Surety vs. Accountant – Pursuing the Principal’s Accountant
June 14, 2022
In this Surety Today blog post we will provide a Case Law Note to consider the issue of a surety asserting a claim against the Principal’s accountant for negligent misrepresentation in audited statements. Read on to learn more about suing the principal’s accountant.
(PLATTE RIVER INSURANCE COMPANY V. JOSEPH P. MELVIN COMPANY, LLC, 2020 WL 6747125 (E.D. Pa. Nov. 17, 2020).
In this case, a federal district court in Pennsylvania held that the bonded Principal’s surety properly stated a negligent misrepresentation claim against an accounting firm that audited the Principal’s financial statements. The Principal was in the business of designing and installing custom metal staircases, railings, and other metalwork products for construction and renovation projects. An accounting firm, audited the Principal’s 2017 financial statements and issued an audit report. The report included the statement that the Principal’s work in progress as shown on an attached schedule to the financial statements reflected that Principal’s construction contracts had been and were expected to remain generally profitable.
Shortly thereafter, the Principal was awarded a construction contract and Platte River issued a Performance Bond and a Payment Bond. Platte River alleged that it issued the Bonds in reliance on the audited financial statements. The next year the accounting firm issued an audit report for the Principal’s 2018 financial statements. The audit report disclosed significant operating losses and raised substantial doubt about the Principal’s ability to continue as a going concern. The audit report further stated that there was a failure to adequately monitor the progress of certain contracts and the gross profit estimates were significantly reduced in 2018. Therefore, losses were recognized on several contracts during 2018. As a result of these losses, the Company has negative stockholders’ equity and current liabilities exceed current assets.
Not long after the 2018 audit report was issued, Platte River was notified that its Principal had been declared in default and the bonded contract was terminated. Demand was made for Platte River to perform under the performance bond. The Surety filed suit against the accounting firm asserting negligent misrepresentation. Platte River pointed to a draft financial statement and work in progress schedule (“WIP”) for the period ending December 31, 2018, which was prepared by the accountants. The WIP schedule reflected an approximate $10 million “revenue adjustment” booked in 2018 due to work in progress completion errors as compared to the 2017 Financial Statement. In response to the Surety’s complaint, the accounting firm moved to dismiss.
Pennsylvania has adopted Section 552 of the Restatement (Second) of Torts, which sets forth the elements of a negligent misrepresentation claim.
Under Section 552, a plaintiff must allege:
(1) that a misrepresentation of a material fact was made
(2) that the misrepresentation was made under circumstances in which the defendant ought to have known of its falsity
(3) that the misrepresentation was made with an intent to induce another to act on it
(4) that the misrepresentation resulted in injury to the party acting in justifiable reliance on the misrepresentation.
In denying the motion to dismiss, the court held that the surety adequately alleged material misrepresentations in the 2017 audit report. Specifically, Platte River alleged that the 2017 Financial Statement overstated the value of the Principal’s contracts by $10 million due to the “completion errors.” The court further held that Platte River adequately alleged that its reliance on the 2017 audit report was foreseeable to the accountants. The court stated that a negligent misrepresentation claim does not require the defendant to have had actual knowledge of the plaintiff’s intended reliance – rather foreseeable reliance is sufficient. The evidence suggested in this case that the accountant was actually aware that the Principal would provide the 2017 audit report to its sureties. Even though Platte River disputed its obligations under the surety bonds, and that dispute was the subject of ongoing litigation in another case, the Court held that Platte River had alleged sufficient damages in the form of significant attorney’s fees in the litigation over its obligations under the surety bonds.
In this case, the issues were discussed in the context of a Motion to Dismiss, so the allegations in the complaint were taken as true. The Surety plead sufficient evidence that the accountants were lax in their auditing duties and were aware that the audit reports were being used to obtain bonding satisfying the elements of Section 552 of the Restatement. Claims against third party professionals like accountants, architects and engineers can be difficult because of the economic loss rule and privity in some jurisdictions. However, in jurisdictions where Section 552 of the Restatement has been adopted or where the strict requirement of privity has been abandoned or relaxed, such claims may be asserted.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.