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Ernst & Young not liable in ZZZZ Best case.

A California appellate court ruled Ernst & Young was not liable to Union Bank of California, which allegedly relied on Ernst's review report in extending $7 million to ZZZZ Best Co. Z Best, a California company, failed in 1986 after authorities discovered a massive fraud involving fictitious customers of its carpet cleaning business and bogus revenue and income reports. Z Best's founder, Barry Minkow, subsequently was convicted of a variety of criminal charges in connection with Z Best's operations and is now serving a long prison term.

Ernst reviewed Z Best's financial statements for the three months ending July 31, 1986. A draft copy of this review report was contained in a preliminary prospectus for a $100 million stock offering by Z Best. Union alleged it extended credit to Z Best based on the preliminary prospectus, oral representation by Ernst that Z Best was growing and the reputation of the professionals involved with Z Best, including Ernst.

The court, in ruling for defendant Ernst, cited several deficiencies in Union's case:

1. Claims by Union based on alleged oral representations by Ernst were barred by the statute of frauds, which requires that a representation concerning the credit of a third person be in writing to be admissible as evidence.

2. Ernst, because it issued only a review report, specifically declined to express an opinion on Z Best's financial statements. The report expressly disclaimed any right to rely on its content, which Union allegedly relied on in extending credit to Z Best. The report, in fact, stated that Ernst had not performed the audit work necessary to form an opinion about Z Best's financial statements for an interim period, let alone its overall financial condition, and therefore reliance on the report should be restricted.

3. Union could not rely on California case law that states an independent auditor owes a duty of care to reasonably foreseeable plaintiffs who rely on its report. The court noted this duty extends only to cases in which the accountant issues unqualified audited financial statements. Furthermore, in this case, Union conducted its own extensive independent investigation before extending credit to Z Best. (Union Bank v. Ernst & Whinney, 91 Daily Journal D. A. R. 2347)
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Title Annotation:California
Author:Berman, Ron
Publication:Journal of Accountancy
Date:Jul 1, 1991
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Next Article:U.S. Supreme Court upholds punitive damage award.

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