Many a lender has been infuriated upon learning that its insolvent borrower's annual financial statements had been materially false. That fury has been particularly fierce when the statements were the subjects of unqualified audit opinions.
In such a situation, the lender's desire to sue the accounting firm to recover losses is understandably very strong. Furthermore, most lenders believe that accounting firms are easy prey.
Last February a Texas jury assessed a $200 million punitive damage award against Coopers & Lybrand. Ernst & Young, which has recently made a $400 million settlement with federal bank and thrift regulators, paid $43.5 million last year to settle a negligence claim involving a predecessor firm's audit.
What is perhaps the most significant court decision - the $338 million awarded against Price Waterhouse in Arizona last May - has been called into question, however. A Superior Court judge, finding that the jury verdicts were so "irreconcilably inconsistent" as to be "blatantly erroneous," ordered a new trial on Wednesday.
Such suits sound easy, but they are not. Invariably, accounting firms defend these cases tenaciously. Furthermore, they are very formidable adversaries.
As every lender knows, the only situation worse than a loan gone bust is one followed by an expensive but unsuccessful lawsuit. Here are some points to consider.
* The first element of proof in an accounting negligence or malpractice claim is that the borrower's accountant owed a duty to the lender - to refrain from negligence.
Most states follow the approach which has been advocated by the American Law Institute. Under this approach, accountants owe a duty of care to third parties, such as lenders, whom they know to rely on their reports and who receive them from the accountant or from the client with the accountant's knowledge.
* Once a lender proves that the accountant owed it a duty to refrain from negligence, it must then prove that the duty of care to refrain from negligence was breached.
* Initially, the extent of the accountant's duty will depend upon what it promised the client that it would do - an audit, for example, or a compilation, or a review.
Unless the engagement required more, the determination of whether the accountant's legal duty of care was fulfilled will depend upon whether the standards of the profession were complied with.
Thus, an accountant's compliance with either generally accepted auditing standards or generally accepted accounting principles will be strong evidence of compliance with the legal duty of care.
* Even if it is proved that the accountant owed the lender a duty of care to refrain from negligence and that this duty of care was breached, still more must be proved.
Because almost all accounting malpractice claims ultimately hinge on whether the financial statements covered by an unqualified audit opinion were materially misleading, lenders must show that they relied upon the opinions of the client's auditors in making credit decisions.
This element of reliance is significant. For example, if the court finds that such reliance was not reasonable, perhaps because the lender had actual knowledge that the company's financial condition differed significantly from the depiction in financial statements, the suit against the accountant will fail.
Furthermore, the reliance by the lender on the financial statements must not only be reasonable, it also must be a substantial factor in the credit decision.
Thus, if the loan should not have been made even on the basis of the financial statement, the lender's suit against the accountant will be difficult.
* The last legal element of an accounting malpractice claim is proof that, as the result of the lender's reasonable reliance upon the materially misleading audit report, the lender sustained economic loss.
Undoubtedly the borrower's accounting firm is often the only solvent potential defendant available after the borrower's demise. Yet that fact alone should not dictate the lender's decision to bring suit. Nor should the accuracy of the financial statements.
The lender's litigation decision should be based on all of the above factors, and should be made with the assistance of experienced counsel. Only that way can a bad loan be prevented from becoming a financial disaster.