Auditor Liability to Non-Clients, ALI-ABA course, May 3-4, 2007

by David A. Bunis, William J. Lovett and Jennifer M. Ryan[1]
Presented at ALI-ABA course, May 3-4, 2007 – Boston, MA

Traditionally, an accountant’s duty only ran to his or her client. The client, typically a company, contracted with the accountant to render an audit opinion. The contract established a relationship and created a duty flowing from the accountant to the company.  Thus any liability that an accountant may have had stemming from his or her own negligence or malpractice was traditionally limited to the client with whom the accountant had a contractual relationship.

However, in recent years, courts have begun to recognize the reality that accountants and auditors play a broader role in today’s complex business environment.  Third parties routinely rely on the unqualified audit opinion, the accountant’s seal of approval, when making routine business decisions. Thus, courts now reject the notion that an accountant’s liability for negligence or malpractice is limited to the accountant’s client.  Rather, an accountant may now be liable to creditors, shareholders and the general investing public who reasonably rely on financial statements certified by public accounting firms.[2] The expansion of accountant’s liability recognizes that an accountant who certifies a client’s financial statements assumes a public responsibility that transcends any relationship with an individual client.[3] Indeed, an independent public accountant performs a unique watchdog role and conducts audits for the “very purpose of providing information – indeed assurances – to third parties”.[4]

The law has evolved to recognize that third parties routinely rely on audit opinions and to define when an accountant’s duty extends to non-clients. This article will first discuss how courts have determined the duty of care owed by an accountant or an auditor to a third party under a theory of negligent misrepresentation. The article will then discuss how unfair and deceptive trade practice statutes, such as Mass. G.L. 93A, may be utilized as a separate basis of accountant liability to third parties.

I.          Different Approaches to Accountant Liability Based on Negligent Misrepresentation

In its 1998 Nycal decision, the Massachusetts Supreme Judicial Court surveyed the three different approaches generally applied to determine the duty of care owed by an accountant to a non-client: the forseeability test, the near-privity test (often referred to as Ultramares), and the test reflected in Restatement (Second) of Torts, § 552 (1977).

a. The Forseeability Test

The forseeability test, the broadest standard of liability, is derived from traditional tort law concepts. Remember those law school days debating poor Mrs. Palsgraf and her fate of being struck with scales dislodged from an explosion that occurred when a train conductor attempted to help a gentleman onto the train dislodging his package containing firecrackers?[5]  The issue was whether it was reasonably foreseeable for the train conductor to know that his action would result in Mrs. Palsgraf’s injury. Pursuant to the forseeability test, “an accountant may be liable to any person whom the accountant could reasonably have foreseen would obtain and rely on the accountant’s opinion, including known and unknown investors.”[6]  This approach, which greatly expands an accountants’ liability, is generally disfavored and has only been adopted by a few jurisdictions.[7]

b. The Near-Privity or Ultramares Test

The near-privity test, the most restrictive of the three tests, limits an accountant’s liability to those with whom the accountant is in privity (i.e. contractual relationship) or in a relationship similar to privity.[8] Under the near-privity test, an accountant may be liable to a non contractual third party who relied on an inaccurate financial statement to his or her detriment if the accountant was aware that the report was to be used for a particular purpose, the non contractual third party was intended to rely on the financial statements for that purpose, and the accountant engaged in some conduct creating a link to that particular third party which evinces the accountant’s understanding of the party’s reliance.[9]  For example, if an accountant knew that the company hired the accountant to prepare financial statements that would be given to a bank who would use the financials to determine whether to provide the company with a loan, and the accountant sent the inaccurate statements to the bank, the near privity test is met.  The near-privity test, originated in Judge Cardozo’s decision in Ultramares Corp. v. Touche, 255 N.Y. 170,179 (1931), was modified in 1985 by Credit Alliance Corp. v. Arthur Anderson & Co., 65 N.Y.2d 536, 553 (1985) and is still utilized today, primarily in New York.

c. Section 552 of the Restatement (Second) of Torts

The third test is derived from the Restatement (Second) of Torts § 552 (1979).  This test describes the tort of negligent misrepresentation.  To state a claim for negligent misrepresentation under § 552 of the Restatement (Second) of Torts (“§ 552”), a plaintiff must allegethe following elements:
 
1)         the defendant, in the course of his business, profession or employment, or in any other transaction in which he has a pecuniary interest, supplied false information for the guidance of others in their business transactions;
 
2)         the plaintiff is a person or one of a limited group of persons for whose benefit and guidance the defendant intended to supply the information or knows that the recipient intends to supply it (even if the plaintiff has no direct contractual relationship with the defendant);
 
3)         through relianceupon such information, in a transaction that defendant intends the information to influence or knows that the recipient so intends or in a substantially similar transaction, the plaintiff suffered harm.[10]
 
In Nycal, the Massachusetts Supreme Judicial Court explicitly adopted the Restatement test as to accountants. By adopting the Restatement (Second) of Torts, Section 552, the Court limited accountants’ liability to “non-contractual third parties who can demonstrate actual knowledge on the part of accountants of the limited – though unnamed – group of potential [third parties] that will rely on the [report], as well as actual knowledge of the particular financial transaction that such information is designed to influence.”[11]  Section 552 “properly balances the indeterminate liability of the forseeability test and the restrictiveness of the near-privity rule . . . [and] recognizes commercial realities by avoiding both unlimited and uncertain liability for economic losses in cases of professional mistake and exoneration of the auditor in situations where it clearly intended to undertake the responsibility of influencing particular business transactions involving third persons.”[12]

Other jurisdictions have likewise recognized negligent misrepresentation claims under § 552 against accountants.[13] In fact, the overwhelming majority of states now recognize § 552 as the standard for an auditor’s liability to third parties with whom the auditor is not in privity.[14]

II.        Accountant Liability to Non Clients Based on Statutory Unfair or Deceptive Trade Practices Law
 
When independently audited and certified financial statements ultimately prove to be misstated, third parties who rely on such financial statements often seek relief by pairing negligent misrepresentation claims with statutory unfair or deceptive trade practices claims against the auditors. In Massachusetts, courts have generally recognized that auditors may be subject to liability under Massachusetts General Law, Chapter 93A, which may also subject the auditor to treble damages and attorney’s fee. 
 
a. Accountant Liability to Non-Clients under Mass. G.L. Chapter 93A.
 
Consistent with the courts’ recognition of accountant’s liability to third parties under       § 552, courts also recognize that accountants may be liable to third parties under Massachusetts General Law, Chapter 93A, which prohibits unfair or deceptive trade practices. Mass. Gen. L. ch. 93A §§ 2 and 11 make unlawful “unfair or deceptive acts or practices in the conduct of any trade or commerce” between two businesses.[15] The enactment of Chapter 93A created new substantive rights and means of relief in addition to -- not as an alternative to -- traditional tort claims.[16]
 
In order for Chapter 93A liability to attach, courts typically rely on the § 552 standard adopted in Nycal. Since Nycal, courts have applied its articulation of the requisite relationship between an auditor and a third party to determine whether the complaint adequately pleads Chapter 93A’s “trade or commerce” requirement. Thus a claim alleging that the accountant: 1) knew or intended that the plaintiff or any limited-though unnamed-group of potential third parties would rely on the accountant’s report; and 2) had actual knowledge of the particular financial transaction that such information is designed to influence, meets the Nycal standard and states a claim for unfair trade practices under Chapter 93A. Alternatively, where the Nycal test is not met, the Chapter 93A claim typically fails.
 
A survey of case law illustrates this point.  For example, in Spencer v. Doyle, the Massachusetts Appeals Court applied the Nycal standard (in the context of the defendant’s summary judgment motion) when analyzing the plaintiff’s Chapter 93A claims against an auditor.[17] The Spencer plaintiffs were investors in “BFG,” a factoring business which purchased accounts receivables from creditors at a discounted rate using funds advanced by BFG’s investors. When BFG failed, the investors sued BFG’s auditors, Coopers & Lybrand, alleging Chapter 93A violations arising from alleged misstatements in BFG’s financial statements audited by Coopers.
 
Coopers moved for summary judgment on the Chapter 93A claim on the grounds that it did not have a “commercial relationship” with the plaintiffs.[18]    After finding that no “commercial relationship” existed because the parties were not in privity, the court applied the Nycal standard to determine whether Cooper’s conduct interfered with trade or commerce. In upholding the lower court’s dismissal of the Chapter 93A claim, the appeals court reasoned that because there was no evidence in the record that Coopers had “actual knowledge of the particular financial transaction for which a participant might use the audit” nor was there evidence that the auditor intended or anticipated that the plaintiffs would rely on the audit, the Chapter 93A claim was properly dismissed.[19]
 
Other courts have followed Spencer, and applied the Nycal standard to determine whether Chapter 93A’s trade or commerce requirement is met.  In Young v. Deloitte & Touche, the court applied the Spencer and Nycal standard to a Chapter 93A claim brought by shareholders and creditors of a Deloitte & Touche audit client.[20]   The complaint was brought by the trustee of the NutraMax Litigation Trust on behalf of NutraMax’s creditors and shareholders. and the corporation itself against NutraMax’s auditor, Deloitte & Touche. The complaint alleged fraud, negligent misrepresentation, unfair and deceptive trade practices under Chapter 93A and professional malpractice relating to Deloitte’s audits.[21]
 
Deloitte moved to dismiss the complaint on the pleadings based, in part, on the plaintiff’s failure to allege a “commercial relationship” between NutraMax’s creditors and shareholders and Deloitte. The court dismissed the shareholders’ and creditors’ fraud, negligent misrepresentation and professional malpractice claims finding that the plaintiffs were unable to meet the standard set forth in Nycal.[22] Relying on Spencer, this Court likewise dismissed the plaintiffs’ Chapter 93A claim because Deloitte was engaged to perform annual audits of NutraMax and not to assist NutraMax in recruiting shareholders or creditors.[23] Thus, the plaintiffs’ Chapter 93A claim failed because the court found that the Deloitte was engaged in nothing more than a minor or insignificant relationship with the shareholders and creditors. Alternatively, the Chapter 93A claim brought on behalf of the company itself was allowed to proceed because without question, Deloitte was in privity with NutraMax.  Other Massachusetts courts faced with the same question have followed suit in applying Spencer’s application of the Nycal standard to Chapter 93A claims brought against auditors by non-clients.[24]
 
III.       Conclusion
 
In today’s business world, investors, creditors and shareholders increasingly rely on information provided by auditors. Such reliance arises out of the auditor’s professional and ethical obligations to perform a careful and diligent audit.  Where professional auditing standards are not met, auditors can expect a variety of third party plaintiffs to come knocking on the door when the client’s true financial situation does not mirror that reflected by an unqualified audit opinion.


--------------------------------------------------------------------------------

[1] David A. Bunis is a partner at Dwyer & Collora LLP, in Boston, Massachusetts. William J. Lovett and Jennifer M. Ryan are associates at Dwyer & Collora.
[2] Reisman v. KPMG Peat Marwick LLP, 965 F. Supp. 165 (D. Mass. 1997).
[3] U.S. v. Arthur Young & Co., 465 U.S. 805, 817-18 (1984).
[4] Fleet National Bank v. The Gloucester Corp., 1994 WL 924308, at * 3 (D. Mass. Aug. 8, 1994).
[5] See Palsgraf v. Long Island R.R., 248 N.Y. 339, 344 (1928).
[6] Nycal v. KPMG Peat Marwick, LLP, 426 Mass. 491, 494 (1998).
[7] See e.g. Touche Ross & Co. v. Commercial Union Ins. Co., 514 So. 2d 315 (Miss. 1987); Citizens State Bank v. Timm. Schmidt & Co., 113 Wis.2d 376 (1983); H. Rosenblum Inc. v. Adler, 93 N.J. 324 (1983).
[8] Nycal, 426 Mass. at 494.
[9] Id.
[10] See Nycal Corp., 426 Mass. at 495-98.
[11] Nycal, 426 Mass. at 498, citing, First Nat’l Bank of Commerce v. Monco Agency, Inc., 911 F.2d 1053, 1062(5th Cir. 1990).
[12] Nycal, 426 Mass. at 497-98, citing, Bily v. Arthur Young & Co., 834 P.2d 745, 769 (Cal. 1992).
[13] See Rhode Island Hospital Trust National Bank v. Swartz, Bresenoff, Yavner, & Jacobs, 455 F.2d 847, 851 (4th Cir. 1972) (recognizing bank’s negligent misrepresentation claim brought against borrower’s accountant under Rhode Island law); Abrams Centre National Bank v. Farmer, Fuqua & Huff, P.C., --SW.3d--, No. 08-05-00140-CV, 2005 WL 2806316, at *4-6 (Tex. Ct. App. Oct. 27, 2005) (recognizing that Section 552 applies to claims against wide range of professionals including accountants); NationsBank, N.A. v. KPMG Peat Marwick, LLP, 813 So.2d 964, 967-68 (Fla. Dist. Ct. App. 2002) (borrower’s accountant liable to lender on negligent misrepresentation claim where accountant knew details of line of credit agreement that required borrower to provide lender with annual audited financial statements); Kohala Agriculture v. Deloitte & Touche, 86 Hawaii 301 (Ct. App. 1997) (Section 552 approved by majority of courts for negligent misrepresentation claims against accountants) (citations omitted); Bily v. Arthur Young & Co., 834 P.2d 745, 769 (Cal. 1992) (no privity required for a Section 552 claim against accountant).
[14] See Jay M. Feinman, Liability of Accountant for Negligent Auditing: Doctrine, Policy and Ideology, 31 Fla. St. U. L. Rev. 17, 41 n. 165 (2003).
[15] Spencer v. Doyle, 50 Mass. App. Ct. 6, n. 6 (2000).
[16] Reisman v. KPMG Peat Marwick LLP, 965 F.Supp. 165, 175 (D. Mass. 1997)
[17] Spencer, 50 Mass. App. Ct. at 13.
[18] Id.
[19] Id.
[20] Young v. Deloitte & Touche,  2004 WL 2341344, at * 8 (Mass. Super. Ct. 2004).
[21] Id.
[22] Id. at * 7-8.
[23] Id. at *7.
[24] See Reisman v. KPMG Peat Marwick, LLP, 57 Mass. App. Ct. 100 (2003) (reversing lower court’s grand of summary judgment on Chapter 93A claim where record showed that KPMG had direct contact with the plaintiff and assigned partner to advise him in the underlying transaction); Imprimis Investors, LLC v. KPMG Peat Marwick, No. 995312 BLS, 2005 WL 704815 (Mass. Super. Feb. 14, 2005) (granting defendant’s motion to dismiss Chapter 93A claim where plaintiff had no contact or any contractual or commercial relationship with the defendant); Congress Financial Corp. v. Kussell, No. 035538 BLS, 2005 WL 2010039, at * 3-4 (Mass. Super. June 29, 2005) (denying 12(b)(6) motion to dismiss 93A claim where Nycal standard is met for negligent misrepresentation claim).