Accountants are frequently confronted with litigation when their audit clients suffer significant financial deterioration. An accountant's potential vulnerability increases when the client files for bankruptcy and charges of financial wrong-doing or "cooking the books" are levelled at members of management by the client's disappointed investors. Indeed, in the current economic environment of increased bankruptcy filings, these circumstances are certainly on the rise.

In such cases, a plaintiff will generally attempt to use events leading up to the bankruptcy, the fact of the bankruptcy itself, and post-bankruptcy financial results to demonstrate the loss of the plaintiff's investment and to inferentially establish that the earlier financial statements were false and that the accountants knew or should have known it. Clearly, awareness of these matters may influence a jury's view of the strength of a plaintiff's claim. But should these matters of hindsight be admitted into evidence?

POST-TRANSACTION EVENTS

The admissibility of evidence about these events at trial is a significant issue to be addressed in cases where an audit client files a bankruptcy petition relatively soon after an unqualified audit report was rendered. The question is whether evidence of the post-transaction events is relevant to the necessary elements of a plaintiff's claim. If the judge is convinced that the events are not relevant, they will not be admitted into evidence. Moreover, even relevant evidence may be excluded; Rule 403 of the Federal Rules of Evidence provides for exclusion "if its probative value is substantially outweighed by the danger of unfair prejudice, confusion of the issues, or misleading the jury."

The plaintiff/investor is likely to argue that post-transaction events are relevant with respect to two elements of the claim: the amount of damages and the falsity of the financials which were allegedly relied upon. As a practical matter, it may be more difficult to offer concrete proof that financial statements were false, than to argue that they must have been false because they appeared to show financial health when only a relatively brief time later the company filed for the protection of the bankruptcy court. Similarly, if a plaintiff could establish its damages by simply pointing to an investment's lack of value post- bankruptcy, it would obviate the need for more demanding proof that the financials overvalued the company at the time of the investment and that the investor, therefore, was damaged by overpaying for the investment.

The resolution of this evidentiary issue has a profound effect on the dynamics of the trial process. For example, if the fact of the bankruptcy is admitted into evidence, the accountants may be compelled to explain why the audit client was required to file for bankruptcy shortly after the issuance of financial statements which suggested the audit client's financial health. In this regard, many significant matters in the financial life of the audit client, such as mismanagement or economic changes, may have occurred between the time of the investment and the actual loss. These matters may have had a major impact on the entity's financial demise and, in fact, may be the cause of an investment's loss in value.

As a corollary, even if the financials are false and the accountant is found liable for them, the damages may, as a matter of law, be restricted to those immediately caused by the subsequent events. Thus, under the "out-of-pocket" measure of damages, the accountant would be liable only for the difference between the amount paid and the actual value of the investment had the financials been accurate, measured as of the time of the investment. Under this theory, post-transaction events and performance are excluded from the measure of damages.

But Can It Be Done?

Assuming that defense counsel plans to seek the exclusion of evidence of the bankruptcy or other post-transaction events, careful planning is required to ensure that these matters are not directly or indirectly made known to the jury. For example, if plaintiff's counsel asks a question that refers to the bankruptcy, even if the defense objects and the objection is sustained, the jury will have been made aware of the fact through the question itself. The problem goes further since the bankruptcy and other matters might be mentioned by plaintiff's counsel in the opening statement. A later direction by the judge that jurors exclude from their consideration matters which have come to their attention, such as a bankruptcy filing, may well be ineffectual.

A MOTION IN LIMINE

The problem may be solved by attempting to obtain pre-trial rulings. In appropriate cases, pre-trial rulings on the admissibility of evidence are obtainable through a procedure known as a motion in limine. A motion in limine may be used to exclude, before a trial begins, anticipated testimony or documents that are potentially damaging because they are prejudicial or inflammatory.

Such a motion permits the parties to fully brief the evidence issues prior to trial, and affords the trial judge an opportunity to consider the matters without the pressure of being required to make an immediate ruling at trial. If successful, an in limine ruling may prevent the plaintiff from mentioning at trial such matters as the audit client's bankruptcy. This would preclude plaintiff's counsel from including this matter in the opening statement to the jury.

THE REALITY OF A TRIAL

The foregoing issues were presented in a matter in which we served as defense counsel. In our case, the plaintiff investors, comprised of sophisticated venture capitalists, purchased $6.5 million of stock and notes in the audit client on December 7, 1983, claiming to have relied on audited financial statements for the fiscal years ending March 27, 1982, and March 26, 1983. The audit client was a large distributor of general non-food merchandise and health and beauty aids, selling to retailers such as supermarkets, discount department stores, and drug stores. On December 31, 1984, the investors consented to the extension of a $34 million line of credit to the audit client, subordinating their notes to the credit in alleged reliance on audited financial statements for the fiscal year ending March 31, 1984.

In January 1985, the defendant accountants were succeeded by another accounting firm for the fiscal year ending March 30, 1985. In the course of their audit, the successor accountants uncovered certain alleged improprieties, including inventory tickets which were apparently altered to reflect higher inventory values and a 1985 intra-company transaction without supporting documentation. These matters led the successor accountants to focus more particularly on the component of the audit client's inventory denominated "returned inventory," which consisted of damaged and undamaged goods returned by customers and not as yet restocked into the regular inventory or returned to suppliers for credit.

A Look at the Returned

Inventory

Three principal areas relating to the returned inventory were addressed by the successor accountants: 1) the audit client's altered returned inventory count sheets, 2) the average box values used to value the returned inventory, the contents of which were not individually counted, and 3) the computation used to value the returned inventory, which included discounting the retail sticker price on a returned item to arrive at the item's cost.

In light of the concerns that arose regarding the inventory, the successor accountants proposed a "wall-to-wall" inventory count for the six-month interim period ending September 29, 1985. It was hoped that they could then work backwards from this number to obtain an inventory value for the March 30, 1985, fiscal year end. Neither the September 29, 1985, inventory count nor the March 30, 1985, audit was ever completed.

The audit client filed for bankruptcy in November 1985. A forensic accounting firm was then hired to prepare certain unaudited reports and a schedule of inventory on hand at March 29, 1986, all relating to the audit client's post-bankruptcy financial condition. These documents reflected management's decision to write off $15 million of inventory. In addition, another accounting firm was engaged by the creditors' committee and prepared a document which made certain hypothetical calculations as to inventory levels in prior fiscal years based upon an assumed reduced gross profit margin. Although based upon speculations, this document ascribed the $15 million inventory write-off to the 1982, 1983 and 1984 financial statements on which the investors claimed to have relied. Furthermore, in 1986 the investors arranged a private sale of their stock in the audit client for a nominal sum, and converted certain of their notes to stock in another entity which ultimately went bankrupt.

Following the bankruptcy, the investors sued the defendant accountants in federal court in New Jersey to recover their lost investment, alleging claims of federal securities fraud, common law fraud, and negligence. The court applied New Jersey law to the common law claims and, thus, held under H. Rosenblum V. Adler, 93 N.J. 321, 461 A.2d 138 (1983), that the investors did not need privity to establish their negligence claim.

ADMISSIBLE EVIDENCE?

It was clear prior to trial that the investors intended to seek to introduce at trial evidence of the audit client's bankruptcy, the $15 million post-bankruptcy inventory write-off, the reports prepared by the foresic accountants employed in connection with the bankruptcy proceeding, and related testimony to substantiate the introduction of these documents. It was equally clear that this evidence would create a powerful and highly prejudicial impression in the minds of the jurors.

The evidentiary problems were obviously of great significance and, if possible, required pre-trial disposition through a motion in limine. It was urged that any attempt to correlate the bankruptcy documents and testimony to the relevant period was based solely on unsupported speculation and that, at best, the tangential relevance of such later- period evidence was far outweighed by the danger of unfair prejudice and the possibility of confusing and misleading the jury.

It was also clear that if evidence of the bankruptcy and post- bankruptcy financial results were introduced, the defense would be compelled, at trial, to examine the impact of numerous intervening events on the company's financial performance. For example, between the time of the investment and the bankruptcy, among other things, the audit client's interest expenses increased, borrowing was significantly increased, customers were lost, inventory levels increased, general and administrative expenses increased, and the client had consummated a major acquisition. As to the alleged post-bankruptcy inventory shortfall, additional issues would be required to be considered, including obsolescence, accelerated liquidation of inventory at discount prices due to the enhanced need for cash, inability to process and monitor inventory as a result of loss of experienced personnel through resignation or termination, and pilferage or theft associated with the deterioration of the company's business post-bankruptcy. It was argued in the in limine motion that the focus on these extraneous matters would ultimately create confusion and obfuscate the real issues.

The trial judge granted a substantial portion of the motion in limine and excluded most of the post-bankruptcy evidence, subject to the investors' ability to introduce, during the trial, other evidence that would render the excluded evidence admissible. They were not able to do so. Accordingly, these matters remained outside the jury's consideration.

EVIDENCE ADMITTED

Certain post-transaction evidence was, however, admitted. Thus, the court permitted evidence regarding the work and findings of the successor accountants. In this regard, the key issue was the extent, if any, that the 1985 accounting work and any conclusions that the successor accountants may have drawn from that work could be said to evidence alleged improprieties in prior years. The goal, therefore, was to neutralize potentially adverse inferences by isolating the facts relating to the 1985 audit by the successor auditors and establishing their, at best, tenous relationship to the audits in prior years.

The investors called the sucessor accountants to testify at trial about the matters discovered in the course of the 1985 audit. The testimony focused primarily on attempts to arrive at an average value per box that would be acceptable. The successor accountants testified that the average box values which the audit client sought to use were greatly in excess of the averages that the successor accountant's audit tests suggested should be used. However, on cross-examination it was established from the successor accountants' own workpapers that the average box value numbers, which the successor accountants determined to be acceptable, were higher than the average box value numbers utilized during the years our client was the auditor. Similarly, the investors criticized as being too low the acceptance by our client of a figure of 10% as a reserve for damaged and unsaleable items among the returned merchandise. Through the successor accountants' own workpapers and the testimony of its senior auditor, it was shown that they had accepted an even lower figure of 5% for the damaged and obsolete returned merchandise.

CALCULATION OF DAMAGES

On another branch of the pre-trial in limine motion it was argued that the out-of-pocket measure of damages was the proper theory to apply in this case. As noted above, the out-of-pocket measure is the difference between what was paid for an investment and the value of what was purchased. Plaintiffs urged on a different damage theory that damages should be measured by the total amount lost by them as a result of their investment. This would be established, under plaintiffs' theory, by introduction of evidence that the stock they purchased was sold post- bankruptcy for a nominal consideration and that the debt portion of their investment had not been paid although payment was past due. Plaintiffs' theory would, in essence, make the auditors potentially responsible for events subsequent to the investment and would, therefore, effectively make them the insurer for risks inherent in the investment, which were voluntarily assumed when the investment was made.

The trial judge ruled on the in limine motion that the out-of-pocket measure of damages was the proper theory to apply. Under the out-of- pocket theory, assuming the jury found liability, damages would be computed by determining the difference between what the investors paid in 1983 for their stock and notes and the actual value of what they received at the time of the investment, giving effect to any alleged misrepresentation. The court excluded evidence of the disposition of the stock and the nonpayment of the notes since it was not relevant to this determination.

Plaintiffs sought to overcome the in limine ruling by offering testimony that revising the financials to reflect the impact of their evidence of inventory overstatement would leave the audit client with a negative net worth at the time of the investment and a pre-tax loss for the prior fiscal year. Plaintiffs then offered further testimony that if this were the case, they would have valued the stock and notes purchased, as at the date of the investment, as worthless or virtually worthless. Cross-examination, however, revealed that the investment value was not derived directly from the financial statements but rather the projected value of the company, resulting from improved gross profit percentages and increased sales.

IT'S NOT THAT SIMPLE

Simply attempting to negate a plaintiff's damage proof, however, presents a difficult dilemma. If the jury finds liability, then the only damage proof available to it is that offered by plaintiffs, even if that proof is somewhat or even largely discredited. On the other hand, the presentation of damages by a defendant might be viewed as reflecting less than total confidence in its ability to prevail. It was felt in this case that if a logical damage analysis could be presented, which would show relatively small damages, then the risk would be worth taking.

The groundwork for the damage analysis was laid during discovery. It was then disclosed in analyzing the proposed investment that the investors prepared their own five-year projections, using the 1983 audited information as a base, premised upon significantly increased gross profit margins and increased sales. In essence, the investors' projection contemplated the transformation of a company that was marginally profitable to one with burgeoning profits. Using the projected net profit figure for the fifth year, the investors multiplied that number by an industry-accepted price/earnings multiple. The resulting figure, referred to as the "terminal" or "end-up" value, was then used to determine the amount and terms of the investment so as to yield the investors' sought after return of 40% to 60% annually.

In presenting evidence of the amount of potential damages in the event liability was found, we sought to establish how hypothetical changes in the value of the inventory would have impacted the value of the investment, using the investors' own valuation technique. Charts were developed from "what if" scenarios and used at trial to illustrate revised valuations based upon hypothetical inventory reductions of various amounts. Our expert explained the meaning and significance of the information contained in the charts, and demonstrated that the impact of the various hypothetical inventory overstatements was very significantly less than that claimed by the investors.

In returning a verdict in favor of the accountants on liability, the jury obviously accepted our explanation that the presentation of an alternative damage computation was simply an attempt to refute plaintiff's proof on this subject and not a concession of liability. The trial judge's in limine and later evidentiary rulings were ultimately sustained on appeal by the Third Circuit Court of Appeals.

A CAREFULLY PLANNED

STRATEGY

It is generally true that "deep pocket" defendants, such as accountants, often settle litigation rather than face the unpredictable outcome of a jury trial. Cases where the audit client files for bankruptcy relatively near in time to the transaction in question present a particular problem since evidence of this and other post- transaction events may influence a jury's view of the accountant's work. However, where settlement is not appropriate or a reasonable settlement is not available, a carefully planned strategy to exclude, prior to trial, evidence of such post-transaction events will enhance the liklihood of a successful defense.