McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Module C
Legal Liability
When men are pure, laws are useless; when men are corrupt, laws are broken. Benjamin Disreali, Former British Prime Minister

Mod C-2

Common Law
Breach of contract: Services not performed by auditors in manner described in contract Tort liability: Obligation based on failure of auditors to exercise appropriate level of professional care
Ordinary negligence is lack of reasonable care Gross negligence is lack of minimal care (similar to constructive fraud) Fraud is a misrepresentation of fact an individual knows to be false

Mod C-3

Common Law Liability: Clients

Sources of Liability Breach of contract Tort liability (ON, GN, F) Clients must show Economic loss Auditors breached contract or failed to exercise appropriate care The loss was caused by the breach of contract or failure of auditors to exercise the appropriate level of care Defenses Auditors did not breach contract or performed with appropriate level of care Causation (something else caused client loss) Contributory negligence (clients were partially responsible for loss)

Mod C-4

Common Law Liability: Third Parties

Generally liable to all third parties for gross negligence and fraud Liability for ordinary negligence
Ultramares: No liability for ordinary negligence Credit Alliance v. Arthur Andersen: Liable to primary beneficiaries for ordinary negligence Fleet National Bank (restatement of torts): Liable to foreseen third parties for ordinary negligence Rosenblum v. Adler: Liable to foreseeable third parties for ordinary negligence

Mod C-5

Proof and Defenses: Third Parties

Third parties must show
Economic loss Auditors failed to exercise appropriate level of care F/S contained a material misstatement Loss caused by reliance on misstated F/S

Defenses
Lack of appropriate standing (relationship with auditor) to bring suit Third partys loss caused by factors other than the F/S and auditors examination (causation defense) Audit conducted per GAAS

Mod C-6

Summary of Liability for Ordinary Negligence

Ultramares: Liable for GN and F

Credit Alliance v. Arthur Andersen: ON to primary beneficiaries

Fleet National Bank v. Gloucester Co: ON to foreseen (restatement of torts)

Rosenblum v. Adler: ON to foreseeable

Less Exposure

More Exposure

Mod C-7

Securities Act of 1933 (Securities Act)

Regulates initial issuance of securities by registrants to investing public Required to file registration statement with SEC that includes F/S To bring suit, investors must show:
Loss F/S contained a material misstatement No need to show reliance on F/S or that loss was caused by misstatement
Mod C-8

Liability Under Securities Act

Auditors responsible for ordinary negligence, gross negligence, and fraud Defenses
Due diligence (auditors performed a GAAS audit) Causation (loss resulted from other factors)

Escott v. BarChris Construction Corp.

Auditors held liable for failure to conduct reasonable investigation (ordinary negligence)

Mod C-9

Securities Exchange Act of 1934 (Securities Exchange Act)

Regulates daily trading of securities and requires periodic financial statements and information to be filed with the SEC Reports filed with SEC
Form 10-K: Annual F/S (audited) Form 10-Q: Quarterly F/S (reviewed) Form 8-K: Current events report filed as appropriate

Mod C-10

Liability under the Securities Exchange Act

To bring suit, investors must show:
Economic loss F/S contained a material misstatement Loss caused by reliance on F/S (burden of proof shifted to investor) Auditors were aware that the F/S contained a material misstatement (has been interpreted as gross negligence)

Mod C-11

Liability Under Securities Exchange Act

Auditors liable for gross negligence and fraud (scienter) Defenses
Auditors acted in good faith Auditors were not aware of material misstatements

Ernst & Ernst v. Hochfelder

Relieved auditors from liability for ordinary negligence Did provide liability for reckless behavior in the absence of scienter
Mod C-12

Summary of Auditor Liability

Source Common Law/Clients Burden of Proof Client Offense Breach of contract ON, GN, F Auditors Defenses No breach or inappropriate performance (GAAS audit) Causation Contributory negligence Lack of appropriate third party standing Causation No inappropriate performance (GAAS audit) Due diligence (GAAS audit) Causation Good faith No knowledge of material misstatements (scienter)

Common Law/Third Parties

Third Parties

ON depends upon party and jurisdiction GN, F

Securities Act of 1933 Securities Act of 1934

Auditors Investors

ON, GN, F GN, F

ON = Ordinary negligence GN = Gross negligence F = Fraud

Mod C-13

Why Has Auditor Liability Increased?

Highly-publicized failures (WorldCom, Enron) Investor awareness of ability to recover monetary losses from auditors Complex accounting standards Joint and several liability Class action suits Auditors are an attractive target for plaintiff attorneys

Mod C-14

Sarbanes-Oxley
Extends statute of limitations for brining suit under the Securities Exchange Act Increased penalties for mail fraud and wire fraud Increased penalties for destruction, alteration, and falsification of records Increased records retention requirements Higher potential liability in civil cases

Mod C-15

Other Developments in Auditor Liability

Auditors not subject to RICO (and treble damages) Limitations on aiding and abetting Organization of firms as limited liability partnerships Private Securities Litigation Reform Act (1995): Proportionate liability Class Action Fairness Act (2005): Moves class action cases from state courts to federal courts Securities Litigation Uniform Standards Act (1998): Requires class action lawsuits with > 50 parties to be filed in federal courts Auditor liability caps
Mod C-16