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The origins of auditor liability to third parties under United States common
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Article  in  Accounting History · May 2008


DOI: 10.1177/1032373207088177

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Accounting History

The origins of auditor


liability to third parties
under United States
common law
C. Richard Baker
Adelphi University
Deborah Prentice
North Carolina A&T State University

Abstract
This article traces the origins of auditor liability to third parties under
United States common law, with a particular emphasis on the role of
Benjamin Cardozo as Chief Judge of the New York Court of Appeals in
the period from 1917 to 1932. Prior to the Ultramares decision, written by
Chief Judge Cardozo in 1931, auditors were relatively shielded from li-
ability against lawsuits brought by third parties (those who are not the
client). In the Ultramares decision, Cardozo opened the door to a possible
expansion of auditor liability to third parties through the introduction of a
relatively new theory of law, that is that an auditor’s negligence was heed-
less to such an extent that it was equivalent to fraud (that is, gross negli-
gence). Subsequent to Ultramares, it appeared likely that the liability of
auditors for negligent acts would be extended beyond their clients to the
third parties who rely upon audited financial statements. However, because
Ultramares has been interpreted in various ways in different jurisdictions,
there has been ambiguity about the exact parameters of auditor liability to
third parties under common law. Nevertheless, the Ultramares decision can
be identified as the first instance in the United States where the courts
opened up the possibility for third parties to sue auditors for negligent acts
that were perceived to be so flagrant as to be equivalent to fraud.

Copyright © 2008 SAGE Publications 163


(Los Angeles, London, New Delhi and Singapore) and AFAANZ
Vol 13(2): 163–182. DOI: 10.1177/1032373207088177

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Accounting History Vol 13, No 2 – 2008

Keywords: Auditors’ liability to third parties; history of auditor


negligence

1. Introduction
This article traces the origins of auditor liability to third parties (that is those
who are not the client of the auditor) under the common laws of the states of
the United States of America. It is argued that these origins can be found specifi-
cally in the Ultramares v. Touche (1931) decision, and more generally in the
legal opinions written by Benjamin Cardozo as Chief Judge of the New York
Court of Appeals during the period 1917 to 1932. The principles of US
common law specify that for a plaintiff to recover damages, the plaintiff must
prove: (1) that they were damaged by an act of the defendant, (2) that the defen-
dant was negligent in performing that act, and (3) that the defendant owed a duty
to the plaintiff not to be negligent while performing the act (Prosser, 1982). Prior
to the Ultramares decision, auditor liability to third-parties under common law
virtually did not exist in the USA. This was because most lawsuits brought by
third parties for auditor negligence were dismissed on the grounds that no con-
tractual agreement existed between the auditor and the third-party user of finan-
cial statement (Davies, 1979). In the Ultramares decision, Judge Cardozo created
the possibility that an auditor’s negligence might be so great that it would be
equivalent to fraud, which would allow a plaintiff to recover even if there were no
contractual relationship between the auditor and the third party.This was a new inter-
pretation of the common law. The contribution of our article consists in demonstrat-
ing how the legal reasoning used by Cardozo in deciding the Ultramares and other
cases related to tort law and negligence during the early years of the twentieth cen-
tury constituted the origins of auditor liability to third parties under US common law.
The remainder of this article is organized as follows. Section 2 outlines the
structure of the American legal system and the context of auditor liability within
that system. Section 3 discusses the evolution of US tort law and negligence during
the later part of the nineteenth century and first decades of the twentieth century
and establishes the theoretical framework for the article. Section 4 summarizes
Judge Cardozo’s legal reasoning and social jurisprudence through an analysis of his
contributions to the development of tort law and negligence. Section 5 summarizes
the facts of the Ultramares decision and the reasoning used by Judge Cardozo in
rendering that decision. Section 6 reviews certain reactions to Ultramares on the
part of the American Institute of Accountants in the period immediately subse-
quent to the decision, and Section 7 examines the manner in which the Ultramares
decision was interpreted in later periods. Concluding and summarising remarks are
provided in the final section.

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2. The American legal system and auditor liability


This section briefly outlines the structure of the American legal system and the
context of auditor liability within that system. The American legal system incorp-
orates both statutory law (that is, laws enacted by a duly constituted legislature
and approved by the executive body) and common law (that is, the accumulated
corpus of legal decisions rendered by judges and by courts). Beyond this primary
distinction into statutory law and common law, the American legal system can be
divided into criminal law (that is, the prosecution of acts deemed criminal by a
state or federal government) and civil law (that is, actions brought by private plain-
tiffs against defendants). Finally, there are both federal laws and state laws.
Auditors may face liability under criminal law and civil law (that is, common law),
as well as state law or federal law. Prosecutions of auditors for violations of crim-
inal laws were not common prior to the Sarbanes-Oxley Act of 2002 (US Public
Law No. 107–204). Legal actions brought against auditors pursuant to federal
statutory laws (primarily the Securities Acts of 1933 and 1934) constitute a major
portion of all legal actions against auditors. These types of actions are civil actions
rather than criminal actions, even though they are based on statutory laws. When
actions are brought under statutory laws, they are often accompanied by compar-
able actions brought under common law using various theories of negligence or
fraud. Malpractice, misrepresentation and economic negligence are similar terms
used in some jurisdictions as the basis for common law actions against auditors.1
These terms, like negligence, are collectively addressed under the law of torts.2
Torts are defined as acts of one person that harm another person or a person’s
property. The harm may be physical, such as death or injury, or involve damage to
a person’s property. Alternatively, the harm may be of an economic nature, such as
damage to a business or diminution in the value of property (for example share
ownership in a company). Legal claims requesting compensation for damages
caused by negligent acts are usually tried before a judge and jury, and the prin-
ciples of common law are applied in deciding such cases (Feinman, 1996).
Because an audit involves a contractual arrangement between an auditor and
a client, contract law has often been used to determine the extent of an auditor’s
liability for negligent acts (Davies, 1979). Since the purpose of conducting an audit,
in a general sense, is to add credibility to the financial statements of the client for
the benefit of the “users” of the financial statements, there needs to be a determin-
ation as to who the users are in order to determine the auditor’s responsibilities.
Among the possible classes of users are: present or prospective shareholders, pres-
ent and potential creditors, employees, customers, labor unions, suppliers and
others. The various users can be described collectively as “third parties” with
respect to the contractual agreement between the auditor and the client. Auditors
may be sued on the grounds that an auditor’s negligence while performing an audit

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caused damage to a user for which compensation ought to be received. However,


courts have had difficulty determining precisely to whom an auditor owes a duty
of care not to be negligent while performing his or her professional duties. For
example, an auditor might owe a duty of care to one of the following three classes
of persons: (1) those with whom the auditor is in privity of contract (that is the
client); (2) a known and intended class of third-party beneficiaries; or (3) any per-
son the auditor should reasonably foresee as actually being or becoming a third-
party beneficiary (Chaffee, 1988). The various legal cases in the USA that have
addressed the matter of auditor liability towards third parties under common law
have struggled to find an answer to the question of exactly to whom an auditor
owes a duty of care not to be negligent.
This brief summary of auditor liability in the context of the American legal
system illustrates several key questions that confronted Chief Judge Cardozo in
1931 when he was faced with a case dealing with auditor negligence. The first ques-
tion was, does an auditor owe a duty of care to anyone other than to the client?
Second, given that there were no established auditing or accounting standards in
the USA in the late 1920s, who should decide what the duties of auditors should
be? Third, is there a distinction between ordinary negligence, for which there may
be no culpability, and a higher degree of negligence (“heedless disregard”) for
which there may be culpability? These questions were at the heart of tort law dur-
ing the first several decades of the twentieth century.

3. Historical developments in tort law and negligence


Although the basic principles of tort law can be traced to the earliest laws of civil-
ization, the emergence of tort as a distinct area within the common law is of rela-
tively recent origin. There were no treatises on torts published before 1850, either
in Great Britain or the USA (Friedman, 1973, p.299). “The explosion of tort law
and negligence in particular, has to be attributed to the Industrial Revolution, to
the age of engines and machines” (Friedman, 1973, p.300).
Rustad and Koenig (2002, p.5) distinguish four eras in the development of tort
law: (1) The Absolute Liability Era: 1200–1825; (2) The Laissez-Faire Negligence
Era: 1825–1944; (3) The Democratic Expansionary Era: 1945–1980; and (4) The
Neo-Conservative Legal Consciousness: 1981 to the present. This article discusses
only the evolution of tort law during the Laissez-Faire Negligence Era; however, as
Rustad and Koenig point out, changes in legal liability through time have often
occurred in response to social and economic conflicts.

As William L. Prosser, in his classic tort treatise, observed, “perhaps more than
any other branch of the law, the law of torts is a battleground of social theory.”
Although torts are sometimes perceived as a system of immutable rules, tort
remedies are inevitably contested and contestable socio-legal terrain. Our

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review of the historical waxing and waning of rights and remedies demon-
strates that torts have never been and can never be value-neutral. As
Mannheim reminded us, all law reflects social and economic interests. (Rustad
& Koenig, 2002, p.8)

The Laissez-Faire Negligence Era (1825–1944), reflected the “laissez-faire” atti-


tudes regarding politico-economic policy and judicial decision-making that pre-
vailed during that period. The assumption was that the economy should be allowed
to function largely on its own (Friedman, 2002a, p.37). Interference with business
activities by the government and the courts was not considered to be appropriate.
The laws pertaining to negligence often reflected the views of judges who were
reluctant to expand the scope of tort law. Limits were placed on the extent of
recovery for negligent acts (Friedman, 2002a, p.301). The courts did not look
favorably on extensions of tort liability (Friedman, 2002a, pp.467–8). “If railroads
and enterprise generally had to pay for all damage done ‘by accident,’ lawsuits
could drain them of their economic blood … The aim of the judges was to limit
damages to some moderate measure” (Friedman, 2002a, p.469). This “moderate
measure” was located within what judges considered to be socially reasonable
bounds. “The spirit of the age was a spirit of limits on recovery. People lived with
calamity; they had no sense (as would be true in the 20th century) that somebody
was always responsible” (Friedman, 2002a, p.470).
During the course of the nineteenth century, most tort actions were based on
injuries to persons (Friedman, 2002a, p.43). Even though the law of torts provided
courts with the legal power to expand liability for negligence, from 1850 to 1910, the
courts developed doctrines, such as contributory negligence, assumption of the risk,
and the fellow servant rule, which limited legal liability. Victims could recover only
if they could demonstrate that the enterprise was clearly negligent. An emphasis on
protecting the business enterprise often precluded recovery. The slightest amount of
contributory negligence would cause dismissal of the case. Public discontent grad-
ually prompted a change in these attitudes. “Modern tort law grew up at the close of
the nineteenth century when progress toward the recognition of fault or moral
responsibility became the chief basis for liability” (Rustad & Koenig, 2002, p.9).
Legislatures began to remove obstacles that previously had stood in the way
of plaintiffs. While this did not take place overnight, the changes eventually led to
what some have characterized as a “liability explosion” (Friedman, 2002b, p.349).
Even though tort law deals with a variety of civil wrongs, the heart of tort law is
based on personal injury arising from negligence. Railroads and factories often
caused injuries that led to lawsuits. Plaintiffs argued that it was the negligence of
the owners and operators of the railroads and factories that caused these injuries,
and the courts began to accept these arguments. What followed was a whole new
body of law, constructed case by case. Consequently, the law of tort became a tool
in the struggle for social justice (Bender, 1998).

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In the early years of the twentieth century, there was an expansion of tort
law, accompanied by the recognition of new classes of plaintiffs and new cate-
gories of action (Dobbs, 2000). For example, the MacPherson v. Buick Motor
Company decision made it possible for the first time for consumers to sue manu-
facturers directly for defective products,3 and the Glazer v. Shepard decision made
it possible to recover damages for economic loss rather than mere physical loss.4
These cases set the stage for a possible increase in the scope of auditor liability to
thirdparties.

The emergence of professional accounting as an institutional mechanism


to facilitate economic transactions
Another factor which set the stage for a possible increase in the scope of auditor
liability to third parties under US common law involved the rapid transition of the
US economy from primarily agricultural to increasingly urban and industrial. One
feature of this transition was the development of new ways of raising capital that
included not only an increased level of participation by banks and other lending
institutions but also the growth of stock exchanges in which individual investors
began to participate in large numbers. Capital market transactions were largely
unregulated in the early years of the twentieth century, and there were asymmetries
in the distribution of financial information, a condition that enhanced risk percep-
tions and transaction costs (North, 1990). In order to reduce the perception of risk,
an institutional mechanism began to evolve in which professional accountants and
auditors located in the major financial centers began to provide “certifications”
regarding the reliability of financial information generated by business entities that
wanted to raise capital from external investors. Because investors and creditors
lacked contractual privity with the auditor, the only legal option available to per-
sons who felt that they had been misled by professional accounting negligence was
litigation for fraud. Fraud was difficult to prove and it typically necessitated a show-
ing of intent to deceive on the part of the auditor. The various legal cases pertain-
ing to auditor liability uniformly found that mere negligence in the performance of
professional duties was insufficient to hold the auditor liable for damages to third
parties (Davies, 1979). In the Seaver v. Ransom decision,5 the court emphasized the
rule that extra-contractual liability would be limited by saying:

The general rule, both in law and equity was that privity between a plaintiff
and a defendant is necessary to the maintenance of an action on contract. The
consideration must be furnished by the party to whom the promise was made.
The contract cannot be enforced against the third party, and therefore it can-
not be enforced by him.

One year later, in the case of Landell v. Lybrand,6 another American court
attempted to formalize the distinction between fraud and ordinary negligence. In

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explaining this distinction the court reasoned:

There was no contractual relationship between the plaintiff and defendants,


and if there is any liability from them to him, it must arise out of some breach
of duty, for there is no averment that they made the report with intent to
deceive him. The averment in the statement of claim is that the defendants
were careless and negligent in making their report, but the plaintiff was a
stranger to them and to it, and, as no duly rested upon them to him, they can
not be guilty of any negligence of which he can complain.

Thus, the court argued that a distinction should be made between fraud and neg-
ligence, and that a distinction should also be made between intent, which is neces-
sary to prove the existence of fraud, and mere negligence. If fraud could be proven,
the plaintiff could recover damages, but if it was a matter of negligence, the plain-
tiff could not recover. This distinction generally provided auditors with a defense
against third-party legal actions. It will be seen that the Ultramares decision, which
opened up the possibility of auditor liability to third parties for negligence, was
based on the legal reasoning used by Chief Judge Cardozo in deciding other cases
unrelated to auditor negligence but which nevertheless required a creative and
progressive interpretation of tort law.

4. The role of Benjamin Cardozo in expanding the law of negligence


Benjamin Cardozo is considered to have been one of the progressive voices in the
development of American tort law and negligence. However, he reflected the spirit
of his times in that while he crafted progressive solutions to social problems, his
decisions were situated within the context of maintaining conformity with legal
precedents. As one commentator put it:

Cardozo’s technique of judging … was not, as he implied, picking and choosing


among “methods”, but rather a use of various justification devices in com-
bination. His “methods” more accurately reflect his conception of how types of
legal transactions could be grouped. His use of the methods illustrated his
instincts for subtlety and artistry and his recurrent concern with preserving a
power in common law judges to be creative. Cardozo’s conception of judging
was activist, innovative, and as his career progressed, increasingly self-confi-
dent. But it was articulated in modes of analysis that de-emphasized activism,
minimized innovativeness, and suggested that judicial wisdom lay in tentative,
measured, incremental decision making. (White, 2003, p.123)

Cardozo was an important contributor to a changing nature of legal scholar-


ship that had begun in the late nineteenth century, which involved an evaluation
of the underlying logic of precedents rather than mere reference to authoritative
texts (Stevens, 1983). It should be noted that while Cardozo was an important

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figure in this trend, he was part of a wider effort that was seeking to extend the
scope of law in response to a changing socioeconomic context in the early years of
the twentieth century. Cardozo’s progressivism embodied a sensitivity to the
changing social context, but it also reflected a new approach to the practice of law
through an emphasis on argumentation based on the analysis of legal precedents.
Cardozo was born and raised in New York City. His ancestors were Sephardic
Jews who immigrated to North America before the American Revolution. His
father was a successful attorney, and Cardozo himself lived a cultured, intellectual
and financially comfortable life. He attended law school at Columbia University
and practiced law in the appellate courts of New York State during the early years
of the twentieth century. He was appointed to be a judge of the Supreme Court (the
lowest court) in 1913, and he was elevated to Court of Appeals in 1917. Later,
he became an Associate Justice of the US Supreme Court (the highest court in the
USA). Cardozo is probably best known for his opinions as Chief Judge of the
New York State Court of Appeals (Levy, 1938).
Cardozo wrote several groundbreaking opinions in the area of tort law and
negligence. For example, the MacPherson v. Buick Motor Co. case,7 previously
referred to, involved an injury to the driver of an automobile when a defective
wheel broke. Cardozo’s opinion, which allowed recovery by the driver against the
manufacturer of the automobile, went against established legal precedents that
had previously prevented consumers from recovering damages from manufactur-
ers of products unless the consumer had bought the product directly from the
manufacturer. In MacPherson, Judge Cardozo circumvented the privity concept
and allowed the injured third party to recover damages from the manufacturer
directly. In order to overcome the precedents, Cardozo referred to the imminent
danger associated with the use of certain products. He argued:

If the nature of a thing is such that it is reasonably certain to place life and limb
in peril when negligently made, it is then a thing of danger. If to the element
of danger there is added the knowledge that the thing will be used by persons
other than the purchaser, and used without new tests, then, irrespective of
contract, the manufacturer of this thing of danger is under a duty to make it
carefully.

Although an argument could be made that an auditor’s services constitute


a product, and thus an audit should fall under the MacPherson rule, American
courts usually made a clear distinction between physical loss and economic loss.
This concept changed in 1922, when the New York Court of Appeals heard the
case of Glanzer v. Shepard.8 In that case, Judge Cardozo crafted an extension of li-
ability to third parties for economic damages. It was the first case to allow a third-
party plaintiff to recover when the only damage was financial loss. The court
imposed liability for the loss incurred by a purchaser of beans when the bean
weigher, under contract to the seller, certified an erroneous weight for the beans.

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Even though Judge Cardozo recognized that the plaintiff was not a party to the
weigher’s contract, his opinion reasoned that the plaintiff was the primary
beneficiary of the contract, and thus, the weigher owed a duty of care to the plain-
tiff. This ‘primary benefit’ concept was summarized by Cardozo as follows:
The plaintiff’s use of the weigher’s certificate was not an indirect or collateral
consequence of the action of the weigher. It was a consequence which, to the
weigher’s knowledge, was the end and aim of the transaction.

Because the ‘end and aim’ of the transaction was to provide a service to the buyer,
the buyer was deemed to have a cause of action against the weigher, either on the
basis of negligent performance of the service, or, alternatively, as the ‘third-party
beneficiary’ of the weigher’s contract with the seller (Feinman, 2003). While the con-
tract for the sale of beans was solely between the buyer and the seller of beans, the
close connection between the weigher and the sale required the weigher to exercise
a higher duty of care than in other circumstances. In addition to creating the possi-
bility of recovery for economic loss, Cardozo also expanded the duty of care concept
to include certain types of third parties, that is those who were specifically foreseen.
In contrast, in the Palsgraf v. Long Island Railroad decision,9 a railroad con-
ductor was alleged to have acted negligently while helping a passenger to climb
aboard a moving train. The passenger dropped a parcel, causing the fireworks
inside the parcel to explode, thus injuring the plaintiff who was standing on the
train platform 25 feet away. Judge Cardozo concluded that the railroad was not
liable because liability would extend only to “foreseeable” plaintiffs, and the
injured plaintiff was not foreseeable in this context. “This triad of cases
(MacPherson, Glanzer and Palsgraf) marked a significant shift in the common law:
the restrictive notion of privity of contract was being phased out as a requirement
to recover for either physical or economic loss. It was being replaced by a liability-
expanding theory of negligence” (Paschall, 1988, p.710). Responsibility for neg-
ligence was no longer determined solely pursuant to the terms of a contractual
agreement; instead it was being expanded to include third parties whom the defend-
ant could foresee would be affected by his or her negligent acts. Based on the logic
of these precedents, it appeared likely that the liability of auditors might be
extended beyond their clients to the third parties who relied on audited financial
statements (Besser, 1983).

5. The Ultramares decision


Ultramares v. Touche,10 decided in 1931, was the most important case dealing with
auditor liability to third parties under US common law during part of the twentieth
century. The Ultramares lawsuit was brought by Ultramares Corporation against
Touche, Niven & Co (Touche). The case involved Fred Stern & Company (Stern),
an importer and trader in rubber products with offices in New York City. In

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January 1924, Touche was employed as an external auditor by Stern in order to


certify a balance sheet that purported to show the financial condition of Stern at
31 December 1923. To finance its operations, Stern regularly borrowed large sums
of money from banks and other lenders. Touche knew that in the usual course of
business the certified balance sheet would be distributed by Stern to banks and
other interested parties. Accordingly, when the balance sheet was prepared, the
auditors supplied Stern with 32 copies. However, nothing was mentioned about the
persons to whom these copies might be shown or the nature of the transactions in
which they would be used. In particular there was no mention of the plaintiff,
Ultramares, a corporation doing business, as a factor.
On 26 February 1924, the audit was completed and the balance sheet was
issued. The balance sheet reflected assets of US$2,550,672 and liabilities of
US$1,479,956, thus showing a net worth of US$1,070,716. In reality, Stern was insol-
vent.The books had been falsified to reflect accounts receivable that were fictitious.
During 1924, Ultramares made several loans to Stern; however, on 2 January 1925,
Stern was declared bankrupt. Ultramares filed a lawsuit against Touche in
November 1926, claiming that Touche was negligent in performing its audit. During
the trial Ultramares also asserted that Touche had engaged in fraudulent behavior.
The trial judge dismissed the fraud charge without submitting it to the jury. The
judge then instructed the jury that the auditors might be held liable if they knew
that the results of their audit would be communicated to creditors and if they per-
formed their work negligently (that is, failure to use reasonable and ordinary care).
The jury issued a verdict in favor of the Ultramares for US$187,576. However, the
judge dismissed this verdict based on a lack knowledge on the part of Touche of the
existence of Ultramares. The Appellate Court affirmed the dismissal of the fraud
charge but reversed the dismissal of the negligence charge, and reinstated the ver-
dict. The decision of the Appellate Court was then appealed to the highest court,
the New York Court of Appeals.
In his opinion as Chief Judge of the New York Court of Appeals, Cardozo
wrote that if the auditor’s actions amounted to “negligent misrepresentation”, they
would not be liable to Ultramares because Ultramares was not a third-party benefi-
ciary of the contract between Stern and Touche. However, if the auditor’s actions
constituted “fraudulent misrepresentation”, then liability would ensue. The question
was whether there was a point in the range of auditor conduct between the negligent
and the fraudulent where the conduct would become culpable. Judge Cardozo
implied that there was such a point. His term for this was “gross negligence”, and he
suggested that if the auditor’s conduct was so negligent as to justify a finding that
they had no genuine belief in the accuracy of the financial statements, their behav-
ior would be culpable. Cardozo argued that gross negligence, “even when not equiv-
alent to fraud, was nonetheless evidence to sustain an inference of fraud” (Ultramares
v. Touche, 1931, p.192). Thus, he opened the door to the possibility of holding an

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auditor liable, even to third parties, for negligent acts so gross that they could be con-
strued as being equivalent to fraud. It would be up to the jury to decide in a particu-
lar case whether the auditor’s conduct could be interpreted to be equivalent to fraud
within the range of conduct from ordinary negligence to gross negligence or fraud.
In reaching these conclusions Judge Cardozo stressed the following points:

From the foregoing analysis the conclusion is, we think, inevitable that noth-
ing in our previous decisions commits us to a holding of liability for negligence
in the circumstances of the case at hand, and that such liability, if recognized,
would be an extension of the principle of those decisions to different condi-
tions, even if more or less analogous. (p.185)
Our holding does not emancipate accountants from the consequences
of fraud. It does not relieve them if their audit has been so negligent as to jus-
tify a finding that they had no genuine belief in its adequacy, for this again is
fraud. It does no more than say that if less than this is proved, if there has been
neither reckless misstatement nor insincere profession of an opinion, but only
honest blunder, the ensuing liability for negligence is one that is bounded by
the contract, and is to be enforced between the parties by whom the contract
has been made. (p.188)
The defendants certified as a fact, true to their own knowledge, that the
balance sheet was in accordance with the books of account. If their statement
was false, they are not to be exonerated because they believed it to be true. We
think the triers of the facts might hold it to be false. (p.189)

6. Reactions to Ultramares
The American Institute of Accountants (predecessor body to the American
Institute of Certified Public Accountants) recognized the potential for the
Ultramares case to have a significant impact on the practice of public accountancy.
This recognition prompted the Institute to file an amicus curiae brief with the
New York Court of Appeals, in which they summarized their concerns as follows.

If the rule contended for by the plaintiff should be finally be sustained, the
more reputable and responsible firms of accountants will not be able to afford
to take the financial risk of a jury finding that the action of some subordinate
constituted negligence by reason of which the accountant would be liable to
the world for an indefinite and unlimited sum and for an indefinite and unlim-
ited period. Such a rule would very seriously affect all business transacted
where statements, certified by accountants, have been customarily used, as in
connection with the lending of money by banks and the purchase of securities
from bankers. (American Institute of Accountants, 1931, p.16)

Judge Cardozo responded to the concerns of the Institute by paraphrasing the


words of the Institute’s brief in his opinion:

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

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accountants to a liability in an indeterminate amount for an indeterminate


time to an indeterminate 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. (p.180)

However, he also wrote that:


We conclude, to sum up the situation, that in certifying to the correspondence
between balance sheet and accounts the defendants made a statement as true
to their own knowledge, when they had, as a jury might find, no knowledge on
the subject. If that is so, they may also be found to have acted without infor-
mation leading to a sincere or genuine belief when they certified to an opinion
that the balance sheet faithfully reflected the condition of the business. (p.193)

What this meant was that if a jury found that the auditor did not perform their
duties in accordance with professional standards, or if they heedlessly disregarded
the facts underlying the financial condition of the client, they might be held liable
under a theory of gross negligence, which would be equivalent to fraud. In this way,
Judge Cardozo was seeking to expand the boundaries of tort law, much as he had
done in the McPherson and Glanzer cases. At the same time, he was reluctant to
extend auditor’s liability to third parties for ordinary negligence because he felt
that this might open up a floodgate of lawsuits. This public policy decision has
obscured the progressive nature of Cardozo’s opinion, given the nature of the times
and circumstances.
It should be remembered that the case took place at the end of the “roaring”
1920s and in the early years of the Great Depression. Audited financial statements
were relatively common, but “generally accepted auditing standards” were only in
rudimentary form. There was no standardized form of audit certification for
receivables. Judge Cardozo was breaking new ground by attempting to determine
exactly what the responsibilities of auditors were and to whom these responsibil-
ities extended. There were no federal securities laws and no state securities laws to
refer to. Hence, his decision had to be made on the basis of prior cases dealing with
tort law and negligence and also his sense of social jurisprudence. Because Judge
Cardozo was one of the progressive voices in tort law, it might have been expected
that he would attempt to expand an auditor’s duty of care to third-party users of
financial statements. However, this would have been a radical position at the time,
and it would have been out of character for Cardozo.
What is interesting to note is that even though Judge Cardozo was searching
for a way to expand auditor’s responsibility to third parties, the Ultramares deci-
sion has generally been interpreted in ways that have protected auditors against
lawsuits from third parties. The Ultramares decision has been upheld on various
occasions in New York State and it has become one of the leading decisions on
auditor liability in the USA.11 It can be seen that the origins of auditor liability to
third parties under US common law can be found specifically in the facts of the

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Ultramares case, and more generally in the legal reasoning employed by Judge
Cardozo when confronted with various cases dealing with torts and negligence
during the 1920s. Judge Cardozo had to determine what an auditor’s responsibil-
ities were and whether the auditor owed a duty of care at all to third parties. With
respect to this latter point he indicated that there was a duty not to heedlessly dis-
regard the facts, which would be equivalent to fraud; however, there might not ne-
cessarily be a duty to third parties with regard to ordinary negligence. To act with
heedless disregard, or gross negligence, would be equivalent to fraud, which would
be culpable, and a third party would have a course of action but there would be no
course of action if the auditor was negligent in an ordinary sort of way. Thus, even
though Judge Cardozo opened the door to an expanded scope of auditor liability
to third parties, the door was not opened widely. It was left up to subsequent courts
to decide how wide the door would eventually be opened. The following sections
discuss several questions originally raised by Judge Cardozo in the Ultramares case
that have not yet been fully answered.

7. Discussion of the law of negligence as applied to auditors


after Ultramares
Because an audit involves a contractual arrangement between an auditor and a
client, there have been ongoing debates about whether contract law or tort law
should be used to determine an auditor’s liability to third parties. Contract law
shields the contracting parties from liability to third parties because it is assumed
that the contracting parties do not owe a duty of care to persons who are not parties
to the contract. “For nearly fifty years, the issue of auditor liability to third-parties
was dominated by whether tort or contract law should govern” (Buffington, 1997,
p.487). Under contract law, third parties must demonstrate that they were the
intended beneficiary of the contract between the parties at the time of the contract,
while in tort law, there may not be a requirement to demonstrate a connection
between the negligent party and the plaintiff; there may only be a need to demon-
strate that the auditor was negligent and that there was a duty of care not to be neg-
ligent. The critical issue is whether tort or contract law governs. “If contract law
governs, this is essentially dispositive because most third-parties, other than those
who meet the strict privity criteria as third-party beneficiaries, will lack standing to
sue” (Garfield, 1995). In a historical sense, auditors were shielded against lawsuits
brought by third parties under contract law. However, a number of states aban-
doned the contract-based theory in favor of a negligence regime, resulting in an
expanded scope of auditor liability to third parties. The question remains, however;
which third parties owed a duty of care by the auditor.
While it is reasonably clear that if an auditor engages in fraudulent conduct,
the auditor’s liability extends both to clients and to third parties; what is not clear

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is the extent of auditor liability to third parties for acts that may be negligent
but not fraudulent. Auditor exposure to liability for ordinary negligence has been
the focus of this article. Ordinary negligence is defined as the failure of the auditor
to exercise due professional care, whereas gross negligence is a reckless disregard
of due professional care (Thompson & Quinn, 1996). For an act to be considered
fraudulent, there must be a showing of intent or scienter, which was defined by the
US Supreme Court in Ernst & Ernst v. Hochfelder as “a mental state embracing
intent to deceive, manipulate or defraud”.12 This was also the definition used in the
Landell v. Lybrand case in 1919, although the term scienter was not used in that case.

Differences among common law interpretations of an auditor’s duty of care


to third parties
The cases that have interpreted the common law regarding an auditor’s duty of
care to third parties have varied from state to state within the USA and are not
uniform among the states (Pacini et al., 2000). In deciding different cases, the
courts have focused on four possible legal standards to decide which third parties
might have a cause of action against auditors for negligence: (1) Privity of Contract
Doctrine; (2) the Near Privity Standard; (3) the Known User or Restatement of
Torts Standard; and, (4) the Reasonable Foreseeability Rule (Pacini et al., 2000).

The privity of contract doctrine


As discussed previously, this standard maintains that an auditor’s duty of care is
only to the client; in other words, the auditor does not owe a duty of care to third
parties. Landell v. Lybrand,13 decided in 1919, held the auditor was not liable to the
plaintiffs for negligence because there was “no averment of intent to deceive”
(Causey, 1979). Since the reason for engaging an auditor in the first place is to
provide an opinion on the financial statements, to say that an auditor owes no duty
of care to third parties seems contrary to common sense. Nevertheless, the privity
of contract doctrine was held to be the rule in many states for many years (Faussie,
1994). A number of courts have questioned the privity of contract doctrine
(Rosenblum v. Adler, 1983), but the highest courts in a majority of the states
have not held auditors liable under common law for ordinary negligence to third
parties (Faussie, 1994).

The near privity standard


The second standard for considering an auditor’s duty of care to third parties under
common law has been referred to as the “near privity” standard. Under this approach,
an auditor is deemed to have a duty of care to those parties with whom the auditor
has an acknowledged relationship. The foreseen user doctrine was developed in the
Credit Alliance case in New York State.14 In Credit Alliance, the New York Court of
Appeals reaffirmed the basic rational of the Ultramares case, but also specified the

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following additional prerequisites before an auditor may be held liable for ordinary
negligence to third parties: (1) the auditor must have been aware that the financial
statements were to be used for a particular purpose or purposes by a known party or
parties; (2) in furtherance of the particular purpose, the known parties were intended
to rely on the financial statements; and, (3) there must be some conduct on the part
of the auditor linking the auditor to the known party or parties that demonstrates the
auditor’s understanding of the reliance.

The Restatement of Torts


Another way of considering an auditor’s duty of care to third parties under com-
mon law is referred to as the Restatement of Torts approach. The Restatement of
Torts is said to be the closest one can come to a consensus of opinion regarding the
issue of duty of care (Bily v. Arthur Young, 1992). Section 552 of the Restatement
of Torts provides:

(1) One who, in the course of his business, profession or employment, or in any
other transaction in which he has a pecuniary interest, supplies false informa-
tion for the guidance of others in their business transactions, is subject to li-
ability for pecuniary loss caused to them by their justifiable reliance upon the
information, if he fails to exercise reasonable care or competence in obtaining
or communicating the information. (2) Except as stated in subsection (3), the
liability stated in subsection (1) is limited to loss suffered (a) by the person or
one of a limited group of persons for whose benefit and guidance he intends
to supply the information or knows that the recipient intends to supply it, and
(b) through reliance upon it in a transaction that he intends the information to
influence or knows that the recipient so intends or in a substantially similar
transaction. (3) The liability of one who is under a public duty to give the infor-
mation extends to loss suffered by any of the class of persons for whose bene-
fit the duty is created, in any of the transactions in which it is intended to
protect them. (American Law Institute, 1990)

Although the Restatement of Torts does not constitute US law, its principles have
been widely used in deciding US cases (Bily v. Arthur Young, 1992, p.15). A strict
reading of the Restatement of Torts might lead one to conclude that an auditor
owes a duty of care to persons who rely on financial statements when making
investment and credit decisions. However, an official interpretation of the
Restatement of Torts states that an auditor is not liable to third-party investors and
creditors generally, but only to those third parties whom the auditor specifically
knows will rely on the audited statements.

The foreseeable user doctrine


A final way of considering an auditor’s duty of care to third parties is referred to
as the “foreseeable user” doctrine. In Rhode Island Hospital Trust v. Swartz et al.,15
and in Rosenblum v. Adler,16 decided in New Jersey in 1983, the courts developed

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the concept that an auditor owes a duty of care to all foreseeable users, including
shareholders and prospective shareholders. This is a minority view among the
states of the USA.

8. Concluding Remarks
Foreseeability remains a complex subject when considering an auditor’s liability to
third parties under common law. How far is foreseeable? For example, there might
be an automobile accident occurring on a bridge connecting two parts of a city. It
may be foreseeable that there would be damage to cars and drivers but what about
the potential losses to enterprises located near the bridge? A doctrine of foresee-
ability could include many potential plaintiffs. The public policy concerns raised by
Judge Cardozo in the Ultramares case prompted most states to move to a middle
ground, like that articulated in the Restatement of Torts. This approach adopts the
position that an auditor owes a duty of care to third parties who are members of a
group whose reliance is actually foreseen (as opposed to merely foreseeable) by the
auditor. This view represents a compromise between a complete shielding of audit-
ors against liability from lawsuits brought by all third parties to a complete protec-
tion of the interests of all users of audited financial statements (Checchia, 1993).
While the adoption of a uniform standard might eliminate uncertainty for
auditors, there is currently no uniform solution. Commentators have disagreed
about the appropriate rule to apply, but they are in agreement that greater
uniformity is needed (Bagby & Ruhnka, 1987; Causey, 1979; Buffington, 1997). The
emergence of new theories of law such as “economic negligence” have been rec-
ommended as a solution for dealing with inconsistencies in the rules (Feinman,
1996). Such an approach may be needed as the common law responds to the
changing needs of society. For example, lawsuits based on negligent preparation of
financial information provided through the Internet may pose new challenges for
the treatment of auditor liability to third parties under common law.
Over time the common law has become more responsive to an increasingly
complex business environment. Has there been progress? Yes, but the common
law is not necessarily the most appropriate institutional mechanism for resolving
the problems posed by an asymmetric distribution of financial information
between companies and third-party investors and creditors (North, 1990). This is
why, shortly after the Ultramares decision, one of the central elements of the New
Deal legislative program of Franklin D. Roosevelt was the drafting of a federal
securities law. Felix Frankfurter, who subsequently became, like Benjamin
Cardozo, a member of the US Supreme Court, was the New Deal staff member
appointed by Roosevelt to draft the federal securities law (Landis, 1959). These
laws contained many aspects dealing with accounting and auditing including the
definitions of “independent accountant” and “generally accepted accounting

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standards”. These provisions were intended to protect the interests of third party
users of financial statements. As a result of the federal securities laws, the risk of
loss in financial transactions was shifted in part from users of financial statements to
auditors. However, the federal securities laws did not prevent significant losses from
occurring as a result of misleading financial statements. Have there been trade-offs
in terms of transaction costs between investors and agents such as public account-
ants because of the redefinition of professional responsibilities? Yes. Lawsuits
against auditors alleging professional negligence have grown significantly in the
years since the Ultramares decision. At the same time, it must be recognized that
this has been largely the result of a general expansion in the ability and willingness
to bring lawsuits in the USA and not due to a fundamental change in the common
law regarding auditor liability to third parties.
Societal changes have often affected the development of tort law and negli-
gence as the common law has been used as a vehicle for implementing changes aris-
ing from cultural and economic shifts.While Cardozo was an important pioneer in the
expansion of tort law, he was also part of a growing trend that sought to extend the
scope of the law in response to a changing socio-economic context. Cardozo’s pro-
gressivism not only embodied a sensitivity to a changing social context; it also re-
flected a new approach to the practice of law through an emphasis on argumentation
based on the analysis of legal precedents (Wiebe, 1967). Liability for negligence, as
well as for auditor liability within negligence, has consequently expanded throughout
the twentieth century. Tort law often expands as a means of deterring undesirable
behavior and as a means of providing compensation to victims. However, the scope
of tort law can sometimes be restricted when public policy concerns concentrate on
the unfavorable results of unlimited liability.Thus, Judge Cardozo’s concerns about an
indeterminate liability to an indeterminate class of plaintiffs continue to be of inter-
est when considering an auditor’s liability to third parties under common law.The ori-
gins of auditor liability to third parties under common law can be found in the legal
reasoning employed by Judge Cardozo in deciding cases unrelated to auditing, but
the factors associated with the origins of auditor liability to third parties have been
enmeshed with the intricacies of answering the question “to whom the auditor owes
a duty of care” and what is the degree of foreseeability of that duty.

Notes
1. See Feinman (1996) for a discussion of the distinctions between malpractice, mis-
representation and economic negligence.
2. The word, “tort”, is an Anglo-French term, which means “wrong”. It encompasses a
collection of misdeeds, with negligence being the primary cause of action. Torts are
usually distinguished from crimes and also from breaches of contract. Consequently,
tort law is concerned with civil wrongs that do not arise from contracts.

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3. MacPherson v. Buick Motor Co. (1916), 217 NY 282.


4. Glanzer v. Shepard (1922), 233 NY 236, 135 NE 275.
5. Seaver v. Ransom (1918), 224 NY 233.
6. Landell v. Lybrand (1919), 264 PA 406.
7. MacPherson v. Buick Motor Co. (1916), 217 NY 282.
8. Glanzer v. Shepard (1922), 233 NY 236, 135 NE 275.
9. Palsgraf v. Long Island Railroad (1928), 248 NY 339, 162 NE 99.
10. Ultramares v. Touche (1931), 255 NY 170.
11. See for example: Security Pacific Business Credit, Inc. v. Peat Marwick Main & Co.
(1992), 79 NY2d 695.
12. Ernst & Ernst v. Hochfelder (1976), 425 US 185.
13. Landell v. Lybrand (1919), 264 PA 406.
14. Credit Alliance Corporation v. Arthur Andersen & Co. (1985), 483 NE 2d 110.
15. Rhode Island Hospital Trust National Bank v. Swartz, Bresenoff, Yavner & Jacobs
(1972), 455 F 2d 847, 851.
16. Rosenblum v. Adler (1983), 93 NY 324.

References

Primary sources: legal cases


Bily v. Arthur Young & Company (1992), 3 Cal.4th 370.
Credit Alliance Corporation v. Arthur Andersen & Co. (1985), 483 NE 2d 110.
Ernst & Ernst v. Hochfelder (1976), 425 U.S. 986.
Glanzer v. Shepard (1922), 233 NY 236, 135 NE 275.
Landell v. Lybrand (1919), 264 PA 406.
MacPherson v. Buick Motor Co. (1916), 217 NY 282.
Palsgraf v. Long Island Railroad (1928), 248 NY 339, 162 NE 99.
Rhode Island Hospital Trust National Bank v. Swartz, Bresenoff, Yavner & Jacobs
(1972), 455 F 2d 847, 851.
Rosenblum v. Adler (1983), 93 NJ 324.
Seaver v. Ransom (1918), 224 NY 233.
Security Pacific Business Credit, Inc. v. Peat Marwick Main & Co. (1992), 79 NY 2d 695.
Ultramares v. Touche (1931), 255 NY 170.

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North, D.C. (1990), Institutions, Institutional Change and Economic Performance,


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Addresses for correspondence: C. Richard Baker, School of Business, Adelphi


University, Garden City, NY 11530. E-mail: Baker3@Adelphi.edu; Deborah
Prentice, School of Business and Economics, North Carolina A&T State
University, Greensboro, NC 27411. E-mail: dprentic@ncat.edu

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