2. BUS 42510/16/2014 1 legal liability

3. BUS 42510/16/2014 2

4. 10/16/2014 3 Cases to study Common Law (Torts) Ultramares Corp v Touche (1931) Credit Alliance v Arthur Andersen (1986) Rusch Factors v. Levin (1968) Restatement Second of Torts (1977) Rosenblum v Adler (1983) Statute Law Securities Act of 1933 Section 11 Securities & Exchange Act of 1934 Sec 10b-5 Ernst & Ernst v Hochfelder (1976)

5. BUS 42510/16/2014 4 vocabulary

6. BUS 42510/16/2014 5 business failure audit failure audit risk

7. BUS 42510/16/2014 6 Norman describe business failure

8. BUS 42510/16/2014 7 Bill define audit risk

9. BUS 42510/16/2014 8 Colleen describe limited liability partnership LLP

10. BUS 42510/16/2014 9 LLP limited liability partnership Taxed like a general partnership Partners are personally liable for the partnership’s debts and obligations Partners are personally liable for their own acts, and the acts of others under their supervision Partners are not personally liable for liabilities arising from negligent acts of other partners and employees not under their supervision

11. BUS 42510/16/2014 10 statute law common law breach of contract tort joint & several liab proportionate liab standard of care privity of contract v. third parties near privity

12. BUS 42510/16/2014 11 Eastwood describe common law describe statute law

13. BUS 42510/16/2014 12 common law contract law (applies to the audit client) tort law (applies to third parties) statute law Securities Act of 1933 Securities Exchange Act of 1934 Foreign Corrupt Practices Act of 1977 The Sarbanes Oxley Act of 2002

14. BUS 42510/16/2014 13 State LawFederal Law Common LawAuditors auditors Statute Law auditors Auditors

15. BUS 42510/16/2014 14 Common Law

16. BUS 42510/16/2014 15 Ifunanya What is the difference between a Breach of Contract and a Tort

17. BUS 42510/16/2014 16 Tort American Heritage Dictionary American Heritage Dictionary A wrongful act, damage, or injury done willfully, negligently, or in circumstances involving strict liability, but not involving a breach of contract.

18. BUS 42510/16/2014 17 JP What type of action would we expect The audit client to file against the auditor? Some one who invested in the audit client to file against the auditor?

19. BUS 42510/16/2014 18 Kelly Discuss the difference between joint and several liability proportionate liability

20. BUS 42510/16/2014 19 standard of care ordinary negligence gross negligence recklessness constructive fraud fraud

21. BUS 42510/16/2014 20 Kyle CDavid discuss ordinary negligence

22. BUS 42510/16/2014 21 Brian discuss gross negligence

23. BUS 42510/16/2014 22 Courtney discuss fraud

24. BUS 42510/16/2014 23 what standard of care (level of performance) is unacceptable for a professional ? Kaitlyn

25. BUS 42510/16/2014 24 Breach of Contract what standard of care unacceptable if the plaintiff has privity of contract and brings the lawsuit under breach of contract ? Megan

26. BUS 42510/16/2014 25 Common Law - Tort In order to recover from an auditor under common law, the plaintiff must prove Duty to perform Breach of Duty Losses Causation

27. BUS 42510/16/2014 26 Burden of Proof Third-party investors must demonstrate Auditor had a Duty to perform Breach of Duty – the Auditor was negligent, did not exercise due professional care Contributory negligence not an issue in most cases dealing with third party investors They suffered a Loss Causation – the loss was caused by reliance on financial statements which were materially misstated

28. BUS 42510/16/2014 27 when talking about Common Law Tort (if the plaintiff is not in privity of contract with the auditor ) Where fraud or constructive fraud is present, most jurisdictions expand the rights of third party investors who do not have privity of contract. Where fraud or constructive fraud is present, we assume the auditor will be held liable to third parties using the financial statements.

29. BUS 42510/16/2014 28 Common Law - Tort (not in privity) third parties To which third parties are we liable for Ordinary Negligence ?

30. BUS 42510/16/2014 29 Melanie Different jurisdictions hold auditors liable for ordinary negligence to different ‘classes of third parties’ what are the three different classes of “third parties”

31. BUS 42510/16/2014 30 common law contract law - contract with the audit client tort law - third parties primary beneficiary Ultramares foreseen class Restatement Rosenblum foreseeable parties Rosenblum

32. BUS 42510/16/2014 31 remember, there is a body of federal common law but most common law pertaining to securities is state common law each state has its own body of common law so, we will need to move our little example around the country

33. BUS 42510/16/2014 32

34. BUS 42510/16/2014 33 New York Ultramares v. Touche (1931) Credit Alliance (1985) only liable to primary beneficiary for ordinary negligence Judge C. J. Cardozo wrote If liability for negligence exists,..., the failure to detect a theft or forgery beneath the cover of deceptive entries may expose accountants to a liability in indeterminate amounts, for an indeterminate time, to an indeterminate class. The hazards of a business conducted on these terms are so extreme ….

35. BUS 42510/16/2014 34 New York Ultramares (1931) Credit Alliance v Arthur Andersen (1985) only liable to primary beneficiary for ordinary negligence accountant must have been aware that the financial reports were to be used for a particular purpose In furtherance of which a known party(ies) was intended to rely There must have been some conduct on the part of the accountants which evinces the accountant’s understanding of that party(ies) reliance. New York Superior Court

36. BUS 42510/16/2014 35 foreseen US District Court - Rhode Island Rusch Factors v. Levin (1968) … the auditor should be liable for ordinary negligence in audits where financial statements are relied on by actually foreseen and limited classes of persons.

37. BUS 42510/16/2014 36 Second Restatement of Torts (1977) liable to reasonably limited and identifiable group of users for ordinary negligence liability is limited to the person or one of a limited group of persons for whose benefit the auditor … knows the audit client intends to supply the financial statements through reliance on the financial statements in a transaction of which the auditor knows the audit client intends to use the financial statements to influence the transaction or a substantially similar transaction

38. BUS 42510/16/2014 37 Second Restatement of Torts (1977) liable to reasonably limited and identifiable group of users for ordinary negligence an auditor is liable for negligence to a third party only if (s)he intends to supply the information for the benefit of one or more third parties in a specific transaction or type of transaction identified to the supplier.

39. BUS 42510/16/2014 38 To offer a simple illustration … an auditor engaged to perform an audit and render a report to a third person whom the auditor knows is considering a $ 10 million investment in the client's business is on notice of a specific potential liability. It may then act to encounter, limit or avoid the risk. In contrast, an auditor who is simply asked for a generic audit and report to the client has no comparable notice.

40. BUS 42510/16/2014 39 For example, the auditor may be held liable to a third party lender if the auditor is informed by the client that the audit will be used to obtain a $ 50,000 loan, even if the specific lender remains unnamed or the client names one lender and then borrows from another.

41. BUS 42510/16/2014 40 Similarly, there is no liability when the client's transaction (as represented to the auditor) changes so as to increase materially the audit risk, e.g., a third person originally considers selling goods to the client on credit and later buys a controlling interest in the client's stock, both in reliance on the auditor's report.

42. BUS 42510/16/2014 41 Under the Restatement rule, an auditor retained to conduct an annual audit and to furnish an opinion for no particular purpose generally undertakes no duty to third parties. … The client uses the financial statements to obtain a loan from bank. Because of negligence, the auditor issues an unmodified opinion upon a balance sheet that materially misstates the financial position … through reliance upon it the bank suffers …. a loss." Consistent with the text of section 552, the authors conclude: "The auditor is not liable to the bank."

43. BUS 42510/16/2014 42 New Jersey (Supreme Court of N.J) Rosenblum v Adler (1983) p. 120 liable to reasonably foreseeable parties for ordinary negligence

44. BUS 42510/16/2014 43 New York Mary invested in Kar Sales, Inc. Kar Sales, Inc. is not publicly traded. They are not required to file with the SEC Kar Sales, Inc. had their financial statements audited …. In order to get a bank loan. They told their auditor they were having their financial statements audited to get a …….. bank loan. Kar Sales, Inc. suffers a major loss and is going bankrupt

45. BUS 42510/16/2014 44 primary beneficiary ( state courts of New York )

46. BUS 42510/16/2014 45 Mary files a common law claim in a New York court Mary can show that the auditor was negligent Is Mary likely to prevail? To which case will the N.Y. courts look for guidance about auditors’ liability ? Matt F

47. BUS 42510/16/2014 46 In our New York example is there a primary beneficiary? to whom in our New York example might the auditor be held liable for ordinary negligence? Brianna

48. BUS 42510/16/2014 47 standard of care (in New York) ordinary negligence primary beneficiariesyes foreseen classno foreseeable partiesno gross negligence primary beneficiariesyes recklessnessforeseen classyes constructive fraudforeseeable partiesyes fraud

49. BUS 42510/16/2014 48 What is Rhode Island’s official name? officially the State of Rhode Island and Providence Plantations

50. BUS 42510/16/2014 49 let’s move our example to Rhode Island Mary invested in Kar Sales, Inc. Kar Sales, Inc. is not publicly traded. They are not required to file with the SEC Kar Sales, Inc. had their financial statements audited …. In order to get a bank loan. They told their auditor they were having their financial statements audited to get a …….. bank loan. Kar Sales, Inc. suffers a major loss and is going bankrupt

51. BUS 42510/16/2014 50 foreseen class ( state courts of Rhode Island )

52. BUS 42510/16/2014 51 Mary files a common law claim in a Rhode Island court Mary can show that the auditor was negligent Is Mary likely to prevail? To which case will the Rhode Island courts look for guidance about auditors’ liability ? Holly

53. BUS 42510/16/2014 52 In our Rhode Island example who in our Rhode Island example might be an actually foreseen and limited class of persons or a foreseen party to whom the auditor would be liable for ordinary negligence? Manuel

54. BUS 42510/16/2014 53 standard of care (in Rhode Island) ordinary negligence primary beneficiariesyes foreseen classyes foreseeable partiesno gross negligence primary beneficiariesyes recklessnessforeseen classyes constructive fraudforeseeable partiesyes fraud

55. BUS 42510/16/2014 54 let’s move our example to Mississippi or Wisconsin Mary invested in Kar Sales, Inc. Kar Sales, Inc. is not publicly traded. They are not required to file with the SEC Kar Sales, Inc. had their financial statements audited …. In order to get a bank loan. They told their auditor they were having their financial statements audited to get a …….. bank loan. Kar Sales, Inc. suffers a major loss and is going bankrupt

56. BUS 42510/16/2014 55 reasonably foreseeable parties ( state courts of Mississippi or Wisconsin )

57. BUS 42510/16/2014 56 Mary files a common law claim in a Mississippi court Mary can show that the auditor was negligent Is Mary likely to prevail? To which case will the Mississippi courts look for guidance about auditors’ liability ? Eric

58. BUS 42510/16/2014 57

59. BUS 42510/16/2014 58 who, in our Mississippi example, would be a reasonably foreseeable party in this example? PJ

60. BUS 42510/16/2014 59 standard of care (in Mississippi) ordinary negligence primary beneficiariesyes foreseen classyes foreseeable partiesyes gross negligence primary beneficiariesyes recklessnessforeseen classyes constructive fraudforeseeable partiesyes fraud

61. BUS 42510/16/2014 60

62. BUS 42510/16/2014 61 Securities Law start here

63. BUS 42510/16/2014 62 Securities Law Securities Act of 1933 ( section 11 ) Securities Exchange Act of 1934 ( section 10 b-5 ) – – Foreign Corrupt Practices Act (1977) – – Sarbanes-Oxley Act (2002)

64. BUS 42510/16/2014 63 Geri, the General Manager of Kar Sales Inc., which is a closely held (not publicly owned) company in San Luis Obispo Geri the Gen. Manager owns stock in Kar Sales Inc. Geri needs some money, so she writes her friend Mary, who lives in New York, and asks her if she would like to buy some of her Kar Sales Inc. stock Geri also mails a copy of Kar Sales Inc. financial statements which have been audited by Miller LLP to Mary Mary buys some stock from Geri

65. BUS 42510/16/2014 64 Kar Sales Inc. suffers a large loss and is going bankrupt

66. BUS 42510/16/2014 65 Securities Act of 1933

67. BUS 42510/16/2014 66 Mary’s attorney believes she can show that the auditor was negligent is Mary likely to prevail if she sues under the Securities Act of 1933 Amanda

68. BUS 42510/16/2014 67 Securities Act of 1933 initial public offerings any person acquiring the security plaintiff (the person acquiring in this case) is not required to show reliance auditor liable for ordinary negligence

69. BUS 42510/16/2014 68 Securities Act of 1933 section 11 any part of the registration statement... contained an untrue statement of a material fact or omitted to state a material fact

70. BUS 42510/16/2014 69 standard of careunder 1933 Act ordinary negligence gross negligence recklessness constructive fraud fraud

71. BUS 42510/16/2014 70 Anna what type of stock transactions does the 1933 Act regulate ? what type of stock transactions does the 1934 Act regulate ?

72. BUS 42510/16/2014 71 Securities Act of 1933 who sells stock in an “IPO” ? who produces the financial statements ? whose interests need be protected in an IPO?

73. BUS 42510/16/2014 72 Calvin who sells stock in an “IPO” ? who produces the financial statements ? whose interests need be protected in an IPO?

74. BUS 42510/16/2014 73 Securities Exchange Act of 1934

75. BUS 42510/16/2014 74 Geri, the General Manager of Kar Sales Inc., which is a closely held (not publicly owned) company in San Luis Obispo Geri the Gen. Manager owns stock in Kar Sales Inc. Geri needs some money, so she writes her friend Mary, who lives in New York, and asks her to buy some of her stock Geri also mails a copy of Kar Sales Inc. financial statements which have been audited by Miller LLP to Mary Mary buys some stock from Geri

76. BUS 42510/16/2014 75 Kar Sales Inc. suffers a large loss and is going bankrupt

77. BUS 42510/16/2014 76 Mary’s attorney thinks she can show that the auditor was negligent Is Mary likely to prevail if she sues under the Securities Exchange Act of 1934 Remember: Mary lives in New York and the General Manager of Kar Sales Inc. mailed the audited financial statements to her from SLO Matt N

78. BUS 42510/16/2014 77 Securities Exchange Act of 1934 section 10b-5... by use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange to employ, any device, scheme or artifice to defraud to make any untrue statement of material fact of to omit to make to engage in any practice or course of business which operates as a fraud or deceit upon any person...

79. BUS 42510/16/2014 78 What is the applicable “standard of care” under the Securities Exchange Act of 1934 ? Is Mary likely to prevail under the 1934 Act if she can prove the auditor was negligent ? Cameron

80. BUS 42510/16/2014 79 Securities Exchange Act of 1934 secondary markets any person acquiring or selling the security plaintiff must show reliance Hochfelder p. 123 auditor is not liable for ordinary negligence

81. BUS 42510/16/2014 80 Hochfelder v. Ernst & Ernst “ “When a statue speaks so specifically in terms of manipulation and deception, and of implementing devices and contrivances - the commonly understood terminology of intentional wrongdoing - and when its history reflects no more expansive intent, we are quite unwilling to extend the scope of the statute to negligent conduct.” Justice Powell, U.S. Supreme Court

82. BUS 42510/16/2014 81 standard of care ordinary negligence gross negligence recklessness constructive fraud fraud

83. BUS 42510/16/2014 82 Chris M who sells stock in the “secondary markets”? who produces the financial statements ? whose interests need be protected in secondary market exchanges ?

84. BUS 42510/16/2014 83 SUMMARY OF DIFFERENCES BETWEEN 1933 AND 1934 ACTS

85. BUS 42510/16/2014 84 Do we agree that auditors, or any professionals, should be liable for gross negligence, recklessness, constructive fraud, or fraud? Notice that the Federal Security’s Laws don’t offer investors recourse for ‘ordinary negligence’ in the secondary markets

86. BUS 42510/16/2014 85 In order to manage legal liability Understand the client’s business Document your work Professional skepticism

87. BUS 42510/16/2014 86 Professional skepticism An attitude that includes a questioning mind and a critical assessment of audit evidence. Auditors should not assume that management is dishonest, but the possibility of dishonesty should be considered. At the same time, auditors should not assume that management is unquestionably honest.

88. BUS 42510/16/2014 87 timing is important

89. BUS 42510/16/2014 88 common law liability to third parties for ordinary negligence 1931UltramaresNew York 1968Rusch FactorsRhode Island 1983RosenblumNew Jersey

90. BUS 42510/16/2014 89 common law liability to third parties for ordinary negligence in California (Supreme Court of CA) 1986 – –International Mortgage (foreseeable parties)

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93. BUS 42510/16/2014 92 common law liability to third parties for ordinary negligence in California (Supreme Court of CA) 1986 – –International Mortgage (foreseeable parties) 1993 – – Bily(primary beneficiary)

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95. BUS 42510/16/2014 94 things are getting better

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98. BUS 42510/16/2014 97 Reeves v. Ernst & Young RICO treble damages racketeer influenced and corrupt practices act with regards to auditors U.S. Supreme Court took the teeth out of Federal RICO laws RICO requires some participation in the operation or management of the enterprise

99. BUS 42510/16/2014 98 Aid and Abet To assist another in the commission of a crime by words or conduct. The person who aids and abets participates in the commission of a crime by performing some overt act or by giving advice or encouragement. He or she must share the criminal intent of the person who actually commits the crime, but it is not necessary for the aider and abettor to be physically present at the scene of the crime. An aider and abettor is a party to a crime and may be criminally liable as a principal, an accessory before the fact, or an accessory after the fact. West's Encyclopedia of American Law, edition 2. Copyright 2008 The Gale Group, Inc. All rights reserved. West's Encyclopedia of American Law, edition 2. Copyright 2008 The Gale Group, Inc. All rights reserved.

100. BUS 42510/16/2014 99 Central Bank of Denver v. First Interstate Bank U.S. Supreme Court 1994 investors and other private parties are no longer able to bring suits against auditors for ‘aiding and abetting’ under section 10B of the Securities Exchange Act of 1934

101. BUS 42510/16/2014 100 The Private Securities Litigation Reform Act of 1995 amends the Securities Exchange Act of 1934 … liable solely for the portion of the judgment that corresponds to the percentage of responsibility proportionate liability Unless it is determined that the person knowingly committed a violation of securities law. In which case they would be jointly and severally liable.

102. BUS 42510/16/2014 101 The Securities Litigation Uniform Standards Act of 1998 with regard to securities litigation Requires that class action suits with 50 or more parties must be filed in the F EDERAL C OURTS.

103. BUS 42510/16/2014 102 New JerseyRosenblum v Adler foreseeable parties N.J.S.A. 2A:53A-251995 statute New Jersey state legislature has subsequently passed legislation that defines auditors liability because of this statute auditors are no longer liable to foreseeable parties for ordinary negligence in N.J.

104. BUS 42510/16/2014 103 we still teach Rosenblum even though New Jersey has passed legislation that overturns this case because the concept of foreseeable parties is still a valid legal concept and Mississippi and Wisconsin adhere to the concept of foreseeable parties

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