Articles: Comment on Frame v. PricewaterhouseCoopers

Originally published in California Civil Litigation Reporter (February 2006), by Farley J. Neuman.

Accounting firm PricewaterhouseCoopers LLP was hired to audit two limited partnerships, Grafton Partners LP and Allied Capital Partners. Both partnerships were vehicles for investing in loans issued by Pinnfund, USA Inc., a mortgage company. In the course of conducting the audit, PwC noticed irregularities indicating possible fraud. PwC told James Hillman, owner and manager of Peregrine Funding, the general partner of Grafton and Allied, that it could not issue audit reports on Grafton and Allied until the questions were resolved. Hillman then terminated the auditor-client relationship. PwC neither issued an audit report on Grafton and Allied nor reported its suspicion of fraud to anyone other than Hillman.

It later came to light that Pinnfund’s owner was misappropriating the money invested in it, and that Hillman, who directed the limited partnerships’ investments into PinnFund, was implicated in the scheme. After the Securities and Exchange Commission shut down PinnFund, Grafton’s and Allied’s limited partners (the investors) sued PwC for aiding and abetting fraud and conspiracy to defraud, among other theories, asserting that PwC should have told them what it knew. The trial court granted PwC’s motion for summary judgment, ruling that PwC had no duty to communicate with the investors.

The First District Court of Appeal affirmed on the conspiracy and third party-beneficiary breach of contract claims, but reversed on the claim of aiding and abetting fraud. Liability for aiding and abetting an intentional tort may arise if the defendant ”knows the other’s conduct constitutes a breach of duty and gives substantial
assistance to the other to so act.” 134 CA4th at 407, quoting Saunders v Superior Court (1994) 27 CA4th 832, 846, 33 CR2d 438, and adding italics. It was undisputed that PwC had some knowledge of the fraud. PwC knew that the partnerships’ only significant assets were funds they had loaned to PinnFund. If PinnFund could not repay those loans, Grafton and Allied had little value. But when PwC asked for PinnFund’s audited financial statements, Hillman responded that they were not yet complete. He and PinnFund later produced reports that PwC discovered were falsified. PwC also realized Hillman had lied about the reports not being completed.

A triable issue exists as to whether PwC provided substantial assistance to the fraud. An audit report would have described the forged financial statements and the absence of verification of assets, and would have been available to the investors. The absence of the written audit report postponed public detection of the fraud, giving Peregrine/Hillman and PinnFund time to solicit and obtain additional investments. It allowed them to maintain the secrecy critical to their fraudulent scheme. This could lead a trier of fact to conclude that PwC provided substantial assistance to Peregrine/Hillman with knowledge of the fraud, which precludes summary adjudication of the aiding and abetting claim.

COMMENT: PricewaterhouseCoopers LLP was between a rock and a not-quite-so-hard place, and unfortunately chose the rock. It discovered strong evidence of fraud and was faced with the dilemma of either (1) disclosing [PAGE 49]that evidence to limited partners, thereby risking a lawsuit by the partnership and/or its general partners, or (2) withdrawing from the audit and remaining quiet, thereby risking a lawsuit by the innocent limited partners. It chose the latter, which in my opinion was a mistake from both a legal and an ethical perspective. It did nothing to prevent a massive fraud from continuing and exposed itself to liability to the victims of that fraud.

The court was obviously troubled by Pricewaterhouse’s decision and was thus willing to stretch existing law to reach what it considered to be an equitable result. Under earlier cases, auditors were granted some protection from liability to third parties (including investors and shareholders) for claims of negligence and negligent misrepresentation, but no protection for claims of fraud. See Bily v Arthur Young & Co. (1992) 3 C4th 370, 11 CR2d 51. In Frame, the court breaks new ground by holding that an auditor’s failure to issue an audit report or otherwise notify limited partners of potential fraud may support a claim for aiding and abetting the fraud, even though the court acknowledges that the auditor did not commit fraud and did not conspire to commit fraud. The Frame court somewhat surprisingly concludes that the auditor’s lack of action could be construed as providing “substantial assistance” to the fraud, although the court agrees with prior decisions holding that auditors do not owe a duty of due care to nonclient investors.

Because of ambiguities in the professional standards for accountants (Generally Accepted Accounting Principles (GAAP) and Generally Accepted Auditing Standards (GAAS)), many accountants believe that they may withdraw from an audit on discovery of facts indicating fraud or other illegal acts. This case strongly suggests otherwise. For many years, I have advised accountants in similar situations to carefully and prudently disclose evidence of fraud to innocent third parties, including limited partners and creditors, based on my belief that it is almost always preferable to be sued by the apparent crooks rather than by the innocent victims. —Farley J. Neuman

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