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Full Opinion
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.
Supreme Court of California.
*375 COUNSEL
Heller, Ehrman, White & McAuliffe, M. Laurence Popofsky, Marie L. Fiala, Kirk G. Werner, Robert B. Hawk, Melanie C. Gold, Paul G. Urla, Paul Buchanan, Adria Balog, Carl D. Liggio and John Matson for Defendant and Appellant.
Wilke, Fleury, Hoffelt, Gould & Birney, Thomas G. Redmon, Matthew W. Powell, Willkie, Farr & Gallagher, Louis A. Craco, Deborah E. Cooper, Diana B. Simon, Pettit & Martin, John L. Boos, Laura D. Cooper, Philip F. Atkins-Pattenson and Dennis P. Scott 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 and Gene K. Cheever 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 for Plaintiff and Respondent.
Wright & L'Estrange, Robert C. Wright and Laurie E. Barber as Amici Curiae on behalf of Plaintiff and Respondent.
Christopher Chenoweth, John J. Gill, Michael F. Crotty, Matthew H. Street, Buchalter, Nemer, Fields & Younger, Marcus M. Kaufman, Ware & Freidenrich, Peter M. Rehon, Lisa C. Roberts and Nels R. Nelsen as Amici Curiae on behalf of Plaintiffs and Appellants and Plaintiff and Respondent.
OPINION
LUCAS, C.J.
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, 74 A.L.R. 1139] (Ultramares), *376 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 *377 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 *378 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 *379 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 disclosed. Arthur Young rendered its unqualified opinion on the 1982 statements a month later.
The case was tried to a jury for 13 weeks. At the close of the evidence and arguments, the jury received instructions and special verdict questions including three theories of recovery: fraud, negligent misrepresentation, and professional negligence. The fraud instructions required proof of an intentional misrepresentation made by defendant "with intent to defraud the plaintiff or a particular class of persons to which plaintiff belonged." Similarly, the negligent misrepresentation instructions required a negligent misrepresentation made "with the intent to induce plaintiff or a particular class of persons to which plaintiff belongs to rely on it."
The negligence instructions stated in part that an independent auditor has a duty to have the degree of skill and learning possessed by reputable certified public accountants in the same community and to use "reasonable diligence and its best judgment in the exercise of its professional skill."
With respect to liability to third parties, negligence instructions were in accordance with International Mortgage Co. v. John P. Butler Accountancy Corp. (1986) 177 Cal. App.3d 806 [223 Cal. Rptr. 218] to the effect that: "An accountant owes a further duty of care to those third parties who reasonably and foreseeably rely on an audited financial statement prepared by the accountant. A failure to fulfill any such duty is negligence."
The jury exonerated Arthur Young with respect to the allegations of intentional fraud and negligent misrepresentation, but returned a verdict in plaintiffs' favor based on professional negligence. No comparative negligence on plaintiffs' part was found. The jury awarded compensatory damages of approximately $4.3 million, representing approximately 75 percent of each investment made by plaintiffs. The Court of Appeal affirmed the resulting judgment in plaintiffs' favor with respect to all matters relevant to the issue now before us.
II.
The Audit Function in Public Accounting
Although certified public accountants (CPA's) perform a variety of services for their clients, their primary function, which is the one that most *380 frequently generates lawsuits against them by third persons, is financial auditing. (Hagen, Certified Public Accountant's Liability for Malpractice: Effect of Compliance with GAAP and GAAS (1987) 13 J. Contemp. Law 65, 66 [hereafter Hagen]; Siliciano, Negligent Accounting and the Limits of Instrumental Tort Reform (1988) 86 Mich.L.Rev. 1929, 1931 [hereafter Siliciano].) (1) "An audit is a verification of the financial statements of an entity through an examination of the underlying accounting records and supporting evidence." (Hagen, supra, 13 J. Contemp. Law at p. 66.) "In an audit engagement, an accountant reviews financial statements prepared by a client and issues an opinion stating whether such statements fairly represent the financial status of the audited entity." (Siliciano, supra, 86 Mich.L.Rev. at p. 1931.)
In a typical audit, a CPA firm may verify the existence of tangible assets, observe business activities, and confirm account balances and mathematical computations. It might also examine sample transactions or records to ascertain the accuracy of the client company's financial and accounting systems. For example, auditors often select transactions recorded in the company's books to determine whether the recorded entries are supported by underlying data (vouching). Or, approaching the problem from the opposite perspective, an auditor might choose particular items of data to trace through the client's accounting and bookkeeping process to determine whether the data have been properly recorded and accounted for (tracing). (Hagen, supra, 13 J. Contemp. Law at pp. 66-67, fn. 15.)
For practical reasons of time and cost, an audit rarely, if ever, examines every accounting transaction in the records of a business. The planning and execution of an audit therefore require a high degree of professional skill and judgment. Initially, the CPA firm plans the audit by surveying the client's business operations and accounting systems and making preliminary decisions as to the scope of the audit and what methods and procedures will be used. The firm then evaluates the internal financial control systems of the client and performs compliance tests to determine whether they are functioning properly. Transactions and data are sampled, vouched for, and traced. Throughout the audit process, results are examined and procedures are reevaluated and modified to reflect discoveries made by the auditors. (Hagen, supra, 13 J. Contemp. Law at pp. 67-68.) "For example, if the auditor discovers weaknesses in the internal control system of the client, the auditor must plan additional audit procedures which will satisfy himself that the internal control weaknesses have not caused any material misrepresentations in the financial statements." (Ibid.)
The end product of an audit is the audit report or opinion. The report is generally expressed in a letter addressed to the client. The body of the report *381 refers to the specific client-prepared financial statements which are attached. In the case of the so-called "unqualified report" (of which Arthur Young's report on the company's 1982 financial statements is an example), two paragraphs are relatively standard.
In a scope paragraph, the CPA firm asserts that it has examined the accompanying financial statements in accordance with GAAS. GAAS are promulgated by the American Institute of Certified Public Accountants (AICPA), a national professional organization of CPA's, whose membership is open to persons holding certified public accountant certificates issued by state boards of accountancy. (Hagen, supra, 13 J. Contemp. Law at pp. 72-73.)
The GAAS include 10 broadly phrased sets of standards and general principles that guide the audit function. They are classified as general standards, standards for fieldwork, and standards of reporting. General Standard No. 1 provides: "The examination is to be performed by a person or persons having adequate technical training as ... auditor[s]." General Standard No. 3 provides: "Due professional care is to be exercised in the performance of the examination and the preparation of the report." Standard of Fieldwork No. 2 provides: "A sufficient understanding of the internal control structure is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed."
The generality of these statements is somewhat mitigated by the Statements on Auditing Standards (SAS), which are periodic interpretations of the standards issued by the Auditing Standards Board of the AICPA. (Miller & Bailey, Comprehensive GAAS Guide (1991) pp. 5.03, 5.11, 6.07 [hereafter GAAS Guide].) For example, SAS-55, which relates to internal financial control structure, includes steps to be followed in understanding and testing accounting control systems in relation to information provided in financial statements. (GAAS Guide at p. 7.03 et seq.) The GAAS Guide, a commonly used summary of GAAS, that purports to integrate and comprehensively restate pertinent auditing standards, includes 140 major sections and more than 1,000 pages.
In an opinion paragraph, the audit report generally states the CPA firm's opinion that the audited financial statements, taken as a whole, are in conformity with GAAP and present fairly in all material respects the financial position, results of operations, and changes in financial position of the *382 client in the relevant periods. (GAAS Guide at p. 11.03; Hagen, supra, 13 J. Contemp. Law at pp. 74-76.)[3]
The GAAP are an amalgam of statements issued by the AICPA through the successive groups it has established to promulgate accounting principles: the Committee on Accounting Procedure, the Accounting Principles Board, and the Financial Accounting Standards Board. Like GAAS, GAAP include broad statements of accounting principles amounting to aspirational norms as well as more specific guidelines and illustrations. The lack of an official compilation allows for some debate over whether particular announcements are encompassed within GAAP. (Hagen, supra, 13 J. Contemp. Law at pp. 74-76.) One standard text purporting to comprehensively restate GAAP includes 90 major sections and more than 500 pages. (M. Miller, GAAP Guide (1991).)
In addition to or in place of the standardized statements in an audit report, the auditing CPA firm may also qualify its opinion, noting exceptions or matters in the financial statements not in conformity with GAAP or significant uncertainties which might affect a fair evaluation of the statements. The report may also contain a disclaimer stating the accountant's inability to express any opinion about the statements or an adverse opinion that the statements do not fairly present the financial position of the client in conformity with GAAP. (Hagen, supra, 13 J. Contemp. Law at pp. 69-72.)
Arthur Young correctly observes that audits may be commissioned by clients for different purposes. Nonetheless, audits of financial statements and the resulting audit reports are very frequently (if not almost universally) used by businesses to establish the financial credibility of their enterprises in the perceptions of outside persons, e.g., existing and prospective investors, financial institutions, and others who extend credit to an enterprise or make risk-oriented decisions based on its economic viability. The unqualified audit report of a CPA firm, particularly one of the "Big Six," is often an admission ticket to venture capital markets â a necessary condition precedent to attracting the kind and level of outside funds essential to the client's financial growth and survival. As one commentator summarizes: "In the first instance, this unqualified opinion serves as an assurance to the client that its own *383 perception of its financial health is valid and that its accounting systems are reliable. The audit, however, frequently plays a second major role: it assists the client in convincing third parties that it is safe to extend credit or invest in the client." (Siliciano, supra, 86 Mich.L.Rev. at p. 1932.)
The GAAP acknowledge that financial audit reporting is "a principal means of communicating accounting information to those outside an enterprise." (Statement of Financial Accounting Concepts of the Financial Accounting Standards Board of the AICPA No. 1, ś 6, p. 7.) As the AICPA recently stated: "The independent audit, through the process of examining evidence underlying the financial statements, adds credibility to management's representations in the statements. In turn, the audit provides investors, bankers, creditors, and others with reasonable assurance that the financial statements are free of material misstatement." (AICPA, Understanding Audits and the Auditor's Report, A Guide for Financial Statement Users (1989) p. 36; see also Bus. & Prof. Code, § 5051, subd. (d) [practice of accountancy includes preparation of reports on audits for purpose of obtaining credit or filing documents with government agencies]; Cal. Code Regs., tit. 16, § 58.3 [accountant may not issue report on unaudited financial statements to client or others without complying with professional standards].)
The AICPA's professional standards refer to the public responsibility of auditors: "A distinguishing mark of a profession is acceptance of its responsibility to the public. The accounting profession's public consists of clients, credit grantors, governments, employers, investors, the business and financial community, and others who rely on the objectivity and integrity of certified public accountants to maintain the orderly functioning of commerce. This reliance imposes a public interest responsibility on certified public accountants." (2 AICPA Professional Standards (CCH 1988) § 53.01.)
The United States Supreme Court had also recognized the public function of the CPA auditor as a reason to deny work product protection to the auditor's work papers. Distinguishing CPA firms from lawyers and other professionals who perform services for clients, the high court stated: "By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This `public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to *384 the public trust." (United States v. Arthur Young & Co. (1984) 465 U.S. 805, 817-818 [79 L.Ed.2d 826, 835-837, 104 S.Ct. 1495].)
III.
Approaches to the Problem of Auditor Liability to Third Persons
The complex nature of the audit function and its economic implications has resulted in different approaches to the question whether CPA auditors should be subjected to liability to third parties who read and rely on audit reports. Although three schools of thought are commonly recognized, there are some variations within each school and recent case law suggests a possible trend toward merger of two of the three approaches.
A substantial number of jurisdictions follow the lead of Chief Judge Cardozo's 1931 opinion for the New York Court of Appeals in Ultramares, supra, 174 N.E. 441, by denying recovery to third parties for auditor negligence in the absence of a third party relationship to the auditor that is "akin to privity." (See pt. III(A), post.) In contrast, a handful of jurisdictions, spurred by law review commentary, have recently allowed recovery based on auditor negligence to third parties whose reliance on the audit report was "foreseeable." (See pt. III(B), post.)
Most jurisdictions, supported by the weight of commentary and the modern English common law decisions cited by the parties, have steered a middle course based in varying degrees on Restatement Second of Torts section 552, which generally imposes liability on suppliers of commercial information to third persons who are intended beneficiaries of the information. (See pt. III(C), post.) Finally, the federal securities laws have also dealt with the problem by imposing auditor liability for negligence-related conduct only in connection with misstatements in publicly filed and distributed offering documents. (See pt. III(D), post.)
In this section we will review and briefly analyze each of the recognized approaches to the problem before us.
A. Privity of Relationship
In Ultramares, supra, 174 N.E. 441, plaintiff made three unsecured loans totalling $165,000 to a company that went bankrupt. Plaintiff sued the company's auditors, claiming reliance on their audit opinion that the company's balance sheet "present[ed] a true and correct view of the financial condition of [the company]." (Id. at p. 442.) Although the balance sheet *385 showed a net worth of $1 million, the company was actually insolvent. The company's management attempted to mask its financial condition; the auditors failed to follow paper trails to "off-the-books" transactions that, if properly analyzed, would have revealed the company's impecunious situation.
The jury, precluded by the trial judge from considering a fraud cause of action, returned a verdict in plaintiff's favor based on the auditor's negligence in conducting the audit. The New York Court of Appeals, speaking through Chief Judge Cardozo, reinstated the fraud cause of action but set aside the negligence verdict.
The auditor in Ultramares knew the company was in need of capital and that its audit opinion would be displayed to third parties "as the basis of financial dealings." (Ultramares, supra, 174 N.E. at p. 442.) In this regard, it supplied to the company 32 copies of the opinion "with serial numbers as counterpart originals." (Ibid.) Plaintiff's name, however, was not mentioned to the auditor nor was the auditor told about any actual or proposed credit or investment transactions in which its audit opinion would be presented to a third party.
With respect to the negligence claim, the court found the auditor owed no duty to the third party creditor for an "erroneous opinion." In an often quoted passage, it observed: "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. The hazards of a business conducted on these terms are so extreme as to enkindle doubt whether a flaw may not exist in the implication of a duty that exposes to these consequences." (Ultramares, supra, 174 N.E. at p. 444.)
Although acknowledging the demise of privity of contract as a limitation on tort liability in the context of personal injury and property damage, the court distinguished between liability arising from a "physical force" and "the circulation of a thought or the release of the explosive power resident in words." (Ultramares, supra, 174 N.E. at p. 445.) It also distinguished its own prior decision in Glanzer v. Shepherd (1922) 233 N.Y. 236 [135 N.E. 275, 23 A.L.R. 1425], in which a seller of beans requested the operator of a public scale to give a certificate of weight to the buyer. When the certificate proved inaccurate and the buyer sued, the court held the operator liable for negligence. As the court explained, the difference between the cases was that "the transmission of the certificate [in Glanzer] was not merely one possibility among many, but the `end and aim of the transaction,' as certain and *386 immediate and deliberately willed as if a husband were to order a gown to be delivered to his wife, or a telegraph company, contracting with the sender of a message, were to telegraph it wrongly to the damage of the person expected to receive it." (174 N.E. at p. 445, italics added.)
In summarizing its holding, the court emphasized that it was not releasing auditors from liability to third parties for fraud but merely for "honest blunder." (Glanzer v. Shepherd, supra, 174 N.E. at p. 448.) It questioned "whether the average business man receiving a certificate without paying for it, and receiving it as one of a multitude of possible investors, would look for anything more." (Ibid.)
In cases following Ultramares, the New York Court of Appeals has not required privity of contract as a universal prerequisite to third party suits against auditors; rather, on occasion, it has found an equivalent privity of relationship between the auditor and the plaintiff. For example, in White v. Guarente (1977) 43 N.Y.2d 356 [401 N.Y.S.2d 474, 372 N.E.2d 315], one of 40 limited partners sued the partnership's auditor for professional negligence in failing to disclose in an audit report that the general partners had withdrawn funds from the partnership in violation of the partnership agreement. Observing: (1) the limited partnership agreement contained an express provision requiring an annual audit by a CPA; and (2) the CPA had also prepared the partnership's tax returns on which the limited partners relied in preparing their personal returns, the court found a duty on the part of the CPA to exercise due care for the benefit of the limited partners.
Distinguishing Ultramares, the court commented that the "services of the accountant were not extended to a faceless or unresolved class of persons, but rather to a known group possessed of vested rights, marked by a definable limit and made up of certain components." (White v. Guarente, supra, 372 N.E.2d at p. 318.) Following Glanzer v. Shepherd, supra, 135 N.E. 275, it found the furnishing of the audit and tax return information to be "one of the ends and aims" of the CPA's engagement and "within the contemplation of the parties to the accounting retainer." (372 N.E. at p. 319.)
The New York Court of Appeals restated the law in light of Ultramares, White v. Guarente, and other cases in Credit Alliance v. Arthur Andersen & Co. (1985) 65 N.Y.2d 536 [493 N.Y.S.2d 435, 483 N.E.2d 110]. Credit Alliance subsumed two cases with different factual postures: in the first case, plaintiff alleged it loaned funds to the auditor's client in reliance on audited financial statements overstating the client's assets and net worth; in the second, the same scenario occurred, but plaintiff also alleged the auditor knew plaintiff was the client's principal lender and communicated directly *387 and frequently with plaintiff regarding its continuing audit reports. The court dismissed plaintiff's negligence claim in the first case, but sustained the claim in the second.
The New York court promulgated the following rule for determining auditor liability to third parties for negligence: "Before accountants may be held liable in negligence to noncontractual parties who rely to their detriment on inaccurate financial reports, certain prerequisites must be satisfied: (1) the accountant must have been aware that the financial reports were to be used for a particular purpose or purposes; (2) in the furtherance of which a known party or parties was intended to rely; and (3) there must have been some conduct on the part of the accountants linking them to that party or parties, which evinces the accountants' understanding of that party or parties' reliance." (Credit Alliance v. Arthur Andersen & Co., supra, 483 N.E.2d at p. 118.)
Discussing the application of its rule to the cases at hand, the court observed the primary, if not exclusive, "end and aim" of the audits in the second case was to satisfy the lender. The auditor's "direct communications and personal meetings [with the lender] result[ed] in a nexus between them sufficiently approaching privity." (Credit Alliance v. Arthur Andersen & Co., supra, 483 N.E.2d at p. 120.) In contrast, in the first case, although the complaint did allege the auditor knew or should have known of the lender's reliance on its reports: "There was no allegation of either a particular purpose for the reports' preparation or the prerequisite conduct on the part of the accountants ... [nor] any allegation [the auditor] had any direct dealings with plaintiffs, had agreed with [the client] to prepare the report for plaintiffs' use or according to plaintiffs' requirements, or had specifically agreed with [the client] to provide plaintiffs with a copy [of the report] or actually did so." (Credit Alliance v. Arthur Andersen & Co., supra, 483 N.E.2d at p. 119.)
The evolution of the New York rule illustrates a primary difficulty of articulating a standard of auditor liability to third parties: As one moves from privity of contract to privity of relationship, a wide variety of possible circumstances and relationships emerges. From preengagement communications with its client, an auditor may acquire full knowledge of third party recipients of the audit report and a specific investment or credit transaction that constitutes the "end and aim" of the audit. As a consequence, the auditor is placed on notice of a specific risk of liability that accompanies the audit engagement. Yet, under the Credit Alliance test, the auditor appears to have no liability in this situation in the absence of further, distinct conduct "linking" the auditor to the third party in a manner that "evinces [auditor] *388 understanding" of third party reliance. (Credit Alliance v. Arthur Andersen & Co., supra, 483 N.E.2d at p. 118.)
The New York court offers no rationale for the distinct "linking" element of its rule nor does it specify what conduct is required to satisfy this element, although direct communications between auditor and third party were deemed sufficient on the facts. One might question whether "linking" conduct should be necessary if, as in the example given in the previous paragraph, the auditor knows his engagement is for the express purpose of benefiting an identifiable class of third parties. Indeed, the New York court's previous decision in White v. Guarente, supra, 372 N.E.2d 315, poses a case in which the auditor knew the audit was to be conducted for the benefit of the limited partners as required by the client's partnership agreement, but was not "linked" to the limited partners in any other significant way. In such cases, "linkage" is arguably achieved by the auditor's conduct in undertaking and carrying out the engagement with knowledge of its specific purpose and the ultimate use to be made of the audit report. (See Credit Alliance v. Arthur Andersen & Co., supra, commenting on White v. Guarente as follows: "Indeed, as a member of the limited partnership and as a specifically intended beneficiary of the partnership's contract with the accountants, the limited partner might well have been considered actually in privity with the accountants." (483 N.E.2d at p. 117, fn. 9.)
The "linking conduct" element of the New York rule will undoubtedly be defined more precisely as New York case law continues to develop. Although the first two elements of the rule (and the New York court's decision in White v. Guarente) are functionally similar to Restatement Second of Torts section 552, the "linking conduct" element appears to require not only that the existence of the third person be known to the auditor, but that the auditor either directly convey the audit report to the third person or otherwise act in some manner specifically calculated to induce reliance on the report. (See Haddon View Inv. Co. v. Coopers & Lybrand (1982) 70 Ohio St.2d 154 [24 Ohio Ops.2d 268, 436 N.E.2d 212, 214-215]; First Nat. Bank of Commerce v. Monco Agency Inc. (5th Cir.1990) 911 F.2d 1053, 1060.) In this regard, a mere "unsolicited phone call" by the third party to the auditor is insufficient. The auditor must be aware of a "particular purpose" for the audit engagement and must act to further that purpose. (Security Pacific Business Credit, Inc. v. Peat Marwick Main & Co. (1992) 79 N.Y.2d 695, 705-707 [586 N.Y.S.2d 87, 597 N.E.2d 1080].) This additional showing is not required by the Restatement test, which is discussed in part III(C), post.
From the cases cited by the parties, it appears at least nine states purport to follow privity or near privity rules restricting the liability of auditors to *389 parties with whom they have a contractual or similar relationship. In five states, this result has been reached by decisions of their highest courts.[4] In four other states, the rule has been enacted by statute.[5] Federal court decisions have held that the rule represents the law of three additional states whose highest courts have not expressly considered the question.[6] The more recent of the cited cases generally follow the New York rule as reformulated in Credit Alliance.
B. Foreseeability
Arguing that accountants should be subject to liability to third persons on the same basis as other tortfeasors, Justice Howard Wiener advocated rejection of the rule of Ultramares in a 1983 law review article. (Wiener, Common Law Liability of the Certified Public Accountant for Negligent Misrepresentation (1983) 20 San Diego L.Rev. 233 [hereafter Wiener].) In its place, he proposed a rule based on foreseeability of injury to third persons. Criticizing what he called the "anachronistic protection" given to accountants by the traditional rules limiting third person liability, he concluded: "Accountant liability based on foreseeable injury would serve the dual functions of compensation for injury and deterrence of negligent conduct. Moreover, it is a just and rational judicial policy that the same criteria govern the imposition of negligence liability, regardless of the context in which it arises. The accountant, the investor, and the general public will in the long run benefit when the liability of the certified public accountant for negligent misrepresentation is measured by the foreseeability standard." (Id. at p. 260.) Under the rule proposed by Justice Wiener, "[f]oreseeability of the risk would be a question of fact for the jury to be disturbed on appeal only where there is insufficient evidence to support the finding." (Id. at pp. 256-257.)
Following in part Justice Wiener's approach, the New Jersey Supreme Court upheld a claim for negligent misrepresentation asserted by stock purchasers against an auditor who had rendered an unqualified audit report approving fraudulently prepared financial statements. (Rosenblum v. Adler (1983) 93 N.J. 324 [461 A.2d 138, 35 A.L.R.4th 199].) The court found no *390 reason to distinguish accountants from other suppliers of products or services to the public and no reason to deny to third party users of financial statements recovery for economic loss resulting from negligent misrepresentation. (Id. at pp. 142-146.) From its review of the purpose and history of the audit function, it conclu