Ruling in Suit Will Determine CPAs’ Liability : Could Trigger a Rash of Third-Party Claims
It was nearly eight years ago when Irvine accountant John P. Butler rendered the certified public accountant’s standard, unqualified opinion on the financial condition of a Costa Mesa mortgage company he audited, saying the figures “fairly represented” the company’s operating results.
Now, Butler’s role in that audit is being challenged in a lawsuit that could expose accountants in California to a wide new range of liability claims.
Butler is accused in the suit by International Mortgage Co. of Los Angeles of being negligent in preparing his audit of the now-defunct Westside Mortgage Co., causing financial injury to a company that claims it relied on Butler’s statement nine months after it was issued and ultimately lost more than $435,000 in a deal with Westside.
The suit raises a controversial issue never decided before in California: Are certified public accountants liable to unknown third parties for negligence in preparing audited financial statements for their clients?
Whether the case ever goes to trial will depend on a decision expected this month from a state Court of Appeal panel in Santa Ana. But that ruling could have a far-reaching effect on the accounting profession.
National Impact
“This case will be of concern to accountants no matter how it’s decided,” said Los Angeles lawyer Paul J. Hall, who represents the plaintiff, IMC.
While a few states have come down with rulings on opposite sides of the issue, the California court’s decision will have a persuasive effect throughout the state and the nation because California’s appellate and supreme courts are generally well-respected and other states tend to look to California courts for precedent.
“Clearly, if the plaintiff wins, that opens up a wider spectrum of liability that would be very costly,” said Robert A. Petersen, president-elect of the California Society of Certified Public Accountants. “The profession at the moment in California and throughout the United States is having serious problems both in the cost and even (renewing) of errors-and-omissions insurance. Anything we can do to narrow liability will increase our ability to get insurance.”
According to Petersen and others in the accounting profession, the ramifications of opening the door to third-party liability claims range from a fear of losing insurance to a fear of more lawsuits by third parties such as lenders, customers, suppliers and investors--all of whom watch their money go down the drain with a bankrupt firm. Such liability could force independent accountants out of business, they warn.
“For any company dealing on a credit basis, the first thing that is asked for is a financial statement. It is the basic document used for credit purposes,” said New York lawyer Melvyn I. Weiss, an attorney at the forefront of suits against accounting firms.
But the public may have the perception that an accountant does much more than he, in fact, does. “The ordinary audit is not meant to detect fraud,” said Louis Craco, a New York attorney for the American Institute of Certified Public Accountants. He said an auditor is “obliged to go forward and investigate only when the circumstances or facts make him reasonably suspicious.”
Couldn’t Deliver
In the pending California appellate court case, IMC claims that it relied on Butler’s March, 1979, audited financial statement of Westside Mortgage when it decided to purchase $4 million in loans from Westside. At about the same time, IMC made commitments to resell those loans in the secondary market.
But Westside could not deliver the mortgages on schedule, and IMC had to buy loans elsewhere to fulfill its commitment. Claiming it lost $435,293, IMC sued Westside and Butler in January, 1981, for the difference. Westside eventually went out of business.
IMC claims that Butler failed to investigate a $100,000 promissory note that represented nearly all of Westside’s capital and that qualified Westside to handle the federally backed mortgages involved in the deal. The note was secured by a trust deed that was noted in Butler’s audit report.
But Butler did not specify that the security was a fourth trust deed, subordinate to three other creditors. Ultimately, the note could not be paid off when Westside’s senior creditors foreclosed on the property.
“Verbally, it was related to me to be a first trust deed, but in a footnote in the financial statement, I just said it was a trust deed,” Butler said. “IMC should have read the footnotes. They could have called me to verify what was in there.”
Follows 1931 Decision
In the lower court, Orange County Superior Court Judge Judith M. Ryan ruled on Dec. 13, 1983, that IMC could not take its lawsuit to trial because IMC had no direct relationship with Butler and because IMC was not an intended user of the financial statement Butler prepared.
The ruling basically follows an influential 1931 decision by New York’s high court in the case of Ultramares Corp. vs. Touche, Niven & Co., which found that accountants cannot be held liable for an indeterminate amount of liability to an indeterminate number of people.
Weiss said the Ultramares decision, which involved a 1924 incident, came at a time when the accounting profession was largely unorganized and had no general accounting principles and no defined structure. Accountants often sat on the boards of the companies that they audited, he said.
Only after the federal securities laws of 1933 and 1934 did accountants--facing the possibility that government auditors might take over their jobs--organize, establish guidelines and promote their independence, Weiss said.
Rulings in Other States
The issue of third-party liability for accountants has raged in other states during the last few years. The high courts in New Jersey and Wisconsin have ruled that accountants are liable to third parties for negligently prepared audits when they should have reasonably foreseen that the third parties would rely on the financial statements in dealings with the audited companies.
Yet last July, New York’s highest court adhered to the 1931 Ultramares decision, stating that accountants are not liable to people who deal with their clients unless the accountants know who the people are and know that they plan to rely on the financial statements.
“In the last 20 years, there has been a very dramatic change in the perception of what accountants are doing and what they aren’t doing,” he said. “The New York court (last July) was relying on a doctrine created in a day when the accountant’s role was different.”
Weiss, Hall and other plaintiffs’ lawyers argue that an audited financial statement--one in which the accountant verifies a company’s financial data independently and, in essence, vouches for it--is a statement for all purposes. It does not matter if the accountant specifically knows everyone who might rely on it, they said.
“It only matters if the plaintiff is part of a group that an accountant could reasonably foresee would be injured by his negligent conduct,” Hall said.
Reject Doctrine
After all, Weiss said, accountants know that their audits are usually included in annual reports, which are sent to lenders, other companies, shareholders, potential investors and the press.
In the California case, IMC attorney Hall contends that the state should not adopt the Ultramares doctrine because there is no justification for relieving accountants of third-party liability when other professionals, such as doctors and lawyers, are held liable to third parties for negligence. A psychiatrist who fails to warn someone about a patient’s threats against him, for instance, would be liable under state law if the patient carried out the threats.
While Hall said he believes that previous California court opinions on negligence should apply to accountants as well, his adversaries claim that those opinions have been restricted to the personal injury field.
Hall’s opponent in the IMC case, Jeffrey H. Leo--who represents Butler--maintains in court filings that in other cases involving economic injuries, rather than personal injuries, the courts consider only “the intent of the parties and the nature of the transaction.”
“The problem is that audits get such wide dissemination that accountants can’t control who gets the information,” said Craco, the attorney for the American Institute of Certified Public Accountants.
“Neither their fee structure nor the insurance structure can remotely compensate accountants for (all third-party) losses,” he said.
Dan L. Goldwasser, an attorney for the New York State Society of Certified Public Accountants, who represented one of the defendants in the New York case last July, said:
“The work of accountants is highly competitive and fees are small. If you let everyone who comes along sue, you won’t have any accountants. You have to draw the line (or else) every action is a bankruptcy.”
The lawyers in the IMC-Butler case acknowledge that, no matter how the appellate court rules, the issue of third-party liability will not go away. Each said that if he loses, his client likely will appeal to the state Supreme Court.
Meanwhile, accountants are considering rewording their standard audit opinions to qualify what they say and to explain in more detail exactly what they did.
And if California follows the Ultramares doctrine, Weiss said, lenders and others dealing with a company will insist on contacting accountants directly and asking them to recertify their financial statements. “It’s happening in New York already,” he said.
