Accounting Firm Found Not Liable to an Investor Claiming "Indirect Reliance" on an Audit Report

Matthew O'Leary, Esq.
September 21, 2009 — 1,765 views  
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In Imprimis Investors, LLC v. KPMG Peat Marwick, LLP, 69 Mass. App. Ct. 218 (2007), the Appeals Court dealt for the first time with the issue of whether an investor could “indirectly rely” on an audit report in making its decision to invest in a company. Imprimis Investors, LLC (”Imprimis”) claimed they relied on a final signed audit report and an unqualified opinion prepared by KPMG Peat Marwick, LLP (“KMPG”) when making their decision to invest in First New England Dental Centers, Inc. (the “company”). They also claimed the company’s financial statements, which were audited by KPMG contained a number of specific and material misrepresentations and omissions.

On December 6, 1996, KPMG issued an unqualified audit opinion on the company’s financial statements “for the year ended December 31, 1995, and the nine months ended September 30, 1996.” The company then filed, on January 31, 1997, an S-1 registration statement with the Securities and Exchange Commission accompanied by its 1995 and 1996 financial statements and KPMG’s unqualified audit report. Notwithstanding the company’s S-1 registration statement, KPMG had sometime earlier informed the company of its concerns over the company’s liquidity and ability to continue as a “going concern.” Nonetheless, KPMG was willing to issue the unqualified audit report for the first nine months of 1996, because of the assurances of the company’s chief executive officer that he would continue to obtain financing.

The company and Imprimis held their introductory meeting on July 3, 1997, followed by a series of communications between them regarding a possible loan. KPMG was not a party to this meeting or the subsequent communications.  On July 23, 1997, the investors agreed to invest $14.5 million in senior secured notes issued prior to the company’s initial public offering, subject to certain conditions set out in a note purchase agreement with the investors. Imprimis’s money was to act as a bridge until the company issued an initial public offering sometime in 1997. The agreement required KPMG issue an audit report on the company’s financial statements as of December 31, 1996, without a “going concern” qualification, the field work for which KPMG had completed in March, 1997. Prior to entering into the agreement, Imprimis obtained detailed information concerning the company’s finances from the company and its investment bankers. At no time did the investors either seek or obtain any information about the company from KPMG.

The closing occurred on Friday, July 25, 1997, and Imprimis transferred most of the loan funds. Although KPMG had completed its audit report before July 25th, it refused to issue a clean report until the company first received all the promised funds from the investors, which would remove its noted concerns about the company’s liquidity. The investors transferred the remaining funds on Monday, July 28, 1997. In its completed report, KPMG stated it had conducted its audit “in accordance with generally accepted auditing standards.” KPMG opined in its report that the company’s financial statements, which were the responsibility of the company’s management, “present [ed] fairly, in all material respects, the financial position of [the company] . . . and the results of their operations and their case flows . . . in conformity with generally accepted accounting principles.” The unqualified report did not contain a “going concern” paragraph indicating that KPMG had no substantial doubt that the company would continue as a going concern for a reasonable period of time, not to exceed one year from the date of the company’s financial statements, i.e., December 31, 1997. The company never became profitable, and the IPO was never approved. On February 13, 1998, the company filed for bankruptcy.

Imprimis acknowledged it closed on the loan before receiving KPMG’s audit report, but argued they could prove they actually relied upon KPMG’s unqualified opinion before the transfer of their funds. Imprimis conceded there was nothing to show they had any direct contact of any kind with KPMG throughout the relevant time.

Imprimis argues the facts showed (1) KPMG had concerns about the unreliability of the company’s 1996 financial statements; (2) in March, 1997, KPMG refused to issue an unqualified audit opinion until the company received financing sufficient to meet its foreseeable obligation; (3) while KPMG promised the company a clean audit opinion upon sufficient financing, it simultaneously informed the company of its many and serious accounting problems that reduced the credibility of the company’s financial statements; (4) during Imprimis’s introductory meeting with the company on July 3, 1997, the investors learned their financing would eliminate KPMG’s “going concern” issue and result in an unqualified audit report; (5) KPMG knew of the Imprimis’s potential investment as well as the proposed financing terms; (6) from the time of the meeting on July 3, 1997, Imprimis relied on KPMG’s anticipated audit report in deciding to invest in the company; (7) Imprimis understood the representations contained in an unqualified audit report without the necessity of physical possession of the formal report; and (8) although the Imprimis made KPMG’s unqualified opinion a condition of their loan, KPMG would not release the opinion in writing until after the loan had been funded because its unqualified opinion was dependent upon Imprimis’s financing.

The Court determined there was nothing to show that KPMG, rather than executives of the company, made assurances to the investors at the meeting of July 3, 1997, or at any time before their loan commitment. The Court determined there was nothing to show, directly or inferentially, that any assurances given by the company to the investors were given with the actual knowledge or consent of KPMG. In short, the Court found KMPG did not agree to supply information for the investors’ guidance. To the contrary, it refused to provide its “clean” audit report to the company until the investors acted on their independently formed investment decision. And, regardless of what KPMG agreed to do, it did not actually deliver its report until after the investors had parted with their funds. Under either view, there was no reliance by Imprimis on KPMG’s report.  Without the transmittal of KPMG’s report prior to the closing, the Court did not allow Imprimis to recover against KPMG for Imprimis’s decision to invest in the company.  Thus, the Court rejected the argument that Imprimis “indirectly relied” on information from KPMG.

Matthew O'Leary, Esq.

LeClair Ryan