State Street Trust Co. v. Ernst

Was the evidence introduced by plaintiff so inadequate that, resolving all contested issues and drawing all possible inferences in plaintiff’s favor, a jury could not find that defendants were guilty of gross negligence raising an inference of fraud, and that plaintiff relied upon the certified balance sheet prepared by defendants, thereby suffering damage? , ..

The Pelz-Greenstein Company was organized in 1922 to engage in the business of financing wholesalers or mills.

On January 19, 1929, the president of Pelz-Greenstein applied to plaintiff for a line of credit and a loan of $300,00,0. He presented an estimated balance sheet of the business as of December 31, 1928, and stated that defendants, a firm of accountants, were making an audit of the condition of the company as of that date and that a balance sheet certified by defendants would be submitted to plaintiff when it had been prepared. Plaintiff refused to grant the application of Pelz-Greenstein for a time loan until it had received the certified balance sheet of defendants and had found that it substantially corroborated the estimated balance sheet. Pending the receipt of the certified balance sheet of defendants plaintiff made a demand loan to Pelz-Greenstein of $300,000.

This certified balance sheet prepared by defendants was dated April 2, 1929, and issued in ten counterparts. The defendants admit that they knew it was to be used to obtain credit., On April 9 a copy was given by Pelz-Greenstein to plaintiff. Plaintiff found that the certified balance sheet substantially corroborated the estimated balance sheet. The demand note was then surrendered and a three months’ time note taken in its place. This

With the certified balance sheet defendants issued the following certificate:

“ We hereby certify that we examined the books of account and record pertaining to the assets and liabilities of Pelz-Greenstein Co., Inc., New York City, as of the close of business December 31, 1928, and, based on the records examined, information submitted to us, and subject to the foregoing notes [not here material], it is our opinion that the above condensed statement shows the financial condition of the company at the date stated and that the related income and surplus account is correct.”

On May 9, 1929, a month after supplying ten copies of the balance sheet to be used, to the knowledge of the defendants, to obtain credit, defendants sent a letter to the Pelz-Greenstein Company containing comments on and explanations of the balance sheet. Apparently only one copy of this letter was sent, and it did not come to the attention of plaintiff nor, so far as the evidence shows, to any one else until after the bankruptcy of Pelz-Greenstein. This accompanying letter contained statements of facts discovered by defendants in the course of their audit, and, therefore, known to them when they prepared the original certified balance sheet, but which were not mentioned therein. One of the defendants testified before trial that the certified balance sheet was subject to the comments contained in the letter and the letter was sent for the purpose of trying to prevent any one from using this balance sheet without knowing the scope of the examination which was made.

In the brief of respondents, Pelz and Greenstein are denominated as deliberately dishonest. It is there conceded that they made old and probably uncollectible accounts appear good by causing payments to be made' to Pelz-Greenstein, Inc., by another corporation owned by themselves, which payments, credited to such old accounts, made it appear as if the debtors had been paying their debts. They induced one Saqui, who freely admitted his own dishonesty and testified on behalf of plaintiff, to furnish false inventories and to assign to Pelz-Greenstein large numbers of false and fictitious accounts. In one account of $800,000 there were $300,000 of wholly fictitious sales. At the time Pelz-Greenstein was hopelessly insolvent.

To what extent may accountants be held liable for their failure to reveal this condition? We have held that in the absence of a contractual relationship or its equivalent, accountants cannot be held liable for ordinary negligence in preparing a certified balance sheet even though they are aware that the balance sheet will be used to obtain credit. ( Ultramares Corp. v. Touche, 255 N. Y.

In Ultramares Corp. v. Touche ( 255 N. Y. 170 ) we said with no uncertainty that negligence, if gross, or blindness, even though not equivalent to fraud, was sufficient to sustain an inference of fraud. Our exact words were: “ In this connection we are to bear in mind the principle already stated in the course of this opinion that negligence or blindness, even When not equivalent to fraud, is none the less evidence to sustain an inference of fraud. At least this is so if the negligence is gross ” (p. 190).

To emphasize our holding that active and deliberate fraud was not necessary to create liability, and that gross negligence, and even blindness to the obvious may be evidence to sustain an inference of fraud, we were careful to point out that the language in Kountze v. Kennedy ( 147 N. Y. 124 ), saying that misjudgment, however gross, or want of caution, however marked, is not fraud, must be confined to the facts of that case, where the trier of the facts had found the defendants guiltless, and the ruling “ amounted merely to a holding that a finding of fraud did not follow as an inference of law.” ( Ultramares Corp. v. Touche, supra, p. 191 .)

The defendants, however, contend that they may escape all liability by insisting that the balance sheet merely

“ His [the auditor’s] business is to ascertain and state the true financial position of the company at the time of the audit, and his duty is confined to that. But then comes the question, ‘ How is he to ascertain that position?’ The answer is, ‘ By examining the books of the company.’ But he does not discharge his duty by doing this without inquiry and without taking any trouble to see that the books themselves shew the company’s true position. He must take reasonable care to ascertain that they do so. Unless he does this his audit would be worse than an idle farce. • Assuming the books to be so kept as to shew the true position of a company, the auditor has to frame a balance-sheet shewing that position according to the books and to certify that the balance sheet presented is correct in that sense. But his first duty is to examine the books, not merely for the purpose of ascertaining what they do shew, but also for the purpose of satisfying himself that they shew the true financial position of the company.” (Matter of London & General Bank, [1895] 2 Ch. 673, 682.)

The record is, indeed, replete with evidence, both oral and documentary, to make a prima facie case against the defendants. In the first place, we have these accountants guilty of an act which is the equivalent of active misrepresentation. On April 2, 1929, they sent to Pelz-Greenstein the certified balance sheet, with ten additional copies, knowing that it was to be used to obtain credit. “ Nothing was said as to the persons to whom these counterparts would be shown or the extent or number of

The above act of the accountants, in placing in circulation a certified balance sheet which they practically conceded should not be used without knowing the scope of the examination set forth in the covering letter, and then allowing a period of thirty days to elapse before 'sending the covering letter, and then only one copy, whereas there had been ten copies of the certified balance sheet issued, was itself gross negligence and an important piece of evidence raising an inference of fraud.

Turning now to .the specific items. The second largest item in the balance sheet was the item:

“ Commission Accounts Receivable — secured by merchandise

Advances..........................$2,043,337 81 Less allowance......................$ 19,767 15 2,023,570 66 ”

The above item represented the advances made by Pelz-Greenstein to its borrowers to finance their operations in the purchase or manufacture of merchandise. These accounts, amounting to over one-fourth of Pelz-Greenstein’s total assets, were shown on the certified balance sheet as good after deducting the $19,000 allowance. Yet, to the knowledge of defendants, according to their own statement, in the delayed covering letter, a very large proportion of these commission accounts receivable “ were comparatively inactive during the year and appeared slow of collection.” Out of the total of $2,043,000 an aggregate of $768,000, or over 38 per cent of the total amount, had unpaid advances at the end of the year 1928, amounting to 125 per cent of the total sales during the year. This meant that these borrowers owed Pelz-Greenstein more money at the end of the year than their total sales during the year by 25 per cent, thus indicating stagnation of inventories. Not only did these stagnant accounts represent over 38 per cent in amount,

One of the experts for the plaintiff testified without contradiction that the percentage of unpaid advances, amounting to 125 per cent of sales, indicated that the accounts were in an over-extended condition and were badly out of proportion to the amount of merchandise sold during the year, indicating that the inventories were either excessive, slow moving or unsalable. In his opinion this condition indicated the likelihood of excessive losses. Furthermore, this expert testified unequivocally that the financial condition of Pelz-Greenstein could not be truthfully expressed without mention of this condition in the balance sheet. Professor Cole, the other expert called by plaintiff, testified that proper accounting practice required that defendants either establish a very large allowance for uncollectible accounts or indicate, in connection with the balance sheet, the existence of approximately $768,000 with a ratio of advances to sales of 125 per cent. The best corroboration of the testimony of both these experts is what defendants themselves said of this condition in the delayed covering letter. In spite of this a reserve of a mere $19,767.15 was set up against this account. This was to cover not only those accounts of $768,000, showing the stagnation of inventories described above, but all other commission accounts in a total of over $2,000,000.

We next come to a very substantial item entitled “ Commission Account Advances — Inactive and in Liquidation..........................$215,124 72.” This item appeared on the certified balance sheet without any reserve. The books of Pelz-Greenstein showed on their face that many of the accounts included in this item had had no transactions for many years, neither sales nor realizations upon security. Furthermore, within this time the books showed systematic inflation of these accounts by steadily increasing interest charges. In fact, these charges were added to one account, even though the account appeared on the face of the books to have been in bankruptcy. The covering letter set forth the real condition of these accounts in detail, thus showing full knowledge on the part of the defendants. Defendants seek to sustain the integrity of this item on the ground that they placed it “ below the fine ” and characterized it as “ inactive and in liquidation.” The only evidence in the record concerning the effect of these acts is the uncontradicted evidence of the accounting experts that placing an item below the line means only that it is not

The defendants urge that these defendants were excused from investigation because of a letter from Leon S. Pelz, treasurer of Pelz-Greenstein, in which he stated that Pelz-Greenstein had in its possession “ sufficient salable merchandise to completely liquidate ” these accounts. In other words, defendants were content to certify a balance sheet knowing it would be used to secure bank credit which contained an item of over $125,000 of apparently dead accounts on the uninvestigated and unsupported statement of the party seeking the credit that these accounts were amply secured, although it appeared on the face of the books that there had been no realization upon this security for years. Where the books indicate the likelihood of a substantial loss, a failure to indicate this on the balance sheet can be justified only by an actual check-up. It does not suffice to rely instead upon the statement of an officer of the firm the books of which are being examined. If an accountant may disregard a situation Which indicates substantial losses because he is informed by the person whose books are being examined that there is adequate security, the balance sheet issued by the accountant, by its failure to point this out, contains a misrepresentation. The very purpose of the bank in seeking the balance sheet

We have explicit expert testimony, uncontradicted, that under these circumstances it was improper accounting practice for defendants to accept a letter from Pelz-Greenstein, and that they should have investigated these accounts very fully to ascertain whether the companies were still in business and to ascertain definitely and independently what security, if any, Pelz-Greenstein held for the payment of these accounts.

We next come to an item which is not as large as those which have gone before, but as to which there was obvious gross negligence. In the “ Accounts Receivable ” item of $3,200,000, protected only by a reserve of $15,000, was a group of accounts totaling over $72,000 denominated by defendants on their work sheet as “ Ocean Bankrupt Accounts.” Defendants stated that the failure to set up a reserve against this $72,000 of bankrupt accounts was justified because they were covered by policies of credit insurance. A mere cursory examination of the policies shows that over $32,000 of these accounts were not covered by the policies at all. Thus the reserve was shown to be inadequate by this one account alone. In addition, defendants’ own work sheets showed that $14,000 of these bankrupt accounts had been with the insurance company from three years 'to fifteen months without action. There was expert testimony which a jury was at liberty to believe that a reserve of at least $46,000 should have been established against this account.

We find, also, a $10,000 demand note listed as part of the assets without reserve although it had been overdue and in the hands of an attorney, who had been unable to collect, for two years.

We come now to evidence from which a jury could find that these defendants were at least heedless and reckless in purporting to reflect the condition of the books. We have an allowance of $101,000 for “ doubtfuls ” and “ discounts,” $86,000 of this $101,000 being for discounts and $15,000 for doubtfuls in the item of Accounts Receivable for $3,200,000. There was evidence that these figures for doubtfuls and discounts were arrived at, not by computation on the basis of business done during the year 1928, but by accepting the figures used for the year 1927. The working papers used by defendants for 1927 showed that in that year the amount of discounts had been based originally upon usual accounting practice, and was much larger than the final figure adopted by the accountants. Also, the original allowance for doubtfuls

The record contains many other important items of evidence to enumerate which would unduly extend this opinion, now beyond reasonable limits.

The foregoing presents abundant evidence from which a jury could find that defendants knew facts which vitally affected the financial worth of Pelz-Greenstein, and which defendants totally suppressed .on the certified balance sheet but disclosed to Pelz-Greenstein alone in the one copy of the covering letter sent thirty days later. The jury further could have found that the computation of reserves on the certified balance sheet was a misrepresentation which did not reflect the facts as known to defendants, and which they in good faith should have revealed. Where the record shows acts on the part of the accountants, as outlined above, we cannot say, as a matter of law, that plaintiff has failed to make out a case for the jury.

This brings us to the question of reliance. Defendants contend that the difference between the estimated balance sheet furnished by Pelz-Greenstein and the certified balance sheet prepared by them was such that as a matter of law plaintiff must have disregarded their certified balance sheet in making the loan and decided to make the loan solely on the basis of the estimated balance sheet

Finally, defendants argue that plaintiff was not damaged by reason of the balance sheet because at the time it was issued plaintiff already had made a demand loan of $300,000, and the company, according to plaintiff’s allegations, was insolvent at that time. There can be no doubt that if at the time the balance sheet was issued plaintiff had been informed of the true condition of Pelz-Greenstein Company it would have insisted upon immediate payment of the demand loan, and there is evidence from which it can be foun’d that at that time full payment of the loan could have been obtained.

Upon all the evidence it cannot be said as a matter of law that plaintiff has failed to make out a prima facie case against defendants.

The judgments should be reversed and a new trial granted, with costs in all courts to abide the event.

(dissenting). The defendants, a firm of accountants, were employed by the Pelz-Greenstein Company to examine the books of the company and to prepare a certified balance sheet of its financial position. To

The only representations made by the defendants are contained in the balance sheet which they prepared after examining the books of account of the Pelz-Greenstein Company and the certificate appended thereto. The certificate states: “ We hereby certify that we examined the books of account and record 'pertaining to the assets and liabilities of Pelz-Greenstein Co., Inc., New York City, as of the close of business December 31 1928, and, based on the records examined, information submitted to us, and subject to the foregoing notes [not material here], it is our opinion that the above condensed statement shows the financial condition of the company at the date stated and that the related income and surplus account is correct.”

To prepare a balance sheet, accountants must, of course, examine the books and accounts submitted to them, and from such examination and any other information which may be furnished to them, they must prepare a balance sheet which, in their opinion, reflects the true financial position of the business. The certificate of the defendants constitutes an express representation of fact that they have “ examined the books of account and record pertaining to the assets and liabilities of Pelz-Greenstein Co., Inc.” The balance sheet itself represents and was understood to represent only the “ opinion ” of the defendants based “ on the records examined ” and on information presented to the defendants.

The defendants are not liable for error of judgment; they are not liable even for lack of care in arriving at their opinion. They are liable only if the opinion expressed was not only erroneous, but was fraudulently expressed. Actual bad faith and intent to deceive is not always, it is true, an essential element in a cause of action for deceit. Such a cause of action may be established against the defendants without proof that they expressed an opinion which they knew was incorrect; at least, however, there must be evidence of a ruthless disregard of whether the opinion was correct or not — the expression of an opinion where “ the grounds supporting it are so flimsy as to lead to the conclusion that there was no genuine belief back of it.” (Ultramares Corp. v. Touche, supra, p. 186 .)

In that case we said that “ negligence or blindness, even when not equivalent to fraud, is none the less evidence to sustain an inference of fraud. At least this is so if the negligence is gross ” (p. 190). That rule was not new; it had been applied in earlier cases cited in the

Judge Finch has, in his opinion, referred to the evidence upon which he bases his conclusion that it. establishes fraud. I shall try to avoid repetition of that evidence. The most important of the alleged errors in the balance sheet is the failure to provide sufficient reserves for the collection of “ commission accounts receivable.” The amount of reserves which should be set aside to take care of loss that may be suffered by reason of inability to collect such accounts is a matter of judgment. The defendants knew of circumstances which it is said pointed clearly to the conclusion that a reserve of $21,000 is insufficient to take care of these accounts of over $2,043,337.81. Perhaps the defendants here showed a lack of caution. Their letter sent thirty days after the certified balance sheet was sent, shows that they knew that the reserve might prove insufficient. None the less, the amount of probable loss even with these circumstances known remained uncertain; the estimate of one per cent loss was doubtless over-optimistic, yet the estimate was based on facts which were not “ so flimsy as to lead to the conclusion that there was no honest belief back of it ” (p. 186).

The" next error which, it is argued, shows negligence so gross as to indicate a lack of honest belief based on substantial grounds is that no allowance was made for “ commission account advances.”. Many of these accounts were old. Again there are circumstances which

I agree that the jury might find gross negligence in failure to provide a reserve of $46,000 against a group of bankrupt accounts aggregating $72,000. Even gross negligence in regard to an item of $46,000 in a balance sheet showing assets of almost $8,000,000 can hardly be regarded as substantial evidence of fraudulent misrepresentation. I do not take up in detail the other items where it is said the jury might find gross negligence. Each one involves the exercise of judgment; in none does it appear that there was no ground for honest exercise of judgment.

Certainly there is here no deliberate intention to deceive, no statement of fact made without actual knowledge, no statement of an opinion which the defendants did not honestly hold; nor, with the possible exception of the one item of $46,000, is there any evidence of an expression of opinion made by a person careless as to whether it was based on sufficient knowledge. The case is entirely different from that presented by Ultramares

Here the defendants examined adequately the books and data which they certified they had examined, and they are not charged with either bad faith or even negligence in making their examination. The balance sheet corresponds with the books and if the defendants were negligent, their negligence, whether gross or slight, com sisted only in failure to give to the information, which they obtained through such examination, the effect which expert witnesses testify should, in their opinion, be given to it. The defendants realized that this information might reasonably affect their judgment. The explanatory letter which they sent later shows that. The jury might find that the defendants’ judgment was bad, but the court pointed out in the Ultramares case that liability cannot be predicated upon error however great in the exercise of judgment. The error of judgment does not indicate a willful expression of a false opinion, or an expression of opinion based on grounds so flimsy that the jury might conclude that the opinion was not based on genuine belief. To permit recovery in a case where the evidence does not sustain such a conclusion is to wipe out the distinction which this court has always drawn and which it reiterated in the Ultramares case.

The judgment should be affirmed.

O’Brien, Loughran and Rippey, JJ., concur with Finch, J.; Lehman, J., dissents in opinion in which Crane, Ch. J., concurs; Hubbs, J., taking no part.

Judgments reversed, etc. (See 278 N. Y. 704 .)