Cecily Zamora
Certified Public Accountants (CPAs) can be held liable for damages under common law, statutory law, or both, depending on the jurisdiction. Common law liability arises from negligence, breach of contract, and fraud. CPAs are normally liable to their clients, the shareholders, for either ordinary or gross negligence. The Ultramares v. Touche case established that auditors could be held liable to any foreseen third party for ordinary negligence. This ruling set a precedent for increased CPA liability to foreseeable third parties for ordinary negligence.
| Characteristics | Values |
|---|---|
| Common law approach leading to increased CPA liability | Ultramares Approach |
| Restatement of Torts Approach | |
| Rosenblum Approach |
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What You'll Learn
Ultramares v. Touche
In Ultramares Corp. v. Touche, Niven & Co., the plaintiff, Ultramares, relied on the defendant's financial statements to make loans to the defendant's clients. The defendant's client, Fred Stern & Co., went bankrupt, and Ultramares sued the defendant, an accounting firm, for negligent misrepresentation and false certification of the truthfulness of the audit. Ultramares argued that the defendant's audit of Fred Stern & Co. was negligent and failed to discover that the company had falsified entries to overstate accounts receivable. The defendant's auditors had provided Fred Stern & Co. with 32 certified and serially numbered copies of the balance sheet, which were used to secure loans. Ultramares relied on one of these copies to lend money to Fred Stern & Co., which later declared bankruptcy.
The case was decided by Cardozo, C.J., who included the famous line that the law should not admit "to a liability in an indeterminate amount for an indeterminate time to an indeterminate class." The jury awarded Ultramares $187,500 in damages, but the trial judge entered judgment for the defendant on the ground that Ultramares failed to state a cause of action. However, the appellate division reversed the trial court's dismissal of the negligence claim.
The rule set forth in Ultramares v. Touche is still the law in New York, as seen in Credit Alliance Corporation v. Arthur Andersen & Co. in 1985. However, less restrictive rules have been followed in other states, such as in Rosenblum Inc. v. Adler in 1983 and Citizens State Bank v. Timm, Schmidt & Co. in 1983.
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Rosenblum v. Adler
The Rosenblum v. Adler case established a precedent that increased CPA liability to "foreseeable" third parties for ordinary negligence. The case involved a dispute between H. Rosenblum, Inc. and Adler, which was heard by the Superior Court of New Jersey, Appellate Division. The plaintiffs' motion for leave to appeal was granted by the Appellate Division, but the trial court's decision was affirmed.
The case set a precedent for increasing liability to third parties arising from audits under common law. This means that CPAs can be held liable for ordinary negligence to identified third parties for whose benefit the audit was performed. CPAs are normally liable to their clients or shareholders for either ordinary or gross negligence.
In the context of CPA liability, ordinary negligence refers to the failure to use reasonable care in the performance of services. CPAs can be held liable for ordinary negligence if they fail to perform their duties with due diligence, good faith, and due professional care.
The Rosenblum v. Adler case also highlighted the distinction between typical negligence cases and business tort cases. The court found that the distinction was based on the probable status, sophistication, and vulnerability of the victim when entering into fee arrangements with an attorney. The case also discussed the applicability of Rule 1:21-7, which protects litigants who may not be sufficiently sophisticated to review and rely upon a certified audit of financial statements when making business decisions.
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Rule 10b-5
To establish a claim under Rule 10b-5, plaintiffs, including the SEC, must demonstrate several elements:
- Manipulation or deception: This includes misrepresentation or omission of material facts.
- Materiality: The information must be significant enough to influence investment decisions.
- "In connection with" the purchase or sale of securities: The fraudulent activity must be directly related to the trading of securities.
- Scienter: This refers to the intent or knowledge of the fraud by the defendant.
- Standing - Purchaser/Seller Requirement: Private plaintiffs must be either buyers or sellers of the company's stock. Potential buyers defrauded into not buying stock cannot bring a claim.
- Reliance: This is presumed if there was an omission.
- Loss Causation: Plaintiffs must show that the fraud proximately caused their losses.
- Damages: Plaintiffs must demonstrate the harm or financial loss they suffered due to the fraud.
The SEC Rule 10b-5 is an essential tool in combating securities fraud and protecting investors from deceptive practices. It empowers both the SEC and private citizens to take legal action against fraudulent activities in the securities market.
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Restatement of Torts
The Restatement of Torts Approach is a common-law approach that increases the liability of CPAs for ordinary negligence to "reasonably foreseeable" third parties. It is one of the approaches, including the Due Diligence Approach, Ultramares Approach, and Rosenblum Approach, that can be used to determine the liability of auditors and accountants in cases of negligence.
Under the Restatement of Torts Approach, CPAs can be held liable to foreseeable third parties for ordinary negligence. This means that if a CPA fails to exercise reasonable care in conducting an audit or providing professional services, they can be sued by third parties who rely on the financial statements or other information resulting from the CPA's work.
For example, if a CPA provides an unqualified opinion on a company's financial statements, and those financial statements are later found to contain material misstatements, the CPA could be held liable to investors or creditors who relied on those financial statements and suffered losses as a result.
It is important to note that CPAs can also be held liable under other legal theories, such as gross negligence, fraudulent activity, or failure to act with good faith. Additionally, CPAs may have criminal and civil liability exposure depending on the specific circumstances of a case.
To defend themselves against allegations of negligence or fraud, CPAs can assert various defences, including lack of due diligence, lack of gross negligence, contributory negligence on the part of the client, or the inclusion of a disclaimer in the engagement letter. However, CPAs should be aware that in some cases, such as those brought under the Securities Act of 1933, proving "due diligence" is essential to their defence.
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Due Diligence Approach
The Due Diligence Approach is one of several common law approaches that can be used to determine whether a CPA has liability for ordinary negligence to a "reasonably foreseeable" third party. This approach considers whether the CPA performed their audit with due diligence, or reasonable care.
Due diligence is the process of assessing the legal, financial, and business risks associated with a merger or acquisition. In the context of CPA liability, due diligence refers to the care and thoroughness with which an audit is performed. This includes reviewing historical financial data, details on owners and employees, client categories and specific material clients, service methodologies, benefit plans, policies, procedures, the quality control system, legal matters, and the condition of assets.
CPAs are generally liable to their clients, the shareholders, for either ordinary or gross negligence. In court cases brought by clients or third parties under common law, CPAs may raise the due diligence defence, claiming that they performed the audit with due diligence and reasonable care. However, this defence can be difficult to prove, and CPAs may be found liable if they are unable to demonstrate that they acted with due diligence.
The Due Diligence Approach increases CPA liability by holding CPAs accountable for ordinary negligence to "reasonably foreseeable" third parties. This means that CPAs can be found liable not only to their clients but also to third parties who rely on their financial statements, even if those third parties are not specifically identified. This approach was established in Rosenblum v. Adler, which set a precedent for increasing CPA liability to third parties arising from audits under common law.
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Frequently asked questions
Ultramares v. Touche.
Rosenblum v. Adler.
Ultramares Approach.
It was established by the American Law Institute’s (ALI) Second Restatement of Law of Torts.
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