Exculpation Ruling Shows Danger Of Overbroad Clauses

It is common that accountants seek to limit their liability to a client in the event of malpractice. Typically, in the retention agreement, the liability is limited to the amount of fees paid by the client to the accounting firm.

It also is increasingly common that professional malpractice claims, as well as officer and director liability claims, are principal sources of recovery for out-of-the-money creditors in a Chapter 11 case.

A post-confirmation litigation or liquidation trustee is often appointed to investigate the merits of a malpractice claim against the debtor's accountant.

The first response by the accounting firm will be a reference to the exculpation language in the retention agreement.

A recent unpublished decision in an adversary proceeding alleging accounting malpractice should be a warning to accountants and financial advisers to reexamine language purporting to limit their liability in retention agreements.

Exculpation language should be specific as to what conduct is exculpated.

Furthermore, the extent of exculpation may be contrary to public policy if it is too broad. Despite exculpation for gross negligence and recklessness in the retention agreement, that language may be unenforceable as against public policy. State law should be researched.

A potential plaintiff seeking a recovery from an accounting firm should not conclude their analysis if confronted by general exculpation language.

Accounting firms relying on general exculpation language should revise the language to be more specific as to what is being exculpated.

In the New Jersey case discussed below, BAK Advisors LLC v. Sax LLP, the exculpation language in an accounting firm's retention agreement, limiting damages to fees paid to the accounting firm by its client, was very broad and did not specifically carve out gross negligence.

In its December decision, the U.S. Bankruptcy Court for the District of New Jersey distinguished between mere negligence and gross negligence, and further opined that exculpation for gross negligence, recklessness, or willful or wanton misconduct was contrary to public policy.

The adversary proceeding was commenced by BAK Advisors, the post-confirmation liquidation trustee of Hollister Construction Co. LLC. The defendant, Sax, filed a motion to dismiss damages in excess of the amount Hollister paid to Sax, for auditing Hollister's financial statements for the fiscal year ending Dec. 31, 2018.

The retention agreement between Sax and Hollister provided that Sax would not be liable for punitive, consequential, special or indirect damages, and that Sax's liability was limited to the amount of fees paid by Hollister to Sax for the services rendered under the retention agreement.

Sax asserted "that any complaint seeking damages in excess of this number should be dismissed."

BAK argued that the limitation of liability provision, if applied, "would effectively exculpate Sax from its negligent conduct." BAK said that "the clause, as written, is unconscionable and violates public policy."

BAK asked the court to adopt an exception to what it said was "established precedent allowing parties to contractually limit liability where the conduct at issue has been performed by a licensed professional."

Sax was "not seeking to dismiss the [c]omplaint in its entirety, but rather to limit BAK's ... recoverable damages." Sax "moved to dismiss the [c]omplaint 'to the extent that it [sought] damages in excess of the amount paid to Sax ... in connection with the 2018 [a]udit."

Chief U.S. Bankruptcy Judge Michael B. Kaplan of the District of New Jersey denied Sax's motion to dismiss based on the record as of the time that the motion was heard.

The court said that it was "unable to ascertain whether Sax's actions [rose] to the level of mere negligence, gross negligence or ... recklessness."

Further, he said that determining the degree of malpractice — if there was any — was "a question of fact that [could not] be decided on a motion to dismiss." No determination was made as to whether Sax committed malpractice.

At the time of the hearing on the dismissal motion, there was no evidence of malpractice. But there also was no evidence that there was not malpractice. Consequently, the judge could not determine if there was simple negligence or gross negligence. 

For the accounting or professional services firm, the timing of a motion to limit damages in a malpractice action where there is an exculpation clause in the retention agreement must be carefully considered.

Filing a dismissal motion before facts regarding malpractice, or lack thereof, are sufficiently developed can result in denial of the motion — thereby increasing the psychological leverage of the plaintiff.

For the plaintiff, a premature motion by the defendant can be a good basis on which to defeat the motion.

Judge Kaplan said that he was not able to find any cases where gross negligence or willful misconduct was exculpated. And he observed that most exculpation clauses carve out gross negligence and willful misconduct.

On the other hand, Sax's exculpation clause was general and did not exempt gross negligence and willful misconduct. The language simply stated that Sax's liability for claims, damages and costs of Hollister was limited to fees received.

So, to start with, an exculpation clause should specifically state that the accounting firm is exculpated for officer and director liability claims.

The court also said that parties cannot limit liability for more egregious conduct than mere negligence because that would violate public policy.

Finally, the judge said that, under New Jersey law, wanton conduct cannot be exculpated. He did not see a reason why gross negligence and willful misconduct are any different.

Even if the exculpation language specifically includes gross negligence, recklessness or willful misconduct, state law should be examined as to whether such broad exculpation violates public policy, even if the parties agreed to it.

Finally, even if the exculpation clause excludes gross negligence and willful and wanton conduct, the issue of whether the alleged malpractice was mere negligence subject to exculpation, or whether it was something more, is not an appropriate subject for a summary motion. Sometimes, it pays for a defendant to be patient.

Reprinted with permission from the January 13, 2022, issue of Law360. © 2022 Portfolio Media, Inc. All Rights Reserved.