California Malpractice Case Highlights Audit Defenses
When an audit client is exposed as a corrupt enterprise and a court-appointed receiver pursues claims against the auditors for malpractice and aiding and abetting, what defenses are available to the auditor? There are some, but you must make sure they are strong and in place at the beginning of an engagement.
by Jonathan S. Ziss, JD Dec 20, 2019, 13:22 PM
Insightful lessons can be learned by reviewing professional liability issues. With this in mind, Arthur J. Gallagher & Co. provides this column for your review. For more information about liability issues, contact Bob Connolly at robert_connolly@ajg.com.When an audit client is exposed as a corrupt enterprise and a court-appointed receiver pursues claims against the auditors for malpractice and aiding and abetting, what defenses are available to the auditor? There are some, but you must make sure they are strong and in place at the beginning of an engagement.
Earlier this year, the U.S. Court of Appeals for the 9th Circuit decided a case that began in federal district court in California that may provide guidance. While not, strictly speaking, a controlling precedent for cases decided under Pennsylvania law, given the national uniformity of accounting and attestation standards, the decision in Mosier v. Stonefield Josephson Inc.1 is certainly worthy of note.
Private Equity Management Group Inc. (PEMGroup) was founded by Danny Pang. PEMGroup, its directors and management, and Pang established subsidiaries Genesis Voyager Equity Corp. (GVEC) and the related entities GVEC II and GVEC IV as special-purpose vehicles. Together, these entities were parts of a swindle that operated along the lines of a Ponzi scheme.
GVEC made debt and equity offerings in life insurance policies and commercial real estate mortgages. These offerings allegedly raised $951 million. In the offering memoranda, GVEC told investors to expect a return on investment in the range of 6 percent to 7 percent. The “returns,” however, did not come from investment performance. Rather, GVEC fraudulently paid its investors with money from new investors and by selling GVEC’s assets to GVEC II and GVEC IV at inflated prices. There were other improprieties as well, including looting by management.
In 2003, GVEC hired Stonefield Josephson Inc. to audit the financial statements for six of its offerings. Stonefield issued 10 audit reports for years 2003 through 2007. Notably, beginning with its March 2004 report, Stonefield issued qualified opinions about its client’s operations. Each audit report expressed significant reservations about its client’s improper method of assigning value to its assets. In a letter to the board of directors and investors, Stonefield warned that GVEC’s “[r]ecording of the sale of special assets were not in accordance with accounting principles generally accepted in the United States of America. The special assets of the portfolio were sold to an affiliated entity that shares the same advisor as [GVEC]. Furthermore, the valuation for the sale price of the special assets could not be concluded to be fair market value independently of management’s internal valuation.”
It is worth noting that Stonefield’s involvement with GVEC and PEMGroup went beyond issuing qualified audit reports. Stonefield attended a meeting with at least one investor and it authored comfort letters stating that its qualified reports were prepared in accordance with GAAS and fairly described the “quality or reliability of the [relevant] financial statements.” Two of its auditors served as character references for Pang and another of PEMGroup’s managers. Additionally, Stonefield prepared for GVEC’s board of directors and investors net asset valuations and limited reports concerning two of the sales between GVEC and its affiliates.
The Court of Appeals explained, “Stonefield never had an entirely comfortable relationship with GVEC. Early on, Stonefield learned that its predecessor had resigned … after GVEC misrepresented the predecessor’s involvement with GVEC’s initial funding period. Furthermore, the manner in which PEMGroup structured GVEC and its offerings – e.g., soliciting only Chinese investors, basing its operations in the British Virgin Islands, and promising seemingly unsustainable rates of return – raised Stonefield’s concerns.” Still, Stonefield resigned only after it learned that the SEC had filed a complaint and that the FBI had arrested Pang.
Robert Mosier was the court-appointed receiver after the massive fraud was exposed. Mosier sued Stonefield for $51 million, contending that its reports materially misrepresented PEMGroup’s financial condition, allowing PEMGroup’s management to prolong the life of their scheme and to loot and to dissipate assets. Mosier felt that if Stonefield had performed its audits competently it would have caught the fraud, resigned, and prevented additional investment.
Mosier asserted three causes of action: professional negligence, aiding and abetting the wrongful conversion of PEMGroup’s assets, and unjust enrichment (seeking recoupment of professional service fees paid). Stonefield filed a motion for summary judgment in the lower court, and prevailed. The district court held that Mosier had failed to prove the element of causation. That is, Mosier could not meet his burden of demonstrating that either PEMGroup or its investors relied on Stonefield’s audits; as a corollary finding, any reliance shown would have been unreasonable. Mosier appealed the dismissal of the malpractice and aiding and abetting claims, but did not oppose dismissal of the unjust enrichment claim.
The Court of Appeals held that, as participants in the fraud, GVEC and PEMGroup cannot have relied on the truth of the fraudulent representations in the audits. Because top management knew of, and participated in, the fraud, they could not have justifiably relied on Stonefield’s audits to uncover a fraud that they themselves perpetrated. Therefore, any professional negligence by the auditors could not have caused the client to suffer harm.
Concerning the alleged reliance on Stonefield’s audit reports by the investors, Mosier again came up short. The appeals court held, “We find it difficult on this record to swallow the idea that PEMGroup showed Stonefield’s qualified audits to investors in Taiwan.” Furthermore, the court looked to the 1984 decision of the U.S. Supreme Court in United States v. Arthur Young, in which the high court said, “The inclusion in an audited financial statement of anything less than an unqualified opinion … could send signals to stockholder, creditors, potential investors, and others that the independent auditor has been unable to give the corporation a clean bill of financial health.” Thus the Court of Appeals concluded, “in light of the statement in the audits regarding [GAAP] violations, it would not have been reasonable to rely on the audits to accurately reflect GVEC’s financial condition.”
Finally, the Court of Appeals noted, “The contractual engagement agreement between Stonefield and PEMGroup stated that Stonefield would not be responsible for any misrepresentations made by GVEC.” The engagement letters included fairly standard language such as, “We understand that you will provide us with the basic information required for our audit, and that you are responsible for the accuracy and completeness of that information. … [T]he responsibility for the financial statements remains with you.” The letters also stated, “Because of the importance of management’s representations to the effective performance of our services, [client] will release Stonefield Josephson and its personnel from any claims, liabilities, costs, and expenses relating to our services under this letter attributable to any misrepresentations in the representation letter referred to above.”
Against this background, the Court of Appeals noted, “If anyone breached this contract, it was PEMGroup, not Stonefield.” The lower court’s dismissal of the case was affirmed.
This case was decided under California law. Had it been decided under Pennsylvania law, the wrongdoing of management may have been imputed to Mosier, as receiver, adding yet another defense to the auditor’s position. (See the Liability Lessons column on the in pari delicto and audit interference defenses in the spring 2016 Pennsylvania CPA Journal.) Regardless of where an audit malpractice case is litigated, the element of causation (reasonable reliance) will likely be central, and the power of properly constructed engagement letter language to allocate responsibility and risk cannot be overemphasized.
1 815 F. 3d 1161 (9th Cir. 2016).
Jonathan S. Ziss, JD, is a partner with Goldberg Segalla in Philadelphia. He can be reached at jziss@goldbergsegalla.com.
Jonathan S. Ziss, JD, is a partner with Goldberg Segalla in Philadelphia. He can be reached at jziss@goldbergsegalla.com.
