Legal Liability Increasing liability costs

1. Legal Liability Increasing liability costs

2. Business Failure, Audit Failure, Audit Risk Business Failure Audit Failure - Failure to follow GAAS Audit Risk- Risk of issuing incorrect opinion

3. BusinessAudit Failures Risk Audit Failure

4. What factors have influenced the amount of audit failures (audit quality)?

5. What factors have influenced the incidence of audit failures? FavorableUnfavorable Legal liability Increased fee competition Peer/PCAOB Past increased review emphasis on consulting Improved audit Decreases in legal technology liability (esp. PSLRA) Audit committees

6. Sources of Legal Liability Client - common law Third parties - common law Federal securities acts Criminal liability

7. Responsibilities to Third Parties under Common Law Ordinary Primary beneficiaries negligence (Ultramares) Foreseen Users Gross negligenceOther third parties

8. Ultramares Doctrine Ordinary negligence insufficientto establish liability to third parties lacking privity

9. Foreseen and Foreseeable Users Ultramares is not strictly adhered to in most jurisdictions • Auditors are generally liable to reasonably foreseen users • A few jurisdictions extend liability to foreseeable users

10. Problem 5-20 Questions to address • Liability regime - Common Law • Standard of duty • Ordinary negligence - Primary beneficiary/known user • Gross negligence - Other third parties

11. Problem 5-20 a. Liable for negligence to Martinson (lender)? No - Not primary beneficiary Maybe - if foreseen user

12. Problem 5-20 b. Liable for gross negligence ? Yes - always liable to third parties for gross negligence d. No recovery unless actual fraud? False - see (b) above.

13. Securities Acts Responsibility to Third Parties 1933 Securities Act- newly issued securities - material misrepresentation or omission ( Reliance not required) - The burden of proof is on the defendant auditor to demonstrate due diligence

14. 1934 Securities Act- existing publicly-traded companies - Hochfelder v. Ernst & Ernst (1976), knowledge and intentto deceive are necessary (scienter) - Gross negligence or recklessness constitute constructive fraud and are equivalent to scienter

15. 5-17 (a) Major, Major and Sharpe audit MacLain industries. Subsequent to the offering, errors were revealed, and Major was sued by purchasers of the stock. Major will avoid liability if: 1. The errors were caused by MacLain 2. It can be shown that at least some of the shareholders did not read the f/s 3. It can prove due diligence in the audit. 4. MacLain expressly assumed any liability in connection with the offering.

16. 5-17 (b) Donalds & Co. audited the f/s of Markum Securities. The audit was improper in several respects, and shareholders have sued under Rule 10b-5 of the 1934 Act. Which is likely to be Donald’s best defense? 1. They did not intentionally certify false financial statements. 2. Section 10b does not apply to them. 3. They were not in privity of contract with the creditors. 4. The engagement letter disclaimed liability.

17. Summary of Liability to Third Parties Liability Degree of Regime Reliance Negligence Common Law: Ordinary Privity/foreseen negligence Required Other 3rd PartyGross negligence 1933 Securities Not No Act Required requirement “Scienter” 1934 Act Required knowledge or intent

18. Defenses Against Third Defenses Against Parties and Under 1934 Client Suits Securities Act Lack of duty Lack of duty Nonnegligent Nonnegligent performance performance Contributory negligence not available No reliance No reliance

19. Defenses Against Third Defenses Against Parties and Under 1934 Client Suits Securities Act Lack of duty Lack of duty Nonnegligent Nonnegligent performance performance Contributory negligence not available No reliance No reliance

20. Problem 5-18 Inventory fraud - inventory not counted simultaneously at request of client a. Defenses against client suit b. Defense against suit by First City Bank

21. Problem 5-18 a. Defenses against client suit Contributory negligence Nonnegligent performance b. Defense against suit by bank Lack of duty (no privity) (first line of defense - unlikely to be successful with known third party) Nonnegligent performance