ACCT 622 Week 5 Discussion Board Forum 3 Thread/Case Study Example

From Ultramares to Bily: How the Classic Court Cases Drew the Line on an Auditor's Liability to Third Parties

Ultramares and the Problem of Indeterminate Liability

Touche, Niven and Company audited Fred Stern and Company and certified a balance sheet that showed the company solvent when, through fictitious receivables, it was not. Touche knew that Stern used certified balance sheets to borrow money, though it did not know which lenders would see them. Ultramares lent to Stern in reliance on the balance sheet and lost its money when Stern failed. New York's highest court, in an opinion by Chief Judge Cardozo, held that Touche owed no duty of care to Ultramares, because extending negligence liability to everyone who might read an audit report would leave auditors open to claims of unknowable size, for an unknowable period, from a class nobody could define (Ultramares Corp. v. Touche, 1931). The court left one door open: an auditor could be liable to third parties for fraud, and negligence so gross as to show that the auditor had no genuine belief in its opinion could support an inference of fraud. Baker and Prentice (2008) trace how this framework grew out of earlier American cases and set the terms of the debate for the rest of the century.

Three Answers to Cardozo's Question

Courts since 1931 have answered the question of who may sue in three ways. New York kept a near-privity rule. In Credit Alliance Corp. v. Arthur Andersen and Co. (1985), its highest court held that a third party may recover for negligence only if the auditor knew the report would be used for a particular purpose, knew that a particular party would rely on it, and engaged in conduct linking it to that party. Most states adopted the Restatement rule, under which a careless auditor answers to the people it meant its report to inform, or knew the client meant it to inform, when they rely on it in the kind of deal everyone had in view (American Law Institute, 1977). New Jersey went furthest in Rosenblum v. Adler (1983), extending the duty of care to any reader the auditor could reasonably foresee, so long as the reader got the statements from the client and used them for a legitimate business end, a rule the state's legislature later narrowed by statute. California rejected foreseeability in Bily v. Arthur Young and Co. (1992), confining negligence claims to clients and allowing negligent misrepresentation claims only by intended beneficiaries.

Applied to a bank that lends to a client after seeing its audited statements, the approaches diverge. Under Credit Alliance, the bank recovers only if the auditor knew the bank by name and dealt with it. Under the Restatement, it recovers if the auditor knew the client was obtaining a loan of this kind from a lender. Under Rosenblum, it would recover simply because lenders are foreseeable readers. The same negligent audit can be actionable in one state and not in another, depending on how far the court thinks an auditor's duty should reach.

Federal Securities Law

Federal law adds a different layer. In Escott v. BarChris Construction Corp. (1968), a federal court held the company's auditors liable under Section 11 of the Securities Act for misstatements in a registration statement, because the accountant who performed the subsequent events review accepted management's answers without checking them and so failed to establish the due diligence defense. For fraud claims under Rule 10b-5, by contrast, the Supreme Court held in Ernst and Ernst v. Hochfelder (1976) that a plaintiff must show scienter, meaning the auditor acted with intent to deceive or defraud, so carelessness alone will not do. Together, the cases mean that an auditor's exposure depends on the type of offering and the type of claim as much as on the quality of the work. Congress later softened the consequences of federal claims in the 1995 Private Securities Litigation Reform Act, which, for defendants who did not knowingly break the law, swapped joint and several liability for a share of damages matched to their share of fault, so that an auditor found partly at fault no longer bears the whole loss caused by a client's fraud. The reform reflects the same concern about indeterminate exposure that Cardozo voiced in 1931.

Where the Law Has Moved

Pacini et al. (2000) document a trend across common-law countries toward shrinking the circle of outsiders who may sue auditors, as courts and legislatures responded to the rising cost of litigation and to concern about auditors' ability to insure against unlimited claims. The New Jersey statute that narrowed Rosenblum and California's decision in Bily are both part of that trend. The direction suggests that Cardozo's concern about indeterminate liability has largely prevailed over the competing view that auditors should answer to everyone who relies on their work.

A Christian Worldview Assessment

Jesus answered the question "who is my neighbor?" with a story about a man who helped a stranger he had no obligation to help (English Standard Version Bible, 2001/2016, Luke 10:29-37). The law asks how far an auditor's legal duty extends; a Christian worldview asks how far the auditor's care should extend, and its answer is broader. An auditor who does careful work for the unknown lender, whether or not the law would let that lender sue, is treating the reader of the report as a neighbor. The narrowing of legal liability makes that ethical commitment more important, not less.

Conclusion

For practicing auditors, the classic cases teach three lessons: know who will rely on the report and document what the firm knows about them, perform registration work as if Section 11 will test it, and treat gross negligence as the line beyond which the protections of privity disappear. Firms have also learned to manage the question in their engagement letters and reports, stating whom the work is for and declining requests from lenders to rely on audits without a separate agreement. Those steps are prudent, but they work best when they describe the truth of the engagement rather than serve as a shield against people the auditor knows will rely on the report.

References

American Law Institute. (1977). Restatement (second) of torts § 552.

Baker, C. R., & Prentice, D. (2008). The origins of auditor liability to third parties under United States common law. Accounting History, 13(2), 163-182. https://doi.org/10.1177/1032373207088177

Bily v. Arthur Young & Co., 3 Cal. 4th 370 (1992).

Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536 (1985).

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).

Escott v. BarChris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968).

Pacini, C., Martin, M. J., & Hamilton, L. (2000). At the interface of law and accounting: An examination of a trend toward a reduction in the scope of auditor liability to third parties in the common law countries. American Business Law Journal, 37(2), 171-236. https://doi.org/10.1111/j.1744-1714.2000.tb00271.x

Rosenblum v. Adler, 93 N.J. 324 (1983).

Ultramares Corp. v. Touche, 255 N.Y. 170 (1931).