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Fraud
Primary Liability. Most securities litigation against accountants is brought under §10(b) and Rule
10b-5 of the 1934 Act. Under §10(b), an auditor is liable for making (1) a misstatement or omission
of a material fact (2) knowingly or recklessly (3) that the plaintiff relies on in purchasing or selling
a security. This is called primary liability because the accountants are liable for statements that they
make themselves. Accountants are liable under §10(b) only if they are know their statement is wrong
or they are reckless in checking the accuracy of their reports.
The following case is famous for its landmark interpretation of§10(b) .
Landmark Case: Ernst & Ernst v. Hochfelder1
Facts: For 19 years, Ernst & Ernst audited a small brokerage firm, First Securities Company of
Chicago (First Securities). Leston B. Nay was president of the firm and owned 92percent of its stock.
He convinced some customers to invest funds in “escrow” accounts that would yield a high rate of
return. And, indeed, from 1942 through 1966, they did. The investments were unusual in that the
customers wrote their checks to Nay personally, not to First Securities. None of these escrow accounts
appeared in First Securities’ records.
As you perhaps have guessed, there were no escrow accounts. Nay was spending the customers’
money on himself. The fraud came to light when Nay killed himself, leaving a note that described First
Securities as bankrupt and the escrow accounts as “spurious.”
In investigating the fraud, customers discovered that Nay had had a rigid rule prohibiting anyone else
from ever opening mail addressed to him, even if it arrived in his absence. The customers alleged that if
Ernst had done a proper audit, they would have found out about this mail rule which would have led to
an investigation of Nay and discovery of the fraud.
The customers filed suit against Ernst under §10(b). The accounting firm filed a motion for summary
judgment, alleging that liability under §10(b) requires scienter, that is, an intent to deceive, manipulate,
or defraud. Ernst admitted that it had been negligent but denied any intentional wrongdoing. The trial
court granted Ernst’s motion, the Court of Appeals reversed and the Supreme Court granted certiorari.
Issue: Was Ernst liable under §10(b) when it acted negligently but not intentionally?
Excerpts from Justice Powell’s Decision: Section 10(b) makes unlawful the use or employment of
“any manipulative or deceptive device or contrivance” in contravention of Commission rules. The
words “manipulative or deceptive” used in conjunction with “device or contrivance” strongly suggest
that § 10 (b) was intended to proscribe knowing or intentional misconduct. In view of the language of §
10 (b), which so clearly connotes intentional misconduct, and mindful that the language of a statute
controls when sufficiently clear in its context, further inquiry may be unnecessary.
We turn now, nevertheless, to the legislative history of the 1934 Act. The most relevant exposition of
the provision that was to become § 10 (b) was by Thomas G. Corcoran, a spokesman for the drafters.
Corcoran indicated: § 10 (b) says, “Thou shalt not devise any other cunning devices. The Commission
should have the authority to deal with new manipulative devices.” It is difficult to believe that any
lawyer, legislative draftsman, or legislator would use these words if the intent was to create liability
for merely negligent acts or omissions.
Holding: The judgment of the Court of Appeals is Reversed.
Question: What was the result for Ernst?
1 425 U.S. 185; 96 S. Ct. 1375; 1976 U.S. LEXIS 2, Supreme Court of The United States, 1976
Gould v. Winstar Communs., Inc.
Facts: Grant Thorton (GT) audited Winstar, a broadband communications company that provided
businesses with wireless Internet connectivity. Winstar was one of GT’s largest and most important
clients, but only 12 percent of the company’s fees came from auditing; the rest were for consulting
projects. Winstar asked that the partner in charge of its audit be replaced and also threatened to fire GT.
In response, Winstar assigned two auditors who had no experience with telecommunication companies.
When Winstar’s real revenues fell, it began to report fake ones. For example, at the end of the fiscal
year. It reported that a large percentage of its revenue was from equipment sales to Lucent
Technologies, a strategic partner. Equipment sales were not part of Winstar’s core business and there
was little documentation that these sales had taken place. Winstar also reported revenue for a
feasibility study for Lucent, which had not yet been performed and promotional credits purchased by
Lucent for services not yet rendered. Rahter than spreading out the revenue over the life of various
leases, it reported most revenue when the document was signed. It also engaged in round-trip
transactions in which it overpaid other companies for goods and services and, in return, those
companies bought unneeded equipment from Winstar. These transactions were material to Winstar’s
results.
These practices violated GAAP and SEC rules. At first, GT warned that the transactions were red flags
and warranted further examination. But GT ultimately allowed the revenues and issued an unqualified
audit opinion. A year later, Winstar filed for bankruptcy protection.
Companies that had purchased stock in Winstar after GT issued its clean opinion filed suit against the
accounting firm alleging securities fraud under 10(b) GT filed a motion for summary judgment , which
the trial court granted on the grounds that the firm had not acted with scienter. Plantiffs appealed.
Issues: Did GT violate 10(b)? Was there scienter?
Excerpts from Judge Lohier’s Decision: Plantiffs may satisfy the scienter requirement by producing
evidence of conscious misbehavior or recklessness. Scienter based on conscious misbehavior, in turn,
requires a showing of deliberate illegal behavior, a standard met when it is clear that a scheme, viewed
broadly, is necessarily going to injure. Scienter based on recklessness may be demonstrated where a
defendant has engaged in conduct that was highly unreasonable, representing an extreme departure
from the standards of ordinary care to the extent that the danger was either known to the defendant or
so obvious that the defendant must have been aware of it. Recklessness may be established where a
defendant failed to review or check information that it had a duty to monitor, or ignored obvious signs
of fraud.
Some evidence supports the Plantiff’s contention that GT consciously ignored Winstar’s fraud when it
approved Sinstar’s recognition of revenue for the suspicious transactions. This evidence goes beyond a
mere failure to uncover the accounting fraud. There is also evidence that GT failed to confirm Winstar’s
representations regarding these transactions or to retain and review documents evidencing each
transaction.
Broadly speaking, there was admissible evidence that in the course of its audit GT learned of and
advised against the use of indisputably deceptive accounting schemes, but eventually acquiesced in the
schemes by issuing an unqualified audit opinion. St this stage, the Plantiffs have proffered enough facts
constituting evidence of conscious misbehavior or recklessness to survive summary judgment.
We note that in granting summary judgment in GT’s favor, the District Court placed particular
emphasis on the magnitude of GT’s audit work, bothi in time spent and documents reviewed. The
number of hours spent on an audit cannot, standing alone, immunize an accountant from charges that it
has violated the securities laws.
A jury reasonably could determine that the audit was so deficient as to be an extreme departure from
the standards of ordinary care to the extent that the danger was either known to GT or so obvious that
GT must have been aware of it.
For the foregoing reasons, we VACATE the District Court’s grant of summary judgment, and we
REMAND for further proceedings.
Criminal Liability
Additional Case: Arthur Andersen LLP v. United States2
Facts: Arthur Andersen audited Enron Corporation’s financial statements. When Enron’s financial and
accounting problems began to surface at the beginning of August, a senior accountant at Enron told two
Andersen partners that Enron could face severe accounting scandals. Shortly thereafter, the SEC
opened an informal investigation. Early in October, Nancy Temple, a lawyer at Andersen, realized that
an SEC investigation was highly probable. A few days later, at a general training meeting attended by
89 employees, including 10 from the Enron engagement team, Odom, an Anderson partner, urged
everyone to comply with the firm’s document retention policy. He added: “If it’s destroyed in the
course of the normal policy and litigation is filed the next day, that’s great . . . . We’ve followed our
own policy, and whatever there was that might have been of interest to somebody is gone and
irretrievable.” Three times that month, Temple reminded Andersen employees to follow the document
retention policy. Andersen employees did indeed destroy a substantial number of paper and electronic
documents. At a meeting on October 31, Duncan picked up a document with the words “smoking gun”
written on it and began to destroy it, adding “we don’t need this.”
On October 30, the SEC opened a formal investigation and sent Enron a letter that requested
accounting documents. In November, the SEC served Enron and Andersen with subpoenas for records.
Duncan’s assistant then sent an e-mail that stated: “Per Dave -- No more shredding . . . . We have been
officially served for our documents.”
Andersen was indicted for obstruction of justice, that is, intentionally persuading its employees to
withhold documents from an official proceeding. A jury returned a guilty verdict. The Court of
Appeals affirmed and the Supreme Court granted certiorari.
Issue: Did Andersen employees commit a crime when they destroyed Enron documents?
Holding: Conviction of Andersen reversed. Document retention policies are legal, even though they
are designed to keep information from falling into the hands of others, including the government. To
violate the law, Andersen had to know that what it did was illegal. Instead, the jury was told that, “even
if [Andersen] honestly and sincerely believed that its conduct was lawful, you may find [Andersen]
guilty.” And there also had to be some evidence that Andersen was aware of a particular proceeding,
not just aware of the general possibility that there might be a proceeding.
Question: What did Andersen do that upset government prosecutors?
Question: Why did it destroy documents?
Question: Did it know that the government would prosecute it or Enron?
Question: How did Andersen decide which documents to destroy?
Question: Is a document retention policy illegal?
Question: What is illegal, then?
2 125 S. Ct. 2129; 2005 U.S. LEXIS 4348 Supreme Court of the United States, 2005
Question: Was this result important for Andersen?
Answer: It was undoubtedly a relief to have the criminal conviction overturned, but the firm had
Other Accountant-Client Issues
The Accountant-Client Relationship
SEC rules of practice specify that an accountant who engages in “unethical or improper professional
conduct” may be banned from practice before the SEC.
Additional Case: Potts v. Securities and Exchange Commission3
Robert D. Potts was a partner at Deloitte & Touche. He served as the concurring partner for audits of
Kahler Corp. Kahler owned the University Park hotel, which it listed in its financial statements as “an
asset held for sale” although the hotel did not meet these standards. As a result, one year Kahler
showed a net gain instead of a $1 million loss, and the next year its loss was $1.8 million instead of
$2.8 million. Potts knew that this property did not meet the standards necessary to count as an asset
held for sale. On Potts’s suggestion, the lead auditor met with Kahler’s internal audit committee, and
afterwards assured Potts that Kahler was committed to meeting the necessary standards. Potts made
no further investigation and signed off on the Kahler audits. When the SEC discovered what Potts had
done, it suspended him from practice before the agency. Potts appealed.
Holding: Potts’s suspension was upheld. Kahler’s accounting treatment of the hotel made all the
difference between showing a profit and showing a loss. Despite this importance, and despite signals
that Kahler’s treatment of the hotel was suspect, Potts approved the audits. The court held that Potts’s
conduct amounted to an egregious refusal to see the obvious, or to investigate the doubtful.
Question: Was Potts responsible for the Kahler audit?
Question: Did he know there was a problem with the Kahler audit?
Question: Why would the company want to do that?
Question: What did Potts do?
Question: What else did he do?
Question: What should Potts have done?
Answer: He should have kept checking until he was satisfied that Kahler officers had actually done
Question: Why was Potts so careless?
General Question: Do you agree with the court’s decision?
3 151 F3rd 810, 1998 U.S. App. LEXIS 17831 Court of Appeals for the Eighth Circuit, 1998
Accountant-Client Privilege
Some states recognize an accountant-client privilege. The following case reveals some of the contours
of this privilege.
Additional Case: McNair v. The Eighth Judicial District Court4
A court in Nevada entered an award in favor of Mark and Janet Brandell for $435,066.82 against United
Productions, Inc. (UP) and Harry R. Jones. When UP and Jones failed to pay the judgment, the court
ordered both of them to appear and answer questions concerning their property. Neither obeyed the
order. In an attempt to execute the judgment, the Brandells subpoenaed Sharon J. McNair, who had
worked as an accountant for both UP and Jones for 15 years. McNair appeared but refused, on the
grounds of accountant-client privilege, to answer the following questions:
In the course of your duties as an accountant for UP did you prepare tax returns?
What type of work did you do for UP from the mid 1980s to the present?
What type of accountant work did you do for Jones from 1980 to the present?
Do you have any tax returns for UP?
Have you prepared tax returns for UP from the mid-1980s to the present?
Do you have in your possession tax returns for UP from the mid-1980s to the present?
What is the most recent tax return you prepared for UP?
What is the most recent tax return you have prepared for Jones?
Do you handle the banking for UP?
Do you handle the banking for Jones?
What documents do you have in your possession regarding accounting records of UP?
Have you ever prepared any accounts receivable for UP?
Have you ever prepared any accounts receivable ledgers for UP?
Have you ever prepared any accounts receivable ledgers for Jones?
Do you have in your possession any documents reflecting the sale of any assets of UP?
Within the last five years to your knowledge has UP sold any of its assets?
Is UP still in existence to your knowledge?
Is Jackie Do Los Reyes still a stockholder of UP?
Who are the stockholders of UP?
Have you ever prepared any financial statements for UP?
Have you ever prepared any financial statements for Jones?
The district court held McNair in contempt, and she appealed.
Issue: Are the answers to any of these questions protected by the accountant-client privilege?
Holding: The Nevada Supreme Court held that McNair was in contempt. The purpose of the
accountant-client privilege is to ensure an atmosphere wherein the client will transmit all relevant
information to his accountant without fear of any future disclosure in subsequent litigation. To claim
this privilege, McNair had to show that the information was confidential and not accessible to the
public, which she did not do. Most of the questions could have been answered by a simple “yes” or
“no.”
Question: What is the purpose of the accountant-client privilege?
Question: Does the accountant-client privilege mean that an accountant cannot disclose anything
her client tells her?
Question: To which of the questions in the case should the privilege extend?
4 110 Nev. 1285, 885 P.2d 576, 1994 Nev. LEXIS 157 Supreme Court of Nevada, 1994
Multiple Choice Questions
1. CPA QUESTION A CPA’s duty of due care to a client most likely will be breached when a CPA:
(a) Gives a client an oral instead of a written report
(b) Gives a client incorrect advice based on an honest error judgment
(c) Fails to give tax advice that saves the client money
(d) Fails to follow GAAS
2. CPA QUESTION One of the elements necessary to hold a CPA liable to a client for conducting
an audit negligently is that the CPA:
(a) Acted with scienter or guilty knowledge
(b) Was a fiduciary of the client
(c) Failed to exercise due care
(d) Executed an engagement letter
3. One of the elements necessary to hold a CPA liable under §10(b) is that the CPA
(a) Acted with scienter or guilty knowledge
(b) Was a fiduciary of the client
(c) Failed to exercise due care
(d) Executed an engagement letter
4. An accountant has a fiduciary duty:
(a) To a client when conducting an audit
(b) To an investor who buys stock in company the accountant has audited
(c) To any third party that the accountant knows will be relying on an audit
(d) Only for services that go beyond routine accounting work
5. Accountants who commit fraud in the preparation of financial statements are liable to any third
party who uses those statements if:
(a) That person is a foreseeable user
(b) The accountant knows that person’s identity
(c) It is foreseeable that that person will receive the financial statements
(d) That person is in the same class as someone who the accountant knew would rely on the
statements
Case Questions
1. ETHICS Wayne and Arlene Selden invested in Competition Aircraft, a fraudulent company that
pretended to sell airplanes. After the company went bankrupt, the Seldens sought to recover from
accountant William Burnett. He had recommended the investment to several of his clients, who
communicated his recommendation to the Seldens. The Seldens were not Burnett’s clients. The
court adopted the Restatement doctrine. Is Burnett liable? Whether or not Burnett faces legal
liability, was it a good idea for him to recommend investments to his clients? Does it create any
potential conflicts of interest?
2. After reviewing Color-Dyne’s audited financial statements, the plaintiffs provided materials to the
company on credit. These financial statements showed that Color-Dyne owned $2 million in
inventory. The audit failed to reveal, however, that various banks held secured interests in this
inventory. The accountant did not know that the company intended to give the financial statements
to plaintiffs or any other creditors. Color-Dyne went bankrupt. Is the accountant liable to plaintiffs
under the Restatement doctrine?
3. You Be the Judge: WRITING PROBLEM Penelope purchased securities offered
by Hughes Homes, Inc., which sold manufactured housing. During its audit, Deloitte found that
the internal controls of Hughes had flaws. As a result, the accounting firm adjusted the scope of its
audit to perform independent testing to verify the accuracy of the company’s financial records.
Satisfied that the internal controls were functional, Deloitte issued a clean opinion. After Hughes
became insolvent, Penelope sued Deloitte for violating §11 of the 1933 Act. She alleged that
Deloitte’s failure to disclose that it had found flaws in Hughes’s internal control system was a
material omission. GAAS did not require disclosure. Is Deloitte liable? Argument for the
Penelope: Under §11, auditors are liable for any material omission. If Penelope had known about
the flaws in the internal controls, she would never have invested. Argument for Deloitte: This
omission could not be material if GAAS does not require it to be reported.
Answer: Deloitte was not liable because GAAS did not require it to disclose the flaws.
4. The British Broadcasting Corp. (BBC) broadcast a TV program alleging that Terry Venables, a
former professional soccer coach, had fraudulently obtained a £1 million loan by misrepresenting
the value of his company. Venables had been a sportscaster for the BBC but had switched to a
competing network. The source of the BBC’s story was “confidential working papers” from
Venables’s accountant. According to the accountant, the papers had been stolen. Who owns these
working papers? Does the accountant have the right to disclose the content of working papers?
Answer: Although, in theory, the accountant owns the working papers, he may not disclose
5. Medtrans, an ambulance company, was unable to pay its bills. In need of cash, it signed an
engagement letter with Deloitte to perform an audit that could be used to attract investors.
Unfortunately, the audit had the opposite effect. The unaudited statements showed earnings of $1.9
million, but the accountants calculated that the company had actually lost about $500,000. While in
the process of negotiating adjustments to the financials, Deloitte resigned. Some time passed before
Medtrans found another auditor, and, in that interim, a potential investor withdrew its $10 million
offer. Is Deloitte liable for breach of contract?
Answer: Although a jury found for the plaintiffs, the court of appeals overruled, holding that an
Discussion Questions
1. Should the IFRS be adopted in the United States?
2. Are the SOX rules on consulting services sufficiently strict? Should auditing firms be prohibited
from performing any consulting services to companies that they audit?
3. 3.Which of the three negligence doctrines—Ultramares, Foreseeable or Restatement— is the most
reasonable and appropriate?
4. Accountants do not have a fiduciary duty to their clients when performing accounting services. Why
not?
5. -Under the 1934 Act, accountants are only liable if they act with scienter. Make an argument that
they should be liable for negligence. What do you think is the right standard?
