Legal Malpractice

A Fiduciary Relationship Exists Between Insured and Attorney Hired by Insurance Company to Represent Insured

In Tower Investments, Inc. v. Rawle & Henderson, LLP, Court of Common Pleas Philadelphia. No. 070503291 (March 3, 2008), Plaintiffs filed suit against Rawle & Henderson (R&H), LLP, Zurich American Insurance Company and Assurance Company of America. Plaintiffs had a commercial liability policy with Assurance and, pursuant to its duty to defend within the policy Assurance retained Rawle & Henderson to defend plaintiffs in an underlying action. Plaintiffs allege that as part of the settlement in the underlying action, R&H executed a release that it knew plaintiff objected to and was contrary to plaintiffs’ interests. R &H filed preliminary objections.

R&H objected to plaintiffs’ claim for breach of contract against R&H arguing that there was no contract between the parties. The court accepted the fact of the existence of the insurance contract with Assurance and Assurance’s retainer of R&H to represent plaintiffs and pay the fees for this service. As such, in overruling this preliminary objection, the court held that plaintiffs could be considered third-party beneficiaries of the agreement between Assurance and R&H.

The court also overruled R&H’s preliminary objections to plaintiffs’ claim for breach of fiduciary duty. In support of this claim, plaintiffs alleged that R&H continued to represent them despite the existence of a conflict of interest as to certain terms of the settlement between plaintiffs and co-defendant Assurance. The court recognized a fiduciary relationship existed between plaintiffs and R&H and noted that “by definition [a fiduciary relationship] does not permit conflicts of interest.” R&H’s objections were overruled based on the court’s finding that the allegations of plaintiff were sufficient to show a potential conflict of interest.

R&H also objected to plaintiff’s claim for punitive damages. The court found that although plaintiffs requested punitive damages in a separate count, the claim was incidental to their cause of action for breach of fiduciary duty. The court held punitive damages may be awarded for a breach of fiduciary duty by an attorney and that “reasons for imposing damages on an errant attorney are even more compelling than those where a non-attorney breaches a fiduciary or other tort duty to a plaintiff.” Since plaintiffs sufficiently pled a claim for breach of fiduciary duty, the court held that plaintiffs may assert a claim for punitive damages against R&H.

The court also overruled R&H’s motion to strike allegations of recklessness based on agency. R&H argued that plaintiffs failed to identify with sufficient particularity, either by name or description, the alleged agents, servants partners and/or employees whose conduct was grossly negligent, malicious and/or reckless. The court found that when the Complaint was read in its entirety, it was evident that plaintiff identified specific attorneys as employees of R&H who acted on behalf of the law firm.

Accounting Malpractice

New Jersey Jurisprudence Recognizes The Theory Of “Deepening Insolvency” As A Theory Of Harm To The Corporation

In NCP Litigation Trust v. KPMG, --- A.2d ---, 2007 WL 5063480 (N.J. Super. June 22, 2007)(approved for publication April 2, 2008), suit was brought against defendant KPMG, LLP arising out of the demise of Physician Computer Network, Inc. From 1993 until 1998, PCN retained KPMG as its independent accounting and auditing firm. Throughout the term of the engagement, two PCN officers, John Mortell and Thomas Wraback, served as the primary liaisons between KPMG and PCN.

During the mid-to-late 1990s, Mortell and Wraback engineered a plan to fraudulently inflate PCN's earnings and decrease its liabilities. During the audit of PCN's financial statements for the fiscal year ending on December 31, 1997, KPMG discovered several accounting irregularities. It brought these irregularities to the attention of Mortell and Wraback, as well as PCN's outside counsel. As a result, on March 3, 1998, PCN 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 for each of those quarters. PCN also announced that it would report a loss for the fourth quarter of 1997. Following those disclosures, the price of PCN stock fell seventy percent, hitting a record low.

In 1998, PCN announced that KPMG was withdrawing its auditor's report for 1996. 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 disclosed 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 to be restated. From August 1998 onwards, PCN operated at a cash flow deficit, filed for Chapter 11 bankruptcy on December 7, 1999, and was ultimately bought out by Medical Manager Corporation.

On May 9, 2002, plaintiff, NCP Litigation Trust (the “Trust”), the successor-in-interest to, inter alia, the claims of PCN against KPMG, filed suit against KPMG alleging that KPMG's breach of contract, negligence, negligent misrepresentation, and breach of fiduciary duty injured PCN. Following a motion to dismiss filed by KPMG, only two claims remained against KPMG-negligence and negligent misrepresentation. KPMG moved to 1) dismiss the complaint on the grounds that the Trust lacks standing because it cannot show that PCN has suffered an injury, and, in the alternative, 2) dismiss the Trust's claims as to KPMG's 1995 audit on the grounds that they are time-barred.

(1) Standing – “Deepening Insolvency Theory”

According to the Trust's complaint, KPMG's negligence and negligent misrepresentation caused PCN to incur additional liabilities and expenses, caused it to default on its bank debt, exacerbated its cash flow problems, and ultimately caused its demise. KPMG contends that PCN's further descent into insolvency and resulting bankruptcy, even if caused by KPMG, did not harm PCN, but rather only harmed its creditors and shareholders.

This argument placed before the court the question of whether New Jersey jurisprudence recognizes the theory of “deepening insolvency” as a theory of harm to the corporation. The theory of deepening insolvency espouses the concept that an insolvent corporation suffers harm when a defendant, either fraudulently or negligently, artificially prolongs, or contributes to the artificial prolongation of, the corporation's life, thereby increasing the corporation's debt and exposure to creditors, and depleting its assets. “Seizing upon the idea, which was coined by academics as “deepening insolvency,” that an insolvent corporation is harmed by the “diminution of its assets and income,” courts began to utilize it as a theory of damages which would support an independent cause of action, for example, malpractice, fraud, breach of fiduciary duty, et cetera.”

The court held that New Jersey jurisprudence recognizes the theory as a legally cognizable harm. The court went further to consider the implications of ignoring deepening insolvency as a legally cognizable harm:

Auditors engaged to conduct their audits in accordance with GAAS, as KPMG was here, have a duty to exercise due care in obtaining reasonable assurances that the company's financial statements are free of material misstatements. If the auditor fails to exercise such care, it shall be made answerable for such failure. The court notes that most corporate shareholders, if not all, will be barred by N.J.S.A. 2A:53A-25 from suing the corporation's auditor for malfeasance. While certain creditors may bring suit against the auditor, they will only do so if their claim is not satisfied by the sale or seizure of the corporation's assets, and even then only if their claim is large enough to justify the cost of suit. That leaves the corporation as the only other “real party in interest.” If this court does not recognize deepening insolvency as a form of harm to the corporation itself (as opposed to the creditors or shareholders) the corporation would be barred from suit by a lack of standing. This consequence would immunize auditors from being held accountable for their negligence, a result our Supreme Court has expressly rejected. See NCP Litig. Trust, supra, 187 N.J. at 380, 901 A.2d 871 . . . . In essence, rejecting deepening insolvency as a theory of damages would “provide a safe haven for negligent conduct.” Ibid. Against this backdrop, it becomes clear that deepening insolvency serves as the practical means for holding auditor's accountable for their negligence.

(2) Statute of Limitations

KPMG also alleges that the Trust's complaint is time-barred with respect to KPMG's audit of PCN's 1995 financial statements. KPMG contends that it discontinued all work on PCN's 1995 financial statements prior to April 1, 1996, and thus, the complaint, which was filed on May 9, 2002, is time-barred by the six-year statute of limitations set forth in N.J.S.A. 2A:14-1. N.J.S.A. 2A:14-1 provides that an action for accounting malpractice shall be filed six years from the date that it accrues. The discovery rule provides that a cause of action only accrues when the plaintiff becomes aware, or reasonably should become aware, that he has suffered harm.

The court noted that the agents charged with the knowledge of KPMG's failure to detect PCN's accounting irregularities were, primarily, Mortell and Wraback, the two officers whose fraudulent conduct caused those irregularities and induced PCN's bankruptcy, and whose actions KPMG is charged with contributing to.

The court applied the “adverse interest exception” which stands for the proposition that an a

gent's conduct will not be imputed to the principal if the agent has totally abandoned his principal's interest. The court held that in order to avoid imputing the knowledge of PCN's rogue managers to PCN, the Trust must show “1) that the rogue managers had completely abandoned the interests of PCN with respect to the fraudulent transactions, and 2) that PCN received no benefit from the fraudulent transactions.” The court held that this is a highly fact sensitive inquiry which the court cannot make, absent discovery.