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Verdict levels playing field for accounting firms.

The jury's verdict in a federal trial has made it harder to hold accounting firms disproportionately liable for damages when they fail to discover accounting irregularities during an audit. The trial, based on a $37 million lawsuit brought against BDO Seidman LLP by shareholders of a pharmaceutical firm it had audited, was the first, under a 1995 federal tort reform law, to be decided by a jury. Previously, such cases often were decided on the basis of joint and several liability, a legal principle adopted to ensure plaintiffs are fully compensated for their damages.

Critics of joint and several liability have pointed out that juries, in attempting to compensate plaintiffs in cases like this one, sometimes unfairly burden "deep-pocketed" accounting firm defendants with a greater share of damages than they caused, simply because they are better able to pay for it than their often bankrupt codefendants, who committed the fraud.

The ground-breaking verdict in favor of BDO was made possible by legislation passed four years ago. Until this case, that law had not been invoked at trial because it generally takes so long for liability cases to complete the pre-trial investigation process and because most cases are settled. In fact, among the more than 700 cases filed following the enactment of the Private Securities Litigation Reform Act of 1995, the BDO case was the first to go to a jury trial. Thus, it has broad implications for cases yet to be tried.

Veteran observers expect other accounting firms, named as defendants in similar actions, may now assume bolder positions in settlement negotiations. "Look at the Cendant case," said one, in reference to the suit that resulted when the travel and real-estate giant, formed by the merger of HFS, Inc., and CUC International, found out after the merger that $500 million of revenue on CUC's books had been falsified, but not detected as such, during E&Y's audit of CUC--a fact which, when revealed, dealt a serious blow to the company's market value and its investors' portfolios.

In December, E&Y agreed to pay Cendant shareholders $335 million as a result of these accounting irregularities. It is fair to ask whether, in the future, accounting firms will seize upon the favorable jury verdict in the suit against BDO to argue that, in similar cases, they shouldn't be paying anything at all--let alone such excessive amounts.

In fact, the last two years have seen such a surge in reported instances of accounting irregularities that SEC Chairman Arthur Levitt instituted a campaign to ensure that audit committees and auditors worked together more effectively to improve the quality of financial reporting.

The BDO lawsuit, brought in 1997 by shareholders of Health Management, Inc. (HMI), a pharmaceutical sales company formerly headquartered in Holbrook, N.Y., alleged that HMI's CEO, CFO and other employees had knowingly committed fraud, and that BDO, its auditor, had knowingly and recklessly failed to detect it during a 1995 audit. Ultimately, the CEO was sentenced to nine years in jail, and the plaintiff shareholders settled with several other defendants, leaving BDO as the only nonindividual defendant. The trial, held in the U.S. district court in Uniondale, N.Y., concluded on October 26, 1999.

Michael R. Young of Willkie Farr & Gallagher, who served as BDO defense counsel in the case, said in an interview with the JofA that, in cases like this, accounting firms historically have been at risk for 100% of the damages, regardless of the proportion of the damage, if any, they actually caused.

The suit was brought under section 10(b) of the Securities Exchange Act of 1934, under which a defendant can be held liable only if it commits fraud knowingly or if it acts recklessly.

"Potentially, the jury could have found that BDO was a knowing participant in the fraud or knowingly didn't conduct a GAAS audit," Young said. "But we know, from documentation of its deliberations, the jury concluded fairly quickly that BDO was not guilty of such violations."

"To the extent responsibility could have been assigned to BDO at all," Young said, "it would have been for failing to catch the deliberate deception of others. If you're just negligent, you're not liable under 10(b). The plaintiff would have had to sue under another law."

"A key thing under the new statute," Young added, "is that, in its defense, the accounting firm can allocate responsibility for wrongdoing not only among the defendants, but among all wrongdoers, whether or not they are defendants. So in a massive fraud like this, which involved $1.8 million in fictitious inventory and millions of dollars in falsified receivable data, we were able to identify a long list of coconspirators."

The fraud, which took place during BDO's audit of HMI for the fiscal year ending April 30, 1995, consisted of falsifying records indicating that large quantities of pharmaceutical products were being shipped between various HMI locations during the audit, preventing BDO from physically verifying their existence. The jury found that HMI management and staff had fabricated inventory and shipping records to deceive BDO's auditors and achieve a passing grade on the audit. The jury's verdict also vindicated BDO's claim that it had no way of detecting HMI had fraudulently reduced the age of its receivables in order to lower reserves and inflate earnings.

"The whole case blew open when the company later hired a new CFO and one of the employees who had participated in the fraud spilled the beans," Young said. The company then hired an investigator to look into these allegations, he added, and ultimately the cover-up unraveled and the details of the fraud were revealed.

Commenting on the change in thinking underlying the verdict, Young said, "The intellectual justification behind joint and several liability goes back several hundred years. The problem is that when you try to apply this concept in the last decade of the 20th century, you find accounting firms have been exposed to shareholder litigation out of all proportion--not only to audit fees, but to any realistic assessment of responsibility."
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Publication:Journal of Accountancy
Geographic Code:1USA
Date:Feb 1, 2000
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