Ausa Life Insurance Co. v. Ernst & Young

206 F.3d 202 (2d Cir. 2000)

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Nature of the Case

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Facts

Ps are insurance companies that invested in the securities of JWP, Inc. Ps made their initial purchases of the notes in November of 1988 through March 1992 with investments totaling $ 149 million. The Note Agreements included 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. Ps relied on JWP's past financial statements, including annual reports certified by D. These financial statements were required, under the Note Agreements, to be kept in accordance with generally accepted accounting principles (GAAP). Under the Note Agreement D was required 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 D had audited JWP's financial statements and that JWP was in compliance with the financial covenants in the Note Agreements. D's statements about JWP's financial health were constantly flawed. They did not meet GAAP or even GAAS (generally accepted auditing standards). D was well aware that D's financial representations about itself were not in accordance with GAAP. D consistently noticed, protested, and then acquiesced in these misrepresentations. John LaBarca was D's partner in charge of the audits. Ernest Grendi was JWP's CEO and either persuaded or bullied D into agreeing that JWP's books met the required standards without adjustments. It is to be noted that Grendi and LaBarca were close personal friends regularly jogging together in preparation for the New York City Marathon. Grendi had also been a partner of LaBarca in D's predecessor firm. The inside joke was the accounting standards at JWP were compliant with 'EGAAP,' an acronym for Ernest Grendi's Accepted Accounting Practices.' JWP acquired Businessland, Inc., in 1991. Businessland was a retailer of computers and a supplier of software. Businessland was labeled as a walking dead company that had lost so much money over the ten months prior to the acquisition, that its auditors had issued a 'going concern' qualification on its most recent audited financial statement, which indicated that the auditors doubted the company could survive. JWP thought that Businessland could be meshed into JWP's existing business which was heavily involved in installing wiring for computer networks, and they intended to capitalize on Businessland's trained sales force and existing clientele. Businessland failed and with it JWP. JWP had a 1992 loss of $612 million with a corresponding net worth of negative $176 million. Eventually, JWP was placed in involuntary bankruptcy. Ps lost $100 million in lost principal and unpaid interest. Ps sued D. The court found that D was aware of serious accounting irregularities. D 'issued unqualified audit reports for the years in question,' and 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. D knew the annual no-default letters were false. The court found the materiality and reliance elements of federal securities law violations were present, but balked on the scienter element and definitively found that Ps did not prove the causation element. Ps could not establish D's egregious accounting caused Ps' losses because JWP ultimately imploded due to Businessland's operations and the uncontrollable effects of the PC price wars. Ps appealed.