1200-1500 word position paper, in which you review the existing law on a particular legal issue and make a proposal as to what the law should be.

Texas Trial Lawyers Association Commercial Litigation Seminar

October 12-13, 2006 Dallas, Texas

ISSUES IN ACCOUNTANT LIABILITY LITIGATION ARISING FROM BUSINESS FAILURES

Rod Phelan Baker Botts L.L.P. 2001 Ross Avenue Dallas, Texas 75201 [email protected] 512.953.6500

Gavin R. Villareal Baker Botts L.L.P. 98 San Jacinto Blvd., Suite 1500 Austin, Texas 78701 [email protected] 512.322.2500

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Issues in Accountant Liability Litigation arising from Business Failures Rod Phelan

Gavin R. Villareal I. INTRODUCTION

More than ever before, when a company fails, someone sues the auditor. The auditor is the last man standing and, much of the time, a deep (enough) pocket. Sometimes the claim is that the auditor actively participated in developing or concealing the activities that led to the company’s failure. More common, though, is an allegation that the auditor's error was one of omission – the auditor failed to detect a damaging practice that, had it been discovered in time, could have been corrected. Frequently, these claims are brought by the bankruptcy trustee or the trustee of a litigation trust to which, under a bankruptcy plan, the company’s claims have been assigned for the benefit of creditors.

Although any number of factors may have contributed to a company's failure – mismanagement; bad strategic decisions, industry downturns, competition, poor oversight by boards of directors, even outright fraud by senior management – lawsuits against auditors inevitably claim that had the auditors done their jobs properly, somebody somewhere would have done something differently that would have somehow enabled the company to avoid bankruptcy. This paper discusses issues that frequently arise in these cases.

II. In the wake of Enron, WorldCom, etc. . . .

The past five years have witnessed spectacular business failures amid allegations of accounting improprieties. While the roles of public accountants are scrutinized more than ever before, the climate for accountant liability litigation remains in flux. Officers and directors are now held to high standards, and their responsibility for a company's problems ordinarily dwarfs that of its auditors. The complexity of the accounting issues arising from business failures complicates any attempt to draw parallels under other facts and circumstances. Fundamental changes are occurring in the way businesses operate and are regulated, and these changes also make suits against accountants more difficult. For instance:

Greater transparency in financial statements. In the wake of the big business collapses, companies face growing pressure, both from regulators and the investing public, to ensure transparency in financial reporting. (Reporting transparency refers to disclosure beyond that required by accounting principles or regulatory requirements; it means disclosure of information, both financial and nonfinancial, that assists the public in making informed decisions about the reporting company.) As PricewaterhouseCoopers notes: “In the post-Enron world, reporting transparency is critical. A growing body of evidence indicates that companies that fall short of the transparency benchmark risk significant damage to management credibility. In the worst case, companies face an erosion of shareholder confidence that can, in turn, do damage to market capitalization, credit, and liquidity.” See “Increased need for transparency and disclosure in financial statements,” at www.pwcglobal.com. The closer a company comes to reporting transparency, the less likely are hidden financial irregularities – and claims that the auditor missed or blessed them. In today's climate, a company's lawyers, board members, and outside auditors all have a common interest in transparent reporting, and more muscle to require it.

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More active and more accountable directors. More is expected and required of corporate directors than ever before. The pendulum of power is swinging away from the powerful CEO and back to boards of directors. See Ruth V. Aguilera, Corporate Governance and Director Accountability: an Institutional Comparative Perspective, 16 BRITISH J. OF MANAGEMENT at 39 (2005) (“In the post-Enron era, corporate governance reforms around the world are fully underway to bring greater power balance within the firm⎯particularly reining in over-mighty chief executives⎯and to resolve power struggles among the different stakeholders.”). An active and informed board reduces the likelihood that improper accounting practices on the part of management will go undetected or uncorrected.

Strengthened regulatory regime. Following the string of major corporate collapses, zeal for corporate governance reform resulted in the passage of Sarbanes-Oxley, the goals of which include “improving accounting oversight, strengthening auditor independence, requiring more transparency in corporate financial matters, eliminating analyst conflicts of interest, and requiring greater accountability from corporate officials.” Kathleen F. Brickey, From Enron to WorldCom and Beyond: Life and Crime after Sarbanes-Oxley, 81 WASH. UNIV. L.Q. 357, 359 (2003). The ultimate impact of Sarbanes-Oxley remains to be seen, but this new era of regulatory restrictions attempts to address many of the issues involved in high-profile business failures.

III. The Role of the Auditor

A company’s auditors issue an unqualified opinion on the company’s financial statements. Some time later, the company files for bankruptcy protection. The auditors must have been negligent, right?

One of the most frequent misunderstandings in accountant liability litigation relates to the auditor’s function and responsibility. Claimants often mischaracterize and overstate what an auditor does and how the auditor does it. It is not unusual to see a company’s outside auditor described as a “safeguard for the investing public,” a “guarantor” of the “accuracy” of a company’s financial statements, a "watchdog," or a “third-party check” on a company’s business decisions. None of these characterizations is correct.

It is a company’s management (and not its auditor) that prepares and has the primary responsibility for the information in the financial statements. After management has prepared the financial statements, the auditor follows generally accepted auditing standards (“GAAS”) to obtain reasonable assurance that the financial statements taken as a whole are fairly stated. It is management (and not the auditor) that has the duty to ensure that the company’s financial statements are fairly stated and in accordance with generally accepted accounting principles (“GAAP”). GAAS requires the independent auditor to obtain written representations from management acknowledging and accepting responsibility for the fair presentation of the financial statements. Management’s responsibility for the financial statements is so fundamental that the auditor cannot complete the audit and render an unqualified opinion without these representations. Thus, when a trustee of a failed company sues the auditors complaining of misleading financial statements, the claims are literally based on management's failure to fulfill its own acknowledged responsibilities.

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The end result of an audit is the expression of an opinion as to whether the audited financial statements taken as a whole present fairly, in all material respects, the financial position, results of operations and cash flows of the company in conformity with GAAP. The auditor obtains reasonable, not absolute, assurance that the financial statements are free of material misstatement. “Since the auditor’s opinion on the financial statements is based on the concept of obtaining reasonable assurance, the auditor is not an insurer and his report does not constitute a guarantee.” AU § 230.13.

GAAS states that an audit does not guarantee the accuracy of the financial statements, nor any specific line item in the financial statements. An auditor does not review all of the client’s accounting records nor all of the client’s financial transactions that have taken place throughout the year. Finally, an audit is not, and was never intended to be, an evaluation or report card on the quality of management, its decisions or its strategies.

Management judgments heavily infuse many entries on a financial statement – whether and to what extent a receivable is collectible, for example; whether and to what extent future earnings will be sufficient to utilize net operating losses; or whether and to what extent good will is impaired. These judgments produce subjective estimates – management estimates. Management ordinarily has substantial familiarity with individual accounts and the reasons for valuing them. The auditor's responsibility for these estimates is quite limited, as a range of reasonableness invariably applies.

Claimants who attempt to enlarge the scope of an auditor’s responsibilities will find that claim undercut by their own expert. All CPAs will acknowledge management's responsibility and the limitations on that of the auditor.

An auditor’s responsibilities are not merely contained within professional literature. Often, the engagement letter between the accounting firm and the defunct company (to which any successor-in-interest to the company is bound) contains precise language explaining both the auditor’s and the company’s responsibilities.

IV. Imputation and In Pari Delicto

When auditors get sued after a company fails, the claimant alleges that audit failures caused the company’s demise. Creative counsel connect the alleged audit failure to some bad business decision that, had the auditor done a better job, the company would not have made. Causation – demonstrating that an audit error caused damages – is an essential element of a professional malpractice claim. See, e.g., FDIC v. Ernst & Young, 967 F.2d 166, 170 (5th Cir. 1992); Salisbury v. Arthur Andersen & Co., 956 S.W.2d 601, 602 (Tex. App.—San Antonio 1997, pet. denied). But when the claimant stands in the shoes of the failed company, he is saddled with management's decisions, good and bad; the board's strategies, good and bad, and oversight or lack thereof; management's responsibility for the financial statements – management established the accounting systems, made the estimates and judgments, and did the accounting from which the financial statements are derived; board oversight of management; and the fact that both management and the board invariably rely on a lot of information other than the audit opinion. Auditors do not make the business decisions or create the external events that cause a company's failure.

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A corporation can only act and acquire knowledge through its agents. Poth v. Small, Craig & Werkenthin, L.L.P., 967 S.W.2d 511, 515 (Tex. App.—Austin 1998, pet. denied). As a result, knowledge gained by corporate representatives, such as its management and board, is imputed to the corporation. See Continental Oil Co. v. Bonanza Corp., 706 F.2d 1365, 1376 (5th Cir. 1983) (“Because a corporation operates through individuals, the privity and knowledge of individuals at a certain level of responsibility must be deemed the privity and knowledge of the organization . . . .”) (citing Coryell v. Phipps, 317 U.S. 406, 410-11, 63 S. Ct. 291, 293, 87 L. Ed. 363 (1943)). A corporation is presumed to know what its representatives know when the representatives act on behalf of the entity. See International Bankers Life Ins. Co. v. Holloway, 368 S.W.2d 567, 580 (Tex. 1963) (“[N]otice to an officer or agent is notice to the corporation in the circumstance where the officer or agent in the line of his duty ought, and could reasonably be expected, to act upon or communicate the knowledge to the corporation.”) (internal quotes omitted); Wellington Oil Co. v. Maffi, 150 S.W.2d 60, 63 (Tex. 1941) (knowledge gained by a corporate officer or agent while acting on the corporation’s behalf is imputed to the corporation).

Imputation becomes particularly significant when, as is often the case following a company’s failure, a bankruptcy or litigation trust trustee asserts claims against both the auditors and the officers and directors. The claimant accuses the officers and directors of reckless or fraudulent conduct that drove the company into bankruptcy and, in a separate but parallel case, alleges that but for the auditors’ negligence, the company’s officers and directors would not have mismanaged or otherwise damaged the company. Having made these admissions of wrongdoing by the officers and directors, a claimant will have great difficulty avoiding having that same wrongdoing imputed to the company into whose shoes he has stepped. See, e.g., In re Mediators, Inc., 105 F.3d 822, 825-26 (2d Cir. 1997) (“The Bankruptcy Code places a trustee in the shoes of the bankrupt corporation . . . .”). Based on the imputation to a successor claimant of the entity’s own wrongdoing, the Fifth Circuit, applying Texas law, has barred claims against the former professionals for a bankrupt entity. See, e.g., FDIC v. Ernst & Young, 967 F.2d 166, 170-72 (5th Cir. 1992) (imputing a dominating shareholder’s fraud to claimant and rejecting the “rescue” theory; the company “cannot claim it should recover from E&Y for not being rescued by a third party for something [the company] was already aware of and chose to ignore.”); FDIC v. Shrader & York, 991 F.2d 216 (5th Cir. 1993) (imputing wrongdoing to claimant even when suing on behalf of third-party creditors).

Two recent Second Circuit cases, one interpreting Texas law, are instructive. In Official Comm. of the Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, LLP, 322 F.3d 147 (2d Cir. 2003), Coopers & Lybrand provided auditing and consulting services to Color Tile, a Delaware corporation headquartered in Texas that was a large specialty retailer of floor covering products. Unable to service debt incurred to finance an acquisition, Color Tile entered bankruptcy. As assignee of Color Tile's claims, the creditor's committee sued Coopers claiming that it breached fiduciary duties owed to Color Tile by not informing Color Tile’s board of negative conclusions discovered during Cooper's due diligence for the acquisition, and that, absent this breach, Color Tile would not have gone through with the acquisition.

Applying Texas law, the district court dismissed the complaint. It found that the doctrine of “in pari delicto” barred the claims because Color Tile’s board of directors and sole shareholder bore at least equal responsibility with Coopers for permitting the transaction to go forward on the basis of inflated projections. 80 F. Supp. 2d at 137-38. The district court noted

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that the in pari delicto defense, “traditionally limited to situations where the plaintiff bore at least substantially equal responsibility for his injury, has been expanded by contemporaneous courts to cover situations ‘more closely analogous to those encompassed by the ‘unclean hands’ doctrine, where the plaintiff has participated ‘in some of the same sort of wrongdoing’ as the plaintiff.’” Id. at 138.

The Second Circuit affirmed. “[W]here, as here, ‘the persons dominating and controlling the corporation orchestrated the fraudulent conduct, their knowledge is imputed to the corporation as principal’ under the ‘sole actor’ rule, which negates the adverse interest exception when the principal and the agent are one and the same.” 322 F.3d at 165. Applying the Fifth Circuit’s decision in FDIC v. Ernst & Young, the Second Circuit also rejected the creditor's committee’s argument that innocent decision-makers would have stepped in to prevent the fraud if they had been made aware of it. Id. at 165-66.

In Breeden v. Kirkpatrick & Lockhart LLP, 336 F.3d 94 (2d Cir. 2003), a bankruptcy trustee sued the corporation’s accountants and attorneys for malpractice, breach of fiduciary duty and negligence in failing to report to the corporation’s innocent directors and officers suspicions that management was using the corporation to perpetrate a Ponzi scheme. The district court granted the defendants' motions for summary judgment based on the trustee’s lack of standing.

The Second Circuit affirmed. It held that management’s misconduct had to be imputed to the corporation and barred the trustee’s claims. Citing its 1991 decision in Shearson Lehman Hutton, Inc. v. Wagoner, the Second Circuit noted that where “a bankrupt corporation has joined with a third party in defrauding its creditors, the trustee cannot recover against the third party for the damage to the creditors.” Id. at 99 (citing Wagoner, 944 F.2d at 118).

Where a corporation’s management and a third party collaborated in the fraudulent scheme, the trustee can sue only if it can establish that there has been damage to the corporation apart from the damage to the third-party creditors. . . . Even if there is damage to the corporation itself, the trustee cannot recover if the malfeasor was the corporation’s sole shareholder and decision maker.

Id. at 100 (citations omitted). The court rejected the counterargument that there were innocent directors; it found no evidence that such directors had any power to do anything to prevent the fraud. Id. at 101 (“Here whether one or more so-called independent directors . . . might have in some metaphysical sense stopped the fraud, it is beyond peradventure that under all the circumstances, it was only their heart that might have been in the right place. Indeed, each so- called independent director was impotent to actually do anything.”).

A 2005 decision by a federal district court in Massachusetts similarly determined that, under Massachusetts law, a litigation trustee did not have standing to pursue claims against the company’s former accountants due to the application of the in pari delicto doctrine. Baena v. KPMG LLP, 389 F. Supp. 2d 112 (D. Mass. 2005). The court noted that the First Circuit had applied in pari delicto, which “provides that a plaintiff may not assert a claim against a defendant if the plaintiff bears fault for the claim.” Id. at 117. While some courts apply the

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doctrine as an equitable defense, the First and Second Circuits view it as a standing issue. Id. at 118.

V. Comparative Fault

A claimant who avoids the bar of imputation and in pari delicto still faces the hurdle of comparative fault. “A claimant may not recover damages if his percentage of responsibility is greater than 50 percent.” TEX. CIV. PRAC. & REM. CODE § 33.001 (West 1997).

In the context of a business failure, the trier of fact will consider the fault of the company’s officers and directors. If the company’s financial statements said one thing but its agents knew or should have known that another was true, then the company cannot be said to have acted solely in reliance on the financial statements. When the claimant is simultaneously claiming that the failed company’s managers engaged in fraud, that fault will be imputed to the company – and to the complaining trustee.

VI. Deepening Insolvency

One of the more significant developments in accountant liability is the rapid growth in case law interpreting the “deepening insolvency” theory. Most commentators trace this theory a 1980 case from the Southern District of New York that rejected the notion that a corporation automatically received a benefit from prolonging its corporate existence. See Investors Funding Corp. of N.Y. Secs. Litig. v. Dansker, 523 F. Supp 533, 541 (S.D.N.Y. 1980) (“A corporation is not a biological entity for which it can be presumed that any act that extends its existence is beneficial to it.”). In very general terms, “deepening insolvency” means the fraudulent prolongation of a corporation’s life beyond insolvency, resulting in damage to the corporation caused by increased debt. See, e.g., In re Global Serv. Group LLC, 316 B.R. 451, 456 (Bankr. S.D.N.Y. 2004) (quoting Schacht v. Brown, 711 F.2d 1343, 1350 (7th Cir. 1983)). The concept was first fully articulated by the Seventh Circuit Court of Appeals in Schacht v. Brown, which rejected the idea that “the fraudulent prolongation of a corporation’s life beyond insolvency is automatically to be considered a benefit to the corporation’s interests.” Schacht v. Brown, 711 F.2d 1343, 1350 (7th Cir. 1983).

In recent years, there has been an explosion in cases asserting the deepening insolvency theory, either as an independent cause of action or as a measure of damages, or both. Before 2001, there were four reported federal cases mentioning deepening insolvency.” Since then, there have been 64 more. These cases are all over the map. Some have recognized deepening insolvency as a measure of damages. See, e.g., Allard v. Arthur Andersen & Co., 924 F. Supp. 488, 494 (S.D.N.Y. 1996); Hannover Corp. of Amer. v. Beckner, 211 B.R. 849, 854 (Bankr. M.D. La. 1997); Feltman v. Prudential Bache Secs., 122 B.R. 466, 473 (Bankr. S.D. Fla. 1990). Others have held that deepening insolvency represents an independent cause of action. See, e.g., Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 344 (3d Cir. 2001); In re Exide Tech, Inc., 299 B.R. 732, 752 (Bankr. D. Del. 2003). More treat deepening insolvency not as an independent cause of action but rather as a concept subsumed within existing causes of action that have less “catchy” names. See, e.g., Coroles v. Sabey, 79 P.3d 974, 983 (Utah Ct. App. 2003); In re Parmalat, 2005 WL 1923839 (S.D.N.Y. Aug. 5, 2005); In re Global Serv. Group LLC, 316 B.R. 451, 458 (Bankr. S.D.N.Y. 2004); see also Sabin Willett, The

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Shallows of Deepening Insolvency, 60 BUS. LAW. 549 (2005) (providing reasons not to recognize deepening insolvency as a cause of action).

• Texas has not recognized a cause of action for deepening insolvency

Almost ten years ago, Judge Kenneth M. Hoyt of the U.S. District Court for the Southern District of Texas (Houston Division) called into question the applicability of deepening insolvency as a measure of damages in a case filed on behalf of a bankrupt entity against its former auditors. Askanase v. Fatjo, 1996 WL 33373364, *28 (S.D. Tex. Apr. 1, 1996) (“The Court is also of the opinion that LivingWell could not have been damaged by E&Y’s alleged negligence while in an insolvent state. The shareholders, who comprise LivingWell, could not be damaged by additional losses incurred after the point of insolvency because they had already lost their equity in the company. The Court is unpersuaded by the plaintiffs’ ‘deepening insolvency theory.’ Moreover, there is no pleading of a single creditor who loaned money in reliance on E&Y’s report or was damaged in any way by E&Y’s alleged negligent conduct.”).

More recently, Judge Harlin D. Hale, of the U.S. Bankruptcy Court for the Northern District of Texas (Dallas Division), joined a growing consensus by holding that the Supreme Court of Texas would not recognize deepening insolvency as an independent cause of action. In re Vartec, Inc., 335 B.R. 631 (Bankr. N.D. Tex. 2005). In re Vartec involved a suit by the creditors committee of a failed telecom company alleging that a financing cooperative, by restructuring certain loan agreements prior to the company’s bankruptcy, had deepened the telecom company’s insolvency. Id. at 633-35. Judge Hale walked through a comprehensive analysis of the current state of deepening insolvency jurisprudence before concluding that Texas would not recognize deepening insolvency as a cause of action, particularly not in the circumstances present in this case Id. at 636-46 (“With this in mind, the Court finds that the Texas Supreme Court would not adopt ‘deepening insolvency’ as a separate tort, because the injury caused by the deepening of a corporation’s insolvency is substantially duplicated by torts already established in Texas.”).

• Other courts are questioning the continued viability of deepening insolvency as either an independent cause of action or a measure of damages.

Two other recent cases from different jurisdictions are significant because they appear to represent a growing discomfort among courts with the logic of deepening insolvency theory. The Third Circuit Court of Appeals, the same court that five years earlier in Lafferty held that Pennsylvania would recognize a cause of action for deepening insolvency, clarified and limited that holding in In re CitX Corp., 448 F.3d 672 (3d Cir. Jun. 6, 2006). CitX involved an insolvent internet company involved in an illegal Ponzi scheme. It used its financial statements compiled by an accounting firm to attract investors. Id. at 674. After the company spent the investors’ money and incurred millions more in debt, it filed for bankruptcy. Id. The bankruptcy trustee sued accounting firm for malpractice and “deepening insolvency.” Id. The district court granted the summary judgment dismissing both claims. Id.

On review, the Third Circuit held that while deepening insolvency may be a cause of action, it does not “create a novel theory of damages for an independent cause of action like malpractice.” Id. at 677. The trustee’s negligence action failed because it could not show any

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harm from the extension of its existence. Id. The court noted that the fact that the company obtained an equity infusion of $1 million during its prolonged existence actually lessened rather than deepened its insolvency. Id. It was management’s misuse of these funds, not the fact that the company had the opportunity and did raise the funds, that harmed the company. Id. at 678. The court of appeals also found no that mere negligence was insufficient to support a claim for deepening insolvency. Id. at 681.

In Trenwick Amer. Litig. Trust v. Ernst & Young LLP, 2006 WL 2434228 (Del. Ch. Aug. 10, 2006), the Delaware Chancery Court criticized a litigation trust’s attempt to assert deepening insolvency as a cause of action in the absence of facts sufficient to make out claims for fraud or breach of fiduciary duties on the part of a company’s directors. The court began by noting that Delaware does not recognize such a cause of action. Id. at *28. But the court continued: “The concept of deepening insolvency has been discussed at length in federal jurisprudence, perhaps because the term has the kind of stentorious academic ring that tends to dull the mind to the concept’s ultimate emptiness.” Id. The court further attacked the logical underpinnings of the theory itself:

Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. . . . If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become the guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather in such a scenario the directors are protected by the business judgment rule.

Id. The court held that rejecting a cause of action for deepening insolvency does not absolve directors of their corporate responsibilities—they can still be sued for fraud or breach of fiduciary duty. Id. at *29. However, “[i]f a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy.” Id.

Conclusion

Anyone who has litigated accountant liability cases knows that they are complex, lengthy and expensive, particularly when the claims arise from a company’s failure. The substantive issues can be daunting. Multiple and overlapping professional and ethical standards apply to accountants. Many of the standards are not black and white but instead require the exercise of professional judgment based on the facts and circumstances known at the time, not through the lens of hindsight. It is a challenge to pin more than 50% of the responsibility for a company’s failure on an auditor’s improper exercise of professional judgment when other events and conduct contributed to the bankruptcy and when management fault is imputed to the company and to any successor. Large accounting firms understand these challenges. They are sophisticated

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litigants, aware that they will become bigger targets if they are known as easy-money settlers. They are wonderful clients for defense lawyers. They understand high fees. They want to win. They know what it takes to win. They are willing and able to pay high-dollar outside lawyers. They are also able to devote lots of internal resources – seasoned accountants and bright lawyers – to defending claims. They are courageous. They can stand to lose, and they are willing to lose rather than settle a case they believe they will win. All of which means they are willing to try cases. If a defense lawyer wants to get to trial, there's no better client. The big accounting firms will mount a well-organized defense even if the legal fees associated with doing so represent a multiple of what it might have cost to settle the claims. Buckle up.