In the 2007 case of Paul V. Anjoorian v. Arnold Kilberg & Company, Arnold Kilberg, and Pascarella & Trench, the Rhode Island Superior Court ruled that a shareholder can sue a companys outside accounting firm for alleged negligence in the preparation of the companys financial statements even though the accountant argued it had no duty of care to third parties like the shareholder, with whom it never engaged in a direct financial transaction. Judge Michael A. Silverstein disagreed, saying an accountant owes a duty to any individual or group of people who are meant to benefit from or be influenced by the information the accountant provides. Silverstein relied on the Restatement (Second) of the Law of Torts: The Restatement approach strikes the appropriate balance between compensating victims of malpractice and limiting the scope of potential liability for those who certify financial statements. While it remains to be proved that [the firm] actually did foresee that [its] financial statements would be used by the shareholders [in the manner alleged], the absence of a particular financial transaction does not preclude the finding of a duty in this case.

The facts of the case are described in Exhibit 1.

Exhibit 1

ANJOORIAN ET AL.: THIRD-PARTY LIABILITY

Facts of the Case

The defendants Pascarella and Trench, general partners of the accounting firm Pascarella & Trench (P&T), asked the court for summary judgment in their favor with respect to plaintiff Anjoorians claim that P&T committed malpractice in the preparation of financial statements, and that the plaintiff (Anjoorian) suffered pecuniary harm as a result.

Anjoorian formerly owned 50 percent of the issued shares of Fairway Capital Corporation (FCC), a Rhode Island corporation. The other 50 percent of the shares were held by the three children of Arnold Kilberg. Kilberg himself owned no stock in the corporation, but he served as the day-to-day manager of the company. FCC was in the business of making and servicing equity loans to small businesses under the regulation of the U.S. Small Business Administration (SBA) and was capitalized by loans from the SBA and a $1.26 million investment by Anjoorian.

Beginning in 1990, P&T provided accounting services to FCC. The firm audited FCCs annual financial statements following the close of each calendar year between 1990 and 1994. In its representation letter (similar to the current Section 302 requirement under SOX), P&T stated that FCC was responsible for the fair presentation in the financial statements of financial position. P&Ts responsibility was to perform an audit in accordance with GAAS and to express an opinion on the financial statements based on the firms audit. The first page of each financial statement contained the auditors opinion that the financial statements referred to above present fairly, in all material respects, the financial position of FCC in conformity with generally accepted accounting principles. Each report is addressed to The Board of Directors and Shareholders. The 19901994 statements indicate that it is managements opinion that all accounts presented on the balance sheet are collectible. In addition, the 19911994 statements indicate that all loans are fully collateralized according to the board of directors.

On March 2, 1994, Anjoorian filed a complaint and motion for a temporary restraining order seeking the dissolution of FCC on various grounds. P&T was not a party to that suit. As a result of that action, the three Kilberg children exercised their right to purchase the plaintiffs shares of the corporation. The court appointed an appraiser to determine the value of Anjoorians shares, which the other shareholders would have to pay. The bulk of FCCs assets comprised its right to receive payment for the loans that it had made. The appraiser determined that the value of the corporation was $2,395,000, plus a payroll adjustment of $102,000, and minus a loss reserve adjustment to account for the fact that 10 of FCCs 30 outstanding loans were delinquent. The loss reserve adjustment reduced the total appraised value of the corporation by $878,234. Consequently, Anjoorians 50 percent interest in the corporation was reduced accordingly by $439,117. He ultimately received a judgment for $809,382.85 against the other shareholders in exchange for the buyout of his shares.

In 1997, Anjoorian brought the lawsuit against Kilberg, Kilbergs company, and P&T. He claimed that P&T was negligent in preparing the annual financial statements for FCC because it did not include an accurate loan loss reserve in the statements. Anjoorian argued that he relied on the financial statements prepared by the defendants, and that if the statements had included a loan loss reserve, he would have sought dissolution of the corporation much earlier than 1994, when his shares would have been more valuable. Anjoorian submitted an appraisal suggesting that the appropriate loan loss reserve figure would have been much lessand, therefore, his share value much higherin the years 1990 and 1991. He alleged that he lost over $300,000 in share value between 1990 and March 2, 1994. Nine years later, the defendants moved for summary judgment on the grounds that P&T owed no duty to Anjoorian as a shareholder.

Accountants Liabilities to Third Parties

Silverstein observed that while the question of accountant liability to third parties was unsettled in Rhode Island, the Rhode Island Supreme Court had identified three competing interpretations. The first interpretation was the foreseeability test, under which an auditor has a duty to all foreseeable recipients of information he provides. This rule gives little weight to the concern for limiting the potential liability for accountants and is not widely adopted, Silverstein noted.

The second interpretation, the judge continued, was the privity test, requiring a contractual relationship to exist between an accountant or auditor and another party.

Finally, the Restatement test, found in 522 of the Restatement (Second) of Torts, states an accountant who does not exercise reasonable care is only liable to intended persons or classes of persons, and only for intended transactions or substantially similar transactions, said Silverstein. [This approach] applies not only [to] specific persons and transactions contemplated by the accountant, but also specific classes of persons and transactions. Silverstein settled on the Restatement rule.²

Applying the rule, Silverstein denied summary judgment for the accounting firm, concluding there was a genuine issue of material fact on whether the accounting firm could be liable.

This court would have no difficulty finding a duty in this case, in the absence of a specific financial transaction, if it can be shown that [the defendant] intended the shareholders to rely on the financial statements for the purpose of evaluating the financial health of the company, and therefore, their investment in the company, wrote Silverstein.³

Case Analysis

The court found that the addressing of the reports to the shareholders, while not conclusive, is a strong indication that P&T intended the shareholders to rely upon them. Therefore, the court concluded that genuine issues of fact exist as to whether P&T intended for Anjoorian to rely on these financial statements. Perhaps the court would have reached a different conclusion for a widely held public corporation with a potentially unlimited number of shareholders whose identities change regularly. Here, however, FCC was a close corporation with only four shareholders, giving greater significance to the fact that the financial statements were addressed to the shareholders.

The defendants also argued that, in order to find a duty to third parties, an accountant must have contemplated a specific transaction for which the financial statement would be used and that no such transaction was contemplated here.⁴ The court found this argument unconvincing, stating that the case is unusual in that the alleged malpractice did not arise from a specific financial transaction. The typical case involves a person whose reliance on a defective financial statement induces the person to advance credit or invest new equity into the corporation.⁵ When the investment is lost, or the loan unpaid, the person sues the accountant. In this case, however, Anjoorian had already invested his capital in the corporation when P&T was hired, and he alleged that he used the financial statements as a tool to evaluate the value of that investment. The alleged malpractice did not result in his advancing new value to the corporation and then losing his investment, but instead resulted in Anjoorian failing to withdraw his capital from the corporation while its value was higher.

The court opined that it would have no difficulty finding a duty in this case, in the absence of a specific financial transaction, if it could be shown that P&T intended the shareholders to rely on the financial statements for the purpose of evaluating the financial health of the company and, therefore, their investment in the company. In this case, the particular transaction contemplated by the Restatement relates to the purpose for which the financial statements would be usedthe shareholders decision whether to withdraw capital or not. While it remains to be proved that P&T actually did foresee that its financial statements would be used by the shareholders in this manner, the absence of a particular financial transaction does not preclude the finding of a duty in this case. Because the value of the shareholders investment was limited to the amounts reflected in the company balance sheets, any loss from malpractice was an insurable risk for which accounting professionals can plan.⁶

The defendants argued that the plaintiffs theory of damages was speculative and against public policy. Anjoorian based his damage claims on the assertion that he relied on four annual audited financial statements to evaluate the status of his $1.26 million investment in FCC. Because the statements failed to include a loan loss reserve figure, he argued that the statements overstated the value of the corporation at the end of each year from 1990 to 1993. When Anjoorian sought dissolution in 1994, the value he obtained for his shares was significantly less than his expectation. He contended that if he had accurate financial information, he would have liquidated his investment earlier when his shares were more valuable. At issue was the existence and amount of the loan loss reserve. An appraiser of the value of the corporation in the dissolution action determined that the inclusion of a loan loss reserve in the financial statements was proper, and that created a genuine issue as to whether a breach of the duty of care occurred. The defendant had questioned the computation of the loan loss reserve but the court disagreed. (A detailed analysis of the amount of loan loss reserve has been omitted.)

1. Analyze the potential for legal liability of P&T under each of the four basic theories of liabilities discussed in Chapter 8.

2. Were the auditors guilty of professional negligence? Explain.

3. Judge Silverstein relied on the Restatement (Second) of the Law of Torts for his ruling. Assume he had relied on the near-privity relationship ruling in Credit Alliance and evaluate the legal liability of the auditors using that standard.

4. The defendants argued in the case that, in order to find a duty to third parties, an accountant must have contemplated a specific transaction for which the financial statement would be used and that no such transaction was contemplated here. Do you agree with this statement from the perspective of auditors' third-party liability? Why or why not?