The opinion of the court was delivered by: Judge Wefing
(This syllabus is not part of the opinion of the Court. It has been prepared by the Office of the Clerk for the convenience of the reader. It has been neither reviewed nor approved by the Supreme Court. Please note that, in the interests of brevity, portions of any opinion may not have been summarized).
Cast Art Industries, LLC v. KPMG LLP
Argued September 13, 2011 -- Decided February 16, 2012
WEFING, P.J.A.D. (temporarily assigned), writing for a unanimous Court.
In this accounting malpractice action, the Court considers whether plaintiffs Cast Art Industries, LLC, and its shareholders (together, Cast Art), a non-client third party to an audit performed by defendant KPMG LLP, satisfied the prerequisites for imposing liability under the Accountant Liability Act, N.J.S.A. 2A:53A-25.
In the spring of 2000, Cast Art became interested in acquiring Papel Giftware (Papel). Cast Art was advised by attorneys, investment bankers, and accountants, and ultimately decided to proceed with a merger. Cast Art negotiated a loan agreement with PNC Bank for $22 million to fund the venture. As a condition of the loan, PNC required that it receive copies of Papel's audited financial statements.KPMG already was in the process of auditing Papel's 1998 and 1999 financial statements when merger discussions began with Cast Art. In a November 1999 letter to Papel's audit committee, KPMG explained that the audit was planned "to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Absolute assurance is not attainable . . . ." The letter cautioned that there is a risk that "fraud" and "illegal acts may exist and not be detected by an audit performed in accordance with generally accepted auditing standards," and that "an audit is not designed to detect matters that are immaterial to the financial statements." In September 2000, KPMG delivered completed audits to Papel. KPMG's accompanying opinion letter, addressed to Papel's audit committee, stated that the audits were conducted in accordance with generally accepted auditing standards. The letter concluded by observing that as of December 31, 1999, Papel was not in compliance with certain agreements with its lenders, which raised "substantial doubt" about Papel's "ability to continue as a going concern."
Cast Art obtained and provided copies of KPMG's audits to PNC. Three months later, Cast Art and Papel consummated the merger. Soon, Cast Art had difficulty collecting accounts receivable that it had believed Papel had outstanding prior to the merger. Cast Art investigated and learned that Papel's 1998 and 1999 financial statements were inaccurate and that Papel had accelerated revenue. For example, Papel did not comply with its own stated policy of recognizing revenue when goods were shipped and invoices sent; rather, it booked revenue from goods that had not yet been shipped. Also, Papel sometimes held its books open at month's end and improperly recorded revenue that was earned in the following period. Although Cast Art knew at the time of the merger that Papel was carrying a significant amount of debt, it was unaware of those accounting irregularities until after the merger was complete. The merged corporation was unable to generate sufficient revenue and eventually failed.
Cast Art sought to recover from KPMG for the loss of its business. Cast Art alleged that KPMG was negligent; that if KPMG had performed a proper audit, it would have uncovered the fraudulent accounting activity that was taking place at Papel; and that Cast Art would not have proceeded with the merger if it had been alerted to the fraud. KPMG argued, among other things, that Cast Art had not retained KPMG and was not its client, and thus Cast Art's claim was barred by the Accountant Liability Act, N.J.S.A. 2A:53A-25.
Following trial, a jury returned a verdict in Cast Art's favor and awarded damages. The Appellate Division affirmed as to liability but remanded for a new trial on damages. 416 N.J. Super. 76 (App. Div. 2010). The Court granted KPMG's petition and Cast Art's cross-petition for certification. 205 N.J. 77 (2011).
HELD: Because Cast Art failed to establish that KPMG either "knew at the time of the engagement by the client, " which means at the outset of the engagement, or later agreed that Cast Art could rely on its work for Papel in proceeding with the merger, Cast Art failed to satisfy the prerequisites of N.J.S.A. 2A:53A-25(b)(2).
1. An audit is an objective examination to determine if a company's financial statements fairly present the condition of the company. Case law has developed three frameworks for considering the circumstances under which auditors may be liable to non-clients for negligence. Early cases required privity of contract or a similar relationship. Another test provided that an accountant may be liable to individuals that he "knows and intends will rely on his opinion." New Jersey rejected those tests in Rosenblum v. Adler, 93 N.J. 324 (1983), and held that an auditor owes a duty to those the auditor "should reasonably foresee as recipients" of the auditor's work. In 1995, New Jersey abandoned the foreseeability test by adopting N.J.S.A. 2A:53A-25. Subsection (b)(2) sets forth preconditions to imposing liability on an accountant to a non-client third party. The preconditions are that the accountant: "(a) knew at the time of the engagement by the client, or agreed with the client after the time of the engagement," that the accountant's services would be provided to that specific third party for a specific transaction; (b) knew the third party intended to rely on those services; and (c) expressed to the third party the accountant's understanding of that reliance. Here, KPMG did not know in November 1999, when it agreed to perform the audit, that its work could play a role in a subsequent merger because its agreement predated Cast Art's interest in Papel. The issue is whether the phrase "at the time of the engagement" means "at the outset of the engagement," as KPMG argues, or "at any time during the period of the engagement," as Cast Art argues. (pp. 13-18).
2. To determine the Legislature's intent, the Court first considers the statute's terms, reading them in context to find vitality in the chosen language. Because the relevant phrase is susceptible of two plausible interpretations, it is appropriate to look at the legislative history. When the bill was introduced, it was accompanied by a clear statement of purpose: to "limit accountants' liability to third parties for the accountants' negligent acts" after the Court's decision in Rosenblum had "weakened" the necessity of privity, and to "restore the concept of privity to accountants' liability towards third parties." Prior to enactment, subsection (b)(2)(a) was amended to add the phrase "by the client" immediately after "at the time of the engagement." This Court disagrees that "engagement" encompasses the entire period of the professional relationship; otherwise, the clause "by the client" would serve no purpose. Construing the phrase "at the time of the engagement by the client" to mean "at the outset of the engagement" is consistent with the Legislature's intent to narrow the circumstances under which an accountant may be liable to a third party. Statutes and case law from other states provide no reason to retreat from this conclusion. Conversely, the Court's conclusion is fortified by the nature of an auditor's engagement letter, which sets forth its understanding of the work it is being asked to perform and the concomitant risk it is being asked to assume. KPMG's letter is silent as to Cast Art. (pp. 18-25)
3. Cast Art alternatively argues that its cause of action fits within that portion of the statute permitting a third party to seek recovery from an accountant if the accountant "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." N.J.S.A. 2A:53A-25(b)(2)(a). At most, testimony offered by Cast Art supports an inference that KPMG was aware that Cast Art required audited financial statements to proceed with the merger. The statute, however, requires agreement, not mere awareness, on the part of the accountant to the planned use of his work product. (pp. 25-27)
4. Cast Art failed to establish that KPMG either "knew at the time of the engagement by the client" or later agreed that Cast Art could rely on its work for Papel in proceeding with the merger. Thus, Cast Art failed to satisfy N.J.S.A. 2A:53A-25(b)(2), and KPMG was entitled to judgment. Other issues raised by the parties are moot. (pp. 27-28)
The judgment of the Appellate Division is REVERSED and the matter is REMANDED to the trial court for entry of a judgment of dismissal.
CHIEF JUSTICE RABNER and JUSTICES LONG, LaVECCHIA, and HOENS join in JUDGE WEFING's opinion. JUSTICES ALBIN and PATTERSON did not participate.
Argued September 13, 2011
On certification to the Superior Court, Appellate Division, whose opinion is reported at 416 N.J. Super. 76 (2010).
JUDGE WEFING (temporarily assigned) delivered the opinion of the Court.
Following a lengthy trial in this accounting malpractice action, a jury returned a verdict in plaintiffs' favor and awarded damages totaling $31.8 million. Following post-trial motions and computation of pre-judgment interest, the trial court entered an amended final judgment against defendant for $38,096,902. Defendant appealed and plaintiffs cross-appealed from that judgment. In a published opinion, the Appellate Division upheld the verdict on liability but vacated the damage award and remanded for a new trial on damages. Cast Art Indus., LLC v. KPMG LLP, 416 N.J. Super. 76 (App. Div. 2010). Defendant petitioned for certification, and plaintiffs submitted a cross-petition, both of which we granted. Cast Art Indus., LLC v. KPMG LLP, 205 N.J. 77 (2011). After reviewing the extensive record and considering the arguments advanced, we have concluded that the verdict in favor of plaintiffs cannot stand, and we reverse the judgment of the Appellate Division.
Plaintiffs commenced this litigation seeking damages for the losses they said they incurred following the bankruptcy and subsequent liquidation of Cast Art Industries (Cast Art). The business of Cast Art was the production and sale of collectible figurines and giftware. The individual plaintiffs, Scott Sherman, Gary Barsellotti, and Frank Colapinto, were Cast Art's shareholders. As Cast Art's president, Sherman managed the business, which was located in California. Barsellotti was responsible for production, and Colapinto was in charge of sales. Because the claims of Cast Art and the individual plaintiffs are inextricably intertwined, we shall hereafter, for purposes of this opinion, refer simply to Cast Art and plaintiff in the singular.
Papel Giftware (Papel), located in New Jersey, was in the same line of business as Cast Art, and in the spring of 2000 Cast Art became interested in acquiring Papel. Among the factors that made such an acquisition attractive to Cast Art were Papel's large number of existing customer accounts, its existing sales force, and its production facilities. Cast Art retained the services of attorneys (Latham & Watkins), investment bankers (Friedman Billings & Ramsey), and accountants (Moss Adams) to advise it in connection with this proposed transaction. Eventually, it decided that a merger, rather than an acquisition, would be the preferable format for such a transaction. Cast Art lacked the financial ability to complete such a transaction on its own. As a result, it negotiated a loan agreement with PNC Bank (PNC) for $22 million to fund the venture. One of PNC's conditions to advancing the $22 million loan, however, was that it receive audited financial statements of Papel. An additional condition, insisted on by PNC and agreed to by Sherman, was that he personally guarantee $3.3 million of the loan.
Defendant KPMG had audited Papel's financial statements since 1997, when Papel's principal, Joel Kier, had acquired it from a prior owner. KPMG was already in the process of auditing Papel's 1998 and 1999 financial statements when Cast Art and Papel began their merger discussions. In its letter to the chairman of Papel's audit committee, dated November 17, 1999, in which it agreed to undertake these audits and report the results, KPMG noted the parameters of its work:
An audit is planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Absolute assurance is not attainable because of the nature of audit evidence and the characteristics of fraud. Therefore, there is a risk that material errors, fraud (including fraud that may be an illegal act), and other illegal acts may exist and not be detected by an audit performed in accordance with generally accepted auditing standards. Also, an audit is not designed to detect matters that are immaterial to the financial statements.
The process of KPMG completing its audits of Papel's financial statements for the years 1998 and 1999 was protracted; KPMG attributed this delay in part to difficulties it encountered in obtaining the necessary records from Papel. In addition, tensions developed between John Quinn, the KPMG partner responsible for the audit, and Frederick Wasserman, Papel's chief financial officer, when Wasserman resisted certain adjustments that KPMG concluded had to be made to Papel's financial statements. Eventually, Wasserman agreed to certain of the adjustments, and KPMG concluded that the remainder were immaterial, and thus it waived their inclusion. In September 2000, KPMG delivered to Papel the completed audits for the years 1998 and 1999. KPMG included the following statement in its accompanying opinion letter, which again was addressed to the chairman of Papel's audit committee:
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
KPMG concluded its opinion letter to Papel with the observation that as of December 31, 1999, Papel "was not in compliance with certain financial covenants" with its lenders, which KPMG characterized as raising "substantial doubt about the Company's ability to continue as a going concern."
Cast Art obtained copies of the completed 1998 and 1999 audits and provided copies to PNC in satisfaction of its obligation under the loan agreement. Three months later, in December 2000, Cast Art and Papel consummated the merger. Shortly after the merger was finalized, Cast Art began to experience difficulty in collecting some of the accounts receivable that it had believed Papel had had outstanding prior to the merger. Cast Art began its own investigation and learned that the 1998 and 1999 financial statements prepared by Papel were inaccurate and that Papel evidently had engaged regularly in the practice of accelerating revenue.
Papel's financial statements had noted that Papel's stated policy was to recognize revenue from sales when goods were shipped and invoices sent. Papel did not comply with that policy, however, and would routinely book revenue from goods that had not yet been shipped. For example, testimony at trial established that Papel would pack goods for shipment and book the revenue but then simply place the shipping cartons in trailers on its property and color code the invoices to note when the goods were, in fact, to be shipped and billed. There was also testimony that at certain points Papel would not close out its books at month's end. Rather, it would hold them open and book in the improperly extended month revenue that was earned in the following period. There was also testimony that at least one transaction, referred to at trial as the "Bookman" transaction, was a fraudulent entry of a $121,244 sale that never occurred.
Although Cast Art knew at the time of the merger that Papel was carrying a significant amount of debt, it was unaware of those accounting irregularities until after the merger was complete. The surviving corporation was unable to generate sufficient revenue to ...