HEADNOTE: The authors review the judicial history of accountants' third- party liability, and categorize its present status by state. They describe the new legislation on this matter in Illinois, discuss its possible legal implications, and report on a survey of firms to determine their response to notification provisions of this law. They also make recommendations regarding action for legislation in other states. For nearly 60 years the courts have determined the extent of the accounting profession's liability to third parties. In 1986 the State of Illinois took a bold step by enacting the first legislated limit on this type of liability. Third parties are seldom owed duties by professionals. Thus, most professionals only need to worry about liability to parties with privity of contract. Accountants, however, are in the unusual position of having potential liability to unspecified or unknown third parties; this is primarily due to the nature of the accountants' work product--the auditor's report. Therefore, accountants are in a unique situation which requires them to work for a particular client and to owe a duty of due care to that client, as well as to unspecified third parties who may use and rely on the report in making business decisions. This situation creates liabilities beyond the scope of other professions. Because of this extended liability, third parties who rely on the auditor's report and subsequently sustain financial loss often sue the accountant as well as the client on theories of negligence and/or fraud. This tendency to name the accountants as defendants is exacerbated because accountants are often the sole remaining solvent party among defendants--the "deep-pocket" concept. As a result state courts have been forced to determine the ultimate extent of an accountant's duty beyond the duty owed to the client.

Since Ultramares Corp. v. Touche (Ultramares), a 1931 New York lawsuit, three different approaches to the extent of accountants' duty to third parties have developed in state courts. Is legislation the unifying solution? Perhaps, but questions of statutory interpretation, as well as the degree of compliance with the notification provisions in the Illinois legislation, leave significant questions regarding the effect of the law.

The Three Judicial Approaches

Ultramares Approach

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.

The Survey

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."

As shown, both the "Big 8 Firms" and "Other Firms" are split on the issue of whether a policy should exist. In addition, and quite surprisingly, two firms will not issue these letters; they take the position that they have responsibility to their clients only. This position appears to be in direct conflict with the good-faith duty discussed earlier. Although it is difficult to predict a judge's action if a case should arise, two viable options surface. First, the judge could revert to the Restatement view set forth by the Appellate Court during the Brumley appeal. This would, by all appearances, extend the firm's liability somewhat beyond the amendment, but not significantly. The second would be to indicate that the absence of a good-faith effort leaves the firm open to suit by all third parties. Although this would be an extreme finding, it is possible; a judge might find that lack of a good-faith effort should cause expansion of liability.

For firms without written policies but which will issue letters, the most common procedure is to use the engagement partner, or this partner in conjunction with legal counsel, to determine when letters should be sent and to whom. This practice is similar to the practices of firms that have policies. Other respondents indicated that letters are sent only when the partner involved believes that the firm will benefit. Although no respondents provided examples of where the firm would benefit, a counter example was cited where the firm clearly would not benefit. That is, if an Illinois-based lender lends to an out-of-state company and requests a letter from the auditor of the out-of-state company, it is highly unlikely that this letter would be issued, as it probably would extend the auditor's liability, particularly if the other state falls under Ultramares.

Regardless of policy, most firms respond primarily to direct requests from the client. Any request from a third party would, of course, be referred to the client if necessary. One respondent indicated that the firm ignores the new privity law except to provide a letter to a third party when that third party requests it; however, the firm will not ask its clients if they require third-party letters. Although all of the "Big 8" firms will send letters, several of them, as well as several of the "Other" firms, indicated that they either discourage sending the letters or that they avoid doing so whenever possible. Although this is clearly contrary to the spirit of the law, it is understandable because of the absence of judicial precedent under this new law. Thus, much of the trepidation regarding these letters stems from the fear of expanding liability beyond the Restatement view (the judicial view accepted in Illinois prior to the new law) by including parties who might not appear under that view.

Little consistency exists regarding the range of indicated types of letter recipients. Table 2 presents the indicated recipients for cases where the respondent indicated this information; current or potential investors are not notified. It is also noteworthy that major brokerage firms are absent from the list. However, this may not be inconsistent with the intent of the law because its indicated purpose is to protect accountants from liability to unknown third parties.

Recommendations on Use of Legislation

Legislation is frequently used to solve social problems. However, the legislative process makes it impossible to predict the form of the solution until it becomes law. The Illinois example clearly resulted in a maverick view somewhere between Ultramares and Restatement. Any organized attempt to legislate in another state should be prefaced by thoughtful consideration of the present law and of whether an attempt to limit liability should be risked.

States currently under the Ultramares approach do not need legislation; it could only expand the potential liability. In the four states where the FTP view has been adopted by judicial decision, legislation should be considered. Although it may appear that there is nothing to lose by attempting a legislative solution, the risk always exists that the result will be unclear and potentially unworkable. However, in states adopting the FTP approach, the extent of potential liability already is very great. Thus, it is possible that a proposal to confirm with Ultramares would result in adopting something less than FTP (possibly Restatement). If any legislative attempt were made, an established view such as Ultramares or the Restatement would have a greater chance of success and would have the advantages of judicial precedent and the experience of time to aid its interpretation.

In the majority of states, any legislative attempt needs most thoughtful consideration. These states are already in the middle ground of accountants' third-party liability, where a limited class of third parties are potential plaintiffs. However, other special interest groups, such as trial lawyers and citizens' interest groups, might lobby against an attempt to limit accountant third-party liability. An attempt might result in a maverick view due to efforts to appease various interest groups. If there is any tendency surfacing in the courts, which would expand the liability in a state, the authors recommend proposing legislation. In a state with a stable judicial opinion supporting Restatement, they recommend caution and a thorough investigation of the judicial climate. In most cases firms should simply monitor the judiciary for signs of change, and react if it appears that liability is being expanded.

EXHIBIT 1

THE RESTATEMENT APPROACH

Restatement (Second) of Torts (1977), Sec. 552. Information Negligently Supplied for the guidance of others: 1. One who, in the course of his business, profession or

employment, or in any other transaction in which he has a

pecuniary interest, supplies false information for the

guidance of others in their business transactions, is subject to

liability; for pecuniary loss caused to them by their

justifiable reliance upon the information, if he fails to exercise

reasonable care or competence in obtaining or

communicating the information. 2. Except as stated in subsection (3), the liability stated in

subsection (1) is limited to loss suffered:

(a) by the person or one of a limited group of persons

forwhosebenefitandguidanceheintendsto

supplytheinformationorknowsthattherecipient

intendstosupplyit;and

(b) through reliance upon it in a transaction that he

intendstheinformationtoinfluenceorknowsthat

therecipientsointendsorinasubstantiallysimilar

transaction.

3. The liability of one who is under a public duty to give the

information extends to loss suffered by any of the class

of persons for whose benefit the duty is created, in any of

the transactions in which it is intended to protect them.

EXHIBIT 2

SIX PUBLIC-POLICY REASONS INDICATED BY THE WISCONSIN COURT

1. The injury is too remote from the negligence; or 2. The injury is too wholly out of proportion to the culpability

of the negligent tort-feasor; or 3. In retrospect it appears too highly extraordinary that the

negligence should have brought about the harm; or 4. Because allowance of recovery would place too

unreasonable a burden on the negligent tort-feasor; or 5. Because allowance of recovery would be too likely to

open the way for fraudulent claims; or 6. Allowance of recovery would enter a field that has no

sensible or just stopping point.

EXHIBIT 3

THE THREE APPROACHES BY STATE

Foreseeable

UltramaresRestatementThird-Party

Arkansas(*)AlaskaCalifornia

Colorado(*)GeorgiaMississippi

DelawareHawaiiNewJersey

FloridaIowaWisconsin

Indiana(*)Kentucky

Kansas(*)Michigan

NewYorkMinnesota

Missouri

Nebraska(*)

NewHampshire

NorthCarolina

Ohio

Pennsylvania(*)

RhodeIsland(*)

Texas

Utah

(*)In these states, a federal court has determined that the state would adopt the view indicated if the case had been heard in state court.

EXHIBIT 4

THE ILLINOIS LAW

Sec. 30.1 No person, partnership or corporation licensed or authorized to practice under this Act or any of its employees, partners, members, officers or shareholders shall be liable to persons not in privity of contract with such person, partnership or corporation, for civil damages resulting from acts, omissions, decisions or other conduct in connection with professional services performed by such person, partnership or corporation, except for: 1. Such acts, omissions, decisions or conduct that constitute

fraud or intentional misrepresentations, or 2. Such other acts, omissions, decisions or conduct, if such

person, partnership or corporation was aware that a

primary intent of the client was for the professional services

to benefit or influence the particular person bringing the

action; provided, however, for the purposes of this

subparagraph (2), if such person, partnership or corporation (i)

identifies in writing to the client those persons who are

intended to rely on the services, and (ii) sends a copy of

such writing or similar statement to those persons identified

in the writing or statement, then such person, partnership

or corporation or any of its employees, partners, members,

officers or shareholders may be held liable only to such

persons intended to so rely, in addition to those persons

in privity of contract with such person partnership or

corporation.

TABLE 1

SUMMARY RESULTS--QUESTIONNAIRE

BIG 8 OTHER TOTAL

Number of firms with written

policy 3 5 8

Policy established by national

office336

Policyestablishedbylocaloffice022

Firmswhichwillissueletters347

Firms which will not issue letters

(no responsibility to third

parties) 0 1 1

Number of firms without a

writtenpolicy5(*)1015

Firmswhichwillissueletters5914

Firms which will not issue letters

(no responsibility to third

parties) 0 1 1

Firms which discourage issuing

letters 2 0 2 (*)2 firms currently considering policies

TABLE 2

LIKELY RECIPIENTS OF LETTERS

Banks8

OtherMajorCreditors4

MajorCustomers2

NoRestrictions5

APPENDIX I Rusch Factors, Inc. v. Levin

A Rhode Island corporation sought financing from Rusch Factors, Inc. Rusch. Rusch requested certified financial statements from the corporation. The defendant accountant, Levin, prepared the statements which represented that the corporation was solvent when it was not. Rusch relied on the statements and loaned the corporation in excess of $337,000. After the corporation went into receivership, Rusch sought to recover the remainder of its loss from the accountant.

The federal court, in its attempt to predict Rhode Island law on this subject, found that Rhode Island would adopt the Restatement view of accountant third party liability.

APPENDIX II Rosenblum, Inc. v. Adler

Plaintiffs were investors in Giant, a corporation operating discount department stores. The investor-plaintiffs acquired the stock in conjunction with the sale of their business to Giant. Since Giant was a publicly traded corporation, it was registered with the SEC and had audited financial statements on file. Touche Ross & Co. had conducted the audits during the period plaintiffs acquired their stock.

Giant had manipulated its books by falsely recording assets that it did not own and omitting substantial accounts payable so that the financial information Touche certified as correct was not. The fraud was uncovered after plaintiffs acquired their stock.

When the financial statements were found to be fraudulent, and the stock was determined worthless, the investors sued Touche. The court found no public policy considerations opposed to holding the auditor liable for the foreseeable consequences of negligent acts.

(*)See also: "The Impact of the Mann Judd Landau Case," by Max Folkenflik and William M. Landau; The CPA Journal, October 1988; and "An Introduction to Concepts of Accountants' Liability," by Stanley H. Weiss; The CPA Journal, July 1987. (1)See Appendix I. (2)See Appendix II.

Sandra Perry Henry, JD, is an Assistant Professor in Business Management and Administration at Bradley University in Peoria, IL. Ms. Henry has published articles in Labor Law Journal and the Illinois Bar Journal. Michael R. Lane, PhD, is Associate Professor and Chairman of the Department of Accounting at Bradley University. He has previously published articles in Management Accounting and the Journal of Accountancy. Dr. Lane recently received a grant from the Illinois CPA Foundation for a study of the "Ethical Decision Bases of Public Accountants."