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R.I. Supreme Court establishes boundaries of liability for accountants

Adopting the “Restatement rule” for assessing whether or not a duty exists between an accountant and an aggrieved third party, the Rhode Island Supreme Court has ruled that an accounting firm could not be liable for a report relied on by the state Industrial-Recreational Building Authority.

The court affirmed that accounting firm Feeley & Driscoll did not owe a duty of care to IRBA as a third party with respect to what IRBA alleged was a negligently prepared report about the finances of Capco Steel in 2009.

cohen-web“The key is to focus on what did the accountants know at the time they did the work.”

— Susan E. Cohen, defense counsel

“In our opinion, the Restatement rule is the most sensible middle-of-the-road approach to the question of the extent of potential liability to third parties to which an accountant/auditor should be exposed for alleged negligence on his or her part,” Justice William P. Robinson III wrote for the unanimous court. “[W]hen the Restatement rule is applied to the case before us, it is our unhesitating judgment that the hearing justice did not err in holding that Feeley did not owe a duty of care to IRBA. For that reason, IRBA’s negligence claim against Feeley cannot proceed, and summary judgment in Feeley’s favor was appropriately granted.”

Susan E. Cohen, a Boston attorney who represented the accounting firm, said the court correctly established the “middle ground” of the Restatement rule as the standard of care between accountants and third parties, rejecting the “very limited” near-privity rule as well as the “overly broad” reasonable foreseeability rule, which would have “opened the door to a lot of problems for accountants.”

“The key is to focus on what did the accountants know at the time they did the work,” she explained.

Providence lawyer Michael T. Eskey, who represented IRBA, did not respond to a request for comment.

The 23-page decision is The Rhode Island Industrial-Recreational Building Authority v. Capco Endurance.

Accounting report

Feeley & Driscoll prepared audited annual financial statements for Capco, including for the year 2009. That report indicated that Capco had earned a profit of $552,000.

In February 2010, Webster Bank agreed to provide Capco with a $20 million revolving line of credit. As part of the agreement, Webster also agreed to make a $6 million term loan to Capco by purchasing the amount in bonds from the Rhode Island Industrial Facilities Corp. IRBA agreed to insure those bonds up to the amount of $5 million.

In early 2011, Capco sought to extend its revolving line of credit to $23.5 million for a period of six months. Capco and Webster requested IRBA’s consent to the temporary extension. IRBA provided consent, alleging that it relied on the 2009 audit report with respect to the credit increase.

After a second extension of credit to $28 million, Capco failed to make required payments on the bonds in March 2012, triggering IRBA’s obligation as the insurer of $5 million worth of the bonds.

IRBA filed suit against Capco, Feeley and numerous other defendants in May 2013. With regard to Feeley, IRBA alleged that it relied on the 2009 audit report, adding that a subsequent accounting firm indicated the report was erroneous and that Capco had actually lost approximately $500,000 in 2009.

Feeley moved for summary judgment, arguing that it did not owe a duty to IRBA with respect to the 2009 audit report. A trial judge granted the motion and IRBA appealed.

Accountant liability standard

The Supreme Court began by tackling an unanswered question in the state: which third-party claimants can file suit against accountants alleging professional malpractice or negligence, and what form of relationship with the accountants or their work product, if any, should be required for non-clients to maintain such a cause of action.

Other courts have generally relied on one of three alternative legal standards, Robinson noted. The “near-privity test” limits an accountant’s liability exposure to those with whom the accountant is in privity or in a relationship sufficiently approaching privity, but the court found that standard “too narrow.”

On the other end of the spectrum, the “reasonable foreseeability rule” would create “expansive liability,” a position the court declined to embrace.

Instead, the court adopted the Restatement rule found in the Restatement (Second) of Torts. The standard limits liability to loss suffered “(a) by the person or one of a limited group of persons for whose benefit and guidance he intends to supply the information or knows that the recipients intend to supply it; and (b) through reliance upon it in a transaction that he intends the information to influence or knows that the recipient so intends or in a substantially similar transaction.”

Robinson said the court decided the Restatement rule struck the appropriate balance between the open-ended nature of the reasonable foreseeability rule and the “overly constrained near-privity rule. Accordingly, we adopt the moderate approach provided in the Restatement rule.”

The court then applied the standard to the issues raised by IRBA on appeal. Although IRBA stressed the “wide-ranging” business relationship between Feeley and Capco, asserting that it was reasonable to infer that Feeley knew when it issued the 2009 report that Webster Bank and IRBA would be relying on it, the court was not persuaded.

“IRBA is, in essence, requesting that we apply the reasonable foreseeability rule in this case, which rule we have now rejected,” Robinson wrote.

While it was “certainly reasonably foreseeable” that IRBA might rely on the 2009 audit report, that was not the proper question, the court found.

“Under the Restatement rule, we are concerned with whether the 2009 Audit Report was relied upon in a transaction which Feeley, at the time it released the report, ‘intend[ed]’ the information to influence or ‘kn[e]w[]’ the recipient so intended,” Robinson explained.

It was undisputed that IRBA, Capco and Webster Bank did not know, at the time when they closed on the $20 million line of credit and bond transactions, that Capco would request a credit increase about a year in the future.

“How could Feeley possibly have intended, at the time it issued the 2009 Audit Report, that that report would influence a transaction that none of the parties knew was going to take place?” Robinson asked. “We unhesitatingly decline to expose an accountant/auditor to the broad scope of potential liability that IRBA’s argument in this regard would create.”

The court also found IRBA’s contention that Feeley owed a duty under the “substantially similar” transaction provision unavailing.

“IRBA has failed to show that the essential character of the transactions had not materially changed between the original line of credit and bond transactions and the first credit increase,” Robinson said, as the transactions took place nearly a year apart and involved a $3.5 million credit increase for Capco.

“[I]t is self-evident that a 17.5 percent increase in the credit amount does not qualify as ‘minor,’” Robinson wrote. “[W]e can perceive no basis whatsoever for holding that the hearing justice erred in concluding that the first credit increase was not substantially similar, under the Restatement rule, to the original line of credit and bond transactions.”

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