Johnson Bank v. George Korbakers & Co., LLP

In this diversity suit governed
by Illinois law, a bank complains that it lost money as a
result of errors in an audit of one of its borrowers, Brandon
Apparel Group, Inc., by the defendant, GKCO. The bank
contends both that it is a third-party beneficiary of the
letter contract by which Brandon retained GKCO to
conduct the audit and that GKCO committed the tort of
negligent misrepresentation. The district judge rejected
the bank's contract claim without much discussion but
conducted a bench trial of the tort claim and afterwards entered judgment in GKCO's favor on both the contract
and tort claims.

GKCO argues that the bank abandoned its contract
claim in the district court and so should not be heard to
renew it in this court. The bank argues that it did not
abandon it. No matter; the claim has no possible merit. To
be a third-party beneficiary of a contract is to have the
rights of a party, which is to say the power to sue to enforce
the contract. People ex rel. Resnik v. Curtis & Davis,
Architects & Planners, Inc., 400 N.E.2d 918, 919-20 (Ill. 1980);
Robins Dry Dock & Repair Co. v. Flint, 275 U.S. 303 (1927)
(Holmes, J.); Restatement (Second) of Contracts § 304 (1981).
Parties to contracts are naturally reluctant to empower
a third party to enforce their contract, so third-party
beneficiary status ordinarily is not inferred from the
circumstances but must be express. People ex rel. Resnik v.
Curtis & Davis, Architects & Planners, Inc., supra, 400 N.E.2d
at 919; 155 Harbor Drive Condominium Ass'n v. Harbor Point
Inc., 568 N.E.2d 365, 374-75 (Ill. App. 1991); A.E.I. Music
Network, Inc. v. Business Computers, Inc., 290 F.3d 952, 955
(7th Cir. 2002) (Illinois law). It wasn't in this case. The fact
that Brandon wanted the audit in order to help it get
additional loans from the bank doesn't show that GKCO
consented to have the bank enforce the engagement
letter. And the fact that the bank knew about the audit
contract and received the audit report doesn't mean that
GKCO knew that the bank would be relying on the
report to guide its decision on lending Brandon more
money, and, knowing that, meant to assume the costs of
misplaced reliance should it make mistakes in the audit. Cf.
Alaniz v. Schal Associates, 529 N.E.2d 832, 834 (Ill. App.
1988).

The claim of negligent misrepresentation has a slightly
better grounding, and let us turn to that claim.

Brandon made and sold clothing, although it also
licensed the making and selling of much of its clothing
in exchange for a percentage of the licensee's sales revenues.
Brandon began borrowing money from Johnson
Bank in 1997 and by the end of April 1999 owed the bank
$10 million - and wanted more, and the bank lent it
more, which the bank lost, along with the $10 million,
when Brandon went broke the next year.

It was in late April of 1999, when Brandon was seeking
the additional loan from the bank, that it instructed GKCO
to give the bank the audit report that GKCO had just
completed. The report summarized Brandon's financial
results for 1998 and revealed that the firm had serious
problems. But the report contained errors, which the
bank argues painted Brandon's situation in brighter hues
than the audit justified and as a result induced the bank to
keep lending to Brandon.

The report classified a $1 million claim in a lawsuit that
Brandon had brought against its previous owner as a
"contra liability," which means an offset to liabilities,
and thus in effect an asset. It should have been classified
as a "gain contingency," and such a contingency, because
of its uncertainty, should not be listed on the company's
books as a gain unless and until it materializes. SEC v.
Yuen, No. CV 03-4376 MRP (PlAX), 2006 WL 1390828, at *9
(C.D. Cal. Mar. 16, 2006); Financial Accounting Standards
Board, Statement of Financial Accounting Standards No. 5,
17, pp. 7-8 (1975); Jan R. Williams & Joseph V. Carcello,
Miller GAAP Guide 9.02 (2004). By treating the claim as a
contra liability, the report made it look (at least if one
looked no farther than the label) as if Brandon were
worth up to $1 million more than it would otherwise have appeared to be worth, though how much more
would depend on the probability of Brandon's prevailing
in the lawsuit, which nobody knew.

Another error was the audit's classification of the licensee's
sales as sales by Brandon itself, which inflated
Brandon's listed sales by more than 50 percent. Brandon's
income from the licensee's sales was not inflated as a result
of the classification. But still it was wrong to treat
sales by another company as if they were Brandon's
sales, because it made Brandon look much bigger than it
actually was.

GKCO also permitted Brandon to treat as prepaid
expenses what the bank argues were actually accounts
receivable. A prepaid expense is an asset created by a
firm's paying for some good or service in advance. An
example is insurance; the premium is paid before a
claim is submitted to the insurance company. An account
receivable is an asset consisting of a right to payment
from a customer. Although there is always a risk that a
supplier whom one has paid in advance will default,
the likelihood is generally less than that an account receivable
will prove uncollectible, because a company is
likely to know its suppliers better than it knows its customers,
and is therefore less likely to be stiffed by a supplier
than by a customer. That is why prepaid expenses
and accounts receivable are required to be listed
separately on the balance sheet - with the latter reduced
by an allowance for bad debts. Williams & Carcello, supra,
at 3.07-.08. But the asset in question in this case involved a
credit from a supplier, which is properly classified as a
prepaid expense. Galli v. Metz, No. 87-CV-973, 1991 WL
175334, at *8 (N.D.N.Y. Sept. 9, 1991), rev'd in part on
other grounds, 973 F.2d 145 (2d Cir. 1992); In re Integrated
Health Services, Inc., 344 B.R. 262, 271 (Bankr. D. Del. 2006).

The other errors of which the bank complains were
contested, and they were either trivial or found by the
district judge, with adequate basis in the record, not to be
errors. Still, there were errors in the report - the listing of
a gain contingency as a contra liability and of a licensee's
sales as the licensor's sales. But here is the rub. The tort of
negligent misrepresentation does not create liability for
violating accounting conventions, as such; the elements of
the tort must be present. In addition, under Illinois law
an auditor is liable to a third party, that is, to someone
different from the firm that hired it to audit its books,
only if the auditor knew that the firm wanted to use the
audit report to influence a third party, 225 ILCS 450/30.1;
Kopka v. Kamensky & Rubenstein, 821 N.E.2d 719, 726 (Ill.
App. 2004). The audit report might flunk Accounting 101,
but if the report didn't mislead anyone toward whom
the auditor had a duty of care, the auditor would not
have committed a tort.

That is this case. A footnote in the report identified the
"contra liability" as a claim in a lawsuit. The note did
not suggest that the lawsuit was a sure thing for Brandon;
all it said was that "The Company [Brandon] is currently
a plaintiff in a lawsuit against Pearson [the company's
previous owner] wherein they allege that Pearson misrepresented
the value of the assets sold and liabilities
assumed in the acquisition of the business . . . . Should
the Company not prevail in the lawsuit, the $1,000,000
will be reclassified to goodwill, representing an additional
amount paid at acquisition in excess of the fair
market value of the assets acquired." 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 Brandon would win its suit and if so obtain and collect a $1 million award. How
would the auditor know? If the bank wondered how
solid the claim was, it could have investigated.

The licensee's sales should not have been lumped in
with Brandon's. But once again, a footnote eliminated
any possibly misleading impression by disclosing clearly
the amount of the licensee's contribution to Brandon's
sales numbers.

At root the bank's argument for liability is that it
was entitled to look no farther than the bottom-line numbers
in the audit report. That is incorrect; it had no right
to ignore the footnotes in the report, which together
with the numbers in it gave the reader an accurate picture
of Brandon's financial situation. The bank cannot base a
claim for damages on a refusal to read. The audit report
even says that "the notes on the accompanying pages
are an integral part of these financial statements." See
Clyde P. Stickney & Roman L. Weil, Financial Accounting:
An Introduction to Concepts, Methods, and Uses 17 (2000).

The bank argues that by the end of 1998, when the
audit was completed, Brandon's financial situation was
so lousy that the audit should have included a "going
concern qualification," that is, a warning that the audited
firm was teetering on the brink of bankruptcy. Copy-Data
Systems, Inc. v. Toshiba America, Inc., 755 F.2d 293, 299 (2d
Cir. 1985); see American Institute of Certified Public
Accountants, "The Auditors Consideration of an Entity's
Ability to Continue as a Going Concern," Statement on
Auditing Standards, No. 59, 5-6, pp. 3-4 (1988). But the
Bank was complicit in the omission of a going-concern
qualification. For before receiving the audit report it had
agreed to waive a number of restrictions in the loan
covenants precisely in order to spare Brandon the dreaded warning, which by indicating a serious risk of bankruptcy
would have scared off trade creditors and accelerated the
bankruptcy.

The bank imputes to GKCO a duty to advise it whether
lending more money to this faltering firm (throwing
good money after bad, as the saying goes) would
make commercial sense. But an auditor's duty is not to
give business advice; it is merely to paint an accurate
picture of the audited firm's financial condition, insofar as
that condition is revealed by the company's books and
inventory and other sources of an auditor's opinion. E.g.,
Bily v. Arthur Young & Co., 834 P.2d 745 (Cal. 1992); Jay M.
Feinman, "Liability of Accountants for Negligent Auditing:
Doctrine, Policy, and Ideology," 31 Fla. St. U. L. Rev. 17, 21-
22, 55-56, 58 (2003). An auditor who fulfills that duty, or
fails but manages not to mislead the intended readers of
the audit report, has no tort liability. Erroneous characterizations
can mislead, but not when the facts mischaracterized
are fully and accurately disclosed in
the audit report, as they were here.

The district judge was right, moreover, to find that
the bank did not rely on the mischaracterizations. It
kept lending money to Brandon in the hope of keeping
the firm from going broke and thus keeping alive the
hope of eventual repayment. That decision - the cause of
the bank's undoing - had nothing to do with the audit.

The losses the bank incurred as a result of the additional
loans that it made beginning in May 1999 could not be
recovered as damages even if GKCO had been guilty of
negligent misrepresentation. GKCO could not have predicted
how much money the bank would lend to Brandon
in reliance on the audit and with what consequences.

Damages so speculative are not recoverable in a lawsuit.
Trigano v. Bain & Co., Inc., 380 F.3d 22 (1st Cir. 2004); AUSA
Life Ins. Co. v. Ernst & Young, 206 F.3d 202 (2d Cir. 2000);
World Radio Laboratories, Inc. v. Coopers & Lybrand, 557
N.W.2d 1 (Neb. 1996); cf. Haslund v. Simon Property Group,
Inc., 378 F.3d 653, 658 (7th Cir. 2004) (Illinois law).

The other issues raised by the bank are thoroughly
considered and correctly resolved in the district judge's
meticulous 35-page opinion; we have nothing to add.
AFFIRMED.