Ncp Litigation Trust v. Kpmg Llp

• Decision Date: 28 June 2006
• Parties: NCP LITIGATION TRUST, Plaintiff-Respondent, v. KPMG LLP, Defendant-Appellant.
• Court: New Jersey Supreme Court

Page 871

901 A.2d 871

187 N.J. 353

NCP LITIGATION TRUST, Plaintiff-Respondent, v. KPMG LLP, Defendant-Appellant.

Supreme Court of New Jersey.

Argued January 3, 2005.

Decided June 28, 2006.

Mitchell A. Karlan, a member of the New York bar, New York City, argued the cause for appellant (Drinker Biddle &amp Reath, Princeton, attorneys; Mr. Karlan, Vincent E. Gentile and Karen A. Denys, Princeton, on the briefs).

James G. Flynn, a member of the New York bar, New York City, argued the cause for respondent (Lite DePalma Greenberg & Rivas, attorneys; Allyn Z. Lite and Katrina Blumenkrants, Newark, on the brief).

Richard I. Miller, a member of the New York bar, argued the cause for amici curiae, The American Institute of Certified Public Accountants and The New Jersey Society of Certified Public Accountants (Riker, Danzig, Scherer, Hyland & Perretti, attorneys; Mr. Miller and Michael K. Furey, of counsel; Mr. Furey and Michael E. Gogal, Morristown, on the brief).

Justice ZAZZALI 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 "material[ly] 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.

I.

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 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 Wismer-Martin Inc., another provider of practice management systems, for PCN to acquire that company, by merger, subject to Wismer-Martin 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 financial statements for 1995 and KPMG's corresponding audit report. Wismer-Martin merged with PCN in September 1996.

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 financial statements for the 1995 and 1996 fiscal years would need...