Legal Liability Lecture Note 1

MODULE C Legal Liability LEARNING OBJECTIVES Review Checkpoints Multiple Choice Exercises, Problems, and Simulations 1. Identify and describe auditors’ exposure to lawsuits and loss judgments. 1, 2 31 83 2. Specify the characteristics of auditors’ liability under common law and cite some specific case precedents. 3, 4, 5, 6, 7, 8, 9 29, 32, 35, 36, 37, 40, 46, 49, 55, 56 61, 62, 63, 64, 65, 66, 67, 68, 69, 70, 71, 72, 76(*), 82 3. Describe auditors’ liability to third parties under statutory law. 10 39 4. Specify the civil and criminal liability provisions of the Securities Act of 1933. 11, 12, 13, 14, 15, 16, 17 38, 42, 44, 47(*), 48, 53, 57, 59, 60 73(*), 74(*), 76(*), 77(*), 78 5. Specify the civil and criminal liability provisions of the Securities Exchange Act of 1934. 18, 19, 20, 21, 22, 23, 24 41, 43, 45, 47(*), 50, 51, 52, 58 73(*), 74(*), 77(*), 79, 80, 81 6. Understand recent developments that affect auditors’ liability to clients and third parties. 25, 26, 27, 28 30, 33, 34, 54 75 (*) Item relates to multiple learning objectives SOLUTIONS FOR REVIEW CHECKPOINTS C.1 Auditors owe clients the responsibility to perform services in accordance with the contract (engagement letter) and to conduct the audit in accordance with generally accepted auditing standards. Auditors owe third parties the responsibility of conducting the audit in accordance with generally accepted auditing standards. In each of these situations, auditors can be held liable if their failure to perform in accordance with the contract or generally accepted auditing standards results in an economic loss to clients or third parties. C.2 Common law liability uses legal precedent to identify the responsibility of parties in situations where there is no violation of a written law or statute. Clients and nonshareholder third parties can bring suit against auditors for common law liability. Statutory law liability involves the violation of a written law. Third-party shareholders can bring suit against auditors for statutory liability. C.3 Under common law liability, clients can bring suit against auditors for either breach of contract or tort actions. Prior to bringing suit, clients must demonstrate: 1. 2. 3. 4. They suffered an economic loss. Auditors did not perform in accordance with the terms of the contact (for breach of contract). Auditors failed to exercise the appropriate level of professional care (for torts). The breach of contract or failure to exercise the appropriate level of professional care caused the loss. C.4 Auditors owe clients the responsibility for conducting the audit using the appropriate level of professional care. If they do not do so, they have tort liability for ordinary negligence, gross negligence, or fraud. C.5 To bring suits against auditors under common law, third parties must demonstrate: 1. 2. 3. 4. C.6 They suffered an economic loss. Auditors failed to exercise the appropriate level of professional care. The financial statements contained a material misstatement. The loss was caused by reliance on the materially misstated financial statements. The Ultramares Corp. v. Touche case concludes that if auditors conduct their work with such gross negligence as to amount to constructive fraud or constructive deceit, they may be liable for damages. The decision, and also a part of the “rule” from Ultramares, was that auditors are not liable to unidentified third parties for ordinary negligence. One can infer that liability for ordinary negligence might be imposed when third-party beneficiaries are known (but this was not explicit in the court opinion). The Ultramares rule is being eroded today. No longer is privity the shield that it was in 1931, and auditors are being held responsible for a greater degree of care. However, in some states, the Ultramares view is still in effect. C.7 Privity refers a situation in which parties have a contractual relationship. Auditors owe contracting parties (e.g. clients) a duty to perform the audit with the appropriate level of professional care. Liability can be imposed for situations in which auditors exhibit ordinary negligence. A primary beneficiary is the party an audit or accounting service is intended to benefit. The distinguishing feature of a primary beneficiary is that this party is either named in the contract or auditors know of this party by name. Auditors are generally liable to primary beneficiaries for ordinary negligence. Foreseen parties are groups or individuals that client intends the information to benefit and that could reasonably be expected to rely on auditors’ work. In certain jurisdictions, auditors can be liable to foreseen parties for ordinary negligence when the plaintiff justifiably relied on the information and suffered a loss on such reliance. Foreseeable parties are the creditors, investors, or potential investors whose decisions normally rely on audited financial statements and opinions on those financial statements. In some jurisdictions, auditors can be liable to foreseeable parties for ordinary negligence. C.8 Auditors’ defenses against clients under common law include: 1. Auditors exercised the appropriate level of professional care (torts) or performed the engagement in accordance with the terms of the contract (breach of contract). 2. The client’s economic loss was caused by a factor other auditors’ failure to demonstrate an appropriate level of professional care or breach of contract (causation defense). 3. Actions on the part of the client were, in part, responsible for the loss (contributory negligence). Auditors’ defenses against third parties under common law include: 1. The third party did not have appropriate standing (privity) to sue in the jurisdiction. 2. The third-party’s loss was caused by events other than the financial statements and auditors’ examination. 3. Auditors’ work was performed in accordance with professional standards (GAAS), which is generally interpreted to mean that auditors did not commit ordinary negligence. C.9 In lawsuits related to compilation and review, accountants can use the proper disclaimers, which were presented in the non-audit service report, as an additional defense to insulate them from lawsuits from third parties. C.10 Liability under statutory law arises when purchasers or sellers of securities suffer an economic loss and the financial statements contain a material misstatement. C.11 Transactions governed by the Securities Act are the initial issuance of securities by registrants to the investing public through a market (primarily through in initial public offering). C.12 A registration statement is a set of documents filed with the SEC prior to the offering of securities. Registration statements introduce liability to auditors because the prospectus (which is contained within the registration statement) includes audited financial statements and disclosures. As a result, if purchasers of securities suffer an economic loss and the financial statements contain a material misstatement, auditors may be liable for the losses suffered by purchasers. C.13 Section 11 of the Securities Act of 1933 effectively shifts the burden of proof regarding the appropriate level of professional care during the examination to auditors, whereas this proof is the plaintiff’s duty under common law. Furthermore, the plaintiff does not have to be in a privity relationship or known third-party beneficiary relationship with auditors. Also, the plaintiff does not have to prove reliance on the materially misstated financial statements or that the loss resulted from the materially misstated financial statements. C.14 In a civil suit under section 11 of the Securities Act of 1933, the plaintiff only has to prove that a loss was suffered and that the financial statements contained a material misstatement. To avoid liability, the defendant auditors can either prove that (1) the engagement was conducted according to GAAS (“due diligence” defense) or (2) the loss was caused by factors other than the misstated financial statements and auditors’ examination (“causation” defense). C.15 The due diligence defense asserts that auditors conducted a reasonable investigation, which ordinarily means that the audit was conducted in accordance with GAAS. The causation defense asserts that all or part of the plaintiffs’ losses were caused by factors other than financial statements and auditors’ examination. C.16 Section 17 of the Securities Act of 1933 is the antifraud provision relating to the offer or sale of securities. Section 24 of the Securities Act of 1933 defines criminal penalties and relates to willful violation of duties with respect to a statutory registration or requirement to register a sale of securities. C.17 In Escott v. BarChris Construction Corp., the court concluded that auditors did not conduct an appropriate review of subsequent events and, in fact, did not perform steps included in the audit program. C.18 Form 10-K includes annual financial statements that are audited by independent auditors. Form 10-Q includes quarterly financial statements that are reviewed by independent auditors. Form 8-K provides a summary of an entity’s major events; auditors may review or assist in the preparation of these reports. C.19 Regulation S-X contains requirements for audited annual and unaudited interim financial statements filed with the SEC. Regulation S-K contains requirements relating to all other business, analytical and supplementary financial disclosures in SEC filings. Financial Reporting Releases are SEC staff reports that express new rules and policies about accounting and disclosures required or encouraged by the SEC. Staff Accounting Bulletins contain unofficial but important interpretations of Regulation S-X and Regulation S-K by SEC staff. C.20 Under the Securities Exchange Act of 1934, purchasers or sellers of securities can bring suit by proving: 1. 2. 3. 4. C.21 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. Auditors’ defenses under the Securities Exchange Act of 1934 are that they acted in good faith and had no knowledge of the material misstatements. C.22 Under section 32 of the Securities Exchange Act of 1934, criminal penalties include fines of up to $5 million and imprisonment for up to 20 years (these levels represent increases provided by Sarbanes-Oxley). In addition, violations of the provisions of Securities Exchange Act of 1934 by entities other than natural persons (such as accounting firms) are punishable by fines up to $25 million. C.23 Scienter is a mental state embracing the intent to deceive, manipulate, or defraud (for example, if auditors have knowledge of misstatements in the financial statements and intentionally fail to disclose these misstatements in their reports). Ernst & Ernst v. Hochfelder and Denise L. Nappier et al. v. PricewaterhouseCoopers both concluded that parties could not recover damages against auditors because they were unable to demonstrate scienter on the part of the defendants. C.24 C.25 C.26 The major differences between auditors’ liability under the Securities Act of 1933 and Securities and Exchange Act of 1934 are: 1. The Securities Act of 1933 applies to original purchasers of securities under a registered offering while the Securities and Exchange Act of 1934 applies to purchasers and sellers of securities under ongoing exchanges after the initial offering. Auditors are liable for ordinary negligence, gross negligence, or fraud under the Securities Act of 1933; they are only liable for gross negligence or fraud under the Securities Exchange Act of 1934. 2. Auditors have the burden of proof under the Securities Act of 1933; plaintiffs (purchasers or sellers of securities) have the burden of proof under the Securities Exchange Act of 1934. 3. Under the Securities Act of 1933, auditors’ defenses are that a GAAS audit was conducted or the loss was caused by factors other than the financial statements and auditors’ examination; under the Securities and Exchange Act of 1934, auditors’ defenses are that the audit was conducted in good faith and auditors were not aware of the materially misstated financial statements. Some of the major changes in auditors’ liability under Sarbanes-Oxley include: 1. Extended the statute of limitations for bringing a suit under the Securities and Exchange Act. 2. Increased monetary fines and imprisonment penalties for violations of the Securities and Exchange Act. 3. Increased imprisonment penalties for mail fraud and wire fraud. 4. Monetary fines and imprisonment penalties for the alteration and destruction of documents. 5. Increased period over which records must be retained by accounting firms. Joint and several liability is a doctrine that allows a successful plaintiff to recover the full amount of a damage award from the any defendant(s), regardless of the defendant’s relative degree of fault. Proportionate liability only permits recover from defendant(s) based on their relative degree of fault. C.27 The Private Securities Litigation Reform Act provided the following terms for proportionate liability: 1. The total responsibility for loss is divided among all parties responsible for the loss. 2. However, if other defendants are insolvent, a solvent defendant’s liability is extended to 50 percent more than the proportion found at trial. 3. Only the defendants who knowingly committed a violation of securities laws remain jointly and severally liable for all the plaintiffs’ damages. The Class Action Fairness Act expanded federal jurisdiction over class action lawsuits and moves many class action cases from state courts to federal courts. C.28 To reverse the perceived concerns with the Private Securities Litigation Reform Act (attorneys filing securities class action lawsuits in state courts that follow joint and several liability doctrines), Congress enacted the Securities Litigation Uniform Standards Act. This act’s most significant provision requires that class action lawsuits with 50 or more parties must be filed in the Federal courts. SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS C.29 C.30 C.31 a. b. c. Incorrect Incorrect Incorrect d. Correct a. Incorrect b. Incorrect c. Incorrect d. Correct a. Incorrect b. Incorrect c. Incorrect d. Correct Constructive fraud represents reckless behavior, not a lack of reasonable care. Fraud represents intention to deceive. Gross negligence is similar to constructive fraud and represents lack of minimal care. Ordinary negligence represents lack of reasonable care and is often proven by demonstrating that auditors failed to follow GAAS in conducting the audit. Joint and several liability can impose the entire amount of loss in a case against auditors, which is less favorable than proportionate liability. The reasonably foreseeable user approach provides auditors with the greatest exposure to liability to third parties for ordinary negligence. The foreseen third party approach is more favorable to auditors than the reasonably foreseeable approach, but auditors may still be exposed to the entire amount of the loss. Proportionate liability is most favorable to auditors because they will only be liable for damages to the extent they were found to be at fault. The difference between the perception of the users of the statements and auditors’ knowledge of the audit objective is known as the expectations gap. One common example of the expectations gap is users’ belief that a GAAS audit will uncover all instances of fraud. The difference between the perception of the users of the statements and auditors’ knowledge of the audit objective is known as the expectations gap. One common example of the expectations gap is users’ belief that a GAAS audit will uncover all instances of fraud. The difference between the perception of the users of the statements and auditors’ knowledge of the audit objective is known as the expectations gap. One common example of the expectations gap is users’ belief that a GAAS audit will uncover all instances of fraud. The difference between the perception of the users of the statements and auditors’ knowledge of the audit objective is known as the expectations gap. One common example of the expectations gap is users’ belief that a GAAS audit will C.32 C.33 C.34 C.35 a. Incorrect b. Correct c. Incorrect d. Incorrect a. Incorrect b. Incorrect c. Correct d. Incorrect a. Correct b. Incorrect c. Incorrect d. Incorrect a. b. Incorrect Correct c. Incorrect d. Incorrect uncover all instances of fraud. Breach of contract depends solely on the performance of auditors and the client per the contract (engagement letter). A tort is a lawsuit filed by the plaintiff who believes that they have suffered damage due to another party’s failure to exercise the appropriate level of professional care. Securities litigation is a term that defines criminal and civil actions regarding unfair or criminal practices in the purchase or sale of securities. Constructive fraud is a term used to define repetitive actions that show a pattern of recklessness or disregard for the truth or other party’s well being. While constructive fraud may be the cause of the losses, the wording in the question does not suggest that such a fraud occurred. This is the total amount of the loss, and auditors were not determined to be 100% at fault. Auditors’ liability cannot be zero because they were found to be partially at fault. Auditors pay 45%, which is the 30% at fault plus another 15% (or 50% of the level at fault) because they are the only solvent defendant. Since auditors are the only solvent defendant, liability is not limited to the 30% at fault. Auditors pay 45%, which is the 30% at fault plus another 15% (or 50% of the level at fault) because they are the only solvent defendant. When auditors knowingly commit violations, the joint and several liability doctrine applies, and auditors pay all the damages as the only solvent defendant. When auditors knowingly commit violations, the joint and several liability doctrine applies, and auditors pay all the damages as the only solvent defendant. Under proportionate liability, auditors would be liable for some extent of the damages, even if they did not knowingly commit the violations. When auditors knowingly commit violations, the joint and several liability doctrine applies, and auditors pay all the damages as the only solvent defendant. The fact that auditors knowingly committed these violations make them liable for the entire amount of the damages. When auditors knowingly commit violations, the joint and several liability doctrine applies, and auditors pay all the damages as the only solvent defendant. The fact that auditors knowingly committed these violations make them liable for the entire amount of the damages. The accountant and client have a privity relationship for the consulting services. The accountant’s best defense would be to prove that the client did not carry out its part of the recommendations from the consulting work. Plaintiffs can always measure some damages, and suit would not be brought if the client did not have good reason to measure damages. While the accountant can argue that the work was done properly, the accountant’s best defense would be to prove that the client did not carry out its part of the recommendations from the consulting work. C.36 a. Correct b. c. d. Incorrect Incorrect Incorrect a. Correct b. Incorrect c. Incorrect d. Incorrect a. Correct b. Incorrect c. Incorrect d. Incorrect C.39 a. b. c. d. Incorrect Incorrect Incorrect Correct Both laws contain both civil and criminal liability sections. Both laws contain both civil and criminal liability sections. Both laws contain both civil and criminal liability sections. Both laws contain both civil and criminal liability sections. C.40 a. Incorrect b. Incorrect c. d. Incorrect Correct Foreseeable third parties are parties whose decisions normally rely on audited financial statements and opinions on those financial statements; however, they are not known to auditors by name. Foreseen third parties are parties that might reasonably be expected to use auditors’ work; however, they are not known to auditors by name. There is no designation known as “general third party”. Primary beneficiaries are known by name to auditors and, in some cases, are specifically identified in the contract (engagement letter). a. Incorrect b. Incorrect c. Correct d. Incorrect C.37 C.38 C.41 The Credit Alliance view holds auditors responsible to primary beneficiaries for ordinary negligence, who are identified and known to name by auditors. This is the broadest view of privity, as defined by Rosenblum, Inc. v. Adler. This is the restatement of torts view of privity. The Credit Alliance view holds auditors responsible to primary beneficiaries for ordinary negligence, who are identified and known to name by auditors, therefore this answer is not correct. The engagement letter obtained at the beginning of the engagement is the most effective method of expressing the nature of limits on compilation and review engagements. Compilation and review engagements do not result in the preparation of auditors’ opinions. The engagement letter obtained at the beginning of the engagement is the most effective method of expressing the nature of limits on compilation and review engagements. Reporting the nature of the work at the conclusion of the engagement is not as effective as doing so in the engagement letter at the beginning of the engagement. Management letters are delivered at the conclusion of the engagement, so reporting the nature of the work at the conclusion of the engagement is not as effective as doing so at the beginning of the engagement. A prospectus is a set of information available to prospective investors that is required by the SEC. This information includes the entity’s financial statements. A prospectus is a set of information available to prospective investors that is required by the SEC. This information includes the entity’s financial statements. A prospectus is a set of information available to prospective investors that is required by the SEC. This information includes the entity’s financial statements. A prospectus is a set of information available to prospective investors that is required by the SEC. This information includes the entity’s financial statements. Privity is not a necessary condition to bring suit under the Securities Exchange Act of 1934. Prior to bringing suit, the investor would need to demonstrate that a loss was suffered. These are appropriate defenses under the Securities Exchange Act of 1934 and demonstrate lack of scienter. Entities are required to file financial statements with the Securities and Exchange Commission for their shares to be traded on national exchanges. C.42 C.43 C.44 C.45 C.46 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. b. Incorrect Incorrect c. Correct d. Incorrect a. Incorrect b. Incorrect c. Incorrect d. Correct a. Incorrect b. Incorrect c. Incorrect d. Correct a. Correct b. Incorrect c. d. Incorrect Incorrect a. Incorrect b. Incorrect c. Correct d. Incorrect The Securities Act of 1933 relates to the initial issuance of securities. Auditors’ liability typically arises because of their involvement with audited financial statements. Third parties are only required to demonstrate that the financial statements are materially misstated; they are not required to demonstrate reliance on these financial statements. Auditors are liable for ordinary negligence under the Securities Act of 1933. Information related to auditor changes is not required to be disclosed in the 10-K annual report. Information related to auditor changes is one of the “special events” entities must report on Form 8-K. Information related to auditor changes is not required to be disclosed in the S-1 registration statement. Information related to auditor changes is one of the “special events” entities must report on Form 8-K. Information related to auditor changes is not required to be disclosed in the 10-Q quarterly reports. Information related to auditor changes is one of the “special events” entities must report on Form 8-K. Information related to auditor changes is one of the “special events” entities must report on Form 8-K. Section 11(b) requirements appear to be satisfied, since the chairman produced the information about the planned use of the proceeds, made a reasonable investigation, and the information is not made on the authority of another “expert.” Section 11(b) requirements appear to be satisfied, since the consulting engineer is an expert and made a reasonable investigation connected with his or her own work. Section 11(b) requirements appear to be satisfied, since the president relied on the work of the consulting engineer expert and had no reason to believe the engineer’s report was erroneous. In this case, while the officers relied on auditors’ work, they were aware of materially misstated financial statements and, therefore, liable under Section 11(b). Under both common law and section 10(b), plaintiffs must prove they suffered losses. Unlike common law, section 10(b) does not have a privity requirement (“any purchaser or seller” can sue the accountants). Under both common law and section 10(b) plaintiffs must prove reliance. Under both common law and section 10(b) plaintiffs must prove their reliance caused their losses. Credit Alliance v. Arthur Andersen established auditors’ liability to primary beneficiaries for ordinary negligence. Fleet National Bank v. Gloucester Co. established auditors’ liability to foreseen third parties for ordinary negligence. Rosenblum, Inc. v. Adler established auditors’ liability to foreseeable third parties for ordinary negligence, which provides broader exposure for auditors than the groups in choices (a) and (b). Ultramares did not establish any exposure for auditors to liability to third parties for ordinary negligence, just gross negligence or fraud. C.47 C.48 C.49 C.50 C.51 C.52 a. Incorrect b. Incorrect c. Correct d. Incorrect a. Incorrect b. c. Incorrect Correct d. Incorrect a. Incorrect b. Incorrect c. Incorrect d. Correct a. Incorrect b. c. d. Incorrect Incorrect Correct a. Correct b. Incorrect c. Incorrect d. Incorrect a. b. c. d. Correct Incorrect Incorrect Incorrect Both the burden of proof and required level of professional care differ across the two acts. Both the burden of proof and required level of professional care differ across the two acts. Both the burden of proof and required level of professional care differ across the two acts. Both the burden of proof and required level of professional care differ across the two acts. The SEC does not guarantee or represent that the information in the registration statement is true. Registration is not insurance against loss from the investment. Financial information that has been examined by independent auditors is either included in the registration statement or incorporated by reference. Inside information about the entity’s trade secrets is not provided in the registration statement. (If it were, it would no longer be inside information!) This is a required element of lawsuits brought under common law that must be proved by the plaintiffs prior to brining suit. As a result, they would not be available as defenses for auditors. This is a required element of lawsuits brought under common law that must be proved by the plaintiffs prior to brining suit. As a result, they would not be available as defenses for auditors. This is a required element of lawsuits brought under common law that must be proved by the plaintiffs prior to brining suit. As a result, they would not be available as defenses for auditors. While the plaintiff has the responsibility to prove AOW failed to exercise the appropriate level of professional care, conducting the audit in accordance with generally accepted auditing standards would be an effective defense. Regulation D governs the nonpublic issuance of securities to limited groups of investors. Form 8-K is the periodic special events report. Form SB-1 is one registration forms of the Securities Act of 1933. Regulation S-X is the compendium of accounting rules that governs the form and content of Forms 10-K and 10-Q. The Ernst & Ernst v. Hochfelder case related to the failure of plaintiffs to prove scienter. The Escott v. BarChris Construction Corp. case demonstrated ordinary negligence on the part of auditors in a review of subsequent events. Smith v. London Assurance Corp. was related to ordinary negligence on the part of auditors in failing to identify an embezzlement scheme occurring at a client. The Ultramares case was related to auditors’ liability for ordinary negligence (and not scienter) to third parties. Form 10-K is the annual report. Form 10-Q is the quarterly report. Form 8-K is the periodic special events report. Regulation S-X provides guidelines for the content of financial information submitted to the SEC.