Bily v. Arthur Young & Co.

• Decision Date: 20 July 1990
• Docket Number: No. H003695,H003695
• Citation: 1 Cal.App.4th 1263,271 Cal.Rptr. 470
• Court: California Court of Appeals Court of Appeals
• Parties: Previously published at 230 Cal.App.3d 835, 1 Cal.App.4th 1263, 7 Cal.App.4th 1636 230 Cal.App.3d 835, 1 Cal.App.4th 1263, 7 Cal.App.4th 1636 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 470

271 Cal.Rptr. 470

Previously published at 230 Cal.App.3d 835, 1 Cal.App.4th 1263, 7 Cal.App.4th 1636

230 Cal.App.3d 835, 1 Cal.App.4th 1263, 7 Cal.App.4th 1636

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. H003695.

Court of Appeal, Sixth District, California.

July 20, 1990.

Review Granted Oct. 18, 1990.

Timm A. Verduin, Karl D. Belgum, Dianne P. Urhausen, Thelen, Marrin, Johnson & Bridges, Paul H. Dawes, Latham & Watkins, San Francisco, for plaintiff and appellant J.F. Shea Co.

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

Bruce Simon, Joseph W. Cotchett, Susan Illston, Burlingame, Karen Karpen, San Francisco, Michael Liberty, Cotchett & Illston, Burlingame, for plaintiff and respondent Robert Bily.

John L. Boos, Laura D. Cooper, Pettit & Martin, San Francisco, for amicus curiae.

CAPACCIOLI, Acting Presiding Justice.

Arthur Young & Company, a firm of certified public accountants, appeals from judgments and postjudgment orders obtained against it, on the ground of its asserted professional negligence, by 13 plaintiffs none of whom were clients of Arthur Young. We are called upon to reassess the nature and scope of duties of certified public accountants, acting as independent auditors, to persons and entities other than their clients; we must also address several procedural issues. The question to which all parties have assigned first priority is whether Arthur Young should have been subject to the rule, applied in International Mortgage Co. v. John P. Butler Accountancy Corp. (1986) 177 Cal.App.3d 806, 818, 223 Cal.Rptr. 218, that an independent auditor will be liable "to those third parties who reasonably and foreseeably rely" on negligently prepared and issued unqualified audited financial statements, regardless whether the third parties were in contractual privity with, or their reliance was actually foreseen by, the auditor. We shall conclude that the foreseeability rule is sound and was applicable. We shall sever and reverse those parts of one of the judgments and one of the orders which inure to the benefit of plaintiff Richard L. King, and shall direct certain other partial reversals and modifications on procedural grounds, but shall affirm the judgments and orders in all other respects.

Osborne Computer Corporation, a manufacturer of portable microcomputers, experienced phenomenal growth in 1980, 1981, and 1982. In 1981 it engaged Arthur Young to audit its financial statements.

To raise capital essential to its continued growth Osborne Computer Corporation planned to make an initial public offering of its stock early in 1983. In mid-January 1983 it was decided that the offering should be postponed for several months. To operate until the postponed offering could be made, corporate management sought "bridge financing" in the form of loans from banks (the "bridge lenders"). To provide security for the bank loans Osborne Computer Corporation entered into a "warrant purchase agreement" with a group of investors (the "warrant investors"). The warrant investors provided security in various forms, most of them by executing irrevocable standby letters of credit in favor of bridge lender Security Pacific National Bank. In return the warrant investors received warrants to purchase Osborne Computer Corporation stock, at an apparently attractive price, immediately after the public offering.

Also in early 1983, several individuals and entities (the "stock buyers") bought sizeable blocks of Osborne Computer Corporation stock from major shareholders of the corporation.

All of the 13 plaintiffs were either warrant investors or stock buyers or (in one instance) both. All but one of the plaintiffs assertedly relied on an unqualified audit opinion issued by Arthur Young in January 1983 with respect to Osborne Computer Corporation's consolidated financial statements for a period of years ending in November 1982.

There were significant weaknesses in Osborne Computer Corporation's internal accounting procedures. As a result the November 1982 financial statements were far too optimistic.

Later in 1983 Osborne Computer Corporation proved unable to cope with the cumulative impact of its own poor business planning and strong competition from other computer manufacturers and went into bankruptcy. The bridge lenders called in the standby letters of credit, which were paid by warrant investors' banks. Osborne Computer Corporation's stock was reduced to nominal value and the warrants became worthless. These plaintiffs among others sued Arthur Young and others in separate lawsuits which were then coordinated. (Code Civ. Proc., § 404 et seq.)

The coordinated actions culminated in a lengthy jury trial. Certain of the plaintiffs' claims were settled, and certain of their theories of recovery were abandoned, along the way. The jury rejected theories of fraud and negligent misrepresentation, but returned verdicts against Arthur Young, on a theory of professional negligence, in favor of plaintiff Robert Bily (an outside director of Osborne Computer Corporation who was a stock buyer) and 12 "Shea plaintiffs" (who were, variously, warrant investors, stock buyers, or both). Judgments on the verdicts were entered and subsequently amended; the trial court made several postjudgment orders.

Arthur Young and the Shea plaintiffs appeal.

DUTIES OF INDEPENDENT AUDITORS

Osborne Computer Corporation engaged Arthur Young as an independent auditor, to review the corporation's financial statements in accordance with generally accepted auditing standards (GAAS) for the purpose of issuing, if appropriate, unqualified opinions to the effect that as of given dates the financial statements "present fairly the financial position" of the corporation "and the results of its operations and the changes in its financial position for the year then ended, in conformity with generally accepted accounting principles [GAAP] applied on a basis consistent with that of the preceding year." (American Institute of Certified Public Accountants (AICPA) Professional Standards, AU § 411.01.) When it issued its January 1983 unqualified audit opinion Arthur Young was aware of Osborne Computer Corporation's proposed initial public offering of stock, and it thereafter became aware of the bridge financing and the warrant purchase agreement, but it was not aware of particular potential investors either individually or as members of identifiable classes.

At trial the plaintiffs' factual theories were

(1) That the consolidated financial statements overstated Osborne Computer Corporation's financial condition, as of November 1982, by approximately $3 million;

(2) That the overstatement was primarily due to "material weaknesses" in Osborne Computer Corporation's "internal accounting controls," but that Arthur Young did not respond appropriately to the material weaknesses;

(3) That when Osborne Computer Corporation thereafter found several accounting anomalies, and recalled Arthur Young to examine them, Arthur Young still failed to take appropriate steps; and

(4) That as a consequence of Arthur Young's issuance of, and failure to remedy, its January 1983 unqualified opinion the investors lost the full amount of their investments.

The jury awarded the investors approximately 75 percent of the amounts they allegedly had lost.

Except as to stock buyer Richard L. King (the Shea plaintiff who did not rely on the First, by incorrectly defining the applicable standard of care, and allowing improper evidence and argument on the issue.

financial statements), and in tangential support of its argument that certain evidence should not have been admitted, Arthur Young does not challenge the sufficiency of the evidence to support the verdicts. Instead, Arthur Young asserts that the trial court erred to its prejudice in three respects relevant to its professional duties:

Second, by improperly defining the scope of Arthur Young's professional duty.

Third, by improperly allowing evidence and argument to the effect that Arthur Young had not discharged its duty to Osborne Computer Corporation to inform the corporation of material weaknesses in internal accounting controls.

1. Standard of care.

With respect to professional negligence the trial court instructed the jury, in part, that "[i]n performing professional services for a client, ... Arthur Young ..., as an independent auditor, has the duty to have that degree of learning and skill ordinarily possessed by a reputable certified public accountant practicing in the same or a similar locality and under similar circumstances. [p] It is ... Arthur Young['s] ... further duty to use the care and skill ordinarily used in like cases by reputable members of its profession practicing in the same or similar locality under similar circumstances, and to use reasonable diligence and its best judgment in the exercise of its professional skill. And in the application of its learning in an effort to accomplish the purpose for which it was employed."

Arthur Young asked for an instruction that "[t]he standard of ordinary skill and competence for accountants is defined by generally accepted accounting procedures, or GAAP, and generally accepted auditing standards, or GAAS." The trial court refused this instruction, and instead instructed the jury that "[i]n determining whether Arthur Young fulfilled its professional duties, you may consider among other evidence whether or not its work complied with ... GAAP and ... GAAS."

Arthur Young argues it was error to permit the jury to consider GAAS and GAAP "merely as evidence along with other unspecified evidence"; it asserts...