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The origins of auditor liability to third parties under United States common
law
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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.
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.
164
165
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
166
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)
167
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 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
168
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.
169
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.
170
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).
171
172
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)
173
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
174
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.
175
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.
176
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.
(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.
177
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
178
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.
179
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