Bank Cannot Recover Damages From Accounting Firm That Mischaracterized Items in Performing an Audit
February 15, 2007
Michael Weissman - Chicago
In Johnson Bank v. George Korbakes & Co., LLP, (United States Court of Appeals for the 7th Cir. No. 05-3580, December 18, 2006) the bank sued an accounting firm that performed an audit of one of the bank’s borrowers, Brandon Apparel Group, Inc., but made an number of errors.
Brandon manufactured and sold clothing and also licensed others to sell its merchandise. It began borrowing from Johnson Bank in 1997 and, as of 1999, owed the bank $10 million.
Late in 1999, when Brandon was trying to obtain additional funding from the bank, it instructed its accountants to give the bank a copy of the audit report the accountants had just finished. The report contained errors.
One error was the classification of a claim in a lawsuit brought by Brandon as a “contra liability.”1 It should have been classified as “gain contingency.” This treatment of a $1 million claim had the effect of making the company’s net worth greater by $1 million than it otherwise would have been. A second error was to classify sales made by Brandon’s licensee as sales by Brandon making it appear that Brandon’s sales were greater than they actually were.
Notwithstanding these errors the court held the bank could not recover from the accountants after Brandon declared bankruptcy and the bank lost over $10 million.
The court noted the Illinois statute, 225 ILCS 450/30.1, that immunizes accountants from liability to third parties for errors unless the accountants have expressly acknowledged that the third party may rely on their work product.
The court went on, however, to expressly point out how the audit report wasn’t really misleading. It said a footnote accurately disclosed the “contra liability” as a claim in a lawsuit. It also said that the bank “could not have reasonably treated the auditor’s characterization as an assurance by the auditor that Brandon would win its suit and if so obtain and collect a $1 million award.” It further noted that a footnote disclosure identified “the amount of the licensee’s contribution to Brandon’s sales numbers.”
In summary, the court said the bank “had no right to ignore the footnotes in the report, which together with the numbers in the report gave the reader an accurate picture of Brandon’s financial situation.” It also noted that the bank did not rely on the mischaracterizations in continuing to lend money to Brandon even after the audit report was issued. The funding after the release of the audit report was because the bank wanted to prevent Brandon from seeking bankruptcy relief.
Deeming the damages sought by the bank as too speculative to justify an award for negligent misrepresentation, the court rejected the bank’s claims.
What’s the Point?
The court could have cited the Illinois statute and concluded with that. However, it discussed the alleged errors in detail and admonished lending institutions that they must read an audit report in full, including footnotes, in order to have an accurate picture of the audited company’s financial condition.
For more information, e-mail Michael L. Weissman at michael.weissman@hklaw.com or call toll free, 1-888-688-8500.
1 The $1 million “contra” was offset against monies due to the former owners of Brandon.