July 22, 2016
Private Fund Disputes Alert
A recent Massachusetts decision provides support for investors to make a Chapter 93A claim against a third-party accounting firm based on misrepresentations or omissions in audit opinions. This alert discusses the decision and its impact.
In making an investment decision, investors often look first to an independent audit of a fund because it provides an objective snapshot of the fund’s financial position. An audit opinion tainted by the fund’s self-interest, however, risks providing an inaccurate portrayal of the investment opportunity. For this reason, when an investment turns sour and losses mount, investors again review the audit opinion to determine whether it contains misleading statements or fails to identify inaccuracies in the fund’s financial statements.
Historically, investors have had difficulties obtaining recoveries from accounting firms based on an audit of a fund’s financial statements in the absence of fraud. After all (the argument goes), the accountant is not guaranteeing the profitability of the investment and, more importantly, the accountant was hired by the fund, not the investor. There is no relationship (i.e., privity) between the investor and the accounting firm on which to base liability. Therefore, negligent misrepresentation claims typically fail because the accountant does not owe the investor a duty of care. Even where fraud is alleged, investors have trouble proving that the accountant had knowledge that the fund was defrauding investors, or that damages were the direct result of the auditor’s fraudulent inducement that occurred at the time the investment was made. Although investors have not been without some victories, such successes are usually associated with substantial evidence of fraudulent conduct by the accountant and/or evidence showing more than a minor insignificant business relationship between the accountant and investor—such as repeated, direct contact and representations—supporting the inference that the accountant should have expected that the investor would rely on the representations for a particular investment.
A recent Massachusetts decision, however, suggests that spurned investors should evaluate whether their state’s consumer protection law may be used against third-party accounting firms for misrepresentations and omissions in audit opinions. In particular, the decision suggests that investors may have an easier road asserting a cause of action against third-party accountants for violations of Massachusetts’ consumer protection law, Mass. Gen. Laws ch. 93A (“Chapter 93A”), than asserting more traditional causes of action like negligent misrepresentation.
In the case Sgarzi v. Sharkansky & Company LLP investors in a corporation brought a multi-count complaint against the defendant accounting firm that audited the corporation’s financial statements. The investors alleged that they lost millions of dollars they had loaned to the company after relying to their detriment on allegedly false representations of the accounting firm in connection with its audit of the corporation’s 2005 financial statements. The company at issue underwrote the lending activities of used car dealerships. It did this by purchasing retail installment sales contracts whereby the dealerships made subprime loans to high risk customers. The customers would then repay the company directly. To fund its operations, the company obtained loans from secured and unsecured lenders, who included the plaintiffs, to whom the company issued promissory notes. Unbeknownst to plaintiffs, the controlling shareholders of the company began using investor money for their own purposes, including to purchase and operate high risk used car dealerships. The plaintiffs alleged that the accounting firm helped the company hide losses from these high risk investments from investors and failed to consolidate the financials of the related entities. The complaint asserted a variety of claims, including (1) aiding and abetting securities fraud; (2) violating Chapter 93A; (3) engaging in securities fraud in violation of federal, Massachusetts and Colorado law; (4) intentional fraud; (5) negligent misrepresentation; and (6) civil conspiracy.
On the Chapter 93A claim, the court rejected the defendant’s argument on summary judgment that it could not be held liable because it had no direct commercial relationship with the plaintiffs. The court stated that Chapter 93A did not require privity of the parties and, instead, simply required showing either “that the defendant had a commercial relationship with the plaintiffs or that the defendant’s actions interfered with trade or commerce in some other way.” The latter theory was implicated because the plaintiffs could show that the defendant’s malfeasance took place in a business context. Specifically, citing the Massachusetts Appeals Court’s 2003 decision Reisman v. KPMG Peat Marwick LLP, the court stated that it was reasonable to infer that the accounting firm expected that investors would rely on the financial statements that were certified as accurate.
By contrast, the court agreed with the defendant that the negligent misrepresentation claim should be dismissed because the accounting firm owed the investors no duty of care. The court explained that “an accountant that issues an audit report concerning a company’s financial statements . . . owes that duty [of care] to a relatively limited set of people.” Specifically, an auditor owes a duty of care to third parties only to the extent that the accountant has both (i) “actual knowledge” that the audit report will be provided to a “limited—though unnamed—group of potential [third parties] that will rely upon the [report],” and (ii) “actual knowledge of the particular financial transaction that such information is designed.” In other words, the court continued, “Massachusetts law does not protect every reasonably foreseeable user of an inaccurate audit report” for purposes of holding an accountant liable for a negligent misrepresentation. This is a high standard that is rarely met by investors.
Sgarzi suggests that investors may find success using the state’s consumer protection law to recover from a third-party auditor where traditional claims such as negligent misrepresentation might otherwise fail. Of course, whether such a claim is likely to succeed will depend not only on the particular facts of the case but also the particular language of the state’s consumer protection statute.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.