Liability of Accountants

1. Liability of Accountants ACC 696 Howard Bunsis Fall 2011

2. History • First 100 years of the accounting profession are summarized at: http://www.aicpa.org/pubs/jofa/oct2005/timeline.htm • The origins of the accounting profession go all the way back to a Franciscan Monk, Fra Luca Pacioli (1445-1509), who is credited with first having devised the double entry method-of-record keeping of financial information • The accounting profession has become a prime targets of change, in large part due to the increased scope of an accountant’s legal liabilities.

3. Why More Lawsuits Against Accountants? • Enron • The growing awareness of the responsibilities of public accountants on the part of users of financial statements. • An increased consciousness on the part of the SEC regarding its responsibility for protecting investors' interests. • The greater complexities of auditing and accounting due to the increasing size of businesses, the globalization of business, and the intricacies of business operations. • Large civil court judgments against CPA firms, which have encouraged attorneys to provide legal services on a contingent fee basis.

4. Why the Changes? • Shift of scope of reliance from a two-party scenario (accountant-client) to a three-party situation. Third parties have found standing in the courts to sue based on their reliance on the accountant’s work product. The work product of accountants is simply too important to be expected to be kept in the four walls of the client’s office. • Certified Public Accountant, and the public is holding accountants more accountable than ever. Ultimate reliance on the work product of the accounting profession will be restored on the basis that what users really want: that they can “bank” on what the financial statements are really saying. • Will the government step in to provide financial assurances to the accounting profession the way it has in the financial institution arena? Today’s changing legal environment has allowed the accountants to become the last deep pocket in a chain of sequential liability traced back to them through a series of bankrupt stock issuers, tax dodgers, and other miscreants. • The future is uncertain

5. Liability of Accountants to Their Clients: Breach of Contract • Terms of engagement are specified when accountant and client enter into contract. • If accountant fails to perform, he is liable for breach. • Damages include: • Expenses incurred in securing new accountant • Fines and penalties owed because of delay

6. Liability of Accountants to Their Clients: Fraud • When accountant is liable for actual or constructive fraud, client can recover proximate damages. • Punitive damages may be awarded in cases of actual fraud.

7. Liability of Accountants to Their Clients: Negligence • Accountants owe duty to use reasonable care, knowledge, skill, and judgment. • Measured against those actions of a reasonable accountant. • May be sued for damages if fails to meet standards.

8. Theories of Accountant Liability to 3rd Parties • The Ultramares Doctrine • Section 552 of the Restatement (Second) of Torts • The foreseeability standard

9. Ultramares Standard (1931 NY Court of Appeals) • Facts: Ultramares Corp. of London, on the strength of the financial statement of Fred Stern & Co., Inc. of Manhattan, loaned Fred Stern & Co. money. Fred Stern & Co. soon went bankrupt. It was learned that the audit had been faulty. The audit had been made by Touche, Niven & Co. Ultramares Corp. brought a $203,000 suit against Touche • Decision: Judge Cardozo held that Touche could not be held liable for negligence unless the plaintiff Ultramares was in either privity of contract or a privity-like relationship with the accountant. Since the financial statements were not prepared specifically for use in obtaining a loan, the accountant was not liable. • Ramification: Provides the narrowest standard for holding accountants liable to third parties for negligence

10. Credit Alliance Corporation v. Arthur Andersen & Co. • Facts: Arthur Andersen & Co., CPAs, prepared audited financial statements of L.B. Smith, Inc., for the years 1977 to 1979. An unqualified opinion was given for all years. These financial statements were prepared negligently, and failed to discover the precarious financial position of Smith. Without Andersen’s knowledge, Smith gave these financial statements to Credit Alliance Corporation, which loaned Smith over $15 million, relying on these financial statements. In 1980, Smith went into bankruptcy. Credit Alliance sued Andersen for negligence. The trial court denied Andersen’s motion to dismiss and the Appellate Division affirmed. Andersen appeals. • Issue: Is Andersen liable to unknown, unintended users of financial statements it prepared for negligence?

11. Decision in Credit Alliance • The court reaffirms Ultramares. For an accountant to be liable in negligence to noncontracting parties, the following must occur: • 1) the accountant must have been aware that the financial statements were to be used for a particular purpose; • 2) in furtherance of that purpose a known party was intended to rely on those statements; and • 3) there must have been some conduct on the part of the accountant linking them to that party which evidences that the accountant understood that party’s reliance. • Here there is no link between Andersen and Credit Alliance, so Andersen is not liable to them.

12. Section 552 of the Restatement (Second) of Torts Standard • A rule that an accountant is liable only for negligence to third parties who are members of a limited class of intended users of the client’s financial statements. • Provides a broader standard for holding accountants liable to third parties for negligence than the Ultramares doctrine.

13. Industrial Loan Thrift Guaranty Corporation of Iowa v. Reese & Company, P.C. • Facts: Reese & Co., CPAs, prepared audited financial statements for First Security Acceptance Corporation from 1974 through 1981. Reese knew that these financial statements were being filed with the Iowa state auditor as required by law. In 1981, Industrial Loan Thrift Guaranty Corporation was established by the State of Iowa to insure deposits in industrial thrifts like First Security. First Security applied for membership and submitted these financial statements to Guaranty Corp. Reese did not know that Guaranty Corp. would receive these statements. First Security was admitted as a member of Guaranty Corp. Later, First Security became insolvent, and Guaranty Corp. had to pay off some of First Security’s investors. Guaranty Corp. sues Reese for negligence. Trial court dismisses. • Issue: Was Guaranty Corp. a member of the class of users covered by the Restatement rule?

14. Decision in Industrial Loan • The State of Iowa courts have adopted the Restatement’s position regarding the liability of accountants to non-contracting third parties. • This rule states that for such third parties to recover, they must be in a group of persons, who the CPA intended to reach and influence, distinct from the much larger group who might eventually use the financial statements. • Here it is not reasonable to assume that a group such as Guaranty Corp. would be intended to use those statements. The intended use was confined to First Security’s internal management and the state auditor. • Reese is not liable.

15. Forseeability Standard • A rule that an accountant is liable for negligence to third parties who are foreseeable users of the client’s financial statements. • Provides the broadest standard for holding accountants liable to third parties for negligence.

16. More on Accountant Liability to 3rd Parties: Breach of Contract and Fraud • Fraud: If an accountant engages in actual or constructive fraud, a third party who relies on the accountant’s fraud and is injured may bring tort action to recover damages. • Breach of Contract: Third parties are usually excluded from bringing a suit for breach of contract because there is no privity of contract. • Constructive Fraud: when the circumstances show that someone's actions give him/her an unfair advantage over another by unfair means (lying), treat as if there was actual fraud even if all the technical elements of fraud have not been proven.

17. Liability of Accountants Under Security Laws • Section 11 – Civil liability is imposed upon accountants who fraudulently or negligently issue financial statements that are included with registration statements in SEC filings. • Accountants have a due diligence defense if they can prove that, after reasonable investigation, grounds to believe that the statements made were true at the time of preparation and certification. • Section 10(b) and Rule 10b-5 –The Supreme Court has ruled that only intentional and reckless behavior can be considered under these sections. • Section 18(a) – The Securities Exchange Act of 1934 imposes civil liability for anyone making false or misleading statements in any application, report, or document filed with the SEC. This section requires a showing of fraud or reckless conduct. • Defenses that can be raised include a showing that the accountant acted in good faith or that the plaintiff had knowledge of the false or misleading statement when the securities were purchased or sold.

18. Private Securities Litigation Reform Act of 1995 (PSLRA) • This act imposed pleading and procedural requirements making it more difficult for plaintiffs to bring class action suits, and replaced the joint and several liability of defendants with proportionate liability based on the degree of fault. • Why did Clinton and others object to this bill? • Investors who had legitimate claims of fraud would not have their day in court. • The safe harbor (off the hook language) for firms was too easy for firms to rely on. • Plaintiff-shareholders were being dealt with more harshly than defendant-corporate wrongdoers.

19. Central Bank of Denver • Supreme Court found that private parties could not sue third parties that had merely “aided and abetted” a fraud by someone else. • The majority opinion in Central Bank of Denver v. First Interstate Bank1 established a literal reading of 10(b) and 10b5: • No liability could extend to aiders or abettors who participate in material misstatements or omissions in connection with the sale of securities. • Private civil liability under Rule 10b-5 does not extend to those who do not engage in a manipulative or deceptive practice but who aid and abet such a violation of 10(b). • The majority in Central Bank based its opinion on a lack of express mention in S.10 (b) and Rule 10b-5 relating to aiding and abetting. The Court rather relied on a strict interpretation of the statute; • In the PSLRA (post Central Bank), Congress has restored to the SEC the right to hold individuals liable for aiding and abetting. However, no private right was enacted.

20. More from Central Bank • Where reliance is present, the Court will extend primary liability under 10b-5 to secondary participants. “Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5. . .." • Scienter is key: Following Ernst & Ernst v.Hochfelder, the Court held that intent rather the negligence was the scienter to plead a Rule 10b-5 violation against a defendant. "[T]he words 'manipulative or contrivance' used in conjunction with 'device or contrivance' strongly suggest that s. 10b was intended to proscribe knowing or intentional misconduct." To be primarily liable under Rule 10b-5, one has to engage in manipulative or deceptive acts in connection with the purchase or sale of securities.10

21. Scienter and Hochfelder Central Bank reinforced the Court's prior ruling in Ernst & Ernst v. Hochfelder1 whereit held that private actions under Rule 10b-5 must plead that the culpable party acted with scienter Hochfelder Case Analysis

22. Why did Aiders Win in Central Bank? • The court allows for instances where an aider and abettor who manifests the requisite scienter still escapes liability under 10b-5. • Despite Central Bank's knowledge that the appraisal was inadequate, it knew investors were relying in part on an outdated appraisal to purchase bonds, yet it chose to acquiesce to the deception to withhold this information. Failure to disclose the revised appraisal to investors proved fatal as the developer defaulted on the bond before Central Bank could issue a revised appraisal of the land serving as collateral securing the bonds. • The Court’s ruling absolved Central Bank of any liability strictly on the grounds that Rule 10b-5 was silent about aiders and abettors, and because Central Bank was not making any direct misstatements or deceptions to the purchasers of the bonds. As the Court concluded, "[r]espondents concede that Central Bank did not commit a manipulative or deceptive act within the meaning of s. 10(b). . . ."

23. Gatekeeper Role of Accountants • In the corporate context, gatekeepers include participants who facilitate transactions although they are not the main participants in them. Auditors, accountants, banks and lawyers and are corporate gatekeepers. They have the ability to monitor corporate conduct and help to prevent fraud by refusing to provide their necessary assistance if they find evidence of wrong doing by the primary participants in a transaction. • For example, an auditor who discovers an anomaly in an issuer’s financial statements can refuse to issue a necessary opinion letter. • Conversely, gatekeepers may help perpetuate a fraud by allowing a transaction to continue despite evidence of wrong doing by the primary actors. Consider a lawyer who during the course of due diligence discovers financial impropriety in an issuers’ books, but says nothing and allows public documents containing the misrepresentations to be filed. While the attorney may not have participated directly in working a fraud on investors, she has allowed fraud to occur when it may have been in er power to prevent it. Thus, she has failed in her gatekeeper function. • It is precisely this kind of gatekeeper failure that is generating extensive discussion.

24. Liability after Enron and Central Bank • Stoneridge Case • Aiding and abetting liability is an important weapon in the fight to deter corporate fraud. Given that the Supreme Court is unlikely to reverse its course on the issue. • Congress could act by amending SOX

25. Stoneridge case • StoneRidge Investment Partners, LLC v. Scientific-Atlantic, Inc: U.S. Supreme Court (2008http://www.supremecourtus.gov/opinions/07pdf/06-43.pdf • Stoneridge brought a class action suit for securities fraud against Charter Communications’ vendors Scientific Atlantic and Motorola. Charter issued false and misleading financial statements, in order to meet certain revenue and income targets. Meeting those targets would affect the stock price of the firm. • SA and Motorola were involved in wash sales, where Charter would buy boxes from SA at a fixed price. Because of schemes they were involved with, Charter was able to falsely increase revenues and income. • Charter committed securities fraud against the public, and SA and MOT helped.

26. More Stoneridge • Main Legal Issue: Can a 3rd party that did not directly commit a fraud be held liable for securities fraud? In other words, if a party aided and abetted but did not commit the fraud, can that aider and abettor be liable?

27. Stoneridge Arguments Plaintiff Arguments: The two aiders and abettors falsified some documents, knew that Charter was messing around, and profited from the whole sordid arrangement. Defendant Arguments: We did not misstate the financial statements, Charter did. At worst we are aiders and abettors, and they are not covered under 10b and 10b-5.

28. Court Opinion in Stoneridge • Investors did not specifically rely on the actions of the defendants (aiders and abettors). Therefore, the liability is too remote. • To hold aiders and abettors liable would go against Congress’ intent. If Congress wants to make aiders and abettors liable, it needs to pass such a law.

29. Dissent in Stoneridge • Investors relied on a fraud, and the defendants were part of that fraud. This fraud is a manipulative device per 10b and 10b-5. • This is not the same as Central Bank. In Central Bank, the defendants did nothing about an appraisal they knew to be wrong. Here, the defendants acted badly. • Congress enacted §10(b) with the understanding that federal courts respected the principle that every wrong would have a remedy.

30. Reaction to Stoneridge Champagne Popping Over Stoneridge Ruling Portfolio.com: Jan 16 2008 Just how thrilled are corporate lawyers over the Supreme Court's decision yesterday to rein in shareholder class actions, declaring that investors cannot sue third-party businesses for their participation in a "scheme" with a public company to inflate its stock price? SkaddenArps (big corporate law firm): "Today's ruling is a significant victory for the business community," says Skadden's client alert. "Had the Court sanctioned "scheme" liability, it would have opened the door to lawsuits targeted at secondary corporate actors merely because they engaged in business transactions with issues who allegedly accounted for transactions fraudulently on their books. As a result of the Court's decision, however, such scenarios will not be allowed to develop."

31. More Stoneridge Reaction Joseph A. Grundfest, a professor at Stanford Law School, former S.E.C. commissioner and consultant to corporate America, published a paper called "Scheme Liability: A Question for Congress, not the Court." And in fact, that is just what Kennedy wrote: "The decision to extend the cause of action is for Congress, not for us," according to the majority opinion. And, at least in Kennedy's view, Congress has already asked and answered the question of whether third parties should be liable. And he ought to know. When Congress passed a 1995 law called the Private Securities Litigation Reform Act, it was just a year after the Supremes had issued a ruling in a case known as Central Bank, declaring there was no "aiding and abetting" liability in class actions for third parties such as accountants and lawyers --- a 1994 case that turned back the clocks on more than a decade of judicial rulings holding these third parties liable.

32. Importance of Stoneridge In what has been billed as the Roe v. Wade of securities law, the U.S. Supreme Court recently decided that secondary actors - including banks, vendors, attorneys, and accountants - cannot be sued for securities fraud merely because they are business partners with a company that committed fraud.  Needless to say, Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al. is a significant victory for business defendants.  By a 5-3 vote, the Court followed its recent trend in favoring corporate defendants over investors, rejecting a theory used by plaintiffs known as "scheme liability."  Prior to Stoneridge, professionals and companies could be sued for securities fraud when they did not directly mislead the public, but simply because they allegedly "schemed" with the company primarily responsible for committing the fraud.  Stoneridge limits investor rights and protects companies and those third parties with whom they do business.

33. Opposition to Stoneridge Sen. Chrisopher Dodd (D-Conn.) and erstwhile candidate for president, a co-sponsor of the P.S.L.R.A., issued this statement about the Stoneridge decision: "Today's decision goes past that common-sense law. Instead of protecting innocent businesses, it would protect wrongdoers from the consequences of their actions." Precisely what Justice John Paul Stevens, who dissented from Central Bank in 1994, says in and authored today's dissent in Stoneridge, lamenting the high court's "continuing campaign" to render these class actions "toothless."

34. Some Caution on Stoneridge While the decision by the Court in Stoneridge appears to benefit accountants and other traditional secondary actors in securities fraud litigation, it is far from a complete shield to future liability.  This decision does not affect or diminish the possibility of claims against auditors alleging a primary violation of Section 10(b) by issuing an allegedly deceptive opinion that the financial statements are fairly presented when the auditor allegedly knows that the financial statements contain false and misleading information.   By issuing an opinion that the financial statements are fairly presented in accordance with GAAP or other applicable standards, the accountant is making a representation to the public, which can form the basis of primary liability.  http://www.wilsonelser.com/Publications/detail.aspx?pub=424

35. Caution, Continued However, for those accountants, professionals and other secondary actors who are doing something less than directly providing information to the markets and investing public about the company at issue, Stoneridge is a very important development.  Consulting services can now be provided to public companies with a greater sense that those services will not expose the accountant to securities fraud liability in many, if not most, situations.  This decision also largely removes the specter of being drawn into private securities litigation involving companies that are not a client merely because the accountant or the accountant's clients did business with the other company or were involved in significant and/or questionable transactions. Nevertheless, even in these situations, which should now fall outside the reach of private securities fraud claims, it should be kept in mind that state law claims may still be available to draw the professional into the litigation, as well as SEC enforcement actions.  Accordingly, whenever a situation arises in which it is possible that a purchaser of securities may have been affected by potentially deceptive conduct, there is reason for caution and the need to consider how to manage the risk of possible future claims.