminary phase of the review, an auditor may conclude that further study and evaluation are unlikely to justify any restriction of substantive tests." Such a conclusion "would cause an auditor to discontinue further study and evaluation of the internal accounting control system and to design substantive tests that do not contemplate reliance on such internal accounting control procedures." AU 320.54. Once an auditor has made the decision not to rely on the internal system to restrict substantive testing, "his documentation may be limited to a record of his reasons for deciding not to extend his [internal control] review." AU 320.55. Coval stated his reason for assessing risk at 100% as "firm policy." He then proceeded to substantively test each material account balance at Midwest in order to reach an opinion regarding the financial statements.

On February 19, 1990, Coval and Pieciak issued its evaluation of the financial statements to Midwest's board of directors and stockholders, concluding that the statements fairly represented the company's financial position. Midwest agrees that Coval and Pieciak's opinion was accurate, i.e., that the statements did fairly represent the financial position of the company. Coval and Pieciak's opinion did not report any internal control weaknesses at Midwest.

At some point after December 31, 1989, James Spillar, an accounts receivable clerk at Midwest, began embezzling checks received from Midwest customers. Spillar apparently continued to embezzle from Midwest until he admitted the wrongdoing to Midwest owner, Nana Kendall, in April of 1991. According to Midwest's pleadings, Spillar performed duties that should have been segregated, but were not. Spillar allegedly had access to cash receipts, recorded cash receipts, and performed collection follow-up. Believing that this "control weakness" enabled the embezzlement to take place, and that Coval and Pieciak should have identified and communicated this weakness as part of their audit, Midwest filed a two count complaint against Coval and Pieciak, claiming breach of contract and negligence.

Following the close of discovery, Coval and Pieciak moved for summary judgment, contending that the undisputed facts demonstrated that Coval and Pieciak did not breach any professional standard. In response, Midwest argued that there remained genuine issues of material fact as to 1) whether Coval and Pieciak attained a general understanding of Midwest's control environment, as required by AU 320, and 2) whether Coval and Pieciak should have become aware of the internal control weakness. In support of its argument, Midwest cited to attached exhibits containing additional facts, including: 1) expert testimony that "it would have taken a blind man to look at the system of internal control for just the amount of time that's required under the planning standard ... to...