Northwest Racquet Swim and Health Clubs, Inc. v. Deloitte & Touche, C9-94-301

• Decision Date: 04 August 1995
• Docket Number: No. C9-94-301,C9-94-301
• Citation: 535 N.W.2d 612
• Court: Minnesota Supreme Court
• Parties: NORTHWEST RACQUET SWIM AND HEALTH CLUBS, INC., Petitioner, Appellant, v. DELOITTE & TOUCHE, f/k/a Touche Ross and Company, Respondent.

Page 612

535 N.W.2d 612

NORTHWEST RACQUET SWIM AND HEALTH CLUBS, INC., Petitioner, Appellant, v. DELOITTE & TOUCHE, f/k/a Touche Ross and Company, Respondent.

No. C9-94-301.

Supreme Court of Minnesota.

Aug. 4, 1995.

Syllabus by the Court

The trial court did not err in holding that appellant's claims against respondent are nonderivative as a matter of law.

Kay Nord Hunt, Philip A. Cole, James M. Lockhart, Lommen, Nelson, Cole & Stageberg, P.A., Minneapolis, for appellant.

Charles W. Quaintance, Jr., Lawrence M. Shapiro, Wayne S. Moskowitz, Brenda J. Arndt, Maslon, Edelman, Borman & Brand, Minneapolis, for respondent.

Heard, considered, and decided by the court en banc.

OPINION

KEITH, Chief Justice.

This case arises from the purchase by appellant Northwest Racquet Swim and Health Clubs, Inc. ("Northwest") of $15 million in subordinated debentures from the now insolvent Midwest Federal Savings & Loan Association ("Midwest"). Respondent Deloitte & Touche ("Touche") performed audit work for Midwest for several years prior to the debenture transaction. At the trial court, Northwest alleged that Touche participated in a plan with Midwest that resulted in material misstatements in Midwest's 1986 year-end audited financial statements, on which Northwest relied in deciding to make the debenture purchase from Midwest. In support of its motion for summary judgment, Touche made four arguments: 1) that Touche is entitled to summary judgment because Northwest's claims against Touche are derivative and therefore barred as a matter of law; 2) that Touche is entitled to summary judgment because no genuine issue of material fact exists as to whether Northwest actually and justifiably relied on Touche's alleged misrepresentations; 3) that Touche is entitled to summary judgment because no genuine issue of material fact exists as to whether Midwest's criminal conduct acted as a superseding cause of Northwest's losses; and 4) that Touche is entitled to summary judgment on Northwest's negligent misrepresentation claim because Touche owed no duty of care to Northwest. The trial court denied Touche's motion for summary judgment on all issues. After granting discretionary review, the court of appeals reversed on the basis of its conclusion that Northwest's claims are derivative and did not reach the other issues. Northwest Racquet Swim and Health Clubs, Inc. v. Deloitte & Touche, No. C9-94-301, 1994 WL 481345 (Minn.App. Sept. 6, 1994). In the appeal to this court, the sole issue properly raised is whether Northwest's claims are derivative. ¹ We reverse the court of appeals and reinstate the decision of the trial court.

Northwest is a closely-held corporation with its principal place of business in St. Louis Park, Minnesota. Harvey Ratner and Marvin Wolfenson make all business decisions for the company, and shares of the corporation are held by members of the Ratner and Wolfenson families.

Until 1989, when it was placed in receivership, Midwest was a federally-chartered savings and loan association operating in Minnesota. Northwest and Midwest maintained a very close business relationship from approximately the mid-1950's until 1987. Green Tree Acceptance, Inc. ("Green Tree") was established by Midwest in 1976 as a wholly-owned subsidiary in the business of purchasing, pooling, and servicing loans for mobile homes and recreational vehicles.

Respondent Touche is a certified public accounting firm with offices in Minnesota. At the time of the transactions at issue in this case, Touche served as the certified public accountant for both Midwest and Green Tree and performed several year-end audits for both entities. Touche has never done audit work directly for Northwest, Ratner, or Wolfenson.

In May or June 1985, Midwest purchased from Green Tree the servicing rights and the net finance income receivable ("FIR") for approximately 88,000 mobile home loans. In the belief that the FIR would generate a significant income stream, Midwest paid Green Tree $188 million for the purchase. ² Green Tree continued to service the loans, but it sent Midwest the payments received along with accounting data.

Touche's involvement with the FIR purchase was through its contact as auditor for both Green Tree and Midwest. In this capacity, Touche recommended and advocated the idea of Midwest's purchase of servicing rights from Green Tree, explained the transaction to both entities, and conducted a number of investigations involving the FIR in connection with its audit work.

By the fall of 1986, Touche became aware that the FIR was not providing the originally anticipated yield. In March or April 1987, Randall Cochrane, a partner at Touche, became concerned that the FIR's service reserve was insufficient to cover potential losses, and he notified Midwest that the FIR was not performing as expected. A Touche auditor was appointed specifically to do audit work on the FIR. Further, in April or May 1987, Midwest determined that Green Tree may have misrepresented the FIR value, resulting in an inflated purchase price paid by Midwest, and it reported this fact to Cochrane. ³ According to information available at that time, Midwest estimated that the FIR would generate approximately $47 million less than initially anticipated.

Although the record indicates that some miscalculations of anticipated losses on the FIR were made, it is disputed whether the errors resulted from Touche's work or from Green Tree and/or Midwest's insistence on particular initial assumptions relating to the FIR performance. Regardless, by the time Touche was to issue its audit report for the 1986 year, the estimated repayment and repossession rate had jumped from the initially estimated 2% to an actual rate for 1986 of 17%. This resulted in higher credit losses than expected, and the entire FIR loss reserve was exhausted.

Although the extent and the adequacy of Touche's investigation into the FIR shortfall are disputed in the record, Touche representatives took part in a series of meetings and discussions in an attempt to resolve the FIR problems. On May 30, 1987, Midwest executives met with Touche and Green Tree representatives in an attempt to resolve the $47 million shortfall so that Touche could issue its 1986 audit report by its June 1 deadline. On the belief that Midwest and Green Tree had resolved the issue, Touche issued the report in the first week of June, 1987. ⁴ The report listed the value of the FIR at roughly $190 million--a $4 million increase in value from 1985.

In fall 1987, Touche learned of an additional $16 or $17 million discrepancy relating to the FIR. Although the parties dispute the impact on the value of the FIR, the record shows that by December 1987, Midwest also became aware that the $47 million FIR shortfall had grown to an approximately $63 million deficit for Midwest.

In November 1987, Midwest filed an application with the Federal Home Loan Bank Board ("FHLBB") for approval to include $25 million of subordinated debt securities ("debentures") in its regulatory capital. Although the approval was not required before Midwest could issue the debentures, it was made a condition precedent to some of the sale agreements, and Midwest waited for approval before issuing the debentures. The parties are in dispute, and the record conflicts, as to whether Touche was aware that Midwest was applying to the FHLBB or whether Touche knew Midwest intended to use Touche's 1986 audit report for issuance of debentures. Regardless, the record demonstrates that Midwest requested 40 additional copies of the 1986 audit report from Touche in October and November of 1987, and the report was included in the application. At the time of the application, Midwest did not notify the FHLBB examiners of the problems with the FIR. The record further indicates that examiners at the FHLBB relied on the value of the FIR reported in Midwest's application in deciding whether to approve it, and the FHLBB relied on Touche's 1986 audit report as reflecting an accurate statement of the financial condition of Midwest. On December 21, 1987, the FHLBB approved the application. It is not clear from the record whether the application would have been denied had it accurately disclosed Midwest's financial condition.

In late summer and fall 1987, Northwest entered into discussions with Midwest to refinance several existing mortgages. At some point after he verbally agreed that Midwest would provide Northwest's requested financing, but possibly prior to the closing of these deals, Midwest's CEO, Harold Greenwood, Jr., approached Wolfenson and asked if Northwest would be willing to purchase $15 million in eight-year subordinated debentures from Midwest with some of the proceeds of the refinancing deals. Although he initially was reluctant to consider such a purchase, Wolfenson agreed he would speak with Ratner. After a follow-up conversation with Midwest officer Richard Nelson in which Wolfenson was told that the debentures could be used as collateral for loans with other lenders, Wolfenson's interest in the purchase heightened.

Shortly following these conversations, Midwest provided Wolfenson with a draft copy of the debenture agreement along with certain financial statements for Midwest. The draft agreement made approval by the FHLBB a condition precedent to the closing. The agreement stated that attached to it were Midwest's audited financial statements for the years 1984, 1985 and 1986. It also stated:

All audited financial statements were prepared in accordance with regulatory accounting principles. Such balance sheets fairly present the financial condition of the Association as of the respective dates indicated and such statements of operations fairly present the results of the operations of the Association for the respective periods indicated.

The draft agreement also indicated that the financial statements contained no misrepresentations.

The 1986 audit report attached to the draft...