Module IV - Readings Flashcards
1
Q
What does the doctrine of joint and several liability say?
A
Plaintiff in an action against an auditor could, until recently, recover potentially all damages from the auditor alone, even though auditor’s report may have only contributed partially to plaintiff’s lost
2
Q
Define privity.
A
Parties in a contractual relationship with the auditor
3
Q
Because auditors have little control over who uses their work product, who may they be liable to?
A
May be liable to parties who are not in privity
4
Q
Define proportionate liability.
A
Defendants liable only for their share of responsibility
5
Q
To protect auditors from extensive lawsuits, what did the profession help the CEASS to introduce and pass?
A
Private Securities Litigation Reform Act of 1995
6
Q
What is Private Securities Litigation Reform Act of 1995?
A
Legislation that reduces the “joint and several liability” to “proportionate liability,” except for defendants for knowingly engage in fraud
7
Q
In civil liability cases against auditors, what four questions underscore the issues at stake?
A
(1) Under what source of law is the plaintiff suing?
(2) Who is the plaintiff?
(3) What is the auditor’s potential liability?
(4) And which party (plaintiff or defendant) has the burden of proving what?
8
Q
What sources of law can the plaintiff sue under?
A
- Common law
- Statutory law
9
Q
What is common law?
A
- Written opinions of prior courts within a state (called legal precedent)
- Each state has its own common law
10
Q
What is common law based in? Expand.
A
- Based in the doctrine of stare decisis
- Stare decisis: handing down precedent-setting principles of law to succeeding cases
11
Q
Are lower courts in a state bound by the precedent of the state’s highest court?
A
- Yes
- Lower courts in state bound by precedent of state’s highest court
12
Q
Is the highest court in a state bound by its own precedent?
A
- No
- Highest court not bound by its own prior opinions and may borrow precedent from other states
13
Q
What does statutory law refer to?
A
- Refers to written statutes established by Congress at the federal level and by state legislatures at the state level
14
Q
What are the two most prominent statues affecting an auditor’s legal liability?
A
- Securities Act of 1933
- Securities Exchange Act of 1934
15
Q
Who is typically the plaintiff if suing under common law?
A
- Client
- Third party
16
Q
If a client is suing under common law, what may the client bring an action against an auditor for?
A
- For breach of contract
- For tort
17
Q
Why may clients sue for breach of contract?
A
- Because clients are parties (they are in privity) to an express or implied contract for audit services
18
Q
What is a tort?
A
- A wrongful act, other than breach of contract
- Results in injury injury to another person
19
Q
What do suits in tort usually allege?
A
- Negligence
- Gross negligence
- Fraud
20
Q
Who may be a plaintiff in an action under the Securities Act of 1933?
A
Securities purchaser
21
Q
Who may be a plaintiff in an action under the Securities Exchange Act of 1934?
A
Securities purchaser/seller
22
Q
In what two states is an auditor liable to foreseeable third parties?
A
- Mississippi
- Wisconsin
23
Q
Under either common or statutory law, an auditor may be liable for what three things?
A
(1) Ordinary negligence
(2) Gross negligence
(3) Fraud
24
Q
In Ultramares Corp. v. Touche, the NY Court of Appeals noted that gross negligence could be so great as to constitute what? Expand.
A
- Constructive fraud (not actual fraud)
- Lacks intent, an essential condition in actual fraud, but result of both constructive and actual fraud is identical (another party is deceived, and then injured)
25
Does the plaintiff or the auditor have the burden of proving/disproving that the plaintiff sustained a damage or loss?
Plaintiff
26
Does the plaintiff or the auditor have the burden of proving/disproving that the audited F/S were materially misstated?
Plaintiff
27
Does the plaintiff or the auditor have the burden of proving/disproving that the plaintiff relied on the F/S?
- Under common law & SEA '34 = burden on plaintiff
| - Under SA'33 = burden on auditor
28
Does the plaintiff or the auditor have the burden of proving/disproving that the auditor's conduct was deficient?
- Under common law & SEA '34 Sec. 10b = plaintiff
| - Under SA '33 and SEA '34 Sec. 18 = auditor
29
What is an auditor's common law liability to clients?
- Ordinary negligence
- Although clients may bring action for gross negligence if they believe auditor departed recklessly from auditing standards
- Or for fraud if they believe auditor intended to deceive and injure
30
Under common law, what does the client have the burden of proving to recover damages?
- Damage or loss
- Misstated F/S
- Reliance on F/S
- Deficient auditor conduct
31
Under common law, what is an auditor liable to a primary beneficiaries for?
- Ordinary negligence (lack of reasonable care)
32
Under common law, what does the primary beneficiary have the burden of proving to recover damages?
- Damage or loss
- Misstated F/S
- Reliance on F/S
- Deficient auditor conduct
33
In the 2003 USA Today article "Investigation of General Mills' Accounting Hits Hards," what was it being investigated for? Why is this such a big risk?
- Investigated for its "sales practices"
| - Big risk b/c sales practices often tie to how revenue is booked (which is #1 cause of earnings restatements)
34
In the 2003 USA Today article "Investigation of General Mills' Accounting Hits Hards," what is General Mills relationship with the Dutch supermarket chain Ahold?
- General Mills does business with Ahold
35
In the 2003 USA Today article "Investigation of General Mills' Accounting Hits Hards," what is the problem with Ahold?
- Mired with accounting problems
| - Ahold found accounting overstatements of roughly $1bn due to improperly booking incentive payments from vendors
36
In the 2003 USA Today article "Investigation of General Mills' Accounting Hits Hards," what was General Mills response to the SEC investigation?
- Asserts it followed all proper accounting rules
37
General Mills has received questions about its accounting before, including its treatment of what two things?
- Restructuring charges (SEC questioned its $190m "cereal reconfiguration" charge after its acquisition of Pillsbury)
- Pension plan assumptions (SEC questioned co. assumption its pension plan would earn more than 10% per year which is higher than 9% figure SEC uses as threshold)
38
"2013 Cornerstone Research, Securities Litigation Settlements"
Boosted by a second-half surge, what type of filings increased in 2013?
- Federal securities fraud class action filings increased in 2013
39
"2013 Cornerstone Research, Securities Litigation Settlements"
What three sectors accounted for 21 percent of total filings in 2013?
- Healthcare co
- Biotechnology co
- Pharmaceutical co
40
"2013 Cornerstone Research, Securities Litigation Settlements"
Define filing lag.
- Time b/w the end of a class period and the filing of a securities class action
41
"2011 PwC, Securities Litigation Study"
The opening of what office is likely to have a significant impact on corporate investigations and SEC enforcement?
- SEC Office of the Whistleblower
42
"2011 PwC, Securities Litigation Study"
The Supreme Court's decision in the Morrison case limited what?
- Limited the jurisdiction of US courts to hear cases brought by foreign investors against foreign companies for shares purchased on a foreign exchange
43
"2011 PwC, Securities Litigation Study"
Who continues to be named in the majority of filings?
- C-suite and senior management
| esp. CEO and CFO
44
"2011 PwC, Securities Litigation Study"
What types of cases shot up by 17% in 2011?
- M&A cases (an emerging focus of litigation)
45
"2011 PwC, Securities Litigation Study"
In M&A related cases, what do plaintiffs primarily allege?
- Allege a breach of fiduciary duty when the BODs accepts an offer that undervalues the company
46
"2011 PwC, Securities Litigation Study"
Why is it attractive for plaintiffs to bring M&A cases?
- Cases filed very quickly following announcement of transaction and the allegations are relatively straightforward
- Cases usually settled shortly thereafter
- Plaintiffs don't require considerable investment of time or resources in M&A cases
47
"2011 PwC, Securities Litigation Study"
In M&A cases, time is of the essence for plaintiffs to do what?
- To file their claim
48
"2011 PwC, Securities Litigation Study"
In M&A cases, what is the defendants priority?
- To close the transaction
49
"2011 PwC, Securities Litigation Study"
What does FI stand for?
- Foreign issuer
50
"2011 PwC, Securities Litigation Study"
What represents about half of the accounting related cases in 2011?
FIs
51
"2011 PwC, Securities Litigation Study"
Accounting allegations fall within what six main categories?
- Overstatement of assets
- Estimates
- Internal controls
- Understatement of liabilities and expenses
- Revenue recognition
- Purchase accounting
52
"2011 PwC, Securities Litigation Study"
Who leads the pack as lead plaintiffs?
- Institutional investors (i.e. public and union pension funds)
53
"AAERS 1405 In the Matter of AA, 2001"
What type of proceeding was instituted against Arthur Andersen?
- Public administrative proceeding
54
"AAERS 1405 In the Matter of AA, 2001"
What did the action arise out of?
- AA's issuance of materially false and misleading audit reports on WM financial statements for period '93 through '96
55
"AAERS 1405 In the Matter of AA"
Why did WM do that led to restatements for '93 through '96?
- Used improper accounting to inflate its operating income and other measures of success
- Primarily by deferring the recognition of current period operating expenses into the future
- And by netting one-time gains against current and prior period misstatements and current period operating expenses
56
"AAERS 1405 In the Matter of AA"
On July 16, 1998, who did WM merge with?
USA Waste Services (but retained WM name)
57
"AAERS 1405 In the Matter of AA"
As early as 1988, what aggressive WM accounting practices did auditors note that WM used to enhance its earnings?
- Repeated Q4 adjustments to reduce depreciation expense on its vehicles, equipment, and containers cumulatively from beg. of year
- Adopted non-GAAP method of capitalizing interest on landfill development costs
- Failed to properly accrue for its tax and self-insurance expenses
- Improper use of purchase accounting to increase its environmental remediation reserves
- Improper charges of operating expenses to the environmental remediation reserves
- Refused to write-off project costs on impaired or abandoned landfills
58
"AAERS 1405 In the Matter of AA"
How did WM's aggressive accounting practices impact the financial statements (1988)?
- Together increased reporting operating income primarily by understating operating expenses
- In most cases, co. deferred recognition of current operating expenses to future periods to inflate its current period income
59
"AAERS 1405 In the Matter of AA"
In the late 1980s and early 1990s, what became more difficult for WM?
- Earnings growth
60
"AAERS 1405 In the Matter of AA"
Why did Andersen's Chicago office place WM on its "monitored client list"?
- WM posed a significant audit risk to firm
- B/c WM actively managed reported results
- B/c WM had a history of making significant Q4 adjustments to its F/S
- B/c WM was in an industry that required highly judgmental accounting estimates
61
"AAERS 1405 In the Matter of AA"
An auditor's ultimate allegiance is to whom?
- Corporation's shareholders and to the investing public
62
"Stanford law review: stock price crashes and 10b-5 damages"
Sharp stock price declines occurring upon the release of negative corporate info often triggers what?
- S/H litigation under SEC rule 10b-5
63
"Stanford law review: stock price crashes and 10b-5 damages"
What do Lev and de Villiers argue in their article?
- Argue that "crash price" is an unreliable, doctrinally erroneous, and economically unsound measure of damages
64
"Stanford law review: stock price crashes and 10b-5 damages"
What do Lev and de Villiers propose in their article?
- Propose alt. methods of damage calculation that extract the crash component from a postdisclosure price and yield a more accurate and fairer estimate of stock's true value
65
"Stanford law review: stock price crashes and 10b-5 damages"
Define crash price.
- Stock price immediately following the disclosure of negative corporate info
66
"Stanford law review: stock price crashes and 10b-5 damages"
Plaintiffs claimed they suffered damages by buying Oracle's stock at an inflate price. To estimate the damages, a plaintiffs' expert in a consolidated proceeding uses what standard method for 10b-5 cases?
Backward induction
67
"Stanford law review: stock price crashes and 10b-5 damages"
What is backward induction?
- Starts by determining when firm's "true" financial situation became public
- Stock price at end of that day is assumed to reflect stock's true value once investors have reacted to new info
- Estimate total damages for the class period by extrapolating the postdisclosure value backwards for every day misrepresentation went uncorrected (experts use a formula)
68
"Stanford law review: stock price crashes and 10b-5 damages"
In backward induction, what does the class period refer to?
- Period starting with the misstatements or breach of the duty to disclose and ending with the disclosure
69
"Stanford law review: stock price crashes and 10b-5 damages"
In backward induction, how do experts typically estimate the damages?
- As the difference between the actual daily price and the "true" value on a given day
- Multiplied by the #shares plaintiffs purchased
70
"Stanford law review: stock price crashes and 10b-5 damages"
In crashes, what four extraneous factors greatly affect a stock's price?
- Type of people investing in a stock
- How much info investors have
- Prevalence of auto trading mechanisms and hedging
- Ability to use specialists on the trading floor to provide liquidity
71
"Stanford law review: stock price crashes and 10b-5 damages"
It is difficult to provide direct evidence of cases in which courts have award crash damages because virtually all 10b-5 cases do what?
Settle
72
"Stanford law review: stock price crashes and 10b-5 damages"
In Elkind v. Liggett, the court chose what as a full disclosure stock price?
- the lowest price in the 8 trading days after the company's surprise announcement
73
"Stanford law review: stock price crashes and 10b-5 damages"
The Tenth Circuit, in Richardson v. MacArthur, stated that a stock's true value is what?
- Its price on the date the fraud was or should have been discovered
74
"Stanford law review: stock price crashes and 10b-5 damages"
The Eight Circuit, in Harris v. American Investment Co, the Eighth Circuit stated what represented the true value of the stock?
- The price after the market reacted to the revelation of securities fraud
75
"Stanford law review: stock price crashes and 10b-5 damages"
Basic economics holds that the value of a security depends on the PV of future cash flows.
These CFs are in turn determined by the firm's fundamentals which include what?
- Includes its assets, earning, and growth potential, as well as by the overall condition of the industry and economy
76
"Stanford law review: stock price crashes and 10b-5 damages"
By definition, a stock price crash is a what?
- A discontinuity b/w the price and the fundamentals (includes its assets, earning, and growth potential, as well as by the overall condition of the industry and economy)
77
"Stanford law review: stock price crashes and 10b-5 damages"
Most investors tend to ignore info about what?
Fundamentals (includes its assets, earning, and growth potential, as well as by the overall condition of the industry and economy)
78
"Stanford law review: stock price crashes and 10b-5 damages"
Economic models typically posit three investor groups. What are these three investor groups?
1) Informed investors
2) Marketmakers
3) Uninformed investors
79
"Stanford law review: stock price crashes and 10b-5 damages"
Who fits the mold of an informed investor?
- People such as financial analysts and their clients who not only pay attention to a stock's price, but also have access to some relevant info on fundaments such as earnings, inventories, order backlogs, and planned products
80
"Stanford law review: stock price crashes and 10b-5 damages"
Who fits the mold of a marketmaker?
- Specialists on the exchange floor who continually observe info about trading, including the flow of trade orders and their sources, as well as the timing and size of new stock issues
- This group is quite small
81
"Stanford law review: stock price crashes and 10b-5 damages"
Who fits the mold of an uninformed investor?
- People who only notice the stock price and are either unaware of or disinterested in additional info, which they deem too costly
- For these people, the stock's price aggregates all info about it
- Most individual investors and "passive" funds, such as indexed portfolios, fall into this category
82
"Stanford law review: stock price crashes and 10b-5 damages"
According to current crash theories, how does a typical stock crash evolve?
1) Informed investors obtain neg. info about stock (like the earnings report that signaled end of Oracle's earnings growth)
2) Some informed investors sell stock based on info
3) At this point, supply outstrips demand and stock price drops
4) Uninformed investors see falling price and conclude informed investors know something they don't
5) Some uninformed investors sell stock and price continues to fall
83
"Stanford law review: stock price crashes and 10b-5 damages"
At a certain point during a crash, stock price disconnects from fundamentals and instead depends largely on what?
Nonfundamental factors (such as ratio of informed to uninformed investors and the extend of hedging in the security)
84
"Stanford law review: stock price crashes and 10b-5 damages"
Common and statutory law suggests that damages in security litigation should be based on what?
- A stock's FMV (i.e. on the fundamental value of the firm which includes its assets, earning, and growth potential, as well as by the overall condition of the industry and economy)
85
"Stanford law review: stock price crashes and 10b-5 damages"
What do the authors argue in terms of damages based on crash prices?
- In many cases neg. corporate announcements trigger a crash of stock price, wherein stock price becomes disconnected with firm's fundamental value
- Damages based on crash prices thus overstate actual change in the fundamentals
86
"Stanford law review: stock price crashes and 10b-5 damages"
Basing damages on crash prices creates perverse incentives for whom?
- Management and auditors (while rendering their fiduciary duties less coherent)
87
"Stanford law review: stock price crashes and 10b-5 damages"
What is the key role of marketmakers?
- Depends on quality of their info
| - Generally they provide liquidity by absorbing any imbalances in supply or demand
88
"Stanford law review: stock price crashes and 10b-5 damages"
All crash theories reject the classical assumption in economic theory that informed investors will quickly step in and do what?
- Stabilize out of equilibrium asset price movements by bucking the trend
- i.e. buy when prices fall below fundamentals
- i.e. sell when prices rise above fundamentals
89
"Stanford law review: stock price crashes and 10b-5 damages"
What does the efficient capital markets theory state?
- Security prices at any point in time reflect all relevant, publicly available info, including misinformation
90
"Stanford law review: stock price crashes and 10b-5 damages"
What was the impact of the efficient capital markets theory on securities litigation cases?
- Theory holds that whether or not an individual investor personally "relied" on a specific source of info is irrelevant since price she paid (or received) for the security already reflected the alleged misrepresentation
- Came to be known as "fraud on the market" theory
91
"Stanford law review: stock price crashes and 10b-5 damages"
What did the "fraud on the market" theory enable plaintiffs to claim in securities litigation cases?
- Claim reliance on "integrity" (or efficiency) of the stock price, rather than on specific info
92
"Stanford law review: stock price crashes and 10b-5 damages"
The "fraud on the market" theory shifts the focus from what to what?
- From an individual's reliance on a misstatement
- To the misstatement's effect on the security's price
- And to the individual's reliance on this price
93
In the 1988 case of Basic Inc. v. Levinson, the Supreme Court sanctioned the use of what theory to show reliance in a 10b-5 action?
"Fraud on the market" theory (hinges on informational efficiency)
94
That many share price movements seem unrelated to specific info strongly suggests what?
- That capital markets are NOT fundamentally efficient
| - And that wide deviations from fundamentals, like those in the crash scenarios, can occur
95
While capital markets are in all likelihood not fundamentally efficient, widely held and heavily traded securities are probably what?
Informationally efficient
96
Informational efficiency allows for stock prices to do what?
Temporarily deviate from fundamentals (as in crashes)
97
Crashes are consistent with what two theories?
- Informational version of the efficient capital markets theory
- And w/ fraud-on-the-market theory
98
Define rule 10b-5.
- Created under SEA '34
- This rule deems it to be illegal for anybody to directly or indirectly use any measure to defraud, make false statements, omit relevant information or otherwise conduct operations of business that would deceive another person; in relation to conducting transactions involving stock and other securities.
99
Rule 10b-5 is the main basis for what?
This rule is the main basis for the SEC to investigate possible security fraud claims.
100
Give an example of an offense that would violate rule 10b-5.
- executives making false statements in order to drive up share prices
- a company hiding huge losses or low revenues with creative accounting practices.
101
A significant portion of large and rapid stock price decline following a neg. announcement may result from factors unrelated to the fundamentals o the company like what?
- Crash may be triggered by
1) trading decisions of uninformed investors
2) or a few large funds using auto hedging programs
102
What is the most common method of calculating damages in 10b-5 cases?
Out of pocket measure (esp. in cases involving corporate misstatements or omissions)
103
The out of pocket measure for calculating damages in 10b-5 cases awards plaintiffs what?
The difference b/w the price they paid for the stock and its FMV, adjusted for any gains made or fraud-related losses suffered on resale
= [ V(s) - V(o) ] - [ P(s) - P(o) ]
104
Crash price is likely the result of what and does not conform to the legal definition of true value?
- Likely result of panic selling, info asymmetries, and temporary illiquidity
105
"Stanford law review: stock price crashes and 10b-5 damages"
Should defrauded plaintiffs be able to recover crash damages as consequential or special damages according to the authors? Expand.
- No
- Crash damages constitute inappropriate consequential damages
- B/c of the combo of (1) lack of a causation nexus b/w defendant's actions and the crash and (2) the business judgment rule
106
"Stanford law review: stock price crashes and 10b-5 damages"
Awarding crash damages creates what sorts of perverse incentives for management and auditors?
1) Excessive risk avoidance (i.e. auditors spend more than optimal time auditing a co. and drive up cost of audit; management make forego high risk, positive NPV projects)
2) Undermining corporate legal doctrines which promote maximization of S/H value
107
"Stanford law review: stock price crashes and 10b-5 damages"
According to the authors, should FMV be based on a crash price?
NO
108
"Stanford law review: stock price crashes and 10b-5 damages"
What are two practical approaches to estimating a net-of-crash stock price?
- Wait for a correction
| - Consensus earnings estimates
