Court rules on duty and reliance. . .Accounting firm not liable for acts of alleged agent.

Duty and Reliance

The South Carolina Supreme Court held that an accounting firm owes a duty to third-party investors in certain circumstances. The case began when Emb-Tex Corp. (ETC) retained Deloitte & Touche to audit its financial statements from 1982 to 1988. ML-Lee Acquisition Fund made investments in ETC in 1988 and in 1990 but learned in 1991 that ETC’s financial statements for 1985 and beyond had overstated the company’s inventory. The financial statements prepared by the firm, therefore, did not reflect ETC’s true financial condition when ML-Lee made its investments. ML-Lee sued the firm for professional negligence and negligent misrepresentation, alleging it had suffered a loss because its agent and investment adviser, Thomas H. Lee Co., had relied on the audit reports and the firm’s 1988 “comfort letter” in recommending the investments in ETC.

The trial court granted summary judgment to the firm on all counts. The court of appeals reversed in part the trial court’s ruling that the firm had no duty to ML-Lee. It found that ML-Lee was the firm’s client for purposes of the 1990 investment and, accordingly, the firm was obligated to disclose to it information regarding ETC’s inventory overstatement. The appeals court also reversed the lower court’s ruling that there was no justifiable reliance and held the reliance of the agent, Thomas H. Lee, was sufficient to establish liability to a principal for a negligent misrepresentation. The state supreme court thus had two issues to decide: (1) Did the firm have a duty to disclose the inventory overstatement? (2) Is the reliance of the agent, Thomas H. Lee, sufficient to establish justifiable reliance on the firm’s audit work?

In the first issue, the supreme court ruled the investor was not the accountant’s client and, therefore, the court of appeals had erred in ruling the firm had a duty to disclose. In the second issue, the supreme court said the party seeking to recover under a theory of negligent misrepresentation must show it justifiably relied on the information the accountant communicated. The trial court had ruled that in order to establish justifiable reliance, a plaintiff must prove it relied directly on the information the accountant provided. It had thus concluded that the facts showed, at best, that Thomas H. Lee had relied on the information in recommending these investments, but the investor had not. The court of appeals then reversed this ruling as inconsistent with the law of agency. The supreme court, noting that it has been well established that the authorized acts of an agent are the acts of the principal, held that Thomas H. Lee’s reliance on the firm’s work was therefore the same as if ML-Lee itself had relied on it.

The case is significant because a state supreme court ruled that third-party investors may rely on the work of an accounting firm in making investment decisions even if such investors are not clients of the accounting firm. ( ML-Lee Acquisition Fund v. Deloitte & Touche , South Carolina Supreme Court, Opinion no. 24676, August 11, 1997)

Liability for Acts of Alleged Agent

An Illinois appellate court ruled that an accounting firm is not liable for the actions of a party who represents, without the knowledge of the firm, that he is acting on behalf of the firm. This case began when investors retained their brother-in-law to invest on their behalf. The brother-in-law represented that he was affiliated with an accounting firm that marketed financial investments. The firm, in fact, was allowing him to use its address, offices and telephone; however, he was also—without the firm’s knowledge—using its letterhead in transmittals to investors. (That is, although this was an official sharing relationship, the brother-in-law tried to represent himself as part of the firm through the letterhead use.) He subsequently converted the investors’ funds to his own use. The investors sued the accounting firm, claiming the brother-in-law had acted with the apparent authority of the firm. The trial court ruled in the investors’ favor. The accounting firm appealed.

The appellate court reversed the trial court’s decision. An apparent agency relationship exists if a principal (the accounting firm) creates the reasonable impression in a third party (the investors) that the agent (brother-in-law) has the authority to act on its behalf. In this case, the firm did not knowingly consent to the agent’s exercise of authority to act on its behalf merely by allowing the agent to use its office and telephone. Also, had the investors done minimal due diligence, they would have found that the firm did not market investment products. Based on these facts, a reasonable person would not have concluded that the brother-in-law was authorized by the firm to market investments on its behalf. ( Raclaw v. Fay, Conmy and Co., Ltd. , 668 N.E. 2d 114)

—Edited by Wayne Baliga, CPA, JD, CPCU, CFE, president of Aon Technical Insurance Services .

©1998 AICPA