Does the outside accountant of a closely-held business and its individual owners owe a legal duty to disclose to one owner the suspected financial improprieties of another?
Does the accountant’s failure to make such disclosure expose the accountant to liability for malpractice and aiding and abetting the unscrupulous business owner’s tortious activity?
Until recently, I would have said no to both questions.
But earlier this month, a Manhattan-based appeals court issued 1650 Broadway Assoc., Inc. v Sturm, ___ AD3d ___, 2024 NY Slip Op 01864 [1st Dept Apr. 4, 2024]), a bombshell decision for already anxious accountants at the height of tax season.
1650 Broadway is a warning to accountants of closely-held businesses that where they allegedly acquire knowledge or information of an owner’s financial improprieties, New York common law may now impose upon them an affirmative duty to make disclosure to a co-owner with whom the accountant has an accountant-client relationship, failure of which may be considered participation or aid in the tort, exposing the accountant to individual liability for professional negligence, aiding and abetting, or both.
Betrayal at the Stardust Diner?
This week’s story pitted mother against son over their ownership and operation of the famous Manhattan tourist trap known for its showtunes singing wait staff, the Stardust Diner.
Ellen and her late husband, Irving, founded and owned the 1950s themed Stardust Diner in the 1980s as a New York corporation, eventually owning a large stake of the business through trusts. They gave their son, Kenneth, an 11% stake in the business. In 2010, Irving died and Kenneth took over the day-to-day management and operation of the business. According to her amended complaint, Ellen was a “figurehead” for the business and “not involved in the finances,” naively “trusting that Kenneth would properly manage the business as Irving had for decades.”
Ellen’s trust in her son, she alleges, was badly misplaced. According to her amended complaint, shortly after Kenneth took over control of the Diner, he embarked upon an “eight-year scheme to defraud the Diner and its other shareholders by taking ‘loans’ from the Diner to fund Kenneth’s fledgling real estate development business and other investments made in his personal capacity or through entities Kenneth owned or controlled without the other Diner shareholders.” Kenneth’s “loans,” some of which he allegedly obtained by forging Ellen’s signature, totaled nearly $12 million.
During this time, a single accounting firm, Getzel Schiff & Pesce LLP (“GSP”), provided financial statement and tax preparation accounting services for the Diner, its individual owners, and various family trusts simultaneously. As many readers know, this is common practice: accountants often provide an integrated suite of services for a family-owned business entity, the various family members, and their trusts, all at the same time.
Ellen alleged that although she was a co-owner, GSP sent all of the Diner’s financial statements, tax documents, and other accounting and legal documents to Kenneth only. Ellen alleged that she did not review the Diner’s financial statements during the years in which Kenneth’s loans were taken, that she relied on Kenneth and GSP to ensure proper maintenance of the Diner’s books and records, and that GSP knew of and should have disclosed to her the massive loans Kenneth took from the Diner.
Discovery of the Alleged Embezzlement and Commencement of the Litigation
Ellen alleged that it was not until in 2019, when she switched accounting firms, that her new accountants alerted her to Kenneth’s scheme. Ellen confronted Kenneth, compelled him to surrender his equity interest in the Diner, and was forced to write off Kenneth’s nearly $12 million in loans as bad debts.
Ellen alleged two claims against the accountant: (i) a claim entitled “Direct and Derivative Claim of Professional Malpractice for Conflict of Interest as Against GSP on Behalf of the Diner” and (ii) a claim entitled “Direct and Derivative Claim for Aiding and Abetting Fraud as Against GSP on Behalf of the Diner, Ellen, and the Trusts.”
In her malpractice claim, Ellen alleged that GSP “breached its duties and failed to comply with common accepted accounting standards and professional duties of care by ignoring the conflicts between Kenneth . . . on the one hand, and Plaintiffs, on the other hand and failed to disclose, alert or otherwise act to notify Plaintiffs of Kenneth’s fraudulent schemes.”
In her aiding and abetting fraud claim, Ellen alleged that GSP either “knew of, or willfully ignored, Kenneth’s fraudulent conduct,” and “substantially assisted” and “actively aided” Kenneth in his fraud by “failing to advise Ellen or the Trusts about Kenneth’s activities, despite knowing that Ellen was completely unaware that Kenneth was taking millions of dollars in loans from the Diner with no ability to repay such funds.”
The Lower Court Decision
In a short decision, Manhattan Commercial Division Justice Andrew Borrok granted GSP pre-answer dismissal of Ellen’s claims, ruling: (i) the alleged loans were “properly disclosed in the financial statements” of the Diner, (ii) Ellen failed to sufficiently allege “how [GSP] deviated from the accepted standard of care for accountants,” and (iii) Ellen failed to sufficiently allege “how they aided and abetted” Kenneth’s “clandestine extraordinary unauthorized” activities.
Ellen appealed (you can read the appeal briefs here, here, and here).
The Appellate Decision
The appeals court framed the issue as “whether an accountant hired to perform ‘compilation services’ is shielded from liability for the alleged improper activities of an officer of the company.”
The Court explained that the elements of accounting malpractice are twofold: “A party alleging a claim of accountant malpractice must show [i] that there was a departure from the accepted standards of practice and [ii] that the departure was a proximate cause of the injury” (quotations omitted).
The Court explained that the elements of aiding and abetting fraud are threefold: “A plaintiff alleging an aiding and abetting fraud claim must allege [i] the existence of the underlying fraud, [ii] actual knowledge, and [iii] substantial assistance.”
Applying these elements, the Court ruled: “Plaintiffs sufficiently pleaded causes of action for accounting malpractice and aiding and abetting fraud, which are not utterly refuted by the documentary evidence.”
The Court explained that GSP “primarily argues that the malpractice and fraud claims are refuted by the fact that the accounting firm was hired to prepare tax returns and other financial statements that documented the loans at issue, and thus that investigating and reporting Kenneth’s alleged fraud were beyond its duties.”
The Court unanimously rejected the accountant’s argument it owed no legal duty to investigate or report Kenneth’s financial improprieties:
Plaintiffs’ claims, however, are not that defendant was hired to discover Kenneth’s wrongdoing, but rather that information obtained by defendant during its business interactions with Kenneth and information used by defendant in order to prepare tax returns and financial statements put defendant on notice about the impropriety of Kenneth’s loans to himself such that defendant had a duty to inform plaintiffs of the questionable payments. The law is very clear that an agreement to perform unaudited services does not shield an accountant from liability because an accountant must perform all services in accordance with the standard of a reasonable accountant under similar circumstances, which includes reporting fraud that is or should be apparent.
The Court next rejected the accountant’s argument that Ellen was incapable of stating viable negligence and aiding and abetting claims because the Diner’s financial statements, had she read them, would have fully disclosed the fraud to her. The Court ruled that information contained in the Diner’s financial statements was relevant to the issue of Ellen’s comparative fault, but not an absolute defense to liability:
[W]hile plaintiffs’ own negligence in monitoring Kenneth’s activities in managing the Diner may have been a factor in enabling Kenneth to continue his alleged fraudulent scheme for several years, the pleadings and documentary evidence submitted do not show that such negligence was the sole proximate cause of the Diner’s loss. It has not been established that such negligence impeded defendant’s duties to reveal to plaintiffs what it knew about Kenneth’s alleged improper conduct regarding the loans.
Thus, the Court reversed dismissal of Ellen’s claims and reinstated them for further litigation in the court below.
Questions for Another Day
1650 Broadway is bad news for outside accountants and their liability insurance companies, and good news for allegedly defrauded close business owners looking for a potential deep pocket, for whom insurance is almost never available in business divorce litigation. But questions remain.
First, the Court addressed the holding of 1650 Broadway to accountants who provide “compilation services” – a term of art for accountants who assist management in the preparation of unaudited financial statements. What about accountants whose services are limited to preparation of tax returns? Can they be liable if they receive knowledge of a close business owner’s financial improprieties but decline to disclose them to a co-owner on whose behalf the accountant also provides services? 1650 Broadway does not answer that question.
Second, what about accountants who provide accounting services solely for the entity, but not its individual owners? If an accountant discovers financial impropriety by one owner, is there a duty to disclose to a co-owner in that situation? The answer is not clear.
Third, to whom exactly did GSP owe its duty to disclose? Ellen individually? Ellen as shareholder of the Diner. The Diner itself? All of the above? Again, not clear. This matters because Ellen pled her claims against the accountants directly and derivatively at the same time, and “a complaint the allegations of which confuse a shareholder’s derivative and individual rights will be dismissed” (Yudell v Gilbert, 99 AD3d 108 [1st Dept 2012] [quotations, brackets, and ellipses omitted]). One may expect further litigation over this issue before the lower court.
Fourth, will liability insurers of accounting firms provide coverage for a claim against an insured for aiding and abetting fraud? Almost all liability policies exclude coverage for claims alleging fraud. Is alleged aiding and abetting of an accounting client’s fraud excluded under a professional liability insurance policy? If so, plaintiffs like Ellen may be better off pleading a standalone claim of accounting malpractice.
For those interested, Peter Mahler wrote a post 16 years ago about another accounting firm sued for malpractice for its role in a business dissolution proceeding, which you can read here.
[View source.]
