• Texas Supreme Court Clarifies Law Regarding Auditors’ Liability to Third Parties
  • October 15, 2010 | Author: Robert W. Coleman
  • Law Firm: Wilson Elser Moskowitz Edelman & Dicker LLP - Dallas Office
  • Overview

    The Texas Supreme Court has strengthened defenses available to auditors in suits brought by third parties for negligent misrepresentation and fraud. In Grant Thornton LLP v. Prospect High Income Fund, et al., the court overruled what had been a broader standard for establishing liability in negligent misrepresentations. The ruling also sets new limitations on “holder” claims, wherein investors contend they were put at a disadvantage because they held securities they otherwise would have sold - based on an auditor’s report. The decision is good news for accountants, who are potential targets in litigation stemming from the financial failings of their clients.

    Background

    Epic Resorts, a timeshare operator, issued $130 million in corporate bonds in 1998 and sold them in the open market. Epic was required to make semiannual interest payments of $8.45 million to bondholders. To secure the interest payments, it was also required to maintain $8.45 million in an escrow account at U.S. Trust, which served as both the indenture trustee and escrow agent, for the benefit of the bondholders. Epic was required to provide annual audited financial statements, as well as a negative assurance statement from its auditors confirming Epic was in compliance with the financial conditions of the indenture and related agreements.

    Grant Thornton was engaged as Epic’s auditor in March 2000, and subsequently audited Epic’s financial statements for both 1999 and 2000. In the course of its 1999 audit, Grant discovered that Epic did not have the minimum required amount in the U.S. Trust account. Despite this deficiency, in April 2000, Grant issued an unqualified opinion on Epic’s 1999 financial statements and confirmed in its negative assurance letter that Epic was in compliance with the escrow requirement. Grant’s opinion and negative assurance were based, in part, upon representations from Epic that it was allowed to use more than one account to meet its escrow responsibilities. Epic had also contended that the combined balances of escrow funds it held never totaled less than the required minimum. U.S. Trust never objected to the lack of sufficient funds in the account it maintained. In April 2001, Grant issued an unqualified opinion on Epic’s 2000 financial statements, despite a continuing shortfall of funds in the U.S. Trust account, but it did not issue a negative assurance letter to the trustee.

    The plaintiffs in this case were hedge funds that over several years purchased Epic bonds. Prospect had made three purchases before Grant was hired to perform its first audit. Thereafter, Highland Capital Management Corporation and its portfolio manager, Davis Deadman, began managing Prospect’s investments and, as a result, became familiar with Epic’s bonds. Deadman, on behalf of Cayman, a second fund, purchased more Epic bonds in December 2000, two days before Epic made its semiannual interest payment. At about the same time, Epic’s primary lender, Prudential, told Epic that it would not renew its credit arrangement. This credit was critical to Epic’s survival and its ability to meet its obligations to bondholders. Deadman learned of Prudential’s decision sometime in the first quarter of 2001, but continued to buy Epic bonds throughout the spring of 2001.

    In June 2001, Epic defaulted on its interest payment to bondholders, claiming Prudential’s failure to renew the credit arrangement forced the timeshare operator to use that money to fund operations. Four days after this default, the hedge funds purchased more bonds and then forced Epic into bankruptcy. The hedge funds then sued Grant Thornton, alleging that the audit reports misrepresented the status of the escrow account.

    Procedural history

    The plaintiff hedge funds sued Grant for negligent misrepresentation, direct negligence, fraud, conspiracy to commit fraud, aiding and abetting fraud, and third-party beneficiary breach of contract. They sought damages equal to the par value of the bonds, plus five years’ interest. The trial court, two months before trial in August 2004, granted summary judgment to Grant Thornton on all counts.  In October 2006, the Dallas Court of Appeals affirmed the judgment on certain claims, but reversed the judgment on the negligent misrepresentation, fraud, conspiracy, and aiding and abetting claims, finding genuine issues as to material facts.

    Grant Thornton filed its petition for review with the Texas Supreme Court in January 2007. The petition argued that the Court of Appeals erred in not holding: (1) there was no evidence of a causal connection between Grant’s alleged misrepresentation and the funds’ alleged injury; (2) there was no evidence of actual and justifiable reliance; and (3) that liability for fraudulent misrepresentations runs only to those whom the auditor knows and intends to influence, all of which was not present. The hedge funds responded that Grant’s misrepresentations caused them to fail to take action to protect themselves earlier and to refrain from selling their bonds (“holder” claims). The petition was granted in August 2008.

    Significant holdings for auditors

    1. Identity of potential plaintiffs significantly reduced - In 1986, the Dallas Court of Appeals in Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co. applied section 552 of the Restatement 2d (Torts) in a case against an accounting firm. Despite stating that it was not deciding whether to adopt a foreseeability test to determine who could be a plaintiff, the Blue Bell court held that if “an accountant preparing audited financial statements knows or should know that such statements will be relied upon by a limited class of persons, the accountant may be liable for injuries to members of that class relying on [the audit report.]” (Emphasis in opinion). The Texas Supreme Court, at that time, refused to grant review of Blue Bell, leaving the impression that it did not have a problem with the broader standard.

    Blue Bell has haunted auditors sued in Texas and elsewhere ever since it was decided. It is referenced in nearly every Texas case involving a negligent misrepresentation claim against an accountant, has been cited in 21 different federal decisions and in opinions in 10 other states, and has been discussed or mentioned in more than 35 law review articles concerning accountant liability to third parties. Prospect, which was decided July 2, 2010, should finally end the confusion and expanded liability created by Blue Bell.

    In Prospect, the Texas Supreme Court expressly rejected the standard set forth in Blue Bell in favor of the stricter standard set forth in the 1999 decision of McCamish, Martin, Brown & Loeffler v. F. E. Appling Interests (a lawyer case). In doing so, it stated:  “McCamish has served as a guidepost for our courts of appeals in analyzing the tort of negligent misrepresentation, in contrast to earlier decisions applying a broader standard.” The only case the Supreme Court cited as applying the rejected broader standard was Blue Bell.

    The significance of adopting McCamish for auditors and others is that it applies a strict standard for determining who can assert a negligent misrepresentation claim - a plaintiff must be “a known person” who relied upon the auditor’s representations for “a known purpose.” The importance of this limitation is apparent from the court’s first holding - the Cayman Fund’s claims were all dismissed because it was merely a potential public investor with no prior connections to either Grant Thornton or the issuer of the bonds. “[P]redicating scope of liability on [the auditor’s] general knowledge that investors may purchase bonds would ‘eviscerate the Restatement rule in favor of a de facto foreseeability approach - an approach [we] have refused to embrace.’”

    2. Limitations on “holder” claims - Most of the plaintiffs’ claims were based upon their contention that the misrepresentation, whether negligent or fraudulent, caused them to refrain from taking action, rather than inducing them to act. They argued that, but for the misrepresentation, they would have sold their bonds sooner - when it would have been more profitable - or would have forced Epic into bankruptcy at an earlier point in time when it had more assets to liquidate. The Texas Supreme Court had never considered the propriety of holder claims before this decision.

    The Supreme Court recounts the history of holder claims under federal securities law (where they have been denied as too speculative and difficult to prove) and in other states where there is a split of authority. It noted that even those states that recognize holder claims generally have required heightened pleading and proof. The Supreme Court, however, decided to adopt a key requirement imposed by a number of the other decisions; namely, that holder claims will not be permitted in the absence of a direct communication between the plaintiff and the defendant. The court declined to decide the broader question of whether any holder claims should be allowed, because in this case it was undisputed that there was not any direct communication between the parties.

    The good news for accountants and other defendants is that this ruling sets forth a strong defense to the otherwise difficult-to-defend claim that, “if I had known, I would have sold” or taken other action to protect myself. Up until now, defendants have had little ability to defend holder claims because there is rarely any proof other than the plaintiff’s testimony of what he did not do or would have done. This unfairness was recognized by the U.S. Supreme Court when it refused to allow holder claims under Rule 10b-5, but that decision left open the possibility that there could be state law causes of action. In Texas, Prospect significantly closes that door. The decision could influence other courts to deny the open-ended holder claims.

    3. Actual and justifiable reliance - In the third significant aspect of the decision, the Texas Supreme Court held that a person may not justifiably rely on a representation if there are “red flags” indicating that reliance is unwarranted. The important part of this ruling is that the red flags that the court pointed out had nothing to do with the audit itself or its alleged deficiencies, but rather with the financial health of the company that was audited. In Prospect, the plaintiffs’ knowledge of the loss of a critical credit arrangement and the depressed price of the bonds were found sufficient to make any reliance unjustified. The plaintiffs also tried to establish reliance by claiming that their agent, the indenture trustee/escrow agent, relied upon the auditor’s 1999 negative assurance letter. The Supreme Court rejected this argument because it refused to allow the plaintiffs to claim the benefit of the agent’s alleged reliance while rejecting the agent’s knowledge of the underlying facts regarding the representation.

    Conclusion    

    Too often, courts in Texas and other states have allowed negligent misrepresentation claims against auditors and others by persons who should not have been considered to be within the “limited group” that the authors of the Restatement of Torts intended to be able to sue. Adopting the McCamish standard of a “known person for a known purpose” to identify proper plaintiffs should reduce litigation against auditors, particularly by potential public investors. Requiring even a known person to have a direct communication with a defendant to assert a claim that a misrepresentation caused the plaintiff to hold onto an investment should eliminate additional claims against accountants and others in litigation. Equally important for both fraud and negligent misrepresentation defense is the finding that a plaintiff who knows the financial condition of a company cannot assert reliance upon an auditor’s opinion as the basis of its damages.

    For further reference, see Grant Thornton LLP v. Prospect High Income Fund, et al., 2010 Tex. LEXIS 478; 53 Tex. Sup. J. 931 (Tex. Sup. July 2, 2010); Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co., 715 S.W.2d 408 (Tex. App. 1986, writ ref’d n.r.e.); and McCamish, Martin, Brown & Loeffler v. F. E. Appling Interests, 991 S.W.2d 787 (Tex. 1999).