Ruling Expands Liability in Audits : ‘Foreseeable’ 3rd Parties Could Sue Negligent Accountants
In a decision that vastly expands the liability of accountants in connection with inaccurate audits, a state appellate court in Santa Ana has ruled that they are liable to “reasonably foreseeable” third parties who are injured by negligently prepared financial statements.
The unanimous opinion by the three-judge Court of Appeal panel opens the door for those who rely on corporate audits in their business transactions to sue certified public accountants for negligence and misrepresentation in the preparation of audits.
Previously, California appellate courts had not ruled on the issue. Until recently, the leading authority was a 1931 New York opinion that had limited accountants’ liability to third parties to cases in which accountants knew who would be relying on their audits or to cases of fraud.
Appeal Planned
“The people (whom an accountant) could ‘reasonably foresee’ are limitless--creditors, business partners, companies, anyone,” said Cathryn M. Brogan of Los Angeles, a lawyer for the losing party, Irvine accountant John P. Butler.
Butler said he would appeal to the state Supreme Court. “I don’t have $700,000 (to pay in damages),” he said.
Paul J. Hall, attorney for the plaintiff, International Mortgage Co., cautioned that the ruling did not break any new ground in negligence law. It simply applied the current state of the law for the first time to accountants, who had previously been shielded from liability to unknown third parties.
“This is the correct decision,” Hall said. “It is simply a quirk in legal history that we never had an opinion on accountant liability before. The legal principles were always out there and any other case previously should have been decided the same way.”
International Mortgage Co. (IMC), a subsidiary of real estate developer Kaufman & Broad, claims it relied on Butler’s March, 1979, audited financial statement of the now defunct Westside Mortgage Co. in Costa Mesa 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 commitments. Claiming it lost $435,293, IMC sued Westside and Butler in January, 1981, for the difference. Westside eventually went out of business.
Westside claims Butler failed to investigate a $100,000 promissory note that represented the bulk 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, which was noted in Butler’s seven-page 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.
IMC’s suit initially was thrown out of Orange County Superior Court when Judge Judith M. Ryan agreed with the New York rationale, which stated that accountants should not be exposed “to a liability in an indeterminate amount for an indeterminate time to an indeterminate class.”
Higher Fees Advised
The appellate panel said accountants can “more appropriately” assume the risk of such loss by increasing their fees, which the public would ultimately pay. Society is better served that way, the court said, because there would be a “financial disincentive” for negligent conduct and a heightening of the profession’s cautionary techniques.
But Alan Lazar, another defense lawyer for Butler, contended that small accountancy operations like Butler’s cannot command higher fees and cannot get insurance to cover possible losses. Colleague Brogan claimed Butler and insurance companies would not even be able to determine how much insurance accountants should carry because a small agency can audit companies involved in multimillion-dollar deals.
“The decision will drive accountants out of business,” Lazar said.
In the opinion, written by Presiding Justice John K. Trotter Jr., the panel said that “audited financial statements are not confidential information for the client only but are instead investigatory reports for possible, if not probable, public use in the business world.”
Ethical Code Cited
The court held the accounting profession to the ethical code issued by the American Institute of Certified Public Accountants. The court said the code “emphasizes the profession’s responsibility to the public, a responsibility that has grown as the number of investors has grown, as the relationship between corporate managers and stockholders has become more impersonal and as government increasingly relies on accounting information.”
A spokesman for the Big Eight accounting firm of Price Waterhouse & Co. in New York said that the decision should have no effect on “good, competent auditors” but that it would hinder the ability of accountants to get insurance, a scarce commodity already.
“California is a major state with major significance to the auditing profession,” said the spokesman, Kenneth J. Doyle. “There’s a good number of major corporations there.”
He worried that lawsuits based on negligence instead of fraud would be difficult to win because auditing is “a very unscientific process and very hard to explain” and that juries could easily see in hindsight that one of the many generally accepted accounting principles that an auditor might not have used in a particular case would have uncovered fraudulent financial figures.
