CASE 7.5
FRED STERN & COMPANY, INC.
(ULTRAMARES)
Synopsis
The 1930 legal opinion written by Judge Benjamin Cardozo in the Ultramares vs. Touche et al.
case would influence, if not shape, the legal liability of public accountants for decades to come.
Prior to the Ultramares case, parties external to the audit contract, such as investors and creditors,
could only bring lawsuits against auditors predicated upon fraudulent conduct. In the Ultramares
case, the plaintiff, which was not a party to the audit contract, maintained that it should be allowed to
recover losses it suffered as a result of alleged negligence on the part of Touche, Niven & Company,
the predecessor of Touche Ross. On this key issue, Judge Cardozo ruled in favor of Touche—and
the public accounting profession. According to Judge Cardozo, non-privity third parties could not
355
Case 7.5 Fred Stern & Company, Inc.
356
Fred Stern & Company, Inc.—Key Facts
1. Before the passage of the federal securities laws in the early 1930s, the financial reporting
practices of companies were not subject to significant government oversight.
3. Unknown to Ultramares and Touche, Stern’s balance sheet contained large errors that were
principally the result of fraudulent journal entries made by an employee of that company.
5. Ultramares’ lawsuit charged Touche with both fraud and negligence.
7. After a reversal of the jury’s decision by the trial judge and a subsequent reversal of the trial
8. Judge Cardozo ruled that if Ultramares had been a primary beneficiary of the Stern audit,
9. Judge Cardozo also suggested that third parties other than primary beneficiaries should be
allowed to recover damages resulting from an audit firm’s gross negligence.
Case 7.5 Fred Stern & Company, Inc.
357
Instructional Objectives
1. To provide a historical overview of the evolution of the independent auditor’s legal liability.
Suggestions for Use
This case can be used as the starting point for discussing auditors’ legal liability. The Ultramares
case is the most important of all litigation cases involving independent auditors since it established
two key legal precedents that would influence auditors’ legal liability under the common law for the
remainder of the twentieth century. This case provides information regarding key contextual
Suggested Solutions to Case Questions
1. The key cost of this phenomenon for audit firms is the increased business risk it imposes upon
them. On an individual level, the ever-present potential for litigation can impose a significant
amount of stress and anxiety on auditors and may be a contributing factor to the high turnover rate
within the public accounting profession. Audit clients also suffer as a result of the apparent trend for
federal and state courts to socialize investment losses by imposing large legal judgments on audit
firms. No doubt, the costs associated with such judgments are eventually passed on to financially
viable audit clients in the form of higher audit fees. The parties most likely to benefit from this trend
are investors and creditors, particularly investors and creditors who make poor or, at least, very
Case 7.5 Fred Stern & Company, Inc.
358
2. Auditors are faced with much more litigation risk when they audit financial statements included
in a registration statement filed under the 1933 Act compared to when they audit financial statements
included in a registration statement filed under the 1934 Act. When filing suit against an auditor
under the 1933 Act, a plaintiff must establish only two general elements of proof to make a prima
facie case. The plaintiff must prove that he or she has suffered damages and that the financial
statements in question contain one or more material errors. Conversely, in a suit filed under the
1934 Act, a plaintiff must establish the following points:
a. there was a material error or material omission in the financial statements included in the
Congress intentionally imposed more legal responsibility on parties associated with financial
statements filed under the 1933 Act than on parties associated with financial statements filed under
the 1934 Act. Companies file S-1 registration statements under the 1933 Act only when they are
selling new securities, while 10-K registration statements filed under the 1934 Act contain the
financial data and other information that public companies are required to provide annually to the
SEC. If new securities are to be marketable, potential investors must have confidence in the
degree of malfeasance on the part of the auditor that must be proven by the plaintiff. Since the U.S.
Supreme Court handed down its ruling in the Hochfelder case in the late 1970s, plaintiffs must
establish more than negligence on the part of a CPA firm to recover damages in a suit filed under the
1934 Act. Specifically, plaintiffs must either prove scienter (intent to deceive) or reckless disregard
for the truth on the part of the auditor. In most cases, it is difficult for plaintiffs to establish explicit
Case 7.5 Fred Stern & Company, Inc.
359
3. Listed next are some of the key differences between the audit report form shown in Exhibit 1 of
this case and the standard audit report form being used presently by non-SEC registrants.
a. No longer do auditors use the term “certify” in their reports; instead, the phrase “in our
opinion” is used.
b. Rather than using the phrase “true and correct” to describe the status of the client’s financial
During the early part of the twentieth century, the auditing profession, at least in the United
States, was still in its infancy. During that time frame, independent audits were much more
mechanical in nature than they are today. That is, the auditor of the 1920s was more concerned with
clerical accuracy, the format of a client’s financial data, and related issues and less focused on
whether the client’s accounting policies captured the substance rather than simply the form of the
changes in the standard audit report. These factors were extensive criticism of the auditing
profession by congressional investigative committees of the 1970s and 1980s and a dramatic
increase in the number of lawsuits filed against audit firms during that same time frame. These
factors likely contributed to the Auditing Standards Board’s decision to include the important caveat
in the current audit report that the financial statements being reported upon are the primary
Case 7.5 Fred Stern & Company, Inc.
360
4. In the early part of the twentieth century, the principal focus of financial reporting and,
consequently, independent auditing, was on the financial condition of companies rather than the
results of their operations. During that time frame, the principal purpose of financial reports was to
5. Auditing standards do not specifically identify the type or number of third-party financial
statement users as factors that an audit firm should consider when attempting to determine the level
to which overall audit risk should be reduced (or, more appropriately, the level to which an audit
firm will attempt to reduce overall audit risk). However, each of those factors does influence the
level of business risk that an audit firm will face on a given engagement. (For instance, an audit firm
will generally face more litigation risk for a public company with a large number of stockholders
than for a private or closely-held company of the same size that relies heavily on one or a small