Opinion ID: 159203
Heading Depth: 3
Heading Rank: 1

Heading: Requiring Proof of Unusual or Infrequently Occurring Losses Under GAAP

Text: 65 In the 1998 Pretrial Order, the Plaintiffs set forth the following claims: 66 KII employed accounting methods that were designed intentionally to understate KII's earnings and assets in the financial statements. . . . 67 To diminish its apparent earnings, KII therefore employed the following accounting practice which violated GAAP and constituted breaches of both warranties in the Stock Purchase and Sale Agreement (quoted above): KII failed to disclose its unusual and/or infrequently occurring losses. KII categorized these losses as recurring expenses or depreciation, thereby artificially reducing what appeared to be KII's ordinarily recurring income. 68 (emphasis added) 69 Later that year, in ruling on a defense motion in limine seeking to exclude some of the Plaintiffs' expert testimony on the accounting claims, the district court responded to the parties' arguments about the parameters of these claims: If the plaintiffs intend to pursue an allegation that the defendants failed to disclose information on items that are neither unusual or infrequently occurring under GAAP, then the court rules that such an allegation or theory is outside the plaintiffs' accounting claim as pleaded in the pretrial order . . . . The district court looked to the 1998 Pretrial Order, which articulated only one factual basis for the Plaintiffs' accounting claim regarding these expenses: KII failed to disclose its unusual and/or infrequently occurring losses. Additionally, the district court noted the Plaintiffs chose to define these losses with accounting parlance borrowed from GAAP. Thus, the district court concluded the Plaintiffs must prove the Defendants failed to disclose unusual or infrequently occurring items, as defined by GAAP, to prevail on their accounting claims and therefore excluded any expert testimony on disclosure requirements for losses that were not unusual and/or infrequently occurring. 70 At trial, Alfred Eckert, a former Goldman Sachs investment banker who led the team hired by William Koch to value KII for purposes of the SPA, explained that when valuing a company's stock, he would add back into the company's earnings certain non-recurring losses. He further testified that his decision to add back these items depended not on generally-accepted accounting principles, but simply on whether, in his opinion, the losses likely would recur. On the Defendants' motion and over the Plaintiffs' objection, the district court then instructed the jury that the plaintiffs' accounting claim is limited to the defendants' failure to disclose items that are unusual and/or infrequently occurring as those terms are defined by [GAAP] and to disregard Eckert's testimony addressing the treatment of non-recurring items that do not fall within these definitions. The district court also issued an order (the May 12, 1998 Order) consistent with these instructions resolving that the accounting claims were predicated on the Plaintiffs' ability to prove the losses at issue were unusual or infrequently occurring under GAAP. Finally, both the instructions which the court gave the jury at the close of the trial and the jury's verdict form all indicated that to prevail on their accounting claim, under any legal theory, the Plaintiffs were required to prove the Defendants failed to disclose infrequently occurring losses as defined by GAAP. 71 On appeal, the Plaintiffs challenge the district court's orders and actions hinging their accounting claims on proof that the items at issue were unusual or infrequently occurring as defined by GAAP. This court reviews for abuse of discretion a district court's exclusion of evidence or issues from trial on the basis of a properly-drawn, detailed pretrial order. See Grant v. Brandt, 796 F.2d 351, 355 (10th Cir. 1986). 72 It is first important to note that the failure to disclose unusual and/or infrequently occurring losses constitutes the sole factual basis pleaded by the Plaintiffs in the 1998 Pretrial Order to support their claims regarding the Defendants' accounting treatment of KII expenses. Because a pretrial order defines the scope of an action for trial, the Plaintiffs were thus obligated to prove this one specific factual contention to prevail on their accounting claims. See Fed. R. Civ. P. 16(e) (A pretrial order entered after a pretrial conference shall control the subsequent course of the action unless modified by a subsequent order.); Trujillo v. Uniroyal Corp., 608 F.2d 815, 817 (10th Cir. 1979) (When issues are defined by the pretrial order, they ought to be adhered to in the absence of some good and sufficient reason.) (citation and internal quotation marks omitted). The question then is whether the district court properly determined the Plaintiffs needed to prove the losses were unusual or infrequently occurring as defined by GAAP, or whether infrequent occurrence under some other standard would have sufficed. 73 As the Plaintiffs point out, this court has recognized that a pretrial order should be 'liberally construed to cover any of the legal or factual theories that might be embraced by [its] language.' Trujillo, 608 F.2d at 818 (quoting Rodriguez v. Ripley Indus., Inc., 507 F.2d 782, 787 (1st Cir. 1974)). A careful reading of this court's cases reviewing trial courts' construction of pretrial orders, however, reveals that a district court may more strictly construe a pretrial order when that order has been refined over time, properly drawn, and drafted with substantial specificity. See, e.g., Cleverock Energy Corp. v. Trepel, 609 F.2d 1358, 1361-62 (10th Cir. 1979) (affirming trial court's exclusion of breach of fiduciary duty issue as beyond the scope of the pretrial order when the objecting party failed to take timely advantage of an opportunity to enlarge upon the general terms used in the order); Rigby v. Beech Aircraft Co., 548 F.2d 288, 291-92 (10th Cir. 1976) (affirming trial court's exclusion of evidence of defects in 40-gallon fuel cells of airplane when the plaintiffs' answers to interrogatories and the pretrial order consistently alleged defects only in the plane's 31-gallon fuel cells). On the other hand, this court has more liberally construed pretrial orders when the orders are not drafted with substantial care and specificity. See, e.g., Whalley v. Sakura, 804 F.2d 580, 582-83 (10th Cir. 1986) (liberally construing pretrial order when pretrial order . . . stated the claims of the plaintiff in general terms); Trujillo, 608 F.2d at 817-19 (broadly construing a pretrial order that was not properly drawn, [was] not definitive, specific, complete or detailed). 74 In Cleverock Energy this court elaborated on the reasons for allowing two divergent approaches to construing pretrial orders: 75 This court is acutely aware of the evils of the inflexible application of a pretrial order. These evils are aggravated when the pretrial order is unrefined. We recently held [in Trujillo] that a coarse pretrial order could not be narrowly applied to exclude one of three subtheories fairly encompassed within its general terms. However, we should not lose sight of the important policies behind the pretrial order mechanism, i.e., the narrowing of issues to facilitate an efficient trial and to avoid surprise. 76 Cleverock Energy, 609 F.2d at 1361-62 (citations omitted). Ultimately, the court held, We cannot in these circumstances conclude that the trial judge, who presided over the pretrial conferences of this extensive litigation and had before him the pleadings, motions and various pretrial statements of the parties, abused his discretion in striking the . . . issue as beyond the scope of the litigation. Id. at 1362. In sum, while pretrial orders generally should be construed liberally, a district court may more strictly construe such an order when the party favoring a liberal construction has had ample opportunity to refine the order and when the final order is properly drawn and substantially specific. 77 The Plaintiffs do not allege that the 1998 Pretrial Order was improperly drawn. Indeed, a pretrial conference was held on August 25, 1997, after which a proposed order was drafted. See Fed. R. Civ. P. 16(d). The district court signed the 1998 Pretrial Order on February 6, 1998. See Fed. R. Civ. P. 16(e). Further, this court has noted a proper pretrial order is definitive, sharpen[s] and simplifie[s] the issues to be tried, and represents a complete statement of all the contentions of the parties. Trujillo, 608 F.2d at 817 (citations and internal quotations omitted). The 1998 Pretrial Order in this case fits that bill, as many years of draft pretrial orders, district court orders, and discovery served to focus the legal and factual contentions of the parties and culminated in this final pretrial order. Additionally, because numerous draft pretrial orders were produced over the many years of this litigation, the Plaintiffs cannot claim that they lacked opportunities to draft the order to clearly encompass their claims. Because the 1998 Pretrial Order was properly drawn, with relative specificity and definitiveness, and because the Plaintiffs had ample opportunity to refine the order, the district court was not required to afford the Plaintiffs overly-generous leeway in its construction of their accounting claims. 78 Indeed, a contextual reading of the 1998 Pretrial Order leads this court to conclude that the district court did not abuse its discretion in determining that the Plaintiffs' accounting claims predicated recovery on their ability to prove the losses at issue were unusual or infrequently occurring as defined by GAAP. Again, the 1998 Pretrial Order frames this accounting claim in the following terms: To diminish its apparent earnings, KII therefore employed the following accounting practice which violated GAAP and constituted breaches of both warranties in the Stock Purchase and Sale Agreement (quoted above): KII failed to disclose its unusual and/or infrequently occurring losses. (emphasis added). As the district court noted in its May 12, 1998 order, the words unusual and/or infrequently occurring are terms of art used in GAAP literature, which the Plaintiffs earlier referenced at the summary judgment stage. Furthermore, this lone factual allegation mentioning unusual and infrequently occurring losses immediately follows a portion of the sentence which asserts a GAAP violation. 79 To support their reading of the 1998 Pretrial Order, the Plaintiffs point to the conjunction and between the asserted GAAP violation and the alleged breaches of two warranties, as well as the reference to both warranties. This language, however, bolsters, rather than subverts, the district court's construction of the pretrial order. The first of the two referenced warranties (the GAAP Warranty) warranted that the financial statements disclosed to the Plaintiffs as of December 31, 1981 and December 31, 1982 fairly present the . . . financial condition . . . of . . . [KII] . . . in accordance with generally accepted accounting principles . . . . The second warranty (the Full Disclosure Warranty) stated that since December 31, 1982, the Defendants had provided all information which if fully disclosed might materially affect the valuation of the stock of [KII] . . . . Although only the first of these warranties explicitly required GAAP compliance, by pleading that the Defendants' accounting practices violated GAAP and both warranties, the Plaintiffs appear to assert that because these practices violated GAAP they necessarily violated the Full Disclosure Warranty as well as the GAAP Warranty. Otherwise, the initial reference to the GAAP violation which precedes the word and would be superfluous, given the factual allegation using GAAP terminology which follows. Thus, the claim ties GAAP requirements to both warranties, as well as to the words unusual and infrequently occurring. 80 Similarly, this court rejects the Plaintiffs' argument that because they separately pleaded breach of fiduciary duty, along with breach of these two warranties, the court should not read the words unusual and infrequently occurring as GAAP terms of art when applied to their breach of fiduciary duty claim. In its May 12, 1998 order, the district court responded to this argument: There is no reasonable construction of this pretrial order that is so liberal as to permit a court to read terms of art in the same sentence as having two different meanings simply because the party subsequently asserts an alternative legal theory. This court concurs with that assessment. Further, as the district court noted in that May 12 order, the Plaintiffs failed to exercise their drafting prerogative to include a different, alternative, or additional definition in the Pretrial Order. Instead, they effectively expressed their satisfaction to be bound by the GAAP definition. 81 Finally, in analyzing the 1998 Pretrial Order, the district court properly considered the parties' motions, briefs, and arguments regarding the accounting claims that came before it throughout the thirteen years in which that court presided over this litigation. The district court stated, [T]he plaintiffs did not allude during the summary judgment proceedings to any position that their two legal theories on the accounting claim were based on alternative meanings to 'unusual and/or infrequently occurring losses.' The record bears out the accuracy of this statement. For example, in its Memorandum in Opposition to the Defendant's Motion for Summary Judgment, the Plaintiffs assert, Thus, Koch . . . failed contrary to GAAP to disclose its 1982 writeoffs as unusual, non-recurring expenses. (emphasis added). 82 In conclusion, this court holds that the district court, with its thirteen years of reading and listening to the parties' assertions and arguments concerning these accounting claims, did not abuse its discretion when it construed a properly drawn, refined, and specific pretrial order as excluding any accounting claims not predicated on proof that the losses at issue were unusual or infrequently occurring by GAAP definitions. 83