834 P.2d 745 (Cal. 1992)
Osborne Computer Corporation was founded in 1980 by entrepreneur Adam Osborne and began manufacturing the Osborne I portable personal computer for the mass market, with shipments starting in 1981.1 By fall 1982, sales of the company's sole product had reached $10 million per month, making the company one of the fastest growing enterprises in the history of American business.2
In 1981 and again in 1982, the company retained Arthur Young & Company to audit its financial statements and issue audit reports.3 Arthur Young issued unqualified audit opinions on the company's 1981 and 1982 financial statements.4 The 1982 opinion was issued on February 11, 1983, appeared on Arthur Young's letterhead addressed to the company, and 100 copies of the professionally printed opinion were personally delivered to the company.5 The 1982 financial statements reported a modest net operating profit of $69,000 on sales of more than $68 million.6
In late 1982 the company postponed a planned initial public offering and instead issued warrants to investors in exchange for bridge financing loans or letters of credit.7 Plaintiffs, a group that included individuals as well as pension and venture capital funds, invested in the company in early 1983; one plaintiff, Robert Bily, purchased 37,500 shares of stock from Adam Osborne for $1.5 million.8 With one exception, plaintiffs testified that they made their investments in reliance on Arthur Young's unqualified 1982 audit opinion.9
After the warrant transaction closed on April 8, 1983, sales declined sharply because of manufacturing problems with the company's new Executive model computer, the public offering never occurred, and the company filed for bankruptcy on September 13, 1983, causing plaintiffs to lose their investments.10 Plaintiffs brought separate lawsuits against Arthur Young in Santa Clara County Superior Court that were consolidated for trial.11
Plaintiffs' expert witness identified more than 40 deficiencies in the 1982 audit amounting to gross professional negligence, including an understatement of liabilities by approximately $3 million that turned the reported $69,000 profit into a loss of more than $3 million, and testified that Arthur Young had discovered but failed to disclose material weaknesses in the company's internal accounting controls.12 After a 13-week trial the jury returned a verdict for plaintiffs on the professional negligence claim and awarded approximately $4.3 million in compensatory damages, but found for Arthur Young on the fraud and negligent misrepresentation claims.13 The trial court granted Arthur Young's motion for judgment notwithstanding the verdict on the negligence claim.14 The Court of Appeal reversed the judgment in favor of Arthur Young.15 The Supreme Court of California granted review.16
Whether an auditor owes a general duty of care in the conduct of an audit to persons other than its client?17
An auditor owes no general duty of care regarding the conduct of an audit to persons who are not its client. Liability for negligence is confined to the client who contracts for the audit services.18
No. The established facts demonstrate that Arthur Young was retained solely by Osborne Computer Corporation to audit its 1981 and 1982 financial statements. The resulting reports were addressed to the company and one hundred copies were delivered directly to it. Plaintiffs were not clients and had no privity or linking conduct with Arthur Young that would place them within any recognized exception under the Ultramares rule as refined.19 The jury's negligence verdict rested on a foreseeability instruction that the court rejects as producing liability out of proportion to fault and connection to injury.20
Therefore no general duty extends to these third-party investors.21
An auditor owes no general duty of care in the conduct of an audit to persons other than its client.22
Related opinions on this issue
Joined by Mosk, J.
Justice Kennard dissents from the majority's revival of a strict privity barrier for negligence claims.23 She maintains that accountants owe a duty of care to all persons who reasonably and foreseeably rely on audit reports.24 Such reliance is the very reason businesses commission audits.25
Liability supplies the necessary incentive for due care while compensating innocent victims.26 In her view the majority's rule arbitrarily rewards an accountant's ignorance of report distribution and fails to serve the policy of preventing future harm from negligent audits.27
Whether an auditor may be held liable for negligent misrepresentations in an audit report to those persons who are the intended beneficiaries of the report?28
An auditor may be held liable for negligent misrepresentations in an audit report to those persons who are the intended beneficiaries of the report. The standard of Restatement Second of Torts section 552 requires that the auditor intend to supply the information for the benefit of a limited group. The auditor must also know that the client intends to supply it for use in a specific transaction or type of transaction.29
Yes. The rule permits recovery by intended beneficiaries because the auditor receives notice of the specific risk and the connection between the misrepresentation and the injury is closer.30 In the established facts, however, Arthur Young prepared the reports for the company alone, delivered them to the company, and had no knowledge of the particular warrant or stock transactions in which plaintiffs invested.31 The jury rejected the negligent misrepresentation claim, consistent with the absence of any showing that plaintiffs belonged to a class the auditor intended to influence.32
An auditor may be held liable for negligent misrepresentations in an audit report to intended beneficiaries, but the plaintiffs in this case do not qualify as such beneficiaries.33
Whether an auditor may be held liable to reasonably foreseeable third persons for intentional fraud in the preparation and dissemination of an audit report?34
Yes. Intentional fraud thrusts the auditor into a primary role that justifies liability to all those the auditor intends or has reason to expect will rely on the false report.37 In the established facts the jury exonerated Arthur Young of intentional fraud, so no liability arose, yet the legal rule itself recognizes this broader exposure for fraudulent conduct.38
An auditor may be held liable to reasonably foreseeable third persons for intentional fraud in the preparation and dissemination of an audit report.