2. BUS 4254/20/2015 1 legal liability

3. BUS 4254/20/2015 2

4. 4/20/2015 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)

5. BUS 4254/20/2015 4 vocabulary

6. BUS 4254/20/2015 5 Peter describe business failure

7. BUS 4254/20/2015 6 Juancarlos define audit risk

8. BUS 4254/20/2015 7 Algernon describe limited liability partnership LLP

9. BUS 4254/20/2015 8 LLP limited liability partnership Taxed like a general partnership 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. BUS 4254/20/2015 9 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. BUS 4254/20/2015 10 David describe common law describe statute law

12. BUS 4254/20/2015 11 common 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. BUS 4254/20/2015 12 State LawFederal Law Common LawAuditors auditors Statute Law auditors Auditors

14. BUS 4254/20/2015 13 Common Law

15. BUS 4254/20/2015 14 Jeff What is the difference between a Breach of Contract and a Tort

16. BUS 4254/20/2015 15 Tort American Heritage Dictionary 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. BUS 4254/20/2015 16 Pei 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. BUS 4254/20/2015 17 Bart Discuss the difference between joint and several liability proportionate liability

19. BUS 4254/20/2015 18 standard of care ordinary negligence gross negligence recklessness constructive fraud fraud

20. BUS 4254/20/2015 19 John discuss ordinary negligence

21. BUS 4254/20/2015 20 Cody discuss gross negligence

22. BUS 4254/20/2015 21 Garren discuss fraud

23. BUS 4254/20/2015 22 what standard of care (level of performance) is unacceptable for a professional ? Melissa

24. BUS 4254/20/2015 23 Breach of Contract what standard of care unacceptable if the plaintiff has privity of contract and brings the lawsuit under breach of contract ? Emily

25. BUS 4254/20/2015 24 Common Law - Tort In order to recover from an auditor under common law, the plaintiff must prove Duty to perform Breach of Duty Losses Causation

26. BUS 4254/20/2015 25 Burden of Proof Third-party investors must demonstrate Auditor had a Duty to perform Breach of Duty – the Auditor was negligent, did not exercise due professional care Contributory negligence not an issue in most cases dealing with third party investors They suffered a Loss Causation – the loss was caused by reliance on financial statements which were materially misstated

27. BUS 4254/20/2015 26 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.

28. BUS 4254/20/2015 27 Common Law - Tort (not in privity) third parties To which third parties are we liable for Ordinary Negligence ?

29. BUS 4254/20/2015 28 Jeanette Different jurisdictions hold auditors liable for ordinary negligence to different ‘classes of third parties’ what are the three different classes of “third parties”

30. BUS 4254/20/2015 29 common law contract law - contract with the audit client tort law - third parties primary beneficiary Ultramares / Credit Alliance foreseen class Rusch Factors / Restatement Rosenblum foreseeable parties Rosenblum

31. BUS 4254/20/2015 30

32. BUS 4254/20/2015 31 New York Ultramares v. Touche (1931) 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 ….

33. BUS 4254/20/2015 32 New York Ultramares (1931) Credit Alliance v Arthur Andersen (1985) only liable to primary beneficiary for ordinary negligence accountant must have been aware that the financial reports were to be used for a particular purpose In furtherance of which a known party(ies) was intended to rely There must have been some conduct on the part of the accountants which evinces the accountant’s understanding of that party(ies) reliance. New York Superior Court

34. BUS 4254/20/2015 33 foreseen US District Court - Rhode Island Rusch Factors v. Levin (1968) … the auditor should be liable for ordinary negligence in audits where financial statements are relied on by actually foreseen and limited classes of persons.

35. BUS 4254/20/2015 34 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

36. BUS 4254/20/2015 35 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.

37. BUS 4254/20/2015 36 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.

38. BUS 4254/20/2015 37 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.

39. BUS 4254/20/2015 38 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.

40. BUS 4254/20/2015 39 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."

41. BUS 4254/20/2015 40 New Jersey (Supreme Court of N.J) Rosenblum v Adler (1983) p. 120 liable to reasonably foreseeable parties for ordinary negligence

42. BUS 4254/20/2015 41 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

43. BUS 4254/20/2015 42 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

44. BUS 4254/20/2015 43 primary beneficiary ( state courts of New York )

45. BUS 4254/20/2015 44 Mary files a common law claim in a New York court Mary can show that the auditor was negligent Is Mary likely to prevail? To which case will the N.Y. courts look for guidance about auditors’ liability ? Priya

46. BUS 4254/20/2015 45 In our New York example is there a primary beneficiary? is there anyone in our New York example to whom the auditor might be held liable for ordinary negligence? Jo Ellen

47. BUS 4254/20/2015 46 standard of care (in New York) ordinary negligence primary beneficiariesyes foreseen classno foreseeable partiesno gross negligence primary beneficiariesyes recklessnessforeseen classyes constructive fraudforeseeable partiesyes fraud

48. BUS 4254/20/2015 47 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

49. BUS 4254/20/2015 48 foreseen class ( state courts of Rhode Island)

50. BUS 4254/20/2015 49 Mary files a common law claim in a Rhode Island court Mary can show that the auditor was negligent Is Mary likely to prevail? To which case will the Rhode Island courts look for guidance about auditors’ liability ? Julia

51. BUS 4254/20/2015 50 In our Rhode Island example is there anyone in our Rhode Island example who might be an actually foreseen and limited class of persons or a foreseen party to whom the auditor would be liable for ordinary negligence? Mackenzie

52. BUS 4254/20/2015 51 standard of care (in Rhode Island) ordinary negligence primary beneficiariesyes foreseen classyes foreseeable partiesno gross negligence primary beneficiariesyes recklessnessforeseen classyes constructive fraudforeseeable partiesyes fraud

53. BUS 4254/20/2015 52 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

54. BUS 4254/20/2015 53 reasonably foreseeable parties ( state courts of Mississippi or Wisconsin )

55. BUS 4254/20/2015 54 Mary files a common law claim in a Mississippi court Mary can show that the auditor was negligent Is Mary likely to prevail? To which case will the Mississippi courts look for guidance about auditors’ liability ? Meredith

56. BUS 4254/20/2015 55

57. BUS 4254/20/2015 56 who, in our Mississippi example, would be a reasonably foreseeable party ? Jordan

58. BUS 4254/20/2015 57 standard of care (in Mississippi) ordinary negligence primary beneficiariesyes foreseen classyes foreseeable partiesyes gross negligence primary beneficiariesyes recklessnessforeseen classyes constructive fraudforeseeable partiesyes fraud

59. BUS 4254/20/2015 58

60. BUS 4254/20/2015 59 Securities Law start here

61. BUS 4254/20/2015 60 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)

62. BUS 4254/20/2015 61 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

63. BUS 4254/20/2015 62 Kar Sales Inc. suffers a large loss and is going bankrupt

64. BUS 4254/20/2015 63 Securities Act of 1933

65. BUS 4254/20/2015 64 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 Joseph

66. BUS 4254/20/2015 65 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

67. BUS 4254/20/2015 66 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

68. BUS 4254/20/2015 67 standard of careunder 1933 Act ordinary negligence gross negligence recklessness constructive fraud fraud

69. BUS 4254/20/2015 68 Levi what type of stock transactions does the 1933 Securities Act regulate ? what type of stock transactions does the 1934 Securities Exchange Act regulate ?

70. BUS 4254/20/2015 69 Securities Act of 1933 who sells stock in an “IPO” ? who produces the financial statements ? whose interests need be protected in an IPO?

71. BUS 4254/20/2015 70 Peter who sells stock in an “IPO” ? who produces the financial statements ? whose interests need be protected in an IPO?

72. BUS 4254/20/2015 71 Securities Exchange Act of 1934

73. BUS 4254/20/2015 72 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

74. BUS 4254/20/2015 73 Kar Sales Inc. suffers a large loss and is going bankrupt

75. BUS 4254/20/2015 74 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 Juancarlos

76. BUS 4254/20/2015 75 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...

77. BUS 4254/20/2015 76 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 ? Algernon

78. BUS 4254/20/2015 77 Securities Exchange Act of 1934 secondary markets any person acquiring or selling the security plaintiff must show reliance Hochfelder p. 123 auditor is not liable for ordinary negligence

79. BUS 4254/20/2015 78 Hochfelder v. Ernst & Ernst “ “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

80. BUS 4254/20/2015 79 standard of care ordinary negligence gross negligence recklessness constructive fraud fraud

81. BUS 4254/20/2015 80 David who sells stock in the “secondary markets”? who produces the financial statements ? whose interests need be protected in secondary market exchanges ?

82. BUS 4254/20/2015 81 SUMMARY OF DIFFERENCES BETWEEN 1933 AND 1934 ACTS

83. BUS 4254/20/2015 82 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

84. BUS 4254/20/2015 83 In order to manage legal liability Understand the client’s business Document your work Professional skepticism

85. BUS 4254/20/2015 84 Professional skepticism An attitude that includes a questioning mind 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.

86. BUS 4254/20/2015 85 timing is important

87. BUS 4254/20/2015 86 common law liability to third parties for ordinary negligence 1931UltramaresNew York 1968Rusch FactorsRhode Island 1983RosenblumNew Jersey

88. BUS 4254/20/2015 87 common law liability to third parties for ordinary negligence in California (Supreme Court of CA) 1986 – –International Mortgage (foreseeable parties)

89. BUS 4254/20/2015 88

90. BUS 4254/20/2015 89

91. BUS 4254/20/2015 90 common law liability to third parties for ordinary negligence in California (Supreme Court of CA) 1986 – –International Mortgage (foreseeable parties) 1993 – – Bily(primary beneficiary)

92. BUS 4254/20/2015 91

93. BUS 4254/20/2015 92 things are getting better

94. BUS 4254/20/2015 93

95. BUS 4254/20/2015 94

96. BUS 4254/20/2015 95 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

97. BUS 4254/20/2015 96 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. West's Encyclopedia of American Law, edition 2. Copyright 2008 The Gale Group, Inc. All rights reserved.

98. BUS 4254/20/2015 97 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

99. BUS 4254/20/2015 98 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.

100. BUS 4254/20/2015 99 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 F EDERAL C OURTS.

101. BUS 4254/20/2015 100 New JerseyRosenblum v Adler foreseeable parties N.J.S.A. 2A:53A-251995 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.

102. BUS 4254/20/2015 101 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

103. BUS 4254/20/2015 102

104. BUS 4254/20/2015 103

105. BUS 4254/20/2015 104