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By Dan L. Goldwasser

After almost three years of debate, the Congress in late 1995 enacted the Private Securities Litigation Reform Act of 1995 (the Reform Act) over President Clinton's veto in an attempt to curb abusive securities litigations, principally class actions. Although this legislation has been one of the primary goals of the AICPA and the Accountants Coalition (who deserve much of the credit for its passage), it is hardly a panacea that will bring securities claims against accounting firms to a halt, even though it does attempt to right the playing field on which securities litigations are fought.

Provisions Impeding Securities Litigation

To be sure, the Reform Act discourages the initiation of abusive securities litigation, and this may be the principal advantage gained by the accounting profession. The act does this in two ways: First, it seeks to wrest control of class actions from the plaintiffs' bar, the primary beneficiary of securities class actions whose members campaigned heavily against the legislation. Second, it increases the responsibilities of class action plaintiffs and their attorneys in an effort to curb abusive practices.

Prior to adoption of the Reform Act, securities class actions were commenced and managed by members of the plaintiffs' bar. The new act requires the court to designate the lead plaintiff in each class action, and that plaintiff presumptively will be the individual or entity with the greatest financial interest in the litigation. Thus, pension funds and mutual funds are likely to control future class action cases. Moreover, the court designated lead plaintiff is empowered to appoint (with the court's approval) the class counsel, which means that the law firm that initiated the action will not necessarily share in the spoils of the litigation. This, in fact, has already happened in one securities class action in which a major pension fund that had been designated as the lead plantiff replaced plaintiff's counsel with a law firm of its own choice.

In addition, the plaintiff who first initiates the action must carefully review the complaint and certify to the court the accuracy of the pleadings. An erroneous certification could lead to significant

Thus, the new legislation is likely to slow the rush to the courthouse to file a class action every time a stock takes a precipitous drop. In the first six months following the adoption of the Reform Act the number of new case filings dropped dramatically. On the other hand, these new requirements are unlikely to deter securities law claims where there has been a restatement of a company's financial statements precipitates a decline in its stock.

Another likely effect of the act is that future class actions may be prosecuted more vigorously. Heretofore, many class action suits were settled at a relatively early stage in the litigation, in large measure to avoid mounting litigation costs on both sides.

Under the Reform Act, not only will there be an interested lead plaintiff who must approve the settlement of the case, a far more extensive notice of the settlement will have to be sent to all class members detailing the maximum recovery that might be attained if the plaintiffs prevail and the percentage of that amount represented by the proposed settlement. This raises the possibility that many "early" settlements simply may not be approved and that the class will demand a more extensive prosecution of claims.

While these changes are certainly bad news for the plaintiffs' bar, they are not necessarily good news for the accounting profession. There is a strong possibility that institutional investors and their hand-picked attorneys may prosecute cases longer and more vigorously. Thus, although this change is likely to reduce the number of securities class actions, it may well increase the severity of those cases that are brought against accounting firms.

Leveling the Playing Field

The new legislation also contains at least three provisions that will make it more difficult for accounting firms to be held liable in securities law cases. Perhaps the most significant of these is that persons not found to have knowingly provided false information are not generally subject to joint and several liability and may only be held responsible for their proportionate share of the plaintiffs' damages. To make this provision more effective, the statute requires that the jury render special verdicts specifying whether each defendant acted intentionally as well as each defendant's proportionate share of the plaintiffs' damages. This represents an important victory for the accounting profession which has long been required to pay far more than its proportionate share of the damages in securities law cases.

This seemingly significant provision, however, has some important loopholes. First, it does not apply with respect to plaintiffs with a net worth of less than $200,000 and whose recoverable damages are equal to more than 10% of their net worth. Thus, if a defendant is unable to pay its proportionate share of such persons' damages, the remaining defendants must make up the difference. In addition, if a defendant is unable to pay its share of the damages, the other defendants (even those who are not subject to joint and several liability) would be required to pay up to 50% more than the amount of damages they would otherwise have been responsible for. Since most suits under securities law are settled for a relatively small proportion of the plaintiffs' damages (around 25%), it is not at all clear that the proportionate liability provision will have any material impact in reducing damage awards and settlements amounts paid by accounting firms.

A second attempt to level the playing field is the requirement in all securities law cases that the plaintiffs plead and prove "loss causation"; i.e., that the facts alleged to have been misstated were the actual causes of the plaintiffs' damages. Most Federal courts had applied a "loss causation" requirement to causes asserting claims under Section 10(b) of the Securities Exchange Act but had imposed no such requirement with respect to certain claims asserted under the Securities Act. This requirement will make it more difficult for plaintiffs asserting claims under the Securities Act to sustain their claim.

The new legislation also imposes more stringent pleading requirements and mandates a stay of discovery pending dispositive motions. This will force plaintiffs to perform their investigations prior to initiating their actions. It may also cause plaintiffs to change their strategies to obtain discovery in collateral proceedings, such as bankruptcy cases, before bringing their claims against the accountants.

Document Retention

In an effort to curtail their liability exposures, many of the larger accounting firms have adopted aggressive document destruction policies on the theory that the plaintiffs' task of satisfying their burden of proof that the accounting firm acted improperly is frequently facilitated by the firm's workpapers. The plaintiffs' bar had been very critical of this practice, with the result that the new legislation contains provisions modifying both the Securities Act of 1933 and the Securities Exchange Act of 1934 so as to proscribe the destruction of relevant evidence by a party after the action has been commenced. Thus, an accounting firm may continue to implement its document destruction policy up until it has been served with the

From an accounting firm's perspective, document retention policies should be rigidly followed on a day-to-day basis so as to minimize the possibility that out-dated documents will still be around after the service of the complaint. Moreover, to protect the firm against the possibility of a post-complaint document destruction, it is essential for a firm to quickly marshall all relevant documents as soon as the complaint has been served and not to wait until discovery of those documents has been demanded by one or more other parties.

The Vanishing Safe Harbor

From the outset, the new legislation contained a safe harbor for forward-looking information as a means of encouraging public companies to issue financial projections. The plaintiffs' bar characterized this provision as a license to commit fraud and the SEC demanded that it be restricted. The safe harbor which was ultimately enacted leaves much to be desired and, in many respects, is less favorable than the "bespeaks caution" doctrine as heretofore articulated by the Second Circuit. Accordingly, the accounting profession has little reason to rejoice over this provision.

First of all, the safe harbor does not apply to companies that are not SEC reporting companies. Thus, projections for oil and gas and real estate partnerships or limited liability companies would not be covered by the safe harbor. In addition, there are a number of circumstances involving publicly owned companies which are expressly excluded from coverage, such as the following:

* Securities offerings involving persons or entities that have previously violated the securities laws (generally referred to as "bad boys");

* Securities offerings by "blank check" companies (i.e., companies with no current operations);

* Initial public offerings; and

* Tender offers.

Secondly, the safe harbor itself is only available if the financial projections are accompanied by "meaningful cautionary statements identifying important factors that could cause actual results to differ materially" from the projected figures. While no one knows for sure just what types of disclosures are necessary to satisfy this requirement, it is clear that general warnings will not suffice.

There have been a number of cases under the more conservative interpretations of the "bespeaks caution" doctrine which may be instructive. Those cases emphasize the following:

* The warning should reference specific risks, such as the possibility of competing products being introduced, a decline in the economy of the markets serviced by the company, an unanticipated increase in interest rates, etc.

* The warnings should also try to quantify the impact of each such contingency that might cause the projections to go awry.

* The basic assumptions underlying the projections should be stated.

* The warnings should be prominently disclosed and should either accompany the projections or should be referenced in the projections.

One other disappointing aspect of the projections' safe harbor is that it has no applicability to historical financial statements. During the course of the Congressional debates, the accounting profession pointed out that many aspects of historical financial statements are also based upon projections, such as decisions with respect to going concern qualifications, estimates of the collectibility of certain receivables, and the value of computer software and other intangible assets. It was, therefore, argued that these aspects of historical financial statements should likewise be covered by the safe harbor as at least one U.S. District Court has held. Congress, apparently seeing no necessity to extend the safe harbor to these types of implied forward-looking statements, chose to expressly exclude them from the safe harbor.

In short, in an effort to secure the support of the SEC for the legislation, Congress virtually gutted the safe harbor provision and actually left the accounting profession more vulnerable in projection claims than it was prior to the adoption of the legislation.

Detection and Reporting of
Illegal Acts

One of the lesser publicized provisions of the Reform Act is Section 10A ("Fraud Detection and Disclosure") which was inserted to secure bipartisan support for the legislation. This section had been proposed as a separate bill in each of the previous three Congresses by Congressman (now, Senator) Wyden. This provision has two important features. First, it empowers the SEC to establish audit standards; and secondly, it requires auditors who detect illegal acts to report their findings to the SEC if the client fails to take appropriate action. As such, this facet of the legislation may have the greatest impact on the day-to-day actions of accountants.

Newly enacted Section 10A mandates that each audit of a public company shall include--

1. procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts;

2. procedures designed to identify related party transactions that are material to financial statements or otherwise require disclosure therein; and

3. an evaluation of whether there is substantial doubt about the ability of the issuer to continue as a going concern during the ensuing fiscal year.

While these requirements do not change the existing audit literature, they do codify it, preventing the profession from reconsidering the basic aspects of SASs 53, 54, and 59. More importantly, this provision expressly authorizes the commission to modify and supplement "generally accepted auditing standards." It is not clear, however, whether this provision was intended to authorize the SEC to adopt audit standards of all types or only those affecting these three aspects of GAAS. Although the commission has interpreted this provision as authorizing it to adopt audit standards without limitation (see proposed SEC Rule 10A-1), the legislative history indicates that the commision's power to establish audit standards was intended to be limited to the three areas noted above.

Perhaps of greater significance to accountants are the illegal acts reporting provisions, which are in large measure based upon SAS No. 54. Indeed, Congressman Wyden sought to elicit the profession's support of this provision by arguing that it does little more than codify SAS No. 54. This provision requires that a public company auditor "who becomes aware of information indicating that an illegal act . . . has or may have occurred, . . . shall . . .(i) determine whether it is likely that an illegal act has occurred; and (ii) if so, determine and consider the possible effect of the illegal act on the financial statements of the issuer, including any contingent monetary effects, such as fines, penalties, and damages. . ."

Next the accountant must convey his or her findings to the client's audit committee or board of directors unless "the illegal act is clearly inconsequential." Thereafter, should the accountant conclude that (i) the "illegal act has a material effect on the financial statements of the issuer"; (ii) "timely and appropriate remedial actions with respect to the illegal act" have not been taken; and (iii) "the failure to take remedial action is reasonably expected to warrant" the issuance of a less than unqualified audit report or the accountant's resignation from the audit engagement, the auditor must send a copy of its report to the commission within one business day after the board's failure to notify the commission of same within one business day after being notified of the accountant's conclusion that remedial action is not being taken. If the audit firm chooses to resign the engagement, it has an additional business day
in which to convey its report to the

Reports of Illegal Acts

In order to encourage accountants to blow the whistle on their clients, Section 10A provides that "no independent public accountant shall be liable in a private action for any finding, conclusion, or statement expressed in a report made to the commission. On the other hand, a failure to comply with this requirement will subject the audit firm to civil penalties as well as a cease-and-desist

The real problem with Section 10A is that it assumes that an audit firm will recognize illegal acts when it comes across signs of them. Fraud and illegal activities do not present themselves in easily identifiable forms. They usually appear among a myriad of similar transactions and even when identified are often easily explained away by the management that has committed them. Thus, notwithstanding the fact that an audit firm has a duty to plan its audit to detect fraud and illegal acts, such acts may go undetected, raising the possibility that someone will claim that the auditor failed to comply with this provision.

Although Section 10A does not require an auditor to report actions which are not "detected," it does not define what is meant by detection. For example, if a staff auditor questions the client's comptroller about an unusual payment to a customer and receives an explanation that the payment was demanded because of defective merchandise previously received, it is unlikely that the auditor would be able to discern that this was an illegal kickback. Yet, if such a fraud were later exposed, you could expect someone to claim that it had been "detected" and ignored.

The act also seemingly requires that each unusual action noticed by the audit team be "investigated," and that all investigative efforts be recorded in the workpapers along with the auditors' conclusions as to whether a crime or fraud is likely to have taken place. In this regard, it should be noted that there is no materiality threshold with respect to the auditor's duty to investigate and report to the client. The materiality exclusion only applies to the auditor's duty to report to the commission. It is for this reason that the cost of an audit may increase substantially as a result of this provision.

No client is likely to be very happy over the prospect that its outside auditors during the course of their engagements are going to stop and conduct a dozen or so mini-investigations just to make sure that unusual transactions are not actually a part of a fraud or illegal act. Clients, simply out of a desire to minimize their audit costs, may become less candid with their auditors in an effort to avoid unnecessary witch-hunts. In this respect, Section 10A may actually make financial statements less (and not more) effective.

What is clearly necessary for accounting firms that practice in the public company arena is better training for staff auditors in recognizing and investigating fraud and illegal acts and internal procedures for dealing with findings of suspicious activities. Such procedures should deal with how and when suspicious activities are reported to the partner-in-charge of the audit, what additional procedures are to be undertaken, how they are to be recorded in the firm's workpapers, and prohibitions regarding private notes and memos concerning any such findings. Staff accountants must be instructed that if they disagree with the partner-in-charge's decisions with respect to these matters, the proper course is to notify the firm's managing partner (or local office manager) or the firm's legal counsel and not to draft a "CYA" memo for their own files.

It should also be noted that the safe harbor provision within Section 10A only applies if the audit firm submits a report to the SEC. It does not protect an audit firm that makes a good faith decision that no such report is required to be filed either because it is satisfied that it is not likely that an illegal act was committed or that any such act was "clearly inconsequential." Thus, the act has a built-in bias in favor of remedial action whenever there is any doubt as to whether an illegal act has been taken.

The Threat Remains

While the Reform Act is likely to change the frequency and nature of securities litigation, it has by no means eliminated the threat of such litigation against accounting firms. Indeed, those litigations which are subsequently brought are likely to be even more hard-fought and the exposure of accounting firms may be even greater than before. Moreover, the safe harbor for forward looking statements is so subjective and so riddled with exceptions that it has undoubtedly made accountants more (and not less) vulnerable to securities law claims. Finally, the fraud detection and disclosure provisions create some new problems for accountants as they are now dutybound to investigate all potential illegal activities on the part of their clients irrespective of whether those activities are likely to be material to the client's financial statements. Such actions are likely to be resisted by cost-conscious clients, posing some interesting dilemmas for auditors. *

Dan L. Goldwasser, Esq., is a partner of Vedder, Price, Kaufman, Kammhotz & Day. He concentrates in counseling and defending accountants in professional practice litigation.

Dan L. Goldwasser, Esq.
Vedder, Price, Kaufman, Kammholz
& Day

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