Opinion ID: 757306
Heading Depth: 3
Heading Rank: 1

Heading: LHLP Investment Proposal

Text: 7 In late July 1989, James Beck approached Edward Williams about investing in the LHLP package that had been offered to the over 100 other potential investors. Beck also mentioned the possibility of the Pension Fund further investing in between ten and twenty hotels currently owned by insurance companies that needed asbestos abatement work. In a memorandum dated August 4, 1989, Edward Williams brought both investment possibilities to Chairman Carlough's attention and added that his initial thought was to find[ ] a way to joint venture the hotels with their existing owners, get Cahill in the hotels as the operator/manager, have Beck help structure the transaction, and [our union] will do all the abatement and renovation work. (J.A. 1680). Edward Williams knew that Chairman Carlough wanted the union to perform asbestos abatement work and wanted the Pension Fund to invest in companies that performed such work. On August 10, 1989, Chairman Carlough replied by letter to Edward Williams' memorandum of August 4, 1989, stating that the first proposal did not excite him but that the second one, the one involving asbestos removal, looks like something we ought to assiduously pursue. (J.A. 1357). 8 On August 8, 1989, James Beck wrote Edward Williams, combining the two investment proposals. According to James Beck, the idea to put together an operating partnership where you would supply the capital and the expertise to remove the asbestos and we would negotiate for the purchase of the properties, market and manage the facilities makes an enormous amount of sense. (J.A. 1681). James Beck proposed that the Pension Fund invest $20 million in LHLP to create the vehicle by which additional properties could be acquired and operated. Id. On August 21, 1989, Edward Williams informed Chairman Carlough that he was extremely excited about the possibilities the [revised] hotel deal offer[ed] and recommended that the Pension Fund proceed with due diligence on this investment as soon as possible. (J.A. 1688-89). 9 In October 1989, Edward Williams assembled a due diligence team to evaluate the revised LHLP investment proposal, consisting of himself, outside legal counsel (the law firm of Rogovin, Huge, and Schiller), an engineer knowledgeable in financial matters (Rick Mandrell), a real estate consultant (Oakleigh Thorne), and an environmental consultant (Mitchell DeCuir). While the due diligence team was investigating the revised LHLP investment proposal, James Beck met with Edward Williams on October 24, 1989, at which time they discussed a structure that would take the 21 Hotel transactions and add at least another 10 hotels or more by raising enough equity from other pension funds to increase the total pool as well as set in motion a business plan that would allow for the acquisition of several new hotels a year. (J.A. 1713). James Beck proposed that Edward Williams, with Charles Underbrink's assistance, establish an entity named the Ed Williams Group. Under the auspices of this entity, Edward Williams would provide due diligence reports to other pension funds on investments that James Beck would propose and receive certain fees for that conduct. LPI would receive fees for putting the deal together and maintaining the newly formed partnership. In accord with James Beck's proposal, Edward Williams subsequently formed the Ed Williams Group. Edward Williams and James Beck then conducted the business arrangement as proposed by James Beck in November 1991 with the Ed Williams Group receiving over $800,000 in fees between October 1990 and November 1991. 10 Once assembled, the due diligence team requested appraisals of the twenty-one hotels. In response to this request, LPI hired American Appraisal Associates (AAA) to perform desk top appraisals of the twenty-one hotels. AAA had previously appraised the hotels in 1987 and 1988. From the beginning, AAA and LPI agreed that in preparing the appraisals AAA would rely on financial data and market survey results provided by Larken, Inc.'s representatives and LPI without verifying that information. 11 AAA completed the appraisals of nine of the twenty-one hotels in mid-November 1989, and the remaining twelve hotels in late November 1989. On several occasions during this period of time, James Berman, an employee of LPI, met with Lawrence Nicholson in an attempt to secure favorable appraisals of the twenty-one hotels. Specifically, James Berman concentrated on AAA's cash flow projections for each hotel. When favorable to his position, James Berman used Larken, Inc.'s internal operating budgets to argue that AAA had underestimated the cash flow of certain hotels. Conversely, James Berman did not bring to Nicholson's attention instances where Larken, Inc.'s internal operating budgets were lower than AAA's projected cash flow. As a result of James Berman's meetings with Lawrence Nicholson, AAA increased the appraised values of fourteen of the hotels by a total of over $14 million. AAA subsequently sent its final appraisals of the twenty-one hotels to the due diligence team, which questioned whether AAA's projections of net operating income were realistic. In this regard, Edward Williams asked James Beck to explain why net operating income appeared to be flat historically, but was projected to increase in 1994. In response to this conversation, James Beck sent a letter to Edward Williams on December 8, 1989, in which he misrepresented that the forecasts for 1990 and after are not our forecasts, but were generated by American Appraisal Associates based on their independent analysis of each of the 21 hotels. (J.A. 1031). 12 The due diligence team included the AAA appraisals as part of its December 1989 report to the Former Trustees, known as the Thorne Report, specifically commenting that the team accepted the projections submitted by AAA as being probable with certain minor exceptions at three hotels. (J.A. 1562). The report also stated that: 13 We also investigated and asked for explanations of those projections illustrating a significant variance from historic actual performance. Members of the Larken group and AAA have been responsive to our questions and pointed to circumstances in the market that logically explain these changes in house profits. 14 (J.A. 1562-63). 15 When the LHLP investment proposal was presented to the Former Trustees on December 12, 1989, Former Trustee Richard Dominico questioned the prudence of investing in hotels, especially these twenty-one hotels because of their age and locations. As a result of Former Trustee Dominico's opposition, the Former Trustees directed Pension Fund General Counsel Raymond Sweeney to retain a firm with experience in the hospitality industry for the purpose of reviewing the underlying assumptions upon which the proposed transaction is based and providing the [Former] Trustees with a written report regarding the reasonableness of those assumptions. (J.A. 1535). Raymond Sweeney in turn hired Arthur Andersen & Co., Inc., specifically its consulting arm in the field of hospitality (Arthur Andersen), to perform the review and forwarded to Arthur Andersen the Thorne Report, the AAA appraisals, historical information from Larken, Inc. and LPI, and internal memoranda from Larken, Inc. 16 Following its review of a package of LHLP investment materials provided by the due diligence team, on December 20, 1989, Arthur Andersen participated in a telephone conference with some of the due diligence team members. During that conversation, Arthur Andersen opined that the LHLP investment proposal was so risky the Pension Fund would be wasting its money by spending any additional time reviewing the package. Arthur Andersen explained that the twenty-one hotels were not investment-grade properties--they [we]re old [h]otels with short remaining economic lives and high risks. (J.A. 598). Moreover, Arthur Andersen stated that [t]here is little likelihood that the value of these [h]otels will increase over the next five years, and a high likelihood that the values will decline in the future. Id. Finally, Arthur Andersen emphasized that the appraisals were deficient in that they did not contain any rationale for their projections of growth in hotel demand, their projections of improvement in the twenty-one hotels' share of the market, or their projections of net operating income. 17 Despite Arthur Andersen's extremely negative oral report, the due diligence team requested Arthur Andersen to conduct further review of the package and submit a written report. On December 26, 1989, Arthur Andersen submitted a draft report to Raymond Sweeney who in turn gave it to Chairman Carlough. Although the report stated that it did not give an opinion concerning the advisability of investing in LHLP, it raised grave concerns about the propriety of the investment. For example, Arthur Andersen questioned whether the amount of expenditures spent during the past five years on refurbishment of the hotels was adequate and whether any significant maintenance had been deferred. In this regard, Arthur Andersen reported that: 18 The average age of the [h]otels is 23 years. The [h]otels, because of their age, are becoming physically obsolete and may require substantial ongoing renovation to retain their market positions. [H]otels this old require substantial maintenance and replacement of plumbing, HVAC systems, roofs, parking lots and walkways. Further, old Holiday Inns and other mid-market full-service franchise properties are very vulnerable to competition from new budget motels and all-suite properties which may provide better value to the guest. 19 (J.A. 1586). For a second example, Arthur Andersen questioned the basis for AAA's projected increases in occupancy rates and the attendant increases in net operating income, given the fact that no increases in the primary competitive supply of lodging accommodations were projected beyond 1990 and the historical net operating income levels of the properties had been flat for the past five years. For a third example, Arthur Andersen opined that [t]here was nothing presented in the material which we reviewed which would indicate how the projected increases in net operating income will be obtained. (J.A. 1591). 20 In response to Arthur Andersen's report, Oakleigh Thorne, as a member of the due diligence team, assured Arthur Andersen by letter on January 9, 1990 as to the independent nature of AAA's appraisals, specifically noting that the increases were projected by AAA, after the benefit of on-site visits in 1987 combined with subsequent updated off-site analysis, not by Larken management. (J.A. 1753). The due diligence team nonetheless continued to examine AAA's projections of net operating income, both on its own and by requesting information from LPI, including Larken, Inc.'s internal operating budgets for 1990. The request for the budgets caused Charles Underbrink and Larry Cahill some concern, because significant differences existed between the budgets for some of the hotels and AAA's projections of net operating income. To conceal those differences, Charles Underbrink and Larry Cahill changed certain figures in the internal operating budgets for those hotels so they appeared consistent with AAA's projections of net operating income. 21 As a result of its further efforts, the due diligence team submitted a supplemental report to the Former Trustees in late January 1990, in which it concluded: 22 [AAA's] income projections for 1990 and 1991 were realistic, and ... the occupancy projections for the 1992 and beyond time period, (which are generally capped in 1993 or 1994) were reasonable. However, we found the projected increases in average daily rates beyond 1992, which continue to increase at 3% to 6%, to be optimistic. (Note: We do accept [AAA's] projections as a possible scenario, but feel a more conservative projection is warranted to bracket the range of expected returns and to serve as the basis to invest.) These average daily rate increases are the primary source of operating income increases in the 1992 and beyond time period. Therefore, as presented in the original Thorne report, we accepted [AAA's] income projections through 1991, but provided a more conservative projection, with a 1.5% annual aggregate portfolio income increase for the rest of the investment period.... 23 (J.A. 1176-77). According to the due diligence team, its findings were supported in part by Larken, Inc.'s internal operating budgets for 1990: 24 Further support for [AAA's] 1990 projections is provided by the recently received Larken 1990 internal operating budgets. In the aggregate, the portfolio net operating income budgets are $13.9 million, or 1.1% above [AAA's] 1990 projections. These budgets are the basis for general manager incentive compensation, and result from negotiated performance projections between Derrick Rackham and each general manager. As a result, these budgets tend to be conservative, and historically Larken general managers do meet or exceed budgets and receive incentive bonuses. 25 (J.A. 1178). 26 Accompanying the due diligence team's supplemental report was the final report of Arthur Andersen, which raised the same concerns regarding the LHLP investment proposal as it had in its draft report, but in slightly watered down language in some instances. Specifically, Arthur Andersen had substituted some of the strongly worded paragraphs setting forth the risks of the LHLP investment proposal in bold, all capital letters, with a series of questions to be answered by the due diligence team. According to Jack Krichavsky, the person heading up Arthur Andersen's review team, the report was changed in response to a suggestion by lawyers at Rogovin, Huge, and Schiller that Arthur Andersen rewrite many of the strongly worded paragraphs. 27 On February 23, 1990, the Former Trustees voted to invest $15 million in LHLP. The deal was structured so that the Pension Fund would own a 37.5% interest in LHLP at a cost of $4,500,000 and would hold a $10,500,000 note from LHLP at 12% interest. The note was payable semiannually with a maturity date of November 30, 1994. 28 The closing occurred on February 26, 1990. As part of the deal, Larken, Inc. provided the Pension Fund with a certificate of representations and warranties and indemnity (the Warranty). The Warranty represented and warranted that the financial forecasts ... delivered to [the Pension Fund] have been prepared on the basis of sound financial planning practice and are neither incorrect nor misleading in any material respect. (J.A. 1337). The Warranty also represented and warranted that neither Larken, Inc. nor LPI had furnished the Pension Fund with any document that contained an untrue statement of a material fact or omit[ted] to state a material fact necessary to make the statements contained therein not misleading. (J.A. 1347). In the Warranty, Larken, Inc. further agreed that it would hold the Pension Fund harmless for any loss suffered as a result of the failure of any of its representations and warranties to be true and correct in any material respect. The Warranty's introductory language states that it was executed and delivered by Larken, Inc. to induce the [Pension Fund] ... to enter into and consummate the transactions contemplated by the various agreements by which the Pension Fund was to invest in LHLP. (J.A. 1334). 29