A California jury recently awarded $42 million in damages against an accounting firm for its work in litigation support. Although the facts in this case may be unique, this and other court cases may erode the protection of immunity normally granted to expert witnesses. Here is the background and what accountants should know and do when practicing in the area of litigation support.

The Mattco Forge v. Ernst & Young case has opened a potentially significant new area of professional liability. Before this case, large judgments against the accounting profession were primarily in auditor real-practice cases. In June 1994, however, a Los Angeles jury awarded a $42 million judgment against Ernst & Young for litigation support negligence and fraud.

This is the first successful case commenced against a major public accounting firm for litigation support negligence and fraud; thus the case is important. It is also a potential precedent for limits on expert witness immunity. This case raises liability concerns for any accountant who acts as an expert witness in a lawsuit.

Litigation Support

In an effort to diversify, expand services, and increase revenues, public accounting firms have moved into a myriad of advisory services. One of these rapidly growing services is litigation support. This specialty can encompass a variety of services including investigation of claims, calculation of damages, interpretation of financial information, assistance in trial preparation, and expert witness testimony in court. These support services have been offered by accounting and consulting firms of all sizes, including many individual practitioners. Common areas where attorneys seek litigation support from accountants include marital dissolution, business valuation, commercial damages, lawsuits against other accountants, bankruptcy proceedings, forensic accounting cases, and tax-related litigation.

Professional standards offer limited guidance for CPAs engaged in litigation support services. The basic principles of the AICPA Code of Conduct including integrity, objectivity, due professional care, and acting in the public interest apply to any professional service a CPA offers and serve as guide for litigation support services. In addition, litigation services are included in the broad definition of consulting services under the AICPA Management Services Division's 1991 Statement on Standards for Consulting Services. This Statement identifies standards under Rule 201 of the Code of Conduct as applicable, including professional competence, due professional care, planning and supervision, and sufficient relevant data. Three additional standards under Rule 202 identified specifically for consulting services are client interest, understanding the client, and communication with the client.

A client naturally expects effective advice and assistance when it engages a CPA as an expert witness. Unsuccessful litigation may result in the client questioning the effectiveness of the litigation support services received. The Mattco Forge case is a stunning example of what can go wrong when a CPA provides litigation support services.

Mattco Forge v. Arthur Young

A California jury decision against the accounting firm of Ernst & Young (formerly Arthur Young) held the accounting film liable on two counts of fraud arising from litigation support rendered on behalf of a manufacturing company. The jury awarded $14.2 million in compensatory damages and $27.8 million in punitive damages in June 1994. The jury also found a former managing partner liable for $250,000 and a former employee liable for $5,000. The case is currently being appealed by the accounting firm.

The size of this judgment and the serious implications of the finding of fraud warrant a close look at the facts surrounding this case.

In the mid 1980s, Mattco Forge, a California small aircraft part manufacturer, commenced a lawsuit against General Electric (GE) alleging wrongful discrimination against the company in the awarding of GE contracts. To prepare for trial and at the urging of one of the accounting firm's managing partners, Mattco retained the public accounting firm of Arthur Young for litigation support. Mattco alleged that one of the reasons they retained the accounting firm was its advertisement that stated the firm was an expert in litigation support and could "assist attorneys and clients having a real or apparent lack of data." In an engagement letter, the accounting firm agreed to assist and supervise Mattco in analyzing financial data needed to calculate Mattco's lost profit resulting from the loss of the GE contracts. The firm was to act as a damage consultant and expert witness. In attempting to calculate lost profits, the accounting firm had difficulty locating essential information. Original estimate sheets were not available for all contracts, so the accounting firm requested that Mattco prepare noncontemporaneous estimated information for the missing estimate sheets. These estimates were later turned over to GE, but were never identified as being noncontemporaneous estimates. Mattco contended they were never informed the sheets would be made available to GE.

After receiving the information, GE attorneys sought a dismissal of the lawsuit alleging Mattco had created and produced fraudulent documents with an intent to deceive GE. In addition, GE contended Mattco artificially inflated its claimed damages. The court found in favor of GE and ordered Mattco to either pay GE $1.4 million in compensatory damages to cover the costs of tracing the noncontemporaneous estimates or dismiss its case. Mattco elected to drop the case and did not appeal the decision. Mattco then filed a suit against Arthur Young alleging professional malpractice, fraud, negligent misrepresentation, breach of fiduciary duty, breach of contract, tortious breach of implied covenant of good faith and fair dealing, constructive fraud, and fraudulent concealment.

The trial court dismissed the Mattco suit on grounds that the accounting firm was protected by a statutory litigation privilege that protects witnesses from liability. The trial court also determined Mattco had acted with unclean hands since the prior court had determined Mattco acted fraudulently. The dismissal was appealed by Mattco and in 1992 the California Court of Appeals reversed the dismissal and ordered the case to trial. This successful appeal led to the June 1994 jury trial.

In the trial, Mattco's attorneys alleged the Arthur Young employee who handled the project was an auditor without previous litigation support experience. One of Mattco's attorneys stated: "The initial mistakes we allege were the result of lack of proper training and supervision. The theory we pursued at trial was that he was ignorant of consequences of his actions, and, since he didn't have training, he didn't appreciate that litigation support was a totally different animal than auditing." The finding of fraud in the Mattco case was apparently a result of the advertisement of the accounting firm claiming expertise the jury felt was not delivered. An apparent coverup by the accounting firm was also alleged, resulting in a jury finding of a fraudulent concealment.

From a legal standpoint, a significant aspect of the case is the court's analysis of the litigation privilege protecting witnesses.

Witness Immunity

Expert witnesses have historically assumed they could testify in court without fear of legal retaliation from parties who may disagree with their testimony. The common law doctrine of witness immunity has been the basis for this legal protection and was, until recently, followed in all states. In addition to this common law protection for witnesses, California has adopted a statute creating a litigation privilege that is designed to encourage witnesses at trial to feel free to give information on the stand. By adopting this statute, California has codified the common law approach used in other states.

Witness immunity first applied to general witnesses at trials and was expanded to cover expert witnesses. The common law expert witness immunity developed because the legal system recognized that the trier- of-fact needed assistance in properly deciding technical problems. Expert witnesses often provide judges or jurors with crucial information needed to properly decide the outcome of a lawsuit. Immunity is granted by common law under the logic that forcing expert witnesses to face retaliatory lawsuits by those who disagree with the expert's opinion may cause the expert to be reluctant, unwilling, or overly cautious in participating in litigation. There is a further fear that if expert witnesses could be held liable for their statements on the stand that this could create a never-ending circle of litigation. Common law witness immunity extends to all aspects of preparing for litigation, including pre-trial proceedings as well as the trial courtroom setting. This witness immunity privilege, as well as the California litigation privilege is now being legally challenged.

The emergence of the legal question of whether witnesses should be protected from liability for their testimony is not surprising given the dramatic increase in the usage of expert witnesses over the past 30 years. There are numerous commercial services that advertise the availability of literally thousands of potential expert witnesses who will testify for a fee. Despite this proliferation of expert witnesses, there has been a surprising lack of litigation brought against expert witnesses.

Previous Witness Immunity Decisions

As of 1993, only five states had decided cases involving lawsuits against expert witnesses. Four of these five cases held expert witnesses accountable for their actions and narrowly construed the protection of witness immunity. Only Washington has held an expert witness immune from liability. California, Missouri, New Jersey, and Texas courts have held expert witnesses liable. In the Missouri case, the court held that general witnesses are immune from liability, but experts who are compensated for their testimony can be held liable for negligent testimony. The New Jersey case found an accountant liable for negligent valuation of a business in a divorce action.

The Washington court protected an expert witness from liability in a case where two property owners sued their neighbor for the cost of restoring lateral support for their land. The property owners hired an expert to estimate the cost of restoration. The expert testified as to his estimate and the court awarded the exact amount of the estimate. The estimate turned out to be grossly underestimated. The property owners unsuccessfully sued their expert for his alleged negligent testimony. The court protected the witness from liability citing several policy reasons. The court felt that without immunity, experts would lose objectivity and experts would adopt the most extreme position favorable to their client. The court also feared that the imposition of liability would discourage anyone who is not full-time professional expert witness from testifying. The court felt that one-time or infrequent experts would not carry the necessary insurance to cover the liability risk in testifying.

In the Mattco case the court noted the Washington case, but declined to follow that court's rationale. The California court felt the litigation privilege should not protect the accounting firm from liability for several reasons. First of all, the court noted the litigation privilege is generally designed to protect expert witnesses from lawsuits by opponents who disagree with an expert's opinion. Mattco was a friendly party, not a hostile opponent. Secondly, Mattco's claim never reached trial and the claim against the accounting firm did not involve the firm's expert testimony regarding the value of damages. Because the accounting firm never made it to the witness stand, the court felt it was inappropriate to protect the firm from liability under California's litigation privilege.

Future decisions by other states will be crucial in developing the responsibilities and liabilities of expert witnesses. Since 45 states have not yet decided the extent of expert witness immunity, it is difficult to predict what approach most states will take. Since four out of five states have held experts liable, however, there obviously appears to be a trend toward limitations on expert witness immunity. It is possible that some states will follow the Washington approach to protect witnesses from liability, but courts will no doubt note the approaches taken by California, Missouri, New Jersey, and Texas.

Litigation Concerns for Accountants

It is essential that accountants who work in the litigation support area be equipped to properly perform their duties. CPA firms have a responsibility to see that all accountants engaging in litigation support are adequately trained and supervised. Accountants doing expert witness work should be educated about how the legal system views evidence, expert testimony, and negligence and should always adhere to their professional responsibilities and ethical standards.

Rules of Evidence. Accountants engaged in litigation services must become familiar with the rules of evidence that govern court proceedings. All judges will follow the rules of evidence that apply to their court in determining if evidence will be admissible. Federal courts follow the Federal Rules of Evidence created in 1975. Most states have patterned their state rules of evidence after the Federal rules making this area of the law fairly uniform.

Expert Testimony. The rules of evidence permit the broad usage of expert testimony. Under Federal Rule of Evidence 702, an expert is allowed to testify when specialized knowledge will assist the trier of fact. Rule 703 allows expert witnesses to form opinions based on three sources of information: firsthand observations, presentations at trial, and preparation of data outside the court. This allows broad leeway for opinions. Finally, under Rule 705 an expert is allowed to give opinions or inferences without disclosing underlying data or facts. The expert can, however, be cross-examined by opposing attorneys regarding the underlying data. The liberal admission of expert testimony makes the role of an expert witness crucial to successful lawsuits.

Two areas of particular importance arising out of the rules of evidence are discovery rules and rules on hearsay evidence.

Discovery Rules. Under the Federal and state rules of evidence there are pretrial discovery rules that specify techniques that can be used by attorneys to obtain information to prepare for trial or to attempt to obtain a favorable settlement. Common discovery activities include depositions, interrogatories, requests for the production of documents, and requests for admissions by opponents. Litigation support in the discovery stage can prove to be an invaluable service. Accounting expertise in determining what type of financial information is needed can be crucial in establishing lost profits as well as evaluating other types of data. Litigation support accountants also can provide a valuable service in responding to discovery requests from party opponents. Litigation attorneys often find themselves inadequately trained in deciphering financial information obtained from opponents or requested by opponents.

Hearsay Evidence. Litigation support accountants must be somewhat familiar with how rules of evidence apply to the admissibility of evidence, especially the hearsay rule. The hearsay rule is designed to prevent the introduction of unreliable second-hand testimony. Witnesses are expected to testify only as to the validity of their statements. The hearsay rule is very complex and is subject to over 20 exceptions. These exceptions generally involve evidence that is inherently reliable and thus deemed admissible.

One of the most important exceptions to the hearsay rule is the "business records exception." Under this exception, business records kept in the ordinary course of business are admissible. Computer- generated information created in the ordinary course of business can be admitted even if the person testifying did not enter the information or accumulate the information. The business records exception can allow a litigation support expert to effectively accumulate information and testify as to its relevance and importance. The testimony can be crucial to the success of litigation involving financial data. It is not necessary that accountants become experts on the hearsay rule, but litigation support accountants should be aware of the rule and its affect on testimony and seek advice from an attorney when uncertainties arise.

Negligence. In addition to the discovery rules, accountants must understand negligence since it is the legal theory most likely used against them in liability cases. Negligence is a common law theory that creates liability if a party fails to use reasonable care resulting in harm. To successfully sue an accounting firm for negligent litigation support, the client will have to establish the four elements of a negligence claim:

* Existence of a legal duty of care;

* Breach of the duty to act as a reasonable prudent professional under the circumstances;

* Causal connection between the actions of the defendant and damages suffered by the plaintiff; and

* Damages suffered by the plaintiff.

The first element of a negligence claim is easily established when a client retains a litigation support accountant to prepare for a trial. The existence of an express contractual relationship between the parties creates a legal duty of care. Under the second element, the accountant will be expected to use the same care, skill, and expertise other members of the profession normally possess. Failure to meet this standard will satisfy this element. Under the third element, the plaintiff must show that proximate cause is present. Thus the plaintiff must be able to establish that the negligent act of the defendant foreseeably caused the harm suffered by the plaintiff. In litigation support claims, the plaintiff will likely have to show that the deficient service of the accountant caused the client to lose the lawsuit. Finally, the plaintiff must establish the damages caused by the deficient actions of the litigation support accountant.

Use Reasonable Care

The Mattco case adds the issue of litigation support liability and witness immunity to the already complex accountant liability picture. However, it is important not to overreact to a decision like Mattco. Even if states choose to limit the extent of the witness immunity, an accountant expert witness can avoid malpractice liability by showing that he/she used reasonable care under the circumstances. The Mattco decision should encourage accounting firms to review their litigation support units to ensure that these accountants are being properly supervised and trained to provide competent advice and assistance. The outcome of the pending appeal of the Mattco case may shed further light on the direction of expert witness liability.

Randall K. Hanson, JD, LLM, associate professor of accounting and recipient of the Cameron Fellowship and Joanne W. Rockness, PhD, CPA, Cameron Professor of Accounting, are professors at the University of North Carolina-Wilmington. Robert L. Woodard is president, Operand Management Inc., Wilmington, North Carolina.