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AUGUST 26, 1987




This case, concerning an independent auditor's liability to a third party, comes to the Court from the Circuit Court of the First Judicial District of Hinds County, where a jury found Touche Ross & Company negligent in its preparation of financial statements, upon which Commercial Union Insurance Company relied when extending coverage to Fidelity Bank. The jury awarded Commercial Union $1,000,000 in actual damages and $500,000 in punitive damages. We reverse.

On September 28, 1979, the State Comptroller declared Fidelity Bank, a state chartered financial institution with offices in Jackson and Utica, insolvent, pursuant to Miss. Code Ann. 81-9-5 (1972). Losses amounted to approximately $7,000,000. Thereafter, the Federal Deposit Insurance Corporation (FDIC) made claim against Commercial Union, which had issued Fidelity Bank a Bankers Blanket Bond, insuring against employee fraud. Upon investigation, Commercial Union agreed to settle the claim for $1,000,000, finding losses attributable to fraud by Fidelity Bank's president, George S. Sanders, Jr., in excess of the policy's limits.

 On May 6, 1983, Commercial Union filed suit against Touche Ross & Company, Fidelity Bank's independent auditor for 1977, alleging gross negligence in the preparation of financial statements, upon which Commercial Union relied, when extending insurance coverage against employee fraud. Specifically, Commercial Union asserted that Touche Ross had failed to disclose adequately certain activities of which it was aware, in violation of Generally Accepted Accounting Principles (G.A.A.P.) and Generally Accepted Auditing Standards (G.A.A.S.). In fact, had Commercial Union known of these activities through the financial statements, Fidelity Bank's request for insurance coverage would have been denied. These activities include (1) the Mississippi Department of Bank Supervision's (MDBS) objections to the payment of a" highly irregular, if not illegal "dividend on March 20, 1977, (2) the Department's letter of June 1, 1977, requiring Fidelity Bank to secure the regulator's permission prior

 to the payment of future" cash dividends or the transfer of any funds . . . to any affiliate or subsidiary corporation, "and (3) Fidelity Bank's $200,000 loan to and $71,773 receivable from Affiliated Investments, Inc., Fidelity Bank's former parent, at a time when Touche Ross, through a separate financial statement on Affiliated Investments, questioned its ability to continue in operation.

 The Dividend

 On March 28, 1977, Fidelity Bank paid a dividend of $275,000 to Affiliated Investments, then Fidelity Bank's parent company, despite earnings of just $3,907 in 1976, and a loss of $16,897 in 1975. Prior to the payment, Sanders consulted with Michael Zito, Touche Ross' partner-in-charge, who told the bank's president that" at least "$275,000 was available for the dividend.

 On May 18, 1977, the MDBS examined Fidelity Bank's records concerning the dividend. It concluded that the payment was" highly irregular, if not illegal ". In particular, the regulator noted that the minutes of the board of directors were silent as to the dividend, minority stockholders failed to receive any like distribution, the State Comptroller had not pre-approved its declaration, and the $275,000 originated from the bank's surplus account, instead of the undivided profits account, thus implicating dedicated capital. Similarly, an FDIC examination of the same date concluded,

 The violation with regard to payment of dividend deserves the special attention of all concerned. A number of regulations, recognized sound practices, and State law were violated with regard to this action. While there may be some question as to whether the funds were really surplus or undivided profits, the bank had used the total of these funds in determining its legal lending limits and bank reports and publications appear to lead one to consider them as true surplus as defined by bankers and bank regulators. In the latter case, the funds would not have been available for payment of dividends.

 In response, the board of directors recorded the dividend's payment on the minutes, and individually executed waivers of their respective rights to the dividend as minority stockholders. Moreover, Touche Ross determined that the MDBS had not filed a regulation with the Secretary of State, requiring the pre-approval of cash dividends, though a common

 practice for state chartered banks.

 At trial, Touche Ross also denied that G.A.A.P. or G.A.A.S. required the payment of a cash dividend only from the undivided profits account, when the bank's cumulative earnings, held in both the undivided profits and surplus accounts, were sufficient to make the $275,000 payment. Alone, the undivided profits account held $175,420.04.

 The Letter

 On June 1, 1977, the MDBS informed Sanders by letter that, due to conditions at Fidelity Bank, the payment of" cash dividends or the transfer of any funds . . . to any affiliate or subsidiary corporation, "required advance regulatory approval, pursuant to Miss. Code Ann. 81-5-75 (1972), which reads in part:

 Should the state comptroller be of the opinion that the condition of any bank organized under the laws of this state is such that no dividends should be declared or paid on common stock of such bank, it shall be his duty to forthwith order and direct such bank to pay no dividend upon its common stock until further ordered by him. A bank upon which such notice has been served shall not thereafter declare or pay any dividend upon its common stock until the state comptroller shall withdraw or cancel the order prohibiting the same.

 On December 30, 1977, Affiliated Investments divested itself of Fidelity Bank. Four days later, Fidelity Bank loaned Affiliated Investments $200,000. At the time of the loan, Sanders was the largest stockholder in Affiliated Investments, as well as an officer, director and largest stockholder in Fidelity Bank.

 Although Touche Ross mentioned the loan on Fidelity Bank's financial statements, the auditors failed to question the loan's legality, or to note any restriction on the bank's capital in light of the letter from the MDBS. In fact, Touche Ross maintains that the letter was not in the bank's records during the audit. Therefore, it had no notice of the letter's content and, as a result, of the letter's effect on the loan or on the bank's capital. Interestingly, the letter does appear in the records of Fidelity Bank now held by the FDIC.

 Touche Ross also avers that even had it discovered the letter, 81-5-75, quoted above, does not provide the MDBS with the authority to bar transfers between a subsidiary and its parent. Likewise, the auditors contend that the letter was not a restriction on capital.

 The Loan

 During the period in which Touche Ross audited Fidelity Bank, it also audited Affiliated Investments. On March 20, 1978, Touche Ross issued a report to Affiliated Investments' board of directors, in which the auditors refused to express an opinion about the firm's financial statements, adding,

 The financial statements have been prepared on the basis of the continuation of the Company as a going concern. However, the Company has incurred losses for the past four years, has a deficiency in assets at December 31, 1977, and, as discussed in Note A-1, the operations of the Company have been substantially reduced. The future of the Company as an operating business will depend upon its ability to operate profitably and the availability of such financing as may be required.

 Ten days later, Touche Ross issued the report on Fidelity Bank, mentioned previously, which noted the $200,000 loan to Affiliated Investments.

 Commercial Union asserts that the omission of information on Fidelity Bank's financial statements, concerning Affiliated Investments' doubtful viability, was in violation of G.A.A.P. and G.A.A.S. In short, Touche Ross should have noted Fidelity Bank's potential collection problems with the $200,000 loan and $71,773 receivable.

 In response, Touche Ross maintains that there was no duty to disclose its views on Affiliated Investments' viability in Fidelity Bank's financial statements, after divestiture, especially where real estate, appraised at $272,000, secured the note and receivable. Parenthetically, Affiliated Investments ceased operations in the Summer of 1978.

 Other Instances

 Commercial Union also argues that Touche Ross was negligent in the treatment of the loan loss reserve at Fidelity Bank, finding it" grossly understated. "In particular, Commercial Union contends that Fidelity Bank's reserve of $154,712 was, at a minimum, $108,032 deficient on December 31, 1977, the audit's examination date. Consequently, instead of $6,196 in profits for 1977, the financial statements should have shown $101,836 in losses. In addition, Commercial Union calculates total losses for loans, appearing in Fidelity Bank's loan portfolio on December 31, 1977, at $1,062,921.

 Touche Ross, in turn, strongly disagrees with the alleged deficiency, finding the reserve" more than adequate. "Specifically, Touche Ross avers that Commercial Union failed to consider the loans' collateral as well as payments, which continue to be received, and wrongly included loans made after December 31, 1977. As a result, Touche Ross calculates total losses for loans appearing in Fidelity Bank's loan portfolio on December 31, 1977, at $101,237, well below the reserve.

 Touche Ross also notes that the loan loss reserve exceeded the amount of loans classified as" losses "and" doubtful, "in audits for 1974, 1975, 1976, and 1977. Yet, loans classified as" substandard "more than doubled in 1977, to approximately $1,300,000, and were not fully covered by the loan loss reserve.

 Commercial Union is especially critical of the treatment accorded an unsecured $240,000 loan in December, 1977, to W. B. Holloway, who, with no prior credit history at Fidelity Bank, borrowed the sum on the basis of an application and an unaudited financial statement, listing his net worth at $1,790,800. On March 3, 1978, Anguilla Investment Company, owned by Holloway, borrowed $244,440, paying off Holloway's personal note. Although Holloway later signed the Anguilla Investment note as co-maker, Touche Ross was unaware of his personal liability at the time of the audit. Significantly, Anguilla Investment's total market value was only $50,000.

 During the audit, Touche Ross questioned the legality of the initial loan, believing that Holloway used the proceeds to purchase Affiliated Investment stock. Nevertheless, Touche Ross failed to reserve the loan in Fidelity Bank's financial statements, since it accepted ...

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