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04/21/94 CONGREGATION PASSION v. TOUCHE ROSS &

April 21, 1994

CONGREGATION OF THE PASSION, HOLY CROSS PROVINCE, APPELLEE,
v.
TOUCHE ROSS & COMPANY, APPELLANT.



Miller, Freeman, Heiple, Harrison

The opinion of the court was delivered by: Miller

JUSTICE MILLER delivered the opinion of the court:

Plaintiff, Congregation of the Passion, Holy Cross Province, brought suit against the defendant, Touche Ross & Company, in the circuit court of Cook County alleging damages resulting from defendant's preparation of financial statements for plaintiff's use. The jury returned verdicts in favor of plaintiff and against defendant for $3.9 million on the negligence count and $1.5 million on the breach of contract count. A directed verdict in favor of defendant had previously been entered on a fiduciary duty count. The trial court entered judgment against defendant for $3,819,352, and the appellate court affirmed. (224 Ill. App. 3d 559.) We allowed defendant's petition for leave to appeal (134 Ill. 2d R. 315), and now affirm the judgment of the appellate court.

Plaintiff is a corporate entity and an order of the Roman Catholic Church. It operates monasteries, retreat houses, and schools. Plaintiff meets its operating expenses by use of contributions and investment income. Rather than make its own investment decisions, plaintiff hires investment advisors to manage its accounts. Defendant is an accounting firm with offices in Chicago and in many other cities throughout the world.

In 1973, plaintiff decided to replace its previous accounting firm with defendant, Touche Ross. Plaintiff and defendant executed an "engagement letter" which listed the services defendant would render for plaintiff. The engagement letter was for a term of one year. On or about June 30 each year, when plaintiff's fiscal year ended, defendant presented a new engagement letter to plaintiff. In each of the engagement letters, defendant agreed to prepare an unaudited financial statement for plaintiff's use for the fiscal year just ended.

Between defendant's preparation of the 1975 and 1976 fiscal year financial statements, plaintiff appointed Cranford D. Newell of San Francisco, California, as an investment advisor. Plaintiff committed two funds to Newell's control: the "retirement fund" and the "permanent fund." Each fund initially consisted of approximately $1 million. By written agreement, Newell was given full discretionary authority over all investment decisions regarding the two funds.

Newell dealt mainly in government bonds with fixed interest rates. Newell employed a modified "arbitrage" trading strategy. He would buy a bond issue that seemed to be trading lower than government bonds generally, and simultaneously sell short an issue trading higher than securities with similar coupons and maturities. If the market stabilized as Newell anticipated, market forces would move each issue price closer to the prices of other government bonds. The transaction could then be liquidated at a profit. Newell entered into these transactions through accounts held with numerous securities dealers. These transactions were highly leveraged, and although plaintiff had entrusted to Newell only $2 million, Newell held positions on behalf of plaintiff totaling $44.5 million on June 30, 1976. The only cash required by Newell to enter into these transactions was the amount of the purchase less the amount of the short sale. This initial difference between the two amounts is called "margin" or "cost," hereinafter referred to as "cost."

The reports that Newell submitted to plaintiff recorded "open arbitrage positions" at cost. Plaintiff's internal bookkeepers also recorded Newell's arbitrage positions at cost. While the cost figure accurately reflected the market value of an arbitrage position at the moment the transaction took place, any future changes in the market values of the bonds would not be reflected in the cost figure. Hence, any unrealized losses or gains occurring due to fluctuations in market prices would not be reflected in the cost figures which were reported in the annual financial reports.

Defendant first encountered the Newell investments in the course of preparing plaintiff's 1976 financial statement. The accountants assigned by defendant to prepare plaintiff's 1976 financial statement left in their work papers the following note regarding the Newell investments:

"3) Arbitrage--when Newell determines that there is a temporary fluctuation in the price of a government security in relationship to other government securities he buys or sells long that security and purchase [sic] or sells short another government security at the same time. When the fluctuation is eliminated he reverses his previous purchase and short sale and takes a profit (or loss). These arbitrages are generally for over $1 million dollars [sic] and a small fluctuation (1/32 of 1%) can involve a substantial amount of money. The only money actually invested by the Congregation is for margin [cost] required by the dealers (typically the amount of the purchase less the amount of the short sale). The risk is minimized since only U.S. government securities are traded and the chance of default is small.

At June 30, 1976 the Congregation had open arbitrages aggregating $22.25 million at par value and short positions in the same amount. Since the trades in these securities involve minor fluctuations in price (1/32 or even 1/64 of a point) and there is no source which can tell us market value closer than 1 point ($222,500) it was decided not to gross up the balance sheet to reflect these items at market.

Instead footnote disclosure will be made of the total amounts involved and only the margin [cost] outstanding on these arbitrages will be included in investments.

W. Cornfield

10/4/76"

During the preparation of the 1976 financial report, the partner of defendant in charge of plaintiff's account, Philip Melchert, called plaintiff's treasurer, Brother James Kent, to inquire about the Newell investments. Plaintiff claims Melchert recommended that the Newell investments be recorded at cost. Melchert purportedly explained that cost was approximately equal to market value. Plaintiff claims that Brother James did not understand the Newell investments and that in agreeing that the investments be recorded at cost, Brother James deferred to defendant's expertise.

Defendant denies that Brother James did not understand the Newell investments. Defendant claims that Melchert and Brother James mutually agreed to report the Newell investments at cost, and that Brother James fully understood the import of that decision.

After defendant completed its work at plaintiff's offices in 1976, Melchert met with plaintiff's governing body, the Provincial Council (the Council), to discuss the annual report. The 1976 financial report contained a footnote which specified that Newell's investments were carried at cost rather than market value. Plaintiff claims Melchert explained this footnote by again stating that cost was essentially equal to market value.

By reporting arbitrage transactions at cost, defendant reported the Newell investments at $2,166,322 in the 1976 financial report. The actual market value of the investments on June 30, 1976, the date of the report, was $1,951,520. By reporting the transactions at cost, there was a discrepancy between the market value of the Newell investments and the figure reported by defendant in plaintiff's financial reports for each fiscal year from 1976-79. The amounts of the discrepancies are shown in the following chart:

Figure Reported Actual Market

Fiscal by Defendant in Value at Time

Year Report of Report Discrepancy

1976 $2,166,322 $1,951,520 ($214,802)

1977 1,795,346 1,471,720 ( 323,626)

1978 1,792,748 878,638 ( 1,472,887)

1979 2,226,014 319,861 ( 1,347,376)

Kenneth Witt, an employee of defendant, did the field work for plaintiff's 1980 financial statement. Witt prepared a draft of the 1980 financial statement which defendant sent to plaintiff in September 1980. The 1980 draft reported the Newell accounts at approximately $3.6 million. Because the $3.6 million cost figure did not reflect unrealized losses, the actual market value of Newell's investments was later shown to have been approximately $1.2 million at the time of the report.

Prior to defendant's submitting to plaintiff a final report for 1980, Melchert contacted Witt and asked him where the $3.6 million reported in the draft financial report was located. Witt was unable to answer the question. Melchert then began an independent investigation of the Newell investments and their values. In October 1980, Melchert contacted Newell and requested information regarding plaintiff's funds. Newell was unable to furnish the material that Melchert requested. Melchert next contacted the securities dealers with whom Newell held accounts on plaintiff's behalf. By January 1981, Melchert had received June 30, 1980, market values for the Newell accounts totaling approximately $1.2 million. When Melchert called Newell with this information, Newell informed him that the $1.2 million figure rather than the $3.6 million cost figure reported in the 1980 draft financial report could be the total market value of Newell's accounts with plaintiff.

On February 11, 1981, a week after Melchert spoke with Newell, Melchert attended a meeting of the Council. Plaintiff claims that Melchert informed the Council that the market value of Newell's accounts was approximately equal to cost; however, recent events had, according to Melchert, caused him to question whether there were unrealized losses. Melchert allegedly offered limited details and promised to investigate the matter further. Defendant contends that Melchert informed the Council he had reason to believe that the market value of the Newell investments was approximately $1.2 million.

Approximately two months after the February 11, 1981, Council meeting, a security dealer made a "margin call" on an account managed by Newell. Newell called plaintiff and requested an additional $500,000 to cover the margin call. Newell explained that if the dealer closed out plaintiff's accounts, substantial "unrealized losses" could be recognized. At the time of the margin call, plaintiff still had in its possession the draft 1980 financial report in which defendant had reported Newell's account at approximately $3.6 million. Plaintiff had not heard anything further from defendant since the February 11, 1981, Council meeting. After a meeting with Newell during which Newell explained to Brother James the negative consequences of not meeting the margin call, Brother James recommended to plaintiff that the additional $500,000 be forwarded to Newell. On April 14, 1981, plaintiff transferred the additional sum to Newell.

After plaintiff forwarded the additional funds to Newell, plaintiff received from defendant a letter in which defendant stated that the market value of the Newell accounts on June 30, 1978, was $319,860, and not the $1,792,748 cost figure reported in the 1978 financial report. Defendant offered in the letter to discuss the matter further if plaintiff desired.

Late in April 1981, defendant sent plaintiff a copy of the final 1980 financial report. According to the report, the market value of the Newell accounts on June 30, 1980, totaled $1,286,411. "Note H" to the report stated, in part:

"Since the Congregation carries investments at market value, the amounts reported previously [for the Newell accounts] have been restated to include unrealized gains and losses as follows:

Previously As

Reported Adjustment Restated

June 30, 1978 $1,792,747 ($1,472,887) $319,860

June 30, 1979 2,226,014 ( 1,347,376) 878,638"

Shortly after plaintiff received the final 1980 financial statement from defendant, it closed its accounts with Newell. The accounts had not only been substantially depleted, but due to a shift in interest rates, several of the security dealers with whom Newell dealt claimed plaintiff owed them additional sums. After plaintiff settled all claims with the security dealers, plaintiff sustained net losses on the Newell accounts in the amount of $3,819,352.

In addition to testimony regarding the actual conduct of the parties, both defendant and plaintiff presented expert testimony concerning the propriety of defendant's recordation of the Newell investments. Plaintiff's witness, Vincent Sparrow, a certified public accountant and partner of Peat, Marwick & Mitchell, testified that defendant's method of recording Newell's investments violated Generally Accepted Accounting Principles (GAAP). Sparrow further stated that the market values of Newell's investments were readily ascertainable from the Wall Street Journal. Defendant called as a witness Leonard Savoie, the chairman of the department of accountancy and a professor at the University of Notre Dame. Savoie testified that the footnote disclosures contained in plaintiff's reports were clear in explaining that Newell's investments were not carried at market value. Savoie further testified that this type of footnote disclosure and recordation was in accordance with GAAP.

Prior to filing the complaint here, plaintiff filed a complaint in Federal court against Newell and four securities dealers alleging Federal security law violations. The dealers counterclaimed for amounts due after the liquidation of plaintiff's accounts. In May 1982, plaintiff amended its Federal complaint to join Touche Ross as a defendant, claiming that Touche Ross aided and abetted the security law violations. Plaintiff also asserted State law claims against Touche Ross. In September 1984, the district court granted the defendants' motion for summary judgment on the security law claims and the aiding and abetting claim. The court declined to exercise pendent jurisdiction over plaintiff's State law claims against Touche Ross, and dismissed those claims without prejudice. Plaintiff appealed the district court's decision, and the Seventh Circuit Court of Appeals affirmed. Congregation of Passion, Holy Cross Province v. Kidder Peabody & Co. (7th Cir. 1986), 800 F.2d 177.

After the adverse ruling in Federal district court, plaintiff filed the instant action in the circuit court of Cook County. Plaintiff's complaint consisted of three counts. The first count alleged that defendant was guilty of professional negligence in the manner in which the Newell investments were reported in plaintiff's financial statements. The second count alleged that defendant breached a fiduciary duty it owed to plaintiff by not properly investigating plaintiff's investments and by failing to take appropriate action after it learned of errors contained in the financial statements. The final count alleged that defendant breached its contract with plaintiff by failing to report certain investments in plaintiff's financial statements at market value.

Prior to trial, defendant presented motions to dismiss and for summary judgment. The motions alleged that plaintiff's claims were barred by collateral estoppel because of the findings in the prior Federal litigation, and that the negligence count of plaintiff's complaint was barred by the economic loss doctrine expressed in Moorman Manufacturing Co. v. National Tank Co. (1982), 91 Ill. 2d 69, 61 Ill. Dec. 746, 435 N.E.2d 443. The trial court denied these motions.

After plaintiff presented its evidence and rested its case, defendant moved for a directed verdict on all three counts of plaintiff's complaint. The circuit court denied defendant's motion as to each of the three counts.

At the close of all evidence, defendant renewed its motion for a directed verdict on all three counts of plaintiff's complaint. The circuit court denied the motion as to the negligence and breach of contract counts, but granted the motion as to the fiduciary duty count.

In its proofs and closing argument, plaintiff sought total damages in the amount of $3,819,352. The jury returned verdicts in favor of plaintiff for $3.9 million on the negligence count and $1.5 million on the breach of contract count. The jury found plaintiff not guilty of any contributory negligence. Because neither the $3.9 million nor the $1.5 million verdict accurately reflected damages sustained by plaintiff, the trial court ordered a remittitur to $3,819,352 on the negligence count and to $0 on the breach of contract count. Plaintiff agreed to the remittitur on the negligence count, but refused to consent to remittitur on the breach of contract count. The trial Judge entered what he called a "judgment of liability" on both counts and entered an award of damages in the amount of $3,819,352 on the negligence count only.

The appellate court affirmed the judgment of the trial court on the condition that plaintiff agree to a remittitur of the contract claim to $0. (224 Ill. App. 3d 559.) If plaintiff refused to consent to the remittitur, the case was to be remanded to the trial court on the question of damages. Plaintiff consented to the remittitur. We allowed defendant's petition for leave to appeal to this court. 134 Ill. 2d R. 315.

Defendant alleges here several points of error which it claims are grounds for reversal. First, defendant claims plaintiff was collaterally estopped from contesting issues that were necessary to the result in the parties' prior Federal litigation. Defendant claims that several findings of fact necessary to the result in the Federal litigation were inconsistent with defendant's liability in the present case.

Defendant further claims that the lower court judgment awarding damages for purely economic losses in tort is contrary to Moorman Manufacturing Co. v. National Tank Co. (1982), 91 Ill. 2d 69, 61 Ill. Dec. 746, 435 N.E.2d 443. Defendant further contends that the appellate court erred in applying the negligent misrepresentation exception to the economic loss doctrine in affirming the trial court.

Finally, defendant claims that the trial court erred in a number of pretrial and evidentiary rulings. Defendant also alleges that because the verdicts did not conform to the evidence, the trial court should have set aside the verdicts.

Plaintiff contends that the judgments below are correct and should be upheld. In the event, however, that this court should determine that further proceedings are required, plaintiff requests the following cross-relief: (1) that the breach of contract verdict be amended to allow full recovery on the contract count; (2) that plaintiff's consent to remittitur on the breach of contract count be rescinded; and (3) that the directed verdict entered in favor of defendant on plaintiff's breach of fiduciary duty count be reversed.

Discussion

I. Collateral Estoppel

In 1981, plaintiff brought suit in Federal district court against its former investment advisor, Cranford D. Newell, and several securities dealers alleging security law violations. Plaintiff later added Touche Ross as a defendant, alleging Touche Ross aided and abetted the security law violations. Plaintiff also alleged State law claims against Touche Ross. Defendants filed a motion for summary judgment, and the Federal district court granted the motion on the security law claims and the aiding and abetting claim. The court, however, declined to exercise pendant jurisdiction over plaintiff's State law claims, and dismissed those claims without prejudice. Plaintiff appealed the district court's grant of summary judgment on the security law claims and the aiding and abetting claim, and the United States Court of Appeals for the Seventh Circuit affirmed. Congregation of the Passion, Holy Cross Province v. Kidder Peabody & Co. (7th Cir. 1986), 800 F.2d 177.

Defendant argues that the doctrine of collateral estoppel precludes plaintiff from relitigating those issues decided in the Federal adjudication. Defendant alleges that plaintiff advanced contentions in the present case which directly contradicted the Federal court findings. Plaintiff, on the other hand, claims that those questions decided during the Federal adjudication are not relevant to the present case.

The appellate court believed that because no determination on the merits of the pendent State claims was made by the Federal court, collateral estoppel could not apply. We agree that collateral estoppel does not preclude plaintiff's claims here, but for reasons different from those advanced by the appellate court.

Three factors are necessary for the application of collateral estoppel: (1) the issue decided in the prior adjudication must be identical with the one presented in the case in question; (2) there must have been a final judgment on the merits; and (3) the party against whom the estoppel is asserted must be a party, or in privity with a party, to the prior adjudication. Ballweg v. City of Springfield (1986), 114 Ill. 2d 107, 113, 102 Ill. Dec. 360, 499 N.E.2d 1373.

While the Federal court's dismissal of plaintiff's State law claims against defendant was not a final judgment on the merits, collateral estoppel could apply to findings made by the Federal courts while ruling on the security law claims. Plaintiff was a party to the Federal litigation, and there was a final judgment on the merits regarding the security law claims. "Summary judgment * * * is the procedural equivalent of a trial and is an adjudication of the claim on the merits." ( Poulos v. Reda (1987), 165 Ill. App. 3d 793, 801, 117 Ill. Dec. 465, 520 N.E.2d 816.) Plaintiff, therefore, is precluded from relitigating any findings that were made during the Federal court's adjudication of the security law claims.

Defendant claims that the following findings of fact were made during the Federal adjudication: (1) Newell was plaintiff's agent; (2) Newell had total discretion to act as plaintiff's agent in executing arbitrage transactions; (3) Touche Ross made no misrepresentations to plaintiff; (4) plaintiff was fully aware of the Newell transactions and the type of risks they involved; (5) Newell acted within his authority; (6) plaintiff relied only on Newell and plaintiff's business advisory board in making investment decisions; (7) plaintiff was able to and did follow the Newell transactions; (8) plaintiff and defendant agreed to report the Newell investments on a cost, not market, basis; and (9) plaintiff was responsible for the losses incurred.

Several of the findings defendant relies on in its collateral estoppel claim are not relevant to plaintiff's theories of recovery here. Accordingly, these findings could have no effect on the judgment rendered in this case. That Newell was plaintiff's agent, that Newell had discretion to invest plaintiff's funds and acted within his authority, that plaintiff was aware of the risks involved in Newell's investments strategy, or that plaintiff relied only on Newell and its own business advisory board in making plaintiff's investment decisions have no bearing on whether defendant is liable to plaintiff for the manner in which defendant recorded the Newell investments in plaintiff's financial report.

We do not believe that the remaining points urged by defendant as findings were actually decided in the Federal adjudication. The doctrine of collateral estoppel applies only to controlling facts or questions material to the determination of both causes. ( Housing Authority v. Young Men's Christian Association (1984), 101 Ill. 2d 246, 252.) As we explain below, none of the remaining points were necessary to the Federal adjudication, and thus collateral estoppel cannot apply.

Whether plaintiff agreed with defendant to report Newell's investments at cost in plaintiff's financial reports was not necessary to the Federal adjudication. The Federal security law claims were based on alleged misrepresentations by Newell and the securities dealers. Defendant was accused of aiding and abetting the security law violations. Once the Federal court determined, however, that no misrepresentations were made by the securities dealers to plaintiff, communications between plaintiff and defendant became irrelevant to the Federal claim. The Federal courts found that defendant could not be guilty of aiding and abetting if no primary violation of the security laws had been established. Any agreement between the plaintiff and defendant, therefore, was not necessary to the Federal adjudication. For the same reason, any misrepresentations by defendant to plaintiff were not relevant to the Federal claims.

Defendant further alleges that the Federal courts found plaintiff was able to track the Newell investments. In its opinion, however, the Seventh Circuit stated that plaintiff's ability to track the Newell investments was not necessary to its decision. ( Congregation of the Passion, 800 F.2d at 182 n.4.) As we have stated, Housing Authority holds that collateral estoppel will not attach to this type of finding.

Regarding this point, the Dissenting Justice asserts the Federal district court found that plaintiff was able to "track" Newell's investments. The quotation contained in the Dissent appears in the transcript of the April 30, 1985, hearing at which the district court granted the securities dealers' motions for summary judgment on counterclaims they had brought against the Congregation to collect sums they were owed as a result of Newell's transactions. In opposition to the motions, the Congregation argued that Newell and the dealers had engaged in unauthorized transactions using funds lent by the dealers to Newell. The Judge rejected the Congregation's theory, determining that the Congregation was aware of' or could "track," each one of Newell's investments as it was made, that the funds invested by Newell belonged to the Congregation, and ...


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