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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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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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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.

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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.

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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