McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 20-1

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Part Seven PROFESSIONAL RESPONSIBILITES

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Chapter 20 CHAPTER 20 LEGAL LIABILITY

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved OVERVIEW Four stages of audit-related disputes: The occurrence of events that resulted in losses. The investigation by plaintiffs attorneys. The legal process commences with filing of suit The final resolution of the dispute.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved KEY LEGAL TERMS Privity Breach of contract Tort Ordinary negligence Gross negligence Fraud

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved SUMMARY OF THE TYPES AND ACTIONS ACCOUNTANT'S LIABILITY

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved COMMON LAW - CLIENT Common law does not require that the CPA guarantee his or her work product. It does require, however, that the accountant perform professional services with due care. Thus, the accountant must perform his or her professional services with the same degree of skill, knowledge, and judgment possessed by other members of the profession.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved ELEMENTS FOR ESTABLISHING AUDITOR LIABILITY TO CLIENTS UNDER COMMON LAW A duty to conform to a required standard of care, A failure to act in accordance with that duty, A causal connection between the CPA's negligence and the client's damage, and Actual loss or damage to the client.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved COMMON LAW - THIRD PARTIES The auditor’s liability under common law to third parties is an area that is very complex and court rulings are not always consistent across federal and state judicial jurisdictions.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved ELEMENTS FOR ESTABLISHING AUDITOR LIABILITY TO THIRD PARTIES UNDER COMMON LAW The accountant had a duty to the plaintiff to exercise due care, The accountant breached that duty by not following professional standards, The accountant's breach of due care was the proximate cause of the third party's injury, and The third party suffered an actual loss as a result.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved STANDARDS FOR ACCOUNTANT’S LIABILITY TO THIRD PARTIES Privity. Foreseen persons or classes. Reasonably foreseeable third parties.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved PRIVITY The traditional view held that auditors had no liability under common law to third parties who did not have privity with the auditor. Privity of contract means that the obligations that exist under a contract are between the original parties to the contract, and failure to perform with due care results in a breach of that duty only to those parties. The landmark decision in this area, Ultramares v. Touche.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved FORESEEN PERSONS OR CLASSES In 1968, a Federal district court decision, Rusch Factors, Inc. v. Levin, applied Section 522 of the Restatement (Second) of the Law of Torts to accountant's third party liability. The Restatement is a compendium of common law prepared by legal scholars and presents an alternative view to the traditional Ultramares rule.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved REASONABLY FORESEEABLE THIRD PARTIES A small number of states have adopted a more expansive view of auditor's liability to third parties; the reasonably foreseeable third parties approach. In the first case in this area, H. Rosenblum, Inc. v. Adler, the New Jersey Supreme Court ruled that Touche was responsible for damages incurred by all reasonably foreseeable third parties who relied on the financial statements.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved COMMON LAW - FRAUD If an accountant has acted with an intent to deceive a third party, the accountant can be held liable for fraud.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved ELEMENTS FOR ESTABLISHING AUDITOR LIABILITY FOR FRAUD UNDER COMMON LAW A false representation by the accountant, Knowledge or belief by the accountant that the representation was false, The accountant intended to induce the third party to rely on the false representations, The third party relied on the false representation, and The third party suffered damages.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved STATUTORY LIABILITY Securities Act of 1933 Securities Exchange Act of 1934 Private securities Litigation Reform Act of 1995 Securities Litigation Uniform Standards Act of 1998 Foreign Corrupt Practices Act Racketeer Influenced and Corrupt Organizations Act

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved SECURITIES ACT OF 1933 Section 11 of the Securities Act of 1933 imposes a liability on issuers and others including auditors for losses suffered by third parties when false or misleading information is included in a registration statement.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved ELEMENTS FOR ESTABLISHING AUDITOR LIABILITY TO THIRD PARTIES - SECURITIES ACT OF 1933 In contrast to common law, the plaintiff does not have to prove negligence or fraud, reliance on the auditor's opinion, a causal relationship, or a contractual relationship. The plaintiff need only prove that a loss was suffered and that the audited financial statements contained a material omission or misstatement. One defense that is available to the auditor is that of "due diligence" That is, the auditor must have made a reasonable investigation.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved SECURITIES EXCHANGE ACT OF 1934 Two sections are particularly important: Section 18 imposes liability on any person who makes a material false or misleading statement in documents filed with the Securities and Exchange Commission (SEC). Section 10(b) and related Rule 10b-5.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved SECURITIES EXCHANGE ACT OF 1934 Rule 10b-5 states that it is... unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, a.To employ any device, scheme, or artifice to defraud, b.To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading, or c.To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved ELEMENTS FOR ESTABLISHING AUDITOR LIABILITY TO THIRD PARTIES UNDER THE SECURITIES EXCHANGE ACT OF 1934 A material, factual misrepresentation or omission, Reliance by the plaintiff on the financial statements, Damages suffered as a result of reliance on the financial statements, and Scienter (defined as an intent to deceive, manipulate, or defraud).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Prior to this act auditors were subject to “joint and several” liability. This legislation provides for “proportionate” liability. Intended to minimize deep-pockets lawsuits. Securities Litigation Uniform Standards Act of 1998 limits certain class actions suits to federal courts.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved SEC SANCTIONS Rule 2(e) of the Rules of Practice empowers the SEC to suspend any person the privilege of appearing and practicing before it if that person has been convicted of a misdemeanor involving moral turpitude; has been convicted of a felony; has had his license to practice as an accountant suspended or revoked; has been permanently enjoined from violating provisions of the federal securities laws; or has been found by the Commission in an administrative proceeding or by a court of competent jurisdiction to have violated provisions of the federal securities laws.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved FOREIGN CORRUPT PRACTICES ACT The Foreign Corrupt Practices Act (FCPA) was passed by Congress in 1977 in response to the discovery of bribery and other misconduct on the part of over 300 American companies. The FCPA imposes record-keeping and internal control requirements on public companies. Companies are required to develop and maintain adequate systems of internal control.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved RACKETEER INFLUENCED AND CORRUPT ORGANIZATIONS ACT The Racketeer Influenced and Corrupt Organizations Act was enacted in 1970 by Congress to combat the infiltration of legitimate businesses by organized crime. However, it has been used against accountants. RICO provides civil and criminal sanctions for certain types of illegal acts, including treble damages. Racketeering activity includes a long list of federal and state crimes with mail fraud and wire fraud the most common acts alleged against accountants.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved CRIMINAL LIABILITY Auditors can also be held criminally liable under federal statues. Criminal prosecution requires that some form of criminal intent be present. Significant cases include: Continental Vending (United States v. Simon) National Student Marketing (United States v. Natelli) Equity Funding (United States v. Weiner) ESM Securities (Alexander Grant & Co. Litigation).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved APPROACHES TO MINIMIZING LEGAL LIABILITY AT THE PROFESSIONAL LEVEL Establishing stronger auditing and attestation standards. Continually updating the Code of Professional Conduct and sanctioning members who do not comply with it. Educating users.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved APPROACHES TO MINIMIZING LEGAL LIABILITY AT THE FIRM LEVEL Instituting sound quality control and review procedures. Ensuring that members of the firm are independent. Following sound client acceptance procedures. Being alert for risk factors that result in lawsuits. Diligently performing and documenting work.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Chapter 20 CHAPTER 20 LEGAL LIABILITY