When Investors Rely on Financial Projections: Ruling Gives New Protection from Lawsuits
Young, Michael, Journal of Accountancy
The story is all too familiar: An investor puts money into a high-risk investment, lured by above-market returns. He or she is given a prospectus plainly disclosing the investment as high-risk and describing in mind-numbing detail--almost everything that could go wrong.
For whatever reason (a change in real estate values, the collapse of oil prices, the movement of interest rates) the investment doesn't perform as projected and the investor, alleging he or she is representative of a class, charges fraud and sues the CPA who examined the prospective financial information.
For CPAs, such cases present serious (and many would say unfair) problems. A jury may be overwhelmed by sympathy for the investor (rarely is a millionaire investment banker chosen as the class representative; the preference is for widows and orphans). The available defenses, which may involve subtle points of financial analysis, cannot be certain to prevail against a tide of emotion.
Another roadblock: The mere process of getting to trial can be extraordinarily expensive because of the wide latitude given plaintiffs by pretrial discovery rules. Even when an innocent CPA believes such problems can be overcome, the sheer risk of the endeavor-- particularly given the threat of punitive damages or treble damages under the Racketeer-Influenced and Corrupt Organizations Act may make out-of-court settlement of even a frivolous case the preferred course of action.
Given this situation, CPAs should cheer an important decision by the Third Circuit Court of Appeals arising from a suit against Donald Trump's ill-fated Taj Mahal casino in Atlantic City. Trump's victory, while not directly concerning the accounting profession, is important to CPAs forming legal defenses to malpractice claims.
The case, In re: Donald J. Trump Casino Securities Litigation--Taj Mahal Litigation (no. 92-5350, 3rd Cir., Oct. 14, 1993), dramatically strengthens an important defense in such lawsuits: that prospective financial information accompanied by warnings that properly "bespeak caution" cannot constitute the basis for a fraud claim.
The facts of Trump's situation will sound familiar to many. In November 1988, Trump needed to raise $675 million to purchase, complete construction on and open the Taj Mahal casino and hotel in Atlantic City. He chose to do so through a public offering of investment bonds bearing an interest rate of 14% a full 5% higher than the yield offered on quality corporate bonds at the time.
Investors were given a prospectus that overwhelmed the reader with attendant risks, including those arising from the intense competition in the Atlantic City casino and hotel market and anticipated restraints on growth of the casinos' win from gaming. Other risks described included the following: that the Taj Mahal had absolutely no operating history, its debt service would depend completely on still-untried operations and interest payments would come due before the casino could generate peak season cash flow. What happened? Investors snapped it up.
A couple of years later they wished they hadn't. The hotel opened in April 1990 but, while larger in size then its competitors, didn't perform as hoped. When press reports and gossip raised the specter of bankruptcy, investors sued. Their main allegation was that the prospectus falsely stated that the defendants believed the funds generated by Taj Mahal operations would be sufficient to cover debt service. …