46-1 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

46-2

10• History and Nature of Corporations

• Organization and Financial Structure of Corporations

• Management of Corporations• Shareholders’ Rights and Liabilities

• Securities Regulation• Legal and Professional Responsibilities

of Auditors, Consultants, and Securities Professionals

Corporations

PART

46-3

Legal and Professional Responsibilities of Auditors,

Consultants, and Securities Professionals

PA ET RHC 46

Madness in great ones must not unwatched go.

William Shakespeare, Hamlet, Act. 3, Scene 1

46-3

46-4

Learning Objectives

• Understand the duties that securities professionals and accountants owe to their clients and third parties

• Learn to behave in a manner that prevents you and your firm from incurring liability to clients and third parties

46-5

• Auditors, consultants, and securities professionals owe a general duty to their clients and other persons affected by their actions to exercise the skill and care of the ordinarily prudent professional in the same circumstances– Professional’s duty to exercise reasonable

care is a subset of negligence standard– Two elements compose the general duty of

performance: skill and care

Overview

46-6

• Professionals are not guarantors of the accuracy of their work or that advice they give to clients will work out well

• However, when clients sue professionals, there are three principal bases of liability: contract, tort, and trust

Professionals’ Liability to Clients

46-7

• A professional contracts with a client to perform as agreed with the implied duty to perform as the ordinarily prudent person in the profession would perform

• If the professional fails to perform as agreed, s/he may be liable for compensatory damages and consequential damages

Contractual Liability

46-8

• A professional is negligent if s/he breaches the duty to act skillfully and carefully and proximately causes damages to the client

• The suitability and know-your-customer rules of the NASD and stock exchanges require a securities broker to know the financial circumstances and investment objectives of the client before recommending securities or executing securities transactions

Tort Liability & Negligence

46-9

• Courts generally prevent a professional from escaping liability merely because client also acted negligently (contributory negligence)– Professional is expected to have skills

superior to a client’s skills

• Some courts allow contributory or comparative negligence defenses– See Scioto Memorial Hospital Ass’n.,

Inc. v. Price Waterhouse

Contributory & Comparative Negligence

46-10

• A professional may be liable to a client for fraud if s/he misstates or omits facts in client communications and acts with scienter– Scienter: knowledge of the falsity of a

statement or a reckless disregard for truth

• Most courts extend a professional’s liability for fraud to all foreseeable users of the professional’s work product

Tort Liability for Fraud

46-11

• In the 1931 Ultramares case, Judge Cardozo required privity of contract (primary benefit) to hold a professional liable for negligence

• State courts now adopt one of three tests to determine whether a nonclient may sue a professional for negligence:– Primary Benefit Test– Foreseeable Users Test– Foreseen Users and Foreseen Class of Users

Test

Third Parties & Liability

46-12

• Section 11 of the Securities Act of 1933 states that an auditor or underwriter may be liable to a purchaser of securities issued pursuant to a defective registration statement– An underwriter is liable for errors in the

entire registration statement– As an expert, an auditor is liable only for

that part of a registration statement for which the auditor has issued an opinion about the financial statements

Section 11 & Professionals

46-13

• Section 12(a)(2) of the Securities Act of 1933 imposes liability on anyone who misstates or omits a material fact in connection with an offer or sale of a security that is part of a general distribution of securities by an issuer– Direct contact with buyer is required,

thus merely performing professional services is not enough

Section 12(a)(2) & Professionals

46-14

• Section 18 of the 1934 Securities Exchange Act imposes liability on persons who furnish misleading and false statements of material fact in any report or document filed with the SEC under the 1934 Act, such as annual 10-K report, monthly 8-K report, and proxy statements– Purchaser or seller of a security must

prove reliance on the defective document

Section 18 & Professionals

46-15

• The Act imposes significant public duties on independent auditors that audit financial statements of public companies

• However, the Act limits the liability of most professionals to the amount of an investor’s loss for which the defendant is responsible

Private Securities Litigation Reform Act of 1995

46-16

• Section 404 requires public issuers to include in their annual reports an “internal control report” acknowledging management responsibility to maintain “an adequate internal control structure and procedures for financial reports”– www.aicpa.org/sarbanes/index.asp

• Auditors must attest to management’s assessment of internal controls

Sarbanes-Oxley Act

46-17

• Authorizes SEC to issue point-of-sale disclosure rules when investors purchase investment products or services (e.g., mutual funds and investment management services)

• Authorizes the SEC to impose a fiduciary duty on broker-dealers and investment advisers in their dealings with their customer

Dodd–Frank Wall Street Reform and Consumer Protection Act

46-18

• 1933 Act imposes criminal liability for willful violations of any section, such as Sections 11, 12(a)(2), and 17(a), or any 1933 Act rule or regulation

• 1934 Act imposes criminal penalties for willful violations of any section, such as Sections 10(b) and 18, and any 1934 Act rule or regulation (e.g., Rule 10b–5)

Professionals & Criminal Liability

46-19

• A client’s personal records, such as accounting records, are the property of the client and the professional must return the records at end of job

• Material created by a professional, such as working papers produced by independent auditors, belong to the professional– Client has a right of access to working papers

Ownership of Working Papers

46-20

• The Arthur Andersen case highlights the rules about document retention– All professional firms have rules about

document retention and destruction– Federal law requires all audit or review

working papers to be retained for 7 years – No requirement to retain documents that

prove professional’s or client’s guilt, as long as they do not destroy documents (i.e., evidence) with the intent to obstruct a criminal prosecution

Document Retention

46-21

Thought Questions

• Joseph Berardino, former Arthur Andersen CEO, testified in an Enron hearing (Dec. 12, 2002): We made a professional judgment about the appropriate accounting treatment that turned out to be wrong.

• What is your opinion of the Enron and Andersen cases during the past decade?