1. Describe the types of accounting irregularities that were going on at Papel.

2. What is the significance of the term “engagement” in the opinion?

3. Where does New Jersey fit with regard to privity and the Restatement rule when it comes to auditor liability to third parties?

Cast Art Industries* produced and sold collectible figurines and giftware. Papel Giftware was in the same line of business as Cast Art, and in spring 2000 Cast Art explored acquiring Papel. Among the factors that made Papel so attractive to Cast Art were Papel’s large number of existing customer accounts, its existing sales force, and its production facilities. Eventually, Cast Art decided on a merger, rather than an acquisition. Cast Art negotiated a loan agreement with PNC Bank for $22 million to fund the venture. PNC’s conditions included that it receive audited financial statements and that Cast Art’s CEO, Scott Sherman, personally guarantee $3.3 million of the loan.

KPMG (defendant) had audited Papel’s financial statements since 1997. KPMG was already in the process of auditing Papel’s 1998 and 1999 financial statements when Cast Art and Papel began their merger discussions. In its letter to the chairman of Papel’s audit committee dated November 17, 1999, in which it agreed to undertake these audits and report the results, KPMG noted the parameters of its work:

[T]here is a risk that material errors, fraud (including fraud that may be an illegal act), and other illegal acts may exist and not be detected by an audit performed in accordance with generally accepted auditing standards. Also, an audit is not designed to detect matters that are immaterial to the financial statements. In September 2000, KPMG delivered to Papel the completed audits for the years 1998 and 1999. KPMG included in its accompanying opinion letter, which again was addressed to the chairman of Papel’s audit committee, that Papel “was not in compliance with certain financial covenants” with its lenders, which KPMG characterized as raising “substantial doubt about the Company’s ability to continue as a going concern.”

Cast Art obtained copies of the completed 1998 and 1999 audits and provided copies to PNC. Three months later, in December 2000, Cast Art and Papel consummated the merger. Shortly after the merger was finalized, Cast Art began to experience difficulty in collecting some of the accounts receivable that it had believed Papel had had outstanding prior to the merger. Cast Art began its own investigation and learned that the 1998 and 1999 financial statements prepared by Papel were inaccurate and that Papel had engaged regularly in accelerating revenue. Papel did not follow its stated policy to recognize revenue from sales when goods were shipped and invoices sent. Papel routinely booked revenue from goods that had not yet been shipped. There was also testimony that at certain points Papel would not close out its books at month’s end. Rather, it would hold them open and book the improperly extended month revenue that was earned in the following period. There was also testimony that at least one transaction, referred to at trial as the “Bookman” transaction, was a fraudulent entry of a $121,244 sale that never occurred. Although Cast Art knew at the time of the merger that Papel was carrying a significant amount of debt, it was unaware of those accounting irregularities until after the merger was complete. The surviving corporation was unable to generate sufficient revenue to carry its debt load and produce new goods, and it eventually failed.

Following a lengthy trial for KPMG’s malpractice, a jury returned a verdict in favor of Cast Art and awarded damages totaling $31.8 million, which was amended to $38,096,902 by the trial court judge. The Appellate Division upheld the verdict on liability but vacated the damage award and remanded for a new trial on damages. The case was certified to the New Jersey Supreme Court.

JUDICIAL OPINION

WEFING, Justice … In this litigation, Cast Art alleged that KPMG negligently audited Papel because its audit had not revealed Papel’s accounting irregularities and sought to recover for the loss of its business. It contended that if KPMG had performed a proper audit, it would have uncovered the fraudulent accounting activity that was taking place at Papel. Cast Art further maintained that it never would have proceeded with the merger if it had been alerted to this fraud. Thus, Cast Art asserted that its losses were caused by KPMG’s negligence, and it argued that KPMG should be responsible to make it whole.

KPMG defended this litigation on several fronts. It argued that because Cast Art had not retained it to audit Papel, Cast Art was not its client, and Cast Art’s claim was consequently barred by the Accountant Liability Act, NJ.SA. 2A:53A–25.  …………………