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H. Rosenblum, Inc. v. Adler
Citations: 461 A.2d 138; 93 N.J. 324
Court: Supreme Court of New Jersey; June 9, 1983; New Jersey; State Supreme Court
The case, H. Rosenblum, Inc. v. Jack F. Adler, addresses the accountability of accountants for negligence in auditing financial statements. The Supreme Court of New Jersey examined whether auditors owe a duty to parties in privity, third parties intended as recipients of the audit, and those who could foreseeably rely on the audit results. The plaintiffs, Harry and Barry Rosenblum, claimed they suffered losses after acquiring common stock in Giant Stores Corporation based on audits performed by Touche Ross & Co., which they alleged were conducted negligently. The stock became worthless after the financial statements were found to be fraudulent. The case arose from a motion for partial summary judgment, with the facts viewed favorably for the plaintiffs. Giant Stores, a publicly traded Massachusetts corporation, was required to file audited financial statements with the SEC. The plaintiffs negotiated a business acquisition with Giant, finalized on March 9, 1972, after Giant's public offering of shares in December 1971 included audited financial data that Touche had certified as accurately representing Giant's financial position. Touche conducted an audit of Giant's financials for the year ending January 29, 1972, completing it on April 18, 1972. The audit opinion mirrored the language used in the 1971 statements. Armin Frankel, a Touche partner, attended some merger discussions but did not actively negotiate. However, he allegedly indicated that preliminary figures suggested a strong year for Giant. The merger agreement stipulated that the Rosenblums would receive up to 86,075 shares of Giant stock based on net income for the fiscal year ending December 31, 1971, with closing scheduled between May 15 and May 31, 1972. Giant warranted that there had been no material adverse changes in the business since July 31, 1971. The plaintiffs claim reliance on the 1972 audited statements before closing on June 12, 1972. After the merger, Giant's stock was publicly traded, but in April 1973, trading was suspended due to uncovered fraud involving misrepresentation of assets and omission of liabilities. Touche withdrew its audit on May 22, 1973, and Giant filed for bankruptcy in September 1973, rendering the Rosenblum's stock worthless. The plaintiffs filed a four-count complaint against Touche for fraudulent misrepresentation, gross negligence, negligence, and breach of warranty. Touche sought partial summary judgment, which was granted for the 1971 audit claims but denied for the 1972 audit claims. The appellate court affirmed the dismissal of the 1971 claims and granted leave to appeal regarding the 1972 claims, bringing the entire matter before the court. The role of an independent auditor includes reviewing financial statements and issuing an opinion on their fairness, which is then distributed for various purposes. Recipients of auditor reports may include stockholders, potential investors, and creditors. When these parties suffer damages due to a negligently prepared auditor's report, they may seek compensation from the auditor. Traditionally, auditors owe a duty only to those in privity or known beneficiaries at the time of the report, as established in Ultramares v. Touche. Section 552 of the Restatement (Second) of Torts expands this duty to a known and intended class of beneficiaries, such as banks when the auditor knows the report is for bank borrowing. Additionally, auditors may owe a duty to those they should reasonably foresee as recipients of the financial statements for legitimate business purposes, as outlined in JEB Fasteners v. Marks, Bloom. Co. Claims against auditors are typically based on negligent representations. The plaintiffs’ claims, while resembling malpractice, can also be viewed as negligent misrepresentation, seeking recompense for economic loss from a service provider with whom they are not in privity. Generally, liability for accountants requires a privity-like relationship with the claimant. Key issues include whether a negligent misrepresentation claim for economic loss can be maintained without privity, involving: (1) a negligent misrepresentation, (2) in providing a service, (3) resulting in economic loss, (4) to a non-privity recipient. The public interest in defining the auditor's duty will also be considered. Negligent misrepresentation is valid in legal terms; a false statement made negligently upon which another party justifiably relies can lead to damage recovery. An example from Pabon v. Hackensack Auto Sales illustrates this, where a driver claimed damages based on negligent misrepresentation regarding the vehicle's safety. The Appellate Division noted that negligence may be inferred from a false representation that induces reliance, affirming that the statement does not have to be factual but can also be an expert opinion. The imposition of a duty of care on a speaker arises from the relationship between the speaker, who claims to possess professional skill, and the relying party, who trusts that skill. The speaker must know or have reason to know that their information is sought for a serious purpose, that the seeker intends to rely on it, and that reliance could lead to personal or property injury if the information is incorrect. Recovery for economic loss due to negligent misrepresentation is allowed when there is a direct contractual relationship or when the injured party is a known beneficiary of the defendant's service. For instance, in Economy B. L. Ass'n v. West Jersey Title Co., the plaintiff successfully sued a title insurance company for failing to disclose a prior mortgage, despite the absence of a direct contractual relationship with the company. However, case law has shown varying opinions regarding the necessity of privity in negligent misrepresentation cases. In Kahl v. Love, the New Jersey Supreme Court reversed a judgment against a tax collector, emphasizing the need for a duty to exist before liability could be established. The Court warned against limitless liability arising from negligence. Conversely, in Immerman v. Ostertag, a lower court ruled that a notary public owes a duty to third parties who rely on their certifications, regardless of privity, which has been acknowledged in subsequent rulings. Additionally, it has been established that lack of privity does not preclude an independent contractor from being liable for negligent actions. In Gold Mills, Inc. v. Orbit Processing Corp., the court established that a contractor can be liable for negligence regardless of whether that negligence arises from actions taken or omitted that a reasonably prudent person would not engage in or neglect. With the privity rule no longer applicable in tort liability, contractors owe a duty of due care to non-contracting third parties to prevent injury. The court noted the absence of a decision regarding an accountant's liability to third parties who rely on negligently audited financial statements. Historically, many jurisdictions have limited such liability to those in privity with the accountant, as evidenced by Landell v. Lybrand, where an accountant was not held liable for misstatements relied upon by a third party purchasing stock. Chief Judge Cardozo's opinion in Ultramares v. Touche articulated concerns over imposing broad negligence liability on accountants, highlighting the risks of indefinite exposure to liability. Conversely, in Glanzer v. Shepard, Cardozo found that an accountant could be liable to a third party if it was clear that the certification was intended for that party's use. Both Ultramares and Glanzer recognized a duty only to those for whom the statements were primarily intended. Critiques of these decisions contributed to the formulation of Section 552 of the Restatement (Second) of Torts, which refines the scope of liability for negligent misrepresentation, limiting it to the party intended to benefit and those within a defined group for whom the information was supplied. This section restricts an auditor's duty to clients, identifiable beneficiaries, and members of the intended class of beneficiaries. The Restatement extends the principles of Ultramares and Glanzer by stating that auditors do not need to know the specific identities of beneficiaries if they are part of a recognizable group intended to receive the information. Courts are divided on the application of these doctrines, with some adhering to Ultramares while others follow the Restatement. Both frameworks require a relationship between the auditor and the third party relying on the information, and privity should not be a barrier to recovery unless justified by policy considerations. Negligence claims can be established based on the foreseeable consequences of negligent acts. The requirement for privity was abandoned in products liability cases, as illustrated in Martin v. Studebaker Corp., which referenced Judge Cardozo's opinion in MacPherson v. Buick Motor Co., asserting that manufacturers owe a duty to ultimate users regardless of contractual relationships. Case law, such as Martin v. Bengue, Inc., demonstrates that misleading product directions can support a negligence claim based on negligent misrepresentation. Similarly, in O'Donnell v. Asplundh Tree Expert Co., misrepresentations about the safety of equipment led to liability for injuries sustained by an employee. Historical cases, like Thomas v. Winchester, reinforce that negligent mislabeling can result in liability even without privity. Furthermore, damages in products liability cases are not confined to physical injuries; claims for economic loss are also recognized. In Santor v. A. M Karagheusian, Inc., the court addressed the implications of reasonable fitness in product liability, questioning why claims for negligent misrepresentation should be barred in the absence of privity when similar tort claims are not. The decision emphasized that both the manufacturer and the declarant of a representation imply that their product and statements are fit for use. A key issue is whether a duty exists to compensate for economic loss to foreseeable users who lack direct privity with the declarant. The court referenced Chief Justice Weintraub's perspective on determining duty based on fairness, which involves assessing the relationships between parties, the nature of the risk, and public interest. The court also considered the responsibilities of professionals, such as auditors and medical providers, suggesting that the imposition of strict liability may not be appropriate due to the essential nature of their services. The discussion highlighted several policy factors, including the burden on defendants, risk associated with their activities, and the importance of accountability in accounting practices, which are critical for societal function. Accounting involves recording and reporting activities and their outcomes, culminating in the discharge of accountability, which differentiates it from other information systems. The company's preparation of financial statements initiates the accountability process, with independent auditors scrutinizing these reports to express an opinion on their fairness. The objective of an audit is to determine if the financial statements accurately reflect the entity's financial position and operations in accordance with generally accepted accounting principles (GAAP). Auditors must understand the business and its industry to provide an informed opinion, as they adhere to standards set by the American Institute of Certified Public Accountants (AICPA). While auditors evaluate the appropriateness of accounting principles, they face limitations due to the subjective nature of some accounting treatments, such as the treatment of research and development costs or the depreciation of intangible assets. The reliability of financial statements is inherently tied to the underlying accounting methodologies. Auditors are not required to investigate every document but should exercise reasonable care to identify illegal or improper actions that could be revealed through normal professional diligence. They must evaluate the underlying data and testing techniques to ensure a thorough examination of the financial statements. Auditors are not guaranteed to uncover all material fraud, but their role in identifying fraud and other illegal acts serves a significant public interest. Initially, audits primarily informed management about internal irregularities; however, the demand for independent audits has evolved due to public ownership of businesses and regulatory requirements from stock exchanges and the SEC. This shift has led to a recognition that audited financial statements are essential for third parties, including institutional investors and lenders, who lack a direct contractual relationship with the auditor. The SEC has long noted that an accountant's responsibility extends beyond their client to include investors and creditors who rely on certified financial statements. The function of auditors has transitioned from merely monitoring management to providing an independent evaluation of financial statements' fairness and adequacy. This change is underscored by governmental reliance on accounting for regulating business activities, such as public utility rates and banking regulations. Auditors must maintain objectivity and impartiality, balancing the potentially conflicting interests of various stakeholders, including management and shareholders. Their moral and legal responsibilities encompass consideration for the interests of third parties who depend on their assessments, ensuring that they uphold a standard of impartiality that is unique among professions. The certified public accountant (CPA) holds a significant dual role, embodying both a heavy responsibility and a proud distinction. This role signifies the CPA's high integrity and steadfast judgment, which remains unaffected by external pressures. CPAs are tasked with providing impartial accounting statements that serve as credible assessments for all stakeholders, thereby acting as arbiters among varying interests. Their expertise and independence are crucial, ensuring fair reporting on financial matters despite potential management biases that could misrepresent performance favorably. The Public Accounting Act of 1977 mandates certification or registration of public accountants to enhance the reliability of financial information used in transactions or enterprise assessments. This legislation aims to ensure that those attesting to financial information possess the necessary qualifications and that an authoritative body governs these standards. Concerns have been raised about imposing a duty on accountants towards third parties receiving company statements, primarily due to fears of catastrophic financial implications for accounting firms. Although these concerns exist, many stakeholders are already protected under existing liabilities for misstatements in public offering securities, as outlined in the Securities Act of 1933. The standards for liability under this Act differ from traditional negligence standards, often allowing claims where negligence might not apply. Under Section 11 of the Securities Act of 1933, the plaintiff does not have to prove scienter, negligence, or proximate cause; instead, the burden is on accountants to demonstrate their freedom from negligence or due diligence. Section 18 of the Securities Exchange Act of 1934 imposes civil liability on individuals who cause misleading statements in SEC filings. The plaintiff must establish reliance, while defendants can avoid liability if they acted in good faith and lacked knowledge of the misleading nature of the statements. Notably, privity is not a defense, and accountants can be liable to third parties. Cases such as Escott v. Bar Chris Construction Corp. and Fischer v. Kletz illustrate auditor liability under both Sections 11 and 18. Accounting firms may be liable for fraud and gross negligence to third parties regardless of privity, as established in Ultramares and other precedents. Auditors can obtain liability insurance to cover risks associated with their negligent acts leading to misstatements. The potential imposition of duties to foreseeable users may prompt accounting firms to adopt stricter auditing standards and closer supervision, potentially reducing liability instances. However, the costs associated with thorough audits and higher insurance premiums would likely be passed on to businesses and their stakeholders. To recover damages, plaintiffs must prove they received audited statements for a legitimate purpose, relied on them, and that any misstatements resulted from the auditor's negligence and were a proximate cause of their damages. Recovery is limited to actual losses, and a plaintiff's negligence could reduce their recovery under the Comparative Negligence Act. Auditors may seek indemnification from the company or at-fault personnel, and they can limit the class of individuals entitled to rely on their audits in certain situations, such as when auditing private companies. A disclaimer of responsibility can limit the reasonable reliance on information provided by accountants, as highlighted in various legal discussions. Courts have established that an injured party should be able to recover damages from an independent auditor's negligence, shifting the loss from innocent creditors to the responsible auditor. This approach encourages accountants to exercise greater care in audits. Civil liability is viewed as an effective incentive for self-regulation within the profession. The burden of an accountant's malpractice should not fall on innocent parties; rather, it would be fairer to distribute the risk among the accounting profession, which can mitigate costs through insurance. A foreseeability standard in liability could enhance caution within the profession. Justice Wiener's recent arguments suggest that the time has come to remove protections that absolve negligent accountants, advocating for liability based on foreseeable injury to ensure compensation and deter negligence. When an independent auditor provides an opinion without limitations on distribution, they owe a duty to those they can reasonably foresee would rely on the financial statements for valid business purposes. However, this duty applies only to foreseeable users who receive the statements directly from the company, excluding those who do not obtain the statements or those who purchase stock post-negligence without meeting necessary conditions. Certified financial statements are established as essential for foreseeable business purposes, necessitating that accountants cannot shield themselves from malpractice liability through privity. The trial court and Appellate Division dismissed the plaintiffs' claim regarding the negligent preparation of the 1971 audit, as the accountants were unaware of the plaintiffs or their limited class at the audit's completion on April 16, 1971, before merger discussions began in September. Although it could be argued that the defendants implicitly authorized the plaintiffs' reliance on the 1971 audit, which they claimed conformed to generally accepted auditing standards, the evidence of negligence and reliance by the plaintiffs suggests potential liability. The defendants' involvement in the merger was not merely incidental, and liability could arise under precedents like Glanzer v. Shepard. However, the supporting facts are tenuous. The need to prevent groundless claims and streamline litigation is acknowledged, justifying a broader approach to the issue. The trial court may need to assess whether a narrow or expansive interpretation of the issue is warranted for clarity to the bar and public. Ultimately, the defendants were aware or should have been aware that Giant would likely utilize the audited figures for legitimate business purposes. The excerpt outlines the responsibilities and potential liabilities of the defendants, who conducted an audit for Giant. The defendants were aware that their audited financial statements would be included in Giant's annual report, distributed to stockholders, and filed with the SEC for a proxy solicitation. They should have anticipated that these financials would be utilized for legitimate business purposes such as public offerings and corporate acquisitions. The defendants acknowledged the plaintiffs' existence and their reliance on the accuracy of the financials prior to their use. The defendants were aware that the merger agreement contained a representation ensuring no material misstatements in the prospectus used for a public offering, which included their opinion on the financial statements' compliance with accounting principles. Their duty to disclose any inaccuracies continued even after the audit was completed, and ignorance of the specific use of the financials did not absolve them from responsibility. The facts, viewed favorably for the plaintiffs, suggest that the defendants negligently prepared the audit for the fiscal year ending January 30, 1971, which was subsequently presented to the plaintiffs as they considered merging with Giant. The plaintiffs claim to have relied on the defendants' representations when entering into the merger agreement, leading to alleged damages. Regarding the 1972 audit, the trial court denied the defendants' motion to dismiss claims of fraud and negligence. The defendants argued that the plaintiffs were bound by the merger contract at the time of the audit's issuance, negating any causal relationship to damages. However, the merger agreement included a warranty of no material adverse change in Giant's situation, suggesting that accurate disclosures from a non-negligent audit could have influenced the plaintiffs' decision to proceed with the merger. There remains a factual dispute regarding the plaintiffs' reliance on the 1972 audit. Evidence from depositions indicates that the plaintiffs were expecting the audited financial figures from 1972 prior to the closing of the transaction and would have refused to proceed if these figures indicated a significant adverse change in Giant's business. Adequate disclosures could have revealed potential fraud by Giant, which would warrant rescission of the contract. A contractual obligation does not compel the closing of a financially detrimental transaction when legitimate reasons exist to reject the contract. Regardless of the defendants' actual knowledge of Giant's intended use of the 1972 audit in the merger, it was foreseeable that such an audit would play a role in the merger's completion, especially since the defendants were engaged to audit the plaintiffs' records for this purpose. The trial court appropriately denied the defendants' motion. The judgment granting partial summary judgment for the defendants concerning the 1971 financial statements is reversed, while the denial of their motion regarding the 1972 financial statements is affirmed. The case is remanded for further proceedings in line with this opinion. Additionally, the SEC found Touche's 1972 audit deficient, leading to a censure. The text notes the relevance of privity in product liability law and acknowledges that some jurisdictions allow recovery in tort for economic loss, though this is not yet a widespread rule. The Securities and Exchange Commission mandates that auditor examinations follow generally accepted auditing standards, as per Release No. AS-195. Under the Securities Act of 1933, prospectuses for public securities offerings must include certified financial statements. Companies typically must file annual reports, Form 10-K, with certified financial statements within 90 or 120 days post-fiscal year-end, as required by the Securities Exchange Act of 1934 for those with assets over $1,000,000 and 500 equity security holders. Liability under Section 10(b) of the 1934 Act necessitates proof of intent to deceive or defraud, with accountants potentially liable under both Section 10(b) and Section 11 of the 1933 Act. Accountants can secure insurance for their securities law liabilities, which is often easier to establish and similar in amount to other liabilities. A survey indicated that in 1976, accounting firms faced little difficulty obtaining reasonably priced insurance, including plans sponsored by the American Home Insurance Company and the AICPA, covering claims excluding intentional fraud. The Ontario High Court in Toromont Industrial Holdings Ltd. v. Thorne determined that a negligent audit did not cause a plaintiff's takeover bid, although the Ontario Court of Appeals recognized damages incurred from having to prepare a new audit. Recovery for plaintiffs is based on actual losses rather than the benefit of the bargain, supported by various case law. Judge Woolf in JEB Fasteners Ltd. v. Marks, Bloom & Co. emphasized that auditors should be liable to those who foreseeably rely on their financial representations. Additionally, the audit report was integral to the SEC Form 10-K filing for Giant, required shortly after the end of its fiscal year.