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Bily v. Arthur Young & Co.
Citations: 834 P.2d 745; 3 Cal. 4th 370; 11 Cal. Rptr. 2d 51Docket: S017199
Court: California Supreme Court; August 27, 1992; California; State Supreme Court
The Supreme Court of California reviewed the case of Bily v. Arthur Young Company to determine the extent of an accountant's duty of care during independent audits concerning third parties. Citing Chief Judge Cardozo's influential opinion in Ultramares Corp. v. Touche, the court noted the ongoing debate regarding an accountant's liability to nonclients who rely on audit reports. The court acknowledged the complexities surrounding the accounting profession's role and the potential for limitless liability. After examining the facts, the court established that an auditor does not owe a general duty of care to nonclients. However, an auditor may be liable for negligent misrepresentations in audit reports if those misrepresentations influence persons relying on them in transactions the auditor intended to affect, following the guidelines of section 552 of the Restatement Second of Torts. Additionally, auditors may face liability for intentional fraud against reasonably foreseeable third parties in the preparation and dissemination of audit reports. The case arose from the rapid growth and subsequent decline of Osborne Computer Corporation, which achieved significant sales shortly after its founding in 1980 but faced challenges by fall 1982. In late 1982, the company initiated plans for an initial public offering (IPO) in early 1983, engaging three investment banks as underwriters. The IPO was delayed due to uncertainties surrounding the hiring of a new CEO and the introduction of a new computer model. To secure 'bridge' financing, the company issued warrants to investors in exchange for loans and letters of credit, allowing holders to purchase stock at favorable prices expected to yield significant profits upon the IPO. Investors, including individuals and pension funds, participated in the warrant transaction, with some, like Robert Bily, purchasing substantial amounts of stock. The company retained Arthur Young & Company, a prominent accounting firm, to audit its 1981 and 1982 financial statements. Arthur Young provided unqualified audit opinions for both years, affirming that the statements complied with Generally Accepted Auditing Standards (GAAS) and Generally Accepted Accounting Principles (GAAP), and fairly presented the company's financial position. The 1981 financial statement showed a net operating loss of approximately $1 million, while the 1982 statement indicated a modest profit of $69,000 on over $68 million in sales. However, following the warrant transaction in April 1983, the company experienced a decline in sales due to manufacturing issues with its new computer model and competition from IBM. The anticipated public offering did not occur, leading to the company’s bankruptcy filing on September 13, 1983, resulting in investment losses for the plaintiffs. The plaintiffs, including J.F. Shea & Co. and Robert Bily, filed separate lawsuits against Arthur Young, which were later consolidated for trial, focusing on the validity of Arthur Young's audit and opinion on the 1982 financial statements. Plaintiffs' expert, William J. Baedecker, critiqued the 1982 audit conducted by Arthur Young, identifying over 40 deficiencies indicative of gross professional negligence. Baedecker asserted that Arthur Young did not adhere to Generally Accepted Auditing Standards (GAAS) and understated the company's liabilities by approximately $3 million, which transformed a reported operating profit of $69,000 into a loss exceeding $3 million. He noted that Arthur Young found material weaknesses in the company's accounting controls but failed to report them. Baedecker highlighted specific failures, including the identification of $1.3 million in unrecorded liabilities, which were not disclosed to the board as recommended. Despite these issues, Arthur Young issued an unqualified opinion on the 1982 financial statements shortly thereafter. The case was presented to a jury over 13 weeks, which received instructions covering three theories of recovery: fraud, negligent misrepresentation, and professional negligence. The jury was tasked with determining whether Arthur Young intentionally misrepresented facts or negligently misled the plaintiffs. The negligence instructions specified the standard of care expected from independent auditors and their duty to third parties relying on their audited financial statements. Ultimately, the jury cleared Arthur Young of intentional fraud and negligent misrepresentation but found them liable for professional negligence, awarding plaintiffs approximately $4.3 million in compensatory damages—75% of their investments. The Court of Appeal upheld this judgment. The document also discusses the primary role of certified public accountants in financial auditing, which is the main source of lawsuits against them. An audit involves verifying an entity's financial statements by examining underlying accounting records and supporting evidence. An accountant reviews the client's financial statements and issues an opinion on their fairness in representing the entity's financial status. Typical audit procedures include verifying tangible assets, observing business activities, and confirming account balances. Auditors may use methods such as vouching, where they ensure recorded transactions are supported by data, and tracing, where they follow specific data through the accounting process to confirm proper recording. Due to time and cost constraints, audits do not examine every transaction; hence, planning requires significant professional skill and judgment. The CPA firm begins by assessing the client's operations and internal controls, determining the audit's scope and methodologies. Throughout the audit, findings lead to adjustments in procedures. If weaknesses in the internal control system are identified, additional procedures are implemented to ensure no material misrepresentations in the financial statements occur. The outcome of an audit is the audit report or opinion, typically addressed to the client and referencing the attached financial statements. An unqualified report includes a scope paragraph affirming compliance with Generally Accepted Auditing Standards (GAAS), established by the American Institute of Certified Public Accountants (AICPA). GAAS encompasses ten sets of standards classified into general standards, fieldwork standards, and reporting standards. Key standards include the requirement for auditors to possess adequate training (General Standard No. 1), exercise due professional care (General Standard No. 3), and gain a sufficient understanding of the internal control structure to effectively plan the audit (Fieldwork Standard No. 2). Statements on Auditing Standards (SAS), issued by the Auditing Standards Board of the AICPA, provide periodic interpretations of auditing standards, such as SAS-55, which outlines procedures for understanding and testing internal financial control systems. The GAAS Guide summarizes these standards across 140 sections and over 1,000 pages. An audit report typically includes the CPA firm's opinion that the financial statements conform to GAAP and fairly represent the client's financial position. GAAP, comprised of various statements from the AICPA, includes broad principles and specific guidelines, with some debate about the official compilation of these standards. The GAAP Guide outlines 90 sections and over 500 pages. Auditors may qualify their opinions, mention exceptions, or express disclaimers about financial statements. Audits serve multiple purposes, primarily to enhance the financial credibility of businesses in the eyes of investors and creditors. An unqualified audit report, especially from a major firm, is crucial for accessing venture capital and validating the client’s financial health, while also helping attract investment and credit. Financial audit reporting is recognized by the GAAP as a key means of conveying accounting information to external parties. The independent audit enhances the credibility of financial statements, providing reasonable assurance to stakeholders such as investors and creditors that the statements are free from material misstatements. The AICPA emphasizes the public responsibility of auditors, highlighting that their role transcends the client relationship, as they serve the interests of clients, creditors, governments, and the public. This public watchdog function necessitates complete independence and fidelity to the public trust. The Supreme Court has supported the notion that auditors owe a duty to the public by asserting that their certification of financial reports imposes obligations beyond the client relationship. Regarding auditor liability to third parties, there are three recognized approaches. A prevalent view, stemming from Chief Judge Cardozo's 1931 ruling in Ultramares, holds that auditors are not liable for negligence to third parties unless a relationship akin to privity exists. Conversely, a minority of jurisdictions have recently allowed recovery for negligence to third parties if their reliance on the audit report was foreseeable, indicating a potential trend toward merging these differing perspectives. Most jurisdictions have adopted a balanced approach based on Restatement Second of Torts section 552, which establishes liability for suppliers of commercial information to intended third-party beneficiaries. Federal securities laws also impose auditor liability for negligent conduct related to misstatements in publicly filed documents. The case of Ultramares is highlighted, where a plaintiff loaned $165,000 to a bankrupt company, relying on the auditors' opinion that the financial statements accurately reflected the company's condition. Despite the balance sheet indicating a $1 million net worth, the company was actually insolvent, and the auditors failed to uncover misleading financial practices. The New York Court of Appeals reinstated the fraud claim but overturned the negligence verdict, finding no duty owed by the auditors to the third-party creditor. The court emphasized the dangers of imposing negligence liability on auditors due to the potential for limitless exposure to claims. It recognized a distinction between tort liability in personal injury cases and liability arising from non-physical harm, noting that the transmission of information differs from direct contractual obligations. The court compared Ultramares to Glanzer v. Shepherd, highlighting that in Glanzer, the certificate of weight was central to the transaction, while in Ultramares, the auditors’ opinion was not explicitly linked to any specific third-party transactions. The court clarified that while auditors are not exempt from liability to third parties for fraud, they are shielded from claims arising from honest mistakes. It questioned whether a typical businessman would seek additional assurance when receiving a certificate as part of a group of investors. In the New York Court of Appeals, privity of contract is not an absolute requirement for third-party suits against auditors; instead, an equivalent privity of relationship can suffice. In **White v. Guarente**, a limited partner successfully sued the auditor for negligence after the auditor failed to disclose improper fund withdrawals by general partners, emphasizing that the audit and tax return preparation were for a defined group with vested rights, not an undefined class. In **Credit Alliance v. Arthur Andersen & Co.**, the court established a framework for auditor liability to third parties, detailing three prerequisites: 1) the accountant must know that the financial reports would be used for specific purposes; 2) a known party must be intended to rely on those reports; and 3) there must be conduct linking the accountants to that party, indicating their understanding of the reliance. The court applied this rule by noting that in a case where the lender had direct communications with the auditor, a nexus akin to privity was established, justifying the claim. Conversely, in another case where the lender's reliance was acknowledged without specific purpose or direct engagement with the auditor, the claim was dismissed due to insufficient linkage. The New York rule on auditor liability to third parties highlights the challenges in defining standards as the relationship between parties evolves from privity of contract to privity of relationship. Auditors may gain full knowledge of third-party recipients of an audit report, which implies a specific risk of liability during the engagement. However, under the Credit Alliance test, auditors lack liability unless there is distinct conduct establishing a connection to the third party that demonstrates the auditor's understanding of third-party reliance. The New York court does not clarify what qualifies as this 'linking' conduct, though direct communication with the third party is considered sufficient. The case of White v. Guarente illustrates a scenario where the auditor knew the audit aimed to benefit limited partners but lacked other significant links to them. This raises questions about whether mere knowledge of the audit's purpose should suffice for establishing linkage. The New York rule's 'linking conduct' requirement necessitates that auditors be aware of a specific purpose for the audit and act to support that purpose, distinguishing it from the Restatement Second of Torts section 552, which does not impose such a requirement. Various states follow similar privity rules limiting auditor liability, with five states having such rules established by their highest courts and four via statute, while federal courts recognize this rule in three additional states without explicit high court consideration. Recent cases tend to align with the New York rule as reformulated in Credit Alliance. Justice Howard Wiener argued for a shift from the traditional Ultramares rule regarding accountant liability to a foreseeability-based standard, asserting that accountants should be liable to third parties for foreseeable injuries. He criticized the existing protections as outdated and posited that liability based on foreseeability would promote compensation for injuries and deter negligence. Wiener emphasized that the same negligence standards should apply across different contexts, benefiting accountants, investors, and the public. The New Jersey Supreme Court partially adopted this approach in Rosenblum v. Adler, allowing stock purchasers to claim negligent misrepresentation against an auditor who approved fraudulent financial statements. The court rejected the notion of treating accountants differently from other service providers and affirmed that third parties could recover for economic losses due to negligent misrepresentation. The court recognized the evolving role of auditors from mere watchdogs to independent evaluators of financial statements, suggesting that imposing liability could enhance audit quality through stricter standards and increased oversight. However, the court limited auditor liability to those whom they could reasonably foresee as recipients of financial statements for legitimate business purposes. This limitation excluded institutional investors or stockholders purchasing stock post-audit without evidence of necessary conditions. The court did not adequately justify this restriction, overlooking that many individuals could still foreseeably access audit reports. The passage highlights a tension between promoting broader accountability for auditors and setting constrained boundaries on their liability. The court reflects an Ultramares-like apprehension regarding the potential for unlimited auditor liability but fails to provide a justification for limiting liability based on a company's distribution, a factor beyond the auditor's control. Wisconsin and Mississippi's high courts have adopted foreseeability rules. The Wisconsin Supreme Court, in *Citizens State Bank v. Timm, Schmidt & Co.*, emphasized the need for imposing liability to protect third parties relying on financial statements, highlighting the risks to creditors and the potential for increased credit costs if accountants are not held accountable. However, it left open the possibility that public policy considerations could warrant liability limitations. In *Touche Ross v. Commercial Union Ins.*, the Mississippi Supreme Court also adopted a foreseeability rule but noted its limited precedential value due to the case specifics, including the absence of auditor liability stemming from post-audit criminal conduct and a unique state statute affecting tort actions. The California Court of Appeal in *International Mortgage Co. v. John Butler Accountancy Corp.* similarly adopted a foreseeability approach, which will be further discussed later. Despite its introduction nearly a decade ago, the foreseeability approach has not gained significant traction, with at least four state supreme courts rejecting it in favor of the Restatement's 'intended beneficiary' approach since the *Rosenblum* decision. Critics have raised concerns about the foreseeability approach's potential for indeterminate liability and its effectiveness in deterring poor audit practices, though some commentators argue otherwise. Section 552 of the Restatement Second of Torts articulates that a party who negligently provides false information for the guidance of others is liable for economic losses incurred through justified reliance on that information. However, this liability is confined to losses suffered by the intended beneficiary or a limited group of beneficiaries, contingent upon reliance in transactions that the provider intends to influence. A supplier of information, such as an auditor, is liable for negligence to a third party only if they intend to provide information for the benefit of that specific third party in a particular transaction. The Restatement Second of Torts, section 552, emphasizes that the liability of a negligent supplier is more limited than that of a fraudulent one, highlighting the importance of the nature and scope of transactions in determining liability. For instance, an auditor is on notice of potential liability if they know their report will be used for a significant investment decision, enabling them to mitigate risks. Conversely, an auditor conducting a generic audit without knowledge of specific uses does not owe a duty to third parties. Illustrations in the Restatement clarify this point: an auditor may be liable if informed that their report will assist in securing a loan, even if the lender is unnamed. However, if the auditor conducts an audit intended for a particular bank and the report is shared with others, liability does not attach. Additionally, if the nature of the client’s transaction changes significantly, increasing the risk based on reliance on the audit, the auditor may not be held accountable. Generally, auditors performing annual audits without a specific purpose do not have a duty to third parties, even if the financial statements are widely used in various transactions. A review of case law indicates that the Restatement rule has gained more acceptance than both the privity of relationship rule and the foreseeability rule, with at least 17 decisions supporting it in relevant contexts. The Restatement rule, endorsed by many courts, serves as a compromise addressing the discomfort with traditional privity and concerns over unlimited liability. Courts face uncertainty when determining intent to benefit third parties through audit engagements and auditor communications. Dean William L. Prosser noted the challenge in drafting a rule that effectively limits liability to a specific group of intended beneficiaries, rather than a broad class of foreseeable individuals. Under federal securities laws, auditors can be liable to third parties for fraud or gross negligence under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. Notably, they may also incur liability without the need to demonstrate fraud or gross negligence under Section 18 of the 1934 Act and Section 11 of the Securities Act of 1933. Section 11 allows individuals who acquire securities with untrue statements or omissions in the registration statement to sue, unless they were aware of the inaccuracies at the time of acquisition. Professionals, including accountants, named in registration statements can defend against liability for misleading statements by proving due diligence, which requires demonstrating that they had reasonable grounds to believe the statements were accurate after conducting a reasonable investigation. Liability under Section 11 is subject to various limitations. Accountants' liability under federal securities law is confined to circumstances where they prepare or certify part of a registration statement, indicating awareness of their role in public communications. Liability extends only to third parties who purchase securities and is limited to actual out-of-pocket losses, not exceeding the offering amount. Section 11 of the Securities Act provides a clear framework for the plaintiff class, proof of violation, and damage measures, allowing accountants to assess their liability exposure in advance. Under Section 18 of the Securities Exchange Act, accountants are liable for misstatements in SEC filings, limited to third parties who rely on such statements when buying or selling securities. Defenses include demonstrating good faith and lack of knowledge regarding the falsehood of the statement. Auditors face civil liability based on tort claims, including negligence, negligent misrepresentation, and fraud. Negligence requires a duty of care towards others, which is determined legally. The existence of this duty is crucial to establishing a negligence claim, with courts evaluating whether the necessary protections against unintentional harm are in place. The concept of duty reflects policy considerations on whether a specific plaintiff deserves legal protection. The concept of duty is essential in limiting potentially infinite liability for negligent acts. Courts use a checklist of factors to assess legal duty when there is no privity of contract between the plaintiff and defendant. In the case of Biakanja v. Irving, liability for negligence was allowed when a notary public's failure to properly attest a will caused harm to the decedent's beneficiary. The decision involved balancing factors such as the intent of the transaction, foreseeability of harm, certainty of injury, connection between conduct and injury, moral blame, and the policy of preventing future harm. In this instance, the defendant was aware that improper solemnization could lead to loss for the plaintiff, who would have inherited the entire estate but received only a fraction due to the defendant’s negligence. However, the court declined to allow all foreseeable third-party users of audit reports to sue auditors for professional negligence, citing three main concerns: 1) Auditors have a secondary role, and the complexity of audit opinions creates tenuous causal links to economic losses, leading to disproportionate liability; 2) The sophistication of plaintiffs allows for risk management through contractual agreements rather than tort claims; 3) Expanding liability could result in resource dislocations, increased costs, and decreased availability of auditing services, despite the foreseeability of economic injury to those relying on audit reports. Foreseeability is considered, but it is only one factor in determining negligence liability. Recovery for negligence claims, particularly regarding the negligent infliction of emotional distress by bystanders, is limited to prevent liability from exceeding fault and to avoid boundless responsibility for intangible injuries. Foreseeability alone, while useful for physical harm, fails to establish a reasonable limit for nonphysical harm. Courts emphasize that mere anticipation of injury does not create a legal duty to prevent harm or justify a cause of action, as policy considerations necessitate limits on liability to avoid excessive societal burdens. Specifically, in the context of audits, auditors operate within a client-controlled environment where the client is responsible for the accuracy of financial statements. The auditor's role is not to challenge the client’s data but to provide an impartial evaluation, while the client's interests may differ from those of the public. The primary responsibility for financial accuracy lies with management, and the auditor relies on information provided by the client, making the relationship inherently unequal in terms of control and responsibility. The distribution and accompanying communications of an audit report are solely managed by the client, who retains primary control over the financial reporting process, irrespective of the auditor's efforts. An audit report is not merely a factual statement but a professional opinion shaped by the auditor's interpretation of complex standards and subjective judgment. Different assumptions, sampling techniques, and hindsight can lead to varying audit outcomes, making audits susceptible to criticism. Despite the auditor's secondary role in financial reporting, they face significant liability in negligence claims from third parties, especially when clients have become insolvent. In such cases, the auditor often becomes the only solvent defendant, facing claims for the total investments made by third parties who relied on the audit report. The nature of damages in these suits—economic loss from investment and credit decisions—adds complexity and potential for extensive liability. While an audit report may influence investment decisions, prudent investors typically conduct thorough due diligence beyond the auditor's opinion. Auditors lack control over a client's operations and decision-making but are targeted in litigation due to their direct involvement with the client's financial matters. The case at hand illustrates this, with plaintiffs claiming reliance on the audit despite a more intricate decision-making process influenced by various factors beyond the auditor's report. The plaintiffs now focus their legal claims on deficiencies in the audit report while overlooking their own misjudgments in evaluating the investment opportunity. Ignoring numerous positive indicators of a company's performance, such as rapid sales growth and strong management, plaintiffs suggest a weak link between Arthur Young's audit report and their investment losses. The argument posits that endorsing third-party negligence claims against auditors, based solely on foreseeability, risks imposing disproportionate multibillion-dollar liabilities on auditors. This concern arises from the auditors' secondary fault, often rooted in complex professional disagreements, and the tenuous connection between their actions and third-party injuries, which are frequently influenced by unrelated business factors. Legal commentary highlights that the limited duty of auditors is justified on proportionality grounds, emphasizing that the wrongdoing of auditors is minor compared to that of clients or plaintiffs. Courts have noted that equating auditor opinions with consumer products is flawed; auditors assess financial statements prepared by their clients, who hold primary responsibility for the information presented. Furthermore, third parties relying on audit reports—such as investors and creditors—tend to be more sophisticated than ordinary consumers and can mitigate risks through contracts or by independently verifying financial data. Thus, the distinction in responsibilities and capabilities between auditors and clients suggests that imposing broad liability on auditors lacks a sound moral, ethical, or economic basis. A third party may establish a privity relationship with an auditor by commissioning its own audit or investigation, allowing it to seek protection from the auditor. Additionally, the third party can negotiate for better security or terms in financial transactions. To fall under the Glanzer exception to Ultramares, the third party could request an audit on its behalf or communicate directly with the auditor regarding its dealings with the client. Encouraging third parties to rely on their own diligence and bargaining power is viewed as beneficial for promoting prudent investment practices and preventing careless financial decisions. The document also discusses the implications of auditor negligence liability towards third parties, suggesting that such liability could lead to more careful audits and better risk management. For instance, the New Jersey Supreme Court noted that establishing a duty to foreseeable users might prompt accounting firms to enhance their audit standards and supervision, potentially reducing errors. However, the text expresses skepticism about the effectiveness of expanding liability rules, citing a lack of empirical evidence for improved audit quality and predicting negative economic impacts instead. Auditors might react to increased liability by limiting their services, especially in high-risk industries, as they may fear lawsuits regardless of the quality of their work. The legal economist mentioned highlights that if the likelihood of incurring liability is high even with adequate performance, it diminishes the incentive to maintain high-quality audits. Unlimited negligence liability for auditors could lead to higher audit costs and reduced availability of audit reports without improving overall quality. The relationship dynamics among auditors, clients, and third parties suggest that auditors may not be the best bearers of losses from financial inaccuracies, as investors and creditors can mitigate risks through diversification. Thus, the costs of accounting errors should not unfairly burden auditors over affected parties. The plaintiffs contend that such factors can be evaluated on a case-by-case basis by triers of fact. However, there is skepticism about this approach, as it might result in numerous complex lawsuits with questionable merit. A foreseeability rule could lead to extensive liability for minor audit errors, thus necessitating a more limited liability framework to deter negligent reporting while avoiding excessive moral and economic burdens on auditors. The court refrains from endorsing broad liability due to the complexity of the issue and the need for legislative input. Ultimately, auditor liability for general negligence is confined to the client who engages the audit services, while a narrow class of intended beneficiaries may recover under negligent misrepresentation. In this case, since the plaintiffs are not clients, they cannot recover for pure negligence, leading to the reversal of the verdict and judgment in their favor. Negligent misrepresentation is identified as a distinct tort, separate from general negligence, with significant implications for legal proceedings, particularly in complex cases. A defendant may be liable if they make false statements, believing them to be true without reasonable grounds for that belief. This form of deceit is characterized by a positive assertion of falsehoods, even when the defendant holds a sincere belief in their truthfulness. Expressions of professional opinion can also be deemed representations of fact if they constitute deliberate affirmations rather than casual beliefs. When a party claims superior knowledge or expertise, their statements may be treated as material facts, provided the plaintiff reasonably relies on that expertise. The class of individuals entitled to rely on these representations is limited to those for whom the misrepresentations were specifically made, thereby preventing liability to unintended parties, even if the defendant could foresee that misinformation could reach others. The Restatement Second of Torts section 552 is noted as aligning with the foundational elements of negligent misrepresentation, offering a balanced approach to liability that recognizes commercial realities while avoiding overly broad liability for professional mistakes. Despite criticisms of vagueness, this rule aims to delineate a specific class of claimants to whom representations are made, ensuring that auditors and professionals are not exposed to unlimited liability. Justice Wiener criticizes the Restatement rule for relying on chance and the accountant's mindset, arguing it does not enhance the flow of accurate information. The authors of the Restatement Second of Torts counter that the rule effectively identifies a specific class of individuals intended to benefit from the supplied information, thus aligning with established tort liability principles. This limited liability framework enables suppliers to anticipate potential third-party claims, allowing for informed decision-making regarding their responsibilities. By focusing on a defined group of plaintiffs linked to the supplier's actions, the Restatement rule clarifies causation and reliance issues, ensuring fairness and enabling excluded recipients to engage auditors directly for information. Furthermore, the Restatement's "intent to benefit" criterion does not examine the supplier's mindset but rather assesses whether the supplier knowingly provides information for a specific transaction, establishing an objective standard for liability based on the supplier's engagement and communications. If a clear undertaking is identified, liability is assigned to the supplier. The supplier is not legally responsible if they simply know of the potential for their information to be repeated without any action taken in reliance upon it. This principle, as outlined in the Restatement Second of Torts § 552, supports consistent legal standards in cases of negligent misrepresentation. Various professionals, including accountants, attorneys, architects, and engineers, are recognized as suppliers of information that may lead to liability claims from third parties who rely on their professional opinions. Courts have upheld liability for negligent misrepresentation when the information is intended for specific beneficiaries. In a notable case, a lender sued attorneys for negligence after they provided an erroneous opinion letter about a partnership structure, which the lender relied upon to extend a loan. The court ruled that attorneys must exercise due care in issuing legal opinions intended to influence third parties. Conversely, in Goodman v. Kennedy, a case involving stock purchasers who alleged negligent advice from a lawyer, the court dismissed the complaint due to a lack of communication of the legal advice to the plaintiffs, distinguishing it from the earlier case. The court emphasized that an attorney owes a duty of care only when their advice is intended for reliance by a third party in a transaction. The plaintiffs in Goodman sought to align their case with the foreseeability theory of liability, but the court found the circumstances did not support their claim. An attorney does not owe a duty of care to purchasers unless it can be shown that the legal advice was foreseeably transmitted to or relied upon by them, or that they were intended beneficiaries of the transaction related to the advice. The plaintiffs argue for two theories of liability: an "opinion letter model" and a "third-party beneficiary model," claiming their case aligns with the first, likening an audit report to an opinion letter. However, the court finds this analogy inapplicable, emphasizing that in Goodman v. Kennedy, there was no transmission of the attorney's advice to the plaintiffs, rendering the "foreseeably transmitted" language mere dictum that underscored the plaintiffs' weak position. California courts generally require a professional to demonstrate intent to benefit a third party in specific transactions to establish liability for professional negligence. The case of Burger v. Pond illustrates that an attorney's duty is to their client alone; mere presence of a third party during consultations does not create a triable issue regarding the attorney's intent to benefit that party. Furthermore, liability for negligent misrepresentation is contingent upon the intended beneficiary standard, where intent to influence is critical; without it, there is no liability, regardless of any reliance or foreseeability. The court concludes that while intended beneficiaries of an audit report may recover for negligent misrepresentation, they cannot do so under a general negligence theory, as nonclients are connected to the audit solely through their reliance on the audit report. The core issue in a negligent misrepresentation claim is the requirement of actual, justifiable reliance on the representations made in the audit report. Without such reliance, recovery is not possible, regardless of how the audit was conducted. The California Supreme Court case Garcia v. Superior Court emphasizes the essential nature of this reliance element. Unlike general negligence claims, which focus on the defendant's care and adherence to professional standards, negligent misrepresentation centers on the truthfulness of the audit report and the plaintiff's reliance on it. Jury instructions for these cases should clearly outline the elements of negligent misrepresentation, ensuring the jury assesses whether the representations were intended to influence the plaintiff or a specific class of individuals. The proposed jury instruction should clarify that the defendant is deemed to have intended to influence the transaction if they knew it was likely the plaintiff or their class would rely on the representation. The court suggests that while other instructions may be provided, they should align with this decision and the established law concerning negligent misrepresentation. The ruling does not alter the traditional elements of misrepresentation; it merely clarifies who may bring a claim, provided all other elements are met. Additionally, it does not imply that intent to benefit a third party will always be a factual question. Competent evidence must indicate that an auditor knew of a specific transaction or type of transaction to place them on notice of audit risks. If such evidence is lacking, summary adjudication under Section 415 is warranted, as the plaintiff does not qualify as an intended beneficiary. In cases of intentional misrepresentation, auditors face different policy considerations, particularly when fraudulent intent is involved. The auditor's secondary role in financial statement presentation does not mitigate potential liability when intentional misconduct is proven. Even without actual knowledge of falsehood, recklessness in making a statement satisfies the element of scienter. Auditors are generally not immune from liability for intentional misrepresentation, which applies to those whom the auditor knows or should expect will act based on the misrepresentation. The tort of intentional misrepresentation requires the representation to be made with intent to defraud the plaintiff or a foreseeable class of persons. Furthermore, the jury instructions in this case followed the general negligence rule and foreseeability approach from a prior case, which was assumed to represent California law. The court has rejected the precedent set by International Mortgage Co. and adopted a negligent misrepresentation standard in line with section 552 of the Restatement Second of Torts. Consequently, the plaintiffs' judgment based on general negligence is overturned, as the plaintiffs were not clients of Arthur Young and thus cannot recover under that theory. Arthur Young's request for remand to the Court of Appeal, to direct judgment in its favor, is mostly granted, with the exception that the plaintiffs' general negligence verdict is reversed. The jury also dismissed claims of negligent misrepresentation and intentional fraud, and the plaintiffs did not cross-appeal regarding these claims, failing to prove any prejudicial error in their trial. Only the Shea plaintiffs, excluding plaintiff Bily, cross-appealed on the misrepresentation claims, alleging the trial court erred by not instructing the jury on Arthur Young's potential liability for aiding and abetting fraud. The Court of Appeal did not address the merits of this cross-appeal. The case is remanded for the Court of Appeal to resolve the cross-appeal and to proceed with appropriate judgments. The judgment of the Court of Appeal is reversed, directing judgment in favor of Arthur Young against plaintiff Bily, and requiring the Court of Appeal to address the Shea plaintiffs' cross-appeal. The dissent from Justice Kennard emphasizes that Arthur Young, as a major accounting firm, issued an unqualified audit report that led many investors, including the plaintiffs, to incur significant losses due to material errors in the financial statements, raising the question of whether Arthur Young had a duty to exercise due care towards foreseeable users of the report. The majority opinion concluded that no such duty existed. The majority opinion revives the privity requirement for negligence claims against accountants, limiting their liability solely to the clients who engage their services for audits. This approach significantly restricts accountability for professional negligence. For negligent misrepresentation, the majority further narrows liability, allowing claims only if a third party relied on misrepresentations that the accountant intended to influence in a transaction. These rulings grant accountants considerable immunity from malpractice claims, undermining the social benefits of tort liability, which incentivizes due care and provides compensation for injuries caused by negligence. The excerpt argues that the scope of duty in negligence cases should strike a balance that does not overly burden professionals while ensuring accountability for their actions. It emphasizes the importance of maintaining high-quality auditing services to inspire confidence in financial reports, crucial for the functioning of capital markets. Historically, California law recognized a broader duty of care, allowing accountability to all foreseeable users of audit reports, which encouraged due diligence and fair compensation for victims of negligence. The author contends that reverting to a more restrictive standard is detrimental to public trust and the effective operation of financial systems. The author argues against the majority opinion that maintaining a defined duty for accountants excessively burdens the profession or reduces auditing services. Instead, they advocate for legislative remedies rather than limiting legal duties. They oppose the idea of differing negligence liability rules for negligence and negligent misrepresentation, asserting that the same standard of care applies to accountants under both theories. The author emphasizes that under California Civil Code § 1714, individuals are liable for injuries caused by their negligence, which includes injuries to foreseeable users, like the plaintiffs in this case. Any special liability limitations for accountants must be justified by public policy considerations, which include factors such as foreseeability of harm, certainty of injury, connection between conduct and injury, moral blame, prevention of future harm, burden on the defendant, and insurance availability. The majority's ruling that exempts negligent accountants from liability requires a thorough examination based on policy considerations. Key points include: 1. **Foreseeability of Harm**: The primary purpose of corporate audits is to enhance the financial credibility of companies for external stakeholders—investors, lenders, and others making economic decisions based on financial statements. The defendant, as a major accounting firm, is aware that its audit reports are relied upon, and negligence in audit practices can foreseeably harm these third parties. The court emphasizes that foreseeability is a critical element in establishing negligence liability. 2. **Economic Injury Certainty**: Unlike intangible harms, economic losses stemming from accountant negligence are concrete and easily provable. The document highlights that when a corporation goes bankrupt, the financial damage to shareholders, suppliers, and lenders is indisputable. The concern about false claims typically associated with emotional distress claims does not apply to economic losses, further supporting the need for accountability in cases of negligent auditing. Overall, the excerpt argues against providing accountants immunity from liability due to the clear foreseeability of harm and the certainty of economic injury resulting from negligent practices. The recognition of accountants' liability to third parties for negligent auditing is supported by the certainty of injury. To recover damages for an accountant's negligence in an unqualified audit opinion, a plaintiff must demonstrate reliance on the audit and establish a factual connection between their loss and defects in the financial statements. Reliance is established by proving the plaintiff reviewed the financial statements, identified material errors or omissions, and would not have engaged in a transaction with the client had the true facts been disclosed. Additionally, the plaintiff must show that the loss was a foreseeable outcome of the misrepresentation or concealment in the statements. When causation is shown, the relationship between the accountant's negligence and the plaintiff's injury is considered close. The majority opinion raises concerns about the potential for false claims of reliance, suggesting that juries may be misled into awarding damages to plaintiffs who did not genuinely rely on the audit report. However, this concern is deemed unwarranted, as independent audit reports typically induce reliance from investors and lenders, making such reliance a predictable outcome. Furthermore, the plaintiff's burden to demonstrate reasonable reliance provides accountants with a defense against dubious claims, which can be rebutted through expert testimony. Issues of feigned reliance are likened to other credibility challenges in civil litigation and do not justify a blanket nonliability rule that would prevent compensation for legitimate injuries caused by negligent auditing. The excerpt references the United States Supreme Court, which dismissed similar concerns about jury capability to discern genuine claims. The excerpt emphasizes the significant moral and legal responsibilities that independent auditors, specifically certified public accountants (CPAs), owe to third parties who rely on their audit reports. It cites several legal precedents, including Barefoot v. Estelle and Rosenblum v. Adler, to underline that CPAs must prioritize the interests of not only their clients but also creditors, investors, and the public at large. This duty is characterized as a "public watchdog" function, necessitating complete independence and fidelity to the public trust, as highlighted by the U.S. Supreme Court in United States v. Arthur Young & Co. The passage also notes that the ethical obligation of accountants to third-party users of their opinions is widely accepted within the profession, reinforcing that a distinguishing feature of professions is the recognition of their responsibility to the public. The reliance on the integrity and objectivity of CPAs is crucial for the smooth operation of commerce, establishing a public interest responsibility that extends beyond the immediate client relationship. The American Institute of Certified Public Accountants recognizes this duty in its professional standards, affirming the accountant's role in maintaining trust within the financial community. An accountant's moral, ethical, and professional responsibilities extend to foreseeable users of audit opinions, such as lenders and investors. When carelessness leads to economic loss for these users, the accountant is as morally blameworthy as other professionals, such as attorneys or brokers, who negligently handle important matters. Liability arises from a breach of professional responsibility due to a lack of due care. The defendant argues that accounting is subjective and that audits cannot guarantee error-free financial statements, suggesting minimal moral blame for failing to detect errors. However, this argument is flawed. It wrongly assumes accountants face strict liability for undetected material mistakes in financial statements, which is not the case. Instead, accountants are held to professional standards and are not required to investigate every document, nor do they possess the same skills as attorneys or investigators. Negligence liability for accountants arises only when they fail to conduct a reasonably careful audit according to generally accepted standards. If such a breach is proven, the accountant's actions are morally blameworthy to the same extent as other professional malpractice cases. The majority opinion contends that accountants should not be liable for failing to detect client errors because the client's wrongdoing is greater. However, this greater fault is relevant only in indemnity claims between the accountant and client. When only the accountant's liability to a third party is considered, the loss should fall on the negligent party, not on an innocent victim who relied on the accountant's expertise. Cases such as Iselin-Jefferson Financial Co. v. United California Bank support this principle, establishing that reliance on professional integrity should protect third parties from negligent conduct. In scenarios where one of two innocent parties must bear loss due to a third party's negligence, the negligent party should bear the burden. The majority opinion expresses concern that imposing liability on negligent accountants for foreseeable users of audit opinions could lead to excessive claims and lawsuits, suggesting an unmanageable financial exposure. However, these concerns are exaggerated; the actual liability for accountants is limited and finite. It extends only to transactions based on reliance on audited financial statements, which become outdated within a few years. The potential liability is measurable, correlating with the client's financial activities. Liability exists only if there's a direct reliance on the audit, and causation must be established, meaning that not all lending or investment decisions are influenced by audit inaccuracies. Therefore, if a lender's decision is based on secured assets unrelated to audit report flaws, the accountant cannot be held liable. The moral aspect supports the principle of holding negligent accountants accountable for economic losses incurred by third parties who reasonably rely on their audits. Furthermore, tort liability serves as a deterrent against negligence, promoting accurate financial reporting essential for sound capital market decisions. The majority's failure to recognize this deterrent effect in auditing undermines the accountability necessary for maintaining the integrity of financial information. Lenders and investors rely on certified public accountants to interpret complex financial information accurately. When accountants fail to provide reliable data, the repercussions extend beyond individual losses, affecting customers and society through increased costs, tighter lending practices, and ultimately, failures of financial institutions. Investors also suffer, as losses from failing businesses limit their ability to support other viable ventures, leading to a concentration of funds in established companies and stifling innovation from start-ups. The resulting economic fallout includes job losses and diminished investor confidence in the market. Liability for negligent accountants to third parties who reasonably depend on their audit reports is posited as a mechanism to mitigate these harms. Holding accountants accountable encourages them to exercise greater diligence in their work, thus reducing instances of negligence. Judicial precedents support this view, indicating that such liability creates a financial deterrent against careless practices and promotes thoroughness in audits. The demand from clients for favorable audit opinions can conflict with the accountants' ethical duty to provide accurate assessments. Accountants often face pressure to deliver unqualified opinions, which can compromise their professional integrity. Therefore, the potential for liability to third parties is crucial in maintaining the independence of accountants from their clients and ensuring adherence to high auditing standards. It is noted that while not every negligent act requires accountability for all resulting injuries, imposing liability on a defined group of affected individuals can effectively deter negligence. Most of this court's recent rulings that limit or exclude negligence liability primarily involve secondary victims seeking compensation for indirect effects of wrongful actions. Specifically, when a defendant causes physical injury to a primary victim, the court has restricted the defendant's liability for emotional distress claims made by third parties. This is illustrated in cases such as *Thing v. La Chusa* and *Elden v. Sheldon*, where recovery for loss of consortium was denied to relatives of physically injured individuals. The court finds that the defendant’s liability to the primary victim serves as a sufficient deterrent. In contrast, the current case presents a different scenario where the accountant's client is not the primary victim, as the client has not suffered harm from the accountant's failure to identify errors in their financial statements. While the majority opinion allows for liability to third parties in cases of negligent misrepresentation intended to influence transactions, it acknowledges that such instances are rare. Generally, if accountants lack knowledge of their clients' dealings with third parties, they can conduct audits with little risk of liability, which diminishes their incentive for care and increases the likelihood of negligence, potentially causing harm to others. The document raises significant questions regarding the burden on accountants and the wider community implications of imposing liability on them for foreseeable users of audit opinions. However, the court notes a lack of competent evidence to adequately address these concerns, and thus cannot make an informed judgment. This absence of evidence is critical, especially since accountants in various states, including California, have been held liable to foreseeable users of audit opinions for several years, as demonstrated in cases from other jurisdictions. The excerpt emphasizes the persuasive nature of the foreseeability test in determining accountant liability within the context of federal securities laws, which impose strict liability on accountants for any untrue statements in registration statements. Under 15 U.S.C. 77k, plaintiffs do not need to prove accountant negligence, although accountants may defend themselves by demonstrating due diligence. The text raises concerns about whether this strict liability has led to accountants being reluctant to certify financial data and questions the availability and cost of liability insurance for accountants in New Jersey compared to New York. It notes the absence of evidence regarding the unavailability or high cost of such insurance, suggesting that if the burden of liability were excessively high, legislative changes would have likely occurred. The text argues that, rather than drastically limiting accountant liability, alternative legislative solutions should be explored, such as capping liability based on a percentage of the audited company's net worth or using surety bonds as a means of recourse for negligence. These proposals aim to maintain the incentives for due care while clarifying accountants' liability exposure. The discussion concludes by asserting that the foreseeability standard offers a reasonable limitation on accountant liability, supporting the idea that careful legislative consideration is needed to address these issues effectively. Holding accountants liable for negligence in audit reports benefits innocent victims, promotes diligence in audits, and supports the independence of accountants, ultimately serving the interests of the profession and the public. There are no sufficient public policy reasons to create an exception to California's established tort liability principles. The majority opinion revives a strict "privity barrier," limiting recovery for negligence solely to the accountant's client, a restrictive stance not seen in recent rulings from other jurisdictions. Even New York has eased its privity rule, allowing broader recovery potential. The majority suggests that third-party recovery should occur under negligent misrepresentation rather than straightforward negligence, claiming it more accurately reflects the cause of action. This approach follows the Restatement Second of Torts, which allows recovery only when the accountant knows the specific intended use of the audit report, a standard criticized for its arbitrariness. The distinction between foreseen and foreseeable users lacks justification, as both parties do not pay for the audit and share equal reliance on the accountant's duty of care. The expectation of third-party reliance on audit opinions renders the majority's proposed distinction indefensible and overly technical. Recovery for audit report reliance is limited to those individuals the accountant is aware of, which creates an imbalance favoring ignorance over knowledge. An accountant can evade liability by agreeing to remain uninformed about the report's distribution. The defendant in this case provided 100 copies of an audit report, indicating awareness of its widespread distribution, yet lacked knowledge of specific capital acquisition plans by the client. This lack of detailed knowledge should not be the basis for liability, as it is arbitrary and unfair. The majority opinion asserts that extending liability to unknown users is unnecessary since those affected can mitigate losses through investment diversification. However, this perspective conflicts with the ethical obligations of accountants to exercise due care. It also misallocates risk, favoring parties best positioned to prevent losses. Additionally, it disproportionately disadvantages those with fewer resources, as larger investors can easily diversify while smaller ones cannot. The suggestion that lenders and investors conduct their own audits or negotiate separate opinions would lead to inefficient duplication of efforts, increasing costs and hindering business operations. Ultimately, these protective measures are more accessible to larger investors and impractical for smaller ones, who may lack the resources or knowledge to seek such protections. The majority's ruling is seen as favoring wealthy and knowledgeable individuals, to the detriment of less affluent investors and lenders who trust independent audit reports. The jury determined that the plaintiffs acted without comparative negligence, contradicting the majority's claim that they should have taken more precautions. Accountants currently have no obligation to safeguard their reports in high-risk situations and can limit their liability through client agreements or disclaimers, which can inform potential users of the report about its limitations. However, accountants should not benefit from anticipated third-party reliance on their reports while avoiding responsibility for negligent actions that harm these third parties. The conclusion emphasizes that the majority's rule undermines the reasonable expectations of third-party users, creating a deceptive situation where the audit report appears to offer assurance but provides no legal recourse. This situation risks misleading third parties and diminishes the role of negligence liability in preventing inaccurate financial data from impacting commerce. A liability rule is essential for ensuring that third-party users of audit reports can reasonably expect due care, which in turn promotes careful auditing practices, efficient capital allocation, and reduces transaction costs in lending and investment. The existing law must remain intact, holding negligent accountants accountable for foreseeable injuries resulting from inadequate auditing of financial statements. The judgment of the Court of Appeal should be affirmed, despite dissenting opinions from Justices Mosk and Kennard who favored granting a rehearing for the petitions from Robert R. Bily and J.F. Shea Co. Inc. The case involves a certified public accountants' audit, where the terms "auditor" and "accountant" are used interchangeably. Notably, one plaintiff, Richard L. King, could not have relied on the audit report he did not receive, leading the Court of Appeal to reverse the jury's favorable verdict. In California, auditors must express an opinion on financial statements per State Board of Accountancy regulations, or state reasons if they cannot. Various precedents from other jurisdictions are cited to illustrate different approaches to liability and foreseeability in auditing cases. The excerpt addresses the adoption of a modified rule regarding liability, emphasizing a rejection of expansive liability to third parties due to concerns over indeterminate liability. It references various legal scholarship and cases that discuss the implications of accountants' liability to nonclients and the responsibilities of independent auditors. The text highlights the stringent liability standards under Section 11 of the 1933 Act, which allows purchasers of registered securities to hold certain parties accountable for false or misleading statements in registration statements. A plaintiff only needs to prove a material misstatement to establish a prima facie case, with nearly absolute liability for issuers, while other defendants must prove due diligence. Additionally, it illustrates the need to limit liability for economic losses, citing a hypothetical scenario involving a negligent automobile accident that disrupts traffic, suggesting courts would likely deny claims from third parties seeking economic damages due to such disruptions. Each plaintiff, except one, testified to having read and relied on Arthur Young's audit report concerning the company's 1982 financial statements prior to investing. The reliability of such testimony is questioned due to the potential for fabrication and the absence of records documenting the audit report's distribution. This raises challenges for auditors in disproving claims of reliance. The timing of when a plaintiff encountered the report—before making an investment or after the company's failure—complicates the verification of reliance. The possibility of numerous complex claims lacking merit adds to the consideration of whether auditors should face negligence liability. The dissent expresses concern for unsophisticated third parties, but it is argued that financial sophistication implies an understanding of an audit report's complexities and limitations. Conversely, if a party lacks such knowledge, they cannot reasonably rely on the report. Therefore, extending limitless liability based on alleged lack of sophistication is deemed unwarranted. Additionally, the California Society of Certified Public Accountants submitted declarations on accountants' professional liability and insurance usage, but the Court of Appeal declined to acknowledge this material, and a motion was filed to strike it. Amicus curiae briefs are permitted to enhance the court's understanding of the issues at stake. The document outlines the court's stance on the amicus curiae privilege, expressing a general reluctance to strike content unless there is clear abuse. Plaintiff Bily's motion is denied, although the court acknowledges concerns regarding the reliability of information from the society, noting that the declarations and data presented are surveys and opinions from parties with lobbying interests and lack judicial notice under the Evidence Code. These materials are deemed irrelevant to the case's legal standards and were not considered in the court's decision. The court references the case of International Mortgage Co. v. John P. Butler Accountancy Corp., which argued that tort liability in audit reports should only hinge on foreseeability, a premise the court has previously rejected. The court disapproves of this reasoning, stating it overlooks critical policy factors and incorrectly assumes that auditor liability to third parties would enhance caution in auditing practices. While the possibility of third-party beneficiaries in audit contracts is acknowledged, no such issue arises in this case as no third parties are named in the engagement contract with Arthur Young. Plaintiff Bily claims he is a client due to his position as a director, but the court disagrees, clarifying that the audit engagement was solely with the company, and the report was directed to the board as a collective entity, not to Bily individually. Bily's lawsuit for damages is based on personal economic loss from his investment in a company, not on any contractual relationship with Arthur Young, thereby indicating a lack of privity. Citing Stevenson v. Oceanic Bank, it is established that an individual cannot claim breach of contract based on communications received in a corporate capacity. Bily is not considered a client of Arthur Young. The excerpt discusses the confidentiality of attorney-client communications and the implications of imposing professional liability on attorneys towards third parties, which could distract from client service. Relevant cases, including Sooy v. Peter and Goldberg v. Frye, illustrate limitations on attorneys' duties to third parties, emphasizing that merely foreseeable users of professional communications do not warrant liability. The text reviews the essential elements required to prove professional negligence, highlighting the duty of care, breach, causation, and resulting damages. The dissenting opinion argues for auditor liability to all foreseeable users of audit reports due to potential disclaimers, but the primary rule maintains that audit reports are directed at clients, with liability existing only for known third parties involved in specific transactions. The excerpt concludes that requiring separate opinions from auditors necessitates greater business insight than just understanding an accountant's audit opinion.