CHAPTER 46
LEGAL AND PROFESSIONAL RESPONSIBILITIES OF
AUDITORS, CONSULTANTS, AND SECURITIES
PROFESSIONALS
I. OBJECTIVES
The purpose of this chapter is to introduce students to the general nature of professional liability
and the specific liability theories under which auditors, consultants, and securities professionals
may be held responsible to their clients and other users of their work products and
communications. After reading the chapter and attending class, a student should:
A. Know the general standard of performance that the law imposes upon professionals.
B. Understand why the law usually defers to a profession in determining the general standard of
performance.
C. Know the bases of a professional’s liability to her client.
D. Know the bases of a professional’s liability to nonclients.
E. Understand how current law regulates securities professionals’ conflicts of interest.
F. Know when qualified opinions and disclaimers of opinions are effective in reducing the
liability of auditors of financial statements.
G. Understand the duties imposed on independent auditors by Section 404 of the Sarbanes-
Oxley Act.
H. Understand the limits of the professional-client privilege, especially the accountant-client
privilege.
II. ANSWER TO INTRODUCTORY PROBLEM
A. CDFC must act as carefully as the ordinarily prudent investment banker when recommending
the promissory note issuance. This duty of skill is embodied in both the contract and tort
duties that CDFC owes to its client, Macrohard.
B. CDFC can have liability for the negligent misrepresentation of its partner under Section 12(a)
(2). That section applies to misstatements of material fact in connection with a distribution of
securities, as in the issuance of notes here. CDFC may not be a seller of the notes
(Macrohard is), but CDFC is actively soliciting the sale of the notes by speaking on the phone
with investors, visiting investors in person, and sending them emails urging them to buy the
notes. CDFC has a financial interest in the sale because it receives a commission on each
sale. CDFC has liability to the investors that the partner contacts unless it proves the partner
did not know and could not reasonably have known of the falsity of his statements. Since the
partner is negligent, that defense cannot be met by CDFC.
CDFC has no risk of liability under Rule 10b-5 for the negligent conduct of its partner,
because that rule requires the defendant to act with scienter, which is intent to defraud or
gross recklessness: negligence is not sufficient to make CDFC liable. If the partner’s
conduct did amount to scienter, Rule 10b-5 liability would be possible, as the rule applies to
any misstatement or omission of material fact in connection with any securities transaction,
and CDFC is a proper defendant since it is primarily responsible for the statements it makes
to investors.
C. A&Y has no liability under Section 12(a)(2), because it is not a seller and does not actively
solicit a sale. A&Y merely provides an audit opinion that is included in the offering circular
and used by others who sell the notes. In addition, A&Y has no financial interest in the sale,
because it receives a fee for the audit that is not contingent on the offering’s success. As for
Rule 10b-5, while A&Y is primarily responsible for its audit opinion, its negligence is not
sufficient to impose liability under the rule, which requires the defendant to act with scienter.
D. In an Ultramares state, CDFC has liability for negligent misrepresentation to foreseen users
of its communications made on behalf of its client Macrohard. CDFC knows the identity of
the investors it called, spoke to in person, and emailed. It knows the extent of the use the
investors will make of the communications made by CDFC, buying up to $10 million of
notes. Consequently, CDFC is liable at least to those persons, if they relied on the
misstatements and suffered damages thereby.
E. A&Y would not have liability in an Ultramares state, because it does not know who will use
the audit opinion. Thus, there is no foreseen user vis a vis A&Y. In a Restatement state,
however, all the investors who use A&Y’s audit opinion to purchase the notes are users in a
foreseen class of users, because A&Y knows the extent of that use of the audit opinion. Thus,
A&Y has potential liability in a Restatement state if it has acted negligently during the audit
and the investors rely on A&Y’s audit opinion to their harm.
F. Under Section 11, CDFC is a statutory defendant, because it is the underwriter with respect to
the issuance of securities pursuant to a 1933 Act registration statement. Therefore, CDFC is
liable for errors in any part of the registration statement. Even though CDFC is an expert in
its field, it is not an expert as far as the registration statement is concerned, since it did not
issue an opinion regarding any part of the registration statement. Therefore, in regard to the
financial statements audited by A&Y, CDFC is a nonexpert regarding an expertised portion of
the registration statement. Therefore, its due diligence defense is that it had no reason to
believe and did not believe that there were any misstatements or omissions of material fact in
the audited financial statements. As for the parts of the registration statement that describe
Macrohard’s business and material risks, CDFC is a nonexpert in regard to a nonexpertised
portion of the registration statement. CDFC’s due diligence defense is that after a reasonable
investigation CDFC had reason to believe and did believe that there were no misstatements or
omissions of material facts in those portions of the registration statement.
G. A&Y is a statutory defendant as an expert who provides an audit opinion for inclusion in the
registration statement. A&Y is liable for misstatements in its audit opinion and in the
financial statements covered by the audit opinion. Its due diligence defense is that after a
reasonable investigation A&Y had reason to believe and did believe that there were no
misstatements or omissions of material facts in the audit opinion or the audited financial
statements.
H. The BarChris case in Chapter 45 at page 1202 is the best source for information regarding
what an auditor and investment banker should do to meet their due diligence defenses. Here
is a checklist culled from BarChris:
1. Know the issuer’s business and industry
2. Read the prospectus/registration statement
3. Read important meeting minutes
a. Board of directors meetings
b. Executive committee meetings
c. Shareholder meetings
4. Read important correspondence
5. Read material contracts
6. Ask questions of management and others who have information
7. Make inquiries that relate to information in the registration statement
8. Follow up red flags
9. Don’t rely on glib statements of management
10. Get confirmations of information from outside sources
11. Comply with GAAP and GAAS (auditors only)
12. Follow the firm’s written review program (auditors and underwriters)
13. Spend adequate time on S-1 review
14. Leave a paper trail of the investigation
III. SUGGESTIONS FOR LECTURE PREPARATION
A. Introduction
1. This chapter reflects the professional opportunities of your students. Many of your
students using this textbook will take jobs not only as auditors, but also as consultants in
areas such as litigation support and taxation. Moreover, many students, even students in
undergraduate and graduate accounting programs, seek and obtain jobs in investment
banking, financial valuation, and securities analysis. To reflect this reality, we have
expanded this chapter to include a wider range of professionals in the accounting,
consulting, and securities industries. We believe this chapter is unique in its treatment of
the legal rules affecting these professionals. Use of this material with our students reveal
that they appreciate being treated them as diverse individuals with diverse professional
objectives. This chapter is relevant to students interested in auditing, yet it also provides
legal rules important to students seeking jobs in consulting, investment banking, and
securities analysis.
2. Review briefly the bases of professional liability: criminal liability, breach of contract,
tort (fraud and negligence under the common law and the securities laws), and breach of
trust.
3. Define the accountant’s general standard of performance. Note that the standard requires
both skill and care. Note also that the accountant is judged in relation to the
circumstances in which she acted. Indicate especially the history of the courts’
willingness to defer to GAAP and GAAS. Also point out that today a national
standard–rather than a local standard–determines the accountant’s general standard of
performance.
Example: Chapter Introductory Problem (p. 1233).
4. Ethics in Action: Public Company Accounting Oversight Board (p. 1236): When you
note the composition of the PCAOB, raise the issue regarding the competency of Board
members if only two members may be CPAs. Why not have all CPAs, or all least all
members who are competent in accounting and financial matters who understand how
accounting numbers are reflected in financial statements, provided all of the Board
members are independent of the auditing profession? Also, does it not make sense that
all Board members should be members of the investment community that uses financial
statements? Shouldn’t the principles issued by the Board be based in what investors need
from financial statements? Don’t experienced investment professionals know best what
they want in financial statements? While giving investment professional control of the
Board may result in the Board asking for more information than auditors and companies
want to provide, isn’t that what a reasonable investor is supposed to do: protect her
interest by demanding the information she wants? Is there a need to temper the demands
of investment professionals by having members of the Board who are representatives of
companies and auditors?
5. The Global Business Environment: U.S. Moving to International Accounting Standards
(p. 1236). This issue will bear watching over the next several years.
B. Professionals’ Liability to Clients. This section includes material on the duties of securities
professionals. Although professionals’ liability to clients is important legally, relatively few
cases arise in this area, largely because there is little uncertainty about what the law is in this
area. Contract and tort liability to clients is well established. The greater number of cases is
in the securities brokerage account area, with customers bringing actions before arbitrators
for breach of the broker’s duties regarding suitability and churning. Review all the bases of
liability to clients giving special attention to the following:
1. Negligence
a. Note the range of actions for which auditors, consultants, securities brokers,
securities analysts, and investment bankers may have liability to their clients for
negligence. Give an example for each type of professional: an auditor’s failure to
comply with GAAS, a broker’s breaching the suitability rule, a securities analyst
failing to investigate a company’s new products prior to making a recommendation of
the company’s stock, and an investment banker’s failing to research adequately the
value of a company acquired by a client and to determine the fit of the acquisition
with the vision or long term strategy of the client. You may want to cover the
material in Chapter 43 to show how consultants and investment bankers help
company’s boards of directors meeting their duty under the business judgment rule
and the intrinsic fairness standard. See pages 1123-1139, especially the material on
“Complying with the Business Judgment Rule” (page 1124), “Complying with the
Unocal Test” (pages 1133-1134), and “Complying with the Intrinsic Fairness
Standard” (pages 1134-1135). By helping board meet their duties under corporation
law, consultants and investment bankers also meet their professional duties to their
clients.
b. At this time, you may want to cover the Millan case on page 981 in Chapter 36, in
which Merrill Lynch was held liable in part for the wrongful conduct of one of its
brokers.
c. Examples: Problem Cases ## 1 and 2.
d. Log On (p. 1242)
2. Audit duties and the discovery of fraud. Note that it is more difficult to uncover fraud,
because the defrauder usually takes steps to hide the fraud. Although GAAS requires
accountants to take steps to verify accounts, an accountant need not assume that fraud
exists and, therefore, need not take extraordinary steps to detect it. Nonetheless, he must
discover fraud that an ordinarily prudent accountant would uncover in the same
circumstances. This requires him to check out red flags concerning fraud, such as not
receiving sales confirmations from customers.
3. Negligent Preparation of Tax Return. Note the limit of a tax accountant’s liability if the
client pays too little or too much taxes. When the client paid too little tax, the client owes
the additional tax but can recover the tax penalty from the negligent accountant. When
the client paid too much tax, the client may recover interest on the tax overpayment from
the accountant.
4. Contributory Negligence and Comparative Negligence. Most states have abandoned
contributory negligence and adopted comparative negligence or comparative fault.
Fehribach v. E&Y LLP (p. 1237). The court found that E&Y was not liable to its client,
who was in a better position to know its financial position and, therefore, know to take
steps to prevent further losses.
Points for Discussion: This is a good case from which students can see the legal
ramifications of the auditor’s duty to disclose substantial doubts about the firm being a
going concern in a year. Judge Posner listed the AICPA’s examples, on page 1239, of
conditions that can lead an auditor to have such doubt. Judge Posner then pointed that
while the auditor is required to investigate internal factors regarding the client’s viability
and to take into account external factors of which it has knowledge, it is not required to
investigate external matters, such as trends in the frozen-meat industry, including
intensified competition, that led to the client’s demise here. E&Y cannot be expected,
Judge Posner wrote, to know more about such trends than its client, who had been in the
industry for 20 years. In other words, the client’s management should have known and
did know more than E&Y about matters affecting the client’s prospects and should,
therefore, have taken steps to protect the firm from suffering more losses.
5. Professionals’ Ethical Obligations to Clients. The CPA Examiners have moved
professional ethics to the Regulation law portion of the CPA Exam. Most accounting
programs cover accountants’ ethical duties in an accounting course, such as auditing or
professional aspects of accounting. Thus, the authors have chosen not to include the
topic in this textbook. Chapter 4 covers business and professional ethics in general.
6. Breach of trust
a. Remind students of the professional conflicts of interests that had existed for years
but became front page material in the last 15 years: auditors who compromised their
audits in order to secure lucrative consulting contracts and securities analysts who
issued buy recommendations for the stocks of companies that the analysts’
investment banking partners wanted as investment banking clients. Add in also
brokers churning investors’ securities accounts. We have included quite a bit of
material regarding Congress’s response to these conflicts of interest: the Sarbanes-
Oxley Act of 2002. Auditor independence aspects of SOA are covered at this point in
the chapter. At this time, you might want to cover the securities analyst conflict of
interest rules and the provisions of the Dodd-Frank Act that apply to brokers and
dealer. See pages 12525-1256.
b. Ethics in Action: The Sarbanes-Oxley Act: Auditor Independence Standards (p.
1241): Note the restrictions that SOA places on audit firms. Do the auditor
independence rules make complete sense? Don’t auditors, because of their intimate
knowledge of the client, have a better ability to provide high quality consulting
advice to clients? Does the consulting prohibition for auditors introduce inefficiency
by requiring multiple firms to do what one firm previously could do? What is the
rationale for the independence rules? To ensure that auditors are focused on one job:
making sure the financial statements fairly present the financial position of the
company. That is a public trust, and no conflicts should interfere with it.
7. In Pari Delicto and the Adverse Interest Exceptions
This new section was added in response to the decisions handed down in New York, New
Jersey, and Pennsylvania, which are excerpted and discussed in the text. It bears
watching how these states and other will choose or not choose to protect shareholders
from professionals who collude with corporate insiders to harm the shareholders’
corporation.
C. Professionals’ Liability to Third Parties
1. Common law negligence and negligent misrepresentation
a. Define negligence: the professional’s failure to act as the ordinarily prudent
professional would act in the same circumstances.
b. Define negligent misrepresentation: the professional negligently misstates a material
fact with the intent to induce another person to rely on the representation of fact. The
professional makes false statements honestly believing they are true but without
reasonable grounds for such belief.
c. Trace the evolution of the courts’ attitude toward privity, which is especially well
developed in the area of auditor liability. Define the three tests accepted by courts
today. Refer to the Concept Review on page 1247.
1) Primary benefit test
Example: National Bank tells its customer that it will not lend $3 million to the
customer unless the customer provides audited financial statements to National
Bank. Customer hires an auditor to prepared financial statements in compliance
with GAAS and GAAP, informing auditor that the financial statements will be
used by National Bank to make a $3 million loan to customer. Auditor prepares
financial statements and issues an unqualified opinion. Customer gives financial
statements and auditor’s opinion to National Bank, which makes a loan to
customer. Customer also gives financial statements and opinion to American
Bank, which makes a loan to customer. National Bank can sue auditor under the
primary benefit test, but American Bank cannot.
2) Foreseen users and foreseen class of users test.
The foreseen users test is the same as the Ultramares primary benefit test. The
foreseen class of users test extends liability to persons in a limited class whose
use is foreseen. American Bank in the previous example is a user in a foreseen
class of users if it the extent of its use was known by the auditor, meaning the
loan amount was the same.
3) Foreseeable users test
Note that this test is closer to the rule regarding ordinary persons’ liability for
negligent acts. Explain why most courts will not apply this in the professional
liability context: liability may exceed what the professional agreed to assume
and expected to assume and is disproportionate to the fee the professional
charged its client.
Example: Note the foreseeability rule of H. Rosenblum, Inc. v. Adler, 461 A.2d
138 (N.J. S. Ct. 1983). An independent auditor has a duty to all those whom that
auditor should reasonably foresee as recipients of the accountant’s reports from
the client for the client’s proper business purposes, provided that the recipients
rely on the reports pursuant to those business purposes. The accountant should
reasonably expect that his client would distribute financial statements in
furtherance of matters relating to his client’s business. That case provides some
guidance in determining when a use is foreseeable: when the nonclient’s use
relates to the business of the client.
4) Example: Chapter Introductory Problem (pp. 1233).
5) Examples: Problem Cases ## 5 and 6.
d. Tricontinental Industries, Ltd. v. PricewaterhouseCoopers, LLP (p. 1244). The court
affirmed the trial court’s grant of PwC’s motion to dismiss on the grounds that PwC
owed no duty to Trincontinental under Illinois’s formulation of the Ultramares test.
Points for Discussion: This is another case in which the client managed or
manipulated its financial results to maintain consistent increases in revenues in order
to meet expectations of securities analysts and investors and, thereby, avoid a hit to
its stock price. Another case like this is the Stoneridge Investment Partners case on
page 1219 in Chapter 45. In such cases, when an auditor’s client fails or its stock
price plummets, it is no surprise that some investors who purchase the client’s stock
try to recover from the solvent auditor.
Additional Points for Discussion: Note that the Illinois statute provides two bases for
auditor liability to a non-client. One, if the client’s primary intent is that the non-
client will be benefited or influenced by the auditor’s work. Two, if the auditor in
writing identifies those persons who are intended to rely on the auditor’s work. The
court called the first basis the general rule; the second was termed an exception,
stating when the auditor owes a duty to a non-client even if the client had no intent
that the non-client would use the auditor’s work. This case focused on the general
rule.
Additional Points for Discussion: As the court explained the general rule, it became
clear that the primary intent of the client may be shown in some less than rigorous
ways. First of all, the court stated the rule less restrictively by stating that the
plaintiff must show that “a”(not “the”) primary purpose and intent of the
accountant-client relationship (not the client’s intent) was to benefit or influence the
non-client. The court also explains the rule by citing three cases in the second column
on page 1246. The first case, Builders Bank, is the typical formulation of the
Ultramares test: the auditor knows a non-client will use its work, because the client
informs the auditor of the non-client’s use. Go through the other two cited case with
your students. In Lipper, the auditor sent its audit opinions to the non-client. In
Chestnut Corp., the non-client visited the auditor’s office. Ask students how these fit
the court’s interpretation of the Illinois statute.
Additional Points for Discussion: Why did the court find that Tricontinental was not
a proper plaintiff under the Illinois statute? The court found that all the alleged
actions of PwC—assisting Anicom in raising money, conducting due diligence for
Anicom, and being on circulation lists—proved that Anicom used PwC’s services for
Anicom’s benefit, not Tricontinental’s. Ask your student whether they agree with the
court.
Additional Point for Discussion: Until this decision was released, it was generally
believed that the Illinois statute permitted a professional to be liable for negligence to
a non-client only if the professional agreed in writing. The court held that the statute
imposed no such requirement.
2. Common law fraud. Note that fraudulent torts are so wrongful that there is no privity
requirement. No privity is required whether there is actual fraud (scienter) or
constructive fraud (recklessness or gross negligence).
3. Securities law violations
a. For more information on the liability sections under federal securities law, see
Chapter 45.
b. Use the Concept Review on pages 1254-1255 as a framework for your lecture. We
cover this material in a way that provides comfort to our students. We show them
that the competent professional should not fear liability under the federal securities
law. We also give them advice on how to manage liability.
c. Section 11 liability
1) Refer to the discussion of Section 11 liability in Chapter 45 at pages 1200-1205.
2) Note the accountants’ standard of conduct, which appears in the due diligence
defense. Have your students read the BarChris case, which appears at page 1202
in Chapter 45. Instructor’s Manual Chapter 45 should be consulted for lecture
preparation suggestions concerning the BarChris case.
3) Point out that Section 11’s due diligence defense requires auditors to have made a
reasonable investigation and have a reasonable belief that audited financial
statements were not defective at the time the registration statement became
effective. This requires an auditor to perform an additional review of the
financial statements. The S-1 review referred to in the BarChris case was such a
review.
4) Note that underwriters’ due diligence defense varies depending on the portion of
the registration statement that is defective. Students may be confused into
thinking that since underwriters like Goldman Sachs are experts in the business
of public offerings they are also experts in regard to Section 11. Underwriters are
not experts under Section 11 because they do not issue a professional opinion like
an auditor does regarding financial statements or that a tax lawyer does regarding
the tax deductibility of an investment’s losses.
5) Example: Chapter Introductory Problem (p. 1233). See the answer above to this
problem, which includes a checklist that will help auditors and underwriters meet
their due diligence defenses. The checklist was largely derived from the
BarChris case.
6) Example: Problem Case #7.
7) Note that Section 11 has a statute of limitations that may have been changed by
the Sarbanes-Oxley Act of 2002. See Chapter 45 page 1205.
d. Section 12(a)(2)
1) Note that auditors have a low risk of liability under this section because they
are not sellers, they do not actively solicit sales, and they do not have a financial
interest in the sales of securities when they act merely as auditors and receive a
fee.
2) Underwriters and other securities professionals, however, do have potential
liability under Section 12(a)(2). Underwriters in a firm commitment
underwriting are sellers and actively solicit sales by preparing the prospectus,
participating in the road show, and contacting investors in other ways. They also
have a financial stake in the sale in the form of a spread or commission.
Additional materials on the role of underwriters in public offerings can be found
in Chapter 45 at pages 1187-1188.
3) Example: Chapter Introductory Problem (p. 1233).
4) Additional Example: Problem Case #7.
e. Section 18(a) liability. Note the importance differences between Section 11 and
Section 18(a):
1) Section 18 applies to documents filed under the 1934 Act, whereas Section 11
applies only to 1933 Act registration statements.
2) Section 18 requires reliance, whereas Section 11 usually requires no reliance.
3) Section 18 imposes meaningful liability on auditors only, not securities
professionals.
4) Section 18 permits an auditor to escape liability when she proves she acted in
good faith without knowledge that the financial statements were misleading,
whereas Section 11 permits an auditor to escape liability only by proving a
reasonable investigation and a reasonable belief that financial statements were
accurate.
f. Section 10(b) liability.
1) To augment the materials in this chapter, see the materials on Section 10(b) in
Chapter 45. Note that auditors, consultants, underwriters, and investment
bankers who receive confidential information from their clients in the course of
an engagement are considered insiders for purposes of insider trading liability
under Section 10(b). See page 1216.
2) Note that Section 10(b) requires proof of scienter. Define scienter, noting that it
is generally interpreted to include recklessness when an auditor owes a fiduciary
duty to the plaintiff.
Ferris, Baker Watts, Inc. v. Ernst & Young, LLP (p. 1250): This is an excellent
case that cites many other cases that help students understand the types of
behavior that amount to scienter under Rule 10b-5. It shows that people are not
liable under Rule 10b-5, unless they deserve to be liable. It should provide a lot
of comfort to your students that they need not fear Rule 10b-5 liability.
Points for Discussion: Note that the court states that mere negligence, the failure
to act like a reasonable person, does not violate Rule 10b-5. The court next says
that severe recklessness may be enough. The courts explain this, nearly equating
recklessness with intentional misconduct, that is, intent to defraud. The cases
cited in the first column of page 1251 provide concrete examples of what is not
scienter. What is the teaching from these cited cases? Bad things happen.
GAAP and GAAS violations occur. But without fraudulent intent, there is no
liability. Negligence, not even perhaps gross negligence, is enough to impose
liability under Rule 10b-5.
Additional Point for Discussion: Why was E&Y not proved to have acted with
scienter? E&Y did more than a cursory audit. Even according to FBW’s
allegations, E&Y knew about the risks of securities borrowing and lending, had
an audit plan that recognized the need for closer testing, confirmed the Native
Nations accounts receivable, noted its excess over the collateral’s value,
interviewed the securities borrowing manager who represented that he performed
regular credit reviews, examined 5 of MLK’s 60 customers’ files for signed
agreements and credit evaluations, inquired about deficiencies, verified securities
borrowing reports, tested internal control activities, identified reconciliations of
balance sheet cash and bank accounts as well as balance sheet securities ledgers
and securities accounts, and concluded that internal controls were effective and
could be relied upon to reduce audit procedures. At most these allegations
proved a poor audit, not E&Y’s intent to deceive, manipulate, or defraud.
3) Proportionate Liability: Note how law changes in 1995 reduced the amount of
liability of auditors and securities professionals.
4) Aiding and Abetting Liability. This is covered more fully in Chapter 45 at pages
1219-1222. Note especially the effects of the Janus case, note in Chapter 46 at
page 1252.
Examples: Problem Cases ## 8 and 9.
5) Example: Chapter Introductory Problem (p. 1233).
6) Additional Examples: Problem Case # 7.
D. Securities Analysts’ Conflicts of Interest, Sarbox, and the Dodd-Frank Act
1. Congress, the SEC, the NYSE, and the NASD have addressed analysts’ conflicts of
interest. Note the charge to the SEC made by the Sarbanes-Oxley Act in the areas of
analyst compensation and approval of analyst recommendations, as well as the
prohibition of retaliation against analysts and the ban of issuances of research reports
when a firm is underwriting a public issuance. Do your students think that in practice
any of the analysts’ independence rules will have any effect on the reliability of research
reports?
2. Cover SEC Regulation AC. Do your students think that Regulation AC meets the
requirements of SOX?
3. Ethics in Action: Securities and Investment Banking Firms Lose and Settle Conflict of
Interest Cases (page 1253): Do the examples illustrate that conflicts of interest inhere in
securities firms, especially multi-function firms that have brokerage, securities analysis,
and investment banking arms?
4. Note the proscriptions of the Dodd-Frank Act, especially the imposition of liability under
new section 9(a)(4) for the 1934 Act, which limits the effect of the Janus case.
5. Example: Problem Case # 8.
E. Limiting Professionals’ Liability
Note that professionals have some ability to limit their liability when they practice with other
professionals by choosing an appropriate form of business. Discuss especially the limited
liability partnership, which is covered more fully in Chapters 37 and 38.
F. Qualified Opinions and Disclaimers of Opinions
1. Note that the issuance of qualified opinions, disclaimers of opinion, adverse opinions,
and unaudited statements will not excuse an accountant from liability. Review the
standards to which an accountant must adhere when such opinions and statements are
issued.
2. In recent years, the SEC has concentrated its enforcement efforts on opinion shopping:
corporations improving their bottom line by shopping around for the most favorable
accountant’s opinion. Point out that the SEC has made it clear that independent auditors
who agree to give a company a favorable opinion after another auditor has refused to do
so may face disciplinary action under SEC Rule of Practice 102(e).
G. Criminal, Injunctive, and Administrative Proceedings
1. Criminal liability. Note that criminal intent is required to impose criminal liability on a
professional, whether under the securities laws, tax laws, mail fraud statutes, or other
statutes.
United States v. Natelli (p. 1257). Note that Natelli and Scansaroli were prosecuted for
errors in their contributions to a proxy statement.
Points for Discussion: What did Natelli and Scansaroli do wrong here? Looking at the
entirety of the transaction, they allowed Student Marketing to account for items as it
pleased, even after a reasonable person--let alone an ordinarily prudent accountant–
would have suspected that Student Marketing was manipulating its sales figures by
reporting fictitious sales. Specifically, the circumstances under which the Eastern
commitment was made available to Natelli should have put him on notice of its being
fictitious. Scansaroli was not liable for this misstatement for he had no discretion
whether to book the commitment. He had no information that would alert him to its
falsity. Both Natelli and Scansaroli were responsible for not noting the effect of bad
commitments on 1968 profits since both knew of the bad commitments and their effect
on profits. And both knew that the commitments discovered by Oberlander were bad, yet
they chose not to write them off. This knowing misconduct was held to constitute willful
violation of the 1934 Act.
Note also that the court based its finding of an intent to conceal the write-offs on its
determination that Natelli had not followed GAAP in booking 1968 sales. His desire to
avoid criticism and liability gave him a powerful motive to conceal the write-offs of the
receivables based on the fictitious sales.
Additional Point for Discussion: Consider the dilemma faced by Natelli and Scansaroli
when they first suspected that some sales were fictitious. If they follow accounting
conventions in recording sales and writing off bad commitments, they upset Student
Marketing’s management, probably resulting in losing the account, which would not
endear them to Peat, Marwick’s management. If they knowingly fail to follow
accounting conventions, they risk criminal liability. This dilemma faces auditors and
other professionals today. Ask your students what they would have done had they been
faced with the same dilemma faced by Natelli and Scansaroli.
2. At this time, you also want to cover Arthur Andersen LLP v. U.S., the text case on page
1262.
3. Professionals’ Liability for Preparation of Tax Returns. Among the duties and liabilities
under the Internal Revenue Code are the following:
a. A tax preparer must not
1) fail to provide a taxpayer with a copy of the tax return. The penalty is $50;
2) fail to include a tax preparer identification number on any return or request for a
refund. The penalty is $50;
3) fail to keep copies or lists of returns prepared for three years. The penalty is $50;
4) promote an abusive tax shelter. The penalty is the greater of $1,000 or 100% of
the income derived from the tax shelter;
5) understate a taxpayer’s liability willfully or due to intentional disregard of IRS
rules and regulations. The penalty is $1,000 for an individual and $10,000 for a
corporation;
6) take a deduction on a client’s return without assurances by the client that
documentation of the deduction exists. The tax preparer is not required to
investigate the documentation but must have no reason to doubt the client;
7) understate a client’s tax liability by taking a unrealistic position with regard to the
treatment of an item under the tax laws, unless the tax preparer acted in good
faith and had a reasonable cause to take the position. The penalty is $250;
8) negotiate a client’s income tax refund check, unless it is deposited into the
client’s account. The penalty is $500;
9) aid and abet tax evasion. The IRS may obtain an injunction barring the tax
preparer from preparing tax returns in the future. The tax preparer may also be
criminally prosecuted.
b. Notice of Assessments by the IRS.
The IRS may notify a tax preparer’s client that it has assessed the client for a tax
deficiency. A tax preparer should assist the client in handling a notice of assessment.
The IRS must give the client 90-days notice of the assessment. The taxpayer may
dispute the assessment within 90 days; if the taxpayer timely disputes the assessment,
the Tax Court may consider the matter. If the taxpayer does not dispute the matter
within 90 days, the tax deficiency is due in 10 days.
4. SEC and NASD Proceedings
a. Note the impact of a successful 102(e) proceeding against an accountant: an
accountant may lose the privilege of engaging in a part of her accounting practice.
Example: Problem Case # 11.
b. The NASD also has power to discipline its members.
H. 1934 Act Audit Requirements
1. Section 10A: carefully list the requirements of Section 10A of the 1934 Act, which
impose significant whistle-blowing responsibilities on auditors.
2. SOX Section 404
a. Cover auditors’ duty to attest to management’s internal control report. There is quite
a bit of material on SOX 404 in Chapter 45 in the ethics box on page 1209.
b. Log On (p. 1261): For current information on the implementation of SOX, direct
students to the AICPA’s website.
Example: Problem Case # 12.
I. Working Papers
1. Note that an accountant’s work papers belong to the accountant, but that his client has a
right of access to them. The client may copy the work papers at her own expense. Note,
however, that a client’s records given to an accountant to permit the accountant to do
work for the client belong to the client. Such records must be returned to the client.
2. A professional has a duty of confidentiality to clients. That duty prohibits most
disclosures to third parties. For example, an accountant who sells her practice to another
accountant may not deliver her work papers regarding a client to the purchasing
accountant without first obtaining permission of the client. An accountant who is a
partner in an accounting partnership may give confidential information to his partners,
including when the partner retires and his partners continue the business. An underwriter
may disclose confidential information pursuant to a subpoena issued to a litigant when
the information is relevant to issues raised in the litigation. Confidential information may
also be disclosed to a voluntary quality control review board.
3. Note that the Sarbanes-Oxley Act requires work paper retention for seven years. At his
time you may want to cover the Arthur Andersen case on page 1262.
J. Professional-Client Privilege
1. State law
a. In general, few clients enjoy a legal privilege to communicate with a non-attorney
professional. Many states, however, recognize an accountant-client privilege, which
protects communications between a client and her accountant by prohibiting
testimony at a legal proceeding concerning the communications. Usually, the
privilege covers only what the client has communicated to the accountant, not what
the accountant communicates to the client. Ordinarily, the privilege belongs only to
the client. An accountant who does not wish to disclose a client’s confidential
communication at a legal proceeding must disclose it if the client waives the
privilege. The privilege would apply only to communications that are necessary to
the accountant’s performance of her duties to her client.
Examples: The privilege would cover communications regarding a client’s doubts
about the accuracy of his records. It would not cover a client’s statement that he got
his money to pay his accountant by hacking someone’s bank account.
b. Note the rationale for creating an accountant-client privilege: it encourages a client
to be open with his accountant rather than withholding information, allowing the
accountant to do a better job. While the privilege results in less evidence being
presented in court, many state legislatures have been persuaded that the benefits of
the privilege outweigh its costs.
2. Federal law. Currently, no professional-client privilege is recognized in federal law,
except for attorneys. For accountants and securities professionals, however, the obstacle
to confidentiality may be circumvented by the professional bringing herself under the
protection of the attorney-client privilege. For example, when it appears that a client is
about to disclose sensitive information to an accountant, the accountant should stop the
conversation, the client should get a lawyer, and the lawyer should hire the accountant to
work for the lawyer on the matter. Anything subsequently disclosed to the accountant
will be covered by the attorney-client privilege.
K. Arthur Andersen LLP v. U.S. (p. 1262): You may want to cover this case during your
coverage of criminal violations or working papers. The Supreme Court held that Arthur
Andersen was not guilty of obstructing justice when it shredded documents regarding its
audit of Enron. Note that subsequent to this decision in December 2005, DOJ decided to
drop all charges against Andersen partner David Duncan.
Points for Discussion: Ask your students why the Supreme Court found for Andersen. Was it
because Andersen in fact did not obstruct justice? No. The Court held that the charge to the
jury was flawed because it misstated the law, by failing to require that Andersen knew its
actions were likely to affect a judicial proceeding.
Additional Points for Discussion: This case has great facts that make it an excellent teaching
tool. The facts show that Duncan and others at Andersen knew that a criminal action was
imminent, but since no action had been commenced against Enron or Andersen and no
subpoena had been served on Enron or Andersen, Andersen’s employees continued to shred
documents. Does that mean that what Andersen did was not criminal? No, the Supreme
Court didn’t write that. But it is likely it wasn’t criminal, since the employees thought they
were acting legally by not affecting a legal proceeding that had not been commenced.
Additional Points for Discussion: Point out that Sarbox to some extent has changed the law
that applies to auditor shredding of work papers by requiring an auditor to retain its audit and
review working papers for at least seven years. After seven years, auditors can shred work
papers unless they do so to obstruct justice. What do your students think audit firms should
do after seven years have passed? Probably shred all documents except those showing that
the auditor has done a creditable job.
IV. RECOMMENDED REFERENCES
A. Berger, Accountants’ Liability after Enron (2002).
B. Bloomenthal, Sarbanes-Oxley Act in Perspective (2014-2015 ed.).
C. Causey, Duties and Liabilities of Public Accountants (7th ed. 2002).
D. Coffee & Sale, Securities Regulation (12th ed. 2012). Has a chapter on broker–dealer
regulation.
E. Epstein & Spalding, The Accountant’s Guide to Legal Liability and Ethics (1993).
F. Goldwasser & Arnold, Accountants’ Liability (2014).
G. Haft & Hudson, Liability of Attorneys and Accountants for Securities Transactions (2014).
H. Haas & Howard, Investment Adviser Regulation in a Nutshell (2008).
I. Hazen, Broker-Dealer Regulation in a Nutshell (2d ed. 2011).
See also the securities regulation references in Chapter 45.