Chapter 44

Accountants’ Legal Liability

 

Learning Objectives:

 

1. Contractual liability of accountant to client

2. Tort liability of accountant

3. Who owns the accountant’s working papers, issues of privilege

4. 1933 Securities Act liability

5. 1934 Securities Act liability

 

I. Common Law

          A. Contract Liability

                   1. Accountant is responsible for fulfilling terms of engagement

                   2. Implicit promise to be competent and professional

                   3. Third party beneficiaries may also rely on the accountant

          B. Consequence of Breach

                   1. Material breach means accountant does not get paid

                   2. Damages for harm caused

          C. Tort Liability

                   1. Negligence

                   2. Foreseen users test (liability to people other than client)

          NorAm Investment Services, Inc. v. Stirtz Bernards Boyden Surdel & Larter, P.A., 611 N.W.2d 372 (Minn.App. 2000)

          Facts: Equisure needed to file audited financial statements when it listed on the AmEx.  Stirtz was a CPA who issued a favorable audit report.  Stirtz was then to prepare audit for Form 10 filing with SEC, knowing that was the purpose.

          NorAm was a securities broker.  It made $2.5m in margin loans to its clients to invest in Equisure.  

          Inside trading and financial manipulation scandal hit the stock, and its value fell to nothing.  NorAm was left with no collateral on its margin loans.

          NorAm sued Stirtz.

          Issue: Is an accountant liable to a brokerage house relying on the accountant’s reports for the purpose of extending margin credit?

          Holding: No, broker is too far out on the chain of reliance.

          Note:  Not all jurisdictions would rule this way.

 

                   3. Fraud—Accountant can be held liable for participating in making fraudulent documents

 

          D. Criminal Liability—Accountant can be criminally responsible for fraud, breaking securities law, etc.

          E. Client Information

                   1. Working papers.  Belong to the accountant.  Documents are privileged, and may not be disclosed without consent or court order.

                   2.  Accountant-client privilege.  Very limited.  Some states recognize it, and IRS recognizes confidentiality of tax advice in some circumstances.

 

II. Federal Securities Law

          A. 1933 Act

                   1. Civil liability for untrue statements in registration materials.  Note due diligence defense.

                   2. Criminal liability also possible.

          B. 1934 Act

                   1. Civil liability for untrue statements in corporate financial reporting.

                   2. 10b-5 liability for securities fraud, but must be intentional misconduct.

                   Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976)

          Facts: Ernst was an accounting firm. They audited First Securities, a small broker, who was a member of the Midwest Stock Exchange.  

          Hochfelder was a customer of First Securities.  He invested in fraudulent investments through First Securities.  Fraud discovered when FS’s boss killed himself.  He left a note saying investments were fraudulent and worthless.

          Hochfelder and other customers sued Ernst, on a negligence theory.  Trial court dismissed, appellate court reversed, and appeal went to Supreme Court.

          Issue:  Can investor sue under Rule 10b-5 for negligence, or must the plaintiff prove intentional misconduct?

          Holding: Rule 10b-5 requires scienter, i.e. intentional wrongdoing.

          Reasoning:  History and language of 1934 Act requires intentional fraud.

 

          C. Sarbanes Oxley Act

                   1. Passed in 2002 in response to major financial scandals

                   2. Increases reporting requirements, requires certification of docs

                   3. Addresses conflict of interest issues, where auditors may not also perform other types of work for client

                   4.  Every company must have an audit committee

 

          D. Audit Requirements

                   1. 1994 Private Securities Litigation Reform Act (also increases reporting requirements)

                   2. Duty to set up system to find illegal acts

                   3. Creates reporting requirements if it looks like company may not survive during the next fiscal year.