1. Chapter 20 Legal Liability McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Historical Perspective
Intro
Historical Perspective
Claims against auditors were relatively uncommon before the 1970’s.
Global credit crisis leads to the Dodd-Frank Act of 2010 and increases scrutiny into auditing profession again.
The recession of led to another upsurge in litigation against auditors.
1970
1980
1990
2002
2010
Due to a slump in the economy in the early 1970’s and the recession of the 1980’s, it became more common for auditors to be sued.
Due to several high-profile frauds, Congress refocused attention on auditors in the Sarbanes-Oxley Act of 2002.
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3. Largest CPA firm payouts in recent class actions
Company
CPA firm
Settlement
Year filed
Cendant Corp.
Ernst & Young
$633,500,000
1998
Adelphia
Deloitte & Touche
$367,500,000
2002
Tyco International
PwC
$225,000,000
Baptist Foundation of Arizona
Arthur Andersen
$217,000,000
1999
Parmalat Finanziaria
$157,500,000
2004
HealthSouth Corp.
$142,500,000
Superior Bank FSB
$125,000,000
Rite Aid Corp.
KPMG
Lernout & Hauspie Speech Products
$115,000,000
Sunbeam Corp.
$110,000,000
Enron Corporation
$105,500,000
2001

4. One way to classify law is common law vs. statutes
LO# 2
Two Classes of Law
Common Law
Case law developed over time by state court judges
Statutory Law
Statutes enacted by Congress, interpreted by federal judges
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5. Another way to classify law: severity of outcome for auditor Note: in most financial reporting lawsuits, auditor is one of several defendants
Least severe: auditor not defendant
More severe: auditor defendant in private lawsuit but avoids paying anything
Still more severe: auditor defendant in private lawsuit and has to pay to settle it
Even more severe: auditor defendant in government (usually the SEC) civil lawsuit
Most severe: auditor defendant in criminal prosecution (in the US, usually the Justice Department)

6. Another way to classify law: who the auditor is liable to
The auditor might be liable to who engaged the auditor (usually, but not always, the company that is audited)
The auditor might be liable to users (called 3rd parties) of the financial statements.
Here is where auditor liability is unique, as we will learn

7. LO# 2
Overview
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8. LO# 2
Overview
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9. Types of Liability to the Client
LO# 3
Common Law—liability to who engaged the auditor Since there is an agreement, there can be contract liability as well as tort liability
Requires Due Care
Types of Liability to the Client
May be held liable for breach of contract (contract law)
Negligence
Gross negligence
Fraud
These are all genres of tort law
Bottom line: if auditor performs with due care he is not liable, if not, he is liable.
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10. Breach of Contract (liability to company that engaged the auditor)
LO# 3
Breach of Contract (liability to company that engaged the auditor)
The contract, law, and GAAS determine what defines “due care.”
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11. Negligence (liability to company that engaged the auditor)
LO# 3
Negligence (liability to company that engaged the auditor)
If an engagement is performed without due care, the CPA may be held liable for an actionable tort in negligence. Tort law – and GAAS - defines what is “due care.”
Requires Due Care
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12. Ordinary negligence or negligence
LO# 3
Common Law Negligence: liability of auditor to company that engaged the auditor
Company must prove, inter alia, that the behavior of the auditor constitutes a lack of due care. Different courts use different language, but #1 is the easiest for the company to prove, since it is just barely a lack of due care. #2 is harder to prove, and #3 is the hardest to prove.
Ordinary negligence or negligence
Gross negligence, recklessness or statutory fraud.
Actual fraud or knowing fraud.
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13. Common Law Negligence: Client
LO# 3
Common Law Negligence: Client
Auditor’s Defense
No duty was owed to the client.
The client was negligent.
The auditor’s work was performed in accordance with professional standards.
The client suffered no loss.
Any loss was caused by other events.
The claim is invalid because the statute of limitations has expired.
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14. Common law liability to 3rd party users of financials
As noted above there’s only tort law liability to 3rd party users of financials (there’s no contract so there’s no possible breach of contract)
We also noted there are 3 severity levels of bad (less than due care) auditor behavior. #1 is easiest for 3rd party users to prove against an auditor, but in a traditional 3rd party “privity” or Ultramares state, e.g. New York, if that is all that 3rd party users can prove against the auditor, they lose and the auditor wins (not liable).
Ordinary negligence or negligence
Gross negligence, recklessness or statutory fraud.
Actual fraud or knowing fraud.

15. Common Law - 3rd party Ordinary Negligence / Negligence
LO# 4
Common Law - 3rd party Ordinary Negligence / Negligence
Four approaches for 3rd Parties: Privity or Ultramares is arguably the most important , because it is the original approach and it is what New York uses. Know how to apply it. Simply know that the other 3 approaches exist.
Privity
Near Privity
Foreseen 3rd Parties
Reasonably Foreseeable 3rd Parties
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16. Negligence Third Party Must Prove
LO# 4
Common Law—3rd Parties
Negligence Third Party Must Prove
The auditor had a duty to the plaintiff to exercise due care.
The auditor was worse than negligence or ordinary negligence (i.e. committed gross negligence, recklessness, constructive fraud, actual fraud or knowing fraud).
The auditor’s breach of due care was the direct cause of the 3rd party’s injury.
The 3rd party suffered an actual loss as a result.
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17. Negligence Auditor’s Defense
LO# 4
Common Law—3rd Parties
Negligence Auditor’s Defense
Auditor’s behavior was not worse than negligence or ordinary negligence.
The 3rd party was negligent.
The 3rd party suffered no loss.
Any loss was caused by other events.
The claim is invalid because the statute of limitations has expired.
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18. LO# 4
Fraud - 3rd parties
If an auditor has acted with knowledge and intent to deceive a third party, he or she can be held liable for fraud.
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19. Fraud – 3rd parties Third Party Must Prove
LO# 4
Fraud – 3rd parties
Third Party Must Prove
A false representation by the CPA.
Knowledge or belief by the CPA that the representation was false.
The CPA intended to induce the 3rd party to rely on the false representation.
The 3rd party relied on the false representation.
The 3rd party suffered damages.
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20. The Securities Exchange Act of 1934
LO# 5
Statutory Liability
Two major federal statutes provide sources of statutory liability for auditors:
The Securities Act of 1933
The Securities Exchange Act of 1934
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21. Only applies re an offering of securities.
LO# 5
Securities Act of 1933
Only applies re an offering of securities.
Could be an IPO or could be
A secondary or other kind of offering
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22. 3rd Party Must Merely Prove
LO# 5
Securities Act of 1933 – auditor’s worst liability exposure to 3rd parties because a) very little must be proved, b) no privity defense allowed, and c) auditor has burden of proof that he performed with due care (“due diligence defense”)
3rd Party Must Merely Prove
The 3rd party suffered losses by investing in the registered security.
The audited financial statements contained a material omission or misstatement.
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23. Securities Exchange Act of 1934
LO# 6
Securities Exchange Act of 1934
Applies to offerings plus ongoing reporting (e.g. 10K or 10Q) by public companies.
Section 10(b) and Rule 10b-5 are the greatest source of liability for auditors under this act.
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24. Securities Exchange Act of 1934
LO# 6
Securities Exchange Act of 1934
3rd Party Must Prove
A material, factual misrepresentation or omission.
Reliance on the financial statements.
Damages suffered as a result of reliance on the financial statements.
Scienter (gross negligence or recklessness is enough).
If 3rd party proves auditor committed knowing fraud then auditor faces joint/several liability instead of proportionate liability
This means that the auditor could have to pay all the money, if the lawsuit is lost, instead of just his proportionate share
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25. SEC and PCAOB Sanctions
LO# 9
SEC and PCAOB Sanctions
Suspend Practicing Privilege
Impose Fines
Remedial Measures
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26. Foreign Corrupt Practices Act (FCPA)
LO# 10
Foreign Corrupt Practices Act (FCPA)
Passed in 1977 in response to the discovery of bribery and other misconduct on the part of more than 300 American companies.
An auditor may be subject to administrative proceedings, civil liability, and civil penalties.
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27. LO#
8 & 12
Criminal Liability
Auditors can be held criminally liable under the laws discussed in the previous section. Criminal prosecutions require that some form of criminal intent (mens rea) be present.
Criminal prosecutions of auditors are rare. In a recent study I did of the Big 5, with 1169 lawsuits filed , the auditor was criminally prosecuted in only 7:
BAWAG (KPMG)
Finance Credit (KPMG)
Parmalat (Deloitte & Touche)
American Tissue (Arthur Andersen)
Peregrine Systems (Arthur Andersen)
Enron (Arthur Andersen)
NextCard (Ernst & Young)
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28. End of Chapter 20
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