Travelers Cas. and Sur. Co. v. Ernst & Young Llp

Decision Date08 September 2008
Docket NumberNo. 07-60379.,07-60379.
PartiesTRAVELERS CASUALTY AND SURETY COMPANY OF AMERICA, A Connecticut Corporation, Plaintiff-Appellee, v. ERNST & YOUNG LLP, Defendant-Appellant.
CourtU.S. Court of Appeals — Fifth Circuit
542 F.3d 475
TRAVELERS CASUALTY AND SURETY COMPANY OF AMERICA, A Connecticut Corporation, Plaintiff-Appellee,
ERNST & YOUNG LLP, Defendant-Appellant.
No. 07-60379.
United States Court of Appeals, Fifth Circuit.
September 8, 2008.

[542 F.3d 478]

Luther T. Munford (argued), Rebecca Hawkins, Phelps Dunbar, Jackson, MS, Andrew V. Tramont, Paulino Antonio Nunez, Tramont, Guerra & Nunez, Coral Gables, FL, for Plaintiff-Appellee.

Reagan W. Simpson, King & Spalding, Houston, TX, L. Joseph Loveland (argued), Joseph B. Haynes, Cheri Alison Grosvenor, Michael M. Raeber, King & Spalding, Atlanta, GA, James B. Galloway, Butler, Snow, O'Mara, Stevens & Cannada, Jackson, MS, for Defendant-Appellant.

Appeal from the United States District Court for the Southern District of Mississippi.

Before JONES, Chief Judge, and DAVIS and GARZA, Circuit Judges.

EMILIO M. GARZA, Circuit Judge:

The district court entered judgment on a jury verdict in favor of Travelers Casualty and Surety Company of America ("Travelers") and against Ernst & Young LLP ("E&Y"). E&Y appeals the district court's denial of its motion for judgment as a matter of law and its motion for new trial. For the following reasons, we affirm.


In November 1999, Friede Goldman International and Halter Marine Group, Inc. merged to form Friede Goldman Halter, Inc. ("FGH"). FGH constructed oil rigs, vessels, and other large maritime equipment. Shortly after the merger, FGH hired E&Y, to audit its 1999 year-end financial statements, and to provide the necessary audit opinion for its 1999 Form 10-K filing with the Securities and Exchange

542 F.3d 479

Commission ("SEC"). FGH filed its 1999 10-K with the SEC on March 31, 2000. E&Y's opinion letter, filed as part of the 10-K, stated that it had "conducted [its] audit in accordance with auditing standards generally accepted in the United States," and that it believed that its audit provided a "reasonable basis" for its opinion that the financial statements "present fairly, in all material respects, the consolidated financial position of Friede Goldman Halter, Inc. and Subsidiaries at December 31, 1999." E&Y did not qualify its audit opinion or issue any disclaimers in its opinion letter indicating that it lacked necessary information for its audit. Nor did the opinion letter raise any question as to FGH's viability as a going concern.1

FGH's 1999 financial statements disclosed two problematic construction projects for the new corporation: the Ocean Rig and Petrodrill projects. The projects involved the construction of large oil rigs. The company accounted for both projects under the "percentage of completion" method, which required FGH to estimate the total expected revenues and cost for each job, and to recognize any expected periodic revenue or loss based on the percentage of the project that had been completed to that point. The statements included projected losses on Ocean Rig of $37.4 million and $60 million on Petrodrill. While this case concerns both construction projects, the projected loss on the Petrodrill project is of central importance. The financial statements included notes regarding the cause of the loss on the Petrodrill project. According to the notes, problems with subcontractors, delays in engineering planning, and contract disputes between an FGH subsidiary and Petrodrill combined to create the anticipated loss of $60 million. The financial statements also provided that "funding these excess costs could have a significant impact on the Company's liquidity." The statements also included forward-looking warnings regarding the uncertainty generally associated with the percentage of completion method, and the fact that loss estimates included in the statements could change in the future.

Because of the size of the construction projects carried out by FGH and the uncertainties attendant in such lengthy projects, FGH was required to obtain surety bonds. A surety bond is a third-party guarantee involving an owner, a contractor, and a surety. The contractor pays a premium for the surety's bond which guarantees the contractor's performance for the owner. If the contractor cannot complete performance, then the surety is obligated to do so. In early May 2000, FGH approached Travelers and several other surety companies seeking an extensive $600 million bond program for future construction contracts. After reviewing FGH's 1999 financial statements, Travelers determined that it could not issue any surety credit to FGH because the company presented too high a risk based on its poor financial outlook. The other companies also declined to issue surety credit.

A few weeks later, FGH again sought to obtain surety bonds from Travelers and other surety companies. At this meeting, FGH promised to revamp its finances and operations such that FGH would be able to

542 F.3d 480

bear the anticipated losses from Ocean Rig and Petrodrill. The other surety companies again declined, but Travelers decided to proceed with further discussions.

In June 2000, FGH management indicated to Travelers that FGH's financial situation was improving. FGH outlined a "liquidity campaign" that would involve FGH disposing of assets, selling stock, and obtaining a new line of credit. FGH also anticipated a tax refund. The campaign was a success and provided approximately $200 million in available liquidity for FGH to use to cover any potential losses. The liquidity campaign "dramatically changed" Travelers' impression as to whether it could possibly issue bonds to FGH. Travelers still understood FGH to be a "high risk" surety situation. Nevertheless, Travelers sent a July 2000 memo to FGH tentatively outlining a proposed surety bond program worth between $200-225 million.

In August, FGH issued its unaudited second quarter Form 10-Q, which provided an updated picture of the expected losses on Petrodrill and Ocean Rig. The 10-Q showed that FGH had increased its loss estimate on Ocean Rig by $28.3 million. The 10-Q provided no change in the Petrodrill loss estimate; it remained at $60 million. After this announcement, Travelers met with FGH management on two occasions to address its concerns, especially with respect to whether Petrodrill's loss estimates were likely to change. FGH acknowledged the change in the Ocean Rig project, but assured Travelers that the Petrodrill estimate remained accurate. FGH provided Travelers with an independent, third-party engineering assessment of both projects. That assessment confirmed the accuracy of the percentage of completion estimates to date on Ocean Rig and Petrodrill. FGH also reassured Travelers that the fruits of its liquidity campaign would be able to cover the expected losses on both Ocean Rig and Petrodrill.

In September 2000, Travelers decided to back off of its original $225 million plan and instead issued approximately $70 million in surety bonds to FGH. These bonds were issued primarily for a vessel construction project known as the Pasha project. The bonds also covered two other small contracts.2 The Pasha bond agreement was not a run-of-the-mill arrangement. Travelers charged a higher bond premium and obtained a special security interest in the project. Travelers also required initial collateral of $15 million, though the agreement provided that half of the collateral would be released once certain security agreements received final sign-off. Soon thereafter, final sign-off occurred and Travelers released half of the $15 million back to FGH.

In November 2000, FGH's agent again approached Travelers to discuss the original $200-225 million bonding program. Travelers declined, stating that it wanted to be more certain about the success of the Ocean Rig and Petrodrill projects before issuing any more bonds.

In March 2001, FGH released its year-end 2000 10-K which revealed new, much higher loss estimates. The new numbers reflected an anticipated loss of $121 million on Petrodrill, double what was reflected in the 1999 10-K, and double what Travelers assumed the loss to be when it issued the Pasha bond. The Ocean Rig estimate also increased dramatically.

Subsequent to issuing the bond, Travelers learned that FGH had diverted somewhere between $17-35 million from the Pasha project towards other work in an

542 F.3d 481

attempt to keep the company viable. This diversion depleted the Pasha project further, and it did not help to keep FGH afloat. Based on insufficient cash and reserves to cover its losses, FGH filed for bankruptcy shortly after the release of its 2000 10-K. FGH was unable to continue construction on the projects under the Pasha bond, and Travelers was required to fulfill its obligation as surety. Travelers paid out approximately $58 million to complete the projects covered by the Pasha bond.

Travelers sued FGH, its officers and directors, as well as E&Y in an attempt to recoup the $58 million it lost as a result of paying out on the Pasha bond. Travelers alleged that FGH's management had misrepresented FGH's financial position and breached its fiduciary duty towards Travelers during the bond negotiation process. Travelers alleged that E&Y was negligent in conducting its audit of FGH's 1999 year-end financials. The FGH officers and directors settled, leaving E&Y as the only remaining defendant. Travelers' claim against E&Y was tried to a jury. Travelers alleged that E&Y was negligent in failing to conduct the necessary inquiries and perform proper audit tests to confirm and substantiate the Petrodrill loss estimates in the 1999 10-K, leading to a gross under-estimate of the Petrodrill loss estimate. Travelers contended that E&Y's negligence was a substantial factor in causing Travelers to issue the Pasha bond because the estimated loss on the Petrodrill contract was of central importance to FGH's viability going forward, and Travelers relied on the accuracy of the loss figure in issuing the bond. The jury found that E&Y was negligent in conducting its audit and that...

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