Is the Storm Ending?

By Dan L. Goldwasser

An update on the progress the accounting profession has made with the problem of liability.

During the first half of the 1990s, the accounting profession was besieged with a large number of extremely severe liability cases arising out of the collapse of the S&L industry and the 1991-1992 recession. While many of those cases continue to be litigated, most of the more serious claims have now been settled, and the accounting profession is starting to return to normalcy. Nevertheless, even after the eye of a hurricane has passed, the backside of the storm can nevertheless carry fatal consequences for those who have not adequately protected themselves. Thus, even though the worst has undoubtedly passed, there could still be further casualties among the members of the accounting profession over the course of the next few years.

The good news is that the most recent litigation crisis has caused CPAs to accelerate their efforts to enhance quality control, adopt loss prevention strategies, and seek tort reform through legislation and court decisions. The result: The accounting profession, more so than at any time during the past 25 years, is better able to defend itself against future liability claims.

The Profession Responds

In 1988, the accounting profession began to realize that to survive the then burgeoning liability crisis, it would have to seek the adoption of legislation that would level the playing field upon which liability claims are resolved. To this end, the AICPA formed its Accountants' Legal Liability Subcommittee that embarked upon an effort to study the Federal and state laws affecting the liability of accountants. In addition, the national accounting firms formed the Accountants' Coalition for the purpose of achieving legislative reforms. Those efforts have now started to bear fruit. There is currently pending tort reform legislation in Congress and in most states' legislatures.

Federal-Level Activities

As a part of its Contract with America, the U.S. House of Representatives passed H.R. 1058, a wide-ranging bill that would impose new obstacles upon the plaintiffs' bar in asserting class action securities fraud claims and would go a long way toward limiting joint and several liability. In addition, H.R. 1058 contains a fee-shifting provision under which an unsuccessful litigant could be charged with the legal fees incurred by its successful adversary. It is generally believed this latter provision will significantly discourage plaintiffs from asserting marginal claims that are often settled simply to avoid ruinous litigation costs.

The U.S. Senate has likewise been busy in its efforts to adopt similar legislation. In 1993, after months of hearings, Senators Dodd and Domenici introduced a bill that included some of the reforms contained in the House legislation as well as a section that would have established a self-disciplinary organization (operating under the supervision of the SEC) under which firms auditing the financial statements of public companies could be sanctioned for substandard performance. That bill was reintroduced in the current Congress as S. 240. The bill was marked up by the banking committee and submitted to the Senate floor. It passed in the Senate by a bipartisan 70-29 vote. It now goes to a conference committee for reconciliation with the House version.

The modified Senate bill contains an explicit and broad safe harbor for forward-looking information (such as financial forecasts and projections) as well as a provision eliminating securities fraud as a basis for asserting RICO claims. It also adopts the Second Circuit's hard line on pleading fraud with particularity and mandates the Federal courts to impose Rule 11 sanctions for abusive litigation practices. Unlike the original Dodd/Domenici legislation, S. 240 does not extend the statute of limitations, nor does it contain a fee shifting (or loser pays) provision. It also does not contain the provision for a self-disciplinary organization that was a prominent feature of the predecessor bill.

The SEC has been an outspoken critic of the proposed legislation and, in particular, of those provisions that would alter the current rule in favor of joint and several liability for persons who violate the anti-fraud provisions of the securities laws. In addition, the SEC has advocated the enactment of a specific aiding and abetting cause of action that was eliminated by the U.S. Supreme Court in its decision in the Central Bank case (Central Bank of Denver v. First Interstate Bank of Denver, 1145 S.Ct. 1439-1994). The SEC also opposed the creation of an explicit safe harbor for forecasts and projections, preferring instead to deal with this issue through rule-making. Notwithstanding these criticisms, the SEC has expressed some mild support for litigation reform as long as the present system is not radically overhauled.

One of more controversial features of S. 240 is its change of the current system of joint and several liability. Under the bill, those found to have been reckless (as opposed to having committed a knowing fraud) would only be responsible for that portion of the plaintiff's damages they caused. This alone will have an enormous impact on the liability exposure of CPA firms in securities law class actions.

President Clinton has voiced his concerns over the extent of the measures contained in the House and Senate bills, raising the specter he may veto any legislation with a strong resemblance to the bill passed by the House. However, the margins of the votes in both houses have caused some commentators to call them veto-proof.

While the accounting profession may not get the complete relief against class action securities law claims it has been seeking, there is nevertheless a possibility that significant reforms will be achieved, thereby lessening the litigation burden of the large accounting firms that have been plagued by securities law class actions.

State-Level Activities

Legislative activity, by no means, has been limited to the federal government. The AICPA's Legal Liability Subcommittee began its GAP program in 1990 under which state CPA societies were encouraged to analyze the legal environment within their state and to seek legislative reforms to improve that environment. As a result of this program and the efforts of the Accountants' Coalition, legislative reforms have been adopted in a number of states. Those reforms have largely been in four areas: 1) privity legislation; 2) statutes limiting joint and several liability; 3) statutes limiting punitive damages; and 4) statutes permitting accounting firms to practice in limited liability entities.

Privity Legislation. In 1983, the Supreme Courts of New Jersey and Wisconsin adopted rulings that made accountants potentially liable for negligence to all persons whose reliance upon their reports was "reasonably foreseeable." These decisions greatly expanded the scope of potential liability of CPA firms practicing in those states, much to the dismay of the accounting profession, which believed the high judicial standards established in New York were far more appropriate. They were followed shortly thereafter by decisions in California and Mississippi that also adopted the "reasonably foreseeable" standard.

The accounting profession fought back and achieved some victories in the courts, with most courts that have addressed this issue opting for the standard contained in Sec. 552 of the Restatement (Seconds) of Torts that limits negligence claims to persons whose reliance upon the accountants' report was specifically foreseen. Where court action was unfavorable, state CPA societies have pressed for legislation that would reinstitute a strict privity rule. Such legislation has now been passed in Illinois, Kansas, Arkansas, Utah, and New Jersey. In addition, privity legislation is presently being seriously considered in Michigan. It was passed in 1994 by the Hawaii legislature only to be vetoed by the governor. As a result of these actions and a California Supreme Court overrule of the case that established the "reasonably foreseeable standard," there are now only two states that utilize the "reasonably foreseeable" standard. The number of states utilizing a strict or near privity standard is now 15, and 21 states follow the restatement standard.

Joint and Several Liability. The efforts of the accounting profession to achieve limits on joint and several liability have enjoyed some success, although joint and several still remains by far the predominant standard for awarding damages in professional liability cases. At present, 10 states (Alaska, Illinois, Indiana, Kansas, Kentucky, Oklahoma, Tennessee, Utah, Vermont, and Wyoming) have abandoned joint and several liability, and 25 states have adopted limitations on the joint and several rule. Seventeen states and the District of Columbia still retain joint and several liability in an unmodified form. In addition, two other states now have bills to limit or eliminate the use of joint and several liability.

Joint and several liability remains high on the agenda of the accounting profession for legislative reform, and it can be anticipated that, over the course of the next 12 months, further reforms in this area will be achieved in at least a handful of additional states. It should be noted, however, that each state must be viewed on an individual basis with its own political and liability environment. There are often complex factors present which can make passage of reform legislation of this kind very difficult.

Punitive Damages. The accounting profession has also enjoyed some minor success in limiting punitive damages. At present, there are five states that do not permit an award of punitive damages in accountants' liability cases (Louisiana, Massachusetts, Nebraska, New Hampshire, and Washington). In addition, 12 states have placed caps on punitive damages, some in the form of aggregate dollar amounts (ranging from $100,000 to $350,000), while other states have limited punitive damages to a multiple of compensatory damages (ranging from one to four times the amount of the plaintiff's compensatory damages). One state (Kansas) limits punitive damages to the lesser of $5 million or 50% of the defendant's net worth or 1.5 times the amount of profit the defendant gained.

While legislative accomplishment in the punitive damages area have been slow, the profession's efforts have not gone wholly unrewarded. Recently two additional states (Wisconsin and Oklahoma) have adopted legislation limiting punitive damages, and five others (Delaware, New Jersey, Alabama, North Carolina, and Alaska) are considering legislation or a constitutional amendment designed to limit the imposition of punitive damages.

Limited Liability Entities. Perhaps the biggest success has been in achieving changes to the laws regarding the form in which accounting firms may practice. Prior to 1988, an accounting firm could practice either as a sole proprietorship, a partnership, or a professional corporation (or professional association). Only professional corporations and professional associations protected members of an accounting firm against vicarious liability (i.e., personal liability for the acts of other partners or employees). Even so, only the statutes in approximately 50% of the states provided such protection.

Around 1988, the movement for states to adopt some form of limited liability company began. At the same time, the accounting profession sought to have accountancy laws modified to permit accounting firms to be organized as limited liability companies. That effort has now resulted in 47 of the 50 states permitting accounting firms to organize themselves as limited liability companies (LLCs), which provide full protection against vicarious liability for firm owners. LLCs, however, are not particularly well-suited for accounting firms with multistate practices. Accordingly, in or about 1990, the accounting profession, began to push for the adoption of limited liability partnership (LLP) legislation. Today, approximately 30 states have adopted LLP laws, and bills for the adoption of similar legislation are currently pending in at least a dozen additional states. It is anticipated that over 40 states will have LLP laws by the end of 1995. All of the six largest accounting firms have registered as LLPs, and many local and regional firms have adopted the LLP format.

While the adoption of LLC and LLP laws will not likely reduce the liability exposure of accounting firms, it may give comfort to CPAs practicing in large firms in which they have little or no control over the actions of their partners.

Regulatory Reforms

Not all reforms will come in the form of new laws. Among the accounting profession's other activities is an effort to have the SEC adopt new safe harbor regulations that will protect CPAs against liability based upon forward-looking information, including financial forecasts. Although many jurisdictions currently employ the "bespeaks caution" doctrine that offers a significant degree of protection in forecast and projection engagements, that doctrine does not enjoy uniform acceptance. A broader safe-harbor rule would go a long way toward limiting the liability exposure of the accounting profession in forecast cases.

Under pressure from Congress, the SEC is now considering amendments to Rule 175 which currently provides an extremely limited and ineffectual safe harbor for financial forecasts and projections. In particular, Rule 175 imposes a good faith standard that generally means the safe harbor cannot be relied upon to dismiss a claim prior to trial.

In all probability, the SEC will press ahead with its project to amend Rule 175 notwithstanding the progress of the tort reform legislation now in Congress. (Both H.R. 1058 and S. 240 contain safe-harbor provisions. H.R. 1058 is the more liberal of the two. The conference committee will have to make the final cut.) The SEC, however, is greatly concerned over the scope of any new rule (i.e., whether it should apply to all forward-looking statements, only those found in documents filed with the SEC, or only those found outside the body of financial statements) and the threshold for the safe harbor. In this latter regard, the SEC does not wish to adopt a rule that will encourage unfounded predictions that might subject investors to even greater dangers.

Court Decisions

The courts have continued the trend started in the mid-1980s toward reducing the liability exposure of the accounting profession. One of the more important developments has been the Supreme Court's decision in the Central Bank case in which it struck down the cause of action for aiding and abetting a violation of Section 10(b) of the Securities Exchange Act of 1934 and its decision in the McDermott case (McDermott, Inc. v. Amclyde and River Don Castings Ltd., 1145 S.Ct. 1461-1994) in which it decided that a nonsettling defendant was entitled to a reduction in its liability based upon the percentage of liability appropriately attributable to settling defendants. Although the McDermott case arose in the admiralty context, the rule stated by the court would seemingly apply also in implied causes of action under Federal securities statutes.

Another notable court decision is Monroe v. Hughes (31F.3d 772), decided by the Ninth Circuit, that held an accountant has no duty to disclose internal control weaknesses in its audit report. A similar decision had been reached many years ago in Adams v. Standard Knitting Mills (623 F.2d 422, 6th cir. 1980, cert. denied, 449 U.S. 1067-1980) in which the Sixth Circuit reversed a U.S. District Court Decision that held a failure to disclose weaknesses in a company's internal controls was a material misstatement. While the decision in Monroe v. Hughes has not established a new precedent, it is significant because since the Standard Knitting Mills case, there have been numerous developments regarding reports on internal controls raising the possibility that the Sixth Circuit's Decision might not be followed in other districts.

Recently, there were two state Supreme Court cases dealing with the statute of limitations in tax preparation cases. In Ackerman v. Price Waterhouse (84 N.Y.2d 535-1994), the New York Court of Appeals (New York's highest court) held that the statute of limitations in a tax preparation case begins to run upon the completion of the accountant's work (i.e., when the tax returns are delivered) and not when additional taxes are assessed as was contended by the plaintiff. This ruling has a particularly onerous effect on third-party claims since New York has a three-year negligence statute of limitations. It will not, however, have a material impact on client cases that enjoy a six-year breach of contract statute of limitations in New York.

In contrast, the California Supreme Court in International Engine Parts, Inc. v. Feddersen (9 Cal. 4th 606-1995), took a contrary position, holding that the statute of limitations in tax preparation cases only begins to run at the point there is an actual assessment of additional taxes.

Loss Prevention

Another reason accounting firms are likely to fair better over the next few years is the greater use of loss prevention techniques. While loss prevention and risk management have become commonplace in American industry, they have only recently been used by the accounting profession, which, over the course of the last 20 years, has largely concentrated on raising professional standards. Over the last two or three years, however, the profession has begun to realize that raising professional standards in many cases only serves to increase litigation burdens because higher professional standards create greater opportunities for substandard practice.

Beginning in the late 1980s, following the collapse in the professional liability insurance market, three small insurance companies entered the market with programs designed to assist accounting firms in reducing their exposure to liability claims. These companies, A/PLS+, CAMICO, and CPA Mutual, began developing loss prevention materials for their insureds. While their efforts were initially largely ignored, over time they have paid off. Each has grown rapidly and achieved enviable operating results. Moreover, state societies have begun to show an interest in loss prevention in an effort to curb the high incidence of claims against their members. As a result, even the large commercial insurance companies that provide professional liability coverage for accountants are now beginning to recognize the importance of loss prevention and incorporate loss prevention techniques into their programs. Because of these efforts, accountants have become acutely concerned with the various potential liability-creating situations and more selective in taking on new client matters.

The profession has also continued to push and upgrade the standards of the peer review and former quality review programs. As a result, compliance with professional standards has improved greatly. Moreover, the accounting profession has recognized that expanded and more stringent professional standards themselves pose liability problems. This realization has prompted the AICPA to adopt new procedures to review new professional standards to make sure they do not pose potential liability traps for their members. In the same vein, the Auditing Standards Board is currently reviewing the standards it adopted in 1988 with respect to the discovery and disclosure of fraud to see if the guidance on the auditor's responsibility to detect fraud requires clarification.

In a further effort to reduce the overall costs of liability claims, the accounting profession and its insurers have begun to embrace alternative dispute resolution (ADR) as a means of achieving quicker and less costly resolutions of claims. Prior to 1990, the profession and its insurers largely took the position that claims against CPA firms were frivolous and should be litigated vigorously to deter others from bringing similar frivolous claims. Over the course of the past few years, however, that attitude has changed, largely because of the very high cost of litigating accountants' liability claims and because "scorched-earth" litigation tactics have proven unavailing in curbing litigation against the profession. Moreover, in many cases exhaustive litigation tactics have only served to demonstrate the frailty of the audit process in uncovering financial statement misstatements. As a result, the profession and its insurers have begun to recognize that accounting firms are vulnerable to professional liability claims. The better policy is to recognize that vulnerability, where it exists, and to move quickly to resolve claims rather than aggravate them through unnecessary and often ineffectual defense efforts.

The Insurance Market

The market for accountants' liability insurance is largely divided into two segments: one for the very large firms that audit public companies and regularly experience claims seeking in excess of $100 million and the other for smaller firms that do not perform audit services for publicly held companies. While both segments of the market are rapidly changing, they are moving in different directions.

Since the mid-1980s, the market for liability insurance for large accounting firms has been undergoing serious deterioration, with the available limits of liability falling to approximately 25% of their 1980 levels. In addition, insurance costs have skyrocketed as have the self-insured retentions (or deductibles) of the insured firms. The financial problems of the London insurance market have greatly contributed to the deterioration. The deterioration in this market, however, has largely run its course. With the conclusion of the S&L claims, that market is now starting to recover, with a number of domestic insurance companies expressing an interest in participating in that market. If securities law tort reform is, in fact, achieved, this process is likely to accelerate. Thus, it clearly appears the worst is over for the large accounting firms with the result that the liability insurance market in which they obtain their coverage is likely to significantly improve.

In stark contrast, however, the market for professional liability insurance for small and medium-size accounting firms has likely reached its peak and may begin to deteriorate during the second half of the 1990s. This market was largely destroyed in 1986 when all but a handful of insurance companies ceased writing this type of coverage. As a result, insurance premiums jumped by approximately 400%, which, in turn, encouraged many insurance companies to enter into the professional liability market. Beginning in or about 1990, the price competition began to take its toll with prices for liability insurance for small and mid-size firms dropping to approximately 75% of their 1986 levels. That process has continued over the last five years, and today insurance coverage can be obtained by small and mid-size accounting firms for little more than the pre-1986 levels. At present, over 20 insurers offer professional liability insurance for small- and medium-sized accounting firms.

Virtually every underwriter in this market now believes rates have fallen too far and must be adjusted upward. Meanwhile, the size of the market has begun to shrink with Home Insurance Company and Continental Insurance Company ceasing operations. In addition, there is a strong possibility at least one other major player in this market will cease offering coverage as a result of prevailing rate levels. In short, there is a strong likelihood that there will be a contraction in the marketplace, and professional liability rates for small and mid-size accounting firms will rise over the course of the next few years.

Liability Threats

Over the past few years, cases against accounting firms have consisted largely of the claims arising out of the S&L crisis, plus the usual post-recession claims consisting of suits arising out of failed bank loans, precipitous drops in stock prices, and employee embezzlements. Over the next few years, this mix of cases is likely to change, largely because the S&L claims have substantially run their course and the economy is likely to stay relatively healthy over the next few years. Accordingly, the bulk of the cases against accounting firms are likely to consist of tax cases as well as cases arising out of the restructuring of real estate transactions that never fully made it off the ground. In addition, it can be anticipated that new areas of claims will emerge.

One new form of claim will be claims based upon the failure of auditors to properly assess and require disclosure of potential environmental liabilities. The SEC has been fanning the flames in this area. Notwithstanding the fact the accounting profession is becoming acutely aware of environmental liabilities and AcSEC has issued an exposure draft on this topic, the possibility seems overwhelming that many such potential liabilities will go unreported and will sow the seeds for claims against accounting firms.

Litigation Support Services as a Source of Liability

Over the past ten years, litigation support services have become a favorite new practice area for CPA firms. This is largely because litigation support work is generally quite lucrative and free of liability exposure. The accounting profession, however, received a rude awakening in 1994 with the decision in the Mattco Forge case (Mattco Forge Inc. v. Arthur Young & Co., 5 Cal. App. 4th 392, 6 Cal. Rptr.2d 781-1992) in which a Big Six accounting firm was held to have misrepresented its expertise in a litigation support engagement, incurring a judgment of over $15 million. While many states still utilize a broad testimonial privilege with respect to the work of trial experts, others have begun to recognize that the public policy of protecting witnesses in a judicial proceeding has dubious application for experts who are well-compensated for their testimony. Accordingly, it can be expected that disappointed litigants will seek to mitigate their plights by asserting their claims against expert witnesses, and the accounting profession will incur its fair share of this form of claim.

In the past year, the investing public also discovered derivative securities can be extremely detrimental to financial health. As a result, Congress, the SEC, and the FASB have pressed for new accounting rules and new disclosures with respect to derivative securities. Undoubtedly, there will be accounting firms that will not stay abreast of the latest developments in this highly volatile area that has demonstrated the potential for huge losses. Orange County, California and the investment banking firm of Barings, P.L.C. are the most notable examples.

The Storm May Be Over

The onslaught of liability claims that has gripped the accounting profession over the course of the past seven or eight years has indeed left its mark. Nevertheless, having weathered the storm, the profession is now poised for future growth and for a period of diminished liability threats, at least for the next few years. The lessons learned should not, however, be quickly forgotten. The profession must remain vigilant and discharge its professional responsibilities with care lest it invite a new wave of claims. *

Dan L. Goldwasser, Esq., is a partner of Vedder, Price, Kaufman, Kammholz & Day, concentrating in counseling and defending CPAs. He is a frequent lecturer and author on the subject of accountant's professional liability and is the editor of The CPA Journal's Accountant's Liability column.

OCTOBER 1995 / THE CPA JOURNAL