In Grant Thornton LLP v. Prospect High Income Fund, ML CBO IV (Cayman), Ltd., et al., No. 06-0975, 2010 Tex. LEXIS 478 (Tex. Jul. 2, 2010), the Texas Supreme Court rejected multiple third party claims against auditor Grant Thornton.

The claims in this case revolved around audit reports issued by Grant Thornton regarding Epic Resorts, LLC’s (“Epic”) compliance with a bond indenture agreement.  Despite allegedly discovering direct evidence to the contrary, Grant Thornton issued reports in 1999 and 2000 confirming that Epic was in compliance with an escrow requirement in the indenture agreement.  On June 15, 2001, Epic defaulted on the bonds in question by missing a scheduled interest payment and the plaintiffs, three hedge funds, forced Epic into bankruptcy.

The court divided the claims against Grant Thornton into two categories: (1) claims brought by purchasers of securities, who indicated that they would not have purchased the securities but for Grant Thornton’s alleged misrepresentations; and (2) claims brought by holders of securities, who stated that the audit reports induced them not to sell the bonds.

Third Party Claims Against Auditors Brought by Purchasers of Securities

With regard to purchaser claims, the court followed the American Law Institute’s Restatement (Second) of Torts § 522 in holding that auditors’ liability is limited to “situations in which the [auditor] is aware of the nonclient and intends the nonclient to rely on the information.”  The court determined that a hedge fund that purchased bonds after Grant Thornton issued its 1999 audit report was not part of the limited group under § 522 for whose benefit and guidance Grant Thornton intended to supply the information and was thus not within Grant Thornton’s scope of liability.

Third Party Claims Against Auditors Brought by Holders of Securities

In considering the holder claims, the court decided a matter of first impression for Texas: are third party holder claims against auditors cognizable under Texas law?  The court held that a plaintiff must show a “direct communication” between the plaintiff and the auditor in order to bring a successful third party holder claim against an auditor.  The plaintiffs in this case did not have direct communications with Grant Thornton, so the court held that the claims failed as a matter of Texas law.

With the onslaught of litigation brought by the market crash, plaintiffs are reaching out more and more to third parties who interacted with failed companies.  Auditor liability in particular has been in the headlines with some frequency recently.  It will be very important going forward for auditors to pay close attention as states continue to redefine the scope of auditor liability.  For now though, in the state of Texas, auditors can breathe a little easier, knowing that ordinary investors will find it much more difficult to successfully bring third party suits against them.

Mark W. Kinghorn contributed to this post.