Accountants’ Liability

Major companies across the country have violated basic accounting principles. As a result, shareholders and others who depended upon sound information in making decisions are bringing lawsuits for negligent misrepresentation and fraud.

For example, a class action lawsuit is pending against Enron and other defendants in Houston, Newby vs. Enron, No. H 01-3624 ( S.D. Tex., filed April 8) but allegations surround Arthur Andersen, it’s clear that the net of potential wrongdoers is widening.

Such Actions, though, would not be surprising given the fundamental precept of American jurisprudence to apportion liability based on fault, with culpable parties paying their fair share of damages.

In determining accountants’ legal liability, the first question is whether to bring an action in state or federal court.

Securities fraud is commonly brought against certified public accountants in federal court. Plaintiffs favored the more liberal discovery rules in federal court until 1995, when Congress passed the Private Securities Litigation Reform Act that imposed a variety of new restrictions on shareholder suits, including limits on the records that can be obtained in discovery.

Accountants long had been held not liable for their negligence to relying third parties. In an quoted opinion, Justice Benjamin Cardozo expressed the concern that " if liability in an indeterminate times to an indeterminate class." Ultramares v. Touche, 255 N.Y. 170, 174 N.E. 441 (1931). It was this case that established a privity requirement in order to find accountants liable to their parties.

The privity rule requires a connection between the accountant and the party relying on the information provided by the accountant, such a contractual obligation binding the auditors to the plaintiff.

In 1986 Illinois was the first state to enact a statute that established what is called a near privity standard of the accountant and those non-client relying on that professional’s written statements.

Illinois Public Accounting Act, 225 ILCS 450 (2002). In interpreting that statute, the court in Chestnut v. Pestine Brinati Gamer Ltd., 281 Ill. App.3d 715, 667 N.E 2nd 543 (1st Dist.1996), found that contractual privity was not necessary.

An investor sued an accounting firm for negligent misrepresentations made about a company’s financial condition. the court held the statute created an exception to the general rule of liability where the accountant prepares and sends a writing to specific persons, intended to rely on the accountant’s services.

In denying the defendant’s motion for summary judgement, the court stated the plaintiff had demonstrated that an issue of fact existed regarding whether defendant’s position would mean "as a matter of law, that accountants are never liable to third parties absent fraud or intentional misrepresentation, unless they agree in writing to expose themselves to liability."

A few states, such as Wisconsin and Mississippi, have adopted a broader standard of liability and hold a defendant liable for all reasonable foreseeable consequences of their negligence.

The Restatement Section 522 is yet another approach followed in many states. Its requires actual knowledge or intent to supply negligently prepared information to another, and an intent or knowledge that such information will influence the transaction causing the plaintiff’s harm.

Thus, under Section 522 accountants must receive notice of potential third party claims or at least know that the misrepresentation will reach the plaintiff.

It appears that the privity and near-privity approaches do not recognize the use of an audit in today’s marketplace. Current auditing practice requires courts to re-examine the prominent role accountants play in the business community, as well as investors’ increasing reliance on audits in making investment decisions.

A growing trend appears to be developing to hold accountants liable to the public in general as courts recognize the "public watchdog" function as accountant. As early at 1984 the Supreme Court of the United States held that the Internal Revenue Service could gain access to an accountant’s work product and stated, " By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibly 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." United States v. Arthur Young & Co., 465 U.S. 805,817-18(1984).

As Americans reel in the wake of a roller-coaster stock market and the increasing rate of insolvency of business and financial institutions, corporations and accounting firms are undergoing more strict security to see if executive "cooked the books" when a loss occurs.

In spreading the loss to auditors and other professionals as providers of financial information, however courts need to find a uniform standard to govern these cases so that plaintiffs as well as defendants know what is expected of them.

It appears that a reasonable foresee ability standard, the established principle governing negligence in Illinois, is fair when dealing with investors and lenders who rely upon accountants’ audits and information.

Look for plaintiffs’ lawyers to exercise their traditional creativity to find ways to hold accountant liable because it had been believe for years, at least anecdotally, that accountants have long been " cooking the books" with corporate executives and the day of reckoning is here.