International Mortgage Co. v. John P. Butler Accountancy Corp.

Citation223 Cal.Rptr. 218,177 Cal.App.3d 806
CourtCalifornia Court of Appeals
Decision Date20 February 1986
Parties, 54 USLW 2469 INTERNATIONAL MORTGAGE COMPANY, Plaintiff and Appellant, v. JOHN P. BUTLER ACCOUNTANCY CORPORATION, a California Corporation, et al., Defendants and Respondents. G001099.
Manatt, Phelps, Rothenberg & Tunney, Paul J. Hall and John W. Cochrane, Los Angeles, for plaintiff and appellant
OPINION

TROTTER, Presiding Justice.

We are asked to declare for the first time that a certified public accountant ("CPA") owes a duty of care to reasonably foreseeable plaintiffs who rely on alleged negligently prepared and issued unqualified audited financial statements.

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John P. Butler Accountancy Corporation ("Butler") entered into an agreement with Westside Mortgage, Inc. ("Westside") to audit Westside's financial statements for the year ending December 31, 1978. Butler completed its audit and issued unqualified audited financial statements on March 22, 1979.

Westside is a mortgage company that arranges financing for real property. It accepts loan applications, screens qualified buyers, obtains real estate appraisals, and then either lends the funds requested or finds outside lenders. The loans are then sold to other mortgage bankers.

The December 31, 1978 financial statements, as audited by Butler, listed Westside's corporate net worth as $175,036. The primary asset shown on its balance sheet was a $100,000 note receivable secured by a deed of trust on real property in Riverside. The footnotes to the financial statements indicated the fair market value of the property to be $115,000 as determined by a January 13, 1975 appraisal. In reality, the note was worthless. The trust deed had been wiped out by a prior foreclosure of a superior deed of trust at a trustee's sale in August 1977.

International Mortgage Company ("IMC"), a subsidiary of Kaufman & Broad, a major real estate developer, approached Westside in October of 1979 for the purpose of buying and selling loans on the secondary market. In order to demonstrate its financial position, Westside provided IMC with copies of the audited financial statements of March 22, 1979.

After reviewing Westside's financial statements, IMC and Westside negotiated a complex master purchase agreement which they signed on December 13, 1979. Under this agreement, Westside and IMC were to buy and sell various government loans, including Federal Housing Administration ("FHA") loans.

The erroneous valuation of the $100,000 trust deed was material to an accurate representation of Westside's financial condition, since the note constituted 57% of Westside's net worth. Without the note, Westside was capitalized at under $100,000 ($75,035) and, thus, not qualified to do business in FHA insured loans such as those included in Westside's contracts with IMC. Butler was aware at the time of the audit that Westside needed to maintain a net worth of at least $100,000 to qualify for FHA business.

Westside entered into a series of contracts to sell government loans to IMC in April 1980. However, it failed to deliver the promised trust deeds to IMC, causing alleged damage of $475,293. In June of 1980, Westside issued a promissory note to IMC for the $475,293; it paid $40,000 on the note and then defaulted on the balance. After further efforts to obtain payment from Westside and its principal owners failed, IMC brought suit against Westside, its owners, principals, and Butler. 1

IMC alleged two causes of action against Butler: negligence and negligent misrepresentation, based on Westside's financial statements of December 31, 1978, which Butler had audited and issued without qualification. It allegedly relied on the defective financial statements in deciding to do business with Westside.

It was admitted Butler had no knowledge of IMC at the time of the audit, nor did IMC contact Butler to verify the financial statements' accuracy. Further, Butler was unaware of IMC's receipt of, and reliance upon, Westside's financial statements.

Butler moved for summary judgment, arguing that, as a matter of law, a CPA owes no duty of care to a third party who was not specifically known to the accountant as an intended recipient of the audited financial statement. The trial court granted Butler's motion, finding no duty of care existed. This appeal followed.

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We recognize the determination of whether a legal 'duty' is owed by one to another in order to give rise to tort liability based on its breach is not a question at all. It is in reality ' 'a shorthand statement of a conclusion, rather than an aid to analysis in itself.... But it should be recognized that "duty" is not sacrosanct in itself, but only an expression of the sum total of those considerations of policy which lead the law to say that the particular plaintiff is entitled to protection.' (Prosser, Law of Torts, supra, at pp. 332-333.) [p ] The history of the concept of duty in itself discloses that it is not an old and deep-rooted doctrine but a legal device of the latter half of the nineteenth century designed to curtail the feared propensities of juries toward liberal awards. 'It must not be forgotten that 'duty' got into our law for the very purpose of combatting what was then feared to be a dangerous delusion (perhaps especially prevalent among juries imbued with popular notions of fairness untempered by paramount judicial policy), viz., that the law might countenance legal redress for all foreseeable harm.' (Fleming, An Introduction to the Law of Torts (1967) p. 47.)" (Dillon v. Legg (1968) 68 Cal.2d 728, 734, 69 Cal.Rptr. 72, 441 P.2d 912.)

The application of the 'duty' doctrine to the accounting profession has been unique. Beginning with Justice Cardozo's seminal opinion in Ultramares Corp. v. Touche (1931) 255 N.Y. 170, 174 N.E. 441, certified public accountants have been shielded from liability for negligence in the preparation and issuance of unqualified audited financial statements when the plaintiff was only a member of a foreseeable class. Liability, based on a 'duty' analysis, was limited to those 'in privity' with the accountant and more recently to those 'intended' recipients of the information. (E.g., Rest.2d Torts (1977) § 552.)

In Ultramares, Fred Stern & Co. employed defendants, a firm of CPA's, to conduct an annual audit. Touche negligently overvalued Stern's assets. Plaintiff, who loaned money to Stern in reliance upon the audited balance sheet supplied to it by Stern, successfully sued Touche on the theories of negligence and fraud. On appeal, the court reversed the negligence cause of action. 'A different question develops when we ask whether they owed a duty to these to make it without negligence. 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 accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class.... [p ] 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 justify 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." (Ultramares Corp. v. Touche, supra, 255 N.Y. at pp. 179, 189, 174 N.E. 441.)

Even as he was limiting accountants liability by requiring privity before a duty could be found, Justice Cardozo recognized such a holding, even in 1931, was against the flow of the common law. For he observed ' [t]he assault upon the citadel of privity is preceding in these days apace. How far the inroads shall extend is now a favorite subject of juridical discussion. [Citations.]' (Ultramares v. Touche, supra, 255 N.Y. at p. 180, 174 N.E. 441.)

Yet, the privity requirement in accountant malpractice suits has survived the shifting sands of time and remains relatively intact today in most jurisdictions. That the "citadel" has not been breached, insofar as certified public accountants' liability, may well be due to the reputation of the distinguished author of Ultramares. While we recognize his brilliance and the then compelling logic of Ultramares, we assert that, in light of other decisions (discussed, infra ) and the role of an independent auditor in today's society, the rule of Ultramares is no longer consistent with the fundamental principles of California negligence law.

Interestingly, Justice Cardozo had no such protectionist concerns for manufacturers. In MacPherson v. Buick Motor Co. (1916) 217 N.Y. 382, 111 N.E. 1050, decided years before Ultramares, Justice Cardozo noted 'We have put aside the notion that the duty to safeguard life and limb, when the consequences of negligence may be foreseen, grows out of contract and nothing else. We have put the source of the obligation where it ought to be. We have put its source in the law.' (Id., 111 N.E. at p. 1053.)

Thus, even as Ultramares was being articulated, the tide of precedent had already begun to move against the privity rule. The erosion continued, washing away the protection from all other professions, leaving accountancy as some ennobled species specially protected by the 'citadel.'

Attorneys had traditionally been the beneficiaries of the privity rule as well. In Nat. Savings Bank v. Ward (1880) 100 U.S. 195, 10 Otto 195, 25 L.Ed. 621, the United States Supreme Court held "[b]eyond all doubt,...

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