McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Module C

Legal Liability

“When men are pure, laws are useless; when men are corrupt,

laws are broken.”

Benjamin Disreali, Former British Prime Minister

Mod C-2

Common Law

• Breach of contract: Services not performed by auditors in manner described in contract

• Tort liability: Obligation based on failure of auditors to exercise appropriate level of professional care – Ordinary negligence is lack of reasonable care

– Gross negligence is lack of minimal care (similar to constructive fraud)

– Fraud is a misrepresentation of fact an individual knows to be false

Mod C-3

Common Law Liability: Clients

• Sources of Liability

– Breach of contract

– Tort liability (ON, GN, F)

• Clients must show

– Economic loss

– Auditors breached contract or failed to exercise appropriate care

– The loss was caused by the breach of contract or failure of auditors to exercise the appropriate level of care

• Defenses

– Auditors did not breach contract or performed with appropriate level of care

– Causation (something else caused client loss)

– Contributory negligence (clients were partially responsible for loss)

Mod C-4

Common Law Liability: Third Parties

• Generally liable to all third parties for gross negligence and fraud

• Liability for ordinary negligence

– Ultramares: No liability for ordinary negligence

– Credit Alliance v. Arthur Andersen: Liable to primary beneficiaries for ordinary negligence

– Fleet National Bank (restatement of torts): Liable to foreseen third parties for ordinary negligence

– Rosenblum v. Adler: Liable to foreseeable third parties for ordinary negligence

Mod C-5

Proof and Defenses: Third Parties

• Third parties must show – Economic loss

– Auditors failed to exercise appropriate level of care

– F/S contained a material misstatement

– Loss caused by reliance on misstated F/S

• Defenses – Lack of appropriate standing (relationship with auditor) to

bring suit

– Third party’s loss caused by factors other than the F/S and auditors examination (causation defense)

– Audit conducted per GAAS

Mod C-6

Summary of Liability for Ordinary Negligence

Ultramares: Liable for GN and F

Credit Alliance v.

Arthur Andersen:

ON to primary

beneficiaries

Fleet National Bank v.

Gloucester Co:

ON to foreseen

(restatement of torts)

Rosenblum v. Adler:

ON to foreseeable

Less Exposure More Exposure

Mod C-7

Securities Act of 1933 (Securities Act) • Regulates initial issuance of securities by

registrants to investing public

• Required to file registration statement with SEC that includes F/S

• To bring suit, investors must show: – Loss

– F/S contained a material misstatement

– No need to show reliance on F/S or that loss was caused by misstatement

Mod C-8

Liability Under Securities Act

• Auditors responsible for ordinary negligence, gross negligence, and fraud

• Defenses – Due diligence (auditors performed a GAAS audit)

– Causation (loss resulted from other factors)

• Escott v. BarChris Construction Corp. – Auditors held liable for failure to conduct “reasonable

investigation” (ordinary negligence)

Mod C-9

Securities Exchange Act of 1934 (Securities Exchange Act)

• Regulates daily trading of securities and requires periodic financial statements and information to be filed with the SEC

• Reports filed with SEC

– Form 10-K: Annual F/S (audited)

– Form 10-Q: Quarterly F/S (reviewed)

– Form 8-K: “Current events” report filed as appropriate

Mod C-10

Liability under the Securities Exchange Act

• To bring suit, investors must show:

– Economic loss

– F/S contained a material misstatement

– Loss caused by reliance on F/S (burden of proof shifted to investor)

– Auditors were aware that the F/S contained a material misstatement (has been interpreted as gross negligence)

Mod C-11

Liability Under Securities Exchange Act • Auditors liable for gross negligence and fraud

(“scienter”)

• Defenses

– Auditors acted in good faith

– Auditors were not aware of material misstatements

• Ernst & Ernst v. Hochfelder

– Relieved auditors from liability for ordinary negligence

– Did provide liability for “reckless behavior” in the absence of scienter

Mod C-12

Summary of Auditor Liability

Source Burden of

Proof

Offense Auditors’ Defenses

Common Law/Clients Client Breach of contract

ON, GN, F

• No breach or inappropriate

performance (GAAS audit)

• Causation

• Contributory negligence

Common Law/Third

Parties

Third Parties ON depends upon

party and

jurisdiction

GN, F

• Lack of appropriate third party

standing

• Causation

• No inappropriate performance

(GAAS audit)

Securities Act of 1933 Auditors ON, GN, F • Due diligence (GAAS audit)

• Causation

Securities Act of 1934 Investors GN, F • Good faith

• No knowledge of material

misstatements (“scienter”)

ON = Ordinary negligence GN = Gross negligence F = Fraud

Mod C-13

Why Has Auditor Liability Increased? • Highly-publicized failures (WorldCom, Enron)

• Investor awareness of ability to recover monetary losses from auditors

• Complex accounting standards

• Joint and several liability

• Class action suits

• Auditors are an attractive target for plaintiff attorneys

Mod C-14

Sarbanes-Oxley

• Extends statute of limitations for brining suit under the Securities Exchange Act

• Increased penalties for mail fraud and wire fraud

• Increased penalties for destruction, alteration, and falsification of records

• Increased records retention requirements

• Higher potential liability in civil cases

Mod C-15

Other Developments in Auditor Liability • Auditors not subject to RICO (and treble damages) • Limitations on aiding and abetting • Organization of firms as limited liability partnerships • Private Securities Litigation Reform Act (1995):

Proportionate liability

• Class Action Fairness Act (2005): Moves class action cases from state courts to federal courts

• Securities Litigation Uniform Standards Act (1998): Requires class action lawsuits with > 50 parties to be filed in federal courts

• Auditor liability caps

Mod C-16