Mishkin v. Peat, Marwick, Mitchell & Co.

• Decision Date: 22 August 1990
• Docket Number: No. 86 Civ. 4301 (MP).,86 Civ. 4301 (MP).
• Citation: 744 F. Supp. 531
• Parties: Edwin B. MISHKIN, as Trustee for the Liquidation of the Business of Parr Securities Corp., Plaintiff, v. PEAT, MARWICK, MITCHELL & CO., Defendant.
• Court: U.S. District Court — Southern District of New York

744 F. Supp. 531

Edwin B. MISHKIN, as Trustee for the Liquidation of the Business of Parr Securities Corp., Plaintiff, v. PEAT, MARWICK, MITCHELL & CO., Defendant.

No. 86 Civ. 4301 (MP).

United States District Court, S.D. New York.

August 22, 1990.

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Thomas J. Moloney, Cleary, Gottlieb, Steen & Hamilton (Mitchell A. Lowenthal and Jonathan A. Willens, of counsel), New York City, for plaintiff.

Sidney Davis, Davis, Markel & Edwards (Marc J. Schiller, Cynthia Feigin, George Salter and Paula Katz, of counsel), New York City, for defendant.

OPINION AND DECISION

MILTON POLLACK, Senior District Judge.

The claims in this case were tried to the Court at a Bench trial. Jurisdiction of the separate Counts in the complaint rests on separate grounds.

Jurisdiction of Count I of the complaint herein is posited on the ground that the plaintiff is a SIPA trustee and that Count I thereof is related to a proceeding conducted in accordance with and as though under Title 11 of the Bankruptcy Code. 28 U.S.C. § 1334(b); 15 U.S.C. § 78fff(b).

Count I of the complaint asserts a state law claim for alleged negligence of a firm of certified public accountants in their performance of a 1983 audit for Parr Securities Corporation ("Parr").

Jurisdiction of Count II is posited on a federal question.

Parr was a non-public registered broker-dealer organized in 1981 as a special purpose wholly-owned subsidiary of Kenney & Branisel, Inc. ("K & B"), a non-public company. The principal owners and key management of K & B were also the sole directors of Parr. In December, 1984, K & B sold Parr to the latter's president, Gregory F. Herbert ("Herbert") who remained its sole owner for the balance of its business existence. In May, 1985, Parr was placed in liquidation by Court order.

Defendant Peat, Marwick, Mitchell & Co. ("PMM") (now KPMG Peat Marwick) is a partnership engaged in providing professional services, including auditing services. PMM audited and reported on Parr's financial statements as of and for the year ended October 31, 1983—the only audit services at issue in this action. PMM's audit report was issued on December 30, 1983.

Plaintiff Edwin B. Mishkin ("Mishkin") was designated by Court order dated May 17, 1985, as Trustee for the Liquidation of the Business of Parr pursuant to the Securities Investor Protection Act ("SIPA"), 15 U.S.C. § 78aaa, et seq. The Securities Investor Protection Corporation ("SIPC") is not a party to this case. Nor are any of the customers of Parr parties to this litigation. The audit was not performed for or requested by customers of Parr. There was no knowledge of or reliance by any customer of Parr on the audit, and the customers themselves never asserted, nor indeed do they have, any cognizable claim to assert against the auditors.

Count I

The setting for the audit

On October 31, 1983, capital and surplus of Parr were intact if the balance sheet was accurate. In reality, both capital and surplus had been wiped out and Parr was insolvent. The books had been falsified by Gregory F. Herbert, Parr's president at the time so as to conceal substantial "off-book" transactions and frauds. The balance sheet corresponded to Parr's books. Herbert's off-the-book transactions were made in the belief that the adverse market which the transactions experienced was bound to turn and the transactions saved thereby with no one the wiser. However, the persistent decline in the market disappointed such hopes and expectations. The house of cards collapsed in May, 1985. A confession by Herbert to the Securities & Exchange Commission ("SEC") on May 3, 1985, unearthed the truth. The trustee's two year investigation of the confession with the aid of a skilled investigative team pieced together how Herbert was able to commit and conceal his frauds.

Herbert pleaded guilty to the frauds and was sentenced to three years in prison.

The Trustee's Claim

Briefly, plaintiff alleges: (1) that Herbert caused Parr to engage in speculative securities transactions in 1983 which resulted in approximately $3.5 million in trading losses to Parr; (2) that Herbert on behalf of Parr replenished those losses by inducing certain large institutional customers to engage unwittingly in sham repurchase transactions;¹ (3) that the funds from these sham transactions were deposited by Herbert into a secret off-book account at Chemical Bank and then utilized on behalf of Parr to pay its trading losses; (4) that Parr's 1983 financial statements were misstated as a result of the omission therefrom of Parr's trading losses; and (5) that PMM negligently failed to discover those misstatements during its audit of Parr's 1983 financial statements.²

Plaintiff has speculated on the basis of testimony of a former SEC accountant that, but for PMM's non-discovery of Parr's financial misstatements, Parr would have been closed down by regulatory authorities at the end of 1983.³

It is not disputed that Parr's 1983 trading losses and fraudulent transactions were successfully buried and hidden from, and remained undiscovered and unsuspected by, (i) Parr's trained internal auditing personnel, (ii) from PMM, (iii) from the auditors of the New York Stock Exchange ("NYSE"),⁴ and (iv) from the SEC by means of various fraudulent devices including:

—destruction and alteration of Parr's books and records;

—collusion with third parties to obtain pre-printed blank trading statements from a futures commission merchant so that false documents could be created;

—use of a secret "Parr" entitled account at Chemical Bank through which fraudulently obtained funds could be used to cover the hidden trading; and

—failure to record the fraudulent transactions on Parr's books and records.

The Auditors Were Not Negligent

The plaintiff has failed to sustain factually his burden of proof of negligent breach of duty on the part of the defendant. The supporting grounds for the auditing acts of defendants were substantial and were established by the evidence and circumstances.

It has been affirmatively established by testimony, which the Court credits, that under all the facts and circumstances in evidence, the defendant exercised due professional care with reasonable professional judgment, acted in good faith in performing the audit and was not guilty of any inattention to the task or of negligence therein. Reasonably sufficient work was done on the audit; the work was competently planned, carried out, reviewed and completed in substantial conformity with the applicable generally accepted auditing standards of the profession, the regulatory requirements and the internal standards of the defendant itself, using permissible and reasonable auditing judgment in the circumstances presented. There were no sufficient circumstances to arouse suspicion or provide notice to the auditors, actual or constructive, of the fraudulent acts and criminal designs of Herbert carried out in the name of and the hoped-for benefit of Parr. The defendant had no sufficient reason or occasion to suspect the books and records of Parr which it was auditing. The criticisms of the audit by the trustee were made from the vantage point of highly costly hindsight wisdom and an undue intolerance of permissible judgmental limits.

On the totality of the evidence, and having seen and heard the witnesses I have resolved the issues of credibility in favor of the defendant and against the plaintiff. Defendant's witnesses proved to be persons worthy of belief, with impressive and lengthy professional backgrounds of vast practical experience in auditing businesses of brokers and dealers, with ample peer recognition of their professional competence, judgment and standing in the profession. PMM's interpretations and exercise of practical judgment in conducting the audit were acknowledged by plaintiff's expert, Daniel Rosenthal, to have been made by PMM in good faith and with their honest professional belief that they were in conformity with generally accepted auditing standards and with the regulatory and PMM's in-house requirements. He conceded that staffing, supervision, planning and execution of an audit were judgment calls; that: "One auditor could disagree with another and they could both be reasonable in their view."; and further that: "Q. Now, the question of reasonable adherence to the standards, in your view, is a judgment matter? A. Yes, I think it is."

In Greater Detail

Applicable Legal Considerations

For negligence, as distinguished from reckless misrepresentation amounting to fraud (not here claimed), an accountant is responsible only to his client, Ultramares Corp. v. Touche, 255 N.Y. 170, 174 N.E. 441 (1931), and to those members of a limited class whose reliance on the accountant's service was or at least should have been specifically foreseen. White v. Guarente, 43 N.Y.2d 356, 372 N.E.2d 315, 401 N.Y.S.2d 474 (1977). See also, Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536, 483 N.E.2d 110, 493 N.Y.S.2d 435 (1985).

PMM furnished its audit with the express caveat:

This report is intended solely for the use of management, the National Association of Securities Dealers, the New York Stock Exchange, Inc. and the Securities and Exchange Commission, and should not be used for any other purpose.

December 9, 1983 /s/ Peat Marwick, Mitchell Co.

No claim is made in this case (certainly there was no proof) that any third-party or customer of Parr ever saw or relied on or expected to see the questioned audit.

Parenthetically, it may be noted in respect to the regulatory filing with the SEC that even where an auditor might incur liability under federal law to members of the public, including lenders, that does not suffice to create liability under state law. Westpac Banking Corp. v. Deschamps, 66 N.Y.2d 16, 484 N.E.2d 1351, 494 N.Y.S.2d 848 (1985). There is no such question raised in this case, at all events. This...