• The Massachusetts Appeals Court Holds Accountants May Be Liable for Fraud, Negligent Misrepresentation and Violation of Chapter 93A
  • June 10, 2003 | Author: Mobina F. Mohsin
  • Law Firm: Donovan Hatem LLP - Boston Office
  • In the July 2001 issue of this Reporter, we reported on the Massachusetts Superior Court's decision in Reisman v. KPMG Peat Marwick, LLP, C.A. No. 97-1383-A (Suffolk County, March 2, 2000), where the Court granted summary judgment to the defendant accounting firm and dismissed all of the plaintiffs' claims for negligence, fraud and violation of Chapter 93A (unfair and deceptive trade practices). The grounds for summary judgment were that the accounting firm was not liable to a third party investor in a company audited by the accounting firm because the plaintiffs could not show that any misrepresentations in the audit reports were made for the purpose of inducing them to act, the plaintiffs could not show that they had relied on any misrepresentations in the audit reports, and the plaintiffs could not prove that any misrepresentations in the audit reports proximately caused their loss. The Reismans appealed, asserting, among other things, that the Superior Court judge had misapprehended the elements that they needed to prove to establish their claims for fraud, negligent misrepresentation and violation of Chapter 93A.

    On January 15, 2003, the Massachusetts Appeals Court overturned the Superior Court's decision, in Reisman v. KPMG Peat Marwick, LLP, 57 Mass. App. Ct. 100 (2003). The Court reversed summary judgment and held that a company's auditor could be liable to an investor for fraud, negligent misrepresentation and violation of Chapter 93A based on the facts construed most favorably to the plaintiffs. The Court rejected the trial judge's conclusion that recovery was barred by Nycal Corp. v. KPMG Peat Marwick LLP, 426 Mass. 491 (1998). As previously reported (see July 2001 issue of this Reporter), the Court in Nycal limited the liability of an accountant providing audit services to non-contractual third parties who can demonstrate actual knowledge of the limited - though unnamed - group of potential third parties that will rely upon the report, as well as actual knowledge of the particular financial transaction that such information is designed to influence at the time the report is issued. Nycal, 426 Mass. at 498-499. In Reisman, the Appeals Court found Nycal inapplicable because there was evidence that the accounting firm (i) was engaged in fraudulent (i.e., knowing) misrepresentations and (ii) knew of the transaction to be influenced by its misstatements.

    Facts relevant to the Appeals Court

    In Reisman, the plaintiffs (the "Reismans") acquired stock in 1993 in Marcam Corporation ("Marcam"), a publicly traded company, in exchange for their interest in the family business, Varnet Software Corporation ("Varnet"), valued at approximately $23 million. Marcam's accountant, the defendant, KPMG Peat Marwick ("Peat Marwick"), audited Marcam's financial statements for fiscal years 1991 and 1992. The claim against Peat Marwick was that those audited financials were materially misleading as Marcam's stock was trading at almost four times its true value.

    In connection with the Varnet-Marcum transaction, both companies hired their own respective teams of professionals. Peat Marwick was on Marcam's team, and advised Marcam on how to structure the deal. Peat Marwick was also involved with the Reismans because Peat Marwick Canada served as Varnet's accounting firm. When the Marcam deal was contemplated, Varnet contacted a partner at Peat Marwick's Boston office, who in turn appointed an advisor to sit on the Varnet side of the negotiating table. As the Court noted, Peat Marwick's status as an "independent" public accounting firm gave the Reismans comfort that Peat Marwick was looking out for their interests also.

    The Court found that the record supported allegations that Peat Marwick knew that the audited financials used at the time of the transaction substantially overstated Marcam's earnings and, consequently, were misleading. Among the questionable practices were Peat Marwick's endorsement of Marcam's treatment of three money-losing European operations as distributors rather than subsidiaries, which misstated profits by $2.4 million (showing net income of $6 million instead of $3.6 million) in the 1991 financial statements, and by $1.6 million (showing net income of $8.3 million instead of $6.7 million) in the 1992 financial statements. As part of the Varnet-Marcum transaction, in May 1993, Peat Marwick consented in writing to the incorporation of its earlier audit opinions on the Marcam financial statements in a Form S-8 Registration Statement filed with the SEC. Before doing so, the Peat Marwick accountant who had worked with Marcam performed a review of Marcam's financial statements to determine whether they were free from false and misleading statements. Peat Marwick also reviewed the 1993 quarterly financial statements prepared by Marcam.

    In June 1993, the Reismans exchanged their $23 million of Varnet's stock for 885,000 shares of Marcam stock. All drafts of the closing documents were sent to Peat Marwick for its review and approval. Approximately six months later, when the Reismans sold their shares in Marcam, the Marcam stock had dropped over sixteen points, from $24 to $7.75 per share. Almost eight months later, Marcam restated its 1991 and 1992 annual financial reports and its 1993 quarterly report, showing substantial losses for the 1991-1993 period.

    Reasoning of the Appeals Court

    1. Fraud. The Court held that if the facts were construed in favor of the plaintiffs, Peat Marwick could be found liable for fraud. The Court rejected the argument that Nycal had changed the basic elements of a claim for fraud or deceit, even if accounting malpractice were implicated. Under the fraud standard, the plaintiff must prove that the defendant or its agent made a false representation of a material fact with knowledge of its falsity for the purpose of inducing the plaintiff to act thereon, and that the plaintiff relied upon the representation as true and acted upon it to its detriment. Reisman, 57 Mass. App. Ct. at 108-109. The Court stated that the Reismans were not required to show under a fraud standard that Peat Marwick's misstatements were made with the specific purpose of inducing the Reismans' reliance. Id. at 110. Rather, the Reismans could also satisfy their burden by showing that they were among those whom Peat Marwick had reason to expect would rely upon its statements. Id.

    The Court found that the facts in the record supporting the fraud claim were that Peat Marwick made misstatements both when the financial reports were first issued and when they were reaffirmed in May 1993. Id. As to the reaffirmation in May 1993, the Court believed reliance by the Reismans was especially predictable where Peat Marwick knew that the earlier financial statements were being relied upon by that specific investor in regard to a specific transaction. Id. at 111.

    Counsel for Peat Marwick also argued that fraud could not be proven because the Reismans had not shown that their post-transaction loss was caused by Peat Marwick's misrepresentations. The Court disagreed, stating that where reliance on a fraudulent misstatement is a substantial factor in the decision to purchase and/or retain stock, the maker of the false representation is liable for a subsequent loss in the value of stock suffered in reliance on the false representation. Id. at 112 (citing David v. Belmont, 291 Mass. 450 (1935)). The Court stressed that the fact that the false representation is not revealed until after the stock has been resold does not defeat the right to recovery of the person deceived. Id. at 115.

    2. Negligent misrepresentation. The Court ruled that if the facts were construed in favor of the plaintiffs, Peat Marwick could be found liable for negligent misrepresentation. It acknowledged the continued viability of the Nycal decision, in which the Court limited the liability of an accountant providing audit services to non-contractual third parties who can demonstrate actual knowledge of the limited - though unnamed - group of potential third parties that will rely upon the report, as well as actual knowledge of the particular financial transaction that such information is designed to influence at the time the report is issued. Nycal, 426 Mass. at 498-499.

    The Reisman Court ultimately did not decide the impact of Nycal on this case because it was persuaded that the Form S-8 filed with the SEC in May 1993 sufficed to establish a claim for negligent misrepresentation. Reisman, 57 Mass. App. Ct. at 123. The Court concluded that Peat Marwick's "reaffirmed misrepresentations" in the Form S-8, issued and circulated in the midst of the Varnet-Marcum deal in which Peat Marwick played an active role, was sufficient to establish a claim for liability. Id. at 124.

    3. Chapter 93A claim. The Court held that if the facts were construed in a light most favorable to the plaintiffs, Peat Marwick could be found liable for violation of Chapter 93A. It found that the record contained sufficient facts to demonstrate that the business relationship between Peat Marwick and the Reismans was more than trivial - Peat Marwick was in direct contact with the Reismans during the Varnet-Marcam transaction; it assigned a partner to advise them, who was added to the project group and sat on the Reismans' side of the negotiating table. Id. at 125. Moreover, Peat Marwick was responsible for the structure of the transaction; reviewed all documents related to it; and reaffirmed that documents it knew or had reason to know the Reismans would receive were free from material misrepresentation. Id. In addition, Peat Marwick - albeit its Canadian affiliate - served as the Reismans' auditor of record, a fact of which Peat Marwick's Boston office was aware. Id. These facts demonstrated to the Court that the nature of the relationship between the Reismans and Peat Marwick was significantly more than merely an arm's-length relationship. Id.

    Implications of the Appeals Court decision in Reisman

    The Appeals Court's decision is significant in demonstrating that an accounting firm may be held liable for fraud, negligent misrepresentation and violation of Chapter 93A when it affirms or reaffirms the veracity of financial statements that it knows may contain misrepresentations and that it knows will be used to influence a particular transaction. The accounting firm's exposure appears to increase if it has a long-standing relationship with each of the parties to the transaction and it actively participates in the transaction. This decision also demonstrates that a court is more likely to find an accountant liable to a third party where intentional fraudulent conduct, as opposed to merely negligent conduct, is involved.