F. DOUGLAS COCHRANE vs. JOHN B. JANIGAN & others.

CUTTER, J. This is a bill of interpleader filed in behalf of the partners of a law firm (the escrow agent) to compel the defendants to litigate among themselves their claims to an escrow fund held by the firm. The fund was paid into court. The trial judge made a report of the material facts found by him. A final decree was entered which directed that, after the payment of $840 to the escrow agent, the remainder of the fund be paid to Janigan. Janigan, in turn, was directed to pay to the defendants Westland Corporation (Westland) and Boston Electro Steel Casting, Inc. (New Casting) the sum of $6,689.89 with interest from May 8, 1959. Westland, New Casting, and Janigan appealed. The evidence is reported.

On November 26, 1957, Janigan and Westland executed an agreement (the sale agreement) by which Janigan agreed to sell to Westland, or its nominee, on December 13, 1957, all the outstanding capital stock of Boston Electro Steel Casting, Inc. (referred to, as it existed prior to the stock transfer on December 13, 1957, as "Old Casting"). On December 13, the stock was transferred to Westland's

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nominee, Westland Enterprises, Inc., and the purchase price was paid to Janigan. Westland Enterprises, Inc., then liquidated Old Casting to itself and changed its own name to Boston Electro Steel Casting, Inc. (New Casting). Pursuant to the sale agreement Janigan placed $50,000 in the hands of the escrow agent under an escrow agreement. As required by the sale agreement, Janigan also executed an indemnification agreement indemnifying New Casting against certain liabilities.

The sale agreement (par. 2) provided in part that Janigan "hereby . . . warrants that . . . [t]he balance sheet of [Old] Casting as at October 31, 1957, attached hereto . . . fairly presents the financial position of [Old] Casting as at said date and the net worth and net quick assets of [Old] Casting as at said date were not less than the respective amounts shown therefor on said balance sheet, except in each case that no provision is made for Federal and State income and excise taxes for periods subsequent to September 30, 1956. [Old] Casting had on October 31, 1957, no contingent liabilities not disclosed or reserved against in said balance sheet" [Note 1] (emphasis supplied). The sale agreement

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(pars. 7, 11) also contained other pertinent provisions which are set out in the margin. [Note 2] Janigan by the indemnification agreement agreed to indemnify Westland and New Casting "against all . . . liabilities . . . of . . . [Old] Casting . . . existing on the date hereof, except those" reflected in the balance sheet (see fn. 1, supra), "Federal and State income and excise tax liabilities [of Old Casting], in respect of . . . periods subsequent to September 30, 1956," and certain other matters not here relevant. Under the escrow agreement, the escrow agent was to pay from the fund to the buyer (Westland or New Casting) the amount of any established "secured loss" as defined in par. 5 of the escrow agreement. [Note 3]

Prior to the closing set for December 13, 1957, Westland engaged the accounting firm of Peat, Marwick & Mitchell Co. (Peat, Marwick) to audit the books of Old Casting for the two preceding years. The trial judge found "that they made no report of their audit to any of the parties . . .

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until December 14, 1957 -- the day after the closing." He also found that the inventory of Old Casting, as of the last day of its fiscal year ended September 30, 1956, "had been understated . . . in the sum of $56,079.76," but that "no party . . . knew the amount of . . . [the] understatement prior to the date of closing."

There was no specific liability for 1956 Federal income tax shown on the balance sheet as of October 31, 1957. At the time of Peat, Marwick's examination of Old Casting's books, there had been imposed no additional Federal or State tax in respect of Old Casting's fiscal year ended September 30, 1956. [Note 4] There was evidence that prior to the closing, Peat, Marwick had reported orally to Westland (a) the alleged $56,079.96 understatement of Old Casting's inventory as at September 30, 1956 (the $56,000 inventory understatement), and (b) an alleged $11,000 overvaluation by Janigan of Old Casting's inventory as at October 31, 1957. Westland's attorney wrote to Janigan about the $11,000 discrepancy. Janigan's attorney testified that Janigan refused to reduce (because of this $11,000 item) either the purchase price or the reserve for "[o]ther [l]iabilities" shown on the balance sheet (see fn. 1, supra). Despite this refusal, the transaction was closed without adjustment based upon the $11,000 item. A representative of Peat, Marwick testified that the $56,000 inventory understatement had been called orally to the attention of the treasurer of Westland, on December 9, 1957, before the closing. The treasurer admitted that about two days prior to December 13 he had been informed by Peat, Marwick that there appeared to be such an understatement on Old Casting's tax return for the year ending September 30, 1956. The president

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of Westland also conceded that by December 13 he had received word of the understatement. Westland's counsel conceded that, before the closing, no notice of the $56,000 inventory understatement was given to Janigan.

After the closing, the United States tax authorities asserted a claim against Old Casting for a 1956 income tax deficiency amounting to about $28,113.71, plus interest and penalties. This deficiency was based mainly on the alleged understatement of Old Casting's 1956 closing inventory. The additional Federal assessment resulted in a claim against Old Casting by Massachusetts for an additional excise of $3,943.31, plus interest.

On February 5, 1958, a further agreement (the 1956 tax agreement) was executed by Westland, New Casting, Janigan, and the escrow agent. Under this agreement New Casting agreed to admit the existence of the principal amount of the 1956 Federal tax deficiency ($28,113.71) and to consent to a 5% negligence penalty. It was also agreed that the principal amount was "a proper liability of Old Casting as at September 30, 1956." New Casting paid this principal amount. Janigan paid an aggregate of $3,566.27, the interest on the tax ($2,065.01) to November 19, 1958, and the negligence penalty ($1,405.69), plus $95.57 of interest on original tax. Janigan now concedes that he remains bound to pay $3,222.54 for certain Federal penalties and, in addition, interest of $709.80 on the Massachusetts tax. New Casting has paid the additional Massachusetts tax of $3,943.31, plus $709.80 interest thereon. [Note 5]

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The trial judge also found that Janigan in Old Casting's balance sheet reserved for "other liabilities" the sum of $30,000. He ruled that this "sum [must] be applied in reduction of . . . [the] sum of $36,689.89 [see fn. 5, supra], leaving a balance of $6,689.89 due from Janigan to Westland" and New Casting "as reimbursement." He found that Janigan owed them "$6,689.89, together with interest . . . from May 8, 1959, the date of the filing of the [b]ill."

1. Janigan and Westland and New Casting request that all the controversies between them be disposed of in this litigation. A leading authority on interpleader has presented persuasive support for "the power of an equity court to admit an additional controversy into the second stage of an interpleader . . . where the court, in its discretion, thinks that such a union would accomplish justice." Chafee, Broadening the Second Stage of Interpleader, 56 Harv. L. Rev. 541, 562. [Note 6] Settlement in this litigation of all the controversies presented, as the parties desire, is consistent with usual equitable principles and will afford the parties complete relief. See Glazer v. Schwartz, 276 Mass. 54, 58; Greeley v. Flynn, 310 Mass. 23, 28. See also Atlantic Natl. Bank v. Hupp Motor Car Corp. 300 Mass. 196, 202-203; McDade v. Moynihan, 330 Mass. 437, 443-445; Piea Realty Co. Inc. v. Papuzynski, 342 Mass. 240, 250.

2. We assume (without deciding) [Note 7] that New Casting,

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Westland's subsidiary (claiming as Westland's nominee), may proceed against Janigan under the indemnification agreement by which Janigan at the time of the closing undertook to hold New Casting harmless "against all . . . liabilities . . . of . . . [Old Casting] existing on . . . [December 13, 1957] except those . . . [r]eflected or reserved against in the balance sheet of [Old] Casting" as of October 31, 1957 (see fn. 1, supra), and except certain other items not here pertinent. Even upon this assumption (that Janigan may be liable under the indemnification agreement notwithstanding Janigan's contentions mentioned earlier, see fn. 7), we hold that Westland and New Casting have not established any breach of the indemnification agreement causing damage to Westland or New Casting above the amount of the $30,000 reserve for "[o]ther [l]iabilities" shown on Old Casting's balance sheet of October 31, 1957.

Of the principal amount ($28,113.71) of the 1956 deficiency tax, more than 90% was based upon a $56,079.76 upward adjustment of Old Casting's 1956 closing inventory. Old Casting's Federal income tax for its fiscal year ending September 30, 1957, was necessarily reduced by reason of the increase in the closing inventory as of September 30, 1956, which, of course, caused a like increase in Old Casting's opening 1957 inventory. See Albino v. Commissioner of Internal Revenue, 273 F. 2d 450, 451 (2d Cir.). By the upward adjustment of the inventory as at September 30, 1956, the cost of goods sold in 1956 was reduced, and the cost of goods sold in 1957 was increased. See Carmichael Tile Co. v. Commissioner of Internal Revenue, 192 F. 2d 209, 210 (5th Cir.); Amory and Hardee, Materials on Accounting (3d ed. Herwitz and Trautman) pp. 33-36. Old Casting had sufficient net income to make it subject to a 52% Federal income tax rate in each of its fiscal years ending in 1956 and 1957. Apart from the relatively minor effect

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of other adjustments, Old Casting's 1957 Federal income tax liability was reduced (as a consequence of the inventory reappraisal) by the same amount by which its 1956 tax liability was increased. See Mertens, Federal Income Taxation (Zimet and Stanley Rev.) Section 16.01 et seq. See also Hartley, 23 T. C. 353, 357; 26 C. F. R. (1961) Section 1.446-1 (a) (4) (i). To the extent that Old Casting's inventory value as of September 30 and October 1, 1956, was increased, there would inevitably be a reduction of Old Casting's 1957 tax liability. This liability, of course, New Casting would have to pay.

New Casting thus has not established that any breach of the indemnification agreement with respect to most of the 1956 tax deficiency has caused it damage, for the very adjustment which gave rise to the 1956 liability gave rise to a substantially comparable benefit in 1957. [Note 8] Janigan, at most, is liable for the actual loss which any breach of his agreement has caused. See Valentine v. Wheeler, 122 Mass. 566, 568-570; Victor v. Levine, 267 Mass. 442, 444; Maxwell Underwriters, Inc. v. Zimmerman, 301 Mich. 485, 488-489; 27 Am. Jur., Indemnity, Section 26. See also Magnolia Metal Co. v. Gale, 189 Mass. 124, 132-133; Ficara v. Belleau, 331 Mass. 80, 82; Wicker v. Hoppock, 6 Wall. 94, 99; In re H. L. Herbert & Co. 262 Fed. 682, 684 (2d Cir.); Tessier v. United States, 164 F. Supp. 779, 780 (D. Mass.), affd. 269 F. 2d 305 (1st Cir.); Corbin, Contracts, Section 1038; McCormick, Damages, Sections 40, 41. Cf. Cormier v. Hudson, 284 Mass. 231, 238; Leshefsky v. American Employers' Ins. Co. 293 Mass. 164, 170; F. A. Bartlett Tree Expert Co. v. Hartney, 308 Mass. 407, 411-413.

We recognize that the escrow agreement expressly gives to Janigan the benefit of any tax saving or benefit to Westland or New Casting arising out of the payment by Janigan of any loss secured under the escrow agreement. The

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absence of such a provision in the indemnification agreement does not mean that Janigan, if liable under the indemnification agreement, cannot have the benefit of any tax saving to New Casting growing out of the same facts which give rise to any liability of Janigan under the indemnification agreement. To the extent that the facts giving rise to the 1956 deficiency tax liability also necessarily furnish to New Casting a substantially corresponding 1957 tax reduction, loss to New Casting does not occur or is reduced.

3. The trial judge correctly ruled that Janigan was entitled to have the $30,000 reserve for "[o]ther [l]iabilities" applied as an offset to any liabilities against which he was bound to indemnify New Casting. The testimony indicates that the $30,000 reserve was "a protection the attorneys had put in there." It was to be "an additional cushion to cover loose ends, inasmuch as the balance sheet . . . was $30,000 better than what the parties had bargained for in their formal talks initially." That Janigan refused to reduce either the $30,000 reserve or the purchase price because of the alleged $11,000 overvaluation of inventory (as of October 31, 1957) may have some tendency to confirm the evidence, mentioned above, that the $30,000 reserve was designed to provide Janigan with that much protection against liabilities not reflected otherwise in the balance sheet of October 31, 1957. Similar confirmation is given by the circumstance that Janigan's principal warranty in par. 2 of the sale agreement was that Old Casting's "net worth" was that shown on the balance sheet.

In any individual case, the purpose of such a general reserve may be somewhat ambiguous. If not required for contingent or uncertain liabilities, it eventually will become fully recognized as a part of surplus. See Hills, Law of Accounting and Financial Statements, Section 4.1; Kester, Accounting, vol. 3, pp. 41-42; Finney and Oldberg, Lawyer's Guide to Accounting, p. 171; Shugerman, Accounting for Lawyers, p. 328. Preferable modern accounting practice perhaps would lead to use of some term other than "reserve" for this type of provision, or to a more specific

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statement of the particular classes of liabilities necessitating the item. See American Institute of Accountants, Accounting Terminology Bulletin, No. 1, pars. 57-64 (reprinted in Amory and Hardee, Materials on Accounting [3d ed.] pp. 453, 466-468). See also 17 C. F. R. (1962) Section 210.3-19. Nevertheless, these authorities (although deploring imprecise use of the term "reserve" and ambiguous general allocations of retained income to somewhat nebulous possible liabilities) recognize that businessmen do set up such general protective balance sheet items, usually in an effort to state company financial positions conservatively. Whatever may be the most approved modern accounting practice, we think that the evidence about the origin of this reserve, and the conduct of the parties with respect to it, amply justified the trial judge in construing the $30,000 reserve as he did. Accordingly, Janigan will not become liable to reimburse New Casting for liabilities (a) which not only were within his indemnification agreement, because not specifically reflected in the balance sheet of October 31, 1957, but (b) which also actually have caused damage to New Casting, until those liabilities in the aggregate have exceeded $30,000.

4. To the extent that loss was caused to New Casting by the increase in Old Casting's 1956 Federal and State tax liability, interest, and penalties, that loss either has been paid already by Janigan or is very much less than the amount of the $30,000 reserve. Janigan thus is bound to pay to New Casting only the items which he concedes that he owes because of the 1956 tax liability agreement, an aggregate amount of $3,932.34. It thus is not necessary for us to make analysis of the escrow agreement in order to ascertain whether these items (if they had exceeded the amount of the $30,000 reserve) would have been "secured" claims or losses under that agreement (see fn. 3, supra). The provisions of the escrow agreement and the 1956 tax agreement reasonably permit payment of these items to New Casting out of the fund. Such a payment is the most convenient method of ensuring complete relief.

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5. Paragraphs 2 and 3 of the final decree are to be replaced by new paragraphs providing (a) that the clerk of court is to pay to New Casting out of the escrow fund the sum of $3,932.34, together with interest thereon from May 8, 1959, and (b) that, after the payments otherwise required to be made from the escrow fund by the decree as modified, the remainder of the escrow fund is to be paid to Janigan. As so modified, the final decree is affirmed. Janigan is to pay one half the expense of printing the record upon this appeal. Westland and New Casting are to pay the other half of the expense of printing the record.

So ordered.