Legal Liability Lecture Note 2

C.53 C.54 C.55 C.56 C.57 a. Incorrect b. Correct c. Incorrect d. Incorrect Scienter must be demonstrated under the Securities Exchange Act of 1934; under the Securities Act of 1933, auditors are responsible for ordinary negligence. Plaintiffs must establish that the financial statements contained a material misstatement. Proving reliance on the materially misstated financial statements is not necessary. Proving that reliance on the materially misstated financial statements caused the loss is not necessary. NOTE TO INSTRUCTOR: Since this question asks which of the statements is not true, the response labeled “correct” is not true and those labeled “incorrect” are true. a. Correct b. c. Incorrect Incorrect d. Incorrect a. Incorrect b. Correct c. Incorrect d. Incorrect a. Correct b. c. d. Incorrect Incorrect Incorrect a. Correct b. Incorrect c. Incorrect d. Incorrect Sarbanes-Oxley does not include new definitions or situations that constitute securities fraud. The amendments in the Act provide greater penalties for auditors, but do not increase auditors’ responsibilities for identifying fraud. Sarbanes-Oxley requires that the CEO and CFO certify the financial statements. Sarbanes-Oxley specifies penalties for destruction of records in federal investigations for both accounting firms and auditors. Sarbanes-Oxley increases penalties for mail fraud and criminal violations of the Securities Exchange Act of 1934. Because the suit is being brought by a third party and not a client, lack of privity is not a viable defense; third parties do not need to demonstrate a privity relationship to bring a suit alleging fraud against auditors. If auditors can demonstrate that third parties did not rely on the financial statements, the loss was not caused by the financial statements or auditors’ examination, providing a basis for the causation defense. Disclaimers in engagement letters cannot protect auditors from lawsuits against third parties for misstated financial statements. Contributory negligence would be an available defense against suits brought by clients, but not third parties. Because Hall engaged Locke and Locke did not perform in accordance with the terms of the engagement letter, Hall can bring suit for breach of contract. Locke’s negligence would also permit a suit to be brought on that basis. Hall could bring suit for negligence as well as breach of contract. Hall could bring suit for breach of contract as well as negligence. Hall could bring suit for either breach of contract or negligence. For initial offerings, investors only need to demonstrate that a loss was suffered and that the financial statements contained a material misstatement. For initial offerings, investors do not need to demonstrate that they relied upon the financial statements in making their investment decisions. For initial offerings, no negligence or culpability on the part of the auditor needs to be demonstrated to bring suit. For initial offerings, no negligence or culpability on the part of the auditor needs to be demonstrated to bring suit. C.58 C.59 C.60 a. Correct b. Incorrect c. Incorrect d. Incorrect a. Incorrect b. c. Incorrect Incorrect d. Correct Under the Securities Exchange Act of 1934, a viable defense for Donalds would be that they were not aware that the financial statements contained a material misstatement, since under this Act plaintiffs must demonstrate scienter on the part of the auditor. Section 10(b) would apply to Donalds, since these securities were publiclytraded and information was filed with the SEC. It is not necessary to demonstrate privity to bring suit under the Securities Exchange Act of 1934. Auditors cannot avoid liability under the Securities Exchange Act of 1934 through any disclaimer language in their engagement letters. Under the Securities Act of 1933, Hex does not need to demonstrate any level of auditor culpability, including knowledge that the financial statements contained a material misstatement. No level of auditor culpability (including negligence) needs to be demonstrated. Under the Securities Act of 1933, Hex does not need to demonstrate that he relied on the financial statements in making his investment decision. Hex needs to demonstrate that he suffered an economic loss and that the financial statements contained a material misstatement. NOTE TO INSTRUCTOR: Since this question asks which of the defenses would be least helpful, the response labeled “correct” would be least helpful and those labeled “incorrect” would be helpful. a. Correct b. Incorrect c. Incorrect d. Incorrect Investors do not need to demonstrate privity to bring suit under the Securities Act of 1933. A viable defense for West would be that the audit was conducted in accordance with GAAS (known as the due diligence defense). A viable defense for West would be that the loss was caused by factors other than the financial statements and auditors’ examination. If Hex was aware of the material misstatements, these misstatements could not have been the cause of Hex’s losses. SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS C.61 C.62 Breach of Contract a. Auditors can be in breach of contract for: Failing to meet established deadlines Failing to provide the services described in the contract Charging fees differently then agreed in the contract b. Clients can be in breach of contract for: Failing to provide documents as agreed in the contract Failing to pay audit fees in a manner described in the contract Failing to make available key personnel as agreed in the contract Failing to disclose information known by management (e.g. known frauds) as agreed in the contract c. The best defenses are: There is no breach of contract (i.e., auditors met all the contract provisions) The breach of contract was due to the client’s failure to perform as specified under the contract Fulfillment of the contract became impossible because of circumstances beyond auditors’ control (for example, auditors cannot be liable for breaching a provision of a contract to count inventory held in a warehouse if the inventory was destroyed) Liability to Clients a. Clients may bring suit against auditors for either breach of contract or tort actions. b. To bring suit against auditors, clients must ordinarily demonstrate: 1. 2. 3. 4. c. They suffered an economic loss. Auditors did not perform in accordance with the terms of the contract (for breach of contract). Auditors failed to exercise the appropriate level of professional care (for tort actions). The breach of contract or failure to exercise the appropriate level of professional care caused the loss. Auditors’ defenses against legal actions brought by their clients include: 1. 2. 3. Auditors exercised the appropriate level of professional care (tort) or performed the engagement in accordance with terms of the contract (breach of contract). The client’s economic loss was caused by a factor other than auditors’ failure to exercise appropriate levels of professional care or breach of contract. Actions on the part of the client were, in part, responsible for the loss. C.62 Liability to Clients (continued) d. The potential basis for legal action in each of these cases is as follows: Brown Company: Because the delay in completing the audit resulted in additional costs of financing, Brown’s legal action would be based on Thomas’ inability to complete the audit on a timely basis. Green Stores: Green Stores’ legal action would be based on Thomas’ failure to identify the embezzlement scheme during its audits of Green Stores’ financial statements. Green Stores would likely seek recovery of the $2 million in losses. Fuchsia, Inc: Fuchsia’s legal action would be based on any additional costs associated with changing auditors and any costs associated with delays in providing audited financial statements to its lenders as a result of the need to change auditors. e. NOTE TO INSTRUCTOR: Depending upon the assumptions made by students, they may arrive at different conclusions with respect to Thomas’ liability to its clients in some of these scenarios. The key is that they considered the relevant facts and potential defenses that may either increase or decrease the likelihood of an unfavorable outcome to Thomas. Brown Company: It appears that Brown Company’s most viable action for recovery will be alleging that it informed Thomas of the need to have the audit completed by a certain date and that failure to do so would constitute a breach of contract. There is no evidence that a substandard audit has been conducted or that Thomas did not exercise the appropriate level of professional care. In this case, the following are important considerations: 1. Was a deadline or other date explicitly communicated by Brown Company to Thomas or otherwise identified in the engagement letter? If no such date was communicated, or any deadline known by Thomas, it would not appear that Brown Company has a viable suit for breach of contract. 2. Regardless of the response to (1) above, did Brown Company’s actions result in delays or otherwise affect Thomas’ ability to complete the engagement on a timely basis? If so, this might serve as a defense for Thomas in the form of contributory negligence on the part of Brown Company. Green Stores: Green Stores would most likely bring suit for tort liability, alleging that an audit conducted under generally accepted auditing standards would have revealed the existence of the embezzlement scheme and prevented the $2 million loss. In this case, the following are important considerations: 1. Were Thomas’ audits conducted in accordance with generally accepted auditing standards? If so, Thomas would likely use the defense that it exercised appropriate levels of care during the engagement and emphasize that a GAAS audit cannot be relied upon to detect all instances of fraud. 2. Regardless of the response to (1) above, could Green Stores have taken actions (through strengthening internal controls or other) to create an environment that would have made the creation and execution of this embezzlement scheme more difficult? Certainly, if Thomas had communicated internal control deficiencies to Green Stores in previous audits related to the treasurer’s role or controls surrounding this function, it would appear that Thomas could assert contributory negligence as a defense. Fuchsia, Inc.: This may appear to be a frivolous suit, but that would not prevent Fuchsia from alleging that Thomas’ actions resulted in the losses described in the scenario. While it is difficult to comprehend how Fuchsia’s decision to change auditors would result in liability to Thomas, Thomas would appear to have a strong defense that its actions were, in fact, done to exercise appropriate levels of professional care by demonstrating how Fuchsia’s accounting treatment departed from generally accepted accounting principles. C.63 C.64 Common Law Responsibility for Errors and Fraud a. Given the nature of the auditing procedure, it appears that Whitman had an obligation to follow up on the 13 missing receiving reports; had he done so, he may have identified the fraudulent scheme involving Lock. The fact that Whitman indicated that the problem was resolved in the audit documentation without any evidence that these receiving reports were located and included in the files would likely expose Hoffman & Whitman to liability. b. The problem description indicates that this portion of the audit was conducted without the appropriate level of professional care. While sampling transactions is acceptable under generally accepted auditing standards, Whitman’s follow-up and explanation of the missing receiving reports leaves much to be desired. At the very least he could have reviewed the reports produced by Lock at a later date, and he could have traced the purchases to the inventory records and perhaps noticed an over-stocking condition. Auditors had some evidence that fraud might exist, but it appears that they failed to apply extended audit procedures properly. Common Law Responsibility for Errors and Fraud Donovan’s responsibility under generally accepted auditing standards is to plan the audit to detect errors and frauds that would have a material effect on the financial statements. Whether McCoy would prevail depends upon two questions: (1) The materiality of the undiscovered embezzlement and whether it was concealed by falsifying the financial statements and (2) Donovan’s planning and performance of appropriate audit procedures. If the amount is material, Donovan is potentially liable. If Donovan performed a careful audit exercising the appropriate level of professional care, liability probably would not attach. If not, Donovan might be found guilty of ordinary negligence and liable to McCoy with whom he had a privity relationship. All the common law features (damage, reliance, cause, failure to perform with the appropriate level of professional care, and privity) are present. The actual resolution of liability is only a matter of their degree. McCoy, however, can be faulted (although probably not in a contributory negligence sense) for not informing Donovan about the anonymous letter. Donovan should have obtained signed representations in which McCoy asserted he knew of no errors or frauds that he had not told Donovan. With such signed representations, Donovan might not be found liable at all. Even if Donovan is judged liable, McCoy could probably recover only the embezzled amounts after the audit ($65,000) but not the amounts embezzled prior to the audit ($40,000). C. 65 Auditors’ Liability for Fraud a. b. c. d. Auditors will be liable for fraud to all third-party users of financial statements under common law or statutory law. Fraud is a misrepresentation of fact that the individual knows to be false. Constructive fraud (sometimes referred to as gross negligence) is the failure to provide any care in fulfilling a duty owed to others. The primary difference between these two levels of professional care is actual knowledge on the part of auditors, which is present under fraud but not under constructive fraud. Auditors will be liable for constructive fraud to all third-party users under common law and the Securities Act of 1933. To be held liable under the Securities Exchange Act of 1934, scienter (or intent to deceive, manipulate, or defraud) must be shown. While scienter may be present in situations representing constructive fraud, this will not always be the case. Clearly, auditors should be liable in cases where they intend to deceive. While intention is not present under constructive fraud, the level of performance and lack of care is so great that it seems appropriate to hold auditors liable for constructive fraud. C.66 Accusation of Fraud a. In this case, a claim for fraud does not appear to exist. To show fraud auditors would have to: 1. Be aware that the inventory amounts were incorrect and not require adjustment of these amounts or modification of the auditors’ opinion. 2. Conclude that the inventory amounts were fairly stated without performing any auditing procedures (reckless disregard for the truth); Neither of these actions can be shown from the information provided. The failure to adequately review the inventory is more likely classified as ordinary negligence, or possibly gross negligence, rather than fraud. b. C.67 If auditors were charged with fraud their defenses would include: 1. They performed the audit of inventory in accordance with generally accepted auditing standards; 2. Management perpetrated the fraud, which included the objective of defrauding auditors; 3. There was no intent or pattern of behavior on the part of auditors that indicates that they committed a fraud. Common Law Liability Exposure a. Creditors appear to be claiming that auditors knew the financial statements were not presented in accordance with generally accepted accounting principles. b. If action is brought based on fraud, the lack of privity would not be an important issue. Auditors are liable to all parties under common law in instances where they commit fraud. c. Yes, the firm is liable to the creditors, because the firm was aware of the failure to disclose the cash received as well as the contingent liability. C.68 C.69 Common Law Liability Exposure a. Under a privity of contract definition, Risk Capital will not prevail. Under the strict privity rule, parties must be signer of a contract to have a standing to sue for ordinary negligence. Therefore, regardless of whether Wilson and Wyatt committed ordinary negligence, Risk Capital has no legal standing to sue Wilson and Wyatt for ordinary negligence. b. While debatable, under a strict primary beneficiary standard, Risk Capital will not likely prevail. In the case of Credit Alliance v. Arthur Andersen (1985), the court held that auditors are not liable for ordinary negligence to third parties unless (1) auditors were aware that a particular third party intended to rely on the auditors’ opinion and the financial statements, (2) the third party was specifically identified to auditors, and (3) some action by auditors showed they acknowledged the third-party’s identification and intent to rely on the opinion and financial statements. For example, auditors could include the name of the bank and acknowledge its intended use of the financial statements in the engagement letter. While elements (1) and (2) are present, it does not appear that element (3) is present (acknowledgement of the third-party’s identification). In addition, the standing of Risk Capital would vary depending upon the jurisdiction in which the case is heard. NOTE TO INSTRUCTOR: There is likely to be some debate about element (3). An effective extension of this part of the problem would be to identify what type of action(s) on the part of auditors would satisfy element (3). c. Under the foreseen party standard defined by restatement of torts, Risk Capital will prevail. The restatement of torts extends liability for ordinary negligence to “foreseen” third parties not explicitly known to auditors. Under this approach, auditors may be subject to claims for ordinary negligence if they know that the auditors’ opinion and financial statements will be delivered to unidentified investors and creditors. Specific acknowledgement is not required. Auditors must only be aware that the auditors’ opinion and financial statements will be used by some third party. In this instance, the contact clearly specified Risk Capital and the use of the financial statements. As a result, Risk Capital would be classified as a foreseen third party (if not a primary beneficiary). Common Law Liability Exposure a. Yes, Smith will be liable to the bank. The elements necessary to establish an action for liability for fraud under common law are clearly present. There was a material misstatement in the financial statements, intent and knowledge of the misstatements (scienter), actual reliance by the bank on the materially misstated financial statements, and economic damages resulting from that reliance. If action is based upon fraud, there is no requirement that the bank establish privity of contract with Smith. If the action by the bank is based on ordinary negligence, the bank may still be in position to bring suit, depending upon the extent to which Smith was aware that his work would be used by the bank and the jurisdiction in which this case occurred. Based on the facts presented, it is difficult to determine whether the bank is a primary beneficiary. However, because Smith was aware that the financial statements would be used to obtain a loan, the bank would appear to be at least a foreseen third party and could prevail under the restatement of torts doctrine. b. No, Smith will not be liable to the lessor because the lessor was a party to the “secret” written agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if the lessor was damaged indirectly, his own fraudulent actions led to his loss, and the equitable principle of “unclean hands” (“contributory negligence”) precludes him from obtaining relief. c. Smith was not independent with respect to the audit of Juniper. The lack of independence is raised by Juniper’s threat to sue Smith in the event the loan was not obtained. C.70 Common Law Liability to Third Parties a. b. 1. Primary beneficiary: A person known by name to the auditors for whose primary benefit the auditor other accounting service is performed. 2. Foreseen third parties: A limited class of individuals or organizations that could be reasonably expected to rely on auditors’ work. 3. Foreseeable third parties: Third parties whose decisions normally rely on audited financial statements and opinions on those financial statements. 1. Because Flacco knew that Raven’s financial statements would be presented to Baltimore National Bank to secure financing, Baltimore National Bank would likely be classified as a primary beneficiary. 2. Because Flacco was aware that the financial statements would be presented for bank financing, Regional State Bank would likely be classified as a foreseen third party. Regional State Bank would not be classified as a primary beneficiary because Flacco was not specifically informed of this party’s potential use of the audited financial statements. 3. Maryland Equity Partners would most likely be classified as a foreseeable third party. While a case could be made that a private equity firm is a foreseen party, based on the pre-audit conference, it appears that Raven Company is pursuing bank financing and not equity financing. In any case, because Flacco was not informed of Maryland Equity Partners’ use of the financial statements, this party would not be classified as a primary beneficiary. c. If Flacco committed ordinary negligence (through failing to conduct a GAAS audit), Baltimore National Bank would prevail in any jurisdiction, since auditors are responsible for ordinary negligence to primary beneficiaries. With respect to Regional State Bank and Maryland Equity Partners, Flacco’s culpability would depend upon the jurisdiction in which the action was brought. If legal action was brought in a state using the Restatement of Torts approach, Regional State Bank would likely prevail against Flacco, but Maryland Equity Partners would not (assuming this latter party would be considered to be a foreseeable third party and not foreseen third party). If legal action was brought in a state using the reasonable foreseeability approach, both Regional State Bank and Maryland Equity Partners would prevail against Flacco. d. It is likely that Flacco’s failure to perform meaningful substantive procedures related to Raven’s accounts receivable would constitute gross negligence. If so, all three parties would prevail against Flacco, since auditors owe all third parties liability for actions that reach the level of gross negligence. C.71 Common Law Liability to Third Parties a. Because these parties provided loans to Madeoff and are non-shareholder third parties, they would pursue litigation against Allen based on common law rather than statutory law. b. Because First Trust and Bank was specifically known to Allen by name (in fact, First Trust and Bank was explicitly identified by name in the engagement letter), it would be classified as a primary beneficiary. Allen was aware that the purpose of the audit examination was to enable Madeoff to obtain financing. Because of this knowledge, as well as the fact that Madeoff had previous business relationships with MoonTrust, MoonTrust would likely be classified as a foreseen third party. The classification of Alice Lay is somewhat debatable. On one hand, any third party could potentially provide funding to Madeoff; using this rationale, one might classify Alice Lay as a foreseeable third party. However, because it is not common practice for entities to obtain financing from customers and Alice Lay had never entered into a loan agreement of this nature in the past, a justification could be made that she does not meet the classification as a foreseeable third party. c. The failure of Allen’s audit to comply with generally accepted auditing standards represents ordinary negligence, assuming that Allen’s audit did not demonstrate a lack of minimum care or Allen did not possess actual knowledge of the material misstatements. For ordinary negligence, the following represents these parties’ abilities to prevail against Allen: As a primary beneficiary who relied upon the audited financial statements and Allen’s report on the financial statements, First Trust and Bank would likely be able to bring suit and prevail against Allen. While MoonTrust’s classification as a foreseen third party suggests that it would be able to prevail against Allen in certain jurisdictions, the fact that MoonTrust did not rely on the audited financial statements and Allen’s report on the financial statements would make it unlikely that MoonTrust could bring suit against Allen. If MoonTrust did bring suit against Allen and Allen could prove that the loan decision was made prior to receipt of the audited financial statements and auditors’ report, Allen could attempt to successfully assert the causation defense. Given Alice Lay’s very remote and unusual relationship to Madeoff as a provider of capital it is unlikely that Alice would have an appropriate level of standing to bring suit against Allen. However, if Alice could demonstrate that she was a foreseeable third party and could meet the other criteria for bringing suit under common law, she could potentially prevail against Allen. d. If Allen was aware of the material misstatements, this would be classified as fraud. Both First Trust and Bank and Alice Lay would be highly likely to prevail against Allen, because auditors are liable to all third party users (regardless of their relationship and classification) for acts of gross negligence or fraud. MoonTrust would still have the burden of demonstrating that they relied on the materially misstated financial statements and Allen’s report in bringing suit against Allen.