KPMG Committed Malpractice Tied to Cast Art Merger, Appeals Court Rules

KPMG LLP engaged in accounting malpractice in connection with a giftware maker’s merger, a New Jersey appeals court ruled. In the same decision, the court ordered a new trial on damages, saying a jury improperly found the firm should pay $31.8 million.

The court ruled Aug. 26 on a 2008 trial in which a jury found KPMG negligent in its work as auditor for Papel Giftware Inc., a Cranbury, New Jersey, company that merged in 2000 with Cast Art Industries of Corona, California.

KPMG breached its duty under the Accountant Liability Act after detecting what Cast Art said were fraudulent financial practices at Papel, the jury said. Cast Art claimed the fraud, uncovered after the merger, caused its failure in 2003.

The company presented “sufficient evidence to establish all the elements of a cause of action for accounting malpractice,” a three-judge panel of the New Jersey Appellate Division in Trenton ruled.

“However, we conclude that the evidence presented by plaintiffs did not provide an adequate foundation for the jury’s damages award and therefore a new trial on damages is required,” the court said.

It didn’t say whether the damages were too high or too low, only that the jury didn’t have enough evidence to calculate them the proper way, by determining the value of the business at the date of the merger.

Fraud Claim Dismissed

The Superior Court trial judge in Middlesex County was correct in dismissing a fraud claim against New York-based KPMG, one of the Big Four U.S. accounting firms, the appeals court said.

A KPMG spokesman, Daniel Ginsburg, said the firm is “considering our available options” after the ruling.

“We are pleased that the court affirmed dismissal of the plaintiff’s fraud claim against us, and also reversed the jury’s verdict by ordering a new trial on the issue of damages,” Ginsburg said in an e-mail. “We are disappointed, however, with the court’s ruling on legal issues regarding the plaintiff’s negligence claim.”

KPMG knew that its audited 1999 financial statement for Papel was a precondition of the transaction, according to the opinion. Jurors heard testimony about “systemic, organized, improper accounting practices at Papel” before the deal, according to the opinion.

The “essential objective” of the practices was to “prematurely report revenue” through various schemes, including creating a phantom order and booking purchase orders as sales and then delaying shipping, according to the opinion.

‘Improperly Acquiesced’

A Cast Art accounting expert testified that when KPMG found “substantial” premature revenue recognition in the third quarter of 1997, KPMG should have obtained a “reasonable assurance” that the practice would end.

After similar practices arose, KPMG “improperly acquiesced in Papel’s requests to consider those discrepancies immaterial,” the court said.

The Cast Art expert cited a July 2000 letter by KPMG partner John Quinn that said Papel Chief Financial Officer Rick Wasserman gave an “unfair and misleading characterization of the accounting and auditing issues.”

Quinn said he was “very much inclined” to recommend ending work with Papel after that year’s audit, according to the opinion.

Expert’s Testimony

The expert said that once KPMG concluded that Papel’s finance chief “was not trustworthy, it should have withdrawn from its audit of Papel and not issued the 1999 financial statement upon which plaintiffs’ claim were primarily based,” according to the opinion.

“This is a huge win and no matter how KPMG wants to spin it, it’s a devastating loss for KPMG,” plaintiffs’ attorney Michael Avenatti said in an interview. “KPMG’s appeal of this case may go down as Exhibit A of ‘Be careful of what you wish for.’ Now, we have the ability to go collect potentially $10 million to $20 million more in additional damages.”

Avenatti’s firm, Eagan O’Malley & Avenatti of Newport Beach, California, represents Cast Art and its three principals, Scott Sherman, Gary Barsellotti and Frank Colapinto, all of California.

Jurors awarded $31.8 million, which plaintiffs said was Cast Art’s worth at the time of the merger. A judge reduced that amount by $1.8 million, which Cast Art recovered from Papel’s principals, according to the opinion. The judge then ordered KPMG to pay $30 million plus $8.1 million in prejudgment interest.

The case is Cast Art Industries v. KPMG LLP, MID-L-3295-03, Superior Court of New Jersey, Middlesex County.

To contact the reporter on this story: David Voreacos in Newark, New Jersey, at dvoreacos@bloomberg.net.

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