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In a corporate buyout, when should a company suspect that the accounting firm in charge of auditing the company on the other side of the transaction hasn’t been doing its job? The Delaware Supreme Court has held that an e-mail from the accounting firm’s client advising an executive of the plaintiffs’ company to carry out a questionable accounting procedure was not enough to put the plaintiffs on notice of a potential accounting malpractice claim. According to the high court’s opinion in Coleman v. PricewaterhouseCoopers, the former owners of California corporation Digital Imaging & Technologies sued PWC after the accounting firm’s client, Lason Inc., was unable to pay the balance of the purchase price for DIT. The plaintiffs alleged that PWC had negligently failed to uncover accounting irregularities at Lason, the opinion said. Lason’s stock price declined significantly after it purchased DIT, and the corporation ultimately filed for bankruptcy three years later, the opinion said. PWC argued that an e-mail from Lason to DIT urging DIT to carry out a questionable accounting procedure triggered the three-year statute of limitations on the plaintiffs’ suit, the opinion said. The accounting firm contended that because plaintiffs filed suit more than three years after the e-mail was sent, the suit was time-barred, the opinion stated. “This court cannot hold, as a matter of law, that the … e-mail … was sufficient to impose upon the plaintiffs a duty to conduct a further investigation,” Justice Jack B. Jacobs wrote for the court. The July 16 decision reversed a Superior Court ruling in the matter. The trial court had agreed with PWC’s statute of limitations argument and granted summary judgment in favor of the defendant. The e-mail that eventually brought the parties before the Supreme Court traces its roots to Lason’s 1998 purchase of DIT, the high court’s opinion said. DIT was a data image/capture company, the opinion said. Lason was in the same business and, between 1996 and 1999, acquired numerous companies like DIT, the opinion stated. In 1998, DIT’s owners agreed to sell the company to Lason, the opinion said. According to plaintiffs’ complaint, DIT’s gross revenues for that year had exceeded $17 million. PWC had prepared Lason’s annual reports, Securities and Exchange Commission filings and financial statements for the periods ending Dec. 31, 1997, and Sept. 30, 1998, the opinion said. The plaintiffs relied upon that information when they decided to go forward with the sale, the opinion stated. Before finalizing the sale, the plaintiffs met with PWC accountant Timothy Molnar, the opinion said. When the plaintiffs asked Molnar whether there was anything else they should know about Lason’s financial condition, the accountant told them that the documents they reviewed presented an accurate picture of Lason’s financial state, the opinion stated. According to the opinion, the base price to be paid for 100 percent of DIT’s outstanding stock was $18 million less existing debt, plus an earnout formula tied to DIT’s future performance. The plaintiffs claimed in their complaint that the price was later renegotiated down to $13 million, but that the earnout could have totaled $25 million over a three-year period. An earnout is an arrangement under which the sellers of a business are to receive future payment for their company in addition to its base purchase price. Earnouts are typically based on future earnings. Whether the base price of DIT was $18 million or $13 million was not material to the disposition of the matter, the court’s opinion said. When the merger was consummated, the plaintiffs received $6.5 million in cash, with the balance of the purchase price to be paid over three years, the opinion said. Shortly before the merger, DIT had renegotiated the terms of a $1.9 million loan, which resulted in the forgiveness of an $800,000 loan, the opinion said. After the Nov. 25, 1998, purchase, the companies’ executives exchanged several e-mails regarding the loan forgiveness, the opinion stated. According to the opinion, a Lason official in a January 1999 e-mail told DIT’s chief financial officer how to treat the $800,000 loan forgiveness. The officer wrote: “‘Take $400,000 of the $800,000 and record [it] into income in December. I don’t really care where you put it so long as it is not obvious to the auditors should they look at your numbers. The remainder we will save for a rainy day in 1999,’” the opinion said. DIT’s CFO was concerned about the propriety of the instruction, the opinion said, but Lason’s chief executive officer assured him that PWC would give its blessing to the suggested accounting treatment of the loan forgiveness. As a result of this assurance, DIT made the adjustment as instructed, the opinion stated. In March 2001, the SEC learned of significant accounting irregularities in some of Lason’s financial statements, the opinion said. Eight months later, Lason filed for bankruptcy, according to the opinion. The plaintiffs filed suit against PWC in February 2003, the opinion stated. In their suit, the plaintiffs alleged that if PWC had properly audited Lason’s financial statements, it would have discovered the accounting irregularities in advance of the completion of the sale of DIT to Lason, the opinion said. The Superior Court, however, had determined that the e-mail to DIT’s CFO was sufficient to put the plaintiffs on notice of potential accounting problems, and therefore held that the statute of limitations on the plaintiffs’ malpractice and negligent misrepresentation claims had run in January 2002, the high court’s opinion said. The Supreme Court disagreed. “First, it is unclear, as a factual matter, whether or not the 1999 e-mail should have aroused the plaintiffs’ suspicions to a degree sufficient to impose upon the plaintiffs a duty of further inquiry. Second, it is impossible to determine from the present record whether a more diligent investigation, even if pursued, would have uncovered facts sufficient to enable the plaintiffs to discover the basis of their accounting malpractice claim,” Jacobs wrote. The court determined that one could draw competing inferences from the statements made in the e-mail, and from the response of Lason’s CEO when the plaintiffs inquired about the accounting instruction. Two DIT owners who were accountants, as well as a certified public accountant who testified as an expert, informed the court that the accounting maneuver was “in the ‘gray area’ of accounting” and was not “per se forbidden” under generally accepted accounting principles, the opinion stated. “Thus there was no ‘red flag’ that clearly and unmistakably would have led a prudent person of ordinary intelligence to inquire whether PWC had negligently failed to determine that Lason’s pre-acquisition accounting practices violated GAAP,” the court concluded. The defendant has filed a motion for reargument en banc, Kevin Gibson of Gibson & Perkins said. Gibson represented the plaintiffs. Gregory Varallo and Lisa Zwally of Richards Layton & Finger, and Martin Perschetz and Joanna Goldenstein of Schulte Roth & Zabel in New York were counsel for the defendant. Neither Varallo nor Zwally could be reached for comment immediately prior to press time.

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