Module C Legal Liability “When men are pure, laws are useless; when men are corrupt, laws are broken.” Benjamin Disreali, Former British Prime Minister McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Module Objectives MODC-3 Identify and describe auditors’ exposure to lawsuits and loss judgments Specify the characteristics of auditors’ liability under common law and cite some specific case precedents. Identify auditors’ liability to third parties under common law. Specify the civil and criminal liability provisions of the Securities Act of 1933. Specify the civil and criminal liability provisions of the Securities Exchange Act of 1934. Understand recent developments that affect auditors’ liability to clients and third parties.

MODC-4 The Legal Environment

Sources of Auditor Liability MODC-5 Sources of Auditor Liability Common law: Uses legal precedent to identify faculty and responsibility. Clients Nonshareholder third parties Statutory law: Based on violations of written statutes. Shareholders

Common Law Breach of contract MODC-6 Common Law Breach of contract Tort liability: Obligation based on failure to exercise appropriate level of professional care Ordinary negligence is lack of reasonable care Gross negligence is lack of minimal care (similar to constructive fraud) Fraud is a misrepresentation of fact an individual knows to be false

Common Law Liability: Clients MODC-7 Common Law Liability: Clients Breach of contract Failure to perform the audit in accordance with engagement letter Tort liability Liable for Ordinary Negligence, Gross Negligence, and Fraud

Proof and Defenses Clients must show Defenses MODC-8 Economic loss Auditors breached contract or failed to exercise appropriate care Defenses Auditors did not breach contract or performed with appropriate level of care Causation (something else caused client loss) Contributory negligence (clients were partially responsible for loss)

Common Law Liability: Third Parties MODC-9 Common Law Liability: Third Parties Generally liable to all parties for Gross Negligence and Fraud Liability for Ordinary Negligence Ultramares: Only liable to third parties for Gross Negligence, Fraud Credit Alliance v. Arthur Andersen: Liable to primary beneficiaries for Ordinary Negligence Fleet National Bank (restatement of torts): Liable to foreseen third parties for Ordinary Negligence Rosenblum v. Adler: Liable to foreseeable third parties for Ordinary Negligence

Proof and Defenses MODC-10 Third parties must show Defenses Economic loss Auditors failed to exercise appropriate level of care F/S were materially misstated Loss caused by reliance on misstated F/S Defenses Lack of appropriate standing to bring suit Third parties did not rely on F/S Third parties’ loss caused by something else (causation defense) Audit conducted per GAAS

Liability Under Statutory Law MODC-11 Liability Under Statutory Law Violations of specific laws or statutes Securities Acts Regulate securities trading in the U.S. Require disclosure of important financial and nonfinancial information using GAAP Require audited F/S Regulate Securities trading in the U.S.

MODC-12 Securities Act of 1933 Regulates initial issuance of securities by registrants to investing public Required to file registration statement with SEC that includes F/S To bring suit, investors must show: Loss F/S contained a material misstatement No need to show reliance on F/S or that loss was caused by misstatement

MODC-13 Liability Under 1933 Act Auditors responsible for Ordinary Negligence, Gross Negligence, Fraud Defenses Due diligence (auditors performed a GAAS audit) Causation (loss resulted from other factors) Escott v. BarChris Construction Corp. Auditors held liable for failure to conduct “reasonable investigation” (Ordinary Negligence)

Securities Exchange Act of 1934 MODC-14 Securities Exchange Act of 1934 Regulates daily trading of securities and requires periodic financial statements and information to be filed with the SEC To bring suit, investors must show: Economic loss F/S were materially misstated Loss caused by reliance on F/S Auditors were aware that the F/S were materially misstated (gross negligence) Investors have burden of proof

Liability Under 1934 Act Auditors liable for Gross Negligence, Fraud MODC-15 Liability Under 1934 Act Auditors liable for Gross Negligence, Fraud Defenses Auditors acted in good faith Auditors were not aware of material misstatements Ernst & Ernst v. Hochfelder Relieved auditors from liability for Ordinary Negligence Did provide liability for “reckless behavior” in the absence of scienter

Summary of Auditor Liability MODC-16 Summary of Auditor Liability

Developments in Auditor Liability MODC-17 Developments in Auditor Liability Sarbanes-Oxley Extends statute of limitations for bringing suit under the Securities Exchange Act Increased penalties for mail fraud and wire fraud Destruction, alteration, and falsification of records Increased records retention requirements Higher potential liability in civil cases

Developments in Auditor Liability MODC-18 Developments in Auditor Liability Auditors not subject to RICO (and treble damages) Limitations on aiding and abetting Organization of firms as limited liability partnerships Private Securities Litigation Reform Act Proportionate liability, instead of joint and several

Developments in Auditor Liability MODC-19 Developments in Auditor Liability Class Action Fairness Act Moves class action cases from state courts to federal courts Securities Litigation Uniform Standards Act Requires class action lawsuits with > 50 parties to be filed in federal courts Auditor liability caps