Cite specific cases to support your answer to question 1 about the differences between common law and statutory law legal liability of auditors.
Common law cases
In the 1933 landmark case, Ultramares v. Touche, the New York State Court of Appeals held that a cause of action based on negligence could not be maintained by a third party who was not in contractual privity. The court did leave open the possibility that a third party could successfully sue for gross negligence that constitutes fraud and actual fraud.
The importance of the Ultramares decision is that third parties (i.e., Ultramares) without privity could sue if negligence was so great as to constitute gross negligence. The opinion of the New York Court of Appeals was written by Judge Benjamin Cardozo.
If a liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class [third parties]. The hazards of a business on these terms are so extreme as to [raise] doubt whether a flaw may not exist in the implication of a duty that exposes to these circumstances.
The Ultramares decision was the first of three different judicial approaches to deciding the extent of an accountant’s liability to third parties. The other two are the Restatement (Second) of the Law of Torts approach and the foreseeable third-party approach.
With respect to liability to third parties, while the Ultramares decision established a strict privity standard, a number of subsequent court decisions in other states moved away from this standard over time. The New York Court of Appeals expanded the privity standard in the case of Credit Alliance v. Arthur Andersen & Co. to include a near-privity relationship between third parties and the accountant. In the case, Credit Alliance was the principal lender to the client and demonstrated that Andersen had known Credit Alliance was relying on the client’s financial statements prior to extending credit. The court also ruled that there had been direct communication between the lender and the auditor regarding the client.
The Credit Alliance case establishes the following tests that must be satisfied for holding auditors liable for negligence to third parties: (1) knowledge by the accountant that the financial statements are to be used for a particular purpose; (2) the intention of the third party to rely on those statements; and (3) some action by the accountant linking him or her to the third party that provides evidence of the accountant’s understanding of intended reliance.
The “middle ground” approach followed by the vast majority of states (and federal courts located within those states) expands the class of third parties that can sue successfully an auditor for negligence beyond near-privity to a person or limited group of persons whose reliance is (actually) foreseen, even if the specific person or group is unknown to the auditor.
The courts have deviated from the Ultramares principle through a variety of decisions. For example, a federal district court in Rhode Island decided a case in 1968, Rusch Factors, Inc. v. Levin, that held an accountant liable for negligence to a third party that was not in privity of contract. In that case, Rusch Factors had requested financial statements prior to granting a loan. Levin audited the statements, which showed the company to be solvent when it was actually insolvent. After the company went into receivership, Rusch Factors sued, and the court ruled that the Ultramares doctrine was inappropriate. In its decision, the court relied heavily on the Restatement (Second) of the Law of Torts.
The Restatement (Second) of the Law of Torts approach, sometimes known as Restatement 552, expands accountants’ legal liability exposure for negligence beyond those with near privity (actually foreseen) to a small group of persons and classes who are or should be foreseen by the auditor as relying on the financial information. This is known as the foreseen third-party concept because even though there is no privity relationship, the accountant knew that that party or those parties would rely on the financial statements for a specified transaction.
A majority of states now use the modified privity requirement imposed by Section 552 of the Restatement (Second) of the Law of Torts. The Restatement modifies the traditional rule of privity by allowing non-clients to sue accountants for negligent misrepresentation, provided that they belong to a “limited group” and provided that the accountant had actual knowledge that his or her professional opinion would be supplied to that group. In some state court decisions, a less restrictive interpretation of Section 552 has been made. For example, a 1986 decision by the Texas Court of Appeals in Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co. (now KPMG) held that if an accountant preparing audited statements knows or should know that such statements will be relied upon, the accountant may be held liable for negligent misrepresentation.
A third judicial approach to third-party liability expands the legal liability of accountants well beyond Ultramares. The reasonably foreseeable third-party approach results from a 1983 decision by the New Jersey Supreme Court in Rosenblum, Inc. v. Adler. In that case, the Rosenblum family agreed to sell its retail catalog showroom business to Giant Stores, a corporation operating discount department stores, in exchange for Giant common stock. The Rosenblum’s relied on Giant’s 1971 and 1972 financial statements, which had been audited by Touche (now Deloitte & Touche). When the statements were found to be fraudulent and the stock was deemed worthless, the investors sued Touche. The lower courts did not allow the Rosenblum’s claims against Touche on the grounds that the plaintiffs did not meet either the Ultramares privity test or the Restatement standard. The case was taken to the New Jersey Supreme Court, and it overturned the lower courts’ decision, ruling that auditors can be held liable for ordinary negligence to all reasonably foreseeable third parties who are recipients of the financial statements for routine business purposes.
The legal liability of accountants is not limited to audited statements. In the 1967 case 1136 Tenants Corp. v. Max Rothenberg & Co. an accounting firm was sued for negligent failure to discover embezzlement by the managing agent who had hired the firm to “write up” the books, which did not include any audit procedures. The firm was held liable for failure to inquire or communicate about missing invoices, despite a disclaimer on the financial statements informing users that “No independent verification were undertaken thereon.” The firm moved to dismiss the case, but the court denied the motion and held that even if a CPA “acted as a robot, merely doing copy work,” there was an issue as to whether there were suspicious circumstances relating to missing invoices that imposed a duty on the firm to warn the client.
(REMIND STUDENTS TO LOOK AT EXHIBIT 6.2)
Exhibit 6.2 Auditor Legal Liability to Third Parties | Legal Approach | Case | Legal Principle | Legal Liability to Third Parties | Ultramares | Ultramares v. Touche | Privity (only clients can sue) | Possibly gross negligence that constitutes (constructive) fraud | Near-privity relationship | Credit Alliance | Three-pronged approach: knowledge of accountant that the statements will be used for a particular purpose; intention of third party to rely on those statements; some action by third party that provides evidence of the accountant’s understanding of intended reliance | Ordinary negligence | Restatement (Second) of the Law of Torts | Rusch Factors | Actually foreseen third-party users | Ordinary negligence beyond near-privity | Foreseeable third party | Rosenblum | Reasonably foreseeable third-party users | Ordinary negligence with reliance on the statements |
Two court decisions illustrate the application of Section 11 of the Securities Exchange Act of 1933 to securities registration matters: Escott v. BarChris Construction Corp. and Bernstein v. Crazy Eddie, Inc. (These cases are summarized in Exhibits 6.4 and 6.5, respectively.)
In Escott v. BarChris Construction Corp., the company issued a registration statement in 1961 in connection with its public offering of convertible bonds. The statements included audited financial statements by Peat, Marwick, Mitchell & Co. The financial statements included material overstatements of revenues, current assets, gross profit, and backlog of sales orders and material understatements of contingent liabilities, loans to company officers, and potential liability for customer delinquencies. BarChris’s worsening financial position resulted in a default on interest payments and the company eventually declared bankruptcy. Barry Escott and other investors sued BarChris’s executive officers, directors, and the auditors under Section 11 of the Securities Act, citing a lack of appropriate professional care during the conduct of the audit. The judge ruled that the auditor’s actions in reviewing events subsequent to the balance sheet date were not conducted with due diligence because the senior auditor in charge of reviewing these events had not spent sufficient time and accepted unconvincing answers to key questions. The court determined that there had been sufficient warning signs that further investigation was necessary. The auditors’ failure to perform a reasonable investigation of subsequent events did not satisfy Section 11(b) and resulted in their liability to investors in BarChris’s bonds.
Crazy Eddie made several public offerings of securities from 1984 through 1987, during which time the prospectuses wrongly gave the impression that the company was a growing concern. The financial statements had been misstated by a number of schemes, including inflated inventory and net income. The plaintiffs in the case were purchasers of the company’s stock prior to the disclosure of the fraudulent financial statements. They sued Peat Marwick, the board of directors, and others, alleging that the accounting firm had violated GAAS and GAAP by failing to uncover the company’s fraudulent and fictitious activities. The plaintiffs were able to show that they suffered a loss and that the certified financial statements in the registration statements and prospectuses had been false and misleading, in violation of Sections 11 and 12 of the Securities Acts of 1933. The court decided the plaintiffs did not have to prove fraud or gross negligence, only that any material misstatements in the registration statements were misleading and that they had suffered a loss. In this case, the auditor was unable to prove that they had exercised appropriate due professional care to rebut the claim.
An important case that strengthens the scienter requirement is the 1976 U.S. Supreme Court reversal in Ernst & Ernst v. Hochfelder. The U.S. Court of Appeals had ruled in favor of Hochfelder and reversed the lower court opinion. The court decision includes this statement: “One who breaches a duty of inquiry and disclosure owed another is liable in damages for aiding and abetting a third party’s violation of Rule 10b-5of the Securities Exchange Act of 1934 if the fraud would have been discovered or prevented but for the breach, and that there were genuine issues of fact as to whether [Ernst] committed such a breach, and whether inquiry and disclosure would have led to discovery or prevention of the… fraud.”
The U.S. Supreme Court reversed the lower court’s decision that a private cause of action can come under Rule 10b-5. The Supreme Court ruled that a private cause of action for damages does not come under Rule 10b-5 in the absence of any allegation of scienter. The Court cited the language in Section 10 that it is unlawful for any person to use or employ any manipulative or deceptive device or contrivance in contravention of SEC rules. The Court ruled that the use of those words clearly shows that it was intended to prohibit a type of conduct quite different from negligence. The term manipulative connotes intentional or willful conduct designed to deceive or defraud investors, a type of conduct that did not exist in the case.
In a footnote to the decision, the Court recognized that in certain areas of the law, recklessness is considered to be a form of intentional conduct for the purpose of imposing liability for some act, thereby providing potential exposure to auditors for gross negligence under the Securities Exchange Act. |