CHAPTER 20 LEGAL LIABILITY Answers to Review Questions 20-1 The four general stages in the initiation and disposition

of audit-relat ed disputes are: (1) the occurrence of events that result in losses for users of the financial statements, (2) the investigation by plaintiff attorneys before f iling suit to link the user losses with allegations of material omissions or mis statements of financial statements, (3) the legal process which commences with t he filing of the suit, and (4) the final resolution of the dispute. The first s tage, the loss-generating events, includes the events that resulted in the losse s; for example, client bankruptcy, financial distress, fraudulent financial repo rting, and misappropriation of assets. The second stage, pre-suit investigation , may involve investigation activities by plaintiffs and their attorneys before initiating legal proceedings. The legal process makes up the third stage. This stage involves activities such as filing of complaints, discovery, trial prepar ation, and the trial. The last stage involves the resolution of the dispute, wh ich may include a summary judgment, a settlement to avoid or discontinue litigat ion, or a court decision on appeal after a trial 20-2 Proportionate liability is where each defendant is liable solely for th e portion of the damages that correspond to the percentage of responsibility of that defendant. Under the doctrine of joint and several liability, each defend ant is held fully liable for all assessed damages, regardless of the extent to w hich they contributed to the injury. 20-3 Under common law, an auditor can be held liable to clients for beach of contract, negligence, gross negligence/constructive fraud, and fraud. A client would prefer to sue an auditor for a tort action because larger amounts for dama ges can be assessed than for a breach of contract. 20-4 The elements required for establishing an auditor's liability for neglig ence to clients are (1) the duty to conform to a required standard of care, (2) failure to act in accordance with that duty, (3) a causal connection between the auditor's negligence and the client's damage, and (4) actual loss or damage to the client. 20-5 The four standards that have evolved for defining the extent of the audi tor's liability to third parties are (1) privity, (2) near privity, (3) foreseen persons or classes, and (4) reasonably foreseeable third parties. The tradition al view held that auditors had no liability under common law to third parties wh o did not have a privity relationship with the auditor. Privity here means that the obligations that exist under a contract are between the original parties to the contract, and failure to perform with due care results in a breach of that duty only to those parties. Near privity does not require strict privity of con tract, but that the third party be known to the auditor and that the auditor has directly conveyed the audit report or acted to induce reliance on the audit rep ort. Many courts have reexamined the privity notion and substituted the concept of public responsibility. Under the foreseen persons or classes approach, Sect ion 522 of the Restatement (Second) of the Law of Torts is applied to an accountant's third-party liability suit. Th e Restatement is a compendium of common law prepared by legal scholars and prese nts an alternative view to the traditional Ultramares doctrine or rule. Finall y, a small number of states have adopted a more expansive view of auditors' liab ility to third parties: the reasonably foreseeable third parties approach. The reasons cited for extending auditors' liability beyond privity include auditors' ability to spread the risk through the use of liability insurance. Auditors' liability to third parties under common law is complex because

court rulings are not consistent across federal and state jurisdictions. 20-6 The Securities Act of 1933 generally regulates the disclosure of materia l facts in a registration statement for a new public offering of securities. Th e Securities Exchange Act of 1934 is concerned primarily with ongoing reporting by companies whose securities are listed and traded on a stock exchange or who m eet certain other statutory requirements. It is easier for a plaintiff to sue an auditor under the Securities Act of 1933, because the plaintiff does not have to prove negligence or fraud, relia nce on the auditor's opinion, a causal relationship, or a contractual relationsh ip; the plaintiff need only prove that a loss was suffered by investing in the r egistered security and that the audited financial statements contained a materia l omission or misstatement. The misstatement can be the result of mere ordinary negligence. Thus, this act, and in particular Section 11, is more favorable fo r plaintiffs than common law since the auditor must prove that he or she was not negligent. 20-7 Under Rule 10b-5 of the Securities Exchange Act of 1934, the following e lements must be proved by a plaintiff: (1) the existence of a material, factual misrepresentation or omission, (2) reliance by the plaintiff on the financial st atements, (3) damages suffered as a result of reliance on the financial statemen ts, and (4) scienter. The Ernst & Ernst v. Hochfelder case was significant because the Supreme Court r uled that an action under Rule 10b-5 may not be maintained by showing that the d efendant was negligent but that scienter, or intent to deceive, had to be presen t. Unfortunately, the Supreme Court did not decide whether gross negligence or r eckless behavior was sufficient for liability under Section 10(b) or Rule 10b-5, and several courts have since determined that gross negligence or reckless beha vior satisfies the scienter requirement of Rule 10b-5. 20-8 Prior to the passage of the Private Securities Litigation Reform Act of 1995, auditors sued under federal statutory law were held to the legal doctrine of joint and several liability. The Act of 1995 limits the legal responsibility to proportionate liability, where each defendant is liable solely for the porti on of the damages that corresponds to each defendant. The act also raises the p leading requirement at the beginning of a case. No longer can plaintiffs plead a general claim of fraud, rather the plaintiff must state the time, place, and co ntents of the allegedly false representations, the identity of the person making them, and what he or she obtained as a results of the fraud. In 1998 Congress passed the Securities Litigation Uniform Standards Act in respo nse to concerns that plaintiff lawyers would circumvent the federal legislation and protections brought by the 1995 Act by bringing class action suits involving nationally trad ed securities to state court. As a result of the 1998 Act, most large class act ions against auditors alleging securities fraud must be brought to federal court . 20-9 Numerous sections of the Sarbanes-Oxley Act include criminal provisions, t he Act enhances prosecutorial tools available in major fraud cases by expanding statutory prohibitions against fraud and obstruction of justice, increasing crim inal penalties for traditional fraud and cover-up crimes, and strengthening sent encing guidelines applicable to large-scale financial frauds. The Act adds a new securities fraud offense and increases authorized penalties for securities and financial reporting fraud (e.g., up to 25 years in prison). It is expected that the Acts increased penalties will result in longer prison terms because of the co rresponding changes in the federal sentencing guidelines. The Sarbanes-Oxley Act increases penalties for impeding official investigations, and because most frauds are discovered by employees rather than external auditors, the Act strengthens the legal protections accorded whistlebl

owers. It is common for employers to retaliate against informants by demoting or firing them. The Act makes it a felony punishable by 10-year imprisonment to re taliate against anyone who voluntarily comes forward to report suspected violati ons of any federal laws. 20-10 Rule 2(e) of the Rules of Practice empowers the SEC to suspend for any per son the privilege of appearing and practicing before it. These sanctions can be applied not only to an individual auditor but also to an entire accounting firm . Typically, if a firm is faced with suspension, it will agree to some type of consent agreement in which the firm does not admit guilt but agrees to lesser sa nctions. These sanctions may include not taking on new SEC clients for a specif ied period of time and submitting to special reviews to ensure that the alleged problems have been corrected. The sanctions can also include substantial fines. The Sarbanes-Oxley Act grants the PCAOB broad investigative and disciplinary authority over registered public accounting firms and persons assoc iated with such firms. When violations are detected, the PCAOB can impose sanct ions such as revoking a firms registration, barring a person from participating i n audits of public companies, monetary penalties and requirements for remedial m easures, such as training, new quality control procedures, and the appointment o f an independent monitor. 20-11 The external auditor may detect activities that violate the FCPA includi ng violations of codes of conduct that prohibit bribery, insufficient detail to accurately reflect transactions, inadequate systems of internal control, and oth er violations of the record-keeping and internal control requirements for public companies under the FCPA. Any such violations should be communicated to managem ent immediately. 20-12 The Racketeer Influenced and Corrupt Organizations Act (RICO) was enacte d by Congress in 1970 to combat the infiltration of legitimate businesses by org anized crime. RICO provides civil and criminal sanctions for certain types of i llegal acts. Racketeering activity includes a long list of federal and state cr imes, with mail fraud and wire fraud the most common acts alleged against audito rs. Plaintiffs seek to sue auditors under RICO because the law provides for treble (i.e., triple) damages in civil RICO cases. 20-13 Auditors can be held criminally liable under various statutes and regula tions. Criminal prosecutions require that some form of criminal intent be presen t, although many of the laws described in this chapter contain provisions for cr iminal penalties if the auditor s actions reflect gross negligence or fraud. Answers to Multiple-Choice Questions 20-14 20-15 20-16 20-17 20-18 20-19 d c b d b d 20-20 20-21 20-22 20-23 20-24 20-25 c c a b d d

Solutions to Problems 20-26 gence. ty must City Bank is not likely to prevail against Salam based on ordinary negli In order to establish a cause of action for negligence against Salam, Ci prove that: Salam owed a legal duty to protect City. Salam breached that legal duty by failing to perform the audit with the due care

or competence expected of members of the profession. City suffered actual losses or damages. Salam s failure to exercise due care proximately caused City to suffer damages. The facts of this case establish that Salam was negligent by not detecting the o verstatement of accounts receivable because of his failure to follow the audit p rogram. However, Salam will not be liable to City for negligence because Salam owed no duty to City. This is the case because Salam was not in privity of cont ract with City, and the financial statements were neither audited by Salam for t he primary benefit of City, nor was City within a foreseen (known and intended) class of third-party beneficiaries who were to receive the audited financial sta tements. City Bank is likely to prevail against Salam based on constructive fraud. To es tablish a cause of action for constructive fraud, City must prove that: Salam made a materially false statement of fact. Salam lacked a reasonable ground for belief that the statement was true. Constr uctive fraud may be inferred from evidence of gross negligence or recklessness. Salam intended another to rely on the false statement. City justifiably relied on the false statement. Such reliance resulted in damages or injury. Under the facts of this case, Salam is likely to be liable to City based on cons tructive fraud. Salam made a materially false statement of fact by rendering an unqualified opinion on Bell s financial statements. Salam lacked a reasonable ground for belief that the financial statements were fairly presented by reckles sly departing from the standards of due care in that it failed to investigate other embezzlements, despite having knowledge of at least one embezzlement, and did not notify Bell s management of the matter. Salam intended that others rely on the audited financial statements. City justifiably relied on the audited financial statements in deciding to loan Becker $600,000 and damages resulted evidenced by Becker s default on the City loan. 20-27 a. The elements necessary to establish negligence are: A legal duty to protect the plaintiff (Musk) from unreasonable risk. A failure by the defendant (Apple) to perform or report on an engagement with th e due care or competence expected of members of its profession. A causal relationship, (i.e., that the failure to exercise due care resulted in the plaintiff s loss). Actual damage or loss resulting from the failure to exercise due care. b. The elements necessary to establish a violation of Rule 10b-5 include: A material misstatement or omission. The material misstatement or omission made by the defendant (Apple) with knowled ge (scienter). Reckless disregard for the truth may constitute scienter. Justifiable reliance on the misstatement or omission. The reliance being in connection with the purchase or sale of a security. c. Apple is not in privity of contract with Musk because there is no direct contractual relationship between them. Therefore, in the absence of other fact ors, Apple would not be liable to Musk for Apple s alleged negligence based on t he Ultramares decision. However, the privity defense would not protect Apple if Musk could prove that Apple had committed actual or constructive fraud (that is , Apple owes a duty to all parties, including third parties, to practice its pro fession in a nonfraudulent manner). 20-28 a. 1. Union Bank will be successful in its negligence suit aga inst Meng. To be successful in a lawsuit for accountant s negligence, there mus t be: Duty.

 Breach. Reliance. Loss. Meng had a duty because it knew that Union would receive the financial statement s and was thereby an intended user. Meng was negligent in performing the audit by failing to confirm accounts receivable, which resulted in failing to discover the overstatement of accounts receivable. Meng s failure to confirm accounts r eceivable was a violation of Meng s duty to comply with generally accepted audit ing standards. Union relied on Meng s opinion in granting the loan and, as a re sult, suffered a loss. 2. Union Bank will be successful in its common-law fraud suit against Meng. To be successful in a lawsuit for common-law fraud, there must be:

An intentional material misstatement or omission. Reliance. Loss. Meng was grossly negligent for failing to qualify its opinion after being advise d of Butler s potential material losses from the product liability lawsuit by le gal counsel. Meng will be liable to anyone who relied on Meng s opinion and suf fered a loss as a result of this fraudulent omission. b. Butler s stockholders who purchased stock will also be successful in the ir suit against Meng under Section 10(b) and Rule 10b-5 of the Securities Exchan ge Act of 1934. Under the act, stock purchasers must show: Intentional material misstatement or omission (scienter). Reliance. Loss. Meng s failure to qualify its opinion for Butler s potential legal liability was material and done intentionally (scienter). Meng will be liable for losses sus tained by the purchasers who relied on Meng s opinion. 20-29 a. Knox would recover from Garson for fraud. The elements of fraud are: the misrepresentation of a material fact (because Garson issued an unquali fied opinion on misleading financial statements; Garson s opinion did not includ e adjustments for or disclosures about the embezzlements and insider stock trans actions); knowledge or scienter (because Garson was aware of the embezzlements a nd insider stock transactions); and a loss sustained by Knox (because of Sleek s default on the loan). b. 1. The general-public purchasers of Sleek s stock offerings would r ecover from Garson under the liability provisions of Section 11 of the Securitie s Act of 1933. Section 11 of the Act provides that anyone, such as an accountan t, who submits or contributes to a registration statement or allows material mis representations or omissions to appear in a registration statement is liable to anyone purchasing the security who sustains a loss. Under the facts presented, Garson could not establish a "due diligence" defense to a Section 11 action beca use it knew that the registration statement failed to disclose material facts. 2. The general-public purchasers of Sleek s stock offerings would also reco ver from Garson under the antifraud provisions of Section 10(b) and Rule 10b-5 o f the Securities Exchange Act of 1934. Under Rule 10b-5, Garson s knowledge tha t the registration statement failed to disclose a material fact, such as the ins ider trading and the embezzlements, is considered a fraudulent action. The omis sion was material. Garson s action was intentional or, at a minimum, a result o f gross negligence or recklessness (scienter). These purchasers relied on Garso n s opinion on the financial statements and incurred a loss. Solution to Discussion Case

20-30 a. The bases for shareholders and creditors suits against CD&A under s tate common law include: Breach of contract: The relationship between CD&A and Lestrad is contractual an d requires that the CPAs performance be rendered in a competent manner. The sh areholders and creditors may claim breach of contract as third-party beneficiari es of the contract between the CPAs and Lestrad, since it could be held that the contract was entered into for their benefit and therefore they are in privity w ith the CPAs. Negligence: The shareholders and creditors could assert an independent claim of negligence in addition to the action for breach of contract. Negligence will b e established when the CPAs fail to exercise reasonable care, taking into accoun t such superior skill and knowledge the CPAs have or hold themselves out as havi ng. Despite their lack of contractual privity, the shareholders and creditors w ill probably be able to successfully assert this action if they can show that th ey are members of a class of persons intended to benefit from the services perfo rmed by the CPAs and that this was reasonably foreseen by the CPAs. Actual fraud or constructive fraud: Recent court decisions have substantially e roded the privity barrier faced by third parties. CD&A may be held liable for a ctual fraud if it can be shown that they intentionally deceived the shareholders and creditors. CD&A may be held liable for constructive fraud if there are def iciencies or lapses in their professional work of such a magnitude that they con stitute gross negligence or a reckless disregard for the truth. b. The bases for shareholders and creditors suits against Conan Doyle & A ssociates (CD&A) under the federal Securities Acts include: That a violation of the 1933 act has occurred as a result of misstatements or om issions in the prospectus or elsewhere in the registration statement required in order to "sell" the securities. The Securities and Exchange Commission has rul ed that the issuance and exchange of stock pursuant to a merger constitutes a "s ale" within the meaning of the Securities Act of 1933. That a violation of the antifraud provisions of the 1934 act and of Rule 10b-5 i ssued pursuant thereto has occurred since misstatements and omissions of materia l facts may be fraudulent. Additionally, the antifraud provision (Sec. 17) of the 1933 act could be asserted. That a violation of the reporting requirements of the Securities Exchange Act of 1934 has occurred to the extent that false or misleading statements were includ ed or material facts were omitted in the reports or other documents relating to the merger that were filed with the SEC. That a violation of the proxy rules of the Securities Exchange Act of 1934 resul ted from misstatements in or omissions from the merger proxy statement used in s oliciting shareholder approval. 20-31 Students will form their own opinions. Possible arguments for and agains t include: Yes SOX Will Deter Fraud By requiring top executives to certify the fairness of financial statements and the effectiveness of internal controls, SOX will deter fraud because top executi ves will take their responsibility for financial reporting more seriously. SOX improves corporate governance and tone at the top as well as other controls, which will reduce the opportunities for fraud. SOX clarifies and increases criminal liability for corporate officers. SOX increases punishment for corporate fraud to better fit the damages caused. SOX has raised the level of performance of internal and external auditors, which will reduce the incentive and opportunity to commit fraud.

No SOX Will Not Deter Fraud Honesty and ethical behavior cannot be legislated. Fraudsters seem to stay one step ahead of the rules, laws, and audit tests. There is limited evidence that white collar crime will not continue to pay well (huge financial rewards, small financial costs, and some limited time in a comfo rtable correctional facility). Most corporate fraud involves management override of controls and collusion, at the same time auditors will be relying more on controls due to AS2 (Section 404) related work. Internal and external auditors are so busy just trying to comply with the new re quirements related to AS2 (Section 404) that they may be less effective at detec ting fraud. The legislation does not increase the ability for law enforcement to find and de tect fraud.