Creditors sue a company’s auditors.

Legal Scene

Auditor Loses Privity Appeal

T he Court of Appeals of North Carolina ruled that a creditor can sustain an action against the auditor of a failed company even though the auditor did not know the creditor was relying on its financial statements.

This appeal arose from a summary judgment in favor of the defendants by a trial court. The plaintiff, Marcus Brothers Textiles, Inc., made several extensions of credit to Piece Goods Shops Co., L.P. between December 30, 1992 and April 5, 1993. Marcus claimed it did so relying on the unqualified opinion issued by Piece Goods’ auditor, Price Waterhouse.

Marcus claimed that the 1992 audited financial statements materially misrepresented Piece Goods’ financial condition and that the CPA firm was aware the company knew that Marcus would rely on the statements in extending credit.

The plaintiff’s case
Marcus alleged that the 1992 financial statements audited by the CPA firm contained several misrepresentations and departures from GAAP:

• The financial statements indicated a Receivable from General Partner in the amount of $30,332,000. This receivable was worthless because the general partner could not pay the amount due.
• Piece Goods erroneously increased the reported value of this receivable by recording accrued interest on the balance sheets although the company knew it was not collectible.
• The financial statements reflected nearly all payables for certain pattern inventories as noncurrent, long-term liabilities, but reflected the inventories themselves as current assets. This resulted in an overstatement of Piece Goods’ working capital.
• One of the largest checks listed in Piece Goods’ accounts payable was made out to Marcus. It may be inferred, therefore, that the CPA firm knew Marcus was one of the company’s major creditors.
• The firm had been Piece Goods’ auditor for the preceding six years.

Marcus argued that the auditors knew Piece Goods would provide it with the 1992 financial statements to influence Marcus’s decision to extend credit to the company.

The defendant’s case
The CPA firm argued that under North Carolina law it was not enough to claim that the firm should have known that Piece Goods might provide the financial statements to trade creditors such as Marcus. Instead the firm argued that Marcus had to prove that the firm knew Piece Goods intended for creditors to rely on the 1992 financial statements in extending credit.

The appeal
In overturning the summary judgment, the court ruled there was a genuine issue of material fact concerning whether the CPA firm knew that Piece Goods supplied the audited financial statements to its creditors.

The court noted as evidence an internal firm memorandum. The memorandum, which was initialed by a partner, said: the firm has historically reported on the financial statements of Piece Goods, and vendors and factors are accustomed to receiving the company’s financial statements.

The CPA firm argued unsuccessfully that the memorandum merely established it knew that Piece Goods’ audited financial statements were customarily used in a variety of financial transactions by the company and that they may have been relied upon by lenders, creditors and others in a variety of transactions.

In the appeal, the court applied the following standard: The text requires only that the auditor know that his client intends to supply information to another person or limited group of persons. Whether the auditor acquires this knowledge from the client or elsewhere should make no difference. If he knows at the time he prepares his report that specific persons, or a limited group of persons, will rely on his work, and intends or knows that his client intends such reliance, his duty of care should extend to them.

Limit access and limit liability
This case illustrates the importance of limiting access to client statements to a select group of third parties. In this way a firm limits its exposure to third-party suits.

In this case an internal memorandum of a CPA firm’s partner was used to support an inference that the firm knew lenders, creditors and others were relying on its client’s financial statements in a variety of transactions. This was the most significant piece of evidence the court cited in overturning the earlier summary judgment by the trial court. ( Marcus Brothers Textiles, Inc. v. Price Waterhouse, LLP , 498 S.E. 2d 196, 1998 N.C. App. LEXIS 428)

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