Recent Cases

Vanderbilt Law Review Volume 23 Issue 4 Issue 4 - May 1970 Article 7 5-1970 Recent Cases Law Review Staff Follow this and additional works at: https://scholarship.law.vanderbilt.edu/vlr Part of the Administrative Law Commons, Constitutional Law Commons, and the Intellectual Property Law Commons Recommended Citation Law Review Staff, Recent Cases, 23 Vanderbilt Law Review 809 (1970) Available at: https://scholarship.law.vanderbilt.edu/vlr/vol23/iss4/7 This Note is brought to you for free and open access by Scholarship@Vanderbilt Law. It has been accepted for inclusion in Vanderbilt Law Review by an authorized editor of Scholarship@Vanderbilt Law. For more information, please contact [email protected]. RECENT CASES Accountants-Auditors-Compliance with General Accounting Principles Not a Complete Defense To Criminal Fraud Defendants' are members of a certified public accounting firm which was retained annually by Continental Vending Corporation (Continental) to audit its financial statements. While conducting a yearly audit, defendants learned that an affiliated company, Valley Commercial Corporation (Valley),2 was not in a position to repay its debt 3 to Continental. .The president of Valley, however, offered to secure the debt personally. Defendants determined that if adequate collateral' was posted, Continental's statements could be certified without reviewing Valley's books.5 The collateral was obtained,, its value was confirmed,7 and the receivable was entered on the balance sheet8 subject to an explanation in a footnote.' The statements were 1. Defendants are a senior partner, a junior partner, and a senior associate in the national accounting firm of Lybrand, Ross Bros. & Montgomery. 2. The president of both Continental and Valley was Harold Roth, who owned about 25% of the stock of each corporation. In a prior proceeding, he was charged with criminal fraud but pleaded guilty and appeared at defendants' trial as a Government witness. Mr. Roth was sentenced to 6 months in jail, with an added year suspended. 3. Valley, whose business was lending money to Continental and other vending machine companies, had conducted numerous business dealings with Continental. Specifically, Continental used Valley as a source of funds by borrowing money from Valley. In return, Continental issued negotiable notes to Valley which were then discounted to local banks. By the end of the fiscal year in question, Continental's debt to Valley was slightly over $1 million. In addition, Continental had, for several years, lent cash to Valley. The debt owed by Valley amounted to $3.5 million at the end of the fiscal year but had increased to $3.9 million by the date of certification. Evidence disclosed that Roth had borrowed a large portion of this money and had used it for private investments. 4. Defendants insisted that a satisfactory legal opinion be obtained and that Continental's board of directors be apprised of the situation. 5. Valley was to be audited by another accounting firm and its statements were not yet available. 6. Approximately 80% of the collateral was stock and convertible debentures of Continental. 7. The collateral was confirmed by another member of the firm (not a party to this suit) who arrived at a value of approximately $3 million. He failed to discover, however, that the stock was subject to other encumberances and that the equity interest was really worth $1 million less. 8. Since the account payable (the amount owed by Continental to Valley) consisted of negotiable notes, it could not be netted against the account receivable, which was a cash item. 9. Defendants' note provided: "The amount receivable from Valley Commercial Corp. (an affiliated company of which Mr. Harold Roth is an officer, director and stockholder) bears interest at 12% a year. Such amount, less the balance of the notes payable to the company, is secured by the assignment to the Company of Valley's equity in certain marketable securities. As of February 15, 1963, the amount of such equity at current market quotations exceeded the net amount receivable." United States v. Simon, CCH FED. SEC. L. REP. 92,511, at 98,384 (2d Cir. Nov. 12, 1969). VANDERBILT LA W REVIEW [Vol. 23 subsequently certified, 0 and, shortly thereafter, Continental failed. The Government, alleging that the balance sheet was fraudulent" and that the footnote was false and misleading,'" charged defendants with conspiracy to commit criminal fraud 3 by knowingly drawing up and certifying a false and misleading financial statement. The defendants contended that since they had followed generally accepted accounting principles," they could not be subjected to liability. Even if the 10. The typical certification statement reads: "We have examined the balance sheet or x company as of [date] and the related statements of income and retained earnings for the year then ended. Our examination was made in accordance with generally accepted auditing standards, and accordingly included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. In our opinion the accompanying balance sheet and statements of income and retained earnings present fairly the financial position of the X company at [date], and the results of its operations for the year then ended, in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year." R. MAUTZ, FUNDAMENTALS OF AUDITING 508 (1967) (emphasis added). II. The Government contended that defendants were under a duty to disclose that the money lent to Valley was subsequently channelledto Roth. 12. The Government claimed that if the defendants had included what they knew, their footnote would have read: "The amount receivable from Valley Commercial Corp. (an affiliated company of which Mr. Harold Roth is an officer, dire'ctor and stockholder), which bears interest at 12% a year, was uncollectible at September 30, 1962, since Valley had loaned approximately the same amount to Mr. Roth who was unable to pay. Since that date Mr. Roth and others have pledged as security for the repayment of his obligation to Valley and its obligation to Continental (now $3,900,000, against which Continental's liability to Valley cannot be offset) securities which as of February 15, 1963, had a market value of $2,978,000. Approximately 80% of such securities are stock and convertible debentures of the Company." United States v. Simon, CCH FED. SEC. L. REP. 92,511, at 98,384 (2d Cir. Nov. 12, 1969). 13. Defendants were charged under 18 U.S.C. §§ 1001 & 1341 (1964), and § 32 of the Securities Exchange Act of 1934, 15 U.S.C. § 78ff (1964). Section 1001 provides: "Whoever, in any matter within the jurisdiction of any department or agency of the United States knowingly and willfully falsifies, conceals or covers up by any trick, scheme, or device a material fact, or makes any false, fictitious or fraudulent statements or representations, or makes or uses any false writing or document knowing the same to contain any false, fictitious or fraudulent statement or entry, shall be fined not more than $10,000 or imprisoned not more than five years, or both," Section 1341 makes criminal the use of the mails in aid of "any scheme or artifice to defraud." Section 32 of the Securities Exchange Act renders criminal a willful and knowing statement in any report which is false or misleadiig with respect to any material fact. A defense of no knowledge, however, is available. The Justice Department, rather than the SEC, normally prosecutes criminal proceedings. 14. Defendants produced eight expert witnesses: six accounting practitioners, a professor of accounting, and a former Chief Accountant of the SEC, who testified that neither generally accepted accounting principles nor generally accepted auditing standards required disclosure of the nature of the collateral or of the increase in the receivable after the closing date of the balance sheet. Likewise, the witnesses testified that disclosure of the Roth borrowings from Valley was not required and would have been inappropriate on the balance sheet. The Government produced two experts, an SEC staff accountant and the Chief Accountant of the SEC, who took a contrary view. For an excellent discussion on generally accepted accounting principles, see Graham, Some Observations on the Nature of Income, Generally Accepted Accounting Principles, and Financial 1970] RECENT CASES financial statement departed from generally accepted accounting principles, the defendants maintained that a jury could not find criminal fraud unless the Government demonstrated a willful disregard of these standards with an intent to deceive. Defendants were convicted by the jury on all counts. On appeal to the United States Court of Appeals for the Second Circuit, held, affirmed. Compliance with generally accepted accounting principles is not an absolute defense to criminal fraud when the certified statements do not fairly present the financial position of the audited company. United States v. Simon, CCH FED. SEC. L. REP. 92,511 (2d Cir. Nov. 12, 1969), cert. denied, 90 S. Ct. 1235 (1970). The standards of reasonable care which apply to auditors or public accountants are the same as those applied to lawyers, doctors, and other professional men.'" Generally, an accountant is not liable to third parties for negligence when there is no privity. 7 Civil liability, however, may run, even in the absence of privity, if there is a reckless misrepresentation 8 or fraud.'9 Fraud may be evidenced by either an affirmative act2 l or a failure to disclose. 2' On the other hand, although criminal convictions have been returned against accountants who have affirmatively misrepresented figures on a financial statement,2' 2 criminal liabilty for failure to make disclosures assertedly required by professional standards is a case of first impression. Reporting, 30 LAW & CONTEMP. PROB. 652 (1965); and Pines, The Securities and Exchange Commission and Accounting Principles,30 LAW & CONTEMP.

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