Court heightens

Malpractice Allegation

A Massachusetts superior court ruled that a complaint for accounting malpractice must allege “with clarity and certainty specific facts” for the court to allow the matter to go forward. Plaintiffs basically have to meet certain standards before proceeding with a malpractice case against a firm.

Cambridge Biotech Corp. hired Deloitte & Touche as its independent auditor for 1991 and 1992. The firm conducted audits and issued its reports dated March 6, 1992, and March 19, 1993. Each year, Cambridge had included these reports in its 10-K report filed with the Securities and Exchange Commission. On March 19, 1996, Cambridge brought suit alleging the firm had failed to conduct its audit in accordance with generally accepted auditing standards, resulting in revenue overstatement for 1991 and 1992. The firm said Cambridges claim arising from the 1992 report was barred by the three-year statute-of-limitations period and moved for a dismissal for this and other reasons.

The court refused to grant the firms motion to dismiss on statute-of-limitations grounds because it had continued to represent Cambridge after the 1992 report. However, the court did say that a complaint for accounting malpractice must contain the following elements to be sustainable: (1) The negligent acts or omissions of the defendants; (2) the content of the auditors reports and certificates; (3) the work the defendants had agreed to do, had stated they had done or omitted and had actually done; (4) the extent to which the defendants representations were qualified, contained disclaimers or expressed as opinions; (5) the generally accepted accounting principles the defendants were alleged to have violated; (6) the facts misrepresented and what the plaintiffs alleged the defendants knew, or after reasonable investigation should have known, concerning them.

This case is significant because it requires plaintiffs to state exactly what the defendants allegedly did wrong. Too often, plaintiffs proceed with actions that are ill-defined or frivolous in nature. It is instructive for firms because it emphasizes the need for specific documentation of the scope and terms of the engagement as well as any qualifications or disclaimers expressed by the auditor. ( Cambridge Biotech Corp . v. Deloitte & Touche , Massachusetts Superior Court, January 28, 1997)

Partnership Withdrawal

A California appellate court upheld a verdict in favor of the former accounting firm of Weber, Lipshie & Co., which had sought to enforce a partnership restrictive covenant against a departing partner, Paul Christian. When Christian became a partner, he agreed that if he withdrew or was expelled from the partnership he would not, for five years, service any of the firms accounts. He also agreed that, if he did violate the agreement, he would pay damages to the firm equal to double the firms charges for those clients for the 12 months immediately preceding its loss (the “liquidated damages” provision of the contract).

After Christian left, certain clients took their business to him. The firm sued Christian for liquidated damages in accordance with the contract and Christian cross-complained for breach of contract. The trial court concluded the liquidated damages provision was an invalid penalty and instructed a jury to determine whether the terms of the restrictive covenant were reasonable, whether Christian had breached the agreement and, if so, what damages flowed from this breach. The jury awarded Weber $447,136.75—exactly the adjusted net fees billed to the affected clients during the 12 months preceding Christians departure. This was thus about half the double charges in the agreement. Despite this verdict, the court ordered a new trial to determine whether Weber had good cause to expel Christian from the partnership. Both parties appealed this ruling: Basically, the firm wanted the double damages and Christian wanted to pay less than the jury award.

The appellate court ruled that not only was the restrictive covenant enforceable but so was the liquidated damages provision. The trial courts granting of a new trial was in error. The covenant was enforceable regardless of the reason for Christians expulsion. The court therefore reversed the order granting a new trial and directed a new judgment to Weber in the amount of the liquidated damages provision of the contract.

This case is contrary to the trend in many jurisdictions to modify or rule restrictive covenants as unenforceable. It is also remarkable for its enforcement of a penal liquidated damages provision that doubled the firms actual fees. This ruling makes it clear that a firm can place substantial restrictions on competition from departing partners long after the partner has left the firm. ( Weber, Lipshie & Co . v. Paul D. Christian , 97 C.D.O.S. 846)

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