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10/15/96 SK HAND TOOL CORPORATION AND CORCORAN

October 15, 1996

SK HAND TOOL CORPORATION AND CORCORAN PARTNERS, LTD., PLAINTIFFS-APPELLEES, CROSS-APPELLANTS,
v.
DRESSER INDUSTRIES, INC., DEFENDANT-APPELLANT, CROSS-APPELLEE.



APPEAL FROM THE CIRCUIT COURT OF COOK COUNTY. HONORABLE MARTIN C. ASHMAN, JUDGE PRESIDING.

Presiding Justice Campbell delivered the opinion of the court: Theis, concurs. Buckley, dissents.

The opinion of the court was delivered by: Campbell

PRESIDING JUSTICE CAMPBELL delivered the opinion of the court:

Plaintiffs SK Hand Tool Corporation ("SK") and Corcoran Partners Limited ("Partners") sued defendant Dresser Industries, Inc. ("Dresser") for fraud in connection with the Partners' purchase of Dresser's hand tool division. Following a trial in the circuit court of Cook County, the jury returned a verdict for plaintiffs in the amount of four million dollars in compensatory damages and 50 million dollars in punitive damages. The trial court denied Dresser's post-trial motion, but granted a remittitur totalling 42 million dollars of the punitive damages. Plaintiffs consented to the remittitur. Both sides now appeal.

The record on appeal indicates that Daniel Czuba and Thomas Corcoran formed Partners in 1982 to acquire and turn around troubled companies. The Partners first sought to buy Dresser's hand tool division.

Dresser CEO Jack Murphy wanted the sale to close before the end of the fiscal year on October 31, 1983. The parties signed a letter of intent on August 16, 1983 and began negotiating a definitive agreement. Murphy would not sell to the Partners on credit. According to Rex Sebastian, a former Senior Vice President of Dresser, Murphy also wanted to ensure that the loss to Dresser would not exceed $1,000,000.

The sale was closed by a Purchase Agreement ("Agreement") signed on October 26, 1983. The purchase was a leveraged buy-out wherein the Partners put up $100,000 cash, pledged their personal assets and borrowed approximately $7.8 million to purchase the business. The estimated sale price was discounted by ten million dollars from book value, reflecting the poor performance and contingent liabilities of the business. The Partners' interest was assigned to SK, a wholly-owned subsidiary of the Partners.

Paragraph 3.2 of the Agreement provided that Dresser warranted an "Effective Date Balance Sheet," prepared from the books of account of the handtool division in accordance with the accounting principles, practices and procedures consistently applied by Dresser with respect to the handtool division. The Effective Date Balance Sheet was to fairly present in all material respects the asset values and liabilities for the items reflected thereon as of the effective date.

Paragraph 2.4 of the Agreement provided that Dresser would have 45 days from the closing date to submit the Effective Date Balance Sheet to the buyer. Paragraph 2.4 also provided that in the event of any disagreement with the balance sheet within 60 days after receipt thereof, the parties would make a good-faith attempt to resolve their differences, with any such resolution becoming final and binding. If the parties were unable to resolve their differences within 30 days of Dresser's receipt of notice from the buyer, the parties would appoint a nationally recognized accounting firm to arbitrate the dispute.

In December 1983, Dresser submitted the Effective Date Balance Sheet, showing that SK owed an additional $28,000 for the purchase of the handtool division. SK submitted the Effective Date Balance Sheet to the accounting firm of Peat, Marwick & Mitchell, which itemized $3.5 million in possible offsets SK might have against Dresser's calculation of the purchase price. SK submitted the list to Dresser, which disputed some of the claimed offsets. In March 1984, the parties unsuccessfully tried to settle their differences. Peat, Marwick & Mitchell later revised its list to $2.5 million in possible offsets. However, disagreements between the parties remained.

On April 25, 1984, the plaintiffs filed a complaint to compel arbitration in the circuit court of Cook County. Dresser filed a petition for removal in the United States District Court for the Northern District of Illinois. Dresser also filed a three-count countercomplaint for sums Dresser allegedly advanced to SK to meet certain payroll obligations after the purchase. The plaintiffs later added counts alleging common law fraud and violation of the federal racketeering statutes to its complaint in federal court. On December 17, 1984, the district court ordered Dresser to submit the claims relating to the calculation of the Effective Date Balance Sheet to arbitration; Dresser's counterclaims were not submitted for arbitration.

On July 25, 1985, the arbitrator awarded the Partners/SK a $1,386,000 reduction in the purchase price. In late 1985, SK was sold to a French entity named Facom. Corcoran and Czuba each made over two million dollars on the sale.

On January 29, 1987, the racketeering count was dismissed. On July 29, 1987, the federal district court granted judgment on the arbitration award to the Partners/SK and to Dresser on all three counts of its countercomplaint. On August 19, 1987, SK and Dresser executed releases in satisfaction of judgment in the amount of $1,357,848.18 and interest and $1,456,121.83 and interest, respectively. In sum, the Partners/SK owed Dresser approximately $98,000. The trial court granted Dresser's motion to dismiss the common law fraud claim for lack of jurisdiction.

Plaintiffs then filed a complaint against Dresser in the circuit court of Cook County on January 27, 1988. The complaint, later amended, alleged that officers and agents of Dresser misrepresented the value of the handtool division's assets and liabilities. In particular, the plaintiffs claimed that William Downey, President of the Dresser Tool Group, told them that the dollar value of "lifts" *fn1 to which the handtool division was committed was "practically nothing." Plaintiffs also alleged that Dresser Tool Group Comptroller John Macaulay falsely told them that the handtool division's accounting practices differed from generally accepted accounting principles ("GAAP") only with respect to intracompany transfers. Plaintiffs also alleged that Macaulay falsely represented that Dresser's figure for obsolete inventory would be "proper," when Dresser had removed items from the list of obsolete inventory that allegedly should have been included. The complaint further alleged that George Fansmith, the comptroller for the handtool division, represented that a liability for cooperative advertising had been accrued, but the liability was allegedly not reflected in Dresser's balance sheets, thereby inflating the purchase price. Finally, the complaint alleged that Dresser's representation that the balance sheet would fairly present the asset values and liabilities for the items reflected thereon was false.

Plaintiffs alleged that they relied on these statements, but after learning of their falsity were forced to curtail marketing expenditures, resulting in lost sales and profits and a lower resale price.

At trial, Daniel Czuba testified that after the Partners signed the letter of intent, he and Corcoran and outside advisors investigated the business. Czuba testified that in late August 1983, he discussed the handtool division's income statement and the balance sheet with comptroller Fansmith. Czuba testified that he asked Fansmith what was included in the accrued liabilities, and that Fansmith replied "just the ordinary things, coop and taxes and all sorts of things that you would expect to find in an accrual account." Czuba asked whether there was anything abnormal in the way Dresser kept the books; Fansmith replied that they "just use conventional accounting." Czuba testified that he then thought he understood how Dresser would have accounted for lifts.

Czuba also testified that he later made several requests to Fansmith for a breakdown of other accrued liabilities, but was told that a complete breakdown could not be supplied. Czuba testified that he did not recall ever asking anybody "flat-out" whether they made accruals for lift expenditures.

Czuba testified about other efforts to determine the amount of lifts that were authorized but had not "come home to roost." Czuba stated that he asked Russ Kennedy, the Vice President of Marketing for the division, about lifts. Kennedy said that he did not know and told Czuba to see Bill Downey, President of the Dresser Tool Group, as the final authority on lifts.

Czuba testified that in mid-September of 1983, he and Corcoran asked Downey how many dollars of lifts were in process or in transit or outstanding. Downey replied "at that point practically nothing, less than $200,000, and it doesn't matter anyway because they'll all be flushed through prior to September 30th." Corcoran testified that he and Czuba asked Downey about the status of "lifts in transit" and were told that they would be flushed through by September 30th.

Downey testified that he told Corcoran and Czuba that as of the end of July -- the last time he had approved lifts -- the amount was near one million dollars. However, Downey testified that he did not believe that it was correct to say that there was over one million dollars of lifts in transit.

Downey testified that he did not tell Corcoran and Czuba how the division accounted for lifts; rather, he told them that if they wanted the specific exposure, they should ask the handtool division. Downey admitted that at the time he spoke to Corcoran and Czuba, he knew that the lift exposure was not reflected in the financial statement. Downey also admitted that he knew that lifts might not be expensed for more than two months after the account receivable was booked.

Czuba testified that he had requested a list of excess and obsolete inventory -- items that are discontinued or faulty in some way. Czuba testified that his request was referred to Macaulay, who reviewed a list that had been prepared, but decided not to provide a copy to the plaintiffs. Macaulay stated that a list would be prepared consistent with Dresser's policies, that he did not want to haggle over "nits and gnats," and that the plaintiffs would have a chance to go over it after the deal closed, make complaints and get adjustments, if needed.

Czuba later testified that Macaulay prepared a list of the inventory, categorizing it as excess, surplus and so on. Czuba testified that Macaulay later departed from Dresser's policies for categorizing inventory by adding several obsolete items to the list of good inventory. One example involved a "pawl," which is part of a ratchet. According to Czuba, the pawl had been made of metal which lasted 20 years, but had been changed to being made out of compressed metal powder, which lasted only two years on average. Before the Partners purchased the business, the handtool division discovered the problem and returned to the metal pawls. Czuba stated that the Partners were charged approximately $35,000 for the compressed metal powder pawls.

On October 4, 1983, Corcoran and Czuba met with Downey, Macaulay, and former handtool division President John Reynertson. The parties, accompanied by counsel, discussed Dresser's representations and warranties regarding its financial statements. The Partners had asked Dresser to represent that the financial statements were prepared in accordance with generally accepted accounting principles ("GAAP"). Macaulay made a flat statement that the division statements do not conform with GAAP. Czuba asked him in what way they did not conform. Macaulay said "well, for example, in the way we account for intercompany [sic] transactions." Czuba asked if there were other examples. According to Czuba, Macaulay replied "none that I can think of right now." The Partners proposed a representation that the statements were prepared in conformance with GAAP except for intercompany transactions. Dresser rejected that proposal. Nevertheless, Corcoran testified that he believed that Dresser's intercompany transfers were the only deviation from GAAP.

Thomas Hunter, one of Dresser's counsels at the meeting, testified that he had said that he did not believe anyone at Dresser knew whether the handtool division's accounting practices complied with GAAP. Macaulay testified that he was not sure whether he knew how the handtool division accounted for lifts on October 4, 1983. ...


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