December 2000

N.Y. Court of Appeals Reaffirms Privity Rule: Unanimously Agrees with Society’s Amicus Brief

ALBANY, N.Y.— In a unanimous opinion issued on December 14, the New York State Court of Appeals re-confirmed New York’s strict privity rule for accounting malpractice cases. The opinion was handed down in a case involving the valuation of an employee stock ownership plan (ESOP) performed by Coopers & Lybrand (C&L), now part of PricewaterhouseCoopers. The New York State Society of CPAs filed a brief as amicus curiae, a friend of the court. Judge Richard C. Wesley wrote the opinion, which was concurred in by Chief Judge Judith S. Kaye and four other judges.

New York follows a privity rule that requires, among other things, that the accountant know who is relying on his or her work product and why and acts accordingly. Other states follow a broader “foreseeability” standard that holds accountants liable to any plaintiff who the accountant could reasonably foresee would rely on the work product. In its seven-page opinion, the court of appeals once again firmly rejected the foreseeability standard.

“We conclude, as did the appellate division, that the plaintiff has not satisfied the test and his complaint must be dismissed,” said Judge Wesley.

In October, the Society filed an amicus brief supporting the defendant’s position that the plaintiff did not rely on the valuation and, therefore, had no foundation to sue the accounting firm.

The case, Parrott v. Coopers & Lybrand, was brought by Harold Parrott, a former director, officer, and shareholder of Pasadena Capital Corp. The company hired C&L to perform semiannual evaluations of its stock for the purposes of its ESOP and also had a stock repurchase agreement with its executives, including Parrott. Under that agreement, the repurchase price was to be determined by an independent third-party appraisal prepared “on a minority basis” in connection with Pasadena’s ESOP.

Upon Parrott’s involuntary departure, Pasadena tried to use the ESOP valuation to buy back Parrott’s stock at a price of $78.21 per share. Parrott objected to the valuation price and initiated both a lawsuit and an arbitration proceeding against Pasadena.

Concurrent with or shortly after Parrott’s departure, Pasadena sought a purchaser for the stock, and, just over a year later, received $172.70 per share. Although following arbitration Pasadena eventually paid Parrott $122.50 per share, Parrott nevertheless commenced a suit against C&L, claiming that the ESOP valuation was negligently performed.

C&L argued that because Parrott refused to accept the $78.21 per share price he did not rely on the valuation and C&L could not, therefore, be held liable. In addition, C&L argued that because Parrott was not a known party intending to rely upon the valuation there was no privity between C&L and Parrott.

The New York State Society of CPAs filed an amicus brief because of the implications the case has on New York’s privity rule.

Before a plaintiff can prevail against an accountant, the plaintiff must show that he or she was “in privity” with the accountant. New York historically has had a very narrow definition of privity, dating back to the 1931 Ultramares Corp. v. Touche decision, which was restated in the 1985 Credit Alliance v. Arthur Andersen, case, as follows:

1) The accountants must have been aware that the financial report was to be for a particular purpose or purposes;
2) in the furtherance of which a known party, or parties, was intended to rely; and
3) there must have been conduct on the part of the accountants linking them to that party or parties, which evinces the accountants’ understanding of that party or parties’ reliance.

This delineation of the privity rule is substantially more restrictive than the rules adopted in other states, giving New York CPAs much greater protection against negligence claims by nonclients. Parrott, however, threatened to relax the New York rule by breathing new life into two appellate court decisions that predated Credit Alliance. These decisions [Glanzer v. Sheppard (1922) and White v. Guarente (1977)] did not contain the third requirement in Credit Alliance, namely, that there be conduct on the part of the accountant evidencing the accountant’s understanding of the plaintiff’s intended reliance upon the report. When the court of appeals decided Credit Alliance, it stated that the rule which it was establishing was intended to supplant its prior decisions but stopped short of saying that those decisions no longer represented the law in New York.

The Society’s brief traced the development of the privity doctrine and pointed out how those decisions were only consistent with Credit Alliance if they were narrowly and not broadly construed, as Parrott was contending. In both Glanzer and White, the scope of the accountant’s potential liability exposure was both limited and known at the time the defendant issued his report. Parrott, however, was unknown to C&L when it rendered its report and was not a member of the Pasadena ESOP. Thus, the NYSSCPA argued that Parrott did not come within the class of persons defined by those two cases—even if they remained New York law in the wake of the Credit Alliance decision.

Reliance upon Unseen Reports

Parrott also raised another issue of importance to CPAs in New York: reliance upon unseen reports. The plaintiff was seeking to impose liability upon C&L for an alleged erroneous report even though he never saw the report and expressly rejected its conclusions, raising the issue as to whether Parrott could be deemed to have reasonably relied upon the C&L report.

The Society’s amicus brief argued that even though a third party in some circumstances might indirectly rely upon a report which he or she had never seen (if the substance of that report has been fairly conveyed to him or her), there could be no liability on the part of the author of an erroneous report if the third party was not misled by it.

Essentially, the Society argued that Parrott could not have it both ways. He could not bring an action against Pasadena arguing that the C&L evaluation was wrong and, therefore, he was not obligated to sell his stocks on the basis of that evaluation and then bring an action against C&L arguing that he relied upon an erroneous evaluation.