California limits accountants' duty to third parties.

In a major victory for the accounting profession, the California Supreme Court overturned the California Court of Appeals and ruled auditors generally owe no duty of care to nonclients.

The appellate court and trial court cases, previously reported in Legal Scene (JofA, Oct.90, page 29) arose from audits of Osborne Computer Corp. by Arthur Young & Company in the early 19808. To raise capital, Osborne had obtained bank loans that were secured by letters of credit from a group of investors. In return, the investors were issued warrants to purchase Osborne stock when a public offering occurred.

In September 1983, before the offering, Osborne filed for bankruptcy. The warrant holders and shareholders sued Young, alleging its January 1983 unqualified audit opinion failed to disclose various problems at Osborne before its bankruptcy.

The issue before the court was whether Young owed a duty of care to the investors. The Court of Appeals adopted a broad "foreseeability rule" under which an auditor could be held responsible to all parties who reasonably relied on Young's audit opinion and whose reliance was reasonably foreseeable by the "professionally sophisticated auditor."

The California Supreme Court rejected this rule, saying an auditor is not liable to nonclients unless the auditor knows the audit is being prepared for the specific benefit of a party or if the auditor engages in fraudulent conduct.

In striking down broad accountant liability to third parties, the court said the rule would "inevitably produce large numbers of complex lawsuits of questionable merit as scores of investors and lenders seek to recoup business losses." The court went on to say its ruling would "deter careless audit reporting while avoiding the specter of a level of liability that is morally and economically excessive."

While this ruling is a welcome reversal of decades of case law in California expanding the scope of professional liability, it is likely plaintiffs will now seek to establish the auditor's report was prepared specifically for their benefit. It is also likely the decision will have little impact on cases brought under sections 10(b) of the Securities Exchange Act of 1934 and section 11 of the Securities Act of 1933.

Nevertheless, cases in which investors, lenders, purchasers and others allege negligence against an accounting firm are likely to fail unless those parties can show the audit was prepared specifically for their benefit. (Bily v. Arthur Young & Company, 92 Daily Journal D.A.R. 11971, August 27, 1992)