SW Legal studies in Business

Surety Bond Issuer Reasonably Relied on Negligently Prepared Audit
Description

Appeals court found accounting firm liable for negligence in its audit practices of a firm it worked for. The accountants knew the audit statement would be used for financial purposes, as it was, and it was directly linked to a large loss suffered by a surety bond issuer that relied on the audits.

Topic

Accountant’s Liability

Key Words

Negligence; Misrepresentation; Surety

C A S E   S U M M A R Y
Facts

FGH built oil rigs, vessels, and other large maritime equipment. It hired Ernst & Young (E&Y) to audit its financial statements and prepare forms for SEC filing. E&Y did the work and did not qualify its audit opinion or issue any disclaimers. The audit noted that one project, Petrodrill, would produce an estimated loss for FGH of $60 million. Soon after, FGH sought surety bonds from Travelers Casualty and Surety to apply to construction contracts. Relying on the audits, Travelers required FGH to do some financial restructuring as part of the provision of the surety. It then agreed to provide a $70 million bond to apply to a specific project, called Pasha. The next year, Travelers learned that FGH diverted funds from Pasha to other activities in an effort to keep the company solvent. Travelers was forced to payout $58 million to cover costs of the Pasha project due to the insolvency of FGH that occurred soon after E&Y finished the next year’s audit. Travelers sued E&Y for negligence in auditing as it grossly underestimated the losses at risk and did not observe the financial reallocations in the company. Travelers also sued FGH and its officers and settled those suits, leaving E&Y as the sole defendant. The jury awarded Travelers $14.4 million. E&Y appealed.

Decision

Affirmed. The evidence was sufficient to prove that Travelers, as surety, reasonably relied on inaccurate results of audit conducted by accounting firm. The losses suffered by FGH were far larger than the estimated losses E&Y stated were reasonable to assume. That was required for a surety to prevail in a negligence claim against an accounting firm. The accounting firm’s negligence was the proximate cause of surety’s decision to issue bond. It was reasonably foreseeable that the audit statement would be used for business purposes such as obtaining surety bonds. The surety relied to its detriment on the financial statement and suffered a loss proximately caused by the auditor’s negligence.

Citation Travelers Casualty and Surety Co. v. Ernst & Young, 542 F.3d 475 (5th Cir., 2008)

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