CPA's liability exposure in feasibility studies.by Goldwasser, Dan L.
This past summer, a jury found Price Waterhouse & Co. (PW) liable for $15.9 million for damages sustained by a hospital corporation in connection with its development of a retirement center. The damages were allegedly sustained because of an erroneous financial projection reviewed by PW. This litigation not only demonstrates the potential liabilities that can arise out of prospective financial statement engagements, but perhaps more importantly, demonstrates just how vulnerable a CPA can be to a finding of liability when his or her client suffers a serious misfortune.
This case, which is still being contested, involved the construction by Scioto Memorial Hospital of a retirement center which was financed through a municipal bond offering. The accountants had been engaged to review a financial projection for the proposed project, and their report was rendered approximately a week after the hospital's board of trustees had determined to proceed with the project. That decision, in large measure, had been made upon the advice of the hospital's president, after he had received reports from outside marketing research consulting firms. In fact, from all appearances, the accountant's report on the financial projections was obtained to satisfy the request of the hospital's counsel who orchestrated the municipal bond offering financing the project.
Although the hospital argued that its decision to proceed with the project was based upon PW's report, the evidence produced at trial was largely in conflict with that assertion. Moreover, plaintiff's damages from the project appear to have been wholly due to a fire which destroyed the project when it was in the final stages of completion, and the hospital's ensuing decision to rebuild the demolished facility. Alternative financing arrangements were utilized in conjunction with the rebuilding of the facility and PW was not consulted nor was it asked to prepare or review any financial projection in connection with the resumption of the ill-fated project.
As in most cases, the plaintiff hospital corporation had the burden of proving that PW had acted negligently and that PW's negligent actions had caused its damages. Plaintiff's proof of these necessary elements was so weak that one has to wonder why a directed verdict was not granted by the court, removing the case from the jury.
Plaintiff's claim of negligence centered on PW's acceptance of an assumption that the project would be 98% sold within one year after its opening. Plaintiff claimed that this assumption was erroneous and that a 95% assumption would have been more reasonable. In support of this assertion, plaintiff cited the testimony of one of PW's expert witnesses who stated that, in his view, the extra costs that would be incurred to achieve the 98% fill-up rate would not have been justified by the additional revenues. An assumption that the projection would have been 95% filled one year after its opening could only have meant that the negative cash flow in the first year would have been slightly larger and that it would have taken a bit longer to repay the debt incurred to build the project.
Instead of proving that the assumption utilized in the PW report was incorrect, the evidence presented to the jury strongly pointed in the other direction. At the time of the fire (approximately two months prior to the scheduled opening of the center) the hospital had presold approximately 60% of the units. PW's projections, based upon the 98% fill-up rate, showed a slightly lesser pre-sale level at that point. Because of the delays and bad publicity arising because of the fire, most of these pre-opening sales evaporated by the time the project was begun anew. Rather than showing that the fill-up rate used by PW was, in fact, unreasonable, the objective evidence supported the assumption used in the PW report.
The plaintiff not only had to prove that the underlying assumption was erroneous, but also that PW was negligent in accepting it. To this effect, there was testimony that the PW accountants reviewed the confirming market research report prior to releasing their report but they did not analyze the back-up material submitted with the market research. In addition, they were criticized for having relied upon the report of one of the plaintiff's marketing consulting firms, when evidence existed that such firm had inadequate experience. Indeed, at the trial, the plaintiff characterized the marketing consultant's report as a "selling document," presumably designed to mislead bond purchasers.
Such attacks appear to fall short of proving negligence. To prove negligence it would have to be shown that PW departed from the standard of care that would have been observed by the average reasonable, prudent and competent accountant. The plaintiff's case, in this report, was aided by happenstance. At the time this engagement was undertaken, the AICPA's October 1985 Statement on Financial Forecasts and Projections had not been published, so there was significant uncertainty regarding the nature of PW's duties and the scope of its engagement.
Under the 1985 statement, an accountant retained to render a report on prospective financial statements to be utilized in a securities offering memorandum is required to perform an examination of the principal assumptions underlying the financial statements. The new 1985 statement allows the accountant to render either a compilation or an examination report, and the statements themselves could be in the nature of a projection based upon a number of hypotheses. Because these standards had not been published at the time of PW's engagement, there was no concensus within the profession as to the steps required to be taken by accountants in performing this type of engagement.
To prove that PW had departed from the prevailing standard of care, plaintiff's counsel presented testimony and continually emphasized that PW was only one of two "Big 8" firms that was undertaking this type of engagement at the time. The absence of authoritative statements undoubtedly gave credence to his assertions that PW's very acceptance of the engagement was a deviation from accepted practice.
The plaintiff's attacks upon PW's actions also succeeded because of certain inconsistencies in the testimonies of the PW employees. Their workpapers lacked documentation fully setting forth the procedures they performed and the findings of those procedures. Thus, among the principal lessons to be learned from this litigation are that complete and well-organized workpapers are essential in financial projection engagements and that reliance upon "experts" should only be undertaken under conditions satisfying the requirements of Statements on Auditing Standards AU Sec. 9336.
Lastly, the plaintiff was required to prove that the damages which it sustained were, in fact, caused by PW's negligence. Here, the plaintiff's proof consisted of little more than wishful thinking. Following the devastating fire, the hospital decided to resume the project. That decision, however, was illfated from the outset. First, because of the delay resulting from the fire, many persons who were committed to buy units cancelled their purchases. Moreover, the bad publicity arising because of the fire impeded marketing efforts when the project was renewed. Lastly, the hospital chose to accept a fast and substantially discounted settlement with its fire insurer and to proceed anew with a more expensive form of financing. This left the new project undercapitalized and doomed to failure. The record indicates that these improvident decisions were made without consulting PW.
In view of the overwhelming factual pattern in favor of PW, it is difficult to see how the plaintiff could have prevailed. The techniques utilized by plaintiff's counsel in enlisting the jurors' sympathy for his client are, therefore, both important and instructive. Rather than try this case as one institution against another, plaintiff's counsel made it appear that this was a litigation between PW and the president of the hospital whose hopes and dreams had been dashed as a result of his reliance upon PW's advice. Plaintiff's counsel virtually ignored the fact that the decision to proceed with the project had been made by the hospital's board of trustees prior to the release of PW's final report.
Plaintiff's counsel also made much of the fact that one of the PW accountants had been engaged in job discussions with the hospital's bond counsel during the course of the project and implied that these discussions somehow impaired PW's independence in carrying out its engagement. Understandably, no effort was made to correlate this "impaired independence" with any actual misstatement in the PW report. At best, plaintiff inferred that it inclined PW not to object when plaintiff's bond counsel overcharged for his services.
In his closing argument, plaintiff's counsel also repeatedly stated that PW had undertaken to advise the hospital if it felt that the project was not feasible and that PW at no time rendered any such advice. To be sure, PW's engagement letter made no reference to rendering any such advice and spoke only of rendering a report on the hospital's financial projections.
To some extent, the plaintiff was able to convince the jury that PW's efforts had fallen short of its engagement, claiming that PW was:
"seeking to hide behind disclaimers, inconsistencies and accountants' mumbo-jumbo that no person without an expert accountant sitting at his elbow could understand."
This demonstrates one of the major obstacles that an accounting firm must overcome in seeking to vindicate itself at trial. By both their nature and training, accountants tend to be very precise in their use of professional terminology; and in many cases, accounting jargon uses terms differently from their lay meaning. Thus, accountants are faced with the unenviable choice of either closely adhering to the technical language of their profession (and, thereby, confusing the jury) or ignoring the specific meanings of technical terms in an effort to enhance jury understanding and thereby leave themselves open to attacks on cross-examination as a result of their misuse of professional terminology.
In the final analysis, plaintiff's principal obstacle in this case was to convince the jury that the project was destined to failure by reason of an unrealistic fill-up assumption; and that the fire was wholly irrelevant to the project's ultimate failure. He overcame this problem largely by diverting the jury's attention from the critical facts. First, he repeatedly told the jury that the fire was irrelevant and that the difference between a 95% and a 98% fill-up assumption made all of the difference between success and the disaster that ensued. Next, he emphasized the lack of sophistication of the plaintiff and its president and how they necessarily relied upon their experts--principally PW. He then went on to point out certain deficiencies in the actions of the PW personnel and how the PW team failed to keep plaintiff advised of various matters which came to their attention. In this way, he won the jury's sympathy for the plaintiff's plight while at the same time portraying PW as a large and dispassionate organization, unconcerned with the success or failure of its clients. Thus, in the jury's mind, the issue probably was not whether the plaintiff had satisfied its legal burden, but rather who should be made to bear the losses sustained in this project.
Another problem faced by plaintiff's counsel was the fact that the hospital's president had executed a representation letter in which he stated that the assumptions underlying the prospective in the hospital's judgment depicted the most likely conditions and future courses of action. Here again, plaintiff's counsel tired to portray the hospital's president as being unsophisticated and, therefore, unable to appreciate the nature of the statements which he was making and the seemingly coercive circumstances under which he signed the representation letter.
All too often, representation letters in both prospective and historical financial statement engagements tend to be "boiler plate" and are signed more as a ritual than as a knowing representation. PW might have avoided plaintiff's somewhat cavalier dismissal of the representation letter by forcing the hospital's president to go over it line-by-line so that he could not disavow his representations after-the- fact. This would have also blunted plaintiff's criticism that the PW personnel did not adequately keep plaintiff's management informed of matters coming to their attention. In this regard, plaintiff's counsel also repeatedly pointed out how PW had not taken the time to review its report with the plaintiff, which he implied would have enabled the plaintiff to better understand its findings and limitations.
Finally, with respect to the PW personnel, plaintiff's counsel pointed out that many of the accountants assigned to the engagement had limited experience with projections for retirement projects, and that one of the accountants displayed a condescending attitude as well as a "foul mouth."
Although the case presented by plaintiff in this action cannot withstand close scrutiny, it was obviously sufficient to persuade the jury to find against PW. As such, it proves the maxim that clients that have financial problems tend to share them with their accountants. It also shows how small indiscretions can be used to build a case against an accountant.
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