Chapter Six Legal and Regulatory Obligations in an Ethical Framework

1. Chapter Six Legal and Regulatory Obligations in an Ethical Framework

2. Duties and Liabilities of Directors and Officers • Duty of Care • Fiduciaries • Ethical and Legal duties • Due care • Liable for negligence • Duty of Loyalty • Faithfulness to one’s obligations and duties • Subordinate personal interests to welfare of organization • Refrain from self-serving • Liability of Directors and Officers • Crimes • Torts

3. Duties and Liabilities of Directors and Officers • Business Judgment Rule • Used to avoid liability for poor business judgments • Chancery Court • Court of equity • Resolution of commercial business litigation • Can issue temporary injunctions & declaratory judgments

4. Legal Liability: An Overview • Events that result in losses for users of financial statements • Investigate by plaintiff attorneys to link the user losses with allegations of material omissions or misstatements • Filing of lawsuit • Final resolution of the dispute

5. Legal Liability: An Overview • Auditors can be sued by clients, investors, creditors, and the government • Auditors can be held liable under two classes of law • Common law • Breach of contract • Torts • Statutory law • Legislation passed at state or federal level that establishes certain courses of conduct that must be adhered to by parties

6. Liability to Clients • A contractual obligation to the client that creates a privity relationship • A client can bring a lawsuit against an accountant for failing to live up to terms of the contract • Ultramares v. Touche, 1933 • Third party not in contractual privity cannot sue based on negligence • Left open possibility for gross negligence and fraud

7. Liabilities to Third Parties • Foreseen Third Parties • Rusch Factors, Inc. v. Levin, 1968 • Restatement (Second) of Torts • Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co., 1986 • Foreseeable Third Parties • H. Rosenblum v. Adler, 1983 • Citizens State Bank v. Timm, Schmidt & Company • Bily v. Arthur Young, 1992 • Murphy v. BDO Seidman, LLP

8. Common LawWhat Plaintiffs Must Prove • Plaintiff must prove • False representation by auditor • Knowledge by auditor representation was false • Auditor intended 3rd party to rely on false statements • 3rd relied on false representations • 3rd party suffered damages

9. Statutory Liability • Securities Act of 1933 • Regulates the initial offering of securities through the mails or interstate commerce • Securities and Exchange Act of 1934 • Regulates subsequent trading of securities sold on national stock exchanges • Sarbanes-Oxley (SOX) Act of 2002 • Civil liabilities • Criminal liabilities • SOX makes it a felony to destroy or create documents to impede or obstruct a federal investigation

10. Potential Criminal Liability • Securities Act of 1933 • Imprisonment up to 10 years, OR • Fine up to $10,000, OR both • Securities Act of 1934 • Imprisonment up to 10 years, OR • Fine up to $100,000, OR both • SOX • Imprisonment of 20 years for obstruction of justice • Imprisonment of 25 years for securities fraud

11. Insider Reporting and Trading • Owners of 10% or more of stock of a company must report ownership and trading of the stock • Legal insider trading when corporate insider trade company stock and report trades to SEC • Illegal insider trading when owner bases trade of stocks on information the public does not know • Also illegal to give a tip of the information to someone else so that he could trade his stock

12. Financial Fraud Detection and Disclosure Private Securities Litigation Reform Act (PSLRA), 1995 • Auditors must report illegal acts (including financial statement fraud) to • Management • Audit Committee or BOD • OR the SEC • Illegal act with material effect on financial statements • Proportionate Liability • A party is liable only for that proportion of damages for which he is responsible

13. Sarbanes-Oxley Act (SOX) Relevant provisions for management and auditors that affect legal liability • Section 302. Corporate Responsibility for Financial Reports • Certification by CEO and CFO that financial reports do contain untrue material fact or omission of such • Section 308. Fair Funds for Investors • Section 401. Disclosures in Periodic Reports • Section 801. Corporate Criminal Fraud Accountability • Section 806. Protection for Employees of Publicly Traded Companies who Provide Evidence in Fraud Cases • Section 806. Protection for Employees of Publicly Traded Companies who Provide Evidence in Fraud Cases • Section 906. Corporate Responsibility for Financial Reports

14. Whistle blowing • Internal • Auditor brings matter to the supervisor • Supervisor informs the partner • Partner discusses the matter with top management and audit committee • Audit committee should support the auditors • External • Auditor violates the confidentiality obligation to client • Auditor may lose license to practice as CPA

15. Other Laws Affecting Accountants and Auditors • Foreign Corrupt Practices Act of 1977 (FCPA) • Establishes standards of acceptability of payments (bribes) made by U. S. multinational entities to foreign government officials • U. S. Federal Sentencing Guidelines • Caremark International, 1991 • Provides scheduled fines • Racketeer Influenced and Corrupt Organizations Act (RICO) • Civil and criminal sanctions for illegal acts • Treble damages

16. Omnibus Trade and Competitiveness Act of 1988 • Amends FCPR • Clarifies when a payment is prohibited • Intended to influence a foreign official to act incompatible with legal duty • Clarifies grease payments and may include • Permits, licenses, documents to qualify for work • Processing papers, such as visas • Providing police protection • Providing utilities