AUDITINGCHAPTER 5Legal LiabilityByDavid N. Ricchiute

GBW 8th ed. Ch. 52

TOPICSIssues of liability to clients, 3rd partiesCommon law liability to foreseen 3rd parties & Restatement of TortsAuditors & the Securities ActsStatutory liability to securities purchasers, sellers & securities litigation reformLiability for criminal offensesResponsibility to detect, report illegal actsMinimizing risk of legal liability

GBW 8th ed. Ch. 53

ISSUES CONTRIBUTING TO LEGAL LIABILITY

Joint-and-several liability Allowed plaintiffs to recover against auditor

alone Revised by Private Securities Litigation

Reform Act of 1995 Changed to proportionate liability, i.e., auditor’s

sharePrivity doctrine limits liability to parties to contract Expanded to include certain 3rd parties

GBW 8th ed. Ch. 54

ISSUES IN CIVILITY LIABILITY

Source of law for suitWho is plaintiff?What is auditor’s potential liabilityWho has the burden of proof, plaintiff or defendant?Penalty is monetary damages

GBW 8th ed. Ch. 55

SUMMARY OF ISSUES:Sources of Law

Common law Written opinions of prior courtsStatutory law Written statutes established by

Congress, state legislatures Securities Act of 1933 Securities Exchange Act of 1934

GBW 8th ed. Ch. 56

SUMMARY OF ISSUES: Plaintiff

Under common law Breach of contract

Client 3rd party primary beneficiaries

Tort (wrongful act) Foreseen 3rd parties Foreseeable 3rd parties

Under Securities Act 1933 Initial purchasers

Under Securities Exchange Act of 1934 Subsequent purchasers, sellers

GBW 8th ed. Ch. 57

SUMMARY OF ISSUES: Auditor’s Potential Liability

Ordinary negligence Lack of reasonable care in performing

services Departure from GAAS

Gross negligence Lack of minimum care in performing services

Reckless departure from GAASFraud

Intentional misstatement or omission of material fact

Constructive fraud lacks intent

GBW 8th ed. Ch. 58

SUMMARY OF ISSUES: Burden of Proof

Plaintiff had damage, lossMaterially misstated financial statementsReliance on financial statements, adviceDeficient auditor conduct

GBW 8th ed. Ch. 59

COMMON LAW: Legal Action

Breach of contract Allege violations of GAAS or

confidentialityTort (wrongful act) Allege injury due to negligence, gross

negligence, fraud

GBW 8th ed. Ch. 510

COMMON LAWPrimary Beneficiaries

Specifically identified to auditors Beneficiaries of services Privity of contractBreach of contractThreshold for primary beneficiaries ordinary negligence

GBW 8th ed. Ch. 511

COMMON LAW: 3rd Parties

General identity, reliance on statements knownForeseen 3rd parties Not specifically identified though known Creditors

Foreseeable 3rd parties Bondholders, shareholders

Uses tort lawThreshold for 3rd parties gross negligence or fraud

GBW 8th ed. Ch. 512

RESTATEMENT OF TORTS

Accepted in majority of statesEstablishes auditor’s liability to foreseen 3rd parties Treats as primary beneficiaries Report used to influence plaintiff who

provided funding

GBW 8th ed. Ch. 513

PRIVITY DOCTRINEUsed in states that don’t accept Restatement of TortsEstablished in Ultramares Corp v. Touche (1931) Auditors liable to 3rd parties for

fraud Reaffirmed in Credit Alliance

Established linkage test to link auditor to plaintiff

GBW 8th ed. Ch. 514

LIABILITY TO FORESEEABLE 3RD PARTIES

Most liberal interpretation of culpabilityUsed only in Mississippi & Wisconsin

GBW 8th ed. Ch. 515

STATUTORY LAW Securities Act of 1933

New issues of securities (IPO)Registration statement (S-1) filed with SECAuditor’s involvement Auditor of annual reports Reviews statements Reviews S-1 for consistency

with statements Issues “comfort letter’ to

underwriters (SAS 72)

GBW 8th ed. Ch. 516

STATUTORY LAW:Securities Exchange of 1934

Regulates trading of securitiesRequires registration with SEC & periodic reporting (10-k, 10-q)Antifraud provisions of Section 10(b) & Rule 10b-5 Protect purchasers, sellers from

manipulation, deception by auditor

GBW 8th ed. Ch. 517

AUDITOR’S LIABILITY UNDER ’33, ’34 ACTS

’33 Act Derives from association with

registration statement’34 Act Derives from association with 10-k,

10-qLiable for untrue statements or omissions of material fact

GBW 8th ed. Ch. 518

STATUTORY LAW: Private Securities Litigation Reform Act

1995Sanctions lawyers who sue auditors for frivolous or factually impertinent argumentsRetains joint-and-several liability for knowingly perpetrating fraudApplies proportional liability for less culpable defendants

GBW 8th ed. Ch. 519

MAJOR CASESSecurities Act 1933 Escott v. BarChris Construction

Corp. (1961) Material, Misleading statements

with registrationSecurities Exchange Act 1934 Ernst & Ernst v. Hochfelder (1976)Auditors not liable in absence of scienter (intent to deceive)

GBW 8th ed. Ch. 520

CRIMINAL LIABILITY: 1930s

Securities Act 1933 & Securities Exchange Act 1934 Willfully making a false

statement or omitting a material fact

Federal Mail Fraud Statute Mailing, conspiracy to mail

false statementsMajor case United States v. Simon (Continental

Vending) 1969

GBW 8th ed. Ch. 521

CRIMINAL LIABILITY:1990s

Racketeer Influenced & Corrupt Organizations Act (RICO)Intended to curtail movement of organized crime into legitimate businessApplies to auditors who are engaged in the management of a business

GBW 8th ed. Ch. 522

FOREIGN CORRUPT PRACTICES ACT

Illegal acts by US multinational companies overseas Influencing foreign governments,

officials, etc. by payments, gifts Multinationals must implement

sufficient internal controls to Comply with authorization Record as necessary Restrict access to assets

GBW 8th ed. Ch. 523

COPING WITH LIABILITYArbitration, mediationPractice development Client acceptance, retention

Engagement lettersGAAS & Quality controlProfessional liability insuranceCountersuitsLimited liability partnerships (LLPs)