Legal Liability Lecture Note 3

C.72 Liability in a Review Engagement a. Hotshot in its own right may bring an action, or the other stockholders may bring a derivative action against Mason & Dilworth on behalf of the corporation, for failure to exercise the appropriate level of professional care in failing to detect the fraud. A lawsuit based on constructive fraud might be brought against Mason & Dilworth, because the conduct of the review may be characterized as gross negligence with reckless disregard for the truth. Individual shareholders and lending institutions will claim this is the case, and if upheld, privity of contract will not be a valid defense. b. Third-party financial institutions have rights to sue accountants for failure to exercise the appropriate level of professional care in performing review engagements. As a general rule, third parties, even though not direct parties to a contract, may successfully assert ordinary negligence if they can show that they are members of a class of persons intended to benefit from the services performed by the auditors and that their use of the statements was reasonably foreseeable by the auditors. C.73 Liability Under the Securities Acts a. To bring suit under the Securities Act of 1933, investors in Orange would need to demonstrate that: 1. 2. They suffered an economic loss. The financial statements contained a material misstatement. b. Under the Securities Act of 1933, LeGrow would be liable to investors for acts of ordinary negligence, gross negligence, or fraud. c. To bring suit under the Securities Exchange Act of 1934, investors in Orange would need to demonstrate that: 1. 2. 3. 4. They suffered an economic loss. The financial statements contained a material misstatement. The loss was caused by reliance on the materially misstated financial statements. Auditors were aware that the financial statements contained a material misstatement (under Hochfelder, auditors may be held liable for gross negligence). Under the Securities Exchange Act of 1934, LeGrow would not be liable to investors for ordinary negligence and would clearly be liable for fraud. While some questions surround auditors’ liability for gross negligence, the findings in the Hochfelder case indicate potential liability for acts of gross negligence. d. The primary differences in LeGrow’s liability under the two securities acts are: Under the Securities Act of 1933, investors are not required to prove that the loss was caused by the materially misleading financial statements, only that a loss occurred and that the financial statements contained a material misstatement. Thus, the burden of proof under this act is with the auditor. In contrast, under the Securities Exchange Act of 1934, investors have the burden of proving that the loss was caused by the misleading financial statements and that the auditors demonstrated some lack of an appropriate level of performance. Under the Securities Act of 1933, investors can bring suit for ordinary negligence, gross negligence, and fraud; under the Securities Exchange Act of 1934, investors can bring suit for fraud and, potentially, gross negligence. Both of the above differences indicate that LeGrow has significantly greater exposure to potential liability under the Securities Act of 1933. C.74 Liability Under the Securities Acts a. Jones’ liability to shareholders of SoftWare would be governed by the Securities Act of 1933, since SoftWare engaged in an initial offering of securities during 2014 and the misstatement related to financial statements filed as part of this offering. Jones’ liability to shareholders of ExternalDrive would be governed by the Securities Exchange Act of 1934, since the misstatement occurred following the initial issuance of securities. b. SoftWare’s shareholders would only need to demonstrate that (1) they suffered an economic loss and (2) Software’s financial statements contained a material misstatement. ExternalDrive’s shareholders would need to demonstrate (1) they suffered an economic loss, (2) ExternalDrive’s financial statements contained a material misstatement, (3) the shareholders’ loss was caused by reliance on the materially misstated financial statements, and (4) Jones possessed scienter, or intention to deceive shareholders. c. With respect to SoftWare, Jones has two potential defenses: due diligence and causation. Because it appears that a violation of GAAS occurred, Jones will not likely be able to assert the due diligence defense. The fact that overall market conditions have caused similar declines in the stock prices of other software companies might make the causation defense viable for Jones. With respect to ExternalDrive, assuming that shareholders could demonstrate that the loss was caused by the materially misstated financial statements (making a causation defense untenable), Jones could likely assert that he acted in good faith and was not aware of the material misstatement this is consistent with the findings related to the quality of Jones’ work. d. C.75 If Jones possessed scienter, the only potential defense in either case would be to argue that the losses were not related to the materially misstated financial statements. While this would be consistent with the observed decline in market prices of other software companies, Jones’ knowledge of the misstatements and scienter would make such a defense less effective. Class Action Lawsuits a. b. c. d. e. A class action lawsuit occurs when a group of individuals come together as plaintiffs in a common action against a defendant. Individually, plaintiffs involved in a class action may not have been able to hire an attorney because the amount of their claim was small and did not justify the cost. Collectively, however, there may be significant numbers of plaintiffs for an attorney to justify the time commitment for such an action. In addition, when a class includes a large number of plaintiffs from many jurisdictions, the plaintiffs’ attorney may choose to initiate the action in a jurisdiction that is the most “friendly” to the plaintiffs. All of the advantages to plaintiffs in (b) can be viewed as disadvantages to defendants. In addition, the mere fact that a class action suit makes litigation more likely to occur is a significant disadvantage. The Class Action Fairness Act of 2005 moves many class action lawsuits to federal court where defendants may have a better opportunity to defend themselves. In addition, the Securities Litigation Uniform Standards Act requires class action lawsuits with 50 or more parties to be filed in federal courts. The inability for the plaintiffs to select the court (and jurisdiction) in which the case will be heard will likely deter many class action lawsuits. The discussion here will vary depending on the case identified by the student. Instructors should be sure to emphasize the fact that a small number of disgruntled plaintiffs can expose auditors to liability to a large number of individuals. C.76 Liability Under Common Law and the Securities Act of 1933 a. 1. Union Bank will likely be successful in its ordinary negligence suit against Weaver. To be successful in a lawsuit for ordinary negligence under common law, Union Bank must show that it (1) suffered an economic loss, (2) Weaver failed to exercise the appropriate level of professional care, (3) the financial statements contained material misstatements, and (4) Union Bank’s loss was caused by reliance on the materially misstated financial statements. Weaver was guilty of ordinary negligence in performing the audit by not confirming accounts receivable, which resulted in failing to discover the overstatement of accounts receivable. Weaver’s failure to confirm accounts receivable violated generally accepted auditing standards and represented ordinary negligence. Because Union Bank relied on these financial statements in granting the loan, and because Weaver knew that Union Bank would be provided with the financial statements in this decision process, Union Bank assumed the role of a primary beneficiary. Auditors are generally liable to primary beneficiaries for acts of ordinary negligence. 2. b. Union Bank will be successful in its fraud suit against Weaver. To be successful in a lawsuit for fraud under common law, Union Bank must demonstrate the same four factors as in part (1). In addition, to demonstrate fraud, Union Bank must prove that Weaver was aware of the material misstatement (in this case, the failure to disclose information about the product liability lawsuit). Butler’s stockholders who purchased stock under the preferred stock offering will also be successful in their suit against Weaver under section 17 of the Securities Act of 1933. Weaver’s failure to qualify the auditors’ opinion for Butler's potential legal liability was material and done with intent and knowledge, which violates the antifraud provisions in section 17. Weaver will be liable for losses sustained by the purchasers who relied on Weaver’s opinion. C.77 Liability Under the Securities Acts a. After the sale, Fancy will have total assets of greater than $10 million and more than 500 shareholders; as a result, Fancy will be required to register under the Securities Exchange Act of 1934 and file reports on Forms 10-K, 10-Q, and 8-K. Fancy will become a public, “reporting” entity. (Fancy will also be subject to the insider trading, proxy solicitation, and other requirements.) NOTE TO INSTRUCTOR: These dollar amounts and number of shareholders are subject to change. b. Any purchaser can sue the entity for failure to file the required registration statement and would be in position to receive a refund of their purchase price. Fancy would also be liable for willful violation of the Securities Act of 1933, which exposes them to monetary fines and imprisonment. c. Accredited investors include the following: Financial institutions, such as banks, savings and loans, and insurance companies. Private business development companies. 501(c)(3) charitable organizations. Directors, general partners, or officers of the registrant. Individuals with wealth in excess of $1 million, individual income in excess of $200,000, or joint income in excess of $300,000. Trusts with assets in excess of $5 million. An offering under Regulation D is exempt from registration requirements under the Securities Act of 1933. Three rules under Regulation D provide exemptions: Rule 504: A sale of “restricted securities” of up to $1 million in a 12-month period. Rule 505: A sale of up to $5 million of securities in a 12-month period to an unlimited number of accredited investors (as defined above) and up to 35 additional non-accredited investors. Rule 506: Private offerings of “restricted securities” to an unlimited number of accredited investors (as defined above) and up to 35 additional non-accredited investors (unlike Rule 505, these non-accredited investors must have sophisticated knowledge and experience in financial and business matters). C.78 Section 11 of Securities Act of 1933: Liability Exposure Yes, May, Clark & Company would be liable. The situation is covered by the Securities Act of 1933. Some of the key elements are as follows: Because the Securities Act of 1933 allows any purchaser to bring suit, privity is not available as a defense to May, Clark & Company. Chriswell Corporation’s financial statements contained a material misstatement. The fact that the market price of the debentures declined following the disclosure of the material misstatements suggests causation. However, it is important to note that demonstrating causation is not necessary to bring suit under the Securities Act of 1933. While May, Clark & Company made inquiries of the financial vice president and controller regarding material changes in Chriswell’s financial position since the date of the audit, it made no reasonable effort to verify the results of these inquiries. This would likely be viewed as a violation of generally accepted auditing standards and, therefore, ordinary negligence on the part of Mary, Clark & Company. Since May, Clark & Company are responsible up to the effective date of the registration statement, they would likely be liable. Chriswell Corporation and its officers would also be liable. C.79 Rule 10b-5 Liability Under the Securities Exchange Act of 1934 a. The case should be dismissed. A suit under section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 must establish intent to deceive, manipulate, or defraud (or scienter). Fraud is an intentional tort and as such requires more than failure to exercise the appropriate level of professional care. Although the audit was admittedly performed without the appropriate level of professional care, Gordon & Groton neither participated in the fraudulent scheme nor did they know of its existence. The element of scienter must exist in order to state a cause of action for fraud under section 10(b) of the Exchange Act 1934, although auditors may have potential exposure for gross negligence even in the absence of scienter. (Refer to the Ernst & Ernst v. Hochfelder decision.) b. The plaintiffs might have stated a common law action for ordinary negligence. However, they may not be able to prevail due to the privity requirement. There was no contractual relationship between the defrauded parties and Gordon & Groton. Although the exact status of the privity rule is unclear, it is doubtful that the level of ordinary negligence in this case would extend Gordon & Groton’s liability to the customers who transacted business with Bank & Company. However, the facts of the case as presented in court would determine this. C.80 Independence and Securities Exchange Act of 1934 a. One of the important concepts governing auditors’ independence is that auditors should not be in a position of serving as advocates for their clients. Testifying in court on behalf of the client’s damage claim is perilously close to serving as an advocate, although many auditors will claim that litigation support services (in general) are appropriate and do not impair independence. While the litigation consulting itself may not impair independence, independence is likely impaired by the unpaid consulting fee of $265,000. AICPA interpretations and rulings hold that past due fees may impair auditors’ independence in certain situations. b. Violations of generally accepted auditing standards are based on the failure of auditors to exercise the appropriate level of professional care (third general standard). This violation is based on Ward (and, therefore, AOW) not insisting upon disclosure of the appeal of the Civic case, improper deferral of losses on new product start-up costs, and inappropriate accrual of sales revenue. c. Ward and AOW appear to have violated section 10(b) by being actively involved in using a “scheme or artifice to defraud,” namely management’s issuing the materially misstated financial statements with full knowledge of the auditors. Ward, and hence AOW, acted with scienter which is required by section 10(b). In addition, Ward, by willfully enabling the 10-K to be filed with the SEC, seemingly violated section 32 of the Securities Exchange Act of 1934 by knowingly causing materially misstated statements to be filed (the financial statements and the auditors’ opinion). C.81 Auditors’ Liability Under Securities Exchange Act of 1934 a. b. c. Because Adam is a purchaser of securities of an established registrant, the most likely basis for suit would be under statutory law violations of the Securities Exchange Act of 1934. Adam’s attorney can bring suit against auditors as follows: 1. Fraud under the Securities Exchange Act of 1934, section 10b-5. In Ernst & Ernst v. Hochfelder, the court’s decision indicated that reckless professional work might be a sufficient basis for 10b liability even though scienter is not clearly established. Therefore, if Adam’s attorney could prove that auditors acted recklessly (i.e., with gross negligence), he might recover loss from auditors. 2. Criminal liability under the Securities Exchange Act of 1934, section 32. Under United States v. Natelli (1975), Adam’s attorney must prove that auditors acted willfully and knowingly. The auditors’ attorney can use the following defenses to protect auditors from legal liabilities. 1. With respect to civil liability, auditors’ primary defenses are that they acted in good faith and had no knowledge of the material misstatements. 2. With respect to the criminal charges, because the burden of proof was provided by the plaintiff’s attorney, the auditors’ attorney should prove that the evidence does not indicate auditors were guilty beyond a reasonable doubt. Most importantly, fraud must be demonstrated to file criminal charges under section 32 of the Securities Exchange Act of 1934. Section 307 of Sarbanes-Oxley includes a rule that requires an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation to the chief legal counsel or the chief executive officer of the entity. If the counsel or officer does not appropriately respond to the evidence, the attorney is required to report the evidence to the audit committee or board of directors. Either Adam’s attorney or Joshua Food’s auditors’ attorneys should report evidence of the violation to the company’s management (or audit committee, if management did not take remedial measures). C.82 Mini-Case: Ethics NOTE TO INSTRUCTOR: For this assignment, questions 1, 2, 3, 4, 5, and 7 from this Mini-Case are applicable. 1. According to the Merriam-Webster Online Dictionary corrupt means (selected meanings relevant to this issue): to change from good to bad in morals, manners, or actions or to degrade with unsound principles and or moral values to become morally debase to cause disintegration or ruin The term corrupt, especially as indicated in second bullet above, could be applied to the actions of Andersen as a firm and might indicate that the firm was corrupt. It is important here to know how the definition normally used by the 5th Circuit Court included the word dishonest, which does not appear in any of these definitions. 2. The issues are debatable and still center on the motives of David Duncan when he ordered the shredding of documents and whether Andersen had an obligation to modify its procedures if an investigation was imminent. Remember, once Andersen was served with formal notice of an investigation, no documents were shredded. 3. The opinions of students will vary. Clearly, the contested issues concerning jury instructions were all decided in favor of the prosecution. The fact that by impeding an investigation, even without meaning to do so, was allowed to indicate that an obstruction of justice occurred could have major legal ramifications if used as a precedent. For example, if on your way home from class you inadvertently got in the way of a police officer responding to a crime, under the “impede” rule, could you be guilty of obstruction of justice? 4. Again, opinions will vary. However, with hindsight and based on the actions taken in the KPMG investigation, the loss of one of the large CPA firms and the loss of jobs appears to be a penalty to too many innocent people. It is probably more appropriate to seek out individuals who engaged or directed illegal activities and take the appropriate actions against those individuals. 5. Students should understand that even if an action is legal it may not be ethical. Clearly, there were some actions taken that are questionable. The principles of ethics require auditors to act with integrity and to be mindful of the public trust. There are clearly issues of integrity and the public trust in both the audit work and the shredding of documents following the disclosure that Enron’s financial statements were fraudulent. C.82 Mini-Case: Ethics (continued) 7. In litigation the plaintiffs’ attorneys often name multiple defendants. They do this for two basic reasons. First, if one of the plaintiffs is found harmless (the tort case equivalent of “not guilty”), other plaintiffs may be found negligent or to have engaged in fraudulent actions. Therefore, the plaintiffs may still prevail (and collect damages) against those defendants. Second, if one or more defendant becomes insolvent (which may happen during a long trial where legal fees can escalate and cause create cash flow problems), the plaintiffs may collect from other defendants found liable in the lawsuit. This ability to collect in full from those who have “the ability to pay” is the basis for joint and several liability. Class action lawsuits can be the most damaging to plaintiffs. Several plaintiffs (sometimes thousands of plaintiffs) can file one lawsuit seeking damages that can total into millions of dollars if proven. In addition, class action lawsuits may often be heard in several jurisdictions, allowing the plaintiffs’ attorneys the ability to shop for a court they believe will be sympathetic to their clients. If a class action lawsuit is not allowed, many of the smaller claims may be dropped (the costs of the lawsuit outweighs the potential reward) and even larger suits must bare the legal fees individually. Further, the defense team is not engaging in a “winner take all” contest. Each suit, possibly heard in different jurisdictions, will be required to prove its individual case for its plaintiff.