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 KEY LEGAL TERMS Privity: Absent a contractual relationship, the auditor does not owe a duty of care to an injured party Breach of Contract: Client or auditor fails to meet the terms and obligations established in the contract (engagement letter) Tort: Wrongful act other than a breach of contract for which civil action may be taken

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved KEY LEGAL TERMS Ordinary Negligence: Absence of reasonable due care in the conduct of an engagement Gross Negligence: Extreme or reckless departure from professional standards of due care (constructive fraud) Fraud: Actions taken with the knowledge or intent to deceive

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 (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 OF NEGLIGENCE 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 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 OF NEGLIGENCE TO THIRD PARTIES UNDER COMMON LAW The auditor had a duty to exercise due care The auditor breached that duty by not following professional standards The auditor's breach of due care was the proximate cause of the third party's injury The third party suffered an actual loss as a result

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved THREE STANDARDS FOR AUDITOR’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 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. Landmark Case: Ultramares v. Touche

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved FORESEEN PERSONS OR CLASSES Narrows auditor’s liability to small group of persons who are foreseen to rely on financial information. In 1968, Rusch Factors, Inc. v. Levin, applied Section 522 of the Restatement (Second) of the Law of Torts to accountant's third party liability.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved FORESEEN PERSONS OR CLASSES Extended Privity Standard Because: Increased liability of profession to nonprivity users Unfair to impose the burden of loss on f/s users Expanded liability will improve audit procedures Auditors can obtain insurance against increased risks Auditors can pass increased costs to clients

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 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, or existence of a 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 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 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 Scienter (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 (fully liable for all assessed damages) This legislation provides for “proportionate” liability (liable only for portion of damages that correspond to percentage of defendant’s responsibility) Intended to minimize deep-pockets lawsuits

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 practicing if that person: 1. Has been convicted of a misdemeanor involving moral turpitude 2. Has been convicted of a felony 3. Has had his license to practice as an accountant suspended or revoked 4. Has been permanently enjoined from violating provisions of the federal securities laws 5. Has been found by the Commission in an administrative proceeding 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 Passed by Congress in 1977 in response to the discovery of bribery and other misconduct on the part of over 300 American companies. Imposes sufficient record-keeping to accurately reflect transactions and adequate systems of internal controls for public companies.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved RACKETEER INFLUENCED AND CORRUPT ORGANIZATIONS ACT 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.

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 (Best Practices) Continually updating the Code of Professional Conduct and sanctioning members in violation. Educating users by closing “expectation gap” Clarify auditor’s responsibility for fraud and illegal acts Revise audit report to better communicate what audit entails

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.