BUSINESS 101 – The defendants Pascarella and Trench, general partners of the accounting

Case 6-4
Anjoorian et al.: Third-Party Liability
In the case of Paul V. Anjoorian v. Arnold Kilberg & Co., Arnold Kilberg, and
Pascarella & Trench, the Superior Court of the State of Rhode Island
used prior SEC rulings to guide its decision on what is the auditor’s liability
to third parties. The court denied the defendant’s motion for summary judgment.
The facts of the case are described in Exhibit 1.
Exhibit 1 – Facts of the Case
The defendants
Pascarella and Trench, general partners of the accounting firm Pascarella &
Trench (P&T), asked the court for summary judgment in their favor with
respect to plaintiff Anjoorian’s claim that P&T committed malpractice in
the preparation of financial statements, and that the plaintiff (Anjoorian)
suffered pecuniary harm as a result.
Anjoorian
formerly owned 50 percent of the issued shares of Fairway Capital Corporation
(FCC), a Rhode Island corporation. The three children of Arnold Kilberg held
the other 50 percent of the shares. Arnold Kilberg himself owned no stock in
the corporation, but served as the day-to-day manager of the company. FCC was
in the business of making and servicing equity loans to small businesses under
the regulation of the U.S. Small Business Administration (SBA), and was
capitalized by loans from the SBA and a $1.26 million investment by Anjoorian.
Beginning in
1990, P&T provided accounting services to FCC. The firm audited FCC’s
annual financial statements ­following the close of each calendar year between
1990 and 1994. In its representation letter (similar to current Section 302
requirement under SOX), P&T stated that FCC was “responsible for the fair
presentation in the financial statements of financial position.” P&T’s
responsibility was to perform an audit in accordance with GAAS and to “express
an opinion on the financial statements” based on the firm’s audit. The first
page of each financial statement contained the auditor’s opinion that “the
financial statements referred to above present fairly, in all material
respects, the financial position of FCC in conformity with generally accepted
accounting principles.” Each report is addressed to “The Board of Directors and
Shareholders.” The 1990–1994 statements indicate that “it is management’s
opinion that all accounts presented on the balance sheet are collectible.”
In addition, the 1991–1994 statements indicate that “all loans are fully
collateralized” according to the board of directors.
On March 2,
1994, Anjoorian filed a complaint and motion for a temporary restraining order
seeking the dissolution of FCC on various grounds. P&T was not a party to
that suit. As a result of that action, the three Kilberg ­children exercised
their right to purchase the plaintiff’s shares of the corporation. The court
appointed an appraiser to determine the value of Anjoorian’s shares, which the
other shareholders would have to pay. The bulk of FCC’s assets were its right
to receive payment for the loans it had made. The appraiser determined that the
value of the corporation was $2,395,000, plus a payroll adjustment of $102,000,
and minus a “loss reserve” adjustment to account for the fact that 10 of FCC’s
30 outstanding loans were delinquent. The loss reserve adjustment reduced the
total appraised value of the corporation by $878,234. Consequently, Anjoorian’s
50 percent interest in the corporation was reduced accordingly by $439,117. He
ultimately received a judgment for $809,382.85 against the other shareholders
in exchange for the buyout of his shares.
In 1997,
Anjoorian brought the lawsuit against Kilberg, Kilberg’s Company, and P&T.
He claimed that P&T was ­negligent in preparing the annual financial
statements for FCC because it did not include an accurate loan loss reserve in
the statements. Anjoorian argued that he relied on the financial statements
prepared by the defendants, and that if the statements had included a loan loss
reserve, he would have sought dissolution of the corporation much earlier than
1994 when his shares would have been more valuable. ­Anjoorian ­submitted an
appraisal suggesting that the ­appropriate loan loss reserve figure would have
been much less—and, therefore, his share value much higher—in the years 1990
and 1991. He alleged that he lost over $300,000 in share value between 1990 and
March 2, 1994. Nine years later, the ­defendants moved for summary judgment on
the grounds that P&T owed no duty to Anjoorian as a shareholder, and that
his claims are barred by the statute of limitations.
Statute of Limitations
A claim for
accounting malpractice must be commenced within three years from the time of
the occurrence of the incident that gave rise to the action. The acts of
malpractice alleged by Anjoorian are the failure of P&T to include an
accurate loan loss reserve in each of four financial statements for the years
1990 through 1993. Anjoorian filed his complaint on February 27, 1997, which
meant that acts of malpractice that occurred prior to February 27, 1994, were
barred unless the discovery rule had applied. The discovery
rule provides that for injuries or damages “which could not in the
exercise of reasonable diligence be discoverable at the time of the occurrence
of the incident which gave rise to the action, the lawsuit shall be commenced
within 3 years of the time that the act or acts of the malpractice should, in the exercise of reasonable diligence, have been
discovered.” Because the defendants did not present evidence that foreclosed
this possibility, the court found that there existed a genuine issue as to when
the pertinent facts were discovered, and therefore the court could not conclude
that Anjoorian’s claims should be barred for purposes of this summary judgment
motion.
Duties Owed by Accountants in the Preparing of
Financial Statements
The defendants
argued that they are entitled to summary judgment on the plaintiff’s negligence
claim because P&T owed no duty to him as a shareholder of FCC. The Supreme
Court has acknowledged that the duty of accounting professionals to third
parties is an open question in Rhode Island, but it did identify at least three
competing views: the foreseeability test, the near-privity test, and the Restatement test.
There are two competing policy concerns
underlying each of the tests. The first is compensation, because a person who
relies on an accountant’s work product should not have to bear the loss arising
from that accountant’s malpractice. However, a second policy favors limiting
liability for accountants to certain individuals or groups of individuals in
order to make the risk of loss manageable. In the financial world, there is a
significant potential for the widespread dissemination of the information from
financial statements beyond the uses for which it was prepared.
An auditor can balance the risks and
rewards involved with the uses of financial information only if he knows the
uses to which the information will be put. “By receiving notice of the third
parties to whom potential liability may be incurred, the auditor can decide
whether to accept the engagement, adjust the audit plan to meet the needs of
third parties, and/or negotiate audit fees that are commensurate with the scope
of liability.” Therefore, many courts have placed limits on the scope of an
auditor’s potential liability so that they might ­successfully manage the risks
inherent in their profession.
Case Analysis
The court found
that the addressing of the reports to the shareholders, while not conclusive,
is a strong indication that P&T intended the shareholders to rely upon
them. ­Therefore, the court concluded that genuine issues of fact exist as to
whether P&T intended for Anjoorian to rely on these financial statements.
Perhaps the court would have reached a different conclusion for a widely held
public ­corporation with a potentially unlimited number of shareholders whose
identities change regularly. Here, however, FCC was a close corporation with
only four shareholders, giving greater significance to the fact that the
financial statements were addressed “to the shareholders.”
The defendants also argued that, in order
to find a duty to third parties, an accountant must have contemplated a
specific transaction for which the financial statement would be used and that
no such transaction was contemplated here. The court found this argument
unconvincing, stating that the case is unusual in that the alleged malpractice
did not arise from a specific financial transaction. The typical case involves
a person whose reliance on a defective financial statement induces the person
to advance credit or invest new equity into the corporation. When the
investment is lost, or the loan unpaid, the person sues the accountant. In this
case, however, Anjoorian had already invested his capital in the corporation
when P&T was hired, and alleges that he used the financial statements as a
tool to evaluate the value of that investment. The alleged malpractice did not
result in his advancing new value to the corporation and then losing his
investment, but instead resulted in Anjoorian failing to withdraw his capital
from the corporation while its value was higher.
The court opined that it would have no difficulty
finding a duty in this case, in the absence of a specific financial
transaction, if it can be shown that P&T intended the shareholders to rely
on the financial statements for the purpose of evaluating the financial health
of the company and, therefore, their investment in the company. In this case,
the “particular transaction” contemplated by the Restatement
relates to the purpose for which the financial statements would be used—the
shareholders’ decision whether to withdraw capital or not. While it remains to
be proved that P&T actually did foresee that its financial statements would
be used by the shareholders in this manner, the absence of a particular
financial transaction does not preclude the finding of a duty in this case.
Because the value of the shareholders’ investment was limited to the amounts
reflected in the company balance sheets, any loss from malpractice was an insurable
risk for which accounting professionals can plan. Further, the accountants may
have further curtailed their exposure by placing an appropriate disclaimer on
the financial statements to warn shareholders that they rely on the financial ­statements
at their peril. Therefore, the policy that would justify limits on accountant
liability would not apply if the requisite intent were found.
The defendants argued that the
plaintiff’s theory of damages is speculative and against public policy.
Anjoorian based his damage claims on the assertion that he relied on four
annual audited financial statements to evaluate the status of his $1.26 million
investment in FCC. Because the statements failed to include a loan loss reserve
figure, he argued that the statements overstated the value of the corporation
at the end of each year from 1990 to 1993. When Anjoorian sought dissolution in
1994, the value he obtained for his shares was significantly less than his
expectation. He contended that if he had accurate financial information, he
would have liquidated his investment earlier when his shares were more
valuable. At issue was the existence and amount of the loan loss reserve.
An appraiser of the value of the corporation in the dissolution action
determined that the inclusion of a loan loss reserve in the financial
statements was proper, and that ­created a ­genuine issue as to whether a
breach of the duty of care occurred. The defendant had questioned the
computation of the loan loss reserve but the court disagreed. (A detailed
analysis of the amount of loan loss reserve has been omitted.)

Ethical Issues
This case uses prior SEC
rulings to identify the scope of the relationship between a shareholder and a
company to determine an auditor’s liability to that third party.
Under the theory of
deontology, in using the foreseeability test, the auditors owe a duty to the
shareholders of FCC since it is reasonably foreseeable that shareholders will
use the financial statements to value their investment. Under the privity and near privity test there
was no duty to the shareholder, only to those in contract with the
auditors.

If analyzing using the
rights theory the shareholders of the corporation had a right to receive
accurate and timely information on the financial statements. Under the justice theory, it is only fair
that the company and the auditors (limited extent) should take responsibility
for the false statements and incur the shareholder’s loss.

Questions
1. The auditors (P&T) claimed to have no duty
to Anjoorian as a shareholder of FCC. The Rhode Island Supreme Court
acknowledged that the duty of accounting professionals to third parties is an
open question in the state, but it did identify at least three competing views:
the foreseeability test, the near-privity test, and the Restatement
test. Briefly describe the legal reasoning with respect to each of the three
liability standards and how they pertain to the facts of the case.

2. The court decision refers to the importance of
the auditors’ knowing about third-party usage of the audited financial
statements. What role does such knowledge play in enabling auditors to meet
their professional and ethical responsibilities?