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The erosion of the privity doctrine.

The Erosion of the Privity Doctrine

The circumstances under which an accountant may be held liable in negligence to persons who are not in contractual privity with the accountant depend largely on the legal doctrine of liability adopted by the highest court of the state in which the negligence action is brought.

The seminal case on the subject of privity of contract is the 1931 New York case of Ultramares Corp. v. Touche, 255 N.Y. 170, 174 N.E. 441. In a decision written by Chief Judge Cardozo (later appointed to the U.S. Supreme Court), the New York court held that a lender who had relied upon inaccurate financial statements to its detriment had no cause of action against the accounting firm which had prepared the statements because of the lack of privity between the parties. In adhering to a strict requirement of privity, Chief Judge Cardozo wrote:

"If liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminable amount for an indeterminable time to an indeterminable class. The hazards of a business conducted on these terms are so extreme as to enkindle doubt whether a flaw may not exist in the implication of a duty that exposes to these consequences."

Almost 60 years have elapsed since the Ultramares decision. The question of an accountant's liability for negligence where there is no privity between the accountant and the party alleging the negligence has been addressed by the highest courts in a dozen states. In an excellent article, "More on the Issue of Privity," in the July 1990 issue of the National Public Accountant, Edward A. Becker of Nova University summarized several recent cases in which the state and federal courts discussed the application of the privity of contract doctrine. This article will explore various lines of judicial authority with respect to the issue of privity.

The "Near Privity"


Essentially, there are four lines of authority that have eroded the strict doctrine of privity. The first of these is the doctrine of "near privity." Except in cases of fraud, an accountant is liable to a party with whom he is in privity or near privity. The near privity doctrine was established in the case of Credit Alliance Corp. v. Arthur Andersen & Co. (65 N.Y. 2d 536, 483 N.E. 2d 110) decided in 1985. That New York landmark case explained the circumstances under which recovery for negligence may be accomplished by persons in near privity with the accountant.

In August 1987, the Federal Court of Appeals for the Seventh Circuit concluded that either a contradictory relationship between the parties (privity of contract) or at least affirmative evidence of contract between the accountant and the third party (near privity) indicating the accountant's knowledge of the third party's reliance was necessary before the accountant could be held liable in negligence. (Toro Co. v. Krouse, Kern & Co., 827 F. 2d 155, 1987)

The Restatements Doctrine

The second line of authority is the restatements doctrine of Section 552 Restatement (Second) of Torts.

The restatements (sometimes called restatements of the law) are produced by the American Law Institute (ALI), an organization of judges, lawyers and law teachers organized in 1923 with the express purpose that its publications would simplify the law and make the application of the law more certain. Courts have accepted and ruled upon the restatements as persuasive authority equal to reputable treatises in a particular field of law, such as contracts or torts. Restatement of Torts (under which negligence litigation is treated) was originally published in two volumes in 1965. A Restatement (Second) of Torts was published in two volumes in 1977-78. It is Section 552 of the Restatement (Second) of Torts that is cited by the courts in privity of contract cases involving accountants' negligence.

The Restatement (Second) of Torts, provides that an accountant is liable to third parties in the absence of privity under circumstances described in Section 552. Briefly, Section 552 says that a professional person (e.g. the accountant) who supplies false information for the guidance of others in their business transactions is subject to liability for the pecuniary loss caused to the other party by their justifiable reliance on the information if the professional person fails to exercise reasonable care or competence in obtaining or communicating the information.

The liability of the accountant is limited to the loss suffered by the person for whose benefit and guidance the accountant supplies accounting information, or where the accountant knows that the client intends to supply the information to a third party and the third party relies upon it in a transaction that the accountant intends to influence, or where the accountant knows that the client intends that the third party will be influenced by or rely upon the information provided by the accountant.

Thus, when carefully read, the Restatement of Torts, Section 552 doctrine limits liability to those persons or classes of persons whom an accountant "knows" will rely on his opinion, rather than those he "should have known" would rely. The Restatement doctrine takes into account the fact that an accountant controls neither his clients' accounting records nor the distribution of his reports.

One of the leading cases upholding the Restatement of Torts, Section 522 doctrine is the North Carolina case of Ruritan River Steel Co. v. Cherry, Bekaert & Holland, 367 S.E. 2d 609, 1988. In that case, the North Carolina Supreme Court concluded that the Restatement doctrine represented the soundest approach to accountants' liability for negligent misrepresentation. The Restatement doctrine constituted a middle ground between the restrictive Ultramares approach and the expansive "reasonably foreseeable" approach that is advocated by several state supreme courts.

The Restatement of Torts, Section 522 doctrine recognizes that liability should extend not only to those persons with whom the accountant is in privity or near privity but also to those persons or classes of persons who the accountant knows and intends will rely on his opinion, or whom the accountant knows that his client intends will so rely.

Accordingly, the Restatement doctrine balances, more than any other standard according to the North Carolina decision in the Ruritan River Steel Co. case, the need to hold accountants to a standard that accounts for their contemporary role in the financial world with the need for protection from liability that unreasonably exceeds the bounds of their real undertaking. The Restatement doctrine has now been adopted by the highest state courts in North Carolina, Florida, Georgia, New Hampshire and Texas. Federal district courts in the states of Nebraska and Rhode Island have also adopted the Restatement doctrine.

The "Reasonably

Foreseeable" Doctrine

The "reasonably foreseeable" doctrine states that the accountant is liable to all persons who might reasonably be foreseen as relying upon his work product. The leading cases under this doctrine are International Mortgage Co. v. John P. Butler Accountancy Corp. 223 Cal Rpts. 218, 1986; H. Rosenbaum, Inc. v. Adler 461 A. 2d 138, N.J., 1983; and Citizens State Bank v. Timm Schmidt & Co., 335 N.W. 2d 361, Wisconsin, 1983.

In the H. Rosenbaum case, the New Jersey court held that the auditor furnishing an opinion with no limitation as to whom the client may disseminate the financial statements has a duty to all those parties whom the auditor should reasonably foresee as recipients of the statements from the client.

In the Timm Schmidt case, the Wisconsin Supreme Court closely followed the reasoning expounded by the New Jersey Supreme Court in the H. Rosenbaum case and reached the conclusion that the accountant's liability to third parties should be determined under the accepted principles of Wisconsin negligence law. According to those principles, liability will be imposed on accountants for the foreseeable injuries resulting from their negligent acts unless, under the facts of the particular case, recovery is denied on grounds of public policy.

The reasonably foreseeable doctrine is criticized on the grounds that the outer limits of foreseeability are vague and untested. Just how far foreseeability extends is an open question limited only by the imagination of counsel. For example, does foreseeability extend to tax returns and schedules filed with the Internal Revenue Service and state tax authorities?

The "Balancing Factors"


The "balancing factors" doctrine states that the accountant's liability to third persons shall be determined by the balancing of various factors, among which are the extent to which the transaction was intended to affect the plaintiff, the foreseeability of harm to him, the degree of certainty that the plaintiff suffered injury, the closeness of the connection between the defendant's (accountant's) conduct and the injury suffered, the moral blame attached to the defendant's conduct and the policy of preventing future harm.

The balancing factors doctrine is discussed in the California case of Biakanja v. Irving, 320 P.2d 16, 1958. In that case the California Supreme Court looked to various balancing factors to decide whether a notary public who undertook to prepare a will could be held liable for negligence to a beneficiary under a will.

The leading case involving accountants and the balancing factors doctrine appears to be Aluma Kraft Mfg. Co. v. Elmer Fox & Co. (493 S.W. 2d 378) decided in 1973 by the Missouri Court of Appeals. In that case, the court upheld a complaint that alleged that the negligent auditors knew their report would be used by third parties to determine book value to be paid for the client's stock.

The balancing factors doctrine may include factors coming within the doctrine of foreseeability when the court weighs the various policy factors relating to the factual situation in deciding whether to impose a liability for negligence upon the accountant. Thus, there are similarities within the two doctrines. Generally, the balancing factors doctrine includes the foreseeability of injury at the time of the engagement to justify imposition of liability.


The doctrine of privity of contract in accountants' negligence cases has undergone considerable erosion since Chief Judge Cardozo first held its applicability in the 1931 Ultramares case. The majority of state courts are now inclined to limit the Ultramares doctrine in favor of one of the other doctrines described in this article.

The general rule now appears to be the Restatement of Torts, Section 552 doctrine where the accountant will be held liable for ordinary negligence to third parties whose reliance is foreseen to the accountant at the time of the engagement. As the North Carolina court stated in the Ruritan River Steel Co. case, the Restatement doctrine balances, more than any other standards, the need to hold accountants to a standard that accounts for their contemporary role in the financial world and the need to protect accountants from liability that unreasonably exceeds the bounds of their undertaking.
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Article Details
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Author:Sager, William H.
Publication:The National Public Accountant
Date:Mar 1, 1991
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