Legal Liability

1
Legal Liability
2
Legal Crisis in Accounting?

• Auditors are potentially liable to many parties
• Legal action often results from business failure
• Audit firms have deep pockets
• Settling may be less expensive than fighting,
  even when innocent
• Vicious cycle!

3
Audit Failure?

• Audit Failure is when the auditors failed to
  follow GAAS and failed to find misstatements or
  fraud
• Business failure is when a company goes bankrupt
• Audit failure is not the same as business
  failure!
• Often business failure is unfairly blamed on
  audit failure

4
Key Sources of Liability

• Common Law
• Liability to clients
• Liability to 3rd parties
• Liability to investors
• Statutory liability

5
Prudent Person Concept

• Auditor expected to exercise due care
• Standard is what a prudent person would do
• Generally relies on expert witnesses
• Good faith and integrity, not infallibility
• Prudent auditor will not generally be held liable
• Imprudent auditor will

6
Liability for Acts of Others

• Must be aware of partnership laws
• Form of business is crucial
• Conviction of Arthur Anderson casts doubt on the
  future

7
Confidentiality

• Remember auditors should maintain confidentiality
• However, auditors do not have privileged
  communication in most states or at federal level.

8
Types of Negligence

• Ordinary negligence
• Gross negligence
• Constructive fraud
• Fraud

9
Liability to Clients

• Cases brought under breach of contract or tort
  law
• Torts result in larger settlements
• Tort is any civil wrong other than breach
• Can be liable under negligence, gross negligence,
  or fraud

10
Defenses for Auditors in Client Cases

• Lack of duty
• Nonnegligent performance
• Contributory negligence
• Absence of causal connection

11
3rd Party Liability

• Ultramares doctrine
• Ordinary negligence is insufficient grounds for
  third parties that lack privity of contract
  unless they are primary beneficiaries
• Requires plaintiff to be a foreseen user
• Credit Alliance approach
• Starts with Ultramares doctrine
• Auditor must know of specific purpose for 3rd
  party and knowledge must be evidenced by auditor

12
3rd Party Liability, continued

• Restatement of Torts
• Foreseen users must be members of a reasonably
  limited and identifiable group of users
• Do not need to be specifically known or evidenced
• Rusch Factors case
• Again refers to liability under ordinary
  negligence

13
3rd Party Liability, continued

• Foreseeable Users
• Very broad definition of foreseen users
• Results in almost unlimited liability
• Only Mississippi and Wisconsin now use this
  standard
• Guess where class action suits get brought?

14
Defenses Against 3rd Parties

• Nonnegligent performance
• Lack of privity
• Ansence of causal connection
• (Note 3 of the 4 from defense against clients)

15
Key Legal Cases to Know

• Ultramares established the Ultramares doctrine
• 1135 Tenants established liability where
  agreement is unclear
• Led to engagement letters
• Led to development of review standards
• Cenco contributory negligence as a defense
• Rusch Factors restatement approach to resonably
  foreseen users
• Credit Alliance evidenced by auditor actions

16
Statutes Related to Auditing

• Securities Act of 1933
• Securities Exchange Act of 1934
• Litigation reform Act of 1998
• Sarbanes Oxley

17
Securities Act of 1933

• Deals with registrations and prospectuses
• First line of defense, therefore stringent on
  auditors
• Auditor is liable for contents of statements
  until date of registration
• Burden of proof is on auditor
• Claimant must only prove
• Purchased securities
• Statements were false
• Auditors only defense is due diligence

18
Key Case to Know

• Bar Chris
• Involved events subsequent to balance sheet but
  prior to effective registration date
• Auditors not held to higher standard than
  professional standards, but must meet them
• May not accept glib responses from management
  where warning signs exist

19
Securities Exchange Act of 1934

• Focuses on annual reports
• Burden of proof is on claimant and is higher
• Claimant must prove reliance
• Hochfelder case requires intent to deceive, as
  noted in the Act
• However, recklessness is often viewed as
  intentional (Solitron Devices case)
• Poor judgment is not proof of fraud

20
Defenses in 1934 cases

• Nonnegligent performance
• Lack of duty
• Absence of causal connection
• Generally, stockholders must sue under this act,
  unless they are in MS or WI

21
RICO

• Racketeer Influenced and Corrupt Organization Act
• This is the anti-mob law
• Must have pettern of racketeering activity
• Supreme Court ruled that outside professionals
  must help run the organization to be liable under
  RICO

22
Foreign Corrupt Practices Act

• Illegal to offer a bribe to foreign officials
• Applies to all U.S. companies as well as foreign
  companies who file with the SEC
• Requires adequate records and internal controls
• May affect auditors responsibility to examine
  controls, but no cases have been brought.

23
Criminal Liability

• Various federal statutes make it illegal to
  knowingly sign off on false statements
• 1933 and 1934 acts
• Federal Mail Fraud Statute
• Obstruction of Justice, Document destruction
  under SarbOx
• Complicity with fraud (knowingly being involved
  with fraudulent statements)
• Accepting a bribe

24
Criminal Cases

• Equity Funding massive fraud, combined with
  such poor audit work that courts concluded
  auditors must have known complicity
• ESM Securities auditor was informed of prior
  fraud, did not disclose while turnaround
  attempted guilty of perpetuating fraud
• U.S. versus Andersen overturned on vague jury
  instructions not requiring intent

25
Litigation Reform Act

• Changed full and several liability to
  proportionate liability
• Ends some of the deep pocket cases