The opinion of the Court was delivered by SCHREIBER, J.
This case focuses upon the issue of whether accountants should be responsible for their negligence in auditing financial statements. If so, we must decide whether a duty is owed to those with whom the auditor is in privity, to third persons known and intended by the auditor to be the recipients of the audit, and to those who foreseeably might rely on the audit. Subsumed within these questions is a more fundamental one: to what extent does public policy justify imposition of a duty to any of these classes?
The issues herein arose on defendants' motion for partial summary judgment. The facts that follow were, therefore, adduced from the record in a light most favorable to the plaintiffs. The plaintiffs Harry and Barry Rosenblum brought this action against Touche Ross & Co. (Touche), a partnership, and the individual partners. Touche, a prominent accounting firm, had audited the financial statements of Giant Stores Corporation (Giant). These plaintiffs, allegedly relying on the correctness of the audits, acquired Giant common stock in conjunction with the sale of their business to Giant. That stock subsequently proved to be worthless, after the financial statements were found to be fraudulent. Plaintiffs claim that Touche negligently conducted the audits and that Touche's negligence was a proximate cause of their loss.
Giant, a Massachusetts corporation, operated discount department stores, retail catalog showrooms and art and gift shops. Its common stock was publicly traded, its initial public offering having been made pursuant to a registration statement filed
In November 1971 Giant commenced negotiations with the plaintiffs for the acquisition of their businesses in New Jersey (H. Rosenblum, Inc. and Summit Promotions, Inc.). These enterprises had retail catalog showrooms in Summit and Wayne. The merger negotiations culminated in an agreement executed on March 9, 1972. During the discussions two significant events occurred. First, on December 14, 1971, Giant made a public offering of 360,000 shares of its common stock. The financial statements included in the prospectus of that offering contained statements of annual earnings for four years ending January 30, 1971, as well as balance sheets as of January 30 for each of those years, which had been audited by Touche. Touche's opinion affixed to those financials stated that it had examined the statements of earnings and balance sheets "in accordance with generally accepted auditing standards" and that the financial statements "present[ed] fairly" Giant's financial position. Similar data had been incorporated in Giant's annual report for the year ending January 30, 1971. Second, Touche began its audit of Giant's financials for the year ending January 29, 1972. This audit was completed on April 18, 1972. The attached Touche opinion bore the same language affixed to the 1971 statements.
One of the Touche partners, Armin Frankel, was present at some of the merger discussions. It does not appear that he participated in the negotiations, though the plaintiffs assert that they received the January 1971 audited statements during a meeting at which Frankel was present. Although he denies making the projection, Frankel is also alleged to have stated during one meeting that the preliminary figures of the 1972 audit then under way indicated it was going to be "a very
The merger agreement provided that the Rosenblums would receive an amount of Giant stock, up to a maximum of 86,075 shares, depending upon the net income of their enterprises for their fiscal year ending December 31, 1971. The closing was to be scheduled between May 15 and May 31, 1972. Giant agreed that as of the closing it would represent and warrant that there had "been no material adverse change in the business, properties or assets of Giant and its Subsidiaries since July 31, 1971." The plaintiffs claim they relied upon the 1972 audited statements before closing the transaction on June 12, 1972. The Rosenblums received Giant common stock, which had been listed on the American Stock Exchange in February 1972 and was being traded on that Exchange when the merger was effected. After the Rosenblum closing, Giant made another public offering of common stock in August 1972. Touche furnished for this Giant registration statement the audited financial statements for each of the five fiscal years ending January 29, 1972, to which was affixed Touche's unqualified opinion.
Giant had manipulated its books by falsely recording assets that it did not own and omitting substantial amounts of accounts payable so that the financial information that Touche had certified in the 1971 and 1972 statements was incorrect.
The Appellate Division granted plaintiffs' motion for leave to appeal, but affirmed the trial court's dismissal of the negligence claim based on the 1971 audit. 183 N.J.Super. 417 (1982). We granted plaintiffs' motion for leave to appeal. 91 N.J. 191 (1982). The defendants had also moved for leave to appeal from the denial of their motion for partial summary judgment addressed to claims predicated on the 1972 financials. The Appellate Division had denied that motion. The defendants subsequently moved before us for leave to appeal from the Appellate Division's denial. We acceded to that motion after we had granted plaintiffs' motion for leave to appeal. Thus the propriety of the trial court's disposition of Touche's entire motion for partial summary judgment is now before us.
An independent auditor is engaged to review and examine a company's financial statements and then to issue an opinion with respect to the fairness of that presentation. That report is customarily attached to the financial statements and then distributed by the company for various purposes. Recipients may be stockholders, potential investors, creditors and potential creditors. When these parties rely upon a negligently prepared auditor's report and suffer damages as a result, the question arises whether they may look to the auditor for compensation.
A claim against the auditor is realistically one predicated upon his representations. Though the theory advanced here by the plaintiffs is directed to the service performed by accountants and thus is in the nature of malpractice, their claim can be viewed as grounded in negligent misrepresentation. In the complaint the plaintiffs seek recompense for economic loss from a negligent supplier of a service with whom the claimants are not in privity. It has generally been held with respect to accountants that imposition of liability requires a privity or privity-like relationship between the claimant and the negligent actor. We must examine a number of issues in order to determine whether we should so limit such actions in New Jersey.
First, we shall consider whether, in the absence of privity, an action for negligent misrepresentation may be maintained for economic loss against the provider of a service. This involves (1) a negligent misrepresentation, (2) in furnishing a service, (3) that results in economic loss, (4) to a person not in privity with the declarant.
Negligent misrepresentation is a legally sound concept. An incorrect statement, negligently made and justifiably relied upon, may be the basis for recovery of damages for economic loss or injury sustained as a consequence of that reliance. Pabon v. Hackensack Auto Sales, Inc., 63 N.J.Super. 476 (App. Div. 1960), presents an example of a valid physical damage claim predicated upon misrepresentation. The driver of an automobile sued the automobile dealer and manufacturer for damages sustained when his steering wheel locked and the automobile went out of control and struck a pole. A judgment of involuntary dismissal at the close of the plaintiff's case was reversed. One theory advanced by the plaintiff was based on the negligent representation made by the dealer that the steering characteristic plaintiff had encountered prior to the accident was not the result of any deficiency, but rather was normal. The Appellate Division observed that negligence might be inferred from the falsity of the representation. It commented:
Recovery of economic loss, due to negligent misrepresentation by one furnishing a service, has long been permitted when
Our case law, however, has been split on whether privity or a similar relationship is necessary in a suit against the supplier of a service for negligent misrepresentation causing economic loss.
Kahl v. Love, 37 N.J.L. 5 (Sup.Ct. 1873), is probably the first reported New Jersey negligent misrepresentation case concerned with a service resulting in economic loss. Defendant was the Jersey City collector of taxes. Upon receiving the check of a landowner in payment of taxes, defendant gave the landowner a receipt in full. The land, the subject of these taxes, was sold to the plaintiff, who relied on the receipt as proof of payment of the taxes. The check was later dishonored and taxes were levied on the lands after the plaintiff acquired title. The plaintiff sued the collector for the damages suffered and obtained a judgment. The Supreme Court reversed, citing both the absence of a duty and the unreasonableness of the plaintiff's reliance. The Court assumed that the defendant knew that these receipts were used on the sale of land to establish that taxes were paid up. It held that a duty, arising from contract or otherwise, had to exist before liability could ensue. Chief Justice Beasley, writing on behalf of the Court, stated:
A more recent lower court decision has held to the contrary. In Immerman v. Ostertag, 83 N.J.Super. 364 (Law Div. 1964), the court stated that a notary public owes a duty to third persons who rely on his acknowledgment to refrain from acts or omissions that constitute negligence. Immerman accepted the proposition that "an acknowledgment-taking officer has a duty to refrain from acts or omissions which constitute negligence, a duty which he owes not only to persons with whom he has privity, but also to any member of the public who, in reasonable contemplation, might rely upon the officer's certification." 83 N.J. Super. at 369. This Court has approvingly cited Immerman as articulating the general rule with respect to notaries. Commercial Union Ins. Co. v. Thomas-Aitken Constr. Co., 54 N.J. 76, 81 (1969).
Similarly, lack of privity has been held not to bar the liability of an independent contractor engaged to perform services for his negligent nonfeasance. Gold Mills, Inc. v. Orbit Processing Corp., 121 N.J.Super. 370 (Law Div. 1972). The court there observed:
We have never passed upon the problem of an accountant's liability to third persons who have relied on negligently audited
Chief Judge Cardozo, like Chief Justice Beasley in Kahl, believed that imposition of this type of exposure would be an undue burden upon the declarants, when balanced against the functions they performed. In Glanzer v. Shepard, 233 N.Y. 236, 135 N.E. 275 (1922), Judge Cardozo had held liability did exist in favor of a third party when it was shown that the certification was made for the use of that third person. There a bean seller contracted with the defendant, a professional weigher, to weigh and certify a shipment of beans being sold to the plaintiff. The plaintiff's suit against the professional weigher was upheld because the weigher knew the certification was to be used by the plaintiff. Ultramares and Glanzer acknowledge the existence
Many commentators have questioned the wisdom of Ultramares and Glanzer. See, e.g., Wiener, "Common Law Liability of the Certified Public Accountant for Negligent Misrepresentation," 20 San Diego L.Rev. 233 (1983); Besser, "Privity? — An Obsolete Approach to the Liability of Accountants to Third Parties," 7 Seton Hall L.Rev. 507 (1976); Marinelli, "The Expanding Scope of Accountants' Liability to Third Parties," 23 Case W.Res.L.Rev. 113, 117-22 (1971); Seavey, "Mr. Justice Cardozo and the Law of Torts," 52 Harv.L.Rev. 372, 398-404 (1939); Solomon, "Ultramares Revisited: A Modern Study of Accountants' Liability to the Public," 18 DePaul L.Rev. 56 (1968). Criticism of the primary benefit rule led in part to the adoption of Section 552 of the Restatement (Second) of Torts, which limited liability for negligent misrepresentation to the loss
When applied to an auditor, the Restatement limits the persons to whom he owes a duty to his client, to intended identifiable beneficiaries and to any unidentified member of the intended class of beneficiaries. The only extension in the Restatement beyond Ultramares and Glanzer appears to be that the auditor need not know the identity of the beneficiaries if they belong to an identifiable group for whom the information was intended to be furnished. There is a substantial split of authority among the courts, some following Ultramares and others adopting the Restatement. See Annot., "Liability of public accountant to third parties," 46 A.L.R.3d 979, 989 (1972).
Both Ultramares and the Restatement demand a relationship between the relying third party and the auditor. Unless some policy considerations warrant otherwise, privity should
We long ago discarded the requirement of privity in a products liability case based on negligence.
It is clear that an action for negligence with respect to an injury arising out of a defective product may be maintained without privity. The negligence involved may be that ascribable to negligent misrepresentation.
In Martin v. Bengue, Inc., 25 N.J. 359 (1957), we held that the plaintiff had a viable cause of action against the manufacturer of an ointment because the manufacturer's directions accompanying the product assured that the ointment could be safely used. The directions were misleading because they made no reference to the dangers of the flammability of the vapors
In O'Donnell v. Asplundh Tree Expert Co., 13 N.J. 319 (1953), the plaintiff, a tree trimmer, fell and was injured when the hook securing his safety belt broke. The hook had been purchased by the plaintiff's employer from the defendant. The defendant had negligently represented to the employer that this safety hook was adequate to be used by tree trimmers as a safety hook or snap. In reversing the trial court's judgment of dismissal entered at the conclusion of the plaintiff's case, we referred to the careless misrepresentations of the defendant to the employer that the hooks were made of proper material, and stated that such representations "are a factor to be considered in determining the defendant's negligence." In O'Donnell we referred to and relied upon Thomas v. Winchester, 6 N.Y. 397 (1852), in which the New York Court of Appeals held that a manufacturer of drugs and medicines who carelessly labeled a deadly poison as a harmless medicine and sent it so labeled into the market was liable to those who were injured by using it.
These cases demonstrate that negligent misrepresentations referring to products may be the basis of liability irrespective of privity.
Why should a claim of negligent misrepresentation be barred in the absence of privity when no such limit is imposed where the plaintiff's claim also sounds in tort, but is based on liability for defects in products arising out of a negligent misrepresentation? If recovery for defective products may include economic loss, why should such loss not be compensable if caused by negligent misrepresentation? The maker of the product and the person making a written representation with intent that it be relied upon are, respectively, impliedly holding out that the product is reasonably fit, suitable and safe and that the representation is reasonably sufficient, suitable and accurate. The fundamental issue is whether there should be any duty to respond in damages for economic loss owed to a foreseeable user neither in privity with the declarant nor intended by the declarant to be the user of the statement or opinion.
There remains to be considered whether the public interest will be served by a proposition holding an auditor responsible for negligence to those persons who the auditor should reasonably foresee will be given the audit to rely upon and do in fact place such reliance on the audit to their detriment. Should there be such a duty imposed? Chief Justice Weintraub in Goldberg v. Housing Auth. of Newark, 38 N.J. 578, 583 (1962), explained the judicial analysis that must be made:
The fairness of the imposition of a duty on accountants cannot be appraised without an understanding of the independent accountant's auditing function. It is particularly important to be aware of the independent auditor's role in order to assess the propriety of imposing any duty to those who may rely on the audit.
Accounting is the act of identifying, measuring, recording, and communicating financial information about an economic unit. W. Pyle & J. White, Fundamental Accounting Principles 1 (1972). It has been said that
The company prepares the financial statements in the first instance. The independent auditor's role in the accountability process is to scrutinize management's accountability reports. Commission on Auditors' Responsibilities, American Institute of Certified Public Accountants, Report, Conclusions and Recommendations 1 (1978). The auditor must make such an examination so as to enable him to express an opinion on the fairness of the financial presentation in the statements. The professional standards of the American Institute of Certified Public Accountants express the auditor's function as follows:
The auditor is concerned with generally accepted accounting principles, that is, acceptable assumptions, procedures and techniques for the preparation of financial statements. Dawson, "Auditor's Third Party Liability," 46 Wash.L.Rev. 675, 691 (1971). Auditing standards have been developed by the American Institute of Certified Public Accountants governing examination of statements and reporting as to whether generally accepted principles and practices have been followed. Statements on Auditing Standards, 1 AICPA, Professional Standards, § 110.01 (1972).
To perform these functions the auditor must, among other things, familiarize himself with the business, its operation and reporting methods and industry-wide conditions. It is necessary
There are certain limitations within the accounting framework. The proper accounting treatment of some matters may not be settled. For example, research and development might be written off immediately as an expense or capitalized and disposed of over a period of time. Similarly, there is considerable debate over the proper method for depreciating intangible assets. An auditor's review is subject to similar constraints because the financial statements cannot be more reliable than the underlying accounting methodology. The auditor must critically evaluate the accounting principles selected to measure performance, but some of the basic data upon which the auditor relies are not as a practical matter verifiable. The auditor is neither required to investigate every supporting document, nor deemed to have the training or skills of a lawyer or criminal investigator. Commission on Auditor's Responsibilities, American Institute of Certified Public Accountants, Report, Conclusions and Recommendations 45 (1978).
Nonetheless, the independent auditor should be expected to detect illegal or improper acts that would be uncovered in the exercise of normal professional skill and care. The auditor should exercise reasonable care in verifying the underlying data and examining the methodology employed in preparing the financial statements. The accountant must determine whether there are suspicious circumstances and, even in the absence of suspicious circumstances, make a reasonable sampling or apply some testing technique. Hawkins, "Professional Negligence Liability of Public Accountants," 12 Vand.L.Rev. 797, 805 (1959). This does not mean the auditor will always be able to discover material fraud. Yet the audit, particularly when it uncovers fraud, dishonesty, or some other illegal act, serves an undeniably beneficial public purpose.
In In re Kerlin, SEC Accounting Release 105 (1966), the Securities and Exchange Commission observed:
The auditor's function has expanded from that of a watchdog for management to an independent evaluator of the adequacy and fairness of financial statements issued by management to stockholders, creditors, and others. Broad, "The Progress of Auditing," 100 J. Accountancy 38, 38-39 (1955); Hallett & Collins, "Auditors' Responsibility for Misrepresentation," 44 Wash.L.Rev. 139, 178 (1968).
The changing function of an independent public accountant has been described as follows by J. Carey, one-time executive director of the American Institute of Accountants, in Professional Ethics of Public Accounting (1946) at 13-14:
The two most important qualities of the auditor are the expertise that he brings to the project and the independence with which he performs his task. See Wixon & Kell, Accountants' Handbook 28.1 (4th ed. 1956). The auditor is not only labeled as independent, but also is expected to be independent in fact. The public accountant must report fairly on the facts whether favorable or unfavorable to the client. See 82 J. Accountancy 449, 453 (1946). It is generally in management's interest that the financial statements reflect performance in the most favorable light. There is an inherent divergence of interests between management and third persons who will rely upon these statements. Without the auditor's oversight, management might be tempted to tilt certain items in its favor or to commit outright misrepresentation.
The Legislature has expressed its concern for the competence of accountants by enacting the Public Accounting Act of 1977, which requires that public accountants be certified or registered upon fulfilling certain standards. N.J.S.A. 45:2B-1 to -37. The declared legislative purpose of the Act is
Many who would benefit from the rule that an auditor owes a duty of reasonable care to those to whom the company may foreseeably deliver the audit are now protected. Accounting firms are presently liable to purchasers of securities in public offerings when they have misstated a material fact in the financial statements. Securities Act of 1933, 15 U.S.C.A. § 77k (1981). It is interesting to compare the elements constituting liability under the Securities Act of 1933 with the traditional negligence (non-privity) standard. Accountants' liability under Section 11 is often available where an action for ordinary negligence would not succeed. Under section 11 the plaintiff need not prove scienter, negligence, or proximate cause; the burden of proof is on the accountants to establish freedom from negligence or "due diligence." See generally Herman & MacLean v. Huddleston, ___ U.S. ___, ___, 103 S.Ct. 683, 687, 74 L.Ed.2d 548, 555 (1983). Section 18 of the Securities Exchange Act of 1934 creates a civil liability for any person who causes a misleading statement to be made in any report filed with the SEC under the 1934 Act. 15 U.S.C.A. 78r. The plaintiff must prove reliance and the defendant is not responsible if "he acted in good faith and had no knowledge that such statement was false or misleading." Under those statutes privity is not a defense and accountants may have substantial liabilities to third persons. Escott v. Bar Chris Construction Corp., 283 F.Supp. 643 (S.D.N.Y. 1968) (auditor liability under Section 11 of Securities Act of 1933); Fischer v. Kletz, 266 F.Supp. 180 (S.D.N.Y. 1967) (auditor liability under Section 18 of the Securities Exchange
Independent auditors have apparently been able to obtain liability insurance covering these risks or otherwise to satisfy their financial obligations. We have no reason to believe that they may not purchase malpractice insurance policies that cover their negligent acts leading to misstatements relied upon by persons who receive the audit from the company pursuant to a proper business purpose.
The extent of financial exposure has certain built-in limits. The plaintiffs would have to establish that they received the audited statements from the company pursuant to a proper company purpose, that they, in accordance with that purpose, relied on the statements and that the misstatements therein were due to the auditor's negligence and were a proximate cause of the plaintiff's damage.
Similar thoughts were expressed in Rusch Factors, Inc. v. Levin:
Recently Justice Wiener, in his article "Common Law Liability of the Certified Public Accountant for Negligent Misrepresentation," concluded:
When the independent auditor furnishes an opinion with no limitation in the certificate as to whom the company may disseminate the financial statements, he has a duty to all those whom that auditor should reasonably foresee as recipients from the company of the statements for its proper business purposes, provided that the recipients rely on the statements pursuant to those business purposes.
Certified financial statements have become the benchmark for various reasonably foreseeable business purposes and accountants have been engaged to satisfy those ends. In those circumstances accounting firms should no longer be permitted to hide within the citadel of privity and avoid liability for their malpractice. The public interest will be served by the rule we promulgate this day.
A. The 1971 Audit
Both the trial court and the Appellate Division ruled that the plaintiffs' claim based on negligent preparation of the 1971 audit could not be sustained because the accountants were not aware at the time the audit was prepared of the existence of the plaintiffs or of a limited class of which the plaintiffs were members. The defendant's audit had been completed on April 16, 1971 and Giant's merger discussions with the plaintiff did not begin until the following September.
It may be contended under one view of the evidence that the defendants knowingly permitted and authorized plaintiffs' use of the 1971 audit. In doing so, they were aware that the plaintiffs would rely on that audit. Under these circumstances,
Defendants' presence and participation in the merger proceedings were not gratuitous. Any representations were made by defendants on behalf of their client Giant. Liability would be sustainable under the traditional rationale of Glanzer v. Shepard, supra, and Economy B. & L. Ass'n v. West Jersey Title Co., supra.
However, the facts supporting this position are somewhat attenuated. We are not unmindful that R. 4:46-2 provides that summary judgment shall be entered when "there is no genuine issue as to any material fact challenged." Implicated is the policy consideration that "protection is to be afforded against groundless claims" to save the expenses of protracted litigation and "reserve judicial manpower and facilities." Robbins v. Jersey City, 23 N.J. 229, 241 (1957); see also United Rental Equip. Co. v. Aetna Life & Cas. Ins. Co., 74 N.J. 92, 99 (1977). We therefore deem it appropriate to apply the somewhat broader principle enunciated above because the trial court may be faced with this issue at the trial. In adopting that position we are aware of the observation of Chief Justice Weintraub in Busik v. Levine, 63 N.J. 351, 363, appeal dismissed for want of substantial federal question, 414 U.S. 1106, 94 S.Ct. 831, 38 L.Ed.2d 733 (1973), that "[w]hether an issue will be dealt with narrowly or expansively calls for a judge's evaluation of many things, including the need for guidance for the bar or agencies of government or the general public." See also Rova Farms Resort v. Investors Ins. Co., 65 N.J. 474, 502 (1974).
Defendants became aware of plaintiffs' existence and their intended use of these statements before the plaintiffs relied on the accuracy of these financials. The defendants knew that the merger agreement included a representation that the prospectus used for the public offering in December 1971 contained no untrue statement of a material fact and did not omit to state any material fact. The defendants knew that this prospectus included their opinion that the financials had been prepared in accordance with generally accepted accounting principles and fairly presented Giant's financial condition. The defendants' representations were of a continuing nature and their obligation was a continuing one. See Fischer v. Kletz, 266 F.Supp. 180 (S.D.N.Y. 1967) (accountants discovering inaccuracy after audit was released held under duty to disclose after-acquired information).
On the motion for summary judgment the facts viewed favorably from the plaintiffs' perspective are that the defendants negligently prepared their audit of Giant's financial statements reflecting Giant's operations for the twelve months ending January 30, 1971 and its financial status on that date. These statements were subsequently delivered by Giant, in furtherance of its business, to the plaintiffs for their consideration in determining whether to sell their enterprises to Giant, whether to accept Giant stock and how much stock to seek. Indeed, the defendants became aware of the fact that these financials had been delivered to the plaintiffs in connection with the proposed merger. The plaintiffs, allegedly relying upon the defendants' express representations, entered into the merger agreement which was subsequently consummated. As a result, plaintiffs claim to have suffered damages. Under these circumstances, the courts below erred in striking the cause of action predicated on the negligent auditing of the financial data for the year ending January 30, 1971.
B. The 1972 Audit
The trial court denied defendants' motion to dismiss the plaintiffs' claims of fraud and negligence ascribable to the 1972 audit. The defendants contend that the plaintiffs had already signed and were bound by the merger contract executed on
Irrespective of whether the defendants had actual knowledge of Giant's proposed use of the 1972 audit in connection with the merger, it was reasonably foreseeable that Giant would use the audited statement in connection with the merger and its consummation. This is particularly so since the defendants were familiar with the merger agreement and had been engaged by Giant to audit the books and records of the plaintiffs' enterprises for the purpose of the merger. The trial court properly denied defendants' motion.
The judgment granting defendants' motion for partial summary judgment with respect to the 1971 financial statements is reversed and that denying defendants' motion for partial summary judgment with respect to the 1972 financial statements is affirmed. The cause is remanded to the trial court for further proceedings consistent with this opinion.
For affirmance — None.
See also 5 Nat'l L.J. 1 (1983).
At oral argument defendants contended that the cost of insurance to cover the claims of all foreseeable users of audits would be catastrophic. Suffice it to say that defendants have not alerted us to data either within or outside the record to support this position.
Judge Woolf agreed with another jurist who found it "paradoxical that no duty of care should be owed to those who can be foreseen likely to sustain damage if carelessness existed, but that a duty of care should be owed to those, their clients, in respect of whom there is no foreseeable risk of damage" when the defalcation is due in the first instance to the client. Id. at 296.