14 November 2011

Auditor Malpractice – Third Circuit's Recent Application Of New York Law

Goldberg Segalla LLP


Goldberg Segalla LLP
In Overland Leasing Group, LLC, two New York-based accounting firms that issued independent audit reports for a company were sued for malpractice and negligent misrepresentation.
United States Accounting and Audit
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In Overland Leasing Group, LLC, two New York-based accounting firms that issued independent audit reports for a company were sued for malpractice and negligent misrepresentation. The audits were issued for a company, Allserve Systems Corporation (Allserve), that, in 2004, had leased computer equipment from two separate leasing companies; Allserve was a Texas company with a principal place of business in New Jersey. Subsequently, in March 2005, a third company, Overland Leasing Group, LLC (Overland), acquired the interest in the computer equipment leased by Allserve by purchasing the underlying lease agreements. Overland, a Delaware company, was headquartered in Massachusetts but maintained an office in New York. The accounting firms, in June 2004 and July 2005, issued separate clean audit reports of Allserve's financial statements. In August 2005, however, "Allserve ceased making payments on the equipment and subsequently declared bankruptcy."

Overland, prior to purchasing the lease agreements for the computer equipment, obtained copies of both audit reports from a third party. Plaintiff had no direct communications with either of the accounting firms at any time prior to completing the underlying transaction. Overland claimed, however, that "it relied upon" the two audits of Allserve's financial statements "in deciding to purchase the equipment leases ...."

Overland appealed a decision by the District Court granting the accounting firms' motions for summary judgment as to its malpractice and negligent misrepresentation claims.

The Third Circuit, as a preliminary matter, analyzed whether New Jersey or New York law applied to Overland's malpractice and negligent misrepresentation claims. The court reasoned that if a state statute aimed at "restor[ing] the concept of privity to accountants' liability toward third parties ..." was inapplicable, "New Jersey law demands application of the broad common-law foreseeability rule." On the other hand, "New York's law ... requires a relationship between accountants and third parties approaching that of privity before liability attaches to an accountant's acts of negligence ...." The District Court, in granting the accounting firms' motions for summary judgment, had applied New Jersey law.

The Third Circuit, despite finding that New York instead of New Jersey law was controlling in the case, upheld summary judgment in the accounting firms' favor. The courts reasoned:

Under New York law, [the accounting firms] cannot be liable to Overland for the negligent preparation of financial reports unless a relationship approaching that of privity existed between them; i.e., (1) [the accounting firms] must have been aware that the financial reports were to be used for a particular purpose or purposes; (2) in the furtherance of which Overland was intended to rely; and (3) there must have been some conduct on the part of [the accounting firms] linking them to Overland, which evinces [the accounting firms'] understanding of Overland's reliance.

Plaintiff was unable to satisfy this standard given the lack of direct communications between the parties and absence of evidence indicating that the accounting firms were either aware or understood that Overland was relying upon the audited financial statements in purchasing the lease agreements. Accordingly, the District Court's decision to grant summary judgment was affirmed as its application of New Jersey, rather than New York, law was harmless error.

Impact: The Third Circuit's opinion in Overland Leasing Group, LLC is noteworthy for two distinct but equally important reasons. First, the decision provides a blueprint for determining which state law applies under New Jersey's choice of law analysis in the context of auditor malpractice cases. In particular, the court, in rendering its decision on this issue, was persuaded by the fact that the case involved "activities by New York licensed accountants ... that allegedly induced a company's New York employees to enter into a contract on behalf of ... [Overland] ...." Choice of law issues regularly arise in accounting malpractice cases given that business transactions frequently involve companies either based in or doing business in multiple states.

Second, the Third Circuit, in affirming summary judgment for the accounting firms, displayed a willingness to apply New York's common law rules insulating accountants from nearly unlimited liability. Specifically, New York law, while no longer recognizing privity of contract as an absolute requirement to asserting a malpractice claim against an accountant, does strictly limit the class Professional Liability Monthly September 2011 Vol.3, No.9 of third parties with standing to assert such claims. The Third Circuit properly found that Overland failed to fall within the narrow class of third parties that could properly pursue an accounting malpractice claim under New York law.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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