Professional Liability Update

Texas Supreme Court Reaffirms Limits on Auditors’ Liability to Third Parties

In a unanimous opinion issued July 2, the Texas Supreme Court issued its most definitive opinion in two decades regarding the limited scope of professional liability to non-clients and, in an issue of first impression, rejected a “holder claim.” The lawsuit was brought against accounting firm Grant Thornton by four investment funds managed by Highland Capital Management. The Court articulated the limited scope of professional liability to non-clients for negligent misrepresentation and fraud under Texas law.

The lawsuit was brought by hedge funds that bought high-yield junk bonds issued by Epic Resorts, a vacation timeshare operator. After timely paying interest for two years, Epic chose not to make an interest payment after its principal lender withdrew critical financing. The plaintiff funds subsequently drove Epic into bankruptcy in 2001. In 2002, the funds sued Grant Thornton, which had issued audit reports on Epic’s financial statements for the periods ending December 31, 1999 and December 31, 2000. The funds alleged that Grant Thornton had misrepresented the status of an escrow account that Epic maintained at U.S. Trust, the trustee under the indenture that defined Epic’s obligations to bondholders.

Embracing the Restatement approach, the Court reaffirmed that Texas law limits liability for negligent misrepresentation to “situations in which the professional who provides the information is aware of the nonclient and intends that the nonclient rely on the information. Unless a plaintiff falls within this scope of liability, a defendant cannot be found liable for negligent misrepresentation.” Liability for fraud is also limited, requiring evidence that the auditor had “reason to expect” that a nonclient would rely, that the claimant’s reliance is “especially likely and justifiable” and that the transaction sued upon is the type the defendant contemplated. The Court held that liability could not be premised on Grant Thornton’s “general knowledge that investors might purchase Epic bonds.”

The Court also rejected “holder claims”—claims not that the funds bought or sold securities based on the audit reports, but instead that they refrained from selling bonds that they had previously purchased. The Texas Supreme Court had never considered whether holder claims were viable under Texas law. The Court concluded that “to the extent they are viable, [holder claims] must involve a direct communication between the plaintiff and defendant.” Because it was undisputed that there had been no direct communication between the funds and Grant Thornton, the Court rejected the asserted holder claims.

The Court’s opinion also addresses two important issues regarding reliance. Most of the funds’ bond purchases occurred after March 2001, when its investment manager learned that Epic had lost the financing critical to its operations. The Court held that if the Funds relied on the 1999 or 2000 audit reports in making these purchases, that reliance would not have been justifiable in light of the funds’ knowledge. As the court concluded, the funds “could not have justifiably relied on the audit report as to purchases made after they knew the corporation was at risk of financial ruin.”

The Court also rejected the funds’ vicarious reliance theory. The funds admitted that they never saw or relied upon a negative assurance statement that Grant Thornton provided to Epic in 2000. The funds argued that U.S. Trust relied on that statement and that they could substitute U.S. Trust’s reliance for their own because U.S. Trust was the bondholders’ agent. Rejecting this argument, the Court held that if that were true, U.S. Trust’s knowledge (that the escrow account was not in place) also must be imputed to bondholders. The Court held that the bondholders “may not substitute their escrow agent’s reliance for their own without also being bound by its knowledge.”

Grant Thornton was represented in the Texas Supreme Court by Baker Botts L.L.P. Samara Kline argued the case and was joined on the brief by Robb Voyles, former Chief Justice of the Texas Supreme Court Tom Phillips and Jessica Pulliam. Also on the brief were Robert Coleman, David Buono and Joel Geary, formerly of Brown McCarroll L.L.P. Grant Thornton’s Deputy General Counsel Tracy Berry supervised the litigation.