Bily v. Arthur Young & Co.
11 Cal.Rptr.2d 51, 834 P.2d 745 (1992)
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Rule of Law:
An auditor’s liability for general negligence in the preparation of an audit report is limited to the client. However, an auditor may be held liable for negligent misrepresentation to a non-client third party if the auditor intended to supply the information for the third party's benefit and guidance in a specific, known business transaction or a substantially similar transaction.
Facts:
- Osborne Computer Corporation hired the accounting firm Arthur Young & Company to perform audits on its 1981 and 1982 financial statements.
- Arthur Young issued an unqualified ('clean') audit opinion on the 1982 financial statements, which reported a net operating profit of $69,000, and delivered 100 printed sets of the opinion to the company.
- In late 1982 and early 1983, the company sought to raise capital through a 'warrant transaction' to secure loans and financing until a planned initial public offering.
- Relying on Arthur Young's unqualified audit report, various plaintiffs, including Robert Bily and other investment funds, purchased the company's warrants or common stock.
- The company's financial statements were materially misstated; liabilities were understated by approximately $3 million, meaning the company actually had a net loss of over $3 million instead of a profit.
- Shortly after the plaintiffs' investments, the company's financial performance declined sharply due to manufacturing and market challenges.
- The planned public offering never occurred, and the company filed for bankruptcy on September 13, 1983, causing the plaintiffs to lose their investments.
Procedural Posture:
- Plaintiffs filed separate lawsuits against Arthur Young in Santa Clara County Superior Court (a trial court), alleging professional negligence, negligent misrepresentation, and fraud.
- The actions were consolidated, and a jury returned a verdict in favor of the plaintiffs on the professional negligence claim, while exonerating Arthur Young on the fraud and negligent misrepresentation claims.
- The jury awarded plaintiffs approximately $4.3 million in damages, and the trial court entered judgment accordingly.
- Arthur Young, as appellant, appealed the judgment to the California Court of Appeal.
- The Court of Appeal affirmed the judgment in favor of the plaintiffs-appellees, holding that an auditor's duty of care extends to all reasonably foreseeable third parties.
- The Supreme Court of California granted Arthur Young's petition for review.
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Issue:
Does an auditor's duty of care for general negligence in preparing an independent audit of a client's financial statements extend to all reasonably foreseeable third parties who rely on that audit?
Opinions:
Majority - Lucas, C. J.
No. An auditor’s duty of care for general negligence in the conduct of an audit does not extend to all foreseeable third parties; liability is confined to the client who engaged the audit services. A narrow class of non-clients may recover, but only on a theory of negligent misrepresentation consistent with Section 552 of the Restatement Second of Torts, which requires that the auditor knew the third parties would receive the report and intended to influence them in a specific transaction. The court reasoned that extending general negligence liability to all foreseeable users would expose auditors to potential liability far out of proportion to their fault, especially given their secondary, 'watchdog' role and the complex nature of audit opinions. The court found that sophisticated plaintiffs, like investors and lenders, can use contractual 'private ordering' to manage their risk. The court concluded that the Restatement approach for negligent misrepresentation strikes a sensible balance, limiting liability to a defined class of intended beneficiaries whom the auditor knows will rely on the report for a particular purpose, thereby giving the auditor notice of the potential risk.
Dissenting - Kennard, J.
Yes. An accountant's duty of care should extend to all persons who reasonably and foreseeably rely on their professional opinions. The majority's holding revives an anachronistic privity requirement for general negligence and adopts an arbitrarily restrictive rule for negligent misrepresentation. This approach fails to provide an adequate deterrent for auditor malpractice and unfairly harms innocent investors who rely on what appears to be a professional assurance of financial accuracy. The Restatement rule is flawed because it rewards auditor ignorance, making liability dependent on the 'fortuitous occurrence' that a client specifically informs the auditor of the report's intended recipients. A foreseeability standard better serves public policy by compensating victims, encouraging due care, and reinforcing the auditor's 'public watchdog' function.
Analysis:
This decision significantly narrowed the scope of auditor liability to third parties in California by rejecting the broad foreseeability standard. The court established a two-tiered framework: auditors owe a duty for general negligence only to their clients, while a duty to non-clients can only arise under the more stringent theory of negligent misrepresentation. This requires the plaintiff to prove they were an 'intended beneficiary' of the audit report for a specific, known transaction. The ruling shifts the risk of loss from auditors to third-party users of financial statements, encouraging investors and creditors to perform their own due diligence or contract directly for assurances rather than relying solely on the client's general-purpose audit.
