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

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 to seventy-five countries around the world have suffered losses in liability lawsuits.(1) The liability increase is greatest in the Western world(2) and has been quite acute in Canada,(3) the United Kingdom,(4) Australia,(5) New Zealand,(6) and the United States.(7) 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.(8)

By 1990, Canadian accountants faced over 100 lawsuits, a substantial increase in a short period of time.(9) By 1994, at least $1.3 billion (Canadian) of unresolved claims were pending against Canadian accountants.(10) In the United Kingdom, the Big Six (now Big Five) accounting firms faced 627 outstanding legal cases claiming damages of 20 billion [pounds sterling] by mid-1994.(11) 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.(12) In Australia, accountants 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 problem.(14) 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 to render services to high-litigation-risk firms

One response of the accounting profession to 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.(20) Using this approach, the auditor assesses the risks and related litigation costs from an alleged audit failure of a current or 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 tort of negligence (or negligent misrepresentation).(23)

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 to nonclients for negligence. This is a significant development given that only about a decade ago, researchers identified a trend toward expanding the auditor’s liability for negligent misstatements in both the United States(24) and the four Commonwealth nations.(25)

The purposes of this article are threefold. The first is to identify court decisions and statutes from the United States, United Kingdom, Canada, Australia, and New Zealand that have slowed or reversed the expansion of auditor liability to nonclients for negligence. The second is to 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 to sue accountants for negligent misrepresentation. The third purpose is to enhance and update the knowledge of accountants, attorneys, standard setters, regulators, and educators about auditors’ legal responsibilities to nonclients for negligence. A precise statement of legal standards and any changes in the law enhances the accountant’s ability, ex ante, to gauge liability exposure.(26)

A TREND IN THE COMMON LAW COUNTRIES TOWARD A NARROWER SCOPE OF ACCOUNTANT LIABILITY

United States

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

Courts apply one of four legal standards to decide which nonclients have a cause of action against accountants for negligent misrepresentation: (1) privity

Privity Rule. The requirement of strict privity to establish an accountant’s duty to nonclients is the most restrictive standard. Strict privity requires a contractual relationship (or direct connection) to exist between an accountant or auditor and another party for the latter to hold the accountant liable for negligence. Strict privity was first established as a legal standard in Landell v. Lybrand.(28) Today, strict privity is the law in only Pennsylvania and Virginia.(29)

Near-Privity. The court in Ultramares Corp. v. Touche(30) was the first to apply the near-privity standard to determine the scope of an accountant’s duty to nonclients for negligence. In that case, the New York Court of Appeals denied plaintiff Ultramares’ negligence claim but fashioned an exception to strict privity that has become known as the primary benefit rule, that is, the plaintiff must be an intended third-party beneficiary.(31) The court reasoned that although Touche knew the balance sheet would be shown to 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 work.(32) Overly rigorous interpretations of Ultramares over the years have resulted in the case symbolizing a privity requirement for recovery for negligent misrepresentation.(33)

Over fifty years later, the New York Court of Appeals affirmed and clarified the near-privity rule in Credit Alliance v. Arthur Andersen & Co.(34) The court set forth a three-prong test that a nonclient must meet to fall within the ambit of an auditor’s duty for purposes of a negligent misrepresentation action. The three prongs are: (1) the accountant must have known that the financial reports were to be used for a particular purpose or purposes

By court decision, several states now follow the Credit Alliance rule or a version of it with minor variations.(37) Also, several states have statutory versions of a near-privity rule.(38)

The Restatement Standard. In 1968, a federal district court in Rhode Island first expanded accountant liability for negligence to specifically foreseen or known users.(39) The court applied section 552 of the Restatement (Second) of Torts.(40) Under this standard, an accountant who audits or prepares financial information for a client: (1) owes a duty not only to the client but to any other person or one of a limited group of persons whom the accountant or client intends the information to benefit

The accountant need not know the exact identity of the nonclient to be held liable under the Restatement standard.(44) A duty is owed to those persons, or the limited group of persons, who the professional is actually aware will rely upon the information.(45) It is the notice of the intended use or reliance which is important, not the size of the group of potential users.(46) In fact, the Restatement standard does not extend accountant liability to third parties if no accountant-client communications exist concerning the intended use of the report.(47) The accountant must supply the information to 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 to the auditor, only that they be members of a limited group known to the auditor.(49) The Restatement standard enlarges the class of persons to whom the accountant owes a duty to intended identifiable beneficiaries and to any unidentified members of the intended class of beneficiaries.(50) Twenty states currently follow the Restatement standard or a variation of it.(51)

The Reasonable Foreseeability Rule. Auditor liability to nonclients expanded again in 1983 with the decision in Rosenblum v. Adler.(52) In its decision, the court concluded that an auditor has a duty to all those whom the auditor should reasonably foresee as receiving and relying on the audited statements.(53) However, the duty extends only to 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 to all who obtain a firm’s financial statement directly from the audited entity, but owes no such duty of care to 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 to reasonably foreseeable third parties under certain circumstances.(56) Presently, however, only Mississippi and Wisconsin follow the reasonable foreseeability standard.(57)

Toward a Narrower Scope of Duty to Nonclients

The trend toward a narrower scope of liability began in 1986 when Illinois passed an accountant liability statute. Since that time, twenty-nine states have either: (1) enacted an accountant liability statute

Statutory Jurisdictions. Since 1986, eight states have enacted statutes which address accountants’ liability to nonclients for negligence.(58) Accountant privity statutes can be classified collectively in the 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 or Ultramares rule.

Accountant liability statutes do, however, exhibit some variation. For example, despite common wording, the Arkansas, Illinois, and Utah statutes(59) have been interpreted in different ways creating uncertainty for accountants and regulators. In Swink v. Ernst & Young,(60) the Arkansas Supreme Court held that an accountant is shielded from liability to 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 to rely on his services, and (2) the accountant furnishes those persons a copy of the writing.(61) The statute is silent, however, on when the identification of third parties who may rely must occur. The court held that liability to 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 to be somewhat stricter than the ruling by an Illinois appellate court. In Chestnut v. Pestine Brinati,(63) an Illinois appellate court found that the same statute merely provides accountants with an exception to a general rule of liability(64) where the accountant prepares and sends a writing to specific persons intended to rely on the accountant’s services. Defendant accountants argued for the statutory interpretation adopted by the Arkansas Supreme Court in Swink v. Ernst & Young.(65) The Illinois First District Appellate Court declined to 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 to benefit or influence the … person bringing the action,” creates a general rifle of accountant liability.(66) The court, however, did not reach the question of the effect of a writing on the accountant’s liability.(67) 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 to restrict his or her liability.(70) Instead, four conditions must occur for a nonclient to have a legal right to sue: (1) the accountant knew the third party intended to rely on the services

In 1990, Utah enacted an accountant liability statute identical to 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(81) in much the same way as the Arkansas Supreme Court in Swink v. Ernst & Young.(82)

Enactment of a statute in 1995 in New Jersey is particularly significant.(83) Between 1983 and 1995, New Jersey adhered to the reasonable foreseeability rule set forth in Rosenblum, but the New Jersey statute(84) is a virtual codification of the three-prong test of Credit Alliance.(85) Despite the statute’s restrictive scope, it does not require any of the three elements for an accountant’s duty to nonclients to 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 reliance.(87)

The New Jersey statute is different from the Arkansas, Illinois, and Utah statutes. The 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.(88) Also, the accountant’s knowledge of the nonclient’s intended reliance must be expressed to the plaintiff (or “linking conduct”) under New Jersey’s statute,(89) but not under the statutes of Arkansas, Illinois, and Utah.

In 1995, Wyoming also enacted an accountant liability statute.(90) Three conditions must be present at the time the engagement is undertaken for a duty to nonclients to arise: (1) the accountant was aware that the services performed were to be made available in connection with a specific transaction

In 1996, an accountant liability law took effect in Michigan.(95) The liability limitation provided by the statute appears to be aimed only at certified public accountants (CPA).(96) A CPA cannot be liable for negligence to a third party unless the CPA was informed in writing by the client at the time of the engagement that it was the client’s primary intent for the accounting services to benefit or influence the nonclient.(97) The statute allows the client to identify in writing not only specific persons but a generic group or class of persons whom the client intends to benefit or influence with the CPA’s services.(98) It is possible that the client could describe a class of users so large that a CPA could face potential liability to a significant number of nonclients.

In 1999, an accountant privity statute was enacted in Louisiana.(99) The statute is almost identical to the New Jersey statute with one exception. In Louisiana, the accountant need not acknowledge in 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.”(100) Accountant privity statutes facilitate client acceptance and retention decisions due to the establishment of known and required conditions under which an accountant may be liable for negligence to a nonclient. Litigation risk for accountants is diminished by the near-privity nature of the eight state statutes(101) in which auditors generally do not need to be concerned about as many third-party claimants.

Common Law Privity 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.(102) In 1995, the same result was reached in another federal district court case,(103) 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 v. Ernst & Young(104) 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 to allow Ward to sue Ernst & Young for negligence.(105) The court accorded due respect to the Restatement but declined to adopt it.(106) The court relied on four of its own prior rulings in negligence actions filed by third parties against architects, a developer, and an attorney.(107) The court upheld the legal principle that a third party cannot recover damages from an accountant for economic losses absent privity of contract.(108)

Common Law Near-Privity Rule States. In 1989, several courts refused to expand the number of third-party users to whom an accountant can be held liable for negligence. In Idaho Bank & Trust Co. v. First Bancorp,(109) 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 Appeals in Credit Alliance.(110) Idaho reaffirmed its adherence to the Credit Alliance standard six years later in Duffin v. Idaho Crop Improvement Ass’n.(111) Interestingly, Idaho does not recognize the tort of negligent misrepresentation except in the confines of a professional relationship involving an accountant.(112) Also, in 1989, the Nebraska Supreme Court adopted the primary benefit rule (or Ultramares approach) in a case of first impression.(113) In doing so, the Nebraska court overturned the decision of a trial court judge who relied on Restatement section 552.(114) The court held that an accountant’s duty of reasonable care extends only to his or her client and not to third parties absent fraud or other facts establishing a duty.(115) The court’s decision contains no reference to Ultramares but relies on the state’s legal position on an attorney’s duty to nonclients.(116) In 1993, Nebraska reaffirmed its support for the primary benefit rule in St. Paul Fire & Marine Insurance Co. v. Touche Ross.(117)

Also in 1989, Alabama adopted the Credit Alliance standard in Colonial Bank v. Ridley & Schweigert(118) and then reversed itself in favor of the Restatement standard in Boykin v. Arthur Andersen & Co.(119) Moreover, the Boykin court may have expanded the number of third-party users entitled to recover under the Restatement standard.(120) The court stated that for a plaintiff to recover, “there must simply be some conduct on the part of the defendant [accountant] that evidences … understanding that their [sic] opinion will be relied upon by a reasonably foreseeable and limited class of persons.”(121) Contrary to this statement, the Restatement expressly rejects foreseeability.(122) Boykin represents the only instance since 1988 in which a state has expanded the scope of an accountant’s liability to third parties for negligent misrepresentation.

In 1990, Montana adopted a modified version of the three-prong Credit Alliance test in Thayer v. Hicks.(123) The court engaged in a thorough review of the various legal standards to define the scope of an accountant’s liability to third parties, including the Ultramares rule, the Restatement, and the reasonable foreseeability standard.(124) 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 element.(125)

Restatement Standard States. Judicial retrenchment from expanding the number of nonclients to 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 v. Cherry.(126) The court examined four legal approaches that have been used to 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 world.”(127) The reasonable foreseeability rule was also not adopted “because it would result in liability more expansive than an auditor should be expected to 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 to which he or she attests.(129) The court also declined to adopt a balancing test that was used by California and Missouri prior to the Restatement standard now employed by those states.(130) The Restatement standard was adopted because it accommodates those nonclients who are foreseen users and accountants who need liability limitations.(131) The court reasoned that the Restatement provides the auditor with sufficient knowledge of which third parties will rely on financial information to allow the auditor to buy liability insurance, set higher fees, or 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 or knows that his client intends such reliance, his duty of care should extend to them.”(133)

The movement away from widening the scope of an auditor’s liability to nonclients for negligence continued with the holding of the West Virginia Supreme Court of Appeals’ decision in First National Bank v. Crawford.(134) In that case, the court answered a certified question on an accountant’s duty to a third party not in privity.(135) The parties to the case stipulated that the First National Bank of Bluefield had relied on a reviewed financial statement(136) for the Erps Construction Co. in making a loan.(137) The court considered the Ultramares, Restatement, and reasonable foreseeability standards.(138) The reasonable foreseeability rule was rejected in favor of the Restatement position.(139) In reaching its decision, the court relied to some extent on the reasoning contained in Raritan River Steel.(140) In 1996, the court reaffirmed its support for the Restatement standard in Cordial v. Ernst & Young.(141)

In 1990, the Florida Supreme Court joined the Restatement camp in First Florida Bank v. Max Mitchell & Co.,(142) relying heavily on one of its own prior rulings in First American Title Insurance Co. v. First Title Services Co.(143) In First American, the Restatement position was adopted in a suit against a title company. The court in First Florida Bank also relied, to a lesser extent, on the rationale of Raritan River Steel. The same year, Colorado implicitly recognized the liability of 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 to ship goods under a credit agreement.(144) In 1991, Tennessee adopted the Restatement standard in Bethlehem Steel Corp. v. 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 to which their opinions will be put.(147) 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 work.(148) The court went on to adopt the Restatement standard because it had applied that standard in negligent misrepresentation cases involving other professionals.(149) The Restatement standard was reaffirmed in 1995 as the appropriate legal standard for third party suits against accountants for negligence in Ritter v. Custom Chemicides, Inc.(150)

In 1992, in Bily v. Arthur Young & Co.,(151) the California Supreme Court overturned the state’s prior adoption of the reasonable foreseeability rule in International Mortgage Co. v. John Butler Accountancy Corp.(152) The Bily case arose from the failure of the Osborne Computer Corporation. After a thorough analysis of the various legal standards applicable to accountants’ liability to nonclients,(153) the Bily court adopted the Restatement standard.(154) Bily is significant because 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.(155) 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” advantages of more accurate auditing and more efficient loss spreading relied upon by those who advocate a pure foreseeability approach are unlikely to occur….(156)

The concept of “private ordering” can be described as a risk management tool implemented by a third party user through contractual agreements with the client or accountant.(157) For example, a third party could hire its own auditor to conduct an 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. v. Harrison.(158) The Restatement standard was first adopted in 1973 in Aluma Kraft Manufacturing Co. v. Elmer Fox & Co.(159) 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 to the plaintiff’s injury.(160) The MidAmerican court, however, explicitly rejected the reasonable foreseeability rule and emphasized the “narrow confines” of the Restatement standard.(161)

In 1994, Georgia and New Hampshire both reaffirmed their support for the Restatement standard. In First National Bank v. Sparkman,(162) a Georgia appellate court refused to apply the Restatement standard to an accountant who had reviewed and compiled a series of financial statements for M & L Electrical Company to use in obtaining bank credit. In citing the Restatement with approval (for audited statements), 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.(164)

In 1995, in a case of first impression, a South Carolina appellate court adopted the Restatement standard in M-L Lee Acquisition Fund v. Deloitte & Touche. (165) The appellate court considered the near-privity, Restatement, and reasonable foreseeability rules.(166) 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 to exert control over the financial statements to which he or she attests(169) Ultimately, the court rejected the foreseeability standard as being too expansive.(170) 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 standard.(172)

In early 1997, an Arizona appellate court adopted the Restatement standard in Standard Chartered v. 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. v. Oberg/Hunt/Gilleland(174) that no privity requirement exists to maintain an action in tort. The appellate court refused to extend the liability of all professionals to include “foreseeable injuries to foreseeable victims which proximately result from their negligent performance of their professional services.”(175) The court proceeded to adopt the Restatement standard as appropriate to establish the scope of an auditor’s duty to nonclients.(176)

In late 1997, an intermediate court of appeals in Hawaii ruled that the Restatement rule applies to third-party actions for negligent misrepresentation against accountants.(177) The appellate court analyzed the privity rule, the Restatement standard, and the reasonable foreseeability rule. The court rejected Deloitte & Touche’s argument to adopt the privity rule because the Hawaii Supreme Court rejected that standard in cases involving the liability of title companies and real estate brokers to nonclients.(178) The lower appellate court referred to two policy reasons for limiting an accountant’s liability. First, a restricted rule of liability is necessary because of the extent to which misinformation may be, and may be expected to be, circulated and the magnitude of the losses which may follow from reliance upon it.(179) Second, the scope of liability for negligence is narrower than that for fraud because of the lesser degree of fault for negligence.(180)

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, the 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.”(181) The lower appellate court also refused to adopt an expansive interpretation of section 552.(182)

In early 1998, the Supreme Judicial Court of Massachussetts ruled that the Restatement standard is the applicable law in that state.(183) The court examined the reasonable foreseeability rule, the near-privity rule as enunciated in Credit Alliance, and the Restatement standard.(184) The reasonable foreseeability rule was summarily rejected based on the distinction between the duty owed by a professional to a third party for personal injuries and that owed a third party for pecuniary loss due to negligence.(185) The court noted that traditional tort principles involving foreseeability of injury are unsuitable for application to 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” or affirmative action on the part of the accountant (or 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 professionals.(187) The Restatement standard was adopted because it comports most closely with the liability standard that has been used in other professional contexts.(188)

United Kingdom

Prior to 1964, it was quite onerous for a third party user of financial statements to sue an accountant in the United Kingdom for negligent misstatements.(189) For example, the court applied the privity doctrine in Candler v. Crane, Christmas & Co.(190) However, Lord Justice Denning wrote a strong dissenting opinion, which later gained widespread approval.(191)

In fact, in Hedley Byrne & Co. v. Heller & Partners Ltd.(192) the House of Lords adopted Lord Denning’s argument in establishing that a third party who had relied to his detriment on a negligent misstatement could sue despite the absence of privity of contract.(193) In that case, Heller & Partners Ltd., a merchant banking firm, provided incorrect data in response to a request from National Provincial Bank for credit information on Easipower Ltd.(194) Heller & Partners knew the credit information would be communicated to a specific unidentified customer of National Provincial Bank. In reliance on the credit information, Hedley Byrne, the unidentified customer, extended credit for services rendered to Easipower Ltd.(195) Easipower then went into liquidation.(196) The House of Lords ruled that accountants and other professionals owed a duty to any third person with whom a “special relationship” existed.(197) A “special relationship” arose in Hedley Byrne because of a “voluntary assumption of responsibility” by the defendant to the plaintiff.(198) The law Lords agreed that a “special relationship” includes more than a fiduciary or contractual relationship

The clear trend in the law of negligent misstatement immediately after Hedley Byrne was toward expanding the scope of duty to more third parties.(201) In general, the basis of the scope of duty or “special relationship” moved from “voluntary assumption” of responsibility by the defendant to the third party’s “reasonable reliance” to “foreseeability.”(202) The application of the foreseeability concept gained currency in Anns v. London Borough.(203) 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 to 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 contemplation of the former, carelessness on his part may be likely to cause damage to the latter–in which case a prima fade 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: “[I]t is necessary to consider whether there are any considerations which ought to negative, or to reduce or limit the scope of the duty or the class of persons to whom it is owed or the damages to which a breach of it may give rise.”(205) Anns is expansive because the balance is shifted toward liability unless negated by policy considerations, rather than requiring policy to justify an extension or expansion of liability.(206) The practical effect of Anns was to render almost any sequence of events foreseeable, leaving any limitation on liability to the vagaries of ad hoc policy assessments freed from precedential constraints.(207)

In the context of accountants’ liability to nonclients for negligence, the Anns foreseeability test was applied in JEB Fasteners Ltd. v. Marks Bloom & Co.(208) 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 numerous errors and thus, the stock acquired by JEB was overvalued.(209) Although the auditors were unaware of any specific takeover bidder at the date of the audit, they later became fully aware of the 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.(211)

The Anns foreseeability test was also followed in the Outer House of Session in Scotland in Twomax Ltd. v. 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.(213) As in JEB Fasteners, the defendant accountants were found to owe a duty of care to the plaintiff investors.(214) The fact that the accountants knew or should have known that the potential investors might rely on the audited financial statements was deemed sufficient to create proximity, thus giving rise to a duty of care. The widening ambit of accountant liability to third parties was arrested in Caparo Industries PLC v. Dickman.(215) Caparo Industries owned shares in Fidelity PLC for which Caparo was considering a takeover bid.(216) Caparo received a copy of the 1984 financial statements audited by Touche Ross. In reliance on a reported profit of 1.3 million [pounds sterling], Caparo made a successful takeover bid for Fidelity.(217) Subsequently, Caparo discovered that Fidelity had actually lost 460,000 [pounds sterling]. Caparo alleged that the audited financial statements had been negligently prepared.(218)

In a unanimous decision, the House of Lords, the highest court of law in the United Kingdom, dismissed the negligence claim. The law 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.(219) In the process, the court fashioned a three-prong test for an auditor’s duty of care.(220) 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 to 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 “proximity” is really just a label, the following conditions must adhere for the proximity prong to be satisfied: (1) the auditor must know that his or her work product would be communicated to a known third party or a known class to which the third party belongs

The third prong of the Caparo test requires the presence of “just and reasonable” grounds to impose a duty. Two commentators suggest that this is a judicial device to capture the importance of policy considerations to limit the scope of an auditor’s duty to nonclients.(228) The 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 to nonclients in many cases. The lack of significant policy analysis in Caparo is in sharp contrast to the open policy discussions in many U.S. cases.(229)

Since Caparo, U.K. courts have continued to limit the imposition on auditors of a duty to nonclients for negligent misstatements.(230) A case in point is James McNaughton Papers Group Ltd. v. Hicks Anderson & Co.(231) The facts involved the plaintiff’s takeover of its rival, MK, which had been in financial distress. MK’s accountants prepared draft financial statements which were shown to the plaintiff. Reversing the trial court judge, the English Court of Appeal found that the accountants owed no duty of care to the plaintiff. In doing so, the court cited Caparo and noted that in England, a “restrictive approach is now adopted to any extension of the scope of the duty of care beyond the person directly intended by the maker of the statement to act on it.”(232) Lord Justice Neill’s leading opinion in James McNaughton states that the important factors to 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 third party, the size of the class to 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 sufficient 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 to the second takeover bid, it indicated such a claim was not bound to fail.(236) 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 to rely, and much of the information in the profit forecast was available only to the defendant.(237) Any potential duty owed by the accountants in Morgan Crucible to the identified nonclient for negligent misstatements is restrictive in scope and consistent with the holding in Caparo.(238)

In sum, the Caparo decision narrowed the scope of accountant liability to third parties for negligent misstatements. The auditor of a public firm, absent special circumstances, does not owe a duty of care to 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 that the accountant knew his work product would be communicated to a nonclient, either individually or as a member of a limited class, and the third party would rely on the work product in connection with a particular transaction.(239) These conditions are, however, not conclusive or exclusive.

Canada

The leading Canadian case on auditor liability to third parties immediately following Hedley Byrne is the Supreme Court of Canada’s ruling in Haig v. Bamford.(240) 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 an unidentified outside investor (who turned out to be Haig).(241) 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 liquidated.(242)

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 to invoke a duty of care. The possible tests were: (1) foreseeability of the use of and reliance on the financial statements by the plaintiff

Significantly, the court stated that no distinction exists between the case in which the accountant delivers information directly to the plaintiff at the client’s request and the situation in which the accountant delivers information to the client who, with the accountant’s knowledge, passes it to unidentified members of a limited class for use in a transaction of which the accountant is aware.(246) Another important aspect of the case with regard to expansionist liability is the fact that the Supreme Court left open the possibility of application of the “foreseeability test.”(247) It is the spectre of indeterminate liability invoked by the foreseeability test that has been of grave concern to 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] to all reasonably foreseeable users of such [financial] information.”(248)

Since the decision in Haig, 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 v. Willson.(250) This case involved the sale of bonds to the public by the client firm. The auditor consented to 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 to Surrey.(251) Although a large class of persons could obtain the prospectus, the court decided it was not too large and unidentifiable a class for a duty of care to arise.(252)

Also, in Kripps v. Touche Ross & Co.,(253) unsecured bonds were sold to the public through a prospectus containing an unqualified audit report asserting compliance with generally accepted accounting principles (GAAP). The auditors consented to having the prospectus contain their work product which included the financial statements that failed to provide for certain expected losses. Relying on Caparo, the auditors argued that they had no duty of care to the plaintiff because the audited statements were not provided for a specific transaction or to a known or 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 to nonclients for negligence suffered a reversal in Hercules Management Ltd. v. 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 to 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 negligently.(258)

The Supreme Court of Canada, in a unanimous decision, dismissed the negligence claim. The court reached its finding by application of the two-pronged Anns/Kamloops 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 to the person suing.(260) If this question is answered affirmatively, part two of the test analyzes policy considerations that could curtail or eliminate any duty of care owed by the accountant to the plaintiff.(261)

Significantly, the court endorsed the use of the Anns/Kamloops 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 to a broader range of liability than other professionals.(263) The majority saw the need for some control device, such as the second prong of the Anns/Kamloops test, to combat the danger of indeterminate liability for accountants and others.(264)

With regard to the first prong of the test, accountants and their lawyers should note that the term “proximity” means that the professional has an obligation to be mindful of the nonclient’s “legitimate interests.”(265) In many instances, according to the court, proximity has just been a label, so it was incumbent upon the majority to give it some meaning. Thus, proximity can be said to exist when the accountant: (1) should reasonably foresee that a third party will rely on the accountant’s representation

The crucial consideration, addressed in the second part of the test, is policy factors that could serve to limit or eliminate any duty established. The court indicated that one fundamental policy consideration is that the alleged wrongdoer should not be exposed to “liability in an indeterminate amount for an indeterminate time to an indeterminate class.” The majority opinion engaged in a long discussion to 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 to reduce the risk of litigation).(271) The court also noted that boundless liability promotes “free ridership” on the part of relying third parties who lose their incentive to exercise vigilance. Another consequence would be a serious logjam of court cases.(272) In the final analysis, the court indicated that concerns over indeterminate liability will serve to negate any duty owed to nonclients in most cases.(273)

Some cases will arise, however, where policy considerations surrounding indeterminate liability will not be a pertinent consideration.(274) For example, if the accountant knows the identity of the nonclient (or a class of third parties) and the accountant’s representations 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 to 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 to assist shareholders as a group in overseeing the corporation’s management, not to assist individual shareholders in making personal investment decisions. In reaching this conclusion, the Hercules court cited the reasoning in Caparo.

In short, after the Haig holding, Canadian courts continued to slowly widen the ambit of an accountant’s duty to third parties for negligent misstatements. This expansionist trend was reversed or slowed by the 1997 decision of the Supreme Court of Canada in Hercules Managements. That decision requires the application of the two-pronged Anns/Kamloops test to cases involving negligent misstatements by auditors to nonclients. Concerns over indeterminate liability will negate any duty owed to 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 to nonclients for negligence in Esanda Finance Corp. Ltd. v. Peat Marwick Hungerfords. (277) The decision clarifies Australian law, which had been very uncertain due to conflicting opinions among state jurisdictions.(278) A better understanding of this case and the significance of its holding are obtained by an 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. v. Evatt.(279) This case did not involve auditor liability to third parties but established the first legal test applied to decide when one owes a duty of care to a third party for negligent misinformation. In Evatt, the High Court of Australia ruled that a person owes a duty of care to another when the one providing information realizes, or ought to realize, that he or she is being trusted to provide information that will be acted upon by that third party.(280) In the oft-quoted words of Chief Justice Barwick:

Whenever 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 or 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 to a third party in response to a request for it because the Evatt facts focused on a direct request from a third party.(282) Thus, Evatt is not an 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. v. Raine & Horne Proprietary Ltd.(284) The case provides some support for the notion that a duty is owed to a known third party, even if the defendant had no intent to induce reliance by the third party.(285) In that case, the plaintiffs were holders of units in an investment trust. The trustee was obligated to obtain periodic valuations of the trust assets to establish the value of the individual units of the trust. The defendants were real estate appraisers hired by the trustee to value certain assets. On one occasion, the appraisers committed a mathematical error which caused an overvaluation 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.(286) The issue of duty of care was treated as an extension of the holding in Hedley Byrne.(287) Moreover, the majority opinion referred to JEB Fasteners without any apparent disapproval.(288) The unit purchasers were deemed by the court to be unidentified members of a limited and known class.(289) Furthermore, the court found that it was apparent from information available to the defendant appraisers that the latter’s work product would be used by the trustee in fulfilling his duties to the limited, known class of unit owners.(290) The fact that the plaintiffs’ reliance was vicarious made no difference.(291) The professional’s scope of duty here is similar to that under the U.S. Restatement standard because the reliance of the third party unit owners, though vicarious, was known to the real estate appraisers at the time the services were rendered.

The expanding ambit of liability for negligent misstatements was applied to auditors in Columbia Coffee & Tea Party Ltd. v. Churchill.(292) 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 to have relied on an audit report and suffered economic loss.(293) This case applies to auditors the proposition in Evatt that a defendant accountant knew or ought to 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 arise.(294) The reasoning in Columbia Coffee is broader in scope than the U.S. Restatement standard but narrower in scope than the reasonable foreseeability rule.(295)

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 to 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 to the availability of the audited financial statements, the plaintiff creditor communicated to the auditors by telephone that it required the financial statements for review purposes.(297) 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 to the plaintiff finance company, was insufficient to establish a duty of care.(298)

A duty of care did not arise because the auditors lacked the intent to induce reliance by plaintiff AGC or a class of persons to which the plaintiff belongs.(299) The court found that the “only intention on the auditors’ part in making their report established in this case … is an intention to discharge their statutory and contractual duties as Lyvetta’s auditors by making the report required by the Companies Acts.”(300) The Victoria court’s approach in focusing on the auditor’s statutory role is analogous to the reasoning applied in Caparo.

Finally, in 1997, the High Court of Australia ruled directly on accountant liability to nonclients for negligence in Esanda Finance Corp. Ltd v. Peat Marwick Hungerfords.(301) The High Court endorsed the reasoning applied in R. Lowe Lippman and continued the trend toward a contraction of accountant liability to third parties for negligent misstatements.(302) The High Court itself noted that it used to be a widely accepted view in Australia that reasonable foreseeability of risk of economic harm was sufficient to create a duty of care.(303) In the case at bar, Esanda Finance provided credit to 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 unanimously held that mere reasonable foreseeability that third parties might rely on audited financial statements was insufficient to give rise to a duty of care.(304) The court reasoned that a duty of care imposed by reference to 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 to impose a duty of care to avoid that loss.(306) The court added that if the circumstances giving rise to 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 to a “relationship of proximity” for a duty to 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 or her work product will be communicated to a nonclient is insufficient to create a duty of care.(308) Also, the High Court refused to endorse the principle that liability of auditors should extend to members of a class whom the auditor knows or ought to know will rely on the audit.(309) A duty of care to a nonclient, absent an auditor’s response to a request for information from a specific third party, is difficult to establish unless the auditor intends to induce reliance on his or her work product by the nonclient or a limited class to which the nonclient belongs.(310) The purpose for which the accountant’s work product is provided can be crucial to the issue of intent to induce reliance.(311) However, a lack of intent to induce reliance is not necessarily fatal to establishing a duty of care because other factors may exist that establish proximity.(312)

Besides analyzing proximity, the High Court went on to outline numerous policy factors that should be weighed in deciding whether an auditor owes a duty to 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 to cover the cost of liability insurance

2) the inability of auditors to obtain liability insurance

3) a reduction in the standard of care due to cost-cutting measures implemented to 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 to a large number of third party users is recognized

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

6) the cost of the risk of accountants’ negligence is likely to 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 or 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

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

10) the imposition of a duty of care under the circumstances in the present case would amount to 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 to 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 to discussing various policy factors that weigh on the scope of an accountant’s duty to nonclients for negligence.(314) This case indicates a clear trend in Australian law toward restriction of auditor liability to third parties for negligent misstatements.

New Zealand

The leading case on accountant liability to nonclients after Hedley Byrne is the New Zealand Court of Appeal decision in Scott Group Ltd. v. Macfarlane.(315) 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 that 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 the 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 to Scott Group, about whom they knew nothing when the audit report was signed.(316) Despite the auditor’s lack of awareness or knowledge concerning the plaintiffs reliance, the court held that a duty of care was owed to Scott Group because it was reasonably foreseeable that someone other than the client might rely on the auditor’s work product.(317) 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 to 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 or its members in significant matters affecting the company’s assets and business.(318)

The majority in the case based their interpretation of an 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 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 Anns two-stage test.(321)

New Zealand adhered to the expansive reasonable foreseeability rule until early 1999. In Boyd Knight v. Purdue,(322) 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 I and August 10, 1988.(324) The purchases were made in response to 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 to detect fraud committed by the CEO.(326) Shareholders’ equity was overstated by $1.15 million (NZ) on the balance sheet included with the prospectus.(327) 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 to anyone other than their corporate client, and through it, its shareholders.(329) Auditors owe no duty to present or future creditors or to those who may be contemplating investing, or further investing, in the company’s debt or equity securities.(330) Accountants owe a duty only to a third person to whom they themselves show the accounts, or to whom they know their client is going to show the accounts, so as to induce him to invest money or take some other action on them.(331) Moreover, any duty applies only to 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 the suing party for the auditor to owe a duty of care to an aggrieved third party suing under a negligence theory. An auditor has no obligation to a nonclient who has not read and relied on the auditor’s work product.(332) For a duty of care to arise, actual reliance refers to a “specific influence of the financial statements on the mind of the investor” not just a general reliance occasioned by an assumption that an 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 that the purpose of audited statements is to fulfill the auditor’s statutory duty to the shareholders collectively to enable them to monitor management.(334) Moreover, no duty is owed to an individual investor or prospective shareholder for inaccuracies in information, in the context of a prospectus, without specific, verifiable reliance on the auditor’s work product.(335) New Zealand is the most recent country of those considered in this article to join a trend toward a narrower scope of accountant liability to nonclients for negligent misstatements.

WHAT FACTORS UNDERLIE THIS TREND?

This section of the paper examines various factors in the accountant’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 gap.(336) and the insurance hypothesis.(337) Another factor we examine is policy factors now used by many courts in deciding the extent of the scope of an accountant’s duty to third parties. Many policy factors are actually consequences of the judicial expansion of the number of third parties to whom an accountant can be held liable. Third, we discuss the tort 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 tort system was abandoning expansive approaches to tort 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 to the expectation gap. This gap refers to 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 to the United States and Canada.(340) Empirical evidence indicates the existence of an expectation gap in the United States,(341) United Kingdom,(342) Canada,(343) Australia,(344) and New Zealand.(345) In fact, the gap between what auditors deliver and what the public expects them to 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 commissions, boards, and roundtables from the common law countries. These bodies include the National Commission on Fraudulent Financial Reporting,(347) the AICPA Expectation Gap Roundtable,(348) and the Public Oversight Board(349) in the United States

The Insurance Hypothesis

Financial statement users who suffer investment or credit losses because of alleged financial statement misrepresentations often seek reimbursement or 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 type of implicit insurance to users and investors.(354) The auditor is considered a potential indemnifier if an investment or credit loss is suffered. In fact, accounting researchers provide empirical evidence that investors assign value to the legal right to 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 or creditor for economic losses suffered. In essence, audit responsibilities are determined by the judicial system as though it compares the cost to 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 to unreliable information in the client firm’s financial statements.(357) 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 v. Arthur Young & Co.:

By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility 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 to be a “deep pocket” because the auditing firm often carries malpractice insurance or, in many cases, is the only solvent defendant in a lawsuit.

Policy Factors Considered in Judicial Decisions

A trend toward expanding the auditor’s liability to third parties emerged during the 1970s and 1980s.(360) The expansion moved the scope of duty away from blind adherence to a privity or near-privity standard to a version of the reasonable foreseeability rule in all five common law countries.(361) This movement is reflected in decisions such as Rosenblum(362) and International Mortgage Co.(363) in the United States, JEB Fasteners Ltd.(364) and Twomax Ltd.(365) in the United Kingdom, Surrey Credit Union(366) in Canada, Columbia Coffee(367) in Australia, and Scott Group Ltd.(368) in New Zealand.

The expansion of accountant liability to third parties was part of a larger movement in tort law toward encouraging risk creators to employ optimal levels of care or allocating accident costs to parties better able to 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 accountant liability to third parties. First, by imposing liability on the one responsible for the loss the foreseeability rule would cause accountants to perform more thorough audits.(371) Second, a more expansive liability rule would compensate the innocent third party who had relied on a defective audit.(372) Third, expansion of liability is consistent with the moral blame attached to auditor misconduct.(373) Fourth, liability expansion would promote efficient loss-spreading.(374) The predicted benefits, however, failed to materialize and the stage was set for judicial reconsideration.(375)

Numerous recent court decisions that narrow the scope of an accountant’s duty to third parties give serious consideration to policy factors. The policy factors of the 1990s are the consequences of the expanded liability of the 1980s. First, accountants generally have not responded to 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, computers/electronics, 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 information.(378)

Reform courts of prior decades failed to 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 to user at a very low cost.(379) Thus, a negligent audit may cause enormous damage as it is relied on by an indefinite chain of users. This situation gives rise to what Cardozo referred to as liability “in an indeterminate amount for an indeterminate time to an indeterminate class.”(380) Hence, many courts in the common law countries have circumscribed accountant liability to third parties so that accountants will “not be liable in circumstances where they are unaware of the use to which their opinions will be put.”(381)

Moreover, the compensation of third parties who have relied on a defective audit often results in a gratuitous guarantee against risk at 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 to rely exclusively on the accuracy of audited financial statements to evaluate a company’s health.(383) Moreover, auditors have been unable to spread or socialize risk through the purchase of professional liability insurance.(384) The unavailability of liability insurance may also reduce the quality of corporate financial reporting.(385)

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

No 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 to 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 to third parties, labeled by courts as “policy factors,” when distilled to their essence, provide strong justifications for auditors owing a legal duty to a reduced number of third parties.

Reform Efforts of the Accounting Profession

One reaction of the accounting profession to the litigation crisis has been to 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.(388) We briefly highlight the profession’s efforts pertinent to 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 to regulate the practice of public accountancy released by the AICPA and the National Association of State Boards of Accountancy (NASBA).(389)

As noted, eight states have enacted statutes that have narrowed accountant liability.(390) Also, accountant privity bills containing language similar to 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 Washington.(391) None of these states ultimately enacted an accountant privity law.(392)

In 1999, however, Louisiana, enacted an accountant privity statute that is almost identical to section 20 of the UAA.(393) At the federal level, the U.S. Congress passed the Private Securities Litigation Reform Act of 1995,(394) which includes numerous amendments to 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 to introduce legislation requiring directors to take out liability insurance so that stakeholders can seek damages from sources other than accountants.(395) The Institute of Chartered Accountants 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.(396) The Law Commission studied both issues and declined to 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 audits.(398) The accounting profession wants section 310 reformed to permit auditors to 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 to 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 to work toward enactment of legislation to cap damage awards in negligence actions against auditors.(400) Reform efforts have been partially successful. In New South Wales, the state legislature passed a law which limits professional liability by insurance arrangements and/or reference to business assets and/or a multiple of fees.(401) The task force has continued its efforts for damage award limitations at the national level.(402)

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.

Retreat from Expansive Tort Liability

It is important to note that judicial retreat from a wide scope of duty to third party users in the United States and United Kingdom occurred at a time when the tort system generally was losing interest in expansive approaches to tort liability.(403) One empirical study demonstrates that in the United States the judiciary actually began to reject expansive tort liability rules in the 1980s.(404) In the 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 in 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 to determine which third party users are owed a duty by accountants for purposes of negligent misrepresentation. The expansion of accountant liability to nonclients from the 1960s through the mid-1980s is evident in the court decisions of these five nations. Knowledge of the various legal standards employed by these five countries allows accountants to 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 the reasonable foreseeability rule in favor of the Restatement standard, four states adopted or reaffirmed some form of the Credit Alliance or 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 to nonclients for negligence. The United Kingdom narrowed the scope of an accountant’s duty in 1990 in the Caparo decision. This case stands for the proposition 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 audited financial statements. In Canada, the 1997 decision in Hercules Managements arrested the expansionist trend toward a wider scope of auditor liability to nonclients for negligence. Canadian law places great weight on policy reasons for limiting an auditor’s liability. Also in 1997, the Australian High Court continued the trend toward contraction of auditor’s liability to 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.

Signs of an Emerging International Trend toward a Narrower Scope of Accountant Liability to Nonclients for Negligence.

Nation/State Statute or Case Name

United States

Alaska Selden v. Burnett, 754 P.2d 256

(Alaska 1988).

Arizona Standard Chartered v. Price

Waterhouse, 945 P.2d 317

(Ariz. Ct. App. 1996).

Arkansas ARK. CODE ANN. [sections] 16-114-302

(Michie 1998). Took effect in

1987. In Swink v. Ernst &

Young, 908 S.W.2d 660 (Ark.

1995), the Arkansas Supreme

Court held that third parties

cannot sue an accountant for

negligence unless the

accountant has identified in

writing those persons who may

rely on his work product and

sent a copy of that writing to

those persons. This ruling

virtually eliminates third-party

negligence claims.

California Bily v. Arthur Young & Co.,

834 P.2d 745 (Cal. 1992).

Colorado Marquest Med. Prod. v. Daniel

McKee & Co., 791 P.2d 14

(Colo. App. 1990)

Rider, Windholz & Wilson v.

Central Bank Denver, 892 P.2d

230 (Colo. 1995).

Florida First Florida Bank v. Max

Mitchell & Co., 558 So. 2d 9

(Fla. 1990)

Ernst & Young, 677 So. 2d 409

(Fla. App. 1996).

Georgia Badische Corp. v. Caylor, 356

S.E.2d 198 (Ga. 1987)

Nat’l Bunk v. Sparkman, 442

S.E.2d 804 (Ga. App. 1994).

Hawaii Kohala Agric. v. Deloitte &

Touche, 949 P.2d 141 (Haw. Ct.

App. 1997).

Idaho Idaho Bank & Trust v. First

Bancorp, 772 P.2d 720 (Idaho

1989)

Improvement Ass’n, 895 P.2d

1195 (Idaho 1995).

Illinois 225 ILL. COMP. STAT. 450/30. 1

(West 1998). Took effect in

1986. Statute is identical to

the Arkansas statute. In

Chestnut v. Pestine Brinati,

667 N.E.2d 543 (Ill. App. Ct.

1996), the court held that a

nonclient may state a valid

legal claim under the statute

without a writing. If no

writing from the accountant

exists, the nonclient must

prove the client’s intent and

the accountant’s knowledge of

that intent.

Iowa Ryan v. Kanne, 170 N.W.2d

395 (Iowa 1969)

Auditor of State, 422 N.W.2d

178 (Iowa 1988)

McGladrey, Hendrickson &

Pullen, 468 N.W. 2d 218 (Iowa

1991).

Kansas KAN. STAT. ANN. [sections] 1-402 (1998).

Took effect in 1987. A

nonclient may sue only if: 1)

the accountant knew the third

party intended to rely

accountant knew the services

would be made available to the

nonclient

identified in writing to the

accountant

nonclient’s reliance must

pertain to specific transactions

identified in writing.

Louisiana La. Rev. Stat. Ann. [sections] 37:91

(West 1999) took effect in 1999.

The statute is virtually

identical to the New Jersey

statute except it has no special

provision that applies to banks.

Massachusetts Nycal Corp. v. KPMG Peat

Marwick, 688 N.E.2d 1368

(Mass. 1998).

Michigan MICH. COMP. LAWS [sections] 600.2962

(1998). Took effect in 1996. A

certified accountant may be

liable for a negligent act if the

certified public accountant

was informed in writing by the

client at 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 ….” The

CPA may be held liable only to

each identified person, generic

group or class description.

Missouri MidAmerican Bank & Trust

Co. v. Harrison, 851 S.W.2d

563 (Mo. App. 1993).

Montana Thayer v. Hicks, 793 P.2d 784

(Mont. 1990).

Nebraska Citizens Nat’l Bank v. Kennedy

& Coe, 441 N.W.2d 180 (Neb.

1989)

Ins. Co. v. Touche Ross, 507

N.W.2d 275 (Neb. 1993).

New Jersey N.J. STAT. ANN. [sections] 2A: 53A-25

(West 1998) took effect in 1995.

A statutory version of the

Credit Alliance rule: ‘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 after the

time of engagement, that

the … service rendered 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 … services in

connection with that specified

transaction

expressed to the claimant by

words or conduct the

accountant’s understanding of

the claimant’s intended

reliance … (3) In the case of a

bank claimant, the accountant

must acknowledge the bank’s

intended reliance … and the

client’s knowledge of that

reliance in a written

communication.”

New York Credit Alliance v. Arthur

Andersen & Co., 483 N.E. 2d

110 (N.Y. 1985)

Pacific Bus. Credit v. Peat

Marwick Main, 597 N.E.2d

1080 (N.Y. 1992).

North Carolina Raritan River Steel v. Cherry,

367 S.E.2d 609 (N.C. 1988)

Liberty Fin. Co. v. BDO

Seidman, 473 S.E.2d 13 (N.C.

Ct. App. 1996).

Pennsylvania Landell v. Lybrand 107 A. 783

(Pa. 1919)

Litig., 892 F. Supp. 676 (W.D.

Pa. 1995)

Co. v. Seidman & Seidman, 579

A. 2d 424 (Pa. Super. Ct. 1990).

South Carolina M-L Lee Acquisition Fund, L.P.

v. Deloitte & Touche, 463

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

Tennessee Bethlehem Steel Corp. v. Ernst

& Whinney, 822 S.W.2d 592

(Tenn. 1991)

Chemicides, Inc., 912 S.W.2d

128 (Tenn. 1995).

Utah Utah Code Ann. [sections] 58-26-12

(1998). The wording of the

Utah statute is virtually

identical to the Arkansas and

Illinois statutes.

Virginia Ward v. Ernst & Young, 435

S.E.2d 628 (Va. 1993).

West Virginia First Nat’l Bank v. Crawford,

386 S.E.2d 310 (W. Va. 1989)

Cordial v. Ernst & Young, 483

S.E.2d 248 (W. Va. 1996).

Wyoming WYO. STAT. ANN. [sections] 33-3-201

(1998). Took effect in 1995.

United Kingdom Caparo Indus. PLC v.

Dickman, 1990 App. Cas. 605

(Eng. H.L.).

Canada Hercules Management Ltd. v.

Ernst & Young [1997] 2 S.C.R.

165.

Australia Esandra Fin. Corp. Ltd. v. Peat

Marwick Hungerfords (1997)

71 A.L.J.R. 448.

New Zealand Boyd Knight v. Purdue [1999] 2

N.Z.L.R. 276.

Nation/State Legal Standard

United States

Alaska Restatement [sections] 552.

Arizona Restatement [sections] 552.

Arkansas Near-privity.

California Restatement [sections] 552. The

accountant must know, with

substantial certainty, that the

nonclient or the class to which

the nonclient belongs will rely

on the accountant’s work

product,

Colorado Restatement [sections] 552.

Florida Restatement [sections] 552.

Georgia Restatement [sections] 552.

Hawaii Restatement [sections] 552.

Idaho Near-privity.

Illinois Near-privity.

Iowa Restatement [sections] 552.

Kansas Near-privity.

Louisiana Near-privity.

Massachusetts Restatement [sections] 552.

Michigan Near-privity.

Missouri Restatement [sections] 552.

Montana Near-privity.

Nebraska Near-privity.

New Jersey Near-privity.

New York Near-privity.

North Carolina Restatement [sections] 552.

Pennsylvania Privity.

South Carolina Restatement [sections] 552.

Tennessee Restatement [sections] 552.

Utah Near-privity.

Virginia Privity.

West Virginia Restatement [sections] 552.

Wyoming Near-privity.

United Kingdom An auditor owes no duty of care,

absent special circumstances, to

an outside investor or existing

shareholder based on a statutory

audit.

Canada The Anns/ Kamloops test was

selected as the national rule of

law. Policy factors that limit

liability are given much weight,

Australia A duty of care to a nonclient,

absent an auditor’s response to a

nonclient’s request, is hard to

establish unless the auditor

intends the third party or

members of an identified class to

rely on his/her work product for

a particular purpose. Policy

factors may compensate for lack

of intent to induce reliance.

New Zealand Auditors owe no duty to present

or future creditors who may be

contemplating investing in a

firm’s debt or equity securities.

Accountants owe a duty only to

a third person to whom they

themselves show the accounts,

or to whom they know their

client is going to show the

accounts. Any duty applies only

to those transactions for which

the auditors know their accounts

were required. A suing party

must prove actual, specific

reliance on the auditor’s work

product.

Nation/State Sign

United States

Alaska In a case of first impression, Alaska

declined to adopt a broad rule of

liability with regard to the private

capacity of accountants (i.e., the

foreseeability rule).

Arizona In a case of first impression, an

appellate court rejected the

reasonable foreseeability standard in

favor of Restatement [sections] 552.

Arkansas Prior to enactment of an accountant

privity statute in 1987, Arkansas had

no direct state court ruling on

accountant liability to third parties.

The Swink interpretation of the state

statute severely restricts accountant

liability to third parties.

California The state supreme court threw out

the reasonable foreseeability rule set

forth in International Mortgage Co. v.

John P. Butler Accountancy Corp.,

177 Cal. App. 3d 306 (Ct. App. 1986)

and adopted the Restatement

standard.

Colorado In a case of first impression,

Restatement [sections] 552 was adopted.

Florida The state supreme court considered

and rejected the reasonable

foreseeability rule of Rosenblum v.

Adler. Restatement [sections] 552 was

adopted.

Georgia In Badische Corp., a case of first

impression, the state supreme court

rejected foreseeability as a basis for

determining an accountant’s duty to

nonclients. In First National Bank,

an appellate court declined to apply

the Restatement standard in favor of

a bank which relied on reviewed and

compiled financial reports.

Disclaimers were deemed sufficient

to preclude reliance.

Hawaii In a case of first impression, an

intermediate appellate court rejected

the reasonable foreseeability rule for

policy reasons and adopted the

Restatement.

Idaho In a case of first instance, the Idaho

Supreme Court flatly rejected the

Restatement and foreseeability rules

in favor of the Credit Alliance test.

Illinois Before enactment of an accountant

privity law in 1986, an Illinois

appellate court adopted the

equivalent of the Restatement

standard in Brumley v. Touche Ross,

463 N.E.2d 195 (Ill. App. Ct. 1984).

Iowa In 1988, the Iowa Supreme Court

narrowed the potential scope of an

accountant’s liability by rejecting the

possibility of application of the

foreseeability rule. In 1991, the

court reaffirmed this stance by

requiring clear proof o f justifiable

reliance by a third party to recover

from an accountant.

Kansas Prior to 1987, Kansas had no direct

state court ruling on accountant

liability to nonclients.

Louisiana Prior to 1999, Louisiana had no

direct state court ruling or statute on

accountant liability to non-clients.

Massachusetts In a case of first impression, the

reasonable foreseeability rule was

rejected based on the distinction

between the duty owed by a

professional to third parties for

personal injuries and that owed to a

third party for pecuniary loss.

Michigan Prior to enactment of an accountant

liability statute, Michigan followed

the Restatement standard as set

forth in Law Offices of Lawrence J.

Stockier, P.C.v. Rose, 436 N.W.2d 70

(Mich. App. 1989).

Missouri Missouri reaffirmed its support for

the Restatement. The standard was

first adopted in Aluma Kraft Mfg. Co.

v. Elmer Fox & Co., 493 S.W.2d 378

Montana In a case of first impression, the

Thayer court adopted a modified

Credit Alliance test. The nonclient

need not show “linking conduct,” but

must show: 1) the auditor knew that

a specific third party intends to rely

on his work product

reliance is in connection with a

particular transaction of which the

auditor is aware.

Nebraska In a case of first impression,

Nebraska adopted the primary

benefit or Ultramares rule. Privity is

required absent fraud or other facts

establishing a duty. The supreme

court overturned the trial court judge

who relied on the Restatement

standard.

New Jersey The state legislature enacted a

standard in 1995 that moved New

Jersey from the reasonable

foreseeability standard set forth in

Rosenblum v. Adler to a near privity

standard.

New York In clarifying the Ultramares rule, the

Court of Appeals set forth the Credit

Alliance three-prong test: 1) the

auditor must have been aware that

the financial reports were to be used

for a particular purpose

furtherance of which a known party

or parties was intended to rely

3) there must have been some

conduct on the part of the auditors

linking them to that party or parties

which shows the auditors’

understanding of the reliance.

North Carolina In a case of first impression, the

North Carolina Supreme Court

adopted the Restatement standard in

Raritan River Steel. The Court

rejected the reasonable foreseeability

rule and the Credit Alliance

standard.

Pennsylvania In 1990, a Pennsylvania trial court

reaffirmed the privity doctrine as the

applicable legal standard. The

Landell case has never been

overruled.

South Carolina In a case of first impression, an

appellate court considered and

rejected the reasonable foreseeability

rule as being too expansive.

Auditors’ lack of control over

distribution of their reports results in

a lack of control over liability

exposure.

Tennessee In a case of first impression, the

supreme court adopted the

Restatement standard while

rejecting the reasonable

foreseeability rule.

Utah Prior to the passage of a statute in

1990, Utah adhered to the

Restatement standard as held in

Millner v. Elmer Fox & Co., 529 P.2d

806 (Utah 1974).

Virginia In a case of first impression, the

supreme court applied the privity of

contract rule after rejecting the

Restatement rule.

West Virginia In a case of first instance, the state’s

highest court rejected the reasonable

foreseeability rule and adopted the

Restatement standard. The court

reaffirmed the Restatement standard

in 1996.

Wyoming Wyoming had no direct state court

ruling or state statute prior to

enactment of an accountant liability

statute in 1995. Three conditions

must exist at the time an

engagement is undertaken for a duty

to nonclients to arise: 1) the

accountant was aware that the

services performed were to be made

available in connection with a

specific transaction

transaction was specifically identified

to the accountant

accountant was aware that the suing

party intended to rely on his services.

The accountant must take the

affirmative step of stating in writing,

on any work product document, those

parties who may rely, the document’s

purpose, and that his liability may be

limited. No liability limitation arises

unless the writing requirements are

met.

United Kingdom The Caparo decision arrested a scope

of accountant liability that had

widened to the reasonable

foreseeability rule in some cases.

Caparo is similar to the Restatement

standard.

Canada The Hercules Management ruling

reversed a slowly widening ambit of

auditor liability to third parties for

negligence. In most cases, policy

considerations will negate any duty

owed to third parties.

Australia The Esanda Finance decision

contracts the scope of an accountant’s

duty to third parties for negligence.

Prior to Esanda Finance, some

Australian courts applied a standard

that is broader in scope than the

American Restatement standard but

narrower than the reasonable

foreseeability rule.

New Zealand The New Zealand Court of Appeal

impliedly overruled the foreseeability

rule. Boyd Knight cites Caparo,

Hercules Managements, and Esanda

Finance with approval.

(1) See David Sands, Accountants Around the Globe See Rise in Professional Liability Suits, WASH. TIMES, Oct. 20, 1992, at C3.

(2) 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

(3) See Scott Haggett, Fears Raised over Liability Issue: Trend Is to Sue the Accountant When Firms Go Under, FIN. POST, June 25, 1993, at 17.

(4) See John Rink, The Shortcomings of Caparo, INT’L. CORP. L.., Mar. 1994, at 18.

(5) See B.J. Cooper & M.L. Barkoczy, Third Party Liability: The Auditor’s Lament, 9(5) MANAGERIAL AUDITING J. 31 (1994).

(6) See Len Bayliss, Arthur Young Lawsuit Highlights Need for Better Standards, ACCT., Feb. 1992, at 7.

(7) See Dan Dalton et al., The Big Chill, J. ACCT., Nov. 1994, at 53.

(8) The accounting practices of a country are related to 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 it is illegal to venture, and within those limits experimentation is encouraged. See Gary Meek & Shahrokh Saudagaran, A Survey of Research on Financial Reporting in a Transnational Context, 9 J. ACCT. LITERATURE 145 (1990).

One recent study provides empirical support for the hypothesis that 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 law/code 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).

(9) See Auditors Must Deal with an Increasing Number of Lawsuits Charging Negligence, FIN. POST, Mar. 20, 1990, at 18.

(10) See Gundi Jeffrey, Accountants Want Relief from Legal Nightmare, FIN. POST, Apr. 29, 1994, at 12.

(11) Michael Beckett, Accountants Debate Move to Limited Liability, DAILY TEL., June 28, 1994, at 28.

(12) See Christopher Napier, Intersections of Law and Accountancy: Unlimited Auditor Liability in the United Kingdom, 23 ACCT., ORG. & SOC’Y. 105, 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 [pounds sterling] million against Binder Hamlyn, a leading firm of British accountants. See id.

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

(14) See John Lepper, N.Z. Auditors Strain Under Litigation Threat, ACCT., Mar. 1992, at 8. (15) See Dalton et al., supra note 7, at 53

(16) 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, at 18

(17) See DAN GOLDWASSER & M.T. ARNOLD, ACCOUNTANTS’ LIABILITY 11-1 to 11-3 (1998)

(18) 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 to 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

(19) See Auditor Liability Evokes Wider Concerns, CMA MAG., July/Aug. 1998, at 31.

(20) See H. Fenwick Huss & Fred Jacobs, Risk Containment: Exploring Auditor Decisions in the Engagement Process, 10 AUDITING: J. PRAC. & THEORY 16, 19 (1991)

(21) See AUDITING STANDARDS BOARD, AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, AUDIT RISK ALERT–1992

(22) An accountant may owe a duty to one or more of three categories of people: (1) the client and any other party with whom the accountant is in privity

(23) Negligence is one of the most significant tort theories used in auditor litigation. The reasons are: (1) it is not as difficult to prove as fraud

(24) See H.D. Brecht, Auditors’ Duty of Care to Third Parties: A Comment on Judicial Reasoning Underlying U.S. 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).

(26) See John Siciliano, Negligent Accounting and 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. v. Peat 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 that 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, an appeals court held that New Jersey law applied giving Performance a legal right to 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 than the one applied in this case for determining the scope of an accountant’s duty to nonclients for negligence. N.J. STAT. ANN. [sections] 2A:53A-25 (West 1998).

(28) 107 A. 783 (Pa. 1919). In Pennsylvania, strict privity continues to be the prevailing rule of law. Raymond Rosen & Co. v. Seidman & Seidman, 579 A.2d 424 (Pa. Super. Ct. 1990)

(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. at 445-46. The decision in Glanzer v. Shepard, 135 N.E. 275 (N.Y. 1922), 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 Ultramares, 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. at 446.

(33) Bonita A. Daley & John M. Gibson, The Delineation of Accountants’ Legal Liability to Third Parties: Bily and Beyond, 68 ST. JOHN’S L. REV. 609, 620 (1994)

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

(35) Id.

(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)

(38) See ARK. CODE ANN. [sections] 16-114-302 (Michie 1998)

(39) Rusch Factors, Inc. v. Levin, 284 F. Supp. 85 (D.R.I. 1968).

(40) RESTATEMENT (SECOND) OF TORTS [sections] 552 (1977). Section 552 provides: [sections] 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 to them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating the information.

(2) [T]he 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 (b) through reliance upon it in a transaction that he intends the information to influence or knows that the recipient so intends or in a substantially similar transaction.

(41) Id. See also Daley & Gibson, supra note 33, at 632.

(42) RESTATEMENT (SECOND) OF TORTS [sections] 552(2), comments i, j

(43) Richard Panttaja, Accountants’ Duty to Third Parties: A Search for a Fair Doctrine of Liability, 23 STETSON L. REV. 927, 941 (1994)

(44) Amwest Sur. Ins. Co. v. Ernst & Young, 677 So. 2d 409, 411 (Fla. Dist. Ct. App. 1996)

(45) Badische Corp. v. Caylor, 356 S.E.2d 198, 200 (Ga. 1987).

(46) Amwest Sur. Ins. Co., 677 So.2d at 411 (Fla. Dist. Ct. App. 1996). By receiving notice of the 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, at 633.

(47) Badische Corp., 356 S.E.2d at 199-200 (Ga. 1987)

(48) 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 at the time the report is audited or prepared that the client intends to supply information to another person or limited group of persons. Whether the auditor acquires this knowledge from the client or elsewhere is irrelevant. Id. at 618.

(49) Thomas Gossman, The Fallacy of 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 an accountant’s misrepresentation but no liability attaches without intent to influence. Bily v. Arthur Young & Co., 834 P.2d 745 (Cal. 1992).

(51) 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. [sections] 2A: 53A-25 (West 1998).

(53) Rosenblum, 461 A.2d at 153.

(54) Id.

(55) Denzl Causey, Accountants’ Liability in an Indeterminate Amount for an Indeterminate Class: An Analysis of Touche Ross & Co. v. Commercial Union Ins. Co., 57 MISS. L.J. 379, 380 (1987).

(56) Willis Hagen III, 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 an accountant privity statute. N.J. STAT. ANN. [sections] 2A: 53A-25 (West 1998).

(57) See Touche Ross & Co. v. Commercial Union Ins. Co., 514 So. 2d 315 (Miss. 1987)

(58) The eight states are Arkansas (ARK. CODE ANN. [sections] 16-114-302 (Michie 1998)), Illinois (225 ILL. COMP. STAT. 450/30.1 (West 1998)), Kansas (KAN. STAT. ANN. [sections] 1-402 (West 1998)), Louisiana (LA. REV. STAT. ANN. [sections] 37:91 (West 1999)), Michigan (MICH. COMP. LAWS [sections] 600.2962 (1998)), New Jersey (N.J. STAT. ANN. [sections] 2A: 53A-25 (West 1998)), Utah (UTAH CODE ANN. [sections] 58-26-12 (1998)), and Wyoming (WYO. STAT. ANN. [sections] 33-3-201 (Michie 1998)).

(59) The Arkansas statute is used here as an 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, or 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 the writing or 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. [sections] 16-114-302 (Michie 1998).

(60) 908 S.W.2d 660 (Ark. 1995).

(61) Id. at 662-63.

(62) Id.

(63) 667 N.E.2d 543 (Ill. Ct. App. 1996).

(64) The general rule of liability is that an accountant owes a duty to a nonclient if the accountant was aware that a primary intent of the client was for the professional services to 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 or nonclient a condition of liability for negligent misrepresentation. Id.

(65) Chestnut, 667 N.E.2d at 546.

(66) Id.

(67) Id. at 547.

(68) Id.

(69) Id.

(70) KAN. STAT. ANN. [sections] 1-402 (West 1998).

(71) Id. [sections] 1-402(b)(2).

(72) Id. [sections] 1-402(b)(1).