Defending Third-Party Audit Claims
Early in the 20th century, audits of company financial statements served merely as verification for management that a company was productive and efficient. After the 1929 stock market crash, the role of the auditor evolved. The Securities Act of 1933 and the Securities Exchange Act of 1934 established requirements for SEC member companies to produce audited financial statements to provide assurance to investors as to the accuracy of those financial statements. In the ensuing years, this led to an expansion of the scope of audit services offered by the CPA profession. In response, the AICPA expanded its audit standards to improve the quality of professional accounting services. Following the savings and loan crisis in the 1980s, legislation and case law in many states extended the obligations of auditors to various third parties. In a typical third-party malpractice case, a nonclient enters into a business relationship with an audit client and receives a copy of the client's audited financial statements. The business relationship sours, and the third party alleges that the audited financial statements misstated the client's true financial condition. The third party further asserts that it entered into the business deal, in part, based on reliance on the accuracy of the audited financial statements, and sues the auditor for damages. Examples of third-party claimants include third-party lenders, investors, and shareholders. For many, the above scenario seems unfair, arbitrary, and fraught with uncertainty How can a third party sue an auditor for malpractice when there was no contract between the two parties? Does it matter that the auditor did not have any contact with or knowledge of the third party? FROM THE DEFENSE COUNSEL Henry E. Kinser, a partner with the law firm Wyatt Tarrant & Combs LLP in Lexington, Ky, is a leading attorney specializing in the defense of audit malpractice claims. He is an experienced trial lawyer with more than 100 jury trials and has attained the highest professional rating by Martindale-Hubbell, a national peer review rating service for lawyers. Kinser shared his insights about these exposures. Sterna: Henry, in recent years there seems to have been an increase in third-party audit claims. To what do you attribute this increase? Kinser: Well, I would say that the downturn in the economy has had a significant impact. Business deals have failed, loans have gone into default, and investments have gone bad. As a result, many businesspeople, lenders, and shareholders are looking for someone to blame for their business failings. Professionals such as auditors, who have liability insurance, are an attractive "deep pocket" from which to recover these losses. Sterna: How is it that a nonclient third party, who never had any dealings with the auditor, can successfully sue the CPA firm? Kinser: It all comes down to a legal term called "privity of contract." Essentially, an auditor will owe a duty of care to a third party only if there is some sort of privity between the accountant and the nonclient. Sterna: Can you define "privity"? Kinser: Privity once meant that a contract between the third party and auditor was required before any liability could exist. However, courts now overlook traditional privity and apply legal approaches referred to as "near privity" as well as other approaches, without giving much weight to traditional privity Today, there are three basic approaches to third-party liability, depending on which state law applies. The first approach is called the privity-of-contract approach. In such a case, a third party must be in privity or near privity with an auditor to recover for ordinary negligence. For this to happen, the auditor must be aware that a known third party intended to rely upon the audit information provided to the client for a particular purpose. There also has to be conduct by the auditor linking it to a third party's reliance. …