2. 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.

3. 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.

4. MODC-4
The Legal Environment

5. 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

6. 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

7. 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

8. 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)

9. 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

10. 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

11. 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.

12. 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

13. 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)

14. 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

15. 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

16. Summary of Auditor Liability
MODC-16
Summary of Auditor Liability

17. 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

18. 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

19. 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