Accountant Malpractice Lawsuits - Collection Tool for
Lenders?
By Grusd, Neville
Lenders occasionally sue accountants for malpractice.
This generally occurs when the lender suffers a loss
and claims that the advances were made in reliance on
incorrect financial statements. For the most part,
lenders and accountants work closely and harmoniously
together. There are many opportunities for mutual
referrals, i.e. the accountants assist their clients
in obtaining additional funding or getting better
terms, and take them to an appropriate lender. On the
other hand, lenders often come across prospects or
clients who are not getting good service or advice
from their accountants, and recommend a change.
Lenders also need to talk to accountants if they have
questions about financial statements and require
projections from the clients. In addition, accountants
are hired lenders to conduct field exams.
This article is not intended to be a legal treatise of
the law relating to accountant malpractice suits, but
rather a practical guide to lenders who are
contemplating taking such action.
A highly experienced accountant, Ben Evans (who was my
mentor at S.D. Leidesdorf, an old-line accounting
firm), was a regular at the CFA convention some years
ago. At one panel on which he was a member, he made
the blunt statement that "we accountants are not
insurers of your bad loans". Where a lender has
suffered a loss, obviously every effort must be made
to recover the funds. Because most accountants have
malpractice insurance, lenders feel that going for the
"deep pockets" can yield some return. Although
insurance companies are known to drag out cases for as
long as possible, they usually settle and some amount
may be recovered, if only to avoid the cost of
litigation. Of course, the lender must ensure that the
amount ultimately recovered at least covers their
legal costs. This is not always the case.
The major legal points involved in an accountant
malpractice lawsuit are:
* Reliance: It is clear that the lender must prove
that its loss, or part thereof, was caused by reliance
on financial statements, later proved to be incorrect
as a result of accountant malpractice. In several
cases involving asset-based lenders, the accountant's
counsel argued that the lender was relying on
collateral and its own field exams, and that the
financiais were a secondary part of its due diligence.
Timing is also an issue. Sometimes the statements are
received after advances have been already made. Of
course, the lender can argue that it continued with
the financing arrangement because the financial
statement showed a reasonable financial condition and
viability of the business, which later proved to be
false. Lenders, such as banks, that rely purely on
financial statements for credit decisions and do not
monitor collateral or perform field exams, are
probably in a stronger position to argue the point
about reliance.
* Standards: To be successful, it must be shown that
the accountant did not follow Generally Accepted
Auditing Standards and recommended procedures,
essential parts of the case. Standards to be followed
by accountants for audits are very different from
those for reviews and compilations. Usually, the
lender will only be successful in the case of an audit
because most auditing standards apply only to this
type of report. In the case of reviews, which many ABL
lenders rely upon, it is much more difficult to prove
malpractice. The tests and procedures that accountants
apply here are far less rigorous. However, if the
lender can prove that the accountant had knowledge of
incorrect disclosures in the financiais, then the
accountant would certainly be liable if that statement
was relied upon by the lender. This applies even in
the case of compilations and this would fall under the
heading of "willful misconduct".
* Privity: There have been arguments in some states
that the accountant does not have a contract with the
lender, but is engaged by the client, i.e. a lack of
privity. Accordingly, accountants tend not to send
financial statements directly to lenders, but give
them to their clients to pass on. Accountants are also
more reluctant today to meet with lenders together
with their clients to discuss financials, projections
and guiding the client through rough patches. However,
virtually all lending agreements include a provision
that financial statements have to be provided as part
of the covenants. And, the accountant has to footnote
the details of the financing contract. Accordingly, it
does not seem logical that the accountants could ever
argue that they were not aware the lender was
utilizing these statements for making credit
decisions.
Many lending agreements include a clause that the
client authorizes the lender to speak with the
accountant if they have any questions about the
financial statements, particularly if there is an
uncured event of default. If this is not a standard
clause, should the need arise to talk to the
accountant, the lender would have to get client
permission. Accountants, in most cases, will not
voluntarily give this information.
The writer discussed with an accountant involved with
litigation support in malpractice cases as to whether
the new rules in the past few years have reduced the
number of these matters. For public companies, the
Sarbanes-Oxley Act was introduced. This includes
requirements for additional disclosures, procedures
and strong emphasis on internal control.
There have also been changes in auditing standards
which emphasize that an accountant should be
considering the possibility of fraud (SAS 99), and
enter into engagements with a degree of professional
skepticism.
Accountants still steadfastly maintain that it is not
their function to find fraud. However, there is
certainly an expectation on the part of the public and
lenders who rely on statements, that they are giving a
seal of approval, and that their procedures should
find any major or blatant frauds or errors. The
consultant referred to above did confirm that
accountants are now more careful in accepting clients.
Also, they are in a stronger position in dealing with
clients regarding grey areas where the accountant
wants to be more conservative. Previously, there was a
great deal of "opinion shopping" where the client was
not satisfied with the way the accountant wanted to
make certain disclosures. Less of this is happening
today. Accountants now are very leery about taking on
new assignments where they see the client is trying to
improve the appearance of its financials.
Hopefully, the relationship between accountants and
lenders will continue to be cordial and productive,
and the amount of malpractice suits will decline.
Neville Grusd, CPA, is president of Merchant Financial
Corporation, New York, NY.
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