Facts
- KPMG LLP audited Papel Giftware’s 1998 and 1999 financial statements pursuant to an engagement with Papel, not with Cast Art Industries, LLC.
- While merger discussions later began between Cast Art and Papel, KPMG’s audit planning materials stated the audit sought reasonable assurance under GAAS, noted limits on detecting fraud or illegal acts, and disclaimed absolute assurance.
- In September 2000, KPMG issued audit opinions to Papel’s audit committee stating the audits complied with GAAS and the financial statements fairly presented Papel’s position under GAAP; KPMG also noted loan covenant noncompliance and “substantial doubt” about Papel’s ability to continue as a going concern.
- Cast Art relied on the audited financial statements to consummate the merger and to obtain acquisition financing, including providing the audited statements to its lender.
- After the merger, Cast Art discovered difficulties collecting accounts receivable and alleged Papel’s financial statements materially overstated its condition through accelerated revenue and other irregularities.
- Cast Art sued KPMG for negligence/accounting malpractice as a nonclient third party, alleging KPMG negligently failed to detect the fraud and that proper auditing would have prevented the merger and ensuing losses.
- A jury returned a verdict for Cast Art and awarded approximately $31.8 million; the Appellate Division largely sustained liability under New Jersey’s Accountant Liability Act with limited remands.
- The New Jersey Supreme Court granted review on whether KPMG could be liable to Cast Art under the Accountant Liability Act.
Issues
- Whether, under N.J.S.A. 2A:53A-25(b)(2), an auditor owes a duty of care to a nonclient that relied on audited financial statements in a merger and related financing.
- Whether evidence of communications, an access letter, and awareness that audited statements would be used by a prospective acquirer or lender satisfies the statute’s requirement that the auditor knew at engagement or later agreed that a specifically identified nonclient would rely on the work for a specified transaction.
Decision
- The court reversed the judgment sustaining liability and entered judgment for KPMG.
- Cast Art failed to satisfy N.J.S.A. 2A:53A-25(b)(2) because it did not prove KPMG either knew at the time of engagement, or later agreed, that the audits would be made available to Cast Art (specifically identified) for Cast Art’s reliance in the Papel–Cast Art merger (a specified transaction).
- Evidence showing, at most, that third-party reliance was foreseeable did not establish a statutory duty to a nonclient.
Legal Principles
- New Jersey’s Accountant Liability Act narrows accountant liability to nonclients and rejects liability based solely on foreseeability of reliance.
- Under N.J.S.A. 2A:53A-25(b)(2), a nonclient must prove the accountant (i) knew at the time of engagement or (ii) agreed after engagement that the services would be made available to a specifically identified nonclient who intended to rely on them in connection with a specified transaction.
- Communications or conduct that do not clearly manifest the accountant’s knowledge or agreement as to the identified nonclient and specified transaction are insufficient to create a duty under the statute.
- Because duty under the statute is a legal prerequisite, failure to establish statutory duty defeats a negligence claim regardless of proof of breach, causation, or damages.
Conclusion
The New Jersey Supreme Court held that an auditor is not liable in negligence to a nonclient acquirer that relied on audited financial statements for a merger unless the nonclient proves the auditor’s statutory knowledge at engagement or a subsequent agreement that the specifically identified nonclient would rely on the work for a specified transaction; foreseeability of third-party use does not create a duty.