Madeoff is a small, nonpublic retailer seeking capital for expansion. To obtain necessary capital, Madeoff engaged Allen, CPAs to audit is annual financial statements. In discussing the engagement, Madeoff explicitly informed Allen that the purpose of the audit was to obtain additional financing for expansion into new markets. Madeoff obtained $ 3 million from lenders. These lenders included the following:
• First Trust and Bank provided $ 2 million. When engaging Allen, Madeoff indicated that it would use the audited financial statements and Allen’s opinion on these statements to seek financing from First Trust and Bank; also, First Trust and Bank was specifically named in the engagement letter. Prior to committing the capital, First Trust and Bank had reviewed Madeoff’s financial statements and, based on the financial condition reflected in its balance sheet, deemed Madeoff to be a qualified loan candidate.
• MoonTrust Bank provided $ 800,000 of capital to Madeoff. Although not named in the engagement letter nor identified to Allen, Madeoff had previous business dealings with MoonTrust and maintained several accounts at MoonTrust. Based primarily on its prior relationships with Madeoff, MoonTrust approved the additional financing to Madeoff prior to receiving the audited financial statements or Allen’s report on those financial statements.
• Alice Lay, a local philanthropist, provided $ 200,000 of capital to Madeoff. Although her decision was primarily motivated by Madeoff’s role in the community and its corporate citizenship, she did request and review Madeoff’s audited financial statements and Allen’s report on those financial statements prior to providing funding. Alice had never entered into a loan agreement of this nature in the past but felt personal ties to Madeoff and was interested in its continued success.
Approximately six months following these loans, Madeoff declared bankruptcy.
Following the bankruptcy, lenders discovered that Allen’s audit failed to disclose several material financial statement misstatements that, if corrected, would have presented a less favorable depiction of Madeoff’s financial condition, results of operations, and cash flows. These lenders are exploring potential litigation against Allen to recover the funds they pro-vided to Madeoff.
a. Would these third parties more likely pursue litigation against Madeoff under common law or statutory law?
b. How would each of the lenders likely be classified based on their relationship with Allen and the potential use of Madeoff’s financial statements and Allen’s report?
c. Assume that Allen’s audit did not comply with generally accepted auditing standards but that it did not demonstrate a lack of minimum care or actual knowledge of the misstatements. Given the circumstances noted, how would you assess each of these parties’ ability to prevail against Allen in a potential claim?
d. Repeat (c), assuming that the parties could prove that Allen was aware that Madeoff’s financial statements contained a material misstatement.