1. BA 427 – Assurance and Attestation Services Lecture 10 The Legal Environment

2. Overview of the legal environment  The American Legal System Federal Courts Administrative Agencies  Exist at the Federal and state levels  Examples include the SEC and the various state boards of accountancy  Enact and enforce regulations  Punish violators State Courts

3.  The American Legal System Common Law (this evolves through court decisions)  Contract Law  Law of Torts Negligence Fraud Statutory Law (laws passed by Congress and other governmental units) Overview of the legal environment

4.  Auditors have four major sources of legal liability: Liability to clients Liability to third parties under common law Civil liability under the federal securities laws Criminal liability

5. Overview of the legal environment  Terminology: Privileged communication  Under federal law and in most states, auditor- client communications are not privileged. Prudent person concept  The standard of due care to which auditors are held. The degree of skill commonly possessed by others in the same employment. The auditor undertakes for good faith and integrity, but not for infallibility. The auditor is liable for negligence, bad faith, or dishonesty, but not for losses consequent upon errors of judgment.

6. Overview of the legal environment  Terminology: Negligence and Fraud:  Ordinary negligence: absence of reasonable care, what other auditors would have done.  Gross negligence: lack of even slight care; reckless behavior. (some states do not distinguish between ordinary negligence and gross negligence).  Constructive fraud: Recklessness, but no intent to deceive or do harm.  Fraud: Knowledge of the misstatement, and intent to deceive.

7. Overview of the legal environment  Terminology: Joint and several liability  Assessment against a defendant of the full loss suffered by the plaintiff, regardless of the extent to which other parties shared in the wrongdoing. Separate and proportionate liability  The assessment against a defendant of that portion of the damage caused by the defendant’s negligence.

8. Liability to Clients  The most common type of lawsuit against auditors Dollar amounts tend to be small.  Examples of causes for these suits: Failure to discover employee theft or fraud. Failure to complete the engagement on time, or as agreed. Breach of confidentiality. Liability to clients extends to non-audit engagements as well as audits.

9. Liability to Clients  These lawsuits can be filed under Contract law  Breach of contract Tort law  Ordinary negligence  Gross negligence  Fraud

10. Liability to Clients  Tort law Negligence: failure to exercise due professional care. Any significant error or mistake in judgment will result in at least a presumption of negligence that the auditor will have to refute. Failure to follow GAAS is often conclusive evidence of negligence.

11. Liability to Clients  Potential defenses against a claim of negligence: Lack of duty to perform  There was no express or implied contract  Engagement letters can help The auditor exercised due care  Compliance with professional standards Contributory negligence Absence of a causal connection

12. Liability to third parties under common law  Who are these third parties: Shareholders Employees Bankers and other creditors Vendors Customers  The claimant suffers a loss due to reliance on misleading financial statements.

13. Liability to third parties under common law  Ultramares Corporation v. Touche (1931) Established the Ultramares doctrine Auditors are not liable to most third parties for ordinary negligence To sue the auditor for ordinary negligence:  The claimant must have privity of contract.  Or the claimant must be a “primary beneficiary” (a known third party)

14. Liability to third parties under common law  Known third parties This concept has been expanded to include foreseen users:  A limited class of users whom the auditor is aware will rely on the financial statements (such as major creditors)

15. Liability to third parties under common law  The concept of foreseen users has developed along three lines (depending on the jurisdiction of the court): Credit Alliance approach, followed in approximately 15 states:  To be liable, the auditor must know and intend that the work will be used by the plaintiff for a specific purpose, and this knowledge must be evidenced by the auditor’s conduct.

16. Liability to third parties under common law  The concept of foreseen users has developed along three lines (depending on the jurisdiction of the court): Restatement of Torts approach, followed in most states:  Foreseen users must be members of a reasonably limited and identifiable group of users that have relied on the auditor’s work, even though those persons were not specifically known to the auditor at the time the work was done.

17. Liability to third parties under common law  The concept of foreseen users has developed along three lines (depending on the jurisdiction of the court): Foreseeable Users approach, used more widely in the past, but now only in Wisconsin and Mississippi.  Any user that the auditor should reasonably have been able to foresee as being a likely user of the financial statements has the same rights as those with privity of contract.

18. Liability to third parties under common law  Potential defenses against a claim of negligence by a third party: Lack of duty to perform  Lack of privity of contract (whether this defense will work depends on the jurisdiction) The auditor exercised due care  Compliance with professional standards Absence of a causal connection  If the auditor can show that the plaintiff did not rely on the financial statements, or that the plaintiff’s loss was not caused by this reliance.

19. Civil liability under the federal securities laws  This is the source of the most significant growth in lawsuits against auditors These lawsuits allow for class-action litigation. Several sections of the securities laws impose strict liability standards on auditors. The Private Securities Litigation Reform Act of 1995 provided significant relief to the accounting profession from class action lawsuits in federal courts, by providing for proportionate liability except in cases where the auditor is guilty of fraud. The Securities Litigation Uniform Standards Act of 1998 requires class action suits involving securities to be address in federal courts, not state courts.

20. Civil liability under the federal securities laws  The relevant statutes and rules: The Securities Act of 1933 The Securities Act of 1934 Rule 2(e) of the SEC’s Rules of Practice RICO (the Racketeer Influenced and Corrupt Organization Act), 1970 The Foreign Corrupt Practices Act of 1977

21. Civil liability under the federal securities laws  Securities Act of 1933 Applies only to registration statements and prospectuses. Hence, the only potential claimants are the original purchasers of securities. The auditor is liable for material misrepresentations or omissions in the audited financial statements. The plaintiff does not have to show reliance on the financial statements, or negligence by the auditor. The auditor must prove that a reasonable investigation was conducted, or that the plaintiff’s losses were not caused by reliance on the misleading financial statements.

22. Civil liability under the federal securities laws  Securities Act of 1933 The auditor’s responsibility extends beyond the date the statements are issued, to the date the registration statement became effective.  This can be months after the end of fieldwork. The 1933 act is perhaps the only common or statutory law where the burden of proof is on the defendant! Escott et al. v. BarChris Construction Corp (1968)  Court determined that the auditor failed to follow professional standards.  Resulted in more GAAS for subsequent events

23. Civil liability under the federal securities laws  Securities Act of 1934 The auditor’s liability usually arises in connection with the financial statements associated with the annual report or the 10K. Auditor liability can also arise in connection with 10Q, 8K, or other SEC filings. Rule 10b-5: This is the antifraud provision of the 1934 Act.  Designed primarily to thwart fraud by persons selling securities, but courts have determined that these provisions also apply to auditors, underwriters, and others.

24. Civil liability under the federal securities laws  Securities Act of 1934 In general, auditors can be liable under 10b-5 if they intentionally or recklessly misrepresent information intended for third-party use. Hochfelder v. Ernst & Ernst (1976)  The U.S. Supreme Court ruled that knowledge and intent to deceive are required before CPAs can be held liable under Rule 10b-5.  In certain areas of the law, recklessness is considered to be a form of intentional conduct.

25. Civil liability under the federal securities laws  Potential defenses against a claim under the 1934 Securities Law: Lack of duty The auditor exercised due care  Compliance with professional standards Absence of a causal connection

26. Civil liability under the federal securities laws  Rule 2(e) of the SEC’s Rules of Practice The SEC may deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found (1) not to possess the requisite qualifications to represent others, or (2) to be lacking in character or integrity or to have engaged in unethical or improper professional conduct.

27. Civil liability under the federal securities laws  Rule 2(e) of the SEC’s Rules of Practice The SEC has imposed the following sanctions in recent years:  Temporarily suspended individual CPAs from auditing SEC clients.  Prohibited CPA firms from accepting new SEC clients for a period of time, such as 6 months.  Required CPA firms to undergo extensive peer reviews.  Required individuals and firms to participate in continuing education programs.

28. Civil liability under the federal securities laws  RICO (the Racketeer Influenced and Corrupt Organization Act), 1970: Allows for treble damages and recovery of legal fees, if a pattern of racketeering is demonstrated. A “pattern” exists if there are at least two instances of racketeering in a 10-year period. Until 1993, courts differed as to whether the issuance of materially false financial statements constitutes racketeering activity. In 1993, the U.S. Supreme Court ruled that outside professionals, if they do not actually help run corrupt businesses, cannot be sued under RICO.

29. Civil liability under the federal securities laws  The Foreign Corrupt Practices Act of 1977: At the time the law was passed, there was considerable debate about the nature of the auditor’s legal responsibilities under the internal controls provisions of the law. To date, there have been no legal cases against auditors under the law.

30. Criminal Liability  Can arise under both federal and state law. The Securities Acts of 1933 and 1934 The Federal Mail Fraud Statute The Federal False Statement Statute The most relevant state laws are the Uniform Securities Acts  In general, these laws apply to an individual who defrauds another person by knowingly being involved with false financial statements.

31. Criminal Liability  Under Sarbanes-Oxley, it is a felony to destroy documents (or create documents) to impede or obstruct a federal investigation.

32. Criminal Liability  The following well-known audit failures resulted in criminal convictions against one or more auditors Equity Funding Corporation of America, 1975 National Student Marketing Corporation, 1975 ESM Government Securities, 1986

33. The Legal Environment  11 steps for public accountants to minimize the risk of legal liability: Only provide professional services to clients of integrity. Thoroughly understand the client’s business. Hire qualified personnel and train and supervise them adequately. Know and follow professional standards. Maintain independence and professional skepticism. Perform high quality audits and document the work properly.

34. The Legal Environment  11 steps for public accountants to minimize the risk of legal liability: Obtain an Engagement Letter and a Letter of Representations from the client. Maintain client confidentiality. Practice in organizational forms that provide individual partners limited liability. Carry adequate malpractice insurance. When potential litigation is identified that might involve the auditor as a defendant, seek legal advice quickly.