1. legal liability

3. 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)

4. vocabulary

5. describe business failure
Brittney
describe business failure

6. Hannah
define audit risk

7. 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

8. describe limited liability partnership LLP
Mark W
describe limited liability partnership LLP

9. 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

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

11. Mikey
describe common law
describe statute law

12. 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

13. State Law Federal Law Common Law Auditors Statute Law

14. Common Law

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

16. 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.

17. 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?

18. Austin Discuss the difference between joint and several liability
proportionate liability

19. standard of care
ordinary negligence
gross negligence
recklessness
constructive fraud
fraud

20. discuss ordinary negligence
Cole
discuss ordinary negligence

21. discuss gross negligence
Dorian
discuss gross negligence

22. Genna
discuss fraud

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

24. 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 ?

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

26. 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

27. 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

28. 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.

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

30. 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”

31. common law p (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

33. 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 ….

34. 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

35. 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.

36. 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

37. 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.

38. 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.

39. 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.

40. 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.

41. 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."

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

43. 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

44. 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

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

46. 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?

47. 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 ?

48. 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

49. 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

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

51. 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?

52. 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?

53. 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

54. 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

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

56. 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?

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

59. 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

61. Securities Law start here

62. 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)

63. 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

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

65. Securities Act of 1933

66. 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

67. 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

68. 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

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

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

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

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

73. Securities Exchange Act of 1934

74. 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

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

76. 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

77. 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...

78. 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 ?

79. 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

80. 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

81. standard of care
ordinary negligence
gross negligence
recklessness
constructive fraud
fraud

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

83. SUMMARY OF DIFFERENCES BETWEEN 1933 AND 1934 ACTS

84. 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

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

86. Julia B
What is the definition of professional skepticism?

87. 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.

88. timing is important

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

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

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

95. things are getting better

98. 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

99. 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.

100. 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

101. 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.

102. 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.

103. New Jersey Rosenblum v Adler foreseeable users
N.J.S.A. 2A:53A 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.

104. 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