California court acknowledges engagement letter's importance.

A California court of appeals ruled that a third party that allegedly relied on an auditor's opinion cannot claim it is a third-party beneficiary of the auditor's engagement unless the third party is specifically named in the engagement letter.

Software Design and Applications Ltd. (SDA) retained Patrick McDonald to manage and invest its funds. McDonald recommended that SDA invest $1 million in Embrace System Corp. SDA insisted that Embrace retain one of the Big Six firms before SDA purchased any Embrace stock. Embrace retained Price Waterhouse to audit the company's December 31, 1992, financial statements.

Meanwhile, McDonald purchased 1,551,136 shares of Embrace at $0.66 per share. He misrepresented to SDA that he had bought 325,000 shares at $3.15 per share and then he converted the remaining shares to his own account. SDA subsequently sued McDonald, alleging he had defrauded SDA of 1,388,550 shares of stock and $685,000 of various other investments.

Price Waterhouse did not issue its audit report until March 31, 1993, after SDA had made its investment. However, before making the investment, SDA alleged it had relied on a 10Q report Embrace had filed with the Securities and Exchange Commission that allegedly contained the firm's work product. However, none of the documents in the 10Q report were on the firm's letterhead or cast as the firm's representation. SDA sued the firm, alleging it had invested in Embrace in reliance on the auditor's representations and work product, saying they contained numerous material errors, inaccuracies and false statements regarding Embrace's financial condition. SDA also submitted a declaration from McDonald, who alleged he had advised the accounting firm that SDA would rely on its work in deciding whether to invest in Embrace System.

In ruling for the firm, the court found that McDonald's declaration could not alter the terms of the accountant's engagement letter because the engagement letter constituted an "integrated agreement" and therefore was the exclusive repository of the parties' agreement. That is, the the engagement letter was the document that defines the parties' agreement. Specifically, the court found that the engagement letter was not ambiguous as to who the accounting firm's client was and that the oral understanding alleged by McDonald was incompatible with the engagement letter. The court also said it was inconceivable that a third party, (SDA) that wanted to be a third-party beneficiary would not insist on written confirmation of its status. The court also noted that the audit report was issued after SDA had made its investment, there was no communication between SDA and the firm and the 10Q contained unaudited financial statements that did not include any representations by the firm.

The court's opinion also narrowly interpreted the circumstances under which a third party could bring a negligent misrepresentation claim by requiring the auditor to have knowledge of the specific identified transaction contemplated by a third party. (Software Design and Application Ltd. v. Price Waterhouse, LLP, August 29, 1996, 49 Cal App. 4th 464)