It was nearly eight years ago when Irvine accountant John P. Butler rendered the certified public accountant's standard, unqualified opinion on the financial condition of a Costa Mesa mortgage company he audited, saying the figures "fairly represented" the company's operating results.
Now, Butler's role in that audit is being challenged in a lawsuit that could expose accountants in California to a wide new range of liability claims.
Butler is accused in the suit of being negligent in preparing his audit of the now-defunct Westside Mortgage Co., causing financial injury to a company that claims it relied on Butler's statement nine months after it was issued and ultimately lost more than $435,000 in a deal with Westside.
The suit raises a controversial issue never decided before in California--whether certified public accountants are liable to unknown third parties for negligence in preparing audited financial statements for their clients.
Whether the case ever goes to trial will depend on a decision expected this month from a state Court of Appeal panel in Santa Ana. But that ruling could have a far-reaching effect on the accounting profession.
"This case will be of concern to accountants no matter how it's decided," said Los Angeles lawyer Paul J. Hall, who represents the plaintiff, International Mortgage Co. of Los Angeles.
Butler's attorney, Jeffrey H. Leo of Los Angeles, agrees: "The court could make a decision that would have a very significant impact either way it ruled."
While a few states have come down with their own rulings on the issue, the California court's decision will have a persuasive effect because the state's higher courts are generally well-respected. And a federal court faced with such a claim would resolve the issue by applying state court decisions from the state where the transaction occurred.
The California Society of Certified Public Accountants is watching the case "with a great deal of interest," said accountant Robert A. Petersen, the society's president-elect and head of a task force examining third-party liability.
"Clearly, if the plaintiff wins, that opens up a wider spectrum of liability that would be very costly," he said. "The profession at the moment in California and throughout the United States is having serious problems both in the cost and even renewance of errors-and-omissions insurance. Anything we can do to narrow liability will increase our ability to get insurance."
The ramifications of opening the door to third-party liability claims, said Petersen and others in the accounting profession, range from a fear of losing insurance to a fear of more lawsuits by third parties such as lenders, customers, suppliers and investors who watch their money go down the drain with a bankrupt firm. Such liability could force independent accountants out of business, they warn.
"For any company dealing on a credit basis, the first thing that is asked for is a financial statement. It is the basic document used for credit purposes," said Melvyn I. Weiss, a New York attorney at the forefront of suits against accounting firms.
But the public may have a perception that an accountant does much more than he, in fact, does. "The ordinary audit is not meant to detect fraud," said Louis Craco a New York attorney for the American Institute of Certified Public Accountants. He said an auditor is "obliged to go forward and investigate only when the circumstances or facts make him reasonably suspicious."
In the pending California appellate court case, International Mortgage Co. (IMC) claims it relied on Butler's March, 1979, audited financial statement of Westside Mortgage Co. when it decided to purchase $4 million in loans from Westside. At about the same time, IMC made commitments to resell those loans in the secondary market.
Sued for Difference
But Westside could not deliver the mortgages on schedule and IMC had to buy loans elsewhere to fulfill its commitments. Claiming it lost $435,293, IMC sued Westside and Butler in January, 1981, for the difference. Westside eventually went out of business.
IMC claims Butler failed to investigate a $100,000 promissory note that represented nearly all of Westside's capital and that qualified Westside to handle the federally backed mortgages involved in the deal. The note was secured by a trust deed which was noted in Butler's audit report. But Butler did not specify that the security was a fourth trust deed, subordinate to three other creditors. Ultimately, the note could not be paid off when Westside's senior creditors foreclosed on the property.
"Verbally, it was related to me to be a first trust deed, but in a footnote in the financial statement, I just said it was a trust deed," Butler said. "IMC should have read the footnotes. They could have called me to verify what was in there."