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Inattention to engagement letter details leads to potential exposure for otherwise time-barred claims

June 2009

Overview

 

Carefully crafted engagement letters are one of the best risk management tools for accountants.  The use of engagement letters across the broad and growing spectrum of services accountants provide is, however, sometimes uneven.  The result can be disastrous.

 

A New York case involving PricewaterhouseCoopers ("PWC"), one of the largest accounting services organizations in the world, provides a stark example of what can happen when proper attention is not given to engagement letter details across all service offerings—in this particular case, tax preparation services.  In a relatively short decision, the court ruled that PWC's annual letters for its tax services were unclear on the crucial issue of whether the tax preparation work was continuous from year to year or constituted separate annual engagements, resulting in the further holding that the claims, which would be dismissed as stale and time-barred if it was clear that the engagements were separate annual engagements, were not time-barred as a matter of law.  Accordingly, PWC must now face a jury on the issue of whether it may be liable for its client's substantial taxes and interest as a result of casual, though possibly negligent, advice.  This outcome potentially was avoidable through careful attention to engagement letter details.

 

Background

 

Apple Bank for Savings v. PricewaterhouseCoopers

 

From 1994 through 2004, PWC served as Apple Bank's auditor and tax preparer.  In 1999, the bank's sole stockholder died and the estate contacted the manager of the PWC tax engagement team to discuss stock redemption scenarios to raise cash for payment of the estate's tax obligations.  Over two limited telephone conversations, the PWC tax manager opined that the redemption would not trigger negative income tax consequences.  Ultimately, the estate and the bank entered into a long-term stock redemption agreement.  However, when PWC reviewed the redemption plan in 2005, the accountants determined that the redemption plan triggered bad debt recapture, resulting in amended tax returns for 2000-2003 and an additional $12 million in income taxes and interest for the bank.

 

Apple Bank then sued PWC, claiming that PWC rendered faulty advice in 1999 and 2000 concerning the redemption plan.  PWC moved for summary judgment seeking dismissal of the tax-related claims for the period more than three years prior to the commencement of the action.  In addition, PWC sought dismissal of the claims for recovery of the $12 million in taxes, plus interest.

 

Unclear engagement letters

 

Ordinarily, in New York, a malpractice claim against an accountant is subject to a three- year statute of limitations.  This seemingly strict three-year time frame can be extended, however, by a judicially created doctrine known as "continuous representation."  According to the continuous representation doctrine, the statute of limitations is tolled (suspended) if the accountant continues to advise the client about the issue alleged to have been negligently handled in the first instance.  Generally, accountants avoid the implication of the continuous representation doctrine by clearly delineating each year's work assignment and not letting the services from one year's engagement bleed into subsequent engagements.  Indeed, several New York cases have dismissed claims against accountants because each year's services constituted a discrete engagement, and PWC itself helped solidify this case law in New York in the frequently cited Williamson v. PricewaterhouseCoopers LLP case from 2007, where the firm's audit engagement letters were used to establish the clear delineation between each year's audits.  The essence of this issue is whether the parties had a clear understanding that the professional services provided were separate and discrete periodic engagements, rather than a single ongoing engagement.

 

In the Apple Bank v. PWC case, PWC did not provide separately titled "Engagement Letters" for each tax year.  Instead, PWC sent letters, apparently at the bank's request, that set forth PWC's estimated fees for the tax return preparation services.  These letters also referenced additional "consultations regarding tax planning ideas" that would be billed separately.  Based upon these letters and other supporting testimony, the court concluded that it was unclear whether the tax advice rendered in 1999 and 2000 was part of a continuous relationship involving tax advice, or whether the tax advice rendered in 1999 and 2000 was a discrete service.  Because of the factual uncertainty, the court declined to dismiss the claim.

 

Back taxes and interest paid by the client may be recoverable

 

The second significant aspect of the Apple Bank decision involves the court's refusal to dismiss the claims for damages consisting of back taxes and interest paid to taxing authorities.  PWC argued that the oft-cited case Alpert v. Shea Gould Climenko & Casey required dismissal of any claims for back taxes and interest.  However, the court declined to accept such a bright line rule, but instead found that "[i]f the tax liability was inevitable, the recovery of taxes and interest is not permitted….However, if the tax liability would have been avoided but for the erroneous advice, it appears that back taxes and interest would be recoverable in order to make plaintiff whole."

 

The court then concluded that it was a question of fact to be determined by the jury whether the taxes were inevitable.  Thus, the court refused to dismiss the claim.  However, the court was silent as to who bears the burden of proving or disproving the inevitability of the taxes and what level of proof would be necessary with regard to the inevitability of the tax liability.

 

Lessons to be learned from Apple Bank v. PWC

 

First, the importance of carefully crafted engagement letters and proper attention to engagement letter practices cannot be overstressed.  Here, rather than utilizing carefully crafted engagement letters setting forth exactly what services were being performed each year, PWC sent letters estimating the potential fees to be charged in connection with certain services, while also indicating that other services might be provided during the year.  An engagement letter should specifically identify the engagement parameters, avoid open-ended services, and leave little unsaid or open to contrasting interpretations.  Here, simply drafting a precise and clear engagement letter might have prevented the court from giving life to an otherwise stale claim.

 

Second, although recent cases have consistently found that taxes and interest are not recoverable in most situations involving tax preparation services, the Apple Bank decision may give future courts pause.  A client may now be in a stronger position to argue that the accountant/adviser should be liable for the taxes and interest because they were "avoidable."  Rather than providing casual advice in a factual vacuum, as was allegedly done by PWC, a client's total tax picture should be examined prior to rendering advice, and any significant tax strategies should be well thought out.  If an informal response to a tax question is requested, consideration should be given to documenting the limitations on the answer and possibly disclaiming an actual opinion.

 

Engagement letters are a powerful risk management tool.  Like any tool, however, an engagement letter is only as useful as the person using it.  While use of engagement letters in audit engagements is nearly universal, many practitioners still fail to spend the time and effort to employ sound engagement letter practices in other areas of their businesses, and this failure is almost chronic when it comes to tax preparation.  The Apple Bank case clearly shows why this failure can be disastrous for defending future claims.

 

For further information or assistance with these issues, please contact Thomas R. Manisero at thomas.manisero@wilsonelser.com or Peter J. Larkin at peter.larkin@wilsonelser.com. They can also be reached by phone at our White Plains office at 914.323.7000.

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