Negligent Misrepresentation and Rating Agencies

One of the leading cases in the Unfair Competition course that I’m teaching this semester is Cardozo’s opinion in 85px-Benjamin_CardozoUltramares Corp. v. Touche.  Ultramares rejected the creation of a negligent misrepresentation action (akin to fraud).  The case involved an accounting firm that negligently audited the books of a company.  That negligent “clean bill of health” led another firm to extend a loan that went bad.  The lender then sued the accountants for damages.  Cardozo reasoned that this theory would “expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class. The hazards of a business conducted on these terms are so extreme as to enkindle doubt whether a flaw ma not exist in the implication of a duty that exposes to these consequences.”

It is interesting to consider this case in light of the Panic of 2008 and other recent breakdowns in the financial system.  I think it’s fair to say that we have not come up with a good mix of regulatory practices that allow credit monitors (accountants, rating agencies, or credit bureaus) to function but be held to account when they go wrong.  For example, rating agencies were sharply criticized because they gave securitized subprime assets a AAA rating in 2006.  Nothing much happened to them as a result though. In part, that is because they operate as an oligopoly (I’m using that term loosely) and thus do not face competition or new entrants when they mess up.  The Government brought a criminal case against Arthur Anderson when they fouled up the Enron books, but that is an awfully blunt instrument.  Allowing third parties to sue for negligence is probably still a bad idea for the reasons that Cardozo gave.  And there is nothing in the President’s financial regulation proposal that does much about the issue.  Perhaps that needs to be reconsidered as Congress work through the bill.

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2 Responses

  1. “That negligent “clean bill of health” led another firm to extend a loan that went bad.”

    Just a pet peeve of mine but the audit report is not a “clean bill of health” – rather that the accompanying financial statements adequately reflect a company’s financial status IAW certain reporting standards.

    Nothing in it opines as to the overall “health” of the company (except perhaps by omission; no “going concern” comment) – that is for the user to decide.

  2. Lawrence Cunningham says:

    Interesting idea, though Cardozo’s Ultramares opinion is now a minority position, with the Restatement (Second) of Torts, Section 552, representing the majority stance, allowing negligent misrepresentation claims by third parites whom the supplier intended to benefit from the opinion or knows its recipient will supply it to. On the other hand, there has been considerable pressure from the auditing profession to curtail that stance, including by urging to recognize as enforceable auditor-client contracts disclaiming or reducing the scope of auditor liability for negligence.