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Business Law Chapter 47 Homework Sought Outside Investors Including David Overton

Page Count
13 pages
Word Count
8486 words
Book Title
Business Law: Text and Cases 14th Edition
Authors
Frank B. Cross, Kenneth W. Clarkson, Roger LeRoy Miller
1
Chapter 47
Professional Liability and Accountability
INTRODUCTION
This chapter gives an overview of the standards imposed on accountants and auditors, as well as other
professionals, and should be of great interest to students planning to sit for the Certified Public Accountant (CPA)
exam. Professionals have found themselves increasingly subject to liability over the past decade. The legal
responsibility of auditors, in particular, has been a subject in recent cases and legislation, which this chapter
discusses, and any changes in this liability in your jurisdiction should be brought to the attention of those students
who may be preparing for a career in accounting. This chapter considers the potential common law liability of
professionals to clients and to third persons, the potential liability of accountants under securities laws and the
Internal Revenue Code, and the relationship of professionals with their clients.
CHAPTER OUTLINE
I. Potential Liability to Clients
Professionals may be liable for breach of contract, negligence, or fraud.
A. LIABILITY FOR BREACH OF CONTRACT
A professional owes a duty to his or her client to honor the terms of their contract and to perform the
contract within the stated time period. If the professional fails to perform, he or she may be held liable for
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expenses incurred by the client to secure another professional to provide the services, for penalties
imposed on the client for failure to meet time deadlines, and so on.
B. LIABILITY FOR NEGLIGENCE
All professionals are subject to standards of conduct established by codes of professional ethics, by state
statutes, and by judicial decisions. In their performance of contracts, professionals must exercise the
established standard of care, knowledge, and judgment generally accepted by members of their
professional group.
1. Accountant’s Duty of Care
The text discusses accountants’ duty in the context of their role in business financial systems.
a. GAAP and GAAS
An accountant who complies with generally accepted accounting principles (GAAP) and
generally accepted auditing standards (GAAS) will not be liable to a client for incorrect
judgment. A violation of GAAP and GAAS is prima facie evidence of negligence.
But compliance does not necessarily relieve an accountant of liabilityhe or she may be held
to a higher standard established by state statute and by judicial decisions.
b. Global Accounting Rules
The Securities and Exchange Commission requires U.S. companies to replace GAAP rules
with the International Financial Reporting Standards (IFRS) established by the International
Accounting Standards Board.
The IFRS are simpler, broader, and more straightforward. Many countries already use the
IFRS, which thus makes financial reporting standards more uniform.
c. Discovering Improprieties
An accountant who uncovers suspicious financial transactions and fails to investigate the matter
fully or to inform his or her client of the discovery can be held liable to the client for the resulting
loss.
d. Audits
An accountant may be liable for failing to detect misconduct that a normal audit would have
revealed.
e. Qualified Opinions and Disclaimers
An auditor is not liable for damages resulting from whatever is specifically qualified or disclaimed.
f. Unaudited Financial Statements
A lesser standard of care is typically required for an unaudited financial statement. An
accountant may be subject to liability, however, for failing, in accordance with standard
accounting procedures, to delineate a balance sheet as “unaudited.” An accountant will also be
held liable for failing to disclose facts or circumstances that give reason to believe misstatements
have been made or fraud has been committed.
g. Defenses to Negligence
Possible defenses include
The accountant was not negligent.
The accountant’s negligence, if any, was not the proximate cause of the client’s loss.
The client was also negligent (depending on whether state law allows contributory negligence
as a defense).
2. Attorney’s Duty of Care
The conduct of attorneys is governed by rules established by each state and by the American Bar
Association’s Code of Professional Responsibility and Model Rules of Professional Conduct.
a. Standard of Care
In judging an attorney’s performance, the standard used is normally that of a reasonably
competent general practitioner of ordinary skill, experience, and capacity.
b. Misconduct
A criminal act that reflects adversely on a person’s “honesty or trustworthiness, or fitness as a
lawyer” is professional misconduct.
c. Liability for Malpractice
When an attorney fails to exercise reasonable care and professional judgment, he or she
breaches the duty of care and may be liable for malpractice.
ADDITIONAL BACKGROUND
Attorney’s Duty of Care
The conduct of attorneys is governed by state law and, where adopted, by American Bar Association
rules relating to professional responsibility. The following is selected from the preamble to the American Bar
Association Model Rules of Professional Conduct.
PREAMBLE: A LAWYER’S RESPONSIBILITIES
A lawyer is a representative of clients, an officer of the legal system and a public citizen having special
responsibility for the quality of justice.
As a representative of clients, a lawyer performs various functions. As advisor, a lawyer provides a client
with an informed understanding of the client’s legal rights and obligations and explains their practical
implications. As advocate, a lawyer zealously asserts the client’s position under the rules of the adversary
system. As negotiator, a lawyer seeks a result advantageous to the client but consistent with requirements of
honest dealing with others. As intermediary between clients a lawyer seeks to reconcile their divergent
interests as an advisor and, to a limited extent, as a spokesman for each client. A lawyer acts as evaluator by
examining a client’s legal affairs and reporting about them to the client or to others.
In all professional functions a lawyer should be competent, prompt and diligent. A lawyer should maintain
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communication with a client concerning the representation. A lawyer should keep in confidence information
relating to representation of a client except so far as disclosure is required or permitted by the Rules of
Professional Conduct or other law.
A lawyer’s conduct should conform to the requirements of the law, both in professional service to clients
and in the lawyer’s business and personal affairs. A lawyer should use the law’s procedures only for
legitimate purposes and not to harass or intimidate others. A lawyer should demonstrate respect for the legal
system and for those who serve it, including judges, other lawyers and public officials. While it is a lawyer’s
duty, when necessary, to challenge the rectitude of official action, it is also a lawyer’s duty to uphold legal
process.
As a public citizen, a lawyer should seek improvement of the law, the administration of justice and the
quality of service rendered by the legal profession. As a member of a learned profession, a lawyer should
cultivate knowledge of the law beyond its use for clients, employ that knowledge in reform of the law and work
to strengthen legal education. A lawyer should be mindful of deficiencies in the administration of justice and
of the fact that the poor, and sometimes persons who are not poor, cannot afford adequate legal assistance,
and should therefore devote professional time and civic influence in their behalf. A lawyer should aid the legal
profession in pursuing these objectives and should help the bar regulate itself in the public interest.
Many of a lawyer’s professional responsibilities are prescribed in the Rules of Professional Conduct, as
well as substantive and procedural law. However, a lawyer is also guided by personal conscience and the
approbation of professional peers. A lawyer should strive to attain the highest level of skill, to improve the law
and the legal profession and to exemplify the legal profession’s ideals of public service.
* * * *
Lawyers play a vital role in the preservation of society. The fulfillment of this role requires an un-
derstanding by lawyers of their relationship to our legal system. The Rules of Professional Conduct, when
properly applied, serve to define that relationship.
C. LIABILITY FOR FRAUD
1. Actual Fraud
A professional may be held liable for actual fraud when he or she intentionally misstates a material
fact to mislead his or her client and the client justifiably relies on the misstated fact to his or her injury.
2. Constructive Fraud
In contrast, a professional may be held liable for constructive fraud whether or not he or she acted
with fraudulent intent. The intentional failure to perform a duty in reckless disregard of the
consequences would constitute gross negligence on the part of a professional.
II. Potential Liability to Third Parties
Many third parties (investors, shareholders, creditors, managers, directors, regulatory agencies, and
others) rely on professional opinions, such as those of auditors. In this light, many courts have all but
abandoned the privity requirement in regard to accountants’ liability to third parties.
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 5
When a business fails, its independent auditor may be one of the few potentially solvent defendants.
Most courts hold auditors liable to third parties for negligence, but the standard for imposing this liability
varies.
A. THE ULTRAMARES RULE
In Ultramares Corp. v. Touche, the New York Court of Appeals concluded that accountants owe a duty of
care only to those persons for whose “primary benefit” financial statements are intended.
1. The Requirement of Privity
Under the Ultramares rule, in the absence of privity or a relationship “so close as to approach that of
privity,” a party cannot recover from an accountant.
2. Modifications to Allow Near Privity
The rule was modified in Credit Alliance Corp. v. Arthur Andersen & Co., in which the New York Court
of Appeals held that if a third party has a sufficiently close relationship or nexus (link or connection)
with an accountant, then the Ultramares privity requirement may be satisfied without establishing an
accountant-client relationship. This is a minority rule.
B. THE RESTATEMENT RULE
Most courts have adopted the position of the Restatement (Second) of Torts, Section 552(2)
accountants are subject to liability for negligence not only to their clients but also to foreseen, or known,
users or classes of users of their reports or financial statements. Liability extends to
Those persons for whose benefit and guidance an accountant “intends to supply the information or
knows that the recipient intends to supply it.”
Those persons whom an accountant “intends the information to influence or knows that the recipient
so intends.”
C. THE “REASONABLY FORESEEABLE USERS RULE
A few courts hold accountants liable to any users whose reliance on an accountant’s statements or
reports was reasonably foreseeable. Criticism of this view and support for the view of the majority of the
courts is that the Restatement’s approach is more reasonable because it allows accountants to control
their exposure to liability.
D. LIABILITY OF ATTORNEYS TO THIRD PARTIES
Like accountants, attorneys may also be held liable under the common law to third parties who rely on
legal opinions to their detriment. The principles stated in Section 552 of the Restatement (Second) of
Torts may apply to attorneys just as they may apply to accountants.
CASE SYNOPSIS
Case 47.1: Perez v. Stern
Domingo Martinez died in a hit-and-run accident. Reyna Guido—the mother of Martinez’s two children,
including Esteban Perez, the named plaintifffiled a wrongful death suit in a Nebraska state court through
attorney Sandra Stern. Stern neglected to perfect service within the required time, however, and the suit was
dismissed. Guido filed malpractice claims on behalf of herself, the children, and Martinez’s estate in a
Nebraska state court against Stern. The court issued a judgment in Stern’s favor on the ground that the
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claims were time barred. Guido appealed.
The Nebraska Supreme Court affirmed the dismissal of Guido’s and the estate’s claimsthey were time
barred—but reversed and remanded with respect to the children. “A lawyer owes a duty to his or her client to
use reasonable care and skill in the discharge of his or her duties, but ordinarily this duty does not extend to
third parties, absent facts establishing a duty to them.” Here, the facts established that “Stern owed a duty to
the children, as direct and intended beneficiaries of her services, to competently represent their interests. . . .
Therefore, they have standing to sue Stern for neglecting that duty and their claims against Stern were tolled
by their minority.”
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Notes and Questions
How might Stern, or anyone in a similar position, have avoided the negative result in this case?
The circumstances here give support to the warning that an attorneyor any professionalshould take steps
to be reminded of deadlines and other important procedural details on their clients’ behalf and the legal
consequences of failing to meet those requirements. The attorney at the center of this case might have
avoided the negative result if she had used something as simple as software on her office computer, or a
calendar in her personal digital assistant, or a paper stock calendar with filled-in information on her office wall,
or even an office administrator who might have kept track of important dates
The standards for defining professional misconduct appear to focus on an act’s impact on third
parties rather than its effect on the professional. Is this the appropriate focus? Why or why not? Yes,
this is the appropriate focus because the protection of the public is the purpose of, and the reason for, the
rules of professional conduct. No, this is not the right focus, although innocent third parties should be made
“whole” if possible, because wrongdoers must also be transformed to conduct themselves properly for their
own “good.”
Should a professional’s misbehavior be considered a violation of the rules of professional
conduct even if he or she is not, for example, convicted of a crime? Yes, and it generally is. Thus, an
attorney's criminal act can support a violation of the rule of professional conduct prohibiting a lawyer from
committing a criminal act that reflects adversely on the lawyer's honesty, trustworthiness, or fitness as a
lawyer, even if the attorney is never charged or convicted. This rule does not require a connection between
the act and any legal services that the lawyer renders. And a criminal act can reflect adversely on a lawyer's
fitness, in violation of the rules, even if the act does not cause the attorney to provide deficient legal services.
For instance, an attorney’s use of drugs during a client’s trial would be a transgression even if the attorney
otherwise represented the client adequately.
ADDITIONAL CASES ADDRESSING THIS ISSUE
Potential Liability to Third Parties
Cases considering professionals’ liability to foreseen or known users include the following.
NationsBank, N.A. v. KPMG Peat Marwick LLP, 813 So.2d 964 (Fla.App. 4 Dist., 2002) (a borrower's
accounting firm could be liable to the lenders on a theory of negligent misrepresentation following the
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 7
borrower’s default, when the firm knew that the annual financial statements prepared for the borrower were
relied on by the lenders in making their decisions concerning the borrower's credit).
North American Specialty Insurance Co. v. Lapalme, 258 F.3d 35 (1st Cir. 2001) (a negligent-
misrepresentation claim against an accounting firm failed because there was no evidence that the firm had
any actual knowledge that the plaintiff would rely on financial statements in undertaking future transactions
that were substantially similar to ongoing transactions known to the defendants).
Glenn K. Jackson, Inc. v. Roe, 273 F.3d 1192 (9th Cir. 2001) (a law firm was not a third-party beneficiary
of an agreement between the firm’s client and its accountants and thus could not recover from the
accountants under a theory of negligent misrepresentation).
Reisman v. KPMG Peat Marwick LLP, 57 Mass.App.Ct. 100, 781 N.E.2d 821 (2000) (an accounting firm
was not liable to shareholders, who acquired their stock in pooling-of-interests transactions, for negligent
misrepresentations in the corporation's Securities and Exchange Commission report, when the report
contained no signature, opinion, representation, or statement of the accounting firm, even though the firm
instructed the corporation on how to report financial transactions and reviewed, edited, and helped prepare
the information reported).
III. The Sarbanes-Oxley Act of 2002
This act imposes requirements on a public accounting firm that provides auditing services to an issuer (a
company that has securities registered under Section 12 of the Securities Exchange Act of 1934; that is
required to file reports under Section 15(d) of the 1934 act; or that files, or has filed, a registration statement
not yet effective under the Securities Act of 1933).
A. THE PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
This board, which reports to the Securities and Exchange Commission, oversees the audit of public
companies subject to securities laws to protect public investors and ensure that public accounting firms
comply with the provisions of the Act.
B. KEY PROVISIONS OF THE SARBANES-OXLEY ACT RELATING TO PUBLIC ACCOUNTING FIRMS
Public accounting firms are firms and associated persons that are “engaged in the practice of public
accounting or preparing or issuing audit reports.”
1. Auditor Independence
It is unlawful to perform for an issuer both audit and nonaudit services, which include
bookkeeping for an audit client, financial systems design and implementation, appraisal
services, fairness opinions, management functions, and investment services.
A public accounting firm cannot provide audit services to an issuer if the lead audit partner or
the reviewing partner provided those services to the issuer in each of the prior five years.
Reports to an issuer’s audit committee must be timely and indicate critical accounting policies
and practices, as well as alternatives discussed, and other communications, with the issuer’s
management.
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A public accounting firm cannot provide audit services to an issuer if the issuer’s chief
executive officer, chief financial officer, chief accounting officer, or controller worked for the
auditor and participated in an audit of the issuer within the preceding year.
2. Document Destruction
The act prohibits destroying or falsifying records to obstruct or influence a federal investigation or in
relation to a bankruptcy. Penalties include fines and imprisonment up to twenty years.
3. Document Retention
Accountants who audit or review publicly traded companies must retain the working papers related
to the audit or review for seven years . Penalties include fines and imprisonment up to ten years.
C. REQUIREMENTS FOR MAINTAINING WORKING PAPERS
Under the common law (codified in a number of states), working papers remain the accountant’s
property. It is important to retain them in the event of a suit for negligence or other action in which the
accountant’s competence is challenged.
The client has a right of access to the papers and must give permission before they can be
transferred to another accountant. Also, without the client’s permission or a valid court order,
disclosure of their contents would breach the accountant’s fiduciary duty to the client.
Accountants must keep working papers for as long as five years from the end of the fiscal period to
which the papers applied, subject to a possible fine and imprisonment.
IV. Potential Liability of Accountants under Securities Laws
A. LIABILITY UNDER THE SECURITIES ACT OF 1933
Accountants often prepare and certify an issuer’s financial statements that are included in a registration
statement under the Securities Act of 1933 (discussed in Chapter 42).
1. Liability under Section 11
An accountant may be held civilly liable if he or she prepared any financial statements in-
cluded in a registration statement that “contained an untrue statement of a material fact or
omitted to state a material fact required to be stated therein or necessary to make the
statements therein not misleading” [15 U.S.C. Section 77k(a)].
Liability extends to anyone who acquires a security covered by the registration statement. No
proof of reliance or privity is required.
a. The Due Diligence Standard
If a purchaser proves a loss on a security, to avoid liability an accountant must show that
he or she exercised due diligence in preparing the financial statements.
Due diligence means an accountant had, “after reasonable investigation, reasonable
grounds to believe and did believe, at the time such part of the registration statement
became effective, that the statements therein were true and that there was no omission
of a material fact required to be stated therein or necessary to make the statements
therein not misleading” [15 U.S.C. Section 77k(b)(3)].
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Proof of following generally accepted standards is proof of due diligence.
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b. Defenses to Liability
Besides proving that he or she has acted with due diligence, an accountant may raise the
following defenses to Section 11 liability
There were no misstatements or omissions.
Any misstatements or omissions were not of material facts.
Any misstatements or omissions had no causal connection to the plaintiff’s loss.
The plaintiff invested in the securities aware of the misstatements or omissions.
2. Liability under Section 12(2)
Civil liability for fraud may be based on a communication to an investor (orally or in a pro-
spectus, of an untrue statement or omission of a material fact.
Some courts have applied Section 12(2) to accountants who aided and abetted the seller or
the offeror of the securities in violating Section 12(2) (that is, if the accountant knew, or should
have known, that an untrue statement or omission of material fact existed in the offer or sale).
Penalties and sanctions include fines up to $10,000, imprisonment up to five years, injunc-
tions, and orders to refund profits.
B. LIABILITY UNDER THE SECURITIES EXCHANGE ACT OF 1934
Under Sections 18 and 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 of the Securities
and Exchange Commission, an accountant may be held liable for fraud. Here, however, an accountant
need not prove due diligence to escape liability.
1. Liability under Section 18
An accountant who makes or causes to be made in any application, report, or document a
statement that, at the time and in light of the circumstances, was false or misleading with respect to
any material fact may be civilly liable [15 U.S.C. Section 78r(a)]. Liability extends only to sellers or
purchasers who must prove
The statement affected the price of the security.
He or she relied on the statement in making the purchase or sale and was not aware of its
inaccuracy.
a. Good Faith Defense
An accountant can be exonerated on proof of good faith in the preparation of a financial
statement.
b. Other Defenses
In addition to a good faith defense, accountants can claim the buyer or seller knew the
statement was false and misleading.
2. Liability under Section 10(b) and Rule 10b-5
a. Prohibited Conduct
Section 10(b) makes it unlawful for a person to use, in connection with the purchase or sale of
a security, a manipulative or deceptive device or contrivance in contravention of SEC rules.
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 11
Rule 10b-5 makes it unlawful for a person to, by use of a means or instrumentality of interstate
commerce, to
Employ a device, scheme, or artifice to defraud.
Make an untrue statement of a material fact or omit to state a material fact necessary to
make statements made, in the circumstances, not misleading.
Engage in an act, practice, or course of business that operates or would operate as a
fraud or deceit on a person in connection with the purchase or sale of a security.
b. Extent of Liability
Accountants may be liable only to sellers or purchasers under Section 10(b) and Rule
10b-5. Privity is not necessary.
Liability may be imposed for fraudulent misstatements in written material filed with the
SEC and for fraudulent oral statements or omissions made in connection with the
purchase or sale of any security.
Ordinary negligence is not enough. A plaintiff must prove scienter.
CASE SYNOPSIS
Case 47.2: Overton v. Todman & Co., CPAs, P.C.
Todman & Co., CPAs, P.C., audited the financial statements of Direct Brokerage, Inc. (DBI), issuing
unqualified opinions that the statements were accurate. Despite the certifications, Todman made significant
errors that concealed DBI's largest liabilityits payroll taxesin two audits. The errors came to light when it
became clear that the company had not filed or paid its payroll taxes for those two years. Owing more than $3
million in unpaid taxes, interest, and penalties, DBI sought outside investors, including David Overton, who
relied on DBI’s statements and Todman’s opinions to invest. When DBI collapsed, Overton and others filed a
suit in a federal district court against Todman, asserting fraud under Section 10(b) and Rule 10b-5. The court
dismissed the complaint. The plaintiffs appealed.
The U.S. Court of Appeals for the Second Circuit held the accountant liable, vacated the dismissal, and
remanded. When an accountant issues a certified opinion, it creates a special relationship with investors.
Thus, accountants have a duty to take reasonable steps to correct misstatements that they discover in
previous financial statements on which they know the public is relying. Silence in this situation can constitute
a false or misleading statement under Section 10(b) and Rule 10b-5.
..................................................................................................................................................
Notes and Questions
Does an accountant have a duty not only to correct prior certified statements, but also a duty to
update those statements? The court explained, “The duty to correct requires only that the accountant
correct statements that were false when made. In contrast, the duty to update requires an accountant to
correct a statement made misleading by intervening events, even if the statement was true when made.” In at
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least one case, it has been noted that in some circumstances, “an issuer may have a duty to update opinions
and projections . . . if the original opinions or projections have become misleading as the result of intervening
events.” The court here commented, however, that “[o]n the facts of this case, we need not, and do not, reach
the issue of whether an accountant has a duty to update.”
Does an accountant have a duty to correct more than those statements on which it certified an
opinion? No, held the court in this case. “[A]n accountant need correct only those particular statements set
forth in its opinion and/or the certified financial statements. . . . [A]n accountant is under no duty to divulge
information collateral to the statements of accuracy and financial fact set forth in its opinion and the certified
financial statements, respectively.”
Apart from issuing a certified opinion, are there other ways in which an accountant creates a duty
to disclose certain facts? Yes. The court in this case noted one: “if the accountant exchanges his or her role
for a role as an insider who vends the company's securities,” then the “accountant shares in an insider's duty
to disclose.” If an accountant neither issues a certified opinion containing a misstatement nor become an
insider, however, the accountant does not have a duty to “speak out,” according to the court in this case.
C. THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This act (the PSLRA) changed the potential liability of accountants and other professionals in securities
fraud cases.
1. Proportionate Liability
A party is now liable only for that proportion of damages for which he or she is responsible (thus, if
an accountant was not aware of any fraud, his or her liability could be proportionately less than if he
or she actively participated in it.
2. Aiding and Abetting
One provision of the PSLRA made aiding and abetting certain securities a crime.
D. POTENTIAL CRIMINAL LIABILITY OF ACCOUNTANTS
An accountant may be found criminally liable for violations of the securities laws, the tax laws, and state
and federal criminal codes.
1. Criminal Violations of Securities Laws
Under both the 1933 act and the 1934 act, accountants may be subject to criminal penalties for
willful violationsimprisonment of up to five years or a fine of up to $10,000 under the 1933 act and
up to $100,000 under the 1934 act.
2. Criminal Violations of Tax Laws
There is specific liability under the Internal Revenue Codeaiding or assisting in the preparation of
a false tax return, for instance, is a felony punishable by a fine of $100,000, or $500,000 in the case
of a corporation, and imprisonment for up to three years.
V. Confidentiality and Privilege
A. ATTORNEY-CLIENT RELATIONSHIPS
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 13
The confidentiality of attorney-client communications is protected by law, which confers a privilege on
such communications. An attorney may not discuss a client’s case with anyone—even under court
order—without the client’s permission.
CASE SYNOPSIS
Case 47.3: Commonwealth of Pennsylvania v. Schultz
An investigation into allegations of sexual misconduct involving Jerry Sandusky, former defensive
coordinator for the Penn State football team, led a grand jury to subpoena Gary Schultz, a retired vice
president of the university. Schultz had overseen the campus police at the time of the alleged events. Before
testifying, Schultz met with Cynthia Baldwin, counsel for Penn State. He told her that he did not have any
documents relating to the alleged incidents, believing this disclosure to be in the strictest confidence between
an attorney and her client. Baldwin, however, saw her role only as counsel for Penn State, representing
Schultz as an agent of the university, not personally. She did not explain this to him, although she appeared
with him during his testimony. Later, a file was found in Schultz’s office containing notes pertaining to the
alleged incidents. When Baldwin was called to testify, she revealed what Schulz had told her at their meeting.
On the basis of this testimony, the grand jury charged Schultz with the crimes of perjury, obstruction of justice,
and conspiracy. Before a trial on the charges in a Pennsylvania state court, Schultz filed a motion to preclude
Baldwin’s testimony and quash the charges. The court denied the motion. Schulz appealed.
A state intermediate appellate court reversed. Baldwin was precluded from testifying relative to Schultz’s
privileged communications with her, and the charges of perjury, obstruction of justice, and conspiracy against
Schultz were quashed. “Communications between a putative client and corporate counsel are generally
privileged prior to counsel informing the individual of the distinction between representing the individual as an
agent of the corporation and representing the person in his or her personal capacity.”
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Notes and Questions
Should lawyers be subject to higher legal and ethical standards than other professionals? Yes,
because the impact that a lawyer (or a judge) may have in a particular case can exceed the impact that other
professionals might havethere can be a far-reaching permanence in a legal matter that may not exist in the
work of other professionalsand because attorneys often deal with many aspects of individuals’ lives. No,
because all professionals should be subject to the same high standards.
ADDITIONAL BACKGROUND
Attorney-Client Relationships
The conduct of attorneys is governed by state law and, where adopted, by American Bar Association
rules pertaining to professional responsibility. These tenets include attorney-client confidentialitykeeping
the communications of clients confidential. The following is the text of Rule 1.6 of the American Bar
14 UNIT NINE: GOVERNMENT REGULATION
Association Model Rules of Professional Conduct, which expresses this tenet, with selected comments.
Rule 1.6 Confidentiality of Information
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 15
(a) A lawyer shall not reveal information relating to representation of a client unless the client consents after
consultation, except for disclosures that are impliedly authorized in order to carry out the representation, and
except as stated in paragraph (b).
(b) A lawyer may reveal such information to the extent the lawyer reasonably believes necessary:
(1) To prevent the client from committing a criminal act that the lawyer believes is likely to result in imminent
death or substantial bodily harm; or
(2) To establish a claim or defense on behalf of the lawyer in controversy between the lawyer and the client,
to establish a defense to a criminal charge or civil claim against the lawyer based upon conduct in which the
client was involved, or to respond to allegations in any proceeding concerning the lawyer’s representation of
the client.
COMMENT:
The lawyer is part of a judicial system charged with upholding the law. One of the lawyer’s functions is to
advise clients so that they avoid any violation of the law in the proper exercise of their rights.
The observance of the ethical obligation of a lawyer to hold inviolate confidential information of the client
not only facilitates the full development of facts essential to proper representation of the client but also
encourages people to seek early legal assistance.
Almost without exception, clients come to lawyers in order to determine what their rights are and what is,
in the maze of laws and regulations, deemed to be legal and correct. The common law recognizes that the
client’s confidences must be protected from disclosure. Based upon experience, lawyers know that almost all
clients follow the advice given, and the law is upheld.
A fundamental principle in the client-lawyer relationship is that the lawyer maintain confidentiality of
information relating to the representation. * * *
* * * *
A lawyer is impliedly authorized to make disclosures about a client when appropriate on carrying out the
representation, except to the extent that the client’s instructions or special circumstances limit that authority.
* * * *
Lawyers in a firm may, in the course of the firm’s practice, disclose to each other information relating to a
client of the firm, unless the client has instructed that particular information be confined to specified lawyers.
* * * *
The duty of confidentiality continues after the client-lawyer relationship has terminated.
B. ACCOUNTANT-CLIENT RELATIONSHIPS
As for accountant-client communications, most states and the federal courts abide by the common law,
which provides that an accountant must disclose information about his or her client under a court order.
Other professionals may also be compelled to disclose information provided in confidence by clients.
16 UNIT NINE: GOVERNMENT REGULATION
TEACHING SUGGESTIONS
1. Impress on accounting students that criminal and civil liability has been imposed on auditors since the
early 1960smerely complying with GAAS no longer guarantees protection. Those who choose to be ac-
countants must practice the profession with skill.
2. It might be pointed out that in a capitalist system it is essential that accurate information be disseminated
to avoid any wasting of assets. Partly for this reason, an independent check on an enterprise’s management
by auditors benefits everyone with an interest in the business.
3. Emphasize that investors and others rely on accountants’ reports and statements, and that is why ac-
curacy in those reports and statements is essential. Public policy demands itit is the cornerstone of an ana-
lytical process. It might also be noted that accountants’ liability carries with it a cost, as is imposed by the lia-
bility of doctors and other professionals.
4. Since at least the movie “2001: A Space Odyssey” in 1968, it has been surmised that one day (possibly
within twenty years) computers will replace human intelligence. Today, however, a computer can only
retrieve, analyze, and report the data that is entered into it. When people enter the data, mistakes are
sometimes made. Because of the widely held notion that computers are infallible, however, whatever a
computer does with data is generally accepted. This can turn what may have been a small error into a major
blunder. How might the losses in such cases be avoided?
Cyberlaw Link
What effect might the availability of financial documents on the Web have on the liability of
auditors for the contents of those documents? Does the existence of the Internet change the
definition of “foreseeable third party”?
DISCUSSION QUESTIONS
1. Identify the broad areas of a professional’s potential common law liability to clients. Professionals
may be liable to clients for breach of contract, negligence, or fraud. A professional’s failure to perform according to
the terms of a contract may constitute a breach for which a client may recover damages for expenses to secure the
services elsewhere, for penalties imposed for failing to meet deadlines, and for any other reasonable and foreseeable
losses. A professional may be liable for negligence in performing a contract. Professionals are also subject to
standards of conduct established by ethics codes, statutes, and judicial decisions, and by their contracts, and must
exercise the standard of care, knowledge, and judgment generally observed by their peers. A professional may be
liable for actual fraud if he or she intentionally misstates a material fact to mislead a client, who justifiably relies on the
misstatement to his or her injury. A professional may be liable for constructive fraud whether or not he or she acts
with fraudulent intent.
2. What is the accountant’s duty of care? Accountants must comply with generally accepted accounting
principles (GAAP) and generally accepted auditing standards (GAAS). GAAP consist of conventions, rules, and
procedures set by the Federal Accounting Standards Board. GAAS are established by the American Institute of
Certified Public Accountants and concern professional qualities and the judgment that an auditor exercises in
performing an examination and report. An accountant who conforms to GAAP and acts in good faith will not be liable
to a client for incorrect judgment. An accountant may be liable if an impropriety, defalcation, or fraud in a client’s
books goes undiscovered because of the accountant’s negligence or failure to perform a duty. An accountant may be
liable if he or she discovers suspicious financial transactions but fails to investigate fully or to inform the client. A
violation of GAAP and GAAS is prima facie evidence of negligence, but compliance with GAAP and GAAS does not
necessarily exculpate an accountant, who may be subject to a higher standard of conduct under a state statute or
judicial decision. Normally, a lesser standard of care applies when an accountant prepares a write-up, but an
accountant may be liable for failing to delineate a balance sheet as unaudited or for failing to disclose to a client facts
that indicate misstatements have been made or fraud has been committed.
3. How can a professional limit his or her liability? Professionals can limit their liability to some extent by
disclaiming it, though not all disclaimers are effective in all circumstances. Professionals may be able to limit their
liability for the misconduct of other professionals with whom they work by organizing their business as a professional
corporation (PC) or a limited liability partnership (LLP).
4. An accountant’s potential common law liability for negligence may extend to what third persons?
Most courts hold that accountants may be liable to third parties for negligence. The majority view is that an
accountant’s liability extends to foreseen, or known, users, or class of users, of the accountant’s reports or financial
statements (for instance, an accountant who prepares a statement for a client, knowing that it will be submitted to a
bank to secure a loan, may be liable to the bank for a negligent misstatement). The minority view is that an
accountant’s liability extends to any users whose use of, and reliance on, an accountant’s statements or reports was
reasonably foreseeable.
5. What alternatives does a client have when he or she is dissatisfied with an attorney? The client has
several alternatives. For example, if a client believes that, in regard to his or her case, the attorney is acting
improperly or is not doing something that the client believes should be done, the client can discuss the situation with
the attorney. This is also a starting point when a client loses his or her case and is unhappy that he or she must
nevertheless pay the attorney’s bill, plus other expenses. If a client is upset with the way the attorney handled the
case, the client can file a complaint with the state bar association or the disciplinary board of the state supreme court.
When a client believes that an attorney is improperly keeping the client’s money or other propertyfor instance, if the
attorney settled the client’s case out of court and is withholding the fundsthe client can contact the state client se-
curity fund, which reimburses clients who have been defrauded by their attorneys. To recover money as a result of
other alleged attorney misconduct, however, a dissatisfied client must file a malpractice suit.
6. How can an accountant avoid liability under the Securities Act of 1933? An accountant must
demonstrate that he or she exercised due diligence in preparing the statements (failure to follow GAAP and GAAS
shows a lack of due diligence). An accountant must show that he or she had, “after reasonable investigation,
reasonable grounds to believe and did believe, at the time such part of the registration statement became effective,
that the statements therein were true and that there was no omission of a material fact required to be stated therein or
necessary to make the statements therein not misleading.” An accountant must verify information that corporate
officers and directors provide. An accountant must show that he or she is free of negligence or fraud (failing to notice
circumstances that, under GAAS, require further investigation, for instance, may result in liability). An accountant
may also raise as a defense that in the statement (1) there were no misstatements or omissions; (2) the
misstatements or omissions were not of material facts; (3) the misstatements or omissions had no causal connection
to the buyer’s loss; and (4) the buyer invested in the securities knowing of the misstatements or omissions.
7. How might an accountant be liable under the Securities Exchange Act of 1934? An accountant may be
liable for fraud under Sections 18 or 10(b) of the Securities Exchange Act of 1934 or SEC Rule 10b-5. (An ac-
countant does not need to prove due diligence to escape liability under these provisions.) Section 18. Section 18
imposes civil liability on an accountant who makes or causes to be made in any application, report, or document a
statement filed with the SEC that at the time, in light of the circumstances, was false or misleading as to any material
fact. This liability extends only to sellers and buyers, who must prove that the statement affected the price of the
security, or the seller or buyer relied on the statement in buying or selling and was not aware of its inaccuracy. A
seller or buyer may bring an action within a year after discovering the facts that constitute the cause of action and
within three years after the cause accrued. An accountant may avoid liability on proof of good faith in a statement’s
preparation (showing that he or she did not know that the statement was false or misleading, that he or she had no
intention to take unfair advantage of another). (Absence of good faith can be shown by reckless conduct and gross
negligence.) Besides showing good faith, an accountant may show that the buyer or seller knew that the statement
was false and misleading. To a successful seller or buyer, an accountant may be liable for costs, including attorneys’
fees. Section 10(b). Under Section 10(b), it is unlawful for any person to use, in connection with the purchase or sale
of any security, any manipulative or deceptive device or contrivance in contravention of SEC rules and regulations.
Rule 10b-5. Under Rule 10b-5, it is unlawful for any person, by use of any means or instrumentality of interstate
commerce (1) to employ any device, scheme, or artifice to defraud; (2) to make any untrue statement of a material
fact or to omit to state a material fact necessary to make the statements made, in light of the circumstances, not mis-
leading; or (3) to engage in any act, practice, or course of business that operates or would operate as fraud on any
person, in connection with the purchase or sale of any security. Accountants’ liability extends only to sellers or buyers
(privity is not necessary) for any oral or written fraudulent statements or omissions made in connection with the
purchase or sale of any security (not only in connection with written material filed with the SEC). A seller or buyer
must prove scienter, a fraud or deception, reliance, materiality, and causation.
8. What are working papers? Working papers are documents used and developed during an auditincluding
notes, memoranda, copies, and other papers that make up the work product of an accountant’s services. Whose
property are they? At common law, and under statutes in some states, working papers are the accountant’s
property. Disclosure of their contents, however, would constitute a breach of the accountant’s fiduciary duty to the
client.
9. What are a client’s rights in regard to working papers? A client has a right of access to working papers
and must give permission before they can be transferred to another accountant. Without the client’s permission or a
valid court order, their contents are not to be disclosed. Unauthorized disclosure could result in a malpractice suit.
10. What is the difference between the attorney-client privilege and the accountant-client privilege?
Professional ethical tenets require professionals generally to keep communications with their clients confidential. The
confidentiality of attorney-client communications is also protected by law, which confers a privilege on the
communications. An attorney and his or her employees may not discuss a client’s case with anyone, even under
court order, without the client’s permission. (This privilege is granted because of the need for full disclosure to the
attorney of the facts of a client’s case.) In a few states, accountant-client communications are privileged by state
statute. In most states, however, an accountant must disclose information about his or her client under a court order.
Professional-client communications, except those between an attorney and his or her client, are not privileged under
federal law. Federal law does not recognize state-provided rights to the confidentiality of accountant-client
communications.
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 19
ACTIVITY AND RESEARCH ASSIGNMENT
Among topics in this chapter that lend themselves to research in state codes and case law are (1) whether
the students’ state is one of the few in which accountant-client communications are privileged, and if they are not
privileged, the extent to which accountant-client confidentiality is protected; (2) crimes for which accountants may be
particularly liable, and criminal penalties; and (3) the common law liability of accountantsthat is, cases in which they
have been charged with negligence, breach of contract, or fraud.
EXPLANATION OF A SELECTED FOOTNOTE IN THE TEXT
Footnote 8: Credit Alliance Corp. is a major financial service company engaged primarily in financing the
purchase of capital equipment through installment sales and leasing agreements. As a condition of extending
additional major financing to L.B. Smith, Credit Alliance required an audited financial statement. Smith provided Credit
Alliance with an audited financial statement prepared by the accounting firm of Arthur Andersen & Co. Later, on
Smith’s petitioning for bankruptcy, it was discovered that Smith, at the time of the audit, had been in a precarious
financial position. Credit Alliance filed a suit in a New York state court against Arthur Andersen, claiming that
Andersen had failed to conduct investigations in accordance with proper auditing standards and that Andersen’s
recklessness had resulted in misleading statements causing Credit Alliance to incur damages. In addition, it was
claimed that Andersen knew, or should have known, that Credit Alliance would rely on these statements in issuing
credit to Smith.
In Credit Alliance Corp. v. Arthur Andersen & Co., the court had to choose between the Ultramares rule
and the Restatement (Second) of Torts in dealing with the rights of third parties against accountants when there is no
privity of contract. Under the Restatement, the third party becomes an “intended beneficiary” when the accountant
knows or should have known that the work done by the accountant was being performed for the benefit of a third
person who would rely upon the accountant’s work. Under Ultramares, the third party must establish that: (1) the ac-
countant was aware that the financial report was to be used for a particular purpose or purposes, (2) a known third
party (or parties) was intended to rely on the financial report, and (3) the accountant’s conduct revealed that he or she
knew of the third party’s reliance. The court chose Ultramares. Because Andersen did not have any direct dealings
with Credit Alliance, nor had it specifically agreed to provide Credit Alliance with the audited financial statements,
Andersen could not be held liable for negligence.
If Credit Alliance had been Andersen’s client, and the accounting firm had been held liable for
negligence, what damages might the plaintiff have recovered? With appropriate proof, the client of a negligent
accounting firm may recover damages for lost profits or lost business opportunities that result from the accounting
firm’s negligent acts.

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