January 18, 2023

Common and Statutory Law

Accounting ethical:

for #1-2: answer the questions (read the power point as needed, around 100 words per question)

for #3-4: read the cases first, then answer the questions. (read the power point as needed, around 150 words per question)

Auditors’ Legal Liabilities and Defenses

Chapter 08

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Learning Objectives

L O 8-1: Describe common-law rulings and auditors’ legal liabilities to clients and third parties.

L O 8-2: Explain auditors' defenses to negligence, negligent misrepresentation, and fraud.

L O 8-3: Explain the basis for auditors’ statutory legal liability.

L O 8-4: Explain the provisions of the P S L R A.

L O 8-5: Discuss auditors’ legal liabilities under S O X.

L O 8-6: Explain the provisions of the F C P A.

Questions to Consider

What are the professional and ethical requirements for auditors to avoid legal liability to clients and third parties?

What legal actions can be taken against auditors?

What are auditor defenses to fraud?

What are additional legal obligations under S O X, the Private Securities Litigation Reform Act, and the Foreign Corrupt Practices Act?

Legal Liability of Auditors: An Overview

Zoe-Vonna Palmrose identifies the 4 general stages in audit-related disputes:

Events that result in losses for users of the financial statements.

Investigation by plaintiff attorneys to link the user losses with allegations of material omissions or misstatements of financial statements.

Filing of the lawsuit.

Final resolution of the dispute.

Auditors can be sued by clients, investors, creditors, and the government.

Auditors can be held liable under common and statutory law.

Common and Statutory Law

Common law:

Evolves from legal opinions issued by judges in deciding a case.

Statutory law:

Legislation passed at state or federal level that establishes certain courses of conduct that must be adhered to by parties.

Breach of contract is a claim that accounting or auditing services were not performed in a manner proscribed in the contract (brought by clients)

Tort actions cover other civil complaints (brought by clients and users of financial statements)

Fraud.

Deceit.

Injury.

Common Law Liability

Auditor must perform professional services with due care.

Evidenced by having exercised same degree of skill and judgment possessed by others in the profession.

Adherence to generally accepted auditing standards can provide evidence of having exercised due care in the audit.

Due care includes exercising the degree of professional skepticism expected in the audit of financial statements.

Audit failures – all possible causes – breach of contract, tort, deceit, and fraud.

Liability to Clients – Privity

A contractual obligation to the client that creates a privity relationship.

A client can bring a lawsuit against an accountant for failing to live up to terms of the contract; plaintiff must demonstrate:

Economic loss.

Auditors breached contract.

Auditors failed to exercise appropriate level of professional care.

Auditors breach or failure of care caused the loss.

Fraud includes gross negligence or constructive fraud that represents an extreme or reckless departure from professional standards of care.

Ultramares v. Touche, 1933.

Third party not in contractual privity cannot sue based on negligence.

Left open possibility for gross negligence and fraud.

Professional Negligence

Professional negligence is the liability theory most often referred to as an “accounting malpractice” claim. The elements of a professional negligence action against an accountant are similar to those present in any other type of negligence lawsuit.

Duty — the accountant must have owed the plaintiff a duty to use reasonable care in delivering accounting services.

Breach of Duty — the plaintiff must show that the accountant failed to use that degree of skill and learning normally possessed and used by public accountants in a similar situation.

Damage — the plaintiff must show that he or she suffered damage as a direct result of the accountant’s breach of duty.

Causation — a causal nexus between the asserted breach and damages, such as a business driven into bankruptcy because it went into debt in reliance on overstated financial statements.

Defending Audit-Malpractice Cases

Contributory negligence of the client can be regarded as a defense to the liability of the accountant for malpractice.

It has to be proved that the negligence of the client has proximately contributed to the accountant’s failure to perform.

The client’s negligence is a defense only when it has contributed to the accountant’s failure to perform his contract and to report the truth.

Comparative Negligence

The comparative negligence rule replaced the harsh all-or-nothing approach of contributory negligence with a formula based upon allocation of fault.

The change from contributory negligence to comparative fault did not totally immunize defendants from liability if the plaintiff was the slightest bit negligent.

Courts now allow accountants to assert a comparative negligence defense and have affirmed the jury’s apportionment of damages between the accountants and the corporation.

Recklessness

Recklessness involves conduct that is short of actual intent to cause harm, but greater than simple negligence.

Unlike negligence, which occurs when a person unknowingly takes a risk that they should have been aware of, recklessness means to knowingly take a risk.

Recklessness is a state of mind that is determined both subjectively and objectively.

What the actor knew or is believed to have been thinking when the act occurred (subjective test)

What a reasonable person would have thought in the defendant’s position (objective test)

Negligent Misrepresentation

Negligent misrepresentation occurs when an accountant gives false information to a third party with respect to financial statement information.

A liability exists when the accountant knows the person who will rely on the statement and knows the purpose of relying.

Auditor liability for negligent misrepresentation does not require proof of the audit that was intended to influence the particular plaintiff.

A complaint for negligent misrepresentation is sufficient if it alleges the audit was intended to influence the particular classes of person to which the plaintiff belongs.

Exhibit 8.3 Accountants’ Liability for Negligence and Recklessness

NEGLIGENCE	RECKLESSNESS
Negligence refers to the failure to take proper and reasonable care, causing injury or loss to another person	Recklessness is the state of mind where a person deliberately pursues a course of action while consciously disregarding any risks stemming from such action
An individual not aware of the risk involved, but should have known what risks are	An individual is aware of the risk involved
Carries a lesser liability than recklessness	Carries a greater liability than negligence

Common Law Liability to Third Parties Near-Privity Relationship

Near privity relationship established in Credit Alliance v. Arthur Andersen & Co.

Case establishes tests for holding auditors liable for negligence to third parties.

Knowledge that financial statements to be used for a particular purpose.

Intention of third party to rely on financial statements.

Action linking the accountant and the third party.

Security Pacific Business Credit, Inc. v. Peat Marwick Main & Co.

Sharpened last criteria of near privity test:

The auditor must directly convey the audited report to the third party, OR.

The auditor acts to induce reliance on the audit report.

Plaintiff Claims Under Common Law

Common-law liability for fraud is available to third parties in any jurisdiction. The plaintiff must prove:

A false representation by the accountant.

Knowledge or belief by the accountant that the representation was false.

The accountant had fraudulent intent or scienter (established by proof that accountant acted with knowledge of the false representation)

The third party relied on the false representation.

The third party suffered damages.

Actually Foreseen Third Parties

“Middle ground” approach followed by most states expands class of third parties that can successfully sue auditor for negligence beyond near-privity to limited group whose reliance is (actually) foreseen, but not necessarily known to the auditor.

Rusch Factors, Inc. v. Levin, 19 68.

Rhode Island federal court held an accountant liable for negligence to a third party not in privity of contract.

Restatement (Second) of Torts.

Expands an accountant’s legal liability for negligence to any third parties (foreseen third party) identified as intended recipients of the work…should be foreseen as a relying on financial information.

Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co., 19 86.

Texas Court of Appeals held that if an accountant preparing audited statements knows or should know…the accountant may be held liable for negligent misrepresentation.

Reasonably Foreseeable Third Parties 1

H. Rosenblum v. Adler, 19 83.

New Jersey Supreme Court ruled that auditors should be liable to all reasonably foreseeable third parties who rely on the financial statements.

“Independent auditors have a duty of care to all persons whom the auditor should reasonably foresee as recipients of the statements from the company for proper business purposes, provided the recipients rely on those … statements”.

Citizens State Bank v. Timm, Schmidt & Company.

Wisconsin Court ruled the cost of credit to lenders would be prohibitive if foreseeable third parties could not sue auditors.

Gross Negligence and Fraud

Gross negligence may be interpreted as fraud.

Gross negligence, or constructive fraud, occurs when the auditor acts so carelessly in the application of professional standards that it implies a reckless disregard for the standards of due care.

Fraudulent intent or scienter must exist.

Scienter is the intent to deceive, manipulate, or defraud.

Statutory Liability for Fraud 1

To establish liability for fraud under Section 10(b) of the Securities Act, a plaintiff must show that:

The defendant made a material misstatement or omission;

The misstatement or omission was made with an intent to deceive, manipulate or defraud (i.e., scienter);

There is a connection between the misrepresentation or omission and the plaintiff's purchase or sale of a security;

The plaintiff relied on the misstatement or omission;

The plaintiff suffered economic loss; and,

There is a casual connection between the material misrepresentation or omission and the plaintiff's loss.

Common Law Liability for Fraud

Common-law liability for fraud is available to third parties in any jurisdiction. The plaintiff (third party) must prove

a false representation by the accountant,

knowledge or belief by the accountant that the representation was false,

that the accountant intended to induce the third party to rely on false representation,

that the third party relied on the false representation, and,

that the third party suffered damages.

Liability for Fraudulent Misrepresentation

General Rule

One who makes a fraudulent misrepresentation is subject to liability to the persons or class of persons whom he intends or has reason to expect to act or to refrain from action in reliance upon the misrepresentation, for pecuniary loss suffered by them through their justifiable reliance in the type of transaction in which he intends or has reason to expect their conduct to be influenced.

Income Tax Fraud versus Tax Negligence

Accountants' legal liability extends to actions of personal tax fraud and negligence as well as permitting and/or enabling the tax fraud of a client.

Income tax fraud is the willful attempt to evade tax law or defraud the I R S including when a client.

Intentionally fails to file a income tax return,

Willfully fails to pay taxes due,

Intentionally fails to report all income received,

Makes fraudulent or false claims in preparing the tax return,

Prepares and files a false return.

Holding Accountants Liable for Fraud

To hold accountants liable under common law, third parties must prove.

That the accountant made a false representation,

The accountant had knowledge or believed that the representation was false,

The accountant intended to induce the third party to rely on false representation,

The third party relied on the false representation, and,

The third party suffered damages.

Auditor Defenses for Negligence

The due care defense is based on the prudent person concept. This defense implies four things:

The auditor possessed the requisite skills to evaluate accounting entries.

The auditor employed such skill with reasonable care and diligence.

The auditor undertook his task(s) with good faith and integrity.

While the auditor may be liable for negligence, the auditor is not liable for errors in judgment.

Auditor Defenses to Fraud

The auditor should be liable only if inadequacies in their audit resulted in failure to detect the fraud.

Fraud requires an intent to deceive another part or scienter. In such cases, the auditor acted with knowledge of a false representation.

Unlike negligence where the auditor might have made a careless statement, fraud requires the belief that representation was false.

Fraudulent intent means a representation was made with reckless indifference to the truth or falsity.

Auditor Requirements to Protect Themselves Against Fraud

Auditor must prove:

Auditor didn’t have duty to the third party.

The third party was negligent.

Auditor’s work was performed in accordance with professional standards.

The third party did not suffer loss.

Any loss to the third party was caused by other events.

The claim is invalid because the statute of limitations has expired.

Requirements For Auditors’ Defense Against Fraud

The representation in question in was not false,

The representation in question was not material,

The auditor did not know the representation was untrue,

There was no intent to deceive,

The third party did not rely on the representation,

The third party did not suffer any damages.

Consideration of Fraud in a Financial Statement Audit

In order to avoid statutory liability for fraud, the auditor must demonstrate that he carefully considered fraud risks in the financial statement audit.

In addition to exercising due care, the auditor should evaluate the conditions for fraud depicted in the fraud triangle.

Statutory Liability for Fraud 2

Auditors may have legal liability under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statutory liabilities may lead to convictions for crimes, provided their conduct was “willful”.

The term “willful” often is influenced by the context of the situation.

Section 32(a) of the Securities Exchange Act of 19 34 provides that any person who “willfully” violates any provision of the Act can be charged with a crime.

Section 15(b)(4) authorizes the S E C to seek civil administrative penalties against any person who “willfully” violates certain provisions of the securities laws.

Securities Act of 19 33

Regulates the initial offering of securities through the mails or interstate commerce.

Companies must file registration statements, (S-1, S-2, and S-3 forms) and prospectuses which contain financial statements that have been audited by an independent C P A.

Accountants who assist in the preparation of the registration statement are civilly liable if the registration statement:

Contains untrue statements of material facts.

Omits material facts required by statute or regulation.

Omits information that if not given makes the facts stated misleading.

Materiality Defense

The term material describes the kind of information that an average prudent investor would want to have to make an intelligent, informed decision whether to buy the security.

A material fact is one that, if correctly stated or disclosed, would have deterred or tended to deter the average prudent investor from purchasing the securities in question.

Facts that tend to deter a person from purchasing a security are those that have an important bearing upon the nature or condition of the issuing corporation or its business.

Section 11 of the 1933 Securities Act

A major opinion of the U.S. Supreme Court on March 24, 2015, in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund changes the legal landscape with respect to when an issuer of financial statements may be held liable under Section 11 of the Securities Act of 1933 for statements of opinion made in a registration statement.

The Court vacated and remanded the Sixth Circuit’s 2013 decision holding that a Section 11 plaintiff need only allege that an opinion in a registration statement was “objectively false,” notwithstanding the company’s understanding when the statement was made.

The Supreme Court ruled a statement of opinion in a registration statement may not support Section 11 liability merely because it is “ultimately found incorrect”.

Material Omission

A material omission claim would require the plaintiff “to identify actual and material steps taken or not taken by [the defendant auditor] in its audit or knowledge it did or did not have in the formation of the opinion” rather than simply “claiming that any reasonable audit would have uncovered a material fact whose omission renders the opinion misleading to a reasonable person reading the statement fairly and in context”.

Securities Exchange Act of 19 34

Regulates subsequent trading and ongoing reporting of securities sold on U.S. stock exchanges.

Entities having total assets of $10 million or more and 500 or more stockholders are required to register under the Securities Exchange Act.

Requires ongoing filing:

Reviewed quarterly filing (10-Q)

Audited annual reports (10-K)

Form 8-K whenever a significant event takes place affecting the entity.

Authoritative literature for information filed with the S E C.

Financial Reporting Releases (F R Rs)

Staff Accounting Bulletins (S A Bs)

Interpretations of Regulations S-X and S-K.

Section 18 of the Securities Exchange Act of 19 34

Imposes liability on any person who makes a material false or misleading statement in documents filed with the S E C.

The auditor’s liability can be limited if the auditor can show that she “acted in good faith and had no knowledge that such statement was false or misleading”

Number of court cases have limited the auditor’s good-faith defense when the auditor’s action has been judged to be grossly negligent.

Section 10 and Rule 10b-5 Securities Exchange Act of 19 34

Unlawful for a C P A to:

Employ any device, scheme, or artifice to defraud.

Make an untrue statement of material fact or omit a material fact.

Engage in any act, practice, or course of business to commit fraud or deceit in connection with the trading of the stock.

Rule 10b-5 of the Securities Exchange Act of 19 34.

Plaintiff must prove:

A material, factual misrepresentation or omission.

Reliance by plaintiff on the financial statement.

Maxwell v. K P M G L L P : Maxwell’s harm wasn’t caused by K P M G’s audit.

Damages suffered as a result of reliance on the financial statements.

Intent to deceive, manipulate or defraud (scienter)

Private Securities Litigation Reform Act (P S L R A)

Amends the Securities Exchange Act of 19 34 by adding Section 10A, “Audit Requirements”

Auditor must include “Procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts”

Auditor’s responsibility to detect fraud and requires auditors to promptly notify the audit committee and board of directors of illegal acts.

Particularity Standard.

Goal to harmonize holdings of courts that led to varying standards of auditor legal liability.

Allows scienter to be pled through “particularized” allegations establishing either.

Strong circumstantial evidence of conscious misbehavior or recklessness, or.

Facts showing that the defendant had both the motive and opportunity to commit securities fraud.

Defined the concept of “motive”.

Allege facts demonstrating a “concrete and personal benefit” that would be realized from the fraud.

Keeping the stock prices high or other motives possessed by most corporate insiders are insufficient evidence.

Proportionate Liability – P S L R A

Attempts to reform auditor liability because tort liability was out of control.

Drops legal standards of joint-and-several liability and adopts proportionate liability for all non-knowing securities violations under the Exchange Acts.

A party is liable only for that proportion of damages for which she is responsible.

Only those who committed "knowing" securities fraud will suffer joint and several liability.

Telltabs, Inc. v. Makor Issues and Rights, plaintiffs did not meet the “strong inference” standard, and were too vague to establish a “strong inference” of scienter.

S O X and Auditor Legal Liabilities Section 404 Internal Control over Financial Reporting

S O X passed to increase the transparency of financial reporting by enhancing corporate disclosure and to foster an ethical climate.

S O X increases auditor liability to third parties by specifying or expanding the scope of third parties to whom an auditor owes a duty of care.

S O X requires accounting firms to review and assess management’s report on internal controls and issue its own report.

Failing to disclose detected material weaknesses exposes auditors to Section 11 liability.

P C A O B inspections to date have shown that auditors’ opinions on internal controls are inadequate in many cases.

S O X and Auditor Legal Liabilities Section 302 Corporate Responsibility over Financial Reporting

Section 302 requires the certification of periodic reports filed with the S E C by the C E O and C F O

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Common and Statutory Law

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