Society Takes Aim at National Surety Doctrine

By Dan L. Goldwasser, Esq., Vedder, Price, Kaufman, Kammholz & Day

The NYSSCPA has filed an amicus curiae brief in a case now on appeal to the Appellate Division in Albany involving a legal doctrine which precludes CPAs from raising their client's own negligence as a defense in malpractice claims.

This doctrine was first invoked in National Surety Co. v. Coopers & Lybrand, a 1935 decision of the New York Court of Appeals, in which the court held that the client's own negligence only operates as a defense in an accounting malpractice claim if the client's negligence prevented the accountant from successfully carrying out his or her engagement. This doctrine places CPA firms at a distinct disadvantage in cases arising out of client employee thefts.

The case that relied on the National Surety doctrine, Collins v. Esserman & Pelter, was tried without a jury before the New York Supreme Court for Broome County. The court found a CPA firm liable for having failed to detect and prevent the thefts of its client's bookkeeper totaling more than $200,000 during a period of 15 months. This adverse finding came even though the defendant CPA firm had been engaged only to perform compilation and review services, and the client itself had been negligent in the hiring and supervision of its bookkeeper. In fact, the client had even rejected the accounting firm's advice, in the face of growing signs of foul play, that the client have its financial statements audited.

The National Surety doctrine, relied upon by the trial court to overlook the client's negligence, was adopted to mitigate the harsh effects of the contributory negligence doctrine, under which a plaintiff is wholly barred from recovering any loss that was in part due to the plaintiff's own actions. In the National Surety case, the Court of Appeals was concerned that an important reason why businesses have their financial statements audited is to protect themselves against acts of disloyal employees, and that the contributory negligence doctrine frustrated that purpose. In its brief, the NYSSCPA argued that the National Surety doctrine has outlived its usefulness, as the New York courts now apply the comparative negligence doctrine (under which responsibility for the plaintiff's losses are apportioned on the basis of comparative fault) in place of the unduly rigid contributory negligence doctrine. Thus, the very reason for the National Surety doctrine has been eliminated.

The Society's brief also focused on the nature of services customarily provided by CPA firms and why traditional accounting and auditing services are not well designed to uncover employee defalcations. The Society contended that the assumption underlying the National Surety doctrine that a CPA can normally uncover employee embezzlement is largely unjustified. This is particularly true of compilation and review services, which were the subject of this case. The brief further argued that even if the National Surety doctrine is basically sound and still serves a useful purpose, it should not be applied where the defendant CPA has not been engaged to perform an audit.

One of the difficult issues posed by the case was the responsibility of a CPA firm encountering a number of "red flags." In this case, the accountants were aware that the client's bookkeeper previously had been dismissed by another employer for suspected thefts, and that the bookkeeper had recorded some large payments (to the IRS and certain vendors) that she never had made. In fact, she had been caught in lies concerning those payments. Faced with these disturbing facts and the ease with which the bookkeeper's successor ultimately uncovered the embezzlement, the trial court found that the defendant accounting firm had a duty to investigate the bookkeeper's activities and, had such actions been taken, the bookkeeper's thefts would have been discovered sooner.