A War Story: Proposed CPA Firm Merger

A War Story: Proposed CPA Firm Merger

By Ron Klein, J.D.

CPA firm Archer Avery (AA) was interested in the possibility of merging with (acquiring) CPA firm Baldwin Bennet (BB) in an effort to branch out from AA’s accounting and audit work and into business valuations, which BB performed on a regular basis.
BB also had expertise in corporate tax and buy-sell transactions, but the firm had been steadily losing business valuation clients to another CPA firm with more expertise in the field. BB was faced with having to lay off personnel because of its loss of business, and the firm expressed interest in joining a larger firm like AA to help it compete in the marketplace.

AA was concerned, however, about BB’s less than ideal reputation for quality control, which was somewhat fast and loose. BB’s recent loss of business was also a concern. AA and BB ultimately decided to work together for a trial period before taking formal steps to make a merger legal.

During the trial period, one of AA’s large clients, Peter Pfeiffer, informed the firm that he was interested in retiring and selling his company, Perfect Plastics, which specialized in manufacturing plastic grocery and trash bags. AA then consulted with BB about a buy-sell transaction for Perfect, and BB already had a potential buyer, George Gordon, among its own clientele.

AA decided to turn Pfeiffer and Perfect over to BB for the transaction groundwork. AA sent a letter to Pfeiffer, informing him of the arrangement and stating that BB would be working with AA on the transaction. Pfeiffer provided his consent to the arrangement by signing and returning the letter.

BB provided the buyer, Gordon, with tax returns, Schedule Cs, and spreadsheets showing income and net cash flow histories and projections. When BB proposed a formal business valuation of Perfect Plastics to Gordon, he decided to forego it (and the accompanying fee) and to use the information already provided for negotiating an agreement and a price of $6.8 million.

Soon after Perfect was sold to Gordon, some of the bag-manufacturing machines began to fail, causing Perfect to run its still functioning machines at longer intervals, which in turn caused them to eventually break down as well. Deadlines for bag deliveries were missed, and customers went elsewhere, causing business to go swiftly downhill for Perfect.

Due to the decline in Perfect’s business, Gordon was unable to make payments on a loan he had taken out to fund part of his purchase of Perfect. When a mechanic at the Perfect plant informed Gordon that the plant machinery was old and in need of replacement, Gordon sued BB and Pfeiffer, alleging a lack of disclosure about the condition of the machinery in the buy-sell agreement. Pfeiffer, upset by the fact that he had to spend money to defend himself in a lawsuit, sued BB for negligence and lack of due care. Pfeiffer also named AA in his lawsuit, since AA had referred him to BB and informed him that BB would be working with AA on the transaction.

AA learned soon thereafter that BB had dropped its professional liability insurance when it was losing business, and that AA’s insurance company would be dealing with BB’s legal liabilities stemming from the engagement. The proposed merger between AA and BB was called off, and AA now has to spend large amounts of time and energy dealing with the lawsuit and trying to control the damage done to its reputation.

Loss-Prevention Tips

AA attempted to use a “trial period” as a substitute for a proper due diligence process for its proposed merger with BB. A trial period is not a bad way for firms to get to know each other, as long as it doesn’t replace due diligence and the firms accept the fact that they take on a certain degree of joint liability for each other’s work as soon as they start working jointly. AA and BB had in effect already merged their liability without realizing it or preparing for it.

The fact that AA was concerned about BB’s reputation and loss of business should have been red flags for further examination and for not going forward until the concerns had been adequately addressed. Proper due diligence also would have turned up the fact that BB no longer had professional liability insurance.

As is often the case, the liability problem was caused by the work of one of the firms, but the other firm had to help carry the burden of the liability. Sometimes liability will stem from past work done by one of the firms before the merger. The other firm then has to help foot the liability costs without having received any of the revenues from the work—a situation that can strain a merger to its breaking point.

Camico recommends having a written merger agreement reviewed by attorneys and risk advisors for both firms. Insurers should be able to provide comprehensive guidance on risk management for CPA firm mergers and dissolutions.

BB’s work on the buy-sell agreement between Pfeiffer and Gordon should have included precautionary language in writing that forewarned the parties about the limitations of the services. At the same time, Gordon’s decision to forego a business valuation did not replace the CPA’s responsibility to follow professional standards. A valuation of Perfect Plastics would have included an expert appraisal of the machinery, which would have revealed its poor condition. With the case in court, BB’s work will be evaluated by an expert witness, who will point out the ways in which the work was deficient.

Ron Klein, J.D., CFE, is vice president of claims with Camico. Recipient of the 2002 Award for Outstanding Conference Speaker from the Education Foundation of the California Society of CPAs, Klein coauthored the CPA’s Guide to Loss Prevention Practices and CPA’s Guide to Effective Engagement Letters.

Editor’s Note: “War Stories,” drawn from Camico claims files, illustrate some of the dangers and pitfalls in the accounting profession. All names have been changed.