Question

AUSA Life Insurance Company and others were institutional investors in the securities of JWP, Inc., a company that went belly up, resulting in nearly a 100 percent loss of their investments. Ernst & Young served as auditor for JWP from 1985 to 1992. During most of that period, JWP was in a period of rapid expansion that was financed by private placements of debt securities, and it became increasingly leveraged. By 1991, it was losing an average of $10 million per month. Ernst & Young knew of “accounting irregularities” from at least 1988 through 1991 but did not insist on their correction. Ernst & Young issued unqualified financial opinions for all of those years. One of the irregularities was recording anticipated future tax benefits of net operating loss in violation of GAAP. AUSA and its fellow investors sued Ernst & Young for their losses. The federal district court dismissed the case and AUSA appealed. Should AUSA be able to recover? Explain your answer.

Answer 1

The appellants are insurance companies that invested in the securities of JWP, Inc., a company that ultimately went belly up, causing the appellants to lose most of their investments.1 The appellee is the accounting firm that served as the independent auditor for JWP from 1985 through 1992, the period during which the appellants invested in JWP and the period during which the the allegedly fraudulent activity was occurring.

The notes were purchased in accordance with agreements (“Note Agreements”) which included, among other things, the financial representations made by JWP at the time of the notes' issuances, future procedures to which JWP agreed to adhere for certifying JWP's maintained financial viability, procedures to be followed in the event of a default on the notes, and the like. Through March 1992, they purchased additional JWP notes, the investments totaling $149 million. The appellants made their initial purchases of JWP's notes in November of 1988.

In purchasing the notes, appellants relied on JWP's past financial statements, including annual reports certified by E & Also, at the time of each annual audit by E Y. These financial statements were required, under the Note Agreements, to be kept in accordance with generally accepted accounting principles (“GAAP”). & Y, E & Y was required under the Note Agreements to furnish to JWP a letter for JWP to transmit to noteholders referred to as a “no-default certificate” or a “negative assurance letter,” which stated that E & Y had audited JWP's financial statements and that JWP was in compliance with the financial covenants in the Note Agreements.

In this instance and consistently, E & However, E Y's statements about JWP's financial health were less than accurate and were not always in accordance with GAAP or GAAS (“generally accepted auditing standards”). & Y did not fail to notice that often JWP's financial representations about itself were not in accordance with GAAP; rather, E & Y consistently noticed, protested, and then acquiesced in these misrepresentations:

E & Y's failure lay in the seeming spinelessness of John LaBarca [the partner in charge of the JWP audit] and the other E & Grendi had been a partner of LaBarca in E Part of the problem was undoubtedly the close personal relationship between Grendi and LaBarca. Grendi almost invariably succeeded in either persuading or bullying them to agree that JWP's books required no adjustment. Y accountants in their dealings with JWP, and particularly with its CEO, Ernest Grendi․ & Y's predecessor firm and they continued to be good friends, regularly jogging together in preparation for the New York City Marathon.

To nail the coffin shut, there was a downward trend in office construction which negatively impacted the electrical construction division of JWP. During the same general time period (the early 1990s), the retail computer market was the battleground for the “PC price wars,” periods of intense competition, on bases including price. As well, the planned closure of most of Business land's retail stores took longer than was initially anticipated. Upon JWP's acquisition of Business land, JWP was forced to advance money to Business land to meet the latter's operating expenditures. Unfortunately, this ambitious business venture did not evolve as envisioned.

In August of 1992, JWP retained Deloitte In early 1992, David Sokol, JWP's new President and Chief Operating Officer, took note of what appeared to be serious accounting irregularities in JWP's records and statements. & Touche (“D & T”), another major accounting firm, to review thoroughly JWP's books and E & Y's audits.

At the end of the day, appellants sustained at least a loss of approximately $100 million in lost principal and unpaid interest. Some appellants sold their notes at a huge loss in 1993 and 1994, and some appellants partially exchanged some of their notes for cash and securities of a lesser total value than the original notes. However, JWP ultimately defaulted and was placed in involuntary bankruptcy in December 1993. JWP was able to continue paying the interest due on its notes through 1992, and JWP made partial payments through April 1993.

The court found the following: From 1988 to 1991, E & Y was aware of serious accounting irregularities with respect to the small tool inventories which increased JWP's net income, but E & E See AUSA, 991 F.Supp. at 242. Y did not insist on the correction of the irregularities. & Y knew that JWP was recording anticipated future tax benefits of net operating loss (NOL) carry forwards in clear violation of GAAP (presumably for the “purpose of dressing up its year-end consolidated balance sheet”), yet E & Id. After discovering more accounting abuses as to NOLs which also seemed to inflate current net operating income, E Y saw “nothing wrong” with this practice. & E Id. at 243. Y again “issued unqualified audit reports for the years in question,” those years including the late 1980s. & Y was also aware of and acquiesced in numerous other accounting abuses in claims and receivables which inflated JWP's earnings and assets at least from 1989 forward. –

78j(b); the rules and regulations promulgated thereunder, including SEC Rule 10b-5; and the common law. Appellants based their claims on Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. §

Section 10(b) provides that

It shall be unlawful for any person, directly or indirectly,․

To use or employ, in connection with the purchase or sale of any security ․ any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. (b)

See Citibank, N.A. v. K-H Corp., 968 F.2d 1489, 1494 (2d Cir.1992). 10(b), a plaintiff must prove (1) damage to the plaintiff,

(2) which was caused by reliance on the defendant's misrepresentations or omissions of material facts,

(3) which were made with scienter-intent to deceive, manipulate, or defraud, or reckless disregard for the resultant deception,

(4) which were made in connection with the purchase or sale of securities, and

(5) which were furthered through the defendant's use of the mails or a national securities exchange. To prove a violation of § 78j(b). 15 U.S.C. §

Standard of Review A.

See id. at 557. Questions of law are reviewed de novo, as are mixed questions of law and fact. See Scribner v. Summers, 84 F.3d 554, 557 (2d Cir.1996). In such a posture, the court's determinations of fact will not be disturbed unless they are “clearly erroneous.” As above stated, this case was tried without a jury before United States District Court Judge Conner.

Causation B.

We agree with the district court that E & See AUSA, 991 F.Supp. at 253-254 (“John LaBarca [senior E Y did not perform the most efficacious accounting in this situation. & However, we part company with the district court on its determination that it was “unforeseeable post-audit developments [that] caused JWP's insolvency and default even if its financial condition had been fully as healthy as was represented in those reports.” Y accountant] and his associates apparently lacked the backbone to stand up to the intransigent and intimidating Ernest Grendi and insist upon the changes necessary for compliance with GAAP”).

Transaction Causation 1.

However, this Court need not resolve the issue of transaction causation because the evidence definitively fails to establish the necessary loss causation.” The district court determined that “It is by no means clear that plaintiffs have proven even transaction causation․

The District Court's Factual Determinations a.

In the section of the “Findings of Fact” labeled “Loss Causation,” the district court made findings focusing on whether the misrepresentations on the financial statements available to the investors prior to their note purchases pertained to JWP's cash flow, which “is the source of interest and principal payments to lenders.

The District Court's Application of Law to Fact b.

The district court said specifically that The appellee maintains-and the district court agreed-that the events leading to the demise of JWP and the loss of appellants' investments were due to external events for which appellee cannot be held accountable, and therefore loss causation was not established.

In the instant matter, however, the systematic fraud was directed by E See Alexander, 43 Stan. L.Rev. at 597 (“[E]vidence seems to show that derivative actions tend to be resolved ․ with no tangible economic benefit to the corporation, plus large attorney's fees.”). And the main financial beneficiaries of class action litigation involving allegations of misleading proxies are generally counsel for the plaintiff class and for the defense. t is an atypical proxy case, for example, in which anyone really thinks that the actual shareholders' vote might have been different if the particular information had been restated or included. & Y specifically at appellants, who have each lost millions of dollars.

In cases where fraudulent accounting acts are isolated and short-run, my view of loss causation would be altered accordingly. That pattern of auditor acquiescence in management fraud is sufficiently longstanding to create the greatly diminished risk averseness discussed in this opinion.  

The misrepresentations at issue had thus gone on for more than two years when the notes were purchased and for almost four years at the time of the Business land acquisition. The notes at issue were purchased in 1990 or later. The district court found that the fraud began at least with the annual report for 1987. Finally, my view of loss causation is not a limitless theory imposing liability for every act of aggressive accounting.