1200-1500 word position paper, in which you review the existing law on a particular legal issue and make a proposal as to what the law should be.

AT THE INTERFACE OF LAW AND ACCOUNTING: AN EXAMINATION OF A TREND TOWARD A REDUCTION IN THE SCOPE OF AUDITOR LIABILITY TO THIRD PARTIES IN THE COMMON LAW COUNTRIES

*CARL PACINI "MARY JILL MARTIN "'LYNDA HAMILTON

INTRODUCTION

As we embark on a new millennium and reflect on the end of the twentieth century, the decades of the 1960s, 1970s, and 1980s may well be remembered as the "dark ages" of liability for auditors. During the last twenty-five years, the accounting profession has confronted an international litigation crisis. Accountants in fifty t o seventy-five countries around the world have suffered losses in liability lawsuits.' The liability increase is greatest in the Western world' and has been

* Assistant Professor, School of Accountancy, Georgia Southern University ** Professor, School of Accountancy, Georgia Southern University

*** Professor, School of Accountancy, Georgia Southern University ' See David Sands, Accountants Around the Globe See Rise in Professional Liability

Suits, WASH. TIMES, Oct. 20, 1992, a t C3. See Jose Gonzalo, The Role, the Position, and the Liability of the Statutory Auditor

Within the European Union, ACCT. HORIZONS, Mar. 1997, at 164,165; Marleen Willekens e t al., Audit Standards and Auditor Liability: A Theoretical Model, 26 ACCT. & BUS. RES. 249, 254 (1996).

172 I Vol. 37 I American Business Law Journal

quite acute in Canada,3 the United Kingdom: Australia: New Zealand,6 and the United States.' It is more than coincidence that these common law countries have such a severe auditor litigation problem given the relationship between legal systems and accounting practices and rules.'

By 1990, Canadian accountants faced over 100 lawsuits, a substan- tial increase in a short period of time.g By 1994, at least $1.3 billion (Canadian) of unresolved claims were pending against Canadian accountants." In the United Kingdom, the Big Six (now Big Five) accounting firms faced 627 outstanding legal cases claiming damages of 220 billion by mid-1994." The largest firms in the United Kingdom are paying as much as eight percent of their auditing and accounting fee income on professional liability insurance." In Australia, accountants

See Scott Haggett, Fears Raised over Liability Issue: Trend Is to Sue the Accountant

See John Rink, The Shortcomings of Caparo, INT'L. CORP. L.., Mar. 1994, a t 18. See B.J. Cooper & M.L. Barkoczy, Third Party Liability: The Auditor's Lament, 9(5)

See Len Bayliss, Arthur Young Lawsuit Highlights Need for Better Standards, ACCT.,

When Firms Go Under, FIN. POST, J u n e 25, 1993, a t 17.

MANAGERIAL AUDITING J . 3 1 (1994).

Feb. 1992, a t 7. ' See Dan Dalton e t al., The Big Chill, J. ACCT., Nov. 1994, at 53.

The accounting practices of a country are related t o that nation's legal system. The degree to which accounting rules are legislated can impact the nature of the accounting system. In code law countries, laws stipulate minimum requirements, and accounting rules tend to be highly prescriptive and procedural. In common law countries, laws establish limits beyond which i t is illegal to venture, and within those limits experi- mentation is encouraged. See Gary Meek & Shahrokh Saudagaran, A Survey of Research on Financial Reporting i n a Transnational Context, 9 J. ACCT. LITERATURE 145 (1990).

One recent study provides empirical support for the hypothesis t h a t a legal system is a significant predictor of accounting practices. A cluster analysis (using the average linkage method) involving a sample of 174 responses from managing partners of international public accounting firms distributed across 50 countries indicates a dichotomization of accounting practices, procedures, and rules consistent with the common lawkode law classification of legal systems. See Stephen Salter & Timothy Doupnik, The Relationship between Legal Systems and Accounting Practices: A Classification Exercise, 5 ADVANCES INT'L. ACCT. 3 (1992).

See Auditors Must Deal with a n Increasing Number of Lawsuits Charging Negligence, FIN. POST, Mar. 20, 1990, at 18.

lo See Gundi Jeffrey, Accountants Want Relief from Legal Nightmare, FIN. POST, Apr. 29, 1994, a t 12.

l1 Michael Beckett, Accountants Debate Move to Limited Liability, DAILY TEL., June 28, 1994, a t 28.

l2 See Christopher Napier, Intersections of Law and Accountancy: Unlimited Auditor Liability in the United Kingdom, 23 ACCT., ORG. & Soc'~.lO5, 106 (1998). The Institute of Chartered Accountants in England and Wales has lobbied the U.K. government consistently over recent years to bring about legislative reform to limit accountants' liability. This effort took on a new sense of urgency after the award of damages of €65 million against Binder Hamlyn, a leading firm of British accountants. See id.

2000 I Auditor Liability I 173

faced more than A$3 billion in claims by mid-1993.13 In New Zealand, the cost of defending legal actions brought against accountants has become a major business pr0b1em.l~ In the United States, in 1993, the Big Six accounting firms’ expenditures for settling and defending lawsuits were $1.1 billion or 11.9% of U.S. domestic auditing and accounting revenue.15

The rise in litigation in these five countries has led to: (1) accounting firms being more aggressive in refusing t o render services t o high- litigation-risk firms;16 (2) a decrease in the availability and a rise in the cost of professional liability insurance;” and (3) an increase in the number of experienced accountants departing the profession, especially in the United States and Austra1ia.l’ Moreover, a recent study by the International Federation of Accountants suggests that harsh legal liability weakens incentives for parties t o monitor enterprises under their control, has a limited effect on reducing negligence by auditors, and may lead t o increased litigation risk because of the availability of insurance money.lg

l3 See Bill Pheasant, Accountants Want to Stop the Damage, AUSTL. FIN. REV., Aug. 12, 1993, at 14.

l4 See John Lepper, N.Z. Auditors Strain Under Litigation Threat, ACCT., Mar. 1992, a t 8.

l5 See Dalton e t al., supra note 7, a t 53; James Granelli, Jumping Ship, L.A. TIMES, Oct. 22, 1995, at D1. In 1994, the Big 6 firms claimed that a tidal wave of liability lawsuits threatened their existence. See Steven Marino & Renee Marino, An Empirical Study of Recent Securities Class Action Settlements Involving Accountants, Attorneys, or Underruriters, 22 SEC. REG. L.J.115, 149-50 (1994). Despite the passage of the Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (1995)(codified as amended in scattered sections of 15 U.S.C.A. (West Supp. 199611, the number of shareholder lawsuits naming accountants as defendants has not declined. See Elizabeth MacDonald, More Accounting Firms Are Dumping Risky Clients, WALL ST. J., Apr. 25, 1997, at A2.

l6 See Andrew Jack, Rise in Legal Claims Hits Top Accountancy Firms: Auditors Say They Are Turning Away High-Risk Clients, FIN. TIMES, Feb. 21, 1994, a t 18; Frederick Jones & K. Raghunandan, Client Risk and Recent Changes in the Market for Audit Services, 17 J. ACCT. & PUB. POL’Y. 169, 171-72 (1998); MacDonald, supra note 15; Alastair Thompson, Big Auditors Priced Out of N.Z. Market, NAT‘L. BUS. REV., (Reuters Textline), Sept. 9, 1994.

l7 See DAN GOLDWASSER & M.T. ARNOLD, ACc0UN”ANTS’ LIABILlrY 11-1 to 11-3 (1998); Ronald B. Johnson e t al., Auditor Preferences for Liability Limitation, ACCT. & FIN., Nov. 1995, at 135.

A rise in the number of experienced accountants leaving the ranks of the profession “is of concern both to CPAs and society, because a sound public accounting profession is essential t o a healthy free enterprise system. In particular, there is concern that an exodus of experienced personnel from public accounting will harm audit quality.” Dalton et al., supra note 7, at 53; Pheasant, supra note 13, a t 14.

See Auditor Liability Evokes Wider Concerns, CMA MAG., JulylAug.1998, at 31.

174 I Vol. 37 I American Business Law Journal

One response of the accounting profession t o the litigation crisis has been the adoption and use of an engagement risk approach which incorporates the accountant’s legal environment into client acceptance and retention decisions and setting audit fees.” Using this approach, the auditor assesses the r i s k s and related litigation costs from an alleged audit failure of a current o r potential client.21 Client risk assessment and setting audit fees are confounded by the uncertainty over who is owed a duty of care by an accountant.22 The auditor’s legal liability may vary considerably based on intended third-party users, especially for the t o r t of negligence (or negligent mi~representation).~~

Although lawsuits against accountants remain a problem in the United States, United Kingdom, Canada, Australia, and New Zealand and accountant liability laws are still not uniform, recent judicial decisions and legislation may limit accountants’ liability and indicate progress toward more consistency. In particular, an international trend has emerged toward a narrower scope of accountant liability t o nonclients for negligence. This is a significant development given that only about a decade ago, researchers identified a trend toward expand- ing the auditor’s liability for negligent misstatements in both the United Statesz4 and the four Commonwealth nations.25

*’ See H. Fenwick Huss & Fred Jacobs, Risk Containment: Exploring Auditor Decisions in the Engagement Process, 10 AUDITING: J. PRAC & THEORY 16, 19 (1991); Jones & Raghunandan, supra note 16, at 170.

*’ See AUDITING STANDARDS BOARD, AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, AUDIT RISK ALERT-1992; Craig Brumfield e t al., Business Risk and the Audit Process, J. ACCT., Apr. 1983, at 60, 60-65.

22 An accountant may owe a duty to one o r more of three categories of people: (1) the client and any other party with whom the accountant is in privity; (2) a known and intended class or group of financial statement users (or beneficiaries of the accountant’s work product); and (3) any person the accountant should reasonably foresee as a beneficiary of his or her work product. See Nancy Chaffee, Note, The Role and Responsibility ofAccountants in Today’s Society, 13 J. COW. L. 863, 866 (1988).

23 Negligence is one of the most significant tort theories used in auditor litigation. The reasons are: (1) i t is not as difficult to prove as fraud; in the latter, the plaintiff must prove intent ta deceive or, in some cases, recklessness on the part of the accountant; ( 2 ) many securities laws apply only to purchasers and/or sellers of securities; and (3) nonclients cannot sue for breach of contract. In the United States, lawsuits involving state claims, including negligence, accounted for about 69% of auditor lawsuits against Big 6 firms resolved in 1990-1992 and approximately 48% of the dollar amount of settlements and court awards in those years. See Robert Mednick & Jeffrey Peck, Proportionality: A Much-Needed Solution to the Accountants’ Legal Liability Crisis, 23 VAL. U. L. REV. 867 (1994).

See H.D. Brecht, Auditors’ Duty of Care to Third Parties: A Comment on Judicial Reasoning Underlying US. Cases, 19 ACCT. & BUS. RES. 175 (1989).

25 See D.R. Gwilliam, The Auditor, Third Parties, and Contributory Negligence, 18 ACCT. & Bus. RES. 25 (1987).

2000 I Auditor Liability I 175

The purposes of this article are threefold. The first is t o identifjl court decisions and statutes from the United States, United Kingdom, Canada, Australia, and New Zealand that have slowed o r reversed the expansion of auditor liability t o nonclients for negligence. The second is t o examine the trend in light of the different legal standards that have been used by different countries in deciding which third parties have a right t o sue accountants for negligent misrepresentation. The third purpose is t o enhance and update the knowledge of accountants, attorneys, standard setters, regulators, and educators about auditors’ legal responsibilities t o nonclients for negligence. A precise statement of legal standards and any changes in the law enhances the accoun- tant’s ability, ex ante, t o gauge liability exposure.26 A TREND IN THE COMMON LAW COUNTRIES TOWARD A NARROWER SCOPE O F ACCOUNTANT LIABILITY United States

Examination of the Various Legal Standards t o Determine Accountant Liability t o Nonclients for Negligence

Courts apply one of four legal standards t o decide which nonclients have a cause of action against accountants for negligent misrepresenta- tion: (1) privity; (2) near-privity; (3) the known users or Restatement rule; and (4) the reasonable foreseeability rule. These four standards lie on a continuum. They can lead t o different outcomes about whether the nonclient has a right t o sue even when they are applied t o the same set of facts.27

Privitv Rule. The requirement of strict privity t o establish an accoun- tant’s duty t o nonclients is the most restrictive standard. Strict privity requires a contractual relationship (or direct connection) t o exist between an accountant or auditor and another party for the latter t o hold the accountant liable for negligence. Strict privity was first

26 See John Siciliano, Negligent Accounting a n d the Limits of Instrumental Tort Reform, 86 MICH. L. REV. 1929,1955 (1988).

27 One example of such a situation occurred in Performance Motorcars, Inc. u. Peut Marwick, 643 A.2d 39 (N.J. Super. Ct. App. Div. 1994). Performance Motorcars, Inc., a New York business, sued Peat Marwick in a New Jersey court, alleging t h a t it suffered losses after one of its customers, Coated Sales, Inc., went bankrupt. Id. at 40. Performance conceded that if New York law applied, it would not be able to sue Peat Marwick. Id. Ultimately, a n appeals court held that New Jersey law applied giving Performance a legal right t o sue under New Jersey law applicable at the time of the suit. In 1995, the New Jersey legislature passed a statute which changed state law to a stricter standard t h a n the one applied in this case for determining the scope of a n accountant’s duty to nonclients for negligence. N.J. STAT. A”. 8 2A53A-25 (West 1998).

176 I Vol. 37 I American Business L a w Journal

established as a legal standard in Landell u. Lybrand.” Today, strict privity is the law in only Pennsylvania and Virginia.”

first t o Near-Privitv. The court in Ultramares Corp. u. Touche3o was the apply the near-privity standard t o determine the scope of an accoun- tant’s duty t o nonclients for negligence. In that case, the New York Court of Appeals denied plaintiff Ultramares’ negligence claim but fashioned an exception t o strict privity that has become known as the primary benefit rule, that is, the plaintiff must be an intended third- party benefi~iary.~~ The court reasoned that although Touche knew the balance sheet would be shown t o various unidentified creditors and shareholders, Touche had not been hired by Stern with the knowledge that Ultramares was an intended third-party beneficiary of Touche’s ~ o r k . ~ ’ Overly rigorous interpretations of Ultramares over the years have resulted in the case symbolizing a privity requirement for recovery for negligent mi~representation.~~

Over fifty years later, the New York C o u r t of Appeals affirmed and clarified the near-privity rule in Credit Alliance u. A r t h u r Andersen & C O . ~ ~ The court set forth a three-prong test that a nonclient must meet t o fall within the ambit of an auditor’s duty for purposes of a negligent

107 A. 783 (Pa. 1919). In Pennsylvania, strict privity continues to be t h e prevailing rule of law. Raymond Rosen & Co. v. Seidman & Seidman, 579 A.2d 424 (Pa. Super. Ct. 1990); In re Phar-Mor Sec. Litig., 892 F. Supp. 676 (W.D. Pa. 1995); PNC Bank, Kentucky, Inc. v. Housing Mortgage Corp., 899 F. Supp. 1399 (W.D. Pa. 1994).

29 In Virginia, strict privity became law in 1993. Ward v. Ernst & Young, 435 S.E.2d 628 (Va. 1993).

30 174 N.E. 441 (N.Y. 1931). 31 Id. a t 445-46. The decision in Glanzer u. Shepard, 135 N.E. 275 (N.Y. 19221,

influenced the outcome reached in Ultramares. In Glanzer, the Court of Appeals held that a public weigher, hired by a seller of beans, was liable to a third party who purchased beans from the bean vendor. The third party was overcharged for the beans because the public weigher negligently overstated the weight of the beans. The public weigher had been hired by the seller to provide a weight certificate directly to the bean purchaser. In distinguishing Glanzer from Ultmmares, Judge Cardozo noted that the service rendered by the public weigher was primarily for the benefit or information of a third person while in Ultramares the auditor’s service was primarily for the benefit of the Stern Company (the auditor’s client) and only collaterally for the use of third persons. Id.

32 Id. a t 446. Bonita A. Daley & John M. Gibson, The Delineation ofAccountants’Lega1 Liability

to Third Parties: Bily and Beyond, 68 ST. JOHN’S L. REV. 609, 620 (1994); R. James Gormley, The Foreseen, the Foreseeable, and Beyond-Accountants’ Liability to Nonclients, 14 SETON HALL L. REV. 528, 531-32 (1984).

34 483 N.E.2d 110 (N.Y. 1985). Credit Alliance Corp. provided equipment financing t o L.B. Smith, Inc. for many years. Id. at 111. In 1978, Credit Alliance advised Smith t h a t any future extensions of credit would require audited financial statements, including a n unqualified opinion from Arthur Andersen, for fiscal years 1976 through 1979. Id. I n 1980, L.B. Smith filed for bankruptcy. Id. a t 112.

2000 I Auditor Liability I 177

misrepresentation action. The three prongs are: (1) the accountant must have known that the financial reports were t o be used for a particular purpose or purposes; (2) in the furtherance of which a known party o r parties was intended t o rely; and (3) there must have been some conduct on the part of the accountant linking him o r her t o that party, which indicates the accountant’s understanding of that party’s reliance.35 New York upheld the Credit Alliance rule in 1992.36

By court decision, several states now follow the Credit Alliance rule o r a version of it with minor variation^.^^ Also, several states have statutory versions of a near-privity rule?’

The Restatement Standard. In 1968, a federal district court in Rhode Island first expanded accountant liability for negligence t o specifically foreseen o r known users.39 The court applied section 552 of the Restatement (Second) of Torts.40 Under this standard, an accountant who audits o r prepares financial information for a client: (1) owes a duty not only t o the client but t o any other person o r one of a limited group of persons whom the accountant or client intends the information t o benefit; (2) if that person justifiably relies on the information in a transaction o r one substantially similar t o it that the accountant or his client intends the information t o influence; and (3) that person suffers

35 I d . 36 Security Pacific Bus. Credit v. Peat Marwick Main, 597 N.E.2d 1080 (N.Y. 1992). 37 Idaho Bank & Trust Co. v. First Bancorp., 772 P.2d 720 (Idaho 1989); Thayer v.

Hicks, 793 P.2d 784 (Mont. 1990); Citizens Nat’l Bank v. Kennedy & Coe, 441 N.W.2d 189 (Neb. 1989); Credit Alliance v. Arthur Andersen, 483 N.E.2d 110 (N.Y. 1985).

See ARK. CODE A”. $ 16-114-302 (Michie 1998); 225 ILL. COMP. STAT. 450/30.1 (West 1998); KAN. STAT. ANN. $ 1-402 (1998); LA. REV. STAT. A”. $ 37:91 (West 1999); MICH. COMP. LAWS $600.2962 (1998); N.J. STAT. A”. $ 2 k 5 3 6 2 5 (West 1998); UTAH CODE ANN. $ 58-26-12 (1998); WYO. STAT. ANN. 9 33-3-201 (Michie 1998).

39 Rusch Factors, Inc. v. Levin, 284 F. Supp. 85 (D.R.I. 1968). ‘’ RESTATEMENT (SECOND) OF TORTS 5 552 (1977). Section 552 provides: 5 552. Information Negligently Supplied for the Guidance of Others

(1) One who, in the course of his business, profession, or employment, or in any other transaction in which he has a pecuniary interest, supplies false information for the guidance of others in their business transactions, is subject to liability for pecuniary loss caused t o them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating the information.

(2) [Tlhe liability stated in subsection (1) is limited to loss suffered ( a ) by the person or one of a limited group of persons for whose benefit

and guidance he intends to supply the information or knows that the recipient intends to supply it; and

(b) through reliance upon i t in a transaction that he intends the information to influence or knows that the recipient so intends o r in a substantially similar transaction.

178 I Vol. 37 I American Business Law Journal

a pecuniary loss as a result of his reliance.41 No liability exists, however, t o parties t o whom the auditor had no reason t o believe the information would be made available, or when the client’s transaction, as represented to the auditor, changes so as t o increase materially audit risk.42 Historically, courts have had some difficulty in applying the Restatement rule because, in any given situation, no bright line exists t o distinguish one type of user from another.43 Despite such difficulty, certain general principles have evolved in numerous cases applying the Restatement standard.

The accountant need not know the exact identity of the nonclient t o be held liable under the Restatement standard.44 A duty is owed t o those persons, o r the limited group of persons, who the professional is actually aware will rely upon the inf0rmation.4~ It is the notice of the intended use or reliance which is important, not the size of the group of potential In fact, the Restatement standard does not extend accountant liability t o third parties if no accountant-client communica- tions exist concerning the intended use of the report.47 The accountant must supply the information t o a person or a limited group of persons.48 The major difference between the primary benefit rule of Ultramares and the Restatement standard is that the latter does not require that the identity of specific parties be known t o the auditor, only that they

41 Id. See also Daley & Gibson, supra note 33, at 632. 4 2 RESTATEMENT (SECOND) OF TORTS $552(2), comments i, j; Daley & Gibson, supra

note 33, a t 627. Audit risk is the risk that the auditor will unknowingly fail to appropriately modify his or her opinion on materially misstated financial statements. WILLIAM C. BOYNTON &WALTER G. KELL, MODERN AUDITING 231 (6th ed. 1996).

43 Richard Panttaja, Accountants’ Duty to Third Parties: A Search for a Fair Doctrine of Liability, 23 STETSON L. REV. 927, 941 (1994); Bethlehem Steel Corp. v. Ernst & Whinney, 822 S.W.2d 592, 595 (Tenn. 1991); Raritan River Steel v. Cherry, 367 S.E.2d 609,617 (N.C. 1988).

44 Amwest Sur. Ins. Co. v. Ernst & Young, 677 So. 2d 409, 411 (Fla. Dist. Ct. App. 1996); RESTATEMENT (SECOND) OF TORTS 8 552, comment h (1977).

45 Badische Corp. v. Caylor, 356 S.E.2d 198, 200 (Ga. 1987). 46 Amwest Sur. Ins. Co., 677 So.2d a t 411 (Fla. Dist. Ct. App. 1996). By receiving notice

of t h e third parties to whom potential liability may be incurred, the auditor can decide whether to accept the engagement, adjust the audit plan to meet the needs of third parties, and/or negotiate audit fees that are commensurate with the scope of liability. Daley & Gibson, supra note 33, a t 633.

47 Badische C o p , 356 S.E.2d a t 199-200 (Ga. 1987); RESTATEMENT (SECOND) OF TORTS § 552 (2)(a) & (b).

Raritan River Steel v. Cherry, 367 S.E.2d 609, 614 (N.C. 1988). According to this case, the Restatement requires only that the auditor know a t the time the report is audited or prepared that the client intends to supply information to another person o r limited group of persons. Whether the auditor acquires this knowledge from the client or elsewhere is irrelevant. Id. a t 618.

2000 I Auditor Liability / 179

be members of a limited group known t o the a ~ d i t o r . ~ ’ The Restate- ment standard enlarges the class of persons t o whom the accountant owes a duty t o intended identifiable beneficiaries and t o any unidenti- fied members of the intended class of benefi~iaries.~’ Twenty states currently follow the Restatement standard o r a variation of it.51

The Reasonable Foreseeabilitv Rule. Auditor liability t o nonclients expanded again in 1983 with the decision in Rosenblum u. Adler.52 In its decision, the court concluded that an auditor has a duty t o all those whom the auditor should reasonably foresee as receiving and relying on the audited ~ t a t e r n e n t s . ~ ~ However, the duty extends only t o those users whose decision is influenced by audited statements obtained from the audited entity for a proper business purpose.54 The court’s holding indicates that “the auditor owes a duty of care t o all who obtain a firm’s financial statement directly from the audited entity, but owes no such duty of care t o those who obtain it from an annual report in a library or from a government file.”55 At the time, Rosenblum radically altered accountants’ negligence liability by extending an accountant’s duty of care t o reasonably foreseeable third parties under certain circum- s t a n c e ~ . ~ ~ Presently, however, only Mississippi and Wisconsin follow the reasonable foreseeability standard.57

49 Thomas Gossman, The Fallacy o f Expanding Accountants’ Liability, 1988 COLUM. BUS. L. REV. 213,218.

50 Ryan v. Kanne, 170 N.W.2d 395, 403 (Iowa 1969). Intent to influence a class of beneficiaries is a threshold issue. A plaintiff may rely on a n accountant’s misrepresentation but no liability attaches without intent t o influence. Bily v. Arthur Young & Co., 834 P.2d 745 (Cal. 1992).

The states which have adopted the Restatement standard or a variation include: Alabama, Alaska, Arizona, California, Colorado, Florida, Georgia, Hawaii, Iowa, Massachusetts, Minnesota, Missouri, New Hampshire, North Carolina, Ohio, South Carolina, Tennessee, Texas, Washington, and West Virginia.

52 461 A.2d 138 (N.J. 1983). The holding in this case ceased to be law in March 1995 upon the enactment of an accountant privity statute. N.J. STAT. ANN. 8 2 A 53A-25 (West 1998).

53 Rosenblum, 461 A.2d a t 153. 54 Id. 55 Denzl Causey, Accountants’ Liability in an Indeterminate Amount for an

Indeterminate Class: An Analysis of Touche Ross & Co. u. Commercial Union Ins. Co., 57 MISS. L.J. 379, 380 (1987).

56 Willis Hagen 111, Accountants’ Common Law Liability to Third Parties, 1988 COLUM. BUS. L. REV. 181,189. The holding in Rosenblum became ineffective in March 1995 upon passage of a n accountant privity statute. N.J. STAT. ANN. 8 2 A 53A-25 (West 1998).

57 See Touche Ross & Co. v. Commercial Union Ins. Co., 514 So. 2d 315 (Miss. 1987); Citizens State Bank v. Timm, Schmidt & Co., 335 N.W.2d 361 (Wis. 1983).

180 I Vol. 37 I American Business Law Journal

Toward a Narrower Scope of Duty t o Nonclients

The trend toward a narrower scope of liability began i n 1986 when Illinois passed an accountant liability statute. Since that time, twenty- nine states have either: (1) enacted an accountant liability statute; (2) judicially adopted o r reaffirmed the Restatement, Credit Alliance, Ultramares, o r privity rules; o r (3) judicially rejected the reasonable foreseeability rule. Alabama is the only state that has widened the scope of an accountant’s duty t o third parties during the last decade.

Statutorv Jurisdictions. Since 1986, eight states have enacted statutes which address accountants’ liability t o nonclients for negligen~e.~’ Accountant privity statutes can be classified collectively in t h e near- privity category because such statutes have a narrower scope of duty than the Restatement standard and a scope of duty similar to the Credit Alliance test o r Ultramares rule.

Accountant liability statutes do, however, exhibit some variation. For example, despite common wording, the Arkansas, Illinois, and Utah statutes5’ have been interpreted in different ways creating uncertainty for accountants and regulators. In Swink u. Ernst & Young,6o the Arkansas Supreme Court held t h a t a n accountant is shielded from liability t o a third person not in privity unless (1) the accountant has identified in writing (the statute does not define the term “writing”) those persons intended t o rely on his services, and (2) t h e accountant furnishes those persons a copy of the writing.61 The statute is silent,

’* The eight states are Arkansas (ARK. CODE ANN. 8 16-114-302 (Michie 199811, Illinois (225 ILL. COMP. STAT. 450/30.1 (West 1998)), Kansas (W. STAT. ANN. 8 1-402 (West 1998)), Louisiana (LA. REV. STAT. A”. $ 3 7 9 1 (West 1999)), Michigan (MICH. COMP. LAWS $ 600.2962 (1998)), New Jersey (N.J. STAT. A”. 8 2 A 53A-25 (West 1998)), Utah (UTAH CODE ANN. $ 58-26-12 (1998)), and Wyoming (WYO. STAT. A”. $33-3-201 (Michie 1998)).

59 The Arkansas statute is used here as a n example. The statute reads as follows: No person . . . shall be liable to persons not in privity of contract . . . for civil damages resulting from acts, omissions, decisions, o r other conduct in connection with professional services, except for: (2) Other acts, omissions, decisions, or conduct, if the person, partnership or corporation was aware that a primary intent of the client was for the professional services to benefit or influence the person bringing the action . . . . For purposes of this subdivision, if the person, partnership, or corporation:

(a) identifies in writing to the client those persons who are intended to rely on the services, and

(b) sends a copy of the writing or similar statement to those persons identified in t h e writing o r statement, then the person . . . may be held liable only to the persons intended to rely in addition to those persons in privity of contract. . . .

ARK. CODE ANN. 8 16-114-302 (Michie 1998). 908 S.W.2d 660 (Ark. 1995).

61 Id. a t 662-63.

2000 / Auditor Liability / 181

however, on when the identification of third parties who may rely must occur. The court held that liability t o a third party for negligent misrepresentation is conditioned upon the accountant taking the affirmative steps of written identification and notification.62 The Swink court’s interpretation eliminates the effect of the “primary intent of the client” clause in the statute and virtually negates third party claims for negligence in Arkansas.

The Arkansas approach appears t o be somewhat stricter than the ruling by an Illinois appellate court. In Chestnut u. Pestine Brinati,63 an Illinois appellate court found that the same statute merely provides accountants with an exception t o a general rule of liability64 where the accountant prepares and sends a writing t o specific persons intended t o rely on the accountant’s services. Defendant accountants argued for the statutory interpretation adopted by the Arkansas Supreme Court in S w i n k u. Ernst & Young.65 The Illinois First District Appellate Court declined t o follow Swink and held that the statutory language, “if such person [accountant] . . . was aware that a primary intent of the client was for the professional services t o benefit o r influence the . . . person bringing the action,” creates a general rule of accountant liability.= The court, however, did not reach the question of the effect of a writing on the accountant’s liabilit~.~’ Under the Illinois reading of the statute, a nonclient may state a cause of action under the statute without a writing.68 If no writing from the accountant exists then the nonclient must prove the intent of the client and the accountant’s knowledge of that intent.69 The Illinois interpretation is still a near-privity standard but is not as narrow as the Arkansas standard.

In 1987, Kansas enacted a statute which does not require affirmative conduct by the accountant t o restrict his o r her liability.” Instead, four conditions must occur for a nonclient t o have a legal right t o sue: (1) the accountant knew the third party intended t o rely on the services;71 (2)

62 Id. 63 667 N.E.2d 543 (Ill. Ct. App. 1996). 64 The general rule of liability is that a n accountant owes a duty to a nonclient if the

accountant was aware that a primary intent of the client was for the professional services t o benefit or influence the particular third party. Christine Guerci, Liability of Independent Accountant to Investors or Shareholders, 48 A.L.R. 5th 389 (1998). The Chestnut court rejected a reading of the statute that makes written notice to a third party o r nonclient a condition of liability for negligent misrepresentation. Id.

65 Chestnut, 667 N.E.2d at 546. 66 Id. ” Id. at 547.

Id. Id.

Id. 0 1-402(b)(2). 70 KAN. STAT. ANN. 0 1-402 (West 1998).

182 I Vol. 37 f American Business Law Journal

the accountant knew the services rendered the client would be made available t o the third party;72 (3) the nonclient must be identified in writing t o the a~countant;7~ and (4) the third party’s reliance must be in connection with specific transactions identified in writing.74 Any writing which identifies the relying plaintiff and specific transaction(s) need not originate with the a c ~ o u n t a n t , ~ ~ as required under the Arkansas, Illinois, and Utah statutes.76 Unlike Arkansas, Illinois, and Utah,77 the Kansas statute clearly indicates that the accountant must have known of the third party’s reliance during the engagement o r assented t o such reliance with the client after the engagement.78 Moreover, the Kansas statute explicitly mentions that liability extends only t o “specified transactions” while the Arkansas, Illinois, and Utah statutes set forth no such req~irement.~’ In sum, the Kansas statute appears t o be somewhat more restrictive than the Illinois statute as presently construed, but not as narrow as the Arkansas statute as currently applied.

In 1990, Utah enacted an accountant liability statute identical t o the Arkansas and Illinois statutes.80 No reported court cases have been decided by any Utah state court. Although not binding on any Utah state court, the federal court in Vermont interpreted the statute” in much the same way as the Arkansas Supreme Court in Swink u. Ernst & Young.82

Enactment of a statute in 1995 in New Jersey is particularly ~ignificant.’~ Between 1983 and 1995, New Jersey adhered t o the reasonable foreseeability rule set forth in Rosenblum, but the New Jersey statute@ is a virtual codification of the three-prong test of Credit

’* I d . 8 1-402(b)(l). l 3 I d . 74 I d . § 1-402(b)(2). 75 I d . 8 1-402(b). 76 ARK. CODE A”. 8 16-114-302 (2) (Michie 1998); 225 ILL. COMP. STAT. 450.30.1(2)

77 The accountant liability statutes in Arkansas, Illinois, and Utah a r e silent on whether the accountant’s awareness or knowledge of the client’s intent can occur after reliance on the financial statements by the nonclient. None of these three statutes defines precisely when the accountant “was aware” of the primary intent of the client.

(West 1998); UTAH CODE ANN. 8 58-26-12(2) (1998).

KAN STAT. ANN. 9: 1-402 (b)(l) (1998). 79 Id. 8 1-402 (b)(2).

*’ Nordica USA, Inc. v. Deloitte & Touche, 839 F. Supp. 1982 (D. Vt. 1993). 82 908 S.W.2d 660 (Ark. 1995). 83 N . J . STAT. ANN. 5 2 A 53A-25 (West 1998). 84 The pertinent language of the New Jersey statute reads as follows: No accountant shall be liable for damages for negligence arising out of and in the course of rendering professional services unless. . . the accountant: (2)(a) Knew at the time of the engagement by the client or agreed with the client

UTAH CODE ANN. 8 58-26-12 (1998).

2000 I Auditor Liability / 183

Allian~e.’~ Despite the statute’s restrictive scope, it does not require any of the three elements for an accountant’s duty t o nonclients t o be in writing, except in the case of a bank.86 When a bank is a claimant, the accountant must acknowledge in writing the bank‘s intended reliance and the client’s knowledge of such relian~e.’~

The New Jersey statute is different from the Arkansas, Illinois, and Utah statutes. “he laws of the latter three states do not mandate that the accountant be aware of a specific transaction in which the nonclient is benefitted or influenced as required under the New Jersey statute.’* Also, the accountant’s knowledge of the nonclient’s intended reliance must be expressed t o the plaintiff (or “linking conduct”) under New Jersey’s statute:’ but not under the statutes of Arkansas, Illinois, and Utah.

In 1995, Wyoming also enacted an accountant liability ~ t a t u t e . ~ ’ Three conditions must be present at the time the engagement is undertaken for a duty t o nonclients t o arise: (1) the accountant was aware that the services performed were t o be made available in connection with a specific transaction; (2) the transaction was specifi- cally identified t o the accountant; and (3) the accountant was aware that the suing party intended t o rely on his or her service^.^' The Wyoming law is similar t o the Kansas statute” except for one signifi- cant difference. Wyoming requires the accountant t o state in writing on any financial statement o r other document those third parties who may rely, the document’s purpose, and that the accountant’s liability may be

after the time of the engagement, that the . . . service rendered t o the client would be made available to the claimant, who was specifically identified to the accountant in connection with a specified transaction. . .; (b) Knew that the claimant intended to rely upon the . . . service in connection with that specified transaction; and (c) directly expressed to the claimant, by words or conduct, the accountant’s understanding of the claimant’s intended reliance.

N.J. STAT. A”. 0 2A53A-25 (West 1998). 483 N.E.2d 110 (N.Y. 1985).

86 The New Jersey statute applies to banks with the addition of the following provision: “In the case of a bank claimant, the accountant must acknowledge the bank’s intended reliance on the . . . accounting service and the client’s knowledge of t h a t reliance in a written communication.” N.J. STAT. A“. 8 2A53A-25 (West 1998).

87 Id. ARK. CODE A”. 0 16-114-302 (Michie 1998); 225 ILL. COMP. STAT. 450/30.1 (West

N.J. STAT. A”. 0 2 A 53A-25(2)(c) (West 1998). WYO. STAT. ANN. 4 33-3-201 (Michie 1998).

1998); UTAH CODE A”. 8 58-26-12 (1998).

91 I d . 8 33-3-201(c)(ii). 92 KAN. STAT. A”. 0 1-402 (1998).

184 I Vol. 37 f American Business Law Journal

limited.93 The accountant’s liability to nonclients is not restricted unless the writing requirements are met.94

In 1996, a n accountant liability law took effect in Mi~higan.’~ The liability limitation provided by the statute appears to be aimed only at certified public accountants (CPA).% A CPA cannot be liable for negligence t o a third party unless the CPA was informed i n writing by the client at the time of the engagement that it was the client’s primary intent for the accounting services t o benefit o r influence the non~lient.’~ The statute allows the client t o identify in writing not only specific persons but a generic group o r class of persons whom the client intends t o benefit o r influence with the CPA’s service^.'^ It is possible t h a t the client could describe a class of users s o large t h a t a CPA could face potential liability t o a significant number of nonclients.

In 1999, a n accountant privity statute was enacted in Louisiana.” The statute is almost identical to the New Jersey statute with one exception. In Louisiana, the accountant need not acknowledge i n writing any intended reliance by a bank.

All eight of the aforementioned statutes reduce the probability of a miscommunication or misunderstanding between the accountant, client, and third party. The statutory requirements provide “more certainty because the third party knows before reading a financial statement whether he can recover from the auditor.””’ Accountant privity statutes facilitate client acceptance and retention decisions due t o the establishment of known and required conditions under which a n accountant may be liable for negligence t o a nonclient. Litigation risk for accountants is diminished by the near-privity nature of the eight

113 WYO. STAT. ANN. g 33-3-201(d) (Michie 1998). ’‘ Id. 95 Under Michigan’s accountant liability law, a certified public accountant may be liable

for a negligent act, omission, decision, or other conduct if the “certified public accountant was informed in writing by the client a t the time of the engagement that a primary intent of the client was for the . . . accounting services to benefit or influence the person bringing the action for civil damages. . . . The certified public accountant may be held liable only to each identified person, generic group o r class description.” MICH. COMP. LAWS 0 600.2962 (1998).

96 Id. ’’ Id. y8 Id. ’’ LA. REV. STAT. ANN. 8 37:91 (West 1999). See supra note 84 for the text of the New

Jersey statute, which is almost identical to the Louisiana statute except for the provision which addresses reliance on the accountant’s work product by banks.

loo E. R. Fencl, Rebuilding the Citadel: State Legislative Responses to Accountant Non- Priuity Suits, 67 WASH. U. L.Q. 863, 887 (1989).

2000 / Auditor Liability / 185

state statutes"' in which auditors generally do not need t o be concerned about as many third-party claimants.

Common Law Privitv Rule States. Since 1919, strict privity has been the applicable legal standard in Pennsylvania for negligence suits against accountants by nonclients. In 1994, a federal district court concluded, based on an application of Pennsylvania state law, that third parties cannot maintain legal actions against accountants for negligent misstatements absent privity.lo2 In 1995, the same result was reached in another federal district court case,lo3 despite a strong argument by the plaintiff that the Restatement standard should be the applicable law in Pennsylvania.

In a narrow ruling, the Virginia Supreme Court held in Ward u. Ernst & Younglo4 that privity of contract is a necessary element of a suit by a nonclient against an accountant for negligence. One of the questions presented on appeal was whether Virginia should adopt section 552 of the Restatement t o allow Ward t o sue Ernst & Young for neg1igen~e.l'~ The court accorded due respect t o the Restatement but declined t o adopt it.lo6 The court relied on four of its own prior rulings in negligence actions filed by third parties against architects, a developer, and an attorney.'" The court upheld the legal principle that a third party cannot recover damages from an accountant for economic losses absent privity of contract."'

Common Law Near-Privitv Rule States. In 1989, several courts refused t o expand the number of third-party users t o whom an accountant can be held liable for negligence. In Idaho Bank & Trust Co. u. First B a n c ~ r p , ~ ~ ~ the Idaho Supreme Court flatly rejected adoption of the approach and the reasonable foreseeability rule without any discussion. The court found persuasive the reasoning of the New York Court of

lo' I t may be argued that under Michigan law circumstances could arise (e.g., a client provides a n accountant a writing that names a large class of users as those to be benefitted by the CPA's services) which could defeat the near-privity character of the statute. However, a CPA may decline a client engagement because the client must inform the CPA at the time of the engagement who is to be influenced by the accounting services. MICH. COMP. LAWS 8 600.2962 (1998).

lo' PNC Bank, Kentucky, Inc. v. Housing Mortgage Corp., 899 F. Supp. 1399 (W.D. Pa. 1994).

lo3 In re Phar-Mor Sec. Litig., 892 F. Supp. 676 (W.D. Pa. 1995). lo' 435 S.E. 2d 628 (Va. 1993). lo5 Id. at 630. lo' Id. at 631. lo' Id. at 631-32.

Id. at 634. log 772 P.2d 720 (Idaho 1989).

186 I Vol. 37 I American Business L a w Journal

Appeals in Credit Alliance."' Idaho reaffirmed its adherence to t h e Credit Alliance standard six years later in D u f i n v. Idaho Crop Improvement Ass'n."' Interestingly, Idaho does not recognize the tort of negligent misrepresentation except in the confines of a professional relationship involving an accountant."' Also, in 1989, the Nebraska Supreme Court adopted the primary benefit rule ( o r Ultramares approach) in a case of first i m p r e ~ s i o n . " ~ In doing so, t h e Nebraska court overturned the decision of a trial court judge who relied on Restatement section 552.'14 The court held that a n accountant's duty of reasonable care extends only t o his or her client and not to third parties absent fraud o r other facts establishing a duty.'15 The court's decision contains no reference t o Ultramares but relies on the state's legal position on an attorney's duty to nonclients.'16 In 1993, Nebraska reaffirmed its support for the primary benefit rule in St. Paul Fire & Marine Insurance Co. u. Touche Ross."~

Also in 1989, Alabama adopted the Credit Alliance standard in Colonial Bank v. Ridley & Schweigert"' and then reversed itself in favor of the Restatement standard in Boykin v. A r t h u r Andersen & C O . " ~ Moreover, the Boykin court may have expanded the number of third-party users entitled to recover under the Restatement standard."' The court stated t h a t for a plaintiff to recover, "there must simply be some conduct on the part of the defendant [accountant] that evidences . . . understanding t h a t their [sic] opinion will be relied upon by a reasonably foreseeable and limited class of Contrary t o this statement, the Restatement expressly rejects foreseeability.'" Boykin represents the only instance since 1988 in which a state has expanded the scope of an accountant's liability t o third parties for negligent misrepresentation.

Id. a t 722. 895 P.2d 1195 (Idaho 1995).

"* I d . a t 1197. '13 Citizens Nat'l Bank v. Kennedy & Coe, 441 N.W.2d 180 (Neb. 1989). 'I4 I d . a t 182. "j I d . l l G I d . T h e cases cited by the Nebraska Supreme Court in support of its holding a r e

Landrigan u. Nelson, 420 N.W.2d 313 (Neb. 1988); Ames Bank v. H a h n , 287 N.W.2d 687 (Neb. 1980); Lilyhorn u. Dier, 335 N.W.2d 554 (Neb. 1983).

'17 507 N.W.2d 275 (Neb. 1993). 'l' 551 So. 2d 390 (Ala. 1989). ''' 639 So. 2d 504 (Ala. 1994). 120 William Hardie, Liability of Professionals for Negligent Certification, ALA. LAW., July

1994, a t 229. Boykin, 639 So.2d a t 505.

lZ2 RESTATEMENT (SECOND) OF TORTS 3 552, comment h (1977).

2000 I Auditor Liability I 1 8 7

In 1990, Montana adopted a modified version of the three-prong Credit Alliance test in Thayer v. The court engaged in a thorough review of the various legal standards t o define the scope of an accountant’s liability t o third parties, including the Ultramares rule, the Restatement, and the reasonable foreseeability standard.lZ4 In stating that the facts of the case satisfy the Credit Alliance test, the court adopted the first two prongs of that test but did not require “linking conduct” as a third elernent.lz5

Restatement Standard States. Judicial retrenchment from expanding the number of nonclients t o whom an accountant can be liable for negligence using the Restatement standard began in 1988 with the North Carolina Supreme Court’s decision in Raritan River Steel u. Cherry.’26 The court examined four legal approaches that have been used t o determine which third parties are owed a duty by accountants. The court rejected the Credit Alliance rule “because it provides inadequately for the central role independent auditors play in the financial The reasonable foreseeability rule was also not adopted “because it would result in liability more expansive than an auditor should be expected t o bear.”128 Two key factors cited by the court in rejecting the foreseeability test were the auditor’s lack of control over financial report distribution and the contents of financial statements t o which he or she attests.lZ9 The court also declined t o adopt a balancing test that was used by California and Missouri prior t o the Restatement standard now employed by those states.’30 The Restatement standard was adopted because it accommodates those nonclients who are foreseen users and accountants who need liability

793 P.2d 784 (Mont. 1990). lZ4 Id. at 785-88. lZ5 Id. at 791. The reason appears to be that the jury instructions at the trial level

covered only the first two elements of the Credit Alliance test and the court did not want to reverse and remand.

lZ6 367 S.E.2d 609 (N.C. 1988). 12’ Id. at 615. lZ8 Id. lZ9 Id. at 616. 130 Specifically, the Supreme Court rejected a balancing test first set forth in Biakanja

u. Irving, 320 P.2d 16 (Cal. 19581, where a notary public was held liable t o a n intended beneficiary under a negligently prepared will. The factors used in the balancing test are: (1) the extent to which the transaction was intended to affect the plaintiff; (2) the foreseeability of harm to the plaintie (3) the degree of certainty that the plaintiff suffered injury; (4) the closeness of the connection between the defendant’s conduct and the injury suffered; (5) the moral blame attached to the defendant’s conduct; and (6) the policy of preventing future harm. The balancing test was rejected because i t “approximates a ‘reasonable foreseeability’ test” and “is difficult to apply.” Raritan River Steel, 367 S.E.2d a t 617.

188 I Vol. 37 / A m e r i c a n Business Law Journal

limitations. 13’ The court reasoned t h a t the Restatement provides the auditor with sufficient knowledge of which third parties will rely on financial information t o allow the auditor t o buy liability insurance, set higher fees, o r adopt other protective measures.132 The words “sufficient knowledge” were clarified in 1998 by a North Carolina appellate court that held that if the auditor “knows at the time he prepares his report that specific persons, or a limited group of persons, will rely on his work, and intends o r knows that his client intends such reliance, his duty of care should extend t o them.”133

The movement away from widening the scope of an auditor’s liability t o nonclients for negligence continued with the holding of the West Virginia Supreme Court of Appeals’ decision in First National Bank u. Crawford.’34 In that case, the court answered a certified question on an accountant’s duty t o a third party not in ~ r i v i t y . ’ ~ ~ The parties to the case stipulated that the First National Bank of Bluefield had relied on a reviewed financial statement’36 for the Erps Construction Co. i n making a loan.’37 The court considered the Ultramares, Restatement, and reasonable foreseeability standard^.'^' The reasonable foreseeability rule was rejected in favor of the Restatement p~sition.’~’ In reaching its decision, the court relied t o some extent on the reasoning contained in Raritan River In 1996, the court reaffirmed its support for t h e Restatement standard i n Cordial u. Ernst & Young.’41

In 1990, the Florida Supreme Court joined the Restatement camp in First Florida Bank u. Max Mitchell & Co. ,14’ relying heavily on one of its own prior rulings in First American Title Insurance Co. v. First Title Services C O . ’ ~ ~ In First American, the Restatement position was adopted in a suit against a title company. The court in First Florida Bank also relied, t o a lesser extent, on the rationale of Raritan River Steel. The same year, Colorado implicitly recognized the liability of

13’ Id. 13’ Id. at 616. 133 Marcus Brothers Textiles, Inc. v. Price Waterhouse, 498 S.E.2d 196 (N.C. Ct. App.

13* 386 S.E.2d 310 (W. Va. 1989). 135 Id.

1998).

A review consists primarily of inquiries of client personnel and analytical procedures applied to financial data. It is substantially less in scope than a financial statement audit. BOYNTON & KELL, supra note 42, at 11.

13’ First Nat’l Rank, 386 S.E.2d at 311. 13* Id. at 311-15. 13’ Id. at 313. 140 Id.; see supra notes 126-32 and accompanying text. 141 483 S.E.2d 248 (W.Va. 1996). 14* 558 So. 2d 9 (Fla. 1990). 143 457 So. 2d 467 (Fla. 1984).

2000 I Auditor Liability / 189

CPAs for negligent misrepresentation under the Restatement standard in a case involving client financial data provided to a third person who relied on the information t o ship goods under a credit agreement.144

In 1991, Tennessee adopted the Restatement standard in Bethlehem Steel C o p . u. Ernst & Whinney.145 The court analyzed the Ultramares and reasonable foreseeability rules and the Restatement standard.146 The reasonable foreseeability rule, which had been applied by the trial court, was summarily rejected by the Tennessee Supreme Court because, in fairness, accountants should not be liable in circumstances where they are not aware of the use t o which their opinions will be

In the eyes of the court, the reasonable foreseeability rule would result in expansive liability for auditors which is not commensurate with those persons or classes of persons whom they know will rely upon their ~ 0 r k . l ~ ' The court went on t o adopt the Restatement standard because it had applied that standard in negligent misrepresentation cases involving other professional^.'^^ The Restatement standard was reaffirmed in 1995 as the appropriate legal standard for third party suits against accountants for negligence in Ritter u. Custom Chemicides, Inc .150

In 1992, in Bily u. Arthur Young & Co.,l5l the California Supreme Court overturned the state's prior adoption of the reasonable fore- seeability rule in International Mortgage Co. u. John Butler Accoun- tancy Corp.152 The Bily case arose from the failure of the Osborne Computer Corporation. After a thorough analysis of the various legal standards applicable t o accountants' liability t o n ~ n c l i e n t s , ' ~ ~ the Bily court adopted the Restatement ~ t a n d a r d . ' ~ ~ Bily is significant because

144 Marquest Med. Prod., Inc. v. Daniel, McKee & Co., 791 P.2d 14 (Colo. App. 1990);

145 822 S.W.2d 592 (Tenn. 1991). 14' Id. at 593-95. 147 Id. a t 594. 14* Id. 14' Id. at 595. 150 912 S.W.2d 128 (Tenn. 1995).

834 P.2d 745 (Cal. 1992). 152 223 Cal. Rptr. 218 (Cal. Ct. App. 1986). 153 Bily, 834 P.2d at 752-59, 768-73. 154 Id. a t 769. The court even suggested a special jury instruction for negligent

misrepresentation cases. The instruction emphasizes the court's intent to narrowly define the class of third parties who can recover from accountants. Thomas G. Mackey, Accountants' Liability after Bily v. Arthur Young & Co.: A More Equitable Proposal for Third Party Recovery, 45 HASTINGS L.J. 147, 160 (1993). The special jury instruction reads as follows:

Mehaffy, Rider, Windholz & Wilson v. Central Bank, 892 P.2d 230 (Colo. 1995).

The representation must have been made with the intent to induce plaintiff, or a particular class of persons to which plaintiff belongs, to act in reliance upon the representation in a specific transaction, or specific type of transaction, that

190 I Vol. 37 I American Business Law Journal

the court’s rejection of the foreseeable user doctrine represents a policy shift away from protecting the rights and expectations of investors, lenders, and the public in favor of a policy that shields accountants from liability to a large number of nonclients.’55 The court gave the following public policy reasons for rejecting the foreseeability rule:

(1) Given . . . the difficult and potentially tenuous causal relationships between audit reports and economic losses from investment and credit decisions, the auditor exposed to negligence claims from all foreseeable third parties faces potential liability far out of proportion to its fault; (2) the generally more sophisticated class of plaintiffs in auditor liability cases (e.g., business lenders and investors) permits the effective use of contract rather than tort liability to control and adjust the relevant risks through “private ordering“; and (3) the asserted advantages of more accurate auditing and more efficient loss spreading relied upon by those who advocate a pure foreseeability approach are unlikely t o occur . . . .156

The concept of “private ordering“ can be described as a risk management tool implemented by a third party user through contrac- tual agreements with the client or a ~ c o u n t a n t . ’ ~ ~ For example, a third party could hire its own auditor to conduct a n audit or review. The Bily case reduces, to some extent, auditor litigation risk in one of the nation’s most important commercial states.

In 1993, Missouri reaffirmed its support for the Restatement standard in MidAmerican Bank & Trust Co. u. Harrison.’58 The Restatement standard was first adopted in 1973 i n Alurna Kraft Manufacturing Co. v. Elmer Fox & Co.l5’ The two cases, however, differ in tenor. In Aluma Kraft, the court focused on the extension of accountant liability based on balancing several policy factors related t o t h e plaintiffs injury.160 The MidAmerican court, however, explicitly rejected the reasonable foreseeability rule and emphasized t h e “narrow confines” of the Restatement standard.16’

defendant intended to influence. Defendant is deemed to have intended to influence [the] transaction with plaintiff whenever defendant knows with substantial certainty that plaintiff, or the particular class of persons to which plaintiff belongs, will rely on the representation . . . .

Bily, 834 P.2d at 772-73. Panttaja, supra note 43, at 930.

156 Bily, 834 P.2d at 761. 157 Siciliano, supra note 26, at 1956-57. 158 851 S.W.2d 563 (Mo. App. 1993). lfi9 493 S.W. 2d 378 (Mo. App. 1973).

155

Id. at 380-83. MidAmerican Bank, 851 S.W.2d at 565-67.

2000 I Auditor Liability I 191

In 1994, Georgia and New Hampshire both reaffirmed their support for the Restatement standard. In First National Bank v. Sparkman,16' a Georgia appellate court refused t o apply the Restatement standard t o an accountant who had reviewed and compiled a series of financial statements for M & L Electrical Company t o use in obtaining bank credit. In citing the Restatement with approval (for audited state- ments), the court found that the disclaimers which appear on reviewed and compiled financial statements preclude any justifiable reliance by third parties,163 The New Hampshire Supreme Court upheld that state's use of the Restatement standard in dismissing a negligence claim against a CPA whose audit report served as the basis for the firing of a business services manager of a mental health services corporation.1M

In 1995, in a case of first impression, a South Carolina appellate court adopted the Restatement standard in M-L Lee Acquisition Fund u. Deloitte & T o u c h . 165 The appellate court considered the near-privity, Restatement, and reasonable foreseeability rules.'66 The court also reviewed various public policy concerns including the needs of the various users of an accountant's work product and the lack of control accountants have over the distribution of their work.167 Auditors' lack of control over the distribution of their reports translates into a lack of control over their liability exposure.168 The court also noted the auditor's inability t o exert control over the financial statements t o which he o r she attests.169 Ultimately, the court rejected the foreseeability standard as being too expan~ive."~ The appellate court concluded the Restatement should be adopted by South Carolina because that state's courts have relied on section 552 in other negligent misrepresentation cases.171 On appeal, the Supreme Court of South Carolina affirmed the holding of the Court of Appeals concerning the adoption of the Restatement ~tandard.'~'

16' 442 S.E.2d 804 (Ga. Ct. App. 1994). 163 Id. a t 805-06. 164 Demetracopoulos v. Wilson, 640 A.2d 279 (N.H. 1994).

166 Id. at 625-28. 16' Id. at 626-27. The M-L Lee court relied upon the public policy analysis contained in

16' M-L Lee Acquisition Fund, 463 S.E.2d a t 626-27. 16' Id. 170 Id. 171 See, e.g., Winburn v. Insurance Co. ofN. Am., 339 S.E.2d 142, 146-47 (S.C. Ct. App.

1985) (analyzing negligent misrepresentation in a case involving a n insurance adjuster); First Fed. Sav. Bank v. Knauss, 370 S.E.2d 906, 908 (S.C. Ct. App. 1988); Daniel W. Hayes, The Law of Torts, 48 S.C. L. REV. 193 (1996).

463 S.E.2d 618 (S.C. Ct. App. 1995).

Raritan River Steel v. Cherry, 367 S.E.2d 609 (N.C. 1988).

"I M-L Lee Acquisition Fund v. Deloitte & Touche, 489 S.E.2d 470 (S.C. 1997).

192 I Vol. 37 I American Business L a w Journal

In early 1997, a n Arizona appellate court adopted the Restatement standard in Standard Chartered u. Price Waterhouse. 173 On appeal, Price Waterhouse argued for the application of a privity standard to deny Standard’s claim based on negligent misrepresentation. The court rejected the privity argument based on the holding in Donnelly Construction Co. u. OberglHunt lGilleland’74 t h a t no privity require- ment exists t o maintain a n action in tort. The appellate court refused t o extend the liability of all professionals to include “foreseeable injuries t o foreseeable victims which proximately result from their negligent performance of their professional services.”175 The court proceeded to adopt the Restatement standard as appropriate t o establish t h e scope of an auditor’s duty t o n0nc1ients.l~~

In late 1997, an intermediate court of appeals in Hawaii ruled that the Restatement rule applies to third-party actions for negligent misrepresentation against accountant^.'^^ The appellate court analyzed the privity rule, the Restatement standard, and the reasonable foreseeability rule. The court rejected Deloitte & Touche’s argument t o adopt the privity rule because the Hawaii Supreme Court rejected t h a t standard in cases involving the liability of title companies and real estate brokers t o n o n c l i e n t ~ . ’ ~ ~ The lower appellate court referred to two policy reasons for limiting a n accountant’s liability. First, a restricted rule of liability is necessary because of the extent t o which misinformation may be, and may be expected t o be, circulated and the magnitude of t h e losses which may follow from reliance upon it.’79 Second, the scope of liability for negligence is narrower t h a n that for fraud because of the lesser degree of fault for negligence.”’

The appellate court also noted that the Hawaii Supreme Court had criticized the foreseeability rule, in cases not involving accountants, as too broad. Specifically, in those other cases, t h e Supreme Court characterized the foreseeability rule as “endless, because it, like light, travels indefinitely in a vacuum” and does not provide a “socially and judicially acceptable limit on recovery for damages.”lS1 The lower

173 945 P.2d 317 (Ariz. Ct. App. 1996). 174 677 P.2d 1292, 1295 (Ariz. 1984) (an action in which a construction contractor sued

an architect for negligent misrepresentation due to errors contained in a set of plans and specifications).

175 945 P.2d a t 365. 176 Id. a t 366. 177 Kohaia Agric. v. Deloitte & Touche, 949 P.2d 141 (Haw. App. 1997). 17* Id. a t 162-64. 179 Id. a t 160.

Id. at 161. Id. a t 162-63.

2000 I Auditor Liability I 193

appellate court also refused t o adopt an expansive interpretation of section 552.‘82

In early 1998, the Supreme Judicial Court of Massachussetts ruled that the Restatement standard is the applicable law in that state.’83 The court examined the reasonable foreseeability rule, the near-privity rule as enunciated in Credit Alliance, and the Restatement standard.’84 The reasonable foreseeability rule was summarily rejected based on the distinction between the duty owed by a professional t o a third party for personal injuries and that owed a third party for pecuniary loss due t o neg1igen~e.l’~ The court noted that traditional tort principles involving foreseeability of injury are unsuitable for application t o accountants where the client retains control of the financial reporting process and dissemination of the auditor’s report.186 The Credit Alliance rule was not adopted because “linking conduct” o r affirmative action on the part of the accountant ( o r other professional) that demonstrates his or her understanding of the client’s reliance on the professional’s work product is not required by Massachusetts cases involving other professional^.'^^ The Restatement standard was adopted because it comports most closely with the liability standard that has been used in other profes- sional contexts.’88

United Kingdom Prior t o 1964, it was quite onerous for a third party user of financial

statements t o sue an accountant in the United Kingdom for negligent misstatement^.'^^ For example, the court applied the privity doctrine in Candler v. Crane, Christmas & C O . ’ ~ ~ However, Lord Justice Denning wrote a strong dissenting opinion, which later gained wide- spread a p p r ~ v a l . ” ~

Id. at 163. Nycal Corp. v. KF’MG Peat Marwick, 688 N.E.2d 1368 (Mass. 1998).

Id. at 1372-73. lS4 Id. at 1372.

186 Id. la7 Id. at 1376-77. The leading case in Massachusetts on the duty owed by a professional

to third parties on which the court relied is Craig v. Everett M. Brooks Co., 222 N.E.2d 752 (Mass. 1967) (considering negligent surveying performed by a civil engineer/surveyor for a general contractor).

Nycal Corp., supra note 183, a t 1378. lag John G. Fleming, The Negligent Auditor and Shareholders, L.Q. REV., July 1990, at

349. 1 All E.R. 426 (Eng. C.A. 1951).

lgl W.A. Seavey, Candler u. Crane, Christmas & Co.: Negligent Misrepresentation by Accountants, L.Q. REV., Oct. 1951, at 466,468. In his dissenting judgment, Lord Denning suggested three conditions for the creation of a duty of care in tort for professionals. First, the advice must be given by one whose profession it is t o give advice upon which

194 I Vol. 37 /American Business Law Journal

In fact, in Hedley Byrne & Co. v. Heller & Partners Ltd.’” the House of Lords adopted Lord Denning‘s argument in establishing that a third party who had relied t o his detriment on a negligent misstatement could sue despite the absence of privity of ~ o n t r a c t . ” ~ In that case, Heller & Partners Ltd., a merchant banking firm, provided incorrect data in response t o a request from National Provincial Bank for credit information on Easipower Ltd.’% Heller & Partners knew the credit information would be communicated t o a specific unidentified customer of National Provincial Bank. In reliance on the credit information, Hedley Byrne, the unidentified customer, extended credit for services rendered t o Easipower Ltd.IQ5 Easipower then went into liq~idation.”~ The House of Lords ruled that accountants and other professionals owed a duty t o any third person with whom a “special relationship” existed.lQ7 A “special relationship” arose in Hedley Byrne because of a “voluntary assumption of responsibility” by the defendant t o the plaintiff.”’ The law Lords agreed that a “special relationship” includes more than a fiduciary o r contractual relationship;’w however, they failed t o specify criteria for deciding when a “special relationship” arises, and thus, when a duty of care comes into existence.200

others rely in the ordinary course of business. Second, i t must be known to the adviser that the advice would be communicated to the plaintiff in order to induce him to adopt a particular course of action. Third, the advice must be relied upon for t h e purpose of the particular transaction for which i t was known to the advisers t h a t the advice was required. Candler, 1 All E.R. at 441-46. However, Lord Denning did not consider these conditions as necessarily exhaustive criteria for the existence of a duty. Caparo Indus. PLC v. Dickman 1990 App. Cas. 605 (Eng. H.L.).

1964 App. Cas. 465 (Eng. H.L.). Napier, supra note 12, at 111. Hedley Byrne is the first significant inroad in the

United Kingdom into the general denial of the ability of nonclients to sue accountants for negligent misstatements. Bruce Chapman, Limited Auditors’ Liability: Economic Analysis and the Theory of Tort Law, 20 CAN. Bus. L. J. 180,189 (1992).

lg4 Hedley Byrne & Co., 1964 App. Cas. at 467. lg5 I d . at 467-69.

I d . a t 469. ’’’ Chapman, supra note 193, a t 180.

Gillian Morris, The Liability of Professional Advisers: Caparo and After, 1991 J. BUS. L. 36 (1991). ”’ M.F. James, Negligent Misstatement: The Special Relationship, 133 SOLIC. J. 1016

(1989). 2w Ivan F. Ivankovich, Accountants and Third-Party Liability-Back to the Future, 23

OTI-AWA L. REV. 505, 509 (1991). The law Lords did, however, endorse the dissenting judgment of Lord Denning in Candler v. Crane, Christmas & Co.,l All E.R. 426,439 (Eng. C.A.), wherein he stated that accountants owe a duty “to any third person to whom they themselves show the accounts, or to whom they know their employer is going to show the accounts . , , b u t that duty is not] extended still further so as to include strangers of whom they have heard nothing. . . .” Id. at 172.

2000 I Auditor Liability / 195

The clear trend in the law of negligent misstatement immediately after Hedley Byrne was toward expanding the scope of duty t o more third parties.”l In general, the basis of the scope of duty or “special relationship” moved from “voluntary assumption” of responsibility by the defendant t o the third party’s “reasonable reliance” t o “foreseeability.”202 The application of the foreseeability concept gained currency in Anns u. London

Although the facts of Anns do not deal with accountants, the case established a two-prong test of liability for negligent misstatements. The first prong asks whether the defendant’s carelessness may be likely t o injure the suing party:

First, one has to ask whether, as between the alleged wrongdoer and the person who has suffered damage there is a sufficient relationship of proximity or neighbourhood such that, in the reasonable contempla- tion of the former, carelessness on his part may be likely to cause damage to the latter-in which case a prima facie duty of care arises.204

If the first question is answered affirmatively, a duty of care arises. The second prong examines any considerations that could reduce or eliminate the scope of the duty owed: ‘‘IIIt is necessary t o consider whether there are any considerations which ought t o negative, or t o reduce or limit the scope of the duty or the class of persons t o whom it is owed or the damages t o which a breach of it may give rise.”205 Anns is expansive because the balance is shiRed toward liability unless negated by policy considerations, rather than requiring policy t o justify an extension or expansion of liability.206 The practical effect of Anns was t o render almost any sequence of events foreseeable, leaving any limitation on liability t o the vagaries of ad hoc policy assessments freed from precedential constraints?”

In the context of accountants’ liability t o nonclients for negligence, the Anns foreseeability test was applied in JEB Fasteners Ltd. u. Marks Bloom & C O . ~ ’ ~ JEB Fasteners acquired all the shares in a private company having relied on an unqualified audit report produced by accountants Marks Bloom. The financial statements contained

’01 Ivankovich, supra note 200, at 510-12; James, supra note 199, at 1017-19. *02 Ivankovich, supra note 200, at 511; M. F. James, Negligence and the Auditor’s Duty

‘03 1978 App. Cas. 728 (Eng. H.L.). ‘04 Id. at 751-52. 205 Id. ‘06 Ivankovich, supra note 200, at 511; Morris, supra note 198, at 38. ‘07 Ivankovich, supra note 200, at 512. 208 3 All E.R. 289 (Eng. C.A. 1981).

of Care after Caparo, PROF. NEGL., June 1990, at 17, 20.

196 I Vol. 37 I American Business Law Journal

numerous errors and thus, the stock acquired by JEB was o v e r v a l ~ e d . ' ~ ~ Although the auditors were unaware of any specific takeover bidder at the date of the audit, they later became fully aware of t h e identity and progress of the bidder and were in touch with him and supplied relevant information.210 JEB Fasteners sued the auditors for damages claiming the provision of negligent auditing services. The Queen's Bench Division ruled that the appropriate test for establishing a duty of care is whether the auditors knew or reasonably should have known that a person might rely on the audited financial statements for making a decision.'"

The A n n s foreseeability test was also followed in t h e Outer House of Session in Scotland in Twomax L t d . u. Dickson, McFarlane & Robinson.212 The court dealt with three separate legal claims from investors who had bought shares in a closely held company. The firm went into bankruptcy shortly after the investors acquired their shares.'13 As in J E B Fasteners, the defendant accountants were found t o owe a duty of care t o the plaintiff investors.'14 The fact that the accountants knew o r should have known t h a t t h e potential investors might rely on the audited financial statements was deemed sufficient to create proximity, thus giving rise t o a duty of care.

The widening ambit of accountant liability to third parties was arrested i n Caparo Industries PLC u. D i ~ k r n a n . ~ ~ ~ Caparo Industries owned shares in Fidelity PLC for which Caparo was considering a takeover bid.'16 Caparo received a copy of the 1984 financial statements audited by Touche Ross. In reliance on a reported profit of S1.3 million, Caparo made a successful takeover bid for Fidelit~.''~ Subsequently, Caparo discovered that Fidelity had actually lost S460,OOO. Caparo alleged that the audited financial statements had been negligently prepared.'l'

In a unanimous decision, the House of Lords, the highest court of law in the United Kingdom, dismissed the negligence claim. The law

'09 Id. a t 293-97. 'lo I.S. Stephenson, A Time ofRejoicing for Company Auditors, SOLIC. J . , Oct. 1990, at

819. '11 The court reached a conclusion that a n auditor's duty to nonclients could be based

on foreseeability alone. Martin Davies, The Liability of Auditors to Third Parties in Negligence, 14 U.N.S.W. L.J. 171, 174 (1991). '" 1982 Sess. Cas. 113. '13 Id. a t 115-21. '14 Id. a t 122-26. '15 1990 App. Cas. 605 (Eng. H.L.); Philip Marshall, Auditors' Duties: A N a r r o w

'16 Caparo Indus., 1990 App. Cas. at 614-15. Approach, L.M.C.L.Q., Nov. 1990, a t 478; Ivankovich, supra note 200, a t 507.

Id. Id. a t 615-16.

2000 I Auditor Liability I 197

Lords ruled that an auditor of a public company, in the absence of special circumstances, owes no duty of care to an outside investor or an existing shareholder who buys stock in reliance on a statutory audit.’19 In the process, the court fashioned a three-prong test for an auditor’s duty of care.’” First, foreseeability must exist. Second, proximity must be present between the suing party, in this case shareholders, and the accountant. Third, it must be just and reasonable on a policy basis t o impose a duty of care on auditors.221

The House of Lords’ legal analysis focused on “proximity,” the second prong of the test. Although the justices indicated that “proxim- ity” is really just a label, the following conditions must adhere for the proximity prong t o be satisfied: (1) the auditor must know that his or her work product would be communicated t o a known third party o r a known class t o which the third party belongs; (2) the third party suffers damage as a result of relying on the auditor‘s work product; and (3) the work product is used for the purpose for which it was prepared.222 The auditor’s knowledge includes not only actual knowledge but such knowledge as would be attributed t o a reasonable person similarly situated t o the defendant.223 The knowledge requirement must be met at the time a financial statement is ~ r e p a r e d . ” ~ Moreover, in the eyes of the court, the purpose of the audited statements of Fidelity PLC was t o fulfill the auditor’s statutory duty t o the shareholders collectively t o enable them t o monitor management.225 No duty is owed t o stockholders

‘I9 An example of a special circumstance would be a n audit report commissioned on behalf of a plaintiff for a particular purpose. Kevin Nicholson, Third Party Reliance on Negligent Aduice, 40 INT’L. COMP. L.Q. 551 (1991).

John Murphy, Expectation Losses, Negligent Omissions, and the Tortious Duty of Care, CAMBRIDGE L.J., Mar.1996, a t 52. The three-prong test of Caparo received endorsement by the House of Lords in Marc Rich & Co. A-G u. Bishop Rock Marine Co. Ltd., 3 W.L.R. 227 (1995).

221 Ivankovich, supra note 200, a t 514; James, supra note 202, at 17. ’” Ivankovich, supra note 200, at 516-18; Marshall, supra note 215, at 479-80. The

three conditions that must be met to satisfy the proximity element make the Caparo test quite similar to the U.S. Restatement standard. The one aspect of the Caparo test not formally outlined in the Restatement standard is imposing liability from a policy standpoint on a “just and reasonable basis.” Ironically, U S . courts often engage in open policy discussions when addressing the scope of a n accountant’s duty to third parties for negligence. 223 Morris, supra note 198, a t 41. 224 Ivankovich, supra note 200, at 516. 225 I n considering the auditor’s liability for negligence, i t is useful to focus on any

liability arising out of a n audit performed in accordance with the requirements of the Companies Act (the U.K. equivalent of the US. securities laws). An important distinction relates to the individuals or groups t o whom the auditor may be liable. Under the Companies Act, the auditor of a British company reports t o the members of the company, but contracts with the company as a corporate entity. Napier, supra note 12, a t 106-07.

198 / Vol. 37 /American Business Law Journal

as individual shareholders o r third parties.226 Such a narrow purpose was ascribed t o the statutory audit t o avoid “indeterminate liability t o an indeterminate class for an indeterminate time.”227

The third prong of the Caparo test requires the presence of “just and reasonable” grounds t o impose a duty. ” w o commentators suggest that this is a judicial device t o capture the importance of policy consider- ations t o limit the scope of an auditor’s duty t o nonclients.228 “he Caparo court engaged in limited discussion of policy considerations but made it clear that concerns over unbounded liability of auditors would negate any duty owed t o nonclients in many cases. “he lack of significant policy analysis in Caparo is in sharp contrast t o the open policy discussions in many US. cases.229

Since Caparo, U.K. courts have continued t o limit the imposition on auditors of a duty t o nonclients for negligent misstatement^.^^' A case in point is James McNaughton Papers Group Ltd. u. Hicks Anderson & Co.=l The facts involved the plaintZs takeover of its rival, MK, which had been in financial distress. MK’s accountants prepared draft financial statements which were shown t o the plaintiff. Reversing the trial court judge, the English Court of Appeal found that the accoun- tants owed no duty of care t o the plaintiff. In doing so, the court cited Caparo and noted that in England, a “restrictive approach is now adopted t o any extension of the scope of the duty of care beyond the person directly intended by the maker of the statement t o act on it.”232 Lord Justice Neill’s leading opinion in James McNaughton states that the important factors t o consider in addressing the scope of duty question are the purpose for which the information was prepared and communicated, the relationship between the accountant, client, and

226 The Caparo case implies that a n auditor can, however, voluntarily assume liability vis-a-vis a third party, but there needs to be some specific act on the part of the auditor by which liability is assumed, or specific knowledge on the part of the auditor t h a t accounts will be relied on by a nonclient. Napier, supra note 12, a t 107; Lloyd Cheyham & C o . Ltd. v. Littlejohn & Co.,1987 BCLC 303 (Eng. C.A.). For example, the recent Binder Hamlyn case involved a careless acknowledgment of responsibility for a set of audited accounts made to a takeover bidder by the firm’s senior partner. Napier, supra note 12, a t 107.

227 The quoted language is from Justice Cardozo’s famous opinion in Ultramares u. Touche, 174 N.E. 441 (N.Y. 1931).

228 Suzanie Chua, The Auditor’s Liability in Negligence, 1995 J. BUS. L. 15, 16 (1995); Ivankovich, supra note 200, at 518-19.

See Raritan River Steel v. Cherry, 367 S.E.2d 609 (N.C. 1988); Bily v. Arthur Young & Co., 834 P.2d 745 (Cal. 1992).

230 Napier, supra note 12, at 107, 110-12; Chua, supra note 228, a t 16-19. 231 1 All E.R. 134 (Eng. C.A.1990). 232 Id. a t 143.

2000 I Auditor Liability I 199

third party, the size of the class t o which the third party belongs, and the extent of the third party’s reliance.233

One of the most significant post-Caparo decisions is Morgan Crucible Co. PLC v. Hill Samuel Bank Ltd.234 In this case, the plaintiff sued a target firm’s auditors and investment bankers. First Castle Electronics, the takeover target, and its investment bankers released a circular stating that an initial hostile takeover bid was too low because it did not place suflicient value on a projected profit rise. First Castle’s accountants had issued a letter, contained in the circular, stating that the forecast had been prepared in accordance with First Castle’s accounting policies. The acquiring firm raised its offer price (the “second takeover bid”) but later claimed the profit forecast was negligently prepared. The English Court of Appeal ruled, as in Caparo, that the accountants did not owe a duty of care to the plaintiff before the first takeover bid.235 In Caparo, all the accountant’s representations relied on by the plaintiff had been made before an identified bidder had emerged. Although the English Court of Appeal did not decide that a duty of care arose with regard t o the second takeover bid, it indicated such a claim was not bound t o The reasons were that it was foreseeable the plaintiff would suffer a loss if the profit forecast was inaccurate, the defendant accountants knew the identity of the plaintiff and intended the plaintiff t o rely, and much of the information in the profit forecast was available only t o the defendantz3’ Any potential duty owed by the accountants in Morgan Crucible t o the identified nonclient for negligent misstatements is restrictive in scope and consistent with the holding in C a p a r ~ . ~ ~ ~

In sum, the Caparo decision narrowed the scope of accountant liability t o third parties for negligent misstatements. The auditor of a public firm, absent special circumstances, does not owe a duty of care t o an outside investor or an existing shareholder who buys stock in reliance on audited financial statements. Accountant liability for negligent misstatements is confined to cases where it can be established

233 Id. at 14348. According to one commentator, Caparo adopts an “end and aim rule” for negligent misstatement cases: liability should be imposed only where damage is incurred in transactions related to the purpose for which the statement or information is provided. B. FELDTHUSEN, ECONOMIC NEGLIGENCE: THE RECOVERY OF PURE ECONOMIC LOSS 199-280 (2d ed. 1989). One major policy consideration in favor of limiting liability is the chilling effect on the free flow of commercial information upon which a capitalist economy depends. The Caparo decision does not mention this consideration.

234 1 All E.R. 148 (Eng. C.A. 1991). 235 Id. at 153-57.

Id. at 154. Id. at 160.

238 The facts in Caparo and Morgan Crucible are, however, distinguishable. Morris, supra note 198, at 45-47; Chua, supra note 228, at 17-18.

200 I Vol. 37 I American Business Law Journal

that the accountant knew his work product would be communicated t o a nonclient, either individually o r as a member of a limited class, and the third party would rely on the work product i n connection with a particular t r a n ~ a c t i o n . ~ ’ These conditions are, however, not conclusive or exclusive.

Canada

The leading Canadian case on auditor liability t o third parties immediately following Hedley Byrne is the Supreme Court of Canada’s ruling in Haig u. B a n ~ f o r d . ~ ~ ~ In that case, the defendant accountants prepared audited financial statements of Scholler Furniture and Fixtures at the latter’s request. The accountants knew that the audited financial statements would be provided to the Saskatchewan Economic Development Corporation (SEDCO) and a n unidentified outside investor (who turned out t o be HaigLz4’ At the time of the audit of the financial statements, Haig was not personally known to Scholler or the accountants. In reliance on negligently audited financial statements, SEDCO loaned $20,000 to Scholler and Haig invested $20,000 in Scholler. Scholler Furniture ultimately ceased doing business and was liq~idated.’~’

The most important issue facing the court was whether the defendant accountants owed a duty of care to Haig. The court outlined three possible legal tests which could be applied t o invoke a duty of care. The possible tests were: (1) foreseeability of the use of and reliance on the financial statements by the p l a i n t i e (2) actual knowledge of the limited class of users who will use and rely on the financial statements; and (3) actual knowledge of the specific plaintiff who will rely on and use the financial statement^.^^ The Supreme Court of Canada adopted t h e “limited class of users” test and rejected the “actual knowledge”

In reaching t h a t decision, one commentator suggests t h a t the

239 James, supra note 202, a t 21. 240 I19771 1 S.C.R. 466.

u2 Id. a t 466-67. 243 I d . a t 476-77. 244 The first of the three tests is based on “foresight”:

Id.

what the reasonable man would expect in the circumstances, the familiar test of responsibility for negligence where physical harm to a person or his property is involved. The remaining tests rely upon “knowledge”: actual appreciation of the facts and awareness that a specific consequence will occur. G.H.L. Fridman, Negligent Misrepresentation: A Postcript, 22 MCGILL L.J. 649, 652 (1976).

2000 I Auditor Liability I 2 0 1

purpose for which the statements were made by the accountants was perhaps the most important factor taken into ~onsideration.2~~

Significantly, the court stated that no distinction exists between the case in which the accountant delivers information directly t o the plaintiff at the client’s request and the situation in which the accoun- tant delivers information t o the client who, with the accountant’s knowledge, passes it t o unidentified members of a limited class for use in a transaction of which the accountant is aware.24s Another important aspect of the case with regard t o expansionist liability is the fact that the Supreme Court left open the possibility of application of the “foreseeability It is the spectre of indeterminate liability invoked by the foreseeability test that has been of grave concern t o the Canadian accounting profession. The Haig decision is the primary reason one leading Canadian legal commentator has written that the “ultimate destination will be liability [of public accountants] t o all reasonably foreseeable users of such [financial] information.”248

Since the decision in Huig, Canadian courts have continued a pattern of establishing a broad duty of care in auditor negligence cases.249 One reflection of this pattern is the British Columbia Supreme Court decision in Surrey Credit Union u. W i Z l s ~ n . ~ ~ ~ This case involved

245 The majority opinion indicates t h a t the accountants knew that the financial statements were being prepared for the very purpose of influencing, in addition to the bank and SEDCO, a limited number of potential investors. The names of the potential investors were not material to the accountants. The nature of the intended transactions is the important factor that delineates liability. Daniel Ish, Liability Arising Out of Negligent Misrepresentation, 42 SASK. L.R. 147, 151 (1977).

246 Arguably, this proposition goes beyond the reasoning in Hedley Byrne. The Supreme Court decided that even though the accountants could not have known of t h e existence and circumstances of Haig when they did their work, they nevertheless owed him a duty of care. At the heart of the issue, as the matter was concluded in Haig, is not the mere extension of third party liability in particular circumstances, but rather the definition of the precise class of persons t o whom such a duty of care may be owed. It is one thing, in a relatively simple situation, to identify a small and discreet group of individuals who are or can be identified as relying directly on the judgments of professionals with whom they have no direct contractual or fiduciary relationship. I t is another question altogether, in more complex cases, to contemplate the dimensions of the liability for negligence which may arise where it is known that the opinions and certificates of a n accountant or other professional are to be widely disseminated and relied upon by a broad class of persons. R.D. Brown, Haig u. Barnford, 15 OSGOODE HALL L.J. 474,481-82 (1977).

247 Ish, supra note 245, at 152-53. 248 A. M. LINDEN, CANADIAN TORT LAW (4th ed. 1988). 249 Bruce Cheffins, Auditor’s Liability in the House of Lords: A Signal Canadian Courts

250 [1990] 73 D.L.R. (4th) 207. The circumstances surrounding the Surrey Credit Union case demonstrate that high litigation costs might arise from auditors having a broad legal duty of care. The case must have generated substantial legal expenses because it consumed over 50 days of trial time. Cheffins, supra note 249, at 132.

Should FOLLOW, 18 CAN. BUS. L. J. 118, 131-33 (1991).

202 I Vol. 37 I American Business Law Journal

the sale of bonds t o the public by the client firm. The auditor consented t o the release of an unqualified audit report as part of the bond offer. Despite meager evidence of reliance on the financial statements by Surrey Credit Union, the court held that the auditor owed a duty of care t o Surrey.251 Although a large class of persons could obtain the prospec- tus, the court decided it was not too large and unidentifiable a class for a duty of care t o arise.252

Also, in Kripps u. Touche Ross & C O . , ’ ~ ~ unsecured bonds were sold t o the public through a prospectus containing an unqualified audit report asserting compliance with generally accepted accounting principles (GAAP). The auditors consented t o having the prospectus contain their work product which included the financial statements that failed t o provide for certain expected losses. Relying on Caparo, the auditors argued that they had no duty of care t o the plaintiff because the audited statements were not provided for a specific transaction o r t o a known o r identifiable group or class of persons.254 The court held that the auditor owed a duty of care to bond purchasers by taking a broad view of the purpose of audited financial statements and the boundaries of the class of intended users.255

The expansionist trend in Canadian auditor liability t o nonclients for negligence suffered a reversal in Hercules Management Ltd. u. Ernst & Young.256 Plaintiffs were shareholders in Northguard Acceptance Ltd. and Northguard Holdings Ltd., companies engaged in commercial and real estate lending.257 Ernst & Young (E&Y) was originally hired by the Northguard firms t o render annual financial statement audits. In 1984, both Northguard companies went into receivership. In 1988, a number of shareholders in the Northguard firms brought suit against E&Y contending that the 1980-82 audit reports, on which they had relied, were prepared negligentl~.’~’

The Supreme Court of Canada, in a unanimous decision, dismissed the negligence claim. The court reached its finding by application of the

The evidence at trial indicated that a Surrey Credit Union director, after examining the audited financial statements of Northland Bank, the auditor’s client and bond-issuing firm, made a n oral report t o the Surrey board about Northland’s financial status. The board itself and the credit union’s officers did not examine the financial statements before deciding to purchase Northland‘s bonds. The plaintiffs damages were estimated at over $7 million. Cheftins, supra note 249, a t 133. ”’ Ivankovich, supra note 200, at 525; Surrey Credit Union, 73 D.L.R. (4th) at 212. 253 [1994] 22 B.C.L.R. (2d) 86.

Peter Wardle & Doris James, Professional Negligence : Has Hercules Given Judges More Discretion? INT’L. COMM. LITIG., Feb. 1998, at 32, 34. ‘5 Id. 2s6 [1997] 2 S.C.R. 165. 257 Id. at 165-66.

I d .

2000 I Auditor Liability I 2 0 3

two-pronged AnnslKamloops test.259 The first part of the test (or “at first sight” test) examines proximity, that is, whether the wrongdoer’s carelessness might reasonably cause damage t o the person If this question is answered affirmatively, part two of the test analyzes policy considerations that could curtail o r eliminate any duty of care owed by the accountant t o the plaintiff.261

Sigmficantly, the court endorsed the use of the AnnslKamloops test for all types of negligent misrepresentation actions regardless of the type of economic loss or the nature of the defendant.262 The court rejected the idea that accountants should be subjected t o a broader range of liability than other professionals?63 The majority saw the need for some control device, such as the second prong of the AnnslKamloops test, t o combat the danger of indeterminate liability for accountants and others .264

With regard t o the first prong of the test, accountants and their lawyers should note that the term “proximity” means that the profes- sional has an obligation t o be mindful of the nonclient’s “legitimate interests.”265 In many instances, according t o the court, proximity has just been a label, so it was incumbent upon the majority t o give it some meaning. Thus, proximity can be said t o exist when the accountant: (1) should reasonably foresee that a third party will rely on the accoun- tant’s representation; and (2) reliance by the third party is reasonable.266 Both criteria must be met for a duty of care t o arise.

259 Anns v. Merton London Borough Council, 1978 App. Cas. 728 (Eng. H.L.); Kamloops

260 Hercules Managements Ltd., 2 S.C.R. a t 167-70. v. City of Nielson 119841 2 S.C.R. 2; see supra notes 203-07 and accompanying text.

Id. a t 175-80; Michael Deturbide, Liability ofduditors, CAN. BAR REV., MarlJune, 1998, a t 262.

The two-stage approach has been applied by the Supreme Court of Canada in the context of various types of negligence actions, including cases involving claims for different forms of economic loss. I t was implicitly endorsed in the context of a n action in negligent misrepresentation in Edgeworth Constr. Ltd. u. N.D. Lea & Assoc. Ltd., [1993] 3 S.C.R. 206. 263 The court explicitly noted that to create a “pocket” of negligent misrepresentation

cases in which the existence of a duty of care is determined differently from other negligence cases would be incorrect. This indicates that economic losses stemming from negligently misstated financial statements will be considered by courts using the same general framework as other cases involving economic losses. Accountants should not be treated any differently than other professionals such as lawyers, architects, etc. Nicholas Rafferty, Recent Professional Negligence Decisions from the Supreme Court of Canada, 14 PROF. NEGL. 72, 73 (1998).

264 Zd. 265 Hercules Managements Ltd., 2 S.C.R. at 179-81.

Id. In negligent misrepresentation actions against accountants, the plaintiffs claim stems from detrimental reliance on the accountant’s statements. As the court aptly noted, however, mere reliance on an accountant’s representation will not, in all

204 I Vol. 37 I American Business Law Journal

Even if the defendant accountant knows that the plaintiff is relying on information provided by him o r her, no duty of care will arise unless i t is reasonable for the plaintiff t o rely under the circumstances.267 Moreover, the requirement of reasonable reliance does not abandon the “basic tenets underlying the first branch of the AnnslKamloops formula.”268 The court also indicated t h a t the prima facie duty of care o r “at first sight” test in many negligent misrepresentation cases against auditors would be satisfied because most third party users are reasonably foreseeable and rely rea~onably.’~’

The crucial consideration, addressed in the second part of the test, is policy factors that could serve t o limit o r eliminate any duty estab- lished. The court indicated that one fundamental policy consideration is t h a t the alleged wrongdoer should not be exposed t o “liability in an indeterminate amount for an indeterminate time t o a n indeterminate class.” The majority opinion engaged in a long discussion t o articulate the undesirable consequences of imposing limitless liability on auditors.270 Some of the consequences would include increased liability insurance premiums, a decrease in the supply of accounting services, increased cost of accounting services, and a negative impact on the timeliness of attested business and financial information (as auditors would expend more time in the performance of services t o reduce the risk of l i t i g a t i ~ n ) . ’ ~ ~ The court also noted t h a t boundless liability promotes “free ridership” on the part of relying third parties who lose their incentive t o exercise vigilance. Another consequence would be a serious logjam of court cases.272 In the final analysis, the court

circumstances, be reasonable. Id. “’ Some Canadian legal commentators urge that foreseeability of harm cannot be the

sole determinant of liability. They argue as follows. The predication of liability upon pure foreseeability of economic harm is incompatible with a competitive economic system. A free market system treats many types of losses as legitimate and even beneficial; the economically inefficient deserve to incur certain losses. Once foreseeability of harm is established, to answer the duty question in any given situation involves a n inquiry into two broad areas. First, does it make economic sense to shift this type of loss? Second, what do community expectations have to say about whether the plaintiff is reasonably entitled to rely upon the defendant to protect him or her from harm in the particular situation? Such questions are unavoidable and a r e matters of policy. Earl Cherniak & Kirk Stevens, Two Steps Forward or One Step Back? Anns at the Crossroads in Canada, 20 CAN. BUS. L. J. 164, 176 (1992). This argument points out the overriding importance of the second prong of the AnnslKamloops test. ’“ Hercules Managements Ltd., 2 S.C.R. a t 179-81. ’‘’ I d . a t 182-83. 270 Id. a t 182-84.

The undesirable consequences cited by the court are outlined in Chefins, supra note 249, a t 125-27, and Cherniak & Stevens, supra note 267, a t 170-71.

272 Hercules Managements Ltd., 2 S.C.R. a t 182-84.

2000 I Auditor Liability 1205

indicated that concerns over indeterminate liability will serve t o negate any duty owed t o nonclients in most cases.273

Some cases will arise, however, where policy considerations surrounding indeterminate liability will not be a pertinent consider- a t i 0 n . 2 ~ ~ For example, if the accountant knows the identity of the nonclient (or a class of third parties) and the accountant’s representa- tions are used for the specific purpose or transaction for which they were made, policy considerations will not be important because the scope of liability can be readily circumscribed.275 In the case of a known class of third party users, this situation is quite similar t o the U.S. Restatement standard.

On the facts of Hercules Managements, the court negated any duty of care. The court reasoned that the plaintiffs did not rely on the audited financial statements for the purpose for which they were prepared.276 In the court’s view, the purpose of audited financial statements is t o assist shareholders as a group in overseeing the corporation’s management, not t o assist individual shareholders in making personal investment decisions. In reaching this conclusion, the Hercules court cited the reasoning in Caparo.

In short, after the Huig holding, Canadian courts continued t o slowly widen the ambit of an accountant’s duty t o third parties for negligent misstatements. This expansionist trend was reversed o r slowed by the 1997 decision of the Supreme Court of Canada in Hercules Managements. That decision requires the application of the two- pronged A n n s / KamZoops test t o cases involving negligent misstate- ments by auditors t o nonclients. Concerns over indeterminate liability will negate any duty owed t o third parties by accountants in most cases.

Australia

In 1997, the High Court of Australia, the highest court of law in Australia, issued the first federal ruling on auditor liability t o nonclients for negligence in Esanda Finance Corp. Ltd. v. Peat Marwick

ns Deturbide, supra note 261, at 262-63. 274 Rafferty, supra note 263, at 72-73. 275 Hercules Managements Ltd., 2 S.C.R. at 182-85. The majority opinion, written by

Justice LaForest, points out that Haig is a n example of a situation where the auditors were found to owe a duty of care because concerns over indeterminate liability did not arise. The very end and aim of the financial statements prepared by the accountants in Haig was to secure additional financing for Scholler from a Saskatchewan government agency and a n equity investor. The financial statements were required primarily for these third parties and only collaterally for use by the company. Id.

276 I d . a t 186-88. Thus, even if the specific identity or class of potential plaintiffs is known to a defendant, use of the defendant accountant’s work product for a purpose o r transaction other than that for which i t was prepared or intended could still lead to indeterminate liability. Id.

206 I Vol. 37 I American Business Law Journal

hunger ford^.'^^ The decision clarifies Australian law, which had been very uncertain due to conflicting opinions among state jurisdiction^.'^^ A better understanding of this case and the significance of its holding are obtained by a n analysis of numerous Australian cases on negligent misstatements in general and auditor liability to third parties.

Following the Hedley Byrne case in the United Kingdom, the first major negligence misstatement decision in Australia was Mutual Life & Citizens Assurance Co. Ltd. u. E ~ a t t . ' ~ ~ This case did not involve auditor liability t o third parties but established the first legal test applied t o decide when one owes a duty of care to a third party for negligent misinformation. In Euatt, the High Court of Australia ruled t h a t a person owes a duty of care to another when t h e one providing information realizes, or ought to realize, that he o r she is being trusted to provide information that will be acted upon by that third party.ao I n the oft-quoted words of Chief Justice Barwick:

w h e n e v e r a person gives information or advice to another, whether that advice is actively sought or merely accepted by that other upon a serious matter, . . . and the relationship of the parties arising out of the circumstances is such that . . . the speaker realises o r ought to realise that he is being trusted . . . to give the best of his information or advice as a basis for action. . . and it is reasonable. . . for the other party. . . to act upon that information . . . the speaker comes under a duty of care.281

The High Court was mainly concerned with information provided t o a third party in response to a request for it because the Euatt facts focused on a direct request from a third party.282 Thus, Evatt is not a n exclusive test of liability for negligent misstatements to third parties.283

Liability for negligent misstatements by a professional appeared to expand somewhat in the ruling of the Supreme Court of New South Wales in BT Australia Ltd. u. Raine & Horne Proprietary Ltd.284 The

277 (1997) 71 A.L.J.R. 448. 276 Andrew Greinke & Gregory Shailer, Auditing the Auditors B the Esanda Case,

''' (1968) 122 C.L.R. 556 (Austl.). "O Id. at 571.

282 Esanda Fin. Corp. L t d . , 71 A.L.J.R. a t 455-57. The duty of care identified and described by Chief Justice Barwick in Euatt was later upheld in Shaddock & Assoc. Proprietary Ltd. u. Parrarnatta City Council, (1981) 150 C.L.R. 225. This case was also concerned with the duty owed in relation to information or advice provided in response to a request. 263 Kevin Nicholson, Third Party Reliance on Negligent Advice, 40 INT'L. COMP. L.Q. 551,

181 (1983) 3 N.S.W.L.R. 221.

AUSTL. ACCT., Aug. 1997, at 16.

Id. at 572-73.

567-68 (1991).

2000 I Auditor Liability / 207

case provides some support for the notion that a duty is owed t o a known third party, even if the defendant had no intent t o induce reliance by the third party.285 In that case, the plaintiffs were holders of units in an investment trust. The trustee was obligated t o obtain periodic valuations of the trust assets t o establish the value of the individual units of the trust. The defendants were real estate apprais- ers hired by the trustee t o value certain assets. On one occasion, the appraisers committed a mathematical error which caused an overvalu- ation of a major trust asset. Existing investment trust unit holders who retained or redeemed their units reaped a windfall at the expense of new unit purchasers. The trustee, not the unit owners and purchasers, relied on the property valuation.

The Supreme Court of New South Wales decided that the unit purchasers (“passive third parties”) were owed a duty of care by the real estate appraisers.2s6 The issue of duty of care was treated as an extension of the holding in Hedley B y r ~ z e . ~ ~ ’ Moreover, the majority opinion referred t o JEB Fasteners without any apparent disapproval.288 The unit purchasers were deemed by the court t o be unidentified members of a limited and known class.289 Furthermore, the court found that it was apparent from information available t o the defendant appraisers that the latter‘s work product would be used by the trustee in fidfilling his duties t o the limited, known class of unit owners.2w The fact that the plaintiffs’ reliance was vicarious made no differen~e.~” The professional’s scope of duty here is similar t o that under the U.S. Restatement standard because the reliance of the third party unit owners, though vicarious, was known t o the real estate appraisers at the time the services were rendered.

The expanding ambit of liability for negligent misstatements was applied t o auditors in Columbia Coffee & Tea Party Ltd. v. C h ~ r c h i l l . ~ ~ ~ In that case, the Supreme Court of New South Wales held that the audit manual of an auditing firm, which stated that nonclients will read and rely on the firm’s audit reports, created a duty in favor of a purchaser of common shares who claimed t o have relied on an audit

285 Davies, supra note 211, at 171, 184. 286 BTAustralia Ltd., 3 N.S.W.L.R. at 233. 287 Nicholson, supra note 283, at 573. 288 1982 Sess. Cas. 113. In JEB Fasteners, the Queen’s Bench Division ruled that an

auditor’s duty to nonclients could be based on foreseeability alone. Davies, supra note 211, at 171,174; see supra notes 208-11 and accompanying text. ’*’ Nicholson, supra note 283, at 573-74. 290 BTAustraZia Ltd., 3 N.S.W.L.R. at 229-31.

Nicholson, supra note 283, at 574. ’’’ (1992) 29 N.S.W.L.R. 141.

208 / Vol. 37 /American Business Law Journal

report and suffered economic This case applies t o auditors the proposition in Evatt that a defendant accountant knew or ought t o have known that the nonclient would rely on the auditor’s report. One Australian legal commentator views the approach in Columbia Coffee as requiring reasonable foreseeability of injury plus proximity of relationship between the accountant and nonclient for a duty to The reasoning in Columbia Coffee is broader in scope than the U.S. Restatement standard but narrower in scope than the reasonable foreseeability

The retrenchment toward a narrower scope of accountant liability began in R. Lowe Lippman Figdor & Franck v. AGC (Advances) Ltd.296 In that case, the plaintiff was a finance company that advanced funds t o a firm (Lyvetta) in reliance on a negligently prepared audit report. The auditors were aware that the plaintiff was a major creditor and probably would receive a copy of the audit report. Prior t o the availabil- ity of the audited financial statements, the plaintiff creditor communi- cated t o the auditors by telephone that it required the financial statements for review p~rposes.’?~ The Supreme Court of Victoria held that the mere act of supplying a signed report setting forth Lyvetta’s financial position, knowing that Lyvetta would provide the financial statements t o the plaintiff finance company, was insufficient t o establish a duty of care.’”

A duty of care did not arise because the auditors lacked the intent t o induce reliance by plaintiff AGC o r a class of persons t o which the plaintiff belongs.299 The court found that the ”only intention on the

293 I d . a t 173-75. 294 The composite phrase ”knew or ought to have known” is often used but not with

much precision. The phrase is used as if it were roughly synonymous with the phrase “reasonably foreseeable.” When used with precision the words signify a kind of half-way house between knowledge and reasonable foreseeability. Davies, supra note 211, at 186.

295 Minnesota and Texas both have adopted liberal interpretations of the Restatement standard. In Bonhiuer u. Gruff; 248 N.W.2d 291 (Minn. 1976), the court stated that “there is no logical justification for denying relief. . . based upon the ’limited‘ or ‘unlimited‘ nature . . . of a class, or whether the reliance of t h e particular injured parties was not ‘specifically foreseeable.”’ Id. a t 302.

In Blue Bell v. Peat, Marwick, Mitchell & Co., 715 S.W.2d 408 (Tex. Civ. App. 1986), the court stated that they “adopt[ed] a less restrictive interpretation” of the Restatement standard. The court concluded that “if a n accountant preparing audited financial statements knows or should know that such statements will be relied upon . . . the accountant may be liable . . . .“ Id. a t 412.

296 (1992) 2 V.R. 671. 297 I d . a t 672-78.

I d . at 682-83. 299 I d . a t 679. The court’s reasoning relied to some extent on the holding in Sari

Sebastian Party Ltd. v. The Minister (1986) 162 C.L.R. 340. In that case, t h e plaintiffs were developers who sued a municipal council and a planning authority for negligent

2000 I Auditor Liability I 2 0 9

auditors’ part in making their report established in this case . . . is an intention t o discharge their statutory and contractual duties as Lyvetta’s auditors by making the report required by the Companies A c ~ s . ” ~ ” The Victoria court’s approach in focusing on the auditor’s statutory role is analogous t o the reasoning applied in Caparo.

Finally, in 1997, the High Court of Australia ruled directly on accountant liability t o nonclients for negligence in Esanda Finance Corp. Ltd u. Peat Marwick hunger ford^.^'^ The High Court endorsed the reasoning applied in R. Lowe Lippman and continued the trend toward a contraction of accountant liability t o third parties for negligent misstatement^.^^^ The High Court itself noted that it used t o be a widely accepted view in Australia that reasonable foreseeability of risk of economic harm was sufficient t o create a duty of care.3o3 In the case at bar, Esanda Finance provided credit t o Excel Finance Corp. and a number of its subsidiaries. Excel guaranteed all debt financing provided by Esanda. Excel went into bankruptcy. Esanda filed suit against Peat Marwick claiming losses as a result of a negligent audit report for the year ended June 30,1989.

In dismissing Esanda’s negligence claim, the High Court unani- mously held that mere reasonable foreseeability that third parties might rely on audited financial statements was insufficient t o give rise t o a duty of care.304 The court reasoned that a duty of care imposed by

misstatements contained in documents dealing with a planning scheme to redevelop a suburban area in Sydney. The Sun Sebastian court held that a duty of care to avoid a negligent misstatement to a third party or class to which the third party belongs arises when the defendant intends the third party or class members to rely on the misstatement or reasonable reliance by the third party or class member is indicated by other circumstances. Angus Corbett, The Rationale for the Recovery of Economic Loss in Negligence and the Problem OfAuditors’Liability, 19 MELB. U. L. REV. 814,865 (1994); Davies, supra note 211, a t 183-85. 300 R. Lowe Lippman, 2 V.C.R. at 682. Following Sun Sebastian, the court indicated

that an intention on the part of the auditor t o induce the plaintiff, or a class to which the plaintiff belongs, to rely on the report need not always exist for a duty t o arise. There must be, however, other circumstances present sufficient to impose a duty of care. Id. at 679. One such circumstance may be where the auditor is aware that a particular party will use the auditor’s report for a specific purpose in an identified transaction. Corbett, supra note 299, at 865. The suggested circumstance is quite similar to the conditions set forth in the accountant privity statutes passed by eight American states. See supra notes 58 & 59. 301 (1997) 71 A.L.J.R. 448. 302 J a n e Swanton & Barbara McDonald, Common Law-The Reach of the Tort of

Negligence, AUSTL. L. J., Nov. 1997, at 822,823. A considerable burden was lifted from auditors with the Esanda decision. It signals a more conservative approach by Australian courts. Greinke & Shailer, supra note 278, at 16.

’03 71 A.L.J.R. at 465-68. For example, see STONE, PRECEDENT AND THE LAW 254-55 (1985) and TRINDADE & CANE, THE LAW OF TORTS IN AUSTRALIA 279 (1st ed. 1985).

304 Swanton & McDonald, supra note 302, at 822.

210 I Vol. 37 I American Business Law Journal

reference t o the mere foreseeability of harm in the form of financial loss would extend liability beyond acceptable bounds.305 Financial loss occurs as a result of legitimate commercial competition and commercial activity would be stifled if the law were t o impose a duty of care t o avoid that The court added that if the circumstances giving rise t o a duty of care were not circumscribed, the extent of any liability imposed on accountants would often be virtually without limit, both in terms of persons and amount.307 Thus, Australian law requires both foreseeability of harm and a special relationship amounting t o a “relationship of proximity“ for a duty t o arise in cases of pure economic loss.

The relationship of proximity can be established in any number of ways. However, mere knowledge by an auditor that his o r her work product will be communicated t o a nonclient is insufficient t o create a duty of care.3o8 Also, the High Court refused t o endorse the principle that liability of auditors should extend t o members of a class whom the auditor knows o r ought t o know will rely on the audit.309 A duty of care t o a nonclient, absent an auditor‘s response t o a request for information from a specific third party, is difficult t o establish unless the auditor intends t o induce reliance on his o r her work product by the nonclient o r a limited class t o which the nonclient belongs.310 The purpose for which the accountant’s work product is provided can be crucial t o the issue of intent t o induce reliance.311 However, a lack of intent t o induce reliance is not necessarily fatal t o establishing a duty of care because other factors may exist that establish proximity.312

305 Esanda Finance, 71 A.L.J.R. at 455-56. 306 Id. 307 I d . 308 Id. at 468-70. 309 Id. at 471-75. 310 One Australian legal commentator has argued that it will be seldom, if ever, that a n

auditor will audit the accounts intending to induce third parties to rely on them. The auditor will not usually have any interest in inducing third parties to rely on t h e audited information, or any reason for wanting third parties t o so rely. Davies, supra note 211, a t 184. By focusing on the intention of the defendant auditor the Esanda court may have stated its support for a test so restrictive that it will hardly ever be satisfied.

311 If the accountant knows the purpose for which information is supplied to a nonclient and the information is in fact used for t h a t purpose (e.g., a specific transaction) then the third party’s reliance is considered reasonable. Esanda Finance, 71 A.L.J.R. at 465-70. Reasonable reliance is the cornerstone of liability for negligent misstatement. Sun Sebastian, 162 C.L.R. a t 357.

”* Esanda Finance, 71 ALJR a t 469-71. Because the decision was concerned with whether the plaintiffs pleadings disclosed a good cause of action, it was not necessary for the court to specify what factors would give rise to a duty of care absent a clear intent on the part of the auditor to induce reliance by a nonclient. Swanton & McDonald, supra note 302, a t 822-23. Certain factors may be identified, however, by the court‘s emphasis

2000 I Auditor Liability I211

Besides analyzing proximity, the High Court went on t o outline numerous policy factors that should be weighed in deciding whether an auditor owes a duty t o a nonclient. These factors include:

1) a duty on auditors in favor of nonclients would probably reduce the supply of accounting services and may also reduce the demand for services when audit fees rise t o cover the cost of liability insurance;

2) the inability of auditors t o obtain liability insurance; 3) a reduction in the standard of care due t o cost-cutting measures implemented t o keep audit fees competitive; 4) potential adverse effects on the administration of justice in the

form of lengthy court hearings clogging the court system if a duty t o a large number of third party users is recognized;

5 ) many potential plaintiffs are sophisticated investors and creditors who have the means t o take steps t o avoid the risk of loss;

6) the cost of the risk of accountants’ negligence is likely t o be placed on the public when all is said and done. Arguably, investors and creditors as a class are more efficient loss absorbers and spreaders than auditors;

7) creditors and shareholders already have an indirect legal remedy against auditors in many instances in the form of an action by the receiver o r bankruptcy trustee on behalf of the audited client;

8) in many cases, the client’s conduct is the primary cause of the nonclient’s loss; the auditor’s role is secondary;

9) the need for the third party t o prove reliance on an audit report is often problematical when it is likely that the nonclient was influenced by a myriad of factors; and

10) the imposition of a duty of care under the circumstances in the present case would amount t o the creation of an unlimited guarantee in favor of nonclients for which auditors receive no payment.313

Finally, the High Court overruled the holding in Columbia Coffee t o indicate that Australian courts should apply a narrow scope of liability in negligent misstatement cases involving accountants. Many aspects of the Esanda ruling are consistent with the Caparo decision except that the Esanda court paid much more attention t o discussing various policy factors that weigh on the scope of an accountant’s duty t o

on their absence from the pleadings: 1) the maker of a statement may possess skill and competence in the area which is the subject of the communication; 2) the maker of a statement has an interest in the recipient of the statement acting in a certain way; or 3) the provider of information may warrant the correctness of the information supplied to a third party.

‘13 Esanda Finance, 71 A.L.J.R. at 469-74.

212 I Vol. 37 I American Business Law Journal

nonclients for negligence.314 This case indicates a clear trend in Australian law toward restriction of auditor liability t o third parties for negligent misstatements.

New Zealand

The leading case on accountant liability t o nonclients after Hedley Byrne is the New Zealand Court of Appeal decision in Scott Group L t d . u. M a ~ f a r l a n e . ~ ~ ~ Scott Group Ltd., the plaintiff, had been interested in acquiring John Duthie Holdings Ltd., a public company. Scott Group made a takeover offer in reliance on the 1970 audited financial statements. The auditors had no knowledge t h a t the audited financial statements would be relied upon at the time of the audit. The first takeover offer made by Scott Group was declined. After acceptance of t h e second takeover offer, new consolidated financial statements for Duthie were prepared. The preparation of the new financial statements indicated that Duthie's assets had been overstated by $38,000. Scott Group sued the auditors for negligence.

On appeal, the main issue of contention was whether the auditors owed a duty of care t o Scott Group, about whom they knew nothing when the audit report was signed.316 Despite the auditor's lack of awareness o r knowledge concerning the plaintiffs reliance, the court held that a duty of care was owed to Scott Group because i t was reasonably foreseeable that someone other than the client might rely on t h e auditor's work produ~t.3~' Justice Woodhouse emphasized foreseeability as the relevant test for the creation of a relationship of proximity:

So I think that when auditors deliberately undertake to provide their formal report upon the accounts of a public company they must be taken t o have accepted not merely a direct responsibility to the shareholders but a further duty to those persons whom they can reasonably foresee will need to use and rely upon them when dealing with the company o r its members in significant matters affecting the company's assets and b ~ s i n e s s . ~ "

The majority i n the case based their interpretation of a n accountant's scope of duty to nonclients upon the opinion of Lord Wilberforce in Anns v. Merton London Borough Council.319 In particular, the existence of a

314 Greinke & Shailer, supra note 278, a t 16. [19781 1 N.Z.L.R. 553. Iain Johnston, Negligent Mis-Statement-Auditor's Liability to Third Parties for

Careless Report on Company's Annual Accounts, 8 N.Z.U.L. REV. 176 (1978). '17 Davies, supra note 211, at 174.

Scott Group L t d . , 1 N.Z.L.R. at 575. 1978 App. Cas. 728 (Eng. H.L.); see supra notes 203-07 and accompanying text.

2000 I Auditor Liability 1213

proximate relationship between the auditor and nonclient, and thus, the creation of a duty of care, was based on satisfaction of the first prong of the two-stage Anns test.320 Within the following decade courts in the United Kingdom, Canada, and Australia rejected this interpretation of the A n n s two-stage test.321

New Zealand adhered to the expansive reasonable foreseeability rule until early 1999. In Boyd Knight u. P ~ r d u e , ~ ' ~ the New Zealand Court of Appeal impliedly overruled the holding in Scott Group Ltd.323 In Boyd Knight, a group of investors purchased secured bonds from Burbery Mortgage Finance & Savings, Ltd., between July 1 and August 10, 1988.324 The purchases were made in response t o an offer in a prospectus that contained an audit report signed by Boyd Knight, a firm of chartered accountants.325 Burbery ultimately failed and the bond purchasers, as a class, sued the auditors for negligently failing t o detect fraud committed by the CEO.326 Shareholders' equity was overstated by $1.15 million (NZ) on the balance sheet included with the prospect~s.~'~ At the trial level, the plaintiffs were awarded $375,000 (NZ).328

In addressing the issue of the auditor's duty of care, the Court of Appeal stated that auditors do not assume a responsibility t o anyone other than their corporate client, and through it, its shareholders.329 Auditors owe no duty t o present o r future creditors or t o those who may be contemplating investing, or further investing, in the company's debt o r equity securities?30 Accountants owe a duty only to a third person t o whom they themselves show the accounts, o r t o whom they know their

320 Justice Woodhouse found no policy reasons for negating the existence of a duty of care under the second prong of the Anns test. The fear of indeterminate liability was, in his view, exaggerated. Liability would be adequately restricted by the foresight criterion and the need to prove causation. Johnston, supra note 316, a t 179-81. Moreover, the court rejected the policy argument of indeterminate liability as merely a plea in mitigation to excuse negligent activity because the consequences of liability are too great t o justify responsibility. Peter Cawthorn, Comment B Scott Group u. McFarlane, 3 AUCKLAND U.L. REV.. 465 (1979).

321 Caparo Indus. PLC v. Dickman, 1990 App. Cas. 605,648-49 (Eng. H.L.); Murphy v. Brentwood Dist. Council, 1991 App. Cas. 398 (Eng. H.L.); Hercules Managements Ltd. v. Ernst &Young [1997l2 S.C.R. 165,183-86; Sutherland Shire Council v. Heyman (1985) 157 C.L.R. 424; Esanda Fin. Corp. Ltd v. Peat Marwick Hungerfords (1997) 71 A.L.J.R. 448,468-70. 322 [1999] 2 N.Z.L.R. 276.

[1978] 1 N.Z.L.R. 553. 324 Boyd, 2 N.Z.L.R. at 280. 325 Id.

Id. 321 Id. 328 Id. at 287. 329 Zd. at 288. 330 Zd.

214 I Vol. 37 I American Business L a w Journal

client is going to show the accounts, so as to induce him to invest money o r take some other action on them.331 Moreover, any duty applies only t o those transactions for which the auditors knew their accounts were required.

The Court of Appeal emphasized that actual reliance on the auditor’s work product must be proved by t h e suing party for the auditor t o owe a duty of care to a n aggrieved third party suing under a negligence theory. An auditor has no obligation t o a nonclient who has not read and relied on the auditor’s work For a duty of care t o arise, actual reliance refers t o a “specific influence of the financial statements on the mind of the investor” not just a general reliance occasioned by a n assumption that a n investment is sound because a prospectus contains audited financial statements required by securities regulators.333

The Boyd Knight decision cites with approval the holdings in Caparo, Hercules Management, and Esanda Finance. Consistent with these three rulings, the Boyd Knight court took the position t h a t t h e purpose of audited statements is to fulfill the auditor’s statutory duty t o the shareholders collectively to enable them t o monitor management.334 Moreover, no duty is owed t o an individual investor o r prospective shareholder for inaccuracies in information, in t h e context of a prospectus, without specific, verifiable reliance o n the auditor’s work New Zealand is the most recent country of those considered in this article t o join a trend toward a narrower scope of accountant liability t o nonclients for negligent misstatements.

WHAT FACTORS UNDERLIE THIS TREND? This section of the paper examines various factors in the accoun-

tant’s legal environment that may explain the trend toward a narrower scope of liability to third parties for negligent misstatements. The first factor considered is the increased level of litigation risk auditors have faced for the last twenty-five years in the common law countries. Increased litigation risk is a consequence of both the expectation gap336 and the insurance hypothesis.337 Another factor we examine is policy

I d . (quoting Candler v. Crane, Christmas & Co., 1 All E . R . 426, 442-3 (Eng. C.A.)). 332 Boyd Knight, 2 N.Z.L.R. a t 290. 333 I d . 334 I d . a t 288. 335 I d . at 290. ’” Brenda Porter, An Empirical Study of the Audit Expectation-Performance Gap, 24

ACCT. & Bus. RES. 49 (1993). 337 Graham W a r d , Auditors’ Liability in the UK: The Case for Reform, 10 CRITICAL

PERSP. ACCT. 387, 389 (1999); Carl Pacini e t al., Assurance Services and the Electronic Frontier: The International Legal Environment of the CPAICA Webtrust, 12 ADVANCES

2000 I Auditor Liability / 215

factors now used by many courts in deciding the extent of the scope of an accountant’s duty t o third parties. Many policy factors are actually consequences of the judicial expansion of the number of third parties t o whom an accountant can be held liable. Third, we discuss the t o r t reform efforts of the accounting profession in the common law countries. Finally, we illustrate that the retreat from expansive accountant liability, at least in the United States, has occurred at a time when the t o r t system was abandoning expansive approaches t o t o r t liability in general.

Rationale Behind Increased Litigation Risk

The Expectation Gap

Concern about the quality of auditors’ performance is evidenced in litigation involving claims of substandard audit work.338 Allegations of substandard audit work are directly related t o the expectation gap. This gap refers t o a difference between auditors’ understanding of their function and investors’, creditors’, and other users’ expectations of the accountant’s role.339 The expectation gap is not an issue limited t o the United States and Canada.340 Empirical evidence indicates the existence of an expectation gap in the United States,341 United King-

INT’L. ACCT. 227, 235 (1999). 338 Christopher Humphrey e t al., The Audit Expectations Gap in Britain: An Empirical

Investigation, 23 ACCT. & BUS. RES. 395 (1993). 339 The expectation gap relates mostly to three troublesome areas: (1) detecting and

reporting on fraud; (2) detecting and reporting on illegal client acts; and (3) reporting when there is uncertainty about the ability of an entity to continue as a going concern. Porter, supra note 336, a t 53-59.

Different underlying explanations have been offered for the continuing presence of significant expectations problems over a long period of time. For example, a common response of the auditing profession has been t o stress the misguided nature of external expectations, arguing that the investing public expects too much and remains largely ignorant as to the precise nature, purpose, and capacities of the audit function. Humphrey et. al., supra note 338, at 395. In contrast, i t has been argued t h a t the legitimacy of the duties and standards adopted by any self-regulating profession can never be isolated from the expectations of the various interest groups who pay for and rely upon its services. David Godsell, Auditors’ Legal Liability a n d the Expectation Gap, 61 AUSTL. ACCT. 22,25 (1991).

340 Christian Bellavance, Liability a n d the “Expectation Gap,” 13 CAIMAG. 11 (1998). 341 A recent survey of investors provides evidence that the expectation gap continues to

exist. Marc Epstein & Marshall Geiger, Investor Views of Audit Assurance: Recent Evidence of the Expectation Gap, J. ACCT., Jan. 1994, at 60. Almost half of the respondents expected complete or absolute assurance that auditors would detect material errors in financial statements. Over 70% expected absolute assurance that material misstatements due t o fraud would be detected. Id.

216 1 Vol. 37 /American Business Law Journal

d ~ m , ~ ~ ' Canada,343 A u ~ t r a l i a , ~ ~ and New Zealand.345 In fact, the gap between what auditors deliver and what the public expects them t o deliver has become so important that it was part of the theme of the XVth World Congress of the International Federation of Accountants held in Paris in October 1997.346

The importance of the expectation gap in the litigation risk environment faced by accountants has been noted by various commis- sions, boards, and roundtables from the common law countries. These bodies include the National Commission on Fraudulent Financial Reporting,347 the AICPA Expectation Gap RoundtableY8 and the Public Oversight Board349 in the United States; the Commission t o Study t h e Public's Expectations of Audits i n Canadat5' the Committee on t h e Financial Aspects of Corporate Governance in the United Kingdom;351 and the Financial Reporting and Audit Expectation Task Force i n A u ~ t r a l i a . ~ ~ ' All these bodies concluded t h a t financial statement users believe independent auditors have a greater responsibility for detecting and reporting fraud and/or financial misinformation than was being met.353

The Insurance Hypothesis

Financial statement users who suffer investment or credit losses because of alleged financial statement misrepresentations often seek reimbursement o r indemnification from auditors. If attempts to settle without litigation are unsuccessful, a lawsuit must be filed in court. The accounting and legal literature both posit that auditors provide a

342 Humphrey et al., supra note 338, at 410. 343 CANADIAN INSTITUTE OF CHARTERED ACCOUNTANTS ( C I C A ) , REPORT OF THE

344 Gary Monroe & David Woodliff, An Empirical Investigation of the Audit Expectation

345 Porter, supra note 336, at 64. 346 Bellavance, supra note 340.

COMMISSION TO STUDY THE PUBLIC'S EXPECTATIONS O F AUDITS (1988).

Gap: Australian Evidence, 34 A C m . & FW. 47, 48 (1994).

347 NATIONAL COMMISSION ON FRAUDULENT FINANCIAL REPORTING, REPORT OF THE

34' AICPA, A SPECIAL REPORT BY THE EXPECTATION GAP ROUNDTABLE (1992). 349 AICPA, A SPECIAL REPORT BY THE PUBLIC OVERSIGHT BOARD OF THE SEC PRACTICE

350 CICA, supra note 343. 351 COMMITFEE ON THE FINANCIAL ~ P E C I S OF CORPORATE GOVERNANCE, REPORT OF THE

NATIONAL COMMISSION ON FRAUDULENT FINANCIAL REPORTING (1987).

SECTION (1993).

COMMI'I'I'EE ON THE F~NANCIAL &PECTS OF COHPOKATE GOVERNANCE (1992). 352 AUSTRALIAN SOCIETY OF CERTIFIED PRACTISING ACCOUNTANTS & THE INSTITUTE OF

CHARTERED ACCOUNTANTS IN AUSTRALIA (1996). 353 Brenda Porter, Review B A Research Study on Financial Reporting and Auditing-

Bridging the Expectation Gap, ACCT. HORIZONS, Mar. 1996, at 130, 131-34.

2000 I Auditor Liability I 2 1 7

type of implicit insurance t o users and The auditor is considered a potential indemnifier if an investment o r credit loss is suffered. In fact, accounting researchers provide empirical evidence that investors assign value t o the legal right t o seek indemnification from auditors for losses sustained. Indeed, this assigned value is a small component of the stock price of publicly traded firms.355

When the investor or creditor suffers a loss, the auditor faces potential legal liability. If found liable, the auditor reimburses the investor o r creditor for economic losses suffered. In essence, audit responsibilities are determined by the judicial system as though it compares the cost t o the investor/creditor of additional auditor effort and the benefits derived from the extra auditor effort.356 The benefits consist of the reduction in the investor’s expected loss due t o unreliable information in the client firm’s financial ~ t a t e m e n t s . ~ ~ ’ The auditor’s paying for this loss is part of the insurance hypothesis.

Legal proponents of the auditor-as-insurer argument assert that because auditors are well-capitalized, they can absorb losses resulting from their own negligence even when the costs cannot be passed along.358 The United States Supreme Court implicitly endorsed the auditor-as-insurer concept in United States u. Arthur Young & Co.:

By certifymg the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibil- ity transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public.359

The accountant is deemed t o be a “deep pocket” because the auditing firm oRen carries malpractice insurance or, in many cases, is the only solvent defendant in a lawsuit.

354 John Hill e t al., Auditing’s Emerging Legal Peril unakr the National Surety Doctrine: A Program for Research, ACCT. HORIZONS, Mar. 1993, at 12, 13; Carl Pacini & Patrick Maroney, Using Changes in Non-Litigating Client Firm Stock Values to Measure the Varying Importance of the Insurance Hypothesis Resulting from Shifis in Auditor Liability Laws, 22 S . BUS. & EcON. J. 243 (1999); Ward, supra note 337, a t 389; Godsell, supra note 339, a t 24-5.

SF, K. Menon & David Williams, The Insurance Hypothesis and Market Prices, 66 ACCT. REV. 327 (1994); William Baber e t al., Client Security Price Reactions to the Lauenthol and Horwath Bankruptcy, 33 J. ACCT. RES. 385,386-87 (1995).

356 Douglas DeJong & John H. Smith, The Determination ofAudit Responsibilities: A n Application of Agency Theory, 4 AUDITING: J. PRAC & THEORY 20,24 (1984).

351 Id. 358 J a m e s John Jurinski, The Common Law Liability o f Auditors: Judicial Allocation

359 465 US. 805, 817-18 (1984). of Business Risk, 23 WILLIAMEITE L. REV. 367, 400 (1987).

218 / Vol. 37 I American Business Law Journal

Policy Factors Considered in Judicial Decisions A trend toward expanding the auditor’s liability t o third parties

emerged during the 1970s and 1980~.~~ The expansion moved the scope of duty away from blind adherence t o a privity o r near-privity standard t o a version of the reasonable foreseeability rule in all five common law countries.361 This movement is reflected in decisions such as Rosenbl and International Mortgage C0.363 in the United States, J E B Fasteners Ltd.364 and Twomax Ltd.365 in the United Kingdom, Surrey Credit Union3% in Canada, Columbia Coffee367 in Australia, and Scott Group Ltd.368 in New Zealand.

The expansion of accountant liability t o third parties was part of a larger movement in t o r t law toward encouraging risk creators t o employ optimal levels of care o r allocating accident costs t o parties better able t o bear the losses.369 The independent audit was no longer seen as the creature of a contract, but rather as a product which, like any other product, foreseeably might harm third parties if it was defectively produced.370

Courts predicted numerous benefits from the expansion of accoun- tant liability t o third parties. First, by imposing liability on the one responsible for the loss the foreseeability rule would cause accountants t o perform more thorough audits.371 Second, a more expansive liability rule would compensate the innocent third party who had relied on a defective Third, expansion of liability is consistent with the

360 Gwilliam, supra note 25. 361 Brecht, supra note 24. 362 461 A.2d 138 ( N . J . 1983). 363 223 Cal. Rptr. 218 (Cal. Ct. App. 1986). 364 3 All E.R. 289 (Eng. C.A.1981). 365 1982 Sess. Cas. 113. 366 [1990] 73 D.L.R. (4th) 207. 367 (1992) 29 N.S.W.L.R. 141. 368 119781 1 N.Z.L.R. 553. 369 Tort law was increasingly viewed as an instrument of social engineering, with

expanded liability serving as a powerful means to encourage greater safety, particularly in the area of products liability. As a result, the foreseeability of harm, rather than the nature of the contract, began to define legal duty in many areas of the law, including accounting services. John Siciliano, Trends in Independent Auditor Liability: The Emergence o f a Sane Consensus? 16 J. ACCT. & PUB. POL’Y. 339,344 (1997); Ivankovich, supra note 200, a t 511-13.

370 Siciliano, supra note 369; Corbett, supra note 299, a t 818-23. 3 7 1 Rosenblum v. Adler, 461 A.2d 138 (N.J. 1983); Scott Group LM. v. Macfarlane [1978]

372 Siciliano, supra note 26, a t 1939; AM. Tettenborn, When Must Accountants Account? 1 NZLR 553; Hercules Managements Ltd. v. Ernst & Young 119971 2 S.C.R. 165.

48 CAMBRIDGE L.J. 177, 179 (1989); Ivankovich, supra note 200, at 519.

2000 I Auditor Liability 1219

moral blame attached t o auditor misc~nduct.~'~ Fourth, liability expansion would promote efficient loss-~preading.3~~ The predicted benefits, however, failed t o materialize and the stage was set for judicial rec~nsideration.~'~

Numerous recent court decisions that narrow the scope of an accountant's duty t o third parties give serious consideration t o policy factors, The policy factors of the 1990s are the consequences of the expanded liability of the 1980s. First, accountants generally have not responded t o greater liability exposure by more thorough auditing but by withdrawing audit services from high risk firms.376 Examples of high-risk firms for auditors include those in financial services, comput- erslelectronics, and real estate, as well as emerging growth firms.377 One of the consequences of a reduced supply of audit services is a diminished flow of inf~rmation.~~'

Reform courts of prior decades failed t o distinguish accounting, where the product is information, from manufacturers of goods. While a defective good, such as a chainsaw, may harm one or two users before it exhausts its defectiveness, bad information, such as an audit, can move from user t o user at a very low Thus, a negligent audit

373 Biankanja, 223 Cal. Rptr. at 220-21; Ivankovich, supra note 200, at 519. 374 Rusch Factors, 284 F. Supp. a t 91; J.G. Fleming, supra note 189, a t 351. Arguably,

this is accomplished by placing the risk of loss on auditors who in turn spread the loss to clients and the ultimate consuming public or purchase insurance to cover such losses. Biankanja, 223 Cal. Rptr. a t 232-33; Ivankovich, supra note 200, at 520. See generally G. CALABRESI, THE COST OF ACCIDENTS: A LEGAL AND ECONOMIC ANALYSIS (1970).

Siciliano, supra note 369, at 345; Ivankovich, supra note 200, a t 520-21. Siciliano, supra note 369; Siciliano, supra note 26, at 1959-60; Esanda Fin., 71

A.L.J.R. at 468; Hercules Managements Ltd., 2 S.C.R. at 179; Bily, 834 P.2d at 761; Jones & Raghunandan, supra note 16; Jack, supra note 16. Audited financial statements are necessary to gain access to the capital markets of the United States, United Kingdom, Canada, Australia, and New Zealand. A decreased availability of audit services produces a barrier to the growth of firms going public and to the ultimate expansion of a n economy. Siciliano, supra note 369, at 346. "' Zoe-Vonna Palmrose, An Analysis of Auditor Litigution and Audit Service Quality,

58 ACCT. REV. 55,70 (1988). 378 Siciliano, supra note 369; Cherniak & Stevens, supra note 267, at 169; Chapman,

supra note 193, at 190-92. 379 Esanda Fin., 71 A.L.J.R. at 470; Cherniak & Stevens, supra note 267, at 169-70;

William Bishop, Negligent Misrepresentation through Economists' Eyes, 96 L.Q. REV. 360, 361-66 (1980); Siciliano, supra note 369, at 346. In Hedley Byrne, Lord Pearce captured this unique characteristic of information when he wrote:

The reason for some divergence between the law of negligence in word and t h a t of negligence in act is clear. Negligence in word creates problems different from those of negligence in act. Words are more volatile than deeds. They are used without being expended and take effect in combination with innumerable facts and other words.

1964 App. Cas. 465, 534 (Eng. H.L.).

220 I Vol. 37 I American Business Law Journal

may cause enormous damage as it is relied on by a n indefinite chain of users. This situation gives rise to what Cardozo referred to as liability “in an indeterminate amount for an indeterminate time t o an indetermi- nate Hence, many courts in the common law countries have circumscribed accountant liability to third parties s o that accountants will “not be liable in circumstances where they are unaware of the use t o which their opinions will be put.”=’

Moreover, the compensation of third parties who have relied on a defective audit often results in a gratuitous guarantee against risk a t the accountant’s expense. Often plaintiffs (lenders and investors, for example) in auditor liability cases are sophisticated and capable of protecting themselves against risk.382 Under a broad liability rule, third parties who previously used a variety of risk assessment techniques before deciding whether to transact started t o rely exclusively on the accuracy of audited financial statements to evaluate a company’s health.”‘ Moreover, auditors have been unable t o spread or socialize risk through the purchase of professional liability i n s u r a n ~ e . ~ ~ The

380 Ultramares Corp. v. Touche, 174 N.E. 441, 444 (N.Y. 1931). Raritan River Steel v. Cherry, 367 S.E.2d 609, 616 (N.C. 1988). A s a matter of

commercial reality, audits are performed in a client-controlled environment. The client typically prepares its own financial statements; it has direct control over and assumes primary responsibility for their contents. Client control also predominates in the dissemination of the audit report. Once the report reaches the client, the extent of its distribution and the communications that accompany it are within the exclusive province of the client management. Thus, regardless of efforts of the auditor, the client retains effective primary control of the financial reporting process. Bily, 834 P.2d a t 762.

382 Hercules Managements Ltd., 2 S.C.R. a t 182; Esanda Fin., 71 A.L.J.R. at 462-63; Bily, 834 P.2d a t 761; Siciliano, supra note 369, a t 348.

3a3 Noel OSullivan, Auditors’ Liability: Its Role in the Corporate Governance Debate, 23 ACCT. &Bus. RES. 412,416-17 (1993). In Hercules Managements Ltd., the Supreme Court of Canada highlighted the impracticality of the auditor-as-insurer argument:

Creditors a n d investors on the other hand are likely to be in a better position than auditors to know the likely extent of their losses . . . . Unlike most plaintiffs in negligence cases, these investors and creditors can take steps to protect themselves against loss. Some creditors and investors will have the staff or means to investigate and verify that part of the audited person’s financial affairs that is relevant to the loan or investment . . . , Investors can spread their risk by diversifying their investments.

2 S.C.R. a t 182-87. 984 In the United States, large accounting firms are now nhle to huy only n portion of the

coverage they could buy prior to 1985 and only for much higher premiums. Virtually all mid-size firms tend to be highly underinsured. Liability insurance for small firms is expensive with almost 50% not carrying any insurance a t all. DAN GOLDWASSER & M.T. ARNOI.D, ACCOUNTANT‘S LIABILITY (1998). In the United Kingdom, below $75 million the Big Five retain the risks themselves as self-insurance using their own captive insurance companies. The effective ceiling on coverage is $340 million. Peter Mozier & Lisa Hansford-Smith, UKAuditor Liability: An Insurable Risk, 2 INT’L. J. AUDITING 197, 204 (1998). In Canada and Australia, the scale of the problem is such that auditors are finding

2000 I Auditor Liability J 221

unavailability of liability insurance may also reduce the quality of corporate financial reporting.385

Finally, expansive third-party liability would lead t o a serious logjam in the courts. This policy factor was emphasized by the Supreme Court of Canada in Hercules Managements:

[ N o examination of the public interest should overlook the effect of an extension of auditor’s liability on the administration of the court. system . . . . Experience of claims against auditors by public company liquidators over the last thirty years . . . indicate that almost any claim is likely to take many months t o hear . . . . Any extension of auditor’s liability . . . is likely to mean that courts and judges hearing such cases will be tied up for many months . . . .386

These same concerns have been echoed in Australia and the US.387 In sum, consequences of the expansion of accountant liability t o

third parties, labeled by courts as “policy factors,” when distilled t o their essence, provide strong justifications for auditors owing a legal duty t o a reduced number of third parties.

Reform Efforts of the Accounting Profession

One reaction of the accounting profession t o the litigation crisis has been t o mount a campaign aimed at leveling the playing field upon which liability claims are resolved. The campaign has been a concerted global effort, particularly in the United States, United Kingdom, Canada, Australia, and New Zealand.38s We briefly highlight the profession’s efforts pertinent t o the common law countries.

In the United States, the effort began in 1986, when the American Institute of Certified Public Accountants (AICPA) proposed a model accountants’ privity statute. The model statute is now incorporated as section 20 of the Uniform Accountancy Act (UAA), a comprehensive bill t o regulate the practice of public accountancy released by the AICPA

it increasingly difficult to obtain insurance and that where it is available it is extremely expensive. Ward, supra note 337.

385 The unavailability of insurance protection affects the U.K. auditing profession’s self- regulation strategy. In order to conform with The Companies Act 1989, auditors must demonstrate an ability to satisfy professional liability claims. Insurers’ underwriting techniques impose financial penalties on low-quality auditors. Insurance schemes provide for the withdrawal of practicing certificates from those auditors unable to obtain insurance protection. The unavailability of insurance is likely to remove insurers’ monitoring of auditor quality which could reduce corporate disclosure quality. OSullivan, supra note 383, at 417.

386 2 S.C.R. at 174-6. 387 Esanda Fin., 71 A.L.J.R. a t 462-63; Bily, 834 P.2d at 763. 388 Duncan Green, Litigation Risk for Auditors and the Risk Society, 10 CRITICAL P E E P .

ACCT. 339 (1999).

222 I Vol. 37 I American Business Law Journal

and the National Association of State Boards of Accountancy (NASBA).389

As noted, eight states have enacted statutes that have narrowed accountant l i a b i l i t ~ . ~ ” Also, accountant privity bills containing language similar t o that in section 20 of the UAA were considered in 1998 as stand-alone legislation or as part of a comprehensive state accountancy bill in Maine, Massachussetts, Tennessee, and Washing- ton.391 None of these states ultimately enacted an accountant privity

In 1999, however, Louisiana, enacted an accountant privity statute that is almost identical t o section 20 of the UAA.393 At the federal level, the US. Congress passed the Private Securities Litigation Reform Act of 1995,3y4 which includes numerous amendments t o the federal securities laws that either restrict the scope of accountants’ liability or reduce the damages paid by accountants.

In the United Kingdom, the accounting profession has lobbied the national government t o introduce legislation requiring directors t o take out liability insurance s o that stakeholders can seek damages from sources other than accountants.395 The Institute of Chartered Accoun-

iaw.392

Section 20 of the Uniform Accountancy Act is a near-privity standard that reflects the holding of the New York Court of Appeals in Credit Alliance. The operative language of the model law is:

Sec. 20-Privity of Contract (b) This section governs any action based on negligence brought against any accountant or firm . . . by any person or entity claiming to have been injured as a result of financial statements o r other information . . . reported or opined on ... by the defendant accountant. . . . (c) No action covered by this section may be brought unless:

(1) The plaintiff (1) is issuer . . . of the financial statements or other information ... reportsd or opined on . . . and (2) engaged the defendant licensee . . . ; or

(2) The defendant . . . (1) was aware at the time the engagement was undertaken t h a t the financial statements or other information were to be made available for use in connection with a specified transaction by the plaintiff who was specifically identified to the . . . accountant, (2) was aware that the plaintiff intended to rely upon such . . . information in connection with t h e specified transaction, and (3) had direct contact and communication with the plaintiff. . . and expressed . . . understanding of the reliance . . . .

390 See supra notes 56-99 and accompanying text. 391 Telephone Interview with Virgil Webb, Assistant General Counsel of the AICPA

392 Id.

”‘ Public Law No. 104-67, 109 Stat. 737 (1995) (codified as amended in scattered 395 J i m Cousins e t al., Auditor Liability: The Other Side of the Debate, 10 CRITICAL

(Apr. 9, 1999).

393 LA. REV. STAT. A”. $ 37:91 (West 1999).

sections of 15 U.S.C.A. (West Supp. 1996).

PERSP. ACCT. 283,285 (1999).

2000 I Auditor Liability I 2 2 3

tants in England and Wales has also pushed for a “capping“ of auditor liability based upon some multiple of audit fees and proportionate, rather than joint and several, liability?% The Law Commission studied both issues and declined t o pursue them.397 The U.K. accounting profession has also sought reform of section 310 of the Companies Act, which prohibits auditors from limiting liability for statutory a~dits.3’~ The accounting profession wants section 310 reformed t o permit auditors t o limit liability by contractual agreement.

In Canada, the accounting profession has also been engaged in reform efforts. For example, in March 1995, the Institute of Chartered Accountants of Alberta (ICAA) issued a discussion paper on auditor liability t o seek legislative changes from the provincial government.399 In Australia, the Australian Society of Certified Practising Accountants and the Institute of Chartered Accountants in Australia established a National Joint Limitation of Liability Task Force t o work toward enactment of legislation t o cap damage awards in negligence actions against auditors.4O0 Reform efforts have been partially successful. In New South Wales, the state legislature passed a law which limits professional liability by insurance arrangements andlor reference t o business assets andlor a multiple of fees.401 The task force has continued its efforts for damage award limitations at the national

In short, the trend toward a narrower scope of accountant liability has been accompanied by strenuous efforts mounted by the accounting profession with the avowed goal of legislative reform. These efforts have met with partial success in the common law countries, most notably the United States.

396 Id. a t 294. 397 The Department of Trade and Industry (DTI) is the government department

responsible for Company Law, Insolvency, and Financial Services Regulation. The U.K. Law Commission generally issues a consultation paper on a given legal issue and solicits comments from the legal, academic, and business communities. DEPARTMENT OF TRADE

398 Cousins e t al., supra note 395, at 296. The practice of restricting liability for non- audit work has become common. In recent years, major accounting firms have worked in concert to set identical limits on their liability. Auditors Limit Liability, DAILY TEL., Jan. 24, 1997, at 24.

AND INDUSTRY, FEASIBILITY OF JOINT AND SEVERAL LIABILITY (1996).

399 Green, supra note 388, at 345. 400 Malcolm Miller, Auditor Liability a n d the Development of a Strategic Evaluation of

401 An insurance arrangement may specify different maximum amounts of liability for

‘02 Miller, supra note 400, at 361-63.

Going Concern, 10 CRITICAL PERSP. ACCT. 355, 358-9 (1999).

different kinds of work within a n occupational association. Id. at 360.

224 I Vol. 37 I American Business Law Journal

Retreat from Expansive Tort Liability It is important t o note that judicial retreat from a wide scope of duty

to third party users in the United States and United Kingdom occurred a t a time when the t o r t system generally was losing interest in expansive approaches t o t o r t liability.403 One empirical study demon- strates that in the United States the judiciary actually began t o reject expansive t o r t liability rules in the 1980~.~’~ In t h e United Kingdom, recovery for pure economic loss in tort has been curtailed by key legal decisions of the House of Lords.405 Thus, the trend analyzed i n this article may stem as much from a general shift in attitudes as from the strength of the arguments against expansive third party liability claims.406

CONCLUSION

Various legal standards have developed in the United States, United Kingdom, Canada, Australia, and New Zealand t o determine which third party users are owed a duty by accountants for purposes of negligent misrepresentation. The expansion of accountant liability t o nonclients from the 1960s through the mid-1980s is evident in the court decisions of these five nations. Knowledge of the various legal stan- dards employed by these five countries allows accountants t o make more informed client acceptance and retention decisions through better assessments of liability exposure.

The last decade has witnessed the development of a trend in all five nations toward a narrower scope of liability to nonclients for negligence. In the United States, fourteen states rejected t h e reasonable foreseeability rule in favor of the Restatement standard, four states adopted or reaffirmed some form of the Credit Alliance o r Ultramares rule (three of which rejected the Restatement), eight states enacted a near-privity accountant liability statute, and two states adopted or reaffirmed the privity standard. Only one state (Alabama) has expanded the scope of an accountant’s duty t o nonclients for negligence. The United Kingdom narrowed the scope of a n accountant’s duty i n 1990 in the Caparo decision. This case stands for t h e proposition t h a t an auditor of a public company, in the absence of special circumstances, owes no duty of care t o a n outside investor o r an existing shareholder

403 Siciliano, supra note 369, at 350. 404 J a m e s Henderson, Jr. & Theodore Eisenberg, The Quiet Revolution in Products

Liability: An Empirical Study of Legal Change, 37 U.C.L.A. L. REV. 479, 480-82 (1990). ‘ 0 5 Anthony Mason, The Recovery a n d Calculation of Economic Loss, in TORTS IN THE

NINETIES (N.J. Mullany ed. 1997). 406 Siciliano, supra note 369, a t 350.

2000 / Auditor Liability / 225

who buys stock in reliance on audited financial statements. In Canada, the 1997 decision in Hercules Managements arrested the expansionist trend toward a wider scope of auditor liability t o nonclients for negligence. Canadian law places great weight on policy reasons for limiting an auditor‘s liabilitj. Also in 1997, the Australian High Court continued the trend toward contraction of auditor’s liability t o third parties in the Esanda Finance decision. Policy factors were weighed heavily in the court’s ruling. Finally, in 1999, New Zealand retreated from the foreseeability rule by adopting a version of the limited class of users’ test in the Boyd Knight decision.

S ig

n s

o f

a n

E m

er gi

n g

In te

rn a ti

o n

a l T

re n

d t

ow ar

d a

N ar

ro w

er S

co p

e of

A cc

o u

n ta

n t

L ia

b il

it y t

o

N o n

cl ie

n ts

fo r

N eg

li g en

ce .

N a ti

o d

S ta

te

U ni

te d

S ta

te s

A la

sk a

A ri

zo na

A rk

an sa

s

S ta

tu te

o r

C as

e N

am e

S el

de n

v. B

ur ne

tt ,

75 4

P. 2d

2 56

(A

la sk

a 19

88 ).

S ta

n d

ar d

C ha

rt er

ed v

. P ri

ce

W at

er ho

us e,

9 45

P .2

d 31

7 (A

rk . C

t. A

pp .

19 96

).

A R

K . C

O D

E A

” .$

16 -1

14 -3

02

(M ic

hi e

19 98

). T

oo k

ef fe

ct i

n 19

87 .

In S

w in

k v.

E rn

st &

Y

ou ng

, 9 08

S .W

.2 d

66 0

(A rk

. 19

95 1,

th e

A rk

an sa

s S

up re

m e

C ou

rt h

el d

th at

th ir

d pa

rt ie

s ca

nn ot

s ue

a n

a cc

ou nt

an t

fo r

ne gl

ig en

ce u

nl es

s th

e ac

co un

ta nt

h as

id en

ti fi

ed i

n

w ri

ti ng

t ho

se p

er so

ns w

ho m

ay

re ly

o n

hi s

w or

k pr

od uc

t an

d

se n

t a c

op y

of t

h at

w ri

ti ng

t o

th os

e pe

rs on

s.

T hi

s ru

li ng

vi

rt ua

ll y

el im

in at

es t

hi rd

-p ar

ty

ne gl

ig en

ce c

la im

s.

L eg

al S

ta n

d ar

d

R es

ta te

m en

t 8

55 2.

R es

ta te

m en

t 5

55 2.

N ea

r- pr

iv it

y.

S ig

n

In a

c as

e of

f ir

st im

pr es

si on

, A la

sk a

de cl

in ed

t o

ad op

t a

br oa

d ru

le o

f li

ab il

it y

w it

h re

ga rd

t o

th e

pr iv

at e

ca pa

ci ty

o f

ac co

un ta

nt s

(i .e

., th

e fo

re se

ea bi

li ty

r ul

e) .

In a

c as

e of

f ir

st im

pr es

si on

, an

ap

pe ll

at e

co ur

t r ej

ec te

d th

e re

as on

ab le

f or

es ee

ab il

it y

st an

d ar

d in

fa

vo r

of R

es ta

te m

en t

5 5

5 2

.

P ri

or to

e n

ac tm

en t o

f an

a cc

ou nt

an t

pr iv

it y

st at

u te

in 1

98 7,

A rk

an sa

s ha

d no

d ir

ec t s

ta te

c ou

rt r

u li

n g

o n

ac co

un ta

nt l

ia bi

li ty

to t

h ir

d p

ar ti

es .

T he

S w

in k

in te

rp re

ta ti

o n

o f

th e

st at

e st

at u

te s

ev er

el y

re st

ri ct

s ac

co un

ta nt

li

ab il

it y

to t

h ir

d p

ar ti

es .

C al

if or

ni a

~ ~

C ol

or ad

o

F lo

ri da

G eo

rg ia

B ily

v . A

rt hu

r Y ou

ng &

C o.

, 83

4 P.

2d 7

45 (C

al . 1

99 2)

.

M ar

qu es

t M

ed . P

ro d.

v . D

an ie

l M

cK ee

& C

o. , 7

91 P

.2 d

14

(C ol

o. A

pp .

19 90

); M

e h

e ,

R id

er , W

in dh

ol z &

W il

so n

v.

C en

tr al

B an

k D

en ve

r, 8

92 P

.2 d

23 0

(c ol

o. 1

99 5)

.

F ir

st F

lo ri

da B

an k v. M

ax

M it

ch el

l & C

o. , 5

58 S

o . 2

d 9

(F la

. 1 99

0) ; A

m w

es t S ur .

C o.

v .

E rn

st &

Y ou

ng , 6

77 S

o. 2

d 40

9 (F

la . A

pp . 1

99 6)

.

B ad

is ch

e C

or p.

v .

C ay

lo r,

3 56

S.

E .2

d 19

8 (G

a. 1

98 7)

; F ir

st

N at

'l B

an k

v. S

pa rk

m an

, 4 42

S.

E .2

d 80

4 (G

a. A

pp .

19 94

).

R es

ta te

m en

t 5 5

52 .

T he

ac

co un

ta nt

m us

t k no

w , w

it h

su bs

ta nt

ia l c

er ta

in ty

, t h

at th

e no

nc li

en t o

r th

e cl

as s

to w

hi ch

th

e no

nc li

en t b el on gs w

il l r

el y

on th

e ac

co un

ta nt

's w

or k

pr od

uc t.

R es

ta te

m en

t 5

55 2.

T he

s ta

te s

up re

m e

co ur

t t hr

ew o

ut

th e

re as

on ab

le f

or es

ee ab

il it

y ru

le s

et

fo rt

h in

I nt

er na

ti on

al M

or tg

ag e Co .

u.

Jo hn

P .

B ut

le r

A cc

ou nt

an cy

C or p. ,

17 7

C al

. A pp

. 3d

3 06

( C

t. A

pp .

19 86

) an

d ad

op te

d th

e R

es ta

te m

en t

st an

da rd

.

In a

c as

e of

f ir

st im

pr es

si on

, R

es ta

te m

en t 5

5 52

w as

a do

pt ed

.

R es

ta te

m en

t §

55 2.

T

he s

ta te

s up

re m

e co

ur t c

on si

de re

d an

d re

je ct

ed t

he r

ea so

na bl

e fo

re se

ea bi

li ty

r ul

e of

R os

en bl

um u

. A

d le

r. R

es ta

te m

en t 8

5 52

w as

ad

op te

d.

R es

ta te

m en

t 5

55 2.

In B

ad is

ch e Co rp ., a

c as

e of

f ir

st

im pr

es si

on , t

he s

ta te

s up

re m

e co

ur t

re je

ct ed

f or

es ee

ab il

it y as a

b as

is f

or

de te

rm in

in g

an a

cc ou

nt an

t's d

ut y

to

no nc

li en

ts . In F

ir st

N at

io n

al B

an k,

an

a pp

el la

te c

ou rt

d ec

li ne

d to

a pp

ly

th e

R es

ta te

m en

t s ta

nd ar

d in

f av

or o

f a

ba nk

w hi

ch r

el ie

d on r

ev ie

w ed

a nd

co

m pi

le d

fi na

nc ia

l r ep

or ts

. D

is cl

ai m

er s

w er

e de

em ed

s uf

fi ci

en t

to p

re cl

ud e

re li

an ce

.

K oh

al a

A gr

ic . v

. D

el oi

tt e

&

T ou

ch e,

9 49

P .2

d 14

1 (H

aw . C

t.

A pp

. 19

97 ).

Id ah

o B

an k

& T

ru st

v .

F ir

st

B an

co rp

, 77

2 P.

2d 7

20 (

Id ah

o 19

89 );

D uf

fi n

v. I

da ho

C ro

p Im

pr ov

em en

t A ss

’n , 8

95 P

.2 d

11 95

(I da

ho 1

99 5)

.

22 5

IL L

. CO

M P.

S T

A T

. 45

01 30

. 1

(W es

t 19

98 ).

T oo k

ef fe

ct i

n 19

86 .

S ta

tu te

is id

en ti

ca l t

o th

e A

rk an

sa s

st at

ut e.

I n

C he

st nu

t v . P

es ti

ne B

ri na

ti ,

66 7

N .E

.2 d

54 3

(i ll

. A pp

. C t.

19

96 1,

th e

co ur

t h el

d th

at a

no

nc li

en t m

ay s

ta te

a v

al id

le

ga l

cl ai

m u

nd er

t he

s ta

tu te

w

it ho

ut a

w ri

ti ng

; If

n o

w ri

ti ng

f ro

m t

he a

cc ou

nt an

t ex

is ts

, t h

e no

nc li

en t

m us

t pr

ov e

th e

cl ie

nt ’s

in te

nt a

nd

th e

ac co

un ta

nt ’s

k no

w le

dg e

of

th at

in te

nt .

R es

ta te

m en

t $5

52 .

N ea

r- pr

iv it

y.

N ea

r- pr

iv it

y.

In a

c as

e of

f ir

st im

pr es

si on

, a n

in

te rm

ed ia

te a

pp el

la te

c ou

rt re

je ct

ed

th e

re as

on ab

le f

or es

ee ab

il it

y ru

le fo

r po

lic y

re as

on s

an d

ad op

te d

th e

R es

ta te

m en

t.

In a

c as

e of

f ir

st in

st an

ce , t

h e

Id ah

o S

up re

m e

C ou

rt f

la tl

y re

je ct

ed t

he

R es

ta te

m en

t an

d fo

re se

ea bi

li ty

r ul

es

in fa

vo r

of t

he C

re di

t A ll

ia nc

e te

st .

B ef

or e

en ac

tm en

t o f a

n a

cc ou

nt an

t pr

iv it

y la

w in

1 98

6, a

n Il

li no

is

ap pe

ll at

e co

ur t a

do pt

ed t

h e

eq ui

va le

nt o

f t he

R es

ta te

m en

t st

an da

rd in

B ru

m le

y u

. T

ou ch

e R

os s,

46

3 N

.E .2

d 19

5 (I

ll . A

pp . C

t. 1

98 4)

.

h 3 h3

00

Io w

a

K an

sa s

L ou

is ia

na

R ya

n v.

K an

ne , 17 0

N .W

.2 d

39 5

(I ow

a 19 69 ); P

ah re

v .

A ud

it or

o f

S ta

te , 4

22 N

.W .2

d 17 8

(I ow

a 19 88 ); E

ld re

d v.

M

cG la

dr ey

, H en

dr ic

ks on

&

P ul

le n,

4 68 N .W . 2

d 21 8

(I ow

a 19 91 ).

K A

N . S TA T. A

" . 5

1 -4

0! ?, (1 99 8) .

T oo

k ef

fe ct

in 1 98 7. A

no

nc li

en t m

ay s

ue o

nl y

iE 1 )

th e

ac co

un ta

nt k

ne w

t he

th ir

d pa

rt y

in te

nd ed

to re

ly ; 2

) t he

ac

co un

ta nt

k ne

w t

he s

er vi

ce s

w ou

ld b

e m

ad e

av ai

la bl

e to

th e

no nc

li en

t; 3 ) t

he n

on cl

ie nt

w as

id

en ti

fi ed

in w

ri ti

ng to

t he

ac

co un

ta nt

; a nd

4 )

th e

no nc

li en

t's r

el ia

nc e

m us

t pe

rt ai

n to

s pe

ci fi

c t ra

ns ac

ti on

s id

en ti

fi ed

in w

ri ti

ng .

L a.

R ev

. S ta

t. A nn .

5 3 7: 9 1

(W es

t 1 99 9) to ok e

ff ec

t i n 19 99 .

T he

s ta

tu te

is v

ir tu

al ly

id

en ti

ca l t

o th

e N

ew J

er se

y st

at ut

e ex

ce pt

it h

as n

o sp

ec ia

l pr

ov is

io n

th at

a pp

li es

to b

an ks

.

R es

ta te

m en

t 5

55 2.

In

1 98 8, th

e Io

w a

S up

re m

e C

ou rt

na

rr ow

ed t

he p

ot en

ti al

s co

pe o

f an

ac

co un

ta nt

's l

ia bi

li ty

b y

re je

ct in

g th

e po

ss ib

il it

y of

a pp

li ca

ti on

o f t

he

fo re

se ea

bi li

ty ru

le .

In 1 99 1, th

e co

ur t r

ea ff

ir m

ed th

is s

ta nc

e by

re

qu ir

in g

cl ea

r pr

oo f o

f j us

ti fi

ab le

re

li an

ce b

y a

th ir

d pa

rt y

to re

co ve

r fr

om a

n ac

co un

ta nt

.

N ea

r- pr

iv it

y.

N ea

r- pr

iv it

y.

P ri

or t

o 1 99 9, L

ou is

ia na

h ad

n o

di re

ct s

ta te

c ou

rt r

ul in

g or

s ta

tu te

o n

ac co

un ta

nt li

ab il

it y

to n

on cl

ie nt

s.

N yc

al C

or p.

v. K

PM G

P ea

t M

ar w

ic k,

6 88 N

.E .2

d 13 68

(M as

s. 1 99 8) .

M IC

H . C O M P . LA

W S

4 60 0. 29 62

(1 99 8) .

T oo

k ef

fe ct

i n 19 96 .

A

ce rt

if ie

d ac

co un

ta nt

m ay

b e

li ab

le fo

r a

ne gl

ig en

t a ct

if th

e “c

er ti

fi ed

p ub

li c

ac co

un ta

nt

w as

in fo

rm ed

i n

w ri

ti ng

b y

th e

cl ie

nt a

t t he

ti m

e of

t he

en

ga ge

m en

t t ha

t a

pr im

ar y

in te

nt o

f th

e cl

ie nt

w as

fo r

th e .

. . ac

co un

ti ng

se rv

ic es

to

be ne

fi t o

r i nf

lu en

ce t

he p

er so

n br

in gi

ng t

he a

ct io

n. . .

.” T

he

C P

A m

ay b

e he

ld li

ab le

o nl

y to

ea

ch id

en ti

fi ed

p er

so n,

g en

er ic

m

ou p

or c

la ss

d es

cr ip

ti on

.

R es

ta te

m en

t 8 55 2.

N ea

r- pr

iv i ty

.

M id

A m

er ic

an B

an k

& T

ru st

C

o. v

. H ar

ri so

n, 8 51 S

.W .2

d R

es ta

te m

en t

6 55 2.

In a

c as

e of

f ir

st im

pr es

si on

, t h

e re

as on

ab le

f or

es ee

ab il

it y

ru le

w as

re

je ct

ed b

as ed

o n

th e

di st

in ct

io n

be tw

ee n

th e

du ty

o w

ed b

y a

pr of

es si

on al

t o

th ir

d pa

rt ie

s fo

r pe

rs on

al i

nj ur

ie s

an d

th at

o w

ed t

o a

th ir

d pa

rt y

fo r p

ec un

ia ry

l os

s.

__

P ri

or to

e na

ct m

en t o

f an

a cc

ou nt

an t

li ab

il it

y st

at ut

e, M

ic hi

ga n

fo llo

w ed

th

e R

es ta

te m

en t

st an

da rd

a s

se t

fo rt

h in

L aw

O ff

ic es

of L

aw re

nc e

J .

St oc

kl er

, P .C

. u . R

os e,

4 36 N

.W .2

d 70

(M ic

h. A

pp . 19 89 ).

M is

so ur

i r ea

ff ir

m ed

i ts

s up

po rt

fo r

th e

R es

ta te

m en

t. T

he s

ta nd

ar d

w as

fi

rs t a

do pt

ed in

A lu

m a

K ra

ft M

& .

C o.

u.

E lm

er F

ox &

C o.

, 4 93 S

.W .2

d 37 8

(M o.

A pp

. 1 97 3) .

In A

lu m

a K

ra ft

, t h

e co

ur t f

oc us

ed o

n th

e ex

te ns

io n

of

au di

to r

li ab

il it

y ba

se d

on w

ei gh

in g

po lic

y fa

ct or

s re

la te

d to

t he

no

nc li

en t’

s in

ju ry

. In

M id

A m

er ic

an

B an

k, th

e co

ur t r

ej ec

te d

th e

re as

on ab

le fo

re se

ea bi

li ty

r ul

e an

d

st re

ss ed

th e

“n ar

ro w

c on

fi ne

s” o

f t h

e R

es ta

te m

en t.

T ha

ye r

v. H

ic ks

, 7 93 P

.2 d 78 4

(M on

t. 19 90 ).

C it

iz en

s N

at 'l

B an

k v.

K en

ne dy

6 C

oe , 4 41 N

.W .2

d 18 0

(N eb

. 19 89 ); S

t. P

au l F

ir e

& M

ar in

e In

s. C

o. v

. T

ou ch

e Ro ss , 5

07

N .W

.2 d 27 6

(N eb

. 1 99 3) .

N .J

. S TA T. AN

N .

0 2A

: 6 3A -2 5

(W es

t 1 99 8) to ok e

ff ec

t i n 19 95 .

A s

ta tu

to ry

v er

si on

o f t

h e

C re

di t A

ll ia

nc e

ru le

: " N

o

ac co

un ta

nt s

ha ll

b e

li ab

le fo

r da

m ag

es f

or n

eg lig

en ce

a ri

si ng

ou

t o f

an d

in th

e co

ur se

o f

re nd

er in

g pr

of es

si on

al s

er vi

ce s

u n

le ss

. . . t

h e

ac co

un ta

nt (

2)

(a ) k

ne w

a t t

h e

ti m

e of

t he

en

ga ge

m en

t b y

th e

cl ie

nt o

r ag

re ed

w it

h th

e cl

ie nt

a ft

er th

e ti

m e

of e

ng ag

em en

t, th

at

th e.

. . se

rv ic

e re

nd er

ed to

th e

cl ai

m an

t, w

ho w as s

pe ci

fi ca

lly

id en

ti fi

ed to

th e

ac co

un ta

nt i

n

co nn

ec tio

n w

it h

a sp

ec if

ie d

tr an

sa ct

io n

. . . (

b) k

ne w

t h

at

N ea

r- pr

iv it

y.

N ea

r- pr

iv it

y.

N ea

r- pr

iv it

y .

~

~

~

~ ~

In a

c as

e of

f ir

st im

pr es

si on

, t h

e T

hn ye

r c ou

rt a

do pt

ed a

m od

if ie

d C

re di

t A lli

an ce

te st

. T

he n

on cl

ie nt

ne

ed n

ot s

ho w

" li

nk in

g co

nd uc

t," b

ut

m us

t s ho

w : 1 )

th e

au di

to r

kn ew

t h

at

a sp

ec if

ic th

ir d

p ar

ty in

te nd

s to

r el

y on h

is w

or k

pr od

uc t;

a nd

2 )

th e

re li

an ce

i s

in c

on ne

ct io

n w

it h

a pa

rt ic

ul ar

t ra

ns ac

ti on

o f w

hi ch

th e

au di

to r is a

w ar

e.

In a

c as

e of

f ir

st im

pr es

si on

, N

eb ra

sk a

ad op

te d

th e

pr im

ar y

be ne

fi t o

r U

lt ra

m ar

es r

ul e.

P

ri vi

ty is

re

qu ir

ed a

bs en

t f ra

ud o

r o th

er fa

ct s

es ta

bl is

hi ng

a d

ut y.

T he

s up

re m

e co

ur t o

ve rt

ur ne

d th

e tr

ia l c

ou rt

ju dg

e w

ho r

el ie

d on

th e

R es

ta te

m en

t st

an da

rd .

T he

s ta

te le

gi sl

at ur

e en

ac te

d a

st an

da rd

in 1 99 5

th at

m ov

ed N

ew

Je rs

ey fr

om th

e re

as on

ab le

fo

re se

ea bi

li ty

st an

da rd

s et

fo rt

h in

R

os en

bl um

u . A

dl er

to a

n ea

r pr

iv it

y st

an da

rd .

N 0 0 0

\

b

f?:

B

b

Fz:

F:

Y

Q

U .

h

$

\

N

0

c. l

N ew

Y or

k

N or

th C

ar ol

in a

th e

cl ai

m an

t i nt

en de

d to

r el

y up

on t

h e.

. . se

rv ic

es in

co

nn ec

ti on

w it

h th

at s

pe ci

fi ed

tr

an sa

ct io

n; a

nd (c

) d ir

ec tl

y ex

pr es

se d

to th

e cl

ai m

an t b

y w

or ds

o r

co nd

uc t t

he

ac co

un ta

nt ’s

u nd

er st

an di

ng o

f th

e cl

ai m

an t’

s in

te nd

ed

re li

an ce

. . .

(3 ) I

n th

e ca

se o

f a

ba nk

c la

im an

t, th

e ac

co un

ta nt

m

us t a

ck no

w le

dg e t

he b

an k’

s in

te nd

ed r

el ia

nc e.

. . a

nd t

he

cl ie

nt ’s

k no

w le

dg e

of t

ha t

re li

an ce

i n

a w

ri tt

en

co m

m un

ic at

io n.

”

C re

di t A

ll ia

nc e

v. A

rt hu

r h

d e

rs e

n &

C o.

, 4 83 N

.E .

2d

11 0

(N .Y

. 19 85 ); S

ec ur

it y

P ac

if ic

B us

. C re

di t v

. P

ea t

M ar

w ic

k M

ai n,

5 97 N

.E .2

d 10 80 (N

.Y . 1 99 2) .

R ar

it an

R iv

er S

te el

v . C

he rr

y,

36 7

S .E

.2 d 60 9

(N .C

. 19 88 );

L ib

er ty

F in

. C o.

v . B D O

S ei

dm an

, 4 73 S

.E .2

d 13 (

N .C

. C

t. A

pp . 1 99 6) .

N ea

r- pr

iv it

y.

In c

la ri

fy in

g th

e U

lt ra

m ar

es r

ul e,

t he

C

ou rt

o f A

pp ea

ls s

et fo

rt h

th e

C re

di t

A ll

ia nc

e th

re e-

pr on

g te

st : 1) th

e au

di to

r m us

t h av

e be

en a

w ar

e th

at

th e

fi na

nc ia

l r ep

or ts

w er

e to

b e

us ed

fo

r a p

ar ti

cu la

r pu

rp os

e; 2

) in

th e

fu rt

he ra

nc e

of w

hi ch

a k

no w

n pa

rt y

or p

ar ti

es w

as in

te nd

ed to

r el

y; a

nd

3) th

er e

m us

t h av

e be

en s

om e

co nd

uc t o

n th

e pa

rt o

f t he

a ud

it or

s li

nk in

g th

em to

t h

at p

ar ty

o r

pa rt

ie s

w hi

ch s

ho w

s th

e au

di to

rs ’

un de

rs ta

nd in

g of

t he

re li

an ce

.

R es

ta te

m en

t 8 55 2.

In a c

as e

of f

ir st

im pr

es si

on , t

he

N or

th C

ar ol

in a

S up

re m

e C

ou rt

ad

op te

d th

e R

es ta

te m

en t

st an

da rd

i n

R

ar it

an R

iv er

S te

el .

T he

C ou

rt

re je

ct ed

t he

re as

on ab

le f

or es

ee ab

il it

y ru

le a

nd th

e C

re di

t A Z

lia nc

e st

an da

rd .

L an

de ll

v .

L yb

ra nd

1 07 A

. 78 3

(P a.

1 91 9) ; I

n re

P ha

r- M

or S

ec .

L it

ig ., 89 2

F. S

up p.

6 76 (W

.D .

P a.

1 99 5) ;

R ay

m on

d R

os en

&

C o.

v . S

ei dm

an &

S ei

dm an

, 5 79

A .2

d 42 4

(P a.

S up

er . C

t. 19 90 ).

M -L

L ee

A cq

ui si

tio n

F un

d, L

.P .

v. D

el oi

tt e

& T

ou ch

e, 4 63

S. E

.2 d 61 8

(S .C

. C t.

A pp

. 19 95 ).

B et

hl eh

em S

te el

C or

p. v

. E rn

st

& W

hi nn

ey , 8 22 S

.W .2

d 59 2

(T en

n. 1 99 1) ;

F tit

te r v

. C us

to m

C

he m

ic id

es , I

nc ., 91 2

S. W

.2 d

12 8

(T en

n. 1 99 5) .

U ta

h C

od e An n. 8 58 -2 6- 12

(1 99 8) .

T he

w or

di ng

o f t

he

U ta

h st

at u

te is

v ir

tu al

ly

id en

ti ca

l to

t he

A rk

an sa

s an

d Il

li no

is s

ta tu

te s.

W ar

d v.

E rn

st &

Y ou

ng , 4 35

S .E

.2 d 62 8

(V a.

1 99 3) .

P ri

vi ty

.

R es

ta te

m en

t 8 55 2.

R es

ta te

m en

t 8 55 2.

P ri

vi ty

.

I

In 1 99 0, a

P en

ns yl

va ni

a tr

ia l

co ur

t re

af fi

rm ed

t he

p ri

vi ty

d oc

tr in

e as

th e

ap pl

ic ab

le le

ga l s

ta nd

ar d.

T he

L

an de

ll ca

se h

as n

ev er

b ee

n ov

er ru

le d.

~ ~

~

~ ~

~

In a

c as

e of

f ir

st im

pr es

si on

, a n

ap

pe ll

at e

co ur

t c on

si de

re d

an d

re je

ct ed

t h

e re

as on

ab le

f or

es ee

ab il

it y

ru le

a s

be in

g to

o ex

pa ns

iv e.

A

ud it

or s’

la ck

o f c

on tr

ol o

ve r

di st

ri bu

ti on

o f t

he ir

re po

rt s

re su

lt s

in

a la

ck o

f c on

tr ol

o ve

r l ia

bi li

ty

ex po

su re

. ~

~

~

In a

c as

e of

f ir

st im

pr es

si on

, t h

e su

pr em

e co

ur t a

do pt

ed th

e R

es ta

te m

en t

st an

da rd

w hi

le

re je

ct in

g th

e re

as on

ab le

fo

re se

ea bi

li ty

ru le

.

P ri

or t

o th

e pa

ss ag

e of

a s

ta tu

te in

19 90 , U

ta h

ad he

re d to th

e R

es ta

te m

en t

st an

da rd

as

h el

d in

Mi ll ne r

v. E

lm er

F ox

& C o. , 5 29 P

.2 d

80 6

(U ta

h 19 74 ).

~ ~

In a

c as

e of

f ir

st im

pr es

si on

, t h

e su

pr em

e co

ur t

ap pl

ie d

th e

pr iv

it y

of

co nt

ra ct

r ul

e af

te r

re je

ct in

g th

e R

es ta

te m

en t

ru le

.

W es

t V ir

gi ni

a

U ni

te d

K in

gd om

F ir

st N

at ’l

B an k

v. C

ra w

fo rd

, 38

6 S.

E .2

d 31

0 (W

. V a.

1 98

9) ;

C or

di al

v .

E rn

st &

Y ou

ng , 4

83

S .E

.2 d

24 8

(W . V

a. 1

99 6)

.

C ap

ar o

In du

e. P

L C

v .

D ic

km an

, 1 99

0 A

pp . C

as . 6

05

(E ng

. H .L .) .

An a

ud it

or o

w es

n o

du ty

o f c

ar e,

ab

se nt

s pe

ci al

c ir

cu m

st an

ce s,

to

an o

ut si

de in

ve st

or o

r ex

is ti

ng

sh ar

eh ol

de r

ba se

d on

a s

ta tu

to ry

I I I

W yo

m in

g W

Y O

. S T

A T

. A ” . B

3 3-

3- 20

1 (1

99 8)

. T

oo k

ef fe

ct in

1 99

5.

R es

ta te

m en

t 6

55 2.

N ea

r- pr

iv it

y.

I au di

t*

In a

c as

e of

f ir

st in

st an

ce , t

he s

ta te

’s

hi gh

es t

co ur

t r ej

ec te

d th

e re

as on

ab le

fo

re se

ea bi

li ty

r ul

e an

d ad

op te

d th

e R

es ta

te m

en t

st an

da rd

. T

he c

ou rt

re

af fi

rm ed

t he

R es

ta te

m en

t st

an da

rd

in 1

99 6.

W yo

m in

g ha

d no

d ir

ec t s

ta te

c ou

rt

ru li

ng o

r st

at e

st at

ut e

pr io

r to

en

ac tm

en t o

f a n

a cc

ou nt

an t l

ia bi

li ty

st

at u

te in

1 99

6. T

hr ee

c on

di ti

on s

m us

t e xi

st a

t t he

ti m

e an

en

ga ge

m en

t i s

un de

rt ak

en fo

r a

du ty

to

n on

cl ie

nt s

to a

ri se

: 1) th

e ac

co un

ta nt

w as

a w

ar e

th at

t h

e se

rv ic

es p

er fo

rm ed

w er

e to

b e

m ad

e av

ai la

bl e

in c

on ne

ct io

n w

it h

a sp

ec if

ic tr

an sa

ct io

n; 2

) t he

tr

an sa

ct io

n w

as s

pe ci

fi ca

ll y i

de nt

if ie

d to

th e

ac co

un ta

nt ; a

nd 3

) t he

ac

co un

ta nt

w as

a w

ar e

th at

th e

su in

g pa

rt y

in te

nd ed

to r

el y

on h

is s

er vi

ce s.

T

he a

cc ou

nt an

t m

us t t

ak e

th e

af fi

rm at

iv e

st ep

o f

st at

in g

in w

ri ti

ng ,

on a

ny w

or k

pr od

uc t d

oc um

en t,

th os

e pa

rt ie

s w

ho m

ay r

el y,

t he

d oc

um en

t’ s

pu rp

os e,

a nd

th at

h is

li ab

il it

y m

ay b

e li

m it

ed .

N o

li ab

il it

y li

m it

at io

n ar

is es

un

le ss

t h

e w

ri ti

ng r

eq ui

re m

en ts

a re

m

et .

T he

C ap

ar o

de ci

si on

a rr

es te

d a

sc op

e of

a cc

ou nt

an t

li ab

il it

y th

at h

ad

w id

en ed

to th

e re

as on

ab le

fo

re se

ea bi

li ty

r ul

e in

s om

e ca

se s.

C

ap am

is s

im il

ar to

th e

R es

ta te

m en

t st

an da

rd .

C an

ad a

H er

cu le

s M an

ag em

en t L

td . v

. E

rn st

& Y

ou ng

[ 19 97 ] 2 S

.C .R

. 16 5.

E sa

nd ra

F in

. C or

p. L

td . v

. P ea

t M

ar w

ic k

H un

ge rf

or ds

( 19 97 )

71 A

.L .J

.R . 44 8.

~ ~

~

B oy

d K

ni gh

t v .

P ur

du e [1 99 91 2

N .Z

.L .R

. 27 6.

T he

A n

n sl

K am

lo op

s te

st w

as

se le

ct ed

a s

th e

na ti

on al

r ul

e of

la

w .

P ol

ic y

fa ct

or s

th at

li m

it

li ab

il it

y ar

e gi

ve n

m uc

h w

ei gh

t.

A d

ut y

of c

ar e

to a

n on

cl ie

nt ,

ab se

nt a

n a

ud it

or 's

r es

po ns

e to

a

no nc

li en

t's r

eq ue

st , is

h ar

d to

es

ta bl

is h

un le

ss t

he a

ud it

or

in te

nd s

th e

th ir

d pa

rt y

or

m em

be rs

o f

an id

en ti

fi ed

c la

ss to

re

ly o

n h

id h

er w

or k

pr od

uc t f

or

a pa

rt ic

ul ar

p ur

po se

. Po

lic y

fa ct

or s

m ay

c om

pe ns

at e

fo r

la ck

of

in te

n t t

o in

du ce

re li

an ce

.

A ud

it or

s ow

e no

d ut

y to

p re

se nt

or

f ut

ur e

cr ed

it or

s w

ho m

ay b

e co

nt em

pl at

in g

in ve

st in

g in

a

fi rm 's d

eb t o

r eq

ui ty

s ec

ur it

ie s.

A

cc ou

nt an

ts o

w e

a du

ty o

nl y

to

a th

ir d p

er so

n to

w ho

m t

he y

th em

se lv

es s

ho w

t h

e ac

co un

ts ,

or to

w ho

m t

he y kn ow t

he ir

cl

ie nt

is g

oi ng

to s

ho w

th e

ac co

un ts

. A

ny d

ut y

ap pl

ie s

on ly

to

th os

e tr

an sa

ct io

ns fo

r w hi

ch

th e

au di

to rs

k no

w th

ei r

ac co

un ts

w

er e

re qu

ir ed

. A

s ui

ng p

ar ty

m

us t p

ro ve

a ct

ua l,

sp ec

if ic

re

li an

ce o

n th

e au

di to

r's w

or k

pr od

uc t.

T he

H er

cu le

s M

an ag

em en

t r ul

in g

re ve

rs ed

a s

lo w

ly w

id en

in g

am bi

t of

au

di to

r li

ab il

it y

to th

ir d

pa rt

ie s

fo r

ne gl

ig en

ce .

In m

os t c

as es

, p ol

ic y

co ns

id er

at io

ns w

ill n

eg at

e an

y du

ty

ow ed

to th

ir d

pa rt

ie s.

T he

E sa

n da

F in

an ce

d ec

is io

n co

nt ra

ct s

th e sc op e

of a

n a

cc ou

nt an

t's

du ty

to th

ir d

pa rt

ie s

fo r n

eg li

ge nc

e.

P ri

or to

E sa

n da

F in

an ce

, s om

e A

us tr

al ia

n co

ur ts

a pp

li ed

a s

ta nd

ar d

th at

is b

ro ad

er i

n s

co pe

th an

t h

e A

m er

ic an

R es

ta te

m en

t st

an da

rd b

ut

na rr

ow er

t h

an th

e re

as on

ab le

fo

re se

ea bi

li ty

ru le

.

T he

N ew

Z ea

la nd

C ou

rt o

f A pp

ea l

im pl

ie dl

y ov

er ru

le d

th e

fo re

se ea

bi li

ty

ru le

. B

oy d

K ni

gh t

ci te

s C

ap ar

o,

H er

cu le

s M an

ag em

en ts

, a nd

E sa

na !a

F

in an

ce w

it h

ap pr

ov al

.