CHAPTER 4

AUDITOR'S LEGAL LIABILITY

Learning Check
4-1. Auditors are often targeted in lawsuits out of proportion to their degree of
wrongdoing because they may be the only party left with sufficient financial
resources to indemnify the plaintiffs' losses (the so-called deep pockets theory).
4-2. he litigation crisis also affects many public companies! especially emerging
high-technology companies who are sued disproportionately! often based
solely on a downward mo"ement in their stock prices. hus! there is a growing
recognition by business people! professionals! senators! and others that
litigation is also a threat to the strength of the #.$. capital markets and the
competiti"eness of the #.$. economy.
4-%. a. &ri"ity of contract refers to the contractual relationship that e'ists between
two contracting parties.
b. An auditor may breach a contract by (1) issuing a standard audit report
when the audit has not been made in accordance with (AA$! (2) not
deli"ering the audit report before the agreed-upon date! and (%) "iolating
the client's confidential relationship.
c. A tort action may be attributable to ordinary negligence! gross negligence!
or fraud.
4-4. a. #nder common law the two classes of third parties are primary
beneficiaries and other beneficiaries.
b. he auditor may be held liable by both classes of third parties for fraud and
gross negligence. he auditor may be held liable for ordinary negligence by
primary beneficiaries.
4-). *oreseen parties are a person or one of a limited group of persons for whose
benefit or guidance the preparer intends to supply the information and who
suffer a loss through reliance upon it in a transaction or similar transactions
that the information is intended to influence. *or e'ample! if the client plans to
use the audit report to obtain a bank loan! all banks who use the report are
foreseen parties.
*oreseeable parties are any parties that are not foreseen. hey include all
creditors! stockholders! and present and future in"estors who suffer a loss by
relying on the accountant's representation.
4-6. Ultramares limited the accountant's liability for ordinary negligence to parties
who are in pri"ity of contract with the accountant (i.e.! primary beneficiaries).
he case did not emancipate the accountant from the conse+uences of fraud!
and it concluded that gross negligence may constitute fraud.
Rusch Factors held that accountants should be liable for ordinary negligence
to actually foreseen and limited classes of persons! e"en if not named or
identified.
Rosenblum vs Adler held that accountants could be sued for ordinary
negligence by foreseeable parties.
Credit Alliance restored a ,near pri"ity rule, in -ew .ork state by establishing
three criteria for determining whether a plaintiff can bring a claim for ordinary
negligence/ (1) plaintiff relied on auditor's report! (2) auditor knew plaintiff
would rely! and (%) the auditor! through some actions on his or her own part!
e"idenced understanding of the plaintiff's intended reliance.
Bily ended the foreseeability standard in 0alifornia! and established that (1) the
auditor owes no general duty of care regarding the conduct of an audit to
persons other than the client and (2) the auditor's liability to third parties for
negligent misrepresentation through a faulty audit report is the same as that
under the 1estatement ($econd) of orts.
4-2. a. he accountant's primary defenses against charges of negligence in tort
actions are due care and contributory negligence.
b. he 1estatement ($econd) of orts defines contributory negligence as
,(0onduct on the part of the plaintiff which falls below the standard to
which he (she) should conform his (her) own protection! and which is a
legally contributing cause co-operating with the negligence of the
defendant in bringing about the plaintiff's harm.,
c. 0ontributory negligence only represents a "alid defense when it directly
contributes to the accountant's failure to perform.
4-3. a. $uits may be brought under the 14%% Act by any person purchasing or
otherwise ac+uiring the securities.
b. he basis for action under the 14%% Act is that the financial statements
contain an untrue statement of a material fact or omit a material fact
necessary to make the statements not misleading.
4-4. he responsibilities of the parties in a 14%% Act suit are
Plaintiff
5ay be any person ac+uiring securities described in the registration
statement! whether or not he or she is a client of the auditor.
5ust base the claim on an alleged material false or misleading financial
statement contained in the registration statement.
6oes not ha"e to pro"e reliance on the false or misleading statement or that
the loss suffered was the pro'imate result of the statement if purchase was
made before the issuance of an income statement co"ering a period of at
least twel"e months following the effecti"e date of the registration
statement.
6oes not ha"e to pro"e that the auditors were negligent or fraudulent in
certifying the financial statements in"ol"ed.
Defendant
7as the burden of establishing freedom from negligence by pro"ing that he
or she had made a reasonable in"estigation and accordingly had reasonable
ground to belie"e! and did belie"e! that the statements certified were true at
the date of the statements and as of the time the registration statement
became effecti"e.
5ust establish! by way of defense! that the plaintiff's loss resulted in whole
or in part from causes other than the false or misleading statements.
4-18. he issue in 9ar0hris was whether the defendant accountants had performed a
proper $-1 1e"iew (a subse+uent e"ents re"iew). he court concluded that a
proper re"iew was not made! stating that
he senior's re"iew was useless because it failed to disco"er a material
change for the worse in 9ar 0hris's financial position that re+uired
disclosure to pre"ent the balance sheet from being misleading.
he senior did not meet the standards of the profession because he did not
take some of the steps prescribed in the written program.
he senior did not spend an ade+uate amount of time on a task of this
magnitude and! most important of all! he was too easily satisfied with glib
answers.
here were enough danger signals in the materials e'amined to re+uire
some further in"estigation.
4-11. a. &laintiffs under the 14%4 Act may be any person buying or selling the
securities.
b. he bases for action are basically the same as under the 14%% Act.
4-12. 1ule 18b-) states that it is unlawful to
:mploy any de"ice! scheme! or artifice to defraud.
5ake any untrue statement of a material fact or omit to state a material fact
necessary in order to make the statements made! in the light of the
circumstances under which they were made! not misleading.
:ngage in any act! practice! or course of business which operates! or would
operate! as a fraud or deceit upon any person in connection with the
purchase or sale of any security.
4-1%. #nder both sections of the 14%4 Act! the plaintiff must pro"e (a) the e'istence
of a material false or misleading statement! and (b) reliance on such statement
and damage resulting from such reliance. #nder $ection 13 the plaintiff does
not ha"e to pro"e the auditor acted fraudulently! but under $ection 18! 1ule
18b-) such proof is re+uired. he defendant under $ection 13 must pro"e he or
she acted in good faith and had no knowledge of the false or misleading
statement.
4-14. a. he basis of the 7ochfelder case was that the auditor's negligence had aided
and abetted the president's fraudulent actions relati"e to an escrow account!
and that the auditor was therefore liable under 1ule 18b-).
b. his decision means the auditor is not liable to unnamed third parties for
ordinary negligence under this rule.
4-1). a. he ;ury in *und of *unds found the defendant accountants guilty of (1)
aiding and abetting "iolations of securities laws (1ule 18b-))! (2) common
law fraud! and (%) breach of contract. he ;ury also found that the re+uisite
of scienter had been met through the accountants' recklessness.
b. he critical issue in 0ontinental <ending was whether the fairness of the
financial statements should be based on (AA&. he ;udge ruled that the
,critical test, was whether the balance sheet fairly presented financial
position without reference to (AA&. he accountants were found to be
guilty of criminal liability under the 14%4 Act.
4-1=. a. &roportionate liability is when a defendant is liable based on the
defendant>s percentage of responsibility. ?n order for a defendant to obtain
the benefits of proportionate liability it must be found that the defendant did
not knowingly commit a "iolation of the law.
b. &re"iously auditors were ;ointly and se"erally for all damage that might be
assessed. *or e'ample! if both management and the auditor were found
guilty and management was bankrupt! then the auditor could be liable for
all the damages. &roportionate liability limits the auditor>s liability to the
proportion that the auditor was held liable (plus the auditor could be liable
for any uncollectible amount up to )8@ of the auditor>s initial share).
4-12. *ollowing is a list of ways that the &ri"ate $ecurities 1eform Act of 144)
(1eform Act) will potentially change auditor>s legal liability. he 1eform
Act/
&laces a cap on damages that would potentially reduce the ma'imum
amount that auditor>s could be liable for.
1e+uires plaintiffs to pay defendant>s reasonable attorney>s fees and
e'penses directly related to litigation found by the court to be fri"olous
and unwarranted. his may make it unlikely that auditor>s will be sued
for deep pockets if the suit is found to bee fri"olous and unwarranted.
&ro"ides for a stay of disco"ery during the period a motion to dismiss is
pending! thereby reducing a cost that often forces innocent parties to
settle fri"olous class action suits.
Aimits puniti"e damages by eliminating securities fraud as a basis for
bringing action under the Raceteer !nfluenced and Corru"t
#r$ani%ation Act which pro"ides for treble damages. he limit on
puniti"e damages will directly reduce the cost of damages to auditors.
&laces limits on the rights of third parties to sue by limiting the number
of times a plaintiff can be a lead plaintiff to no more than fi"e class
actions in any three-year period and by imposing stricter pleading
standards to be met by plaintiffs. his limits the number of indi"iduals
that may sue auditors and reduces the likelihood of suit by Bprofessional
plaintiffs.C
0hanges the manner in which the court appoints lead plaintiffs in class
actions to fa"or institutional in"estors likely to ha"e the largest financial
state in the relief sought and to mitigate the Brace to the courthouse by
professional plaintiffsC who hold minimal ownership interests. his also
limits the number of indi"iduals that may sue auditors and reduces the
likelihood of suit by Bprofessional plaintiffs.C
4-13. he 1eform Act imposed new reporting re+uirements on auditors of public
companies who detect or otherwise become aware of illegal acts by issuers of
securities. ?f an auditor concludes that an illegal act has a material effect on the
financial statements! that senior management has not taken appropriate action!
and the failure warrants a departure from a standard report or a resignation from
the engagement! the auditor should report these conclusions directly to the board
of directors. he board should then notify the $:0 within one day. ?f the board
does not file a timely report with the $:0! the auditor should make a report to
the $:0. he 1eform Act e'plicitly states that the auditor will not be held
liable in a pri"ate action for any finding! conclusions! or statements made in such
reports.
4-14. a. 1?0D was originally drafted to curtail inroads of organiEed crime into
legitimate business. 7owe"er! 1?0D has been e'tended to losses suffered
from fraudulent securities offerings and failures of legitimate businesses.
b. A plaintiff "ictimiEed by a ,pattern of racketeering acti"ity, may sue for
treble damages and attorneys' fees. ?n addition! a plaintiff may sue when he or
she cannot satisfy the re+uirements for bringing suit under the antifraud
pro"isions of the federal securities acts.
c. A 0&A may be in"ol"ed in a 1?0D suit due to an audit failure. ?n such cases!
it is usually alleged that the 0&A either (1) knew or should ha"e known that
the financial statements were materially misstated or (2) recklessly ignored
indications of fraud by management. o be liable! there must be some
,scienter, or actual knowledge of the fraud. ?n addition! based on the 1e"es ".
:rnst F .oung decision! 1?0D re+uires some participation in the operation or
management of the enterprise itself.
4-28. he essence of the "iews on the importance of professional standards are/
A?0&A--standards set by e'perts should not be +uestioned in court.
$:0--auditor has a responsibility to go beyond standards to effecti"ely
communicate material information.
0ourts--standards and e'pert testimony as to compliance with standards
will be persuasi"e! but not conclusi"e.
4-21. o a"oid litigation! the auditor should
#se engagement letters for all professional ser"ices.
5ake a thorough in"estigation of prospecti"e clients.
:mphasiEe +uality of ser"ice rather than growth.
0omply fully with professional pronouncements.
1ecogniEe the limitations of professional pronouncements.
:stablish and maintain high standards of +uality control.
:'ercise caution in engagements in"ol"ing clients in financial difficulty.
Objective Questions
4-22. 1. d 2. a %. c
4-2% 1. a 2. d %. b 4. d ). b
Comprehensive Questions
4-24. (:stimated time - 28 minutes)
0ity is likely to pre"ail against $alam based on constructi"e fraud. o establish
a cause of action
for constructi"e fraud! 0ity must pro"e that/
$alam made a materially false statement of fact.
$alam lacked a reasonable ground for belief that the statement was
true. 0onstructi"e fraud may be inferred from e"idence of gross
negligence or recklessness.
$alam intended another to rely on the false statement.
0ity ;ustifiably relied on the false statement.
$uch reliance resulted in damages or in;ury.
#nder the facts of this case! $alam is likely to be liable to 0ity based on
constructi"e fraud. $alam made a materially false statement of fact by rendering
an un+ualified opinion on 9ell's financial statements. $alam lacked a
reasonable ground for belief that the financial statements
were fairly presented by recklessly departing from the standards of due care in
that it failed to in"estigate other embeEElements! despite ha"ing knowledge of
at least one embeEElement! and did not notify 9ell's management of the matter.
$alam intended that others rely on the audited financial statements. 0ity
;ustifiably relied on the audited financial statements in deciding to loan Astor
G=88!888 and damages resulted e"idenced by Astor's default on the 0ity loan.
0ity is not likely to pre"ail against $alam based on negligence. ?n order to
establish a cause of action for negligence against $alam! 0ity must pro"e that/
$alam owed a legal duty to protect 0ity.
$alam breached that legal duty by failing to perform the audit with the
due care or competence e'pected of members of the profession.
0ity suffered actual losses or damages.
$alem's failure to e'ercise due care pro'imately caused 0ity to suffer
damages.
he facts of this case establish that $alam was negligent by not detecting the
o"erstatement of accounts recei"able because of its inad"ertent failure to follow
its audit program. 7owe"er! $alam will not be liable to 0ity for negligence
because $alam owed no duty to 0ity. his is the case because $alam was not in
pri"ity of contract with 0ity! and the financial statements were neither audited
by $alam for the primary benefit of 0ity! nor was 0ity within a known and
intended class of third party beneficiaries who were to recei"e the audited
financial statements.
4-2). (:stimated time - 28 minutes)
he facts re"eal negligence on *ield's part in that it did not follow its own audit
program nor did it make a proper in"estigation into the many irregularities and
suspicious circumstances.
0ompliance with (AA& is of some e"identiary "alue to *ield if it in fact
complied with the principles set forth therein. 7owe"er! the courts do not
in"ariably accept (AA& as the conclusi"e test to dispro"e negligence.
*urthermore! e"en if assuming (AA& were followed literally! (AA$ certainly
were not under the facts stated.
*ield will undoubtedly rely upon the pri"ity defense to a"oid liability to
$lade! a third party to the *ield-yler contract. 7owe"er! most ;urisdictions
recogniEe the standing of a third party beneficiary to sue. herefore! $lade
would assert such status. ?n a ma;ority of ;urisdictions $lade would be regarded
as a third party beneficiary if it is within a known and intended class of
beneficiaries. Dther ;urisdictions ha"e gone e"en further in recogniEing a duty
is owed to those whom the 0&A should reasonably foresee as recipients of the
financial statements for authoriEed business purposes. here are insufficient
facts to determine whether *ield knew that yler
intended to use the audited financial statements to secure credit from $lade.
herefore! it is not possible to determine whether the pri"ity defense will bar
reco"ery.
*raud does not re+uire that the party suing be in pri"ity of contract with the
defendant. 7owe"er! the most significant problem in proceeding based upon
fraud is that fraud re+uires a knowledge of falsity (scienter) or a recogniEed
substitute therefor. 9ased upon the facts! *ield did not actually know of
management's fraud. 7owe"er! it may be guilty of conduct which may be
deemed to be a reckless disregard for the truth. he courts also resort to the
constructi"e fraud theory where the facts are compelling! i.e.! a shutting of one's
eyes to the ob"ious. $ometimes! the conduct is labeled gross negligence! and an
inference of fraud may be drawn from this by the trier of fact.
4-28. (:stimated time - 28 minutes)
a. &ri"ity is an early common law concept that was adopted by the courts to
pre"ent third parties from bringing a legal action based upon a contract to
which they were not parties. Hilliam
was in pri"ity of contract with &erfect! its audit client! but Hilliam had no
contractual relationship with 0apitol despite 0apitol's reliance upon the
statements audited by Hilliam. 5oreo"er! 0apitol ga"e no consideration to
Hilliam. herefore! under strict application of the pri"ity rule! 0apitol lacks
the standing to sue for breach of contract or negligence since 0apitol is not
in direct contractual relationship with Hilliam.
&ri"ity has been the sub;ect of much critical ree"aluation! and the courts
ha"e fre+uently narrowed or re;ected it. 7owe"er! in a landmark opinion
(#ltramares)! pri"ity was retained to some e'tent in an action against a 0&A
firm based partially upon negligence. $ome court decisions! howe"er! ha"e
directly o"erruled the pri"ity defense in actions against 0&As! particularly
when the third party was contemplated as a user of the financial statements!
as in this case.
b. he first ma;or e'ception to the pri"ity re+uirement is fraud. Although a
0&A may generally a"oid liability for ordinary negligence based upon
pri"ity! where the action is for fraud! an in;ured third party has the re+uisite
standing to sue. 7owe"er! in order to reco"er based on fraud! the third party
(0apitol) must pro"e scienter or guilty knowledge on the part of the 0&A
he second e'ception to the pri"ity defense is constructi"e fraud.
0onstructi"e fraud is generally defined as a false representation of a material
fact with lack of reasonable ground for belief and with an e'pectation of
reliance by another! and! in fact! there is reasonable reliance resulting in
damage. 0onstructi"e fraud may also be inferred from e"idence of gross
negligence or recklessness! although they are not necessarily constructi"e
fraud in and of themsel"es. he di"iding line between what actions will
meet the scienter re+uirement for actual fraud and what is necessary to
e"oke the constructi"e fraud doctrine is not clear.
he third e'ception to the pri"ity defense is gross negligence. (ross
negligence represents an e'treme! flagrant! or reckless departure from
standards of due care. *or e'ample! a
knowing failure to follow (AA$ on a material matter might be held by a
;ury to be gross negligence. he ;ury might then find that the defendant's
conduct was so gross as to satisfy the scienter re+uirement.
?n addition to fraud and its "arious offshoots! one may a"oid the pri"ity
barrier if it can be established by the third party that it was the party that the
contract was intended to benefit. hus! if a third party plaintiff suing a 0&A
can establish that the audit was for his benefit! then the in;ured third party
may ha"e standing to sue. 7e or she is a third party beneficiary of the
contract and pri"ity will not bar him or her from reco"ery. 1eco"ery under
this theory has
been significantly e'panded. ?t has recently been held that liability e'tends
to those in a fi'ed! definable! and contemplated group whose conduct is to
be go"erned by the contract's performance.
4-22. (:stimated time - 2) minutes)
1. rue. he offering was filed with the $:0 and was public.
2. rue. his is the essence of the 14%% Act.
%. rue. &laintiffs can show that the financial statements omitted material
facts necessary to pre"ent the statements from being misleading.
?n"estors need not pro"e that they relied on the statements! howe"er.
he burden is on the auditors to demonstrate that the losses were not the
result of omissions in the financial statements.
4. rue. Accountants ha"e no liability if they can show that their work was
ade+uate to support their opinion (the ,due diligence, defense).
). rue. Dne defense a"ailable to the accountants is to demonstrate that the
losses of the in"entories were due to causes other than errors or
omissions in the financial statements.
=. rue. Any action must be filed within three years after the securities
ha"e been offered to the public and within one year after the disco"ery
of the error or omission has been made.
2. *alse. hat is not the function of the $:0.
3. *alse. he fact that the financial statements are management>s
responsibility is not a defense if the auditor know of loans and collateral
that were not disclosed.
4-23. (:stimated time - 28 minutes)
0rea will not be liable to the purchasers of the common stock. Although an
offering of securities made pursuant to 1egulation 6 is e'empt from the
registration re+uirements of the $ecurities Act of 14%%! the antifraud pro"isions
of the federal securities acts continue to apply. ?n order to establish a cause of
action under $ection 18(b) and 1ule 1Db-) of the $ecurities :'change Act of
14%4! the purchasers generally must show that/ 0rea made a material
misrepresentation or omission in connection with the purchase or sale of a
securityI 0rea acted with some element of scienter (intentional or willful
conduct)I 0rea's wrongful conduct was materialI the purchasers relied on 0rea's
wrongful conductI and! that there was a sufficient causal connection between
the purchasers loss and 0rea's wrongful conduct.
#nder the facts of this case! 0rea's inad"ertent failure to e'ercise due care!
which resulted in 0rea's not detecting the president's embeEElement! will not be
sufficient to satisfy the scienter element because such conduct amounts merely
to negligence. herefore! 0rea will not be liable for damages under $ection
18(b) and 1ule 1Db-) of the $ecurities :'change Act of 14%4.
0rea is likely to be held liable to $afe 9ank based on 0rea's negligence
despite the fact that $afe is not in pri"ity of contract with 0rea. ?n general! a
0&A will not be liable for negligence to creditors if its auditor's report was
primarily for the benefit of the client! for use in the de"elopment of the client's
business! and only incidentally or collaterally for the use of those to whom the
client might show the financial statements. 7owe"er! a 0&A is generally liable
for ordinary negligence to third parties if the audit report is for the identified
third party's primary benefit.
?n order to establish 0rea's negligence! $afe must show that/ 0rea had a
legal duty to protect $afe from unreasonable riskI 0rea failed to perform the
audit with the due care or competence e'pected of members of its professionI
there was a causal relationship between $afe's loss and 0rea's failure to e'ercise
due careI actual damage or loss resulting from 0rea's failure to e'ercise due
care. Dn the facts of this case! 0rea will be liable based on negligence since the
audited financial statement reports were for the primary benefit of $ale! an
identified third party! and 0rea failed to e'ercise due care in detecting the
president's embeEElement! which resulted in $afe's loss! i.e.! 6ark's default in
repaying the loan to $afe.
4-24. (:stimated time - 28 minutes)
a. he elements necessary to establish negligence are/
A legal duty to protect the plaintiff (5usk) from unreasonable risk.
A failure by the defendant (Apple) to perform or report on an
engagement with the due care or competence e'pected of members of
its profession.
A causal relationship! i.e.! that the failure to e'ercise due care resulted
in the plaintiffs loss.
Actual damage or loss resulting from the failure to e'ercise due care.
b. he elements necessary to establish a "iolation of 1ule 18b-) include/
A material misstatement or omission.
he material misstatement or omission made by the defendant (Apple)
with knowledge (scienter). 1eckless disregard for the truth may
constitute scienter.
Justifiable reliance on the misstatement or omission.
he reliance being in connection with the purchase or sale of a security.
c. Apple is not in pri"ity of contract with 5usk because there is no direct
contractual relationship between them. herefore! in the absence of other
factors! Apple would not be liable to 5usk for Apple's alleged negligence
based on the #ltramares decision. 7owe"er! the pri"ity defense would not
protect Apple if 5usk could pro"e that Apple had committed actual or
constructi"e fraud (that is! Apple owes a duty to all persons! including third
persons! to practice its profession in a non-fraudulent manner).
4.%8 (:stimated time - 28 minutes)
Part I
a. Yes. $ection %2(a) of the $ecurities :'change Act of 14%4 pro"ides that
any person who ,willfully, "iolates a substanti"e pro"ision of the 14%4 act
or any person who ,willfully and knowingly, makes! or causes to be made!
false or misleading statements in reports re+uired to be filed with the $:0
shall be sub;ect to criminal sanctions. he elements of the go"ernment's case
would be (1) falsity! that is! the false information included in the *orm 18-KI
(2) of a ,material, fact! satisfied here based on the factI and (%) criminal
intent!' as e"idenced by the acceptance of the additional G28!888 fee by
6anforth as payment for not mentioning the 06 in the report. o pro"e
criminal intent! it need only be established that 6anforth rendered the
opinion knowing that the financial statements were false.
b. Yes. he fact that 6anforth can establish that no one was damaged will not
be a "alid defense to the criminal action. he reason is that such damage is
not an element of proof in criminal proceedings.
Part II
Yes. 6anforth would be found liable to the bank. According to the facts! the
bank made the loan to 9lair in reliance on the audit report and financial
statements. 6anforth's failure to disclose the subse+uently disco"ered
information to the bank! constituted a common law fraud. 6anforth had a duty
to correct the financial statements! which he knew to be in error and which he
knew the bank would rely upon. 'he necessary fraudulent intent of the auditor
may be inferred where! as here!
the auditor sits by silently while others rely on his original representations.
6anforth's performance of his audit in accordance with (AA$ did not
relie"e him of his responsibility to disclose to the bank the fact that the 06 was
erroneously included in the financial statements. he auditor owes such a duty
to third parties! the breach of which constitutes an intentional misrepresentation
rather than mere negligence.
Cases
4-%1. (:stimated time - 2) minutes)
Part I
a. -o. &eters will not pre"ail. he facts do not in"ol"e liability in the sale of
registered
securities nor liability for reports filed with the $:0. 9ecause the stock
transaction in"ol"ed interstate commerce! &eter's claim may be based on
$ection 12 (the antifraud pro"ision) of the $ecurities Act of 14%% and 1ule
1Db-) under the $ecurities :'change Act of 14%4. ?n either case! he will
ha"e to show fraud on the part of 6oe! or a manipulati"e de"ice or scheme!
in connection with the sale of a security under the 14%% act or the purchase
or sale of a security under the 14%4 act. ?f this can be shown! an implied
ci"il damage remedy is a"ailable to &eters against 6oe. (-ote - $ection 12 is
not discussed in the chapter.)
Although 6oe was negligent! the #nited $tates $upreme 0ourt! in the
7ochfelder case! held that a "iolation of 1ule 18b-) re+uires scienter!
something greater than mere negligence. #nless the "iolation of (AA$
in"ol"es intent! or gross negligence! 6oe would not be held in "iolation of
1ule 18b-).
$imilarly! &eters might claim a remedy against 6oe for "iolation of
$ection 12 of the 14%% $ecurities Act. he $upreme 0ourt! in the Aaron
case! held no scienter is re+uired in certain $ection 12 cases brought by the
$:0! but it appears that pri"ate actions! such as the one by &eters! would be
sub;ect to pro"isions similar to those in 1ule 18b-).
b. No. &eters will not pre"ail based upon his state common law action either.
At common law! pri"ity is re+uired before an accountant can be held liable
to users of the financial statements! absent fraud. 6oe was not in pri"ity of
contract with &eters! nor does the +uestion indicate that 6oe was e"en aware
that &eters would rely on the financial statements.
Part II
Yes. ?ra will pre"ail and reco"er damages from 9aker. 7e will base his action
on $ection 11 of
the $ecurities Act of 14%%. $ection 11 imposes liability on e'perts! including
accountants! whose opinions appear in a registration statement. he e'perts are
liable to all those who in reliance on their opinions purchase securities in a
public offering under the 14%% act. ?ra does not ha"e to pro"e 9aker was
negligent in auditing Able. All he need allege and pro"e is that there is a
material false statement or omission of a material fact in the registration
statement. he only defense that 9aker may assert is that it e'ercised the degree
of care that would be e'ercised by certified public accountants in similar
circumstances. his is commonly referred to as the ,due diligence, defense.
-egligence by 9aker is therefore a "iolation of $ection ??! and makes 9aker
liable to ?ra for his damages.
Research Questions
*or the reasons specified in the introduction to this manual! solutions are not pro"ided
for this category of +uestions.