Using the Client Engagement Letter to Avoid CPA Malpractice Claims
Malpractice suits against accountants are on the rise. Avoiding claims starts — and often ends — with the engagement letter.
May 11, 2009
Conventional wisdom suggests that malpractice claims against financial professionals rise during a bad economy. When failed corporations seek protection under bankruptcy laws, CPAs often are the subject of lawsuits by court-appointed trustees trying to hold the CPA responsible for the corporation’s demise. And CPAs often are the targets of banks seeking to hold the accountant responsible for bad loans that the banks contend were made based upon financial representations by the accountant. A properly drafted engagement letter may be the first line of defense for these and other claims.
Establishing the Terms of the Engagement
The legal theories and rules that may govern the CPA’s potential legal liability often flow from the nature of the accountant-client relationship and, specifically, the terms of the engagement. No formal or express agreement is necessary to form the relationship. Courts have sustained malpractice lawsuits against CPAs based upon oral agreements about the work to be performed and have implied the existence of an accountant-client relationship based upon the conduct of the parties. Accordingly, memorializing the terms of the engagement is an important step in avoiding or minimizing your exposure.
The engagement letter serves two primary purposes relating to malpractice liability. First, it may define the scope and extent of the duties undertaken by the accountant on behalf of your client. Second, it may limit liability to third parties. These topics are considered below.
Related purposes of the engagement letter include clearly articulating the fee arrangement so as to avoid any misunderstanding about the client’s financial obligations. CPA firms may also want to include in the engagement letter a provision that requires the resolution of disputes through mediation or private arbitration. These forms of alternative-dispute resolution often cost less than full-blown litigation and typically proceed in private without a public record of the dispute. Finally, have an authorized representative of your client sign the engagement letter so that there is a clear acknowledgment that your client understood the terms of the engagement.
Defining the Scope of the Engagement
A written statement of the scope of work is the easiest way to avoid misunderstandings about what services the CPA is or is not providing and to disclose matters appropriate to the engagement. The letter should state specifically what the CPA will and will not do for the engagement. For tasks included in the engagement, the letter should state client instructions and responsibilities for completing those tasks. For example, the letter should state whether the CPA is relying on information provided by the client and identify such information as clearly as possible. The letter also should disclose known adverse or negative conditions that may impact the CPA’s work and conclusions. Lastly, be careful about what you promise because it could result in expanded liability. For example, a court may have sustained a breach of contract claim against a CPA because the CPA agreed to perform services by a particular date but failed to do so.
The engagement letter should also use clear terms to define the scope of the engagement and include an “integration clause” stating that the letter is the exclusive repository of the parties’ agreement. Using unambiguous language is important because an ambiguous agreement is typically construed against the party that drafted it — i.e., the CPA — and may result in erroneous expectations by the client about the scope of the engagement. Integration clauses can be helpful in refuting a claim that the CPA promised, either before or after execution of the engagement letter, to perform tasks not specifically identified in the parties’ agreement.
Avoiding Third-Party Liability
The question of third-party liability is one of the most important issues facing CPAs today. The nature of the profession is such that the CPA is potentially liable to a vast number of entities that may one day claim reliance on the CPA’s work. Perhaps recognizing the need to protect CPAs from liability that would unreasonably exceed their actual undertaking, a number of states have limited the CPA’s liability to third parties either through legislative enactments or court decisions adopting common law protections. The starting point for these protections, however, is the engagement letter.
In states where they exist, the statutory protections will apply in most circumstances if the CPA identifies in writing the specific parties intended to rely on the CPA’s work. There are often two important exceptions. First, the protection is inapplicable where the CPA’s performance constituted fraud or misrepresentation. Second, the protection does not apply if the CPA was aware that the client intended the work to benefit a third party. Those states that have not adopted specific statutes may instead follow common law rules concerning the tort of negligent misrepresentation that can limit liability to third persons. These rules, where adopted, hold that liability should extend to those with whom the CPA has a client relationship and also those persons, or classes of persons, whom the CPA knows and intends will rely on his or her work, or whom he or she knows the client intends will so rely. As with the statutory protection, the engagement letter may be used to memorialize those persons the CPA and the client know and intend will rely on the CPA’s work. But again, the engagement letter should use clear and simple language when limiting third-party liability.
End of the Road
Just as an engagement letter is important to signify the start of a relationship, it is also important to set forth in writing when an engagement is over. Too often CPAs and other service providers fail to document the end of a project or relationship, which can be equally important. It is also important to review engagement letters at least once a year and to revise the letter if the nature of the engagement has changed. Finally, the end of an engagement is also a good time to address with the client what will happen to any client files or other documents, and whether they should be returned or destroyed (the CPA firm may not want to remain responsible for storing or maintaining custody of certain documents). The above-matters should be addressed in a letter concluding the engagement.
The engagement letter is an important and simple tool for avoiding malpractice claims. The letter identifies through limiting language the responsibilities of both the CPA and client for the successful completion of the engagement and the parties whom the CPA and client intend to rely on the CPA’s work. The engagement letter also serves to manage clients and their expectations by clearly defining, at the outset, the scope of the work that the CPA will perform. The engagement letter is a relatively effortless means for reducing the risk of being on the receiving end of a malpractice threat or claim, and will better position CPA firms in the event they do face such claims.
Jason M. Rosenthal, Esq. and Robert J. Palmersheim, JD are partners with Schopf & Weiss LLP, a national business litigation firm based in Chicago. For more information, you can contact Rosenthal at 312-701-9300 or Palmersheim at 312-701-9319 or visit sw.com.