Opposition Brief — Delta Holdings, Inc. v. National Distillers & Chemical Corp.
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Supreme peur’ J,
FILED
“
oF, VAR 25 1992
No. 91-1361 ; ; =
Bites . itt Gicanr
IN THE
Supreme Court of the United States
OcToBER TERM, 199]
Detta Houprncs, INc.,
Petitioner,
— against —
NATIONAL DISTILLERS AND CHEMICAL CORPORATION,
Respondent.
ON PETITION FOR A WRIT OF CERTIORARI TO THE UNITED
STATES COURT OF APPEALS FOR THE SECOND CIRCUIT
BRIEF IN OPPOSITION TO WRIT OF CERTIORARI
JosePH P. DaILey
Counsel of Record for Respondent
565 Peralta Hills Drive
Anaheim, California 92807
(714) 282-1170
Of Counsel:
Loren F. SELZNICK
James T. SouTHWICK
Corporate Disclosure Statement
Respondent National Distillers and Chemical Corporation
makes this statement pursuant to Rule 29.1 of the Rules of the
Supreme Court. On January 4, 1988, National Distillers and
Chemical Corporation changed its name to Quantum Chemical
Corporation. Respondent has no parent corporation and has the
following subsidiary or affiliate companies (excluding wholly-
owned subsidiaries):
Domestic Companies State of Incorporation
Atlantic Energy, Inc. Delaware
Fallon Propane and Butane Nevada
Company
Petrolane Incorporated California
Petrolane Finance Corporation Delaware
Foreign Companies Country of Incorporation
Cue Insurance Limited Bermuda
Quantum Petrochemical England
Corporation Ltd.
Petrolane Offshore Limited Bermuda
Northwest L.P.G. Supply Ltd. Canada
ill
TABLE OF CONTENTS
ES eee eee
Additional Opinion Below................-----
eee ee ce
OO Ee ee ee
The Proceedings Below ............-.--
Loss Reserves And Casualty Reinsurance .
. The Elkhorn Reserves ............-..--
= Oo 0 *
The Reinsurance Experience And
Sophistication Of Delta Holdings........
F. The Preacquisition Investigation ........
REASONS FOR DENYING THE WRIT ....
1. The Court Of Appeals Decided The
Reserve Issues Under The Contract,
Not The Federal Securities Laws .....
2. The Court Of Appeals Never Held
That The Materiality Standard Was
Inapplicable To Investors Who Retain
GS ea a a
3. The Court Of Appeals Did Not Usurp
The Function Of The District Court . .
ee ikea eee AOA
11
12
15
16
20
TABLE OF AUTHORITIES
Case
Basic Inc. v. Levinson, 485 U.S. 224 (1988) .....
Dick v. New York Life Ins. Co., 359 U.S. 437
(1959) (Frankfurter, J., dissenting) ...........
Dower v. Mosser Indus., Inc., 648 F.2d 183 (3d
a
Elkind v. Liggett & Myers, Inc., 635 F.2d 156
tel i UIE Sc tree eee
Frigitemp Corp. v. Financial Dynamics Fund,
Inc., 524 F.2d 275 (2d Cir. 1975) ............
Godchaux v. Conveying Techniques, Inc., 846
F.2d 306 (5th Cir. 1988) ................00..
Hafner v. Forest Lab’s, Inc., 345 F.2d 167 (2d
Cie; BR eel eee
Hunt Ltd. v. Lifschultz Fast Freight, Inc., 889
eS BR be | eee re re
Johnson v. Wiggs, 443 F.2d 803 (5th Cir. 1971) ..
Kademian v. Ladish Co., 792 F.2d 614 (7th Cir.
SOUND . oivs vs anes cdaekowee en en eee
Kas v. Financial General Bankshares, Inc., 796
ee Fikes || ere eee err eT
Page
18
19
Case Page
Koplin v. Labe Federal Sav’s ¢ Loan Ass’n, 748
F.Supp 1336 (N.D. II. WE sre eee 19 n.22
Layne & Bowler Corp. v. Western Well Works,
Inc., 261 U.S. 387 (1923) ................... 1]
Levy v. Gadsby, 7 U.S. 180, 3 Cranch 109 (1805) 12n.1]
Mayer v. Oil Field Systems Corp., 803 F.2d 749
ree. TO is 19 n.22
McNabb v. Thomas, 190 F.2d 608 (D.C. Cir.
1951), cert. denied, 342 U.S. 859 (1951) ...... 14 n.13
Michaels v. Michaels, 767 F.2d 1185 (7th Cir.
1985), cert. denied, 474 U.S. 1057 (1986) ..... 16 n.16
Myzel v. Fields, 386 F.2d 718 (8th Cir. 1967),
cert. denied, 390 U.S. 95] GE eles cue, 14 n.13
NLRB v. Pittsburgh Steamship Co., 340 U.S. 498
Saat, MITTEE ETT ee rs Ue ee a 18
Peurifoy v. Commissioner, 358 U.S. 59 (1958) ... 18
Pittsburgh Coke & Chemical Co. v. Bollo, 421
F.Supp. 908 (E.D.N.Y. 1976), aff'd, 560 F.2d
ee 8 Cir NGTT) ss i 15 n.15
In re RAC Mortgage Inv. Corp., 765 F.Supp. 860
rere es | Sires 15 n.15
Vii
Page
SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d
Cir. 1968), cert. denied, 394 U.S. 976 (1969)... 15 n.15
Shappirio v. Goldberg, 192 U.S. 232 (1904) ..... 14 n.13
Teamsters Local 282 Pension Trust Fund v.
Angelos, 762 F.2d 522 (7th Cir. 1988) ........ 14 n.13,
19 n.22
Thor Power Tool Co. v. Commissioner, 439 U.S.
Pres er ar een ene ee 18,
Titan Group, Inc. v. Faggen, 513 F.2d 234 (2d
Cir.), cert. denied, 423 U.S. 840 (1975) ....... 16
TSC Industries, Inc. v. Northway, Inc., 426 U.S.
ee EE so Mi oe ee eae Aa eee 15, 16
United States v. Johnston, 268 U.S. 220 (1925) ... 1]
United States v. United States Gypsum Co., 333
6 te fF Ppaeitar ae rrr e hires tere 17
Vulcan Metals Co. v. Simmons Mfg. Co., 248 F.
853 (2d Cir.), cert. denied, 247 U.S. 507 (1918) 14n.13
Ward v. Freeman, 854 F.2d 780 (5th Cir. 1988),
cert. denied, 490 U.S. 1065 (1989) ........... 19 n.21
Wielgos v. Commonwealth Edison Co., 892 F.2d
ee ee es cee on cee ce eecies a 15 n.15
Wollins v. Antman, 638 F.Supp. 989 (S.D.N.Y.
ee Fd Cay eae each eee came 19 n.22
Page
Statutes & Regulations
ee ef 15 n.15
kk 12, 16
Securities Act Release No. 5992, F ed.Sec.L.Rep.
(CCH) 4 81,756 (Nov. 7, 1978) .............. 15 n.15
Ky.Rev.Stat. § 304.6-100(3) ................... 7 n.6
Other Authorities
American Institute of Certified Public
Accounting, Audits of Fire and Casualty
Insurance Companies (1966) ................. 6 n.4,
7 n.6,
18 n.19
Financial Accounting Standards Board, Statement
Of Financial Accounting Standards No. 60,
“Accounting and Reporting By Insurance
Enterprises” (1982) ......................... 6 n.5
“
IN THE
Supreme Court of the United States
OcroBER TERM, 1991
No. 91-1361
Dera Ho.opincs, INC.,
Petitioner,
— against —
NATIONAL DISTILLERS AND CHEMICAL CORPORATION,
Respondent.
ON PETITION FOR A WRIT OF CERTIORARI TO THE UNITED
STATES COURT OF APPEALS FOR THE SECOND CIRCUIT
BRIEF IN OPPOSITION
TO WRIT OF CERTIORARI
National Distillers and Chemical Corporation, now known
as Quantum Chemical Corporation (“Quantum”), opposes the
Petition for a Writ of Certiorari filed by Delta Holdings, Inc.
(“Delta Holdings”). The Petition has misstated the decision of
the Court of Appeals and the issues that would properly be
before this Court if certiorari were granted. The controversy
turns on its own facts and does not raise any serious issues under
the federal securities laws.
ADDITIONAL OPINION BELOW
The summary judgment decision of the district court, which
was not appended to the Petition For Writ Of Certiorari, is
reported at [1987-1988 Transfer Binder] Fed.Sec.L.R. { 93,700
(S.D.N.Y. April 8, 1988).
ne
Statement Of The Case
A. The Transaction.
This action arose out of the sale of the Elkhorn Re Insurance
Company (“Elkhorn”), a casualty reinsurer owned by Quantum,
to Delta Holdings on September 30, 1983 for $18 million. The
sale followed four months of face-to-face negotiations and a
detailed investigation of the loss reserves and financial condi-
tion of Elkhorn by a team of experts hired by Delta Holdings,
including American Risk Management, Inc. (“ARM”), Peat, Mar-
wick & Mitchell (“Peat Marwick”) and Conning & Company
(“Conning”).
The terms and conditions of the Elkhorn sale were set forth
in a Stock Purchase Agreement. Under § 5(g) of the Agreement,
Quantum warranted that a June 30, 1983 balance sheet of
Elkhorn was complete and accurate, prepared in accordance
with generally accepted accounting principles (“GAAP”), and
fairly presented the financial position of Elkhorn. Under § 12
of the Agreement, the parties agreed that after petitioner ac-
quired control on October 1, 1983, it would prepare a September
30, 1983 balance sheet which would be used to adjust the $18
million purchase price paid at the closing. Quantum guaranteed
in § 12 that the net worth shown on the September 30, 1983
balance sheet would not be less than $18 million and, if it were,
agreed to pay any deficiency by October 31, 1983. The parties
further agreed that if a dispute arose concerning the net worth
of Elkhorn as of September 30, 1983, it would be promptly sub-
mitted to Peat Marwick for “final and conclusive and binding”
arbitration. '
The September 30, 1983 balance sheet prepared by petitioner
after the sale showed a net worth of $18 million, as did a June
30, 1983 Pro Forma Statement of Net Assets audited by Peat
' § 12 of the Stock Purchase Agreement is set forth in Note 7 of the Court
of Appeals opinion. See Appendix to Petition For Writ Of Certiorari (“P.App.”)
at 47a.
rr ee
Marwick before the sale. In the spring of 1984, another balance
sheet was prepared and audited by Peat Marwick showing that
Elkhorn, which had changed its name to the Delta America Re
Insurance Company (“Delta Re”), had a net worth of $19.2
million as of December 31, 1983.
After operating for twenty months under the management
of petitioner, Delta Re was declared insolvent by the Kentucky
Insurance Department. Delta Re was a victim of the worst
downturn in the reinsurance market since 1906, the year of the
San Francisco earthquake. More than 90 reinsurers were forced
out of business as the result of overcapacity in the industry and
unexpected claim development on policies written in previous
decades. Delta Re was placed in rehabilitation on May 29, 1985
and in liquidation on September 15, 1985. The present action
ensued.
B. The Proceedings Below.
The complaint filed by petitioner in the Southern District of
New York in 1985 claimed, among other things, breaches of §
5 and § 12 of the Stock Purchase Agreement and violations of
the federal securities laws. Underlying the claims were the allega-
tions, first, that Elkhorn was insolvent at the time of the sale
due to a massive deficiency in the loss reserves; second, that the
reserve deficiency was concealed by improperly prepared loss
development triangles which actuaries use to make reserve
estimates;? and, third, that the President of Elkhorn, Robert
Norton, was aware of the alleged deficiency by reason of two
actuarial reports prepared in early 1982 by Tillinghast, Nelson
& Warren.
In an April 1988 summary judgment decision, the District
Court dismissed the claim under § 12 of the Stock Purchase
Agreement, ruling that submission to Peat Marwick for “final
and conclusive and binding” resolution by October 31, 1983 was
the “exclusive remedy” for resolving disputes concerning the net
2 Loss development triangles are computer-generated summaries of reported
claim information. See P.App.7a.
worth of Elkhorn at the time of the sale.? The Court refused
to dismiss the breach of warranty and securities law claims,
holding that a trial was required to determine if there was any
deception relating to the loss development triangles or any con-
cealment of material information during the preacquisition in-
vestigation (R.App. 13-14).
After a six-week bench trial in 1988, the District Court ruled
on April 10, 1990 that Quantum breached the accounting war-
ranties in § 5 of the Stock Purchase Agreement by failing to
disclose a substantial reserve deficiency at the time of the sale
and violated the federal securities laws by concealing the Til-
linghast reports. The Court construed § 5 as a warranty on the
adequacy of the reserves that provided a second and unqualified
right to dispute the net worth of Elkhorn, free of the restric-
tions of § 12. The Court did not find there was any deception
concerning the loss development triangles, nor did it find, with
the exception of the Tillinghast reports, any concealment of
material information during the four-month investigation. While
the Court concluded the Tillinghast reports were material, it
never explained what the reports would have added to the two
in-depth studies of the reserves conducted by Conning and Peat
Marwick before the sale.
On October 1, 1991, the Court of Appeals unanimously
reversed the trial court, ruling, among other things, that:
* Quantum did not make any representations in the
Stock Purchase Agreement concerning the ade-
quacy of the Elkhorn reserves and the represen-
tations it did make concerning compliance with
GAAP and accounting regularity were truthful.
P.App.44a-5la.
¢ The construction of the Stock Purchase Agreement
adopted by the District Court was “so one-sided so
as to be implausible” (P.App.45a) and the decision
3 See Appendix to this Brief (“R.App.”) at 8.
\
|
to allow petitioner to dispute the net worth under
§ 5 was “anomalous” in light of its earlier ruling
that § 12 was the exclusive remedy for resolving
net worth disputes. P.App.8a-49a n.8.
e The Elkhorn method of establishing reserves was
well known within the reinsurance industry, fully
disclosed to petitioner prior to the sale, and
recognized as acceptable under GAAP. P.App.5a,
20a-2la, 50a-5la.
e The massive reserve deficiency established at trial
was developed in the “glow of hindsight” by trial
court experts who did nothing after the fact that
Peat Marwick and Conning could not have done
before the sale. P.App.45a-46a.
e The method of preparing the Elkhorn triangles
was disclosed to Peat Marwick before the sale and
the injury to petitioner was caused by its own
misunderstanding of the triangles, not by the con-
duct of Quantum. P.App.2la-24a, 39a-43a.
e The Tillinghast reports were “red herrings” that
did not contain any material information except
what was already in the public domain or disclosed
to petitioner before the sale. P.App.34a-39a.
C. Loss Reserves And
Casualty Reinsurance.
Unlike most businesses, the net worth of a casualty reinsurer
is difficult to determine because the largest liability on the
balance sheet, the reserve for unpaid claims, is unknown and
must be estimated.* As the Court of Appeals observed,
* “In most businesses cost information is available before sales are made. In
the insurance business, however, the cost of the protection sold cannot be finally
(Footnote continued)
underwriting casualty risks “leads to complex problems of finan-
cing and accounting because assumptions of third-party liability
risks involves substantial delays or ‘tails’ in the discovery and
reporting of claims” (P.App.4a). For long-tail casualty reinsurers
like Elkhorn, the 15 to 20 year delays in the reporting process
“inevitably create considerable uncertainty” in establishing
reserves (id.).
While GAAP requires reinsurers to make a reasonable estimate
of reserve liabilities,* it neither specifies a precise method of
estimating reserves or even requires that an actuary prepare or
review the estimates (P.App.5a). All of the actuarial methods
require subjective judgments and assumptions that can substan-
tially affect the estimated liability, particularly for incurred but
not reported (“IBNR”) reserves that are highly “conjectural
because they must be calculated without knowing even the num-
ber of claims” (P.App.9a). As a result, even the most conservative
method
“relies on assumptions as to future events and condi-
tions, that, if wrong, will lead to substantial errors
in the final estimate. Consequently, regardless of the
actuarial method used, the preparation of, and
reliance upon a net worth calculation in a balance
sheet for a casualty risk reinsurer is based in large part
upon informed guesswork.” Id.
determined until after policies have expired and any losses adjusted. . ..[T]he
need to make provision, frequently far in advance of settlement for many
casualty losses. . .and for losses which have been incurred but have not been
reported, presents a difficult problem. ...” American Institute of Certified
Public Accountants, Audits of Fire and Casualty Insurance Companies (1966)
(the “Audit Guide”) at 34.
* The fairness of a balance sheet under GAAP “rests on the reasonableness
of the estimates of unpaid losses more than on any other item. However, it
is extremely difficult to estimate this element of cost accurately.” Audit Guide
at 34. See Financial Accounting Standards Board, Statement Of Financial Ac-
counting Standards No. 60, “Accounting and Reporting By Insurance Enter-
prises” (1982).
D. The Elkhorn Reserves.
Elkhorn was a small property and casualty reinsurer incor-
porated in Kentucky with a staff of twelve employees, including
secretaries. The President of Elkhorn, Robert Norton, began his
career as an accountant and did not have any actuarial train-
ing or experience (P.App.13a). In 1972, Elkhorn began reinsur-
ing casualty risks of third parties, where claims typically take
15 to 20 years to develop and the settlement cost is difficult to
estimate. To establish reserves for these risks, Elkhorn used the
loss ratio method under which it recorded 65% of earned
premiums as IBNR reserves unless a ceding company recom-
mended another ratio. The loss ratio method was a recognized
method for establishing reserves under GAAP and was express-
ly authorized by the Kentucky Insurance Code (P.App.5a).°
In October 1981, Elkhorn decided to have its reserving pro-
cedures reviewed by Tillinghast, Nelson & Warren. In February
1982, Tillinghast delivered a report that described a particular
reserving methodology, recommended its use, and appended
worksheets that would assist in applying the methodology as
of December 31, 1980, but did not express an opinion on the
adequacy of the reserves (P.App.35a). In April 1982, Tillinghast
delivered a second report covering the reserves on three canceled
reinsurance contracts (the “Barrett treaties”), which it estimated
were deficient by $10.8 million. Two months later, Elkhorn pur-
chased a $10 million reinsurance policy to cure the estimated
deficiency on the Barrett treaties (P.App.16a).
E. The Reinsurance Experience And
Sophistication Of Delta Holdings.
Delta Holdings was incorporated in 1982 to engage in a
worldwide reinsurance business. Delta Holdings was operated
by ARM, a reinsurance management company with a staff of
® See Audit Guide at 38. Kentucky permits reinsurers to establish reserves by
using a 65% loss ratio for workers compensation risks and a 60% ratio for
other risks. Ky.Rev.Stat. §304.6-100(3).
300 specialists that provided financial and underwriting services
to reinsurers around the world. In March 1983, ARM raised $24
million for Delta Holdings to enter the reinsurance market by
selling stock to 24 clients or affiliates, mostly insurance sub-
sidiaries of Fortune 500 companies.’
In addition to ARM, Delta Holdings was advised by two other
firms with considerable experience in reinsurance, Peat Mar-
wick, which specialized in auditing insurance and reinsurance
companies, and Conning, which provided actuarial services to
reinsurers in the United States and Europe. The Board of Direc-
tors also had substantial experience in reinsurance, since most
of the directors managed the insurance subsidiaries of their
parent corporations.
F. The Preacquisition Investigation.
At the end of 1982, Quantum decided to withdraw from the
insurance business and, in May 1983, began exploring the sale
of the assumed reinsurance business of Elkhorn to Delta Holdings
for a book value price of $18 million. Prior to speaking with
Quantum, ARM had been actively searching for reinsurance ac-
quisitions for Delta Holdings and had already reviewed four
other companies where the asking price was more than twice
book value. Like many other observers, ARM believed the Oc-
tober 1, 1983 renewal season would mark the beginning of a
profitable turnaround for the reinsurance industry.
Petitioner began its investigation of Elkhorn in early June
1983. Recognizing that Elkhorn lacked actuarial expertise, Delta
Holdings hired a team of 2] professionals to review the Elkhorn
loss reserves and reinsurance business, including five actuaries
from Conning and Peat Marwick, six Peat Marwick accountants,
three attorneys from a Wall Street law firm, six reinsurance
specialists from ARM, and an unknown number of investment
bankers from Merrill Lynch. Over the next four months, this
” Shareholders in Delta Holdings included Alcoa, American Cyanamid,
Cargil, Celanese, Eli Lilly, Firestone, Kaiser Aluminum, Kellogg, Rockwell
International, Scott Paper, Sperry, and Weyerhaeuser.
battery of experts descended upon the Elkhorn offices to pour
over the books and records and interview the twelve-man staff.
With the exception of the Tillinghast reports, the witnesses who
participated in the investigation testified that they were given
all the documents and other information they requested during
the four-month inquiry.
Shortly after the investigation began, Alan Kaufman, a senior
Peat Marwick actuary, was asked to provide petitioner with a
preliminary opinion on the Elkhorn reserves. During a June 10,
1983 meeting with Kaufman, Norton explained the data,
methodology, and assumptions Elkhorn used to test its reserves,
giving Kaufman a copy of worksheets containing his most re-
cent analysis that estimated a $250,000 deficiency as of
December 31, 1982. The worksheets revealed exactly how the
estimate was derived, including loss ratio and loss development
assumptions. When Kaufman asked Norton how he learned to
prepare a reserve analysis, Norton said he learned the method
from Tillinghast, but did not give Kaufman a copy of the 1982
reports (P.App.33a). Norton also told Kaufman about the poorly-
performing Barrett treaties and the $10 million reinsurance pol-
icy that was purchased to cover expected losses (P.App.18a-19a).
After the meeting, Kaufman advised petitioner that some of the
loss ratios selected by Elkhorn appeared to be too low and the
reserves were deficient by approximately $5 million.
In July 1983, Conning was retained to perform another review
of the Elkhorn reserves. On August 3, 1983, the Conning actuaries
met with Norton and were told that Elkhorn established reserves
by applying a 65% loss ratio to earned premiums unless a ceding
company recommended a different ratio (P.App.20a-2la). Norton
also gave Conning a copy of his December 31, 1982 reserve anal-
ysis showing the data, methodology, and assumptions he used to
test the reserves. In September, Conning submitted a report to pe-
titioner estimating a $1.6 million surplus in the reserves, but cau-
tioned that actual losses “may vary significantly from our esti-
mates since underlying data is quite variable and difficult to pro-
ject” (P.App.2la). Conning also advised petitioner that the Elk-
horn reserves depended on loss ratio assumptions and if different
assumptions were used, the estimates could change significantly.
10
While the actuaries were reviewing the reserves, Peat Mar-
wick spent 327 hours auditing the books and records (P.App.2la).
As the audit was drawing to a close, one of the auditors, Amy
Factor, noticed that the numbers on the Elkhorn loss develop-
ment triangles were changing, which she knew was not supposed
to happen if the triangles were prepared on what is known as
a “book-date” basis. When Factor noticed the changes, she spoke
with Norton who said he did not know why the numbers were
changing and referred her to his staff (P,App.22a). After speak-
ing with the staff, Factor learned the changes were occurring
because the Elkhorn computer software prepared triangles on
an “account-date” basis.* Factor immediately reported her
findings to the Peat Marwick actuaries, who were making an
independent review of the reserves as part of the audit. The ac-
tuaries knew that account-date triangles would result in an
understatement of reserves unless adjusted, but after reviewing
their earlier work, concluded that a previous adjustment would
be sufficient to correct for any understatement
(P.App.22a-24a).°
On September 28, 1983 the Board of Directors of Delta
Holdings met in Hamilton, Bermuda to consider the proposed
acquisition. ARM strongly recommended the Board approve the
Elkhorn purchase because the company was being sold at book
value, when other reinsurers were selling at twice book, and
because Delta Holdings would be in an ideal position to take
advantage of an expected turnaround in the reinsurance market.
The directors were given the Conning report on the Elkhorn
reserves and the Peat Marwick report on the June 30, 1983
balance sheet, which showed a net worth of $18 million. The
audit report certified that the balance sheet was prepared in
accordance with GAAP and fairly presented the financial posi-
tion of Elkhorn, noting, however, that the largest item on the
balance sheet, the loss reserves, was only an estimate and the
* The nature and significance of “account-date” and “book-date” triangles is
described in detail in the Court of Appeals opinion. See P.App.7a-12a.
* The Peat Marwick witnesses testified that Conning was also notified of the
account-date issue, but Conning denied learning this before the sale
(P.App.22a).
11
actual liability could be higher or lower than the estimate. Peat
Marwick also warned petitioner that
“Insurers who establish claim reserves by applying
selected loss ratios to earned premium (such as
Elkhorn) often understate IBNR due to management's
optimism in making loss ratio selections.” P.App.25a.
After hearing from their advisors, the directors voted unani-
mously to approve the Elkhorn acquisition. Petitioner assumed
control of Elkhorn on October 1, 1983 and immediately began
preparing the September 30, 1983 balance sheet pursuant to
§ 12 of the Stock Purchase Agreement. On October 24, 1983,
the contract balance sheet was completed by ARM and reviewed
by Peat Marwick. It showed a net worth of $18 million. With
the parties in agreement over the value of the business, the price
adjustment and arbitration provisions of § 12 were never in-
voked (P.App.25a).
REASONS FOR DENYING THE WRIT
This privately-negotiated securities transaction turns prin-
cipally on an issue of contract interpretation and the “specific
facts” of the Elkhorn sale. United States v. Johnston, 268 U.S.
220, 227 (1925). The particulars of the face-to-face negotiations
and four-month investigation which preceded the sale do not
present any issues “of importance to the public as distinguished
from. . .the parties. . ..” Layne & Bowler Corp. v. Western Well
Works, Inc., 261 U.S. 387, 393 (1923).
In asking this Court to grant certiorari, petitioner has
misstated the rulings of the Court of Appeals. The Second Cir-
cuit did not hold that reserve estimates are exempt from the
disclosure requirements of the securities laws, it ruled as a matter
of contract law that Quantum did not make any representations
in the Stock Purchase Agreement concerning the adequacy of
the reserves, except for the carefully-worded and limited
guarantee in § 12. Nor did the Court rule that materiality stan-
dards are inapplicable to investors who retain professional
12
advisors, it held that information disclosed to the experts in this
transaction made the Tillinghast reports immaterial as a mat-
ter of law. Finally, the Court did not overstep the bounds of
Fep.R.Civ.P.52: It set aside a finding under the clearly er-
roneous rule, applied accounting standards recognized by the
District Court in its summary judgment decision, and ruled as
a matter of law that the Tillinghast reports were immaterial.
1. THE COURT OF APPEALS DECIDED THE
RESERVE ISSUES UNDER THE CONTRACT,
NOT THE FEDERAL SECURITIES LAWS.
The Court of Appeals never held that reserve estimates “can-
not be the basis of claims under § 12(2) or § 10(b)” or that “only
misrepresentations of ‘hard’ facts are actionable under the
securities laws. ...” (Pet. at 15). It simply held as a matter of
contract law that Quantum did not make any representations
concerning the adequacy of the reserves in the Stock Purchase
Agreement, other than the limited guarantee in § 12, and that
the representations it did make concerning compliance with
GAAP and accounting regularity in § 5 were truthful. The Court
of Appeals, therefore, resolved the primary issue presented for
review under state contract law, not the federal securities laws.
In this regard, the approach (if not the judgment) of the Se-
cond Circuit was identical to that of the District Court.!°
While the construction of a privately-negotiated agreement
does not merit the attention of this Court, the interpretation
adopted by the Court of Appeals was correct under New York
law.'! The absence of a specific warranty on the reserves in
'© The District Court restricted its rulings under the federal securities laws
to the alleged concealment of the Tillinghast reports. See P. App.67a-70a.
'! Since the District Court held that the contract was unambiguous (R.App.
8-9), the Court of Appeals was entitled to review its construction de novo.
Levy v. Gadsby, 7 U.S. 180, 185, 3 Cranch 109, 112 (1805); Hunt Ltd. v.
Lifschultz Fast Freight, Inc., 889 F.2d 1274, 1277 (2d Cir. 1989).
13
the contract combined with unequivocal warranties on other
balance sheet items, such as the adequacy of the tax reserves
and the value of the bond portfolio, strongly indicated that § 5
was nothing more than “a warranty as to accounting accuracy
and regularity, not a blanket guarantee of net worth”
(P.App.48a). The construction adopted by the Second Circuit
was buttressed by “a binding, post-purchase opportunity to ar-
bitrate. . .the adequacy of Elkhorn’s loss reserves” under § 12
of the contract (id.), which the trial court had earlier ruled was
the exclusive remedy for resolving net worth disputes (R.App.
8-10).
Having decided that the representations in the contract were
limited to accounting regularity and compliance with GAAP,
the Second Circuit concluded that they were truthful as a mat-
ter of law. Peat Marwick certified that the June 30, 1983 balance
sheet was prepared in accordance with GAAP and the Conning
and Peat Marwick actuaries certified that the reserves were
reasonable. Certifications by experts who knew exactly how the
reserves were established was conclusive proof that the
methodology and assumptions were reasonable and complied
with GAAP (P.App.50a-5la).'? Petitioner used the same
reserve methodology when it prepared the September 30, 1983
balance sheet after the closing, which Peat Marwick also con-
cluded was in accord with GAAP (P.App.25a). On appeal, peti-
tioner did “not even argue that the actuarial method employed
by Elkhorn . . . was inherently unreasonable or inconsistent with
GAAP” (P.App.50a), nor did it present any evidence that the
65% ratio “was at the time viewed by professionals as so over-
ly optimistic as to violate GAAP” (P.App.51a).
The fact that a third group of experts with the “glow of hind-
sight” produced a more “compelling” reserve estimate at trial
showing a substantial deficiency was irrelevant in determining
whether the Elkhorn reserving procedures were reasonable in
2 See infra at 14-15.
14
1983.'° Petitioner never explained what this third battery of ex-
perts did after the fact that Conning and Peat Marwick could
not have done before the sale (P.App.45a-46a). As a result, the
Court of Appeals refused to construe the contract “to allow
recovery of the full purchase price based on professional expert
testimony in court that disagrees with the contemporaneous
professional opinions expressed by Conning and Peat Marwick,
firms hired by [petitioner] itself to render such opinions.”
Id.
Since the warranties in the contract were truthful, it follows
a fortiori that they could not support a claim under the federal
securities laws.'* Even if the Court of Appeals had considered
the reserve estimates under the securities laws, the result would
have been the same. While reserve estimates are actionable if
they lack a reasonable basis in fact, where the data, method-
ology, and assumptions underlying an estimate are disclosed
- Although the Court of Appeals accepted the District Court finding that
a substantial deficiency in the reserves “could have been detected from in-
formation available” in 1983 (P.App.44a), it also emphasized that this belated
discovery was made “in the glow of hindsight” (P.App.22a-23a & n.2) and had
“no relevance to the question of whether the June 30 balance sheet conformed
with GAAP” (P.App.50a). With its team of actuaries and accountants, peti-
tioner was in a better position than Quantum to understand the effect of
account-date triangles on reserve estimates and therefore could not claim it
was deceived. See Vulcan Metals Co. v. Simmons Mfg. Co., 248 F. 853, 856-57
(2d Cir.), cert. denied, 247 U.S. 507 (1918) (L. Hand, J.); Teamsters Local 282
Pension Trust Fund v. Angelos, 762 F.2d 522, 530 (7th Cir. 1985); Myzel v.
Fields, 386 F.2d 718, 736 (8th Cir. 1967), cert. denied, 390 US. 95] (1968);
McNabb v. Thomas, 190 F.2d 608, 610-611 (D.C. Cir. 1951), cert. denied, 342
U.S. 859 (1951). Cf. Shappirio v. Goldberg, 192 U.S.. 232, 241-42 (1904).
'* While the Court of Appeals did not reach the reserve claim under the
federal securities laws, it did consider whether there were any violations of
federal law for knowingly or recklessly misrepresenting the effect of the Elkhorn
triangles, concluding, as did the trial court sub silentio, that no deception or
recklessness was established. P.App.39a-43a. This was far from a “dead issue”,
as petitioner asserts (Pet. at 9 n.7), since it was the only reason why the reserve
claim under the federal securities laws was not dismissed on summary judg-
ment. See R.App. 13-14.
15
to a knowledgeable buyer, as they were here, the requirements
of the federal securities law are fully satisfied. '®
2. THE COURT OF APPEALS NEVER HELD
THAT THE MATERIALITY STANDARD WAS IN-
APPLICABLE TO INVESTORS WHO RETAIN
ADVISORS.
In asserting that the Court of Appeals “carved out an excep-
tion to the well-established objective standard of materiality” (Pet.
at 18) and departed from the “total mix” test of TSC Industries,
Inc. v. Northway, Inc., 426 U.S. 438 (1976), petitioner has again
misstated the ruling below. The Court of Appeals expressly ap-
plied the TSC Industries standard and concluded that the Till-
inghast reports would not have affected the “total mix” of infor-
mation disclosed to petitioner (P.App.34a-39a). The alleged “ex/
ception” to the objective standard was nothing more than the
application of the total mix test to the circumstances of this case.
In assessing the significance of the Tillinghast reports to Delta
Holdings, the Second Circuit necessarily restricted its analysis
to the actuaries who were responsible for evaluating the reserves,
as did petitioner and its expert witnesses in arguing the reports
were material (P.App.37a). It would have been difficult to con-
sider the reports in any other context since the business of Delta
Holdings was run entirely by professionals in 1983. The Court
of Appeals, however, did not vary the standard of materiality
'S The law “requires nothing more than the disclosure of basic facts so that
outsiders may draw upon their own evaluative expertise in reaching” their
decisions. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 849 (2d Cir. 1968),
cert. denied, 394 U.S. 976 (1969). See Wielgos v. Commonwealth Edison Co.,
892 F.2d 509, 512-16 (7th Cir. 1989); Dower v. Mosser Indus., Inc., 648 F.2d
183, 188 (3rd Cir. 1981); In re RAC Mortgage Inv. Corp., 765 F.Supp. 860,
864-65 (D.Md. 1991); Pittsburgh Coke & Chemical Co. v. Bollo, 421 F. Supp.
908, 924 (E.D.N-Y. 1976), aff'd, 560 F.2d 1089 (2d Cir. 1977). The significance
of the information provided petitioner is apparent from the SEC rules on
forward-looking statements, 17 C.F.R. § 240.175, which encourage but do not
require disclosure of assumptions. According to the SEC, “disclosure of assump-
tions is perhaps the most significant factor in facilitating investor understand-
ing” of estimates and projections. See Securities Act Release No. 3992.
Fed.Sec.L.Rep. (CCH) 4 81,756 at 81,038 (Nov. 7, 1978)
16
because advisors were used, it applied the objective standard
and concluded that in this transaction the reports “would have
added nothing material” to what was already disclosed to Peat
Marwick (P.App.40a). In a different transaction, the Court
noted, the reports might have been significant to another ac-
tuary who did not have the benefit of the information available
to Peat Marwick (P.App.37a).
The approach of the Court of Appeals was consistent with
the requirement that materiality be “determined on a case-by-
case basis”, Basic Inc. v. Levinson, 485 U.S. 224, 250 (1988), tak-
ing into account “all the circumstances” of a particular trans-
action. TSC Industries, Inc. v. Northway, Inc., 426 U.S. at 449.
Implicit in the “total mix” test is the recognition that materiality
will vary from case to case and that a document which might
be significant in one case, may be immaterial in another. Titan
Group, Inc. v. Faggen, 513 F.2d 234, 239 (2d Cir.), cert. denied,
423 U.S. 840 (1975).'°
3. THE COURT OF APPEALS DID NOT USURP
THE FUNCTION OF THE DISTRICT COURT.
The claim that the Court of Appeals overstepped the bounds
of Fep.R.Crv.P.52(a) is without foundation. The judgment of the
District Court was reversed as a matter of law on all major issues.
In fact, were it not for the allegations of deception relating to
the account-date triangles, the entire complaint should have
been dismissed on summary judgment based on undisputed
evidence provided by Peat Marwick, Conning, and ARM dur-
ing pretrial discovery."’
16 See Kademian ». Ladish Co., 792 F.2d 614, 623 (7th Cir. 1986); Michaels v.
Michaels, 767 F.2d 1185, 1197 (7th Cir. 1985), cert. denied, 474 U.S. 1057 (1986).
'’ The breach of waivanty claim should have dismissed after the District Court
ruled that § 12 was the exclusive remedy for resolving net worth disputes. The
securities law claim for misrepresenting the reserves would have been distnissed
on summary judgment were it not for the account-date triangle allegations.
See K.App. 13-14. The summary judgment record showed, among other things,
that Peat Marwick and Conning knew exactly how the reserves were
(Footnote continued)
17
In any event, each of the assigned errors was a proper exer-
cise of appellate power. Initially, the Court of Appeals did not
exceed its authority by setting aside the finding that Norton
knew Elkhorn was insolvent before the sale. An appellate court
is empowered to set aside a finding “when although there is
evidence to support it, the reviewing court on the entire
evidence is left with the definite and firm conviction that a
mistake has been committed.” United States v. United States
Gypsum Co., 333 U.S. 364, 395 (1948). After a meticulous review
of the record, and without overturning the credibility findings
of the trial court,'* the Court of Appeals concluded there was
no evidentiary basis for the finding that Norton “knew” the
reserve estimates were understated to the point of insolvency
in 1983 (P.App.3la-33a).
While petitioner may disagree with the clearly erroneous rul-
ing, it cannot claim that the approach was in error or that the
Court exceeded its authority. The unusually thorough opinion
established before the sale, that Peat Marwick certified the June 30, 1983
balance sheet, that Conning and Peat Marwick conducted two independent
examinations of the reserves for petitioner, that ARM and Peat Marwick
prepared the September 30, 1983 balance sheet after the closing, and that
the substance of the Tillinghast reports was disclosed to Peat Marwick, ARM,
and Conning. Based on this nucleus of undisputed facts, the Court of Ap-
peals reversed the District Court judgment as a matter of law.
" Although the Court of Appeals accepted the credibility findings that Nor-
ton prepared an initial calculation showing a $10 million deficiency as of
December 31, 1980 (P.App.15a) and failed to disclose the Tillinghast reports to
petitioner (P.App.33a), neither finding supported the conclusion that Norton
“knew” the reserves were understated in 1983. The Court of Appeals proper-
ly concluded there was no support in the record for the finding that dated
knowledge of the alleged insolvency to October 1981 when Tillinghast was
engaged (P.App.3la). Nor was there any evidence in the record that Norton
even “suspected Elkhorn’s insolvency” after he prepared a reserve analysis show-
ing a negligible deficiency at the end of 1982 (P.App.32a-33a). Norton gave
copies of his 1982 analysis to Peat Marwick and Conning, who reviewed his
assumptions and methodology and, after performing their own studies, con-
cluded the estimates were reasonable. If Norton “knew” the reserves were defi-
cient, so did Peat Marwick and Conning.
18
by a distinguished panel of judges demonstrates that the proper
standard of review was applied and the “Court of Appeals .. .
made a fair assessment of the record.” Peurifoy v. Commissioner,
358 U.S. 59, 61 (1958). Because another reviewing panel might
“find the record tilting one way rather than the other, though
fair-minded judges could find it tilting either way”, NLRB v.
Pittsburgh Steamship Co., 340 U.S. 498, 503 (1951), is not a
special or important reason for granting certiorari. See Dick v.
New York Life Ins. Co., 359 U.S 437, 461-63 (1959) (Frankfurter,
J., dissenting).
The claim that the Second Circuit exceeded its appellate
authority by deciding “factual issues” concerning the re-
quirements of GAAP is also misplaced. The relevant account-
ing standards for establishing reserves were never in dispute and
were set forth in the summary judgment decision of the District
Court.'® Moreover, the critical issue was not what GAAP
required, but what the contract required. Did Quantum warrant
that the reserves were “accurate”, as petitioner and the District
Court believed, or did it warrant that the balance sheet com-
plied with GAAP and, implicitly, that Elkhorn selected from “a
range of ‘reasonable’ treatments” in establishing reserves? Thor
Power Tool Co. v. Commissioner, 439 U.S. 522, 544 (1979).?° The
Court of Appeals construed § 5 as a warranty concerning reserve
methodology, not a guarantee of reserve accuracy, and properly
concluded that it was truthful as a matter of law (see supra
as Citing the Audit Guide, the District Court found in its summary judgment
opinion that the fairness of a reinsurance balance sheet under GAAP “rests
on the reasonableness of the estimates of unpaid losses” (R.App. 13). The court
also found that “[l]oss reserves are contingent on future events, and are very
difficult to estimate” (id.). See Notes 4, 5, & 6, supra at 6-7.
20 GAAP recognizes that in many areas there is no such thing as a “correct”
answer, only “a range of ‘reasonable’ treatments” where “the choice among
alternatives” is left to the discretion of management. Thor Power Tool Co.
v. Commissioner, 439 U.S. 522, 544 (1979). “Thor requires the district court
to defer to the professional judgment of the accountant who prepared” the
balance sheet and “also limits a district court. . .to deciding only whether the
accountant chose a procedure from the universe of generally accepted account-
ing principles.” Godchaux v. Conveying Techniques, Inc., 846 F.2d 306, 315
(5th Cir. 1988).
|
19
at 13-14). In any event, petitioner does not challenge the va-
lidity of the accounting principles recognized by the Court
of Appeals, only its failure to cite specific authorities (Pet.
at 23).
Finally, the claim that the Court of Appeals engaged in im-
permissible fact-finding when it determined that the Tillinghast
reports were immaterial does not withstand scrutiny. A docu-
ment is immaterial as a matter of law if its contents are in the
public domain, Johnson v. Wiggs, 443 F.2d 803, 806 (5th Cir.
1971),”" or its substance has been otherwise disclosed to the
purchaser. Kas v. Financial General Bankshares, Inc., 796 F.2d
508, 517 (D.C. Cir. 1986).”* The information relating to reserve
methodologies in the February 1982 report was in the public
domain and was well known to Peat Marwick and Conning.
The December 31, 1980 data in the appendix was provided peti-
tioner in updated form in the June 30, 1983 triangles and, to
the extent the format of the 1980 data would have revealed the
account-date nature of the 1983 triangles, this matter was in-
dependently disclosed to Peat Marwick, as were the problems
relating to the Barrett treaties in the April 1982 report
(P.App.35a-39a).
*! See, e.g., Ward v. Freeman, 854 F.2d 780, 792-93 (5th Cir. 1988), cert.
denied, 490 U.S. 1065 (1989); Elkind v. Liggett & Myers, Inc. 635 F.2d 156,
166 (2d Cir. 1980); Hafner v. Forest Lab's, Inc., 345 F.2d 167, 168 (2d Cir.
1965).
2? See, e.g., Mayer v. Oil Field Systems Corp., 803 F.2d 749, 755 (2d Cir.
1986); Frigitemp Corp. v. Financial Dynamics Fund, Inc., 524 F.2d 275, 282
(2d Cir. 1975); Teamsters Local 282 Pension Trust Fund v. Angelos, 762 F.2d
522, 530 (7th Cir. 1985); Koplin ». Labe Federal Sav’s ¢& Loan Ass'n, 748
F'Supp. 1336, 1342 (N.D. Ill. 1990); Wollins v. Antman, 638 FSupp. 989, 994-95
(E.D.N-Y. 1986).
20
CONCLUSION
For these reasons, the Petition For Writ Of Certiorari should
be denied.
Dated: Anaheim, California
March 25, 1992
Respectfully submitted,
JosePH P. DaILEy
565 Peralta Hills Drive
Anaheim, California 92807
(714) 282-1170
Counsel of Record for Respondent
OF COUNSEL:
LOREN F. SELZNICK
JaMEs T. SOUTHWICK
APPENDIX
R.App. 1
UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK
icin sslbteessiiieipadaiighindbasagclgiapeniglamplansiapaanonatinnndembianaee 4
DELTA HOLDINGS, INC.,
Plaintiff,
— against —
NATIONAL DISTILLERS AND CHEMICAL :
CORPORATION, : 85 Civ.
: 3439 (JFK)
Defendant and Third-
Party Plaintiff,
— against — : OPINION
: and ORDER
PEAT, MARWICK, MITCHELL & CO.,
AMERICAN RISK MANAGEMENT, INC.,
and FREDERIC M. REISS,
Third-Party Defendants.
APPEARANCES:
For Plaintiff:
David Klingsberg, Esq.
Kaye, Scholer, Fierman, Hays & Handler
New York, New York
Of Counsel: Paul J. Curran, Esq.
Alan F. Goott, Esq.
Michael Braff, Esq.
For Defendant and Third-Party Plaintiff:
Joseph P. Dailey, Esq.
Breed, Abbott & Morgan
New York, New York
Of Counsel: Joseph J. Tesoriero, Esq.
Nancy A. Brownstein, Esq.
Paul D. Young, Esq.
R.App. 2
APPEARANCES: (cont'd)
For Third-Party Defendant
Frederic M. Reiss:
William G. Primps, Esq.
LeBoeuf, Lamb, Leiby & MacRae
New York, New York
Of Counsel: Jonathan E. Polonsky, Esq.
For Third-Party Defendant
Peat Marwick Main & Co.
(formerly Peat, Marwick, Mitchell & Co.):
David R. Hyde, Esq.
Cahill, Gordon & Reindel
New York, New York
Of Counsel: Kevin J. Burke, Esq.
—and—
Joseph I. Loonan, Esq.
Assistant General Counsel
Peat Marwick Main & Co.
New York, New York
JOHN F. KEENAN, United States District Judge
R.App. 3
JOHN F. KEENAN, United States District Judge:
Background
Plaintiff, Delta Holdings, Inc., (“Delta Holdings”) brought
this lawsuit against defendant and third-party plaintiff National
Distillers and Chemical Corp., (“National Distillers”) for events
arising out of a commercial transaction. In turn, National
Distillers impleaded Peat, Marwick, Mitchell & Co. (“PMM”)!
American Risk Management, Inc. (“ARM”) and Frederic M. Reiss
seeking indemnification and contribution for any liability
resulting from Delta Holdings’ complaint.
In an Opinion and Order dated September 4, 1986, this Court
dismissed National Distillers’ claims for indemnification, and
also dismissed National Distillers’ claims for contribution with
respect to the federal causes of action. At that time, the Court
declined to dismiss the contribution claims on the state law
claims. After that Opinion and Order was issued, the parties
conducted and completed discovery.
Currently before the Court are various summary judgment
and dismissal motions made by National Distillers, Reiss and
PMM. National Distillers moves to dismiss the negligent
misrepresentation and federal racketeering counts of the com-
plaint. In addition, National Distillers seeks summary judgment
on the claims that the contract between it and Delta Holdings
was breached, as well as on the claims alleging common law
fraud and violations of the federal securities laws. Reiss seeks
summary judgment on the remaining claim National Distillers
asserts against him, and PMM moves again to dismiss, in part,
the claim asserted by National Distillers.
For the reasons set forth below, the Court grants in part, and
denies in part, National Distillers’ summary judgment motion.
In addition, Reiss’ motion for summary judgment is granted in
full, and PMM’s motion to partially dismiss is granted in full.
' Peat, Marwick, Mitchell & Co. is now known as Peat Marwick Main & Co.
In 1981, an entity known as the Reiss Organization began to
consider forming a new venture in the reinsurance industry.
Simply put, reinsurance involves an insurer assuming a portion
of the risks for which another insurer is liable. A reinsurer may
insure either primary insurers or other reinsurers in return for
a share of the premium. A company obtaining reinsurance, and
relinquishing some of its risk, is known as a ceding company.
These arrangements are established through what are called |
reinsurance treaties, which frequently involve the participation
of numerous reinsurers. The new venture, which became known
as Delta Holdings, would enter the reinsurance industry by either
obtaining licenses in various jurisdictions, or by acquiring other,
already licensed, reinsurance companies.
One such company was the Elkhorn Reinsurance Company
(“Elkhorn”), a wholly owned subsidiary of National Distillers.
Elkhorn was formed in 1965 to insure and reinsure the proper-
ty and casualty risks of National Distillers. National Distillers
retained ARM, a corporation formed by Reiss in 1962, to manage
Elkhorn’s business. In 1971, Elkhorn began assuming reinsurance
risks other than those of its parent corporation. At the end of
1982, National Distillers decided to get out of the insurance in-
dustry, and focus on its other businesses. In April, 1983, discus-
sions began between ARM and National Distillers concerning
the possible sale of Elkhorn to Delta Holdings. After months
of negotiation, and investigation by outside experts, a Stock Pur-
chase Agreement (“SPA”) was entered on September 30, 1983,
pursuant to which Delta Holdings paid $18 million to National
Distillers for Elkhorn. This agreement was based on a balance
sheet showing Elkhorn had a net worth of $18 million.
After the transaction it became evident that Elkhorn, which
had been renamed Delta Reinsurance, was not a financially
healthy enterprise. While the trial of this action will resolve the
numerous factual questions present, it is nonetheless useful at
this time to outline what was seemingly wrong with Elkhorn.
a ere eae
R.App. 5
In the reinsurance business, income is realized from two
primary sources — premiums and investments. On the other
side of the ledger, liabilities are somewhat uncertain and are
categorized as loss reserves. As will be described below, loss
reserves are a most critical calculation in determining the value
of a reinsurance business. In essence, loss reserves are an estimate
of the final settlement cost of all unpaid liabilities associated
with insurance premiums that have been earned. Loss revenues
are broken into two categories: case reserves, which are estimates
of the cost of settling reported claims and IBNR (incurred but
not reported) reserves, which are estimates of the cost of settling
unknown or unreported claims. What makes loss reserves so
critical, and hazardous, is the fact that the figure is merely an
estimate.
In arriving at a loss reserve figure, at least two methods are
used. The first, and more conservative, method is the book date
basis which reflects the date a loss or premium was received and
entered on the books of the reinsurer. The second approach is
the account date basis. This latter method was used by Elkhorn,
and reflects the date a loss or premium was reported to the
ceding company and not to the reinsurer. Apparently, this
method can cause a loss reserve estimate to be too low, which
can result in financial instability for a reinsurer.
Reduced to its essentials, this case concerns Delta Holdings’
charge that National Distillers knowingly sold it a reinsurance
subsidiary that was worthless due to inaccurate loss reserve
calculations. National Distillers basically responds that Delta
Holdings and its agents, which included PMM and Conning &
Co., had access to all the available information, and hence knew,
or should have known, of Elkhorn’s potential difficulties.
The true financial plight of Delta Reinsurance, formerly
Elkhorn, began to emerge during 1984. In July, 1984, the Ken-
tucky Insurance Department conducted an audit of Delta Rein-
surance that revealed a $38 million deficiency in the loss reserves
as of December 31, 1983. The Kentucky Insurance Department
further employed an actuary to analyze Delta Reinsurance. This
R.App. 6
study estimated the loss reserve deficiency as of December 31,
1983, to be between $34.5 million and $44.4 million. The ac-
tuary provided a final report to the Kentucky Insurance Depart-
ment in March, 1985 which indicated that the loss reserve defi-
ciency as of December 31, 1984 was between $67.8 million and
$77.6 million. Not surprisingly, Delta Reinsurance was placed
in rehabilitation on May 29, 1985 and in liquidation on approx-
imately September 1, 1985.
It is Delta Holdings’ view that National Distillers concealed
Elkhorn’s problems through, inter alia, the work of Robert Nor-
ton, Elkhorn’s president, and a National Distillers director. This
position is based in part on the fact that in 1982, Norton? re-
tained the actuarial firm of Tillinghast, Nelson & Warren to
examine Elkhorn’s method of computing loss reserves, and to
determine whether the loss reserves Elkhorn was carrying were
adequate. The Tillinghast report of February, 1982 found
Elkhorn’s loss ratio too low and a loss reserve deficiency of $11
million as of December 31, 1980. A second report, issued in April,
1982, found that as of December 31, 1981, Elkhorn’s loss reserve
was deficient by $20 million. It is asserted that these facts, as
well as Norton’s own calculations, were concealed from Delta |
Holdings during the negotiations. The complaint sets forth other |
alleged misrepresentations and omissions that will also be con-
sidered at trial.
National Distillers takes the position that Delta Holdings ig-
nored its own experts. It is advanced that despite the fact that
Delta Holdings went through with the transaction two PMM
actuaries found that Elkhorn had a tota! reserve deficiency of
$8.5 million. Moreover, a PMM auditor discovered that the loss
reserves Elkhorn calculated used the account date basis, instead
of the more frequently employed book date basis.
This outline of the facts is hardly exhaustive, and the instant
motions clearly do not dispose of the case. However, these
* After the SPA was executed, Norton remained on as president of :
Elkhorn/Delta Reinsurance. He resigned on September 14, 1984, after the in-
itial findings of the Kentucky Insurance Department.
ain i
R.App. 7
motions, which have been well briefed by the parties, and this
decision will hopefully serve to narrow somewhat the issues to
be tried.
DISCUSSION
I. Delta Holdings’ Claims Against National Distillers
A. The Alleged Breach of § 12 of the Stock Purchase
Agreement.
National Distillers seeks summary judgment on Delta
Holdings’ contention that § 12 of the SPA was breached because
Elkhorn’s net worth was less than $18,000,000 as of September
30, 1983. Section 12 provides as follows:
12. Adjustment To Purchase Price. No later than Oc-
tober 17, 1983, Buyer shall deliver a balance sheet of
Elkhorn as at September 30, 1983 (the “September
30th Balance Sheet”), prepared in accordance with
GAAP and on the same basis as used in the prepara-
tion of the June 30th Balance Sheet. The book value
of all Bonds, Preferred and Common Stocks includ-
ed in the September 30, 1983 Balance Sheet will be
determined by Princeton Financial Systems Inc. and
shall be binding on all parties. Seller guarantees to
Buyer that the Net Worth of Elkhorn, as at September
30, 1983 shall not be less than $18,000,000.
In the event that the Net Worth of Elkhorn is greater
than $18,000,000 as shown on the September 30th
Balance Sheet, then Elkhorn shall pay a dividend to
the Seller on or before the 28th October 1983 in an
amount sufficient to reduce the Net Worth of Elkhorn
to $18,000,000 in accordance with Clause 10 hereof.
In the event that the Net Worth of Elkhorn as shown
on the September 30th Balance Sheet is less than
$18,000,000, then Seller shall pay such deficit to the
Buyer at Fort Lee, New Jersey, or before the 3lst of
October, 1983, or if such Balance Sheet shall be
ae a ee ae
R.App. 8
disputed (as below provided) then payment shall be
made promptly after the settlement of such dispute.
In the event Seller disputes the September 30th
Balance Sheet, Seller shall advise the Buyer not later
than the 25th October, 1983 and any such dispute, if
not resolved promptly between the parties, shall be
resolved by the opinion of Peat, Marwick, Mitchell
& Co., which said opinion shall be final and conclusive
and binding on all parties hereto.
Delta Holdings posits that the guaranty of Elkhorn’s value,
set forth in the last sentence of the first paragraph, stands apart
from the rest of § 12. According to Delta Holdings, that sentence,
when read in conjunction with § 15,* supports a cause of ac-
tion in the event Elkhorn’s net worth was less than $18,000,000
on September 30, 1983. Delta Holdings argues that such a sur-
viving guaranty was important to it when negotiating the pur-
chase. Moreover, it is asserted that the clause only makes sense
when read as a full fledged guaranty that Delta Holdings would
receive $18,000,000 in value in exchange for its $18,000,000 pay-
ment to National Distillers. Delta Holdings urges that summary
judgment is inappropriate on this claim since there are two
reasonable interpretations of § 12.
On the other hand, National Distillers’ motion for summary
judgment argues that § 12 is clear, unambiguous and suscepti-
ble to only one reasonable interpretation. According to National
Distillers, the rights granted to the parties under § 12 expired
on October 31, 1983. In addition, the parties’ exclusive remedy
for resolving disputes concerning Elkhorn’s September 30, 1983
net worth was submission to PMM for a “final and conclusive
and binding” resolution. In the Court’s view, these points are
clearly and unambiguously articulated in § 12, and summary
judgment in favor of National Distillers is required on this claim.
> Section 15 of the SPA provides, “[e]ach of the representations, warranties,
covenants and other agreements made in this Agreement shall survive the ex-
ecution and delivery of this Agreement, the delivery and transfer of the shares
and the payment of the Purchase Price, and shall continue in full force and
effect.”
ie
, ——
R.App. 9
The standard for granting summary judgment is clear. Where
no genuine issue of material fact exists, and the applicable law
is in the movant’s favor, then summary judgment in favor of
the movant is mandated. In contract actions, summary judg-
ment is an appropriate manner of disposition when the con-
tract’s terms are clear and not conducive to more than one
reasonable interpretation. Tokio Marine and Fire Ins. Co. v.
McDonnell Douglas Corp., 617 F.2d 936, 940 (2d Cir. 1980).
A threshold question of law for the Court is whether the terms
of the agreement are clear and unambiguous. Walk-In Medical
Centers, Inc. v. Breuer Capital Corp., 818 F.2d 260, 263 (2d
Cir. 1987).
As noted above, the Court finds § 12 to be clear and unam-
biguous. Although National Distillers guaranteed the net worth
of Elkhorn in § 12, this particular guarantee is intertwined with
procedures and remedies lucidly set forth within that section.
If Elkhorn’s net worth were determined to be more than
$18,000,000, then Delta Holdings was to pay National Distillers
the difference between the net worth and $18,000,000 on or
before October 28, 1983. If Elkhorn’s net worth were determined
to be less than $18,000,000, then National Distillers was to pay
Delta Holdings that difference by October 31, 1983. Disputes
were to be resolved either by the parties themselves, or by PMM.
It is significant to note that the guaranty of Elkhorn’s worth
was set forth in the section entitled “Adjustment to Purchase
Price,” and not in § 5 of the SPA which contained general war-
ranties and representations. Moreover, § 12 makes no reference
to § 15 which provides for the continuing effect of “representa-
tions, warranties, covenants and other agreements.” The par-
ties clearly understood the need for cross-references to other sec-
tions within the SPA as shown by the reference in § 12 to § 10.
Section 12 makes no reference to either § 5 or § 15.
Section 12 is a specific provision. New York law, which ap-
plies in this case pursuant to a clause in the SPA, is clear regard-
ing the relationship between general and specific provisions
within a contract. “A specific provision will not be set aside in
R.App. 10
favor of a catchail clause.” Williams Higgins ¢& Sons, Inc. v. State,
20 N.Y. 2d 425, 428, 284 N.Y.S. 2d 697, 699, 231 N.E.2d 285
(1967); see also John Hancock Mutual Life Ins. Co. v. Carolina
Power & Light Co., 717 F.2d 664, 669 n.8 (2d Cir. 1983) (“New
York law recognizes that definitive, particularized contract
language takes precedence over expressions of intent that are
general, summary, or preliminary.”).
This Court is powerless to hear parole evidence as to Delta
Holdings’ intent and understanding of the provision because the
agreement is clear, complete and valid. See New York State
Energy Research & Development Authority v. Nuclear Fuel Ser-
vices, Inc., 640 F. Supp. 1555, 1557 (W.D.N.-Y. 1986); United
States v. Wallace ¢> Wallace Fuel Oil Co., 540 F. Supp. 419, 425
(S.D.N.Y. 1982). This Court is also powerless to “rewrite a con-
tract to accord with its instinct for the disposition of equity under
the facts of a case.” Broad v. Rockwell Intl Corp., 642 F.2d 929,
947 (5th Cir.), cert. denied, 454 U.S. 965 (1981). The Court will
not transform the clear, specific and narrow guaranty of § 12
into a general warranty that should have been, for Delta
Holdings’ purposes, set forth in § 5.
Summary judgment is entered in National Distillers’ favor con-
cerning claims that § 12 of the SPA was breached.
B. The Alleged Breach of Representations and Warran-
ties Contained in §5 of the Stock Purchase
Agreement.
Section 5(g) of the SPA contains a warranty by National
Distillers that,
[t]he June 30th [1983] Balance Sheet and related state-
ment of income are complete and accurate in all
material respects, were prepared in accordance with
Generally Accepted Accounting Principles (“GAAP”),
and the June 30th Balance Sheet presents fairly the
financial position of Elkhorn as at that date.
The complaint alleges that this warranty was breached. The
June 30, 1983 balance sheet indicated that Elkhorn had an
reread
R.App. 11
$18,000,000 net worth and loss reserves of $45,017,000. Accord-
ing to Delta Holdings, however, the balance sheet understated
the loss reserve liability by at least $34,000,000, and as a result,
Elkhorn had a negative net worth of at least $16,000,000.
The SPA further provided, at section 5(f), a warranty from
National Distillers that,
[t]he books and records of Elkhorn are complete in
all material respects and have been maintained in ac-
cordance with good business and accepted insurance
practices and principles and accurately reflect the
financial condition and results of the operation of
Elkhorn.
The complaint asserts that this warranty was breached in that
the June 30, 1983, and September 30, 1983 balance sheets did
not accurately reflect Elkhorn’s condition. Furthermore, Delta
Holdings contends that Elkhorn’s records were not kept in ac-
corance with good business and accepted insurance practices.
As mentioned earlier in this Opinion, the essence of this claim
is that Elkhorn should have employed a book date basis, rather
than an account date basis, in calculating loss reserves.
National Distillers moves for summary judgment on these
breach of warranty claims, asserting that Delta Holdings did
not rely on these warranties in making the contract. Further-
more, National Distillers states that Delta Holdings knew that
the warranties and representations were inaccurate when made.
The Court denies summary judgment on these claims. The
parties vigorously dispute whether reliance is an element in a
breach of warranty claim. The Court concludes that reliance
is not an element in that cause of action, and follows CPC In-
ternational, Inc. v. McKesson Corp., 134 Misc. 2d 834, 513 N.YS.
2d 319 (N.Y. Sup. Ct. 1987), and Ainger v. Michigan General
Corp., 476 F. Supp. 1209 (S.D.N.Y. 1979), aff'd, 632 F.2d 1025
(2d Cir. 1980). As Judge Cannella stated in Ainger, “[w]here
the warranty is proved — and especially where it is expressly
stated in a signed writing — the promisor should be allowed
R.App. 12
to disclaim ‘the bargain of the parties in fact as found in their
language’. . . only in an extraordinary case, such as one in-
volving illegality or some other overriding consideration of public
policy.” Ainger, 476 F. Supp. at 1225.
This is a case where the warranties are clearly set forth in
a signed writing. To require reliance as an element of a breach
of warranty claim in such a case would create uncertainty in
the commercial context, and blur the differences between war-
ranty claims and misrepresentation claims. The Court also notes,
for reasons set forth later, that questions of fact clearly exist con-
cerning Delta Holdings’ knowledge of the financial statements’
accuracy, and the role National Distillers played in Delta
Holdings’ obtaining and understanding this knowledge.
C. The Allegations of Fraud.
Delta Holdings claims that National Distillers committed
common law fraud and violated the federal securities laws. The
federal claims are asserted under § 12(2) of the Securities Act,
15 U.S.C. § 771, and § 10(b) of the Securities Exchange Act, 15
U.S.C. § 78j, and Rule 10b-5 promulgated thereunder, 17 C.F-R.
§ 240.10b-5. National Distillers seeks summary judgment on
these claims of fraud.
National Distillers argues that actual knowledge of inaccurate
representations or warranties bars an action for fraud. See
Rosenbloom v. Adams, Scott & Conway, Inc., 521 F. Supp. 372,
390 (S.D.N.Y. 1981), affd mem., 688 F.2d 816 (2d Cir. 1982);
Pittsburgh Coke & Chemical Co. v. Bollo, 421 F. Supp. 908,
925 (E.D.N.Y. 1976), affd, 560 F.2d 1089 (2d Cir. 1977); 200
East End Avenue Corp. v. General Electric Co., 5 A.D.2d 415,
418, 172 N.Y.S.2d 409 (Ist Dep't 1958), affd, 6 N.Y.2d 731, 185
N.Y.S.2d 816, 153 N.E.2d 508 (1959). National Distillers asserts
that no genuine issue of material fact exists concerning Delta
Holdings’ knowledge of Elkhorn’s true financial condition at the
time of the SPA. The Court differs, and declines to grant sum-
mary judgment to National Distillers on the fraud claims.
a
R.App. 13
According to National Distillers, Delta Holdings knew before
September 30, 1983 that the Elkhorn loss development triangles
used to calculate loss reserves were done on an account date basis.
National Distillers reasons that this information was known to
PMM and Conning, and since they served as agents for Delta
Holdings, the information is to be imputed to the plaintiff. Further-
more, National Distillers notes that no fraud claim can arise out
of any inaccuracy in the June 30, 1983 and September 30, 1983
financial statements because Delta Holdings had actual know-
ledge of the basis on which the loss reserve estimates were made.
Through its agents, Delta Holdings knew that loss reserve
figures were estimates. Loss reserves are contingent on future
events, and are very difficult to estimate. However, the impor-
tance of these loss reserves is profound. In fact, the American
Institute of Certified Public Accountants (“AICPA”) has stated
that, “[t]he fairness of the [insurance] company’s representation
of its financial position and results of operations usually rests
on the reasonableness of the estimates of unpaid losses more than
on any other item.” Tesoriero Affidavit, Exh. 2, AICPA Industry
Audit Guide, Audits of Fire and Casualty Insurance Companies
at 28. The critical nature of loss reserves was certainly known
to National Distillers and Norton.
Although Delta Holdings knew that Elkhorn used an account
date basis to formulate its loss reserves, Delta Holdings was
unaware of certain facts that could have altered its view of
Elkhorn as an acquisition. During PMM’s evaluation of Elkhorn,
the accounting firm sought Norton’s assistance in certain areas.
PMM observed that certain development point numbers on the
Elkhorn loss development triangles were changing between the
December 31, 1982 analysis, and the June 30, 1983 analysis. This
concerned PMM officials who sought the assistance of Norton
and Cascio. Elkhorn personnel, who presumably knew more
about their company than anyone else, indicated that the main
difference between use of the account date instead of the book
date would be seen in the most recent underwriting year. See
Tesoriero Affidavit, Exh. 39, Wasserman Deposition at 12]-22:
Id., Exh. 29, Kaufman Deposition at 178-79. An issue of fact
exists concerning the depth of Norton's knowledge on this subject.
R.App. 14
See Tesoriero Affidavit, Exh. 40, Factor Deposition at 134.
Norton’s important role in PMM’s examination is clear from
another portion of the Wasserman deposition. PMM wanted to
see whether Elkhorn’s use of the account date basis only effected
1982 figures, as indicated by Elkhorn personnel. To do this, PMM
asked Norton and Cascio to produce representative brokers’
statements. A question of fact exists concerning whether Norton
produced truly representative statements, or whether certain
statements were chosen in an effort to mollify PMM’s concerns.
See id., Exh. 39, Wasserman Deposition at 126-28.
Moreover, serious questions of material fact exist concerning
the non-disclosure of the Tillinghast documents. As mentioned
earlier, it is alleged that the actuarial firm of Tillinghast, Nelson
& Warren was retained by Elkhorn in 198] to examine Elkhorn’s
procedures and formulas. In February, 1982, Tillinghast com-
pleted its report which contained a different methodology for
the calculation of loss reserves. When Norton applied this ap-
proach, he found that the loss reserves as of December 31, 1981
were understated by $6,300,000. Tillinghast issued another
report in April, 1982 that evaluated the loss reserves for three
reinsurance treaties. This report indicated ultimate losses on
these three treaties would be $26,800,000. However, the loss
reserves carried by Elkhorn for these treaties was only
$18,700,000 as of December, 1981. These facts were withheld
from PMM, and could have alerted the firm to the magnitude
of Elkhorn’s financial problems. See Appendix to Delta Holdings’
Memorandum of Law, Exh. 23, Kaufman Deposition at 73-75.
Thus, Norton, and others for whom National Distillers is respon-
sible, may have withheld material information from Delta
Holdings’ agents in an effort to brighten Elkhorn’s financial pic-
ture, and curtail Delta Holdings’ understanding of the situation.
The legal significance of these issues is clear. The duty under
the federal securities laws to disclose all material facts necessary
to make other statements fair, “is not discharged merely by giving
the purchaser access to company records and letting him piece
together the materiai facts if he can.” Metro-Goldwyn-Mayer,
Inc. v. Ross, 509 F.2d 930, 933 (2d Cir. 1975). The securities
ee
R.App. 15
laws contemplate investors having “full access” to material in-
formation. Hirsch v. du Pont, 553 F.2d 750, 763 (2d Cir. 1977).
In this case, factual questions concerning Delta Holdings’ ac-
cess to information and National Distillers’ assistance to Delta
Holdings in evaluating Elkhorn’s financial condition remain
unanswered.* For this reason, National Distillers’ motion for sum-
mary judgment on the fraud claims is denied.
D. Alleged Violation of § 12(2) of the Securities Act of
1933.
Delta Holdings alleges that National Distillers violated § 12(2)
of the Securities Act of 1933 by making material misrepresen-
tations and omissions in connection with the Elkhorn sale.
Specifically, it is claimed that National Distillers concealed the
two reports prepared by Tillinghast in 1982, Norton’s calcula-
tions based on those reports, and certain monthly management
reports. National Distillers argues that this cause of action is
barred by the one year statute of limitations applicable to sec-
tion 12(2), see 15 U.S.C. § 77m, and that summary judgment
is appropriate.
According to National Distillers, the lawsuit was commenced
20 months after the sale, and that during this period, Delta
Holdings had constructive knowledge of the alleged mis-
statements and omissions. This constructive knowledge argu-
ment is based upon Delta Re’s employment of three holdovers
* The establishment, and judgment, of loss reserves can lead to liability under
the federal securities laws whether one views loss reserve estimates as either
facts or opinions. See Lewis v. Black, Fed. Sec. L. Rptr., 4 95,715 at 90,476
(E.D.N.Y., Sept. 3, 1976) (CCH); Oleck v. Fischer, 401 F. Supp. 651, 657
(S.D.N.Y. 1975); cf. CPC International, Inc. v. McKesson Corp., 70 N.Y.2d
268, 519 N.Y.S.2d 804, 813, 514 N.E.2d 116 (1987) (projection of corporation's
expected financial performance may constitute material facts to support a fraud
claim). This is also true in the context of common law fraud and the insurance
industry. See Glacier General Assurance Co. v. Casualty Indemnity Exchange,
435 F. Supp. 855, 860 (D. Mont. 1977) (“If the [loss reserve] figures so published
are determined arbitrarily and with the intent to deceive and are in fact false,
then the publisher is guilty of fraud regardless of whether his expression be
one of fact or one of opinion.”).
R.App. 16
from Elkhorn: Robert Norton, Hugh C. Brewer, III and James
D. McGurty. National Distillers contends that the knowledge
of these individuals is to be imputed to Delta Holdings under
established principles of agency.
Delta Holdings argues that Brewer and McGurty did not know
about all of the alleged misrepresentations and omissions made
by Norton. Moreover, it is contended that these two individuals
lacked knowledge of all of the underlying facts. Regarding Nor-
ton, Delta Holdings seeks application of the adverse interest ex-
ception that would prevent it from being imputed with Nor-
ton’s knowledge. Therefore, this reasoning continues, Delta
Holdings cannot be deemed to have known of these misrepresen-
tations and omissions until it obtained actual knowledge of them
in September, 1984. Since the action was filed in May, 1985,
the statute of limitations defense would fail.
The Court concludes that summary judgment is inappropriate
on the statute of limitations defense. The extent of Brewer’s and
McGurty’s knowledge of the concealments is unclear, and is
much better resolved at trial. If it is established at trial that these
individuals had full knowledge of the concealments, and were
not part of the alleged fraud, then the statute of limitations could
bar the section 12(2) claims. Under the adverse interest excep-
tion, Norton’s knowledge can certainly not be imputed to Delta
Holdings at this point in the case because Norton’s failure to
disclose his earlier concealments was possibly done in an effort
to protect himself from a lawsuit such as this one.
The New York Court of Appeals has limited the circumstances
in which the adverse interest exception may be used. It is only
applicable when an agent has “totally abandoned his principal's
interests and . . . [is] acting entirely for his own or another’s
purposes. It cannot be invoked merely because he has a con-
flict of interest or because he is not acting primarily for his prin-
cipal.” Center v. Hampton Affiliates, Inc., 66 N.Y.2d 782, 785,
497 N.Y.S.2d 898, 900, 488 N.E.2d 828 (1985). At the present
time, one can reasonably infer from the facts presented that as
to the earlier misstatements and omissions, Norton “totally aban-
doned” the interests of Delta Re. Denial of summary judgment
R.App. 17
on the statute of limitations issues is entirely consistent with “the
ancient principle that no man can take advantage of his own
wrong.’ Katz v. Amos Treat ¢ Co., 411 F.2d 1046, 1055 (1969)
(citing Glus v. Brooklyn Eastern District Terminal, 359 U.S. 231,
232-34 (1959)).
E. Alleged Violations of RICO.
Delta Holdings’ complaint alleges that National Distillers
violated the Racketeer Influenced and Corrupt Organizations
Act, 18 U.S.C. §§ 1961-1968 (1982 & Supp. III 1985) (“RICO”),
and that Elkhorn constituted the enterprise. According to Delta
Holdings, National Distillers violated section 1962(c), which re-
quires “(1) conduct (2) of an enterprise (3) through a pattern
(4) of racketeering activity.” Sedima, S.P.R.L. v. Imrex Co., Inc.,
473 U.S. 479 (1985). National Distillers moves to have this cause
of action dismissed.
In essence, Delta Holdings’ contention is that in conjunction
with the SPA, National Distillers concealed the understatement
of Elkhorn’s loss reserves and overstated Elkhorn’s net worth.
In so doing, National Distillers committed the predicate acts
of mail fraud and wire fraud. Although more than one predicate
act is alleged, this Court rules that the complaint does not state
a cause of action under RICO. Delta Holdings does not plead,
as is required by the Second Circuit, “the existence of an enter-
prise whose illicit activities or unlawful goals are continuing
ones.” Creative Bath Products, Inc. v. Connecticut General Life
Insurance Co., 837 F.2d 561, 564 (2d Cir. 1988) (citing Albany
Insurance Co. v. Esses, 831 F.2d 41 (2d Cir. 1987); Beck v.
Manufacturers Hanover Trust Co., 820 F.2d 46 (2d Cir. 1987),
cert. denied, 108 S. Ct. 698 (1988). This case involves allega-
tions of fraud in the context of one stock purchase agreement.
The illicit goal of the alleged enterprise was “straightforward”
and “short-lived.” See Beck, 820 F.2d at 51. It is claimed that
‘National Distillers engaged in fraud when it sold Elkhorn to
Delta Holdings. This does not present a situation posing the
threat of continuing criminal conduct that RICO seeks to com-
bat. See United States v. lanniello, 808 F.2d 184, 192 (2d Cir.
1986), cert. denied, 107 S. Ct. 3229 (1987); Chamarac v. Pike,
No. 86 Civ. 7919 slip op. at 19-20 (S.D.N.Y. Oct. 28, 1987) (JFK)
R.App. 18
(complaint describing on-going, open-ended limited real estate
partnership stated RICO claim). The RICO cause of action in
Count V of Delta Holdings’ complaint is dismissed.
F. The Alleged Negligent Misrepresentations.
Delta Holdings claims that National Distillers negligently mis-
represented material facts, ir cluding Elkhorn’s net worth as
reflected on the June 30, 1983 net assets statement, and on the
September 30, 1983 balance sheet. National Distillers moves to
dismiss this claim, arguing that it fails to meet the required
elements under New York law.
It is well-established in this state that in a negligent mis-
representation claim, a “special relationship” must exist between
the parties. This rule was first set forth by the New York Court
of Appeals in International Products Corp. v. Erie R.R. Co.,
244 NY. 331, 155 N.E. 662, cert. denied, 275 U.S. 527 (1927).
There, the court stated that “the relationship of the parties, aris-
ing out of contract or otherwise, must be such that in morals
and good conscience the one has the right to rely upon the other
for information, and the other giving the information owes a
duty to give it with care ... An inquiry made of a stranger is
one thing; of a person with whom the inquirer has entered or
is about the enter into a contract concerning the goods which
are or are to be its subject is another.” 244 N.Y. at 338. Although
there is some suggestion that parties who are negotiating do not
have the requisite “special relationship,” see Accusystems, Inc.
v. Honeywell Information Systems, Inc., 580 F. Supp. 474, 481
(S.D.N.Y. 1984); Dynamics Corp. of America v. International
Harvester Co., 429 F. Supp. 341, 356 (S.D.N.Y. 1977); the words
of International Products indicates that such a black-letter rule
is inappropriate. The “special relationship” concept must be
adaptable to numerous contexts, and turns on the facts of each
case. While the complaint describes a commercial relationship,
the Court cannot conclude that the relationship could not have
been “special.” This determination must await the development
of all of the facts at trial.
The motion to dismiss the negligent misrepresentation claim
is denied.
R.App. 19
II. National Contribution Claim
Against Frederic M. Reiss
Reiss moves for summary judgment against National Distillers’
third-party complaint seeking contribution on the state iaw
claims. The Court has previously dismissed the third-party
claims as to the federal causes of action in an Opinion dated
September 4, 1986.
Although the broad facts were set forth earlier, some par-
ticular circumstances concerning Reiss should be noted here.
Reiss had a long career in the reinsurance industry, stretching
back to 1946. In the early 1960's, Reiss moved to Bermuda where
he built a network of management companies that administered
his various insurance and reinsurance operations. During the
early 1980's, he was an active player in the formation of Delta
Holdings, and had served as Chairman of the Board of Direc-
tors for a period of time. Reiss was also an active participant
in Delta Holdings’ consideration of possible acqusitions of rein-
surance companies, including Elkhorn Reinsurance. In fact, on
July 18, 1983, Reiss indicated to the Advisory Committee of Delta
Holdings’ Board that the Elkhorn acquisition initially looked
positive, but much work would still have to be done. Reiss also
recommended that outside professional firms be retained to
verify independently the assets and reserves of any possible ac-
quiree with an ongoing book of business. After Elkhorn emerged
as a candidate, the Advisory Committee approved the engage-
ment of Conning & Co. and PMM to review Elkhorn and its
reserves. Conning & Co. opined that the loss reserves were ade-
quate, and PMM certified the June 30, 1983 pro forma state-
ment of Elkhorn’s net assets.
An examination of the material facts and relevant law
demonstrates that summary judgment must be entered in favor
of Reiss. As an initial proposition, the Court again notes that
contribution is available when “the third-party’s conduct con-
tributed to the ‘same injury’ suffered by the plaintiff.” Delta
Holdings v. National Distillers and Chemical Corp., [1986-1987
Transfer Binder] Fed. Sec. L. Rep. (CCH) 4 92,910 at 94,427
(S.D.N.Y. September 4, 1986). Delta Holdings’ harm in this action
R.App. 20
is the purchase and possession of a valueless asset. See id. Any
claim that Reiss should contribute to National Distillers — in the
event National Distillers is found liable under state law — due
to his failure to evaluate Elkhorn’s future profitability is
meritless. This case essentially concerns the sale of a company
allegedly worthless at the time of the transaction, and not the
extent of the company’s future profitability.
Several additional grounds exist that compel summary judg-
ment in Reiss’ favor. National Distillers urges that Reiss is liable
for contribution due to his failure to review personally Elkhorn’s
business. National Distillers further contends that Reiss failed
to keep himself abreast of the investigation into Elkhorn per-
formed by his staff, Conning & Co. and PMM. Moreover, Na-
tional Distillers argues that Reiss had a duty to supervise ac-
tively the investigation because he was a Delta Holdings direc-
tor, and was ARM's sole beneficial officer and chief executive
officer. Lastly, National Distillers asserts that Reiss is liable for
telling the Delta Holdings directors that the Elkhorn transac-
tion looked positive at first review, and for relying on outside
experts to evaluate Elkhorn. Each of these positions is unavailing.
First, the claims against Reiss as a director of Delta Holdings
cannot be asserted by National Distillers. National Distillers was
not a Delta Holdings shareholder at the time of the challenged
conduct. Therefore, National Distillers lacks standing to assert
this claim since allegations that a director breached his affirma-
tive duties to a corporation may only be maintained by the cor-
poration or its shareholders. See Index Fund, Inc. v. Hagapian,
417 F. Supp. 738, 745 (S.D.N.Y. 1976). The business judgment
rule, recognized in both New York and Delaware, further bars
the claim for contribution. Under this rule, a director will not
be liable for actions taken in the honest belief that they were
in the corporation’s best interests, provided the actions were in-
formed and made in good faith. See Hanson Trust PLC v. ML
SCM Acquisition, Inc., 781 F.2d 264, 273 (2d Cir. 1986); Auer-
bach v. Bennett, 47 N.Y.2d 619, 629, 419 N.Y.S.2d 920, 926, 393
N.E.2d 994 (1979); Smith v. Van Gorkum, 488 A.2d 858, 872
(Del. 1985). To hold Reiss liable as a director, there would have
to be evidence that his conduct was fraudulent or in bad faith,
R.App. 21
or constituted a gross abuse of discretion. Even when considered
in the light most favorable to National Distillers, the facts ad-
duced on this motion do not raise a question of material fact.
In hindsight, one could argue Reiss might have been wise to
ask more questions or read more documents. However, hind-
sight is not the relevant analysis. One must evaluate Reiss’ con-
duct as of the time it took place. Reiss did not blindly urge Delta
Holdings to plunge into an $18 milion purchase. Rather, he in-
dicated that while the Elkhorn acquisition appeared promis-
ing, much investigating needed to be done. Outside experts were
hired to evaluate Elkhorn, and their conclusions, albeit flawed,
were relied on in good faith. The Court finds nothing to sug-
gest the contrary. Reiss further relied in good faith on other
favorable reports and representations, included among them
representations from Norton. Reiss’ conduct does not approach
the required standard at which he would lose the protection of
the business judgment rule.
Reiss cannot be found liable for contribution to National
Distillers based on his alleged nonfeasance as an ARM officer.
National Distillers contends that Reiss did not meet personally
with the auditors and insure that all of the transaction’s risks
were resolved. These are charges of nonfeasance, and do not sup-
port a finding of an agent's liability to one other than his prin-
cipal. See Marine Midland Bank v. John E. Russo Produce Co. :
50 N.Y.2d 31, 45, 427 N.Y.S.2d 961, 969, 405 N.E.2d 205 (1980);
Jones v. Archibald, 45 A.D.2d 532, 534-35, 360 N.YS.2d 119,
122 (4th Dep't 1974).
Equally erroneous is National Distillers’ argument that Reiss
made negligent misrepresentations at the July 18, 1983 Advisory
Committee meeting. At that time, Reiss apparently stated that,
“Elkhorn Re looked very positive on first review, but still required
a lot of work. On the positive side, National Distillers was will-
ing to sell Elkhorn Re for (GAAP) book value.” When made,
this statement was not a misrepresentation. Reiss did not state
that Elkhorn was a flawless acquisition and that the transac-
tion should be completed immediately. Rather, he noted that
more work needed to be done. This was accurate, as was Reiss’
statement of the positive aspects of the transaction.
R.App. 22
National Distillers argument that Reiss breached his duties
as a promoter of Delta Holdings also misses the mark. By the
time the transaction at issue occurred, Reiss’ duties as a pro-
moter had ceased. A Board of Directors was in place and was
operating. Furthermore, there is no allegation that Reiss con-
cealed any facts from the subscribers, even if National Distillers
possessed standing to assert such a claim. Finally, the Court re-
jects National Distillers position that Reiss may be liable because
he is the sole beneficial owner of ARM. Generally, stockholders
are not liable for the obligations of a corporation unless the cor-
porate entity is a sham and agent for a controlling shareholder.
This has not been alleged in this case, and no evidence before
the Court presents a genuine issue of material fact in this regard.
The summary judgment motion made by Reiss as to National
Distillers’ contribution claim is hereby granted.
III. The Motion of Peat, Marwick, Mitchell & Co.
to Dismiss National Distillers’ Contribution Claims
PMM renews its motion to dismiss National Distillers’ con-
tribution claim to the extent it is based on National Distillers’
liability to Delta Holdings for breaches of the SPA. As set forth
earlier, the Court grants summary judgment to National
Distillers on that part of Count I of the complaint alleging § 12
of the SPA was breached. The Court, however, denies summary
judgment on the allegations in Count I concerning breaches of
§§ 5(g) and 5(f) of the SPA.
The Court need not dwell on PMM’s instant motion because
the central issue has been resolved by the New York State Court
of Appeals. In Board of Education v. Sargent, Webster, Cren-
shaw & Foley, 71 N.Y.2d 21 (1987), aff'g 125 A.D.2d 27, 511
“N.Y.S.2d 961 (3d Dep’t 1987), the court ruled that New York’s
contribution statute, CPLR § 1401, does not apply in the breach
of contract setting. The court traced the evolution of contribu-
tion in New York and noted that § 1401 “had its genesis in tort
law and in the complications surrounding the apportionment
of liability among joint tort-feasors.” Id. N.Y.2d at 27. Thus, Na-
tional Distillers may not seek contribution from PMM to the
R.App. 23
extent National Distillers is found liable for breaching §§ 5(g)
and 5(f) of the SPA.
PMM's partial motion to dismiss is granted.
CONCLUSION
National Distillers motion for summary judgment on that por-
tion of Count I dealing with § 12 of the SPA is granted. In ad-
dition, the RICO cause of action is dismissed because no pat-
tern of racketeering activity is present. All other portions of Na-
tional Distillers’ motion are denied. The motion of Reiss is
granted in full, and PMM’s motion for partial dismissal is
granted.
The parties are to appear for a pretrial conference on April
20, 1988 at 9:45 a.m. At that time, a firm date for trial will be set.
SO ORDERED.
Dated: New York, New York
April 8, 1988
/s/ John F. Keenan
JOHN F. KEENAN
USD].
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.