Court: Supreme Court of New Jersey; February 16, 2012; New Jersey; State Supreme Court
Judge Wefing, temporarily assigned, delivered the Court's opinion in an accounting malpractice case where a jury initially awarded plaintiffs $31.8 million in damages following a trial. After post-trial motions and the calculation of pre-judgment interest, the trial court amended the final judgment to $38,096,902 against the defendant. The defendant appealed, and the plaintiffs cross-appealed. The Appellate Division upheld the liability verdict but vacated the damage award, remanding for a new trial on damages. Both parties subsequently petitioned for certification, which was granted.
Upon reviewing the extensive record and arguments, the Court concluded that the plaintiffs' verdict could not stand and reversed the Appellate Division's judgment. The plaintiffs, including shareholders Scott Sherman, Gary Barsellotti, and Frank Colapinto, sought damages related to the bankruptcy and liquidation of their company, Cast Art Industries, which produced collectible figurines and giftware. Cast Art aimed to merge with Papel Giftware, prompting the need for a $22 million loan from PNC Bank, which required audited financial statements from Papel and a personal guarantee from Sherman for $3.3 million.
KPMG, which had audited Papel since 1997, was engaged to audit its financial statements for 1998 and 1999 during the merger discussions. KPMG's audit agreement emphasized that while it aimed to provide reasonable assurance of the financial statements' accuracy, absolute assurance was unattainable due to the inherent risks of material misstatement and fraud. The auditing process faced delays attributed to difficulties in obtaining necessary records from Papel.
Tensions arose between John Quinn, KPMG's audit partner, and Frederick Wasserman, Papel's CFO, over necessary adjustments to Papel's financial statements. Ultimately, Wasserman agreed to some adjustments, while KPMG deemed others immaterial and waived their inclusion. In September 2000, KPMG completed and delivered the audits for 1998 and 1999, asserting compliance with U.S. auditing standards and providing reasonable assurance that the financial statements were free of material misstatement. KPMG's opinion letter highlighted that as of December 31, 1999, Papel was not compliant with certain financial covenants, raising "substantial doubt about the Company’s ability to continue as a going concern."
Following the audits, Cast Art received copies and provided them to PNC as required by their loan agreement. In December 2000, Cast Art merged with Papel. Subsequently, Cast Art encountered difficulties in collecting accounts receivable it assumed were valid prior to the merger. An investigation revealed inaccuracies in Papel's 1998 and 1999 financial statements, with evidence of revenue acceleration practices. Contrary to its stated policy of recognizing revenue upon shipment, Papel often booked revenue for goods not yet shipped and manipulated accounting periods to record future revenue prematurely.
Testimony revealed instances of fraudulent entries, including a non-existent $121,244 sale. Although Cast Art was aware of Papel's significant debt, it was unaware of these accounting irregularities until after the merger. The merged entity struggled to manage its debt and ultimately failed. Cast Art subsequently alleged KPMG's negligence in auditing Papel, arguing that a proper audit would have uncovered the fraudulent activities and prevented the merger.
Cast Art claimed that its financial losses were due to KPMG’s negligence and sought compensation. KPMG countered that it was not liable since Cast Art had not engaged KPMG for the audit of Papel, thus invoking the Accountant Liability Act, N.J.S.A. 2A:53A-25. KPMG's motion for summary judgment on this basis was denied before trial. At trial, KPMG denied negligence, arguing that it had advised Cast Art against the merger due to Papel's poor financial status, and contended that Cast Art's difficulties were unrelated to KPMG's actions, citing a pre-existing sales decline and a downturn in the collectibles market. Cast Art won at trial, but KPMG appealed, reiterating its argument regarding the Accountant Liability Act and asserting that Cast Art had not proven negligence on KPMG’s part, nor established a causal link between KPMG’s actions and Cast Art’s losses. KPMG also challenged the jury instructions regarding negligence and the sufficiency of Cast Art's damage claims. The Appellate Division dismissed most of KPMG's arguments but agreed that Cast Art's evidence of damages was inadequate, leading to a remand for a new trial solely on damages. KPMG maintains that the Appellate Division misinterpreted the Accountant Liability Act and that it was unaware of Cast Art’s reliance on its audit when it performed the work for Papel. Furthermore, KPMG argues that the Appellate Division wrongfully inferred a duty owed to Cast Art based on its knowledge of the audit's use in the merger and claims the trial court misdirected the jury regarding the standard of care by including KPMG's internal training materials.
Plaintiff asserted that KPMG breached the professional standard of care by failing to identify improper accounting practices during the trial, referencing training materials as evidence. KPMG countered that Cast Art did not prove that any audit deficiencies led to its collapse and argued for dismissal rather than remand due to insufficient damage evidence. KPMG also contended that the damages should be based on lost profits rather than the overall business value. Cast Art argued against KPMG's interpretation of N.J.S.A. 2A:53A-25, claiming accountants can be liable to third parties if they know their work will be relied upon by nonclients. Testimony from Sherman indicated KPMG was aware of the importance of its audit reports to Cast Art. Cast Art maintained that the trial court's instructions on the standard of care and proximate cause were appropriate, emphasizing expert testimony that KPMG failed to meet auditing standards. It rejected KPMG's argument that it needed to show that negligence caused Cast Art's failure, asserting that KPMG was misapplying concepts from federal securities law. Cast Art's cross-petition claimed the Appellate Division wrongly vacated the jury's damage award. Amici, including the New Jersey Society of Certified Public Accountants and the American Institute of Certified Public Accountants, argued that the Appellate Division misinterpreted the statute and that the trial court’s use of internal training materials was not a harmless error. They warned that the appellate approach could deter accountants from implementing fraud detection measures. The court determined that the key issue was the interpretation of the Accountant Liability Act, necessitating an understanding of historical auditor liability to nonclient third parties and the nature of audits.
An audit is a systematic examination of a company's financial statements aimed at assessing their fairness in presenting the company's financial condition. After an audit, the auditor issues a report expressing their independent opinion on the financial statements. Due to the potential for auditors' reports to be widely circulated, case law has established three frameworks for determining auditors' liability for negligence. The foundational case, Ultramares v. Touche, established that auditors could not be held liable to third parties for negligence without privity or a similar relationship. In this case, the auditor certified a financially misleading balance sheet for Byed Stern Co., leading a factor to advance funds based on the inaccurate audit. The New York Court of Appeals ruled that the auditor owed no duty of care to the factor, emphasizing that imposing liability without privity could lead to indefinite liability. While New York still requires some connection to the parties claiming losses, the Restatement (Second) of Torts offers a broader standard for liability based on the provision of false information in business contexts, allowing for claims if reasonable care is not exercised. However, to prevent indeterminate liability, it limits recovery to those whom the accountant knows will rely on their opinion. New Jersey, in Rosenblum v. Adler, rejected these tests, illustrating a different approach to auditor liability.
The firm was not directly involved in negotiations between the plaintiffs and Giant. The plaintiffs received Giant stock that became worthless due to false financial statements audited by Touche. They sued Touche for negligence in its audit. Touche argued it could not be liable to the plaintiffs due to the lack of a contractual relationship. The Court rejected this argument, stating that when an independent auditor issues an unrestricted opinion, they have a duty to all reasonably foreseeable recipients of the financial statements who rely on them for business purposes. This marked a departure from traditional privity requirements for liability in malpractice cases.
Only a few states adopted this foreseeability standard, but New Jersey has since enacted N.J.S.A. 2A:53A-25, which imposes specific conditions for holding accountants liable to nonclient third parties. These conditions require the accountant to know that their services would be available to a specifically identified claimant, to know that the claimant intended to rely on those services, and to communicate their understanding of such reliance.
In this case, KPMG contends it was unaware that its audit would impact a subsequent merger when it agreed to conduct the audit in November 1999, prior to Cast Art's interest in Papel. Cast Art argues for a broader interpretation of the phrase “at the time of the engagement” to include the entire engagement period, whereas KPMG asserts it refers to the outset. The principles of statutory interpretation emphasize determining legislative intent based on the clear language of the statute, ensuring that every word has meaning and is not considered surplusage.
Statutory interpretation allows courts to consult extrinsic evidence, such as legislative history, when legislative language is ambiguous. The Appellate Division analyzed the phrase "at the time of the engagement" in the context of the Accountant Liability Act and referenced the American Institute of Certified Professional Accountants' Code of Professional Conduct, which defines "engagement" as encompassing the full duration of the professional-client relationship. The court rejected KPMG’s restrictive interpretation of this phrase but acknowledged that it could be understood in two plausible ways. Therefore, examining the legislative history becomes pertinent to determine which interpretation aligns with legislative intent.
The legislative intent was articulated in the Sponsor’s Statement, emphasizing a limitation on accountants' liability to third parties for negligent acts, particularly in light of the previous court ruling in Rosenblum that had diminished the requirement of privity. The court noted that the legislation aimed to restore this privity concept. Amendments made to the original bill prior to its passage included key changes to the conditions under which an accountant could be held liable, specifically altering the language regarding the accountant's knowledge of third-party reliance on their work. These legislative modifications reflect a clear intention to restrict the scope of accountants' liability, guiding the court's interpretation of the statutory language.
The Appellate Division's interpretation of the phrase "by the client" was deemed insufficient, as it argued this phrase could not change the meaning of "engagement" in the Code of Professional Conduct. The conclusion that "engagement" encompasses the entire professional relationship contradicted the principle that every word in a statute carries meaning. Legislative intent was emphasized, particularly the introduction of "by the client," which clarified that liability arises only at the beginning of the engagement, thus limiting an accountant's liability to third parties. Other states have statutes modeled on the Uniform Accountancy Act, with only Kansas and Michigan using similar phrasing but lacking New Jersey’s specific modification. Research revealed three relevant cases, each supporting the conclusion that accountants must be aware at the outset of the engagement if their work is intended for third-party use. The definition of an auditor's liability is tied to the engagement letter, which must clearly outline the scope and associated risks. In this instance, KPMG's engagement with Papel did not indicate that a nonclient would rely on their work, reinforcing the conclusion about the limitations of liability under the Accountant Liability Act.
Cast Art argues that it can seek recovery from KPMG under N.J.S.A. 2A:53A-25(b)(2)(a), which allows third-party claims against accountants if there is an agreement that their services would be available to the claimant regarding a specific transaction. Cast Art cites testimony from Sherman about a call with a KPMG representative regarding the audit's status, claiming this demonstrates KPMG’s agreement to provide the audit for Cast Art's merger. However, the court finds that Sherman’s testimony only implies KPMG was aware of Cast Art's need for audited financial statements and does not establish the required agreement for reliance on KPMG's work.
Additionally, evidence showed that while awaiting the final audit report, Cast Art requested to review KPMG's work papers, which KPMG permitted under specific conditions. KPMG clarified in a letter that their audit was conducted only to assess Papel's financial statements, not for Cast Art's merger, and that access to work papers did not confer additional rights or obligations. Cast Art’s CFO signed this letter, accepting the terms. The court concluded that Cast Art did not demonstrate that KPMG had agreed to allow reliance on its work for the merger, thus failing to meet the statutory requirements. As a result, KPMG was entitled to judgment, leading to the reversal of the Appellate Division’s decision and a remand for dismissal. The remaining issues in the appeal were deemed moot. The judgment was reversed, and the matter was remanded for entry of a judgment of dismissal, with a majority of justices in agreement.
