Narrowing the Scope of Auditor Duties

By: David Margulies

St. John's Law Student

American Bankruptcy Institute Law Review Staff

 

Applying Indiana law, the Seventh Circuit firmly rejects the idea that a financial auditor has any obligation to investigate circumstances external to a company’s books and records in connection with its determination whether a going concern qualification should be included in an audit report.

[1]

The auditor must, however, consider and factor into its going concern determination information about external matters that it is “told by the firm or otherwise learns.”

[2]

 The trustee’s negligence and breach of contract claims against financial auditor Ernst & Young arose out of the collapse of Taurus Foods, a frozen meat distribution company that was involuntarily forced into bankruptcy two years after the issuance of an allegedly defective audit report.

[3]

The trustee asserted a “deepening insolvency” theory based on the auditor’s failure to include a going-concern qualification, thereby causing the managers of Taurus to refrain from liquidating immediately and losing an additional $3 million through continued operation.

[4]

The court first rejected the auditor’s argument that the trustee’s action was barred by the Indiana law principle that an auditor owes no duty to creditors of an audit client and that they cannot sue an auditor unless there is a contractual relationship with them.

[5]

 Although the trustee’s suit was really on behalf of the creditors, it did not constitute an impermissible end run around Indiana’s limitation on creditor suits.

[6]

  The trustee’s action was based on the duty the auditor owed to its client, Taurus, and that duty did not evaporate just because Taurus was bankrupt and the recovery would accrue to its creditors.

[7]

 

In general, an auditor’s duty is limited to reviewing the company’s self-prepared financial statements and confirming that they conform to the standards of the accounting industry.

[8]

Ernst & Young did not contract with Taurus to provide management consulting services, and as a financial auditor it is not required to give business advice, but merely reports a company’s financial condition.

[9]

Although the auditor’s duty does expand to include consideration of external matters in connection with a going concern opinion, the auditor is not required to investigate external matters and cannot be expected to duplicate the industry expertise that the audit client has in-house.

[10]

The audit need only consider external matters that are brought to its attention or of which it is aware and is not negligent for failing to discover or consider the negative trends in the frozen meat industry relied upon by the trustee.

[11]

 

The court’s limited view of the auditor’s duty regarding external matters is consistent with the earlier Seventh Circuit decision in Johnson Bank v. George Korbakes & Co.

[12]

 There, a financial auditor was not liable to a bank in negligent misrepresentation for additional money the bank loaned to a borrower. Although the auditor made errors in its report, it did not owe a duty of care under the relevant Illinois statute, and the report was not misleading when read in its entirety.

[13]

 The external factor involved in Johnson was whether the audit client would prevail in a pending lawsuit. The court noted that, “As a sophisticated financial enterprise, the bank could not reasonably have treated the auditor's characterization of the claim as an assurance by the auditor that [the company] would win its suit . . .”

[14]

 Accordingly, the bank could have investigated its claim on its own.

[15]

 

The Fehribach decision represents a victory for financial auditors who may be looked to as a possible source of recovery in bankruptcy.  However, the court’s suggestion that claims may be based on external information learned from sources other than the audit client may make it harder to dismiss suits against auditors with special industry expertise.  Although the Fehribach court did not outright reject the theory of deepening insolvency, Judge Posner’s musings about it may lay the foundation for its demise in the Seventh Circuit.


[1]

 Fehribach v. Ernst & Young LLP, 493 F.3d 905 (7th Cir. 2007).

[2]

Id. at 911.

[3]Id. at 908.

[4]Id.

[5]

See id. at 909.

[6]See id.

[7]See Fehribach v. Ernst & Young LLP, 493 F.3d 905, 909 (7th Cir. 2007).          

[8]Id. at 910.       

[9]See Johnson Bank v. George Korbakes & Co., 472 F.3d 439 (7th Cir. 2006).

[10]

See Fehribach, 493 F.3d at 911.

[11]

Id. at 911.

[12]

472 F.3d 439 (7th Cir. 2006).

[13]Id.

[14]

Id. at 443.

[15]

Id.