Andrew J. Maxwell, as the Chapter 7 bankruptcy trustee for marchFIRST, filed a lawsuit against KPMG LLP, claiming damages exceeding $600 million due to KPMG's alleged breach of duty of care under Illinois tort law. The case, initially in bankruptcy court, was removed by the district judge, who ultimately granted summary judgment in favor of KPMG.
KPMG served as the auditor for Whittman-Hart, which sought to acquire US Web/CKS for over $7 billion in stock in March 2000. Following the acquisition, marchFIRST declared bankruptcy in April 2001, thirteen months later, amid a downturn in Internet-related businesses. The trustee contends that KPMG improperly approved Whittman-Hart's inflated fourth-quarter 1999 earnings, which were allegedly based on misleading accounting practices, including "round-tripping," where loans were disguised as revenue.
Additionally, the trustee argues that KPMG should have classified prepaid consulting fees received in that quarter as revenue for the subsequent year, leading to further earnings overstatement. Although it is assumed for argument's sake that KPMG was negligent, the analysis reveals that Whittman-Hart's eagerness to acquire US Web might have led them to offer a higher price despite poor earnings, suggesting KPMG's alleged negligence could have inadvertently benefited Whittman-Hart's shareholders had marchFIRST succeeded. The trustee also posits that if the acquisition had not occurred, Whittman-Hart might have survived the downturn in the dot.com sector.
US Web, a larger dot.com business, was argued to have contributed to Whittman-Hart's financial demise due to its acquisition. However, if the trustee wins the lawsuit, the primary beneficiaries would be former US Web shareholders, despite no evidence that US Web would have survived independently. The trustee seeks over $500 million in damages, significantly exceeding the $93.6 million owed to marchFIRST’s unsecured creditors, with US Web shareholders already possessing 57% of marchFIRST stock. The assertion that US Web caused marchFIRST’s bankruptcy contradicts the notion that it can simultaneously be deemed both the cause and the primary beneficiary of the bankruptcy. Further complicating the case is the confusion between 'but-for cause' (a necessary condition) and 'proximate cause' (a more meaningful cause producing injury through a continuous sequence of events). The demise of Whittman-Hart is attributed to its decision to acquire US Web and the decline of the dot.com market, neither of which was influenced by KPMG's actions. KPMG’s role as Whittman-Hart’s auditor involved a duty to protect creditors and investors from misleading financial statements, as defined by Illinois law and relevant statutes. Thus, KPMG's advice, while potentially influential, is deemed not to have caused harm to US Web due to the inevitable market collapse.
Auditors are not obligated to provide business advice, such as guidance on acquisitions, as established in Johnson Bank v. George Korbakes, Co. and Fehribach v. Ernst, Young LLP. The necessary knowledge for such advice lies with the businesses and consulting firms, not auditors, whose primary focus is the accuracy of financial statements. Although KPMG offered consulting services alongside auditing for Whittman-Hart, the lawsuit pertains solely to their auditing functions, which were not influenced by their consulting. Any inaccuracies in Whittman-Hart’s fourth-quarter earnings attributed to KPMG do not constitute a wrong against Whittman-Hart, as KPMG was neither asked to advise on the acquisition of US Web nor responsible for the business risks taken by Whittman-Hart. The distinction between 'transaction causation' and 'loss causation' illustrates that a misrepresentation by an issuer does not automatically lead to liability for losses resulting from market forces beyond their control. Over-deterrence could occur if auditors were held liable for losses from unrelated business decisions. Additionally, the evidence presented for damages was criticized for its speculative nature, as the plaintiff's expert failed to demonstrate a reliable correlation between the stock performances of comparable companies and the impact of the acquisition on Whittman-Hart’s value.
An expert's valuation of Whittman-Hart's stock in April 2001 was flawed due to reliance on the average stock price decline of comparable companies without considering their capital structures. High debt levels exacerbate stock price declines during external shocks; for example, a 50% drop in asset value leads to an 83% decline in equity value for a company with 40% debt. The expert's assumption that US Web would not have been acquired contradicted his analysis, as it would result in former US Web shareholders receiving 57% of the awarded damages, which he had deemed impossible.
The trustee's lawyer misrepresented his role, claiming to represent only unsecured creditors, while he was actually representing the entire bankrupt estate of marchFIRST, which sought damages exceeding creditor claims. The weakness of the trustee's case raises concerns about the litigation judgment of Chapter 7 trustees, who face fewer constraints than those of ongoing businesses. Judges must scrutinize the actions of bankruptcy trustees and may impose sanctions for frivolous lawsuits. The Bankruptcy Code prohibits reimbursement for actions unlikely to benefit the estate and allows for sanctions against frivolous claims.
The substantial damages claim of $626 million was deemed groundless and intimidating, as the trustee's reasoning for pursuing it was flawed. The probability of success for such claims must be low for them to be considered frivolous. Thus, while a frivolous appeal may have some chance of success, frivolous lawsuits are not permissible. The court noted that a defendant could seek attorney’s fees from the trustee personally, but did not make any prejudgment on the motions for fees. The ruling was affirmed.
