South-Western Legal Studies in Business

Accountants Not Liable for Deepening Insolvency of Scam Corporation
Description

Appeals court held that the failure of a CPA firm to uncover the scam at the heart of a corporation did not support a malpractice claim since there was no evidence that any of the losses suffered in the collapse of the firm were due to the behavior of the accountants.

Topic Accountant’s Liability
Key Words

Financial Statements; Malpractice; Deepening Insolvency

C A S E   S U M M A R Y
Facts

During the Internet bubble in the late 1990s, CitX was formed to do internet shopping, but it was essentially a scam, in violation of the securities laws, that resulted in losses by those who did business with it. After the company was shut down, a trustee, Seitz, was appointed to guide it through bankruptcy. A CPA firm, Detweiler, Hershey and Associates (DHA) had worked for CitX. Seitz sued, contending that DHA missed many “red flags” about CitX operations that should have been recognized before prosecutors moved in. Seitz claimed malpractice by DHA and that it deepened the insolvency by not taking steps when it should have realized that the company was a scam. The district court dismissed the suit. Seitz appealed.

Decision

To establish professional malpractice, the trustee would have to show that DHA 1) had a duty to its debtor-client, 2) breached that duty, 3) injured the debtor-client, and 4) caused the harm. The purported harm, in the form of deepening insolvency is not a valid theory of damages to support the malpractice claim. There is no evidence that the scam at CitX was furthered by the actions of DHA. No credit was extended to CitX in reliance on financial statements compiled by DHA, as is required to establish causation in a malpractice claim.

Citation

In re: CitX Corporation, 448 F.3d 672 (3rd Cir., 2006

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