1 Chapter 51 Liability of Accountants and Other Professionals

2 § 1: Common Law Liability to Clients Under the common law, professionals may be liable to clients for: Breach of contract. Negligence. Fraud.

3 Liability for Breach of Contract If professional breaches (express or implied) the terms of a contract, then the client has the right to recover damages from the professional. Not on time or did not complete work. Professional performed work below standard of care of professional peers.

4 Liability for Negligence E lement to establish negligence: Duty of care existed. Breach of duty. Plaintiff suffered an injury. Breach of duty was the cause of injury. All professionals are subject to standards of conduct established by codes of professional standards and ethics, by state statutes, and by judicial decisions.

5 Liability For Fraud Elements to establish fraud: Misrepresentation of a material fact. Intent to deceive. Reliance on misrepresentation. For damages, the innocent party must have been injured.

6 § 2: Liability to Third Parties The Ultramares Rule. Accountants should be liable only to those with whom they are in privity or “near privity” of contract. The Restatement of Torts Rule. Accountants should be liable to foreseen, or known, users of their reports or financial statements. Liability to Reasonably Foreseeable Users. Accountants should be liable to those whose use of their reports or financial statements is reasonably foreseeable.

7 § 3: Liability of Accountants under Securities Laws Liability under the Securities Act of Liability under Section 11. Liability to Purchasers of Securities. Due Diligence Standard. Defenses. Penalties and Sanctions.

8 Liability of Accountants Liability under the Securities Exchange Act of 1934 Liability under Section 18. Liability under Section 10(b) and SEC Rule 10b-5. Private Securities Litigation Reform Act of 1995.

9 § 4: Potential Criminal Liability of Accountants Securities Act of Securities Act of Internal Revenue Code. State and Federal Criminal Codes.

10 § 5: Working Papers Professional has custodial ownership of client’s working papers. She may: Keep for own protection and lawsuit defense. Not reveal without client’s permission or, in some states, court order.

11 § 6: Confidentiality and Privilege Confidentiality. Professionals are restrained by the ethical tenets of their profession to keep all communications with their clients confidential. Privilege: Right to refuse to testify against client in a court of law. Attorneys. In all state and federal courts. Accountants Only in some states’ courts. Not in federal court (IRS!).

12 Case 51.1: Boykin v. Arthur Anderson (Accountant’s Liability to Third Parties) FACTS: Secor Bank hired Arthur Andersen to certify the bank’s annual reports. The reports did not mention losses resulting from millions of dollars of bad commercial loans. When Boykin, a Secor Bank shareholder, learned of the losses, he sued Anderson alleging fraud and negligence. The court dismissed the suit, ruling in part that the claim did not satisfy the Credit Alliance “near privity” rule. Boykin appealed.

13 HELD: FOR BOYKIN. REVERSED. Boykin relied on the fraudulent statements to his detriment. No privity with Anderson was required. “Basic principles of justice require that an accounting firm be held liable for its intentional or negligent dissemination of inaccurate financial reports to specifically foreseen and limited groups of third parties for whose benefit and guidance the accounting firm supplied the information.” Case 51.1: Boykin v. Arthur Anderson (Accountant’s Liability to Third Parties)

14 Case 51.2: Endo v. Arthur Anderson (Accountant’s Liability under Securities Laws) FACTS: Arthur Andersen audited the financial statements of Fruit of the Loom, Inc. (FOL), for The statements included a footnote that warned FOL was involved in litigation with the IRS that could result in tax liability exceeding $105 million. This warning did not appear in FOL’s 1986 financial statements, which were audited by Ernst & Young. In 1987, the 1985 statements were republished, as part of a stock offering, without the warning in the old footnote, with Andersen’s consent. Within a year, FOL was ordered to pay the IRS more than $105 million.

15 FACTS (cont’d): The price of the FOL stock dropped by 33 percent. Endo, an investor, sued Andersen alleging that omitting the warning from the footnote in the republished report violated Section 11 of the Securities Act of The court granted a summary judgment in Andersen’s favor. The plaintiffs appealed. HELD: FOR ANDERSON. AFFIRMED. The omitted warning was a past prediction about a future event as to which Andersen’s successor Ernst & Young had more current information and was responsible. Case 51.2: Endo v. Arthur Anderson (Accountant’s Liability under Securities Laws)