Module 6 Flashcards
(34 cards)
Duty of Care
- Fiduciaries for corporation & stockholders (owners with limited access to information)
- Good faith & prudent
- Potentially liable to stockholders for negligence – usually related to fraud; rarely for poor decisions-making, except when unethical
Corporate directors and officers are expected to exercise an appropriate level of care and loyalty to the corporation and its shareholders. Not doing so can result in lawsuits from shareholders.
The duty of care means that you act as a fiduciary agent for shareholders and you make or approve decisions that are with good faith and prudent under the circumstances. Acting prudent is generally define as what a reasonable person would do.
Some of the largest lawsuits stem from participation in, or negligent in not detecting or preventing financial statement fraud. Lawsuits can also result from negligence in making decisions regarding mergers and acquisitions – generally when the financial data for the other corporation was materially misstated and the misstatements were not detected until after a merger or acquisition.
Duty of Loyalty
- Faithfulness to one’s obligations and duties
- Subordinate personal interests to welfare of the corporation
- Refrain from self-serving decisions
Corporate directors and officers are also expected to be loyal to the interests of the corporation, even if some decisions that benefit the corporation, but not you as an individual. Loyalty can be more difficult for officers because their compensation is more likely impacted by their decisions.
A good example of misplace loyalty was Andy Fastow, the Enron CFO made a number of decisions affecting special purpose entities that did fraudulently help Enron temporarily, but the decisions affected his personal wealth even more. He had personal interest in virtually all of the special purpose entities Enron established. Apparently, some or all members of Enron’s board of directors knew that Fastow had some financial interest in these special purpose entities when they approved them.
Liability of Directors and Officers
Generally Liable for:
Not Generally Liable for:
Generally Liable for:
- Crimes and torts committed by themselves or by employees under their supervision.
- When they obviously failed in carrying out their duties.
Not Generally Liable for:
- Business Judgments Rule
- Poor business judgments or decisions
- Acting within powers of the corporation
- Reasonable basis for decisions
Clawback of Incentive Compensation
- Public companies need to “clawback” incentive-based compensation paid to senior executives for 3 years prior to when financial restatement occurs under SOX and Dodd-Frank acts.
- Each Act has somewhat different requirements.
Legal Liability for External Auditors
Auditors can be sued by clients, investors, creditors, and the government.
Auditors can be held liable under two classes of law
- Common law
- Statutory law
- Legislation passed at state or federal level that establishes certain courses of conduct that must be adhered to by parties.
- Primarily securities laws
- Other federal laws to prohibit or discourage unethical actions
External auditors are generally sued for negligence in performing their services, where the client or others using the auditor’s work product, are harmed. Government can take action under various securities laws or where the government becomes a successor to the client as in the case of failed federally insured financial institutions.
Primary Plaintiffs for External Accountants & Auditors
Clients
- Breach of contract or negligence
3rd Party beneficiaries (users of F.S.)
- Negligence
Government & Taxpayers
- Violate security laws because of negligence or for government insured financial institutions
These 3 sources account for virtually all CPA lawsuits related to job performance. Sometimes the government sues as a client when it takes over a failed, federally insured financial institution. The Savings & Law scandal in the 1980s and smaller numbers of bank failure after the 2008 financial crisis are perfect examples.
What is Negligence?
Ordinary Negligence
Violation of a legal duty to exercise a degree of care that an ordinarily prudent person (CPA) would exercise under similar circumstances.
Gross Negligence
Reckless disregard for professional responsibilities.
How to Determine:
- Reference to Professional standards (GAAS)
- CPA as an Expert Witness
From a legal perspective, negligence is generally classified as ordinary or gross and the distinction between the two make a significant difference in the external auditor’s legal liability, especially under U.S. security laws.
Gross Negligence usually results from:
- Multiple & significant noncompliance with standards and rules for the service performed.
- Ignoring multiple red flags of problems with information provided by the client.
- Not being professionally skeptical in evaluating information provided by the client.
Most Likely Client Lawsuits
Loss could include fines, penalties, interest, higher interest rate on a loan, lost assets for undetected theft of asset fraud. etc. Common Law is not based on laws based by legislators, but is based on precedent-setting prior cases or the Uniform Commercial Code and the allegation that the CPA was negligent in carrying our the service they provided to the client.
Such cases are usually small dollars and covered by COA malpractice insurance, unless there was “gross” negligence. Even for undetected fraudulent financial reporting, losses are usually smaller to clients and client management is usually participating in the fraud if it is very significant.
Clients Must Generally Prove
- CPA accepted duty to exercise due professional care. (Level of care should be included in the engagement letter - based on level of service.)
- Breach of duty (through negligence)
- Client suffered a loss
- Loss resulted from CPA’s negligence or can be linked to the CPA’s negligence of either not detecting errors or fraud in the information provided by the client or in errors made by the CPA.
Level of service relates to the level of assurance the CPA offered, which for financial statement audits and other attestation engagements where reliability is offered to 3rd parties the auditing & attestation standards describe the level of service for audit/examinations, reviews, agreed upon procedures and compilations.
3rd Parties Must Generally Prove Under Common Law
- They sustained a loss.
- Auditor was negligent.
- 3rd party relied on the financial statements.
- Financial statements were either misleading or had misstatement, which is the proximate cause for the loss.
- Privity exists (as defined by state precedent or law)
3rd party plaintiffs must generally prove all 5 of these items to be successful in a lawsuit against a CPA for negligence when the case is brought directly by the 3rd party. As we will see later, the required proof is less under one of the U.S. security laws when the suit is filed by the federal government.
Basis for 3rd Party Lawsuits
- Basically an inferred-breach of contract.
- 3rd party must be in privity (contractual relationship) with the CPA.
- Privity is defined by precedent setting cases and varies by state.
- Generally, there are 3-levels of defining privity in terms of the universe of potential 3rd parties who can sue CPAs.
- Some states enacted laws to define when privity exists.
3rd party lawsuits generally involve financial statement engagements. Except in rare cases when report use restrictions are clearly stated in the engagement letter, CPAs must assume that their report and the accompanying F.S. will be given to various 3rd parties to support their financial dealings with the client – whether it is for investing, divesting, loaning funds or granting credit.
Therefore, CPAs should know that people and organizations other than the client will be relying on their report and the related F.S.
Inferred contractual relationship, or privity, defines who, besides the client, is eligible to file a lawsuit against a CPA for negligence in providing services to another.
3 Basic Approaches to Defining 3rd Party Privity Under Common Law
- Ultramares Approach
- CPAs liable to identified/known third parties
- Restatement of Torts Approach
- CPAs liable to foreseenclass(es) of third parties
- Rosenblum Approach
- CPAs liable to all foreseeable third parties
These 3 “approaches” really just define what category of 3rd parties can successfully sue a CPA for negligence. The 3 levels basically represent overlapping circles.
Securities Exchange Act of 1933
Act applies to original purchasers of securities (stocks and bonds) from the issuer.
Secondary purchasers can also use this act for up to one year after the registration statement.
This Act has been modified multiple times since it was initially enacted in 1933. Because this Act primarily applies to individuals r organizations who buy the stock directly from the issuer based on the issuers registration statement, the burden of proof required is much less than what we have for lawsuits under common law. As a result, CPAs are at greater risk under this Act.
3rd Party Liabilities Under Common Law
The scope of privity goes from limited to broad. Although not really addressed in the text, a few states have enacted laws to define 3rd party privity, taking it somewhat out of the court’s hands. This resulted from pressure from the CPA profession.
California used to use the most liberal, Rosenblum approach, until a California Supreme Court decision around 1995 after the court became more conservative. Approximate breakout: Ultramares - 30% (many by statute rather than common law) Restatement of Torts - 40% Rosenblum - 5% Unknown/undecided (few cases) - 25%.
Securities Exchange Act of 1934
Act applies to purchases of securities from secondary sources like stock exchanges.
Although purchasers of stock and bonds from secondary sources rely on published client financial statements that CPAs audited, that is not always the case and they may rely on more information for which the CPA had no duty to evaluate. Consequently, CPAs have a lower risk under the Act of 1934.
CPA Liability Under Federal Securities Laws
- Under the 1933 Act, CPAs could also possibly prove that the loss was not caused by F.S. misstatement or that the investor knew of the misstatement (hard to do unless the investor is an insider).
- There’s more protection for, and less burden on, the investor under the 1933 Act probably because they are buying from the most common cause of misleading or misstated F.S. – a CPA’s client.
- Generally under the 1934 Act, CPAs must be grossly negligent or a party to intentional misstatements to be prosecuted under this act. However, this act has “criminal” aspects.
- What’s the difference between Civil & criminal? –Jail time is possible.
Potential Criminal Liability
- To be subject to criminal liability, auditors must generally be shown to be guilty of fraud, scienter or gross negligence.
- Securities Act of 1933
- Imprisonment up to 10 years, or
- Fine up to $10,000, or both
- Securities Act of 1934
- Imprisonment up to 10 years, or
- Fine up to $100,000 or both
Sarbanes-Oxley (SOX) Act of 2002
- SOX makes it a felony to destroy, alter or create documents to impede or obstruct a federal investigation.
- SOX applies to management, accountants and auditors.
- SOX has penalties for CEO & CFO for false certification of F.S.
- SOX has civil & criminal provisions.
- Criminal penalties:
- Imprisonment of 20 years for obstruction of justice
- Imprisonment of 25 years for securities fraud
We can thank Enron and Arthur Andersen for SOX and the first bullet is what Arthur Andersen was originally prosecuted for rather than negligence in performing audits of Enron’s financial statements. Eventually, after Arthur Andersen basically went out of business, the conviction was over-turned by a technicality by the U.S. supreme.
Many believe that the U.S. Department of Justice prosecuted Arthur Andersen for obstruction of justice because there were several other failed audits at large public companies at the time and they did not consider Arthur Andersen to be cooperating. Namely, Worldcom and Waste Management.
Section 18 of the SEC Act of 1934
- Imposes liability on any person who makes a material false or misleading statement in documents filed with the SEC.
- Unlawful to make a false or misleading statement with respect to a material statement unless done in “good faith”.
- Various court cases have shown both positive & negative outcomes for CPAs.
Private Securities Litigation Reform Act
Private Securities Litigation Reform Act:
- Amended securities acts to limit auditor liability to “proportionate” liability.
- Requires auditor whistle blowing to SEC if client management does not take remedial action and report materially misstated financial statements
Proportionate liability can limit a CPA’s liability to a share of the plaintiff’s loss when the auditor’s negligence was not 100% of the reason for the misstated financial statement – generally true.
Because auditors are frequently the only parties left with financial resources after a company fails and fraud is detected, plaintiffs do not like proportionate liability.
Racketeer Influenced & Corrupt Organizations Act (RICO)
- Act covers as “racketeering activities” e.g., mail fraud and fraud in the sale of securities.
- Act has civil and criminal sanctions for illegal acts.
- Act provides for possible assessment of treble damages or 3 times the loss.
- Rarely used for auditors as they must knowingly participate in the illegal act to be prosecuted under this act.
This Act was passed to fight organized crime and brings the concept of holding all parties to a conspiracy to commit a crime to similar liability.
It provides for extended criminal penalties and a civil cause cause of action for acts performed as part of an ongoing criminal organization. The RICO Act focuses specifically on racketeering, and it allows the leaders of a syndicate to be tried for the crimes which they ordered others to do or assist in, closing a perceived loophole that allowed someone who told a man to, for example, murder, to be exempt from the trial because he did not actually do it.
RICO was enacted by section 901(a) of the Organized Crime Act of 1970. In a 1993 case (Reves v. Ernst & Young), the court decided that CPAs cannot be held liable under RICO act unless they actually participated in the operation or management of the organization.
Foreign Corrupt Practices Act of 1977
- Prohibits payments (bribes) made by U. S. multinational entities, and SEC regulated foreign entities, to foreign government officials, including intermediaries to sell products or gain business.
- Requires internal controls to prevent.
- Violations can result in fines and enhanced controls.
- Prohibited payment as one intended to influence a foreign official to act incompatible with his/her legal duty.
- There are acceptable “facilitation” payments, but these would probably have to be to a governmental agency rather than an individual and for effort actually performed or expenses incurred.
This Act was passed after some very high profile payments by U.S. companies to sell their products or services to foreign governments. The excuse that it was standard practice to make such payments to foreign officials in these countries was deemed unacceptable. Acceptable facilitation or “grease” payments may include payments for: Permits, licenses, documents to qualify for work. Processing papers, such as visas. Providing police protection. Providing utilities. Travel expenses.
- Applies to all firms, U.S. and foreign, filing with SEC.
- Dept of Justice oversees criminal and civil enforcement.
- SEC oversees civil enforcement with respect to registrants.
- Corporation may be fined up to $1 million.
- Officers may be fined up to $10,000; imprisoned up to 5 yrs or both. Corporation cannot indemnify officers.
Overview
The Act imposes liability on any person or corporation who “knowingly presents, or causes to be presented, a false or fraudulent claim for payment” to the federal government. Any company that does business with the government—even indirectly (subcontractor) —may face FCA damages and penalties.
A lawsuit can be filed by U.S. government or by a “relator” in name of the U.S. and get 15 – 30% of any judgment or settlement. Although external auditors are rarely at risk under the FCA, internal accountants or auditors could be held liable if they had a role in the making or concealing the over charges to the government.
False Claims Today
- Most are now healthcare related:
- Overcharges to Medicare
- Marketing of Drugs for unapproved uses
- Many relate to sale of goods or services at inflated prices or for substandard material or services.
- Some relate to home mortgage & housing.
- $4.9 billion in settlements & judgments in civil cases in FY 2012.
Healthcare and procurement related violations frequently involve accountants to craft or conceal the overcharges. In 1994, Litton paid over $80 million in over charges related to how it allocated computer center operating costs to divisions primarily selling products to the government. In 2012, Oracle paid almost $200 million for over charges from lower price discounts for software licenses and technical services than it had agreed to.
