Chapter 40: Liability of Accountants and Other Professionals 3

Chapter 40

Liability of Accountants and Other Professionals

INTRODUCTION

This chapter gives an overview of the standards imposed on accountants and auditors, as well as other professionals, and should be of great interest to students planning to sit for the Certified Public Accountant (CPA) exam. Professionals have found themselves increasingly subject to liability over the past decade. The legal responsibility of auditors, in particular, has been a subject in recent cases and legislation, which this chapter discusses, and any changes in this liability in your jurisdiction should be brought to the attention of those students who may be preparing for a career in accounting. This chapter considers the potential common law liability of professionals to clients and to third persons, the potential liability of accountants under securities laws and the Internal Revenue Code, and the relationship of professionals with their clients.

CHAPTER OUTLINE

I. Potential Liability to Clients Professionals may be liable for breach of contract, negligence, or fraud.

A. LIABILITY FOR BREACH OF CONTRACT A professional owes a duty to his or her client to honor the terms of their contract and to perform the contract within the stated time period. If the professional fails to perform, he or she may be held liable for expenses incurred by the client to secure another professional to provide the services, for penalties imposed on the client for failure to meet time deadlines, and so on.

B. LIABILITY FOR NEGLIGENCE All professionals are subject to standards of conduct established by codes of professional ethics, by state statutes, and by judicial decisions. In their performance of contracts, professionals must exercise the established standard of care, knowledge, and judgment generally accepted by members of their professional group.

1. Accountant’s Duty of Care The text discusses accountants’ duty in the context of their role in business financial systems.

a. GAAP and GAAS

• An accountant who complies with generally accepted accounting principles (GAAP) and generally accepted auditing standards (GAAS) will not be liable to a client for incorrect judgment. A violation of GAAP and GAAS is prima facie evidence of negligence.

• But compliance does not necessarily relieve an accountant of liability—he or she may be held to a higher standard established by state statute and by judicial decisions.

b. Global Accounting Rules

• The Securities and Exchange Commission requires U.S. companies to replace GAAP rules with the International Financial Reporting Standards (IFRS) established by the International Accounting Standards Board.

• The IFRS are simpler, broader, and more straightforward. Many countries already use the IFRS, which thus makes financial reporting standards more uniform.

c. Discovering Improprieties An accountant who uncovers suspicious financial transactions and fails to investigate the matter fully or to inform his or her client of the discovery can be held liable to the client for the resulting loss.

d. Audits An accountant may be liable for failing to detect misconduct that a normal audit would have revealed.

e. Qualified Opinions and Disclaimers An auditor is not liable for damages resulting from whatever is specifically qualified or disclaimed.

f. Unaudited Financial Statements A lesser standard of care is typically required for an unaudited financial statement. An accountant may be subject to liability, however, for failing, in accordance with standard accounting procedures, to delineate a balance sheet as “unaudited.” An accountant will also be held liable for failing to disclose facts or circumstances that give reason to believe misstatements have been made or fraud has been committed.

g. Defenses to Negligence Possible defenses include—

• The accountant was not negligent. • The accountant’s negligence, if any, was not the proximate cause of the client’s loss. • The client was also negligent (depending on whether state law allows contributory negligence as a defense).

2. Attorney’s Duty of Care

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• The conduct of attorneys is governed by rules established by each state and by the American Bar Association’s Code of Professional Responsibility and Model Rules of Professional Conduct. • In judging an attorney’s performance, the standard used is normally that of a reasonably competent general practitioner of ordinary skill, experience, and capacity.

a. Misconduct A criminal act that reflects adversely on a person’s “honesty or trustworthiness, or fitness as a lawyer” is professional misconduct.

b. Liability for Malpractice When an attorney fails to exercise reasonable care and professional judgment, he or she breaches the duty of care and may be liable for malpractice.

CASE SYNOPSIS—

Case 40.1: In re B.L.H.

The parents of B.L.H. (Barbara) lived in Virginia until their divorce when primary custody of Barbara was granted to the mother. Barbara and her mother moved to North Carolina Two years later, Barbara’s father was convicted of federal drug-related offenses and incarcerated. Meanwhile, Barbara’s mother remarried, and her new spouse sought to adopt Barbara. Her mother filed a petition in a North Carolina state court to terminate her father’s parental rights. The court appointed an attorney to represent the father. The attorney did not contact him or present any evidence on his behalf. The court terminated his parental rights. He appealed.

A state intermediate appellate court reversed on this issue, holding that a new hearing was warranted because the father received ineffective assistance of counsel. “The only affirmative act undertaken by counsel even arguably constituting an attempt to communicate with [Barbara’s father] was to contact the federal prison to learn about the prison's email system.” The lack of contact resulted in the attorney’s inability to present any evidence on the father's behalf.

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Notes and Questions

The standards for defining professional misconduct appear to focus on an act’s impact on a party other than the professional. Is this the appropriate focus? Yes, this is the appropriate focus because the protection of the public is the purpose of, and the reason for, the rules of professional conduct. No, this is not the right focus, although innocent third parties should be made “whole” if possible, because wrongdoers must also be transformed to conduct themselves properly for their own “good.”

Suppose that the father’s attorney in the custody hearing is held legally liable on claims of malpractice. What acts of ethical misconduct might this indicate? If any of the liability involves criminal acts—deceit, for example, with regards to the representation of the father—dishonesty, a lack of trustworthiness, and even a lack of fitness as a lawyer would be indicated. These would most likely violate the state’s rules of professional conduct, or ethics. The state could discipline the lawyers for this type of

misconduct.

ADDITIONAL BACKGROUND—

Attorney’s Duty of Care

The conduct of attorneys is governed by state law and, where adopted, by American Bar Association rules relating to professional responsibility. The following is selected from the preamble to the American Bar Association Model Rules of Professional Conduct.

PREAMBLE: A LAWYER’S RESPONSIBILITIES

A lawyer is a representative of clients, an officer of the legal system and a public citizen having special responsibility for the quality of justice.

As a representative of clients, a lawyer performs various functions. As advisor, a lawyer provides a client with an informed understanding of the client’s legal rights and obligations and explains their practical implications. As advocate, a lawyer zealously asserts the client’s position under the rules of the adversary system. As negotiator, a lawyer seeks a result advantageous to the client but consistent with requirements of honest dealing with others. As intermediary between clients a lawyer seeks to reconcile their divergent interests as an advisor and, to a limited extent, as a spokesman for each client. A lawyer acts as evaluator by examining a client’s legal affairs and reporting about them to the client or to others.

In all professional functions a lawyer should be competent, prompt and diligent. A lawyer should maintain communication with a client concerning the representation. A lawyer should keep in confidence information relating to representation of a client except so far as disclosure is required or permitted by the Rules of Professional Conduct or other law.

A lawyer’s conduct should conform to the requirements of the law, both in professional service to clients and in the lawyer’s business and personal affairs. A lawyer should use the law’s procedures only for legitimate purposes and not to harass or intimidate others. A lawyer should demonstrate respect for the legal system and for those who serve it, including judges, other lawyers and public officials. While it is a lawyer’s duty, when necessary, to challenge the rectitude of official action, it is also a lawyer’s duty to uphold legal process.

As a public citizen, a lawyer should seek improvement of the law, the administration of justice and the quality of service rendered by the legal profession. As a member of a learned profession, a lawyer should cultivate knowledge of the law beyond its use for clients, employ that knowledge in reform of the law and work to strengthen legal education. A lawyer should be mindful of deficiencies in the administration of justice and of the fact that the poor, and sometimes persons who are not poor, cannot afford adequate legal assistance, and should therefore devote professional time and civic influence in their behalf. A lawyer should aid the legal profession in pursuing these objectives and should help the bar regulate itself in the public interest.

Many of a lawyer’s professional responsibilities are prescribed in the Rules of Professional Conduct, as well as substantive and procedural law. However, a lawyer is also guided by personal conscience and the

approbation of professional peers. A lawyer should strive to attain the highest level of skill, to improve the law and the legal profession and to exemplify the legal profession’s ideals of public service.

* * * *

Lawyers play a vital role in the preservation of society. The fulfillment of this role requires an understanding by lawyers of their relationship to our legal system. The Rules of Professional Conduct, when properly applied, serve to define that relationship.

C. LIABILITY FOR FRAUD

1. Actual Fraud A professional may be held liable for actual fraud when he or she intentionally misstates a material fact to mislead his or her client and the client justifiably relies on the misstated fact to his or her injury.

2. Constructive Fraud In contrast, a professional may be held liable for constructive fraud whether or not he or she acted with fraudulent intent. The intentional failure to perform a duty in reckless disregard of the consequences would constitute gross negligence on the part of a professional.

II. Potential Liability to Third Parties • Many third parties (investors, shareholders, creditors, managers, directors, regulatory agencies, and others) rely on professional opinions, such as those of auditors. In this light, many courts have all but abandoned the privity requirement in regard to accountants’ liability to third parties. • When a business fails, its independent auditor may be one of the few potentially solvent defendants. Most courts hold auditors liable to third parties for negligence, but the standard for imposing this liability varies.

A. THE ULTRAMARES RULE In Ultramares Corp. v. Touche, the New York Court of Appeals concluded that accountants owe a duty of care only to those persons for whose “primary benefit” financial statements are intended.

1. The Requirement of Privity Under the Ultramares rule, in the absence of privity or a relationship “so close as to approach that of privity,” a party cannot recover from an accountant.

2. “Near Privity” Modification The rule was modified in Credit Alliance Corp. v. Arthur Andersen & Co., in which the New York Court of Appeals held that if a third party has a sufficiently close relationship or nexus (link or connection) with an accountant, then the Ultramares privity requirement may be satisfied without establishing an accountant-client relationship. This is a minority rule.

B. THE RESTATEMENT RULE Most courts have adopted the position of the Restatement (Second) of Torts, Section 552(2)— accountants are subject to liability for negligence not only to their clients but also to foreseen, or known, users or classes of users of their reports or financial statements. Liability extends to—

• Those persons for whose benefit and guidance an accountant “intends to supply the information or knows that the recipient intends to supply it.” • Those persons whom an accountant “intends the information to influence or knows that the recipient so intends.”

C. THE “REASONABLY FORESEEABLE USERS” RULE A few courts hold accountants liable to any users whose reliance on an accountant’s statements or reports was reasonably foreseeable. Criticism of this view and support for the view of the majority of the courts is that the Restatement’s approach is more reasonable because it allows accountants to control their exposure to liability.

D. LIABILITY OF ATTORNEYS TO THIRD PARTIES Like accountants, attorneys may also be held liable under the common law to third parties who rely on legal opinions to their detriment. The principles stated in Section 552 of the Restatement (Second) of Torts may apply to attorneys just as they may apply to accountants.

CASE SYNOPSIS—

Case 40.2: Perez v. Stern

Domingo Martinez died in a hit-and-run accident. Reyna Guido—the mother of Martinez’s two children, including Esteban Perez, the named plaintiff—filed a wrongful death suit in a Nebraska state court through attorney Sandra Stern. Stern neglected to perfect service within the required time, however, and the suit was dismissed. Guido filed malpractice claims on behalf of herself, the children, and Martinez’s estate in a Nebraska state court against Stern. The court issued a judgment in Stern’s favor on the ground that the claims were time barred. Guido appealed.

The Nebraska Supreme Court affirmed the dismissal of Guido’s and the estate’s claims—they were time barred—but reversed and remanded with respect to the children. “A lawyer owes a duty to his or her client to use reasonable care and skill in the discharge of his or her duties, but ordinarily this duty does not extend to third parties, absent facts establishing a duty to them.” Here, the facts established that “Stern owed a duty to the children, as direct and intended beneficiaries of her services, to competently represent their interests. . . . Therefore, they have standing to sue Stern for neglecting that duty and their claims against Stern were tolled by their minority.”

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Notes and Questions

Why did the court affirm the dismissal of Guido’s individual claim but not the claims that she had brought on behalf of the children? Guido’s claim was dismissed because she had not filed the malpractice suit against the attorney until after the Statute of Limitations had expired. The claims she had brought on behalf of the children, however, were not dismissed. This was because the court held that the Statute of Limitations was “tolled,” or suspended, during their minority, meaning that they were still entitled to bring suit against the attorney (through Guido).

If one of the children had not been a minor at the time of the father’s death, the court would have

dismissed his or her claims against Stern, even though he or she was an intended beneficiary. Is it fair for the law to treat minors differently than other children with regards to a statute of limitations? Why or why not? As you learned in the contracts chapters, the law has always treated minors differently with respect to their legal capacity., In the context of this case, the law generally allows a person’s status as a minor to toll (or temporarily suspend) the statute of limitations period. That is why the court affirmed the dismissal of the mother’s case, but allowed the children’s claims to go forward. The rule suspending the statute of limitations for minors may sometimes seem unfair. For example, if one of the children in this case had been eighteen and one had been sixteen, the court would likely have dismissed the older child’s claims, but allowed the sixteen-year-old to recover from Stern. The older child was still an intended beneficiary of the wrongful death suit, so Stern still had a duty to the adult child. But the law treats that child as an adult, and adults are expected to pursue remedies for the harm that they suffer in a timely fashion (within the limitations period). To be fair to defendants in lawsuits, the law must establish rules to limit the time during which a claim can be filed. That is the whole purpose of statutes of limitations. Allowing a minor’s status to toll the statute of limitations period is fair, because it means that minors—who may not realize while they are minors that they have legal rights—can pursue claims later. Even though there might be a few situations in which the rule pertaining to minor children is unfair, overall tolling the statute of limitations only for minors produces the most just results.

How might Stern, or anyone in a similar position, have avoided the negative result in this case? The circumstances here give support to the warning that an attorney—or any professional—should take steps to be reminded of deadlines and other important procedural details on their clients’ behalf and the legal consequences of failing to meet those requirements. The attorney at the center of this case might have avoided the negative result if she had used something as simple as software on her office computer, or a calendar in her personal digital assistant, or a paper stock calendar with filled-in information on her office wall, or even an office administrator who might have kept track of important dates

ADDITIONAL CASES ADDRESSING THIS ISSUE —

Potential Liability to Third Parties

Recent cases considering professionals’ liability to foreseen or known users include the following.

• NationsBank, N.A. v. KPMG Peat Marwick LLP, 813 So.2d 964 (Fla.App. 4 Dist., 2002) (a borrower's accounting firm could be liable to the lenders on a theory of negligent misrepresentation following the borrower’s default, when the firm knew that the annual financial statements prepared for the borrower were relied on by the lenders in making their decisions concerning the borrower's credit).

• North American Specialty Insurance Co. v. Lapalme, 258 F.3d 35 (1st Cir. 2001) (a negligent- misrepresentation claim against an accounting firm failed because there was no evidence that the firm had any actual knowledge that the plaintiff would rely on financial statements in undertaking future transactions that were substantially similar to ongoing transactions known to the defendants).

• Glenn K. Jackson, Inc. v. Roe, 273 F.3d 1192 (9th Cir. 2001) (a law firm was not a third-party beneficiary

of an agreement between the firm’s client and its accountants and thus could not recover from the accountants under a theory of negligent misrepresentation).

• Reisman v. KPMG Peat Marwick LLP, 57 Mass.App.Ct. 100, 781 N.E.2d 821 (2000) (an accounting firm was not liable to shareholders, who acquired their stock in pooling-of-interests transactions, for negligent misrepresentations in the corporation's Securities and Exchange Commission report, when the report contained no signature, opinion, representation, or statement of the accounting firm, even though the firm instructed the corporation on how to report financial transactions and reviewed, edited, and helped prepare the information reported).

III. The Sarbanes-Oxley Act of 2002 This act imposes requirements on a public accounting firm that provides auditing services to an issuer (a company that has securities registered under Section 12 of the Securities Exchange Act of 1934; that is required to file reports under Section 15(d) of the 1934 act; or that files, or has filed, a registration statement not yet effective under the Securities Act of 1933).

A. THE PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD This board, which reports to the Securities and Exchange Commission, oversees the audit of public companies subject to securities laws to protect public investors and ensure that public accounting firms comply with the provisions of the Act.

B. KEY PROVISIONS OF THE SARBANES- OXLEY ACT RELATING TO PUBLIC ACCOUNTING FIRMS Public accounting firms are firms and associated persons that are “engaged in the practice of public accounting or preparing or issuing audit reports.”

1. Auditor Independence • It is unlawful to perform for an issuer both audit and nonaudit services, which include bookkeeping for an audit client, financial systems design and implementation, appraisal services, fairness opinions, management functions, and investment services. • A public accounting firm cannot provide audit services to an issuer if the lead audit partner or the reviewing partner provided those services to the issuer in each of the prior five years. • Reports to an issuer’s audit committee must be timely and indicate critical accounting policies and practices, as well as alternatives discussed, and other communications, with the issuer’s management. • A public accounting firm cannot provide audit services to an issuer if the issuer’s chief executive officer, chief financial officer, chief accounting officer, or controller worked for the auditor and participated in an audit of the issuer within the preceding year.

2. Document Destruction The act prohibits destroying or falsifying records to obstruct or influence a federal investigation or in relation to a bankruptcy. Penalties include fines and imprisonment up to twenty years.

C. REQUIREMENTS FOR MAINTAINING WORKING PAPERS

Under the common law (codified in a number of states), working papers remain the accountant’s property. It is important to retain them in the event of a suit for negligence or other action in which the accountant’s competence is challenged. • The client has a right of access to the papers and must give permission before they can be transferred to another accountant. Also, without the client’s permission or a valid court order, disclosure of their contents would breach the accountant’s fiduciary duty to the client. • Accountants must keep working papers for as long as five years from the end of the fiscal period to which the papers applied, subject to a possible fine and imprisonment.

IV. Potential Liability of Accountants under Securities Laws

A. LIABILITY UNDER THE SECURITIES ACT OF 1933 Accountants often prepare and certify an issuer’s financial statements that are included in a registration statement under the Securities Act of 1933 (discussed in Chapter 42).

1. Liability under Section 11 • An accountant may be held civilly liable if he or she prepared any financial statements included in a registration statement that “contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the

statements therein not misleading” [15 U.S.C. Section 77k(a)]. • Liability extends to anyone who acquires a security covered by the registration statement. No proof of reliance or privity is required.

a. The Due Diligence Standard • If a purchaser proves a loss on a security, to avoid liability an accountant must show that he or she exercised due diligence in preparing the financial statements. • Due diligence means an accountant had, “after reasonable investigation, reasonable grounds to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission of a material fact required to be stated therein or necessary to make the statements therein not misleading” [15 U.S.C. Section 77k(b)(3)].

• Proof of following generally accepted standards is proof of due diligence.

b. Other Defenses to Liability Besides proving that he or she has acted with due diligence, an accountant may raise the following defenses to Section 11 liability— • There were no misstatements or omissions. • Any misstatements or omissions were not of material facts. • Any misstatements or omissions had no causal connection to the plaintiff’s loss. • The plaintiff invested in the securities aware of the misstatements or omissions.

2. Liability under Section 12(2) Civil liability for fraud may be based on a communication to an investor (orally or in a prospectus, of an untrue statement or omission of a material fact. • Some courts have applied Section 12(2) to accountants who aided and abetted the seller or the offeror of the securities in violating Section 12(2) (that is, if the accountant knew, or should have known, that an untrue statement or omission of material fact existed in the offer or sale). • Penalties and sanctions include fines up to $10,000, imprisonment up to five years, injunctions, and orders to refund profits.

B. LIABILITY UNDER THE SECURITIES EXCHANGE ACT OF 1934 Under Sections 18 and 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 of the Securities and Exchange Commission, an accountant may be held liable for fraud. Here, however, an accountant need not prove due diligence to escape liability.

1. Liability under Section 18 An accountant who makes or causes to be made in any application, report, or document a statement that, at the time and in light of the circumstances, was false or misleading with respect to any material fact may be civilly liable [15 U.S.C. Section 78r(a)]. Liability extends only to sellers or purchasers who must prove—

• The statement affected the price of the security. • He or she relied on the statement in making the purchase or sale and was not aware of its inaccuracy.

a. Good Faith Defense An accountant can be exonerated on proof of good faith in the preparation of a financial statement.

b. Other Defenses In addition to a good faith defense, accountants can claim the buyer or seller knew the statement was false and misleading.

2. Liability under Section 10(b) and Rule 10b-5

a. Prohibited Conduct Section 10(b) makes it unlawful for a person to use, in connection with the purchase or sale of a security, a manipulative or deceptive device or contrivance in contravention of SEC rules. Rule 10b-5 makes it unlawful for a person to, by use of a means or instrumentality of interstate commerce, to— • Employ a device, scheme, or artifice to defraud. • Make an untrue statement of a material fact or omit to state a material fact necessary to make statements made, in the circumstances, not misleading. • Engage in an act, practice, or course of business that operates or would operate as a fraud or deceit on a person in connection with the purchase or sale of a security.

b. Extent of Liability • Accountants may be liable only to sellers or purchasers under Section 10(b) and Rule 10b-5. Privity is not necessary. • Liability may be imposed for fraudulent misstatements in written material filed with the SEC and for fraudulent oral statements or omissions made in connection with the purchase or sale of any security. • Ordinary negligence is not enough. A plaintiff must prove scienter.

CASE SYNOPSIS—

Case 40.3 Overton v. Todman & Co., CPAs, P.C.

Todman & Co., CPAs, P.C., audited the financial statements of Direct Brokerage, Inc. (DBI), issuing unqualified opinions that the statements were accurate. Despite the certifications, Todman made significant errors that concealed DBI's largest liability—its payroll taxes—in two audits. The errors came to light when it became clear that the company had not filed or paid its payroll taxes for those two years. Owing more than $3 million in unpaid taxes, interest, and penalties, DBI sought outside investors, including David Overton, who relied on DBI’s statements and Todman’s opinions to invest. When DBI collapsed, Overton and others filed a suit in a federal district court against Todman, asserting fraud under Section 10(b) and Rule 10b-5. The court dismissed the complaint. The plaintiffs appealed.

The U.S. Court of Appeals for the Second Circuit held the accountant liable, vacated the dismissal, and remanded. When an accountant issues a certified opinion, it creates a special relationship with investors. Thus, accountants have a duty to take reasonable steps to correct misstatements that they discover in previous financial statements on which they know the public is relying. Silence in this situation can constitute a false or misleading statement under Section 10(b) and Rule 10b-5.

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Notes and Questions Did Overton have a valid reason to sue DBI’s auditors? Yes, the investors were dissatisfied with the result of their investment and looked for the most likely scapegoat, which here was the accountant. Sometimes, one must simply suffer the consequence of a bad turn o fate. No, because for economic and other progress, there must be standards and those standards must be applied. In circumstances like those in the Overton case, when an accountant issues a certified opinion, it creates a special relationship with investors. Thus, accountants have a duty to take reasonable steps to correct misstatements that they discover in previous financial statements on which they know the public is relying. The applied standard here is that silence in this situation can constitute a false or misleading statement under Section 10(b) and Rule 10b-5.

Does an accountant have a duty not only to correct prior certified statements, but also a duty to update those statements? The court explained, “The duty to correct requires only that the accountant correct statements that were false when made. In contrast, the duty to update requires an accountant to

correct a statement made misleading by intervening events, even if the statement was true when made.” In at least one case, it has been noted that in some circumstances, “an issuer may have a duty to update opinions and projections . . . if the original opinions or projections have become misleading as the result of intervening events.” The court here commented, however, that “[o]n the facts of this case, we need not, and do not, reach the issue of whether an accountant has a duty to update.”

Does an accountant have a duty to correct more than those statements on which it certified an opinion? No, held the court in this case. “[A]n accountant need correct only those particular statements set forth in its opinion and/or the certified financial statements. . . . [A]n accountant is under no duty to divulge information collateral to the statements of accuracy and financial fact set forth in its opinion and the certified financial statements, respectively.”

Apart from issuing a certified opinion, are there other ways in which an accountant creates a duty to disclose certain facts? Yes. The court in this case noted one: “if the accountant exchanges his or her role for a role as an insider who vends the company's securities,” then the “accountant shares in an insider's duty to disclose.” If an accountant neither issues a certified opinion containing a misstatement nor become an insider, however, the accountant does not have a duty to “speak out,” according to the court in this case.

C. THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This act (the PSLRA) changed the potential liability of accountants and other professionals in securities fraud cases.

1. Proportionate Liability A party is now liable only for that proportion of damages for which he or she is responsible (thus, if an accountant was not aware of any fraud, his or her liability could be proportionately less than if he or she actively participated in it.

2. Aiding and Abetting One provision of the PSLRA made aiding and abetting certain securities a crime.

V. POTENTIAL CRIMINAL LIABILITY An accountant may be found criminally liable for violations of the securities laws, the tax laws, and state and federal criminal codes.

A. CRIMINAL VIOLATIONS OF SECURITIES LAWS Under both the 1933 act and the 1934 act, accountants may be subject to criminal penalties for willful violations—imprisonment of up to five years or a fine of up to $10,000 under the 1933 act and up to $100,000 under the 1934 act.

B. CRIMINAL VIOLATIONS OF TAX LAWS There is specific liability under the Internal Revenue Code—aiding or assisting in the preparation of a false tax return, for instance, is a felony punishable by a fine of $100,000, or $500,000 in the case of a corporation, and imprisonment for up to three years.

VI. Confidentiality and Privilege

A. ATTORNEY-CLIENT RELATIONSHIPS The confidentiality of attorney-client communications is protected by law, which confers a privilege on such communications. An attorney may not discuss a client’s case with anyone—even under court order—without the client’s permission.

B. ACCOUNTANT-CLIENT RELATIONSHIPS As for accountant-client communications, most states and the federal courts abide by the common law, which provides that an accountant must disclose information about his or her client under a court order. Other professionals may similarly be compelled to disclose information given to them in confidence by clients.

ADDITIONAL BACKGROUND— Attorney-Client Relationships

The conduct of attorneys is governed by state law and, where adopted, by American Bar Association rules pertaining to professional responsibility. These tenets include attorney-client confidentiality—keeping the communications of clients confidential. The following is the text of Rule 1.6 of the American Bar Association Model Rules of Professional Conduct, which expresses this tenet, with selected comments.

Rule 1.6 Confidentiality of Information

(a) A lawyer shall not reveal information relating to representation of a client unless the client consents after consultation, except for disclosures that are impliedly authorized in order to carry out the representation, and except as stated in paragraph (b).

(b) A lawyer may reveal such information to the extent the lawyer reasonably believes necessary:

(1) To prevent the client from committing a criminal act that the lawyer believes is likely to result in imminent death or substantial bodily harm; or

(2) To establish a claim or defense on behalf of the lawyer in controversy between the lawyer and the client, to establish a defense to a criminal charge or civil claim against the lawyer based upon conduct in which the client was involved, or to respond to allegations in any proceeding concerning the lawyer’s representation of the client.

COMMENT:

The lawyer is part of a judicial system charged with upholding the law. One of the lawyer’s functions is to advise clients so that they avoid any violation of the law in the proper exercise of their rights.

The observance of the ethical obligation of a lawyer to hold inviolate confidential information of the client not only facilitates the full development of facts essential to proper representation of the client but also encourages people to seek early legal assistance. Almost without exception, clients come to lawyers in order to determine what their rights are and what is, in the maze of laws and regulations, deemed to be legal and correct. The common law recognizes that the client’s confidences must be protected from disclosure. Based upon experience, lawyers know that almost all clients follow the advice given, and the law is upheld. A fundamental principle in the client-lawyer relationship is that the lawyer maintain confidentiality of information relating to the representation. * * * * * * *

A lawyer is impliedly authorized to make disclosures about a client when appropriate on carrying out the representation, except to the extent that the client’s instructions or special circumstances limit that authority. * * * * Lawyers in a firm may, in the course of the firm’s practice, disclose to each other information relating to a client of the firm, unless the client has instructed that particular information be confined to specified lawyers. * * * * The duty of confidentiality continues after the client-lawyer relationship has terminated.

TEACHING SUGGESTIONS

1. Impress on accounting students that criminal and civil liability has been imposed on auditors since the early 1960s—merely complying with GAAS no longer guarantees protection. Those who choose to be accountants must practice the profession with skill.

2. It might be pointed out that in a capitalist system it is essential that accurate information be disseminated to avoid any wasting of assets. Partly for this reason, an independent check on an enterprise’s management by auditors benefits everyone with an interest in the business.

3. Emphasize that investors and others rely on accountants’ reports and statements, and that is why accuracy in those reports and statements is essential. Public policy demands it—it is the cornerstone of an analytical process. It might also be noted that accountants’ liability carries with it a cost, as is imposed by the liability of doctors and other professionals.

4. Since at least the movie “2001: A Space Odyssey” in 1968, it has been surmised that one day (possibly within twenty years) computers will replace human intelligence. Today, however, a computer can only retrieve, analyze, and report the data that is entered into it. When people enter the data, mistakes are sometimes made. Because of the widely held notion that computers are infallible, however, whatever a computer does with data is generally accepted. This can turn what may have been a small error into a major blunder. How might the losses in such cases be avoided?

Cyberlaw Link

What effect might the availability of financial documents on the Web have on the liability of auditors for the contents of those documents? Does the existence of the Internet change the definition of “foreseeable third party”?

DISCUSSION QUESTIONS

1. Identify the broad areas of a professional’s potential common law liability to clients. Professionals may be liable to clients for breach of contract, negligence, or fraud. A professional’s failure to perform according to

the terms of a contract may constitute a breach for which a client may recover damages for expenses to secure the services elsewhere, for penalties imposed for failing to meet deadlines, and for any other reasonable and foreseeable losses. A professional may be liable for negligence in performing a contract. Professionals are also subject to standards of conduct established by ethics codes, statutes, and judicial decisions, and by their contracts, and must exercise the standard of care, knowledge, and judgment generally observed by their peers. A professional may be liable for actual fraud if he or she intentionally misstates a material fact to mislead a client, who justifiably relies on the misstatement to his or her injury. A professional may be liable for constructive fraud whether or not he or she acts with fraudulent intent.

2. What is the accountant’s duty of care? Accountants must comply with generally accepted accounting principles (GAAP) and generally accepted auditing standards (GAAS). GAAP consist of conventions, rules, and procedures set by the Federal Accounting Standards Board. GAAS are established by the American Institute of Certified Public Accountants and concern professional qualities and the judgment that an auditor exercises in performing an examination and report. An accountant who conforms to GAAP and acts in good faith will not be liable to a client for incorrect judgment. An accountant may be liable if an impropriety, defalcation, or fraud in a client’s books goes undiscovered because of the accountant’s negligence or failure to perform a duty. An accountant may be liable if he or she discovers suspicious financial transactions but fails to investigate fully or to inform the client. A violation of GAAP and GAAS is prima facie evidence of negligence, but compliance with GAAP and GAAS does not necessarily exculpate an accountant, who may be subject to a higher standard of conduct under a state statute or judicial decision. Normally, a lesser standard of care applies when an accountant prepares a write-up, but an accountant may be liable for failing to delineate a balance sheet as unaudited or for failing to disclose to a client facts that indicate misstatements have been made or fraud has been committed.

3. How can a professional limit his or her liability? Professionals can limit their liability to some extent by disclaiming it, though not all disclaimers are effective in all circumstances. Professionals may be able to limit their liability for the misconduct of other professionals with whom they work by organizing their business as a professional corporation (PC) or a limited liability partnership (LLP).

4. An accountant’s potential common law liability for negligence may extend to what third persons? Most courts hold that accountants may be liable to third parties for negligence. The majority view is that an accountant’s liability extends to foreseen, or known, users, or class of users, of the accountant’s reports or financial statements (for instance, an accountant who prepares a statement for a client, knowing that it will be submitted to a bank to secure a loan, may be liable to the bank for a negligent misstatement). The minority view is that an accountant’s liability extends to any users whose use of, and reliance on, an accountant’s statements or reports was reasonably foreseeable.

5. What alternatives does a client have when he or she is dissatisfied with an attorney? The client has several alternatives. For example, if a client believes that, in regard to his or her case, the attorney is acting improperly or is not doing something that the client believes should be done, the client can discuss the situation with the attorney. This is also a starting point when a client loses his or her case and is unhappy that he or she must nevertheless pay the attorney’s bill, plus other expenses. If a client is upset with the way the attorney handled the case, the client can file a complaint with the state bar association or the disciplinary board of the state supreme court. When a client believes that an attorney is improperly keeping the client’s money or other property—for instance, if the attorney settled the client’s case out of court and is withholding the funds—the client can contact the state client security fund, which reimburses clients who have been defrauded by their attorneys. To recover money as a result of other alleged attorney misconduct, however, a dissatisfied client must file a malpractice suit.

6. How can an accountant avoid liability under the Securities Act of 1933? An accountant must demonstrate that he or she exercised due diligence in preparing the statements (failure to follow GAAP and GAAS

shows a lack of due diligence). An accountant must show that he or she had, “after reasonable investigation, reasonable grounds to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission of a material fact required to be stated therein or necessary to make the statements therein not misleading.” An accountant must verify information that corporate officers and directors provide. An accountant must show that he or she is free of negligence or fraud (failing to notice circumstances that, under GAAS, require further investigation, for instance, may result in liability). An accountant may also raise as a defense that in the statement (1) there were no misstatements or omissions; (2) the misstatements or omissions were not of material facts; (3) the misstatements or omissions had no causal connection to the buyer’s loss; and (4) the buyer invested in the securities knowing of the misstatements or omissions.

7. How might an accountant be liable under the Securities Exchange Act of 1934? An accountant may be liable for fraud under Sections 18 or 10(b) of the Securities Exchange Act of 1934 or SEC Rule 10b-5. (An accountant does not need to prove due diligence to escape liability under these provisions.) Section 18. Section 18 imposes civil liability on an accountant who makes or causes to be made in any application, report, or document a statement filed with the SEC that at the time, in light of the circumstances, was false or misleading as to any material fact. This liability extends only to sellers and buyers, who must prove that the statement affected the price of the security, or the seller or buyer relied on the statement in buying or selling and was not aware of its inaccuracy. A seller or buyer may bring an action within a year after discovering the facts that constitute the cause of action and within three years after the cause accrued. An accountant may avoid liability on proof of good faith in a statement’s preparation (showing that he or she did not know that the statement was false or misleading, that he or she had no intention to take unfair advantage of another). (Absence of good faith can be shown by reckless conduct and gross negligence.) Besides showing good faith, an accountant may show that the buyer or seller knew that the statement was false and misleading. To a successful seller or buyer, an accountant may be liable for costs, including attorneys’ fees. Section 10(b). Under Section 10(b), it is unlawful for any person to use, in connection with the purchase or sale of any security, any manipulative or deceptive device or contrivance in contravention of SEC rules and regulations. Rule 10b-5. Under Rule 10b-5, it is unlawful for any person, by use of any means or instrumentality of interstate commerce (1) to employ any device, scheme, or artifice to defraud; (2) to make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in light of the circumstances, not misleading; or (3) to engage in any act, practice, or course of business that operates or would operate as fraud on any person, in connection with the purchase or sale of any security. Accountants’ liability extends only to sellers or buyers (privity is not necessary) for any oral or written fraudulent statements or omissions made in connection with the purchase or sale of any security (not only in connection with written material filed with the SEC). A seller or buyer must prove scienter, a fraud or deception, reliance, materiality, and causation.

8. What are working papers? Working papers are documents used and developed during an audit—including notes, memoranda, copies, and other papers that make up the work product of an accountant’s services. Whose property are they? At common law, and under statutes in some states, working papers are the accountant’s property. Disclosure of their contents, however, would constitute a breach of the accountant’s fiduciary duty to the client.

9. What are a client’s rights in regard to working papers? A client has a right of access to working papers and must give permission before they can be transferred to another accountant. Without the client’s permission or a valid court order, their contents are not to be disclosed. Unauthorized disclosure could result in a malpractice suit.

10. What is the difference between the attorney-client privilege and the accountant-client privilege? Professional ethical tenets require professionals generally to keep communications with their clients confidential. The confidentiality of attorney-client communications is also protected by law, which confers a privilege on the

communications. An attorney and his or her employees may not discuss a client’s case with anyone, even under court order, without the client’s permission. (This privilege is granted because of the need for full disclosure to the attorney of the facts of a client’s case.) In a few states, accountant-client communications are privileged by state statute. In most states, however, an accountant must disclose information about his or her client under a court order. Professional-client communications, except those between an attorney and his or her client, are not privileged under federal law. Federal law does not recognize state-provided rights to the confidentiality of accountant-client communications.

ACTIVITY AND RESEARCH ASSIGNMENT

Among topics in this chapter that lend themselves to research in state codes and case law are (1) whether the students’ state is one of the few in which accountant-client communications are privileged, and if they are not privileged, the extent to which accountant-client confidentiality is protected; (2) crimes for which accountants may be particularly liable, and criminal penalties; and (3) the common law liability of accountants—that is, cases in which they have been charged with negligence, breach of contract, or fraud.

EXPLANATIONS OF SELECTED FOOTNOTES IN THE TEXT Footnote 2: Oregon Steel Mills, Inc. (OSM), hired Coopers & Lybrand, LLP. On Coopers’ advice, OSM reported a stock sale as a $12.3 million gain on its 1994 financial statements. The next year, OSM planned a public offering of its own stock, expecting to file the necessary documents with the Securities and Exchange Commission (SEC) in February 1996 and sell the stock on May 2. The SEC required OSM to restate its 1994 statements. This delayed the public offering until June 13, when, due to unrelated factors, the stock price was lower than it had been on May 2. OSM filed a suit in an Oregon state court against Coopers, claiming that its advice regarding the 1994 transaction was negligent and caused the delay. The court issued, in Coopers’ favor, a summary judgment, which a state intermediate appellate court reversed. Coopers appealed. In Oregon Steel Mills, Inc. v. Coopers & Lybrand, LLP, the Oregon Supreme Court reversed. “[D]efendant’s conduct caused the delay in the offering that led to an unintended adverse result. However, the intervening action of market forces on the price of plaintiff’s stock was the harm-producing force, and defendant’s actions did not cause the decline in the stock price so as to support liability for that decline. As a matter of law, the risk of a decline in plaintiff’s stock price in June 1996 was not a reasonably foreseeable consequence of defendant’s negligent acts in 1994 and early 1995. * * * [A]lthough defendant breached its duty to plaintiff by failing to provide competent accounting services, defendant had no duty to protect plaintiff against market fluctuations in plaintiff’s stock price.” Is there any basis for imposing on Coopers a standard of conduct beyond protecting OSM from the reasonably foreseeable consequences of Coopers’ negligent conduct? No. In the words of the court, “[n]othing in the complaint or in the summary judgment record indicates that defendant’s duty to plaintiff was any broader than” that owed by any accountant retained by a client. “Plaintiff asserted the ‘special relationship’ of accountant and client, and defendant admitted that it was negligent in performing its work as plaintiff’s accountant, but nothing in the record suggests that the relationship between the parties imposed a duty on defendant to protect plaintiff from market losses.” What was Coopers’ duty to OSM in the circumstances of this case? The duty that Coopers owed to OSM was protecting OSM from the reasonably foreseeable consequences of Coopers’ negligent conduct. In the words of the court, Coopers was “to act with reasonable competence in performing the professional services for which it was retained.”

Based on the court’s reasoning in this case, what damages might OSM recover for Coopers’ negligence? As the court stated, “[w]ith appropriate proof, the client of a negligent accounting firm may recover damages for lost profits or lost business opportunities that result from the accounting firm’s negligent acts.” For example, OSM “should be able to recover all the out-of-pocket expenses it incurred because of defendant’s accounting errors—and perhaps other identifiable damages.”

Footnote 3: Michael Inglimo was an attorney in Wisconsin. Among other misconduct, Inglimo used marijuana with clients whom he represented in criminal cases. Inglimo was accused of being sometimes high during trial, for which he was otherwise unprepared. He commingled personal funds in client trust accounts, used client funds for personal expenses, used one client’s funds to balance another’s account, and failed to keep records on the accounts, receipts, and disbursements. After Inglimo was convicted for misdemeanor possession of marijuana, the state Office of Legal Regulation (OLR) filed a complaint against Inglimo. A referee recommended in part the suspension of Inglimo’s license to practice law. OLR and Inglimo appealed. In In re Disciplinary Proceedings Against Inglimo, the Wisconsin Supreme Court imposed a three-year suspension. “A substantial period of suspension is necessary in this case to impress upon Attorney Inglimo and other lawyers in this state the seriousness of the professional misconduct at issue here and to protect the public from similar misconduct in the future.” A rule of professional conduct bars a lawyer from having “sexual relations” with a current client. During Inglimo’s representation of L.K., Inglimo had sexual relations with L.K.'s girl friend in L.K.'s presence and with L.K. also engaging in sexual relations with his girl friend during the encounter. Did this conduct violate the rule? No, at least not according to the authorities in the Inglimo case. The referee interpreted the rule to require that an attorney have intimate contact with the client, and concluded that because L.K.’s girl friend was not Inglimo’s client, and Inglimo and L.K. did not have sexual contact, there was no violation. The state supreme court agreed. Should lawyers be subject to higher legal and ethical standards than other professionals? Yes, because the impact that a lawyer (or a judge) may have in a particular case can exceed the impact that other professionals might have—there can be a far-reaching permanence in a legal matter that may not exist in the work of other professionals—and because attorneys often deal with many aspects of individuals’ lives. No, because all professionals should be subject to the same high standards. The standards for defining professional misconduct appear to focus on an act’s impact on third parties rather than its effect on the professional. Is this the appropriate focus? Why or why not? Yes, this is the appropriate focus because the protection of the public is the purpose of, and the reason for, the rules of professional conduct. No, this is not the right focus, although innocent third parties should be made “whole” if possible, because wrongdoers must also be transformed to conduct themselves properly for their own “good.” Should an attorney's misbehavior be considered a violation of the rules of professional conduct even if he or she is not convicted of a crime? Discuss. Yes, and it generally does. In this case, the court held that an attorney's criminal act can support a violation of rule of professional conduct prohibiting a lawyer from committing a criminal act that reflects adversely on the lawyer's honesty, trustworthiness or fitness as a lawyer, even if the attorney is never charged or convicted. The court also held that the rules, which prohibit a lawyer from committing a criminal act that reflects adversely on the lawyer's honesty or trustworthiness, or fitness as a lawyer, do not require a connection between the act and any legal services that the lawyer renders. Further, the court ruled that a criminal act can reflect adversely on a lawyer's fitness, in violation of the rules, even if the act does not cause the attorney to provide deficient legal services. Thus, Inglimo’s use of drugs during L.K.’s trial would have been a transgression even if Inglimo otherwise represented his client adequately.