By Matthew D. Holmes of Ernstrom & Dreste LLP
Published Summer 2021
A surety typically relies, at least in part, on reports and financial statements provided by its principal to make bond underwriting decisions. What happens if the principal’s accounting firm misrepresents the financial health of the principal’s company and the surety later incurs losses? A federal district court in Pennsylvania ruled that a surety’s claim against an accounting firm in just those circumstances could proceed, finding that the surety showed sufficient details of the misrepresentation.1 The decision highlights important considerations for any similarly situated surety, including the need to review applicable state law.
In the case, the surety alleged that the accounting firm (“JPMC”) prepared a 2017 independent auditor’s report, financial statement and related schedules for its principal (“Cohen”), concluding that Cohen was expected to remain profitable in the upcoming year. JPMC affirmed that the audit conformed to generally accepted auditing standards (“GAAS”). The financial statement:
“…opined that the information [therein] presented fairly, in all material respects, the financial position of Cohen in conformity with generally accepted accounting principles (“GAAP”) …”
The surety further alleged that it justifiably relied on JPMC’s representations in evaluating and approving Cohen’s requests for surety bonds and surety credit, including performance and payment bonds for a 2018 project in Princeton, New Jersey.
It soon became apparent that the 2017 report and financial statement significantly oversold Cohen’s financial status and ability to operate as a going concern. Cohen defaulted on the Princeton project and the surety was called upon to complete the work, allegedly incurring significant losses and expenses, including attorney’s fees. JPMC’s 2018 independent auditor’s report disclosed significant operating losses for Cohen, and liabilities markedly exceeding assets.
In 2020, the surety brought suit against JPMC for negligent misrepresentation alleging that the information contained in Cohen’s 2017 financial statement provided by JPMC was not GAAP-compliant, and that JPMC’s audit itself was not GAAS-complaint, at least in part because of its reliance on unverified figures from Cohen. The surety presented a JPMC draft financial statement reflecting a nearly $10 million “revenue adjustment” due to work in progress and percentage completion errors, as compared to the 2017 financial statement.
JPMC moved to dismiss the surety’s complaint, arguing that the surety failed to allege a specific misrepresentation of material fact. The court was unpersuaded, finding that the surety identified several specific misrepresentations, including that JPMC’s 2017 financial statement overstated the value of Cohen’s contracts by $10 million.
JPMC next argued that the surety failed to show an intent by JPMC to induce the surety to act. Under Pennsylvania law, the court explained, a negligent misrepresentation claim does not require actual knowledge, but instead requires only a traditional duty of care for foreseeable harm. Even so, the court said, the surety here sufficiently alleged both foreseeability and actual knowledge by JPMC that its reports would be shared with, and relied upon by, the surety.2
Finally, the court found the surety had properly alleged damages, despite unresolved disputes as to its obligations on the Princeton project.3 It is sufficient at the early stages of litigation that the surety claims that it “is incurring significant expenses, including attorney’s fees, in attempting to mitigate and recover for its losses in connection with the [bonds],” reasoned the court.
Negligent misrepresentation actions against a principal’s accountant can be tricky but, as this case shows, are not impossible. Be aware that jurisdictions vary as to the proof required to be successful, but if the accountant reports provided are way out of line with the principal’s actual condition, it may be worth exploring such a claim if losses are experienced.
1 Platte River Ins. v. Joseph P. Melvin Co., 2020 U.S. Dist. LEXIS 214284 (E.D. Pa., November 17, 2020).
2 Some states, like New York, have circumscribed liability for negligent misrepresentation claims against accountants by non-clients, requiring a “near privity” relationship, proof that reports were created for a particular purpose, and conduct by the accountant linking it to the third party. See, e.g. Credit Alliance Corp. v. Andersen & Co., 65 N.Y.2d 536 (1985).
3 The issue of the surety’s obligations on the Princeton project was the subject of litigation pending before another court.
Matthew D. Holmes is an Associate with Ernstrom & Dreste LLP. He represents sureties, corporations, contractors, subcontractors, design professionals, and construction managers on a wide array of commercial, construction, and surety issues. He can be reached at mholmes@ed-llp.com or 585.473.3100.