Lead Opinion
delivered the opinion of the Court.
In the mid-1990s, two officers of a corporation intentionally misrepresented details concerning the corporation’s financial status to an independent auditing firm. That firm in turn failed to detect those misrepresentations for several years. After subsequent audits revealed the officers’ fraud, the corporation was forced to acknowledge previously unreported losses of tens of millions of dollars and to declare bankruptcy. A litigation trust, acting as the corporation’s successor-in-interest and representing the corporation’s shareholders, filed suit against the auditor for negligently conducting the audit. The trial court granted the auditor’s motion to dismiss based on the imputation doctrine, which holds that knowledge of an agent generally is attributed to its principal. The trial court concluded that the fraud was imputable to the litigation trust, as the corporation’s successor, and that the litigation trust cannot sue the auditor unless the auditor intentionally and “materiaiPy] participat[ed]” in the fraud. The Appellate Division reversed, concluding that the trust’s complaint alleged sufficient facts to support an equitable fraud claim against the auditor.
In this matter, we therefore must decide whether the imputation doctrine bars the litigation trust’s action. We hold that the imputation doctrine does not bar corporate shareholders from recovering through a litigation trust against an auditor who was negligent within the scope of its engagement by failing to uncover or report the fraud of corporate officers and directors. Imputation, however, may be raised as a defense by auditors to bar such claims against corporate shareholders who engaged in or were aware of the wrongdoing of corporate agents. In light of our holding, and for the reasons set forth below, we affirm the Appellate Division decision, as modified, and remand this matter to the trial court for reinstatement of the complaint.
A.
Physician Computer Network, Inc. (PCN), a publicly traded New Jersey corporation with offices in Morris Plains, was engaged in the business of developing and marketing software to assist doctors in communicating with hospitals, insurers, laboratories, and group health care providers. From mid-1993 until mid-1998, PCN retained defendant KPMG LLP, an international accounting firm with a regional office in Short Hills, as its independent auditor. During that time, two PCN officers, John Mortell and Thomas Wraback, served as the primary contacts with KPMG. John Mortell was a director of PCN during all relevant times and PCN’s President from January 1998 until March 1998, when he was removed from his position. Mortell also served as the corporation’s Chief Financial Officer from May 1992 to March 1995 and as its Executive Vice President and Chief Operating Officer from March 1995 to December 1997. Thomas Wraback was PCN’s Senior Vice President and Chief Financial Officer from September 1996 until August 1998, when PCN terminated his employment.
During the mid-to-late 1990s, Mortell and Wraback orchestrated a series of fraudulent transactions to inflate PCN’s reported revenues and reduce its reported expenses. On April 1, 1996, PCN filed its annual report on Form 10-K with the Securities and Exchange Commission (SEC) for the fiscal year ending on December 31, 1995. In that filing, PCN reported revenues of over $41 million for 1995, a 104% increase over revenues of approximately $20 million in 1994, and a 584% increase over revenues of approximately $6 million in 1993. Despite that increase, the corporation also reported a net loss before extraordinary items of over $11 million. The 1995 financial statements were accompanied by an unqualified audit opinion by KPMG directed to PCN’s Board and stockholders, stating:
We have audited the consolidated financial statements of the Physician Computer Network, Inc. and subsidiaries as of December 31, 1995 and 1994, and the*359 related consolidated statements of operations, changes in shareholders’ equity (deficiency), and cash flows for each of the years in the three-year period ended December 31, 1995. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Physician Computer Network, Inc. and subsidiaries as of December 31, 1995 and 1994, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1995, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, and in all material respects, the information set forth therein.
The following day, April 2, 1996, PCN issued a press release announcing that it had filed a registration statement and prospectus with the SEC to offer seven million shares of PCN’s common stock for sale to the public. PCN later filed an amended statement with the SEC, lowering that amount to 5.6 million shares. With KPMG’s express consent, each SEC registration statement and prospectus included a copy of the corporation’s audited financial statements for 1995 and KPMG’s accompanying audit report.
Two months later, PCN issued another press release, this time announcing that PCN had signed an agreement with WismerMartin Inc., another provider of practice management systems, for PCN to acquire that company, by merger, subject to WismerMartin shareholder approval. The agreement provided that PCN was to obtain all of Wismer-Martin’s issued and outstanding stock in exchange for approximately $2 million in cash and 935,000 shares of PCN common stock. In connection with that merger, PCN filed a form S-4 registration statement with the SEC, which, with the express consent of KPMG, included PCN’s audited
In 1997, PCN filed its annual report for 1996 with the SEC, which included its audited financial statements for the year ending on December 31,1996, and an unqualified audit opinion by KPMG, stating that KPMG’s audit was conducted in accordance with Generally Accepted Auditing Standards (GAAS) and Generally Accepted Accounting Principles (GAAP). According to those financial statements, PCN’s 1996 revenues were almost $96 million, more than double that of 1995. Throughout 1997, PCN continued to report increased revenues and income as compared to corresponding periods in the prior year.
During the course of its audit work for the fiscal year ending on December 31, 1997, KPMG discovered several accounting irregularities. In February 1998, KPMG raised those concerns with Mortell, Wraback, and PCN’s outside counsel. As a result, on March 3, 1998, the corporation issued a press release announcing that it would restate its previously reported financial results for each of the first three quarters of 1997 and instead report a loss from operations for each of those quarters. The corporation also announced that it would report a loss for the fourth quarter of 1997, yielding a total expected loss of between $27 and $31 million for the year. In that same announcement, the corporation stated that Mortell had “taken a temporary leave of absence” pending completion of the corporation’s 1997 audit. Following those disclosures, the price of PCN stock fell seventy percent, hitting a record low.
In April 1998, PCN announced both that KPMG was withdrawing its auditor’s report for 1996 and that PCN had appointed a Special Committee of its Board to conduct an investigation into the matter. From April 1998 to June 1998, KPMG continued its audit procedures and found additional irregularities in the 1996 consolidated statements. At the end of August, PCN filed a Form 8-K with the SEC, disclosing that KPMG had withdrawn its audit opinion for the 1994 and 1995 fiscal years and had discovered that
The effect of PCN’s announcements and disclosures was disastrous for the corporation. Thereafter, PCN continually operated at a cash flow deficit and was in default on its bank debt. The corporation ultimately filed a petition for bankruptcy on December 7, 1999. As part of the bankruptcy plan, the corporation’s assets were acquired by Medical Manager Corporation. PCN no longer operates as a public corporation.
B.
Beginning in 1998, several class action lawsuits were filed against PCN on behalf of various shareholder groups and consolidated in the United States District Court for the District of New Jersey. The consolidated action, which eventually settled for $21,150,000, was comprised of persons who purchased or otherwise acquired PCN common stock from February 1996 to April 1998. The settlement expressly denoted that it did not preclude claims against KPMG, Mortell, or Wraback. Nine months later, the same group settled their claims against Mortell and Wraback for $45,000, to “be used to fund the investigation and prosecution of claims the Class may have against KPMG.”
Then, in 2001, a class of plaintiffs, consisting of shareholders for the period of April 1996 through April 1998, filed suit against KPMG in the United States District Court for the District of New Jersey. The complaint alleged securities fraud violations under Section 10(b) of the Securities Exchange Act of 1934 in connection with KPMG’s 1995 and 1996 audits and Section 11 of the Securities Act of 1933 in connection with the 1995 audit. KPMG filed a motion to dismiss. In an unpublished opinion, Judge Dickinson
In 2002, the SEC filed a complaint in the United States District Court for the District of Columbia, charging six former officers and managers of PCN, including Mortell and Wraback, with accounting fraud. The SEC also filed a notice of settlement, indicating that all defendants had consented to the entry of “a permanent injunction enjoining [each person] from violating or aiding or abetting violations of the anti-fraud, periodic reporting, record-keeping, internal controls and lying to the auditors provisions of the federal securities laws.” As part of the settlement, Mortell agreed to be permanently barred from acting as an officer or director of a public company, and Wraback agreed to be barred for ten years.
C.
The present action against KPMG was filed in May 2002 by plaintiff NCP Litigation Trust (Trust). The Trust was created pursuant to PCN’s confirmed bankruptcy plan, approved by the United States Bankruptcy Court for the District of New Jersey. The formal agreement creating the Trust provides:
[T]he Debtors [PCN and related entities] have agreed to contribute to the Litigation Trustee in trust ... all of their interests in any Causes of Action (the “Litigation Claims”) ... [and] have requested that the Litigation Trustee enforce the Litigation Claims, if any, for the benefit of all holders of Allowed Class 7B Equity Interests____
The record reflects that the term “Allowed Class 7B Equity Interests” refers to shareholders of the debtor corporation.
The Trust’s amended complaint alleges that KPMG committed negligence, negligent misrepresentation, breach of contract, and breach of fiduciary duty. As part of those allegations, the Trust asserts that KPMG failed to perform its audits in conformity with GAAS and GAAP, the professional guidelines that auditors must adhere to while conducting an audit. In essence, the Trust claims that
*363 KPMG negligently failed to exercise due professional care in the performance of its audits and in the preparation of the financial statements and audit reports. Had KPMG not performed negligently, and had it instead exercised due care, it would have detected PCN’s fraud and prevented the losses PCN sufiered.1
According to the Trust, PCN’s 1995 financial records, which KPMG certified, were in such disarray that the successor auditor, Arthur Anderson, was unable to reconstitute them. The Trust also cites an investigation by the Special Committee of PCN’s Board that found that the corporation’s 1995 fiscal results had been overstated. PCN’s 1996 financial records also are alleged to have suffered from substantial irregularities. For example, KPMG purportedly failed to verify PCN’s receipt and deposit of a $3.5 million check that was part of a fraudulent asset purchase arranged by Mortell and Wraback. According to the Trust, a simple examination of PCN’s bank records would have revealed that this amount—the largest single source of PCN’s 1996 income—was never deposited. KPMG also allegedly allowed for the improper reversal of an approximate $1.8 million liability, thereby offsetting an increase in PCN’s accounts receivable reserve, even though “KPMG knew that the reversal of [that] obligation was not supported by GAAP.”
The complaint further alleges that KPMG failed to discover PCN’s improper recognition of income on its software maintenance agreements. Specifically, PCN entered into maintenance service contracts with its software customers that required customers to pay the fees for the entire maintenance contract when the contract was executed. The Trust alleges that KPMG neglected to comply with GAAP because, although PCN received payment up front for the full amount of the maintenance contracts, GAAP requires that revenue be recognized over time as the services are provided, not at the time of the initial sale. As a result, PCN reported nearly $1.5 million in 1996 that was not actually earned until 1997. The Trust also maintains that KPMG
Finally, the complaint asserts that individual audit team members were distracted and deficient in the performance of their duties:
The KPMG audit team assembled for the 1996 audit was not a strong one. Upon information and belief, the partner on the PCN audit for years was distracted by another client which was having substantial trouble which required him to spend a lot of time away from PCN during the audit. The audit manager was new to the PCN audit and was therefore unfamiliar with the Company. Also, the audit senior, who was also new to the PCN audit, was so preoccupied about leaving KPMG to attend law school that he spent substantial time asking Wrabaek about apartment-hunting in New York rather than performing the necessary audit work; his audit work suffered as a result.
KPMG moved to dismiss, contending that the fraud of Mortell and Wrabaek, as agents of PCN, should be imputed to the Trust, as PCN’s successor-in-interest, thereby barring the Trust’s action against KPMG. The trial court agreed and granted the motion. The court reasoned that to defeat the imputation defense the Trust would have to show “that there has been a material participation by the third party, a material form of culpability.” After reviewing the record, the court concluded that it found “no evidence of any material fault, accounting irregularity, [or] participation of the defendants in the fraudulent conduct of these senior participants that would in any way be deemed sufficient to estop the rule of imputation as the case was in [In re Integrity Insurance Co., 240 N.J.Super. 480,
In an unreported decision, the Appellate Division reversed in part, concluding that “Integrity supports the sufficiency of [the Trust’s] complaint.” In the panel’s view, “[n]egligence, negligent misrepresentation, and breach of contract, as well as legal fraud, surely can be culpable conduct that ‘contributed to the misconduct of another.’ ” As such, the Appellate Division found that “[t]he
KPMG appealed, and we granted certification. 181 N.J. 286,
II.
At the outset, we observe that this matter is before us on a Rule 4:6-2(e) motion to dismiss. On such motions, a trial court should grant a dismissal “in only the rarest of instances.” Printing Mart-Morristown v. Sharp Elecs. Corp., 116 N.J. 739, 772,
The liberal standard that governs a motion to dismiss has particular relevance to imputation cases because “[d]eciding whether to permit an auditor to utilize imputation requires a detailed factual analysis of the dispute.” Maureen Mulligan et al., Recent Developments in the Law Affecting Professionals, Officers, and Directors, 36 Tort & Ins. L.J. 519, 535 (2001). Consequently, many courts have held that the applicability of the imputation
III.
The imputation doctrine is derived from common law rules of agency relating to the legal relationship among principals, agents, and third parties. Pursuant to those common law rules, a principal is deemed to know facts that are known to its agent. Restatement (Third) of Agency § 5.03 (Tentative Draft No. 6, 2005) (“[N]otice of a fact that an agent knows or has reason to know is imputed to the principal if knowledge of that fact is material to the agent’s duties to the principal.”). Courts have used interchangeable terms to express this legal rule with some describing the principal as “imputed” with the agent’s knowledge, Hercules Powder Co. v. Nieratko, 113 N.J.L. 195, 199, 173 A. 606 (Ch.Ct.1934), and others stating that the principal has “constructive knowledge,” Hollingsworth v. Lederer, 125 N.J.Eq. 193, 206,
Under the doctrine, a third party may invoke imputation as a defense against a principal seeking to enforce an agreement when the principal’s agent fraudulently induced the third party to enter into that agreement. In other words, an agent’s fraud is imputed to a principal, thereby barring the principal from suing the third party. See Gordon v. Cont’l Cas. Co., 319 Pa. 555, 181 A. 574, 578 (1935) (“A principal who sues to enforce a contract is bound by the representations made by his agent, in order to induce the opposite party to make it.”) (citation omitted). Courts have found that it is unfair to allow a principal to enforce an agreement in such a situation, even when both the principal and the third party have acted in good faith. The party who selected the agent—the principal—should bear the loss stemming from the agent’s misconduct. Ibid.
Imputing an agent’s actions and knowledge to the principal serves several salutary purposes. By allocating the risk of injury to the principal, the imputation doctrine “creates incentives for a principal to choose agents carefully and to use care in delegating functions to them.” Restatement (Third) of Agency, supra, § 5.03 cmt. b. Because the principal cannot avoid responsibility through ignorance, imputation also “encourages a principal to develop effective procedures for the transmission of material facts, while discouraging practices that isolate the principal or co-agents from facts known to an agent.” Ibid. Moreover, third parties who are aware that the principal is ultimately accountable for its agent’s actions and representations are more likely to conduct business through an agent.
Such an application of the imputation defense has been criticized, however, because “agency doctrines ... operate on an all- or-nothing basis.” Deborah A. DeMott, When is a Principal Charged with an Agent’s Knowledge, 13 Duke J. Comp. & Int’l L. 291, 319 (2003). That is, the negligent auditor either faces total liability or none. Morris, supra, 2001 Colum. Bus. L.Rev. at 353 (“As a device for assigning responsibility, [imputation] is unforgivingly binary.”). Those disparate results seem “severe and unmodulated by concern for the specifics of individual cases.” Demott, supra, 13 Duke J. Comp. & Int’l L. at 319. Absolving negligent corporate auditors “is difficult to rationalize and to justify or explain in any satisfying or comprehensive way.” Id. at 291 (citation omitted). As a result, “courts have struggled to determine what circumstances permit an auditor to invoke this defense.” Mulligan, supra, 36 Tort & Ins. L.J. at 533.
IV.
With that background as our guide, we turn to the issue in this appeal—whether the imputation doctrine bars the Trust, representing shareholders of PCN, from bringing suit against the corporation’s auditor for its alleged negligence in failing to detect the fraud of PCN’s directors and officers.
Those arguments require that we consider whether this State’s jurisprudence permits the Trust to maintain an action for negligence. Because the Trust represents shareholders of PCN, we also must determine whether to follow Cenco and hold that the imputation doctrine bars suit on behalf of shareholders.
Y.
A.
The Supreme Court teaches that the application of the imputation doctrine is a matter of state law. O’Melveny & Myers v. FDIC, 512 U.S. 79, 83-85, 114 S.Ct. 2048, 2052-54,
as a result of mismanagement and fraud, the [defendant officers and directors] caused Integrity to become statutorily insolvent ... and then, with the active participation of [the auditor], concealed the company’s true economic condition by preparing and disseminating materially false financial statements.
[Id. at 488, 573 A.2d 928.]
In response, the auditor argued that “any knowledge by the individual defendant officers and directors must be imputed to [the insurance company] as a corporation,” and, therefore, the liquidator’s action should be barred by the imputation defense. Id. at 505,
In this matter, although we reach the same conclusion as the Appellate Division—that Integrity permits the Trust’s claims—we do not adopt the panel’s reasoning, which was based on equitable fraud. Instead, we reject KPMG’s assertion that Integrity stands for the proposition that only an auditor who actively participated in the corporate fraud can be barred from raising the imputation defense. Although the complaint in Integrity alleged that the defendant auditors had “aetive[ly] participat[ed],” id. at 488,
B.
The dissent states that under our holding, “for all practical purposes, the imputation defense ... no longer exists.” Post at 395,
However, this matter does not present the typical circumstance for which the imputation defense was designed because PCN’s agents did not directly defraud an innocent third party. They defrauded the corporation and its creditors instead. In that respect, KPMG is not a victim of the fraud in need of protection. Further, KPMG had an independent contractual obligation, at a level defined by its agreement with PCN, to detect the fraud, which it allegedly failed to do. Allowing KPMG to avoid liability for its allegedly negligent conduct would not promote the purpose of the imputation doctrine—to protect the innocent. Therefore, by not extending the imputation doctrine to this context, we do not eviscerate it, as the dissent argues, but rather, we refuse to stretch it to its breaking point. Cf. In re Jack Greenberg, Inc., 240 B.R. 486, 508 (Bankr.E.D.Pa.1999) (“[Wjhile the imputation doctrine may be applied in auditor liability cases, the doctrine was not crafted with that purpose in mind.”).
In sum, we hold that the Trust’s suit is not barred because one who contributed to the misconduct cannot invoke imputation. We therefore conclude that a claim for negligence may be brought on behalf of a corporation against the corporation’s allegedly negligent third-party auditors for damages proximately caused by that negligence.
We turn our attention from the question whether a claim for negligence against an auditor can be brought to the issue of who may bring that claim. For the reasons expressed below, we hold that in this case the Trust, as the representative of PCN’s shareholders, may bring this action.
A.
The seminal case on the issue is Cenco, supra, in which the Seventh Circuit, interpreting Illinois law, held that allegedly negligent auditors could invoke imputation as a defense when corporate management committed fraud that benefited the corporation.
The Seventh Circuit rejected the “extreme position” that an employee’s fraud is always attributable to the corporation, reasoning that such a position “would exonerate auditors from all liability for failing to detect and prevent frauds by employees of the audited company.” Id. at 454. “Auditors are not detectives hired to ferret out fraud, but if they chance on signs of fraud they may not avert their eyes—they must investigate.” Ibid. In deciding whether imputation should bar the shareholder suit, the court looked to tort law principles, rather than to rules of agency, because tort law is designed to “compensate the victims of wrongdoing and to deter future wrongdoing.” Id. at 455. Applying those principles, the court determined that a judgment in favor of the corporation would be “perverse from the standpoint of compensating the victims of [the] wrongdoing,” because the culpable
Turning to considerations of deterrence, the Seventh Circuit recognized that auditor liability would create an incentive for auditors to be “more diligent and honest in the future.” Ibid. Nonetheless, considering the question in the context of a contributory negligence framework, which applied in Illinois at the time, the court found that shareholders of a corrupt enterprise should not be allowed to shift the entire responsibility for fraud to the auditor because “their incentives to hire honest managers and monitor their behavior will be reduced.” Ibid. The court refused to permit the company to recover because, during the fraud, the corporation had large corporate shareholders who were in a position to watch over the firm’s operations but who “were slipshod in their oversight.” Id. at 456.
Finally, the court examined whether the fraudulent acts of management benefited or harmed the corporation. Ibid. The court stated:
Fraud on behalf of a corporation is not the same thing as fraud against it. Fraud against the corporation usually hurts just the corporation; the stockholders are the principal if not only victims; their equities vis-á-vis a careless or reckless auditor are therefore strong. But the stockholders of a corporation whose officers commit fraud for the benefit of the corporation are beneficiaries of the fraud.
[Ibid.]
Concluding that the malfeasant acts of management were for the benefit of the company, the court barred the corporation’s suit against the auditor. Ibid.
One year later, in Schacht v. Brown, 711 F. 2d 1343 (7th Cir.), cert. denied, 464 U.S. 1002, 104 S.Ct. 509, 78 L.Ed.2d 698 (1983), the same circuit revisited the issue of auditor liability and reached a different result. In Schacht, the officers and directors of an insurance corporation allegedly arranged a fraudulent scheme to
The Seventh Circuit rejected the auditor’s reliance on Cenco, finding Cenco factually distinct from the case at bar. The court first rejected the argument that the fraud benefited the corporation, explaining that
the fact that [the corporation’s] existence may have been artificially prolonged pales in comparison with the real damage allegedly inflicted by the diminution of its assets and income____We do not believe that such a Pyrrhic “benefit” to [the corporation] is sufficient to even trigger the Cenco analysis which seeks to determine the propriety of imputing to the corporation the directors’ knowledge of fraud.
[Ibid.']
The Schacht court also found Cenco distinguishable on its facts. In Cenco, any recovery from the auditors would have benefited the corporation’s shareholders, whereas in Schacht any recovery would benefit the corporation’s creditors and policyholders. Ibid. The court explained that in “Cenco, we undertook a two-pronged analysis to determine whether ... imputation should occur: whether a judgment in favor of the plaintiff corporation would properly compensate the victims of the wrongdoing, and whether such recovery would deter future wrongdoing.” Ibid. First, the court found that any recovery would compensate only the victims of the wrongdoing because the creditors and policyholders were
Following in the footsteps of Schacht, other jurisdictions have distinguished Cenco and not applied the imputation defense in cases in which recovery against allegedly negligent third parties would inure to the benefit of creditors of the insolvent corporation. See, e.g., In re Phar-Mor, Inc. Sec. Litig., 900 F.Supp. 784, 787 (W.D.Pa.1995) (rejecting application of imputation defense in summary judgment motion against auditors for negligence, misrepresentation, outrageous conduct and breach of contract when any recovery under litigation trust would “inure to the benefit of the secured and unsecured creditors having an interest in the trust”); Welt v. Sirmans, 3 F.Supp.2d 1396, 1402-03 (S.D.Fla.1997) (holding that imputation defense does not bar bankruptcy trustee from bringing “a claim for damages stemming from a third party’s negligent failure to discover a fraud perpetrated by such corporation’s officers and directors,” when such action benefits corporation’s creditors); Greenberg, supra, 240 B.R. at 489, 517-18 (permitting claims for negligence, fraud, negligent misrepresentation, and aiding and abetting fraud against auditor where proceeds of recovery would benefit creditors). Like Schacht, those courts have reasoned that allowing creditors to recover against a negligent auditor would serve the objectives of tort liability because, unlike Cenco, neither the fraudulent actors nor the corporation’s shareholders would benefit from a recovery.
Although we accept Cenco’s premise that tort principles are a useful guide in determining when the imputation defense may be invoked, we decline to follow Cenco’s conclusion that the imputation defense should prohibit all shareholder lawsuits against auditors who were allegedly negligent within the scope of their engagement. We note that Cenco was decided under Illinois law, and so we “write on a clean slate” in addressing the issue under New Jersey law. Schacht, supra, 711 F. 2d at 1347. Further, Cenco was decided over twenty years ago. Events since then suggest that auditors must be more alert to corporate fraud and, where appropriate, courts should take steps to protect and safeguard the public from that fraud.
We first address Cenco’s reasoning that shareholders should not be permitted to recover against allegedly negligent auditors because such a recovery would conflict with the tort principle of only compensating victims. As the circuit recognized in Cenco, if the veil of imputation is completely lifted there will be occasions when offending officers and undeserving board members, as shareholders of the corporation, will be in a position to recover from a negligent auditor. Simply put, under our laws, a shareholder cannot and should not benefit from his or her own wrongdoing. But we should not punish the many for the faults of the few. Allowing the impropriety of some shareholders—who, as directors and officers, perpetrated or did not prevent the fraud— to bar all shareholders from recovery is unfair and improper. Indeed, although shareholders elect the board of directors, that does not necessarily make them culpable in the fraud. In large corporations only shareholders with a substantial ownership of stock may have the ability to affect board elections. Accordingly, we find that the imputation doctrine should not bar suit by all shareholders.
Our conclusion, however, is subject to certain limitations. We agree with the dissent that “no one should profit from a
We also disagree with Cenco that imputation must be applied to shareholder suits to deter future such wrongdoing. In Cenco, supra, the circuit reasoned that “if the owners of the corrupt
Further, our focus cannot be limited only to deterring wrongdoing on the part of corporate shareholders. We also must seek to deter wrongdoing on the part of corporate auditors. See Greenberg, supra, 240 B.R. at 507 (“Unlike traditional imputation cases, in auditor liability cases ... the defendant is not an innocent party.”). If we allow imputation to shield a negligent auditor from the consequences of its actions, we will force shareholders to shoulder the entire loss—a result that violates principles of fairness and equity. Although the auditor in this matter was not accused of committing fraud, the Trust claims that the auditor negligently failed to detect the corporate fraud, thereby violating its contractual obligation to the corporation and allowing the fraud to remain undetected. By way of illustration only, in one allegation the Trust maintains that KPMG failed to comply with GAAS
We observe, further, that Cenco, supra, interpreted Illinois law, which, at the time of that decision, applied contributory negligence in negligence cases.
Even if the fraud of Mortell and Wrabaek could be considered a “benefit” to the corporation, the limited record before the Court precludes us from definitively making such a determina
Accordingly, we conclude that tort principles do not require that the imputation defense bars shareholder suits against allegedly negligent auditors. To the contrary, those principles, applied in light of the nature of today’s corporations, require that such suits be permitted and that negligent auditors be held responsible for their wrongdoing.
C.
In so holding, we note that KPMG’s liability must be defined by the scope of the engagement it entered into with PCN. As such, we disagree with the dissent that by allowing a claim for negligence, the Court “ignores the basis of the bargain between PCN and KPMG and, instead, imposes its own view of the services an auditor is retained to perform.” Post at 403-04,
We have audited the consolidated financial statements of Physician Computer Network, Inc. and subsidiaries as of December 31, 1995 and 1994, and the related consolidated statement of operations, changes in shareholders’ equity (deficiency), and cash flows for each of the years in the three-year period ending December 31, 1995. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express*383 an opinion on these consolidated financial statements and financial statement schedule based on our audits.
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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Physician Computer Network, Inc. and subsidiaries____
Any suit brought in negligence against KPMG must be based on the scope of that, or related, understandings and agreements to determine whether KPMG violated any duty. That review includes, but is not limited to, the engagement letter and GAAS. Cf. N.J.A.C. 13:29-3.5 (stating that auditor “shall not permit [his/her] name to be associated with financial statements ... unless [he/she] has complied with [GAAS or Statements on Auditing Standards issued by the American Institute of Certified Public Accountants]”). Here, the complaint alleges that
[c]ontrary to the representations in its audit opinions, KPMG’s audits of PCN’s 1995 and 1996 financial statements were not conducted in accordance with GAAS. KPMG certified PCN’s 1995 financial statements, even though PCN’s 1995 books and records were in such disarray that, when the irregularities in PCN’s financial statements came to light, another ... auditing firm ... was unable to recreate accurate financial statements for that period.
Ultimately, the issues to be resolved are whether KPMG was negligent in performing its agreed duties and to what extent such negligence proximately contributed to the damages suffered by plaintiff. In so providing, we do not re-write the agreement; we effectuate it.
Nor do we see how the dissent’s application of the imputation doctrine to this context would further its goal of holding KPMG liable based on the scope of its engagement. According to the dissent, KPMG only can be held liable if it “actively participated in the fraud.” Post at 397,
Finally, the dissent asks us to adopt “the thoughtful, reasoned and comprehensive opinion” by Judge Debevoise in a federal case against KPMG. Post at 404,
VII.
We thus conclude that when an auditor is negligent within the scope of its engagement, the imputation doctrine does not prevent corporate shareholders from seeking to recover. A limited imputation defense will properly compensate the victims of corporate fraud without indemnifying wrongdoers for their fraudulent activities. To the extent that shareholders are innocent of corporate wrongdoing, our holding provides just compensation to those plaintiffs.
With that conclusion in mind, we return to the procedural posture of this matter. We agree with the Trust that the pleadings do not support the availability of the imputation defense in
Notes
This allegation and all other statements below are derived from the Trust's complaint and have not been substantiated at this early stage in the proceedings.
The presence of auditor negligence arguably could be called an “exception" to the imputation doctrine. However, Integrity, supra, refers to estoppel, that is, the accountant’s culpability "would estop it from raising the defense of imputation.” 240 N.J.Super. at 506,
The task of separating those shareholders who should be barred by the imputation defense from those that should not is generally a question of fact that can be addressed at the trial level and, more particularly, is a function of the discovery process and motion practice. For example, KPMG is entitled to a list of shareholders represented by the Trust and, based on that list, can assert the imputation defense against appropriate shareholders. If it is revealed that the Trust represents Mortell and Wraback, then KPMG would be entitled to raise the imputation defense to preclude any recovery by those individuals. Similarly, the auditors may claim that shareholders who own large blocks of stock knew or should have known of the misconduct, in which case evidence can be presented concerning those shareholders’ knowledge.
Trial courts thus will be able to address these matters on a case-by-case basis until experience presents an opportunity for further guidance. Finally, this process also may have the salutary effect of encouraging plaintiff groups to ensure that they represent only the appropriate shareholders, thereby saving time and resources.
The principles set forth in this Court's decision in Frugis v. Bracigliano, 177 N.J. 250,
Dissenting Opinion
dissenting.
Although I agree with most of Justice Rivera-Soto’s dissenting opinion, I write separately in dissent because I differ from my colleague in that I believe that it may be appropriate to deny an imputation defense to a litigant based on a theory of negligence in certain circumstances. In other words, I would not foreclose consideration of extending a carve-out from the imputation defense based on certain instances of recklessness or gross alleged professional negligence. That said, I agree that this matter properly was dismissed at the pleading stage.
The majority is altering our ease law to include negligence as among the torts that will justify a carve-out from the application of the strict rule of the imputation defense. That approach may be appropriate for some negligent behavior, depending on the extent
In respect of the procedural posture in which the question is presented, I must add that it would have been my preference not to decide whether to extend the current carve-out from the imputation defense until a properly pled complaint and developed record brought a cause of action based on recklessness or gross negligence before the Court. However, because the majority has elected to recognize a new rule of law that would deny imputation of wrongdoing in favor of any accountant who may have negligently audited the books of the wrongdoer, I cannot wait to make my decision. I can only state my present view that I do not endorse the wholesale adoption of simple negligence as the basis for permitting a carve-out from application of the imputation defense.
Moreover, given the different standard of negligence that I would require in order to consider expansion of the carve-out, I also cannot agree with the determination to remand this matter for discovery. Normally, we are loath to dismiss at the pleading stage because we do not want to deny a litigant an opportunity to flesh out a complaint through discovery. See R. 4:5-7 (stating
As noted by the majority, a similar action was filed in federal court against KPMG by a group of shareholders.
Specifically, in respect of the G. Barry transaction, the court found that “there was no allegation that KPMG knew that the transaction was fictitious.” There was “no allegation of facts constituting strong circumstantial evidence of conscious misbehavior or recklessness by KMPG. [Plaintiffs’] allegations that KPMG violated GAAP and GAAS without more, are insufficient to state a
In the wake of those circumstances, the instant complaint had to have pled something more than worn allegations from prior proceedings to overcome a defendant’s motion to dismiss based on an imputation defense. To me, the failure in pleading is dispositive in these unique circumstances involving multiple prior litigations on the same alleged facts. In the context of a novel theory that a shareholder’s negligence action against a third-party auditor should be carved out from the application of the imputation defense, more was required for this action to avoid dismissal. In the end, Judge Debevoise’s analysis and conclusion is instructive. Just as the federal action was dismissed because neither recklessness nor other evidence of conscious participation in the wrongdoing was shown, those same standards remain unsatisfied by the pleadings in this matter. In other words, absent any credible claim of recklessness, gross negligence or other similar culpable conduct by the auditor that contributed to the wrongdoing, defendants were entitled to a dismissal. Thus, there was no basis presented on which I would consider expanding the carve-out from the imputation defense. The defendant, therefore, was entitled to the defense and the defense is all-or-nothing.
Accordingly, I respectfully dissent.
See Cenco, Inc. v. Seidman & Seidman, 686 F.2d 449, 454 (7th Cir.1982) (recognizing that there is "[an] extreme position" that "employee’s fraud is always attributed to the corporation____").
Although those claims involved violations of federal securities law, the claims in the Trust’s complaint in this matter recited the identically pled facts as are found in the federal complaint.
Dissenting Opinion
dissenting.
In the inevitable casting about for redress that follows the discovery of inflated financial results that falsely improve a corpo
This ease, however, differs in two fundamental respects from those eases. First, unlike the instances where auditor misdeeds were part and parcel of the wrongdoing committed, in this case KPMG relied—as it had the right to do—on the representations made to it by Mortell and Wraback, the persons selected by PCN as its gatekeepers for accounting information, yet who also were the corrupt wrongdoers and masterminds of the fraud here. Second, it was KPMG itself that ultimately discovered and exposed Mortell’s and Wraback’s wrongdoing. Despite those incontrovertible facts evident on the face of the complaint, the majority concludes that this case cannot be disposed of on motion and must return to the Law Division for additional proceedings because, in the majority’s view, “KPMG does not deserve the same protection as an innocent, uninvolved third party.” Ante, 187 N.J. at 385,
I.
I am in substantial agreement with the majority’s recitation of the facts here.
The trial court granted KPMG’s motion and dismissed the Trust’s complaint with prejudice. After concluding that the Trust was the unquestioned “successor in interest” to PCN,
if an officer or agent acting within the general scope of powers requires knowledge of a fact while committing a fraud upon a third person in a matter pertaining to the business of the corporation, although the fraud is perpetrated for his own benefit, the corporation will be imputable [with] such knowledge, as well as with knowledge of the fraud, especially where it ratifies the transaction.
Relying on both Hollingsworth v. Lederer, 125 N.J.Eq. 193,
there can be no doubt in the Court’s mind that the doctrine of imputation is indeed a viable doctrine in New Jersey. And that [it is] incumbent upon the parties to demonstrate that there has been a material participation by the third party, a material form of culpability to the extent that it would estop that third party from raising the defense of imputation.
The review of the record is satisfactory to lead this Court to conclude and to find no evidence of any material fault, accounting irregularity, participation of [KPMG] in the fraudulent conduct of these senior participants that would in any way be deemed sufficient to estop the rule of imputation____
There has not been demonstrated [to] the Court from the evidentiary material in [the] record that [KPMG’s] culpability was indeed allegedly material, significant, and contributory to the falsity and financial irregularities that were ultimately determined to be found subsequently by other parties.
As thus supplemented, the facts properly frame the issue before us.
II.
I address first the majority’s new iteration of the imputation defense in this State. As the majority notes, it is unarguably a matter of state law “whether the knowledge of corporate officers acting against the corporation’s interest will be imputed to the corporation____” O’Melveny & Myers v. FDIC, 512 U.S. 79, 83-89,114 S.Ct. 2048, 2053-56,
A.
Since at least 1916, New Jersey has recognized that
[a] private or a municipal corporation, as a legal entity, cannot itself have knowledge. If it can be said to have knowledge at all, that must be the imputed*393 knowledge of some corporate agent____[T]he knowledge of the proper corporate agent must be regarded as, in legal effect, the knowledge of the corporation. [Allen v. City of Millville, 87 N.J.L. 356, 357,95 A. 130 (Sup.Ct.1915), aff'd, 88 N.J.L. 693,96 A. 1101 (E. & A.1916) (per curiam).]
Accord, Hercules Powder Co. v. Nieratko, 113 N.J.L. 195, 199, 173 A. 606 (Sup.Ct.1934) (“[A] corporate body, as a legal entity, cannot itself have knowledge. If it can be said to have knowledge at all, that must be the imputed knowledge of some corporate agent. Knowledge of the proper corporate agent must be regarded as, in legal effect, the knowledge of the corporation.”).
The common sense notion that the knowledge of a corporate officer acquired in the course and scope of his employment should be imputed to the corporation itself was later questioned in the context of fraudulent acts by the corporate officer that harmed third parties. In Hollingsworth v. Lederer, 125 N.J.Eq. 193,
It has been held that the corporation is affected with constructive knowledge, regardless of its actual knowledge, of all material facts of which its officer or agent receives notice or acquires knowledge while acting in the course of his employment and within the scope of his authority, and the corporation is charged with such knowledge even though the officer or agent does not in fact communicate his knowledge to the corporation.
This rule appears to apply to vice-presidents, agents or managing agents, or any other officer or agent who acquires such notice or knowledge concerning matters pertaining to his department or scope of authority.
If any officer or agent acting within the general scope of his powers acquires knowledge of a particular fact while committing a fraud, upon a third person in a matter pertaining to the business of the corporation, although the fraud is perpetrated for his own benefit, the corporation will be imputable with such knowledge, as well as with knowledge of the fraud, especially where it ratifies the transaction.
[Supra, 125 N.J.Eq. at 206,4 A.2d 291 (citations and internal quotation marks omitted; emphasis supplied).]
The basis for this doctrine is firmly grounded in one of the core principles of our jurisprudence: “it is well settled that, as between two innocent parties, public policy requires that the principal must bear the loss occasioned by the act of his servant.” Stanley v. Chamberlin, 39 N.J.L. 565, 567 (Sup.Ct.1877).
That said, the reach of the imputation defense is not without bounds: the party invoking the imputation defense cannot be complicit in the fraud perpetrated. In one of its earliest formulations, that limitation was described as “[i]n the law of agency the doctrine of constructive notice is intended to shield from loss an innocent party who deals with the agent in good faith----” Id. at 568 (emphasis supplied). More recently, the Appellate Division concluded that
it is clear that the doctrine of constructive notice to the principal is not available to one who contributed to the misconduct sought to be imputed. Therefore, even though an agent (the directors and officers) of a principal [the corporation] may be responsible for falsity, the third party’s [the auditors’] culpability, if established, would estop it from raising the defense of imputation. The rule of implied notice is invocable to protect the innocent, never to promote an injustice.
[In re Integrity Ins. Co., 240 N.J.Super. 480, 506,573 A.2d 928 (App.Div.1990) (citations, internal quotation marks and internal parentheticals omitted).]
Citing Integrity, the Appellate Division here ruled that, because the Trust’s “complaint sets forth the facts necessary to support a claim of equitable fraud, as well as negligence and breach of contract on the part of KPMG, the PCN corporate officers’ knowledge and participation in the fraud are not imputed to the corporation to bar the action.” I disagree for several reasons.
The rule of Integrity, as the trial court correctly noted, is broader than the narrow reading given to it by the Appellate Division here. Under Integrity, the wrongful acts of a corporate officer are imputed to the corporation he represents and, unless the third party actively participated in the corporate officer’s wrongful acts, any action sounding in negligence by the corporation against a third party that relied on the corporate officer is barred.
Holding, as the Appellate Division did, that simple negligence and breach of contract claims are sufficient to strip from the third party the right to reasonably rely on representations made by duly appointed and constituted corporate officers in the course and scope of their employment—a reasonable reliance strongly engrained in our case law—eviscerates the doctrine of constructive notice. As the panel would have it, once a claim of equitable fraud is cobbled together, no third party will be entitled to the protection of the imputation defense when the wrongful corporate actor who was engaged in a fraud was the corporate representative with whom the third party interacted. That, simply, is not sensible.
Also, the rule of Integrity should not be rendered irrelevant at the motion to dismiss stage, as the majority would have it ripen only in respect of a motion for summary judgment filed after the completion of discovery. According to the majority, “the Trust’s suit is not barred because one who contributed to the misconduct cannot invoke imputation.” Ante, 187 N.J. at 372,
The imputation defense, if it is to have reasoned and continued viability, should protect a third party who relies on the representations of a corporate officer and who does not actively participate in that corporate officer’s wrongdoing. When, as here, the issue arises in the context of a motion to dismiss for failure to state a claim upon which relief can be granted, resort should be had to plaintiffs allegations as set forth in the complaint. If, with the particularity required by Rule 4:5-8(a), the plaintiff alleges that the third party engaged in a fraud, then that third party should be deemed, for motion to dismiss purposes only, to have actively participated in the fraud and the case should continue. On the other hand, when, as here, the plaintiff only alleges negligence and never alleges that the third party actively participated in the fraud, and when a broad reading of the complaint cannot be so construed, then, for motion to dismiss purposes, the third party should be entitled to the bar to liability provided by the imputation defense.
That statement of the rule is consistent with our prior law, accords with the great weight of authority elsewhere,
*397 [I]f the owners of the corrupt enterprise are allowed to shift the costs of its wrongdoing entirely to the auditor, their incentives to hire honest managers and monitor their behavior will be reduced. While it is true that in a publicly held corporation such as [plaintiff] most shareholders do not have a large enough stake to want to play an active role in hiring and supervising managers, the shareholders delegate this role to a board of directors, which in this case failed in its responsibility-
[Cenco Inc. v. Seidman & Seidman,686 P.2d 449 , 455-56 (7th Cir.1982).]
Basic principles of fairness and common sense demand that when, as here, one who already has knowledge of a fraud, either directly or by imputation, and later seeks relief from a third party because of reasonable reliance on the third party’s failure to expose the fraud, that claim must be rejected. It has long been the law in New Jersey that “[o]ne who engages in fraud ... may not urge that one’s victim should have been more circumspect or astute.” Jewish Ctr. of Sussex County v. Whale, 86 N.J. 619, 626 n. 1,
Those principles apply with equal force here. Because the fraud perpetrated by Mortell and Wraback clearly was knowledge imputed to PCN; because, by virtue of the litigation trust agreement, the Trust stands in the stead of PCN itself; and because there is nothing in a fair reading of the complaint that leads to a conclusion that KPMG actively participated in the fraud designed, engineered, and implemented by Mortell and Wraback, the imputation defense should be available to bar liability to the Trust.
The majority takes the position that KPMG is not entitled to dismissal at this stage because the Trust is entitled to additional discovery. That position is based on the generally correct principle that the imputation defense recognized in Integrity does not extend to “one who contributed to the misconduct.” Supra, 240 N.J.Super. at 506,
In general, New Jersey regulations governing the provision of auditing services by a licensed certified public accountant require that the auditor
shall not permit [his/her] name to be associated with financial statements in such a manner as to imply that [he/she] is acting as an independent public accountant with respect to such financial statements unless [he/she] has complied with applicable generally accepted auditing standards (GAAS). Statements of Auditing Standards (SAS) issued by the American Institute of Certified Public Accountants, and other pronouncements having similar generally recognized authority, are considered to be interpretations of generally accepted auditing standards, and departures therefrom shall be justified by those who do not follow them.
[N.J.AC. 13:29-3.5.]
As those regulations acknowledge, an auditor’s responsibilities are more specifically codified in and defined by the Statements on Auditing Standards issued by the Auditing Standards Board, “the senior technical body of the AICPA [American Institute of Certified Public Accountants] designated to issue pronouncements on auditing matters applicable to the preparation and issuance of
An independent auditor plans, conducts, and reports the results of an audit in accordance with generally accepted auditing standards (GAAS). Auditing standards provide a measure of audit quality and the objectives to be achieved in an audit. Auditing procedures differ from auditing standards. Auditing procedures are acts that the auditor performs during the course of an audit to comply with auditing standards.
[SAS at AU § 150.01.]
Although variously defined, the scope of the auditor’s engagement—what the auditor is to do in an engagement as opposed to how it is to be done—is driven exclusively by the specific wishes of the client. As set forth in the AICPA’s Attestation Standards (AT), audit engagements are grouped into four distinct general categories. In ascending order of detail, these are: compilations of prospective financial statements; review reports; examination or audit reports; and reports on agreed-upon procedures engagements. Because the scope of the services PCN purchased from KPMG defines KPMG’s liability, an understanding of the differences among the available auditing services is crucial.
1. Compilations.
When performing a compilation of prospective financial statements, the auditor’s engagement is limited to assembling projected financial statements, determining whether “the prospective financial statements with their summaries of significant assumptions and accounting policies ... appear to be presented in conformity with AICPA presentation guidelines and are not obviously inappropriate,” and issuing a compilation report to that effect. SAS at AT § 301.12. Significantly, “[a] compilation is not intended to provide assurance on the prospective financial statements or the assumptions underlying such statement.” Id. at AT § 301.13. Instead, “[bjecause of the limited nature of the practi
2. Review Reports.
Review reports are at a level once removed from compilations. The distinguishing characteristics of a review report are that:
the practitioner’s conclusion should state whether any information came to the practitioner’s attention on the basis of the work performed that indicates that (a) the subject matter is not based on (or in conformity with) the criteria [established as relevant in consultation with the client] or (b) the assertion is not presented (or fairly stated) in all material respects based on the criteria.
[Id. at AT § 101.88.]
The language an auditor is to use in the presentation of a review report has been standardized. Although the examples provided by the AICPA vary depending on their subject matter,10 the core language required for the issuance of a review report remains constant, expressly distinguishes between a review report and an examination report, and disavows any opinion on the subject matter. See id. at AT § 101.115. Because a review report expresses no opinion on the part of the auditor, a review report is “designed to provide a moderate level of assurance” and “the objective is to accumulate sufficient evidence to restrict attestation risk to a moderate level.” Id. at AT § 101.55. In order “[t]o accomplish this, the types of procedures performed generally are limited to inquiries and analytical procedures (rather than also including search and verification procedures).” Ibid.
3. Examinations or Audit Reports.
In contrast, an examination or audit report requires a more detailed level of performance from the auditor. As noted by the AICPA,
10 The AICPA distinguishes among review reports on a subject matter for general use, review reports on a subject matter that is the responsibility of a party other than the client, and review reports on an assertion. See id. at AT § 101.115, Examples 1, 2 and 3.
*401 [i]n an attest engagement designed to provide a high level of assurance (referred to as an examination), the practitioner’s objective is to accumulate sufficient evidence to restrict attestation risk to a level that is, in the practitioner’s professional judgment, appropriately low for the high level of assurance that may be imparted by his or her report. In such an engagement, a practitioner should select from all available procedures-that is, procedures that assess inherent and control risk and restrict detection risk-any combination that can restrict attestation risk to such an appropriately low level.
[Id. at AT § 101.54.]
Unlike a review report, the language designated for use in an examination or audit includes the expression of the auditor’s opinion based on statistically significant sampling techniques and the specific language in which that opinion is expressed as provided by the SAS. See id. at AT § 101.114.
4. Agreed-upon Procedures.
Finally, the highest and most defined level of an auditor’s services are agreed-upon procedures engagements, where
a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed-upon procedures may vary as well; consequently, the specified parties assumed responsibility for the sufficiency of the procedures since they best understand their own*402 needs. In an [agreed-upon procedures] engagement ... the practitioner does not perform an examination or a review ... and does not provide an opinion or negative assurance. Instead, the practitioner’s report on agreed-upon procedures should be in the form of procedures and findings.
[Id at AT § 201.08.]
Unlike other audit functions, agreed-upon procedures engagements are tailored to identify and examine areas as defined by, and in as much detail as specifically requested by, the client. Due to the limitations of an engagement that requests that the auditor perform an examination or audit report of a corporation’s financial statements, requests that an auditor investigate whether financial statements are misstated due to fraud perforce fall squarely within the category of agreed-upon procedures. Because KPMG’s liability must be defined by the scope of the engagement it entered into with PCN, the threshold question that must be addressed is what level of auditing services KPMG was engaged by PCN to perform.
D.
Even the most cursory review of what PCN and KPMG agreed to in respect of KPMG’s provision of auditing services to PCN makes clear that KPMG was not retained to prepare compilations or generate a review report. It is equally clear that KPMG was not engaged to provide the highest level of auditing services: agreed-upon procedures. Indisputably, KPMG was retained to provide garden-variety examination or audit report services. That is the yardstick against which KPMG’s performance must be measured.
KPMG was engaged to perform an examination of PCN’s financial statements for 1994, 1995, 1996, and 1997, the period of time when Mortell and Wraback, supported by other PCN senior accounting and operations officers, were engaged in their fraudulent scheme to artificially inflate PCN’s revenues.
However, because PCN designated Mortell and Wraback as the exclusive conduits through which KPMG could secure information to carry out its examination or audit engagement, KPMG’s audit data came from a polluted source and produced similarly polluted results. Thus, the proper issue here is whether, in the context of an examination or audit of financial statements, a corporation injured by the wrongful acts of its own officers can recover from its auditors for failing to discover and expose the corporate officers’ wrongdoing that caused the falsity in the financial statements in the first place.
In this context, the governing principle of law is, to me, obvious: no one should profit from a fraud he himself perpetrated, either directly or through his designated agents. If that principle is applied to the issue as presented, the result is equally obvious: the Trust’s complaint against KPMG properly was dismissed by the trial court.
The respective duties of the corporation and its auditors are defined by the contractual relationship between a corporation and its auditors. That contractual relationship is defined in the engagement letter between the corporation and its auditors, as interpreted and supplemented by professional standards of the auditing profession. What the majority ultimately does is re-write the engagement between PCN and KPMG from an examination or audit report to an engagement for the agreed-upon procedures in respect of a revenues fraud audit. That is not what PCN requested or paid for, and it is also not what KPMG committed itself to do. In the end, the majority ignores the basis of the bargain
III.
I also dissent from the majority’s rejection of the thoughtful, reasoned and comprehensive opinion of the United States District Court for the District of New Jersey, which dismissed, for failure to state a claim upon which relief can be granted, an earlier almost identical complaint filed against KPMG in respect of the same claims raised in this case involving KPMG’s audit work for PCN. State of Wis. Inv. BA. v. KPMG, LLP, Civil Action No. 01-751 (DRD) (D.N.J. June 18, 2001). According to the majority, the claims in the matter before Judge Debevoise “were based on violations of Section 10(b) of the Securities and Exchange Act of 1934 and Section 11 of the Securities Act of 1933[, and t]his appeal, although grounded on similar facts, involves entirely different claims based on state law.” Ante, 187 N.J. at 384,
Although the federal court matter involved securities fraud claims, and the claims pending before this Court allege common law causes of action for negligence and deceit, that is, at most, a distinction without a difference. As the Supreme Court of the United States recently noted, private federal securities fraud
The federal court’s reasoning is compelling and presents lessons we ignore at our own peril. The court explained that
courts have consistently found incredible allegations of an auditor’s purported participation in a client’s fraud. See, e.g., Melder v. Morris, 27 F.3d 1097, 1102 (5th Cir.1994) (finding it “extremely unlikely” that auditor would risk professional reputation by conducting fraudulent auditing work); DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir.1990) (finding it “irrational” that auditor would have risked reputation for honesty by participating in fraud for client); Reiger v. Price Waterhouse Coopers LLP,117 F.Supp.2d 1003 , 1007 (S.D.Cal.2000) (stating that independent accountants “will rarely, if ever, have any rational economic incentive to participate in its client’s fraud____ The accountant’s success depends on maintaining a reputation for honesty and integrity, requiring a plaintiff to overcome the irrational inference that the accountant would risk its professional reputation to participate in the fraud of a single client.”).
Additionally, courts have found the notion that defendants were motivated by the prospect of fees similarly unavailing. See Vogel v. Sens [Sands] Bros. & Co.,126 F.Supp.2d 730 , 739 (S.D.N.Y.2001) (finding allegation that defendant sought greater fees insufficient to show motive); In re SmarTalk Teleservices, Inc. Sec. Litig.,124 F.Supp.2d 505 , 518 (S.D.Ohio 2000) (finding allegation that defendant sought to maintain fees insufficient to infer scienter); Duncan v. Pencer, No. 94 Civ. 0321,1996 WL 19043 , at *9-10 (S.D.N.Y. Jan. 18,1996) (same).
The case presently before us has been litigated and dismissed in the federal court in and for this State; it should meet an equal fate here.
IV.
Other public policy considerations caution against the result the majority reaches. Save for a passing reference, ante, 187 N.J. at
Those points were made clearly and succinctly by amici curiae the American Institute of Certified Public Accountants and the New Jersey Society of Certified Public Accountants. Highlighting that “[a]n auditor’s role in the accurate presentation of a client’s financial statement is limited, and most importantly, secondary to that of the client[,]” they assert that we “should not allow companies that have engaged in fraud to recover damages from their auditors based purely on a showing of negligence because it results in a misallocation of responsibility between auditor and client for the preparation of financial statements.” They also pragmatically point out that “[i]n addition to causing a misallocation of liability, allowing a company’s management to shift the consequences of its own executive’s fraud to its accountants where the auditor is not alleged to have assisted in that fraud may diminish management’s incentive to exercise due care in its own
Nothing in the majority’s opinion fairly addresses these self-evident points. That is because there simply is nothing that can be stated in rebuttal to those logical and understandable points. In these circumstances, the Legislature may wish to review the consequences of the majority’s decision and correct the imbalance it creates in the relationship between an auditor and his client.
V.
In the context of this suit, a suit brought by and on behalf of the shareholders of a bankrupt entity not as a shareholders’ derivative action but as one clothed as a trust, we must address the scope of the unprecedented remedy afforded by the majority. In similar circumstances, this Court recently denied relief to shareholders who also attempted a feint around the salutary and long-standing restrictions against shareholder actions. E. Dickerson & Son, Inc. v. Ernst & Young, LLP, 179 N.J. 500,
Moreover, the remedy fashioned by the majority is fraught with practical impossibilities. Without the benefit of any authority, the majority concludes that, because “we should not punish the many for the faults of the few[,]” ante, 187 N.J. at 377,
One is entirely at a loss to understand how the majority’s construct can be applied. For example, if a corporation has 1,000 shareholders, must the trial court hold 1,000 separate mini-trials to determine whether each specific shareholder is barred from recovery because he either “engaged in the fraud[, ...] should have been aware of the fraud[, or who], by virtue of their ownership of a large portion of stock, ha[d] the ability to conduct oversight of the firm’s operations[?]” What if the corporation has not 1,000 shareholders, but 5,000,000? Assuming, as one must, that plaintiffs in this new construct still have the burden of proving their entitlement to recovery, must each plaintiff appear and prove himself free of taint? Will the majority ultimately conclude that, contrary to basic tenets of our jurisprudence, the burden should fall on the party asserting the imputation bar to prove it? If so, how can they, given that the proofs of complicity will lie solely with the plaintiffs and are readily susceptible to spoliation? In the end, the parsing-out required by the majority’s
Finally, it must be recognized that the majority effects a fundamental transformation of the imputation defense. As a result of the majority’s construct, the imputation defense ceases to be a defense to liability and becomes, instead, an item in mitigation of damages. Thus, instead of providing a bulwark against claims by vicarious wrongdoers, the now-transformed imputation defense is relegated to the piecemeal diminution of the damages alleged. Having put an untimely end to the imputation defense, the least the majority can do is to give it a proper burial instead of sentencing it to some jurisprudential limbo.
VL
In the end, the principles we should be embracing are simple. First, we should reaffirm the core principle that an actor is liable for his actions. Second, we should ratify once more our agency principles and hold that a principal is vicariously liable for the acts of his chosen agent. Third, we should give breath to the bedrock concept that no one should profit from their wrongdoing. Finally, we should return to one of the fundamental principles underpinning our jurisprudence that bars the culpable from recovery.
The majority wishes to penalize KPMG because it did not uncover soon enough an elaborate ruse intentionally planned and deliberately executed by PCN’s highest level executives, the very persons to whom PCN gave the gatekeeper responsibility for the information KPMG needed to ferret out their fraud. PCN’s common shareholders—the defined beneficiaries of the Trust
Therefore, I respectfully dissent.
For Affirmance as Modified/Remand—Chief Justice PORITZ, and Justices LONG, ZAZZALI, ALBIN and WALLACE—5.
Dissenting—Justices LaVECCHIA and RIVERA-SOTO—2.
This matter comes to us on defendant’s Rule 4:6-2(e) motion to dismiss the complaint for failure to state a claim upon which relief can be granted.
That action and its import to this case are more particularly addressed below. See infra, 187 N.J. at 371-72,
Specifically, the March 2002 litigation trust agreement provides that PCN and its affiliated corporate entities "absolutely and irrevocably grant, assign, transfer, convey, and deliver to the [Trust] and its successors, ... all right, title and interest of [PCN and its corporate affiliates] in and to any and all Litigation Claims, the Other Assets and the Cash deposited herewith, and the proceeds therefrom[.]” The agreement defines "Litigation Claims" as all claims "Mgainst KPMG LLP and all other appropriate parties for accounting malpractice, breach of contract and any and all other appropriate causes of action arising out of KPMG's audits of [PCN’s] financial statements." The agreement further defines "Other Assets" as "[a]ny and all tax refunds, reserves, etc. of [PCN] remaining after [PCN's] liquidation and dissolution." Finally, the agreement quantifies "the Cash deposited herewith, and the proceeds therefrom” as $750,000.
As an assignee, the Trust stands in PCN’s stead and, hence, has no rights greater than those of its assignor PCN. Borough of Brooklawn v. Brooklawn Hous. Corp., 129 N.J.L. 77, 79,
That conclusion is not challenged by the Trust and, regardless, is well founded in the instrument that created the Trust.
For that reason, the majority’s extensive discussion of federal cases concerning the imputation defense is instructive but not dispositive. See ante, 187 N.J. at 373-76,
Although it affirms the result obtained—a reversal of the trial court's dismissal of the Trust's complaint and a remand for further proceedings—even the majority resoundingly disavows the Appellate Division's reasoning. Ante, 187 N.J. at 371,
Even the majority concedes that the wrongful acts here were not those of KPMG but those of PON’s senior corporate officers—its agents—who "defrauded the corporation and its creditors[.]” Ante, 187 N.J. at 372,
Although the Appellate Division discerned an equitable fraud claim from the allegations of the complaint, that exercise never was ratified by the Trust for an obvious reason: a claim in equitable fraud only allows for equitable relief, and not money damages. Foont-Freedenfeld Corp. v. Electro-Protective Corp., 126 N.J.Super. 254, 257,
See, e.g., Brown v. Deloitte & Touche LLP, No. 98 Civ. 6054, 1999 WL 269901, at *2 (S.D.N.Y. May 4, 1999) (stating that "whatever damages [the accountant's] alleged negligence may have caused the debtors, the damages are the result of a financial transaction debtor management implemented itself.”); Miller v. Ernst & Young,
The AICPA provides seven examples of examination or audit reports: a standard examination report on subject matter for general use; a standard examination report on an assertion for general use; an examination report for general use; an examination report on a subject matter; an examination report with a qualified opinion because conditions exist that, individually or in combination, result in one or more material misstatements or deviations from the criteria; an examination report that contains a disclaimer of opinion because of a scope restriction; and an examination report on subject matter that is the responsibility of a party other than the client. See id. at AT § 101.114, Examples 1 to 7.
Although KPMG’s audit responsibilities spanned PCN's 1994 through 1997 fiscal years, the complaints raised by the Trust deal exclusively with 1995 and 1996.
Tellingly, the only substantive difference between the two complaints lies in the fact that one was filed in federal court, charging federal claims, while the other was filed in state court and pled state common law claims. The facts as pled here in respect of the negligence claims are no different from, and add nothing to, those pled in the federal complaint.
Only cold comfort can be derived from the majority’s conclusion that KPMG can simply proceed with discovery and that, once discovery is complete, "KPMG may move for summary judgment if the evidence demonstrates that no rational factfinder could conclude that the audits were negligently conducted.” Ante, 187 N.J. at 385,
The trust agreement provides that the beneficiaries of the Trust are “all holders of Allowed Class 7B Equity Interests.” Under PCN’s bankruptcy plan of reorganization, those who represent the “Class 7B Equity Interests" are those who held PCN's common stock; the holders of PCN's preferred stock were designated in the reorganization plan as "Class 5 Preferred Stock Interests."