On appeal from Superior Court of New Jersey, Law Division, Middlesex County, Docket No. L-3295-03.
The opinion of the court was delivered by: Skillman, P.J.A.D.
NOT FOR PUBLICATION WITHOUT THE APPROVAL OF THE APPELLATE DIVISION
Before Judges Skillman, Gilroy and Simonelli.
This appeal presents significant issues regarding the interpretation of the Accountant Liability Act, N.J.S.A. 2A:53A-25, which delineates the circumstances under which an accountant may be held liable for accounting malpractice to a party other than the accountant's client. The appeal also presents significant issues regarding the elements of a cause of action for accounting malpractice and the measure of damages if a plaintiff establishes that accounting malpractice caused the destruction of its business.
We conclude that the evidence presented by plaintiffs satisfied the prerequisites of the Accountant Liability Act for imposition of a duty of care upon an accountant to a party other than its client. We also conclude that plaintiffs presented sufficient evidence to establish all the elements of a cause of action for accounting malpractice and that the value as of the date of the merger of plaintiffs' business, which failed after the merger, was a proper measure of plaintiffs' damages. However, we conclude that the evidence presented by plaintiffs did not provide an adequate foundation for the jury's damages award and therefore a new trial on damages is required.
Plaintiff Cast Art was a California giftware manufacturer and wholesale distributor. Plaintiff Scott Sherman was its president, and the other individual plaintiffs were shareholder/officers of Cast Art.
Papel Giftware was a rival distributor of giftware. Sometime in late 1999 or early 2000, Cast Art's management began discussions with Papel's management concerning the possible acquisition of Papel.
These discussions resulted in a merger of the two companies in late 2000. To be able to enter into this transaction, Cast Art had to borrow $22 million to refinance Papel's excessive debt. Sherman guaranteed $3.3 million of this amount personally. Under the merger agreement, Papel's shareholders obtained 19% of the stock in the new company and Cast Art's shareholders retained the remaining 81%.
Within a year of the merger, Cast Art's management learned that Papel's accounts receivable in the years before the merger were significantly less than had been represented in Papel's financial statements. The merged company experienced substantial financial losses, and in 2003, it terminated the business and liquidated its assets.
At the time of the merger, and for a number of years before, defendant KPMG had been Papel's auditor. KPMG prepared audited financial statements for Papel for its fiscal years ending December 31, 1997, 1998, and 1999. The problems KPMG's auditors encountered with Papel's management in preparing those audits, KPMG's awareness of the negotiations between Papel and Cast Art during the period when the 1999 financial statement was being prepared, and the communications between Cast Art's management and KPMG representatives before the 1999 financial statement was issued and the merger consummated, are discussed in detail later in this opinion.
After its demise, Cast Art and its principals brought this accounting malpractice action against KPMG. Plaintiffs asserted claims for negligence, negligent misrepresentation, and fraud, and sought both compensatory and punitive damages. Plaintiffs subsequently moved for leave to amend their complaint to assert claims for recklessness and aiding and abetting fraud. The trial court denied these motions.
Following discovery, KPMG moved for summary judgment. The trial court granted summary judgment dismissing plaintiffs' fraud claims, but denied the motion with respect to plaintiffs' negligence claims. The trial court dismissed plaintiffs' punitive damages claim at an early stage of the case and later reaffirmed that dismissal on several subsequent occasions.
The case was tried before a jury over the course of twenty-two days. We defer discussion of the trial testimony and exhibits until later in the opinion.
The jury decided plaintiffs' malpractice and negligent misrepresentation claims in their favor and awarded them $31.8 million in damages, which represented what plaintiffs claimed Cast Art was worth at the time of the merger. KPMG filed a motion for a judgment notwithstanding the verdict, new trial, and remittitur. The trial court denied the motion, except for a $1.8 million reduction in the damages award, representing the amount Cast Art recovered in an action against Papel's principals.*fn1 Accordingly, the court entered an amended final judgment against KPMG for $30 million plus $8,096,902 in prejudgment interest.
KPMG has appealed from this judgment, and plaintiffs have filed a conditional cross-appeal from the dismissal of their fraud and punitive damage claims and the denial of their motions to amend their complaint to assert claims for recklessness and aiding and abetting fraud.
The threshold issue presented by this appeal is whether plaintiffs presented sufficient evidence to support a finding that KPMG owed them a duty of care under the Accountant Liability Act, which provides in pertinent part:
b. Notwithstanding the provisions of any other law, no accountant shall be liable for damages for negligence arising out of and in the course of rendering any professional accounting service unless:
(1) The claimant against the account was the accountant's client; or
(a) knew at the time of the engagement by the client, or agreed with the client after the time of the engagement, that the professional accounting service rendered to the client would be made available to the claimant, who was specifically identified to the accountant in connection with a specified transaction made by the claimant;
(b) knew that the claimant intended to rely upon the professional accounting service in connection with that specified transaction; and
(c) directly expressed to the claimant, by words or conduct, the accountant's understanding of the claimant's intended reliance on the professional accounting service[.] . . . [N.J.S.A. 2A:53A-25.]
Cast Art and its principals were not KPMG's clients. Consequently, KPMG owed them a duty of care only if KPMG's dealings with them satisfied the three-part test set forth in N.J.S.A. 2A:53A-25(b)(2).
The Legislature's objective in enacting this three-part test was to overturn the test set forth in H. Rosenblum, Inc. v. Adler, 93 N.J. 324, 352 (1983), which held that an accountant has a duty of care to a party other than its client in auditing a financial statement if the accountant should "reasonably foresee" that that party will rely upon the financial statement for a proper business purpose, and to establish a more restrictive test for imposition of a duty of care upon an accountant to parties other than its client. See E. Dickerson & Son, Inc. v. Ernst & Young, LLP, 179 N.J. 500, 504 (2004).
Initially, we note that KPMG did not become aware of Papel's discussions with Cast Art concerning a possible acquisition of its business until the spring of 2000. By that time, KPMG had already issued the audited financial statements of Papel for 1997 and 1998. Cast Art does not claim that KPMG took any action with respect to those previously issued statements that could be found to satisfy the demanding requirements of N.J.S.A. 2A:53A-25(b)(2). Therefore, the question whether KPMG assumed a duty of care to Cast Art under the three-part test set forth in N.J.S.A. 2A:53A-25(b)(2) must focus upon the process of KPMG's preparation of the 1999 audited Papel financial statement and the issuance of that statement in September 2000.
The record contains substantial evidence that KPMG knew not only that Papel's audited 1999 financial statement would be made available to Cast Art but also that Cast Art would rely upon the statement and thus that issuance of the statement was a precondition of the proposed merger between Papel and Cast Art going forward. The president of Cast Art, Scott Sherman, testified that PNC Bank would not provide the financing required to complete the merger without an audited Papel financial statement. He also testified that there were one or more conference calls between Papel's management, Cast Art's management, and KPMG's representatives during which the need for the audited Papel financial statement was discussed. Although Sherman could not identify the KPMG representative or representatives who participated in the conference calls or how many conference calls KPMG participated in, this uncertainty did not preclude the jury from crediting Sherman's testimony. Plaintiffs also presented testimony that Paul Lowry, a partner of KPMG who acted as an advisor to Papel in connection with the proposed merger, acquiesced in attachment of the 1999 KPMG audited Papel financial statement to the merger agreement between Papel and Cast Art. This evidence was sufficient to support the jury's findings that KPMG had a duty of care to plaintiffs under each of the three tests set forth in N.J.S.A. 2A:53A-25(b)(2).*fn2
N.J.S.A. 2A:53A-25(b)(2)(a) requires a non-client asserting an accounting malpractice claim to show that the defendant accountant
 knew at the time of the engagement by the client, or  agreed with the client after the time of the engagement, that the professional accounting service rendered to the client would be made available to the claimant, who was specifically identified to the accountant in connection with a specified transaction made by the claimant[.] [Emphasis and bracketed numbers added.]
In interpreting this subsection, the essential question is whether "at the time of engagement by the client" refers solely to the date on which the client retained the accountant's services or encompasses the entire period of performance of those services. If this phrase refers solely to the date of the accountant's initial retention, plaintiffs would have to show that KPMG "agreed with [Papel]" that its 1999 financial statement would be made available to Cast Art, because Papel retained KPMG on November 17, 1999, which was well before KPMG became aware of the proposed merger between Cast Art and Papel in the spring of 2000. However, if this phrase refers to the entire period of performance of KPMG's services until it issued the audited Papel financial statement in September 2000, plaintiffs would only have to show that KPMG "knew" that the audited 1999 financial statement would be made available to Cast Art in connection with the proposed merger.
The Code of Professional Conduct issued by the American Institute of Certified Public Accountants (AICPA) supports the conclusion that an accountant's "engagement" spans the entire period from when the engagement letter is signed to when an audit report is issued:
Period of the professional engagement.
The period of the professional engagement begins when a member either signs an initial engagement letter or other agreement to perform attest services or begins to perform an attest engagement for a client, whichever is earlier. The period lasts for the entire duration of the professional relationship . . . and ends with . . . the termination of the professional relationship or by the issuance of a report, whichever is later. . . . [AICPA, Code of Professional Conduct § 92.26 (2010) (emphasis added).]
This understanding of the meaning of an accountant's engagement by a client is also reflected by KPMG's "Completion Memorandum" for the audit of Papel's 1999 financial statement, which refers to the "wrap-up stage of the engagement."
KPMG argues that even if "engagement" or "time of the engagement" refers to the entire period of the accountant's performance of professional services, as the AICPA's Code of Professional Conduct indicates, N.J.S.A. 2A:53A-25(b)(2)(a) should be construed more restrictively to refer solely to the date on which the client retained the accountant because it refers to what the accountant knew "at the time of the engagement by the client," rather than "at the time of the engagement." We see no reason why the addition of the words "by the client" should result in such a significant change in the meaning of "at the time of the engagement." By definition, the client is the party who engages the accountant. Therefore, the addition of the words "by the client" cannot reasonably be construed to give the first clause of N.J.S.A. 2A:53A-25(b)(2)(a) a different meaning than it would have had if those words had been omitted.
KPMG also relies upon our statement in E. Dickerson & Son, Inc. v. Ernst & Young, LLP, 361 N.J. Super. 362, 368 (App. Div. 2003), aff'd, 179 N.J. 500 (2004), that "[u]nder subsection [(a)] of the statute, the accountant must know when engaged, or must thereafter agree with the client, that his work will be made available to a 'specifically identified' claimant 'in connection with a specified transaction made by the claimant,'" (emphasis added), as support for its argument that "at the time of the engagement" refers solely to the client's initial retention of the accountant rather than the entire period during which the accounting services are performed. However, the meaning of the phrase "at the time of the engagement" in N.J.S.A. 2A:53A-25(b)(2)(a) was not at issue in Dickerson, and "when engaged" could be construed to refer to the entire period during which an accountant performs a service for a client rather than just the time of initial retention.
The second question involved in determining whether plaintiffs satisfied the prerequisite of N.J.S.A. 2A:53A-25(b)(2)(a) for imposition of a duty of care upon KPMG is a factual question: whether plaintiffs presented sufficient evidence to support the jury finding that KPMG "knew . . . that the professional accounting service rendered to the client [the 1999 audited Papel financial statement] would be made available to [Cast Art], who was specifically identified to [KPMG] in connection with a specified transaction made by [Cast Art,]" specifically its proposed merger with Papel. N.J.S.A. 2A:53A-25(b)(2)(a). Cast Art's president, Scott Sherman, testified that he participated in a conference call or calls in which a KPMG representative was told that Cast Art had to receive the audited financial statement in order for the merger to go forward. KPMG partner Paul Lowry testified that he reviewed a draft of the merger agreement, which indicated that the KPMG audited 1999 Papel financial statement would be attached. Moreover, KPMG's lead auditor in the 1999 Papel audit, John Quinn, acknowledged that KPMG knew while performing the audit that its report would be made available to Cast Art in connection with the proposed merger. Therefore, plaintiffs presented more than sufficient evidence to establish that KPMG knew that its audit of Papel's 1999 financial statement would be "made available" to Cast Art in connection with its proposed merger with Papel and thus satisfied the prerequisite for imposition of duty of care to a non-client set forth in N.J.S.A. 2A:53A-25(b)(2)(a).*fn3
KPMG does not dispute that the evidence was sufficient to satisfy the test set forth in N.J.S.A. 2A:53A-25(b)(2)(b), --that KPMG "knew that [Cast Art and its principals] intended to rely upon [the 1999 audited financial statement] in connection with [the proposed merger with Papel]."
The same evidence that provided a sufficient foundation for finding that the tests set forth in N.J.S.A. 2A:53A-25(b)(2)(a) and (b) were satisfied also supports the finding that the test set forth in N.J.S.A. 2A:53A-25(b)(2)(c) was satisfied. There are several observations that need to be made about this subsection. First, it does not require the accountant to agree that a third-party claimant such as Cast Art will rely upon the accounting professional service. It only requires a showing of the accountant's "understanding" that there would be such reliance. Second, although that understanding must be "directly expressed to the claimant," this direct expression may take the form of either "words or conduct."
Sherman's testimony regarding the conference call or calls with a KPMG representative, and Lowry's review of the merger agreement, which indicated that the KPMG audited Papel financial statement would be attached, clearly provided a sufficient evidential foundation for a finding of KPMG's "understanding" that Cast Art would rely upon that statement in going forward with the merger. We also conclude that KPMG's "conduct" in issuing the financial statement with this understanding, and its acquiescence in the attachment of the statement to the merger agreement, constituted the required "direct expression" to Cast Art of KPMG's understanding of the "intended reliance" of Cast Art and its principals upon that statement.
KPMG places heavy reliance upon a letter executed by Cast Art on August 28, 2000, as a condition of obtaining access to KPMG's work papers relating to preparation of Papel's 1998 financial statement, under which Cast Art agreed "that it does not acquire any right as a result of such access that it would not otherwise have had." However, this letter related solely to those 1998 work papers. Cast Art did not execute any comparable document relating to the KPMG audited 1999 financial statement. Therefore, the August 28, 2000 access letter did not negate KPMG's understanding that the 1999 Papel financial statement would be made available to and relied upon by Cast Art in connection with its proposed merger with Papel.
KPMG argues that even if it owed Cast Art a duty of care under the Accountant Liability Act, plaintiffs failed to present sufficient evidence to support a finding that KPMG breached that duty. In particular, KPMG argues that plaintiffs failed to establish the materiality of the misstatements in the 1999 KPMG audited Papel financial statement.
In conducting an audit, an accountant is required to follow generally accepted accounting principles (GAAP) and generally accepted auditing standards (GAAS). See NCP Litig. Trust v. KPMG LLP, 187 N.J. 353, 380 (2006); Rosenblum, supra, 93 N.J. at 342-43. However, these principles and standards are general in nature, and their application in the conduct of any particular audit requires the exercise of professional judgment. Thus, one section of the GAAS states:
The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures. [AICPA, Codification of Statements on ...