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Eldridge v. Gordon Brother Group, LLC

United States District Court, D. Massachusetts

March 18, 2016

DAVID KAY ELDRIDGE, RAY ELDRIDGE, JR., D. CHRIS ELDRIGE, as trustee, not individually, of the C. ELDRIDGE 1994 GST TRUST, PATRICIA K. SAMMONS, as trustee, not individually, of the P.K. SAMMONS 1994 GST TRUST, C. ELDRIDGE 1994 GST TRUST, P.K. SAMMONS 1994 GST TRUST, and K’S MERCHANDISE MART, INC. Plaintiffs.
v.
GORDON BROTHERS GROUP, LLC, WILLIAM WEINSTEIN, FRANK MORTON, Defendants.

MEMORANDUM AND ORDER

DOUGLAS P. WOODLOCK, UNITED STATES DISTRICT JUDGE

March 18, 2016 Plaintiffs, K’s Merchandise Mart, Inc., (“Old K's”) and its shareholders, brought this action against Gordon Brothers Group, LLC, (“GBG”) and two of its executives, William Weinstein and Frank Morton, alleging fraud, breach of the implied covenant of good faith and fair dealing, and breach of contract. The lawsuit arises from the formation of New K's Merchandise, LLC (“New K’s” or “the LLC”) by the parties and the subsequent liquidation of the LLC by GBG. On August 4, 2011, I granted Defendants partial summary judgment. The parties thereafter filed cross-motions for summary judgment regarding the remaining claims. Additionally, Defendants filed a motion for sanctions against Old K's counsel pursuant to Fed.R.Civ.P. 11 and 28 U.S.C. § 1927 based on Old K's filing of its motion for summary judgment.

I. BACKGROUND

A. Factual Background

On May 1, 2006, Old K's and GBG entered into the New K's Merchandise LLC Limited Liability Company Agreement (“the LLC Agreement”) forming New K's as a Delaware LLC. Old K's was a retail business incorporated in Illinois, while GBG was a Delaware LLC with its principal place of business in Massachusetts. The only members of the LLC are Old K’s and GBG. Under the agreement, they respectively owned 22.5% and 77.5% interests in the business.

The LLC Agreement designates GBG as “the sole manager” of the LLC. LLC Agreement § 3(b). As the manager, GBG is given the authority to “exercise all the powers and privileges granted to a limited liability company by the Act or any other law or this Agreement.” LLC Agreement § 3(a). The LLC Agreement states that “[t]he Manager shall use its best efforts to consult with K’s Merchandise regarding the Manager’s conduct of the affairs of the Company and will also use its best efforts to keep each Case 1:08-cv-11254-DPW Document 103 Filed 03/18/16 Page 3 of 83 Member fully informed of any material decisions and activities of the Manager with respect to the Company.” Id.

1. Management of the Furniture Department

New K's, like Old K's before it, included a furniture department. Gordon Brothers had limited experience running furniture departments, although GBG employee Joseph McLeish had some experience with ready-to-assemble furniture departments, and GBG had run a few store closing sales for furniture businesses. However, GBG did not rely on its internal expertise; it hired High Point Group (AHPG") to run New K's furniture department.

Edward Borowsky, the head of HPG and New K's furniture department, stated at his deposition that when HPG took over, it looked into furniture sales; looked at the inventory; determined what pieces were mismatched, damaged, or disorganized; compared inventory levels to sales levels; and discussed the inventory with the New K's buying department. He stated that HPG brought in independent contractors who were engaged in the field and gave feedback regarding personnel, attempting to change the attitudes of a demoralized staff. He stated that HPG restructured New K's warehousing distribution, establishing satellite warehouses instead of relying on the central warehouses previously used. He further stated that HPG did not do market surveys or statistical analysis of the furniture department.

Kay Eldridge, a shareholder of Old K's; Richard Powers, Chief Financial Officer of both Old K's and New K's; and Geoff Clouser, Senior Vice-President in charge of the furniture department, all opined that the furniture department was mismanaged. Mr. Clouser stated that it was his opinion that the changes made to the furniture department, including changes in inventory, purchasing furniture for liquidation retailers, and establishing satellite warehouses, were unreasonable given the paucity of analysis conducted beforehand. Kay Eldridge stated that the merchandise purchased was scratched and damaged, which was “a terrible thing.” Richard Powers stated that the merchandise that was brought in was overpriced.

Michael Pakter submitted an expert report on behalf of Old K's quantifying the lost profits resulting from the alleged mismanagement. He calculated that if the gross margin of profits were at the level attained in the period of May 1, 2006, through October 4, 2006, but the sales had remained at the levels achieved during the period of May 1, 2005, through September 30, 2005, then the furniture department would have earned an additional $579, 210 in profits. He also calculated that the cost of maintaining the new satellite warehouses was $558, 579. Relying on Geoff Clouser's affidavit, Mr. Pakter stated that it was his understanding that the establishment of satellite warehouses increased expenses without adding to revenues. He concluded that the total lost profits for New K's furniture department was the sum of the lost profits on sales and the satellite warehouse costs, or $1, 137.789.

Peter N. Schaeffer submitted an expert report on behalf of Defendants that evaluated Mr. Pakter’s analysis of the furniture department. Schaeffer stated that it was his opinion that Mr. Pakter’s conclusions were flawed. He stated that the assumption that the sales would have remained at 2005 levels was unwarranted because “sales for the Company were falling and as word of the Company's troubles became public, large price purchases such as furniture would be jeopardized.” He further questioned why Mr. Pakter used the 2005 sales as his revenue base but retained the 2006 gross margin, which was significantly higher. Finally, he stated that Mr. Pakter did not support his claim that the satellite warehouse program was unnecessary and that the money spent on it was wasted.

2. Financial Record Keeping

The LLC Agreement obligates GBG, as the manager, to “keep or cause to be kept complete and accurate books and records of the LLC, using the same methods of accounting that are used in preparing the federal income tax returns of the LLC to the extent applicable and otherwise in accordance with generally accepted accounting principles consistently applied.” LLC Agreement § 12(a). GBG is also required to “provide such information respecting the financial condition and operations of the LLC as either Member may from time to time reasonably request.” Id.

Old K’s alleges that Defendants did not consult with it or keep it informed during the operation or liquidation of the business. Old K’s further alleges that its shareholders requested accounting and financial information regarding New K's from GBG numerous times from April 2007 through the discovery period for this case, and that they were rebuffed or provided with insufficient information. Defendants dispute that any information was delayed or withheld.

3. Liquidating Distributions

The LLC Agreement addresses distributions on the occasion of a liquidation of the LLC. It states that “a distribution made upon a liquidation or winding up of the LLC (the “Liquidating Distribution”) shall be made to the members, from all cash or property available for distribution.” LLC Agreement § 6(b). Under the LLC Agreement, the Members receive liquidating distributions “on a pro rata based on their respective Percentage Interests, ” with a minimum distribution to Old K's of three million dollars.[1] Id. The LLC Agreement further specifies that “[e]xcept as the Manager may otherwise determine, all distributions to Members shall be made in cash. If any assets of the LLC are distributed in kind, such assets shall be distributed on the basis of their fair market value as determined by the Manager.” LLC Agreement § 6(d).

In March, 2008, New K’s made a payment to Old K’s in the amount of $1, 748, 217, which represents the minimum three million dollar distribution less certain adjustments for monies owed by Old K's to New K’s or to GBG or withheld as a reserve for future expenses expected to be paid on Old K’s behalf. On May 18, 2009, GBG sent Old K’s a document entitled “Balance Sheet for Reconciliation” (“Reconciliation”) which provided balance sheets and explained the distribution amount.

a. The Reconciliation

The Reconciliation includes a calculation of New K’s Expected Revenue as follows:

Data From

Assets

Amounts

Totals

Balance Sheet C144

Bank of America Cash

6, 817, 471.77

Balance Sheet C152

Distribution to Old K's

3, 000, 000

Balance Sheet C153

Distribution to GB

3, 000, 000

Davenport Real Estate Not Sold

0.00

Decatur Land Not Sold

0.00

Balance Sheet C22

Bank of America and CIB Cash Account

210, 204.19

Subtotal Assets

13, 027, 675.96

Liabilities

Balance Sheet C147-145

Liabilities from Balance Sheet

1, 059, 400.75

Balance Sheet C55

Old K's Deduction Expense (800k, 175l, 100k)

1, 075, 645.47

Estimated Accruals E1

Estimated Accruals for additional 12 months

753, 760.00

Subtotal Liabilities

2, 888, 806.22

Current

Expected

Revenue

10, 138, 869.74

The Reconciliation provides a “Calculation of Payout Due” as follows:

Total Expected Revenue

10, 138, 869.74

Old K's Merchandise Share

22.50%

2, 281, 245.69

If Old K's Sharing Less than $3 million then Guarantee of $3M is the floor

3, 000, 000

Total Due to Old K's Merchandise

3, 000, 000

The Reconciliation provides a “Calculation of Wire” as follows:

Distribution Made March 2008

3, 000, 000.00

Less Amounts Due New K's / GB:

Fee for Busey Guarantee Agreement

800, 000.00 Due to GB

Old Champaign Settlement

175, 000.00 Due to GB

Don Oulette Settlement

71, 923.00 Reimbursement to New K's

Rick Powers Severance Payment per Contract with Old K's

45, 360.00 Reimbursement to GB

Busey Forbearance Renewal

7, 500.00 Reimbursement to New K's

Busey Forbearance Renewal

10, 000.00 Reimbursement to New K's

Busey Forbearance Renewal thru Oct 2007

10, 000.00 Reimbursement to New K's

Busey Forbearance Renewal Thru Jan 2008

10, 000.00 Reimbursement to New K's

AR Accounts for Kay Eldridge

11, 354.53 Payment due to New K's for AR

Reserve

100, 645.47 Reserve

Subtotal Deductions

1, 251, 783.00

Total Amount Funded to K's Merchandise Mart Inc.

1, 748, 217.00

b. The Real Estate

The Reconciliation lists two pieces of property, the “Davenport Real Estate” and the “Decatur Land, ” which had not been sold at the time the Reconciliation was prepared. It valued each at “0.00.” After December 31, 2008, the “Decatur Land” was sold for a net revenue to New K's of $16, 705.47. The Davenport Real Estate remains unsold. Patricia Parent, a Principal and Managing Director of GBG, stated that it is currently listed for sale at $1, 900, 000. David Coles, who submitted an expert report on behalf of GBG, estimated that the property value was $1.5 million.

c. The $1, 075, 645.47 Liability

The Reconciliation identifies $1, 075, 645.47 as a liability. This number includes $800, 000 which was due from Old K's to GBG and was paid out of the distribution to Old K's. It includes $175, 000 for the settlement of liabilities in connection with the Old Champaign Store which was due from Old K's to GBG and was paid out of the distribution to Old K's. Finally, it includes another $100, 645.47 in reserve for payments for preparation of Old K's income tax returns, state income taxes owed by Old K's, annual report fees owed by Old K's and other miscellaneous billings that might be discovered on review.

Parent stated in an affidavit that these amounts were listed as liabilities because they were owed to others (GBG or third parties) and being held by New K’s. She stated that the amounts were also included as assets, because New K's had not yet paid the amounts and therefore held them in its accounts. She stated that the $1, 075, 645.47 was a part of the asset line item identified as “Bank of America Cash, ” which totaled $6, 817, 471.77. Regarding the reserve in particular, she stated that New K's was only holding the $100, 645.17 in cash until Old K's expenses were paid, and to the extent that any amounts were left over, they would be repaid to Old K’s.

d. The $130, 777.53 in Deductions

The Reconciliation provides a calculation of the distribution made to Old K’s. The calculation includes deductions for the payment of a settlement with Don Oulette, forbearance fees on New K’s on mortgages, and accounts receivable, which were sums owed by Old K’s and Kay Eldridge (a principal shareholder of Old K's) to New K’s. These deductions total $130, 777.53.

Parent stated that the first two deductions represented reimbursements for expenses New K's had already paid out on Old K's behalf. They were not included as either liabilities or assets because receipt of the reimbursement did not generate revenue or a new asset but instead canceled out prior expenditures. She stated that the final component, representing accounts receivable owed by Kay Eldridge, was originally one asset (accounts receivable), and after payment to New K's through the deduction became another asset (cash). She stated that because the amount was already considered an asset when it was accounts receivable, it would not increase New K's assets after payment was taken out of the Old K's distribution. She stated that the accounts receivable therefore were reflected in the cash assets without increasing New K's gross revenues.

e. The Inventory Balance

The Reconciliation provides a zero inventory balance as of December 31, 2008. Old K's expert Michael Pakter, however, provided a report stating that this number was incorrect. Mr. Pakter calculated that the ending inventory should be equal to the opening inventory plus the purchases less the cost of sales. Into this formula, he plugged numbers derived from (1) the ending inventory balance of Old K's as of April 30, 2006 (used as the opening inventory of New K's); (2) an “Inventory Update Summary” report created by GBG (used for the purchases numbers); and (3) other internal GBG documents. Using these numbers, he calculated that the ending inventory should have been $13, 923, 576. In other words, Pakter concluded that over $13.9 million worth of inventory was unaccounted for by GBG.

Parent stated that the numbers that Pakter plugged into his formula did not represent opening inventory or purchases. She stated that not all of Old K's inventory balance was brought over to New K's on May 1, 2006 when it commenced operations, and that specific items of inventory were excluded from the transaction. For this reason, the ending inventory balance of Old K's was not the opening inventory of New K's. She also stated that the “Inventory Update” report at GBG, the source of Pakter's numbers for monthly “purchases, ” was an operational report that did not reflect “purchases” but instead tracked the total amount of inventory physically present in the store. Thus, it included inventory that was at the stores but was not an asset, much like consignment inventory that was not owned by New K’s. Finally, she stated that at least one data point for ending inventory (that for December 31, 2006) was taken from the wrong point in time (namely from the week ending December 17, 2006).

GBG expert Jeffrey Szafran submitted a report criticizing Pakter's analysis in much the same way as Parent did. Szafran stated that “the basic accounting equation used by Mr. Pakter is reasonable” but “certain data points used in the analysis were wrong.” Szafran explained that the opening inventory balance was wrong because it reflected the ending inventory balance of Old K's instead of the opening inventory balance of New K's. He stated that Pakter's use of the wrong balance improperly inflated his ending inventory calculation by approximately $2 million. Id. Szafran cited to work papers produced by Buccino & Associates, Inc., which was engaged to identify the assets and liability that were to be transferred from Old K's to New K's, and concluded that a Adownward adjustment of approximately $2.1 million" should have been made. Id. Szafran did not provide Old K's with a copy of the Buccino & Associates work papers.

Szafran also stated that the “purchases” data points used by Pakter were obtained from the “Inventory Update Summary” produced by GBG, which did not reflect assets correctly but instead analyzed all orders and perpetual merchandise on hand. He stated that this did not represent New K's inventory balance, because, for example, it included consignment product. For his information regarding the numbers in the Inventory Update Summary, he cited a conversation with GBG employee Rhonda Hebert.

Szafran stated that Pakter's cost of goods numbers were also incorrect, and were taken from New K's operational “sales summary” reports instead of from its general ledger accounting system, J.D. Edwards. He noted that the sales summary reports provided numbers that could not appropriately be used for the “cost of goods” data points because they included layaway sales that were not a part of “cost of goods” prior to the ultimate purchase by the customer. He stated at his deposition that he was able to understand why there was a difference between the GBG operational data and the accounting records after speaking with Sherry Wittig, a GBG accounting employee.

Szafran provided his own inventory analysis, relying on the same accounting principles as those used by Pakter but using data points from New K's general ledger accounting system, J.D. Edwards. His analysis showed an ending inventory number of $580, 000. He explained that “[t]he cumulative difference in my expected ending inventory amount did not differ substantially from the reported ending inventory, therefore I did not attempt to reconcile the difference.” Id.

f. Updates to the Reconciliation

At her deposition on March 25, 2010, Rhonda Hebert, the GBG employee responsible for creating the Reconciliation, stated that GBG was working on updates to particular parts of the document, namely how an $11.7 million advance to K's was documented and updates to a valuation to correct certain estimates. GBG has not provided Old K's with an updated version of the Reconciliation.

4. The Emails Regarding Financial Projections and Accounting

On January 19, 2007, Rhonda Hebert emailed Tricia Parent, Billy Weinstein, and Frank Morton of GBG. The email stated:

Attached is a revised estimated recovery on the balance sheet for your review With the changes implemented, the bottom line is current showing: 7, 937.
Please advise of an changes/reprojections that need to be made.

On January 20, 2007, Frank Morton forwarded the January 19, 2007, email to Parent and included his own email:

A few weeks we sat done with Rhonda and reviewed the P&L (12/29 updated) . . . and we also discussed several circumstances where we felt the P&L was conservative including the following:

Sales- plan had 178mm, we did $181.2mm (obviously some COGS here on the memo)
Paduca loss overstated (100k)
Payroll overstated (500k)
G/C liability overstated (300k)
Bessler add back (400k)
Windown overstated (1mm)
VBO (250k)
Obviously, we need a true picture here to see if we should buy out the back end . . . . Seems like we should be in the $17.0-$17.5mm range for total JV, not included the financing of $1.5mm to GB, with a break of $13.3mm.

Id.

Later that day, Parent responded to Morton with the following email:

As you are probably are aware we have a lot of people using different numbers not understanding what is in or what is out. Billy is saying one thing for [Old K's attorney] Cobb, we have one set of numbers for Rick etc...nothing has changed between the numbers we have published between us. if you want to go over we can at your convience, but understand we are following on the same path we have discussed.

On January 21, 2007, Morton responded to Parent with the following email:

I understand, we just need to get a clear picture of the numbers, so wan make a judgment on the buyout of the backend. this has nothing to do what we share with [Old K's attorney] Cobb et al... I want to buy it out but I also don't want to be stupid. If you can look at the numbers and give your opinion, I'd appreciate

Parent stated at her deposition that the reason for the overstatement of the items listed in Morton's January 20, 2007, email was that projections are formulated to leave room for any unexpected expenses that can be incurred. She further explained the chain of emails by stating:

It’s not uncommon that our people that are not close to the numbers are all using different numbers. For whatever reason, people that are not looking at financial statements and what is going through the books and records have numbers in their heads, okay? I believe at the time we received something from Rick Powers, who was actually working on behalf of New K's, created a document that was completely incorrect. So what I'm telling Frank is, you're saying one thing, Rick's saying something else, and we've got a set of books that the company has.

She stated that she did not know what her understanding was of what Morton meant when he emailed “this has nothing to do with what we share with Cobb . . . .”

B. Procedural Background

Plaintiffs commenced this case on July 22, 2008, filing a Complaint containing three counts: (1) fraudulent inducement, (2) accounting, and (3) breach of contract. Included within the breach of contract count was a claim for breach of the implied covenant of good faith and fair dealing.

1. Damages Disclosures

On December 24, 2008, Plaintiffs filed initial disclosures pursuant to Fed.R.Civ.P. 26(a)(1)(A). In response to the requirement that each party provide “a computation of each category of damages claimed by the disclosing party, ” Fed.R.Civ.P. 26(a)(1)(A)(iii), Plaintiffs stated:

Plaintiffs have been damaged by Defendants failure to provide an accounting, compensatory and exemplary damages as a result of Defendants' breach of the LLC Agreement, fraud, and their attorney fees and expenses in bringing this suit. Plaintiffs cannot determine the amount of the damages until Defendants provide Plaintiffs their document production responses and an accounting . . . .

On June 11, 2009, Plaintiffs responded to Defendants' First Set of Interrogatories, which were served on March 5, 2009. Interrogatory 13 stated:

Please describe in detail including exact dollar amount each and every element of damages the Plaintiffs are claiming in this action and identify each and every document that the Plaintiffs rely on in responding to this interrogatory.

Plaintiffs responded with the following:

The exact dollar amount of damages cannot be determined at this time prior to the completion of Defendants' discovery disclosures and expert economic analysis. Investigation continues and Plaintiffs will supplement their ...

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