Fehribach, Gregory v. Ernst & Young LLP ( 2007 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 06-3366
GREGORY S. FEHRIBACH,
Plaintiff-Appellant,
v.
ERNST & YOUNG LLP,
Defendant-Appellee.
____________
Appeal from the United States District Court
for the Southern District of Indiana, Indianapolis Division.
No. 03-CV-00551—John Daniel Tinder, Judge.
____________
ARGUED MAY 24, 2007—DECIDED JULY 17, 2007
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Before POSNER, KANNE, and ROVNER, Circuit Judges.
POSNER, Circuit Judge. The plaintiff is the trustee of
Taurus Foods, Inc., a small company engaged in the
distribution of frozen meats and other foods, which was
forced into bankruptcy under Chapter 7 of the Bankruptcy
Code by three of its creditors. The suit charges the com-
pany’s auditor, Ernst & Young, with negligence and
breach of contract in failing to include a going-concern
qualification in an audit report. The charges are governed
by Indiana’s Accountancy Act of 2001 because they arise
out of an agreement to provide professional accounting
services. Ind. Code § 25-2.1-1. The case is before us on the
2 No. 06-3366
trustee’s appeal from the grant of summary judgment to
the defendant.
In October 1995, Ernst & Young issued its audit report
for Taurus’s fiscal year 1995, which ran from January 1994
to January 1995. The report did not indicate a “substantial
doubt about the [audited] entity’s ability to continue as a
going concern for a reasonable period of time, not to ex-
ceed one year beyond the date of the financial statements
being audited.” American Institute of Certified Public
Accountants, Statement on Auditing Standards No. 59 (1988);
see Johnson Bank v. George Korbakes & Co., 472 F.3d 439, 443
(7th Cir. 2006); Copy-Data Systems, Inc. v. Toshiba America,
Inc., 755 F.2d 293, 299 (2d Cir. 1985); Drabkin v. Alexander
Grant & Co., 905 F.2d 453, 456 (D.C. Cir. 1990). That date
was January 1995. So the report indicated no “substantial
doubt” that Taurus would continue as a going concern
until at least January 1996. In fact Taurus didn’t declare
bankruptcy until two years later.
Taurus’s principal banker was Bank One. In May 1996,
some months after Taurus received the audit report from
Ernst & Young, the bank became alarmed by the deteri-
oration in Taurus’s financial condition and handed the
account to its Milwaukee office, which specialized in
handling risky loans. That office imposed restrictions on
Taurus that exacerbated the company’s business troubles.
In an attempt to stave off disaster, Lisa Corry, the com-
pany’s chief financial officer (and the daughter of one of
the company’s two owners), started defrauding Bank
One by inflating the company’s sales and accounts
receivable in daily reports that Taurus was required to
make to the bank. She was eventually caught, prosecuted,
convicted, and sent to prison. United States v. Corry, 206
F.3d 748 (7th Cir. 2000). The bankruptcy followed closely
upon the exposure of her fraud.
No. 06-3366 3
The trustee presented expert evidence that Ernst &
Young was negligent in failing to include a going-concern
qualification in its audit report for the 1995 fiscal year,
and that if it had done so the owners of Taurus—who were
not absentees, but managed the company—would have
realized that the company had no future and would
immediately have liquidated, averting costs of some $3
million that the company incurred as a result of its contin-
ued operation under the restrictions imposed by Bank
One’s Milwaukee office and other adversities.
The trustee’s damages claim thus is based on the theory
of “deepening insolvency.” This controversial theory (see,
e.g., In re Global Service Group, LLC, 316 B.R. 451, 456-59
(Bankr. S.D.N.Y. 2004)) allows damages sometimes to be
awarded to a bankrupt corporation that by delaying
liquidation ran up additional debts that it would not have
incurred had the plug been pulled sooner. As originally
formulated, the theory was premised on the notion that
borrowing after a company becomes insolvent would
“ineluctably” hurt the shareholders. Schacht v. Brown, 711
F.2d 1343, 1350 (7th Cir. 1983). That was a puzzling sug-
gestion because by hypothesis a company harmed by
deepening insolvency was insolvent before the borrowing
spree, so what had the shareholders to lose? But a corpora-
tion can be insolvent in the sense of being unable to pay its
bills as they come due, Jeffrey M. Lipshaw, “Law as
Rationalization: Getting Beyond Reason to Business
Ethics,” 37 U. Toledo L. Rev. 959, 1016 (2006) (“equity”
insolvency), yet be worth more liquidated than the sum
of its liabilities and so be worth something to the share-
holders; this was assumed to be a possibility in Schacht. 711
F.2d at 1348.
The theory could also be invoked in a case in which
management in cahoots with an auditor or other outsider
4 No. 06-3366
concealed the corporation’s perilous state which if dis-
closed earlier would have enabled the corporation to
survive in reorganized form. Sabin Willet, “The Shallows
of Deepening Insolvency,” 60 Bus. Law. 549, 565-66 (2005).
However, as explained in Trenwick America Litigation Trust
v. Ernst & Young, L.L.P., 906 A.2d 168, 204 (Del. Ch. 2006),
the theory makes no sense when invoked to create a
substantive duty of prompt liquidation that would
punish corporate management for trying in the exercise of
its business judgment to stave off a declaration of bank-
ruptcy, even if there were no indication of fraud, breach of
fiduciary duty, or other conventional wrongdoing. Nor
would it do to fix liability on a third party for lending or
otherwise investing in a firm and as a result keeping it
going, when “management…misused the opportunity
created by that investment…. [T]hey [management] could
have instead used that opportunity to turn the company
around and transform it into a profitable business. They
did not, and therein lies the harm to [the company].” In re
Citx Corp., 448 F.3d 672, 678 (3d Cir. 2006).
The present case is different from any of the cases that
we have cited. The owners of Taurus lost their entire
investment when the company became insolvent. They had
nothing more to lose. The only possible losers from the
prolongation of the corporation’s miserable existence
were the corporation’s creditors. In a state that allows
creditors (or shareholders) of the audited firm to sue the
auditor for negligent misrepresentation, provided that
the creditors’ reliance on the auditor’s report was foresee-
able, e.g., Citizens State Bank v. Timm, Schmidt & Co., 335
N.W.2d 361, 366 (Wis. 1983)—or, in some states, was
actually foreseen, Rhode Island Hospital Trust Nat’l Bank v.
Swartz, Bresenoff, Yavner & Jacobs, 455 F.2d 847, 851 (4th Cir.
No. 06-3366 5
1972); Ryan v. Kanne, 170 N.W.2d 395, 401-03 (Iowa
1969)—Taurus’s creditors could sue Ernst & Young di-
rectly. But Indiana, we have held (albeit with only tenuous
support in Indiana case law, as pointed out in First Commu-
nity Bank & Trust v. Kelley, Hardesty, Smith & Co., 663
N.E.2d 218, 219-20, 223-24 (Ind. App. 1996)), adheres to a
close approximation to Ultramares Corp. v. Touche, 174 N.E.
441 (N.Y.1931) (Cardozo, C.J.). And under the Ultramares
doctrine, or what we have taken to be its Indiana version,
creditors in the position of Taurus’s creditors, not having
a contractual relation with the auditor, have no claim
against it. Decatur Ventures, LLC v. Daniel, 485 F.3d 387, 390
(7th Cir. 2007) (Indiana law); Ackerman v. Schwartz,
947 F.2d 841, 846-47 (7th Cir. 1991) (same); see
PricewaterhouseCoopers, LLP v. Massey, 860 N.E.2d 1252,
1259-60 (Ind. App. 2007).
Taurus had the contractual relation, and thus could
sue, though because it is in bankruptcy and has been
liquidated the suit is really on behalf of the creditors;
anything that reduces the liquidation value of the corpora-
tion hurts them. That doesn’t make the suit an impermis-
sible end run around Indiana’s limitation of creditor
(or shareholder) suits against auditors. Realistically, a
corporation is a conduit for its stakeholders, but that does
not affect the corporation’s legal rights. Suppose Taurus
were solvent, yet still had been injured by the auditor’s
alleged negligence. The ultimate beneficiaries of the
suit would be Taurus’s shareholders, but no one would
suppose this anomalous even though the shareholders
themselves—the stakeholders in this example—could not
have sued the auditor. Remember that under Indiana law
(or what we have assumed to be Indiana law), Ernst &
Young has no duty of care to the creditors. But it does of
course have such a duty to its client, Taurus, and that duty,
6 No. 06-3366
on which this suit is founded, does not evaporate just
because the client is bankrupt and any benefits from suing
will accrue to its creditors.
The trustee’s claim fails nevertheless, but fails on the
facts, though not because Taurus survived for more than a
year (in fact three years) after the audit period. A going-
concern qualification is just a prediction; if it should
have been included in the audit report and harm resulted
as a foreseeable consequence of its omission, the auditor
is liable to the firm audited for that harm. Johnson Bank v.
George Korbakes & Co., supra, 472 F.3d at 443; see Ziemba v.
Cascade Int’l Inc., 256 F.3d 1194, 1208-11 (11th Cir. 2001).
Such cases are rare because it is unusual for the audited
firm to be able to make a plausible contention that it
could not have been expected to recognize its financial
peril on its own even though it supplied the financial
information on which the audit was based. Devaney v.
Chester, No. 83 CIV. 8455, 1989 WL 52375 (S.D.N.Y. May 10,
1989). The purpose of an audit report is to make sure the
audited company’s financial statements—which are
prepared by the company, not by the auditor, Jay M.
Feinman, “Liability of Accountants for Negligent Auditing:
Doctrine, Policy, and Ideology,” 31 Fla. St. U.L. Rev. 17, 21-
22 (2003)—correspond to reality, lest they either have been
doctored by a defalcating employee or innocently misrep-
resent the company’s financial situation. The auditor is
therefore required “to state whether, in his opinion, the
financial statements are presented in conformity with
generally accepted accounting principles and to identify
those circumstances in which such principles have not been
consistently observed in the preparation of the financial
statements of the current period in relation to those of the
preceding period.” American Institute of Certified Public
No. 06-3366 7
Accountants, “Responsibilities and Functions of the
Independent Auditor,” in Codification of Statements on
Accounting Standards, § 110.01 (2007); see Bily v. Arthur
Young & Co., 834 P.2d 745 (Cal. 1992). There is no conten-
tion that Ernst & Young failed to notice discrepancies
between the statements and the company’s actual financial
situation. There were no discrepancies. And no informa-
tion that the report contained or should have contained if
the audit was carefully done indicated that Taurus couldn’t
limp through another year—the report revealed positive
though slight net income in the most recent fiscal year
and no obligations that would mature in the next year
and by doing so might drive the firm under.
It is true that the report failed to warn Taurus of ominous
trends in the frozen-meat distribution business. Intensified
competition from national firms was causing Taurus to
lose customers, thus depressing the firm’s revenues; at the
same time, the company’s costs were rising because of
higher workers’ compensation premiums and other
untoward developments. But predicting Taurus’s future
cash flow on any basis other than the financial state-
ments for the audit year (which would for example reveal
existing loan-repayment obligations) was not the function
of the audit report. Ernst & Young had not contracted to
provide Taurus with management-consulting services.
“[A]n 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.” Johnson Bank v. George Korbakes &
Co., supra, 472 F.3d at 443.
But there is need to qualify what we have just said. The
requirement that the auditor disclose in its report any
8 No. 06-3366
substantial doubt it has that the firm will still be a going
concern in a year expands the auditor’s duty beyond that
of verifying the accuracy of the company’s financial
statements. The accounting standards require the auditor
to be on the lookout for “certain conditions or events that,
when considered in the aggregate, indicate there could be
substantial doubt about the entity’s ability to continue as a
going concern for a reasonable period of time. . . . The
following are examples of such conditions and events”:
# Negative trends—for example, recurring operating
losses, working capital deficiencies, negative cash
flows from operating activities, adverse key finan-
cial ratios
# Other indications of possible financial difficulties—for
example, default on loan or similar agreements,
arrearages in dividends, denial of usual trade
credit from suppliers, restructuring of debt, non-
compliance with statutory capital requirements,
need to seek new sources or methods of financing
or to dispose of substantial assets
# Internal matters—for example, work stoppages or
other labor difficulties, substantial dependence on
the success of a particular project, uneconomic
long-term commitments, need to significantly
revise operations
# External matters that have occurred—for example,
legal proceedings, legislation, or similar matters
that might jeopardize an entity’s ability to operate;
loss of a key franchise, license, or patent; loss of a
principal customer or supplier; uninsured or
underinsured catastrophe such as a drought,
earthquake, or flood.
No. 06-3366 9
American Institute of Certified Public Accountants, “The
Auditor’s Consideration of an Entity’s Ability to Continue
as a Going Concern,” supra, § 341.06. It is the last bullet
point, referring to “external matters,” that stretches the
auditor’s duty—especially, so far as bears on this case, the
reference to “loss of a principal customer or supplier.”
Elsewhere the standards emphasize that the auditor must
have “an appropriate understanding of the entity and its
environment.” Id., §§ 314.01-.02 (emphasis added).
Yet nowhere is the auditor required to investigate external
matters, see id., §§ 314.01-.17, as distinct from “discover[ing
them] during the engagement.” Elizabeth K. Venuti, “The
Going-Concern Assumption Revisited: Assessing a Com-
pany’s Future Viability,” CPA Journal (May 2004),
www.nysscpa.org/printversions/cpaj/2004/504/p40.htm
(visited June 25, 2007). An accounting firm that conducts
an annual audit of a multitude of unrelated firms in a
multitude of different industries cannot be expected to be
expert in the firms’ business environments. Large account-
ing firms like Ernst & Young do divide their practice into
industry groups, and the accountants assigned to a particu-
lar group doubtless know a lot about the companies. But
the auditor is not hired to assess the supply and demand
conditions facing the audited firm. If the auditor is told
by the firm or otherwise learns from the information that it
collects in conducting the audit that the firm’s near-term
prospects are endangered by pending legislation, the loss
of a customer, or other “conditions or events,” then it must
factor the information into its assessment of the firm’s
risk of going under within a year. But it is not expected to
duplicate the expertise assumed to reside in the firms
themselves and in management consultants specializing
in the firm’s industry. Ernst & Young could not have been
expected to know more about trends in the frozen-meat
10 No. 06-3366
distribution business than Taurus, which had been in that
business for more than 20 years.
So the trustee’s claim has no merit—and it is also barred
by the one-year statute of limitations in the Accountancy
Act, which begins to run when “the alleged act, omission,
or neglect is discovered or should have been discovered by
the exercise of reasonable diligence.” Ind. Code § 25-2.1-15-
2. The parties assumed in the district court that only if the
date of discovery was more than a year before the bank-
ruptcy was filed, which was in January 1998, rather than
more than a year before the action against Ernst & Young
was brought by the trustee (originally as an adversary
action, but later moved to the district court under 28 U.S.C.
§ 157(d)), would the suit be time-barred. The Bankruptcy
Code extends the statute of limitations for the filing of
adversary actions by the trustee to two years after the
declaration of bankruptcy. 11 U.S.C. § 108(a). The suit was
filed more than three years after the declaration of bank-
ruptcy, but Ernst & Young failed to raise the point in the
district court, so it is forfeited in this court.
The district judge found, however, that by the fall of
1996, more than a year before the bankruptcy, Lisa Corry
knew everything she had to know in order to determine
whether the company had been injured by Ernst & Young’s
failure to have included a going-concern qualification
in the audit report for Taurus’s 1995 fiscal year. Her
knowledge—that of a senior officer responsible for the
company’s finances—is treated as that of the company. It
would not be had she been stealing from the company,
Cenco Inc. v. Seidman & Seidman, 686 F.2d 449, 454 (7th Cir.
1982), since as we mentioned earlier one task of an auditor
is to protect the company against dishonest employees. But
she was stealing for the company. More precisely, she
No. 06-3366 11
was stealing for the owners, id. at 454-55; for all we know,
she may have been hurting the creditors. But remember
that the auditor had no legally enforceable duty of care
to the creditors.
The parlous state of Taurus’s finances was fully known
by Corry (a C.P.A., though she had allowed her C.P.A.
license to expire since she was working exclusively for
Taurus) when she embarked on her course of fraud
more than a year before the bankruptcy. The trustee
argues that Corry thought Taurus could weather the
storm—which is indeed a possible explanation of her
decision to commit fraud on the company’s behalf. If
Taurus would indeed have been better off liquidating
earlier than later, Corry would not have been motivated to
commit a fraud intended to delay the liquidation. Yet the
critical event that doomed the company, according to the
trustee, was Bank One’s imposition of restrictions on
Taurus in May of 1996. So the argument has to be that
had Ernst & Young included the going-concern qualifica-
tion in its audit report of October 1995, Bank One
would have acted sooner, precipitating an earlier liquida-
tion. This possibility was fully known to Corry by the fall
of 1996. The effect of the restrictions imposed by Bank
One was amplified when Taurus’s sales plummeted dur-
ing the summer of 1996, but Corry knew all about this too,
yet it didn’t deflect her from trying to avert liquidation.
So the suit was correctly dismissed. But the trustee
argues that, even if that is so, the district court should not
have taxed costs to him because Taurus is indigent. The
idea that an indigent should not be taxed costs, though it
crops up from time to time (not as an absolute bar, but as
a factor for the district court to consider, e.g., In re Paoli
R.R. Yard PCB Litigation, 221 F.3d 449, 462-64 (3d Cir. 2000);
12 No. 06-3366
Flint v. Haynes, 651 F.2d 970, 973-74 (4th Cir. 1981)), is
peculiar, since if a defendant is truly indigent, he (or it)
can’t pay costs. However, “indigency” rarely connotes
absolute poverty, for think of the requirement that prison-
ers pay a portion of their filing fees even if they can’t pay
the whole amount up front. 28 U.S.C §§ 1915(b)(1), (2). And
when the “indigent” is a bankrupt, the issue will usually
be, as in this case, not whether the bankrupt can pay but
whether it should be required to allocate part of its remain-
ing assets to a victorious opponent in litigation rather
than to its creditors.
We cannot think of any reason to prefer the creditors
over the winner of a suit brought on their behalf against
him. Corporations, moreover, are not allowed to proceed in
forma pauperis, Rowland v. California Men’s Colony, 506 U.S.
194, 201-06 (1993), and to allow them to escape paying
costs, on grounds of indigency, would blur the distinction
between individuals and corporations. For these reasons,
it is indeed “better to award costs ‘as of course’ (which is
what [Fed. R. Civ. P. 54(d)] says) and leave to bankruptcy
the question whether collection is possible. Discretion may
be exercised against an award when the victor has run up
costs or otherwise abused the judicial process, but the
parties’ relative wealth is not a good reason to deny costs
to the winner, any more than a losing litigant’s indigence
would be a good reason to withhold an award of damages
for battery, theft, or breach of contract.” Rivera v. City of
Chicago, 469 F.3d 631, 637 (7th Cir. 2006) (concurring
opinion).
The judgment and the award of costs are
AFFIRMED.
No. 06-3366 13
ROVNER, Circuit Judge, concurring. I agree that this action
is barred by the statute of limitations, and would limit the
decision to that issue alone.
A true Copy:
Teste:
_____________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—7-17-07