Ludowici v Pitcher

[2001] NSWSC 728

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
CASES CITED:	Prudential Insurance v Newman Industries Limited (No 2) (1982) Ch D 204 Gould v Vaggelas (1985) 157 CLR 215 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: [phone]

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, trading	Ludowici	20.05.98 & Continuing
6. Instruct Rushtons re plant valuation	Ludowici	27.05.98
7. Discuss with Malco senior personnel - Adelaide - Sydney	Ludowici Ludowici	4&5.06.98 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 - -commence -complete	Ludowici/ Rushtons	03.6.98 26.6.98
· 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 $ 000’s	Actual 95/96 $000’s	Actual 96/97 $000’s	Actual 97/98 $000’s	Budget 98/99 $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 21.83%	4,013 21.50%	5,144 20.60%	6,799 27.4%	5,213 27.00%
Overheads (1) (4)	2,669 17.77%	3,039 16.29%	3,312 13.27%	3,619 14.45%	3,455 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	1,425	176	1,531	N/A (7)
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
Jobs raised for the manufacture of stock items:	Represented by: Stock - Raw materials Work in Progress*	282,395	282,395	243,690 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.

$
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.

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Last Modified: 10/29/2001