By Matthew Garza,  JD, Writer/Analyst, Corporate Secretary's Guide, Federal Securities Law Reports

Court considers whether deficient auditing ''caused'' investors' loss

Could an accountant that knowingly certified false financial statements have foreseen that its certification would permit a company to avoid default on its debt obligations, thus allowing it to make a disastrous acquisition which would cause the company's investors to lose approximately $100 million? This question of ''loss causation'' will be answered by the United States District Court for the Southern District of New York, which will reconsider the case on remand from the Second Circuit U.S. Court of Appeals. The appeals court said that some may feel that the case could open the ''barn door'' for abusive law suits against accountants, but it felt nonetheless that ''proper commercial morality'' compelled it to afford a remedy to the investors.

The case arose when a group of insurance companies lost money on the securities of a company that went belly up after acquiring a computer retailer described as a ''veritable sinkhole for cash.'' The accounting firm partner in charge of the company's audits was a former colleague and good friend of the company's CEO, and was consistently persuaded by the CEO to overlook the company's financial misrepresentations when issuing ''no-default certificates'' to the investors. The investors' suit was dismissed in December of 1997 when the district court held that they did not establish that the accountant caused their loss by acquiescing to the company's financial misrepresentations. The district court criticized the ''seeming spinelessness'' of the partner, but reasoned that the company's downfall was not caused by his acquiescence, but rather by ''unforeseeable and independent post-audit events'' in the competitive world of personal computer sales. The Second Circuit Court of Appeals found that the lower court did not make sufficient factual findings to settle the causation question.

Causation

The second circuit opinion explained that the term ''causation'' includes two elements: transaction causation and loss causation. Transaction causation was found to be present in this case because there was sufficient evidence to show the investors relied on the certifications of financial soundness made by the accountant in making the decision to invest in the company. Indeed, the private placement notes held by the investors specifically required audits from the accountant as a condition of the investment.

The question of loss causation, or whether ''egregious accounting idiosyncrasies'' by the accountant proximately caused the investors' monetary loss, is more difficult to establish and will require further fact finding, second circuit Judge Oakes wrote. While the lower court found that the investors' loss was caused by outside forces, the court of appeals focused on the possibility that, if the accountant had accurately represented the company's financial condition, the acquisition might not have happened at all because the company would have been in default on the investors' notes. The court proffered that without a waiver or cure of the default, the acquisition could not have taken place.

Foreseeability

The focus of the appeals court was on foreseeability, saying the investor's damage must be a foreseeable consequence of the accountant's misrepresentation for liability to be established. The court asked whether the accountants could have reasonably foreseen that their certification of false financial information could lead to the demise of the company (and thus harm to the investors) by enabling the company to make an acquisition that otherwise would have been subjected to higher scrutiny. Upon remand the district court is charged with making the difficult factual determination of whether or not the accountant should have foreseen that its deficient no-default certifications would cause the investors' loss. A dissenting opinion issued by second circuit Chief Judge Winter stated that the lower court's findings were already sufficient to support a finding that loss causation existed, while a concurring opinion by Judge Jacobs said that the findings showed no loss causation could be established. AUSA Life Insurance Company v. Ernst and Young (2ndCir 2000) Docket No. 98-7162. The full text of this case is reported in the Federal Securities Law Reports, ¶90,772, available April 5, 2000.