legal liability

Cases to study Common Law (Torts) Ultramares Corp v Touche (1931) Credit Alliance v Arthur Andersen (1986) Rusch Factors v. Levin (1968) Restatement Second of Torts (1977) Rosenblum v Adler (1983) Statute Law Securities Act of 1933 Section 11 Securities & Exchange Act of 1934 Sec 10b-5 Ernst & Ernst v Hochfelder (1976)

vocabulary

describe business failure Brittney describe business failure

Hannah define audit risk

The risk the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of the risk of material misstatement and detection risk

describe limited liability partnership LLP Mark W describe limited liability partnership LLP

Taxed like a general partnership -- the LLP does not pay income tax The profits and tax liability pass through to the partners Partners are personally liable for the partnership’s debts and obligations Partners are personally liable for their own acts, and the acts of others under their supervision Partners are not personally liable for liabilities arising from negligent acts of other partners and employees not under their supervision

statute law common law breach of contract tort joint & several liab proportionate liab standard of care privity of contract v. third parties near privity

Mikey describe common law describe statute law

common law statute law contract law (applies to the audit client) tort law (applies to third parties) statute law Securities Act of 1933 Securities Exchange Act of 1934 Foreign Corrupt Practices Act of 1977 The Sarbanes Oxley Act of 2002

State Law Federal Law Common Law Auditors Statute Law

Common Law

What is the difference between a Miki What is the difference between a Breach of Contract and a Tort

Tort American Heritage Dictionary A wrongful act, damage, or injury done willfully, negligently, or in circumstances involving strict liability, but not involving a breach of contract.

Mitchell What type of action would we expect The audit client to file against the auditor? Some one who invested in the audit client to file against the auditor?

Austin Discuss the difference between joint and several liability proportionate liability

standard of care ordinary negligence gross negligence recklessness constructive fraud fraud

discuss ordinary negligence Cole discuss ordinary negligence

discuss gross negligence Dorian discuss gross negligence

Genna discuss fraud

Haley what standard of care (level of performance) is unacceptable for a professional ?

Julia L Breach of Contract what standard of care unacceptable if the plaintiff has privity of contract and brings the lawsuit under breach of contract ?

Common Law - Tort Auditor’s Defense p. 120-21 (126-27) Lack of Duty Nonnegligent Performance Contributory Negligence Absence of Causal Connections

Common Law - Tort In order to recover from an auditor under common law, the plaintiff must prove Loss Duty to perform lack of duty Breach of Duty nonnegligent performance contributory negligence Causation absence of causal connection

Burden of Proof Third-party investors must demonstrate Investor suffered a Loss Auditor had a Duty to perform Auditor was negligent, Breach of Duty - auditor did not exercise due professional care Contributory negligence not an issue in most cases dealing with third party investors Causal Connection – the loss was caused by reliance on financial statements which were materially misstated

when talking about Common Law Tort (if the plaintiff is not in privity of contract with the auditor) Where fraud or gross negligence is present, most jurisdictions expand the rights of third party investors who do not have privity of contract. Where fraud or gross negligence is present, we assume the auditor will be held liable to third parties using the financial statements.

Common Law - Tort (not in privity) third parties To which third parties are we liable for Ordinary Negligence ?

Max “third parties” what are the three different classes of Different jurisdictions hold auditors liable for ordinary negligence to different ‘classes of third parties’ what are the three different classes of “third parties”

common law p. 122-23 (128-29) contract law - contract with the audit client tort law - third parties primary beneficiary Ultramares / Credit Alliance foreseen users Rusch Factors / Restatement foreseeable users Rosenblum

New York Ultramares v. Touche (1931) (N.Y. Court of Appeals) Credit Alliance (1985) only liable to primary beneficiary for ordinary negligence Judge C. J. Cardozo wrote If liability for negligence exists, ... , the failure to detect a theft or forgery beneath the cover of deceptive entries may expose accountants to a liability in indeterminate amounts, for an indeterminate time, to an indeterminate class. The hazards of a business conducted on these terms are so extreme ….

New York Ultramares (1931) Credit Alliance v Arthur Andersen (1985) only liable to primary beneficiary for ordinary negligence The accountant must have been aware that the financial reports were to be used for a particular purpose In the furtherance of which a known party or parties was intended to rely There must have been some conduct on the part of the accountants linking them to that party or parties New York Superior Court

US District Court - Rhode Island Foreseen Users US District Court - Rhode Island Rusch Factors v. Levin (1968) … the auditor should be liable for ordinary negligence in audits where the financial statements are relied on by actually foreseen and limited classes of persons.

Second Restatement of Torts (1977) liable to reasonably limited and identifiable group of users for ordinary negligence liability is limited to the person or one of a limited group of persons for whose benefit the auditor … knows the audit client intends to supply the financial statements through reliance on the financial statements in a transaction of which the auditor knows the audit client intends to use the financial statements to influence the transaction or a substantially similar transaction

Second Restatement of Torts (1977) liable to reasonably limited and identifiable group of users for ordinary negligence an auditor is liable for negligence to a third party only if (s)he intends to supply the information for the benefit of one or more third parties in a specific transaction or type of transaction identified to the supplier.

To offer a simple illustration … an auditor engaged to perform an audit and render a report to a third person whom the auditor knows is considering a $ 10 million investment in the client's business is on notice of a specific potential liability. It may then act to encounter, limit or avoid the risk. In contrast, an auditor who is simply asked for a generic audit and report to the client has no comparable notice.

For example, the auditor may be held liable to a third party lender if the auditor is informed by the client that the audit will be used to obtain a $ 50,000 loan, even if the specific lender remains unnamed or the client names one lender and then borrows from another.

Similarly, there is no liability when the client's transaction (as represented to the auditor) changes so as to increase materially the audit risk, e.g., a third person originally considers selling goods to the client on credit and later buys a controlling interest in the client's stock, both in reliance on the auditor's report.

Under the Restatement rule, an auditor retained to conduct an annual audit and to furnish an opinion for no particular purpose generally undertakes no duty to third parties. … The client uses the financial statements to obtain a loan from bank. Because of negligence, the auditor issues an unmodified opinion upon a balance sheet that materially misstates the financial position … through reliance upon it the bank suffers …. a loss." Consistent with the text of section 552, the authors conclude: "The auditor is not liable to the bank."

Foreseeable Users New Jersey (Supreme Court of N.J) Rosenblum v Adler (1983) p. 123 (129) liable to foreseeable users for ordinary negligence

remember, there is a body of federal common law but most common law pertaining to securities is state common law each state has its own body of common law so, we will make up an example and move our example around the country

New York Mary bought some Kar Sales, Inc. common stock Kar Sales, Inc. is not publicly traded. They are not required to file with the SEC Kar Sales, Inc. had their financial statements audited …. In order to get a bank loan. They told their auditor they were having their financial statements audited to get a …….. bank loan. Kar Sales, Inc. suffers a major loss and is going bankrupt

( state courts of New York ) primary beneficiary ( state courts of New York )

Michelle Mary files a common law claim in a New York court Mary can show that the auditor was negligent To which case will the N.Y. courts look for guidance about auditors’ liability ? Is Mary likely to prevail?

Navid In our New York example is there a primary beneficiary? Are any of the parties described in our New York example a primary beneficiary to whom the auditor might be held liable for ordinary negligence ?

standard of care (in New York) ordinary negligence primary beneficiaries yes foreseen users no foreseeable users no gross negligence primary beneficiaries yes recklessness foreseen users yes constructive fraud foreseeable users yes fraud

let’s move our example to Rhode Island Mary bought some Kar Sales, Inc. common stock Kar Sales, Inc. is not publicly traded. They are not required to file with the SEC Kar Sales, Inc. had their financial statements audited …. In order to get a bank loan. They told their auditor they were having their financial statements audited to get a …….. bank loan. Kar Sales, Inc. suffers a major loss and is going bankrupt

( state courts of Rhode Island) foreseen user ( state courts of Rhode Island)

Stephanie Mary files a common law claim in a Rhode Island court Mary can show that the auditor was negligent To which case will the Rhode Island courts look for guidance about auditors’ liability ? Is Mary likely to prevail?

In our Rhode Island example Danny In our Rhode Island example are any of the parties described in our Rhode Island example an actually foreseen and limited class of persons or a foreseen party to whom the auditor would be liable for ordinary negligence?

standard of care (in Rhode Island) ordinary negligence primary beneficiaries yes foreseen users yes foreseeable users no gross negligence primary beneficiaries yes recklessness foreseen users yes constructive fraud foreseeable users yes fraud

let’s move our example to Mississippi or Wisconsin Mary bought some Kar Sales, Inc. common stock Kar Sales, Inc. is not publicly traded. They are not required to file with the SEC Kar Sales, Inc. had their financial statements audited …. In order to get a bank loan. They told their auditor they were having their financial statements audited to get a …….. bank loan. Kar Sales, Inc. suffers a major loss and is going bankrupt

( state courts of Mississippi or Wisconsin ) foreseeable users ( state courts of Mississippi or Wisconsin )

Felix Mary files a common law claim in a Mississippi court Mary can show that the auditor was negligent To which case will the Mississippi courts look for guidance about auditors’ liability ? Is Mary likely to prevail?

Haileeeeeeeee who, in our Mississippi example, would be a reasonably foreseeable party ?

standard of care (in Mississippi) ordinary negligence primary beneficiaries yes foreseen users yes foreseeable users yes gross negligence primary beneficiaries yes recklessness foreseen users yes constructive fraud foreseeable users yes fraud

Securities Law start here

Securities Law Securities Act of 1933 ( section 11 ) Securities Exchange Act of 1934 ( section 10 b-5 ) Foreign Corrupt Practices Act (1977) Sarbanes-Oxley Act (2002)

Geri, the General Manager of Kar Sales Inc Geri, the General Manager of Kar Sales Inc., which is a closely held (not publicly owned) company in San Luis Obispo Geri the Gen. Manager owns stock in Kar Sales Inc. Geri needs some money, so she writes her friend Mary, who lives in New York, and asks her if she would like to buy some of her Kar Sales Inc. stock Geri also mails a copy of Kar Sales Inc. financial statements which have been audited by Miller LLP to Mary Mary buys some stock from Geri

Kar Sales Inc. suffers a large loss and is going bankrupt

Securities Act of 1933

John Mary’s attorney believes she can show that the auditor was negligent is Mary likely to prevail if she sues under the Securities Act of 1933

Securities Act of 1933 initial public offerings any person acquiring the security plaintiff (the person acquiring in this case) is not required to show reliance auditor liable for ordinary negligence

Securities Act of 1933 section 11 any part of the registration statement ... contained an untrue statement of a material fact or omitted to state a material fact

standard of care under 1933 Act ordinary negligence gross negligence recklessness constructive fraud fraud

Karissa what type of stock transactions does the 1933 Securities Act regulate ? what type of stock transactions does the 1934 Securities Exchange Act regulate ?

Securities Act of 1933 who sells stock in an “IPO” ? who produces the financial statements ? whose interests need be protected in an IPO?

Laura who sells stock in an “IPO” ? who produces the financial statements ? whose interests need be protected in an IPO?

Securities Exchange Act of 1934

Geri, the General Manager of Kar Sales Inc Geri, the General Manager of Kar Sales Inc., which is a closely held (not publicly owned) company in San Luis Obispo Geri the Gen. Manager owns stock in Kar Sales Inc. Geri needs some money, so she writes her friend Mary, who lives in New York, and asks her to buy some of her stock Geri also mails a copy of Kar Sales Inc. financial statements which have been audited by Miller LLP to Mary Mary buys some stock from Geri

Kar Sales Inc. suffers a large loss and is going bankrupt

Malcolm Mary’s attorney thinks she can show that the auditor was negligent Is Mary likely to prevail if she sues under the Securities Exchange Act of 1934 Remember: Mary lives in New York and the General Manager of Kar Sales Inc. mailed the audited financial statements to her from SLO

Securities Exchange Act of 1934 section 10b-5 ... by use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange to employ, any device, scheme or artifice to defraud to make any untrue statement of material fact of to omit to make to engage in any practice or course of business which operates as a fraud or deceit upon any person...

Courtney What is the applicable “standard of care” under the Securities Exchange Act of 1934 ? Is Mary likely to prevail under the 1934 Act if she can prove the auditor was negligent ?

Securities Exchange Act of 1934 secondary markets any person acquiring or selling the security plaintiff must show reliance Hochfelder p. 126 (132) auditor is not liable for ordinary negligence

Hochfelder v. Ernst & Ernst p. 126 (132) “When a statue speaks so specifically in terms of manipulation and deception, and of implementing devices and contrivances - the commonly understood terminology of intentional wrongdoing - and when its history reflects no more expansive intent, we are quite unwilling to extend the scope of the statute to negligent conduct.” Justice Powell, U.S. Supreme Court

standard of care ordinary negligence gross negligence recklessness constructive fraud fraud

Jane who sells stock in the “secondary markets”? who produces the financial statements ? whose interests need be protected in secondary market exchanges ?

SUMMARY OF DIFFERENCES BETWEEN 1933 AND 1934 ACTS

Do we agree that auditors, or any professionals, should be liable for gross negligence, recklessness, constructive fraud, or fraud? Notice that the Federal Security’s Laws don’t offer investors recourse for ‘ordinary negligence’ in the secondary markets

In order to manage legal liability Understand the client’s business Document your work Professional skepticism

Julia B What is the definition of professional skepticism?

Professional skepticism An attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence. `` Auditors should not assume that management is dishonest, but the possibility of dishonesty should be considered. At the same time, auditors should not assume that management is unquestionably honest.

timing is important

common law liability to third parties for ordinary negligence 1931 Ultramares New York 1968 Rusch Factors Rhode Island 1983 Rosenblum New Jersey

common law liability to third parties for ordinary negligence in California (Supreme Court of CA) 1986 International Mortgage (foreseeable users)

common law liability to third parties for ordinary negligence in California (Supreme Court of CA) 1986 International Mortgage (foreseeable users) 1993 Bily (primary beneficiary)

things are getting better

Reeves v. Ernst & Young RICO treble damages racketeer influenced and corrupt practices act with regards to auditors U.S. Supreme Court took the teeth out of Federal RICO laws RICO requires some participation in the operation or management of the enterprise

Aid and Abet To assist another in the commission of a crime by words or conduct. The person who aids and abets participates in the commission of a crime by performing some overt act or by giving advice or encouragement. He or she must share the criminal intent of the person who actually commits the crime, but it is not necessary for the aider and abettor to be physically present at the scene of the crime. An aider and abettor is a party to a crime and may be criminally liable as a principal, an accessory before the fact, or an accessory after the fact. West's Encyclopedia of American Law, edition 2. Copyright 2008 The Gale Group, Inc. All rights reserved.

Central Bank of Denver v. First Interstate Bank U. S Central Bank of Denver v. First Interstate Bank U.S. Supreme Court 1994 investors and other private parties are no longer able to bring suits against auditors for ‘aiding and abetting’ under section 10B of the Securities Exchange Act of 1934

The Private Securities Litigation Reform Act of 1995 amends the Securities Exchange Act of 1934 … liable solely for the portion of the judgment that corresponds to the percentage of responsibility proportionate liability Unless it is determined that the person knowingly committed a violation of securities law. In which case they would be jointly and severally liable.

The Securities Litigation Uniform Standards Act of 1998 with regard to securities litigation Requires that class action suits with 50 or more parties must be filed in the Federal Courts.

New Jersey Rosenblum v Adler foreseeable users N.J.S.A. 2A:53A-25 1995 statute New Jersey state legislature has subsequently passed legislation that defines auditors liability because of this statute auditors are no longer liable to foreseeable parties for ordinary negligence in N.J.

we still teach Rosenblum even though New Jersey has passed legislation that overturns this case because the concept of foreseeable parties is still a valid legal concept and Mississippi and Wisconsin adhere to the concept of foreseeable parties