Surety Company Sues Accountants After Contractor Defaults

Surety Company Sues Accountants After Contractor Defaults

A Pennsylvania federal judge ruled that a surety company had the right to rely on audited financials prepared by an accounting firm on behalf of a construction company. This case is yet another example on how third parties often have the right to sue for accounting malpractice even when they were not a client of the accounting firm.

Platte River Insurance Company is based in Wisconsin. A large portion of their business is derived from issuing performance bonds to construction companies. In 2018, M. Cohen and Sons (Cohen) was awarded a contract to provide metalwork needed in a large construction project in Princeton, New Jersey.

Typical of construction projects, the project owner wanted Cohen to provide a surety bond in case Cohen was unable to complete the project. Cohen obtained a bond from Platte River.

Before issuing the bond, Platte River wanted to see audited financials. They wanted to know that Cohen was financially secure and therefore able to complete the multi-million dollar project. Cohen provided a financial statement performed in 2017 by Joseph P. Melvin Company (JPMC), a Pennsylvania accounting firm.

The financials received by Platte River consisted of an Independent Auditor’s Report and a financial statement signed by the accounting firm. Those financials said that,

 “JPMC had conducted an audit in accordance with generally accepted auditing standards (GAAS) of Cohen’s balance sheet, related statement of income and retained earnings, cash flow, and the related notes and schedules to the financial statement, and, except for certain qualifications that are not relevant for the purposes of this action opined that the information in Cohen’s financial statement and related schedules, presented fairly, in all material respects, the financial position of Cohen, in conformity with generally accepted accounting principles (GAAP).”

By issuing the bond, Platte River agreed to become liable for the cost of performing the contract should Cohen fail to do so, and to pay the laborers, subcontractors and materials suppliers for the cost of the labor and materials provided by Cohen should it fail to pay those costs.

It doesn’t take a genius to figure out what happened next. The project owner declared Cohen in default. Although Cohen is litigating that issue, the building owner called on Platte River to pick up the pieces and finish Cohen’s obligations under the contract.

What went wrong? It appears that Cohen was financially unable to finish the contract.

According to the lawsuit, a year after issuing the bond, Cohen’s controller sent Platte River a revised financial statement that now said the company’s liabilities exceeded its assets. Suddenly JPMC ,which just a year earlier said the company was solid, was now questioning its ability to continue as a going concern. Too late for Platte River, however. They had already issued the bond.

Changing a financial statement is bad but that alone isn’t enough to cause an accounting firm to be liable to a third party which had relied on its financial statements. After all, a construction company can have a great year and 12 months later have a terrible year.

Platte River says JPMC is liable, however, because the 2017 audited financials were based on internal figures supplied by Cohen “without performing the level of testing and procedures that one would expect in a full audit. At this meeting, a representative of Cohen further expressed that Cohen had suspected problems with its financial reporting for approximately two years, and that had JPMC performed a proper audit, Cohen [believed the issues would have been caught earlier.” In other words, JPMC simply took Cohen’s word for some financial data without performing any type of audit. Platte River believes the accounting firm was lazy.

In July 2020, Platte River sued the accounting firm claiming that it had the right to rely on its audited financial statements and that those financial statements were faulty.

Typical in these third party liability cases, the accounting firm JPMC filed a motion to dismiss. They claimed that since Platte River had never hired them to audit Cohen, Platte River had no right to rely on their financials.

The court disagreed.

Accounting Malpractice – Negligent Misrepresentation Claims

Platte River says it not only had the right to rely on the audited financials but that those financials were incorrect. The insurance company sued on a theory of negligent misrepresentation.

In Pennsylvania – like most states – the elements of negligent misrepresentation require the person suing to prove the following:

  • A misrepresentation of a material fact
  • made under circumstances in which the defendant ought to have known its falsity
  • with an intent to induce another to act on it
  • which results in injury to a party acting in justifiable reliance on the misrepresentation.

Note that there is no requirement that the victim be a client of the accounting firm. Instead, the victim merely must prove that it justifiably relied on the misrepresentation.

Can a bonding company rely on work done by an accounting firm if they didn’t hire that firm? Yes.

Here, the judge correctly ruled that there was no requirement that Platte River prove that the accounting firm actually knew that Platte River was going to rely on its financial statement. It was enough that accounting firms knew or should know that construction companies use audited financials in order to get surety bonds. In other words, by providing audited financials to a construction company like Cohen, it was “foreseeable” that JPMC’s financials would be used by bonding companies.

The American Institute of Certified Public Accountants’ Audit and Accounting Guide notes:

“On virtually all public work and on some private work, bid security is usually required to provide some assurance that only qualified, responsible contractors submit bids. In the construction industry, bid security bonds, as well as performance bonds and payment bonds, are provided by surety companies. … Because of the large number of small enterprises in the construction industry, construction contractors' financial statements are used most frequently for credit and bonding purposes…”

The case is still in its early stages. By ruling against the motion to dismiss, the court merely ruled that the accounting malpractice and negligent misrepresentation case against JPMC could move forward. Unless the case is later settled or dismissed, a jury will determine whether JPMC was negligent in its preparation of the financial statements and if Platte Rivers’ reliance on those statements was reasonable.

Are You the Victim of Audit Malpractice?

It’s not just surety companies that rely on audited financial statements. They are routinely relied on by investors, insurance companies, prospective clients, purchasers, and banks. If you reasonably relied on a financial statement that turned out to be false, you may have a claim against the accounting firm who prepared the financials.

To learn more, visit our accounting malpractice information page. Ready to see if you have a case? Contact us online, by email [hidden email] or by phone at 877.858.8018. All inquiries are kept strictly confidential.

Photo credit: Scott graham and unspash.com

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