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Court Rules on Contributory Negligence

A n appellate court in Washington state ruled that the principles of comparative negligence apply in a malpractice case against an accounting firm. ESCA Corp., a computer software company, hired KPMG Peat Marwick to audit its 1988 and 1989 financial statements, which reported the companys net income at approximately $1.4 million. However, those statements did not disclose that a purchase order worth approximately $2.5 million had contingencies and therefore was not a firm order for which the company could recognize income under generally accepted accounting principles. Consequently, ESCAs income showed a record profit when, absent the purchase order, it would have shown a record loss.

ESCAs secured lender, Seattle-First National Bank (Seafirst), claimed it had relied on a draft of the firms audit report when it agreed to increase ESCAs line of credit from $6 million to $8 million. It also alleged it had relied on the firms audit opinion when it subsequently approved ESCAs request to renew this $8 million line of credit. Before Seafirst renewed the line, it had received ESCAs first-quarter results for the subsequent fiscal year, which showed a large loss for the quarter. Also before the renewal—but after the raise—Seafirst downgraded the loan and also recognized that ESCA was in default. Nevertheless, SeattleFirst National Bank disbursed more than $1.4 million after the loan had been downgraded.

Partly responsible
At trial, the firm proposed a jury instruction that expressed the defense of contributory negligence. Under that instruction, if the jury found Seafirst negligent in relying on the information supplied by the firm, that finding would act as a complete defense to Seafirsts claim. The trial court rejected the instruction. The jury then returned a verdict for Seafirst but found it was 60% contributorily negligent. (That is, the jury decided Seafirst partly responsible.) The jury also found Seafirst had incurred total damages of $2.505 million. This amount was reduced by 60% to $1.2 million. The accounting firm appealed that verdict.

The appellate court analyzed the Washington courts comparative fault statute, concluding that comparative fault must apply to all actions based on fault. The court also said the finding that Seafirst had been contributorily negligent did not bar its recovery, so it was allowed to keep its $1.2 million settlement. However, as a part of its claim, Seafirst also asserted it had relied on a draft audit report the firm had issued. The firm, before trial, had obtained partial summary judgment on the basis of its uncontradicted affidavit that its draft report had "preliminary draft, for discussion purposes only" stamped on every page and had been distributed only to limited members of ESCAs staff. The firms affidavit also established that it did not know the report would be circulated outside of ESCA or that it would be used by Seafirst as a basis for increasing ESCAs line of credit. The court of appeals agreed with the trial courts ruling that Seafirst had no basis to rely on the firms draft report to make decisions regarding ESCAs line of credit.

Lessons to be learned
The decision is a mixed bag for the accounting profession. Unlike Washington, many jurisdictions hold that when recovery for purely economic harm is sought based on a defendants alleged negligent misrepresentation, the plaintiffs contributory negligence is a complete defense to the claim. A case such as ESCA, in which a plaintiff is found to be 60% contributorily negligent and still recover over $1 million, is clearly not a victory for the accounting profession. On the other hand, the courts ruling on the accounting firms draft report highlights how prudent risk management at a firm can prevent or reduce the magnitude of a claim. Frequently, a firm distributes draft reports to clients without conspicuously labeling such reports as draft. Also, firms haphazardly distribute such reports to lenders, investors and other third parties. These actions can come back to haunt a firm in a malpractice action. In this case, the firms conspicuous labeling of every page of the draft report and its limited distribution of the report prevented a much larger verdict against the firm.

ESCA Corp. v. KPMG Peat Marwick, no. 37012-0-I (Wash. App. June 9, 1997)

Editors note: Thanks to John Hughes of Hutchins, Wheeler & Dittmar for the ESCA Corp. case.

—Edited by Wayne Baliga, CPA, JD, CPCU, CFE, president of Aon Technical Insurance Services.

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