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Chapter 46 - Legal and Professional Responsibilities of Auditors, Consultants, and Securities Professionals
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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.
Oxley Act.
H. Understand the limits of the professional-client privilege, especially the accountant-client
privilege.
II. ANSWER TO INTRODUCTORY PROBLEM
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
any misstatement or omission of material fact in connection with any securities transaction,
Chapter 46 - Legal and Professional Responsibilities of Auditors, Consultants, and Securities Professionals
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© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
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
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,
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
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
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
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3. Read important meeting minutes
a. Board of directors meetings
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
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
securities analysis.
2. Review briefly the bases of professional liability: criminal liability, breach of contract,
trust.
3. Define the accountant’s general standard of performance. Note that the standard requires
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
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© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
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
representatives of companies and auditors?
5. The Global Business Environment: U.S. Moving to International Accounting Standards
cases arise in this area, largely because there is little uncertainty about what the law is in this
liability to clients giving special attention to the following:
1. Negligence
a. Note the range of actions for which auditors, consultants, securities brokers,
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
Unocal Test” (pages 1133-1134), and “Complying with the Intrinsic Fairness
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
receiving sales confirmations from customers.
Chapter 46 - Legal and Professional Responsibilities of Auditors, Consultants, and Securities Professionals
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3. Negligent Preparation of Tax Return. Note the limit of a tax accountant’s liability if the
overpayment from the accountant.
4. Contributory Negligence and Comparative Negligence. Most states have abandoned
contributory negligence and adopted comparative negligence or comparative fault.
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
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,
5. Professionals’ Ethical Obligations to Clients. The CPA Examiners have moved
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
brokers churning investors’ securities accounts. We have included quite a bit of
material regarding Congress’s response to these conflicts of interest: the Sarbanes-
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
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
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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.
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
auditor should reasonably foresee as recipients of the accountant’s reports from
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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.
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
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.
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
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
statute imposed no such requirement.
Chapter 46 - Legal and Professional Responsibilities of Auditors, Consultants, and Securities Professionals
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© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
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
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
preparation suggestions concerning the BarChris case.
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
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)
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
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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.
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.
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
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
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?
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
