Commercial Law
03/17/2013
Facts of the case
Brandon Apparel Group, Inc. (“Brandon”) was involved in the business of manufacturing and sales of casual apparel as well as licensed other companies to manufacture, distribute and sell its clothing lines. Additionally, Brandon had licensing agreements with several colleges, universities, and sports organizations, such as the National Football League. In 1997 Brandon borrowed funds from Johnson Bank (the “Bank”). Brandon’s owners signed all the necessary paperwork and personally guaranteed a $5 million term loan and a $4 million line of credit. Brandon agreed to make monthly payments for the term loan and pay the full balance by June …show more content…
1, 2004. The maximum amount of money that could be borrowed under the revolving credit line was set at 80% of accounts receivable that were not more than 90 days past due and 50% of eligible inventory. At some point the initial amount of eligible inventory was raised from $1.5 million to $3.5 million. In the end of 1997 Brandon requested additional credit and in 1998 a third revolving credit line of $2 million was approved by the Bank. Additionally, Brandon was supposed to provide the Bank with monthly “borrower’s certificates” that contained information about eligible receivables and inventory. In the end of 1998 Brandon owed the Bank $9,354,093. The term loan was due on June, 2004, and the two revolving credit lines were due in May, 1999 and in March, 1999. In the end of 1998 the Bank determined that Brandon represented a high credit risk and asked the company to find another financing institution. In January of 1999, despite the decreased credit rating, Thomas Wolfe, Senior Vice President of the Bank, requested the Bank’s loan committee to renew and increase Brandon’s credit lines. Later, the Bank postponed the due date of one of the credit lines and issued additional letters of credit to Brandon increasing the total exposure to Brandon to approximately $10 million by April 30, 1999. George Korbakes & Co., LLP (“GKCO”) was engaged by Brandon to perform an audit for the year ending on December 31, 1998. The Bank was not referenced in the engagement letter. In the process of working on the audit, GKCO discovered that Brandon violated several covenants associated with the credit agreements. Brandon was informed of the violations. GDCO was going to include “going concern” qualification in the audit report unless the Bank agreed to waive the violations. On April 29, 1999 the Bank agreed to waive the violations. GDKN completed the audit on April 29, 1999 and sent a copy to the Bank. The audit did not include a going concern qualification. According to the Bank, information contained in the audit violated Generally Accepted Accounting Principles (“GAAP”), Generally Accepted Audit Standards (“GAAS”), and the opinions of the Financial Accounting Standards Board (“FASB”).
On April 16, 2001, the Bank filed a lawsuit against GKCO in the Unites States District Court for the Northern District of Illinois, Eastern Division. The Bank alleged that it lost money because the audit report prepared by GKCO contained errors. The U.S. District Court entered judgment in favor of GKCO and the Bank filed an appeal (Cheeseman, 2012, p. 897).
The main issue in question is: did the auditing company commit the tort of negligent misrepresentation and is therefore liable for the losses incurred by the bank as a result of errors in the audit report ?
Rule of Law
The court identified, discussed, and relied on several rules of law in the process of making its decision.
The primary legal issue was the claim of negligent misinterpretation and the secondary issue was the third party breach of contract. The Bank claimed that it suffered losses as a third-party beneficiary of the engagement contract to conduct the audit between Brandon and GKCO. The Bank also claimed that GKCO committed the tort of negligent misrepresentation. According to the definition, when the parties enter into a contact, they can agree that the performance of one of the parties should be rendered to or directly benefit a third party, which then becomes an intended third-party beneficiary (Cheeseman, 2012, p. 266). An intended third-party beneficiary has the right to enforce the contract against the breaching party. As described in Section 552 of the Restatement (Second) of Torts, an accountant is liable for his or her negligence to any member of a limited class of intended users for whose benefit the accountant has been employed to prepare the client’s financial statements or to whom the accountant knows the client will supply copies of the financial statements (Cheeseman, 2012, p. 896). An accountant can be found liable to a third-party beneficiary if the following conditions are met: (1) the client intended the accountant’s work to benefit or influence the third party; and (2) the accountant knew of that intent (Johnson Bank v. Korbakes, 2005). Both the U.S. …show more content…
District Court and the U.S. Court of Appeals for the Seventh Circuit determined that the breach of contract claim made by the Bank did not have possible merit and they devoted majority of the discussion to the primary legal question of the negligence of misinterpretation.
In order to prove the negligent misrepresentation claim, a party must establish: (1) the defendant’s duty to communicate accurate information; (2) a false statement of material fact; (3) the defendant’s carelessness or negligence in determining the truth or falsity of the statement; (4) defendant’s intent to induce the other party to act; (5) the plaintiff’s reliance on the false statement; and (6) the plaintiff’s damages resulting from that reliance (Johnson Bank v. Korbakes, 2005). Judge Pallmeyer believes that the court in Compass Bank v. King Griffin & Adamson P.C. made a relevant comment to § 552(2)(b) of the Restatement (Second) of Torts, which states that “the liability of the maker of a negligent misrepresentation is limited to the transaction that he intends, or knows that the recipient intends, to influence, or to a substantially similar transaction” (Johnson Bank v. Korbakes, 2006). Applied to the current case, it means that GKCO’s liability would be limited to the amount of the transaction it was intending to influence. Based on the evidence, the auditing company did not have knowledge regarding the amount of additional credit that the Bank claimed it extended based on the report, therefore it could not be liable for the loss due to credit extension.
Court’s Decision
The court’s opinion was delivered by the Circuit Judge Posner. The primary legal issue is the Bank’s claim of negligent representation. The court stated that the secondary issue of auditor’s liability for the loss suffered by the Bank as a third-party beneficiary to the audit engagement contract between Brandon and GKCO did not have a solid legal grounding. Judge Posner stated, that a third-party beneficiary status must be expressed in order for the breaching party to be found liable, as it was determined in prior court decisions in the following cases: People ex rel. Resnik v. Curtis & Davis, Architects & Planners, Inc., supra, 400 N.E.2d at 919; 155 Harbor Drive Condominium Ass 'n v. Harbor Point Inc., 209 Ill. App. 3d 631, 568 N.E.2d 365, 374-75, 154 Ill. Dec. 365 (Ill. App. 1991); A.E.I. Music Network, Inc. v. Business Computers, Inc., 290 F.3d 952, 955 (7th Cir. 2002) (Illinois law) (Johnson Bank v. Korbakes, 2006). The court did not find any evidence that showed that GKCO consented to have the Bank enforce the engagement letter or that GKCO knew that the Bank was going to rely on the audit in order to increase the amount of credit available to Brandon. The engagement letter did not reference the Bank in any way and the testimony suggested that a primary reason Brandon needed the audit was to enable the Bank to rectify a former employee’s error (Johnson Bank v. Korbakes, 2005). GKCO stated that a similar situation was addressed in Compass Bank v. King Griffin & Adamson P.C., 2003 U.S. Dist. LEXIS 15532, No. Civ. A. 3:01-CV-2028-N, 2003 WL 22077721 (N.D. Tex. Sept. 5, 2003), aff 'd, 388 F.3d 504 (5th Cir. 2004) (Johnson Bank v. Korbakes, 2005). In the referenced court case, the auditing company was not aware that the audited financial statements would be sent to the bank for the purpose of providing additional financing. Additionally, the court agreed with GKCO’s argument that the Bank was not able to prove in what way it relied on the misrepresentations made in the audit and, most importantly, prove that GKCO’s breach caused the damages.
The primary legal issue in the center of the court’s discussion was the negligent misinterpretation. The Bank stated that it relied on the audit prepared by GKCO when making the decision to increase the amount of credit available to Brandon, and it would not extend the credit if the audit did not violate GAAP, GAAS, and the FASB. Based on the evidence, the court confirmed that the audit contained two significant errors: the gain contingency was classified as a contra liability and a licensee’s sales were reported as the licensor’s sales. Even with the presence of the errors, the tort of negligence is not defined by the compliance of the audit report with the accounting rules and standards. Additionally, according to Illinois law, an auditing company is liable to a third party only if it was aware that the purpose of the audit report is to influence the third party, 225 ILCS 450/30.1; Kopka v. Kamensky & Rubenstein, 354 Ill. App. 3d 930, 821 N.E.2d 719, 726, 290 Ill. Dec. 407 (Ill. App. 2004) (Johnson Bank v. Korbakes, 2005). GKCO did not owe a duty of care to the Bank, and therefore it did not commit a fraud of negligent misrepresentation.
The judge noted that even though the gain contingency was erroneously classified as a contra liability, the additional information provided in the footnotes of the audit report specified that if the company lost the lawsuit, the $1,000,000 would be reclassified from the gain contingency to goodwill (Johnson Bank v. Korbakes, 2006). It was not reasonable for the Bank to reply on the opinion of the auditing company regarding the outcome of the pending lawsuit. As a sophisticated financial institution, it could conduct additional investigation regarding the likelihood of winning the lawsuit (Johnson Bank v. Korbakes, 2006). Similar situation occurred with the incorrect reporting of licensee’s sales: GKCO provided additional information in the notes that would enable the bank to determine the amount of sales specifically attributed to the licensee. The judge summarized his opinion regarding the reliability of the audit report by stating that the Bank could not base its claims on a refusal to read the audit report in its entirety, especially considering that it is clearly stated in the report that "the notes on the accompanying pages are an integral part of these financial statements” (Johnson Bank v. Korbakes, 2006). The Bank also argued that GKCO must have included “going concern qualification” in the audit report in order to correctly reflect that situation where the company’s statements demonstrate the high risk of bankruptcy. The judge doubted the reliance of the Bank on the possible presence of the “going concern” qualification in the audit report, considering that the Bank demonstrated the awareness of the increased risk of bankruptcy when it agreed to waive the violations of the credit agreement with Brandon prior to receiving the audit report. According to the opinion of the U.S. District Court for the Northern District of Illinois, the analysis of the loan history between the Bank and Brandon prior to the audit engagement with GKCO does not support the Bank’s claim regarding reliance on the audit report in extending the additional credit to Brandon (Johnson Bank v. Korbakes, 2005). The Bank chose to ignore various signs of financial distress, such as large overdrafts in Brandon’s checking account, and made the decision about providing additional funds to Brandon prior to the receipt of the audit report. The Banks decisions regarding lending to Brandon seemed to be driven by the fear of Brandon going bankrupt and hope of possibility of future repayment, rather than on the data contained in the audit. Upon the receipt of the audit report, Thomas Wolfe, Senior Vice President of the Bank, did not forward the report to any other lending officers. He did not express any concerns regarding the findings of the report or regarding the discrepancies that existed between the data contained in the “borrower’s certificates” and the audited statements. The main purpose of the audit report is to express an opinion regarding the compliance of the financial statements of the company with GAAP and to detect any material misstatements, rather than provide an estimate of its ability to pay back loans.
The court believed that even with presence of some errors, the audit report fully disclosed all the important information regarding the state of the company’s financial
health.
Conclusion
The auditing company is not liable for the losses incurred by the Bank as a result of the additional loans it made to Brandon after the receipt of the audit. Even if GKCO was found liable of the negligent misrepresentation, it did not have any information about the amount of additional loans that the Bank would lend Brandon relying on the audit.
References
Cheeseman, H. (2012). Contemporary business and online commerce law. (7th ed., p. 8). Upper Saddle River, NJ: Prentice Hall
Johnson Bank v. Korbakes. 472 F.3d 439. (2005). Retrieved from www.lexisnexis.com/hottopics/lnacademic
Johnson Bank v. Korbakes. 472 F.3d 439. (2006). Retrieved from www.lexisnexis.com/hottopics/lnacademic