John H. Kent was the sole proprietor of a business that performed work for utility companies. In late 2016, Kent sought advice from a partner and CPA at an accounting firm that Kent knew from prior work. Kent’s concern was that he and his wife—who was the business’s bookkeeper—might divorce. Kent spoke with the CPA for an hour about some of the business issues divorce might create. The CPA did not bill Kent for this time, and they did not enter into a written agreement.
In March 2017, Kent and his wife separated. Then, Kent suspected that his wife had not been paying the business’s taxes, or even filing returns, for a number of years. At the end of March, Kent and the CPA discussed these issues at length, and it became clear that Kent needed to recreate the business’s financial records and to file returns for the past six years.
The firm immediately undertook this challenging assignment, even though it did not have a written agreement with Kent. Another partner, a CPA with forensic accounting experience, also worked on the assignment. This partner later testified that his overriding concern was with moving the project forward quickly—especially given Kent’s desire to rely on the anticipated work product at upcoming alimony and divorce hearings—and that executing a formal agreement took second priority.
Obtaining the necessary information proved an ongoing challenge. Virtually all of the business’s records were on Kent’s wife’s laptop, which she refused to provide. Kent was unable to answer even basic questions, like the nature of the business entity, or whether it had any employees or made any tax filings during the relevant time frame. Furthermore, Kent and his wife’s personal and business transactions were commingled in a single account.
By mid-May 2017, Kent supplied the firm with what records he did have, which essentially amounted to boxes full of bank statements. The firm hired an independent contractor to create general ledgers by entering and coding tens of thousands of individual transactions reflected on the statements. The firm continued working with Kent to resolve questions about how to treat particular transactions, and communicated with the IRS about how to resolve Kent’s issues.
The firm sent a formal agreement to Kent along with the firm’s first invoice at the end of May 2017; Kent executed the agreement on June 1, 2017. Unfortunately, after Kent signed the agreement, the firm was unable to complete the work. Kent could not provide the necessary information; consequently, nearly $1 million in transactions could not be categorized. Kent was also unable to provide details about roughly $750,000 in fixed assets. As a result, the firm was unable to recreate the general ledgers or prepare the returns. By late August, Kent was delinquent on the firm’s invoices, and the firm ceased its efforts. Eventually, Kent filed for bankruptcy and sued the firm for, among other things, breach of contract.
By the time a formal contract was executed, the firm had already completed roughly two months of intensive work for Kent. What, then, was the relationship between Kent and the firm prior to the execution of the formal agreement?
The court determined that the executed agreement was simply confirmation of a contractual relationship that already existed. In other words, the conduct of both parties demonstrated that an implied contract was in effect between the firm and Kent during March, April, and May. The phrase “implied contract” says it all—when the facts demonstrate that the parties formed an agreement, such an agreement exists; it is implied, even if not reduced to a formal writing. The court noted that, absent some unusual circumstances, common sense dictates that when someone seeks professional services from an accounting firm, there is a concomitant promise by the client and expectation by the firm that payment will be made for those services.
Embarking on work without a written contract creates risk that future disputes about an agreement’s terms, or whether the agreement existed at all, will be resolved not by looking to an executed document, but instead by evaluating the evidence of the parties’ relationship.
The important point is that, if an implied contract exists, the duties owed under that contract are enforceable. That is, one can breach a contract even if there is no written agreement. An implied contract cannot exist where an express agreement covers the same subject matter. Embarking on work without a written contract creates risk that future disputes about an agreement’s terms, or whether the agreement existed at all, will be resolved not by looking to an executed document, but instead by evaluating the evidence of the parties’ relationship. That evidence may not always be clear, or in the accountant’s favor. This recognition of an implied contract highlights the importance of establishing the ground rules governing the accountant-client relationship early, and in an executed writing.
The key question in Kent was whether the CPA firm breached its contract by not finishing the work it undertook and providing Kent with that work product. The court held that there were two independent bases for finding the firm did not breach its contract. First, Kent’s own breach of contract—failure to deliver enough information for the firm to do its job ethically and professionally—prevented the firm from upholding its end of the bargain. Second, Kent had voluntarily paid some (though not all) of the fees that he owed the firm.
The executed contract between Kent and the firm—which the court concluded also covered the period of time before its formal execution—included the following provision: “You [Kent] agree to provide all financial and nonfinancial information and documentation reasonably deemed necessary or desirable by us in connection with the engagement.” It was abundantly clear from the evidence that the firm repeatedly sought information from Kent that was necessary to create general ledgers and prepare tax returns, but Kent was unable to provide that information. The court also credited the CPA’s testimony that filing any tax returns based on incomplete information would have breached the CPA’s ethical obligations. [See Circular 230 section 10.22 (requiring diligence as to accuracy); IRC section 6694 (prohibiting unreasonable position on returns).] Although the firm did not provide Kent with the work product he sought, that did not constitute a breach of contract given Kent’s own conduct.
The firm’s successful defense against Kent’s breach of contract claim underscores the importance of a thoughtfully drafted agreement. It is important to specify the client’s obligations as early as possible, in writing. Before undertaking particularly complex or novel assignments, one should consider which information will be necessary, and who will be responsible for furnishing that information. Once work is underway, requests for information should be made clearly and, if possible, in writing. If a dispute emerges later, a clear written record showing what was done to attempt to obtain information will always be preferable to reliance on memories of acts and conversations.
Additional Lessons Learned
Although it was Kent’s failure to fully satisfy his invoices that eventually convinced the firm it needed to end the relationship, Kent did make some payments. That fact, the court held, provided an alternative basis to protect the firm from Kent’s breach of contract claim.
The so-called voluntary payment doctrine generally “bars recovery of payments voluntarily made with full knowledge of the facts, and in the absence of fraud or mistake of material fact or law” [Dillon v. U-A Columbia Cablevision of Westchester, Inc., 100 N.Y.2d 525, 526 (2003)]. Kent argued that he did not have “full knowledge of the facts” because the invoices he received from the firm did not attach detailed time entries. But the court did not find that factor persuasive, particularly in light of testimony from the firm’s partners that, had Kent ever asked for itemized breakdowns of time spent on his matter, the firm would have provided them. (Indeed, the firm did promptly provide that information to Kent’s attorney during the litigation.)
But the lesson from Kent is not that once a client makes some payments a future breach of contract action is off the table. A court’s analysis of whether the voluntary payment doctrine applies to any given situation will be highly fact-dependent. Transparency with clients about the nature of work being performed is therefore vital.
In a case from New York, Dubrow v. Herman & Beinin [70 N.Y.S.3d 181 (App. Div., 1st Dept. 2018)], attorneys were accused of breach of contract by a plaintiff who made payments in exchange for the attorneys’ services. The attorneys filed a motion to dismiss, arguing that those payments were voluntary and thus barred the suit. But the court declined to dismiss the case, noting that the attorneys failed to show—at least at that stage of the litigation—that the plaintiff understood all the relevant facts, such as how many hours the attorneys spent on the matter, and whether the plaintiff’s payments were reasonably related to the value of the attorneys’ services. It did not affect the court’s determination that the plaintiff never even questioned the attorneys’ fees until after the unsuccessful resolution of the case the attorneys were hired to handle. Dubrow shows the limits of the voluntary payment doctrine as a safe harbor from breach of contract claims. While failing on a motion to dismiss does not necessarily portend losing the case entirely, it does mean additional legal fees and the stress of continued litigation.
Although the firm in Kent successfully beat back the breach of contract claim, the case contained an ironic coda involving a provision of the bankruptcy code. The court ordered the firm to turn over the work-product they possessed regarding Kent (whatever that might have been) pursuant to section 542(e) of the Bankruptcy Code.
The last thing any accountant wants to imagine when entering into a relationship with a client is the possibility that the relationship sours and leads to litigation.
Section 542(e) provides: “Subject to any applicable privilege, after notice and a hearing, the court may order an attorney, accountant, or other person that holds recorded information, including books, documents, records, and papers, relating to the debtor’s property or financial affairs, to turn over or disclose such recorded information to the trustee [of the bankruptcy estate]” [11 USC section 542(e)]. The contract with Kent reserved the firm’s right to withhold work product if they were not paid. The AICPA Code of Professional Conduct 1.400.200 allows CPAs to withhold work product if fees are due for the specific work product, or the work product is incomplete. If the bankruptcy court, however, determines that the work-product is needed to administer the bankruptcy estate, then section 542 trumps any contract-based right to withhold work-product.
This provision of the Bankruptcy Code mitigates the risk that attorneys or accountants might pressure debtors into paying their claims ahead of other creditors by using their work product as leverage. An accountant facing a situation like the one in Kent has the option of placing a retaining lien on the work-product. But such a lien does not prohibit a court’s order to turn over the work-product pursuant to section 542. Instead, if the court orders accountants to turn over work-product, they may be entitled to a replacement lien or administrative expense. [See In re Herrera, 390 B.R. 746, 748 (Bankr. S.D. Fla. 2008).]
The last thing any accountant wants to imagine when entering into a relationship with a client is the possibility that the relationship sours and leads to litigation. But, as Kent shows, choices made at the outset of a relationship can end up being highly consequential. It is therefore important to consider all scenarios—including the worst-case—before undertaking new work.