Accountants Responsible to Non-Clients for Material Misrepresentations in Audit

In a very important case, the Business Litigation Session of the Massachusetts Superior Court has ruled that an accounting firm and one of its partner accountants were responsible for misrepresentations contained in an audit report of its client’s financial statements. Plaintiffs were investors who lost millions of dollars in investments in a car loan company. Plaintiffs alleged that the defendants failed to disclose that its client was using money from investments and loans to purchase high risk used car companies and that those activities resulted in substantial losses. The auditors failed to file consolidated financial statements that would have alerted investors. Plaintiffs claimed they relied on false representations and omissions contained in the audit. They sought relief, among other theories, under Mass General Laws Chapter 93A, the Consumer Protection Statute, which has a business component. The defendant accounting firm and its partner moved for summary judgment, claiming that they could not be responsible to their client’s investors as they had no direct relationship with them. That defense succeeded against the traditional claims asserted by the Plaintiffs, but not the Consumer Protection claim. The Court ruled that the Plaintiffs could prevail on the Consumer Protection claim if they could prove that the “…defendants’ actions interfered with trade or commerce...” If an accountant knowingly or recklessly conveys false information in the audit to assist the client to complete a transaction, the accountant can be liable. The Court also ruled that the accountant did not need to know that the “victims” would rely on the audit, because when an accountant certifies an audit, it knows that lenders, investors and others will rely on the representations contained in the audit.

This is an extremely important case for accountants, lenders and other members of the business communities that rely on audited financial statements. In the past, it was very difficult to succeed in a case against an auditor brought by people and businesses that did not have a direct relationship with the accounting firm or accountant because the legally required direct relationship was absent and also because accountants are not guarantors of their clients’ accounting practices and reports. But this decision, Sgarzi v. Sharkansky & Company LLP, has lowered the bar considerably. Accountants will face liability exposure which will be very costly to insure against. Every audit will be a potential exposure to judgments in amounts that are very difficult to limit or predict.

Of equal import, businesses and people who otherwise would have no recourse, now have an avenue to recourse that was not available previously. The statute provides multiple damages and attorneys’ fees which traditional theories did not provide. From the vantage point of a lender or investor, this decision is a positive development.

There is every reason to believe that this decision will be reviewed and possibly reversed due to its potential impact. We will follow this case and advise as to further developments.

In the meantime, if we can help you analyze a situation that may be worthwhile based on this development, please call. We have an excellent relationship with forensic accountants that can assist, if need be.