Justice Cardozo, writing on New York law, “expressed doubt over expansive liability for accountants, stating that ‘[a]f liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class.” Under Delaware law, while it is possible for a third party to state a claim against an auditor for negligent misrepresentation, a recent case shows how high the pleading bar must be.
In Otto Candies, LLC et al. v. KPMG LLP et al., C.A. No. 2018-0435-MTZ (Del. Ch. Feb. 28, 2019), a group of creditors and bondholders sued the accounting firm KPMG and two of its affiliates for negligent misrepresentation based on KPMG’s audits of a Mexican company, Oceanografía S.A. de C.V. (“OSA”), and OSA’s banker, Banamex, a Mexican subsidiary of Citigroup, Inc. OSA was at one time the largest offshore oil and gas services company in Latin America. OSA allegedly scammed Citigroup for years using forged and fraudulent invoices. When the fraud was exposed, Citigroup withdrew its credit line and OSA “crumpled into bankruptcy.”
OSA’s creditors and bondholders sued KPMG, along with its Mexican subsidiary and its Swiss parent, alleging that the three KPMG entities negligently failed to catch OSA’s frauds in their audits of OSA, Citigroup, and Banamex. Vice Chancellor Morgan T. Zurn of the Delaware Court of Chancery dismissed the claims against the Mexican and Swiss KPMG entities based on lack of personal jurisdiction and forum non conveniens. She dismissed the claims against KPMG US for failure to state a claim and failure to plead negligent misrepresentation with the required particularity.
The Court found that the claim against KPMG would be dismissed under Delaware law, New York law, or Mexican law. First, under Delaware law, the Court found that to state a claim for negligent misrepresentation, plaintiffs “must adequately plead that (1) the defendant had a pecuniary duty to provide accurate information, (2) the defendant supplied false information, (3) the defendant failed to exercise reasonable care in obtaining or communicating the information, and (4) the plaintiff[s] suffered a pecuniary loss caused by justifiable reliance upon the false information.”
The Court found that the plaintiffs failed to plead the first element of negligent misrepresentation, a duty owed by KPMG to the plaintiffs. Under Section 552 of the Restatement (Second) of Torts, a duty is owed to “the person or one of a limited group of persons for whose benefit and guidance [the supplier of information] intends to supply the information or knows that the recipient intends to supply it.” Comment h to Section 552 of the Restatement explains “[i]t is enough that the maker of the representation intends it to reach and influence either a particular person or persons, known to him, or a group or class of persons, distinct from the much larger class who might reasonably be expected sooner or later to have access to the information and foreseeably to take some action in reliance upon it.”
So the issue in Otto Candies was whether the plaintiffs were “a group or class of persons” that KPMG intended the information “to reach and influence” or whether the plaintiffs were part of “the much larger class” to which KPMG did not owe a duty.
The plaintiffs relied on Carello v. PricewaterhouseCoopers LLP, 2002 WL 1454111, at *8 (Del. Super. Ct. July 3, 2002), in which the Delaware Superior Court permitted negligent misrepresentation claims against an auditor to go forward. In Carello, the plaintiffs were the sole stockholders of a company that was sold subject to earn-out payments to be based on future performance. The buyer filed for bankruptcy shortly after the acquisition and could not meet its earn-out obligations. The seller sued the buyer’s auditor, alleging that it “misrepresented the buyer’s financial health and specifically advised the sellers that the acquisition was a good deal.” There was evidence that the auditor “may have prepared its audits to influence the acquisition of plaintiffs’ company.”
The Court in Otto Candies found that an auditor is not liable to non-contractual parties unless the auditor intends to supply the information, or knows that the client intends to supply it, “for the benefit and guidance of a limited group” and the auditor “must also know, or have reason to know, how that group intends to use the information.” In other words, the auditor “has or should have (a) knowledge of a limited, but perhaps unnamed, group, as well as (b) knowledge of the actual financial transactions that the information is designed to influence.”
The Court concluded that those criteria were not met. KPMG US audited Citigroup, which only did business with OSA through its Mexican subsidiary, Banamex. KPMG Mexico, and not KPMG US, audited OSA. Thus, the plaintiffs had only “distant relationships” with KPMG US. “Creditors with distant relationships to an auditor, like Plaintiffs to KPMG US, may be able to allege that the auditor intended to supply information to that creditor or knew the auditor’s client would do so.” But the Court concluded that the plaintiffs had failed to adequately plead that KPMG US (or even KPMG Mexico) “knew of, or intended to influence, the myriad transactions in which Plaintiffs engaged with OSA.” The plaintiffs’ relationship to KPMG US was too distant.
The Court also found that the plaintiffs failed to plead the element of “justifiable reliance” “with particularity” as required for a claim of negligent misrepresentation. The 520-paragraph complaint contained only conclusory allegations of reliance on KPMG’s audits. The Court again distinguished Carello, finding that in that case “the sellers had pled that the buyer’s auditor specifically advised the seller plaintiffs that the acquisition was a ‘good deal,’ and that the auditor may have slanted the financial statements to be more attractive to those sellers.” The plaintiffs in Otto Candies, by contrast, did not allege that KPMG US was involved in OSA’s frauds or that they relied on communications with KPMG US. Nor did the plaintiffs identify any specific audits, reports or financial statements they allegedly relied on. Under Delaware law, the plaintiffs failed to state a claim for negligent misrepresentation.
Under New York law, the Court found that the standard for pleading a claim of negligent misrepresentation is “more chary of Plaintiffs’ claims than Delaware’s” and that the result would therefore be the same. Under New York law, “(1) the accountants must have been aware that the financial reports were to be used for a particular purpose or purposes; (2) in the furtherance of which a known party or parties was intended to rely; and (3) there must have been some conduct on the part of the accountants linking them to that party or parties, which evinces the accountants’ understanding of that party or parties’ reliance.” (quoting Credit Alliance Corp. v. Arthur Andersen & Co., 483 N.E.2d 110, 118 (N.Y. 1985), amended, 489 N.E.2d 249 (N.Y. 1985)). New York law is “designed to limit liability in cases like this one.”
Under Mexican law, the Court considered declarations submitted by the parties’ experts. The plaintiffs’ expert argued that Mexican law applies a “broad standard” that “leaves room for third-party auditor liability.” The Court found that that would be “enough to preclude dismissal” of the plaintiffs’ negligent misrepresentation claim. However, the plaintiffs “falter[ed] on causation” for extra-contractual damages. The Court found that it was “not reasonably conceivable that the Audits directly and immediately caused Plaintiffs’ harm. That harm flows principally from OSA’s fraud and its subsequent filing for bankruptcy protections, or potentially from misconduct by Citigroup and Banamex.” Thus, Mexican law would arrive at the same result as Delaware or New York law through a different path.
Auditors Can Be Held Liable for Negligent Misrepresentation by Third Parties
Under Delaware law, it is possible for a third party to state a claim for negligent misrepresentation against an auditor. The third party must allege – with particularity – that the auditor (1) intended to supply information, or knew that its client intended to supply it, for the benefit and guidance of a limited group, and (2) knew of the actual financial transactions that the information was designed to influence. The third party must also allege with particularity its reliance on specific information and when it relied on it. In Otto Candies, the creditors and bondholders failed to state a claim because their relationship to KPMG US was too distant and because they did not adequately allege reliance. But in Carello the plaintiffs successfully pled a claim for negligent misrepresentation because they alleged that the auditor was aware of the plaintiffs as sellers and was aware of and supported the acquisition of the plaintiffs’ company by its client, and that the plaintiffs relied on the auditor’s reports and representations.
In short, accountants, and the lawyers advising them, should be especially wary when asked to provide information in connection with specific transactions with limited groups, and should in all events avoid “slanting” information to make a transaction more attractive, or opining to the client’s counter-party that the transaction is “a good deal.”
James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.