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August 3, 2005.

JOHNSON BANK, Plaintiff,

The opinion of the court was delivered by: REBECCA PALLMEYER, District Judge


Plaintiff Johnson Bank (the "Bank") filed suit against Defendant George Korbakes & Co., LLP ("GKCO") alleging claims for breach of contract and negligent misrepresentation*fn1 in connection with GKCO's year-end 1998 audit of Brandon Apparel Group, Inc. ("Brandon"). The Bank, which had already loaned Brandon some $10 million, claims that it extended additional credit to Brandon in reliance on the Audit, and that it suffered resulting damages when Brandon's business failed a short time later. The Bank contends that if GKCO had prepared an accurate financial statement it would not have made additional loans to Brandon and would have called in the loans sooner such that the Bank would have collected a much larger portion of the sums Brandon owed. The court held a bench trial to resolve the matter. For the reasons explained below, the court concludes that, even if the Bank can show the GKCO Audit was flawed in certain respects, it has not met its burden of establishing that it reasonably relied on the Audit in extending credit to Brandon. Nor has the Bank presented evidence from which the court could determine the damages, if any, suffered by the Bank. As a result, the court enters judgment in favor of Defendant GKCO. BACKGROUND

The Bank is a state banking association, chartered pursuant to Chapter 221 of the Wisconsin Statutes. The Bank maintains its principal place of business in Racine, Wisconsin. (UF ¶ 1.)*fn2 GKCO is a limited liability partnership with its principal place of business in Burr Ridge, Illinois. GKCO's two partners, George P. Korbakes and Barry L. Gershinzon, both reside and work in Illinois. The court has diversity jurisdiction over the parties' dispute pursuant to 28 U.S.C. § 1332(a). (Id. ¶¶ 2, 3.)

  A. The Bank's Relationship with Brandon

  Brandon was a company engaged in the manufacture, distribution, and sale of children's and adults' casual apparel throughout the United States. (Id. ¶ 4.) Brandon had licensing agreements with a number of colleges and universities, as well as sports organizations including Major League Baseball ("MLB"), the National Football League ("NFL"), and the National Basketball Association ("NBA"). (Tr. 122.)

  On May 12, 1997, Brandon entered into a borrowing relationship with the Bank. Specifically, Brandon received a $5 million term loan and a $4 million revolving line of credit ("LOC#1"), both personally guaranteed by Brandon's two owners, President Bradley A. Keywell and Secretary Eric P. Lefkofsky.*fn3 (UF ¶¶ 5, 6, 8, 9, 13.) In connection with the term loan, Brandon signed a Term Loan Agreement, a Term Note, a Real Estate Mortgage Security Agreement and Fixture Filing (with Assignment of Rents), and a Security Agreement — Term Loan, agreeing to repay the loan in monthly installments of $80,445.29 due on the first day of each month, with the full balance due by June 1, 2004. (Id. ¶ 5; Exs. 1-4.) In connection with LOC#1, Brandon signed a Revolving Credit Loan Agreement, a Revolving Credit Note, and a Security Agreement — Revolving Credit Loan. LOC#1 allowed Brandon to borrow up to $4 million subject to a "Borrowing Base," defined as 80% of eligible accounts receivable, plus 50% of eligible inventory. The Agreement defined "eligible accounts" as accounts receivable that were not more than 90 days past due. (Tr. 717 (Wolfe); Revolving Credit Loan Agreement of 5/12/97, Ex. 6, at 8.) For purposes of the "eligible inventory" component, the Bank would only lend Brandon up to 50% of the value of its raw material and 50% of the value of finished inventory, both on a first-in, first-out ("FIFO") basis. (Tr. 718 (Wolfe); Exs. 6, 16.) Eligible inventory was initially capped at $1.5 million, but the cap was later raised to $3.5 million;*fn4 that is, the Bank would not loan money to Brandon under the line of credit in an amount that exceeded the eligible inventory cap. (UF ¶ 6; Revolving Credit Loan Agreement of 5/12/97, Ex. 6; Tr. 624-25, 718-20; Exs. 7-9.)

  By May 16, 1997, the Bank had extended to Brandon the full $5 million value of the term loan. (Tr. 720-21; Ex. 5.) In late 1997 or early 1998, Brandon requested that the Bank provide it with additional credit for working capital purposes. The Bank agreed and, in March 1998, established a third credit facility with Brandon, consisting of a $2 million revolving line of credit ("LOC#2"). LOC#2 was subject to the same Borrowing Base as LOC#1. (UF ¶ 7.) In connection with the two revolving lines of credit, Brandon was required to furnish the Bank with monthly statements — called "borrower's certificates" — setting forth the eligible inventory and accounts receivable. The borrower's certificates were prepared without input from GKCO and had to be certified by Brandon's chief financial officer or president as being true, correct, and complete. (Id. ¶ 33; Tr. 952.) With only a few exceptions, Brandon did submit the required monthly borrower's certificates between June 1997 and September 1999.*fn5 (Ex. 16.) As of December 31, 1998, Brandon's debt to the Bank totaled $9,354,093, consisting of $4,175,675 due on the term loan; $4 million due on LOC#1; and $1,178,418 due on LOC#2. At that time, the term loan was due to mature in June 2004; LOC#1 was due to mature on May 1, 1999; and LOC#2 was due to mature in March 1999. (Id. ¶¶ 12, 13.)

  By the end of 1998, the Bank had determined that Brandon was no longer a good credit risk and decided that it wanted to transfer Brandon's loans out of the Bank. By early 1999, the Bank had told Brandon's owners to look for other sources of financing. (Tr. 902-03, 905-06 (Wolfe).) Nevertheless, in January 1999, Thomas Wolfe, Senior Vice President of the Bank, and others working at his direction, prepared a loan presentation to the Bank's loan committee requesting approval to renew LOC#1 and LOC#2, and to increase the total line of credit from $6 million to $6.5 million. The Bank approved the request in late January 1999. (UF ¶ 16; Tr. 881-82; Ex. 13, Loan Presentation of 1/26/99.) When LOC#2 matured in March 1999, moreover, the Bank renewed the loan for 30 days until May 1, 1999. (Tr. 906-07.) In addition, during 1998 and part of 1999, the Bank extended still more credit to Brandon by issuing letters of credit. (UF ¶ 15.) As of April 30, 1999, Brandon's outstanding debt due to the Bank (excluding letters of credit and overdrafts) was greater than $9,900,000. Brandon also had a $40,000 negative balance in its checking account at the Bank, and the Bank had issued a letter of credit on Brandon's behalf with an exposure of approximately $51,000. It is undisputed that the Bank's total exposure to Brandon as of April 30, 1999 was approximately $10 million. (Id. ¶ 17.) B. The GKCO Audit

  In December 1998, Brandon engaged GKCO to perform an audit for the year ending December 31, 1998. (Id. ¶ 18.) The engagement letter, dated December 1, 1998, did not reference the Bank in any way, but did indicate that GKCO was expected to perform the audit in conformance with generally accepted auditing standards ("GAAS"). (Id. ¶ 38; Letter from GKCO to Brandon of 12/1/98, Ex. 57A, at GK0084-85.) GKCO performed field work for the audit during the first quarter of 1999, including an inventory count conducted on January 8, 1999. (Id. ¶¶ 18, 46.)

  1. The Bank Waives Financial Covenant Violations

  During the course of the audit, GKCO determined that Brandon was in violation of certain financial covenants associated with the term loan and the two revolving lines of credit. (Tr. 72.) One of those covenants required that Brandon have a consolidated tangible net worth in an amount no less than $1,500,000 (the "net worth covenant").*fn6 A second financial covenant required Brandon to maintain a debt-to-tangible-net-worth ratio not greater than 3.5 to 1.0 (the "net worth ratio covenant"). A third financial covenant required Brandon to have a ratio of assets to liabilities of not less than 1.5 to 1.0 (the "current ratio covenant"). (UF ¶¶ 19, 40, 42; Ex. 6.) As of December 31, 1998, Brandon's consolidated tangible net worth was only $1,078,784, some $400,000 less than the minimum required. In addition, Brandon's net worth ratio was 10.33 to 1, well above the required 3.5 to 1. (Tr. 748-50.) Barry Gershinzon of GKCO informed Brandon of these covenant violations and indicated that GKCO would have to include a "going concern" qualification in its audit report unless the Bank agreed to waive the violations.*fn7 (Tr. 72, 230; Memorandum from B. Keywell to T. Wolfe of 4/28/99, Ex. 57A, at GK0087.)

  On April 14, 1999, Eric Lefkofsky of Brandon sent Thomas Wolfe at the Bank a copy of GKCO's audit work papers, which were still in the process of being translated into a final audit report. (Memo from E. Lefkofsky to T. Wolfe of 4/14/99, Ex. 17.) Sometime between April 14 and 29, 1999, Wolfe had a conference call with Gershinzon of GKCO, Lefkofsky, and Keywell. (Tr. 543-44 (Wolfe).) The men discussed a reclassification of accounts receivable to prepaid expenses in the amount of $653,857. (Tr. 544-46.) Wolfe claims that he was assured by either Lefkofsky or Gershinzon that the reclassification was appropriate. (Tr. 545.)

  The three men also discussed the treatment of a $1 million promissory note held by Pearson. Brandon's current owners (Keywell and Lefkofsky) had purchased the assets of Brandon from Pearson Properties, Ltd. and its two owners, Clyde Pearson and Helenann Pearson, (collectively "Pearson"), in August 1994.*fn8 Brandon Apparel Group, Inc. v. Pearson Properties, Ltd., 221 Wis.2d 597, 586 N.W.2d 699 (Wis.Ct.App. 1998). At the time of the Audit, Brandon and its owners were involved in a lawsuit charging Pearson with having sold defective manufacturing equipment. Id. Pearson, in turn, had filed a counterclaim alleging that Brandon still owed $1 million on the purchase price. (Tr. 1217.) See Brandon Apparel Group, Inc. v. Pearson Properties, Ltd., 247 Wis.2d 521, 634 N.W.2d 544 (Wis.Ct.App. 2001). GKCO's work papers treated Brandon's claim against Pearson as a "contra liability," meaning it functioned as an offset against liability.*fn9 Wolfe testified that when he asked Gershinzon and Lefkofsky about the contra liability, Lefkofsky explained that Brandon was confident that it would prevail in its lawsuit against Pearson and, thus, decided to reclassify the debt as an asset. (Tr. 546-47.) Wolfe did acknowledge, however, his understanding that if Brandon lost the Pearson lawsuit, the $1 million contra liability would be eliminated. (Tr. 549.)

  On April 28, 1999, Brad Keywell sent a written memorandum to Wolfe at the Bank requesting that the Bank waive the financial covenant violations (i.e., the net worth covenant, the net worth ratio covenant, and the current ratio covenant) as of December 31, 1998. (UF ¶¶ 20, 44; Memorandum from B. Keywell to T. Wolfe of 4/28/99, Ex. 18.) The Bank agreed to waive the violations, as reflected in an April 29, 1999 letter to Keywell from Wolfe. (Id. ¶¶ 21, 45; Letter from Wolfe to Keywell of 4/29/99, Exs. 18, 224.)

  2. The Audit Report

  Also on April 29, 1999, GKCO issued its audit report (the "Audit") and sent a copy to Wolfe at the Bank, which he received during the first week of May 1999. (Id. ¶ 18.) The Audit stated that "[t]he financial statements referred to above present fairly, in all material respects, the financial position of Brandon Apparel Group, Inc. as of December 31, 1998, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles." (Id. ¶ 39.)

  In light of the Bank's agreement to waive Brandon's financial covenant violations, the Audit did not include a going concern qualification. (Id. ¶ 41.) It did, however, include a variety of determinations that, in the Bank's view, violated Generally Accepted Accounting Principles ("GAAP"), Generally Accepted Auditing Standards ("GAAS"), and the opinions of the Financial Accounting Standards Board (the "FASB").*fn10

  a. Contra Liability

  As noted, the Audit treated Brandon's $1 million debt to Pearson as a "contra liability" account, stating in Note 4 that:
The Company is currently a Plaintiff in a lawsuit against Pearson Properties, Ltd. (f/k/a Brandon, Inc.), wherein they allege that Pearson Properties, Ltd. misrepresented the value of the assets sold and liabilities assumed in the acquisition of the business. Although the lawsuit is in excess of $1,000,000 due to damages, the Company has limited its recognition of the contra liability to the amount of the note payable to Pearson Properties, Ltd. Should the Company not prevail in the lawsuit, the $1,000,000 will be reclassified to goodwill, representing an additional amount paid at acquisition in excess of the fair market value of the assets acquired.
(Audit of 12/31/98, Ex. 57A, at GK0078; Tr. 66.)

  According to the Bank's accounting expert, Professor Larry E. Rittenberg of the University of Wisconsin, characterizing a debt as a contra liability has the effect of "essentially saying that the liability no longer exists," which in turn causes an increase in a company's retained earnings. (Tr. 25-26, 65.) Professor Rittenberg explained that with respect to the $1 million promissory note owed to Pearson, "you are decreasing liabilities in this case by a million dollars and you are increasing equity, in this case retained earnings, by a million dollars." (Tr. 65-66.) The flaw in such an approach, Professor Rittenberg stated, is that the claim against Pearson should have been treated as a "gain contingency," which is "an existing condition, situation, or set of circumstances involving varying degrees of uncertainty that may, through one or more related future events, result in the acquisition or loss of an asset or the incurrence or avoidance of a liability."*fn11 Morrison v. Mahaska Bottling Co., 39 F.3d 839, 846 (8th Cir. 1994) (quoting Miller Comprehensive GAAP Guide, at 7.01 (1993)). According to Professor Rittenberg, the Audit thus "recognize[d] an anticipation of an accounting gain" in violation of FASB No. 5, which requires that "gain contingencies are not to be recognized until they are realized." (Tr. 66-67.)

  Professor Rittenberg believes that this improper treatment made Brandon "look much healthier than it would have looked had not this gain been recognized on the financial statements." (Tr. 68.) Specifically, it allowed Brandon to increase stockholders' equity by $1 million and increase retained earnings by $1 million; it kept Brandon's debt-to-equity ratio within the 3.5 to 1 range required by the financial covenants under the loan documents; and it allowed Brandon to state a tangible net worth in excess of the $1,500,000 required by the loan documents. (Tr. 68, 71-72, 79-80.) In Professor Rittenberg's view, if the Audit had treated the promissory note as a gain contingency, then Brandon's debt-to-equity ratio would have been as high as 36 to 1, and its consolidated tangible net worth would have been as low as $696,000, both in violation of the financial covenants. (Tr. 71-72, 79-80.)

  GKCO points out that the Audit expressly disclosed that the contra liability was recorded to offset the $1 million note obligation to Pearson, and that the Bank understood that the indebtedness reflected in that note was subordinate to the Bank. (Audit of 12/31/98, Ex. 57A, at GK0078; Tr. 973 (Wolfe).) Specifically, in addition to Note 4 above, the Audit disclosed in Note 10, entitled "Debt," that:
The Pearson Note, which is subordinate to the Bank and SBA debt, matures in August, 2004 and requires monthly interest at prime plus 3%, with a minimum rate of 10%. This Note is subordinate to the bank and SBA loans. As discussed in Note 4, the Company has recorded a $1,000,000 contra liability against this loan. There is no security on the Pearson note, however default on payment allows the holder to exercise an option to convert the note to equity.
(Audit of 12/31/98, Ex. 57A, at GK0080.) GKCO claims that it properly recorded "an offset which Brandon had taken against the Pearson note, with adequate disclosure that Pearson disputed the offset and was suing Brandon for the sums due on the $1 Million note obligation." (Def. Mem. at 26 ¶ 94.)*fn12 Wolfe testified that though he thought the contra liability was "unusual," he never asked for an explanation and understood that it did not reflect an asset on Brandon's account. (Tr. 968-69, 971-72.)

  b. Midwest Cadre Contract

  Brandon had a contractual relationship with Midwest Cadre ("Midwest") that allowed Midwest to produce and sell adult wear using Brandon's licenses*fn13 under Brandon's name. Brandon licensed to Midwest the production, sales, design, and distribution of a second line of Brandon adult wear, and in return, Midwest agreed to report all sales of this second line and remit 17.5% of its net sales to Brandon. (Tr. 82-84, 1047.) Brandon was obligated to make royalty payments to its licensees on sales made by Midwest. (Tr. 786-87 (Wolfe).)

  Professor Rittenberg observed that under this Brandon/Midwest contract, Brandon was "not at risk in selling any of these products." (Tr. 82.) The Audit nevertheless treated the 17.5% of net sales remitted by Midwest as revenue-producing activity. In Professor Rittenberg's view, this allowed Brandon to recognize $7,320,000 in sales that it had no activity in producing or selling in fiscal year 1998. Brandon's gross sales were thus recorded as approximately $19,000,000, which reflected a substantial (12%) increase from the approximately $17,000,000 in gross sales recorded for fiscal year 1997. (Tr. 83, 85-88.) If the Audit had recognized Midwest's 17.5% of net sales as Rittenberg deemed appropriate, the statement would have reflected a material decline in Brandon's sales and revenues, as well as an increase in goods returned to Brandon from 1997 to 1998. (Tr. 87-91.)

  GKCO again notes that the Audit did fully disclose that $7,320,000 of the gross sales figure came from Midwest. Note 1 of the Audit specifically states:
The Company uses a subcontractor to produce, sell and distribute its line of adult product. Under this arrangement, the subcontractor reports the sales to the Company and remits the proceeds net of the agreed upon cost. In 1998 sales of adult product amounted to approximately $7,320,000.
(Audit of 12/31/98, Ex. 57A, at GK0077.) Indeed, Wolfe testified that he understood that $7,320,000 of Brandon's gross sales came from Midwest. (Tr. 930-32.)

  c. Inventory Calculations

  Professor Rittenberg takes issue with several of GKCO's calculations relating to Brandon's inventory. First, he argues that the Audit improperly includes an overhead allocation of $1.9 million in Brandon's selling costs, and treats 75% of Brandon's selling costs as "inventoriable costs." (Tr. 100-01.) Inventoriable costs are the costs of developing merchandise and getting it into position for sale (i.e., production costs). (UF ¶ 43.) Inventoriable costs include the costs of purchasing raw materials, the freight to bring the materials to the plant, the labor, and specific manufacturing overhead costs. (Tr. 97-98 (Rittenberg).) "Selling costs," on the other hand, are generally considered to be the costs of operating a business, such as accounting costs, administrative expenses, and the costs of actually selling the product. (Tr. 98-99.) In Professor Rittenberg's view, the Audit's improper allocations of inventoriable and selling costs resulted in an overstatement of Brandon's inventory and net income. (Tr. 102-03.) If the Audit had properly ...

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