Northeast Mortgage Corporation v. Robison, Hill & Co. (2013)

MEMORANDUM OF DECISION

FACTS

This is a claim sounding in professional malpractice brought against two public accounting firms in two separate actions which were consolidated (companionized) in January of 2011.   The defendants, Robison, Hill & Company (hereafter “RHC”) and Kahan Steiger & Company P.C. (hereafter “KSC”), are certified public accounting firms located in Salt Lake City, Utah and Stamford, Connecticut respectfully.   Each of these public accounting firms was hired by the plaintiff, Northeast Mortgage Corp. (hereafter “NEM”), to perform certain auditing functions for the fiscal years 2004 and 2005.   RHC was to do the audit for calendar year 2004 and KSC for calendar year 2005.   Both audits were to be completed by the end of March of the following year respectively.

The plaintiff was headed and principally represented by its chief executive officer and majority stockholder, Brian Rogerson (hereafter “BR”), who started in the mortgage lending business in 1985.   Over the ensuing eleven (11) years he developed his own business in the form of Northeast Mortgage Company with his brother, Sean Rogerson (hereafter “SR”), and a close associate, Anthony Gabriele, as the principal members of the plaintiff, then an LLC.¹ The plaintiff is licensed in the State of Connecticut and other states, with eight offices, operating as a lender and broker of residential mortgages.   NEM had a wholesale line of credit with various banks (People's Bank and Horizon Bank) and was able to market HUD and FHA mortgage products at the retail level to the general public.   The business expanded to the point that, in the year 2000, it had over 200 employees and was processing tens of million of dollars worth of mortgages during the ensuing years.   Up until 2007, the company's headquarters was located in Southbury, Connecticut, but BR moved part of the operation and himself to Arizona with satellite offices in various locales along the East Coast.  (KSC Exh. # 117 History of Co.)

The defendant RHC had done prior audits for the plaintiff in 2002 and 2003.   (KSC Exh. # 105.)   RHC was engaged for the 2004 audit by way of a February 1, 2005 engagement letter (RHC Exh. # 222;  NEM Exh. # 4) and a March 28, 2005 management representation letter (KSC Exh. # 123), which describe the scope of the audit to be performed and management's responsibilities.   In order for the plaintiff to maintain its line of credit and remain certified by HUD and other lending entities, NEM had to meet certain criteria set by these various federal agencies to include verification of net worth and available net cash.

The main thrust of the plaintiff's case was directed at establishing that both defendants, respectively for the calendar years '04 and '05 failed to detect any material misstatements in the financial records which would adversely reflect the financial condition of NEM. The allegation is that the defendants did not properly apply generally accepted accounting principles (GAAP), generally accepted auditing standards (GAAS), generally accepted governmental auditing standards (GAGAS) (NEM Exhs. # 51–64) and statement on auditing standards (SAS–99) (NEM Exh. # 10) in their audit procedures and testings.   The plaintiff argues that this failure by both auditors meant that the embezzling of company assets and the non-payment of certain recurring tax obligations, namely IRS Form 941,² went undetected over the subject years and in prior and subsequent years.

The plaintiff's claims for breach of contract and professional malpractice/negligence are based primarily on the failure of the two auditing firms to detect the malfeasance and nonfeasance of the company controller, Paula Borsari, resulting in alleged misstatements of the company's financial condition, starting in 2003 through 2006.

LEGAL ANALYSIS

“The elements of a breach of contract action are the formation of an agreement, performance by one party, breach of the agreement by the other party and damages.”  (Internal quotation marks omitted.)  Rosato v. Mascardo, 82 Conn.App. 396, 411, 844 A.2d 893 (2004) (citing Bouchard v. Sundberg, 80 Conn.App. 180, 189, 834 A.2d 744 (2003)).  “The rules governing contract formation are well settled.   To form a valid and binding contract in Connecticut, there must be a mutual understanding of the terms that are definite and certain between the parties ․ To constitute an offer and acceptance sufficient to create an enforceable contract, each must be found to have been based on an identical understanding by the parties ․ If the minds of the parties have not truly met, no enforceable contract exists ․ [A]n agreement must be definite and certain as to its terms and requirements ․ So long as any essential matters are left open for further consideration, the contract is not complete.”  (Internal quotation marks omitted.)  Duplissie v. Devino, 96 Conn.App. 673, 688, 902 A.2d 30 (2006).  “A contract requires a clear and definite promise ․ A court may, however, enforce an agreement if the missing terms can be ascertained, either from the express terms or by fair implication ․ Thus, an agreement, previously unenforceable because of its indefiniteness, may become binding if the promise on one side of the agreement is made definite by its complete or partial performance.”  (Citations omitted;  internal quotation marks omitted.)  Geary v. Wentworth Laboratories, Inc., 60 Conn.App. 622, 627, 760 A.2d 969 (2000).

“[P]rofessional negligence or malpractice ․ [is] defined as the failure of one rendering professional services to exercise that degree of skill and learning commonly applied under all the circumstances in the community by the average prudent reputable member of the profession with the result of injury, loss, or damage to the recipient of those services.”  (Internal quotation marks omitted.)  Gold v. Greenwich Hospital Association, 262 Conn. 248, 254, 811 A.2d 1266 (2002).   To state a claim for professional negligence, the plaintiff must show the existence of “[1] duty;  [2] breach of that duty;  [3] causation;  and [4] actual injury.”  (Internal quotation marks omitted.)   Silano v. Cumberland Farms, Inc., 85 Conn.App. 450, 453, 857 A.2d 439 (2004);  see also Curtis Packaging Corp. v. KPMG, LLP, Superior Court, complex litigation docket at Hartford, Docket No. X06 CV 99 0156558 (July 31, 2002, McWeeny, J.);   Faulise v. Eisenstein, Superior Court, judicial district of New Britain, Docket No. CV 98 0490341 (October 30, 2000, Kocay, J.).

An examination of the probative and credible exhibits, as well as certain trial testimony, will establish whether the plaintiff has met its burden of proof under either one of the claimed causes of action.   The exhibits ³ offered by all three parties and admitted by the court were voluminous and include the 10 days of testimony spread over a 45–day period.   The court requested proposed findings of fact, a time line, as well as briefs on any relevant legal issues which were properly indexed by each of the parties to the evidence as an aid to the Court.

Before the court develops any factual findings and conclusions of law, it will rule upon motions made by both defendants under Practice Book § 15–8.   The defendant RHC claims that the plaintiff failed to establish a prima facie case and that its original complaint, dated December 30, 2008, should be dismissed.⁴  The respective complaints, companionized for trial purposes, allege professional malpractice based on negligence in their first counts, and each second count alleges breach of contract by each defendant in the said respective year of each audit engagement.⁵

The court focuses on the defendant RHC's claim that the three-year statute of limitations under Connecticut General Statutes § 52–577 applies.   RHC argues that the audit period of January to December 2004, assumed by RHC and completed by March 28, 2005, is outside the three-year statute in that the above action was not brought against the defendant RHC until December 30, 2008.   Both defendants also allege in their respective § 15–8 motions that the plaintiff has failed to establish sufficient evidence to determine fair, just and reasonable damages which plaintiff alleges to have suffered.   The defendant KSC argues further in its memorandum that the plaintiff has failed to establish the necessary causal linkage between any alleged deficiencies in its audit to any damages that the plaintiff may have suffered before and after 2008.

First, the court addresses the defendant RHC's § 15–8 motion as it relates to the three-year statute of limitation under § 52–577.   The plaintiff filed objections to each of the motions to dismiss, claiming there was a continual duty to report and oversee any corrective steps to be taken by the plaintiff which would toll the statute.   Such a continuing course of conduct argument is not supported by the evidence nor by the law.⁶

“Section 52–577 is a statute of repose in that it sets a fixed limit after which the tortfeasor will not be held liable and in some cases will serve to bar an action before it accrues ․ Nonetheless, [w]hen the wrong sued upon consists of a continuing course of conduct, the statute does not begin to run until that course of conduct is completed.”  (Internal quotation marks omitted.)  Targonski v. Clebowicz, 142 Conn.App. 97, 108, 63 A.3d 1001 (2013).

“[I]n order [t]o support a finding of a continuing course of conduct that may toll the statute of limitations there must be evidence of the breach of a duty that remained in existence after commission of the original wrong related thereto.   That duty must not have terminated prior to commencement of the period allowed for bringing an action for such a wrong ․ Where we have upheld a finding that a duty continued to exist after the cessation of the act or omission relied upon, there has been evidence of either a special relationship between the parties giving rise to such a continuing duty or some later wrongful conduct of a defendant related to the prior act.”  (Internal quotation marks omitted.)  Watts v. Chittenden, 301 Conn. 575, 584, 22 A.3d 1214 (2011).  “Therefore, a precondition for the operation of the continuing course of conduct doctrine is that the defendant must have committed an initial wrong upon the plaintiff.”  (Internal quotation marks omitted.)  Id., 585.  “A second requirement for the operation of the continuing course of conduct doctrine is that there must be evidence of the breach of a duty that remained in existence after commission of the original wrong related thereto.”   (Internal quotation marks omitted.)  Id. “The doctrine of continuing course of conduct as used to toll a statute of limitations is better suited to claims where the situation keeps evolving after the act complained of is complete ․” (Internal quotation marks omitted.)  Targonski v. Clebowicz, supra, 142 Conn.App. 108.

The period of engagement by RHC for any ensuing negligence is measured by an ending date of March 28–30, 2005.   Therefore, the commencement of the action under count one, sounding in professional negligence against RHC, is outside of the three-year statute and therefore is dismissed as it relates only to the first count of the original complaint, dated December 30, 2008.   The remaining second count, sounding in breach of contract, remains viable, as do both counts one and two against the defendant KSC in the revised complaint of April 29, 2010.⁷

The court now turns to the evidence it found relevant and credible concerning the liability of the two defendants.

The standards that a plaintiff must meet in a professional malpractice action to establish liability consists of four elements:  1) the defendant was obligated to conform to a recognized standard of care;  2) the defendant deviated from that standard of care;  3) the plaintiff suffered some harm or loss and, 4) the defendant's departure from that standard of care caused the plaintiff's harm or loss.

This negligence malpractice claim lies only against the defendant KSC in its first count.   A breach of contract claim lies against both defendants based on the respective engagement letters (NEM Exh. # 4, RHC Exh. 222 and NEM Exh. # 1) and any responsive management letters,⁸ and e-mails which would respectively establish a contract for auditing services with each defendant.   These engagement letters promulgated by each defendant set the scope of each audit for calendar years 2004 and 2005.   These audits were to be performed in conformity with GAAS, GAGAS, GAAP and other applicable standards, which were promulgated and endorsed by the American Institute of Certified Public Accountants (AICPA).⁹

In conjunction with the court's review of all of the relevant exhibits and transcript testimony, the court is able to make certain findings of fact and draw certain permissible inferences.   The engagement letters issued by the respective defendants to the plaintiff (NEM Exh. # 1 & 4) follow a certain format and are designed by the auditing firm to limit the scope of their undertaking, but also to provide some guidance as to the breadth and depth of the particular audit.

The respective engagement letter from each firm also indicates that it was the responsibility of plaintiff company and its managers to maintain the financial records and statements and internal controls in conformity with GAAP.

The wording is almost identical in each engagement letter in placing on the plaintiff's management the responsibility of designing and implementing “programs and controls to prevent and detect fraud, and for informing us about all known or suspected fraud affecting the plan ․” There is further similar wording in each engagement letter to the effect that management is responsible for designating “a qualified management-level individual to be responsible and accountable for overseeing our (these) services.”

Similar wording imposes on management the responsibility “for making all financial records and related information available to us ․ and that you are responsible for the accuracy and completeness of that information.”   Unfortunately for the plaintiff, the management-level individual and person responsible for overseeing the plaintiff's financial records to include tax returns was Paula Borsari, designated as controller of the plaintiff.   The plaintiff alleges that both defendants failed in several ways to discover and report that there was internal embezzling being committed by a NEM employee (Paula Borsari) who was acting in said capacity as the company controller.

In general, the plaintiff has the burden of establishing by a fair preponderance of the evidence, within the context of either a tortious malpractice or a breach of contract theory, that a particular standard of care existed within the engagement letters and within certain objective standards.   The plaintiff must further establish that the said standards were deviated from by either defendant with resulting damages or loses to the plaintiff.   See Cross v. Huttenlocher, 185 Conn. 390, 393, 440 A.2d 952 (1981);  Pisel v. Stamford Hospital, 180 Conn. 314, 430 A.2d 1 (1980);  Buckley v. Lovallo, 2 Conn.App. 579, 582, 481 A.2d 1286 (1984);  Lapoint v. Houghtaling, Superior Court, judicial district of Hartford, Docket No. 05 4018716 (September 24, 2009, Satter, J.);  Alliance Group Services, Inc. v. Grassi Co., 406 F.Sup.2d 157 (2005).

The court finds that the second count of each respective complaint is viable, in that there was a contract formed between plaintiff and the two defendants for their respective auditing services during the subject dates.

The GAAS and GAGAS standards are accepted and overseen by the AICPA.   These standards are incorporated into each of the engagement letters issued by the respective defendants (RHC for year ending 2004 and KSC of year ending 2005).   These standards are to be applied in any such audit in order to detect and report any noncompliance with such standards and to bring to management's attention any significant deficiencies that would cause a “material misstatement” within a company's financial documents.  (Tr. Eric Wallace, 12/12/12, a.m. p. 43, 45.)   Further, these standards relate to the design and effectiveness of any risk management evaluation that a company would want to implement and maintain on an ongoing basis to insure its financial integrity.

The plaintiff's own compliance with the standards is something that would be tested by an independent audit.   Any “reportable conditions” in violation of any such standards should be detected in the course of any such audit.   As part of any such audit, the respective defendants looked to the internal controls and assess whether or not such controls were appropriate for the level of risk involved.  (Tr. Eric Wallace, 12/11/12, p.m. p. 33–36.)   The lack of segregation of duties allowed flaws to go undetected and allowed circumvention of internal controls.  (Tr. Eric Wallace, 12/12/12, a.m. p. 75–76.)

The plaintiff, through its CEO (BR), claims that the defendants were made aware that internal controls were insufficient to prevent fraud, (Tr. BR., 1/16/12, a.m. p. 8) and were compromised by the intentional and criminal acts of the company controller, Paula Borsari.   The specific issue involved a general ledger account payable, number 23400, which was addressed by various witnesses, but specifically by Eric Wallace.  (Tr., 12/11/12, p.m. p. 70–76.)   The credible evidence generally indicates that that account payable over the period of 2000 to 2007, and specifically from 2005 through 2007, would be considered to be at a high point if it were only trade payables and not tax liabilities.   This 941 tax liability was not segregated or detailed sufficiently in the payable account or on the balance sheet for the year ending 2004.  (Tr. Eric Wallace, 12/12/12, a.m. p. 49, 96);  (KSC Exh. # 116 and RHC Exh. # 202 Balance Sheet, p. F–4 Accts.   Payable–Balance $643,494.)

The plaintiff makes allegations against both auditing firms for failing to exercise reasonable care and competence during each auditing period.   The plaintiff alleges further that the defendants failed to exercise that degree of inquiry and “professional skepticism” that would lead to further testing of how the accounts payable account was being handled.¹⁰

The central focus of the plaintiff's case is directed at an employee of the plaintiff who was hired in the position of comptroller of NEM and worked in such position from October 1997 to October 2006.   The plaintiff alleges, and it is uncontested, that during the time frame from 2000 to 2007, Borsari engaged in various types of defalcation, larcenies and forgeries which were suspected prior to, but not verified until October 2007.   Tr. BR., 1/16/12, a.m. p. 24–27, p. 43–47.   She committed a series of acts and omissions which had a direct impact on the financial well-being and viability of the plaintiff as a mortgage broker/lender.   She was the party principally responsible for paying and accounting for, among other things, the 941 tax withholding liability on the federal level and to various state tax authorities.  (Tr. BR., 12/14/12 a.m. p. 7–8.)   Her failure to pay these withholding trustee funds belonging to both the employer and the employees resulted in serious tax consequences for the plaintiff and its principal owners and officers.¹¹  It was the direct intervention of the IRS into the daily functioning of the plaintiff ¹² that precipitated the loss of certain lines of credit, business opportunities and relationships and eventual close down of the plaintiff in October 2009.  (KSC Exhs. # 164, 186–88);  (NEM Exh. # 50);  (RHC Exhs. 227–28).   There were indications starting in 2005 that the internal accounting functions were failing and that cash flow problems were becoming more evident.¹³  One salient point was when ADP payroll services stopped paying the 941 withholding trust amount to the IRS in 2004 because of insufficient funding by the plaintiff.  (Tr. BR., 12/14/12 p.m. p. 2–3;  Tr. BR., 12/14/12 a.m. p. 43 & 84.)  (Tr. Paula Borsari's Depo., 2/27/13, p. 99–101.)

The unsupervised control over the general ledger, Borsari's unfettered check writing authority, as well as her unilateral access to the computer network and all incoming mail allowed Borsari to conceal her misreporting and embezzlement of company funds.  (NEM Exhs. # 31 & 33.)   This control of the mail facilitated her concealment of any notices from creditors and/or taxing authorities.   There was no independent disbursement oversight being exercised by the company through its officers and no effective internal controls were in place to prevent such defalcations.   These 941 deficiencies created an inflated Accounts Payable, which ultimately led to the IRS making personal demand on BR in the summer of 2007.   At that point, Borsari was terminated and a new auditor, Moss Adams, was brought in to determine actual tax liability that the plaintiff may be facing as well as a restatement of a prior financial period (2005), increasing the plaintiff's net loss to $755,000.  (KSC Exhs. 188–91.)

There was a recovery by the plaintiff (KSC Exh. # 163) under a fidelity bond issued by Federal Insurance Company that resulted in a payment of $266,005.77 to the plaintiff for Borsari's criminal activity.¹⁴  (KSC Exh. # 162.)   This amount reflects only those ascertainable funds misappropriated by Borsari between 2004 to 2007 and apparently not any tax liabilities.

As a subchapter to the main issues in this case, in March 2005, BR induced certain investors i.e. Terrence Scali and P. Vianson, known as S & V Mortgage Investors, LLC to buy a thirty-five percent (35%) equity interest in NEM for $4 million.  (Tr. BR., 1/15/13 p. 12–17.)   In return, the new investors would receive preferred stock with a 5% dividend.   Under the agreement, (NEM Exh. # 28;  KSC Exhs. # 110–12), Terry Scali would become chairman of the Board of Directors and NEM would receive an infusion of capital, some of which went directly to the three original shareholders in NEM. (KSC Exhs. # 111, # 112, # 121);  (RHC Exh. # 245);  (NEM Exh # 28).

Apparently none of this new liquidity was to be used to pay any 941 tax obligations to the IRS. (Tr. Paula Borsari's Depo., 2/22/13, p. 27.)   Evidence indicates that the 941 liability was categorized as an account payable on the balance sheet in 2005 and was listed under accounts payable in account # 23400 in the general ledger.

To what extent BR knew, or should have realized as CEO of the plaintiff, that the accounts payable with accrued expenses was unusually large and not itemized sufficiently to meet auditing standards is difficult to analyze.   Neither auditor clearly indicated in their notes that 941 tax liability was a reportable condition that should have been brought to the attention of management.  (Tr. BR., 1/15/13, p. 84–85, p. 109.) ¹⁵  (RHC Exhs. # 262 & 263—Accounts Payable March–July 2005.)

Certain inferences can be drawn that, during the period starting around June 2005 through August 2005, certain parties and/or their agents knew that there were deficiencies and irregularities in the payroll tax account going back into the prior year.  (KSC Exhs. # 127–29;  # 131–32.)   These emails between Paula Borsari and Terry Scali and Scali's accountant, Pamela Thomas, reveal a certain level of uneasiness concerning the liquidity and financial stability of NEM after the $4 million buy-in by S & V. Scali's anxieties about the 941 tax liabilities were made known to BR directly in October 2006.   As NEM's financial position became more precarious, S & V investors started an action in Arizona against the plaintiff.  (KSC Exh. # 141.) ¹⁶

The court looks to the case of Curtis Packaging Company v. KPMG, LLP, Superior Court, complex litigation docket at Hartford, Docket No. X06 CV 99 0156558 (July 31, 2002, McWeeny, J.), as detailing the standards that need to be met in this type of audit.   See also Waters v. Autuori, 236 Conn. 820, 676 A.2d 357 (1996);  Vigilant Ins. Co. v. PricewaterhouseCoopers, LLP, Superior Court, complex litigation docket at Hartford, Docket No. X07 CV 07 5010699 (March 2, 2011, Berger, J.).   The Curtis case has many parallel similarities to the present case, to include embezzlement by an outside third party with inside connections.   In the present case, the relationship between the plaintiff and the two auditing firms was contractual in nature, as reflected in each engagement letter, which required the annual audit of the plaintiff's financial statements to be done in accordance with GAAS. (NEM Exhs. # 2 & 5.) Those standards would require each auditor “to state with reasonable assurance” that the financial statements prepared by the plaintiff were free of material misstatements.   The court looks to the Curtis case as defining the generally accepted auditing standards and the basic categories that make up the standards.

The court recognizes and accepts those standards, as articulated in the Curtis case as follows:  a) there are three general standards;  b) three standards for field work;  c) and the four reporting standards.   The three general standards relate to the auditors' qualifications, training, independence and professional due care.   The three field work standards are:  (1) the audit planning and supervision;  (2) evaluation and understanding of internal controls;  (3) obtaining sufficient evidentiary material to support the auditor's opinion.   The four reporting standards are:  (1) adherence to generally accepted accounting principles (GAAP);  (2) the consistent application of such accounting principles on an annual basis;  (3) adequate disclosure in the financial statements;  and (4) an expression of an opinion at the end of the audit or some rationale as to why such an opinion cannot be rendered.   Waters v. Autuori, supra, 236 Conn. 828.

The plaintiff called an expert witness, Eric Wallace, to testify as to the standard of care to be exercised by an auditor and how that standard of care might have been deviated from by these defendants.   His testimony as already indicated (Tr. Eric Wallace, 12/11/12 through 12/12/12) was relevant as to the standard that each auditor was to observe in compliance with GAAS and GAGAS (so-called Yellow Book).   Wallace testified that certain significant areas were not being reported properly.   For example, the accounts payable and accrued expenses were not being segregated properly:  specifically, the IRS 941 payroll taxes.   The accounts payable were being treated as one so that no differentiation could be made between true payables versus tax liabilities.   (KSC Exh. 143;  Tr. BR., 1/16/12 a.m. p. 8–9.)   His testimony went on to state that both auditors were not complying with GAGAS and AICPA standards.   His testimony detailed those areas, where he felt the auditors were deficient.   (Tr. Eric Wallace, 12/11/12 p.m. p. 25–45, (specifically p. 41–43);  12/12/12, p. 11–72.)   In particular, there was lack of segregation of duties, specifically in those areas that were exclusively overseen by the company controller, Paula Borsari.   Specifically, in his testimony, he identified fraud risk as an area that needs to be evaluated and tested by the GAAS standard in a heightened way.  (Tr. Eric Wallace, 12/12/12, p. 21.)

He stated that auditing field standards were not being complied with and that further testing of those accounts through the general ledger and the working checkbook were not being properly reconciled or tested and, therefore, certain “red flags” existed that the auditors should have noted.  (Tr. Eric Wallace, 12/12/12, p. 28, 45.)

It was Wallace's opinion that the auditors' reports for both years (NEM Exhs. # 2 & # 5) did not report certain “red flags” that should have been pursued for further evidence and proof.   Therefore, the financial statements did not accurately disclose in proper form the IRS 941 payroll tax obligations that were pending against the plaintiff.

Such failure by each auditor to pursue those “reportable conditions” did breach the standard of care and the terms of each engagement owed to the plaintiff.   Mr. Wallace did not opine in any way about the actual damages that the plaintiff alleges to have suffered nor the causation of any such damages.   (Tr. Eric Wallace, 12/12/12 p.m. last session p. 16–17, 21.)

Mr. Wallace further opined that the lack of risk assessment and segregation of duties constituted deficiencies in the internal controls and, therefore, should have caused concern and become the grounds for further inquiry by management and should be noted as such within any audit.  (Tr. Eric Wallace, 12/12/12 a.m. p. 57–59);  (Tr. BR., 1/15/13 p. 72–75).

He testified further about a series of questions that were posed to various employees of the plaintiff specifically, Brian Rogerson as the plaintiff's CEO. (Tr. Eric Wallace, 12/12/12 a.m. p. 65–73.)   Wallace suggested that “[t]here was a lack of management oversight of assets susceptible to misappropriation,” to which BR responded that he had no such knowledge at that time (July 2005) of any such conditions.   BR further responded that he had no knowledge of any lack of segregation of duties, especially as it related to the controller, Paula Borsari, who was committing various levels of fraud and financial concealment within the company.  (Tr. Eric Wallace, 12/12/12 a.m. p. 113–14);  Tr. BR., 1/15/13 above (KSC Exh. # 115).

In summary, Mr. Wallace concluded that both auditors failed to follow through on the “red flags” that were identified in their work papers.¹⁷  Further, that both auditors failed to apply the “yellow book” standards that require “professional skepticism” to follow from whatever “red flags” are identified and to document the work that they did to obtain competent evidentiary data.   Both auditors failed to report material weaknesses as they appeared within the company's documentation and functioning of certain capacities within the company.   This allowed the Accounts Payable line and accrued expenses to be blended in such a way as to be indistinguishable from one another and thereby concealable, for example the 941 tax liability.   Such liabilities were not being addressed in a timely manner.  (NEM Exh. # 5, Balance Sheet as of 12/31/04, Accts.   Payable $643,494;  NEM Exh. # 2 RHC Exh. # 274, Balance Sheet as of 12/31/05, Accts.   Payable $960,512.)  (Tr. BR., p.m. p. 68–74.)

The Curtis case posits the defenses that an auditor may raise in order to deflect liability.  Curtis Packaging Corp. v. KPMG, LLP, supra, Superior Court, Docket No. X06 CV 99 0156558.  “It is not the auditor's responsibility under GAAS to detect thefts.   A GAAS audit in most cases is not to disclose defalcations but to render an opinion on the financial statements as audited by the accountant through following accepted accounting procedures ․ Auditors are not required to be detectives hired to ferret out fraud.”  (Citations omitted;  internal quotation marks omitted.)  Id.

The defendants offered little probative evidence to rebut the plaintiff's expert that there was some level of deviation from the standard of care by each defendant.¹⁸  Although preceding the 2005 KSC audit by one year, RHC appears to have failed in highlighting in its audit at least the shortcomings in the internal controls at NEM. The ongoing defalcations by Paula Borsari should have triggered further inquiries by each auditor and corresponding notices to management that there was at least the appearance of irregularities in the internal accounting and reporting systems within the company.   The court finds that the opinions expressed by the plaintiff's expert, Eric Wallace, to be credible, probative and reliable regarding the applicable standards of care and the respective deviations therefrom by each defendant in their respective audit periods.

The underlying issue facing the plaintiff in this matter is what actions by one or both defendants caused the alleged losses to the plaintiff.   The plaintiff has offered evidence through its CEO, BR, and through its expert witness, Eric Wallace, that each defendant failed during their respective audit periods to detect the fraudulent activity of Paula Borsari.   The plaintiff alleges that each defendant failed to follow certain procedures under GAAP, GAAS and GAGAS guidelines and relied too heavily upon Borsari's representations without exercising the independence and “professional skepticism” necessary for an effective and meaningful audit.   Although the audits were being done obstensively to satisfy certain HUD, SEC and FHA standards,

the accountant performs a public responsibility transcending any employment relationship with the client, and owes allegiance to the corporation's creditors and stockholders as well as to the investing public.

United States v. Arthur Young & Co., 465 U.S. 805, 104 S.Ct. 1495, 79 L.Ed.2d 826 (1984).

“It is a generally recognized rule in malpractice cases that a plaintiff must plead and prove not only that injury occurred and that the defendant was negligent, but also that the defendant's negligence caused the injury.”   (Emphasis in original.)  LaBieniec v. Baker, 11 Conn.App. 199, 202, 526 A.2d 1341 (1987);  see also Barnis v. Ichlein, 192 Conn. 732, 735, 473 A.2d 1221 (1984).

“[A] plaintiff must establish that the defendant's conduct legally caused the injuries, that is, that the conduct both caused the injury in fact and proximately caused the injury.”  (Internal quotation marks omitted.)   Mulcahy v. Hartell, 140 Conn.App. 444, 451–52, 59 A.3d 313 (2013).  “Because actual causation, in theory, is virtually limitless, the legal construct of proximate cause serves to establish how far down the causal continuum tortfeasors will be held liable for the consequences of their actions.”   (Internal quotation marks omitted.)  Sapko v. State, 305 Conn. 360, 372–73, 44 A.3d 827 (2012).  “The existence of the proximate cause of an injury is determined by looking from the injury to the negligent act complained of for the necessary causal connection ․ This causal connection must be based upon more than conjecture and surmise.”  (Internal quotation marks omitted.)   Winn v. Posades, 281 Conn. 50, 56–57, 913 A.2d 407 (2007).  “The test of proximate cause is whether the defendant's conduct is a substantial factor in producing the plaintiff's injury.   The substantial factor test asks ․ whether the harm which occurred was of the same general nature as the foreseeable risk created by the defendant's negligence.”  (Internal quotation marks omitted.)   Mulcahy v. Hartell, supra, 452.

Based on the more credible and relevant evidence, the court finds that both defendant accounting firms deviated from the accepted standards of care as set by AICPA and contributing agencies.

Such a finding that there was a breach of duty by each auditing firm during their respective audit period does not lead to the automatic conclusion that such breaches were the proximate and real cause of the plaintiff's losses and ultimate closure.

This court's search for a fair and reasonable judgment requires a finding that these breaches by the defendants resulted in ascertainable damages to the plaintiff.   If any causal linkage is to be found, it would appear to arise in the area of the 941 payroll tax liability.   The misdeeds and their concealment by Paula Borsari, as controller of the plaintiff, become the probative evidence of the complacency and lack of “professional skepticism” exhibited by both auditing firms during their respective auditing periods.¹⁹

Further testing and inquiry into the substance of the accounts payable would have been a logical and prudent application of GAAS, GAGAS and SAS–99 principles.   Such professional curiosity is the recognized role of an auditor to ensure the integrity of the financial statements, particularly the balance sheet and its underlying accounts.   Both auditors failed in this regard.

Such a finding does not immediately lead the court to any apparent and causally connected damages.   The credible evidence indicates that these audits of the plaintiff's financial statements were being generated out of compliance with HUD and various banking regulations relating to net worth and available cash.  (Tr. BR., 1/15/13 a.m. p. 69–73.)   BR insinuated that these financial statements and audits were not necessarily relied upon for future business planning or historical overview of prior business decisions.  (Tr. BR., 12/14/12 p.m. p. 41–44.)

From the extensive testimony of BR (three days interrupted), the court can infer that his poor management skills, lack of concern, self-deception and/or simple incompetence contributed to the plaintiff's financial difficulties.   However, the court cannot find that such comparative negligence on BR's part is chargeable against the plaintiff in light of the holding in Vigilant Ins. Co. v. PricewaterhouseCoopers, LLP, supra, Superior Court, Docket No. X07 CV 07 5010699.   In spite of BR's lack of attention to NEM's general ledger accounts, IRS inquiries over a period of years and Paula Borsari's deceptions and nondisclosures, the court cannot find that BR actively and intentionally interfered with either defendant's audit procedures for 2004 or 2005.   Therefore, no comparative negligence can be charged against the plaintiff through BR.

DAMAGES

The measure of damages that the plaintiff may be entitled to is somewhat problematic.   The law prohibits an award of damages where the damages are speculative.   See Bridgeport Harbour Place I, LLC v. Ganim, 131 Conn.App. 99, 123, 30 A.3d 703 (2011);  Beverly Hills Concepts, Inc. v. Schatz & Schatz, 247 Conn. 48, 75–76, 717 A.2d 724 (1998).   The court rejects the plaintiff's claim that a potential sale of NEM in the year 2004 is strong evidence of NEM's value prior to the two audits.   Such a measure would be too speculative and not probative of actual market value, especially after the general economic collapse of 2008–2009, particularly in the real estate markets.

The extrapolation from the $4 million paid by S & V Mortgage Investors for 35% of NEM in 2005 cannot be relied upon as a bona fide measure of fair market value of the plaintiff in 2009, nor a reliable measure at any earlier point in time.

The subsequent audit by Moss–Adams, LLP in September 2007, which suggested adjustments to “prior years,” gives little guidance to the court in assessing damages or making evaluations, especially if such adjustments were attributed to collateral factors from prior audit years that were not causally related to either defendant's audit period, nor the plaintiff's ultimate closure and dormancy.  (KSC Exh. # 164;  Tr. BR., 12/14/12 p.m. p. 33–36.)

The Connecticut Department of Banking's January 2009 examination of NEM's financial practices over past years resulted in a finding of thirteen violations with potential fines and the ultimate surrender of the plaintiff's mortgage lender license in October 2009.   Again, this loss is not causally linked to the two subject audits.²⁰  (KSC Exh. # 164.)

Objectively, the court can find only certain applicable measures in arriving at fair, just and reasonable damages to be awarded to the plaintiff, NEM and as proximately caused by each defendant.   Any such damages should be allocated equally to each defendant where possible.

Therefore the Court concludes that it cannot assess any damages against the two defendants relating to the dissolution and closure of the plaintiff in October 2009 (KSC Exh. # 164).   There are multiple reasons and causes for the ultimate closure of the plaintiff which BR recognizes in his e-mails, particularly:  (RHC Exh. # 207;  Tr. BR., 12/14/12 p.m. p. 2–5).   The subsequent personal bankruptcies (Chapter 7) are some indication of the depth of the problems facing the owners (RHC Exhs. 238–40).   This is in contrast with the optimism reflected in August 2007 by BR in his e-mail to various individuals (RHC Exh. # 243).

The first such measure of damages relates to ascertainable losses caused by Paula Borsari in her capacity as controller of the company which went unnoticed for audit purposes by both defendants.   The payment under the fidelity bond was intended to compensate the plaintiff for her defalcations, although the amount paid by the bond company ($266,005) does not necessarily reflect the actual monetary losses inflicted on the plaintiff by Paula Borsari.   However, it is a sum certain with a deductible of $10,000.   The court finds that such deductible amount should be shared equally by both defendants at $5,000 each.

Further, the court finds that the actual accounting and auditing fees charged to the plaintiff for the respective audit years of 2004 and 2005 by each defendant should be remitted and/or forgiven, if not already paid by the plaintiff.²¹  These audit bills were suggested by the plaintiff in the amount of $13,000 and $5,000, but they need to be verified.

Further, the plaintiff is awarded that portion of Attorney Robert Percy's legal fees relating to his resolution with the IRS of the 941 tax liability only, subject to proper allocation of such fee to each defendant between the two audit years.

Further the defendants are charged with any and all interest charges and penalties, if any, assessed by the IRS and by any other state taxing authority relating to the said 941 payroll tax deficiencies and actually paid by the plaintiff.   The court finds that such interest charges and penalties were proximately caused by the defendants' breaches for their respective audit periods.   Such damage assessments against each defendant may be difficult to specifically compute, but certain testimony and exhibits (KSC # 162) do make reference to such assessments.   The plaintiff is charged with producing documentary evidence of all late payment penalties to the IRS which were waived with the assistance of counsel.   Any 941 related interest payments are limited to the two (2) audit periods and should be allotted separately to each defendant if possible, unless otherwise agreed.  (NEM Exh. # 41.)

This court reserves judgment on the specific interest charges for the 941 payroll taxes owed to any taxing authority.   The court will accept relevant and probative input from all parties through counsel in order to accurately compute any such interest charges that the plaintiff actually paid for such late payments relating to said 941 tax liabilities unless stipulated to by the parties.

All of these damage awards are found to be proximately caused by the breaches of contract by each defendant.

Each party has sixty (60) days from the date of this decision to submit supplemental evidence and/or documents relating to each damage award, particularly any 941 payroll interest charges relating to the subject audit periods as well as Attorney Percy's legal fees allocated to the two audit periods.

Reasonable costs may be awarded to the plaintiff.   No legal fees beyond Attorney Robert Percy's allocated fees are awarded to any party.

BY THE COURT

V. ROCHE, J.

FOOTNOTES

FN1. In 2002 Northeast Mortgage, LLC was a Connecticut limited liability company, heavily involved in the mortgage lending business.   NEM converted to a full corporation in 2002 in order to sell its stock publically and expand its national base.   Sean Rogerson and Anthony Gabriele had minority interests in NEM..  FN1. In 2002 Northeast Mortgage, LLC was a Connecticut limited liability company, heavily involved in the mortgage lending business.   NEM converted to a full corporation in 2002 in order to sell its stock publically and expand its national base.   Sean Rogerson and Anthony Gabriele had minority interests in NEM.

FN2. This is an employee withholding fund entrusted to the employer for timely payment to the IRS per IRS regulations for 941 tax liability and payment..  FN2. This is an employee withholding fund entrusted to the employer for timely payment to the IRS per IRS regulations for 941 tax liability and payment.

FN3. There were 64 plaintiff's exhibits.   Defendant KSC had 96 exhibits and defendant RHC had 84 exhibits, some of which were not fully admitted into evidence..  FN3. There were 64 plaintiff's exhibits.   Defendant KSC had 96 exhibits and defendant RHC had 84 exhibits, some of which were not fully admitted into evidence.

FN4. A revised complaint was filed against Kahan Steiger on April 29, 2010, sounding in two counts..  FN4. A revised complaint was filed against Kahan Steiger on April 29, 2010, sounding in two counts.

FN5. A third count sounding in gross negligence and misrepresentation was, in effect, withdrawn by the plaintiff before trial..  FN5. A third count sounding in gross negligence and misrepresentation was, in effect, withdrawn by the plaintiff before trial.

FN6. There is no credible evidence that RHC did any further audit work beyond its audit report of March 28, 2005.  (NEM Exh. # 5.).  FN6. There is no credible evidence that RHC did any further audit work beyond its audit report of March 28, 2005.  (NEM Exh. # 5.)

FN7. KSC's motion under Practice Book § 15–8 is therefore denied..  FN7. KSC's motion under Practice Book § 15–8 is therefore denied.

FN8. NEM's management letter (RHC Exh. # 223) to RHC at the end of its audit in 2005 was admitted as a full exhibit..  FN8. NEM's management letter (RHC Exh. # 223) to RHC at the end of its audit in 2005 was admitted as a full exhibit.

FN9. NEM Exhs. # 43–64;  KSC Exhs. # 136–41, 175–76;  RHC Exh. 205, 246–47..  FN9. NEM Exhs. # 43–64;  KSC Exhs. # 136–41, 175–76;  RHC Exh. 205, 246–47.

FN10. Plaintiff's expert, Eric Wallace's (trial testimony) on 12/11/12, p.m. p. 65–69 and 12/12/12, a.m. p. 45 Re:  KSC;  p. 107–14 Re:  RHC..  FN10. Plaintiff's expert, Eric Wallace's (trial testimony) on 12/11/12, p.m. p. 65–69 and 12/12/12, a.m. p. 45 Re:  KSC;  p. 107–14 Re:  RHC.

FN11. Between January 1, 2005 and March 2005, the plaintiff owed the IRS for 941 taxes between $347,695 to $609,140.  (Tr. BR. 12/14/12 a.m. p. 70–72.).  FN11. Between January 1, 2005 and March 2005, the plaintiff owed the IRS for 941 taxes between $347,695 to $609,140.  (Tr. BR. 12/14/12 a.m. p. 70–72.)

FN12. One and at times two IRS agents were on the plaintiff's premises on a weekly if not daily basis.   Re:  Corp tax returns and 941 taxes.   Tr. BR. 1/16/12 p. 28–29..  FN12. One and at times two IRS agents were on the plaintiff's premises on a weekly if not daily basis.   Re:  Corp tax returns and 941 taxes.   Tr. BR. 1/16/12 p. 28–29.

FN13. KSC Exhs. # 124–44:  A series of e-mail exchanges between Paula Borsari, Pamela Thomas, Brian Rogerson and Terry Scali.  (Tr. BR. 12/14/12 a.m. p. 41–43;  65–67.).  FN13. KSC Exhs. # 124–44:  A series of e-mail exchanges between Paula Borsari, Pamela Thomas, Brian Rogerson and Terry Scali.  (Tr. BR. 12/14/12 a.m. p. 41–43;  65–67.)

FN14. Borsari pled guilty to a first degree larceny charge and received a suspended sentence with a conditional discharge.  (NEM Exh. # 30.).  FN14. Borsari pled guilty to a first degree larceny charge and received a suspended sentence with a conditional discharge.  (NEM Exh. # 30.)

FN15. B. Rogerson claims that he knew of no fraud within plaintiff's operations at year end 2004.  (KSC Exh. # 115) and management letter of March 28, 2005 (KSC Exh. # 123)..  FN15. B. Rogerson claims that he knew of no fraud within plaintiff's operations at year end 2004.  (KSC Exh. # 115) and management letter of March 28, 2005 (KSC Exh. # 123).

FN16. NEM allowed a default judgment to enter in favor of S & V Mortgage Investors, LLC in Superior Court in Maricopa County, Arizona on April 14, 2010.  (KSC Exh. # 165.).  FN16. NEM allowed a default judgment to enter in favor of S & V Mortgage Investors, LLC in Superior Court in Maricopa County, Arizona on April 14, 2010.  (KSC Exh. # 165.)

FN17. Both auditors used a programmed audit format (MCX and MAP–RHC Exh. # 246A) that made set inquiries into all aspects of a company's operation.  (Tr. E. Wallace, 12/11/12 p.m., p. 51–54.).  FN17. Both auditors used a programmed audit format (MCX and MAP–RHC Exh. # 246A) that made set inquiries into all aspects of a company's operation.  (Tr. E. Wallace, 12/11/12 p.m., p. 51–54.)

FN18. Employees from each defendant testified in a self-serving and understandably self-protective manner..  FN18. Employees from each defendant testified in a self-serving and understandably self-protective manner.

FN19. NEM was attempting from 2000 through 2003 to comply with the filing requirements of the SEC in order to be a publicly traded company.  (Tr. BR., 1/15/13 a.m. p. 40–45.)  (RHC Exhs. # 250, 251, 253.).  FN19. NEM was attempting from 2000 through 2003 to comply with the filing requirements of the SEC in order to be a publicly traded company.  (Tr. BR., 1/15/13 a.m. p. 40–45.)  (RHC Exhs. # 250, 251, 253.)

FN20. To what extent the court must travel to find some etiological basis for assessing causally related damages against the two defendants based on their specific contractual relationship with the plaintiff has its boundaries..  FN20. To what extent the court must travel to find some etiological basis for assessing causally related damages against the two defendants based on their specific contractual relationship with the plaintiff has its boundaries.

FN21. This does not include any costs, expenses or fees (legal or accounting) invoiced to the plaintiff for the IRS corporate/LLC tax audit conducted during parallel periods..  FN21. This does not include any costs, expenses or fees (legal or accounting) invoiced to the plaintiff for the IRS corporate/LLC tax audit conducted during parallel periods.

Roche, Vincent E., J.