ALI-ABA Course of Study
Accountants' Liability: Litigation and Issues
July 9 - 10, 2009
Excerpt From:
Theories of Liability
By
Richard P. Swanson
Arnold & Porter LLP
New York, New York
This article is reproduced from the ALI-ABA Course of Study Materials, Accountants'
Liability, held May 15 - 16, 2008 , in San Diego, California.
For the archived online course: http://www.ali-aba.org/
24
2
25
TABLE OF CONTENTS
Page
INTRODUCTION .......................................................................................................................... 1
I.
COMMON LAW LIABILITY — ULTRAMARES AND THE PRIVITY BAR.............. 1
A.
Background — Ultramares. .................................................................................... 1
1.
Privity.......................................................................................................... 2
2.
Fraud. .......................................................................................................... 3
3.
Known Recipient. ....................................................................................... 3
4.
Criticism of Ultramares............................................................................... 4
B.
Developments in New York Since Ultramares....................................................... 5
1.
Credit Alliance. ........................................................................................... 5
2.
Security Pacific. .......................................................................................... 7
3.
Parrott and BDO. ........................................................................................ 8
C.
Approaches in Other States..................................................................................... 9
1.
States Which Reject Ultramares. .............................................................. 10
2.
States Which Continue to Adhere to Ultramares. ..................................... 13
3.
Restatement Approach. ............................................................................. 13
4.
California. ................................................................................................. 15
5.
Texas. ........................................................................................................ 17
6.
State Statutes............................................................................................. 17
D.
Liability to Client; Peculiar Defenses. .................................................................. 19
1.
Cenco Defenses — “To Impute or Not to Impute”................................... 19
2.
Causation................................................................................................... 23
3.
Contributory/Comparative Negligence..................................................... 25
4.
Defalcations. ............................................................................................. 26
5.
Client Financings. ..................................................................................... 26
E.
A Special Case — Compilation and Review Reports........................................... 26
II.
SECURITIES LAW CLAIMS AGAINST ACCOUNTANTS ........................................ 27
A.
Securities Act of 1933........................................................................................... 27
1.
Section 11.................................................................................................. 28
2.
Section 12(a)(2). ....................................................................................... 29
3.
Section 17(a). ............................................................................................ 32
B.
Securities Exchange Act of 1934.......................................................................... 32
1.
Section 10(b)............................................................................................. 32
(a) Purchase or Sale. ................................................................................ 32
(b) Scienter. ............................................................................................. 33
(c) Reliance.............................................................................................. 33
(d) “Fraud on the Market”. ...................................................................... 34
(e) Loss Causation. .................................................................................. 34
(f) Controlling Persons/Aiding and Abetting. ......................................... 35
(g) Damages. ........................................................................................... 36
(h) Rule 9(b) and the PSLRA Pleading Standards. ................................. 36
2.
Section 18.................................................................................................. 37
C.
The Private Securities Litigation Reform Act. ..................................................... 37
III.
RICO ................................................................................................................................. 38
CONCLUSION............................................................................................................................. 39
Copy of Swanson-2008 ALI-ABA Theories of Liability_(NY_356629_1).DOC
i
26
ACCOUNTANTS’ LIABILITY
ALI-ABA Course of Study
May 15-16, 2008
San Diego, California
Theories of Liability
By: Richard P. Swanson
Arnold & Porter LLP
INTRODUCTION
In the wake of almost any kind of adverse financial news, accountants and other
persons are commonly sued. Many times the primary wrongdoers in a financial debacle are
insolvent, and a lender or investor must look to other parties to recoup losses. Frequently
accountants are among the primary targets. The recent environment, after Enron, Worldcom and
other well-publicized financial scandals, is a difficult one for accountants, as the profession has
cost itself credibility and jurors are often hostile as a result. It is therefore important to have an
overview of the principal theories of liability which can be asserted against accountants, and the
defenses.
I.
COMMON LAW LIABILITY —
ULTRAMARES AND THE PRIVITY BAR
One important area of litigation against accountants involves the liability of
accountants for negligence to third parties who are not their clients — for example, shareholders
and creditors of the companies who employ them. Commonly, those claims are barred because
the third party was not in “privity” with the accountant, although courts in different states apply
varying approaches to the problem.1
A.
Background — Ultramares.
In the seminal case of Ultramares Corp. v. Touche,2 New York’s highest court,
the Court of Appeals, held that persons damaged by their reliance on an accountant’s negligently
prepared financial statements who were not in privity with the accountant may not recover,
1
See Brodsky and Swanson, “The Expanded Liability of Accountants for Negligence,” 12 Sec. Reg. L.J. 252 (1984);
Feinman, “Liability of Accountants for Negligent Auditing: Doctrine, Policy and Ideology,” 31 F.S.U. L.Rev. 17 (2003).
2
255 N.Y. 170, 174 N.E. 441 (1931).
1
27
unless they could show either (i) that the accountant defrauded them, or (ii) that the accountant
actually knew they would rely on the financial statements. Thus, under the traditional common
law rule, a typical creditor or investor who loaned or invested money in reliance on negligently
prepared financial statements could not recover from the accountant unless he could prove that
the accountant knew that the particular creditor or investor would rely on the statements.
The defendants in Ultramares were certified public accountants who had been
employed by Fred Stern & Co., Inc., to prepare a balance sheet for Stern, which required
substantial credit to finance its purchase of rubber for importation and resale, a fact which the
accountants knew. The Stern balance sheet was materially false because Stern fraudulently
created fictitious accounts receivable and other assets. The plaintiff, a factor, made loans to
Stern, relying on the balance sheet, and when Stern went bankrupt, the plaintiff sued the
accountants, accusing them of negligently preparing the financial statements.
1.
Privity.
Although the accountants were negligent, they were not held liable on that theory,
because they were not in privity with the factor. In an opinion written by Judge Benjamin
Cardozo, the Court of Appeals acknowledged that “[t]he assault upon the citadel of privity is
proceeding in these days apace,”3 but the Court nevertheless declined to reject the privity
doctrine in that case. Judge Cardozo said, in an oft-quoted passage, that, absent privity, there is
no duty owed by an accountant to a third party for negligence because:
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. The
hazards of a business conducted on these terms are so extreme as
to enkindle doubt whether a flaw may not exist in the implication
of a duty that exposes to these consequences.4
The only exceptions to this rule which the Court of Appeals recognized were
(i) where the accountant fraudulently prepared a financial statement, or (ii) where he negligently
prepared a financial statement primarily for the benefit of a particular third party specifically
known to him.5
3
Id. at 180, 174 N.E. at 445.
4
Id. at 179-180, 174 N.E. at 444.
5
Id. at 182-183, 189, 174 N.E. at 445-446, 448.
2
28
2.
Fraud.
The first of these two exceptions to Ultramares’ privity bar has proven to be
relatively unimportant as a practical matter, because it is unusual for a plaintiff to be able to
allege in good faith that an accountant was actually involved in a scheme to defraud — although
such cases do exist.6
While the fraud exception has generally been unimportant in actual litigation,
plaintiffs might be able to use the exception to avoid the privity bar more often than they have in
the past, because it is often forgotten that what Judge Cardozo called “fraud” embraced
something more akin to gross negligence:
Our holding does not emancipate accountants from the
consequences of fraud. It does not relieve them if their audit has
been so negligent as to justify a finding that they had no genuine
belief in its adequacy, for this again is fraud. It does no more than
say that, if less than this is proved, if there has been neither
reckless misstatement nor insincere profession of an opinion, but
only honest blunder, the ensuing liability for negligence is one that
is bounded by the contract and is to be enforced by the parties by
whom the contract has been made.7
Judge Cardozo went on to state that “fraud includes the pretense of knowledge when knowledge
there is none,” and that gross negligence is “evidence to sustain an inference of fraud.”8 On that
basis he permitted the fraud claim in Ultramares to proceed, even absent privity, under a standard
which is closer to gross negligence than actual fraud.
Thus, while Ultramares dismissed the negligence claim on grounds of lack of
privity, it did not dismiss the entire case against the accountant on that basis — a fact which is
often forgotten.
3.
Known Recipient.
The second exception to the Ultramares rule has provoked more controversy
because, as is set forth below,9 parties can reasonably disagree as to whether or not a third party
was a known and intended beneficiary or recipient of the accountant’s financial statements.
As Judge Cardozo pointed out in Ultramares, this second exception to the privity
rule has its foundation in a prior decision of the Court of Appeals, Glanzer v. Shepard.10 In
6
See, e.g., Warner v. Alexander Grant & Co., 828 F.2d 1528 (11th Cir. 1987).
7
255 N.Y. at 189, 174 N.E. at 448.
8
Id. at 179, 190-91, 174 N.E. at 444, 449.
9
See nn. 44-52, infra, and accompanying text.
10
233 N.Y. 236, 135 N.E. 275 (1922).
3
29
Glanzer, Judge Cardozo permitted an action for negligence to proceed absent privity. Glanzer
involved a seller of beans who had requested the defendant, a public weigher, to weigh the beans
and to furnish the buyer with the results. The buyer paid the seller for the beans based on his
belief in the accuracy of the weight certificate, which ultimately turned out to be erroneous. The
buyer then sued the weigher. Judge Cardozo held for the buyer, finding a duty on the part of the
weigher to the buyer, even though there was no privity between them, because the weigher knew
the buyer was the intended recipient of the certificate and would rely on it.
Because of Glanzer, Judge Cardozo was forced to acknowledge in Ultramares that
when an accountant prepares a financial statement for someone who is not his client but who he
knows is the person for whose benefit the statement is being prepared, liability for negligence is
appropriate even absent privity between the accountant and the third party.11
4.
Criticism of Ultramares.
Because privity is no longer a bar to liability in other areas of tort law, its
continued existence as applied to accountants is perhaps anomalous. The privity requirement is
arguably inconsistent with the two primary policy goals of tort law — compensating persons
injured by the negligence of others and deterring future negligent conduct. Those policies have
led most state courts to conclude that negligent tortfeasors generally should be liable to
reasonably foreseeable victims of their negligence, regardless of lack of privity.12 Judge
Cardozo himself wrote the opinion in one of the leading cases eliminating the privity bar to
recovery in the product liability area, MacPherson v. Buick Motor Co.13
For those reasons, many commentators have criticized Ultramares.14 One
commentator even went so far as to say that the continued adherence of Ultramares in most states
is “inexplicable” and may be based on “awe for Cardozo.”15 Nevertheless, as recently as 1968,
one court was able accurately to state that “[no] appellate court, English or American, has ever
held an accountant liable in negligence to reliant parties not in privity.”16 Although some cases
in some states did relax the privity rule somewhat, more recently, led by the New York Court of
Appeals, there has been a renewed emphasis on the privity bar.
11
255 N.Y. at 182-83, 174 N.E. at 445-46.
12
See nn. 13-14 and 29-39, infra, and accompanying text.
13
217 N.Y. 382, 111 N.E. 1050 (1916).
14
See, e.g., Wiener, “Common Law Liability of the Certified Public Accountant for Negligent Misrepresentation,” 20 San
Diego L. Rev. 233 (1983); Mess, “Accountants and the Common Law: Liability to Third Parties,” 52 Notre Dame Law. 838
(1977); Besser, “Privity? An Obsolete Approach to the Liability of Accountants to Third Parties,” 7 Seton Hall L. Rev. 507
(1976); Solomon, “Ultramares Revisited: A Modern Study of Accountants’ Liability to the Public,” 18 De Paul L. Rev. 56
(1968).
15
Wiener, n. 14, supra, at 236.
16
Rusch Factors, Inc. v. Levin, 284 F. Supp. 85, 90 (D.R.I. 1968). Rusch contained a particularly vehement criticism of the
foundations of the Ultramares doctrine. Rusch and other cases are collected in Annot., “Liability of Public Accountant to
Third Parties,” 46 A.L.R.3d 979.
4
30
B.
Developments in New York Since Ultramares.
While Ultramares has been criticized by some commentators, it has been
rigorously adhered to in New York, where the State’s highest court, the New York Court of
Appeals, has repeatedly turned back efforts to overturn Ultramares or to diminish its effect by
broadening the “known third party/conduct approaching privity” exception. If anything, the New
York Court of Appeals has recently taken a more rigid privity approach than was foreshadowed
by Ultramares itself.
1.
Credit Alliance.
In Credit Alliance Corp. v. Arthur Andersen & Co.,17 the Court of Appeals
strongly reaffirmed the continuing vitality of Ultramares, even though a lower court stated in that
case that “the time has come” to reconsider it. Credit Alliance involved a creditor which claimed
that a financial statement on which it relied in deciding to make a loan had negligently overstated
the company’s earnings and net worth. When the company went bankrupt, the creditor sued the
accountant.
While the creditor and the accountant were not in privity, the creditor argued,
first, that Ultramares should be overruled, and second, that in any event the accountant knew that
the financial statement was prepared to show to potential lenders who would rely on it in making
credit decisions.
As to the first argument, the New York Court of Appeals squarely rejected the
direct challenge to Ultramares, reaffirming its continued validity in New York.
As to the second argument, the creditor relied on the Court of Appeals’ prior
decision in White v. Guarente,18 in which the Court held that an accountant could be held liable
for negligence to forty limited partners of a partnership for negligent preparation of partnership
financial statements and tax returns. The Court of Appeals in White concluded that, while the
accountant was in privity with the partnership and not the limited partners, he nevertheless knew
that the limited partners would rely on his partnership audit tax return in preparing their own
individual tax returns.
White in turn had relied on Glanzer v. Shepard for the proposition that a known
and intended beneficiary of the accountant’s work could hold the accountant liable for
negligence, even absent privity. White could have been used to broaden the scope of persons to
whom the accountant could be held liable, because the accountant’s client was the limited
partnership, not the partnership’s limited partners. The creditor-plaintiff in Credit Alliance
argued that the import of White was that an accountant could be held liable to a general class of
persons whom the accountant knows might rely on his work, such as potential creditors and
stockholders who are deciding whether to invest.
17
65 N.Y.2d 536, 483 N.E.2d 110, 493 N.Y.S.2d 435 (1985).
18
43 N.Y.2d 356, 372 N.E.2d 315, 401 N.Y.S.2d 474 (1977).
5
31
If White is read so expansively, it substantially eviscerates the privity
requirement. If an accountant can be liable to forty limited partners, because he knows they will
rely on his financial statements, the next logical step might be to hold the accountant liable to a
corporation’s stockholders and creditors, whom he also knows may rely on his work product.
But if the class of person to whom the accountant may be liable is stretched that far, the next
logical step after that might be to hold the accountant liable to potential stockholders and
creditors who might rely on his work. That last step, after all, is arguably not an enormous
difference from the prior one. But that is precisely the position adopted by the courts and
commentators which urge rejection of Ultramares.19
The Court of Appeals in Credit Alliance rejected the expansive reading of White
which would have allowed the accountant to be liable to classes of persons with whom he was
not in privity. The Court stated instead that, to be liable to a person with whom the accountant
was not in privity, the accountant must know when he prepares his financial report that the
particular person would use the report and would rely on it, and that the preparation of the report
was for that specific purpose. The Court of Appeals enunciated a three-part test:
Before accountants may be held liable in negligence to
noncontractual parties who rely to their detriment on inaccurate
financial reports, certain prerequisites must be satisfied: (1) the
accountants must have been aware that the financial reports were
to be used for a particular purpose or purposes; (2) in the
furtherance of which a known party or parties was intended to rely;
and (3) there must have been some conduct on the part of the
accountants linking them to that party or parties, which evinces the
accountants’ understanding of that party or parties’ reliance.20
Because there was no allegation in Credit Alliance that the accountant knew anything about the
specific creditor, or of his possible reliance on the accountant’s financial report, there could be
no liability for negligence without privity.
Contrast, however, the Court of Appeals’ decision on the same day in the
companion case of European American Bank & Trust Company v. Strauhs & Kaye,21 where the
accountant’s audit was performed at the request of a lender for his specific use and where the
accountant and the lender met several times to discuss the financial report. On these facts the
Court of Appeals found a sufficient nexus between the accountant and the lender to sustain
liability absent actual privity, based on the accountant’s knowledge of the lender and his
intended use of the financial statements.
Strauhs & Kaye suggests that a creditor or investor who wants to create a nexus
approaching privity may do so, for example, by insisting prior to investment that he be allowed
19
20
21
See nn. 30-39, infra, and accompanying text. See also n. 14, supra.
65 N.Y.2d at 551, 483 N.E.2d at 118, 493 N.Y.S.2d at 443.
65 N.Y.2d 536, 483 N.E.2d 110, 493 N.Y.S.2d 435 (1985).
6
32
to meet with the accountant to discuss the company’s financial statements. Thus, careful
planning in advance of litigation can create the right to sue the accountant later, notwithstanding
Credit Alliance and the privity bar.
2.
Security Pacific.
The next case in the New York Court of Appeals’ reaffirmance of the continued
vitality of Ultramares, was the case of Security Pacific Business Credit, Inc. v. Peat Marwick
Main & Co.22 There, a secured loan had been expressly conditioned on receipt by the lender of
an audit report, but the accountant had not been told prior to the audit that the report would be
provided to the particular lender prior to the making of the loan. There was evidence that the
lender had spoken to the accountant by telephone after the audit report was prepared and
distributed to lenders but before the loan was made. According to the lender, in the telephone
conversation the accountant verbally re-confirmed his “comfort” with the audit results.
When large amounts of accounts receivable proved to be uncollectible, the lender
sued, but the Court of Appeals dismissed the claim, once again strongly reaffirming Ultramares.
The lender argued that its direct contact with the accountant constituted conduct which satisfied
the “near privity” exception of Glanzer and its progeny, but the Court of Appeals rejected that
suggestion, on the rationale that by one telephone call, after the audit report was prepared, in
which general responses to the lender’s queries were provided, the lender could not “unilaterally
create such an extraordinary obligation.”23 Over a vigorous dissent, the Court of Appeals
rejected the contention that the lender had a sufficient relationship approaching privity to impose
liability, finding instead that there was no evidence that the accountant knew that the primary
purpose of his audit was for the particular use of the specific potential lender.
Security Pacific shows just how narrowly New York construes an accountant’s
duties. The dissent in the case found sufficient “linking conduct” between the lender and the
accountant at least to raise a fact issue, precluding summary dismissal. But the majority
apparently wanted to allow accountants to be able to control the potential liability from their
work by being able to know, in advance, who can and will be relying on their reports.
The Court of Appeals in Security Pacific distinguished its prior Strauhs & Kaye
decision by emphasizing that in that use there had been numerous contacts between accountant
and lender, some of which occurred prior to completion of the audit report, rather than a single
telephone call afterwards. Thus, in Strauhs & Kaye there was a more substantial basis for
concluding that the accountant knew the lender would rely.
Thus, in New York, it now appears that, to fall within the “near privity”
exception, the accountant has to know, prior to completing his work, that an identified specific
recipient intends to rely on the work.
22
79 N.Y.2d 695, 586 N.Y.S.2d 87, 597 N.E.2d 1080 (1992).
23
79 N.Y.2d at 706, 586 N.Y.S.2d at 92, 597 N.E.2d at 1085.
7
33
The Court of Appeals’ holdings in Ultramares and Credit Alliance were strongly
reaffirmed by that Court, in William Iselin & Co., Inc. v. Mann Judd Landau.24 Thus, New York
has firmly placed itself in the camp of those states which continue to adhere to the Ultramares
doctrine.
3.
Parrott and BDO.
The most recent re-affirmances by the Court of Appeals of the Ultramares
doctrine came in two separate decisions in 2000. In the first case, Parrott v. Coopers & Lybrand
L.L.P.,25 the accounting firm provided an annual evaluation of a closely-held client corporation’s
stock for ESOP purposes. A separate agreement provided that if a shareholder left the
corporation, his shares would be brought at the then-current ESOP valuation set by the
accounting firm. The plaintiff had left the corporation, and he complained about the price set for
his shares. After completing other proceedings to set the value of his shares, the plaintiff sued
the accountants.
The Court of Appeals found that the plaintiff shareholder was not in privity with
the accountants. It was conceded that the plaintiff had never spoken with the accountants, and
had never read or relied upon their ESOP valuation report. The Court of Appeals thus said there
was no reliance and no linking conduct, failing two of the three Credit Alliance tests.
Parrott can be criticized. First, the plaintiff in that case was one of a small class
of shareholders in a closely-held corporation, arguably analogous to the limited partners in
White. Second, there was some evidence that the accounting firm knew its ESOP valuations
were also being used to set the price for other shareholder stock transaction, which arguably
constituted linking conduct and an awareness of the possible ESOP valuation use. Third, the
plaintiff in Parrott had the fair value of his shares set and paid by the corporation in another
proceeding, so how could there have been any damages? Thus, it does not appear that there was
any necessity to reach the privity question. Nevertheless, the Court of Appeals used Parrott to
reaffirm Ultramares, once again.
Barely two months later, the Court of Appeals again ruled that a case should be
dismissed against an accountant, this time involving a fraud claim, in SIPC v. BDO Seidman
LLP.26 BDO came to the Court of Appeals by way of a certification of a state law question from
the Second Circuit. There BDO’s audit client was A.R. Baron, a notorious “pump and dump”
penny stock broker. BDO’s audit reports were filed with the NASD, as applicable SEC values
required, certifying that Baron complied with net capital rules. As is also required by SEC rules,
BDO issued an annual report concerning Baron’s internal bookkeeping and its procedures for
safeguarding securities, noting no problems.
24
71 N.Y.2d 420, 522 N.E.2d 21, 527 N.Y.S.2d 176 (1988). See also Ossining Union Free School District v. Thune
Associates Consulting Engineers, 73 N.Y.2d 417, 541 N.Y.S.2d 335, 539 N.E.2d 335 (1989), and Prudential Insurance Co.
v. Dewey Ballentine Bushby Palmer & Wood, 80 N.Y.2d 377, 590 N.Y.S.2d 831, 605 N.E.2d 318 (1992), in which the New
York Court of Appeals applied the Ultramares approach to other kinds of professionals.
25
95 N.Y.2d 479, 718 N.Y.S.2d 709, 741 N.E.2d 506 (2000).
26
2001 WL 139117.
8
34
When A.R. Baron failed, SIPC stepped in, and sued BDO, claiming that had
BDO’s audit reports noted Baron’s financial condition and its violations of securities laws, SIPC
and/or the NASD could have stepped in earlier, avoiding many of the resulting losses. The Court
of Appeals characterized the claim as “no news is good news,” which the Court said “is an
insufficient basis for SIPC’s fraud claim here.” Because the BDO reports had not been
forwarded to SIPC, but rather to the NASD, the Court of Appeals said there could not have been
any reliance by SIPC. In addition, even if BDO’s reports had been prepared as SIPC contended
they should have been, the possibility that the NASD might not have acted upon them disrupted
the causal link.
While BDO nominally involved a fraud claim, as to which the privity doctrine
would ordinarily not apply, the way the Court of Appeals dealt with it is remarkably similar to its
treatment of the privity issue in Parrott. Had there been a privity-like relationship between SIPC
and BDO, there might have been a basis for a finding of reliance. Thus, while Ultramares may
have said privity is not necessary in the case of fraud, BDO may have imported the privity
concept into accounting fraud claims via the back door, by adopting a privity-like reliance
requirement. Parrott is a good example of how the privity, reliance and causation requirements
often blend together.27
The degree to which the privity bar limits negligence claim against accountants in
New York is shown by LaSalle National Bank v. Ernst & Young. There, a bank lender sued,
alleging that it had insisted that a borrower replace a small accountant with “a nationally
recognized accounting firm”. The bank alleged that it recommended and spoke with the
replacement accountant. That, the lower court said, was enough to meet the three-part Credit
Alliance test. The Appellate Division, New York’s intermediate appellate court, reversed,
however, finding that a brief telephone call was not enough to provide “linking conduct”.28
While the Appellate Division seemed to be concerned about the lack of specificity alleged by the
bank about the call and the absence of a confirming letter – casting doubt on whether the call had
actually happened – the case was dismissed on the pleadings in the face of an allegation that the
lender and the accountant had spoken and the accountant had given the lender assurances.
Because New York has been such a leading jurisdiction in the law of auditor’s liability, it has to
be assumed that many other states may follow this highly restrictive interpretation of the privity
doctrine.
C.
Approaches in Other States.
While New York continued to follow Judge Cardozo’s opinion in Ultramares,
some states have adopted different approaches. New Jersey, Wisconsin and Mississippi have all
at one time rejected Ultramares, holding instead that accountants should be liable to all
27
See also White v. BDO Seidman LLP, slip op., No. A01A0316, decided May 22, 2001 (Ga. App.), in which the court
dismissed a noteholder case against an accountant, because the noteholders were not in privity with the accountant and did
not receive or review the financial statements. The noteholders’ theory was described by the court as “indirect reliance”,
based on their allegation that the SEC would not have accepted the prospectus and registration statements for filing without
BDO’s audit opinions.
28
LaSalle National Bank v. Ernst & Young LLP, slip op. No. 3196, decided August 9, 2001 (App. Div. 1st Dep’t), reversing,
No. 115040/99 (Sup. Ct. N.Y. Co., decided August 30, 2000).
9
35
reasonably foreseeable users of their financial statements. Other states adhere to Ultramares and
still other states employ an intermediate approach.
1.
States Which Reject Ultramares.
The first state which squarely rejected Ultramares was New Jersey, which
abandoned the privity doctrine in favor of the general tort law standard of reasonable
foreseeability as demarcating the scope of the accountant’s duty.29 In H. Rosenblum, Inc. v.
Adler,30 the New Jersey Supreme Court held that an accountant could be liable for negligence to
a purchaser of stock who was not the accountant’s client and who was not specifically known to
the accountant.
Rosenblum was an action against Touche, Ross & Co., the auditor for Giant
Stores Corporation, which had acquired the plaintiff’s company for shares of Giant common
stock. Shortly thereafter, Giant went bankrupt and the stock became worthless.
In deciding to sell his business for Giant stock, the plaintiff relied on materially
false Giant financial statements certified by Touche, Ross. The plaintiff sued Touche, Ross,
claiming that the financial statements had been negligently prepared.
The New Jersey Supreme Court stated the issue as follows:
This case focuses upon the issue of whether accountants should be
held responsible for their negligence in auditing financial
statements. If so, we must decide whether this duty is owed to
those with whom the auditor is in privity, to third parties known
and intended by the auditor to be the recipients of the audit, or to
those who foreseeably might rely on the audit. Subsumed within
these questions is a more fundamental one: to what extent does
public policy justify imposition of a duty to any of these classes?31
In Rosenblum, the plaintiff fell within the last of those three classes — someone who foreseeably
might rely on the audit.
The New Jersey Supreme Court reviewed Ultramares and its progeny, and noted
that while many commentators have criticized Ultramares, as applied to accountants, no court
had abandoned the privity requirement altogether. Nevertheless, the Court said that unless
policy considerations dictated a different result, the privity requirement should not prevent
recovery, because the reasonably foreseeable consequences of the negligent act should define the
duty and should be actionable. The Court, finding no reason to differentiate accountants from
others, said:
29
See Palsgraf v. Long Island R. Co., 248 N.Y. 339, 162 N.E. 99 (1928).
30
H. Rosenblum, Inc. v. Adler, 93 N.J. 324, 461 A.2d 138 (1983).
31
93 N.J. at 329, 461 A.2d at 140.
10
36
When the independent auditor furnishes an opinion with no
limitation in the certificate as to whom the company may
disseminate the financial statements, he has a duty to all those
whom that auditor should reasonably foresee as recipients from the
company of the statements for its proper business purposes,
provided that the recipients rely on the statements pursuant to those
business purposes.32
The most critical factor to the New Jersey Supreme Court was that its decision
might deter negligent accounting practices and prevent innocent parties from suffering losses for
which accountants are responsible:
In the final analysis the injured party should recover damages due
to an independent auditor’s negligence from that auditor. This
would shift the loss from the innocent creditor or investor to the
one responsible for the loss. Accountants will also be encouraged
to exercise greater care leading to greater diligence in conducting
audits.33
Rosenblum rejected Touche, Ross’s suggestion that such liability might carry
with it “the spectra of financial catastrophe.”34 First, the Court noted that accounting firms were
already subject to significant liabilities under the federal securities laws, which had not proved
catastrophic. Second, the wide availability of insurance limits the likelihood of catastrophe.
Third, the extent of financial exposure has “certain built-in limits,”35 because the plaintiff must
prove that he received the financial statements for a proper business purpose, that the statements
were false due to the accountant’s negligence, and that the plaintiff relied upon the misstatements
which were the proximate cause of the plaintiff’s injury. Fourth, the accounting firm might be
able to assert the plaintiff’s comparative negligence as a partial defense. Fifth, the firm also
might be able to obtain contribution or indemnification from the company for which the
statements were prepared, or from its blameworthy officers and employees. Finally, the
accounting firm could limit in its certificate the persons or classes of persons who might be
entitled to rely upon the audit.36
Shortly after the New Jersey Supreme Court’s decision in Rosenblum, the
Wisconsin Supreme Court reached the same result, in Citizens State Bank v. Timm, Schmidt &
Co., S.C.37 There the Court said that “the fundamental principle of Wisconsin negligence law is
32
Id. at 352, 361 A.2d at 153.
33
Id. at 351, 461 A.2d at 152.
34
Id. at 348, 461 A.2d at 151.
35
Id. at 350, 461 A.2d at 152.
36
Id. at 350-51, 461 A.2d at 152.
37
113 Wis.2d 376, 335 N.W.2d 361 (1983).
11
37
that a tortfeasor is fully liable for all foreseeable consequences of his act,” and there were no
policy considerations which justified a more restrictive rule of liability for accountants.38 The
Court relied in part on the general tort law policies of compensation and deterrence to support its
decision.39
The United States Supreme Court has also suggested that the fundamental
premise of Ultramares — that accountants do not owe duties to the public at large — may be
outdated. In United States v. Arthur Young & Co., the Supreme Court held that a corporate
accountant’s tax accrual work papers are not protected from disclosure to the Internal Revenue
Service.40 In the course of its opinion, in dicta, the Supreme Court said:
[T]he 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. This “public
watchdog” function demands that the accountant maintain total
independence from the client at all times and requires complete
fidelity to the public trust. To insulate from disclosure a certified
public accountant’s interpretations of the client’s financial
statements would be to ignore the significance of the accountant’s
role as a disinterested analyst charged with these public
obligations.41
The adoption of this principle — that accountants have duties to third parties transcending any
employment relationship with the client — by the United States Supreme Court has not led many
other states to join New Jersey and Wisconsin in rejecting the Ultramares rule.
In fact, in the case of New Jersey, the AICPA was instrumental in convincing the
state legislature to pass a bill in 1995 overruling Rosenblum and reinstating Ultramares in New
Jersey.42 Thus, at the moment only Wisconsin has unequivocally rejected Ultramares and
replaced it with a general foreseeability principle, and the current trend is back towards a privity
bar.
38
Id. at 386, 335 N.W.2d at 366.
39
Id. at 384, 335 N.W.2d at 365. See also Chevron Chemical Co. v. Deloitte & Touche, 483 N.W.2d 314 (Wis. App. 1992);
Touche Ross v. Commercial Union Ins. Co., 514 So.2d 315 (Miss. 1987); Bradford Sec. Processing Servs., Inc. v. Plaza
Bank & Trust, 653 P.2d 188 (Okla. 1982).
40
465 U.S. 805 (1984).
41
465 U.S. at 817-18.
42
N.J. Stat. §2A:53A-25. For the most definitive construction of the statute, see E. Dickerson & Son, Inc. v. Ernst & Young
LLP, 179 N.J. 500, 846 A.2d 1237 (2004), which rejected negligence claims against an auditor by shareholders of a closely
held cooperative corporation.
12
38
2.
States Which Continue to Adhere to Ultramares.
While some states have rejected Ultramares, many more states continue to adhere
to it.43 Federal cases interpreting state law have also predicted that many other states would
continue to abide by Ultramares.44 Not surprisingly, there has been some confusion at times as
to where a particular state stands.45
Also not surprisingly, there has been some confusion over how Ultramares and
Credit Alliance should be applied in specific cases.46 For example, reasonable people can
disagree as to whether or not a particular third party was adequately alleged to be a known and
intended recipient of the financial statements — this was the disagreement between the majority
opinion and the dissent in Security Pacific.47 This may be an issue of fact which in some cases
cannot be resolved on the pleadings.48
3.
Restatement Approach.
An intermediate approach, which neither adopts Ultramares nor rejects it in its
entirety, is set forth in Section 552 of the Restatement (2d) of Torts. That section limits the
liability of professionals, including accountants, who supply information for the guidance of
others, to losses suffered by classes of generally intended recipients who the accountant knows
will rely on his report:
43
See, e.g., Walpert Smullian & Blumenthal P.A. v. Katz (Md. App., slip op., No. 50, decided November 21, 2000);
MidAmerican Bank & Trust Company v. Harrison, 851 S.W.2d 563 (Mo. App. 1993); Thayer v. Hicks, 793 P.2d 784
(Mont. 1990); Citizens Nat’l Bank of Wisner v. Kennedy and Coe, 232 Neb. 477, 441 N.W.2d 180 (1989); Colonial Bank of
Alabama v. Ridley & Schweigert, 551 So.2d 390 (Ala. 1989); Idaho Bank & Trust Co. v. First Bancorp of Idaho, 115 Idaho
1082, 772 P.2d 720 (1989); Selden v. Burnett, 754 P.2d 256 (Alaska 1988); Gordon v. Etue, Wardlaw & Co., P.A., 511
So.2d 384 (Fla. App. 1987); Investors Tax Sheltered Real Estate, Ltd. v. Laventhol, Krekstein, Horwath & Horwath, 370
So.2d 815 (Fla. App. 1979), cert. denied, 381 So.2d 767 (Fla. 1980); MacNerland v. Barnes, 129 Ga. App. 367, 199 S.E.2d
564 (1973); Landell v. Lybrand, 264 Pa. 406, 107 A. 783 (1919).
44
See, e.g., Tricontinental Industries Ltd. v. PricewaterhouseCoopers LLP, slip op., No. 05-4322 (Seventh Circuit, decided
January 17, 2007) (Illinois law); Toro Co. v. Krouse, Kern & Co., 827 F.2d 155 (7th Cir. 1987) (Indiana law); McLean v.
Alexander, 599 F.2d 1190 (3d Cir. 1979) (Delaware law); Nortek, Inc. v. Alexander Grant & Co., 532 F.2d 1013 (5th Cir.
1976), cert. denied, 429 U.S. 1042 (1977) (Kansas law); Ackerman v. Schwartz, 947 F.2d 841 (7th Cir. 1971) (Colorado
law); Robertson v. White, 633 F. Supp. 954 (W.D. Ark. 1986) (Arkansas law); Hartford Accident & Indemnity Co. v.
Parente, Randolph, 642 F. Supp. 38 (M.D. Pa. 1985) (Pennsylvania law); Pennine Resources, Inc. v. Dorwart Andrew &
Co., 639 F. Supp. 1071 (E.D. Pa. 1986) (Pennsylvania law).
45
Compare Eisenberg v. Gagnon, 766 F.2d 770 (3d Cir.), cert. denied, 474 U.S. 946 (1985), with Hartford Accident, supra, n.
44 and Pennine Resources, supra, n. 44.
46
See, e.g., Banco Totta & Acores v. Stockton Bates & Co., slip op., 84 Civ. 7041 (S.D.N.Y., decided March 13, 1987), which
held that the mere sending of an audit confirmation was sufficient to create a nexus approaching privity under Ultramares
and Credit Alliance. It is questionable whether this approach would survive more recent New York authorities.
47
See also Second National Bank of Warren v. Demshar, slip op., No. 97-A-022 (Ohio App., decided December 26, 1997);
First Florida Bank, N.A. v. Max Mitchell & Co., 558 So.2d 9 (Fla. Sup. 1990).
48
See, e.g., Marcus Brothers Textiles Inc. v. Price Waterhouse LLP, slip op., No. COA97-435 (N.C. App., decided April 7,
1998); Chemical Bank v. Berenson, Berenson, Adler & Co., slip op., No. 6224/87 (Sup. Ct. N.Y. Co., decided April 19,
1989).
13
39
§ 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)
Except as stated in Subsection (3), the liability
stated in Subsection (1) is limited to loss suffered
(a)
by the person or one of a limited group of
persons for whose benefit and guidance he intends to
supply the information or knows that the recipient intends
to supply it; and
(b)
through reliance upon it in a transaction that
he intends the information to influence or knows that the
recipient so intends or in a substantially similar transaction.
(3)
The liability of one who is under a public duty to
give the information extends to loss suffered by any of the class of
persons for whose benefit the duty is created, in any of the
transactions in which it is intended to protect them.
Thus, Section 552 of the Restatement limits liability to a small class of persons for whose
intended use and benefit the accountant’s information was supplied.49
The Restatement approach is broader that the one adopted in New York in Credit
Alliance, which requires knowledge by the accountant of the specific person who relies on the
financial report, but less broad than in New Jersey, where the accountant may be liable to all
reasonably foreseeable users of the financial report, regardless of whether the report was actually
intended for their use. The Restatement approach has been adopted in a number of states,50 and
49
The Official Comment explains that Section 552 is based on the understanding that recipients of commercial information
expect honesty in the provision of the information, but not necessarily due care. One can ask whether this expectation is
accurate. The Comment also notes that limiting professional liability for negligence “promotes the important social policy
of encouraging the flow of commercial information upon which the operation of the economy rests.” However, it may be
reasonable to ask whether there is an “important social policy” in encouraging the flow of commercial information where
that information has been negligently prepared.
50
See, e.g., Nycal Corp. v. KPMG Peat Marvick LLP, 688 N.E.2d 1368 (Mass. 1998); Standard Chartered PLC v. Price
Waterhouse, slip op., Nos. 93-0461 and 93-0442 (Ariz. App. November 7, 1996); ML-LEE Acquisition Fund, L.P. v.
Deloitte & Touche, 463 S.E.2d 618 (S.C. App. 1995); Boykin v. Arthur Andersen & Co., 639 So.2d 504, modified, slip op.,
No. 1920638 (Ala. 1994); Bethlehem Steel Corporation v. Ernst & Whinney, 822 S.W.2d 592 (Tenn. 1991); First Florida
Bank, N.A. v. Max Mitchell & Co., 558 So.2d 9 (Fla. 1990); First National Bank of Bluefield v. Crawford, 386 S.E.2d 310
(W. Va. 1989); Pahre v. Auditor of State, 422 N.W.2d 178 (Iowa 1988); Badische Corp. v. Caylor, 257 Ga. 131, 356 S.E.2d
198 (1987); Raritan River Steel Co. v. Cherry, Bekaert & Holland, 322 N.C. 200, 367 S.E.2d 609 (1988); First Interstate
14
40
federal courts have also predicted its adoption in other states.51
One problem with the Restatement point of view is that it can be a “slippery
slope,” if the class of persons to which the accountant may be held liable is considered to be as
broad, for example, as all purchasers of securities in an offering, on the rationale that the
accountant knew they were intended recipients of the financial statements.52 There can come a
point where, if the Restatement approach is interpreted broadly enough, there is little practical
difference between that approach and the approach adopted by the states which reject Ultramares
altogether.
4.
California.
The California Supreme Court has clearly aligned that state with the states that
adopt a relatively restrictive view of an accountant’s common law liability to third parties.
While previous lower court decisions in California had adopted the New Jersey/Wisconsin
approach,53 in Bily v. Arthur Young & Co.54 the California Supreme Court squarely rejected
H. Rosenblum and adopted the Restatement approach. In discussing the policy reasons for its
decision, the court referred to (i) the primary responsibility of management in preparing financial
statements, (ii) the greater degree of control which the client has as compared with the
accountant in controlling dissemination of the report, and thus the potential scope of liability
exposure, (iii) the fact that audit reports are not simple statements of verifiable fact, but rather
involve much exercise of judgment which may be subject to second-guessing, (iv) the heavy
exposure which an accountant faces, relative to his fees realized on the engagement, when the
client is bankrupt and the accountant is the only remaining solvent party, (v) the potential for
sophisticated lenders and investors (who are often the typical plaintiffs in non-securities and nonclass action common law accounting liability suits) to protect themselves through contractual
mechanisms, and (vi) the fact that loans and investments are often made based on multifaceted
factors, only one element of which is an audit report, but that when a company goes bad the
lender or investor will re-characterize his thought process to focus primarily on the accountant’s
work.
Bank v. Foutz, 764 P.2d 1307 (N.M. 1988); Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co., 715 S.W.2d 408 (Tex. Ct.
App. 1986); BancOhio Nat’l Bank v. Schiesswohl, 33 Ohio App. 329, 515 N.E.2d 997 (1986); Spherex, Inc. v. Alexander
Grant & Co., 122 N.H. 898, 451 A.2d 1308 (1982); Haddon View Investment Co. v. Coopers & Lybrand, 70 Oh. St. 2d 154,
436 N.E.2d 212 (1982); Bonhiver v. Graff, 311 Minn. 111, 248 N.W.2d 291 (1976); Aluma Kraft Mfg. Co. v. Elmer Fox &
Co., 493 S.W.2d 378 (Mo. App. 1973); Shatterproof Glass Corp. v. James, 466 S.W.2d 873 (Tex. Civ. App. 1971); Ryan v.
Kanne, 170 N.W.2d 395 (Iowa 1969).
51
See, e.g., In re Intelligent Electronics, Inc. Securities Litigation, 1996 U.S. Dist. LEXIS 7674 (E.D. Pa. June 6, 1996)
(Pennsylvania law); First Nat’l Bank of Commerce v. Monco Agency, Inc., 911 F.2d 1053 (5th Cir. 1990) (Louisiana law);
Merit Ins. Co. v. Colao, 603 F.2d 654 (7th Cir. 1979), cert. denied, 445 U.S. 929 (1980) (Illinois law); Island Hosp. Trust
Nat’l Bank v. Swartz, Bresenoff, Yavner & Jacobs, 455 F.2d 847 (4th Cir. 1972) (Virginia law); Ingram Indus. v. Nowicki,
527 F. Supp. 683 (E.D. Ky. 1981) (Kentucky law); Seedkem, Inc. v. Safranek, 466 F. Supp. 340 (D. Neb. 1979) (Nebraska
law); Rusch Factors, Inc. v. Levin, 284 F. Supp. 85 (D.R.I. 1968) (Rhode Island law).
52
See, e.g., Dalton v. Alston & Bird, 741 F. Supp. 1322 (S.D. Ill. 1990).
53
E.g., International Mortgage Co. v. John P. Butler Accountancy Corp., 177 Cal. App. 3d 806, 223 Cal. Rptr. 218 (1986).
54
3 Cal. 4th 370, 11 Cal. Rptr. 2d 51, 834 P.2d 745 (1992), modified, 1992 Cal. Lexis 5583 (Cal. 1992).
15
41
With regard to this last consideration, the court pointed out:
Investment and credit decisions are by their nature complex and
multifaceted. Although an audit report might play a role in such
decisions, reasonable and prudent investors and lenders will dig far
deeper in their “due diligence” investigations than the surface level
of an auditor’s opinion. And, particularly in financially large
transactions, the ultimate decision to lend or invest is often based
on numerous business factors that have little to do with the audit
report. The auditing CPA has no expertise in or control over the
products or services of its clients or their markets; it does not
choose the client’s executives or make its business decisions; yet,
when clients fail financially, the CPA auditor is a prime target in
litigation claiming investor and creditor economic losses because it
is the only available (and solvent) entity that had any direct contact
with the client’s business affairs . . . .
*
*
*
The facts of this case provide an apt example. Although plaintiffs
now profess reliance on Arthur Young’s audit report as the sine
qua non of their investments, the record reveals a more
complicated decision-making process. As a group of corporate
insiders and venture capitalists who were closely following the
Cinderella-like transformation of the company, plaintiffs perceived
an opportunity to make a large sum of money in a very short time
by investing in a company they believed would (literally within
months) become the dominant force in the new personal computer
market.
Plaintiffs would [now] have us believe that, had the Arthur Young
report disclosed deficiencies in accounting controls and the $3
million loss (on income over $68 million), they would have
ignored all the other positive factors that triggered their interest . . .
and flatly withheld their funds.55
Because it is often hard for the accountant to refute the investor’s self-serving statements about
how he relied on the audit report, and because of the disproportionate liability which can result,
the California Supreme Court limited the class of persons to whom the accountant could be held
liable to those persons meeting the test of Section 552 of the Restatement.56
55
3 Cal. 4th at 388, 11 Cal. Rptr. 2d at 69-70.
56
An interesting recent California case applying Bily is AC Holdings v. Barnard, slip op., No. 949247 (Cal. Sup., decided
March 26, 1998), which held that an ousted CEO in a takeover fight could not sue the accountant for the acquiror over his
severance package because the CEO was not within the class of protected persons. Compare Arthur Andersen LLP v.
Quackenbush, slip op., No. B118547 (Cal. App. 1999), holding that the State Insurance Commissioner, as a representative
of policyholders and creditors, is within the zone of persons to whom the auditor owes a general duty of care when auditing
16
42
5.
Texas.
A recent case in Texas concerning the privity doctrine is Ernst & Young L.L.P. v.
Pacific Mutual Life Insurance Co.57 There the Texas Supreme Court rejected a privity defense to
a fraud claim, in a decision which arguably confuses separate and distinct concepts. In that case,
the accountants audited a bank in the early 1980s, and the bank merged in the mid-80s, following
the date of the accountant’s last audit. Notes were issued in connection with the merger, and the
plaintiff was a purchaser of the notes. When the merged entity failed in the late 1980s, the
plaintiff sued the accountant, alleging fraud.58 The accountant responded by interposing a privity
defense.
Under the traditional Ultramares approach, of course, privity is not a defense to a
fraud claim, and the Texas Supreme Court rejected the defense as a result. The Texas Supreme
Court went on, however, to rule the appropriate standard to apply is from Section 531 of the
Restatement (Second) of Torts, which the court said recognizes liability without privity for fraud
to all persons whom the alleged tortfeesor “had reason to expect” may rely on the
misrepresentations. This standard of course is very close to Section 552 of the Restatement and
its “limited class” concept derived from the negligence and negligent misrepresentation
context.59 The accountant argued, and the court agreed, that because the notes were issued after
the date of the last audit, the noteholder was not a person whom the accountant had reason to
expect would rely on the audit. The noteholder’s argument, of course, was that it was
foreseeable and there was reason to expect that the audit would be used for securities offerings
and would be relied upon by purchasers of the securities. Pacific Mutual is a good example of
how seemingly distinct concepts like fraud and negligence, and privity, reliance and the scope of
duty, can become confusingly similar in this area of law.
6.
State Statutes.
In addition to the New Jersey statute overruling Rosenblum60, the Illinois
legislature has codified the Ultramares rule when it passed a statute which limits the liability of
accountants to persons with whom they are in privity or whom they intend to rely on their work:
§ 30.1. No person, partnership or corporation licensed or
authorized to practice under this Act or any of its employees,
partners, members, officers or shareholders shall be liable to
persons not in privity of contract with such person, partnership or
corporation, for civil damages resulting from acts, omissions,
an insurance company.
57
Slip op., No. 00-0232, decided June 21, 2001 (Tex. Sup.).
58
Why it took until 2001 to get to the Texas Supreme Court is not clear.
59
See nn. 49-52, supra, and accompanying text.
60
See, n. 42, supra.
17
43
decisions or other conduct in connection with professional services
performed by such person, partnership or corporation, except for:
(1)
such acts, omissions, decisions or conduct that
constitute fraud or intentional misrepresentations, or
(2)
such other acts, omissions, decisions or conduct, if
such person, partnership or corporation was aware that a primary
intent of the client was for the professional services to benefit or
influence the particular person bringing the action; provided,
however, for the purposes of this subparagraph (2), if such person,
partnership or corporation (i) identifies in writing to the client
those persons who are intended to rely on the services, and
(ii) sends a copy of such writing or similar statement to those
persons identified in the writing or statement, then such person,
partnership or corporation or any of its employees, partners,
members, officers or shareholders may be held liable only to such
persons intended to so rely, in addition to those persons in privity
of contract with such person, partnership or corporation.61
Similar statutes have been enacted in Arkansas, Kansas and Michigan.62 Many
other states have enacted general tort reform legislation which may also restrict accountants’
liability, for example by limiting joint and several liability and restricting claims for contribution.
A complete review of these legislative enactments is beyond the scope of these materials,
although they do need to be consulted in litigating specific cases.
It seems that the passage of this recent legislation in Illinois and other states,
together with the strong affirmance of Ultramares by the New York Court of Appeals in the
Security Pacific, Credit Alliance, Parrott and BDO cases, and with the California Supreme
Court’s decision in Bily, and state law tort reform generally, is indicative of a trend away from
the broadening of the common law liability of accountants for negligence to persons with whom
they are not in privity — a result which some commentators have advocated on the grounds that
expanded liability increases accountants’ insurance rates, and thus clients’ audit costs, and
decreases the availability of accounting services generally.63
61
Ill. Rev. Stat., Ch. 111, § 5535.1, added by P.A. 84-1241, eff. August 6, 1986. But see Dougherty v. Zimbler, 922 F. Supp.
110 (N.D. Ill. 1996), which holds that the Illinois statute offers no protection against an accountant’s alleged participation in
a fraud. See also Chestnut Corporation v. Pestine, Brinati, Gamer Ltd., 217 Ill. 454, 667 N.E.2d 543 (1996), which
construes the statute’s “writing” requirement.
62
See Ark. Stat. Ann., § 16-114-302; Kan. Stat. Ann., § 1-402; Mich. C.L. §600.2962, Mich. Stat. Ann. §27A.2962. See also
Ohio Farmers Insurance Co. v. Shamie, slip op. No. 96-528871 (Mich. App., decided April 30, 1999) (statute will not be
given retroactive effect).
63
Dawson, “Auditors’ Third Party Liability: An Ill-Considered Extension of the Law,” 46 Wash. U. L. Rev. 675 (1971).
18
44
D.
Liability to Client; Peculiar Defenses.
1.
Cenco Defenses — “To Impute or Not to Impute”.
While the issue of when an accountant can be liable for negligence to persons
other than his client has been litigated fairly often, another issue which arises with regularity is
the accountant’s liability to his own client, in tort for negligence, or in contract for failure to
perform his services with the implied obligation of due care. Obviously such a claim by the
accountant’s own client is not subject to a defense of lack of privity.
While at first blush it would appear to be somewhat unusual for a client to sue his
own accountant, this kind of litigation actually arises with frequency, as bankruptcy trustees,
receivers or other persons who step into the shoes of the client, such as the FDIC or SIPC,
become aggressive about asserting claims.64 The theory is that, but for the accountant’s
negligence, the company would not have become insolvent, and the accountant’s negligence
therefore contributed to the company’s downfall.
These claims are subject to potential defenses of in pari delicto, contributory
negligence or fault, and unclean hands, because the accountant can argue that the trustee or
receiver steps into the shoes of the company, with no greater rights and subject to all existing
defenses, including the defense that the company’s management was far more culpable than the
accountant.65
For example, a claim by a bankruptcy trustee against an auditor for financial
statement fraud was rejected by a court which said that an insider’s “fraudulent conduct is
attributable to [the company] and precludes plaintiffs, who stand in the shoes of [the company],
from recovering from Ernst & Young for the alleged negligence of Ernst & Young” because the
plaintiffs “are subject to the same defenses that would have been available to the defendant if
[the company] had brought the action.”66
Other problems in these cases which are not necessarily present in the lack of
privity cases relate to causation of damages — if the company became insolvent because it was
loaned money on the strength of erroneous financial statements, then arguably the company
benefited from receipt of funds it otherwise would not have had and it was the creditors rather
than the company who suffered damages, but the creditors were not in privity and thus cannot
recover. Also, the accountant can argue that the company’s management caused the losses, not
the accountant’s financial report.
64
One such case in In re Wedtech Corp., 81 B.R. 240 (S.D.N.Y. 1987), an action brought by a bankruptcy trustee for
negligence against the debtor’s accountants. Many such suits have been filed by bank regulators. See, e.g., Tucker and
Eisenhofer, “Negligent Representation Suits Multiply in Wake of S&L Crisis,” Natl. L.J., June 25, 1990, p. 17.
65
See, e.g., Schacht v. Brown, 711 F.2d 1343 (7th Cir.), cert. denied, 464 U.S. 1002 (1983); In re Wedtech Corp., 81 B.R. 240
(S.D.N.Y. 1987); In re Investors Funding Corp., 523 F. Supp. 533 (S.D.N.Y. 1980). See also Mid-Continent Paper
Converters Inc. v. Brady, Ware & Schoenfeld Inc., slip op., No. 89A05-9810-CV-390 (Ind. App., decided August 26, 1999)
(CFO’s fraud imputed to company; accounting firm absolved of liability).
66
Miller v. Ernst & Young, No. 70262 (Mo. App. February 4, 1997).
19
45
Arguments of this type are sometimes referred to as the “Cenco defense,” after
Judge Posner’s decision in a Seventh Circuit case which employed these arguments concerning
wrongdoing by management to dismiss a claim by a client against his accountant.67 Others have
referred to these arguments as a defense of “adverse domination and control” or “adverse
interest.” While many cases have adopted this defense, others have rejected it, out of a concern
for impeding the work of independent trustees by imputing to them bad acts for which they had
no responsibility.68
Good examples of the kinds of differences of opinion one often sees in these cases
are provided by Capital Wireless Corp. v. Deloitte & Touche,69 Allard v. Arthur Andersen &
Co.,70 and Grove v. Sutcliffe.71 Capital and Allard both refused the accountant’s effort to impute
the fraud of the client’s senior employees to the client, and to argue that the accountant was also
duped. Grove, on the other hand, went the other way, holding that a liquidator could not sue the
accountant because the liquidator had no greater right to sue than the client, and the client had
been an active participant in the fraud and so could not himself sue.
In a similar kind of case, a Florida appellate court absolved an accountant from
liability for failing to discover a fraud in a suit brought by the liquidator of a failed insurance
company.72 The court indicated that the fraud benefited the corporation by enabling it to raise
funds and that the fraud therefore had to be imputed to the corporation and its liquidator. The
court held that the corporation’s fraud was a defense to the accountant’s negligent failure to
discover the fraud. It may well be asked, of course, why an accountant should bother to search
for fraud when if he does not find it, he cannot be held liable for his failure.
The active involvement of bank regulators in litigation in this area has caused a
substantial evolution in the law. For example, in O’Melveny & Myers v. FDIC,73 the Supreme
Court held that whether or not a professional could assert a Cenco-type defense against the FDIC
when it stepped into the shoes of a failed bank to sue the bank’s attorneys, was a matter of state
law and not federal common law. There the professional sought to hold that the FDIC was
barred or estopped by the unclean hands of the bank’s senior executives, which the professional
tried to attribute to the bank, and thus the FDIC, as a defense. The FDIC argued —
unsuccessfully — that as a matter of federal common law it should not be subjected to this
“imputation” defense. The effect of the Supreme Court’s decision that there is no federal
67
Cenco Inc. v. Seidman & Seidman, 686 F.2d 449 (7th Cir.), cert. denied, 459 U.S. 880 (1982).
68
See, e.g., nn. 64-65, supra.
69
216 A.D.2d 663, 627 N.Y.S.2d 794 (3d Dep’t 1995).
70
924 F. Supp. 488 (S.D.N.Y. 1996).
71
Slip op., No. 50722 (Mo. App. decided December 26, 1995).
72
Seidman & Seidman v. Gee, 625 So.2d 1 (Fla. App. 1992). A similar conclusion was reached in Curiale v. Peat, Marwick,
Mitchell & Co., 214 A.D.2d 16, 630 N.Y.S.2d 996 (1st Dep’t 1995), which upheld a claim by the New York Superintendent
of Insurance, as receiver for a failed insurance company, against the insurance company’s accountants.
73
114 S. Ct. 2048 (1994). See also Atherton v. FDIC, 117 S. Ct. 666 (1997).
20
46
common law of “imputation” in the banking arena is to leave the development of the law to each
of the fifty states.74
Not surprisingly, the results of this state-by-state effort have sometimes been
confusing, and will continue to generate reasonable differences of judicial opinion. Diversity of
opinion exists in the federal courts as well. For example, in banking regulation cases, the Tenth
Circuit has rejected the assertion of a “Cenco”, or “imputation”, defense. The Fifth Circuit, on
the other hand, handed down a decision which reached the opposite result, holding that the FDIC
was an assignee which had no greater rights than the bank; if the accountant could assert
defenses against the bank based on its officers’ misconduct, it could assert those defenses against
the FDIC as well.75
The Second Circuit reached a similar conclusion, in Hirsch v. Arthur Andersen &
Co., which rejected a bankruptcy trustee’s standing to bring a claim against the bankrupt
company’s accountants.76 Similarly, the Second Circuit ruled in In re Mediators, Inc.77 that a
liquidator could not bring a claim against an accountant where the debtor’s sole shareholder and
principal was involved in the fraud, rendering the debtor a participant. In the course of its
discussion, the Second Circuit suggested that if other decision-makers in management or among
the shareholders were not involved in the fraud, a claim might lie. Then the accountant’s
negligence arguably did cause the loss, because someone was in a position to stop the fraud had
the true facts been disclosed.
This rule is arguably a sensible one, in the sense that if there was a person in the
client’s organizational structure who was not involved in the fraud, and was in a position to stop
it had he known the facts, perhaps the accountant should be under a duty to do a careful audit
which would have disclosed those facts to the innocent management or equity representative.
Difficult and often fact-specific questions of “adverse domination and control”, including who
was actually in a position to make what decisions, and what causal impact the disclosure might
have had, can be expected to arise. While these factual questions can sometimes be difficult, the
law appears to be evolving toward a sensible application of the in pari delicto doctrine, in which
the doctrine may be invoked unless there were independent actors in the organization who could
have stopped the fraud had the accountants alerted them to it. A lower court has recently
concluded:
[A] corporation whose management was involved in fraud is not
barred from asserting claims for professional malpractice in not
detecting the fraud, provided the corporation has at least one
74
See, e.g., Seamons, “To Impute or Not to Impute: The Professionals Fight Back,” 8 Insights 18 (October 1994).
75
Compare FDIC v. Clark, 978 F.2d 1541 (10th Cir. 1992), with FDIC v. Ernst & Young, 967 F.2d 166 (5th Cir. 1992). But
see In re Hedged Investment Associates, Inc., 84 F.3d 1281 (10th Cir. 1996), where the Tenth Circuit applied an in pari
delicto defense.
76
72 F.3d 1085 (2d Cir. 1995). See also In re Gouiran Holdings, 165 B.R. 104 (Bankr. E.D.N.Y. 1993) (an accountant’s
alleged negligence in preparing financial statements may have harmed investors, but it benefited the company by helping it
to raise funds).
77
105 F.3d 822 (2d Cir. 1997). See also Shearson Lehman Hutton Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991).
21
47
decision-maker in management or among its stockholders who was
innocent of the fraud and could have stopped it.78
The Third Circuit adopted this approach, in Official Committee of Unsecured
Creditors v. R.F. Lafferty & Co., Inc.,79 when it rejected a claim against an accountant by a
creditors committee to a bankrupt corporation. The corporation, which was family run, was
engaged in a “Ponzi” scheme that the creditors committee said the accountant (and others) had
failed to stop, causing the corporation to extend itself deeper and deeper into the bowels of
insolvency as more and more investors were duped. The court held that the active involvement
by the family members in the Ponzi scheme created an in pari delicto bar.
The dissent in the case said that so long as “the miscreants” were not realizing a
benefit from the recovery, the suit should be allowed. This approach is arguably correct if there
is anything the accountant could have done as a causal matter to stop the fraud – which generally
would require the existence of independent, innocent actors who could have stopped the fraud
had they been alerted, which in this case there were not since the facts involved a family
corporation where all the principals were actively involved in the fraud. The dissent’s approach,
if adopted as broadly as the dissent articulated, would effectively end the in pari delicto,
imputation and Cenco defenses, as it is generally innocent creditors on whose behalf such suits
are brought.80
A similar in pari delicto case is Breeden v. Kirkpatrick & Lockhart.81 There, the
Second Circuit squarely adopted, in a law firm case, the approach of searching for independent
directors, or other innocent, independent, uninvolved corporate participants, to circumvent an in
pari delicto defense.82
78
CBI Holding Company, Inc. v . Ernst & Young, 2000 WI 354184 (S.D.N.Y. 2000). See also Wechsler v. Squadron,
Ellenoff, Plesant & Sheinfeld, LLP, 212 B.R. 34 (S.D.N.Y. 1997); and In re Wedtech Securities Litigation, 138 B.R. 5
(S.D.N.Y. 1992).
79
267 F.3d 340 (3d Cir. 2001).
80
Note also that the dissent’s approach is arguably inconsistent with the approach of the New York Court of Appeals in BDO
Seidman, n. 26, supra. The suit there was on behalf of innocent creditors, by a trustee of a defunct broker-dealer engaged in
a fraud, and the theory was that the SEC or the NASD could have stopped the fraud had they been alerted by the accountant.
81
336 F.3d 84 (2d Cir. 2003) (“imputation [in pari delicto] applies unless at least one decision maker in a management role or
amongst the shareholders is innocent and could have stopped the fraud (emphasis in original); investors may nevertheless
sue for the harm done to them personally, as opposed to harm done to the corporation). See also Official Committee of
Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand LLP, 322 F.3d 147 (in pari delicto defense and standing of
creditors committee to assert claim on debtor’s behalf); American Tissue, Inc. v. Arthur Andersen L.L.P., 2003 WL
21036233 (S.D.N.Y.) (in pari delicto applies where dominant shareholders who were wrongdoers were alter egos of
corporation).
82
Judge Sprizzo below actually held an evidentiary hearing to determine whether there were in fact any independent directors
who had they been apprised of the fraud by the accountants would have stopped it. 2001 WL 946350 (S.D.N.Y.) The case
involved Bennett Funding, where allegations were made that fictitious equipment leases had been created and financed.
One of the directors of the company, William MacPherson, was a former coach of the New England Patriots. Referring to
him as “Coach MacPherson”, Judge Sprizzo found that he would not have acted to stop the fraud, saying that even if he had
been informed of the fraud, he would not have disclosed it to the Securities and Exchange Commission, because “Coach
MacPherson testified that as far as he knew the SEC was a good football conference.”
22
48
In Bondi v. Bank of America, which arose out of the Parmalat scandal, the court
upheld an in pari delicto defense to a claim against a lending bank, imputing the wrongdoing of
the debtor and its management to a receiver, utilizing general agency principles. The only
exception in that case, according to the court, was a claim for looting, because “[b]y any
standard, theft from a corporation by insiders is self-dealing by the insiders and not in any sense
in the interest of the entity” and “therefore cannot be imputed to the company.”83
It is clear that there is substantial confusion in this area of the law and that judges
continue to struggle with in pari delicto and other “Cenco”-type defenses.
When such a defense is rejected, and the suit is allowed, the theory of damages is
generally one of “deepening insolvency,” i.e., that had the fraud been uncovered earlier, the
company at a minimum would have been much less deeply insolvent, owing less to its
creditors.84 Even this theory has generated controversy and confusion. For example, the Third
Circuit recently held there was a cause of action for “deepening insolvency” in favor of a
bankruptcy trustee when the underlying challenged conduct was fraudulent (as opposed to
merely negligent).85 But the Delaware Chancery Court rejected that view, concluding instead
that “deepening insolvency” was not an independent cause of action, but merely a theory of
damages when there was another available liability theory.86
Under a “deepening insolvency” theory, of course, there may be substantial
overlap with the damages incurred by creditors and shareholders, who may be pursuing their
own separate claims.
2.
Causation.
Causation defenses are also common in accounting cases. Usually a major loss
arises out of a variety of complex factors, and the accountant’s role in the loss, and how the
accountant might have helped to avoid the loss, often is not clear.
83
Bondi v. Bank of America Corporation, slip op., No. 05 Civ. 4015 (LAK) (S.D.N.Y., decided August 5, 2005). Judge
Kaplan’s Parmalat decisions cover a host of issues relevant to accountants’ liability litigation. See also Baena v. KPMG
LLP, slip op., No. 04-12606 (PBS) (D. Mass., decided September 27, 2005) (rejecting claims by a liquidating trustee for
allegedly deficient audits, which caused incurrence of debt and deepening insolvency, on grounds of in pari delicto);
Stanziale v. McGladrey & Pullen, LLP, slip op., No. 05-72 (JJF) (D. Del., decided December 20, 2005) (rejecting a trustee’s
attempt to “plead around” an in pari delicto defense by claiming he was suing not on behalf of the debtor but on behalf of
creditors).
84
See, e.g., Allard v. Arthur Andersen & Co., 924 F. Supp. 488 (S.D.N.Y. 1996), arising out of the DeLorean Motor Cars
debacle, and Seidman & Seidman v. Gee, 625 So. 2d 1 (Fla. App. 1992). Some courts have suggested that “deepening
insolvency” is an independent tort, e.g., Lafferty, n. 79, supra, but the better view is that it is a measure of damages if
another applicable tort theory can be found.
85
In re CitX Corp., 448 F.3d 672 (3d Cir. 2006). The Third Circuit said in CitX it was clarifying and extending that court’s
prior Lafterty decision, n. 79, supra.
86
Trenwick America Litigation Trust v. Ernst & Young LLP, 906 A.2d 168 (Del. Ch. 2006).
23
49
A good example of the kind of causation defenses which can also be mounted to
these claims is provided by Drabkin v. Alexander Grant & Co.87 There the D.C. Circuit rejected
a claim by a bankruptcy trustee against the company’s accountants for alleged failure to disclose
various deficiencies supposedly learned by the accountants during the course of their audit. The
court said that, even though the board did not necessarily know the same things that the
accountants had learned, they nevertheless blithely ignored other “storm warning signs” but still
failed to take corrective action. The court concluded that even if the accountants had made
disclosure, there was no evidence that disclosure would have changed the outcome or had any
other meaningful effect.
The difficulties that can be encountered in grappling with causation issues is
demonstrated by the recent Second Circuit decision in AUSA Life Insurance Co. v. Ernst &
Young.88 In that case, each of the three judges on the panel came to a well-reasoned, but entirely
different, conclusion on whether an accountant’s failures had caused a loss. That case involved
both a bankruptcy trustee and noteholders who had privity by reason of having received letters
from the accountant stating that there was no default in certain loan covenants. The performance
of the accountant was found by the lower court to have been deficient. The Company involved
was JWP, the former Jamaica Water Power, and it had sought to convert itself into a computer
company by buying Businessland, an ill-fated acquisition that led to JWP’s demise. The lower
court had dismissed, holding that while the accountant’s performance was deficient there was no
causation. The Second Circuit reversed, but only because one of the three judges changed his
position simply to have a mandate.
Judge Dennis G. Jacobs found there was no causation as a matter of law, because
the Businessland acquisition was a separate, subsequent and unrelated event from the Ernst &
Young audit. Judge Ralph K. Winter, on the other hand, said that there was sufficient evidence
of causation, because the accountant’s certification of no loan agreement defaults when there
were in fact defaults created a foreseeable “zone of risk” which included engaging in a
transaction which the noteholders would not have been permitted had the defaults been known.
Judge James L. Oakes, on the third hand (if there is such a thing), said that Judge
Winter’s causation test was “transaction” (or “but-for”) causation, and not necessarily “loss”
causation which is governed by a foreseeability test. Referring to causation questions as
involving “a Serbonian Bog”, Judge Oakes found the lower court’s ruling insufficient to make a
finding one way or the other on loss causation, and he voted to reverse and remand for further
factual findings on causation. Judge Jacobs switched his vote (but not his opinion) to join Judge
Oakes, simply for the purposes of producing a mandate, stating that while he did not believe
further fact-finding was necessary, he was confident the District Court would perform a
sufficient factual analysis as to causation so as to be able, once again, to dismiss the complaint.
Thus, the District Court was reversed and the case remanded.
87
905 F.2d 453 (D.C. Cir. 1990).
88
206 F.3d 202 (2d Cir. 2000)
24
50
That three such distinguished judges could write three such different but
persuasive opinions shows how intractable causation issued can be.89
3.
Contributory/Comparative Negligence.
A related defense to the accountant of course would be the client’s own
contributory or comparative negligence — except that the courts in some states have held that
defense is not available to the accountant.90 The gist of the traditional view rejecting the
application of contributory or comparative negligence is that the client's negligence must actually
interfere with the accountant’s audit before the client’s negligence will reduce or bar recovery.
This view, while it appears to be eroding as an outmoded approach to comparative fault, is an
impediment to what can be the most effective defense to these kinds of client claims, where the
accountant accuses the client of being in a better position to know the relevant facts.
That the so-called “audit interference” rule nevertheless has continued vitality is
shown by a divided Oklahoma Supreme Court decision, which rejected a statutory comparative
negligence defense in a case against an accountant, because the client’s negligence had not
actually interfered with the audit.91 The court therefore reinstituted a jury verdict for the
plaintiff.
The Oklahoma Supreme Court’s decision can be criticized as contravening the
state’s statutory comparative negligence scheme, which has a substantial policy basis and was
also enacted by the state’s legislature without any indication that the legislature ever considered
carving out accountant’s claims from the comparative negligence statute, and the dissent so
noted. The Oklahoma Supreme Court in this case also did not consider whether its approach to
comparative and contributory negligence was consistent with the in pari delicto and “Cenco”
defenses, referred to above,92 which can be characterized as implementing another form of
contributory or comparative fault.
89
After trial, the District Court in AUSA again dismissed the plaintiff’s complaint. 94 Civ. 3116 (WCC) (decided October 11,
2000). Judge Conner found after trial on remand that JWP could have paid off its debt, notwithstanding the loan covenant
defaults, and the additional debt taken on to finance the Businessland acquisition, and the negative cash flow generated by
that business, were the real causes of the loss.
90
Compare National Surety Corp. v. Lybrand, 256 A.D. 226, 9 N.Y.S.2d 554 (1st Dep’t 1939), and Halla Nursery, Inc. v.
Baumann-Furrie & Co., 454 N.W.2d 905 (Minn. 1990). See generally Note, “The Peculiar Treatment of Contributory
Negligence in Accountants Liability Cases,” 65 N.Y.U. L. Rev. 329 (1990). This topic will be covered more
comprehensively in other panelists’ materials. It is worth noting, however, that at least one court has recently rejected these
competing doctrines in favor of a statutory comparative negligence approach. See ESCA Corp. v. KPMG Peat Marwick,
No. 37012-0-1 (Wash. App. June 9, 1997).
91
Stroud v. Arthur Andersen & Co., slip op. No. 92033, (decided September 18, 2001) (Okl. Sup.).
92
See nn. 64-82, supra, and accompanying text.
25
51
4.
Defalcations.
One area of client suits where a Cenco-type defense has generally not been
recognized is the rather typical fact pattern in which the accountant is sued by the client for
having failed to detect an employee’s defalcations.93 Plaintiffs in such cases argue that detecting
defalcations is one of the reasons why they hired an outside accountant in the first place
(although no audit is an insurance policy or a guarantee that all such instances have been found).
The accountant may be able to defend against such a claim by arguing the client’s contributory
or comparative negligence.
5.
Client Financings.
Another special kind of client claim arises under circumstances where the client
asserts, for example, that had the accountant permitted a more liberal (or aggressive) accounting
treatment, the company would have been able to get financing by showing higher earnings or a
more solid balance sheet. A variation is that if the accountant had not been so careful,
conservative and slow, a market window would not have been missed. Since these kinds of
claims implicitly ask a judge or jury to rule that the accountant was insufficiently permissive,
typically (and happily) these claim do not succeed.94
E.
A Special Case — Compilation and Review Reports.
A special problem area which has resulted in litigation is whether an accountant
can be held liable for a mere “review” or “compilation” report, which under AICPA standards is
the result of considerably less work than a full certified audit report prepared in accordance with
GAAP and GAAS. While the New York Court of Appeals was asked to address this issue in the
Iselin case, it side-stepped it, ruling instead that even assuming liability could result from a
review report, there was no privity.95
Courts elsewhere have sustained liability for a review report.96 This is consistent
with other decisions which sustain liability for something less than full audit.97
However, this liability would have to be circumscribed by the much lower duty
imposed by the accounting profession on review reports, as set forth in SSARS No. 1.98
93
See, e.g., Herbert H. Post & Co. v. Sidney Bitterman, Inc., 219 A.D.2d 214, 639 N.Y.S.2d 329 (1st Dep’t 1996); Unadilla
Silo Co. v. Ernst & Young, 234 A.D.2d 754, 651 N.Y.S.2d 216 (3d Dep’t 1996); Nate B. & Frances Springold Foundation v.
Wallin, Simon, Black & Co., 184 A.D.2d 464, 585 N.Y.S.2d 416 (1st Dep’t 1992).
94
E.g., Oregon Steel Mills, Inc. v. Coopers & Lybrand LLP, slip op., No. SC 548978 (Ore. Sup., decided January 23, 2004).
95
N. 24, supra.
96
See Robert Wooler Co. v. Fidelity Bank, 330 Pa. Super. 523, 479 A.2d 1027 (1984); Spherex, Inc. v. Alexander Grant &
Co., 122 N.H. 898, 451 A.2d 1308 (1982).
97
See Ryan v. Kanne, 170 N.W.2d 395 (1969); Bonhiver v. Graff, 311 Minn. 111, 248 N.W.2d 291 (1976); Seedkem, Inc. v.
Safranek, 466 F. Supp. 340 (D. Neb. 1979).
98
AICPA, Accounting and Review Services Committee, Statement on Standards for Accounting and Review Services No. 1.
26
52
However, the Wooler case does hold that there may be liability in connection with the
preparation of a review report for failure to disclose weaknesses in accounting controls.99
In addition to review reports, a recent New York case upheld a claim against an
accountant for delivery of a solvency opinion which the accountant knew would be sent to a
particular lender.100 While the case concerned a solvency opinion rather than an audit, the court
nevertheless applied the same Security Pacific privity principles.
In all of these cases, of course, the accountant always has available to him the full
panoply of defenses to these claims, including the investor’s lack of reliance on the alleged
misrepresentations,101 as well as lack of proximate causation, contributory negligence,102 or any
other defenses that may be applicable.
II.
SECURITIES LAW CLAIMS AGAINST ACCOUNTANTS
Accountants are also commonly sued under the federal securities laws. Their
financial statements are used in connection with various kinds of securities offerings as well as in
connection with annual reports and other periodic filings required of public companies by the
SEC. When the financial statements are erroneous, a market impact can result, and investors
may seek to recoup their losses by asserting securities claims, which are not necessarily subject
to a privity requirement.
While a detailed review of possible federal securities law claims is beyond the
scope of these materials, it is important to have an overview of possible civil causes of action
available against accountants under the federal securities laws. In assessing the future of federal
securities claims against accountants, it is also important to keep in mind the impact of the
Private Securities Litigation Reform Act and the Securities Litigation Uniform Standards Act,
described below.
A.
Securities Act of 1933.
Some of the most important provisions of the federal securities laws from the
standpoint of accountants are contained in the Securities Act of 1933, having to do with the
offering of securities based in part on an accountant’s financial statements. Section 11 of the
1933 Act provides for liability for material misstatements or omissions in connection with public
offerings, including liability against accountants whose erroneous financial statements are
99
Wooler, supra, n. 96. See also Zupnick v. Thompson Parking Partners, Fed. Sec. L. Rep. (CCH) ¶ 95,388 (S.D.N.Y. 1990)
(duties in connection with a compilation report are far less extensive than in connection with a full audit); Rino v. Mead, 55
P.3d 13 (Wyoming Sup. 2002) (same).
100
Cherry v. Joseph S. Herbert & Co., 212 A.D.2d 203, 627 N.Y.S.2d 679 (1st Dep’t 1995).
101
See, e.g., Semida v. Rice, 863 F.2d 1156 (4th Cir. 1988).
102
See, e.g., E.F. Hutton Mortgage Corp. v. Pappas, 690 F. Supp. 1465 (D. Md. 1988).
27
53
included in the prospectus. Section 12(a)(2) is a more general anti-fraud provision which may
sometimes be asserted in connection with public and private offerings in which financial
statements are used.
1.
Section 11.
Section 11 generally provides for liability when untrue statements are made in a
registration statement or prospectus pursuant to which a public offering of securities is made.
Section 11(a) provides for liability if “any part of the registration statement . . . contained an
untrue statement of a material fact or omitted to state a material fact necessary to make the
statements made therein not misleading . . . .”103 Thus, a public offering containing inflated
financial information may give rise to a cause of action under Section 11.
The most important thing about liability under Section 11 is that it is absolute
liability without fault. Plaintiffs need not prove (i) scienter; (ii) reliance; (iii) causation; or
(iv) privity.104 All that the plaintiff need show is that there was a misstatement or omission, and
that it was material, meaning that a reasonable investor would want to have the full and accurate
information before deciding to invest.105
Any person “acquiring” a security under the registration statement may sue under
Section 11, generally including purchasers who bought in the offering as well as traders who
bought in the aftermarket.106 Persons who may be sued include the issuer and its directors,
persons who signed the registration statement, underwriters, accountants and other experts.107
“Control” persons can also be sued.108
While liability under Section 11 is potentially broad, there are defenses. First, a
defendant may argue that there were no misstatements, or that any misstatements which were
made were not material.
Second, defendants other than the issuer may be able to assert a defense of “due
diligence,” that is, that the defendant performed a reasonable investigation and had reasonable
grounds to believe that the registration statement was not misleading.109 This defense is of
103
15 U.S.C. § 77k(a).
104
See, e.g., In re Gap Stores Securities Litig., 79 F.R.D. 283 (N.D. Calif. 1978). See also L. Loss, Fundamentals of Securities
Regulation, Ch. 10E.2.a (2d ed. 1988).
105
17 C.F.R. 230.405(1); Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 544 (E.D.N.Y. 1971). The same standard
was applied by the Supreme Court to the proxy rule provisions contained in Section 14(a) of the Exchange Act in TSC
Indus. v. Northway, 426 U.S. 438 (1976), and to Section 10(b) of the Exchange Act in Basic, Inc. v. Levinson, 485 U.S. 224
(1988).
106
See MacFarland v. Memorex Corp., 493 F. Supp. 631 (N.D. Calif. 1980); In re Equity Funding Sec. Litig., 416 F. Supp. 161
(C.D. Calif. 1976). See also n. 118 and materials there cited.
107
Section 11(a)(1)-(5), 15 U.S.C. § 77k(a)(1)-(5).
108
Section 15, 15 U.S.C. § 770.
109
Section 11(b)(3), 15 U.S.C. § 77k(b)(3).
28
54
particular importance to accountants, who can argue that their audit work was proper and there
was no basis to believe the financial statements were erroneous.
It is important to note that the accountant’s liability under Section 11 is limited to
the financial statements which he certified and which were included in the registration
statement.110 Thus, the accountant is typically not responsible for non-audited financial
information or textual material set forth in the registration statement or prospectus.
The statute of limitations on a Section 11 claim is short — one year after a
misstatement was discovered, or should have been, up to a maximum of three years from the
offering date.111 Damages are rescissionary in nature — the offering price less the sale price or,
if the security is not sold, its value.112
2.
Section 12(a)(2).
Section 12(a)(2) of the 1933 Act (previously denominated as Section 12(2)), is a
general anti-fraud provision which imposes liability on “[a]ny person” who “offers or sells” a
security “by means of a prospectus or oral communication, which contains an untrue statement
of a material fact or omits to state a material fact necessary in order to make the statements, in
the light of the circumstances under which they were made, not misleading.”113
The advantage to Section 12(a)(2) from a plaintiff’s point of view is that he need
not prove scienter, reliance or causation.114 There are, however, several impediments to recovery
under Section 12(a)(2) which are of importance to accountants.
First, the language of Section 12(a)(2) by its terms appears to limit liability to the
actual seller of the security. Most accountants fall outside of this ambit.
While the language of Section 12(a)(2) appears to limit liability to the actual
seller of the security, some courts adopted a broader approach, holding for example that persons
who were “substantial participants” in a sale could be held liable as sellers.115 Obviously an
110
Section 11(a)(a)(4), 15 U.S.C. § 77k(a)(4). See also McFarland v. Memorex Corp., supra, n. 106; Escott v. BarChris Constr.
Corp., 283 F. Supp. 643 (S.D.N.Y. 1968). One District Court dismissed a Section 11 claim against an accounting firm for
allegedly failing to disclose a loss which accrued after the period covered by the accountant’s report included in the
registration statement. Adair v. Kaye Kotts Associates Inc., slip op., No. 97 Civ. 3375 (SS) (S.D.N.Y., decided March 27,
1998).
111
Section 13, 15 U.S.C. § 77m. Compare Section 804 of the Sarbanes-Oxley Act of 2003, where Congress lengthened the
statute of limitations for securities claims sounding in fraud to two years from the date the fraud was known or should have
been, up to a maximum of five years from the date of sale. The degree to which this statute applies to 1933 Act claims
sounding in misrepresentation is unclear. Cf. Rombach v. Chang, 355 F.3d 164 (2d Cir. 2004).
112
Section 11(e), 15 U.S.C. § 77k(e).
113
Section 12(a)(2), 15 U.S.C. § 77l(a)(2).
114
See L. Loss, Fundamentals of Securities Regulation, Ch. 10E.1.a (2d ed. 1988).
115
See, e.g., Davis v. Avco Fin. Servs., Inc., 739 F.2d 1057 (6th Cir. 1984), cert. denied, 470 U.S. 1005 (1985).
29
55
accountant whose financial statement was used in a securities offering might be found to be a
“substantial participant” in the sale.
However, the Supreme Court has rejected this expansive reading of Section 12.
In Pinter v. Dahl,116 the Supreme Court held it was not enough to be a “substantial factor” or a
“substantial participant” in a sale to be liable under Section 12. The Court also rejected a
restrictive reading of Section 12 which would have limited liability only to the actual seller or
issuer who passes title to the security. Instead, the Supreme Court held that liability under
Section 12:
extends only to the person who successfully solicits the purchase,
motivated at least in part by a desire to service his own financial
interests or those of the securities owner.117
Thus, the Supreme Court appears to have restricted liability under Section 12 to the seller or
issuer of the securities who passes title, as well as to other persons commonly referred to as
“sellers” such as brokers, salesmen and agents of the issuer in the selling process who offer or
solicit the sale. Accountants will ordinarily not fall within this ambit.
Indeed, the Supreme Court specifically stated in Pinter that purchasers do not “in
any meaningful sense” buy securities from professionals “such as accountants.”118 The Supreme
Court thus appears to have insulated accountants from liability under Section 12(a)(2) so long as
they are acting as accountants (as opposed, for example, to acting as financial advisers helping
their clients to invest in transactions, which might be deemed to be an offer or a solicitation
under Section 12).
In addition to the “seller” limitation on Section 12(a)(2) liability, another
important defense for accountants under Section 12(a)(2) is that of due diligence. Section
12(a)(2) exempts from liability persons who “did not know, and in the exercise of reasonable
case could not have known” of the misstatement or omission.119
Co., Inc.,
120
Subsequently, the Supreme Court also decided the case of Gustafson v. Alloyd
which like Pinter also took a restrictive approach to liability under Section 12(a)(2).
116
486 U.S. 622 (1988).
117
486 U.S. at 623.
118
486 U.S. at 651. See also Wilson v. Santine Exploration and Drilling Corp., 872 F.2d 1124 (2d Cir. 1989), in which the
Second Circuit relied on Pinter v. Dahl in reversing a prior holding, at 844 F.2d 81, that an attorney could be a “substantial
participant” in a § 12(a)(2) sale, by simply preparing offering materials. After Pinter the Second Circuit held that
involvement alone was insufficient to be a § 12(2) seller. Accord, Moore v. Kayport Package Express, Inc., 885 F.2d 531
(9th Cir. 1989) (accountants performing audit and other professional services, without more, were not “sellers” under
§ 12(2), even though the accountant’s services may have facilitated an offering). See also Klock, “Death of a Theory:
Pinter v. Dahl and the Scope of Liability under Section 12(2) of the Securities Act,” 17 Sec. Reg. L.J. 408 (1990), which
discusses “aider and abettor” liability under § 12(2).
119
Section 12, 15 U.S.C. § 771.
120
513 U.S. 561 (1995).
30
56
In Gustafson the Supreme Court declined to apply Section 12(a)(2) to a privately negotiated
stock sale, limiting liability under that section to statements made in a prospectus or a
registration statement filed in connection with a public offering. Thus, efforts to apply Section
12(a)(2)’s more liberal liability requirements to a broader range of transactions than public
offerings was rejected.
The logic of Gustafson and Pinter together suggests that Section 12(a)(2) should
not apply to after-market purchasers. Some decisions had suggested that after-market purchasers
who could show that they had purchased their shares not from the underwriters but who did
receive shares issued pursuant to a registration statement could sue for misstatements in the
registration statement. Gustafson and Pinter together can be read to negate such a claim.
Given the number of purchasers in public offerings who “flip” their shares within
minutes, this would sharply limit the number of potential plaintiffs under Section 12(a)(2).
Someone who buys from the underwriter and immediately “flips” has no damages. And
subsequent purchases are then barred from pursuing Section 12(a)(2) claims since they did not
deal with the original seller of the shares, i.e., the issuer and the underwriter. This of course
blunts the impact of Section 12(a)(2).121
Damages under Section 12(a)(2) are rescissionary in nature, allowing the recovery
of consideration paid less income received, or, if the security had been sold, out-of-pocket
damages.122 The statute of limitations is the same as for Section 11 claims.123
Significantly, the Private Securities Litigation Reform Act largely left 1933 Act
claims untouched. 1933 Act claims evidently were not considered to be an area of class action
litigation abuse. Whether or not this conclusion was correct, plaintiffs try very hard to fit their
claims under the 1933 Act wherever possible, particularly since not only is there no scienter
requirement under the 1933 Act, but in addition a number of courts have ruled that the
heightened fraud pleading standards of the PSLRA do not apply to 1933 Act claims.124
121
A few courts have even applied Gustafson in such a fashion to dismiss claims under Section 11 of the 1933 Act. See, e.g.,
Van de Walle v. Salomon Brothers, CCH Fed. Sec. L. Rep., ¶ 99,577 (Del. Chan. 1997); Gannon v. Continental Ins. Co.
Inc., 920 F. Supp. 566 (D.N.J. 1996); Gould v. Harris, 929 F. Supp. 353 (C.D. Cal. 1996); Murphy v. Hollywood
Entertainment Corp., 1996 WL 393662 (D. Or. May 9, 1996). Other courts permit purchasers who can “trace” their shares
to the offering to sue. See, e.g., Lee v. Ernst & Young LLP, slip op., No. 01-1369 (8th Cir., decided June 18, 2002); In re
Turkcell Securities Litigation, slip op., No. 00-8913 (S.D.N.Y., decided August 22, 2002); In re Web Secure Inc. Securities
Litigation, slip op., No. 97-10662 (D. Mass., decided September 24, 1998); and Lincoln Adair v. Bristol Technology
Systems, Inc., Fed. Sec. L. Rep. (CCH), ¶ 90,218 (S.D.N.Y. 1998). This latter approach works well enough in a typical IPO
case, but is problematic in the case of secondary offerings where “tracing” is difficult if not impossible in an active trading
market. The Ninth Circuit has held, however, that any person acquiring shares when a registration statement is effective and
contains a material misstatement or omission can sue, even open market purchasers. See Hertzberg v. Dignity Partners, Inc.,
slip op., No. 98-16934 (9th Cir., decided August 27, 1999). That decision leaves open how far after the effective date of the
registration statement the liability may extend. See also DeMaria v. Andersen, 318 F.3d 170 (2d Cir. 2003); In re
WorldCom Securities Litigation, 294 F. Supp. 382 (S.D.N.Y. 2003); In re Global Crossing Ltd. Securities Litigation, 2003
WL 22999478 (S.D.N.Y.).
122
Section 12, 15 U.S.C. § 771.
123
Section 13, 15 U.S.C. § 77m.
124
But see Rombach v. Chang, 355 F. 3d 164 (2d Cir. 2004), where the Second Circuit held that the PSLRA’s heightened fraud
31
57
3.
Section 17(a).
Section 17(a) of the 1933 Act is a general anti-fraud provision which is broader in
some respects than Sections 11 or 12(a)(2).125 However, it does not contain an express private
right of action, and there is presently a sharp split of authority as to whether one can be
implied.126
B.
Securities Exchange Act of 1934.
1.
Section 10(b).
The most important provision imposing liability on accountants in the Securities
Exchange Act of 1934 is Section 10(b), and Rule 10b-5 thereunder.127 Section 10(b) and Rule
10b-5 are broad anti-fraud provisions, which generally proscribe all material misstatements or
omissions made with an intent to defraud, on which a plaintiff relies in deciding to purchase or
sell securities.128 While no express private right of action is set forth in Section 10(b), one has
universally been implied.129
Section 10(b) is an important provision from the standpoint of accountants,
because erroneous financial statements which induce the purchase or sale of securities may
constitute material misstatements resulting in liability. This potential liability arises not only in
connection with the issuance of new securities, but also in connection with the trading of existing
securities where the market price may be determined by the company’s reported financial
condition.
(a)
Purchase or Sale.
There are several important requirements to a Section 10(b) claim, in addition to
the basic requirement of a material misstatement or omission. First, there must be a purchase or
sale of securities.130 A mere inducement not to buy or sell is insufficient.
pleading standard applies to claims sounding in fraud and misrepresentation under the 1933 Act.
125
15 U.S.C. § 77q(a).
126
See generally Note, “A Plea for Consistency: Refusing Implication of a Private of Action Under Section 17(a) of the
Securities Act of 1933,” 62 N.Y.U. L. Rev. 116 (1987).
127
15 U.S.C. § 78j(b) and 17 C.F.R. 240.10b-5.
128
See generally A. Jacobs, Litigation and Practice Under Rule 10b-5 (1981).
129
See Herman & MacLean v. Huddleston, 459 U.S. 375 (1983).
130
Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). There must also of course be a “security.” See Reves v.
Ernst & Young, 494 U.S. 1092 (1990).
32
58
(b)
Scienter.
Second, a plaintiff must plead and prove that the defendant acted with scienter, or
an intent to defraud.131 Most courts have held that recklessness suffices to meet the scienter
test.132 Thus, an accountant’s reckless misstatements and misrepresentations will support an
action under Rule 10b-5.
The scienter requirement is an important one for accountants. While courts can
and do disagree as to whether particular allegations give rise to an inference of scienter or
recklessness, the scienter requirement is a meaningful one which often leads courts to dismiss
Rule 10b-5 claims against accountants on the pleadings.133 Scienter is also a common trial issue
in securities cases involving accountants.
However, a Rule 10b-5 claim was held to have been stated against an accounting
firm for having engaged in reckless behavior by handing over to its client the audit confirmation
process.134 Many other fact patterns in which scienter is an issue can be
imagined.135 Significantly, many cases hold that allegations of violations of GAAP and GAAS,
by themselves, are not sufficient to allege scienter.136
(c)
Reliance.
Third, the buyer or seller must show he relied on the misstatement in deciding to
buy or sell, and that his reliance was reasonable.137 This defense can be important where the
defendant can show that the plaintiff did not know of the misstatement, because for example he
never read the offering memorandum, prospectus or annual report containing the alleged
misstatement.138 In the case of accountants, it is common for a plaintiff to be unable to prove
131
Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).
132
See Steinberg and Gruenbaum, “Variations of ‘Recklessness’ After Hochfelder and Aaron”, 8 Sec. Reg. L.J. 179 (1980), and
cases therein cited.
133
See, e.g., DSAM Global Value Fund v. Altris Software, Inc., CCH Fed. Sec. L. Rep., ¶ 91, 773 (9th Cir. 2004); In re IKON
Office Solutions Securities Litigation, slip op., No. 01-1553 (3d Cir., decided January 11, 2002); In re K-tel International
Securities Litigation, slip op., No. 00-3210 (8th Cir., decided August 7, 2002; Wells v. Monarch Capital Corp., Fed. Sec. L.
Rep. (CCH), ¶ 90,110 (11th Cir. 1998); Friedman v. Arizona World Nurseries, 730 F. Supp. 521 (S.D.N.Y. 1990), later
proceeding, 1990 U.S. Dist. Lexis 9088 (S.D.N.Y. 1990), aff’d, 927 F.2d 594 (2d Cir. 1991); Goldman v. McMahan,
Brafman, Morgan & Co., 706 F. Supp. 256 (S.D.N.Y. 1989).
134
In re Regal Communications Corporation Securities Litigation, Fed. Sec. L. Rep. (CCH), ¶ 92,274 (E.D. Pa. 1996).
135
See, e.g., Leibensburger and Pepenhauser, “Auditor Liability for Securities Fraud After the PSLRA and Sarbanes-Oxley”
ALI/ABA Business Law Course Materials Journal 15 (February 2004) collecting cases.
136
E.g., DSAM Global Value Fund v. Altris Software, Inc., CCH Fed. Sec. L. Rep. ¶ 91,773 (9th Cir. 2004); In re Software
Toolworks Securities Litigation, 50 F.3d 615 (9th Cir. 1994); Druskin v. Answerthink, Inc., CCH Fed. Sec. L. Rep. ¶ 92,663
S.D. Fl. 2003) (departure from GAAP or GAAS, unless unreasonable or extreme, is merely negligent).
137
See, e.g., DuPont v. Brady, 828 F.2d 75 (2d Cir. 1987).
138
While the requirement of reliance exists when there is an actual misstatement, there is no such requirement when there is a
material omission. See Affiliated Ute Citizens v. United States, 406 U.S. 128, 153 (1972). The logic to this distinction is
33
59
that he either read or understood the financial statements, or the notes, which forms the basis for
the accountant to argue that the plaintiff could not possibly have relied on the accountant’s work.
(d)
“Fraud on the Market”.
While reliance is generally a requirement to a Section 10(b) claim, one exception
to this rule is the so-called “fraud on the market” theory of liability, which provides generally
that a misstatement or omission which has a general effect on the level of a security’s price in the
market can result in a liability even without actual reliance by specific plaintiffs. Thus, an
accountant who issues erroneous financial statements may contribute to the inflation in the price
of a particular stock, and purchasers who buy while the price is inflated may have a Section
10(b) claim even though they did not themselves review or rely on the accountant’s financial
statements. The logic is that the entire integrity of the market, and thus the security’s price, was
infected by erroneous information. The Supreme Court adopted the “fraud on the market” theory
in Basic, Inc. v. Levinson.139
(e)
Loss Causation.
The final requirement for a Section 10(b) claim is that of “loss causation.” That
is, the misstatement or omission must not only induce a purchase or sale, but it must also
produce a loss.140 It is not sufficient for a plaintiff to show he bought or sold in reliance on a
misstatement and a loss then ensued (“transaction causation”). The plaintiff must also show that
the loss was as a result of the misstatement (“loss causation”).
Thus, it is not enough for the plaintiff to show he bought a security in reliance on
a misrepresentation and the price of the security then fell for reasons unrelated to the
misrepresentation. Instead, the plaintiff must show that the misrepresentation is somehow
related to or connected with the reasons for the resulting loss.
The Second Circuit has been a leading exponent of the “loss causation”
requirement.141 Thus, it is not enough to allege that there was a misrepresentation which induced
the purchase; the misrepresentation must also be the cause of the loss.
that it is not possible to rely on what is not stated but rather is omitted.
139
485 U.S. 224 (1988).
140
See, e.g., Bennett v. United States Trust Co., 770 F.2d 308 (2d Cir. 1985), cert. denied, 474 U.S. 1058 (1986). An important
loss causation case is Bastian v. Petren Resources Corp., 892 F.2d 680 (7th Cir. 1990), where Judge Posner said that the real
cause of the demise of an oil and gas venture was not the accountant’s work, but rather the severe decline in oil prices. See
also the discussion of AUSA and other causation cases at nn. 87-89, supra, and accompanying text.
141
See, e.g., Suez Equity Investors v. Toronto-Dominion Bank, 250 F.3d 87 (2d Cir. 2001); Castellano v. Young & Rubicam,
Inc., 257 F.3d 171 (2d Cir. 2001); First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763 (2d Cir. 1994); Citibank, N.A.
v. K.H. Corp., 968 F.2d 1489 (2d Cir. 1992); Lentell v. Merrill Lynch, 396 F.3d 161 (2d Cir. 2005); Latlanzia v. Deloitte &
Touche LLP, 476 F.3d 147 (2d Cir. 2007). See also nn. 87-89 and accompanying text. Causation matters generally are
considered in Rosen and Richards, “A Defendant’s Guide to Loss Causation,” 18 Securities Insights 13 (2004).
34
60
In Dura Pharmaceuticals v. Broudo,142 the Supreme Court added its voice to the
“loss causation” debate. There, the Supreme Court held that it was not enough for a
misrepresentation to cause an inflated purchase price; the correction of the misrepresentation
must also be causally related to the subsequent decline as well. In Dura, plaintiff alleged that a
pharmaceutical company misrepresented the status of certain FDA approvals, inflating the price
of the stock. Subsequently, the company announced an earnings shortfall, and the price of the
stock fell. The Supreme Court concluded there was no causal connection between the status of
the FDA approvals and the earnings shortfall, since the earnings shortfall from existing
operations was not brought about by the lack of timely FDA approvals relating to drugs which
were still in development and therefore not generating revenue.
The potency of the “loss causation” doctrine in accounting cases is demonstrated
by the Eleventh Circuit’s decision, in Robbins v. Koger Properties, Inc.,143 where the court
reversed a multi-million dollar jury verdict against an accounting firm on loss causation grounds.
Koger was cited favorably by the Supreme Court in Dura. In Koger the court found that, while
the accounting firm had overstated the company’s earnings and cash flow during the class
period, thus inflating the company’s stock price, the non-disclosures had not yet been cured
when the company announced a dividend cut and the stock price declined. Therefore the court
found that the immediate cause of the stock price decline was not the accountant’s work, even
though the accountant’s work had led the investors to overpay.144
(f)
Controlling Persons/Aiding and Abetting.
Persons who may be sued under Section 10(b) include not only primary
wrong-doers but also “controlling persons” under Section 20(a) of the 1934 Act.145 For quite
some time, it was also thought that “aiders and abettors,” who act with knowledge of the
wrongdoing in order to assist in it, could also be liable, but the Supreme Court’s Central Denver
Bank decision reached the opposite result.146
Plaintiffs tried thereafter to plead around Central Denver Bank by trying to limit
its result to the traditional “misstatement or omission” prong of Rule 10b-5(b), and arguing that
secondary market players could still be held liable for participating in a “scheme” on an “artifice
142
___ U.S. ___, 125 S. Ct. 1627 (2005).
143
116 F.3d 1441 (11th Cir. 1997).
144
The court’s decision can be criticized, on the ground that the overstatement contributed to a higher dividend level during
earlier periods, thus contributing to the dividend cut. Overpayment itself is also arguably a contributing factor to the loss.
In Koger, a stronger causal connection could be alleged between the allegedly mis-stated financials and the reasons
underlying the dividend cut then could have been alleged in Dura. Based on Koger, accountants can argue that virtually any
corrective or other disclosure which produces a stock price decline which is something less than a financial restatement is
not causally connected to the original financial overstatement or the plaintiff’s resulting loss.
145
15 U.S.C. § 78t(a).
146
Central Bank of Denver v. First Interstate Bank, 511 U.S. 164 (1994).
35
61
to defraud” under 10b-5(a) and (c). The Supreme Court soundly and squarely rejected that
“scheme liability” theory in the Stoneridge case.147
Accountants, however, may not get quite the relief from liability they expect
under Stoneridge, because when they deliver an audit opinion they can be characterized as
primary speakers. Many courts have held, after Central Denver Bank, that when an accountant
states in his audit opinion that the financial statements are prepared in accordance with GAAP,
and that the audit was conducted in accordance with GAAS, those are primary statements, made
by the accountant. If the statements are (i) intentionally or recklessly wrong, and (ii) made in
connection with a purchase and sale, even after Stoneridge and Central Denver Bank the
accountant may be held to be a primary violator of Section 10(b).148 It is too soon after
Stoneridge to know whether those arguments by plaintiffs will continue to succeed.
(g)
Damages.
Damages under Section 10(b) are generally measured on an “out-of-pocket” basis
(as opposed to a “benefit of the bargain” basis).149 Thus, someone who buys a security at $10 on
the representation that it is worth $12 can only recover $3 rather than $5 when the price of the
security falls to $7.150 However, the Second Circuit has recently allowed the use of a “benefit of
the bargain” damage theory in a securities case.151
(h)
Rule 9(b) and the PSLRA Pleading Standards.
One important practical defense for accountants in Section 10(b) cases is set forth
in Rule 9(b) of the Federal Rules of Civil Procedure, which requires that allegations of fraud be
made with particularity, as enhanced by the Private Securities Litigation Reform Act, in
securities cases. In Tellabs, the Supreme Court interpreted the particularity requirement in a prodefendant manner, requiring not only a detailed statement, but an inference of fraudulent
behavior and intent which was more plausible or likely than an alternative, innocent explanation.
147
Stoneridge Investment-Partners LLC v. Scientific-Atlanta, Inc., No. 06-43 (decided January 15, 2008).
148
Perhaps the leading case in this regard is Wright v. Ernst & Young, Fed. Sec. L. Rep. (CCH), ¶ 90,266 (2d Cir. 1998), which
held that an auditor is not liable for a company’s press release, even though the auditor reviewed the press release before it
was issued. See, also, McGann v. Ernst & Young, 95 F.3d 821, amended, 1996 U.S. App. Lexis 31149 (9th Cir. 1996);
Bank v. Ernst & Young, Fed. Sec. L. Rep. (CCH), ¶ 99,062 (S.D. Fla. 1996); In re Chambers Development Securities
Litigation, 848 F. Supp. 602 (W.D. Pa. 1995); Cashman v. Coopers & Lybrand, 877 F. Supp. 425 (N.D. Ill. 1995); In re
ZZZZ Best Securities Litigation, Fed. Sec. L. Rep. (CCH) ¶ 98,485 (C.D. Cal. 1994); In re Software Toolworks, 38 F.3d
1078, amended, 50 F.3d 615 (9th Cir. 1994); In re Kendall Square Research Corp. Securities Litigation, 869 F. Supp. 53 (D.
Mass. 1994); Employers Insurance of Wausau v. Musick, Peeler & Garrett, 871 F. Supp. 381 (S.D. Cal. 1994); Forcier v.
Cardello, 173 B.R. 973 (D.R.I. 1994).
149
See Randall v. Loftsgaarden, 478 U.S. 647 (1986).
150
A good example of the application of this theory in an accounting case is Edward J. DeBartolo Corp. v. Coopers & Lybrand,
Fed. Sec. L. Rep. (CCH) ¶ 99,287 (W.D. Pa. 1996).
151
McMahan & Co. v. Wherehouse Entertainment, Inc., 65 F.3d 1044 (2d Cir. 1995). This approach can be criticized as being
inconsistent with the Second Circuit’s much more restrictive view of loss causation. See nn. 124-25, supra, and
accompanying text.
36
62
The decision has helped accountants secure dismissals at the pleading stages of a number of
cases, by arguing things like violations of GAAS and GAAP, without more, do not demonstrate
scienter, or that allegations which could be equally characterized as an intentional decision to
mis-state financial results or as an exercise of professional judgment, also do not adequately
allege scienter.152
2.
Section 18.
Another provision of the 1934 Act which may impose liability on accountants but
which has not often been litigated is Section 18.153 Section 18 imposes civil liability for
damages on accountants and other persons for misstatements made in documents filed with the
SEC.154 However, the accountant may assert defenses of good faith and lack of knowledge that
the statements which he made were false and misleading. Furthermore, Section 18 by its terms is
limited to documents filed with the SEC and does not impose any liability for misstatements
made in other documents and in other contexts.
C.
The Private Securities Litigation Reform Act.
One of the most significant changes affecting the securities law liability of
accountants in recent years of course was the passage, over President Clinton’s veto, of the
Private Securities Litigation Reform Act of 1995.
One of the major highlights from the standpoint of accountants includes the bill’s
elimination of joint and several liability for securities law claims. No longer will an accountant
assessed with only 5-10% responsibility for a securities law violation have to pay for the full
amount of a plaintiff’s losses. Instead the accountant will only be assessed for the proportionate
share of the losses which the jury finds he caused, so long as he has not acted “knowingly,” i.e.,
with an actual intent to defraud, as compared with mere reckless disregard. This reduces many
plaintiffs’ incentive to look upon the accountant as a deep pocket who can pay for the entire loss
even though the accountant’s role in the creation of the loss was at best tangential. It has also
substantially changed the dynamics and tactics of trial and even settlement of securities cases
involving accountants.
The PSLRA also provides for a safe harbor for certain forward-looking statements
and projections, provided they are accompanied by a “meaningful cautionary statement.” The
safe harbor does not apply to audited financial statements or registration statements, however, so
this aspect of the safe harbor may be of limited significance to accountants.
152
Tellabs Inc. v. Makor Issues & Rights Ltd., 127 S.Ct. 2411 (2007).
153
15 U.S.C. § 78r.
154
See Fischer v. Kletz, 266 F. Supp. 180 (S.D.N.Y. 1967).
37
63
III.
RICO
Accountants have also recently been held liable under the Racketeer Influenced
and Corrupt Organizations Act (“RICO”).155 While a complete discussion of RICO claims is
beyond the scope of these materials, RICO generally makes it unlawful for any person employed
by or associated with an enterprise to conduct or participate in the conduct of the enterprise’s
affairs through “a pattern of racketeering activity.”156 The statute defines a “pattern of
racketeering activity” to be at least two acts of racketeering activity within ten years of each
other.157 “Racketeering activity” in turn is defined to include offenses such as murder,
kidnapping, gambling, arson, robbery, bribery, extortion, drug dealing and obstruction of justice,
as well as mail fraud,158 wire fraud159 and “fraud in the sale of securities.”160 RICO then goes on
to provide a treble damage remedy to “any person injured in his business or property by reason
of” the conduct of an enterprise through a pattern of racketeering activity.161
A literal reading of RICO suggests that a plaintiff who can allege he was the
victim of a common law fraud or a securities fraud perpetrated through two letters, two telephone
calls or one letter and one telephone call can sue for treble damages, because he has been injured
in his business or property by reason of two acts of mail or wire fraud, which constitute a pattern
of racketeering activity. The temptation for plaintiffs to assert such claims against accountants
and other persons in many otherwise routine commercial cases has proved irresistible.
The principal manner in which courts have attempted to restrict RICO’s reach,
with mixed success and many conflicting results, is by reading RICO’s “pattern” requirement to
require a great deal more than simply two unrelated acts of fraud, or two acts in support of one
fraudulent scheme.162 This approach is based on the famous “footnote 14” of the Supreme
Court’s decision in the Sedima case,163 where the Supreme Court said that while “two acts are
necessary, they may not be sufficient” and that what was required to constitute a pattern was
“continuity plus relationship” among the various predicate acts. In H.J., the Supreme Court
decided that a single episode of illegal activity involving two or more illegal acts could be
155
18 U.S.C. §§ 1961-68.
156
18 U.S.C. § 1962(c).
157
18 U.S.C. § 1961(5).
158
18 U.S.C. § 1341.
159
18 U.S.C. § 1343.
160
18 U.S.C. § 1961(1).
161
18 U.S.C. § 1965(c).
162
See generally Batista, “‘Patterns’ Under RICO -- A Circuit-by-Circuit Review,” N.Y.L.J., December 13, 1988, p. 1, col. 1.
163
Sedima, S.P.R.L. v. Imrex Co., 473 U.S. 479, 496 n. 14 (1985).
38
64
sufficient to constitute a “pattern,” and that proof of an organized crime nexus was not
required.164 Other than that, however, the Supreme Court’s decisions have done little to clear up
the confusion over what constitutes a RICO “pattern,” and lower courts have continued to
struggle as a result.
Nevertheless, the Supreme Court sharply restricted RICO’s reach, at least insofar
as accountants are concerned, in Reves v. Ernst & Young.165 There the Supreme Court held that
outside accountants do not ordinarily “participate” in the “conduct” of the affairs of an
“enterprise”, as RICO requires. The affairs of the “enterprise” are “conducted” by its officers
and directors, not its outside advisors. The beneficial impact that Reves will continue to have in
restricting RICO’s reach to accountants has been confirmed by subsequent decisions which
relied on Reves to dismiss RICO claims against accountants.166
Reves of course does not mean that accountants can never be held liable under
RICO where they become sufficiently involved in the allegedly fraudulent acts. As one court has
said, “Reves did not hold that an accountant could never be held liable under section 1962(c) for
preparing a financial report.”167
The Private Securities Litigation Reform Act of 1995 removed securities fraud
from RICO’s list of predicate acts. Together with Reves and the “pattern” requirement, RICO
claims against accountants have been sharply limited.
CONCLUSION
There are many theories of liability available against accountants. Jury verdicts
and claims have both continued at high levels. The current climate, in the wake of Enron and
Worldcom, makes jurors, and even judges, distrustful of accountants. Thus, accountants must
always be cognizant, in every financial statement which they prepare and every audit
engagement which they accept, of the broad range of potential liabilities to broad classes of
persons which their work may entail.
164
H.J. Inc. v. Northwestern Bell Tel. Co., 492 U.S. 229 (1989).
165
507 U.S. 170 (1993).
166
See, e.g., University of Maryland v. Peat, Marwick, Main & Co., 996 F.2d 1534 (3d Cir. 1993); and Cope v. Price
Waterhouse, 989 F.2d 1564 (9th Cir. 1993). In Department of Economic Development v. Arthur Andersen & Co., 924 F.
Supp. 449 (S.D.N.Y. 1996), the court relied on both Reves and Central Denver Bank to dismiss a claim against an
accountant for allegedly aiding and abetting a RICO violation.
167
Acebey v. Shearson Lehman Bros, Inc., No. CV 92-5926-WMB, 1993 U.S. Dist. LEXIS 19659, at p. 8 (C.D. Cal. 1993).
See also Circle Business Credit Inc. v. Becker, slip op., No. 92-3177 (E.D. Pa., decided February 18, 1994).
39