January 2021 Litigation Newsletter - Auditor Liability

January 2021

Audits are critical to the surety industry.  An audit is the touchstone for the decision to extend surety credit, and when auditors fail, it usually leads to the losses for the Surety. In recent years, pursuing salvage for misstatements made in a clean audit opinion has become more common. Some of the classic indicators of a potential claim include a good, stable account that falls off a cliff in less than a year and runs out of cash. Because many auditing firms have significant insurance, as well as other assets, pursuing recovery is often worth the risk and expense.

As you can imagine, however, these auditing firms (and their carriers) do not go quietly into the night. Rather, there are usually spirited fights throughout the case. Recently, a federal court in Pennsylvania was confronted with some of the common arguments we see: (1) lack of specificity on alleging exact problems with the audit; (2) lack of standing for a surety to pursue the auditor; and (3) damages are not fully liquidated. It is always a good feeling when a Court gets the right answer, and that was the case with this judge in looking at an early motion to dismiss by an auditing firm. The Court rejected three classic arguments:

• You have to show a math error. The basis of a negligent misrepresentation claim against an auditor is usually (1) the clean audit opinion failed to comply with generally accepted accounting principles (GAAP); and (2) the auditor failed to conduct the audit in accordance with generally accepted auditing standards (GAAS). An example of the latter is an auditor failing to exercise the requisite amount of professional skepticism, which can be the case when it becomes a consultant for the audit target. Thus, it is not necessary for a surety to reconstruct the audit at the outset of a suit and demonstrate that revenue should have been $17 instead of $21, etc. The Court agreed.
• I don't know who you are. Auditors often argue that they did not know that a surety would rely on the audit in issuing surety credit. Most underwriters laugh at this notion given that surety credit is usually the only reason an audit is required at all. In examining Pennsylvania's specific law for a negligent misrepresentation claim, the Court also rejected this idea, finding that it was foreseeable that a surety would receive the audit and rely on its contents. This is a more liberal standard than we see in places like Texas (and most of the rest of the country), which has a middle ground standard of known party for a known purpose. Regardless, the idea that the auditor needs to know the surety by name or hand deliver the audit to the underwriter is not a requirement anywhere.
• The damages are up in the air. There is a pretty short window to bring this type of claim. Moreover, there can be a fight with the auditor on when the clock starts running. The auditor usually will argue that it starts at the time the audit is prepared. This is the wrong answer, but it does demonstrate that a surety needs to act quickly to pursue this salvage. That typically means that all losses of a surety have not yet been realized. Indeed, in many cases the surety is just starting to see the effects of the cratering of the principal. As a result, the auditor argues that because the damages have not been fully liquidated, a critical element of the claim is missing. The Court in Pennsylvania rejected this argument as well, holding that this level of specificity is not necessary in order to bring a claim in the first place. This is important given that it would be expected that a damage number would fluctuate greatly as projects are finished and vendors are paid, not to mention other salvage that might be applied to the bottom line.

For reference, the case out of Pennsylvania is Platte River Insurance Company vs. Joseph P Melvin, Cause No. 20–3380. Feel free to let me know if you would like a copy and I would be happy to send it on. Happy New Year to all as well, and here’s to heading to a brighter 2021!

Author - Brandon Bains
Langley L.L.P., Attorneys & Counselors
P. O. Box 94075, Southlake, TX 76092 214.722.7160
Licensed in Texas, Florida, and Arkansas

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