Court Expands Accountants’ Liability for Audits

In a decision that increases accounting firms’ liability for the audits they conduct, an appellate court has ruled that the state insurance commissioner can sue accountants for negligent misrepresentation if they fail to reveal an insurance company’s insolvency.

Judges for the state Court of Appeal for the 2nd District rejected arguments by Arthur Andersen that it could be sued only by clients and a limited number of others who rely on its audits, and not by the state Department of Insurance.

The case stems from Arthur Andersen’s 1992 audit of Cal-American Insurance Co. The accountants’ audit did not reveal that Cal-American was concealing its insolvency by inflating its assets and shifting liabilities to related companies. The Insurance Department uncovered the ruse in 1993 and took over the company, eventually liquidating it.

In arguing its case, Arthur Andersen relied on a California Supreme Court ruling that limited who could sue an auditor for negligent misrepresentation to clients and others “who act in reliance upon those misrepresentations in a transaction which the auditor intended to influence.”

The accounting firm said it had not intended to influence the Insurance Department. The only people who could be expected to rely on the audit, Cal-American’s officers, already knew the company was broke and concealed the fact from the auditors, Andersen said.

Andersen also contended that unless it caused damage to the value of Cal-American, it could have no liability for a negligent audit. Because Cal-American was already insolvent when the audit was conducted, it was impossible to further damage its value, the firm argued.

The Insurance Department countered that it routinely relies on audit opinions to monitor insurance companies. Insurance Commissioner Chuck Quackenbush said his office would have acted sooner if the Andersen audit had revealed the insolvency.

The appellate court’s decision strengthens Quackenbush’s regulatory authority and clarifies issues raised by the earlier Supreme Court ruling, said Jean Pierre Nogues, an attorney representing the insurance department.

Arthur Andersen has until Jan. 5 to appeal the ruling to the state Supreme Court.

Liz Pulliam can be reached by e-mail at liz.pulliam@latimes.com.