Opinion
601091/03.
Decided April 19, 2004.
Defendant Deloitte Touche, LLP (Deloitte) moves for an order, pursuant to CPLR 3211 (a) (1) and (7A), and 3016 (b), dismissing the complaint. Deloitte is a large accounting and consulting firm, and plaintiff Water Street Leasehold LLC (Water Street) is the owner and landlord of premises located at 77 Water Street in downtown New York City (the premises).
BACKGROUND
This action arises from a commercial lease agreement between Sage Realty Corporation (Sage), a New York corporation acting in its capacity as managing agent for landlord Water Street, and its commercial tenant, Reliance Insurance Company (Reliance). Reliance, which is currently in liquidation, traces its roots back to 1817, when it was established under Pennsylvania law, with its headquarters and principal place of business in Philadelphia, Pennsylvania. During the 1970's, Reliance became part of a three-tier holding company structure, with a publically traded parent company, Reliance Group Holdings, Inc. (RGH). RGH owned 100% of the stock of Reliance Financial Services Corp. (RFS), which in turn, owned 100% of the stock of Reliance. Both RGH and RFS are New York companies. Reliance was active in a number of states, including New York, where it maintained offices at plaintiff's Water Street location.
It is undisputed that, on or about August 26, 1987, Reliance and Sage executed the first of a series of lease agreements by which Reliance had exclusive occupancy of eleven of floors of commercial office space, as well as partial occupancy of three additional floors of plaintiff's premises. The Lease was periodically amended and supplemented between August 1987 and June 1998.
On June 8, 1998, Reliance and Water Street, through its agent Sage, entered into a Restated and Amended Indenture of Lease (the Restated Lease), which was then supplemented on August 31, 1998, in a First Supplement of Lease, and again on October 31, 1998, in a Second Supplement of Lease. The Second Supplement of Lease was amended by a First Amendment of Lease, dated December 29, 1999. Pursuant to the Restated Lease, Reliance agreed to make lease payments from March 1, 1998 through February 29, 2012, plus an additional 5 year option. The earliest possible date for terminating the lease, under the terms of the Restated Lease, was February 29, 2010. Base rent for the first year, from January 1, 1999 to December 31, 1999, was $8.408 million. With additional charges related to administrative reimbursement, electricity, real estate tax, sales tax, and common charges, (together, the operating expenses), the total amount due Water Street for the year 1999, was $8.963 million.
According to the complaint, Reliance approached Water Street in the summer of 2000, with proposed changes in their lease arrangement. Specifically, Reliance requested an early termination of its leasehold, that Water Street seek a replacement tenant to occupy its space, and, that if a replacement tenant was found, that Water Street would then provide Reliance with sufficient time to vacate the premises in an orderly manner, in either one or two phases, at Reliance's option. On September 29, 2000, the parties executed the Second Amendment, including subsection 2 (iii). This subsection prescribes the period of time, either 120 or 180 days, at Reliance's option, following Reliance's receipt of notification that Water Street found a replacement tenant, for Reliance to vacate the premises. Water Street refers to this 'two-tiered' period of time as a forbearance period, as it receives no real economic benefit for agreeing to the termination and surrender of the Lease prior to the scheduled expiration date of February 29, 2010, in the manner set forth in subsection 2 (iii). The Second Amendment was incorporated into the parties' prior lease agreements.
It is undisputed that on October 16, 2000, Water Street notified Reliance that it had found a replacement tenant, The Goldman Sachs Group, Inc. (Goldman Sachs). On October 26, 2000, Reliance notified Water Street that it had elected, under the terms of the Second Amendment, to vacate the premises in two phases, the first phase by February 28, 2001, and the second and final phase by, April 30, 2001. During the first phase, Reliance vacated five floors, less than 50% of its leased space, and then failed to provide confirmation of its withdrawal until March 19, 2001. The second phase was completed by April 30, 2001. Contrary to the terms of the Second Amendment, Reliance did not the pay rent, including the operating expenses, owed to plaintiff for the forbearance period.
On May 29, 2001, the Pennsylvania Insurance Department obtained an order from the Commonwealth Court of Pennsylvania placing Reliance in rehabilitation. On or about June 11, 2001, RGH and RFS jointly filed for federal bankruptcy protection in the Southern District of New York. On July 5, 2001, Water Street served a Notice of Default on Reliance, and on October 3, 2001, the rehabilitation ended and Reliance was placed into liquidation due to its insolvency, which was claimed to exceed $1 billion.
At all relevant times, defendant Deloitte was employed by Reliance as its independent accounting firm, responsible for auditing and certifying Reliance's annual financial statements. Deloitte also performed actuarial services for Reliance. On or about April 7, 2003, Water Street commenced this action seeking to recover damages stemming from Deloitte's alleged improper auditing procedures and certification of Reliance's financial statements, which Water Street allegedly relied on to its detriment, when it agreed to forgo its rights under the Restated Lease and accept the less favorable terms of the Second Amendment. The complaint alleges three causes of action against Deloitte: (1) fraud (intentional misrepresentations); (2) negligent misrepresentations; and (3) gross negligence.
Deloitte was also employed by Reliance's parent companies.
Defendants seek a dismissal of the amended complaint, dated July 11, 2003, on the grounds that:
On June 6, 2003, Deloitte served a motion to dismiss Water Street's initial complaint. The motion was withdrawn upon plaintiff's service of an amended complaint. Deloitte now seeks a dismissal of the amended complaint, which, will be referred to in this decision as simply, the complaint.
(1) each cause of action fails to adequately allege 'reliance,' by Water Street; (2) Water Street's damages, if any, resulted from Reliance's breach of contract, and not from any actions taken, or not taken, by Deloitte; (3) the amended complaint lacks factual allegations that Deloitte acted with the specific intent to defraud Water Street; (4) Water Street fails to allege facts showing that the parties had a relationship "sufficiently approaching privity"; or (5) Water Street fails to demonstrate the requisite "linking conduct" for a charge of negligent misrepresentation.
Water Street contends that Deloitte audited and certified Reliance's financial statements in a manner which concealed the insurance company's precarious financial condition from Water Street, who Deloitte knew to be a major creditor of its client, Reliance. The alleged false and material representations include, but are not limited to, the adequacy of Reliance's loss reserves, the appropriateness of the actuarial methods used, and Deloitte's confirmation of Reliance's internal audit controls. Plaintiff specifically alleges that, Deloitte intentionally or recklessly miscalculated a reasonable range of loss reserves for Reliance, thereby allowing Reliance to understate is reserves and to overstate its surplus, and that Deloitte, intentionally made these fraudulent, and negligent misstatements as to Reliance's finances with the express purpose of misleading and inducing plaintiff to enter into the Second Amendment.
Water Street's complaint asserts that, because it was being asked to give up certain rights that it had under the Restated Lease, including the default provision entitling it to evict Reliance for its failure to make timely payments, and to accelerate all further monthly payments due under the Restated Lease from the time of a default through February 29, 2012, it required proof from Reliance that it was solvent and capable of fulfilling its financial obligations under the proposed Second Amendment.
To this end, Reliance provided a representation by its Board of Directors, by way of an opinion letter from both its Philadelphia, Pa. attorneys, Saul, Ewing, Remick Saul LLP, and from its New York attorneys, Stroock Stroock Lavan LLP, confirming Reliance's ability to meet its obligations under the Second Amendment. As further assurance that Reliance was financially solvent, with adequate reserves to cover its financial obligations to Water Street, Water Street reviewed, and then relied on, the financial statements audited and certified by Deloitte, for the years 1997, 1998 and 1999, the 1999 statement, certified on March 5, 2000, being most relevant to Water Street's decision. According to the complaint, without these certified statements Water Street would not have agreed to the Second Amendment, which included the forbearance clause, preventing Water Street from mitigating their damages by commencing Goldman Sachs' tenancy immediately upon Reliance's default. Water Street, therefore, seeks damages in the amount of the lease payments it would have received from Goldman Sachs for the period of time that Reliance occupied Goldman Sachs' space and for which Reliance failed to pay rent. It is undisputed that Reliance ultimately failed to pay the more than $1 million owed to Water Street under the Second Amendment.
DISCUSSION
This case involves the claims of negligence and fraud brought by an injured party against an accounting firm with whom the injured party is not in privity. When third parties, such as Water Street commence these actions, the defendant accountants invariably seek a dismissal of the complaint and it is incumbent upon the motion court to examine the specific relationship at issue.
The complaint alleges that Deloitte concealed the financial collapse of Reliance by certifying inaccurate financial statements. As a result, corrective action by the appropriate regulatory agencies was not triggered, losses were not mitigated, and extra time was provided to Reliance's officers and directors to take unwarranted dividends, and to drain the company's cash by up-streaming it to its parent companies, whose boards of directors mirror that of Reliance. According to the complaint, between 1998 and the first half of the calendar year 2000, Reliance paid its unregulated parent companies over $500 million, failed to collect $200 million owed to it by its parent company, RGH, overstated its surplus by approximately $1 billion as of the end of 1999, allowed for improper methods of calculating the loss reserves which were ultimately determined to be approximately $500 million too low, and none of this is properly reflected in the financial statements that were audited and certified by Deloitte.
Deloitte's certification of the 1999 financial statement clearly states that the audit was conducted according to generally accepted auditing standards [GAAS], which requires Deloitte, as Reliance's accountant, to investigate the internal controls used by Reliance, so that Deloitte can identify and disclose any weaknesses in its system. The certification provides, in relevant part: We have audited the accompanying consolidated balance sheets of Reliance Group Holdings, Inc. and subsidiaries [including Reliance] as of December 31, 1999 and 1998, and the related consolidated statements of operations, changes in shareholders equity, comprehensive income (loss) and cash flows for each of the three years in the period ended December 31, 1999. . . .
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements . . . and assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. . . .
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Reliance Group Holdings, Inc. and subsidiaries [Reliance] as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years for the period ended December 31, 1999 in conformity with generally accepted accounting principles [GAAP].
As a disgruntled creditor, Water Street alleges that Deloitte was either grossly negligent in the manner in which it performed these services, or that it intentionally covered for its lucrative client. Water Street reasons that if Deloitte had actually performed the accounting services in accordance with the certification, then, at a minimum, the amount of loss reserves reflected on the financial statements would not have been off by approximately $500 million (too low), and the amount of surplus would not have been overstated by approximately $450 million for the tax year 1999 alone, without Deloitte, as an independent accountant, identifying and addressing these errors.
Combined surplus is alleged to be overstated by nearly $1 billion as of December 31, 1999, rendering Reliance nearly insolvent (Compl. ¶ 110).
The complaint also alleges that Reliance's true financial situation required that Deloitte issue a "going concern opinion" which it failed to do. Deloitte chose instead, to accept, without corroborating documentation, "wildly optimistic and sometimes contradictory representations from Reliance and RGH about future speculative if not fraudulent improvements in the company's financial condition" (Compl. ¶ 121).
In its cause of action for fraud, Water Street attacks the validity of the financial statements certified by Deloitte, pointing out that nowhere, does Deloitte mention the increasing financial difficulties or irregularities that ultimately formed the basis of Reliance's insolvency.
Prior to Houbigant, Inc. v. Deloitte Touche LLP, ( 303 AD2d 92 [1st Dept 2003]), the First Department's position with respect to a non-client's charge of fraud against an accountant was that, to plead a prima facie case, a plaintiff must allege, with particularity, the elements of scienter, deception, misrepresentation of material fact, falsity and injury. Furthermore, fraud allegations must identify the particular manner in which a defendant intentionally or recklessly misrepresented an item included in the fianancial statement which was then relied upon by a plaintiff. Mere negligence by a defendant is not enough. Furthermore, the element of scienter is not sufficiently alleged against a preparer of a financial statement "when the accountant's knowlingly false statement, and knowing and direct participation in the fraud, are not shown"
LaSalle National Bank v. Ernst Young LLP, ( 285 AD2d 101, 110 [1st Dept 2001] [citations and quotations omitted]).
However, in 2003, the First Department reversed a pre-answer motion to dismiss charges by an injured, non-client against an accounting firm for, among other things, fraud. In Houbigant, Inc. v. Deloitte Touche LLP ( 303 AD2d 92, supra) the third-party, non-client plaintiff alleged that, when the accounting firm, Deloitte, certified the accuracy of the financial statements, it knew, but failed to acknowledge, that the client's financial statements contained numerous serious irregularities and errors, which could have a material impact on the accuracy of the financial statements' recitation of the client's net worth. The First Department found that these allegations sufficiently pled both misrepresentation and scienter, the elements necessary to support a fraud claim by a non-client against an accountant. The First Department emphasized that a fraud claim need only be pled in sufficient detail to appraise the defendant of the nature of the claim, and citing to the Court of Appeals case of Jered Contr. Corp. v. New York City Tr. Auth. ( 22 NY2d 187), it specifically recognized that: with respect to fraud, sometimes the surrounding circumstances are peculiarly within the knowledge of the party against whom the claim is being asserted. The element of scienter, that is, the requirement that the defendant knew of the falsity of the representation being made to the plaintiff, is, of course, the element most likely to be within the sole knowledge of the defendant and least amenable to direct proof ( Houbigant, Inc., 303 AD2d at 97 [quotations and citations omitted]).
Where, as here, the parties have not completed, or even commenced discovery, a claim for fraud will be deemed sufficient when it contains:
some rational basis for inferring that the alleged misrepresentation was knowingly made. Indeed, to require anything beyond that would be particularly undesirable at this time, when it has been widely acknowledged that our society is experiencing a proliferation of frauds perpetrated by officers of large corporation, for their own person gain, unchecked by the "impartial" auditors they hired" ( Houbigant Inc., 303 AD2d at 98).
To this end, the complaint claims that, as Reliance's allegedly independent auditor and appointed actuary, Deloitte propped up Reliance's reported financial position, deflected regulatory scrutiny, and permitted Reliance to payout enormous quantifies of cash to its cash-starved, unregulated, parent companies and to undertake additional policy holder and other obligations, including the Second Amendment, while Deloitte knew, or should have known, that Reliance was seriously financially troubled and was, or would shortly be, insolvent. Concluding that the assurances contained in Deloitte's certification were knowingly false, the complaint adequately states a cause of action for fraud.
With respect to the claim of gross negligence, the complaint alleges that, based on the magnitude of the inaccuracies and irregularities contained in the Reliance's financial statements, Deloitte could not have performed a proper audit under the standards set forth in GAAS or GAAP. The glaring inaccuracies could not have been a result of ordinary and innocent error, and clearly demonstrate gross negligence on the part of Deloitte.
It is well settled that accountants may be liable to third parties for gross negligence in their performance of a certified audit.
A representation certified as true to the knowledge of the accountants when knowledge there is none, a reckless misstatement, or an opinion based on grounds so flimsy as to lead to the conclusion that there was no genuine belief in its truth, are all sufficient upon which to base liability. A refusal to see the obvious, a failure to investigate the doubtful, if sufficiently gross, may furnish evidence leading to an inference of fraud so as to impose liability for losses suffered by those who rely on the balance sheet ( State Street Trust Co. v. Ernst, 278 NY 104, 112 [1938]).
The Court of Appeals further reasoned, that the accountant's job is to examine the books of the company and to take reasonable care to ascertain that the company's books reflect the true financial position of the company at the time of the audit. "Unless he [the accountant] does this his audit would be worse than an idle farce" ( id., at 113).
The complaint sufficiently particularizes the claim of gross negligence. Water Street alleges that Deloitte failed to verify the financial information provided to it by Reliance and its parent companies, and, based on the assertion that Reliance's loss reserves were approximately $500 million too low, its surplus was overstated by approximately $1 million, Reliance was undeniably close to insolvency, yet none of this was detected and revealed in the certified audit. Instead, Deloitte confirmed the numbers presented on the financial statements, certifying that Reliance's statements were free of material misstatement and that they presented fairly, in all material respects the financial position of Reliance and its parent companies. Detailing the inaccuracies of Deloitte's certification, the complaint sufficiently states a claim for gross negligence.
With respect to the allegation of negligence, this court, once again looks to the facts of this particular case in conjunction with prior case law.
In LaSalle National Bank v. Ernst Young LLP, ( 285 AD2d 101 [1st Dept 2001]), the Appellate Division reversed the lower court's denial of Ernst Young's pre-answer motion to dismiss the plaintiff's causes of action sounding in, among other things, negligence, in connection with accounting services that Ernst Young provided to its client, non-party Kent International Associates, Ltd. The First Department reasoned:
In order to impose negligence liability on an accountant for injury to a non-contracting third party resulting from the accountant's advice or services, the third party must establish each prong of the Credit Alliance test, that is: [1] the accountant's awareness that the financial reports were to be used for a particular purpose or purposes, [2] reliance on the reports by a known party or parties, and [3] some linking conduct on the part of the accountant which evinced the accountant's understanding regarding the third party's reliance. * * * [T]hese requirements . . . must be distinctly pleaded and, . . . since we review a CPLR 3211 motion to dismiss on the pleadings . . . the standard guiding us is whether the allegations in the complaint, construed liberally, satisfy each of these three requirements. Although we focus here on the pleadings, the pleadings still must establish a basis of liability arising from either actual privity or contract between the parties or a relationship so close as to approach that of privity requiring a clearly defined set of circumstances which bespeak a close relationship premised on knowing reliance ( id. at 105-106).
Credit Alliance Corp. v. Arthur Andersen Co., 65 NY2d 536 (1985).
In an effort to meet this standard, the complaint alleges that, as a Pennsylvania insurance company, Reliance was required to provide a copy of the audited and certified financial statements to the Insurance Commissioner of the Commonwealth of Pennsylvania (ICCP), whose responsibilities include protecting policyholders and creditors of Pennsylvania insurance companies, including Water Street. As Reliance's independent accountant, Deloitte knew that its work product was being provided to the ICCP. Plaintiff also alleges that the same information that was provided on the certified 1999 financial statement, was provided to the ICCP and also filed with the United States Securities and Exchange Commission (SEC), on Reliance's SEC Form 10-K. Knowing that the financial statements were used for these official and regulatory purposes, plaintiff felt confident in the accuracy of financial statements certified by Deloitte, as they had "the imprimatur of authority" (Compl. ¶ 31).
The complaint alleges that Water Street was not one of an indeterminate number of potential creditors who might deal with Reliance, but was a substantial creditor who held that position since 1987 when the leasehold began. Furthermore, Deloitte knew that Water Street was one of several major creditors that routinely reviewed, and relied on, the annual certified statements, based on the annual appearance of Water Street's name on the financial documents being audited. The complaint further alleges that it was precisely because Deloitte knew that Water Street relied on its work product, that Deloitte certified the subject financial statements to induce Water Street to enter into the Second Amendment. Whether motivated by the substantial fee income it received from Reliance, or conflicted by undertaking the dual roles of auditors and appointed actuaries for both Reliance and its cash-starved parent companies, Deloitte strayed from its responsibilities as independent accountant when it conducted the audit and certified the financial statements. Water Street contends that discovery will yield proof that Deloitte knew that the certified statements were going to be relied upon by Water Street to assess Reliance's financial capabilities when approached with the Second Amendment, and that Deloitte, for the reasons set forth above, tailored the audits and certification accordingly.
Accordingly, it is
ORDERED that the motion to dismiss the complaint as to the causes of action for fraud (intentional misrepresentation) and gross negligence is denied; and it is further
ORDERED that the motion to dismiss the complaint as to the cause of action for negligence is denied without prejudice to renew at the completion of discovery; and it is further
ORDERED that defendant is directed to serve an answer to the complaint within 10 days after service of a copy of this order with notice of entry.