Ultramares was the first of the landmark cases which limited an accountant’s liability to third parties by eliminating ordinary negligence as a cause of action. The New York State Court of Appeals held that a cause of action based on negligence could not be maintained by a third-party who was not in contractual privity. However, the court ruled that a cause of action based on fraud could be maintained. Despite the growth and maturity of today’s accounting profession, seven states still hold the views expressed in Ultramares.
Restatement of Torts Approach
Other states have subsequently expanded the exposure of accountants. The Restatement approach expands accountants’ liabilities for negligence; any third parties to whom the accountant supplies the work and any third parties or groups (even though specific identifies are unknown) identified by the client as intended recipients of the work will have a cause of action for negligence. Rusch Factors Inc. v. Levin, 1968,(1) (which applied Rhode Island Law) held an accountant liable for negligence to a plaintiff not in privity of contract. See Exhibit 1.
Foreseeable Third Party Approach
The Foreseeable Third-Party Approach (FTP) is the third judicially developed approach; it expands the liability to third parties further than the Restatement. Currently four states have adopted this approach: New Jersey,
Wisconsin, California, and Mississippi. The first of these resulted from Rosenblum, Inc. v. Adler,(2) a New Jersey case in which the court considered the Ultramares rule and the Restatement approach and rejected both while adopting the following view: generally, within the outer limits fixed by the courts as a matter of law, the reasonably foreseeable consequences of the negligent act define the duty and should be actionable.” The apparent intent of the court was to place the responsibility for negligence upon the party most capable of preventing it. Shortly thereafter, Wisconsin adopted a similar position with some important modifications. In Citizens State Bank v. Timm, Schmidt & Co., Wisconsin adopted the FTP approach with a clause allowing for avoidance of the liability in the presence of strong public policy requiring the avoidance. See Exhibit 2.
Under the FTP approach, the accountant does not have to know that the client intends to distribute the audit report to third parties or that the third parties rely upon it. Therefore, a third party, totally unknown to the accountant, can have a cause of action. This view represents a significant broadening of scope from the narrow privity rule established in Ultramares.
Exhibit 3 lists the states which have adopted one of the three approaches. When a federal court decides these cases, the court is bound to apply the law of the state where the federal court is located. If the state has expressly adopted an approach to accountant third-party liability, then the federal court can apply that approach. However, if the state has not expressly adopted an approach, the federal court must predict which approach the state court would adopt if presented with the case.
The problem with such predictions is that federal courts can and do disagree about the approach a state would adopt. For example, two 1985 federal cases disagreed about which approach Pennsylvania would adopt. In Exhibit 3, the state has been categorized by the most recent or highest court prediction. For states which have not adopted an approach, the use of legislation could provide clarity and assist federal courts in a uniform application of the law.
The Legislative Approach
Some states have not addressed the question of third-party liability of accountants. Illinois, for example, has had little need to do so. In fact, only one case has been addressed in Illinois. In Brumley v. Touche, Ross & Co. the trial court ruled that the plaintiff had no cause of action and dismissed the suit. However, on appeal the Illinois Appellate Court reversed and remanded the finding based on adoption of the Restatement approach.
In August 1986, the Illinois General Assembly passed an amendment to the Illinois Public Accounting Act, which has left Illinois somewhere between Ultramares and Restatement. The law allows two exceptions to the rule of
privity. First, as in all the cited judicial findings, third parties who suffer a loss as the result of fraud or intentional misrepresentation by the accountant will have an actionable suit. The second exception places Illinois between the two previously identified judicial positions. The accountant will be liable to third parties who rely on the accountant’s report if the accountant knows of the intended reliance and if the third parties are identified in writing and receive a copy of the writing. Exhibit 4 shows the text of the amendment.
The unprecedented portion of this law is the required written notification by the accountant–an unusual and confusing provision. In the majority of instances, the accountant received notice of the identity of any third parties from the client. Thus, it seems redundant that the accountant must notify the client of the third parties who receive written notice. As a result, only specifically identified third parties who have not been notified of their identified third-party status will have an action against the accountant for ordinary negligence.
Issues the Law Raised
Several issues exist that will be resolved only when legal action occurs under this law; however, a brief discussion of a few issues is in order. First, what are the implications of a client wanting to add one or more third parties to list subsequent to the engagement? Because the law is written in the past tense, it appears that such additional third parties are not covered. However, if the accountant consents to their addition, will this allow action by a third party? It appears that the action would be allowed because the purpose of the law is to protect the accountant from liabilities to unknown third parties.
Does the law create a conflict of interest on the part of the accountant? If the accountant is working for the best interest of the client, the list of identified third parties should be as long and as broad as possible. This would allow the client latitude in the use of the report. This same logic would apply if the accountant is assumed to be working for the interest of the public. However, in this litigious society accountants have an interest in protecting themselves and their firms. Because a long list, or any list for that matter, may extend the accountant’s liability, the accountant would prefer as short a list as possible, or no list. At some point a compromise will be reached, but does this allow for the protection of appropriate third parties? In legal parlance, the accountant should have a good-faith duty to be informed of third parties who are intended to receive the report. However, the client also must have a good-faith duty to name only those third parties reasonably expected to receive the report.
In the absence of judicial precedent interpreting the Illinois law, the authors surveyed the 25 largest accounting firms in Chicago, of whom 23
responded, including the 15 largest. Three pieces of information were requested:
1. Does your firm have a written policy regarding who can be identified as “identified third parties” under Illinois Law? If so, what is the policy?
2. Will your firm send letters to identified third parties?
3. To whom will you send letters, or, why will your firm not send these letters? The results were segregated into two groups in Table 1: “Big 8 Firms” and “Other Firms.”