CREATIVE LIABILITY CLAIMS AGAINST CPA FIRMS FOILED
By Dan L. Goldwasser
The plaintiffs' bar has demonstrated on many occasions that it is quite creative in devising claims against accounting firms. In recent months, two such exercises in creativity have been successfully thwarted.
The first case, Fireman's Fund Insurance Co. v. Glass, 1997 WL 289858 (S.D. N.Y., May 30, 1997), involved a suit by a surety against a CPA firm that had audited the financial statements of a construction company that defaulted on jobs bonded by the plaintiff. In order to avoid New York's three-year statute of limitations and potential defenses based upon the plaintiff's own negligence, plaintiff's counsel asserted a claim based upon a breach of contract theory, alleging that, as the surety for the construction company, it was a third-party beneficiary to the accounting firm's engagement by its client. The law recognizes that a person who is not a party to an agreement may nevertheless bring suit to enforce the terms of the agreement if the agreement was specifically entered into for that person's benefit. In this case, the surety claimed that the sole purpose for the contractor's obtaining audited financial statements was to secure bonding from it. Accordingly, it argued that it was a third-party beneficiary of the agreement and was entitled to sue the accounting firm for any and all breaches of that agreement, including an alleged failure by the accounting firm to conduct its audits in accordance with GAAS.
The plaintiff's claim to third-party beneficiary status was highly plausible as there had been at least two other cases outside of New York in which a surety had been allowed to sue as a third-party beneficiary. Nevertheless, the plaintiff's contractual claim was thwarted, in this case because it was demonstrated that the construction company had many reasons for obtaining audited financial statements, including satisfying the requirements of its bank loan. Moreover, the construction company had been obtaining audited financial statements for many years prior to the inception of its relationship with the surety. Thus, the surety could not rightfully claim that its agreement to provide bonding was the factor motivating the construction company's retention of the CPA firm.
Defendant's attorney further argued that the very nature of an auditor/client relationship does not lend itself to third-party beneficiary claims. This is because a CPA firm has a duty of confidentiality and may only make disclosures to a third party (such as a surety) if its client consents to those disclosures. A surety, with third-party beneficiary status, however, would have the right to demand disclosures of client information, placing the CPA firm in a position of possibly having to violate this ethical standard. In addition, a CPA firm can only perform an audit with the complete cooperation of its client. Thus, it was argued that it is absurd for a surety to have the right to compel a CPA firm to complete its audit engagement if the client was either objecting or not cooperating. These factors also make it highly unlikely that either the CPA firm or the client intended to give the surety the right to enforce the agreement pursuant to which the CPA firm was conducting its audit.
The court never reached the question of whether an audit engagement could ever give rise to a third-party beneficiary relationship. Instead, it ruled that, under the circumstances in this case, there was no evidence of an intention on the part of either the CPA firm or the construction company to grant the surety third-party beneficiary status. In this regard, the court seized upon the fact that the CPA firm's engagement letter made no mention of the surety, which had never been given a copy of that letter. The court also noted that the agreement between the surety and the construction company did not even specify that the construction company was to provide the surety with audited financial statements. Instead, it simply stated that the construction company was to provide such financial information as the surety might request. While the court did not mention it in its opinion, the accounting firm had consistently delivered copies of its report directly to its client which, in turn, provided them to the surety. Based upon this pattern of evidence, the court concluded that the accounting firm and its client had not intended to accord third-party beneficiary status to the surety, and granted the CPA firm's motion for summary judgment with respect to the surety's breach of contract claim.
The case is instructive in the ways in which an accounting firm can prevent sureties and other financial institutions from claiming third-party beneficiary status. Such steps include the following:
First, the CPA firm's engagement letter should specify that the engagement is being undertaken solely for the client's benefit and that the parties do not intend to provide contractual rights to any other persons. Secondly, the engagement letter should include a clause reaffirming the accountant's duty of confidentiality, stating that no client information will be disclosed to a third party except upon the client's express instruction. Lastly, the accounting firm should be careful not to deliver financial statement reports directly to the client's bank or surety, but rather deliver them to the client who, in turn, can deliver them to such persons.
Although an accounting firm will probably not be able to prevent its client from entering into a surety or loan agreement that calls for the production of audited financial statements, it should, by taking the foregoing measures, be able to prevent a court from finding that it and its client intended to confer third-party beneficiary status upon the client's bank or bonding company.
A Higher Standard
The second case, Adair v. Kaye Kotts, Inc., 1998 WL 142353 (S.D. N.Y., March 27, 1998), involved an attempt to expand the duties of a CPA firm whose report on its client's 1993 and 1994 financial statements had been included in the client's prospectus for a registered public offering of securities. Although there was no allegation that the numbers in the financial statements audited by the CPA firm were in error, the plaintiff tried to hold the auditors responsible for failing to report subsequent losses incurred by the client in 1995 on the theory that the CPA firm had a duty to include such subsequently incurred losses in a subsequent events footnote. In Kaye Kotts, the company had been profitable in 1994 as well as in the ensuing first nine months of 1995. Unfortunately, it incurred substantial losses in the fourth quarter of 1995, converting what had appeared to be a profitable year into a loss year. The company's prospectus included the audited financial statements for 1993 and 1994 and the unaudited financial statements for the first nine months of 1995. The prospectus, however, was not declared effective until mid-February 1996, by which time the plaintiff alleged that the company and its auditors should have known that the company had incurred a loss in 1995.
To be sure, the audited financial statements did include a subsequent events footnote, although that footnote did not discuss post-balance sheet operating results. Instead, it only discussed an acquisition that the client had made between the end of the audited fiscal year and the date of the public offering. The plaintiff tried to bolster its contention that the CPA firm had a duty to report the subsequently incurred loss, pointing out that in a registered public offering a CPA firm has a duty to conduct an "S-1 review" through the effective date of the registration statement, in which it is required to have discussions with management, review subsequent interim financial statements, and read the minutes of the meeting of the client's board of directors. The plaintiff thus argued that, had the CPA firm properly performed its S-1 review, it should have discovered the subsequently incurred losses and noted those losses in the financial statements covered by its report.
Attorneys for the defendant were successful in having the plaintiff's case dismissed by arguing that an auditor's responsibility only pertains to the period covered by the financial statements which it has audited and does not extend to subsequent periods even though auditors do frequently note subsequent events which have an impact on the financial statements upon which they have reported. Moreover, an S-1 review is undertaken strictly for the purpose of determining whether changes are required in the financial statements which have been audited and not for the purpose of reporting upon the financial condition or results of operations subsequent to the balance sheet that they have audited.
In rejecting the plaintiff's contention, the court stated:
An accurate [audit] report simply does not become misleading because an issuer suffers a material loss subsequent to the period covered by the report. There must exist materially false or misleading information in the report itself.
Citing an Illinois District Court decision, the court went on to state:
Although accountants are required to take reasonable steps to correct misstatements discovered in previous financial statements, they need not disclose events that occur subsequent to the period that they purport to certify.
The court thus held that the plaintiff's claims under Section 11 of the Securities Act of 1933 and under Section 10(b) of the Securities Exchange Act of 1934 had to be dismissed since the CPA firm had no duty to report on its client's subsequent operating results notwithstanding the inclusion of a "subsequent events" footnote in the financial statements which it had audited. *
Dan L. Goldwasser, Esq., is a partner of Vedder, Price, Kaufman & Kammholz, the law firm representing the defendant accountants in both these cases. He is also an editor of The CPA Journal.
Dan L. Goldwasser, Esq.
Vedder, Price, Kaufman, & Kammholz
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