Plaintiffs purchased stock warrants (rights to purchase) for blocks of Osborne Computer Corp., the manufacturer of the first mass-market portable personal computer. Because of inability to produce a new product line with sufficient speed and the entry of IBM-compatible software into the personal computer market, Osborne filed for bankruptcy shortly after the warrants were issued. Plaintiffs thus received nothing for their investment.
Arthur Young had audited Osborne’s financial statements for the two years preceding the issuance of the warrants and had issued unqualified opinions on their fairness and compliance with generally accepted accounting principles. Plaintiffs sued Arthur Young for fraud, negligence, and negligent misrepresentation.
After a 13-week trial in which the plaintiffs’ expert witness alleged 40 deficiencies in Arthur Young’s audit and its noncompliance with generally accepted auditing standards, the jury found Arthur Young liable for professional negligence. Arthur Young appealed based on the jury instructions regarding its liability to third parties.
CHIEF JUSTICE LUCAS The AICPA’s professional standards refer to the public responsibility of auditors:
A distinguishing mark of a profession is acceptance of its responsibility to the public. The accounting profession’s public consists of clients, credit grantors, governments, employers, investors, the business and financial community, and others who rely on the objectivity and integrity of certified public accountants to maintain the orderly functions of commerce. This reliance imposes a public interest responsibility on certified public accountants. [2 AICPA Professional Standards (CCH 1988) §53.01]
[The court then discussed different states’ approaches to the issue of accountant liability to third parties.]
A. Privity of Relationship The New York Court of Appeals restated the law in light of Ultramares, White v. Guarente, and other cases in Credit Alliance v. Arthur Andersen & Co. (1985) 65 N.Y. 2d 536 [493 N.Y.S. 2d 435, 483 N.E. 2d 110]. Credit Alliance subsumed two cases with different factual postures: in the first case, plaintiff alleged it loaned funds to the auditor’s client in reliance on audited financial statements which overstated the client’s assets and net worth; in the second, the same scenario occurred, but plaintiff also alleged the auditor knew plaintiff was the client’s principal lender and communicated directly and frequently with plaintiff regarding its continuing audit reports. The court dismissed plaintiff’s negligence claim in the first case, but sustained the claim in the second.
The New York court promulgated the following rule for determining auditor liability to third parties for negligence:
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 accountant 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 party or parties, which evinces the accountants’ understanding of that party or parties reliance. (Credit Alliance v.
Arthur Andersen & Co., supra, 483 N.E. 2d at p. 118)
Discussing the application of its rule to the cases at hand, the court observed the primary, if not exclusive, “end and aim” of the audits in the second case was to satisfy the lender. The auditor’s direct communications and personal meetings [with the lender] resulted in a nexus between them sufficiently approaching privity. In contrast, in the first case, although the complaint did not allege the auditor knew or should have known of the lender’s reliance on its reports: “There was no allegation of either a particular purpose for the reports’ preparation or the prerequisite conduct on the part of the accountants … [nor] any allegation [the auditor] had any direct dealings with plaintiffs, and agreed with [the client] to prepare the report for plaintiffs’ use or according to plaintiffs’ requirements, or had specifically agreed with [the client] to provide plaintiffs with a copy [of the report] or actually did so.”
B. Foreseeability Arguing that accountants should be subject to liability to third persons on the same basis as other tortfeasors, Justice Howard Wiener advocated rejection of the rule of Ultramares in a 1983 law review article. In its place, he proposed a rule based on foreseeability of injury to third persons. Criticizing what he called the “anachronistic protection” given to accountants by the traditional rules limiting third person liability, he concluded:
Accountant liability based on foreseeable injury would serve the dual functions of compensation for injury and deterrence of negligent conduct. Moreover, it is a just and rational judicial policy that the same criteria govern the imposition of negligence liability, regardless of the context in which it arises. The accountant, the investor, and the general public will in the long run benefit when the liability of the certified public accountant for negligent misrepresentation is measured by the foreseeability standard.
Under the rule proposed by Justice Wiener, foreseeability of the risk would be a question of fact for the jury to be disturbed on appeal only where there is insufficient evidence to support the finding.”
C. The Restatement: Intent to Benefit Third Persons Section 552 of the Restatement Second of Torts covers “Information Negligently Supplied for the Guidance of Others.” It states a general principle that one who negligently supplies false information “for the guidance of others in their business transactions” is liable for economic loss suffered by the recipients in justifiable reliance on the information. But the liability created by the general principle is expressly 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.” To paraphrase, a supplier of information is liable for negligence to a third party only if he or she intends to supply the information for the benefit of one or more third parties in a specific transaction or type of transaction identified to the supplier.
The authors of the Restatement Second of Torts offer several variations on the problem before us as illustrations of section 552. For example, the auditor may be held liable to a third party lender if the auditor is informed by the client that the audit will be used to obtain a $50,000 loan, even if the specific lender remains unnamed or the client names one lender then borrows from another. However, there is no liability where the auditor agrees to conduct the audit with the express understanding the report will be transmitted only to a specified bank and it is then transmitted to other lenders. Similarly, there is no liability when the client’s transaction (as represented to the auditor) changes so as to increase materially the audit risk, e.g., a third person originally considers selling goods to the client on credit and later buys a controlling interest in the client’s stock, both in reliance on the auditor’s report.
Under the Restatement rule, an auditor retained to conduct an annual audit and to furnish an opinion for no particular purpose generally undertakes no duty to third parties. Such an auditor is not informed of any intended use of the financial statements; but … knows that the financial statements, accompanied by an auditor’s opinion, are customarily used in a wide variety of financial transactions by the [client] corporation, and that they may be relied upon by lenders, investors, shareholders, creditors, purchasers, and the like, in numerous possible kinds of transactions. [The client corporation] uses the financial statements and accompanying auditor’s opinion to obtain a loan from [a particular] bank. Because of [the auditor’s] negligence, he issues an unqualifiedly favorable opinion upon a balance sheet that materially misstates the financial position of [the corporation] and through reliance upon it [the bank] suffers pecuniary loss.
Consistent with the text of section 552, the authors conclude: “[The auditor] is not liable to [the bank].”
Analysis of Auditor’s Liability to Third Persons for Audit Opinions D. Negligence In permitting negligence liability to be imposed in the absence of privity, we outlined the factors to be considered in making such a decision: “The determination whether in a specific case the defendant will be held liable to a third person not in privity is a matter of policy and involves the balancing of various factors, among which are the extent to which the transaction was intended to affect the plaintiff, the foreseeability of harm to him, the degree of certainty that the plaintiff suffered injury, the moral blame attached to the defendant’s conduct, and the policy of preventing future harm.”
Viewing the problem before us in light of the factors set forth above, we decline to permit all merely foreseeable third party users of audit reports to sue the auditor on a theory of professional negligence. Our holding is premised on three central concerns: (1) Given the secondary “watchdog” role of the auditor, the complexity of the professional opinions rendered in audit reports, and the difficult and potentially tenuous causal relationships between audit reports and economic losses from investment and credit decisions, the auditor exposed to negligence claims from all foreseeable third parties faces potential liability far out of proportion to its fault; (2) the generally more sophisticated class of plaintiffs in auditor liability classes (e.g., business lenders and investors) permits the effective use of contract rather than tort liability to control and adjust the relevant risks through “private ordering”; and (3) the asserted advantages of more accurate auditing and more efficient loss spreading relied upon by those who advocate a pure foreseeability approach are unlikely to occur; indeed, dislocations of resources, including increased expense and decreased availability of auditing services in some sectors of the economy, are more probable consequences of expanded liability.
For the reasons stated above, we hold that an auditor’s liability for general negligence in the conduct of an audit of its client’s financial statements is confined to the client, i.e., the person who contracts for or engages the audit services. Other persons may not recover on a pure negligence theory.
There is, however, a further narrow class of persons who, although not clients, may reasonably come to receive and rely on audit reports and whose existence constitutes a risk of audit reporting that may fairly be imposed on the auditor. Such persons are specifically intended beneficiaries of the audit report who are known to the auditor and for whose benefit it renders the audit report. While such persons may not recover on a general negligence theory, we hold they may …
recover on a theory of negligent misrepresentation.
CRITICAL THINKING:
If you were a justice on the supreme court of a state that had yet to decide which of the three rules to follow in determining the extent of auditors’ liability to third parties, which would you adopt? Why?
ETHICAL DECISION MAKING:
Which stakeholders would primarily benefit from each of the three alternatives?