Hidden Stakeholders: A War Story

By Ron Klein

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

“The only constant is change.” To the CPA that often means that the dynamics among parties in a given situation or engagement will change over a period of time, and some of those changes may greatly expand a CPA’s exposure to risk without any clear warnings.

Camico’s claims department frequently encounters situations in audit or auditlike engagements in which a critical stakeholder is behind the scenes, has a low profile, or is simply quieter than most, giving the impression that all is well and good. It is very easy to neglect the risk exposures posed by such a stakeholder. Audits, business valuations, buy-sell agreements and percentage leases are especially prone to “hidden” stakeholders such as absentee owners, minority shareholders and small community banks.

The liabilities stemming from these engagements are compounded when the stakeholder appears to be relatively defenseless compared to the CPA, causing the CPA to be held to standards that are higher than normal. Even if nothing else changes in the engagement, the mere passage of time increases the appearance that the CPA knew, or should have known, that one of the stakeholders was (allegedly) being damaged. As more time passes, the damages may continue to grow.

Stakeholder dynamics can also change over a period of time to the point where a party that appeared to be strong in the beginning of an engagement now appears to be weak or defenseless, and vice versa.

The following war story illustrates a typical situation in which stakeholder positions of perceived strength and weakness are gradually reversed, creating an additional risk exposure that didn’t exist for the CPA when the engagement began.

Outland Property Co., the owner and manager of large tracts of land in the Rocky Mountains, leases a large mountain slope on a percentage-lease basis to Sugar Pine Ski Resort, which plans to build chair lifts and a ski lodge to provide skiers with rental equipment, lessons and meals.

The lease agreement specifies a percentage of receipts from the lift tickets, rentals, lessons and food sales. Any future modifications to the lease agreement will be negotiated between Outland and Sugar Pine.

Over the next 20 years, Sugar Pine grows steadily into a major ski area. The company adds condominiums to the property, as well as restaurants, retail shops and spas. The ski lifts and slopes are enhanced and expanded to the point where Sugar Pine is now able to host major ski championships, sponsored by corporations paying fees to Sugar Pine. Income paid from Sugar Pine to Outland under the terms of the lease grows from about $75,000 per year to $500,000 per year.

Sugar Pine is now a highly successful corporate entity, and the owners of Outland are now elderly retirees who rely entirely on their managers for the direction of Outland. The managers, lawyers and CPAs of Outland and Sugar Pine negotiate a new lease agreement that excludes certain fees—for instance, sponsorship fees paid by corporations to Sugar Pine for ski championships, and fees paid to Sugar Pine to cover the costs of water and other utilities by customers renting condos.

Another 10 years go by, and income paid from Sugar Pine to Outland under the terms of the lease grows to about $800,000 per year. The CPAs for the retired owners of Outland astutely perceive the change in dynamics between their elderly clients and the corporate management teams running Outland and Sugar Pine. The CPAs working for both management teams can also be seen as a little too “cozy” with their clients.

The retirees’ CPAs closely examine the lease agreement and find definitions in it that can be construed to be self-contradictory, especially where the word “receipts” is used. The retirees then file a lawsuit claiming that certain receipts excluded by the agreement should have been included.

Jury Is Sympathetic

During the trial, the jury is sympathetic toward the elderly retirees and generally interprets the terms of the lease agreement in their favor, finding that fees specifically excluded from the agreement should have been included, namely the ski championship sponsor fees and the utility fees for condo rentals.

As a consequence, the fees payable by Sugar Pine to Outland are increased by about $400,000 per year over the 10-year period, totaling about $4 million. Sugar Pine then sues its CPA for a failure to correctly determine the amounts payable under the lease agreement.

Loss Prevention Tips

In this case, the absentee owners were represented by a management team that did not adequately include them in the lease negotiations. The resulting agreement appeared to neglect the best interests of the elderly retirees, who turned to their own CPAs and attorneys to rectify a perceived wrong.