Third-Party Liability: The Sun Is Coming out Today!

By Wootton, Charles W.; Moore, Mary Virginia | The National Public Accountant, February 1995 | Go to article overview

Third-Party Liability: The Sun Is Coming out Today!


Wootton, Charles W., Moore, Mary Virginia, The National Public Accountant


During the last few years, accountants have been held liable to various parties for hundreds of millions of dollars. From the one-person accounting firm to the largest international firm, it seems that juries have been willing to hold the accounting firm liable for losses incurred by lenders or investors of failed businesses. It also appears that the parties to which an accountant could be held liable were constantly expanded. Courts were often willing to expand the accountant's liability beyond the primary beneficiary (client) rule of a firm's services established in the landmark decision, Ultramares Corp. v. Touche (1931).(1)

Moreover, the number of juries willing to assess large damages against accounting firms has greatly increased. Often, because of these large awards, accounting firms are inclined to settle law suits they would have contested in the past. Some accountants have stated that if the liability trend continues, they will be forced to eliminate preparing audits or reports for certain clients.

Just as the liability cloud appeared darkest, several recent court decisions indicate that the future for accountants might not be as dark as it once appeared. These decisions, at both the national and state level, have somewhat restricted the parties who may bring suit and/or have reduced the grounds on which a suit can be based. Moreover, a few states have passed laws that provide accountants with limited protection against third-party liability. This article traces the development of a broad definition of accountants' liability to third parties and reviews recent court decisions and state statutes that may restrict this definition.

Background

Although there were earlier cases regarding accountant's liability, the seminal case on privity of contract is Ultramares Corp. v. Touche, a 1931 New York Court of Appeals case. This decision dominated case law for over 30 years and, with slight modifications, the so-called "Ultramares approach" is still followed in New York and several other states.

In Ultramares, Touche, Niven & Co. had conducted an audit of Fred Stern & Co. Stern, seeking a loan, later provided a copy of the audit report to a potential creditor. The creditor provided the loan and when Stern failed, the creditor sued Touche to recover its loss. In its opinion, the court declined to hold the accounting firm liable to an unknown third party who relied on the audit report. In his famous statement, Judge Benjamin N. Cardozo distinguished accountants from others and set forth the consequence of extending liability to parties whose reliance upon a statement could not be foreseen:

"If liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class."(2)

Expansion Of Accountant's Liability

Under the Ultramares approach, accountants (guilty of ordinary negligence) only have a duty to people for whose "primary benefit" the statements are intended. For the next 30 years, many courts followed this approach. However, in the 1960s, the close privity requirement for liability began to erode.

One of the first cases to extend an accountant's liability was Rusch Factors, Inc., v. Levin(3) In this case, Rusch Factors, Inc., requested a set of certified statements from a corporation seeking financing. After reviewing the statements, Rusch Factors loaned the corporation more than $337,000. Subsequently, the corporation failed and Rusch Factors incurred a loss of more than $121,000. Rusch Factors sued the accounting firm to recover the loss.

In denying the defendant's motion to dismiss based on no privity of contract, the United States District Court set forth two important theories. First, the court held that an accountant is liable for negligence for financial misrepresentations relied upon by those actually foreseen, a limited class of persons. …

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