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Holland v. Arthur Andersen & Co.

OPINION FILED SEPTEMBER 27, 1984.

J. WILLIAM HOLLAND, TRUSTEE IN BANKRUPTCY FOR THE ESTATE OF AMERICAN RESERVE CORPORATION, PLAINTIFF-APPELLANT,

v.

ARTHUR ANDERSEN & COMPANY, DEFENDANT-APPELLEE.



Appeal from the Circuit Court of Cook County; the Hon. Paul F. Elward, Judge, presiding.

JUSTICE JIGANTI DELIVERED THE OPINION OF THE COURT:

This action was brought by J. William Holland, trustee in bankruptcy for the estate of American Reserve Corporation (ARC) against Arthur Andersen and Company (Andersen), one of ARC's independent public accountants, to recover damages on six counts of either misrepresentation or breach of contract in regard to auditing services provided by Andersen for ARC. Andersen filed a motion to dismiss all six counts of the complaint pursuant to section 2-615 of the Illinois Code of Civil Procedure (Ill. Rev. Stat. 1983, ch. 110, par. 2-615), alleging that the trustee could not bring this action because the trustee can assert only those causes of action held by the debtor, ARC, and that the instant causes of action belonged to ARC's shareholders and creditors, not ARC. Andersen further argued that even if these causes of action were held by ARC that ARC was bound by the knowledge, acts and omissions of its officers and directors and that such knowledge, acts and omissions precluded recovery by the trustee against Andersen. Andersen also contended that ARC failed to allege sufficient facts to constitute claims for misrepresentation and that the complaint failed to state a cause of action in contract.

After memoranda were submitted and a brief hearing on the motion was heard, the trial court entered an order striking each and every count of ARC's complaint, denying ARC's leave to file an amended complaint and dismissing the causes of action against Andersen with prejudice. ARC now appeals.

All facts presented in the following statement of facts were extracted from a detailed complaint and attached exhibits filed by ARC. ARC is an insurance holding company incorporated in Delaware, with its principal place of business in Chicago. Several of its principal, wholly owned subsidiaries were Reserve Insurance Company (Reserve), Market Insurance Company (Market), American Reserve Insurance Company (ARIC), and Guaranty Reinsurance Company (GRC). These subsidiaries primarily engaged in property and casualty insurance involving high-risk coverage. ARC's financial demise began when court orders were issued in May and July 1979, placing Reserve and ARIC into liquidation and Market into rehabilitation. Subsequently, on April 21, 1980, ARC filed a voluntary bankruptcy petition for reorganization under chapter 11 of the Bankruptcy Code. In November 1981, ARC's bankruptcy was converted from a chapter 11 reorganization to chapter 7 liquidation proceeding. J. William Holland was appointed by the court as permanent trustee in bankruptcy for ARC on December 31, 1981.

The two relevant factual settings that are the focal points for the instant action involve the reissuance in 1977 of Andersen's unqualified opinion for ARC's 1975 consolidated financial statement and a reinsurance treaty entered into in 1974 by Reserve with an alien reinsurance company. ARC and Andersen developed their business relationship as a result of Andersen's being retained by ARC to audit its consolidated financial statements for the years ending December 31, 1958, through 1975. In each of those years, Andersen issued an unqualified opinion with respect to those consolidated financial statements. However, due to the highly speculative nature of its insurance business, the stated level of ARC's loss reserves proved to be the most significant and controversial calculation of the consolidated financial statement. Based on the exhibits attached to ARC's complaint, it appears that historically ARC and Andersen had a difference in philosophy with respect to evaluating the adequacy of loss reserves. ARC displayed a constant optimism in their evaluation by assuming a reversal of unfavorable trends, which resulted in consistently low estimates, while Andersen projected a need for a more conservative approach in order to guarantee a higher and more adequate loss reserve figure.

In late 1975, ARC, in concert with a casualty actuary, determined the level of loss reserves to be carried on the 1975 consolidated financial statement and prepared working papers for Andersen to use during its audit examination. In early 1976, Andersen, after reviewing the determinations made by ARC, questioned various assumptions made by ARC with respect to the level of loss reserves, which were not supported by ARC's historical experience. Andersen indicated that based, on ARC's significant reserve deficiencies in the past, several of Andersen's computations showed ARC insolvent for the year-end 1975. However, after a series of discussions between ARC and Andersen, in which ARC was apparently able to persuade Andersen that ARC's loss reserves were adequate, Andersen rendered an unqualified audit report on ARC's 1975 consolidated financial statement on March 29, 1976.

Shortly thereafter, on April 8, 1976, ARC informed Andersen that ARC's board of directors had determined to change auditors. ARC explained to Andersen that it decided to engage Coopers & Lybrand in order to create greater efficiency, because Coopers already audited two companies acquired by ARC, and that it was easier to consolidate ARC's and its subsidiaries' auditing work with a single auditing firm. After some discussion between ARC and Andersen regarding the appropriate explanatory language to use a Form 8-K, a form required by the SEC when a firm changes auditors, the parties reached a mutual understanding, and the form was submitted containing the agreed-upon language.

In March 1977, Coopers & Lybrand audited ARC's 1976 consolidated financial statement and thereafter issued an unqualified opinion. Coopers then informed Andersen that Coopers' audit examination disclosed that during 1976 ARC had reduced its consolidated earnings by charging its income approximately $25 million for claim and claim adjustment expenses in excess of the loss reserves provided as of December 31, 1975, for claims incurred in 1975 and prior years. Coopers treated such charge as resulting from a change in estimate in 1976, but further informed Andersen that it would not state in its comfort letter that the charge was not a prior period adjustment. Coopers indicated that it based its determination that the deficiency represented a change in estimate only on what it saw developed in 1976 and that Andersen, when reissuing its opinion on the 1975 consolidated financial statement, would have to make its decision based on information available to it from the prior years. In April 1977, ARC included its 1975 and 1976 consolidated financial statements for comparative purposes in its annual report to shareholders and its report to the SEC. At that time, Andersen reissued its original unqualified opinion with respect to the 1975 consolidated financial statement.

The second major factual setting regards a reinsurance agreement and is as follows. In 1973 and 1974, ARC and Reserve suffered substantial operating losses with respect to insurance written in previous years involving particularly high-risk and surplus liability lines of coverage. Such operating losses reduced Reserve's and Market's statutory surplus, and because of State insurance regulations, Reserve and Market were restricted in the amounts of insurance they could continue to write. This development jeopardized Reserve's and Market's ability to preserve their existing market structure.

In response to these adverse financial and business developments, Reserve, Market and GRC, another subsidiary of ARC and previous reinsurer for Reserve and Market, entered into a series of reinsurance agreements or treaties with Societe Commerciale De Reassurance (SCOR), a major European reinsurance company. Under the terms of these agreements, SCOR assumed a large percentage of premiums written by Reserve and Market and then immediately retroceded them to GRC. In consideration of these premiums SCOR paid to Reserve and Market a commission, but in return received a slightly higher commission from GRC. However, because the capitalization of GRC was insufficient to cover the potential losses involved in its assumption of the business from SCOR, ARC agreed to guarantee GRC's obligations to SCOR.

On March 15, 1975, an Andersen auditor submitted a handwritten memorandum that outlined the details of the SCOR treaties and described the apparent effect the treaties had on ARC and its subsidiaries. This memorandum stated that

"Reserve needed surplus relief and Guaranty [GRC] didn't have enough surplus to provide it. SCOR provided the letter of credit as a financial mechanism and very little else."

The memorandum further stated:

"In view of the `quality' of the reported surplus, there appears to be a reasonable uncertainty as to the company's ability * * * to remain in business * * *."

Thereafter, Andersen conducted an audit of ARC's 1974 and 1975 consolidated financial statements and rendered an unqualified opinion with respect to each year.

Because the instant action was decided on a section 2-615 motion to dismiss that challenged the legal sufficiency of ARC's complaint, we find it necessary to state with some particularity the allegations contained in the six count complaint. Counts I and II respectively allege misrepresentation and breach of contract for Andersen's reissuance in 1977 of their unqualified opinion regarding ARC's 1975 financial statement. These counts allege that at the time Andersen reissued their opinion they knew that 1976 earnings had been reduced by $25 million so that an additional $25 million increase in 1975 loss reserves could be covered. The counts also allege that Andersen knew that this $25 million increase in loss reserves for 1975 meant that ARC was actually insolvent as of December 31, 1975, and that if adequate loss reserves had been included in the 1975 financial statements then ARC and Andersen would have had ...


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