Houbigant, Inc. v. DELOITTE

• Citation: 753 N.Y.S.2d 493,303 A.D.2d 92
• Court: New York Supreme Court Appellate Division
• Decision Date: 21 January 2003
• Parties: HOUBIGANT, INC., et al., Respondents-Appellants,<BR>v.<BR>DELOITTE & TOUCHE, LLP, Appellant-Respondent, et al., Defendants.

303 A.D.2d 92

753 N.Y.S.2d 493

HOUBIGANT, INC., et al., Respondents-Appellants,

v.DELOITTE & TOUCHE, LLP, Appellant-Respondent, et al., Defendants.

SAXE, J.

January 21, 2003.

John W. Schryber of counsel, Washington, D.C. (Mary E. Flynn, New York City, and Kieran X. Bastible on the brief; Patton Boggs, LLP, and Morrison Cohen Singer & Weinstein, LLP, attorneys), for respondents-appellants.

Michael P. Carroll of counsel (Jerome G. Snider, Michael S. Flynn, William C. Komaroff, Matthew S. Stewart and Susan L. Shin on the brief; Davis Polk & Wardwell, attorneys), for appellant-respondent.

NARDELLI, J.P., BUCKLEY, ELLERIN and MARLOW, JJ., concur.

OPINION OF THE COURT

SAXE, J.

This appeal focuses on claims of accounting malpractice and fraud against Deloitte and Touche LLP (Deloitte). Plaintiffs Houbigant, Inc. and Etablissement Houbigant (collectively, Houbigant) own the trademarks for various perfumes, the marketing and sales of which they licensed to various subsidiaries of Renaissance Cosmetics, Inc. (RCI) beginning in 1994. RCI and another of its subsidiaries, Cosmar Corp., executed guaranties in connection with those licenses, in which they warranted that they had and would maintain a net worth of at least $10 million, and in which they gave Houbigant the right to terminate the licenses in the event a guarantor became insolvent or failed to comply with its net worth warranty. These two guarantors also agreed to furnish the same financial statements to Houbigant that they were required to provide their lenders. Houbigant asserts that the net worth requirement was included in order to protect it against failure by the licensees to meet their multiyear, multimillion dollar royalty payment obligations.

Then, despite several years' worth of audited financial statements certifying the financial well-being and substantial net worth of RCI and its subsidiaries, in June 1998 it was disclosed publicly that RCI's net worth had been overstated by nearly $200 million. Because Houbigant had been induced three months earlier, in March 1998, to enter into a modification agreement with RCI in which it waived for one year its right to terminate its licensing agreements, it had to wait until March 1999 to terminate its licenses. It claims that in the intervening nine-month period, its brand equity was severely damaged by the insolvent RCI.

We hold that Houbigant's negligence claim against Deloitte as the auditor of RCI's financial statements must be dismissed, since the allegations do not support a claim of privity or a relationship "approach[ing] that of privity" between Deloitte and Houbigant, a nonclient (see Ultramares Corp. v Touche, 255 NY 170, 183; Credit Alliance Corp. v Arthur Andersen & Co., 65 NY2d 536, 550; Parrott v Coopers & Lybrand, 95 NY2d 479, 483; Security Pac. Bus. Credit v Peat Marwick Main & Co., 79 NY2d 695, 702). Before the law will allow a claim of negligence against an accountant by a nonclient third party, there must be some allegation of "linking conduct" by the accountant, that is, "any word or action on the part of [the accountant] directed to plaintiffs," so as to "link" the accountant to the nonclient (see Credit Alliance Corp. v Arthur Andersen & Co., 65 NY2d 536, 553-554).

The requisite linking was not established by Houbigant's entitlement under the terms of the license to receive a copy of RCI's audited financial statement, by Deloitte's consent to RCI forwarding a copy of the financial statements to Houbigant, or by Deloitte's knowledge that Houbigant would rely upon the information contained in the financial statements (see Credit Alliance at 553-554). Deloitte's task, in the course of the audit, of assessing whether RCI was complying with its contractual obligation to Houbigant to maintain a $10 million net worth, was a task performed pursuant to professional standards applicable in the context of any audit, and was not undertaken pursuant to any duty owed toward Houbigant. Therefore, it cannot constitute the type of "linking conduct" required by Ultramares, Credit Alliance and subsequent cases.

However, the fraud cause of action should not have been dismissed. As Chief Judge Cardozo pointed out in Ultramares (255 NY at 189), even where the law does not permit a claim of negligence to be brought against a professional by a person not in privity with the professional, this rule "does not emancipate accountants from the consequences of fraud."

Houbigant's claim of fraud concerns Deloitte's certification of the accuracy of RCI's audited financial statements for the years ending March 31, 1995, March 31, 1996 and March 31, 1997. Deloitte's certification each year specifically stated that RCI's consolidated financial statements "present[ed] fairly, in all material respects, the financial position of Renaissance Cosmetics, Inc. and subsidiaries." Plaintiffs have provided allegations containing sufficient specificity to make out a claim that these assurances by Deloitte regarding RCI's financial statements for those three years were knowingly false.

Houbigant alleges that RCI's net worth was materially misrepresented each year, in view of the absence of competent support for the values set forth in the financial statements for four asset accounts—inventory, accounts receivable, intangible assets and fixed assets. It relies in part upon a private letter by Deloitte to the RCI audit committee dated June 27, 1997, in which Deloitte recognized and identified various "[r]eportable conditions" and "significant deficiencies in the design or operation of the internal control structure * * * [bearing on the] ability to * * * report financial data consistent with the assertions * * * in the financial statements." The letter, plaintiffs assert, explained some of the causes of those deficiencies. Indeed, Houbigant asserts, these deficiencies and problems were so significant that they appear to have formed the basis for RCI's ultimate insolvency. Yet, none of these deficiencies and problems were mentioned in Deloitte's audit report; further, it is alleged, Deloitte took no action to verify the information called into question by these deficiencies in its subsidiaries' internal control structure.

For one thing, it is alleged that there were deficiencies regarding net accounts receivable. It was finally publicly acknowledged in June 1998 that RCI's sales for the period from March 31, 1996 through March 31, 1997 were overstated by $18.8 million, due to an understatement of returns, and, thus, an overstatement of sales and accounts receivable. This comports with Houbigant's allegation that RCI's financial statements improperly recorded as sales transactions that were "right of return" consignment sales, which, in the absence of historical experience regarding returns of similar products (as was the case for at least for some of RCI's subsidiaries), should not have been reported as sales. Since the June 27, 1997 letter indicated Deloitte's knowledge that RCI had no methodology in place for measuring historical experience regarding returns, there is reason to conclude both that the financial statements were materially inaccurate and that Deloitte knew this.

Further, repeated corporate acquisitions made by RCI in 1995 and 1996 brought RCI's reported intangible assets to $82 million in 1995, and to $184 million by 1997. It is alleged that Deloitte had an interest in overstating the values of these acquisitions, because it had performed the due diligence for those acquisitions, and had financed some of them. Houbigant claims that despite the representation in RCI's financial statements that it regularly assessed the "recoverability" of such intangible assets, which would correct any initial overstatement, in fact these assets were not subjected to any independent appraisal until January 1997, when they were found to be overstated by $57 million. Houbigant further asserts that because of yearly cash flow losses, the $57 million overstatement should have been the basis for a write-down of fair value for the year ending March 31, 1997, but that, instead, Deloitte chose to ignore the appraisal. These allegations further support the fraud claim. Any contention that Deloitte was in fact unaware of the appraisal must be addressed at trial.

As to the allegation of substantial overstatements in the reporting of net inventory, although Houbigant cannot yet quantify its exact amount, the allegation is supported by the claim that RCI had no system for determining the age of its inventory, and therefore ignored the requirement that it verify the age of inventory so as to determine whether it should be valued at market or cost. Deloitte's argument that this deficiency was not significant is one which may be tested at trial, but it does not suffice to dismiss the claim here.

Other aspects of the June 27, 1997 letter provide further support for the claim that serious accounting deficiencies known to Deloitte led to the material overstatements regarding RCI's net worth, which Deloitte certified as accurate. For instance, the letter reported that one of the RCI subsidiaries acting as licensee, Houbigant (1995) Limitee, whose insolvency would contractually entitle Houbigant to terminate the license, had failed to maintain any separate financial books and records, actually preventing Deloitte from being able to properly certify the accuracy of its financial statements.

In sum, Houbigant alleges that when Deloitte certified the accuracy of RCI's financial statements, it knew, but failed to acknowledge, that RCI's financial statements actually contained numerous serious irregularities and inaccuracies, which it knew could have a material impact on the accuracy of the financial statements' recitation of the corporation's net worth. This is sufficient to adequately plead misrepresentation and scienter.

There is, indeed, a body of case law dismissing fraud claims against accountants pursuant to CPLR 3016 due to insufficiencies in the...