Chapter 44
ACCOUNTANT’S LEGAL LIABILITY
A. Common Law
1. Contract Liability
2. Tort Liability
a. Negligence
b. Fraud
3. Criminal Liability
4. Client Information
a. Working Papers
b. Accountant-Client Privilege
B. Federal Securities Law
1. Securities Act of 1933
2. Securities Exchange Act of 1934
a. Civil Liability
b. Criminal Liability
c. Audit Requirements
d. Sarbanes-Oxley Act
Cases in This Chapter
Murphy v. BDO Seidman, LLP
Ernst & Ernst v. Hochfelder
Chapter Outcomes
After reading and studying this chapter, the student should be able to:
Describe the contract liability of an accountant to her client.
Describe for what and to whom an accountant has tort liability.
Describe who owns the working papers an accountant generates and
TEACHING NOTES
A. COMMON LAW
*** Chapter Outcome***
Explain the contract liability of an accountant to her client.
Contract Liability
Common law contract elements must be satistied. The accountant agrees to
perform all duties stated in the contract and impliedly agrees to perform in a
professional manner. A breach of contract will make the accountant liable to
the client and to any third party bene#ciaries who were intended to
primarily benefit from the work product. Under general contract law,
accountants are not entitled to compensation following a material breach,
although, if the accountant substantially performs, compensation minus
losses su’ered by the client are recoverable.
*** Chapter Outcome***
Describe for what and to whom an accountant has tort liability
Tort Liability
Negligence — Accountants incur negligence liability if they do not exercise
the degree of care a reasonably prudent accountant would have exercised
under similar circumstances. Most courts do not permit an accountant to
raise the defense of the plainti”s contributory (or comparative) negligence.
An accountant’s negligence liability has traditionally been restricted to
clients and intended third party bene#ciaries under the privity of contract
doctrine (Ultramares v. Touche). Recently, most courts have extended the
CASE 44-1
MURPHY v. BDO SEIDMAN, LLP
Court of Appeal, Second District, 2003
113 Cal.App.4th 687, 6 Cal.Rptr.3d 770 http://scholar.google.com/scholar_case?
case=6493495192376414472&hl=en&as_sdt=2&as_vis=1
Rubin, J.
In November 1995, respondent accounting #rm Logan, Throop &
Company (Logan) prepared a financial statement for World Interactive
Networks, Inc. (WIN), a non-publicly-traded corporation, for the period
ending in August 1995. The statement misrepresented the value of
various WIN assets, claiming they were worth $145 million when in fact
they amounted to only $30 million. Logan also claimed the financial
statement complied with generally accepted accounting principles
(GAAP) when it did not. In February 1996, Logan repeated essentially the
same misrepresentations in its auditors’ report of WIN’s 1995 balance
sheet.
$121 million, when they were truly worth only $6.9 million. In addition,
Seidman misrepresented WIN’s shareholder equity as $88 million, when
the company was worthless. Several months later, Seidman repeated
essentially the same misrepresentations when it released its review of
WIN’s quarterly balance sheet for the period ending March 1996.
Struthers Industries, Inc. (Struthers), was a publicly traded
corporation. In 1995, WIN and Struthers agreed to a reverse merger,
subject to shareholder approval, in which WIN would sell its assets to
In March 1998, WIN and Struthers #led for bankruptcy, and appellants,
who allege they relied on Seidman’s and Logan’s financial statements to
buy stock in the companies, lost their investments. Consequently,
appellants sued both accounting firms, alleging causes of action for
negligent and intentional misrepresentation. * * *
* * *
Respondents’ Duty to Appellants
* * *
In Bily v. Arthur Young & Co. [citation], our Supreme Court formulated a
hierarchy of duty for accountants who prepare inaccurate financial
statements. Casting an ever-widening circle of obligation, Bily established
that the more egregious the misstatement, the broader the duty:
For ordinary negligence, an auditor owes a duty only to its client. As
Bily explained, “[A]n auditor’s liability for general negligence in the
conduct of an audit of its client financial statements is con#ned to the
client, i.e., the person who contracts for or engages the audit services.
Other persons may not recover on a pure negligence theory.”
[Citation.]
representation was made “with the intent to induce plainti’, or a
particular class of persons to which plainti’ belongs, to act in reliance
upon the representation in a specific transaction, or a specific type of
transaction, that defendant intended to inKuence. Defendant is
deemed to have intended to inKuence [its client’s] transaction with
plainti’ whenever defendant knows with substantial certainty that
plainti’, or the particular class of persons to which plainti’ belongs,
will rely on the representation in the course of the transaction.”
[Citations.]
For intentional misrepresentation, the duty expands yet further to
include anyone whom the auditor should have reasonably foreseen
would rely on the misrepresentations. Bily explained, “The
Bily can thus be brieKy summarized as follows: (1) ordinary negligence
—no duty to third parties; (2) negligent misrepresentation—duty to third
parties who would be known with substantial certainty to rely on the
misrepresentation; and (3) intentional misrepresentation—duty to third
parties who could be reasonably foreseen to rely on the
misrepresentation.
* * *
1. Appellants Allege the Duty for Negligent Misrepresentation. The
complaint alleges WIN and Struthers hired respondents to prepare
various financial statements that appellants relied upon in buying WIN
or Struthers stock and in approving their merger. The complaint also
alleges respondents knew WIN or Struthers would distribute the
2. Appellants Allege the Duty for Intentional Misrepresentation. The
complaint alleges respondents either intentionally or recklessly
misstated the value of WIN’s assets and shareholder equity. It further
alleges respondents should have foreseen that current and future
investors in WIN and Struthers would rely on the misstated values in
deciding whether to invest in those companies and to approve their
merger. * * * The complaint therefore states a cause of action for
intentional misrepresentation.
3. Appellants Who Bought Struthers Stock Allege Causes of Action. Some
appellants bought only Struthers stock. Respondents note that
Bily imposes on respondents a duty to more than just their clients.
Respondents owed a duty to anyone whom they (1) should have
reasonably foreseen would rely on their intentional misrepresentations, or
(2) knew with substantial certainty would rely on their negligent
misrepresentations. [Citation.] The complaint alleges respondents knew
the proposed merger of WIN and Struthers would induce investors in
statements in deciding whether to approve the merger itself. The
complaint therefore alleges a duty from respondents to Struthers’
shareholders, making respondents liable to those shareholders for their
misrepresentations.
Reliance
1. suffcient Detail. Logan contends the complaint does not describe
appellants’ reliance on Logan’s alleged misrepresentations with
enough detail. According to Logan, appellants must identify the “when,
where, and how” of their reliance. Our review #nds most appellants
2. Forbearance Is Reliance. A number of appellants, whom we identify in
Appendix 2, bought WIN or Struthers stock before Logan and Seidman
issued their first reports, and thereafter relied on respondents’ rosy
misstatements in deciding not to sell their stock. * * * After brie#ng
ended in this appeal, our Supreme Court held in [citation] that holding
stock can be actionable reliance. * * *
is thus not actionable.
The law is otherwise. Indirect reliance is actionable if Logan or
Seidman had reason to know others would convey their
misrepresentations to appellants. Under Bily, respondents are liable for
(1) negligent misrepresentation if they knew it was substantially certain
that appellants would receive the misstatements and (2) intentional
misrepresentation if it was reasonably foreseeable appellants would
* * *
The trial court’s judgment is reversed in part and aFrmed in part. * * *
Fraud — Accountants may be liable for intentionally tortious conduct
constituting fraudulent misrepresentation. In recent years, accountants also
have been subject to a number of civil lawsuits based on the Racketeer
InKuenced and Corrupt Organizations Act (RICO).
Criminal Liability
An accountant’s potential criminal liability is primarily based on federal
securities and federal tax law. Additionally, fraudulently certifying financial
statements constitutes a crime in most states.
*** Chapter Outcome ***
Describe who owns the working papers an accountant generates
and whether client information is privileged.
Client Information
Working Papers — An accountant is considered the owner of his working
papers but may not disclose their contents unless the client agrees or a
court orders the disclosure.
*** Chapter Outcome***
Discuss the potential civil and criminal liability of an accountant under the 1933
Securities Act.
B. FEDERAL SECURITIES LAWS
Securities Act of 1933
Subject to civil liability under Section 11 for preparing or certifying for
inclusion in a securities o’ering a false or omitted material statement. Due
diligence is a defense to negligence claims made under Section 11. Criminal
*** Chapter Outcome***
Discuss the potential civil and criminal liability of an accountant under the 1934
Securities Act.
Securities Exchange Act of 1934
Section 18 imposes civil liability on an accountant for any false or misleading
information #led with the SEC. A showing of good faith and lack of actual
knowledge of falsity will serve as a defense.
CASE 44-2
ERNST & ERNST v. HOCHFELDER
Supreme Court of the United States, 1976
425 U.S. 185, 96 S.Ct. 1375,47 L.Ed.2d 668
http://scholar.google.com/scholar_case?case=4219834259989886465&hl=en&as_sdt=2&as_vis=1&oi=scholarr
Powell, J.
The issue in this case is whether an action for civil damages may lie
under §10(b) of the Securities Exchange Act of 1934 (1934 Act), * * *, and
Securities and Exchange Commission Rule 10b-5, * * * in the absence of
an allegation of intent to deceive, manipulate, or defraud on the part of
the defendant.
Respondents were customers of First Securities who invested in a
fraudulent securities scheme perpetrated by Leston B. Nay, president of
the firm and owner of 92% of its stock. * * *
Federal regulation of transactions in securities emerged as part of the
aftermath of the market crash in 1929. The Securities Act of 1933 (1933
Act), [citation] was designed to provide investors with full disclosure of
material information concerning public o’erings of securities in
commerce, to protect investors against fraud and, through the imposition
of specified civil liabilities, to promote ethical standards of honesty and
fair dealing. [Citation.] The 1934 Act was intended principally to protect
investors against manipulation of stock prices through regulation of
transactions upon securities exchanges and in over-the-counter markets,
and to impose regular reporting requirements on companies whose stock
Section 10 of the 1934 Act makes it “unlawful for any person * * * (b)
[t]o use or employ, in connection with the purchase or sale of any
security * * * any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Commission may
prescribe as necessary or appropriate in the public interest or for the
protection of investors.” [Citation.] In 1942, acting pursuant to the power
conferred by §10(b), the Commission promulgated Rule 10b-5.
* * *
Although §10(b) does not by its terms create an express civil remedy
for its violation, and there is no indication that Congress, or the
elements. Courts and commentators long have di’ered with regard to
whether scienter is a necessary element of such a cause of action, or
whether negligent conduct alone is suFcient.
* * *
* * *
The Commission argues that Congress has been explicit in requiring
willful conduct when that was the standard of fault intended. * * *
* * *
The structure of the Acts does not support the Commission’s
argument. In each instance that Congress created express civil liability in
favor of purchasers or sellers of securities it clearly specified whether
recovery was to be premised on knowing or intentional conduct,
negligence, or entirely innocent mistake. [Citations.] For example, §11 of
the 1933 Act unambiguously creates a private action for damages when a
registration statement includes untrue statements of material facts or
fails to state material facts necessary to make the statements therein not
misleading. Within the limits specified by §11(e), the issuer of the
securities is held absolutely liable for any damages resulting from such
misstatement or omission. But experts such as accountants who have
prepared portions of the registration statement are accorded a “due
15, [citations] is subject to signiticant procedural restrictions not
applicable under §10(b). * * *
* * *
We have addressed, to this point, primarily the language and history
of §10(b). The Commission contends, however, that subsections (b) and
(c) of Rule 10b-5 are cast in language which—if standing alone—could
encompass both intentional and negligent behavior. These subsections
respectively provide that it is unlawful “[t]o make any untrue statement
of a material fact or to omit to state a material fact necessary in order to
make the statements made, in the light of the circumstances under which
they were made, not misleading * * *” and “[t]o engage in any act,
practice, or course of business which operates or would operate as a
fraud or deceit upon any person * * *.”
* * *
The judgment of the Court of Appeals is reversed.
Criminal liability — imposed for willful violation of ß 18 or Rule 10b-5. As
amended by the Sarbanes-Oxley Act, conviction may carry a #ne of not more
than $5 million or imprisonment for not more than twenty years, or both. An
accounting firm may be #ned up to $25 million. Moreover, under the Federal
Audit requirements — The Private Securities Litigation Reform Act of 1995
imposes obligations upon public accountants who audit financial statements
required by the Act of 1934. These requirements include the establishment
of procedures capable of detecting material illegal acts, identifying material
related party transactions, and evaluating whether there is a substantial
doubt about the issuer’s ability to continue as a going concern during the
next #scal year.
Sarbanes-Oxley Act — Passed by Congress in 2002 in response to the
business scandals involving companies such as Enron, WorldCom, Global
Crossing, and the accounting firm of Arthur Andersen. This Act provides for
the establishment of the #ve-member Public Company Accounting Oversight
Board. The SEC has oversight and enforcement authority over the Board. The
Board enforces the Sarbanes-Oxley Act, the Federal securities laws, the
SEC’s rules, the Board’s rules, and professional accounting standards. The
duties of the Board include (1) registering public accounting firms that
prepare audit reports for issuers; (2) overseeing the audit of public
The Act also prohibits accounting firms from performing eight specified
non-audit services for audit clients, including bookkeeping or other services
related to the accounting records or financial statements; financial
information systems design and implementation, appraisal or valuation
services; fairness opinions; management functions or human resources; and
actuarial services. Accounting #rms may perform other non-audit services
not expressly forbidden by the Act if the company’s audit committee grants
auditor; and (3) other material written communications between the auditor
and management.