Holland v. Alexander Grant & Co. (In Re American Reserve Corp.)

Citations: 70 B.R. 729; 1987 U.S. Dist. LEXIS 635Docket: Bankruptcy No. 86 C 833, Adv. Nos. 82 A 4214, 83 A 2485

Court: District Court, N.D. Illinois; January 23, 1987; Federal District Court

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The case involves J. William Holland, the trustee for the bankrupt American Reserve Corporation (ARC), who filed lawsuits against Alexander Grant Co. and Arthur Andersen Co. for allegations of common law fraud, breach of contract, civil conspiracy, and RICO violations. ARC, an insurance holding company, faced severe financial difficulties leading to the liquidation of its major subsidiaries in 1979, prompting ARC to file for reorganization under Chapter 11 on April 21, 1980, which was later converted to a Chapter 7 liquidation in 1981.

The lawsuits stem from audits conducted by Grant and Andersen, which allegedly misrepresented ARC's financial status, allowing insolvency to occur without corrective actions. The complaint against Grant includes nine counts related to its audit of ARC's 1977 financial statements, which were claimed to be fraudulent despite receiving an unqualified opinion. The trustee contends this misrepresentation contributed to the loss of ARC's primary assets.

The action against Andersen consists of three counts: the first concerns Andersen's failure to disclose adverse financial developments in ARC's 1975 financial statement; the second involves the nondisclosure of disagreements over loss reserves leading to Andersen's removal as auditor; and the third relates to the failure to inform regarding a reinsurance agreement impacting the financial statements for 1974 and 1975. The cases were initially filed in state court but were removed to bankruptcy court, where the trustee sought to remand them, a motion that was denied.

Both actions have been withdrawn from the bankruptcy court, prompting Grant and Andersen to file motions to dismiss the complaints against them. Andersen challenges the court's subject matter jurisdiction, arguing that it was lost when the Interim Jurisdictional Rule expired on June 27, 1984, following the Supreme Court's ruling in Northern Pipeline Construction Co. v. Marathon Pipe Line Co. He asserts that jurisdiction was not restored until after the Bankruptcy Amendments and Federal Judgeship Act of 1984 took effect on July 10, 1984, and claims that the action needed to be refiled post-June 10, 1984. However, the court clarifies that post-Marathon, jurisdiction reverted to the district courts, and the Interim Rule simply redelegated some jurisdiction to bankruptcy courts. Therefore, the court maintains subject matter jurisdiction.

Grant raises an objection to the trustee's amendment of the complaint on August 31, 1983, which added a civil RICO claim without seeking the court's permission. While Federal Rule of Civil Procedure 15(a) allows for amendments before a responsive pleading is served, Grant argues that the trustee waived this right by moving to remand the case, claiming the original complaint was based solely on Illinois law without federal RICO claims. The court finds Grant's argument unconvincing, noting that the cited authority does not support the claim of waiver, and it is unwilling to rule that the trustee forfeited the right to amend.

Both Andersen and Grant assert that the RICO claims must be dismissed because ARC is not a proper party to bring the suit, thus the trustee is also not a proper plaintiff. Under Federal Rule of Civil Procedure 17(a), actions must be prosecuted in the name of the real party in interest, defined as the individual who possesses the right being enforced, which may not be the same as the ultimate beneficiary. In cases involving federal statutes, the determination of the real party in interest is governed by federal substantive law.

The civil damages provision of RICO, under 18 U.S.C. 1964(c), allows individuals injured in their business or property due to RICO violations to recover triple damages and attorney's fees. However, the Seventh Circuit, in Carter v. Berger, established that not all injured parties have standing to pursue claims under this provision. In Carter, taxpayers claimed injury from a bribery-related RICO violation that resulted in increased taxes due to a reduction in property valuations. The court ruled that these taxpayers were indirectly injured and thus lacked standing, affirming that only the county, as the directly injured party, could bring a suit. 

The court reasoned that allowing indirectly injured parties to sue could lead to excessive liabilities, potentially multiplying damages. This principle was applied in Todd v. Bio-Scientific Clinical Laboratory, where a shareholder and former president of Bio-Scientific alleged injuries from actions that perpetrated RICO violations against the corporation. The court determined that her injuries were too indirect to establish standing under RICO, emphasizing that standing should be granted only to those who suffer immediate injuries. The decision aligns with other rulings in various jurisdictions that similarly restrict RICO standing to directly injured parties, reinforcing the need for a balance between private enforcement and the avoidance of excessive treble damage claims.

ARC functioned as a holding company rather than directly engaging in the insurance business, with its primary operations occurring through its subsidiaries, notably Reserve. The insolvency of ARC was primarily due to the financial difficulties and eventual failure of Reserve, its main subsidiary. ARC's position as Reserve's parent company aligns it with plaintiffs like Todd, who suffered indirect damages from the actions of a defendant involved in racketeering. Although the trustee claims ARC was independently harmed by remaining operational past insolvency, this was fundamentally linked to Reserve's own insolvency. Allowing ARC's trustee to pursue RICO claims would essentially permit ARC to seek recovery for injuries that Reserve's trustee is already pursuing in Washburn v. Brown.

The law specifies treble damages for civil RICO violations, implying that ARC, as an indirectly injured party, should seek restitution through Reserve's recovery. The trustee's assertion of ARC's contractual relationships with Grant and Andersen, which arose from audit engagements, does not establish sufficient RICO standing, as indicated by the precedent in Gallagher. Consequently, the court determined that the trustee lacks standing to pursue RICO claims against Andersen and Grant, leading to their dismissal.

Following the dismissal of the RICO claims, only the state law claims against Grant remain. Grant's motion to dismiss the fraud claims, based on ARC's inability to show reliance on misrepresentations and insufficient specificity in fraud allegations, was found unmeritorious. Grant argued that because ARC prepared its own financial statements and Grant merely reviewed them, the knowledge of ARC's top officials regarding the alleged misrepresentations should be imputed to the company, precluding recovery for fraud. The Cenco, Inc. v. Seidman case addressed similar issues of knowledge imputation regarding accountant liability under Illinois law, where a corporation's claim against its auditors involved allegations of fraud connected to inflated inventory values. The case hinged on whether the jury was correctly instructed on the imputation of corporate wrongdoing as a defense for the auditors.

The Seventh Circuit upheld the propriety of an instruction regarding Cenco's managers' fraudulent acts, determining these acts constituted fraud on behalf of the corporation rather than against it. As a result, Cenco was barred from recovering for fraud that it benefited from. The court referenced Schacht v. Brown, where the Illinois Director of Insurance filed a RICO claim against Reserve's management for failing to disclose insolvency. The Seventh Circuit found Cenco inapplicable to federal RICO claims but ruled that the liquidator's claims were not barred since the alleged fraud did not benefit Reserve. Instead, Reserve’s prolonged existence only benefited its managers. The Illinois Appellate Court supported this view, rejecting Grant's position in a related state court case, affirming that ARC could not be held liable for management misconduct that did not benefit it. Grant's argument that the Illinois court misapplied Cenco and Schacht was dismissed, as the court found the decisions clearly dictated the outcome. Additionally, Grant contended fraud claims lacked specificity under Federal Rule of Civil Procedure 9(b); however, the court noted that the allegations sufficiently detailed the misleading statements and Grant's involvement in the fraud. Counts II, III, V, and VIII involved breach of contract claims, with ARC asserting that Grant audited ARC's financial statements under a written engagement letter. Despite ARC not having a copy of the letter, one provided by Grant outlined the limitations of the audit, acknowledging the inherent risk of undetected errors or irregularities.

ARC claims that Grant implicitly agreed to provide auditing services with the skill and care typical of accounting professionals, particularly for property and liability insurance audits. ARC asserts that Grant breached this agreement by not disclosing inadequacies in ARC's loss reserves, employing insufficiently skilled audit personnel, failing to report adverse developments regarding ARC's 1976 loss reserves in 1977, and not disclosing the reinsurance treaty's effects on ARC's financial status. 

Grant argues that these allegations pertain to tort rather than contract, referencing case law from other jurisdictions. However, under Illinois law, professionals can be understood to contractually commit to a standard of care reflective of their profession, which can establish contractual liability based on a failure to meet this duty rather than mere negligence. 

The court finds that ARC has adequately alleged that Grant promised to notify them of any discovered errors or irregularities during its audit and that Grant breached this agreement. Additionally, Count VI accuses Grant of conspiring with Coopers & Lybrand to misrepresent a $22 million adjustment in loss reserves as a ‘prior period adjustment’ instead of a ‘change in estimate.’ While civil conspiracy itself is not actionable, the complaint alleges sufficient fraudulent acts that could lead to liability. 

The court also determined that the trustee lacks standing to pursue RICO claims against Grant and Alexander, leading to their dismissal. However, the remaining claims against Grant are valid under Illinois law and will proceed.