United States 7th Circuit Court of Appeals Reports

BANK v. GEORGE KORBAKES & CO., 05-3580 (7th Cir.
12-18-2006) JOHNSON BANK, Plaintiff-Appellant, v. GEORGE
KORBAKES & CO., LLP, Defendant-Appellee. No. 05-3580.
United States Court of Appeals, Seventh Circuit. Argued
September 12, 2006. Decided December 18, 2006.

Appeal from the United States District Court, for the
Northern District of Illinois, Eastern Division, No. 01 C
2678 — Rebecca R. Pallmeyer, Judge.

Before EASTERBROOK, Chief Judge, and POSNER and SYKES,
Circuit Judges.

POSNER, Circuit Judge.

In this diversity suit governed by Illinois law, a bank
complains that it lost money as a result of errors in an
audit of one of its borrowers, Brandon Apparel Group, Inc.,
by the defendant, GKCO. The bank contends both that it is a
third-party beneficiary of the letter contract by which
Brandon retained GKCO to conduct the audit and that GKCO
committed the tort of negligent misrepresentation. The
district judge rejected the bank’s contract claim without
much discussion but conducted a bench trial of the tort
claim and afterwards entered judgment in GKCO’s favor on
both the contract and tort claims.

GKCO argues that the bank abandoned its contract claim in
the district court and so should not be heard to renew it
in this court. The bank argues that it did not abandon it.
No matter; the claim has no possible merit. To be a
third-party beneficiary of a contract is to have the rights
of a party, which is to say the power to sue to enforce the
contract. People ex rel. Resnik v. Curtis & Davis,
Architects & Planners, Inc., 400 N.E.2d 918, 919-20 (Ill.
1980); Robins Dry Dock & Repair Co. v. Flint, 275 U.S. 303
(1927) (Holmes, J.); Restatement (Second) of Contracts
§ 304 (1981). Parties to contracts are naturally
reluctant to empower a third party to enforce their
contract, so third-party beneficiary status ordinarily is
not inferred from the circumstances but must be express.
People ex rel. Resnik v. Curtis & Davis, Architects &
Planners, Inc., supra, 400 N.E.2d at 919; 155 Harbor Drive
Condominium Ass’n v. Harbor Point Inc., 568 N.E.2d 365,
374-75 (Ill.App. 1991); A.E.I. Music Network, Inc. v.
Business Computers, Inc., 290 F.3d 952, 955 (7th Cir. 2002)
(Illinois law). It wasn’t in this case. The fact that
Brandon wanted the audit in order to help it get additional
loans from the bank doesn’t show that GKCO consented to
have the bank enforce the engagement letter. And the fact
that the bank knew about the audit contract and received
the audit report doesn’t mean that GKCO knew that the bank
would be relying on the report to guide its decision on
lending Brandon more money, and, knowing that, meant to
assume the costs of misplaced reliance should it make
mistakes in the audit. Cf. Alaniz v. Schal Associates, 529
N.E.2d 832, 834 (Ill.App. 1988).

The claim of negligent misrepresentation has a slightly
better grounding, and let us turn to that claim.

Brandon made and sold clothing, although it also licensed
the making and selling of much of its clothing in exchange
for a percentage of the licensee’s sales revenues. Brandon
began borrowing money from Johnson Bank in 1997 and by the
end of April 1999 owed the bank $10 million — and
wanted more, and the bank lent it more, which the bank
lost, along with the $10 million, when Brandon went broke
the next year.

It was in late April of 1999, when Brandon was seeking the
additional loan from the bank, that it instructed GKCO to
give the bank the audit report that GKCO had just
completed. The report summarized Brandon’s financial
results for 1998 and revealed that the firm had serious
problems. But the report contained errors, which the bank
argues painted Brandon’s situation in brighter hues than
the audit justified and as a result induced the bank to
keep lending to Brandon.

The report classified a $1 million claim in a lawsuit that
Brandon had brought against its previous owner as a “contra
liability,” which means an offset to liabilities, and thus
in effect an asset. It should have been classified as a
“gain contingency,” and such a contingency, because of its
uncertainty, should not be listed on the company’s books as
a gain unless and until it materializes. SEC v. Yuen, No.
CV 03-4376 MRP (PlAX), 2006 WL 1390828, at *9 (C.D. Cal.
Mar. 16, 2006); Financial Accounting Standards Board,
Statement of Financial Accounting Standards No. 5, §
17, pp. 7-8 (1975); Jan R. Williams & Joseph V. Carcello,
Miller GAAP Guide 9.02 (2004). By treating the claim as a
contra liability, the report made it look (at least if one
looked no farther than the label) as if Brandon were worth
up to $1 million more than it would otherwise have appeared
to be worth, though how much more would depend on the
probability of Brandon’s prevailing in the lawsuit, which
nobody knew.

Another error was the audit’s classification of the
licensee’s sales as sales by Brandon itself, which inflated
Brandon’s listed sales by more than 50 percent. Brandon’s
income from the licensee’s sales was not inflated as a
result of the classification. But still it was wrong to
treat sales by another company as if they were Brandon’s
sales, because it made Brandon look much bigger than it
actually was.

GKCO also permitted Brandon to treat as prepaid expenses
what the bank argues were actually accounts receivable. A
prepaid expense is an asset created by a firm’s paying for
some good or service in advance. An example is insurance;
the premium is paid before a claim is submitted to the
insurance company. An account receivable is an asset
consisting of a right to payment from a customer. Although
there is always a risk that a supplier whom one has paid in
advance will default, the likelihood is generally less than
that an account receivable will prove uncollectible,
because a company is likely to know its suppliers better
than it knows its customers, and is therefore less likely
to be stiffed by a supplier than by a customer. That is why
prepaid expenses and accounts receivable are required to be
listed separately on the balance sheet — with the
latter reduced by an allowance for bad debts. Williams &
Carcello, supra, at 3.07-.08. But the asset in question in
this case involved a credit from a supplier, which is
properly classified as a prepaid expense. Galli v. Metz,
No. 87-CV-973, 1991 WL 175334, at *8 (N.D.N.Y. Sept. 9,
1991), rev’d in part on other grounds, 973 F.2d 145 (2d
Cir. 1992); In re Integrated Health Services, Inc., 344
B.R. 262, 271 (Bankr. D. Del. 2006).

The other errors of which the bank complains were
contested, and they were either trivial or found by the
district judge, with adequate basis in the record, not to
be errors. Still, there were errors in the report —
the listing of a gain contingency as a contra liability and
of a licensee’s sales as the licensor’s sales. But here is
the rub. The tort of negligent misrepresentation does not
create liability for violating accounting conventions, as
such; the elements of the tort must be present. In
addition, under Illinois law an auditor is liable to a
third party, that is, to someone different from the firm
that hired it to audit its books, only if the auditor knew
that the firm wanted to use the audit report to influence a
third party, 225 ILCS 450/30.1; Kopka v. Kamensky &
Rubenstein, 821 N.E.2d 719, 726 (Ill.App. 2004). The audit
report might flunk Accounting 101, but if the report didn’t
mislead anyone toward whom the auditor had a duty of care,
the auditor would not have committed a tort.

That is this case. A footnote in the report identified the
“contra liability” as a claim in a lawsuit. The note did
not suggest that the lawsuit was a sure thing for Brandon;
all it said was that “The Company [Brandon] is currently a
plaintiff in a lawsuit against Pearson [the company’s
previous owner] wherein they allege that Pearson
misrepresented the value of the assets sold and liabilities
assumed in the acquisition of the business. . . . Should
the Company not prevail in the lawsuit, the $1,000,000 will
be reclassified to goodwill, representing an additional
amount paid at acquisition in excess of the fair market
value of the assets acquired.” As a sophisticated financial
enterprise, the bank could not reasonably have treated the
auditor’s characterization of the claim as an assurance by
the auditor that Brandon would win its suit and if so
obtain and collect a $1 million award. How would the
auditor know? If the bank wondered how solid the claim was,
it could have investigated.

The licensee’s sales should not have been lumped in with
Brandon’s. But once again, a footnote eliminated any
possibly misleading impression by disclosing clearly the
amount of the licensee’s contribution to Brandon’s sales

At root the bank’s argument for liability is that it was
entitled to look no farther than the bottom-line numbers in
the audit report. That is incorrect; it had no right to
ignore the footnotes in the report, which together with the
numbers in it gave the reader an accurate picture of
Brandon’s financial situation. The bank cannot base a claim
for damages on a refusal to read. The audit report even
says that “the notes on the accompanying pages are an
integral part of these financial statements.” See Clyde P.
Stickney & Roman L. Weil, Financial Accounting: An
Introduction to Concepts, Methods, and Uses 17 (2000).

The bank argues that by the end of 1998, when the audit was
completed, Brandon’s financial situation was so lousy that
the audit should have included a “going concern
qualification,” that is, a warning that the audited firm
was teetering on the brink of bankruptcy. Copy-Data
Systems, Inc. v. Toshiba America, Inc., 755 F.2d 293, 299
(2d Cir. 1985); see American Institute of Certified Public
Accountants, “The Auditors Consideration of an Entity’s
Ability to Continue as a Going Concern,” Statement on
Auditing Standards, No. 59, § 5-6, pp. 3-4 (1988).
But the Bank was complicit in the omission of a
going-concern qualification. For before receiving the audit
report it had agreed to waive a number of restrictions in
the loan covenants precisely in order to spare Brandon the
dreaded warning, which by indicating a serious risk of
bankruptcy would have scared off trade creditors and
accelerated the bankruptcy.

The bank imputes to GKCO a duty to advise it whether
lending more money to this faltering firm (throwing good
money after bad, as the saying goes) would make commercial
sense. But an auditor’s duty is not to give business
advice; it is merely to paint an accurate picture of the
audited firm’s financial condition, insofar as that
condition is revealed by the company’s books and inventory
and other sources of an auditor’s opinion. E.g., Bily v.
Arthur Young & Co., 834 P.2d 745 (Cal. 1992); Jay M.
Feinman, “Liability of Accountants for Negligent Auditing:
Doctrine, Policy, and Ideology,” 31 Fla. St. U. L. Rev. 17,
21-22, 55-56, 58 (2003). An auditor who fulfills that duty,
or fails but manages not to mislead the intended readers of
the audit report, has no tort liability. Erroneous
characterizations can mislead, but not when the facts
mischaracterized are fully and accurately disclosed in the
audit report, as they were here.

The district judge was right, moreover, to find that the
bank did not rely on the mischaracterizations. It kept
lending money to Brandon in the hope of keeping the firm
from going broke and thus keeping alive the hope of
eventual repayment. That decision — the cause of the
bank’s undoing — had nothing to do with the audit.

The losses the bank incurred as a result of the additional
loans that it made beginning in May 1999 could not be
recovered as damages even if GKCO had been guilty of
negligent misrepresentation. GKCO could not have predicted
how much money the bank would lend to Brandon in reliance
on the audit and with what consequences. Damages so
speculative are not recoverable in a lawsuit. Trigano v.
Bain & Co., Inc., 380 F.3d 22 (1st Cir. 2004); AUSA Life
Ins. Co. v. Ernst & Young, 206 F.3d 202 (2d Cir. 2000);
World Radio Laboratories, Inc. v. Coopers & Lybrand, 557
N.W.2d 1 (Neb. 1996); cf. Haslund v. Simon Property Group,
Inc., 378 F.3d 653, 658 (7th Cir. 2004) (Illinois law).

The other issues raised by the bank are thoroughly
considered and correctly resolved in the district judge’s
meticulous 35-page opinion; we have nothing to add.