October 2016 Headnotes: Business Litigation

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12 H e a d n o t e s l D a l l a s B a r A s s ociation


October 2016

Business Litigation

The Audit Interference Rule: Accounting Malpractice in Texas BY MARTIN WOODWARD

An auditor’s sign-off on a company’s financial statements is a signal to other businesses that the audited company is in good financial shape. Of course, if the company later proves to be undercapitalized or even insolvent, those who relied on the audit may—to use the obvious pun—look to hold the accounting firm accountable. If you are tasked either with recovering from or defending the accounting firm, you might start building your litigation strategy from the reasonable assumption that the comparative fault scheme in Texas will let it point fingers elsewhere. But be aware that an old legal doctrine might prevent the accountant from ever putting the claimant’s fault in play—and that should factor into your planning.

The “audit interference rule” has its roots in early 20th century jurisprudence. It emerged as an exception or reaction to the then-prevalent doctrine of contributory negligence, the all-or-nothing principle that completely bars a plaintiff’s recovery even if the plaintiff is only partly at fault. In accounting malpractice cases, contributory negligence had shielded accountants from liability in cases where, for example, an audit failed to discover embezzlement by an employee of the audited company. But in the landmark case of National Surety Corp. v. Lybrand, 256 A.D. 226, 9 N.Y.S.2d 554 (1939), the New York Court of Appeals announced a new rule: an accountant may assert contributory negligence only if it contributed to the accountant’s failure to perform the audit properly. Thus, broadly expressed, the hold-

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ing makes whatever happened before the audit irrelevant—and it keeps the claimant off the verdict form. The rule of National Surety, later dubbed the “audit interference rule,” was adopted by courts in several jurisdictions across the country, effectively leaving accountants without a contributory negligence defense. But over time, almost all jurisdictions abandoned contributory negligence in favor of some form of a comparative negligence model, reducing a plaintiff’s damages in proportion to fault. Predictably, with the dawning of the age of comparative negligence, courts in some jurisdictions—noting the contributory negligence pedigree of the audit interference rule—rejected it, restoring a viable comparative negligence defense to accountants in cases challenging their conduct. Other courts, though, continued to find support for the audit interference rule even where a comparative negligence scheme was in place. For these courts, the rule is consistent with principles that apply in other areas of professional liability jurisprudence, such as those preventing physicians from using a comparative negligence defense against a patient on the basis of the patient’s pre-treatment conduct. Today, there is no national consensus on whether to limit an accountant’s use of a comparative negligence defense in a malpractice suit in keeping with National Surety: high courts in some states have expressly adopted the audit interference rule, high courts in others have rejected it, and in several states—such as Texas—the highest court has not weighed in definitively. So, for Texas litigators on either side of a negligent audit case, a significant legal battle awaits. In arguing either for the applica-

tion of the audit interference rule, or, conversely, for the availability of a comparative negligence defense, both sides will find plenty of ammunition in the out-of-state opinions supporting and rejecting the rule. For accounting malpractice plaintiffs in Texas, the arsenal includes at least one Texas case applying the audit interference rule: Greenstein, Logan & Co. v. Burgess Marketing, Inc., 744 S.W.2d 170 (Tex. App.—Waco 1987, writ denied). This opinion discusses and endorses the reasoning of the audit interference rule. But even a quick glance at its citation history shows that it has been criticized and distinguished, more than once, by courts in other states that ultimately rejected the audit interference rule (and, of course, it is not a Texas Supreme Court case). For defendant accountants looking to stave off the audit interference rule and use a comparative negligence defense, Richardson v. Cheshier & Fuller, L.L.P., 2008 WL 5122122 (E.D. Tex. Dec. 3, 2008) is an arrow in your quiver. This case squarely rejects the audit interference rule in favor of the Texas statutory comparative negligence scheme. But the discussion is perfunctory and the case is unpublished, leaving it open to attack. Until Texas law is settled, the audit interference rule may prevent an accounting firm from using a comparative negligence defense—unless the accountant succeeds in persuading a court to reject it. Texas litigators faced with pursuing or defending claims involving faulty audits should therefore be familiar with this rule and ready to fight for or against it. HN Martin Woodward practices with The Stanley Law Group. He can be reached at mwoodward@stanleylawgroup.com.