Bily v. Arthur Young & Co.

• Decision Date: 27 August 1992
• Docket Number: No. S017199,S017199
• Citation: 11 Cal.Rptr.2d 51,3 Cal.4th 370
• Court: California Supreme Court
• Parties: , 834 P.2d 745, 61 USLW 2145, Fed. Sec. L. Rep. P 96,978, 48 A.L.R.5th 835 Robert R. BILY, Plaintiff and Respondent, v. ARTHUR YOUNG & COMPANY, Defendant and Appellant. J.F. SHEA CO., INC., et al., Plaintiffs and Appellants, v. ARTHUR YOUNG & COMPANY, Defendant and Appellant.

Page 51

11 Cal.Rptr.2d 51

3 Cal.4th 370, 834 P.2d 745, 61 USLW 2145,

Fed. Sec. L. Rep. P 96,978, 48 A.L.R.5th 835

Robert R. BILY, Plaintiff and Respondent, v. ARTHUR YOUNG & COMPANY, Defendant and Appellant.

J.F. SHEA CO., INC., et al., Plaintiffs and Appellants, v. ARTHUR YOUNG & COMPANY, Defendant and Appellant.

No. S017199.

Supreme Court of California In Bank.

Aug. 27, 1992.

As Modified on Denial of Rehearing Nov. 12, 1992. ^*

Heller, Ehrman, White & McAuliffe, M. Laurence Popofsky, Marie L. Fiala, Kirk G. Werner, Robert B. Hawk, Melanie C. Gold, Paul G. Urla, Paul Buchanan, San Francisco, Adria Balog, Washington, D.C., Carl D. Liggio and John Matson, New York City, for defendant and appellant.

Wilke, Fleury, Hoffelt, Gould & Birney, Thomas G. Redmon, Matthew W. Powell, Sacramento, Willkie, Farr & Gallagher, Louis A. Craco, Deborah E. Cooper, New York City, Diana B. Simon, Washington, D.C., Pettit & Martin, John L Boos, Laura D. Cooper, Philip F. Atkins-Pattenson and Dennis P. Scott, San Francisco, as amici curiae, on behalf of defendant and appellant.

Thelin, Marin, Johnson & Bridges, Paul H. Dawes, Karl D. Belgum, Timm A. VerDuin, Jennifer M. Wilcoxen, Dianne P. Urhausen, San Francisco, and Gene K. Cheever, Palo Alto, for plaintiffs and appellants.

Cotchett & Illston, Cotchett, Illston & Pitre, Joseph W. Cotchett, Susan Illston, Bruce L. Simon, Karen Karpen, Michael Liberty and Nancy L. Fineman, Burlingame, for plaintiff and respondent.

Wright & L'Estrange, Robert C. Wright and Laurie E. Barber, San Diego, as amici curiae, on behalf of plaintiff and respondent.

Christopher Chenoweth, John J. Gill, Michael F. Crotty, Washington, D.C., Mathew H. Street, Arlington, Va., Buchalter, Nemer, Fields & Younger, Marcus M. Kaufman, Newport Beach, Ware & Freidenrich, Peter M. Rehon, Lisa C. Roberts and Nels R. Nelsen, Palo Alto, as amici curiae, on behalf of plaintiffs and appellants and plaintiff and respondent.

LUCAS, Chief Justice.

We granted review to consider whether and to what extent an accountant's duty of care in the preparation of an independent audit of a client's financial statements extends to persons other than the client.

Since Chief Judge Cardozo's seminal opinion in Ultramares Corp. v. Touche (1931) 255 N.Y. 170, 174 N.E. 441 (Ultramares ), the issue before us has been frequently considered and debated by courts and commentators. Different schools of thought have emerged. At the center of the controversy are difficult questions concerning the role of the accounting profession in performing audits, the conceivably limitless scope of an accountant's liability to nonclients who may come to read and rely on audit reports, and the effect of tort liability rules on the availability, cost, and reliability of those reports.

Following a summary of the facts and proceedings in this case, we will analyze these questions by discussing the purpose and effect of audits and audit reports, the approaches taken by courts and commentators, and the basic principles of tort liability announced in our prior cases. We conclude that an auditor ¹ owes no general duty of care regarding the conduct of an audit to persons other than the client. An auditor may, however, be held liable for negligent misrepresentations in an audit report to those persons who act in reliance upon those misrepresentations in a transaction which the auditor intended to influence, in accordance with the rule of section 552 of the Restatement Second of Torts, as adopted and discussed below. Finally, an auditor may also be held liable to reasonably foreseeable third persons for intentional fraud in the preparation and dissemination of an audit report.

I. Summary of Facts and Proceedings Below

This litigation emanates from the meteoric rise and equally rapid demise of Osborne Computer Corporation (hereafter the company). Founded in 1980 by entrepreneur Adam Osborne, the company manufactured the first portable personal computer for the mass market. Shipments began in 1981. By fall 1982, sales of the company's sole product, the Osborne I computer, had reached $10 million per month, making the company one of the fastest growing enterprises in the history of American business.

In late 1982, the company began planning for an early 1983 initial public offering of its stock, engaging three investment banking firms as underwriters. At the suggestion of the underwriters, the offering was postponed for several months, in part because of uncertainties caused by the company's employment of a new chief executive officer and its plans to introduce a new computer to replace the Osborne I. In order to obtain "bridge" financing needed to meet the company's capital requirements until the offering, the company issued warrants to investors in exchange for direct loans or letters of credit to secure bank loans to the company (the warrant transaction). The warrants entitled their holders to purchase blocks of the company's stock at favorable prices that were expected to yield a sizable profit if and when the public offering took place.

Plaintiffs in this case were investors in the company. They include individuals as well as pension and venture capital investment funds. Several plaintiffs purchased warrants from the company as part of the warrant transaction. Others purchased the common stock of the company during early 1983. For example, one plaintiff, Robert Bily, who was also a director of the company, purchased 37,500 shares of stock from company founder Adam Osborne for $1.5 million.

The company retained defendant Arthur Young & Company (hereafter Arthur Young), one of the then-"Big Eight" public accounting firms, to perform audits and issue audit reports on its 1981 and 1982 financial statements. (Arthur Young has since merged with Ernst & Whinney to become Ernst & Young, now one of the "Big Six" accounting firms.) In its role as auditor, Arthur Young's responsibility was to review the annual financial statements prepared by the company's in-house accounting department, examine the books and records of the company, and issue an audit opinion on the financial statements.

Arthur Young issued unqualified or "clean" audit opinions on the company's 1981 and 1982 financial statements. Each opinion appeared on Arthur Young's letterhead, was addressed to the company, and stated in essence: (1) Arthur Young had performed an examination of the accompanying financial statements in accordance with the accounting profession's "Generally Accepted Auditing Standards" (GAAS); (2) the statements had been prepared in accordance with "Generally Accepted Accounting Principles" (GAAP); and (3) the statements "present[ed] fairly" the company's financial position. The 1981 financial statement showed a net operating loss of approximately $1 million on sales of $6 million. The 1982 financial statements included a "Consolidated Statement of Operations" which revealed a modest net operating profit of $69,000 on sales of more than $68 million.

Arthur Young's audit opinion on the 1982 financial statements was issued on February 11, 1983. The Arthur Young partner in charge of the audit personally delivered 100 sets of the professionally printed opinion to the company. With one exception, plaintiffs testified that their investments were made in reliance on Arthur Young's unqualified audit opinion on the company's 1982 financial statements. ²

As the warrant transaction closed on April 8, 1983, the company's financial performance began to falter. Sales declined sharply because of manufacturing problems with the company's new "Executive" model computer. When the Executive appeared on the market, sales of the Osborne I naturally decreased, but were not being replaced because Executive units could not be produced fast enough. In June 1983, the IBM personal computer and IBM-compatible software became major factors in the small computer market, further damaging the company's sales. The public offering never materialized. The company filed for bankruptcy on September 13, 1983. Plaintiffs ultimately lost their investments.

Plaintiffs brought separate lawsuits against Arthur Young in the Santa Clara County Superior Court. Plaintiffs J.F. Shea & Co., et al. (the "Shea plaintiffs"), brought one lawsuit; plaintiff Robert Bily brought another. The two actions were consolidated for trial. The focus of plaintiffs' claims was Arthur Young's audit and audit opinion of the company's 1982 financial statements.

Plaintiffs' principal expert witness, William J. Baedecker, reviewed the 1982 audit and offered a critique identifying more than 40 deficiencies in Arthur Young's performance amounting, in Baedecker's view, to gross professional negligence. In his opinion, Arthur Young did not perform its examination in accordance with GAAS. He found the liabilities on the company's financial statements to have been understated by approximately $3 million. As a result, the company's supposed $69,000 operating profit was, in his view, a loss of more than $3 million. He also determined that Arthur Young had discovered material weaknesses in the company's accounting controls, but failed to report its discovery to management.

Although most of Baedecker's criticisms involved matters of oversight or nonfeasance, e.g., failures to detect weaknesses in the company's accounting procedures and systems, he also charged that Arthur Young had actually discovered deviations from GAAP, but failed to disclose them as qualifications or corrections to its audit report. For example, by January 1983, a senior auditor with Arthur Young identified $1.3 million in unrecorded liabilities including failures to account for customer rebates, returns of products, etc. Although the auditor recommended that a letter be sent to the company's board of directors disclosing material weaknesses in the company's internal accounting controls, his superiors at Arthur Young did not adopt the recommendation; no weaknesses were...