Law360 – January 13, 2022

It is common for accountants to seek to limit their liability to a client for malpractice. Typically, in the mandate contract, the liability is limited to the amount of the fees paid by the client to the accounting firm.

It is also increasingly common for malpractice claims, as well as officers’ and directors’ liability claims, to be the primary sources of recovery for creditors out of the money in a Chapter 11 case.

A post-confirmation litigation or liquidation trustee is often appointed to investigate the merits of a malpractice claim against the debtor’s accountant.

The accounting firm’s first response will be a reference to exculpatory language in the retention agreement.

A recent unpublished decision in adversarial proceedings alleging accounting malpractice should be a wake-up call to accountants and financial advisers to reconsider language purporting to limit their liability in retention agreements.

The wording of the exculpation should be specific as to the conduct to be exculpated.

Moreover, the scope of the exculpation may be contrary to public order if it is too broad. Despite the exoneration of gross negligence and recklessness in the retention agreement, this wording may be inapplicable to public order. State law should be sought.

A potential plaintiff seeking recovery from an accounting firm should not conclude their analysis if faced with general exculpatory language.

Accounting firms that rely on general exculpatory language should revise the language to be more specific as to what is being exculpated.

In the New Jersey case discussed below, BAK Advisors LLC v. Sax LLP, the exculpatory language in an accounting firm’s retention agreement, limiting damages to fees paid to the accounting firm by its client, was very broad and did not specifically exclude gross negligence.

In its December ruling, the United States Bankruptcy Court for the District of New Jersey distinguished between mere negligence and gross negligence, and further held that exoneration for gross negligence, recklessness, or willful or gratuitous fault was contrary to public order.

The adversarial proceeding was initiated by BAK Advisors, the post-confirmation liquidation trustee of Hollister Construction Co. LLC. The defendant, Sax, filed a motion to dismiss damages in excess of the amount paid by Hollister to Sax, for the audit of Hollister’s financial statements for the fiscal year ending December 31, 2018.

The retention agreement between Sax and Hollister provided that Sax would not be liable for any punitive, consequential, special, or indirect damages, and that Sax’s liability was limited to the amount of fees paid by Hollister to Sax for services rendered under retention agreement.

Sax asserted “that any claim seeking damages in excess of this number should be dismissed.”

BAK argued that the limitation of liability clause, if enforced, “would effectively absolve Sax of his negligent conduct.” BAK said “the clause, as drafted, is inadmissible and violates public order”.

BAK asked the court to adopt an exception to what it called “established precedent allowing parties to contractually limit liability where the conduct at issue was performed by a licensed professional.”

Sax “did not seek to reject the [c]complaint in its entirety, but rather to limit BAK’s recoverable damages. [c]complaint “in so far as it [sought] damages exceeding the amount paid to Sax … in connection with the 2018 [a]verification.”

U.S. Chief Bankruptcy Judge Michael B. Kaplan for the District of New Jersey denied Sax’s motion to dismiss based on the record at the time the motion was heard.

The court said it was “unable to determine whether Sax’s actions [rose] at the level of simple negligence, gross negligence or … recklessness.”

Furthermore, he said that the determination of the degree of professional misconduct – if there was one – was “a question of fact which [could not] be decided on a motion to dismiss. No decision has been made as to whether Sax was guilty of professional misconduct.

At the time of the hearing on the motion to dismiss, there was no evidence of professional misconduct. But there was also no evidence that there had been no professional misconduct. Therefore, the judge could not determine whether there was simple negligence or gross negligence.

For the accounting or professional services firm, the timing of a motion for limitation of damages in a malpractice action when there is an exculpation clause in the retention agreement must be carefully considered.

Filing a motion to dismiss before the facts of the malpractice, or lack thereof, are sufficiently developed may result in the motion being denied, increasing the psychological influence of the plaintiff.

For the plaintiff, a premature motion by the defendant may be a good basis for dismissing the motion.

Judge Kaplan said he was unable to find cases where gross negligence or willful misconduct was exonerated. And he observed that most exculpatory clauses exclude gross negligence and willful misconduct.

On the other hand, Sax’s exculpation clause was general and did not exempt gross negligence and willful misconduct. The language simply stated that Sax’s liability for Hollister’s claims, damages and costs was limited to the fees received.

So, for starters, an exculpation clause should specifically state that the accounting firm is exonerated for officer and director liability claims.

The court also said parties cannot limit liability for conduct more egregious than mere negligence, as that would violate public order.

Finally, the judge said that under New Jersey law, gratuitous conduct cannot be exculpated. He did not see why gross negligence and willful misconduct were different.

Even if the wording of the exculpation specifically includes gross negligence, recklessness, or willful misconduct, state law must be reviewed to determine whether such a broad exculpation violates public policy, even if the parties have argued it. accepted.

Finally, even though the exculpation clause excludes gross negligence and willful and wanton conduct, the question of whether the alleged professional misconduct was mere exculpatory negligence, or whether it was something more, does not is not an appropriate topic for a summary query. Sometimes it pays for a defendant to be patient.

Reprinted with permission from the January 13, 2022 issue of Law360. © 2022 Portfolio Media, Inc. All rights reserved.