Hefty Audit Malpractice Case Dismissed due to Lack of Reliance

It is inevitable that blame will be cast on the auditor: when an investment tanks, when embezzlement is discovered, when stocks take a plunge. It is the independent auditor that concluded that the financial statements were presented fairly and therefore the auditor should have uncovered the ______________. Many plaintiffs follow this script. As a result, the defending auditor is left to argue that he is not responsible for the intentional acts of others or unforeseen changes in the underlying client’s business. This defense requires a fact intensive debate and the involvement of CPA experts; i.e. it’s expensive. A recent decision out of California, however, provides a strong argument for auditors that the plaintiff must establish actual reliance on the audit report in order to prove a claim.

The APL community has seen this countless times: once the cat is out of the bag and the true financial condition of an entity is uncovered, the plaintiff undoubtedly will allege that it was the auditor’s failure to detect/uncover the issue that caused the loss. That issue was recently adjudicated in Robert P. Mosier v. Stonefield Josephson, Inc., SDCA No. 2:11-cv-02666 PSG, a case arising from a massive Ponzi scheme.  In 2009, the SEC brought an action against a private equity group which was running a Ponzi scheme.  Two-years later, the group’s court-appointed receiver sued the group’s auditors for professional negligence.  According to the receiver, the auditor should have detected that the group’s management ran a fraud that bilked investors out of over $800 million.

In granting summary judgment, the district court agreed with the auditor’s argument that California law required the receiver to establish causation through reasonable reliance on the audit reports. According to the court: “instead of presenting actual evidence of reliance, the receiver argues that he need not prove reliance, and that there is causation because ‘[h]ad the proper standard of care been exercised by Defendant in preparing the audits, the fraud would undoubtedly have been publicly revealed much sooner, and tens of millions of dollars in damages would have been avoided.”  The court was unpersuaded by the Receiver’s argument regarding the alleged standard of care and dismissed the complaint due to failure to prove reliance on the audit reports. 

The fundamental element of causation generally, and reliance specifically, is often missing from the face of a professional malpractice claim. Particularly in the audit negligence context, a plaintiff may gloss over the fact that it did not actually rely on the audit report at any point before making any relevant decisions. Often, the decision to sue an independent auditor is hindsight driven and based on a series of unfortunate results, without proof that the auditor caused that result. This decision serves as an important reminder to all professionals, and those that defend them, to consider the fundamental elements of each cause of action including the requirement of causation and reliance when defending a claim.

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