Illinois trial court rejects privity statute.

An Illinois circuit court ruling limits the effectiveness of section 30 of the Illinois Public Accounting Act ("the Privity Act"), which defined statutorily the accountant's duty to third parties relying on financial statements.

The ruling stems from an action brought by Chestnut Corp. against an accounting firm, Pestine, Brinati, Gamer, Ltd., and a CPA sole practitioner, Robert Davidson. The case began in late 1988 when Chestnut became interested in investing in Alphatype Corp., a manufacturer of photo-typesetting systems. In making its decision on whether to purchase stock in Alphatype, Chestnut reviewed the 1987 and 1988 financial statements prepared and issued by Pestine. The 1988 workpapers also were reviewed by Davidson under an agreement with Pestine.

Sometime in 1989, a Chestnut officer also visited with Pestine. After this visit, the accounting firm provided workpapers to Chestnut, but the firm did not write a letter to Alphatype or Chestnut identifying Chestnut as a third-party reliant on those statements. Further, there was no contractual relationship between Chestnut and Pestine.

Subsequently, Chestnut purchased 82% of Alphatype's stock for $1.3 million and a $300,000 note. Shortly thereafter, Chestnut discovered material misrepresentations in the value of both inventory and accounts receivables. Alphatype lost a large amount of money after the stock purchase and filed for bankruptcy.

Accounting firm takes the initiative. After Chestnut filed suit against Pestine, the accounting firm moved for summary judgment in its favor on the grounds that under the Illinois Public Accounting Act, it owed no duty to Chestnut.

Pestine argued the act clearly states that accountants must send a written notification to the client and to a third party before the accountant can be liable to a third party.

In deciding for the plaintiff, Chestnut, the court rejected this argument on several grounds:

1. The act's express purpose, to "promote the dependability of information used for guidance in financial transactions...and protecting the public interest," would be undermined by giving accountants an incentive not to identify those whom they intend to rely on their services and would enable accountants to avoid liability if they know a third party intends to rely on their services (that is, if the accountant does nothing).

2. A literal reading of the act would require Illinois accountants retained by public companies to know of, identify and notify every potential reliant third party across the country. In view of the "impossibility...of this Herculean task," financial statements produced by Illinois accountants could not routinely be relied upon by investors and would be "worthless."

3. The act's plain language encourages accountants to identify in the financial statement and notify in writing those parties whom they intend to rely on the financials. If they do make such an identification, they will be potentially liable only to the parties identified.

This is an important case because Illinois was the first large commerical state to define statutorily the duties of accountants to third parties. The act attempts to limit accountants' liability to unknown or even reasonably foreseeable parties unless such parties are identified and notified in writing.

This strict privity standard has served the Illinois accounting profession well since its enactment. The statute could serve as a model act for other states wishing to define accountants' duty to third parties. This case is already being prepared for appeal and will include amicus briefs filed by the Illinois CPA Society. It is likely this matter ultimately will be appealed to the Illinois Supreme Court. (Chestnut Corp. v. Pestine, Brinati, Gamer, Ltd., and Robert Davidson, Circuit Court, Cook County, Illinois, 91 L 18515)

Editor's note: Special thanks to Randy Sue Schriber of Querrey & Harrow for submitting this case. Querrey and Harrow will be handling the petition for appeal of this case.