ML-Lee Acquisition Fund, L.P. v. Deloitte & Touche, ML-LEE

• Decision Date: 04 April 1995
• Docket Number: ML-LEE,No. 2391,2391
• Citation: 320 S.C. 143,463 S.E.2d 618
• Court: South Carolina Court of Appeals
• Parties: ACQUISITION FUND, L.P., Appellant, v. DELOITTE & TOUCHE, Respondent. . Heard

Page 618

463 S.E.2d 618

320 S.C. 143

ML-LEE ACQUISITION FUND, L.P., Appellant, v. DELOITTE & TOUCHE, Respondent.

No. 2391.

Court of Appeals of South Carolina.

Heard April 4, 1995.

Decided Aug. 21, 1995.

Rehearing Denied Nov. 17, 1995.

Certiorari Granted Aug. 22, 1996.

Wilburn Brewer, Jr., Marcus A. Manos and Jennifer J. Aldrich, of Nexsen, Pruet, Jacobs & Pollard, Columbia; and John D. Hughes, of Hutchins, Wheeler & Dittmar, Boston, MA, for appellant.

Jefferson V. Smith, Jr., of Carter, Smith, Merriam, Rogers & Traxler, of Greer; James T. Williams, Jr., and S. Leigh Rodenbough, IV, of Brooks, Pierce, McLendon, Humphrey & Leonard, Greensboro, NC, for respondent.

HOWELL, Chief Judge:

In this negligent misrepresentation case, ML-Lee Acquisition Fund, L.P. (ML-Lee) appeals the trial court's grant of summary judgment in favor of Deloitte & Touche (Deloitte). We affirm in part, reverse in part, and remand.

I.

Emb-Tex Corporation (Emb-Tex), formed in 1962, is a textile embroidery facility in Travelers Rest, South Carolina. Emb-Tex was a subsidiary and sole material asset of ETC Corporation (ETC). Until 1979, Emb-Tex was operated as a family-owned business. Between 1979 and 1986, Emb-Tex was the subject of three leveraged buyouts before being purchased in December 1986 by David McKane and Peter Robbins.

Formed in 1987, ML-Lee is a Delaware limited partnership investing in "mezzanine" securities. ¹ ML-Lee invests primarily in unrated securities or securities rated by Standard & Poor's Corporation as BB or lower. In May 1988, ML-Lee invested in Emb-Tex through a $16,000,000 loan to a newly formed holding corporation which then purchased the stock of Emb-Tex. At the time of this investment, Emb-Tex had outstanding debt of more than $23,000,000 secured by liens on Emb-Tex's assets, including $18,000,000 of debt incurred in February 1987. ² In December 1990, ML-Lee directly invested another $2,000,000 in Emb-Tex. ML-Lee claims it made the investments after relying on the audit reports of Emb-Tex's financial statements produced by Deloitte for the years 1985 through 1988.

Deloitte is an accounting firm. From 1983 to 1988 Deloitte prepared the audited financial statements for Emb-Tex. When Deloitte accepted Emb-Tex as a client in 1983, Deloitte was generally aware that one of the reasons Emb-Tex wanted audited financial statements was to provide them to outside investors. However, at the time the 1983-1986 reports were prepared, Deloitte was not aware of ML-Lee, which was formed in 1987, nor of any intention by Emb-Tex to deal with ML-Lee.

ML-Lee operates through an investment advisor, Thomas H. Lee Company, Inc. (Lee Advisor), which analyzes and recommends investments to ML-Lee. Sometime before February 1988, Lee Advisor was contacted by Kidder, Peabody (Kidder), a New York investment banking firm hired by Emb-Tex, about a possible investment in Emb-Tex. Emb-Tex and Kidder produced an offering memorandum dated January 18, 1988. In the offering memorandum, Emb-Tex provided background information on itself, while Kidder provided historical financial information for the years 1983-1987, as well as financial projections through 1996. The offering memorandum also included the audited financial statements produced by Deloitte for the years 1983-1986.

Evaluation of the proposed investment was performed by a Lee Advisor "deal team" whose members were Glenn Hutchins, Steven Segal, and Warren C. Smith, Jr. Lee Advisor generated computer models that projected Emb-Tex's future growth by incorporating historical financial information. On February 26, 1988, Lee Advisor issued its analysis to ML-Lee and recommended the investment in Emb-Tex. On March 1, 1988, the ML-Lee partners voted favorably on the proposed investment.

On or near March 1, 1988, Lee Advisor hired Peat Marwick to review Emb-Tex's records, including the Deloitte audits. On March 14, 1988, after reviewing the workpapers prepared by Deloitte in connection with its 1987 audit, Peat Marwick recommended further investigation and testing. Peat Marwick's report included the results of inventory valuation samples in which three of twenty-one samples taken by Deloitte resulted in an overstatement of inventory. Peat Marwick also reported the inventory valuation method was unusual, and recommended that further testing be performed.

On March 21, 1988, Lee Advisor, on behalf of ML-Lee, wrote a letter to Kidder offering a commitment to purchase $16,000,000 of subordinated notes in Emb-Tex. The commitment letter, however, expressly conditioned the consummation of the purchase on the fulfillment of several conditions, including a requirement that ML-Lee be satisfied that there had been no material adverse change in the financial condition of ETC and Emb-Tex, and a comfort letter "for the purpose of assuring that the transactions contemplated by [the offer] would not be avoidable under any bankruptcy or fraudulent conveyance law." This offer was accepted by Emb-Tex on March 22, 1988.

On May 23, 1988, Deloitte issued the comfort letter to Emb-Tex and ML-Lee. The letter stated Deloitte had read Emb-Tex's unaudited financial statements for the four months ending April 30, 1988, and had made certain inquiries of Emb-Tex and ETC officials with regard to Emb-Tex's accounting procedures and financial condition. The letter further stated:

The foregoing procedures do not constitute an examination made in accordance with generally accepted auditing standards, and they would not necessarily reveal matters of significance with respect to the comments in the following paragraph. Accordingly, we make no representations as to the sufficiency of the foregoing procedures for [ML-Lee's] purposes.

Based upon [these procedures], nothing has come to our attention which causes us to believe that the unaudited financial statements ... have not been prepared in accordance with generally accepted accounting principles applied on a basis consistent with that of the [1987 audited financial statements] ... or that there has been, as of May 20, 1988, an increase in long-term debt, a decrease in stockholder's equity or total assets of [Emb-Tex] or a material change in the internal accounting controls of [Emb-tex] as compared to such amounts or matters for the year ended December 31, 1987.

... [N]othing has come to our attention as a result of the foregoing procedure, however, that causes us to believe that during the period from December 31, 1987 to May 20, 1988, there has been a decrease in stockholder's equity or total assets of ETC Corporation as compared to such amounts for the year ended December 31, 1987.

A new corporation, Emb-Tex Holdings Corporation (Holdings), was formed for the purpose of entering into the purchase agreement with ML-Lee. On May 24, 1988, the transaction was closed. ML-Lee transferred the $16,000,000 to Holdings, and, pursuant to the Note and Warrant Purchase Agreement (Purchase Agreement), ETC (the parent company of Emb-Tex) merged into Holdings. Lee Advisor, Kidder, McKane and Robbins, and legal counsel for Emb-Tex and ML-Lee all received fees in association with the transaction. Deloitte did not receive any payment.

On November 2, 1990, Lee Advisor prepared a memorandum recommending an additional $2,000,000 investment in Emb-Tex by ML-Lee. Lee Advisor used the Deloitte audited financial statements for 1988 and draft financial statements for 1989 in preparing the financial summary that accompanied its recommendation. At the time, Lee Advisor was aware Emb-Tex was not performing as well as initially anticipated. Lee Advisor believed the major problem was the large disbursements made by Emb-Tex to McKane and Robbins in a two year period. Many of the disbursements were for personal expenses of McKane and Robbins, and were made without the knowledge of Emb-Tex's creditors. Lee Advisor was aware that McKane and Robbins, in violation of their agreement with ML-Lee, set up a partnership to buy assets that were to be leased back to Emb-Tex. Lee Advisor was also aware of numerous problems at Emb-Tex, including Emb-Tex's failure to pay income taxes withheld from payroll, failure to pay pension fund payments, and Emb-Tex's failure to make quarterly interest payments to ML-Lee. Lee Advisor advised ML-Lee to purchase the assets of Holdings instead of stock because it was concerned there would be hidden problems due to the poor management of McKane and Robbins. At the time Lee Advisor recommended the additional investment, ML-Lee had written off $8,000,000 of its original investment in Emb-Tex.

On November 6, 1990, the ML-Lee partners approved the additional $2,000,000 investment. On November 21, 1990, ML-Lee entered into a letter of intent with McKane and Robbins to purchase certain assets of Holdings, including the stock of Emb-Tex, in consideration for ML-Lee's agreement not to demand repayment of the $16,000,000 loan. The letter of intent contained many conditions precedent to the closing of the transaction, including the completion of the "financial and accounting investigation and due diligence" with respect to Holdings and its subsidiaries.

By the fall of 1990, Deloitte still had not completed its audit of Emb-Tex's financial statements for 1989. In late November 1990, Janice Thomas, the managing auditor on the Emb-Tex account, reviewed the inventory workpapers and realized they needed further work. During this time, Thomas had lunch with Lamar Forsythe, a former Deloitte accountant then working for Emb-Tex. Forsythe indicated to Thomas that Emb-Tex's inventory may be overvalued. Upon her return to the Deloitte offices after the lunch, Thomas destroyed the inventory workpapers, intending to completely redo the inventory analysis. Thomas reported the action to David Sutton, a Deloitte partner.

Within a week of Thomas' report to Sutton, Sutton participated in a conference call with John Sanders, a former Deloitte employee, and Warren Smith of Lee Advisor. Sutton...