New South Wales Supreme Court CITATION : Ludowici v Pitcher [2001] NSWSC 728 revised - 25/10/2001 CURRENT JURISDICTION: Equity Division Commercial List FILE NUMBER(S) : SC 50033/00 HEARING DATE(S) : 21.5.01, 22.5.01, 23.5.01, 24.5.01 JUDGMENT DATE : 30 August 2001 PARTIES : Ludowici Limited & Ludowici Mineral Processing Equipment Pty Ltd v R G Pitcher & Ors JUDGMENT OF : Hunter J COUNSEL : Plaintiffs: I M Jackman SC & S A Goodman Defendants: M Thompson SOLICITORS : Plaintiffs: Clayton Utz Defendants: Herbert Geer & Rundle CATCHWORDS : Contract - duty of care - accountant retained to review financials of target company & perform special audit work in connection with company acquisition - standards of review work - failure to detect major management oversight - company acquired on basis of advice -defendant bound by method of conduct of hearing - entitlement of parent company to sue for loss represented by loss of wholly owned subsidiary. LEGISLATION CITED : Fair Trading Act Trade Practices Act Prudential Insurance v Newman Industries Limited (No 2) (1982) Ch D 204 Gould v Vaggelas (1985) 157 CLR 215 CASES CITED : Morwood v Chemdata Pty Ltd (1995) ATPR 40,827 George Fischer (Great Britain Ltd) v Multi-Construction Ltd [1995] 1 BCLC 260 Hadley v Baxendale (1854) 156 ER 145 Potts v Miller (1940) 64 CLR 282 DECISION : Judgment for the plaintiffs in the sum of $2,320,000 together with interest at schedule rates from 3 August 2001. IN THE SUPREME COURT OF NEW SOUTH WALES EQUITY DIVISION COMMERCIAL LIST HUNTER J THURSDAY 30 AUGUST 2001 50033/00 LUDOWICI LIMITED & LUDOWICI MINERAL PROCESSING EQUIPMENT PTY LTD -v- R G PITCHER & ORS REASONS FOR JUDGMENT 1 These proceedings arise out of the acquisition by the second plaintiff, (Ludowici Mineral), a wholly owned subsidiary of the first plaintiff (Ludowici), of all of the ordinary shares issued in the capital of Malco Engineering Pty Ltd (Malco), a manufacturing engineer whose capital was held by Moore Industries Pty Ltd (Moore); Malco and Moore being members of a group of companies known as Portland House. 2 The agreement between Ludowici Mineral and Moore to purchase the shares in Malco (the agreement) was executed by the parties on 3 August 1998. Negotiations for the purchase had been undertaken by Ludowici with Portland House over the preceding six months. 3 The purchase price under the agreement was based upon a figure of $7,400,000, which, in turn, had been derived from the average of Malco's actual earnings before interest and tax (EBIT) for the year ended 30 June 1997, the expected EBIT for the year ended 30 June 1998, and forecast earnings for 1999. In the case of the 1998 year, the expected EBIT was founded upon financials recording performance of the year to date, while, in the case of the 1999 year, budget figures were utilised. The ascertaining of the purchase price called for various adjustments which need not be identified at this stage. 4 The defendants (Pitchers) are a group of accountants who had performed the audit work for Portland House for several years prior to the 1998 year, and, as such, they were familiar with the system of accounting adopted by corporations within that group. Somewhat unusually, they were retained by Ludowici to perform accountancy work as part of the due diligence process involved in reaching final agreement with Moore. 5 The express terms of Ludowici's retainer of Pitchers is not in dispute. However, the true meaning of those express terms and the ambit of work embraced within them is a matter of some dispute. They are to be found in the letter from Ludowici to Pitchers of 29 May 1998 together with its attachments, being a letter from Ludowici to Portland House of 13 May 1998 and a facsimile of 21 April 1998, attaching a copy of a letter of that date from Ludowici to Portland House (the retainer). 6 It is useful to set out the whole of that material, as, in addition to the knowledge that Pitchers had of the accounting systems in place within Portland House, the retainer explained, in some detail, the purpose and importance of the services required of Pitchers in the context of an agreement then under consideration by Ludowici for the acquisition of Malco. "29 May , 1998 PRIVATE & CONFIDENTIAL Mr S Catlin Partner Pitcher & Partners Level 6 161 Collins Street Melbourne VIC 3000 Dear Mr Catlin MALCO ENGINEERING PTY LTD (ME) Further to your discussions with Mr Christofi on 28 May, 1998, we set out below the work we require your firm to undertake: Background We have made an offer to the shareholders of ME to purchase the engineering division of ME by acquiring all the shares in ME for a price based on the adjusted earnings of ME engineering division. Prior to the sale, the other two operating divisions and non engineering assets will be removed from ME. A copy of this offer contained in two letters to David Hains, dated 21 April, 1998 and 13 May, 1998 is attached for your information. Subsequent to this offer, we have been informed that the business of the engineering division will be transferred to a new company, Malco Honert Pty Ltd on 30 June, 1998. As part of our due diligence exercise we seek your assistance in the following areas: 1. Audit of the 30.6.98 accounts of ME and Malco Honert (MH) We request that in addition to carrying out your normal statutory audit you include the following: (a) your audit should be unqualified and the accounts should fully comply with accounting standards (general purpose accounts); (b) as these accounts will be relied on in acquiring this business , you are asked to note and acknowledge this. (c) in carrying out your statutory audit, we would like to receive details of : (i) any weaknesses in systems and internal control that your audit may encounter; (ii) any concerns you may have on the valuation of inventories and work in progress ; warranty claims; potential losses not provided for on any contracts outstanding at year end ; (iii) debtors/provision for doubtful debts ; (iv) the year 2000 bug; (v) currency risks and any other areas you may consider need specific comment or attention. 2. Maintainable Profits Review ME's calculation of earnings before tax and interest for the engineering division for the years 1996/1997 and 1997/1998 ($2.0m and $2.5m (projected) respectively) and confirm that these are reasonable and can be relied upon . Clearly attention should be focussed on ensuring that these are not overstated . 3. Review ME's 1998/1999 Budget (Engineering Division) We request that you review the above budget and express an opinion as to whether, based on your extensive knowledge of ME and the above review, the budgets are soundly based and the profit expectations (EBIT $1.5m) reasonable . 4. Transfer of the Engineering Business of ME to MH In addition to 1 above, please confirm that in your opinion the business of the engineering division has been successfully transferred from ME to MH e.g all of the relevant assets and liabilities; employees; contracts etc.; and that no company tax or stamp duties will arise out of the transfer of this business, other than accounted for in MH's balance sheet. At this stage we anticipate interim settlement on 1 July, 1998 and final settlement on 17 August, 1998. We would like to receive a verbal interim report on 15 June, 1998 and your written report on Items 2 and 3 above, by 26 June, 1998 . A final report dealing with Items 1 and 4 and updating your report on Item 2 (actual profits for 1998) should be in our hands by 14 August , 1998, assuming of course that the information you require from the management of ME is available to allow you to meet this deadline. We realise that the above deadlines are tight but we understand that the vendor is keen to see this matter finalised as soon as possible and would like to speed up the preparation of accounts and other items. An estimate of the costs, other than your normal statutory audit, would be appreciated as these will be paid by Ludowici Limited. Our due diligence team which will be spending time in Melbourne in May/June will be headed by myself and for accounting and financial matters by Mr H (Chris) Christophi (Ph. 0412 295 073). After you have had the opportunity to consider this matter would you please confirm your agreement to carry out the assignment. I attach a copy of Ludowici's 1997 Annual Report for your information. Yours faithfully Glenn Turner Managing Director " (Emphasis added) "13 May 1998 Mr David Hains Portland House Corporation Pty Ltd 8 Collins Street Melbourne VIC 3000 Fax: 03 9650 1011 Dear David, Further to our discussions I enclose two draft letters. These are to Pitcher Partners who we understand are the current auditors to Malco and to Polymex Consultants for a briefing for the market research we would like conducted. Following confirmation of your agreement we will send the letter directly to Pitcher Partners and perhaps you would nominate the relevant partner we should direct the letter to. Also, subject to your agreement, the letter to Polymex can be issued by Malco directly to Steffen Rath who is aware that Malco may be seeking this work. I confirm Ludowici's agreement - to pay for this study. Also attached is a revised timetable for the due diligence process. As you will see we anticipate a visit to Melbourne 20,21 and 22 May, 1998 and thereafter for as long as it takes to satisfy ourselves in relation to the questions previously directed to you and other issues which we will seek to work through. The Ludowici personnel involved would include myself, Mr H (Chris) Christofi, Mr John Harvey and Mr Tom Fairhall. Mr Christofi is a consultant (previously Company Secretary/General Manager Finance of Ludowici), Mr John Harvey is the General Manager of our Dembicon diamond tool manufacturing business unit based in Adelaide and Mr Tom Fairall is the General Manager of CMi, the business unit with the most synergy with the Malco Engineering operation. In addition our tax adviser, Colin Thomas of Hudson Croft Thomas, will be involved and can work with your advisers to ensure taxation aspects are dealt with appropriately. As can be seen from the timetable we would like to hold discussions with Malco personnel in Adelaide on 4 and 5 June, 1998, and Sydney on 9 June, 1998. By this time we would expect to have satisfied ourselves on the critical issue of the engineering division EBITs and adjustments (although still subject to final approval by the auditors ) and to have largely satisfied ourselves from information made available by you on matters other than the profit and final asset numbers. I would appreciate your formal advice of agreement to our conditional offer as per our letter dated 21 April, 1998 in order that we may now progress the matter with appropriate haste. For your information we have already requested our legal advisers, Clayton Utz (Mr John Elliott) in Sydney, to commence drafting the purchase agreement. Other legal documents required such as lease agreements and the option agreement can be dealt with in due course. Yours sincerely Glenn Turner Managing Director" ………. " MALCO DUE DILIGENCE & COMPLETION TIMETABLE By Whom By When 1. Brief solicitors and draw agreement Ludowici In progress 2. In principle acceptance of offer Portland 15.05.98 3. Commission Polymex Report Portland 15.05.98 4. Commission audit and special report Ludowici 20.05.98 5. Investigate Malco business records, accounts, Ludowici 20.05.98 & Continuing trading 6. Instruct Rushtons re plant valuation Ludowici 27.05.98 7. Discuss with Malco senior personnel - Adelaide Ludowici 4&5.06.98 - Sydney Ludowici 09.06.98 8. Interim report from auditors Pitcher Partners 16.06.98 9. Formal proposal to Ludowici Board Ludowici 18.06.98 10. Ludowici Board formal approval of offer Ludowici 25.06.98 11. Polymex and Rushton reports received Polymex/Rushtons 26.06.98 12. Auditors confirm EBIT numbers (not assets) Pitcher Partners 26.06.98 13. Sign agreements - Ludowici take control All 01.07.98 14. Pay first instalment (70% of $8.0m) Ludowici 01.07.98 15. Audited accounts as at 30.6.98 Pitcher Partners 14.08.98 16. Pay second instalment (30% of $8.0m) and issue 5 year options Ludowici 17.08.98 17. Audited accounts as at 30.6.99 Pitcher Partners 17.08.99 18. Pay escalator if applicable Ludowici 19.08.99" (Emphasis added) "21 April, 1998 Mr David Haines Portland House Corporation Pty Ltd 8 Collins Street Melbourne VIC 3000 Facsimile: 039650 1011 PRIVATE & CONFIDENTIAL Dear David MALCO ENGINEERING PTY LTD (ME) Attached is the letter I undertook to provide formalising our understanding. I have not attached Appendices "B" and "C" to the fax copy of this letter due to volume. They do however attach to the original of the letter which I will dispatch to you today. (Appendix "B" is, is (sic) my letter of 27 March, 1998 to yourself and the attachments, Appendix "C" are the standard warrants and indemnities which I undertook to obtain for you). I will be overseas from p.m Wednesday 22 April to Tuesday 5 May, 1998 inclusive, back in the office a.m Wednesday 6 May, 1998. I shall of course be in touch with my office and if there are any queries or messages which you wish to leave I can access these. I look forward to your response in due course and trust that the attached also reflects your understanding of where we are at Yours faithfully Glenn Turner Managing Director " …… "21 April, 1998 Mr David Hains Portland House Corporation Pty Ltd 8 Collins Street Melbourne VIC 3000 PRIVATE & CONFIDENTIAL Dear David Further to our various discussions over the past weeks and other information supplied to us, I hereby detail our conditional offer for the purchase of the engineering business of Malco Engineering Pty Ltd. We understand this purchase will be by way of the acquisition of the shares in Malco Engineering Pty Ltd with the other two business activities namely the truck and merchandising divisions having been transferred or otherwise removed from the corporate structure of Malco Engineering Pty Ltd prior to purchase by us. We confirm our conditional offer (for conditions see later) of $8.0m plus 500,000 share options in Ludowici Limited with an exercise price of $2.60 each and an exercise period of any time within five years from the date of issue, for all the shares in Malco Engineering Pty Ltd. As previously discussed we have framed our offer of $8.0m on the basis that it represents four times the average maintainable EBIT of the Malco Engineering division (adjusted by you for one off and other abnormal/extraordinary items) and which have been represented to us as: EBIT Year Ended June 1997 $2.0m Actual Year Ended June 1998 $2.5m Expected Year Ended June 1999 $1.5m Estimated Average $2.0m In addition we offer an escalator whereby Ludowici would pay to you as vendor an adjustment equal to four times the amount by which the actual average EBIT exceeds the above average of $2.0m . The above conditional offer is subject to the following conditions and clarifications: 1. Timetable for completing the acquisition: Acceptance of this offer 30.4.98 Commence due diligence 01.5.98 Sign agreements 01.7.98 Pay first instalment (70% of $8.0m) 01.7.98 Ludowici take control of ME 01.7.98 Audited accounts as at 30.6.98 14.8.98 Pay second instalment (30% of $8.0m) 17.8.98 Audited accounts as at 30.6.99 17.8.99 Pay final instalment - per escalator 19.8.98 2. Timetable for Due Diligence By Whom By When · Commission market report Polymex 01.5.98 · Start due diligence Ludowici 01.5.98 · Instruct auditors to prepare special report as at 30.6.98 Ludowici 05.5.98 · Carry out normal statutory audit as at 30.6.98 Auditors Continuing · Advise ME management of acquisition Vendor 03.6.98 · Inspect, list and value plant - 03.6.98 -commence Ludowici/ Rushtons 26.6.98 -complete · Completion of market report Polymex 26.6.98 · Completion of audited accounts as at 30.6.98 -unqualified Auditors 14.8.98 · Completion of special audit report Auditors 14.8.98 3. Minimum net tangible assets (NTA) as at 30.6.98 In making this offer we have relied on the attached balance sheet as at 31.12.97 (Appendix A) which shows net assets of $6.7m. It is a condition of this offer that the NTA at 30.6.98 are at least the NTA required to operate the business (including a minimum amount of cash), but in any case not less than $6.5m excluding the amounts for future income tax benefit and deferred income tax liability . Any dividends paid between 31.12.97 and 30.6.98 should conform to the above condition. 4. Payment of Purchase Price The first instalment will be 70% of $8.0m, the second instalment 30% of $8.0m. The payment for the escalator, if any, will be determined when the 30.6.99 accounts are available. 5. Change of Control It is envisaged that Ludowici will take control of ME on 1 July, 1998 with a change of directors occurring at the same time. 6. Market Report This report will be prepared by Polymex on behalf of Ludowici. However, in order to maintain confidentiality, it will be commissioned by you to a brief we will prepare. 7. Valuation of Plant Ludowici will instruct Rushtons, licensed valuers, to carry out an inventory and valuation of all ME plant during June, 1998. In accordance with accounting standards the resulting value of the plant will be entered into the books of ME as at 1.7.98. 8. Retention of Key Personnel It is a condition of this offer that Ludowici are satisfied that key personnel in ME, particularly sales and technical staff, will remain with the company after acquisition. 9. Warranties and Indemnities You have indicated that warranties usual for a sale by shares will be provided by you to Ludowici. As an indication of these warranties, we attach draft standard warranties from our solicitors for your perusal (Appendix C). These will need to be customised as necessary to fit the ME acquisition. 10. Premises We understand that the land and buildings owned by ME will be sold and settled prior to 30.6.98 but will be available for lease to ME. It is envisaged that all premises required by ME to operate its business will be leased-to ME under secure, formal leases for medium to long term periods at commercial rents which we understand are rents presently charged to ME. All premises used by the truck and merchandise divisions or which are surplus to the requirements of ME, will become the responsibility of the vendor. 11. Maintainable EBIT If the maintainable EBIT for 1997 and 1998 proves to be lower than indicated, as a result of due diligence, then Ludowici reserve the right to withdraw or vary its offer. In case of a dispute on the adjustments required to arrive at maintainable EBIT, we would accept an arbitrator's decision as final. 12. Due Diligence The offer is subject to a satisfactory outcome as a result of carrying out due diligence. In addition to specific terms mentioned in this offer, a list of other items was supplied to you with our covering letter dated 27.3.98 and we attach this as Appendix B. We acknowledge that a substantial amount of the information is now available. We propose a small team of Ludowici staff, say three myself included, visit Melbourne in mid May to go through it. We reserve the right to carry out additional work if matters of concern arise in the course of due diligence. 13. Auditors and Their Reports We envisage that your current auditors, Pitcher Partners will be asked to do the statutory and special audits but if any problems arise such as conflict of interest, we will appoint our own auditors. The special audit report referred to in Item 1 above, will include a review of the 98/99 budgets and pay special attention to areas that may be of concern such as provisions, contingent liabilities and valuation of inventories. We note however that we have no reason to be concerned with these areas at this stage. The special audit report will be addressed to Ludowici and acknowledge that Ludowici will be relying on both the statutory and special audit reports in acquiring ME. 14. Intercompany Balances It is envisaged that all balances owing between ME and the rest of the Portland Group will be settled and cleared on or prior to 30.6.98. Our above offer is not an offer which is capable of acceptance in a manner which will form a binding contract, it being our intention that a binding contract will arise upon signing full agreements approved by our solicitors. We look forward to your early response. Yours sincerely Glenn Turner Managing Director " (Emphasis added) 7 Of particular note is the disclosure to Pitchers that the proposed purchase price, then being $8,000,000, was arrived at by applying a multiplier of four to the average of the actual EBIT for 1997 ($2,000,000), the 'expected' EBIT for 1998 ($2,500,000), and the 'estimated' EBIT of $1,500,000 for 1999. As stated in the 21 April 1998 letter which was part of the retainer, the offer had been "framed… on the basis that it [represented] four times the average maintainable EBIT of the Malco Engineering division… " 8 The second point of interest is the inclusion in the offer of 'an escalator' in the event that the average EBIT exceeded the anticipated average of $2,000,0000. 9 Finally, it was envisaged at that time that Ludowici "reserved the right to withdraw or vary its offer" if "the maintainable EBIT for 1997 and 1998 [proved] to be lower than indicated, as a result of due diligence." 10 That proviso did not find its way into the agreement. While the agreement provided for an escalator along the lines envisaged at the time of the retainer, there was introduced into the agreement an adjusting mechanism to accommodate variation in the average of the actual EBITs for the three years from the average EBIT of $2,000,000 assumed at the date of the agreement. That was achieved by stipulating a first payment of $7,400,000 and a "second amount" of $600,000 to be paid subject to an adjustment calculated in accordance with the following formula: "EA = 4 x (EBIT 97 + EBIT 98 + EBIT 99) - 2,000,000" 3 11 "EA" represented the adjusting amount. "EBIT" represented the actuals for the years identified. Their total was divided by "3" to give the average EBIT for those years. $2,000,000 was deducted to isolate the variation from the average from which the purchase price under the agreement was derived. The variation could be a negative, zero or a positive amount : the multiple of "4" to the variation was in keeping with the method of deriving the purchase price under the agreement, namely, by multiplying the average EBIT by four. 12 In the case of a positive variation, the 'second amount' was adjusted in accordance with the formula in favour of Moore and was uncapped. In the case of a zero variation, the 'second amount' remaining unchanged at $600,000. Where the application of the formula resulted in a negative amount, the 'second amount' of $600,000 was reduced accordingly. In other words, the adjustment downwards was capped at $600,000. 13 In the broadest of terms, the agreement may be described as one in which Ludowici accepted the risk that the expected and 'estimated' EBITs for the years 1998 and 1999 were wrong, relying for protection upon (a) the capped adjustment down, (b) the carrying out of a due diligence protocol which included the auditing of Malco's financials and review of its budget for the year ending 30 June 1999, and (c) a further adjustment of the purchase price in the event that the net tangible assets fell below the figure of $6,500,000. 14 As it happened, Ludowici's due diligence, in particular, the accounting work carried out by Pitchers, failed to disclose a major error in Malco's accounts for the year ended 30 June 1998, which, as found in these reasons, had ramifications for both that year and the year ended 30 June 1999. The error occurred in the subsidiary ledger of work in progress. 15 Malco's accountancy system, of which Pitchers was aware, was described by Malco's state administration manager, Stephen Robert Hutchins (Hutchins) as follows: "3. The WIP subsidiary ledger is a record kept on the Malco computer system. It contains a list of work in progress (" WIP "), that is jobs which have been commenced but which are not completed. At the start of each job, information is entered in this ledger comprising a general description of the work required and the selling price. During the course of a job, information is entered directly into the ledger to reflect all labour and materials costs required to complete the work. When work on a job is completed, the job is closed and the costs transferred to the profit and loss account. 4. The WIP subsidiary ledger is updated on a "real time" basis with costs entered as they are incurred (except for labour costs which are recorded on time sheets and input at the end of each day). The WIP subsidiary ledger is printed out at the end of each month for the purpose of reconciling it to the general ledger. Once this is accomplished, the printout of the WIP report is disposed of. I am unable to printout (sic) the WIP report for a previous month as the continual "real time" updating of the WIP subsidiary ledger means only the current balance of the WIP ledger will be shown if a report is now printed out. The WIP subsidiary ledger does not allow the printout of a report at a fixed date in the past. 5. It has been the practice of Malco since at least 1995 to: (a) create a job number and an entry on the WIP ledger for all work undertaken by Malco staff. This includes both work for which customers can be charged and non-chargeable work which is an internal cost to Malco, such as repairs to plant, and re-work (i.e work which was not done correctly the first time and which is re-done at Malco's expense); and (b) to transfer, prior to the end of each financial year (usually in the last few days of June and no later that (sic) the last day of June), the non-chargeable elements of the WIP ledger (repairs, rework etc) to either the profit and loss account, a capital account or a provisions account." 16 Of the implementation of that practice in the year ended 30 June 1998, he gave the following evidence: "7. The transfer of non-chargeable items of WIP to the profit and loss account, capital account or provision accounts did not occur in June 1998. I believe that this was because: (a) June 1998 was an unusually busy period for Malco; (b) the computer system was in the process of being gradually modified and upgraded. This was a 2 year project which commenced on 1 September 1997 and was completed in September 1999. A number of problems had been encountered in ensuring that part of the system which was to handle WIP was operating properly; and (c) a lot of my time was taken up assisting in the sale of Malco by Portland House Corporation Pty Limited (" PHC ") to Ludowici Limited (" Ludowici ")." 17 The effect of that failure was to include in the calculation of EBIT for the year ended 30 June 1998 a sum of $564,735 as an asset, whereas it should have been transferred from the work in progress subsidiary ledger to the profit and loss account. This error was missed by Pitchers in their interim report to Ludowici, called for under the retainer, and in their audit of Malco's accounts for the year ended 30 June 1998. 18 The principal question to be addressed is whether, prior to the execution of the agreement, this serious omission by management should have been detected by Pitchers in the performance of Ludowici's retainer by Ludowici. 19 I think it is beyond argument that a full audit of Malco's accounts should have disclosed that failure in the accounting system of Malco. The dispute centres upon the question whether the special accountancy required of Pitchers under the Ludowici retainer should have identified it prior to the execution of the agreement on 3 August 1998. 20 In response to the requirement under the retainer of the provision of an interim report in writing by 26 June 1998, Pitchers produced a nine page report dated 29 June 1998 (the interim report),y which was forwarded to Ludowici by facsimile of 3 July 1998. It was accompanied by an attachment entitled "SUMMARY OF 'NORMALISED EBIT'" for the years ended 30 June 1997 and 1998, the first being noted as "actual" in the sum of $2,000,035, and in the case of 1998, "estimated" in the sum of $3,000,004. Most of the report was taken up with the review of the 1998/99 budget. 21 In relation to the EBIT for 1997 and 1998 the attached "Summary" was commented upon in the body of the interim report as follows: "2.1 We have attached as Appendix One, the summary of normalised EBIT for 1997 and 1998 (estimated) which was subject to our review. 2.2 We understand that the expected profit previously advised by ME for the 1998 financial year was $2.5m, however, our review is based on a figure of $3.0m which reflects the current expectations of the company. 2.3 The result for 1997 is as per our audited accounts, however, the Sales and Cost of Sales figures include a reallocation being the addition of work in progress claims and related costs to Sales and Cost of Goods Sold respectively. This alteration, which we understand has already been explained to you, makes the disclosed 1997 result comparable in disclosure presentation to internal 1998 management accounts and has no effect on the profit for the 1997 year. We are satisfied that the alteration is appropriate to ensure a consistent calculation of gross profit. 2.4 Our review of the 1998 result to date has been limited to the analysis of the unaudited results to 31 May 1998. A redundancy provision of $180,000 has been deducted from the expected break-even result for June to produce a profit of $2.8m. We have been advised by ME that you have agreed that this expense should be treated as abnormal and added back in the EBIT calculations. The resulting projected profit of $3.0m for 1998 appears reasonably stated subject to the completion of our audit . Based on the above we are satisfied that the Normalised EBIT figures for 1997 and 1998 as disclosed on schedule 1 are reasonably stated for purposes of calculating an updated average maintainable EBIT on the basis outlined in your letter of 21 April 1998 ." (Emphasis added) 22 The opinion expressed in the last paragraph quoted above is of particular significance having regard to the reliance placed in these proceedings by Pitchers and their accountant expert upon the tasks associated with an "audit" and those required under a "review", Pitchers having been requested by Ludowici in paragraphs numbered "2" and "3" of its 29 May 1998 retainer letter to "review" the EBIT figures for the three nominated years. 23 The actual process by which Pitchers became "satisfied that the Normalised EBIT figures for 1997 and 1998 [were] reasonably stated for the purpose of calculating an updated average maintainable EBIT" is not precisely stated in the evidence adduced by Pitchers, as the audit manager of Pitchers, who had the responsibility of carrying out Malco's audit and the performance of Ludowici's retainer, was not called to give evidence. 24 Sidney Peter Catlin (Catlin), Pitchers' audit partner, gave evidence of the work performed by Pitchers' audit manager and of his role as audit partner. The June report described the scope of work as follows: " 1 Scope of Work Our work on this assignment has included the following: 1.1 Attendance at the Adelaide branch office where we had discussions with Steve Hutchins and Ron Shipp. 1.2 A review of the draft management accounts to 31 May 1998. 1.3 A review of the budget for the year ended 30 June 1999 and supporting workpapers. 1.4 Review and discussion of the Equipment sales quotations reported at the May board report. 1.5 Comparison of the 1997 normalised EBIT figure to the audited results." 25 Hutchins gave evidence of the visit to Adelaide by the audit manager in mid June in the following terms : "8. During June 1998, Ms Clare Luehman from Pitcher Partners attended Malco's offices in Adelaide for 2 days. During those 2 days Ms Luehman asked questions of me from time to time. I provided to Ms Luehman documents she requested access to. 9. During her visit, Ms Leuhman requested access to the Uncompleted Major Jobs Report (" the UMJ Report ") for May 1998. A copy of the UMJ Report for May 1998 is annexed hereto and marked "A". I understood that she wished to have access to this report to allow her to ensure that the profit taken up by Malco for the period ended 31 May 1998, as recorded in the May 1998 Malco management accounts, was reasonable. Whenever Ms Luehman required assistance, she usually spoke to me. This would occur after Ms Leuhman or her colleagues from Pitcher Partners had reviewed a particular job and obtained access to all available information. During this visit, I was asked approximately 6 questions by Ms Leuhman or her colleagues, all of which related to whether profits had been taken up correctly in respect of uncompleted jobs. … 18. During Ms Leuhman's visit during June 1998: (a) I was asked a number of questions by Ms Leuhman on the reasons why the Moranbah Project had gone wrong. The Moranbah Project was a contract worth $15 million to supply mining equipment in the form of 2 stackers and 1 reclaimer. The JCAR for this project indicated good profits could be expected on completion. However, when this job was completed and fully costed, the profits which had been expected did not eventuate. The reason for this was that the project manager had withheld a number of invoices and these did not appear on the JCAR. This meant the cost of the project has been understated. The questions asked by Ms Leuhman also included what procedures could be put in place to prevent a recurrence of this type of event. (b) the then current WIP report printout, that is as at the end of May 1998 was available for review but, to my recollection, was not requested. Nor did Ms Leuhman ask me to printout (sic) a WIP report. The main focus appeared to be on the Moranbah project." 26 The work papers of the audit manager were reviewed by Catlin and from that review he described the work undertaken for the June report as follows: "32.1 the actual EBIT for 1997 reflected in the Malco EBIT calculation was agreed to the figure in the 1997 audit file and traced through to the figure appearing in the 1997 audited accounts by Clare. The relevant 1997 audit file work papers were reviewed by Clare. 32.2 A review of the 1998 normalised EBIT calculation (including adjustments) performed by Malco staff. The normalised EBIT calculation document (tab 5 - discovered document 9) had been provided to Pitcher Partners prior to Clare's visit to Adelaide. I cannot recall when it was received but by looking at the file I believe that it is likely that it was received by way of facsimile transmission on the day that it was printed, namely 3 June 1998; 32.3 The 1998 estimated EBIT was independently recalculated by Clare after the adjustments and their accounting basis were confirmed by her with Ian Kiefel of Portland House Group. All components and additions within the calculation were checked by Clare. 33. The Malco 30 June 1998 results were not available when Clare was considering the anticipated 1998 EBIT. Clare reviewed the management accounts to 31 May 1998 for reasonableness. The management accounts were prepared by Malco and/or Portland House Group staff. Clare also reviewed and checked for reasonableness an estimated result for the month of June 1998. The estimation of the June 1998 result was performed by Malco and/or Portland House Group staff. 34. The 1997 annual results were provided to us in Malco's management accounting format to facilitate an easier comparison of the May 1998 management accounts with historical figures. I was satisfied upon my review of Clare's work papers that the May 1998 management accounts reasonably reflected Malco's net profit to 31 May 1998. 35. Clare reviewed the combined actual result to 31 May 1998 and the estimated result to 30 June 1998. This review involved comparisons between the 1997 and 1998 results and between the 1998 budgeted and actual results. The review took into account the actual and anticipated effect of a restructure at Malco as reported to Clare by Malco and/or Portland House Group staff. 36. I cannot now tell from the work papers whether or not a full work in progress listing whether as at 31 May 1998 or current as at the date of the visit was produced to Clare. She did, however, review the Uncompleted Major Jobs Report ("the UMJ") for May 1998. The UMJ is a work in progress report which deals with uncompleted contracts with a value of $50,000 or more. Historically this was the material area of work in progress for audit purposes as it was the area of work in progress in which Pitcher Partners had located errors. For that reason it was also the area of work in progress that we concentrated on for the purposes of the June 1998 review of EBIT. I was not told during the course of the review or at any time after the review that there were problems with any ongoing jobs or work in progress. 37. The work performed on the 1998 EBIT figure was interim in nature as a final opinion of the 1998 EBIT could not be given until after the 30 June 1998 results were available and a full audit had been completed. This was reflected in Ludowici's letter of 29 May 1998 (tab 1). 38. During my review of Clare's work papers I also completed my own analysis of gross profit percentages by making comparisons with previous periods, the 1998 projection and the 1999 budget. The results of the analysis gave me comfort that there was no material difference with historical gross profit percentages for this business. 39. I can say from my recent review of the work papers (and which would have been apparent to me during the review referred to in paragraph 31 of this affidavit) that the work undertaken by Clare in respect of Item 3 consisted of discussion with Malco management as to how the budget had been prepared, a review of all data utilised to prepare the budget, and a check of the additions within the budget, a review of the assumptions underlying the material expense and revenue categories in the budget, and a comparison of prior years budgeted and actual results. 40. Clare's work plan is contained in work sheet which can be found behind tab 5 in SPC-1 (discovered document 6). Clare's conclusions are outlined in an overview worksheet which is also behind tab 5 (discovered document 25). 41. My diary entry for 22 June 1998 indicates that I spoke with Turner on that day. 42. I do not recall the content of this conversation, although Pitcher Partners had not at this time provided any report to Ludowici. Turner may have been inquiring as to when a report may be expected or he may have been enquiring about the matters referred to in paragraph 43 below. 43. By 22 June 1998 it had been agreed between Portland House and Pitcher Partners that Pitcher Partners would in its report to Ludowici on the 1999 budget address various questions in section C of the list of questions annexed to the document at tab 4. I do not recall when that agreement was made. It was made orally between me and David Harris. I do not recall the specific conversation that occurred. 44. By reference to my diary entries I can say that my review of Clare's work papers with respect to the review of the May 1998 management accounts and the 1998/1999 budget and the preparation of what was to become our report of 29 June 1998 continued on 23,24,25 and 26 June 1998." 27 The instructions given to the audit manager by Catlin before she embarked on her task were as follows: "… I confirm our discussion about the work you are required to do as per Ludowici's letter of 29 May 1998 and in particular your initial visit to Adelaide to review ME's calculation of maintainable profits and ME's 1998/99 budget. In relation to the 1997/98 projected earnings of $2.5m you should endeavour to obtain the ME management accounts as support for the projection. We are not verifying the management accounts because we will be conducting our usual year end audit together with additional checks specified by Ludowici. However you will need to analyse them so as to understand how the business has traded during the year compared with 1997 and this will assist with understanding the 1999 budget. You should make enquiries of Steve Hutchins on the basis of his preparation of the management accounts. That is has he been consistent with how he has gone about them compared to 97 etc. Look at his workpaper files to ensure that appropriate work has been done by him. In particular enquire if there are any major jobs which might impact on the result for 98 or 99. My understanding is that Ian Kiefel is quite involved in reviewing the management accounts and discussing same with Steve Hutchins. You should enquire if this is correct as it will provide some additional comfort. In relation to the 1999 budget you need to understand how thoroughly they prepare the budget especially sales, materials and direct labour. Don't forget to examine the accuracy or otherwise of previous years forecasts and also enquire as to the extent of involvement of Ron Shipp. I understand that he is retiring soon but I would hope that he has the same level of involvement in the budget as previously. We haven't been given much time to do this job, nor have we been given detailed instructions by Ludowici however their own people are conducting the due diligence and may require your assistance in certain areas. The audit is being brought forward as well and I expect that we will be required to answer questions from them throughout the next couple of months. Please note that we need to give a verbal report by 15 June which doesn't give you much time and accordingly you should concentrate most of your effort on verifying the budget." 28 It appears from Catlin's evidence of the instructions given to the audit manager that she was provided with a copy of Ludowici's 29 May 1998 letter of instructions. The audit manager's "work plan" for the review was described as follows: " 1997 & 1998 Maintainable profits review 1. Obtain copy of IK normalised EBIT calculation, and review adjustments, recalculate estimated 1998 result and check additions. 2. Agree 1997 EBIT to 19997 (sic) audit file. 3. Obtain results to 31 May 1998 and review result. Consider major components in relation to prior year and budget and perform analytical review. 4. Review 1998 result at end of audit when final, compare to interim results and conduct usual analytical review of balances, investigating variances. 1999 budget review 1. Discuss budget preparation with management. 2. Obtain copy of budget and all supporting data and check additions. 3. Review underlying assumptions of each material expense and revenue category. In particular: 4. Revenue: What contracts have been signed but not commenced what orders are outstanding and what is the probability that they will be won by Malco. What margins are predicted. 5. Compare predictions with interim 1998 and final 1997 results for reasonableness. 6. Review prior year budgets and results to determine accuracy of budgeting process." 29 Included in Pitchers' working papers which preceded the interim report was the "Summary of Normalised EBIT". That revealed a gross margin of 21.4% for the year ended 30 June 1997 on sales of $24,000,000 and an estimated gross margin of 24.6% for the year ending 30 June 1998 on sales of $26,836,000. 30 Also of relevance is the work sheet entitled "CALCULATION OF 'NORMALISED' EBIT". That spreadsheet contained the following historical and forecast table of sales and gross margins: "MALCO ENGINEERING PTY LTD - ENGINEERING DIVISION CALCULATION OF "NORMALISED" EBIT Actual 94/95 Actual 95/96 Actual 96/97 Actual 97/98 Budget 98/99 $000's $ 000's $000's $000's $000's Sales (1) (4) 15,022 18,661 24,966 25,051 19,305 Cost of Sales (1) (4) 11,742 14,648 19,822 18,252 14,092 Gross margin (1) (40 (sic) 3,280 4,013 5,144 6,799 5,213 21.83% 21.50% 20.60% 27.4% 27.00% Overheads (1) (4) 2,669 3,039 3,312 3,619 3,455 17.77% 16.29% 13.27% 14.45% 17.90% Other income (1) (4) 128 41 127 EBIT before adjustments for abnormal items 739 1,015 1,959 3,180 1,758 Abnormal head office charges (2) 193 218 N/A (7) Unreconciled difference 151 112 N/A (7) Other (4) 76 N/A (7) Normalised EBIT as previously advised in information package 1,083 1,345 2,035 N/A (7) Remove unreconciled difference above (151) (112) 0 N/A (7) Normalised Eng Divsn EBIT 932 1,233 2,035 N/A (7) Add/(less) Unallocated expenses (1)(3) (238) (821) N/A (7) Reverse elimination of "other" items per above (76) N/A (7) March divsn result (1) (5) 776 191 (152) N/A (7) Truck Divisn result (1) (5) 150 23 331 N/A (7) MPI & Dencol result (1) (2) (232) N/A (7) Abnormal head office charges eliminated above (193) (218) N/A (7) Corporate/ head office (from 7/96) (5) (607) N/A (7) Other Profit/(loss) before tax per statutory accounts 176 1,531 N/A (7) 1,425 Total manufacturing expenses incl in cost of sales (1) 2,551 2,944 (8) " 31 The difference in gross margin percentages between the pre-1998 actuals of approximately 20% and the figure of approximately 27% for the estimates for 1998 and 1999, a difference of 6% in gross margins, represented something like $1,500,000 in the gross margin estimated for 1998 and in the order of $1,150,000 for the 1999 year based on the sales figures of $25,510,000 and $19,305,000 respectively for those years. 32 If the steep increase in the estimated percentage gross margin for the 1998 and 1999 years was unjustified, it translated into a very serious overstatement of estimated EBIT for each of those years. 33 Having presented the interim report, Pitchers wrote further to Ludowici in terms of their letter of 14 July 1998, which was in the following terms: "We were pleased to receive your request to assist with your due diligence review of Malco Engineering Pty Ltd (ME). In particular you have requested we confirm various matters in relation to our audit of accounts of Malco Engineering Pty Ltd (ME) for the year ended 30 June 1998. Our audit was also to include Malco Honert Pty Ltd however we understand that the business will now not be transferred to this new company. Please note that our audit will be conducted in the ordinary course, and audit statements will be prepared in accordance with appropriate accounting standards and audit guidelines. You have asked us to acknowledge that you will be relying on the audited accounts in Ludowici's acquisition of the M.E engineering division. Please note that the directors have resolved to prepare general purpose financial statements and these accounts will carry our usual statement in relation to the conduct of the audit. In particular, the statement will confirm the scope of the audit, namely: "We have conducted an independent audit of these financial statements in order to express an opinion on them to the members of the company. Our audit has been conducted in accordance with Australian Auditing Standards to provide reasonable assurance whether the financial statements are free of material misstatement. Our procedures include examination, on a test basis, of evidence supporting the amounts and other disclosures in the financial statements, and the evaluation of accounting policies and significant accounting estimates. These procedures have been undertaken to form an opinion of whether, in all material respects, the financial statements are presented fairly in accordance with Accounting Standards and other mandatory professional reporting requirements (Urgent Issues Group Consensus Views) and statutory requirements so as to present a view which is consistent with our understanding of the company's financial position, the results of its operations and its cash flows". In particular, we advise that a statutory audit is prepared for a particular purpose, and that purpose does not include assessing the accounts or business of the company in relation to an acquisition. Different issues in relation to materiality of amount, and different considerations would apply in relation to any report examining the financial accounts and operations of the company for that purpose. Accordingly, we can take no responsibility to you in respect of the audit other than our statutory audit responsibilities as defined under the Corporations Law. As advised verbally, we are pleased to provide any additional services compatible with that appointment that may be required from time to time, although such services are to be regarded as distinct from the performance of our duties as statutory auditor. In relation to our estimate of fees we advise that to complete the additional audit tasks you require and to report on the average maintainable EBIT and the 1999 Budget, our fees will be in the order of $28,500. Please do not hesitate to contact us should you require clarification of the foregoing." 34 The evidence disclosed that the audit proceeded with attendance at Malco's Adelaide premises by the audit manager in the last week of July 1998. 35 On 29 October 1998 Pitchers wrote to Ludowici in the following terms: " 29 October 1998 Mr Glenn Turner Managing Director Ludowici Limited 12 Victoria Parade CASTLE HILL NSW 2154 Dear Sir MALCO ENGINEERING PTY LTD - ENGINEERING DIVISION (ME) As requested in your letter of 28 May 1998 and further to our letters of 29 June 1998 and 16 July 1998, we have now finalised our audit of ME for the year ended 30 June 1998 and our review of ME's normalised earnings before interest and tax (EBIT) for years 1996/97 and 1997/98. Our findings are outlined below and include answers to the questions raised by Chrisofi Consulting Pty Ltd in their letter dated 12 August 1998. Executive Summary We have summarised the main findings as follows: 1. Our audit of the 30 June 1998 financial statements has been completed in accordance with our letter of 14 July 1998, and our opinion is unqualified. The financial statements have been prepared to comply with all relevant accounting standards (general purpose accounts). 2. In our view of the ME systems we did not note any weaknesses in the systems and internal controls which were likely to cause any material errors within the accounts. However we have made some internal control recommendations specifically in relation to large projects to avoid a repeat of the recording problems encountered on the Moranbah North Coal Project. 3. From the testing we conducted we believe debtors, provision for doubtful debts, inventories, work in progress (WIP) and provision for warranty claims to be materially correct. Also, we did not note any potential losses not provided for on contracts outstanding at year end. 4. In general, we believe that management are conducting an appropriate review of current systems for Y2000 compliance and implementation of procedures to ensure no foreseeable problem will eventuate. 5. We note that there are no potentially material exposures to currency risks. 6. The separation of Malco Industrial Products Pty Ltd ("MIP") and Malco Engineering Pty Ltd has been successfully completed. We understand the company secretary is to provide you with relevant directors minutes.…" 36 A detailed report on the "additional tasks in relation to [their] statutory audit of [Malco]" concluded with the following: " D. Update on the review of maintainable profits Further to our letter dated 29 June 1998, we have now taken into account our audit adjustments and we have determined that the final EBIT after abnormal items for 1997/98 year is $2,196,097. We believe that this figure is reasonable and can be relied upon, and are satisfied that the profit recorded for the year has not been materially overstated. … E. Conclusion Based on our review and previous knowledge of ME we believe that the calculations of EBIT for the year ended 1997/98 appear reasonable and are not materially overstated. In relation to the transfer of the business we believe that all relevant assets and liabilities have been transferred into the new entity. Further we are satisfied that the accounts are true and fair and accordingly, we have issued an unqualified audit opinion. Please do not hesitate to contact either Clare Luehman or the writer if you have any questions in regard to this report." 37 It is apparent from that report that Pitchers failed to expose the serious error in the accounts of Malco for the year ended 30 June 1998 and consequently failed to report that the declared profit was grossly overstated. In the body of the report under the heading "Inventory" the following statement appeared: "We have reviewed the value of inventories, WIP, warranty claims and potential losses on contracts outstanding at year end and we are satisfied that no material adjustments are required." 38 Under "Audit Adjustments" the following statement appeared: "12. Audit Adjustments The major adjustments resulting from our audit were in relation to the reconciliation of work in progress, the write downs of stock and the raising of the provisions for O'Connor Resources. A full listing of these adjustments is contained in Appendix 2." 39 The appendix referred to included a detailed schedule of work in progress amongst which there appeared the following description: "Job No Client Description Cost WIP WIP (detailed) Repairs to building/plant & equipment which are expensed or capitalised on completion, including warranty repairs 834,090 834,090 Represented by: Repairs and maintenance 157,995 Plant and equipment 139,544 Provision for warranty 53,005 CoGs (net of subsequent recovery) 107,232 Warranty expense 282, 678 Stock - Raw materials 3,485 Other expenses (R&D, Export) 9,328 Work in Progress* 80,823 834,090 Represented by: Jobs raised for the manufacture of stock items: Stock - Raw materials 282,395 282,395 243,690 Work in Progress* 38,705 282,395 Customer jobs with a contract value of < $50,000 283,648 283,648 283,648 2,811,543 3,008,371 3,008,371 *Repair/rework or stock jobs determined to be work in progress have been ultimately classified as customer jobs with a contract value of <$50,000. " 40 The error in the accounts relating to work in progress was uncovered as a consequence of probing by Glenn Thurston Turner (Turner), the managing director of both Ludowici and Ludowici Mineral, whose interests lay in understanding the tax implications of provisions in the account for future income tax benefits (FITB), and for deferred income tax (PDIT), and the manner in which work in progress was treated in relation to the determination of the net tangible assets of Malco for the purposes of the agreement. 41 Turner was puzzled by the fact that PDIT was greater than FITB in the 1998 accounts, in the face of a declining value of work in progress. He enlisted the aid of Herodotus Christofi (Christofi), a consultant who had previously been the company secretary and finance manager of Ludowici, and as a consultant had assisted in the due diligence exercise involving the acquisition of Malco. Turner also sought the advice of Ludowici's accountant Colin Winn Thomas (Thomas). 42 I think it is unnecessary to recite the detail of communications between Turner, Christofi, Thomas and Pitchers in the months between October 1998 and March 1999, other than to observe that Ludowici and its advisers experienced considerable difficulty in extracting satisfactory explanations from Pitchers in relation to the treatment of WIP for tax purposes and to note that the principal interest of these inquiries by and on behalf of Ludowici were primarily taxation orientated. 43 On 9 March 1999 Thomas wrote to Catlin in terms which included the following: "Thankyou for your letter dated 2 March 1999. I tried to contact Mr Cumming and left messages, however, he has not returned my call. I consequently write to you again on the issues raised in your letter :- 4. I note that the work in progress includes an item described as "Repairs to building/plant & equipment which are expensed or capitalised on completion, including warranty repairs $834,090". Could you please explain:- (a) What is it and how was the expenditure treated post 1 July 1998. (b) Why were the costs not expensed against profit in the 1997/1998. What is the benefit of carrying forward the costs. (c) What was the accounting policy/treatment in prior years, has there been a change and why? It appears to me that the expenditure may qualify as a prepayment for tax purposes, however, it does not appear to be a tangible asset and your comment on the above questions would assist me in reporting to Mr Turner on the issues." 44 Thomas' letter did not expose his full thoughts on the subject, as, in his facsimile to Ludowici of 8 March 1999, he commented on the amount of $834,090 WIP in the following terms: "Repairs to buildings and plant or warranty repairs. This expenditure of $834,090 is not work in progress. For tax purposes if the expenditure is indeed repairs and not capital it is a deduction when incurred. In such circumstances the expenditure creates a deferred tax liability as a result of claiming a tax deduction in the year prior to expensing the cost." 45 On 29 March 1999 Catlin communicated with Ludowici in the following terms: "Glenn, I thought I should bring you up to date on what has transpired since our last communication. We have received a letter from Hudson Croft Thomas dated 9 March 1999 which I believe you have been copied in on. This letter essentially raises a number of questions in relation to the tax treatment of various items and seeks clarification and explanation. One of the items raised was in relation to an item described in our last correspondence to Hudson Croft Thomas as "Repairs to building/plant & equipment which are expensed or capitalised on completion, including warranty repairs - $834,090." These amounts form part of closing work in progress at 30 June 1998. We became concerned that perhaps some of these items were more appropriately expensed in the year ended 30/6/98 than carried forward as assets and began investigations accordingly. At this stage our investigations have been inconclusive as we have received a number of contradictory communications as to the nature of the component items and the subsequent treatment in the books of the company. We have discussed this matter with the management of Portland House Group and they are aware of our concerns. We have however not been able to speak with Ron Shipp on this matter and we believe it is essential that we do so before we draw any conclusions. We understand that this matter has been continuing for some time and are aware of the desire to wrap things up however given the amounts involved we believe it is appropriate to get the facts straight so that we can present to you a picture of the situation that we can have confidence in. We have considered the various other taxation matters raised in the letter and will address them in the context of the final numbers once this other matter is resolved." (Emphasis added) 46 It is difficult to avoid the inference that, at this time, Catlin was alerted to the serious implications of the failure to expense items for the work in progress to the profit and loss account of Malco as at 30 June 1998 upon the EBIT as reported upon by Pitchers for the purpose of the acquisition of Malco by Ludowici. This inference is somewhat strengthened by the terms of Catlin's further letter to Turner of 29 April 1999 which included the following: "2. Work in Progress - 30 June 1998: The following matters arose recently after ascertaining the accounting treatment of sundry work in progress jobs in the period after 1 July 1998. We have had considerable discussions with Malco management in an effort to resolve the correct treatment and impact on the six (6) months result to 31 December 1998. It appears that the level of scrutiny by management of these sundry work in progress jobs was not the same as in previous years (only $52,000 remained in WIP at 30 June 1997). Also, it should be noted that the nature of these jobs were not identified during Ludowici's review and in addition were outside our audit sample for testing. These jobs were included in the WIP listing as the 4xxxx and 5xxxx categories and, whilst the initial advice was that these were of a capital nature or were recoverable from customers, the correct treatment is outlined below based on subsequent advice from management on the treatment post 30 June 1998. We note that the majority of these jobs were written off after 1 July 1998 to overheads and therefore, if the same amount is now written off at 30 June 1998 the trading result for the six (6) months ended 31 December 1998 (post acquisition) is significantly improved. The improvement is not the same amount because the same issues existed at 31 December 1998, however the net improvement in the six (6) months result should be in the order of $360,000. … 3. Work in Progress - 31 December 1998 The value of 4xxxx and 5xxxx categories included in WIP at this date was: 4xxxx Plant jobs 164,986 5xxxx Rework 118,292 283,278 We have obtained further information from Malco management about the above and the following outlines the treatment that should be adopted at 31 December 1998. The same commentary as outlined above for 30 June 1998, should also apply for December. These figures include jobs that were also in the June WIP and therefore, the value of these jobs at 30 June (shown in brackets) would have to be deducted from the above figures when the December accounts are adjusted. 3.1 Plant and equipment ($45,661) 101,283 3.2 Provision for warranty ($2361) 16,995 118, 278 3.3 Repairs and Maintenance ($6913) 100,963 3.4 Warranty expense ($5712) 64,037 165,000 283,278 4. Warranty expense The provision for warranty at 30 June 1998 was $358,500 and after allocating $53,000 of WIP against this (refer 2.2 above) then a decision needs to be made as to the adequacy of the remaining $305,500. The Net Tangible Assets figure cannot be determined until this provision is re-assessed and is subject to audit review. This re-assessment should be undertaken by Malco management because they should be aware of any warranty work still required beyond 31 March 1999 on contracts completed by 30 June 1998. We can provide guidelines if required. The warranty provision at 31 December 1998 was $250,000 as assessed by Ron Shipp.…" 47 The remainder of the letter then addresses individual costs in "WIP" in detail that is unnecessary to record. With the letter came a schedule upon which the following comment was made: " 2.6 … This Schedule indicates that $6.5M of Net Tangible Assets as defined in the Sale Agreement may not have been delivered at 30 June 1998. Any shortfall could be made up by the revaluation of the fixed assets and we understand that the required revaluation increment can be supported by an independent valuation." 48 In my view this communication from Catlin did not expose the full implications of Pitchers' failure to detect the error in Malco's accounts for the 1998 year. 49 The error was described more graphically in a facsimile of 29 April 1999 from the manager of Malco Engineering Adelaide to Turner in the following terms: "Glenn, do you know about the $834,000 hole in the accounts at 30 June, 1998? David Hains has been on the phone and I have explained to him that there is a substantial amount of rework and repairs which need to be charged against profit which has been missed by accounts here and the auditors". 50 Of the WIP schedule, Turner gave the following evidence: "165. The items referred to included provision for warranty, repairs and maintenance jobs and warranty expense. Schedule 1 to the letter identifies an adjustment of $564,735 on account of repairs and rework to the profit before tax in the draft financial statements of $2,042,095. My understanding is that, taking other adjustments into account, the 1998 EBIT figure became $1,631,362." 51 Turner took the matter up with Catlin in a conversation on 7 April 1999 as follows: "I said: "I am not happy given the late reductions in profit on the Moranbah North job and the results of Malco Engineering since acquisition. Malco Engineering at June 1998 was represented during due diligence as having up to $3.5m EBIT. This eventually became $2.2m and now further significant dollar adjustment downward will be required and any claiming of repairs as capital would need to be consistent with previous years." 52 On 27 May 1999 Turner replied by letter in some detail to Catlin's letter of 29 April 1999 as follows: " 2 . Work in Progress The matters surrounding work in progress are a concern. We disagree with the second sentence of your second paragraph wherein you state that "…nature of these jobs were not identified during Ludowici's review and in addition were outside (Pitcher's) (sic) audit sample for testing". We note that we asked you to comment on work in progress in our letter of 29 May, 1998 and would have expected that with work in progress constituting $3.0m of a net $6.5m assets to be delivered you would have conducted a review of this number. The treatment of various items in the work in progress which is now being proposed appears correct subject to receipt of additional information requested (including the revised profit and loss and balance sheet schedules and journal entries requested in our fax of 21 May, 1999) and confirmation by our tax adviser. As a result of these adjustments we make the following observations and further adjustments. 2.1 Plant and Equipment Jobs The inclusion of $139,544 as capitalised plant and equipment brings the total plant work capitalised for 1998 to $182,164. This is in contrast to expenditure on plant capitalised in previous years of $3,950 in 1997 and $27,869 in 1996. Notwithstanding the higher level of repairs claimed in 1998 due to alleged need would you please provide us a schedule of the $139,544 as it seems extremely high by previous years figures. 2.2 Provision for Warranty As a result of the adjustment the provision for warranty has now reduced to $305,500. Attached to this letter is a recast of the provision for warranty calculated by Malco management consistent with previous methodology and based on knowledge certain since 30 June, 1998 and which shows that the provision for warranty should be a figure of $411,000 at 30 June, 1998. Malco management advise that this figure includes the $53,005 and hence there should be an upward adjustment to the provision for warranty of $52,500 to $357,995. Prior to the adjustment above the provision for warranty account at 30 June, 1998 was as follows: Opening Balance $472,000 + provided $152,357 - incurred $265,857 Closing Balance $358,500 The incurred expenses as a result of the adjustment of $53,005 now become $318,862. In addition however the further adjustment (your paragraph 2.5) of a sum of $282,678 is also treated as warranty expense and debited directly to the profit and loss in 1998. This brings the actual warranty expenses for 1998 to a figure of $601,540. As a result of this adjustment and representations to Malco since acquisition by customers with claims for alleged warranty work we are concerned that the provision for warranty in previous years may have been bypassed and not reflected the true cost of warranty work. Certainly in 1998 it cannot be said that Malco has lived within its warranty (a statement made to us on a number of occasions during due diligence). We are seeking further information on the issue of warranty expenses prior to 1998." 53 On 13 December 1999 Ludowici and Ludowici Mineral entered into a deed of mutual release with Portland House under which Ludowici received $250,000, which, as a matter of fact, was the amount of the short fall in the net tangible assets of $6,500,000 warranted under the agreement. 54 Malco suffered "an audited pre-tax loss of $914,000" for the year ended 30 June 1999. Mark Brinley Bryant (Bryant), a chartered account who is the partner in charge of Arthur Anderson's dispute analysis practice, was retained by Ludowici to report on the accountancy issues in these proceedings. He adjusted the pre-tax loss of Malco for the period ended 30 June 1999 to arrive at an EBIT of ($884,000). 55 As at 30 June 1999 Malco ceased to continue the operation of its business in the following circumstances: "4. The business of Malco was operated on a stand alone basis from the date of its purchase until 30 June 1999. On 30 June 1999, its business was transferred to LMPE. This was achieved by taking new business into LMPE and running down the trading in Malco. Employees were transferred to LMPE effective 1 July, 1999 and inventory was purchased by LMPE as required from Malco at an agreed selling price of cost plus 12.5%. From 1 July 1999, Malco continued to hold its fixed assets and LMPE paid rent to Malco for their use." 56 The case against Pitchers is set out in the Contentions as follows: "10. On or about 29 June 1998 , the Defendants provided a report ( "the 29 June 1998 Report" ) to the Plaintiffs. Particulars Letter from the Defendants to Mr Glenn Turner, Managing Director of the Plaintiffs dated 29 June 1998 and received by facsimile on 3 July 1999. 11. In the 29 June 1998 Report, the Defendants represented to the Plaintiffs that: (a) the Estimated 1998 EBIT Amount was reasonable; (b) the Estimated 1998 EBIT Amount was not overstated; and (c) the actual 1998 EBIT amount could be as high as $3.0m. ( "the 29 June 1998 Representations"). 12. The 29 June 1998 Representations were made in trade and commerce. 13. To the extent that the 29 June 1998 Representations related to future matters, the Plaintiffs rely on section 41 of the Fair Trading Act 1987 (NSW). 14. At the time of the making of the 29 June 1998 Representations the Defendants intended and well knew or ought to have known that the Plaintiffs would rely upon the 29 June 1998 Representations and be induced thereby to purchase the issued shares in Malco. Particulars Letter dated 29 May 1998 from Mr Glenn Turner, the Managing Director of the Plaintiffs to Mr Sid Catlin on behalf of the Defendants. … 16. On or about 3 August 1998 : (a) and in reliance upon the 29 June 1998 Representations, the Second Plaintiff executed a Share Sale Agreement for the purchase of the issued shares in Malco from Moore; (b) the Defendants were appointed to calculate the NTA of Malco as at 30 June 1998. 17. In the process of performing the Retainer Agreement, the Defendants failed to detect and advise the Plaintiffs that a significant proportion of construction WIP in the amount of approximately $564,735 was not in fact WIP but items of expense by way of repairs and rework which should have been charged to the profit and loss account and repair items subsequently capitalised. Particulars The Defendants expressly acknowledged this matter in a facsimile from Mr S Catlin of the Defendant, to Mr Glenn Turner, Managing Director of the Plaintiff, dated 29 April 1999. First Cause of Action: Breach of Contract 18. By reason of the matters pleaded in paragraph 17, the Defendants breached the term of the Retainer Agreement pleaded in paragraph 9(b) above. 19. By reason of the matters pleaded in paragraph 17, the Defendants breached the term of the Retainer Agreement pleaded in paragraph 9(f) above. 20. By reason of the matters pleaded in paragraph 17, the Defendants breached the term of the Retainer Agreement pleaded in paragraph 9(g) above. 21. By reason of the matters pleaded in paragraph 17, the Defendants breached the term of the Retainer Agreement pleaded in paragraph 9(h) above. Second Cause of Action: Misleading and Deceptive Conduct 22. Contrary to the 29 June 1998 Representations, and by reason of the matters pleaded in paragraph 17, the Estimated 1998 EBIT Amount: (a) was not reasonable; and (b) was overstated. 23. By reason of the matters pleaded in paragraph 22, the 29 June 1998 Representations were misleading or deceptive or likely to mislead or deceive and the Defendants have engaged in conduct that is misleading or deceptive or likely to mislead or deceive in dealing in securities in contravention of section 42 of the Fair Trading Act (NSW). Third Cause of Action: Negligence 24. By reason of the matters pleaded in paragraphs 8, 9 and 14, the Defendants were under a duty to take care in the provision of advice to the Plaintiffs and in the making of representations to the Plaintiffs. 25. In breach of the duty of care pleaded in paragraph 24, and by reason of the matters pleaded in paragraph 17, the Defendants were negligent in failing to identify and advise the Plaintiffs that approximately $564,735 attributed to WIP consisted of items of expense by way of repairs and rework which should have been charged to the profit and loss account and the repair items subsequently capitalised." 57 The terms of the retainer referred to in pars 18 to 21 of the Contentions were alleged to be the following: "9. The following were terms of the Retainer Agreement: … (b) the Defendants would report to the Plaintiffs upon: (i) any weaknesses in systems and internal control that the audit may uncover; (ii) any concerns the Defendants had as to the valuation of work in progress ( "WIP" ) and warranty claims; and (iii) any other areas the Defendants considered needed specific comment or attention. Particulars This term is contained in a letter dated 29 May 1998 from Mr Glenn Turner, the Managing Director of the Plaintiffs to Mr Sid Catlin on behalf of the Defendants. ... (f) the Defendants would be diligent, exercise due care and undertake a thorough investigation of the books and records of Malco; Particulars This term is implied from the nature of the relationship between the Plaintiffs and the Defendants including the Defendants' knowledge of the Plaintiffs' reliance upon the Defendants. (g) the reports provided by the Defendants to the Plaintiffs would be accurate; Particulars This term is implied from the nature of the relationship between the Plaintiffs and the Defendants including the Defendants' knowledge of the Plaintiffs' reliance upon the Defendants. (h) the Defendants would bring to these tasks a special knowledge and familiarity with the financial position of Malco arising out of their longstanding position as accountants, auditors and advisors to that company." 58 For the most part, Pitchers denies the Contentions. Of the allegations of the terms set out in par 9 of the Contentions they pleaded as follows: "(c) they deny that the terms alleged in paragraphs 9(a), 9(b), 9(c), 9(d) and 9(e) arose in the terms as alleged by the first plaintiff and say that the subject matter of those allegations whilst part of the work to be undertaken by the defendants pursuant to the retainer of the defendants by the first plaintiff arose in the context where: (i) the work to be performed by the defendants was to be limited in nature and scope in that the defendants were not authorised by the first plaintiff to expend unlimited resources in investigating all aspects of the matters contained in those allegations and were, rather, authorised by the first plaintiff to conduct an examination of matters relevant to the matters contained in those allegations within a context where the resources to be expended were limited; (ii) that the works undertaken by the defendants on behalf of the first plaintiff in the circumstances referred to in sub-paragraph (i) above accorded with and complied with the nature of the works to be performed in that context and were performed in accordance with applicable according standards; and (iii) the first plaintiff was aware of the matters referred to in sub-paragraphs (i) and (ii) above." 59 Ludowici and Ludowici Mineral contend that the accountancy practice of Malco in adjusting work in progress at financial year's end to distribute expenses either to Malco's profit and loss or capital accounts, as known by Pitchers, required Pitchers' audit manager to ascertain what adjustments were necessary for the purpose of the interim report and in performing the special audit work under the retainer in July 1998. Second, it was contended that the auditor manager of Pitchers should have been put on notice of irregularity in Malco's accounts by the working paper which showed historical gross margins for the years ended 30 June 1995, 1996, and 1997 of approximately 21% and an "expected" gross margin of 27% for the year ending 30 June 1998, and in the budget for the year ending 30 June 1999. 60 A similar contention was based upon the working paper which showed a gross margin of 21.4% for the year ended 30 June 1997 and an estimated percentage of 24.6% for the year ending 30 June 1998. 61 Bryant's evidence, in summary, of Pitchers' failure to detect the error in Malco's accounts for the year ended 30 June 1998 was as follows: "11. The strong possibility of material error to Malco's 1998 EBIT was readily detectable by a reasonably competent accountant who was auditing Malco's WIP in late July 1998, which was when Pitcher Partners were performing this work. 12. There is a very high probability that a reasonably competent accountant who was auditing Malco's WIP in late July 1998 would have identified the actual errors which are now apparent." 62 For the reasons that follow, I am satisfied that Pitchers were negligent in the advice tendered to Ludowici in their interim report in advising Ludowici of the reasonableness of the expected EBIT figure for the year ending June 1998 and the reasonableness of the estimated EBIT for the year ending 30 June 1999: in failing to ascertain what adjustment of the WIP subsidiary ledger was necessary, the consequent distorting effect on the financials of Malco and to report upon that to Ludowici. 63 Pitchers' position was that, in carrying out its accountancy work for the purpose of providing the interim report, it had satisfied the requirements of the retainer, and in particular, the standards laid down for such a "review". Pitchers deny that their audit work, duly performed, should have exposed the error prior to the execution of the agreement. 64 Their case rests largely on the evidence of Catlin and of Aubrey Lawrence Whitear (Whitear), a chartered accountant and partner of Price Waterhouse Coopers, whose statements were made respectively on the 16th and 17th May 2001, in the week preceding the hearing: despite a Court direction on 25 August 2000 to file and serve statements of evidence upon which Pitchers relied by 12 October 2000: on 13 October 2000 to file such evidence on liability by 27 October 2000 and, on damages, by 15 November 2000: on 3 November 2000 to file and serve that evidence by 7 December 2000 and on 9 February 2001 to file and serve that evidence by 16 March 2001. None of those directions were complied with. On 4 May 2001 I declined to give any further directions to extend the time for filing and serving statements of evidence. I refer to this as the late serving of statements of evidence, particularly as to quantum, I think, has had an impact on the way in which the issues in this case have been addressed on the hearing. 65 Essentially, Whitear's evidence as to Pitchers' satisfaction of appropriate standards of accountancy in preparing and providing its interim report of 29 June 1998 turns on his acceptance that Australian Standard AUS 902, or AUS 904 is the applicable standard by which that work should be judged. He relied mainly on AUS 902. I am satisfied that they are not, or more accurately, that they are to be read subject to the particular terms of Pitchers' retainer. 66 The substance of Whitear's report constituting his evidence in chief is addressed to AUS 902. Without explaining the significance, or reason for the departure in par 4.18 of his report of 17 May 2001, he appears to treat AUS 904 as applicable to the engagement. Either way, his approach is unacceptable as he fails to recognise the specific terms of the 19 May 1998 engagement and, more importantly, appears to place little or no reliance upon the consequence of Pitchers' knowledge of Malco's accountancy practice requiring adjustment of the WIP subsidiary ledger at year's end. 67 He does not address the obvious need, prior to year's end, for Pitchers to make inquiries as to the carrying out of necessary adjustments to the subsidiary ledger in order to provide the interim report required by Ludowici's terms of engagement. 68 In what may be described as a bold, fall-back position, Pitchers contend that there was no evidence that Pitchers failed to make an inquiry of Malco concerning the necessary adjustment to the WIP subsidiary ledger. I say 'bold' because it was never suggested in cross examination of Hutchins that any such inquiry was made of him by Pitchers' audit manager. There was no suggestion by Catlin that he made any such inquiry either of the audit manager, or of Hutchins. The audit manager of Pitchers was notable by her absence from the witness box and all of the working papers of Pitchers contained no record of any note of such an inquiry. In the many months from October 1998 until mid 1999, during which Ludowici endeavoured to extract from Pitchers the anomaly in the 1998 accounts which eventually exposed the error, it was never suggested by Pitchers that the error arose as a result of Pitchers receiving misleading information from Malco in response to any such supposed inquiry. 69 The evidence of Hutchins, although not specific in this regard, should be read as evidence that no such inquiry was made of him by Pitchers' auditing team. 70 Auditing Standard AUS 902 entitled "Review of Financial Reports" has as its purpose the following: ".01 The purpose of this Auditing Standard (AUS) is to establish standards and provide guidance on the auditor's professional responsibilities when an engagement to review a financial report is undertaken, and on the form and content of the report that the auditor issues in connection with such a review. 1 The term "auditor" is used throughout the AUS. Such reference is not intended to imply that a person performing a review need necessarily be the auditor of the entity nor that the service being provided is an audit. The term is used to indicate that the work is required to be performed and the report prepared by persons who have adequate training, experience and competence in auditing." 71 Its use is identified as follows: ".02 This AUS is directed towards the review of financial reports. However it is to be applied to the extent practicable to engagements to review financial or other information (such as reports on the design or effective operation of a system of internal accounting control or computer software and on compliance with statutory or regulatory requirements). This AUS is to be read in conjunction with AUS 106 "Explanatory Framework for Standards on Audit and Audit Related Services". Objective of a Review Engagement .03 The objective of a review of a financial report is to enable an auditor to state whether, on the basis of procedures which do not provide all the evidence that would be required in an audit, anything has come to the auditor's attention that causes the auditor to believe that the financial report is not prepared, in all material respects, in accordance with an identified financial reporting framework (negative assurance)." 72 The manner in which the standards contained within AUS 902 are to be applied is expressed in the following way: ".05 The auditor should conduct a review in accordance with Australian Auditing Standards applicable to review engagements. AUS's are mostly written in the context of audits. However they are to be applied and adapted as necessary to review engagements." 73 The manner in which the "review" is to be performed is stated as follows: ".06 The auditor should plan and perform the review with an attitude of professional scepticism, recognising that circumstances may exist which cause the financial report to be materially misstated . .07 For the purpose of expressing a negative assurance in the review report, the auditor should obtain sufficient appropriate evidence primarily through inquiry and analytical procedures to be able to draw conclusions ." 74 The function of a "review" engagement is stated as follows: ".09 A review engagement provides a moderate level of assurance that the information subject to review is free of material misstatement. The report provides this assurance in the form of negative assurance." 75 A comparison of a 'review' and of an 'audit' is described in the following way: ".10 While reviews involve the application of audit skills and techniques, they do not usually involve many of the procedures ordinarily performed during an audit. In an audit, because the auditor's objective is to provide a high, but not absolute, level of assurance on the reliability of the financial report, the auditor will use more extensive audit procedures than in a review. .11 Reviews involve limited procedures comprising inquiries of company personnel and analytical procedures applied to financial or non-financial information. Reviews of financial reports do not ordinarily involve: (a) a study and evaluation of internal accounting controls; (b) tests of accounting records; and (c) tests of responses to inquiries by obtaining corroborating evidence through: (i) inspection: (ii) observation; and (iii) confirmation. The auditor may, however, decide that additional information is required from management and/or additional procedures are necessary to obtain sufficient appropriate evidence on aspects of the financial report subject to a review (for example when the auditor has doubts as to the completeness and accuracy of the financial report). The acquisition of information in this way does not convert the engagement to an audit engagement. A review engagement may bring to the auditor's attention significant matters affecting the financial report, but it provides less assurance than would be provided by an audit that the auditor will become aware of all significant matters." 76 That the "review" is to be understood in the context of the terms of the subject engagement is made clear by the following: ".13 The auditor and the entity should agree on the terms of the engagement. The agreed terms would ordinarily be recorded in an engagement letter or other suitable form. .14 It is in the interest of both the entity and the auditor that the auditor send an engagement letter, preferably before the commencement of the engagement, to help in avoiding misunderstandings with respect to the engagement. The engagement letter documents and confirms the auditor's acceptance of the appointment, the objectives and the scope of the engagement, the extent of the auditor's responsibilities to the entity and the form of any reports. .15 Matters that would be included in the engagement letter include: (a) the objective of the service being performed; (b) management's responsibility for the financial report; (c) the scope of the review, including a statement that the review has been performed in accordance with Australian Auditing Standards applicable to review engagements; (d) unrestricted access to whatever records, documentation and other information requested in connection with the review; (e) a sample of the report expected to be rendered; (f) the fact that the engagement cannot be relied upon to disclose errors, illegal acts or other irregularities, for example fraud or defalcations that may exist; and (g) a statement that an audit is not being performed and that an audit opinion will not be expressed. To emphasise this point and to avoid confusion, the auditor may also consider pointing out that a review engagement will not satisfy any statutory or third party requirements for an audit." 77 Of particular interest I think is the way in which planning is discussed in the Standard, in particular, the following: ".17 In planning a review, the auditor should obtain or update a knowledge of the business including consideration of the entity's organisation, accounting systems, operating characteristics and the nature of its assets, liabilities, equity, revenues and expenses . .18 The auditor needs to possess an understanding of such matters relevant to the financial report, for example a knowledge of the entity's production and distribution methods, product lines, operating locations and related parties. The auditor requires this understanding to be able to make relevant inquiries and to design appropriate procedures, as well as to assess responses and other information obtained. 19. The knowledge and understanding of the entity required would have been acquired by an auditor who has carried out audits or reviews of the entity's financial reports in recent previous periods. Where a review engagement is undertaken by an auditor who does not have the knowledge acquired from recent previous periods, that auditor needs to be satisfied that sufficient knowledge and understanding can be obtained to meet the requirements of AUS 304 "Knowledge of the Business". The auditor would consider the need to increase the extent and/or broaden the nature of the procedures to be performed during the review engagement. In the case of an auditor who has knowledge acquired from recent previous periods, procedures would be performed to update that knowledge and identify significant changes. .20 The knowledge of the business would include an understanding of the internal control structure as it relates to the preparation of the financial report. This helps to ensure that appropriate attention is given to the impact of the internal control structure on the risk of occurrence of material misstatements. …. .29 If the auditor has reason to believe that the information subject to review may be materially misstated, the auditor should seek additional information from the management of the entity and/or carry out additional or more extensive procedures to obtain sufficient appropriate evidence to be able to express negative assurance, or to confirm that a qualification is required . Conclusions and Reporting .30 The review report should contain a clear written expression of negative assurance. The auditor should review and assess the conclusions drawn from the review evidence obtained as the basis for the expression of negative assurance . … .33 The report on a review of a financial report should contain the following basic elements ordinarily in the following layout: … (c) a section describing the review scope, which for a financial report review includes : … (d) an expression of negative assurance; … " 78 It is plain that the interim report required under the retainer was not limited to a review in terms of the AUS 902, I think for the compelling reason that the terms of Pitchers' engagement, set out in Ludowici's letter of 29 May 1998, clearly do not call for a report in the form of a negative assurance. In conformity with the terms of that agreement the interim report states the nature of the review in its opening paragraph in the following terms: "As requested in your letter of 28 May 1998 we have completed our interim review of ME's normalised earnings before interest and tax (EBIT) for the years 1996/97 and 1997/98 (projected), and we have also reviewed the 1989/99 Budget. Our findings are outlined below which include answers to various budget queries you raised in your letter of 15 June 1998 to Mr Hains…" 79 There then followed a section entitled "Review of maintainable profits (Engineering division)" which, in appendix form, summarised the estimated EBIT for the year ending 30 June 1998 and the manner in which it had been "normalised". A similar, but far more detailed review of the estimated figures for the year ending 30 June 1999 followed in the interim report and, most notably, the conclusion is expressed, not in a negative assurance, but as follows: "Based on our review and previous knowledge of ME, we confirm that ME's calculation of EBIT for the years 1996/1997 and 1997/1998 appears reasonable and not materially overstated. In addition the 1998/1999 Budget (Engineering Division) appears soundly based and the profit expectation reasonable." 80 That is to be read in conjunction with the further assurance given in relation to the 1997 and 1998 figures as follows: "Based on the above we are satisfied that the Normalised EBIT figures for 1997 and 1998 as disclosed on schedule 1 are reasonably stated for purposes of calculating an updated average maintainable EBIT on the basis outlined in your letter of 21 April 1998." 81 As a consequence of Whitear's report only being served in the week before the hearing, the expert evidence report filed and served before the hearing on behalf of Ludowici and Ludowici Mineral, did not address this basis of Pitchers' defence which turned on the application of AUS 902 or AUS 904. It had not been particularised in Pitchers' defence. In paragraph 9 of the defence, the alleged limitation on the accountancy report for which Pitchers were retained was described as follows: "9. They deny the allegations contained in paragraphs 8 and 9, and they say that: … (c)…the retainer of the defendants by the first plaintiff arose in the context where: (i) the work to be performed by the defendants was to be limited in nature and scope in that the defendants were not authorised by the first plaintiff to expend unlimited resources in investigating all aspects of the matters contained in those allegations and were, rather, authorised by the first plaintiff to conduct an examination of matters relevant to the matters contained in those allegations within a context where the resources to be expended were limited; (ii) that the works undertaken by the defendants on behalf of the first plaintiff in the circumstances referred to in sub-paragraph (i) above accorded with and complied with the nature of the works to be performed in that context and were performed in accordance with applicable according (sic) standards;…" 82 Quite clearly that defence, in referring to "applicable according (sic) standards", was relying on a limitation on the obligations of Pitchers arising out of alleged financial constraints imposed by Ludowici. No such case was pressed on behalf of Pitchers in these proceedings. 83 It is clear, in my view, that Pitchers were being called upon to provide in their interim report some assurance of the reliability of the actual EBIT as disclosed in the financials of Malco for the year ended 30 June 1997, the expected EBIT for the year ending 30 June 1998 and the estimated EBIT for the year ending 30 June 1999, as part of the due diligence exercise then underway in relation to Malco's acquisition. Moreover, Pitchers were made aware of the fundamental importance of those EBITs in the formulation of the purchase price of Malco then under consideration. Far from seeking a negative assurance, Ludowici was intent on co-opting the services of Pitchers as part of the due diligence process. That was explicit in Ludowici's letter of retainer of 30 May 1998 in which the following appears: "As part of our due diligence exercise we seek your assistance in the following areas:…" 84 Pitchers were not asked for a negative assurance but a confirmation that the EBIT for 1997/1998 was "reasonable and [could] be relied upon" and they were directed to focus attention on "ensuring that these [were] not overstated". 85 Similarly, in relation to the 1999 figures, Pitchers were requested to "express an opinion as to whether, based on your extensive knowledge of [Malco] and the above review, the budgets are soundly based and the profit expectations (EBIT $1.5m) reasonable". 86 I think it is bordering on the indefensible to suggest that what Ludowici was seeking was a review in the manner advanced by Pitchers through the evidence of Catlin and Whitear. 87 Even if one saw in AUS 902 relevant limitations on the requirements of Pitchers in providing their interim report pursuant to Ludowici's terms of engagement, the standard is of little comfort to Pitchers, in my view. It requires that: "…the auditor …update a knowledge of the business including consideration of the entity's …. accounting systems … an understanding of the internal control structure as it relates to the preparation of the financial report…. to ensure that appropriate attention is given to the impact of the internal control structure on the risk of occurrence current material misstatements". 88 Further it is noted that in relation to 'Procedures of Evidence' as follows: "The auditor will be guided by such matters as : (a) any knowledge acquired by carrying out audit or reviews of the financial reports for prior periods; (b) the auditor's knowledge of the business including knowledge of the accounting principles and business practices of the industry in which the entity operates; (c) the entity's accounting systems;…" 89 Amongst analytical procedures expected of the auditor under AUS 902 were the following : "(i) comparison of the financial report with reports for prior periods; … (iii) study of the relationships of the elements of the financial report that would be expected to conform to a predictable pattern based on the entity's experience or industry norm." 90 It is common ground that Pitchers knew Malco's business, knew its accounting procedures and, in particular, knew that adjustments of the WIP subsidiary ledger were necessary to properly allocate expenses where appropriate to either profit and loss, or capital accounts within Malco and that this was not done by Malco until close of the subject financial year. 91 Clearly, that adjustment could not have taken place at the time of the interim report. It would have been an essential step in carrying out the review to ascertain from Malco what the position was in relation to adjustments to the ledger items. That is given further emphasis if one has regard to the contracting nature of Malco's engineering business and the fundamental importance of proper accounting in relation to work in progress in any analysis of its EBIT, whether actual, estimated or expected. 92 Similarly, I think it is plain from the evidence that the interim report and the special auditing work required of Pitchers in response to Ludowici's retainer was not limited to a report in terms of AUS 904. 93 That is an auditing standard relating to "… agreed upon procedures and engagement". Of such an engagement AUS 904 stipulates as follows: ".05 As the auditor provides a report of the factual findings of agreed-upon procedures, no assurance is expressed. Instead, users of the report assess for themselves the procedures and findings reported by the auditor and draw their own conclusions from the auditor's work." 94 The standard emphasises the importance of ensuring the terms of the subject engagement are spelt out and agreed upon. I think it is obvious that Pitchers' retainer to participate in the due diligence process relating to the acquisition of Malco did not call for a report in the form of AUS 904 from which Ludowici was to draw its own conclusions, for the reasons given in relation to the applicability of AUS 902. Bryant's evidence in chief on this subject included the following: "JACKMAN: You will see in paragraph 2.5 that Mr Whitear contrasts the scope of an audit with the scope of what he calls a review? A. Yes. Q. Can you tell the Court, please, what are the accounting standards which govern reports by auditors other than the statutory audit itself? A. Well, the ones that are relevant here are AUS902 and AUS904. They deal respectively with reviews and with engagements to perform agreed upon procedures. Q. When you say that those standards were relevant here, do you mean to say that either or both of those standards supplied to the engagement of Pitcher Partners by Ludowici set out in Ludowici's letter of 29 May 1998? A. Well, your Honour, one or the other of them should have the difficulty that we're in is that the reporting that Pitcher Partners made was not actually in accordance with either of those two standards and, in my view, those were the only two alternatives that were open to them. Significantly neither of them permits the auditor to give a degree of positive assurance. In the first one, a review in the auditing literature is defined as a review that enables an auditor to state whether having done some procedures that are short of an audit, whether anything has come to the auditor's attention that causes the auditor to believe that a financial report is not prepared in accordance with the - in a typical review report an auditor does some procedures in the report that is issued - says that as a result of doing those, nothing has come to my attention, that suggests that these accounts are not true and fair, for example. That wasn't the wording that was adopted here, it was more positive assurance given. The other alternative is what is referred to as an agreed upon procedures report which is covered by AUS904. Now, in that sort of engagement, which is perhaps what should have resulted here, the client defines precisely the steps that the auditor is to undertake. The auditor reports an AUS904 as a specimen report. The auditor reports what steps have been taken. There is to be a paragraph emphasising that it is for the client to decide whether those steps are adequate to meet the client's needs. The auditor, and I should say, there are a number of other requirements for the reporting of the results of this work and then the auditor is simply then to report that the work has been done, the factual findings and then stop, no opinion as to what reliance can be placed on these figures. I'm sorry, that's a long answer to the question but the difficulty in, I don't know - it's not at all clear what Pitcher Partners thought they were doing, but I have to say the report they issued was not in accordance with either of them. HIS HONOUR: Q. As an accountant, would you regard that as the paragraph 1 set of instructions in any particular way? A. In general if I'd received that letter I think I'd firstly have been slightly-- Q. I should withdraw that question, it's probably in terms of, can you express a view as to how a reasonably competent accountant regard that set of instructions? A. I think what a reasonably competent auditor would do would be to go back to the author of the letter and explain what the auditing standards that I've talked about permit and either say, I can do this one or I can do that one but the limit on the sort of report you are going to get is this: you are not going to get a positive assurance from me because the auditing standards do not permit me to give a degree of positive assurance that you're asking for short of failure. Would you like a review that would lead to this sort of report or would you like an agreed upon procedures engagement where you and I will negotiate exactly what you want to do but at the end of the day I will just tell you that I've done it, whatever I've found factually, but you cannot replace reliance on those figures. All of that that I've been talking about in my last couple of answers is to do with historic information. There are also auditing standards dealing with what an auditor ought to say about perspective financial information and in this case the 1999 information was perspective and again the degree of assurance that should be given as limited precisely because users of auditors work out not to take greater comfort from it than is justified by the work that's been done and in relation to perspective financial information, again the auditing standards are very restricted in what an auditor ought to say." (T53:20 - T54:54) 95 In cross examination as to the way in which AUS 902 operated he gave the following evidence: "A… but one wouldn't assume that the accounts are right before you start work on them. Q. You wouldn't for an audit, but according to AS902, you would for a review, would you not? Did you have a copy of the standard? A. I think I do. Q. I have a copy if you would like one. A. Yes, I do. Sorry, which paragraph? Q. Paragraph 11 (c) on page 2: "Reviews of financial reports do not ordinarily involve; (a) tests of responses to inquiries by obtaining corroborating evidence through inspection, observation and confirmation, or; (b) a test of accounting records." A. But that's not to say that the reviewer assumes that the figures that he or she has been given are correct. It merely deals with what work is to be done or not done in relation to them. Q. Can I suggest that a reviewer is entitled to report upon the basis that the figures provided are accurate, and have not been tested by the reviewer? That's the entire distinction philosophically between a review and an audit, or a principal one? A. No, I think we are agreed as to the output, which is a report that gives less assurance than an audit. I think what you are saying is that going into that process the auditor or reviewer is entitled to assume that the accounts are right or are appropriate, and I don't agree. Q. If you look at paragraph .09: "A review engagement provides a moderate level of assurance that the information subjected to review is free of material misstatement. The report provides this assurance in the form of negative assurance." In other words, you say we don't have any reason to doubt what we have been given? A. Yes, that's so. But that's not the same as saying that you start off by assuming that it is right. It merely deals with the degree of assurance that you give somebody at the end." (T59:16 - T60:6) 96 As stated earlier in these reasons, the interim report called for bore little or no resemblance to a report pursuant to AUS 902 or AUS 904 as standards providing, respectively, a negative assurance or no assurance in relation to the reasonableness of the EBITs for Malco upon which the acquisition price of Malco was constructed. 97 Bryant gave evidence of the obvious nature of the error in Malco's accounts in the following cross examination: "Q. You say in paragraph 63, finally, fifth line down: "However, we conclude that there was a very high probability that an accountant undertaking the audit would have identified the errors, this was because"-- And I want to look at the three bases of that conclusion? A. Yes. Q. "The errors were very material, work in progress was misstated by a million, which over $600,000 reflected an overstatement of profit." Now, the quantum of the error would only be relevant in your conclusion clearly if it were known to the auditor at the time? A. Well, I am not sure that is right. Sorry, perhaps we are at cross purposes. You are talking about a process which in July might not have been completed. Q. Well, you are saying that your conclusion that the accountant should have identified the errors is based firstly on this first bullet point that the errors quantitatively were high? A. Yes. Q. But that begs the question, doesn't it, as to whether or not the quantum of the error or the fact of the error was known at all to Pitchers? A. The point I am making is that an audit sets out to detect material errors, it doesn't guarantee it, but sets out to detect them. And this was an error which was very material and the circumstances of it were such that it was not hard to find. Q. Well, it was hard to find, was it not? All they knew was that the EBIT had increased, which could arise for a number of reasons. If we assume, and there is no evidence of this, that they had not been advised by management that the work in progress included rework and repairs, and if they were only commencing perhaps - I will follow-up with this. If we are talking about the period prior to the execution of the contract of 3 August, it is highly unlikely they would have picked it up by then? A. I think we are back to how far had they got through their work. Q. That is the point, isn't it, because their audit was not completed until the end of the year? A. I don't think their audit was completed until sometime into the following year. Q. But in any event, it was completed well after they had entered into this transaction? A. Well, excepting that would require knowledge of what further work was done after July but before whenever it is you want to define as being the end of the audit." (T70:31 -T71:29) (Emphasis added) 98 When looking at the position as at the time of the interim report, Bryant's evidence was as follows: "Q. If you go to the Australian Standard 902.6 and .7, do you have that? A. Yes, I do. Q. What, if anything, would that require the accountant to do in relation to, for example, the work in progress ledger? A. I think that the steps are given that the auditor was aware that - sorry, assuming that the auditor was aware that it was the normal practice to make an entry at the end of June, I think it is reasonable to say that the auditor in this circumstance and in accordance with these sorts of approaches should have said "Has that adjustment been made earlier this year?" Q. Would you expect the WIP ledger, the subsidiary ledger, to be made available to the auditor in that exercise, a printout of it? A. Quite possibly. I mean, it is difficult because we are dealing with a hypothesis. I think the first question is, what would the accountant have been told if he had asked "Have you made an entry or not?" If the accountant had been told, "No, we haven't", then I think it very likely that the accountant would say, "I better look at the detailed listing and see what is there". Q. You say the inquiry would need to be made all the same? A. Yes, so that is the first step, the knowledge that there was a practice of doing something before the end of the year, and here you are looking at one month to the end of the year. That is one thing in terms of this that would give a degree of skepticism (sic). The second thing is that you find that the reported profit, gross margin, has increased $800,000, I think again skepticism (sic) would cause you to say, "What is that?" Q. You are still talking about the June stage? A. Yes." … (T 72:31-T 73:10) 99 In relation to the importance of such an inquiry Bryant's evidence was as follows: "Q. You say: "A reasonably competent accountant who had detected the errors would, in our opinion, have reported them to Ludowici immediately in writing but received by verbal notification if there was to be any delay in the written report." You set out your reasons but presumably you would see a sense of urgency in notification once any such discovery had been made? A. Yes. Q. And principally because the company might be entering into this acquisition and ought to know the true facts before it did so? A. Yes. Q. And, as I say, you are aware, are you not, that with the 29 May engagement, a timetable set out was for the contract of purchase to have been executed on 1 July? A. Something called interim settlement, yes. Q. So you would agree in respect of the statutory audit at least that the sense of urgency would only arise if Pitchers were aware that there had been a departure from that timetable? A. Yes. Q. You set out your reasons. Firstly, the client relationship. That is self-explanatory. 68, secondly, Ludowici's engagement letter made it clear they were relying on Pitcher Partners to identify the matters relevant to the purchase and we have just covered that. You say, thirdly, because it may reflect upon the 1999 projected budget? A. Yes." (T76:22 - T76:58) 100 In their case, Pitchers sought to gain some comfort from Ludowici's departure from the timetable referred to in the retainer. In my view, that material is sterile ground for any successful defence in these proceedings. The communications between Ludowici and Pitchers between May and July 1998 are consistent only with the continued importance of Pitchers' services in relation to the basis upon which the acquisition price of Malco was under consideration. In my view, Pitchers gain no comfort from the extended timetable, nor, for that matter, from any change in the terms of the acquisition of Malco as set out in the agreement when contrasted with the acquisition proposal disclosed in the retainer. 101 What I think is fundamental in the understanding of the failure of Pitchers in discharging its responsibilities is the nature of the subject matter of the error. I think this is exposed, in part, in Bryant's evidence in response to questions from the bench inviting him to comment on Catlin's instructions to the audit manager which have been quoted earlier in these reasons. 102 His evidence included the following: "Q. And then in the last sentence of paragraph 2, she is instructed to analyse the accounts so as to understand how the business has traded compared with 97 and for the assistance of the understanding of the 99 budget? A. Yes. Q. What would that involve? A. As a starting point, the sort of exercise that we saw that Pitchers did do, which is to, at a high level, look at the profit and loss account, in particular, and see what gross profit percentage and EBIT figures were produced and then to obtain explanations of them and particularly movements from the previous year so the starting point for the analysis is fairly simple. What you then do depends upon what you find and then what you are told is the explanation for what you find. Q. What I am trying to find out is from the information that one would expect to get in Malco's case in that exercise, what that would throw up by way of further inquiry, if any? A. Well, if - if in this - as in this case it threw up that there was a fairly significant increase in gross profit, the next question would be why and again I suppose with the benefit of hindsight at least, the question might have been asked-- Q. You are not being asked to use hindsight. A. Okay. Once the analysis had established that there was a significant increase in gross profit, what you would then do to determine whether that was reasonable would depend upon what you were told was the reason for it. Q. Then in the third paragraph, the manager was instructed to make inquiries of the administration manager? A. Yes. Q. On the basis of preparation of the management accounts and the consistency with the 97 accounts? A. Yes. Q. In this situation, what would that involve, and particularly in relation to work in progress, if at all? A. Well, the next sentence I think, "look at his work paper files to ensure that appropriate work has been done by him". Your Honour, I think I say in the report that work in progress is probably the highest risk area in a company like this for something to be misstated because there is judgment involved in assessing the amounts that should be work in progress. In this case, of course, it wasn't actually a judgmental error that occurred. It was a factual error that occurred. But once - if you are going to move beyond just doing a brief analysis of the profit and loss account, and if you are going to look at work paper files as this suggests, you are likely to get to work in progress. You are likely to want to get some analysis of work in progress because if the numbers are wrong, that is - in a company like this, this is where they are most likely to be wrong. Q. I want you to assume that there was a printout of the WIP report as at the end of May 1998? A. Yes. Q. But was not requested by the audit manager. Can you comment on that? A. As I have already said, I think that the circumstance called for some work to be done in relation to work in progress and some sort of analysis to be done and one of the most basic things that an auditor does when confronted with a total, in this case work in progress 2.8 million, is to say, "Well, I would like to understand what makes it up. I would like to break it down to its component parts". Q. And that would be provided as a printout, presumably? A. Yes, yes, although, as I say, at least in relation to the one in June, it was a little cumbersome and not all the subtotals were shown. In some cases, you actually had to add a number of pages to get to the subtotals that came to the total of 2.8 million dollars but it seems that if - if anybody had said, "I want to understand what is in that 2.8 million", that that printout is what they would be given." (T80:9 - T81:32) (Emphasis added) 103 As earlier stated in these reasons the audit manager and Catlin clearly failed to inquire of Hutchins what would be involved in the end of year adjustment to the WIP subsidiary ledger. That failure I think is fatal to the defence of Pitchers. 104 I also am of the view that, if the auditing activities at the end of July carried out by Pitchers had been performed efficiently and in accordance with the required standards, the error in the accounts would have been disclosed at about that time. That position is not so clear, as Bryant accepted. However, given the basic importance of the WIP ledger, the descriptions of expenses within the ledger should have drawn inquiries of Hutchins by the audit manager, or by Catlin which would have revealed (a) something which Pitchers already knew, namely, that until year's end the WIP subsidiary ledger was the repository of expenses whether recoverable or otherwise: (b) that the usual end of financial year adjustments had not been effected. There is a telling record in Pitchers' working papers which go a long way to explaining why the audit work of Pitchers failed to expose this error and why it took several months of probing by those in the Ludowici camp to expose the error. The document is entitled 'Background notes' and it is accepted that it was authenticated by the audit manager's initialling on 21 July 1998. What is of significance in that record is the following audit note: " WIP adjustments Stock Jobs: This adjustment is necessary to transfer completed jobs out of work in progress into stock. These jobs are for the constructions of stock, which is not specifically for a customer. Plant Jobs: This adjustment is necessary to back out of WIP those costs incurred on repairs and maintenance to plant equipment for administrative purposes the client find it easier to treat repairs and maintenance projects as if it were a job for WIP purposes. Rework Jobs: This adjustment is necessary to back out costs incurred under warranty for which recoupment from customers is not envisaged. Non-Productive Hours: This adjustment is for time not directly attributable to a specific job (ie. smoko etc). Also, included in this is the time that goes into tendering for a job that is not won." 105 That audit note is crossed out. I have been invited by counsel for Pitchers to treat that record and its striking out as carrying no inference. I am unable to accept that submission in the absence of (a) the audit manager from the witness box; (b) any record in the working papers; or (c) any evidence from Catlin, evidencing that those necessary adjustments had been the subject of any review or audit work by Pitchers. 106 I think the proper inference is that the "WIP adjustments" as noted were not undertaken. That is entirely consistent with Pitchers' failure to make any such inquiries of Hutchins or to expose the management's accountancy error in either the interim report or in Pitchers' audit for the 1998 year. 107 On behalf of Pitchers it was submitted that such reasoning was erroneous as there was no evidence that any such adjustments to the WIP subsidiary ledger were material. In my view, that submission is without any merit. The very nature of adjustments in the contracting engineering business would, prima facie, be material and I think this is glaringly obvious from the above quoted extract from the working papers of Pitchers' auditing team. Catlin sought to support Pitchers' position in his evidence in a way that, in my view, was less than convincing, as may be seen from the following extract from his cross examination: "Q. A major risk area in a review or an audit of Malco in 1998 was work in progress, was it not? A. Yes. Q. And an error in work in progress in a construction or engineering company like Malco would often represent an error in profit; would it not? A. It could do. … Q. For about eight audit years prior to June 1998, you were aware that, prior to the audit commencing, Malco management needed to transfer out of the work in progress ledger all work that could not be charged to its customers? A. I can't say I was aware of it for the full eight years. Q. You were aware of it for a number of years? A. I thought you said for the eight years. Q. I see, but you were aware of that for a number of years-- A. I was aware that was a task that was done. Q. You were aware of that for a number of years before June '98? A. Yes. Q. And you were aware that that adjustment made by Malco management was performed in the last few days of June each year? A. Before finalisation of the June accounts when we made our visit. Q. You agree with what I say? A. Yes. I am not sure about the last few days before June, year end. Q. I beg your pardon? A. I am not quite sure at the last few days before year end. Basically it is correct what you said. Q. But it was done very shortly prior to the commencement of your audit work in July each year? A. I believe so. Q. After making that adjustment for non-recoverable jobs which initially had been included in the work in progress ledger, Malco management would give you a breakdown or summary of work in progress? A. I believe so. Q. And unless and until that breakdown or summary was provided, the management accounts in respect of work in progress in fact misstated the true position? A. I can't answer that from a materiality point of view. Q. They included non-chargeable work as work in progress, isn't that right? A. If those adjustments were made, then they would have included them, that's correct, yes. Q. And you are not able to say that those adjustments were immaterial, are you? A. No, I am not able to say they were material or immaterial. Q. My question was whether you are unable to say that they were immaterial? A. That's right. Q. And with a large factory and many billions of dollars of sales, you would expect, would you not, that repairs to plant and rework would usually be a material item for a company of Malco's size? A. I can't say that. I am not aware of any materiality in that area. Q. Is this the position, that for the whole eight years from when you started performing audit work for Malco in 1989 up until June 1998, you never inquired into the materiality of those adjustments which had to be made to the work in progress ledger before you commenced your audit? A. I can't comment on that. Q. The position is, isn't it, that Pitcher Partners could not rely on the unaudited management accounts in respect of work in progress until that adjustment to the work in progress ledger had been made; isn't that right? A. Not necessarily. As I said, we were not aware that this area was a material area of adjustment in the management account, so that was not seen as a material error, the area we had to work on, so we were comfortable that the management accounts would reflect a reasonably accurate result. Q. You couldn't be comfortable about that without satisfying yourself that that adjustment for work in progress not chargeable to a client was immaterial; do you agree? A. Sorry? Q. You couldn't be comfortable about that unless and until you satisfied yourself that the adjustment necessary for work in progress not chargeable to Malco's customers was immaterial; don't you agree? A. I felt we looked at the areas that were material. Q. Do you agree with what I put to you? A. It sounds sensible, yeah. Q. You have indicated that you did not satisfy yourself one way or the other whether this was material or not, is that right? A. At the time in June, that's correct. Q. Or at any earlier period from 1989? A. I can't recall prior. … Q. I think what you said before was that you made no inquiry into its materiality, don't you agree with that? You never formed a positive view, did you, that those adjustments were immaterial? A. Well, we were not aware that was in the area where there were material adjustments made. HIS HONOUR: Q. But you were aware, weren't you, that all costs related to went into the subsidiary venture ledger whether they were recoverable or not in relation to all projects? A. That's correct. Q. I have to say that in a manufacturing, contracting or engineering organisation, it wouldn't surprise me if rectification costs could be on occasion quite significant. Do you care to comment on that? A. Yes, some rectification costs are significant and they are also recoverable from the customer. Q. I am talking about rectification costs that are not recoverable? A. Well, they could be significant. JACKMAN: Q. And you never took steps to satisfy yourself from 1989 to 1998 that those repair to plant and rework costs were immaterial as you have said already, do you agree? A. Yes, what I said before applies." (T101:41- T101:48 … T102:14 - T104:02 … T107:4-T107:31 - corrections made to transcription error). 108 As noted earlier in these reasons Pitchers were required to ensure that all material adjustments had been made to the WIP subsidiary ledger entries and that clearly was not done. Further, it is not disputed that in the 1998 financial year the adjustments required were material. The fact that the error in the accounts was not exposed by Pitchers without extensive and persistent inquiries from Ludowici makes it clear that there was something significantly defective in the standard of inquiry and analysis carried out by Pitchers. In my view it evidences the fact that the review or auditing process was flawed from the start. 109 Catlin was cross examined on Pitchers' working papers and his evidence does little to advance Pitchers' case, as appears from the following: "Q. The breakdown or summary which you received from Malco management each year after that adjustment had been made indicated seven categories of work in progress, didn't it? A. That's correct. Q. One category was described by a five digit number beginning with the digit 4? A. That's correct. Q. And that was for "Plant Jobs (Repairs)"? A. I think that is correct, yes. Q. And another category was described by a five digit number beginning with the numeral 5, is that right? A. Yes. Q. And that was for "Rework Jobs"? A. Yes. Q. Can I ask you to turn to tab 155 in volume 5. And can you go through that to the last document which has in the top right-hand corner 8-120. If a document like that had been shown to you in June 1998, you would have been concerned, wouldn't you, at the size of the items for Plant Jobs (Repairs) and Rework Jobs, which are in the column headed 30 June 1998, would you not? A. If I received it in June? Q. Yes? A. Yes. Q. And you would have instigated some inquiries and steps of analysis to see what comprised those figures? A. I would make inquiries. Whether we tested it or not is another matter. I would have made inquiries of the company officers because we were doing a review at that time. Q. The inquiries you would have raised are explanations as to why those figures were so large by comparison to the nil entries for 30 June '96 and the much lower figures for 30 June '97, is that right? A. Yes. Q. Until you received satisfactory explanation for that, you would not have given the advice that you gave Ludowici Limited in your letter dated 29 June '98, correct? A. Yes." (T104:4 - T104:50) 110 There was a working paper of Pitchers relating to the 1998 financial year which is entitled "Substantive Audit Programme: Inventories and Cost of Sales". It provides for "risk assessments" and states five "Audit Objectives" and on the first page the "Conclusion" section is signed off. The working paper contains five pages detailing "substantive audit procedures". Provision is made for noting the performance of each of those procedures by initialling and dating. A comments column is also provided for each item. Of fifteen audit program references, within reference number eleven there appears a program for "Work in progress". The procedure for this item commences with the following: ".7 Obtain reconciliation and vouch major adjustments to underlying reports. Investigate material unexpected adjustments." 111 There are several other procedures identified which have been signed off. The procedure in .7 has not been signed off and this is in marked contrast to the remainder of the procedures set out in the fifteen numbered references. 112 Catlin was cross examined on this document in the following terms: "Q. Can you go to the next tab, please. A. 156? Q. Yes. Do you have there a page headed "Pitcher Partners, Client Malco Engineering, Balance Date 30 June '98, Substantive Audit Programme, Inventories and Cost of Sales"? A. That's correct. Q. At the foot of that page in the box headed "conclusion", is that Clare Luehman's signature? A. I believe that is correct. Q. And the practice, I take it, within Pitcher Partners would be that Clare Luehman would sign that once she thought that she had completed the steps set out in this part of the audit programme? A. Yes. Q. Can I ask you to turn, please, to page 5 in the top right-hand corner - sorry, page 1220 in the machine printed number? A. Yes. Q. Can you go down two-thirds of the page, you will see the first line in the lowest box the heading "work in progress"? A. Yes. Q. You see step 7, "Obtain reconciliation and vouch major adjustments to underlying reports, investigate material unexpected adjustments" and beside that you will see there is no signature to indicate that the work was performed? A. That's correct. Q. And that would have concerned you at the time, would it not, if you had learned that Clare Luehman had signed the conclusion on the first page and yet had not undertaken step 7? A. Not necessarily. The signature is signing off the conclusion as meeting the audit objectives. Q. Can I ask you to accept that there is a signature beside every step in this part of the audit programme with the exception of step 7 under "work in progress". Don't you agree it would have concerned you if Clare Luehman had signed the conclusion on the first page without doing that step number 7? A. Not necessarily. Q. You would have asked Clare Luehman for an explanation as to why she had drawn the conclusion she did without doing step 7, is that right? A. I may have. Q. And you wouldn't have regarded the conclusion as reliable unless and until you had a satisfactory explanation from her, isn't that right? A. Not necessarily. I might have been satisfied with the rest of the work. Q. You are aware, aren't you, that Mr Bryant in his affidavit made express reference to that step number seven and said that that step should have generated the kind of analysis which I showed you a moment ago in audit working paper 8-120 - you are aware of that, aren't you? A. Sorry, 8-- Q. 8-120 you will find behind tab 155, the last page behind 155? A. Sorry, could you repeat the question, please? Q. You are aware, aren't you, that Mr Bryant has referred to step seven under work in progress at page 1220 and said that undertaking that audit step would have generated the kind of document that one sees at 8-120, are you aware of that? A. I seem to recall him saying something like that, yes." (T104:52- T106:17) 113 The document referred to as "8-120" is the document which identified work in progress as including the items described as "plant jobs/repairs" and "rework jobs". The evidence of Bryant, to which reference is made in that cross examination, included the following: "53. A reasonably competent accountant who was auditing Malco's financial statements would have known that the major risk area of the audit was WIP. This is because a company engaged in construction contracts exercises considerable judgement in assessing its profit. When construction contracts extend over a year-end, standards require the estimation at year-end of:- the probable final profit on each incomplete contract; the degree of completion of each such contract In WIP are recorded the costs to date on each contract (less progress billing) plus profits recognised to date.. An error in WIP will often represent an error in profit. Errors in WIP can result from all of the possible causes of error in any accounting information, plus any which may result from misjudgment of probable final contract profit or degree on completion. One of the most significant tasks in the audit of a construction company is thus the examination of what is recorded in WIP and what judgements have been exercised in arriving at its components. 54. A reasonably competent accountant would, therefore, as a starting point in auditing WIP, have obtained or prepared some breakdown of the WIP total. He or she would expect that breakdown to identify different jobs, or categories of jobs. We note that the first step in Pitcher Partner's audit work programme (referred to at paragraph 48 above) included "Obtain reconciliation and vouch major adjustments to underlying reports". We take this to be a reference to the sort of breakdown which we would have expected. 55. Pitcher Partners' working paper dated 9 June 1999 which contains a breakdown of the sort to which the previous paragraph refers. We reproduce part of that breakdown here: WIP at cost represented by: 30/6/96 30/6/97 30/6/98 _______________________________________________________________ 1XXXX General engineering 240,906 144,575 379,572 2XXXX Contracts and systems 210,210 5,749,272 49,057 6/7XXXX Screens 1,162,344 2,330,238 1,265,630 3XXXX Stock jobs 260,964 332,565 282,395 4XXXX Plant jobs (repairs) - 12,677 463,179 5XXXX Rework jobs - 39,162 370,911 Other - 3,276 799 1,874,423 8,611,765 2,811,543 56. Total WIP at 30 June 1998 of $2,811,543, as shown in the above analysis, is the same (except for a $1 rounding difference) as WIP at cost as disclosed in note 8 to Malco's draft 1998 accounts. 57. No such breakdown appears in Pitcher Partners' papers relating either to their June 1998 or July 1998 to October 1998 work. We are aware of no reason to assume that such an analysis could not have been produced in July 1998. 58. Given such an analysis, the categories "Plant jobs (repairs)" and "Rework jobs" would, to a reasonably competent accountant, have called out for questioning. This is because expenditure on repairs is not normally an asset (Unless the repairs represent billable work to a third-party's asset); and "reworking" may not be billable to anyone. (Further, an analysis such as that above, which includes prior year figures, would have highlighted that these two categories had increased dramatically compared with prior periods). In total these categories comprised 30% of total WIP ($2,811,543); 7% of total assets ($12,194,064); 28% of net assets ($3,022,708) and 38% of operating profit before abnormal items ($2,196,097). 59. These categories were plainly material and, on the face of the descriptions recorded at paragraph 55 above, quite possibly classified wrongly as assets rather than costs to be written off. 60. As noted above, no such analysis appears in Pitcher Partners' 1998 audit working papers. However, in those papers, at 8-512 dated "27 July" (presumably 1998), is a document which is attached as page 1 of Appendix 17 to this report. That document includes: WIP adjustments Stock Jobs: This adjustment is necessary to transfer completed jobs out of work in progress into stock. These jobs are for the constructions of stock, which is not specifically for a customer. Plant Jobs: This adjustment is necessary to back out of WIP those costs incurred on repairs and maintenance to plant equipment for administrative purposes the client find it easier to treat repairs and maintenance projects as if it were a job for WIP purposes. Rework Jobs: This adjustment is necessary to back out costs incurred under warranty for which recoupment from customers is not envisaged. Non-Productive Hours: This adjustment is for time not directly attributable to a specific job (ie. smoko etc). Also, included in this is the time that goes into tendering for a job that is not won." We note that this part of working paper 8-512 has been crossed out. 61. We do not know the origin of this document (or why part has been crossed out). We observe, however, that the "WIP adjustments" referred to are those which would be necessary to avoid misstatement and, indeed, are those which are ultimately reflected in Malco's final 1998 accounts. 62. We conclude that a reasonably competent accountant would have been on notice when performing audit work in July 1998, of the strong possibility of a significant misstatement in 1998 EBIT. Whether the auditor would have identified an actual error depends upon what the auditor would have found if investigating further (as he or she should have done). 63. The possibility of - for example - the successful deliberate misleading of an auditor prevents us from concluding whether, as a certainty, a reasonably competent accountant would have identified the actual errors. However, we conclude that there was a very high probability that such an accountant would have identified the errors. This is because:- · The errors were very material: WIP was misstated by $1 million of which over $600,000 reflected an overstatement of profit. · That the errors might have occurred is evident simply from the descriptions 'Plant jobs (repairs)" and "Rework jobs". · There existed a document (Page 1 of Appendix 17) which spelt out the adjustments needed to correct the errors." 114 Catlin was cross examined on the significance of the procedure which had not been signed off in Pitchers' working papers, and gave the following evidence, a portion of which is repeated for ease of reference: "Q. And may we take it that you could not think of any matter on that topic which, in your view, might have explained the fact that that step was not undertaken? A. Well, that step is obtaining a reconciliation from the client. Now, there may not have been a reconciliation between the general ledger, control account and work in progress. That could be one reason for not receiving it. Q. And if you were the auditor actually performing this work, you would want to find reasons, wouldn't you, for step seven not having been completed? A. Well, not necessarily. Q. Is the answer that you just gave about the lack of a reconciliation as a reason for not doing step seven something that occurred to you when you were preparing your affidavit? A. I can't answer that. Q. And you see that step seven also requires a vouching of major adjustments to underlying reports? A. That's right. Q. And that wasn't done on this occasion as far as you can see, was it? A. If we weren't given a list of major adjustments then we would not have done the work. Q. And it requires also an investigation of material unexpected adjustments, isn't that right? A. It says that here, yes. Q. And one of those which should have been identified and investigated is the matter I drew your attention to on paper 8-120, namely the very high amount of plant jobs, repairs and rework jobs for 30 June 98, don't you agree? A. As I said before, that area was not one we considered as material, material adjustments in previous years. Q. I think what you said before was that you made no inquiry into its materiality, don't you agree with that? You never formed a positive view, did you, that those adjustments were immaterial? A. Well, we were not aware that was in the area where there were material adjustments made. HIS HONOUR: Q. But you were aware, weren't you, that all costs related to the subsidiary venture whether they were recoverable or not in relation to all projects? A. That's correct. Q. I have to say that in a manufacturing, contracting or engineering organisation, it wouldn't surprise me if rectification costs could be on occasion quite significant. Do you care to comment on that? A. Yes, some rectification costs are significant and they are also recoverable from the customer. Q. I am talking about rectification costs that are not recoverable? A. Well, they could be significant." (T106:23-T107:25) 115 Earlier in these reasons I noted that part of the working papers that were brought into existence prior to the interim report of 29 June 1998 showed historical gross margins of 21% as compared with the estimated gross margin for the year ending 30 June 1998 of 27.4%, with 27% being used in the budget for year 1999. In addition there was a working paper entitled "Summary of 'Normalised EBIT'" which showed a gross margin of 21.4% for the year ended 30 June 1997, noted as actual, and an estimated gross margin for 1998 of 24.6%. 116 Bryant was asked to express his views as to the significance of these figures as follows: "Q. Under that the first page you'll see is headed "Malco Engineering Proprietary Limited Engineering Division Summary of Normalised EBIT"? A. Yes. Q. I want you to assume that these are documents which were created or made available to Pitcher Partners during June 1998 in the course of their review which they were engaged to perform by Ludowici Limited. Can I ask you to look at the item described as "gross margin" which is about three lines down and you'll see the figure of 21.4 per cent for 1997 actual? A. Yes. Q. And a figure of 24.6 per cent for 1998 estimated? A. Yes. Q. Do you see that? A. Yes. Q. Can I ask you to turn the page and that page should have in the top right-hand corner a dash, 200 and a 9 underneath? A. Yes. Q. Can I ask you to look several lines down the left hand column which is described as "gross margin"? A. Yes. Q. Can I ask you to look across the line that reads 21.83 per cent for 94/95 actual, 21.5 per cent for 95/96, 26.6 per cent for 96/97, 27.4 per cent for 97/98 estimate and 27 per cent for 98/99 budget. Do you see that? A. Yes, I do. Q. If a reasonably competent accountant looked at those documents in performing the review which Pitcher Partners were engaged to do during June 1998, would those figures for gross margin which I've referred you to, have been regarded as having any significance to that accountant? A. Yes. Q. And what is that significance? A. The figures suggest a significant increase in the percentage gross right in between 97 actual and 98 estimated. On the first schedule you were looking at it shows a 3.2 per cent increase, on the second schedule it shows as a 6.8 increase. I'm not sure why those figures differ, but in either case it's a significant increase in the estimated gross margin for 98. Q. And would a review of those gross margin percentages have formed a part of what a reasonably competent accountant would have done in June 1998 pursuant to the engagement which I've referred to? A. Yes. Q. And would it be possible for a reasonably competent accountant having reviewed those figures to draw the conclusion that there were no material differences between historical gross profit percentages for this business and the estimate for 98 and the budget for 99, which is set out in those documents? A. No, because even if we take the lower increase in gross margin that is indicated there on the first page, that was the 3.2 per cent increase, that translates to somewhere around $800,000 of extra margin in 98 compared to 97. That eight or so hundred thousand dollars is clearly material in relation to earnings before interest to either 2.8 million after the normal items or the $3 million at the bottom. Q. Having formed that conclusion, at what steps, if any, would a reasonable competent accountant have then undertaken pursuant to the engagement which Pitcher Partners accepted from Ludowici in June of 1998? A. Well, in general, I would say some form of inquiry of what might have caused that increase. I mean, a possible step is one we've already referred to which is to inquire whether these figures are distorted by the failure to back out the items in inventory that should not be in inventory and the effect of correcting that entry would be indeed to reduce this gross margin, that would be one of the inquiries, but there are a number of possible inquiries." (T51:39 - T53:4) 117 Counsel for Pitchers advanced the following in relation to the significance of those gross margin variations as follows: "It is submitted that even if the increase in gross margins led the defendants to ask "why have gross margins increased by 3% or 6% with the result that non-recoverable WIP was identified and located this would not have caused the defendants to give essentially different advice to that actually given in their letter 29 June 1998." 118 That is not the evidence of Catlin, and totally ignores the evidence of Turner that, prior to the agreement, in discussions between Turner and representatives of Portland House, it was disclosed that the 1998 profit would be closer to "$2.2M than $2.5M, because of the late emergence of unrecorded costs at the Moranbah North job": that being a major contract undertaken by Malco in 1998. Accordingly, a suggestion that a further reduction in profit of some $560,000 as a result of the adjustment to the work in progress subsidiary ledger items would have been of no consequence is without justification. 119 Leaving aside the major variation in gross margins from the historical figures to the expected and estimated percentages for the 1998 and 1999 years, which I think should have alerted Pitchers to the possibility that there was something amiss in Malco's financials, the simple oversight for which Pitchers were responsible is reflected in the following cross examination of Bryant: "Q. Pitchers knew that year in year out the standard management practice of Malco was to make this end of year adjustment? A. That seems to be so. Q. I suggest you would be entitled to assume no departure from that procedure in this year? A. No, I don't think you would be entitled to assume that. Q. It has been going on for years-- HIS HONOUR: I think you may be at cross-purposes when you refer to the procedure. THOMPSON: Q. The procedure of adjusting out of the work in progress, the unrecoverable costs? OBJECTION. QUESTION REPHRASED. Q. I will put it again to you. We are assuming that Pitchers were aware that the standard practice of management for a number of years prior to the year ending 1998, was to make an end of year adjustment out of the work in progress of unrecoverable costs to the profit and loss account, so that the work in progress would accurately reflect the work in progress? A. Yes. Q. I suggest to you that certainly in the context of a review, whatever we say - and you at least accept the review as something less than an audit - the reviewer is entitled to assume that the figures provided by management have been produced in accordance with management procedures of previous years? A. Sorry, first of all when we were talking about this a little while ago, I thought we were talking audit. If we are now talking review-- Q. Yes? A. A review on the May figures, and as I have already dealt with, if Pitchers knew that it was normal to make the entry at the end of June in relation to the whole year, then they would have know (sic) that it had not been made in May, and that that might still figure. … THOMPSON: Q. Can I suggest to you that in bringing the figures up to the time of the report shortly before 29 June, Pitchers were dependent upon the information provided to them by management? A. Well, the starting point was to review that information. If they were going to assume it was right, there is no point in doing anything. Q. I think even you accept that as a review it is not part of their job to act as an auditor and to verify the figures provided by management? A. Not to the extent of an audit, no. Q. I am suggesting that they were entitled to presume that if management had failed to make that end of year adjustment in accordance with their practice of previous years, management would have pointed that out? … Q. I mean, they are given the figures through to May. Asking for those figures for the purpose, and known to management presumably, of producing a report through to 30 June? A. Yes. Q. And therefore would be entitled to assume that the figures provided had been adjusted, if necessary, to enable that exercise to be properly undertaken? A. So we are now assuming. I think what you are suggesting is that the auditor should have assumed that the normal practice - that I am asked to assume, the auditor is asked to assume - which existed for the last six or seven years had been departed from for this special purpose, but the auditor does not have any obligation to ask that question. That seems to be what you are putting to me and I don't agree. Q. Because management would be presumed to know the reason why the information was being requested? A. Well, yes. But again I say, if you are going to assume that the accounts that management give you are right, then you might as well not do anything. The whole purpose of doing any form of review or audit is to determine whether they are right or not, and one of the reasons that they can be wrong is because somebody has forgot to do something. Q. But the principal reason in part 2 of the letter is to undertake the review for the purpose of advising or confirming as to EBIT for the years ending 1997, '98 and projected 1999? A. Yes. Q. So that is what is being asked for, not an analysis of the underlying figures from which those concluded EBITs had been drawn? A. But the EBITs don't mean anything if the figures underneath them are wrong. That is the whole purpose of looking at them is to determine whether they are right or wrong or give assurance as to whether they are right or wrong. (T62:24 - T64: 31… T64:42 - T65:23) 120 I was impressed by Bryant's expertise in this matter. His answers were prompt. There was no semblance of bias in the expression of views, particularly as to the audit standards. In fact I considered that it was open to him to be far more critical of Pitchers' reliance on AUS 902 or AUS 904, having regard to the terms of the engagement that Pitchers accepted. 121 Whitear's evidence, as stated earlier, I think was seriously flawed by his reliance on those standards without due regard to the influence of the specific terms of the engagement on which Pitchers acted and to Pitchers' knowledge of Malco's accountancy practices. 122 I think the evidence clearly demonstrated that, had Pitchers alerted Ludowici to the error in the 1998 accounts and the of the general effect of the error on the EBIT for that year, there would have been no agreement. I think it is quite obvious that Portland House would not have been interested in negotiating an acquisition price for Malco that reflected the true EBIT for 1998 and it is equally clear that Ludowici would not have been interested in the acquisition on the terms agreed upon. 123 In final submissions, counsel for Pitchers expressly refrained from putting submissions on the issue of reliance and I understand that matter not to be in issue. However, it is sufficient to state, that the evidence of Turner and Ludowici's directors is conclusive on the question that Ludowici did depend upon Pitchers' advice on the reasonableness of the EBIT figures as part of the due diligence process in the acquisition of Malco. Turner described the reliability of the EBIT figures as critical in Ludowici's consideration. I think that much is apparent from the terms of the 29 May 1998 retainer letter. The central concept in the purchase price for Malco was an expression of the maintainable EBIT of Malco. 124 I think it is noteworthy that the reduced estimate of the 1998 EBIT to $2,200,000, disclosed in discussions with Portland House prior to the agreement gave a price based on the formula in the agreement of $7,600,000: assuming $2,000,000 for 1997 and $1,500,000 for 1999. Such a variation in the average EBIT for those years was capable of being accommodated by the adjustment provisions of the agreement. 125 As at 3 August 1998 a revised EBIT for the 1998 year of approximately $1,600,000, or, if adjusted for a certain redundancy payment of approximately $1,800,000, would have produced an acquisition price, based on the average EBIT, well below $7,400,000. That would not have satisfied Ludowici's alternative criteria for acquisitions. I see no merit in examining those alternatives given the absence of challenge by Pitchers to that aspect of Ludowici's case. 126 The adjustment to the 1998 figure, in my view, impacts upon the estimated EBIT in the budget for the 1999 year. There was a downturn under-way at the close of the 1998 year that was reflected in the 1999 budget by way of a substantial drop in forecast sales to approximately $19,300,000. Pitchers accepted that as reasonable as well as the estimate of a gross margin percentage of 27%. If one looks at the historical gross margin figures and at the expected 1998 figure, adjusted for the accountancy error, the more appropriate gross margin percentage for 1998 would be approximately 21%. If one applied that gross margin percentage to the budgeted figure for 1999 it would represent a decrease in gross margin of over $1,000,000 and lead to an EBIT of a little over $500,000: leaving aside further adjustments which Ludowici may have made to that figure. 127 On that basis, a purchase price calculated in accordance with the formula upon which the purchase price in the agreement was reached would be something in excess of $5,700,000. I consider there is no room for the possibility that Portland House would have entered into negotiations at such a lower acquisition price or that Ludowici would have been interested in pursuing the acquisition. Turner's evidence is that in all probability he would have recommended against proceeding with the purchase and there is no doubt from the evidence of Board members that that advice would have been heeded. 128 In carrying out that analysis I have ignored the implications of a further reduction in EBIT for the 99 budget year that may have been triggered by a warning drop in sales for July 1998. On Ludowici's case that would have warranted an adjustment downwards of the $19,300,000 sales figure used in the budget. However, I have not been persuaded that any such adjustment was warranted prior to the execution of the agreement: nor do I think that such a drop in the July 1998 sales figures justified a departure from budget which had built into it a very substantial allowance for economic downturn. 129 One of the most glaring failures of Whitear to come to terms with the consequences of the 1998 accountancy error was his conclusion that the error had no flow-on effect, as expressed by him in the following terms: "2.8 The work in progress (WIP) error at 30 June 1998 had no bearing on an independent calculation of Malco's future maintainable profits or future maintainable EBIT at 30 June 1998 because it was a loss of a once off nature. Accordingly, any failure to adjust Malco's 30 June 1998 accounts to recognise the WIP error by 3 August 1998 would not have caused a properly prepared independent valuation of Malco at that date to be overstated." 130 That conclusion is expressed on the basis of assumed facts which follows in par 2.9 of his evidence in chief as follows: "2.9 Furthermore, according to document 25 of Pitcher Partners' working papers for their interim review of Malco's 30 June 1998 results, the 1999 budget prepared by Malco was driven by the sales budget, which was the product of a two day conference held in Adelaide. In preparing the sales budget, consideration was given to the expected orders for the coming year after a product line by product line review. Manufacturing costs including direct labour and oncosts were mainly sales-driven. This is further confirmation that the alleged EBIT errors of $561,529 in 1998 would not have had any direct impact on Malco's 1999 budgeted profit or EBIT." 131 Whitear's evidence in cross examination was as follows: "Q. I would just like you to observe that the gross margin in 1994/1995 was actually 21.83 percent? A. Correct. Q. The gross margin in 1995/1996 was actually 21.50 percent? A. Yes. Q. The gross margin in 1996/1997 was actually 20.60 percent? A. Yes. Q. In a business of this kind you would expect the gross margin to be relatively constant as those three years demonstrate, do you agree? A. I'm not sure that I would, because this is an engineering business which relies, as I understand it, on largish contracts with individual customers. It seems to me that in that sort of business gross margin tends to reflect your abilities to negotiate those individual contracts. In that regard it can be somewhat different from a business which is manufacturing a large scale product in repetitive ways, like biscuits or something like that. I am not sure that you can say that in an engineering type business the year to year gross margin would necessarily show the same stability as in a bulk manufacturing type business. HIS HONOUR: Q. That is not quite the question you were asked, I suspect. Rather whether you would expect it to be in the same order, rather than whether it would necessarily be in the same order? A. Well, if I am being asked whether I would expect it to be the same, then my answer really is not necessarily. JACKMAN: Q. Could I explore that a little with you. You will see that the first line item deals with sales. You will see sales fluctuate markedly over those three years, $15 million, $18.6 million, and almost $25 million, do you see that? A. Yes. Q. Notwithstanding those marked fluctuations, the gross margin figure has remained relatively constant, do you agree? A. Yes. Q. I want you to assume that in the column for 1997/1998, instead of 27.14 percent, that had read 12 [21] percent. Will you make that assumption? A. Yes. Q. Just pausing there. Based upon the figures revealed for the actual performance in 1994/1995 and the two subsequent years, that would be a reasonable assumption based on the historical performance? A. It would be consistent with historical numbers, yes. Q. Making the assumption that the figure for 1997/1998 should have been 21 percent, unless there were some very exceptional circumstances in respect of variable costs for 1998/1999, then it would have been reasonable to forecast a gross margin of about 21 percent for 1998/1999, wouldn't it? A. No. I say no because you have to, in an engineering business, look at the contracts, individual contracts you have on hand at any particular time, in order to estimate the margins that you are going to make on them. So whilst it - I certainly agree with you it is possible that the margin could be constant year on year, I don't think you can necessarily say because it was one level in one year, it will be the same, a similar level in the next year, without taking a look at what is happening within the business. Q. The contracts that are performed in 1998/1999 will comprise the completion of work in progress as at 1 July 1998, and also new contracts which are won in the 1998/1999 year, won't they? A. Yes. Q. While one might be able to forecast the completion of work in progress as at 1 July 1998, one doesn't really know how negotiations for new contracts are going to proceed in 1998/1999, do you agree? A. Yes, certainly. If you hadn't started the negotiation, you don't know what the contract is going to be. Q. A prudent assumption for gross margin in 1998/1999 if the previous four years have shown a gross margin of about 21 percent, would be to forecast 21 percent for 1998/1999, would it not? A. Unless you had reasons to believe that the contracts that you had on hand would cause it to be different. Q. Then you agree with what I say? A. Yes. Q. With that qualification? A. Provided you look at the contracts you had on hand, and see the profitability on those contracts. The contracts that you hadn't actually signed for the forthcoming year, some of them might be in negotiation phase, some might be completely blue sky, they might not even start. So you use the experience you gain from historical business to estimate margins you would make in the future. Q. Unless you were aware of some unusual or exceptional circumstances as to the profitability of contracts which would be performed in the 1998/1999 year, a prudent assumption for gross margin would have been 21 percent, don't you agree? A. It would be a conservative assumption. Q. But it would be prudent? A. Prudent or conservative, yeah. HIS HONOUR: Q. Would that be supported by a view that the year 1998/1999 would see a downturn? A. Certainly in estimating any budget you should take into account the likely economic conditions in which you are going to be operating. Q. I am asking you in this instance to assume that there was an anticipated downturn for that year? A. Right. That would tend to cause you to take a more pessimistic view about the likely margins." (T121:40 - T123:46) 132 The evidence in relation to the damages issues is, in some fundamental respects, unsatisfactory and not unrelated to the delinquency of Pitchers in failing to comply with the several succeeding directions of the Court for the filing of statements of evidence. That was compounded by the Court's exercise of discretion in favour of Pitchers in permitting Pitchers to rely upon statements of evidence filed in the week prior to hearing. 133 One unsatisfactory aspect of the quantum evidence is the manner in which the parties conducted their respective cases on the basis that no distinction was to be drawn between the entitlement to damages by Ludowici, on the one hand, and Ludowici Mineral. 134 Both parties treated the measure of damages as being that in deceit whether the case was founded upon breach of a duty of care or one for damages for misrepresentation under the Fair Trading Act 1987. Neither party advanced a separate case expressly based upon the second limb of the rule in Hadley v Baxendale (1854) 156 ER 145. 135 To illustrate the respective approaches of the parties, counsel for Pitchers in written submissions expressed the principle as follows: " QUANTUM In contract or tort damages are awarded to place the Plaintiff in the position in which it would have been, had the contract been performed or the tort not committed. Commonwealth v Amann Aviation Pty Ltd (1991) 174 CLR 64, 99 per Brennan J, citing Taylor and Owen JJ in Butler v Egg & Egg Pulp Marketing board (1966) 114 CLR 15, 191 . Prima facie the measure of damages in a case where a Plaintiff purchases an asset by reason of the Defendant's misrepresentation of fact is the difference between the price paid and any lesser actual value of the asset acquired. Toteff v Antonas (1952) 87 CLR 647, 650 per Dixon J This is so for the claim for damages under s 82 of the Trade Practices Act . Sellars v Adelaide Petroleum NL (1992-94) 179 CLR 332, 355 It is submitted that in this case the appropriate method of assessing any loss arising from the mistake as to EBIT should be by reference to the formula for valuing the company deemed appropriate by both purchaser and vendor. There is no other expert evidence as to how the diminution in the value of Malco at the date of sale ought to be established. In this regard, it is submitted that the figure of $1.5m should remain as the EBIT figure for 1999. It was the figure set by Malco management as a result of lengthy consideration of likely 1999 performance and not as an accounting exercise merely reflecting the 1998 EBIT. In this regard, the reduction in 1998 EBIT should be viewed as a once off reduction with no flow on effect." 136 The reference in that concession to the "formula" for valuing the company "deemed appropriate by both purchaser and vendor" is a reference to the formula of multiplying the adjusted maintainable EBIT by a factor of four. In this case the maintainable adjusted EBIT was based upon the average EBIT of the actual for the 1997 year, expected for the 1998 year and estimated for the 1999 year. That formula was subject to the qualification in the agreement which permitted an adjustment upwards in the event that the actual average for those EBIT years varied from that stated in the agreement and with an adjustment downwards, not to exceed $600,000, in the event of the average falling below the average of the stated figures. 137 The position of Ludowici and Ludowici Mineral on the question of damages was submitted to be as follows: " H. Quantification of loss 1. Where property is acquired under the inducement of a misrepresentation (whether fraudulent, negligent, or in breach of s 52 of the Trade Practices Act), the general principle is that the proper measure of damages is the difference between the real value of the property acquired as at the date of acquisition and the price paid for it. … Lehane J [in Flemington Properties Pty Ltd v Raine & Horne Commercial Pty Ltd (1997) 148 ALR 271 at 310-318] provides a useful analysis of the principle, and of the rationale for it. In particular, Lehane J observed (at 316.6) that although the principle is often referred to as prima facie rather than absolute, such descriptions are usually followed by a statement of well-established exceptions and no others. None of those exceptions arise in the present case." 138 In oral submissions counsel for Ludowici and Ludowici Mineral responded in the following way to questions about damages in contract: "HIS HONOUR: What about the measure of damages being contract in one case, possibly tort on the other? JACKMAN: We don't see that as being relevant because it is not a case where contractual damages would lead to a loss of expectation. It is a case where the contractual measure would be reliance, that is in reliance we paid out 7.4 million and look at what we got for it. So the contractual measure would be the same as the tortious measure, there would only be a difference if we were suing for a contractual profit which would not be able in tort (sic). That is how we put that. There is an issue of principle which arises as to whether the Potts v Miller general principle applies in this particular case, that is the damages that one looks at are purchase price minus value of the asset when bought. That is a principle which is in most cases seen as a limitation on damage. By preventing you from suing for loss, that is the damages are those at the date of purchase, it is a limiting principle. In this case if one did the best one can on the available evidence it would actually lead to a higher recovery. That is why I am cautious in advocating it and I recognise that the experts on both sides have agreed that an appropriate methodology is to look at alternative cash flows in and out for the business and to give credit for the business as it stood at the date of Mr Bryant's report which is October 2000. … JACKMAN: If the Potts v Miller formula has been adopted then either the first or the second plaintiff would be entitled to that difference between purchase price and actual value of the date of purchase. Given the difficulties in this case in applying the Potts v Miller formula what in our submission ought to be adopted is the methodology agreed between Mr Bryant and Mr Whitear and to award on a cash flow basis and to award damages in that measure to either or both first and second plaintiffs." (T144:28 - T144:56… T145 52 - T146:02) 139 The reference to the "cash flow basis" is a reference to the third basis for assessment of damages advanced through the evidence of Bryant and which is examined later in these reasons. That third basis is probably recoverable under the second limb of the rule in Hadley v Baxendale, particularly having regard to the way in which it was approached by Bryant. 140 To add to the irony of circumstances surrounding the approach to quantum, Whitear accepted Bryant's third measure of quantification as an appropriate method of assessment, if it is accepted, as I do, that, but for the negligent advice of Pitchers, Ludowici would not have caused Ludowici Mineral to acquire Malco. 141 Any attempt to apply the Potts v Miller (1940) 64 CLR 282 measure of damages runs into the difficulties that, strictly speaking, neither party adduced evidence directed at the value of Malco as at the date of acquisition. That position, on one view, has been saved by the concession of counsel for Pitchers that "an appropriate method of assessing any loss" was to apply the formula adopted by the parties in the agreement, as earlier quoted in these reasons. That concession proceeded upon the understanding that no distinction was to be drawn between Ludowici's loss and Ludowici Mineral's loss. They were treated as synonymous. 142 During the course of oral submissions, referring to the manner in which the proceedings had been conducted without distinction between Ludowici and Ludowici Mineral, the following exchange occurred between the bench and counsel: "HIS HONOUR:….. It seems to me neither party have invited me to examine, expressly to examine that dichotomy. I would like to think I don't have to do it. JACKMAN: That is our submission was because one is dealing with 200 per cent (sic). HIS HONOUR: Mr Thompson, I notice in your submissions there is no point raised in that. Is that your position? THOMPSON: I must say in the back of my mind I have always had a thought about the interrelationship of the two plaintiffs and certainly I put nothing in my written outline. Clearly the retainer was only by Ludowici. HIS HONOUR: So you are thinking on your feet, are you? I really wasn't inviting a problem, at the same time I didn't want to hide behind the fact that neither party had expressly adverted to it. As I say perhaps the problem will go away but I think I need to raise it to know what your position is. THOMPSON: Indeed, I am still trying to remember who was the purchaser of the shares, it was the second plaintiff who was the purchaser of the shares, wasn't it? HIS HONOUR: Yes. What does all that mean? THOMPSON: It means I will clutch at anything. I will give it some thought. HIS HONOUR: The point is raised then it seems to me I will need a little more assistance than I have had to date on that aspect." (T143:17- T143:51) 143 That led to supplementary submissions in writing of 28 May and 30 May 2001. In his supplementary submissions counsel for Pitchers purported to withdraw from the manner in which the proceedings had been conducted as to damages in a number of ways by submitting as follows: (a) there was no contractual relationship between Pitchers and Ludowici Mineral; (b) Ludowici Mineral was an entity unknown to Pitchers and, accordingly, a party to which there was no duty of care owed; (c) as to liability under the Fair Trading Act 1997, there was "no evidence that Pitchers had any knowledge that use would be made of [the interim report] by Ludowici Mineral"; (d) Relying on Prudential Insurance v Newman Industries Limited (No 2) (1982) Ch D 204 at 210 and 222-223, Gould v Vaggelas (1985) 157 CLR 215 at 219-220 and Morwood v Chemdata Pty Ltd (1995) ATPR 40,827 at 40,837, Ludowici, as a shareholder in Ludowici Mineral, had no standing in respect of any loss suffered by that wholly owned subsidiary. (e) Ludowici, as a financier to Ludowici Mineral, was "owed no duty of care by auditors of the company in which the investment is made". Further, that there was no evidence of loss suffered by Ludowici as a financier. 144 I think the approach by counsel for Ludowici and Ludowici Mineral, in his supplementary submissions, implicitly reflected a return to a Potts v Miller approach to damages rather than the "cash flow" based third measure of quantification by Bryant which primarily was concerned with the implications of the Malco acquisition on Ludowici's cash flow. 145 Counsel for Ludowici and Ludowici Mineral took issue with each of the supplementary submissions for Pitchers. In what, I think, was more in the nature of a throw away line, it was further submitted as follows: "15. In any event, Ludowici has suffered a direct loss, by reason of its provision of the $7.4m paid to acquire Malco: Ex C, para 9. It is artificial to regard Ludowici merely as the financier for the purchase of the shares. In reality, the financier was Westpac Banking Corporation: Ex C, para 9." 146 There is no substance, in my view, in this submission if it is put as a foundation for recovery of $7,400,000. 147 As earlier stated neither party adduced evidence along conventional lines as to the value of the business as at date of acquisition as against what was paid for the Malco acquisition. That evidentiary situation did not present a major obstacle in light of the concession made by counsel for Pitchers. 148 As to (a): it was common ground that there was no contractual relationships between Pitchers and Ludowici Mineral, both parties conducting their cases on the basis that no distinction was to be drawn between Ludowici and Ludowici Mineral on the issue of quantum. 149 As to (b): it does not follow from the fact that Pitchers may not have been aware of the proposal by Ludowici to acquire Malco through a wholly owned and controlled subsidiary that a duty of care was not owed to Ludowici Mineral by Pitchers. No evidence was directed to this question of knowledge of Pitchers, largely, I assume, as a consequence of the absence of any issue distinguishing between Ludowici and Ludowici Mineral as to their respective entitlement to damages. 150 If I was not of the view that a duty of care was owed to Ludowici Mineral I would not allow Pitchers to raise such an issue after the conclusion of the hearing and the hearing of principal submissions, having regard to the way in which the case was conducted. In a modern commercial setting, it is common place for major corporations to use subsidiary vehicles within their groups for acquisitions such as this. In providing the advice required under the retainer, I think Pitchers should be taken as owing a duty of care to Ludowici and to any subsidiary vehicle Ludowici chose to effect the Malco acquisition. 151 As to (c): in considering Pitchers' liability in damages under the Fair Trading Act, it has been conceded by counsel for Pitchers that I am entitled to assess damages on the same basis whether founded in contract, tort or the Fair Trading Act. Moreover, the matter relied upon by Pitchers is, in the circumstances of this case, irrelevant to any liability Pitchers may have to Ludowici or Ludowici Mineral under the Fair Trading Act. 152 As to (d), it was submitted that there was "no expert evidence of the type discussed in George Fischer (Great Britain) Ltd v Multi-Construction Ltd [1995] 1 BCLC 260 establishing that any particular loss sustained by [Ludowici Mineral] resulted in a loss to Ludowici". Otherwise, it was contended that ordinarily a shareholder cannot sue for the loss in the value of the shareholding caused by tortious conduct of a third party to the subject company. 153 I think Pitchers' conduct of these proceedings has some bearing on the way in which the matter of damages should be resolved. Having regard to the concession made on behalf of Pitchers as to how damages may be assessed and the conduct of the case on the basis that no distinction was to be drawn between Ludowici and Ludowici Mineral on the issue of damages, Pitchers, in my view, should not be allowed to depart from those concessions. 154 Bryant was asked to approach the assessment of damages on three alternative bases: "2. We have been asked by Clayton Utz to express our opinion as to the combined loss of the plaintiffs on three alternative formulations (all expressed with interest to 30 September 2000): a) the difference between the price paid, and the price which would have been paid if the Share Sale Agreement had been renegotiated in circumstances where Ludowici was aware of the Alleged 1998 EBIT Error (defined below) and those negotiations had either of the following outcomes: (i) the cap on the negative amount in the definition of "Second Amount" in the Share Sale Agreement had been removed ( "the first measure of loss" ); (ii) The "Purchase Price" in the Share Sale Agreement had been amended (in accordance with the formula by which the Purchase Price was derived, and assuming no mechanism to adjust for actual EBITs) with knowledge of the Alleged 1998 EBIT Error and July 1998 actual sales and consequential reassessment of the estimated EBIT for 1999 ( "the second measure of loss" ) b) assuming that Ludowici and Portland House would have been unable to reach agreement on a renegotiated Share Sale Agreement, the sum as at 30 September 2000 which will restore the Plaintiffs to the position in which they would have been had the shares in Malco not been purchased ( "the third measure of loss" ). 155 The three approaches resulted in the following assessments: " B. Summary of conclusions 11. In our opinion, the loss of the plaintiffs on the three alternative formulations of loss set out in paragraph 2 above, including interest to 30 September 2000 is: $ The first measure of loss 3.749m The second measure of loss Between 2.470m and 3.493m The third measure of loss 3.490m" 156 In approaching the assessment of loss Bryant made allowance for the reimbursement to Ludowici Mineral of $250,000, that being the adjustment under the agreement. That brought the "net purchase price paid" down to $7,150,000. In assessing the "first measure of loss" Bryant used the actual EBIT as $2,035,000. In relation to the EBIT for 1998 he adopted the figure of $1,814,568. This figure was reached after adjusting for the error in the accounts of Malco relating to work in progress and adding back a redundancy expense of $180,000. 157 The most controversial aspect of this approach was the use of a loss of $884,000 for the 1999 EBIT. The major difficulty with accepting that EBIT is that it is not, in my view, a true indication of the maintainable earnings of Malco either historically or as a long term acquisition, that being the basis upon which it came into the Ludowici group. It is best illustrated by the opinion of Turner as expressed in the board papers comprising his recommendation to purchase Malco as follows: "3.2 Compatibility with Ludowici/CMi The product range of Malco represents a product extension to CMi. There are no areas where CMi competes with Malco. Malco claim to be an Australian mechanical engineering company, specialising in the design, sales and manufacture of mining and industrial products and plants. Essentially Malco provide hardware and spares for mineral processing prior to and subsequent to the processes that CMi presently supply. As a consequence the acquisition would result in a combined CMi Malco having a significant product range for mineral handling and processing, particularly coal. Malco presently purchase about $1.0m of products which may be able to be provided by CMi e.g. jet slinger belts, ceramic linings, polyurethane screen panels, wedge wire screen panels. From a market point of view the compatibility is evident with CMi having as major clients 32 out of the 50 major clients identified by Malco. The other 18 major clients are not presently clients of CMi and may represent some potential for sales by CMi in the future. Like CMi, Malco in recent times had been heavily dependent on the coal industry with current sales approximately 80% coal dependent although forecast to reduce in 1998/99 to 75%. The dependence on coal will not lessen significantly in the short term as the potential to grow the spares and service side of the business is greatest in the coal sector. Malco are somewhat in advance of CMi in developing the service market. Whilst this is still relatively small business for Malco (less than $0.5m) it is growing and there are plans to provide additional resources to take advantage of opportunities which are said to be apparent. This is an area into which CMi also wish to move. Geographically the businesses are compatible and there is expected to be some scope for integration and cost savings in due course although these have not been used in the financial evaluation. There is an obvious ability to rationalise premises in Queensland and Western Australia and ultimately New South Wales. Some numerical comparisons of CMi and Malco are included in Appendix C. 3.3 Market Standing Malco has been established for 80 years and is widely known in the industry. Malco is similar to Ludowici in that it has a respected name and reputation for sound technical ability. The fact that Malco is some 80 years old and has not grown the engineering base beyond its current level of around $20m sales is however testimony to the lack of attention to customer service, product innovation and general growth aspirations. Importantly Malco enjoy a first rate reputation with engineering consultants in the mineral processing industry. Our view, to be confirmed upon receipt of the Polymex report, is that Malco are the current leaders in their principal product lines of vibrating screens and feeders, stackers, reclaimers and coal valves. 3.4 Growth Prospects Growth Prospects for Malco as it is presently are for steady but not spectacular growth in line with volume growth in the mineral sector (+3% to 4% p.a.). David Hains asserts that he has held Malco back; they have had to live within their depreciation for capital expenditure, overseas expansion has been curtailed (risk issues) and the business regarded as a cash generator for his group. As a result there is little evidence of continuing product innovation (there is one patent - the coal valve originally patented and now some 12 years old although with some recent improvements) and the Malco side of the business based in Adelaide does not impress as marketing oriented. This contrasts with Honert in Sydney who design (for manufacture in Adelaide) vibrating feeders and screens. There are a number of other areas where Malco has operated in the past which appear to have been let go. Principal amongst these has been the exit from manufacturing a range of products for which licences were held associated with environmental and sanitary engineering. These areas can and should be reactivated. This means that Malco is presently 90% dependent on activity in the mineral industry which is presently in sombre state. Under CMi management however we assess the future as brighter." 158 There is nothing, in my view, in the evidence to detract from the core value of Malco as an "established [business] for 80 years … widely known in the industry", nor from the view that Malco was "similar to Ludowici in that it [had] a respected a name and reputation for sound technical ability". I think the reality underlying the losses suffered within the Malco business after its acquisition is found, principally, in the evidence of Hutchins. When cross examined about the down-turn in Malco's trading, he gave the following evidence : "[THOMPSON] Q. You are aware, are you not, that really from the time that Ludowici took over in August of 98, the division traded unprofitably? A. I guess so. Q. And indeed if the documents supplied to Mr Turner from Mr Hains, that had never been the case in the past? A. That's correct. Q. And that loss was subsequently the subject of an examination by a Mr Neil Stack who prepared a report dated 15 January 1999. Are you familiar with that document? Could the witness be given that exhibit, please. (Handed). Just have a look at that document, please, Mr Hutchins. Are you familiar at all with that document? A. No, I'm not. Q. Can you tell us who Neil Stack is? A. Neil Stack is the manager of finance for Ludowici Limited. Q. If you could look, please, at the third page of that document in the fourth paragraph the author concludes, "Realistically the Asian and world resources demand downturn greater than forecast in the first quarter of 98 and it now appears that the downturn would be longer than many experts had contemplated." Does that accord with your recollection? A. Yes. Q. And "Recent to modest prior reductions had driven project evaluations and deferments and at the end of the day higher costs will be forced out of the mining market." So there was a general downturn in the industry at that time? A. Yes, there was. Q. Is it that to which you principally attribute to the losses of the company? A. Yes. … … Q. In appendix to Mr Bryant's affidavit there were documents which indicate a trading loss of almost half a million dollars for the six months July 99 to 31 December 1999, that's after the company had been profitable through to June 98. Was there any particular reason for such, from what you observed, for such a sudden turn around in performance? A. My interpretation is that the market dried up virtually overnight and instead of having a normal amount of work, we didn't have any opportunity to quote. There was actually no work going ahead at all. It was virtually overnight things just stopped. Q. And there were redundancies, I believe, within the company? A. There were redundancies prior to July 98. There was some in July. Q. When were the redundancies prior to June 98? A. In May, and there was some further. Q. Was that because of the downturn in orders? A. In the 97/98 year we had two very large contracts. The company actually rammed up personnel to be able to carry those contracts. Unfortunately there was another contract looming, we were unsuccessful tenderers and we had to let people go from there. … A. It was still very quiet for the six months of June 99 through to January 2000. The work started to pick up after January 2000, not on large contract orders, but in our bread and butter line which is vibrating screens. Work started to pick up on those but there was no large contracts for a good two, two and a half years. Q. And eventually the business closed, did it not? A. No. What happened, we close the manufacturing operation down. Q. When was that? A. August 2000. Q. And what, you continued servicing and sales? A. That's right. We moved from being in-house manufacturers to using subcontractor manufacturers. Q. Can I take you please to your-- HIS HONOUR: Q. How's that, so far as Malco's business was concerned? Was that in that form continued? A. Yes, it has. It's still run of the base in Adelaide. We are still tendered for large contracts. We have just completed a large contract last week in Central Queensland, a contract worth about $6 million, but that was the first major contract we'd had for a good three years." (T85:31 - T 86:11 …. T86:21- T 86:47 …. T87:14 - T87:40) 159 I think it would be completely inappropriate to regard the maintainable EBIT of Malco as dominated by the 1999 EBIT loss. 160 In relation to this basis of assessment, Whitear expressed the view that if the formula of four times EBIT was to be adopted then the appropriate EBIT could be taken as the budgeted EBIT of $1,500,000. There are a number of reasons why that approach should not be adopted. Principal among which is that it fails to recognise the unrealistic gross margin percentage of 27% built into that EBIT. If a more realistic percentage of 21% was applied that would bring the gross margin down to $4,054,000 and after allowing for adjustments, in particular in overheads of approximately $3,455,000, one is left with an EBIT of approximately $600,000. Conversely, the adoption of that EBIT as the maintainable earnings, as suggested in an alternative submission by counsel on behalf of Ludowici and Ludowici Mineral, would be equally unjustified as it would give too much weight to the economic downturn which had been anticipated, in part, in Malco's 1999 budget. 161 If an estimate of value of the business was to be based on the formula akin to that adopted in the agreement, I am satisfied that an EBIT for the 1999 year of $600 would have to be weighted to reflect better economic times and I think that can be achieved by adopting the adjusted EBIT for the 1998 year, after putting back in the redundancy figure. On that basis the average EBIT for two years would be $1,208,000, which translates into a purchase price of $4,832,000, which may be compared with the amount outlaid by way of purchase of $7,400,000 less the $250,000 refunded under the deed of release. The difference in price paid and the value so estimated would then be approximately $2,320,000. That is the basis upon which, in my view, damages should be allowed for reasons that are further elaborated upon below. 162 Bryant's second measure of loss is more closely aligned to the approach I have adopted, except that he adopted a 1999 EBIT of $164,000 and took the average from the 1997 actual and the 1998 corrected EBIT. On that basis he used an average of $1,338,000 to which the multiplier of four is applied to give an estimate of value of $5,352,000. As with his first measure of loss, he contrasted that estimate of value against the purchase price of $7,400,000 without allowance for the refund of $250,000 which, as I have earlier stated, I think should be taken into account. The 1999 EBIT of $164,000 is taken from Turner's calculation which adjusted the estimated sales of $19,300,000 downwards to a figure of $18,463,000 to take account of the July 1998 sales figures that were available to Pitchers prior to the agreement. 163 In my view that adjustment is too favourable an approach to Ludowici and Ludowici Mineral, particularly having regard to the fact that the 1999 budget had allowed for approximately $6,450,000 to represent a drop in sales. The EBIT is also arrived at by allowing for "Ludowici adjustments" of $258,000 which have been introduced to bring the adjustments into line with Turner's report to the board of Ludowici of 19 June 1998 on due diligence and recommendation to purchase Malco. I am not aware of any evidence to support that additional adjustment other than the report itself, which in a footnote describes it as follows: "additional depreciation $125k - allowance for head office charges/ costs $125k" 164 Although similar adjustment is noted in the report for the 1998 year that does not appear to be the basis upon which the EBIT for that year adjusted for the accountancy error was calculated. I am unable to accept the 1999 EBIT of $164,000 as adopted by Bryant in the second measure of loss. 165 The third measure of loss is required to be addressed, although I think that, in the way these proceedings were conducted, it is an inappropriate basis of calculation of loss. It is an amalgam of benefits received and expenses incurred variously by Ludowici and Ludowici Mineral as though they were one enterprise suffering one loss based on the impact on a single cash flow of the acquisition costs of Malco. 166 As earlier noted, Whitear considered the approach, in principle, as appropriate if it is accepted that Ludowici would not have proceeded with the acquisition. However, that is essentially a reflection of the way in which the proceedings were conducted which did not distinguish between Ludowici and Ludowici Mineral in respect of any losses sustained. 167 Bryant's approach is founded, principally, on the evidence of Turner in his affidavit sworn 10 October 2000 which was admitted without objection. Notwithstanding, I think there are some very significant unsatisfactory aspects of that affidavit which was one clearly aimed at providing a basis for the cash flow approach to assessment of loss. 168 Although the affidavit refers variously to Ludowici and Ludowici Mineral it does not appear to distinguish carefully between those two entities when describing the various events in the acquisition of Malco. 169 To illustrate the uneasiness that I have in using Turner's calculations which have been adopted by Bryant in his third measure of loss, I set out below pars 9 and 10 of Turner's affidavit of 10 October 2000 as follows: "9. Upon the completion of the sale, Ludowici assumed responsibility for the lease of the premises at which Malco business is situated in Adelaide. That lease is due to run to 2008. The lease costs are $276,000 per annum (indexed to the CPI) plus outgoings of $68,000 per annum. I further estimate that it will require the sum of $175,000 as a minimum to clear the site of existing plant and machinery and make it ready for subleases. Due to the depressed state of the Adelaide industrial property market and the size of the property (10 acres) I estimate that Ludowici will only recover approximately one half of its lease costs by sub-leasing this property from 1 January 2001. 10. The existing plant and equipment has a current written down book value at 30 September, 2000 of $0.915m. It is intended to auction the plant and equipment in 2000. Whilst it is unusual for plant and equipment of the type Malco owns to achieve book value at auction it has been depreciated more heavily than usual and I have advised Ludowici's directors I expect we will achieve book value." 170 Bryant simply accepted the book value as there stated in par 10. 171 As to par 9 the following was the evidence of Bryant: " Expected Future Cashflows 63. We are instructed that the plaintiffs expect to spend $0.175m in clearing the Adelaide site (paragraph 9 of Mr Turner's affidavit). We are instructed that the cost to Ludowici of maintaining the Adelaide lease, to which the group is committed, will be $0.344m per annum with this cost increasing with inflation each year (up to 2008), (paragraph 9 of Mr Turner's affidavit). We have applied an inflation factor of 3% per annum commencing in the year 30 June 2002. Ludowici expect to be able to recover approximately half of its lease costs by sub-leasing this property from 1 January 2001. We allow for the present value of the after-tax net loss on the lease as an addition to the loss " (Emphasis added) 172 Bryant adopted those figures without any express, critical analysis. 173 The problem of the amalgam of receipts and costs on a notional single cash flow may be seen in appendix 8 to Bryant's affidavit of 11 October 2000. The cash flow is identified as follows: (a) Price paid including stamp duty $7,420,668: presumably this was in fact paid by Ludowici Mineral from funds which Ludowici caused to be provided by means of a bank facility (b) Cost to Ludowici of consulting and legal fees $107,285: presumably this was primarily a Ludowici expense although it is far from clear that that is so from appendix 12 to Bryant's affidavit. (c) Cash flow from Malco assets transfers $273,083: this in fact is one of several "cash benefits received by [Ludowici Mineral] from the transfer of Malco net assets" totalling $3,277,000 which was assumed by Bryant to have been received over a twelve month periods. (d) Malco losses for six months ending 31 December 1999 $443,200: presumably, that was a loss incurred by Ludowici Mineral after the restructuring which involved the acquisition of Malco's business by Ludowici Mineral. (e) Refund from Portland House $250,000: that was in fact paid to Ludowici under the deed of release. (f) Malco profit for sixth months ending 30 June 2000 $12,000: the same comments apply as to item (d). (g) Malco's losses for the months of July and August 2000 $35,933 per month: the same comments apply as in item (d). (h) Redundancy costs $776,000: I assume that is a Ludowici Mineral costs. (i) Malco profit for September 2000 $61,667: the same comments apply as to item (d). (k) Lease costs for the month of September 2000 $30,000: according to Turner's affidavit of 10 October 2000 the lease had been taken over by Ludowici and presumably this was a Ludowici cost. (l) Site clearance $175,000: again it is not clear by whom this cost was incurred. Presumably, on the basis of Turner's affidavit it was a Ludowici expense. (m) Value of Malco net assets salvaged $862,000 : presumably this was a benefit received by Ludowici Mineral. (n) Value of business salvaged $2,960,000 : again this would appear to be a benefit to Ludowici Mineral. (o) Net present value of lease costs $1,092,104: based on Turner's affidavit this would be a Ludowici cost (p) Net present value of tax losses $546,431: presumably that goes with the lease costs. 174 It can be seen from the foregoing that there is a great difficulty in approaching the assessment of loss on this "cash flow" basis if I am required to distinguish between Ludowici and Ludowici Mineral in the assessment of damages. I think, short of reopening the case, it is completely impractical to even attempt a separate assessment of damages for Ludowici and Ludowici Mineral on this basis. 175 The supplementary submissions of counsel for Ludowici and Ludowici Mineral contend that their damages were the same. As appears from the above, that could not apply to Bryant's third measure of loss as so calculated by him. 176 Given the concession by counsel for Pitchers that the measure of damages is to be assessed by ascertaining the value of the Malco business at date of acquisition by the application of a formula such as that adopted by the parties to the agreement, having regard to the way in which these proceedings were conducted on behalf of Pitchers both prior to and during the hearing and, further, having regard to the acceptance by Whitear of the application of a multiplier of four to the appropriate EBIT figures for the purpose of evaluating the Malco business, I have come to the conclusion that the assessment of damages is to be treated on the basis to which I have earlier favoured and that Pitchers are to be held to the manner in which the proceedings were conducted, in which it was accepted that the damages so assessed represented the loss to each of Ludowici and Ludowici Mineral. 177 I think it is note-worthy that in Bryant's third measure of loss he identified $5,327,000 in the form of net working capital, $915,000 in the form of fixed assets of Malco, the benefit of which was enjoyed by Ludowici and Ludowici Mineral. In a similar category he assessed the ongoing value of the Malco business as incorporated in the Ludowici group in, approximately, the sum of $2,900,000. 178 Accordingly there is to be judgment in favour of the plaintiffs in the sum of $2,320,000 together with interest calculated at schedule rates under the Supreme Court Rules, to run from 3 August 1998. The plaintiffs are directed to bring in short minutes of order in accordance with these reasons with a calculation of interest to date of judgment. ********** .. Last Modified: 10/29/2001 DISCLAIMER - Every effort has been made to comply with suppression orders or statutory provisions prohibiting publication that may apply to this judgment or decision. The onus remains on any person using material in the judgment or decision to ensure that the intended use of that material does not breach any such order or provision. Further enquiries may be directed to the Registry of the Court or Tribunal in which it was generated.