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Jan 1990

Changing standards for commissions and contingent fees. (includes related articles on exclusions in a mutual malpractice policy and the Internal Revenue Service's view of contingent fee selection)

by Allen, Paul W.

    Abstract- The Federal Trade Commission (FTC) is reviewing whether or not to make final the proposed consent agreement it entered into with the American Institute of Certified Public Accountants (AICPA). The agreement established that the AICPA would agree not to maintain and enforce ethical standards against commissions and contingent fees. Accountants should evaluate their circumstances before accepting commission, contingent fees, or referral fees covered by the FTC-AICPA agreement because state jurisdiction over the legality of these arrangements remains in force regardless of the FTC-AICPA agreement. Accountants finding themselves in violation of state statutes or state board rules may face state disciplinary action, suspension or termination of AICPA membership, or legal action. Furthermore, malpractice insurance for activities involving commissions, contingent and referral fees is unlikely.

The author describes the FTC agreement, as well as state requirements which are based on a Model Code of ethics issued by NASBA. The uncertain effect of the agreement on state rules is dealt with, as well as the limitations of most liability insurance contracts for work in a professional capacity involving fees and commissions.

In March 1989 the AICPA entered into a proposed consent agreement with the Federal Trade Commission (FTC) not to maintain or to enforce ethical standards against certain commissions, contingent fees, or referral fees.

The required 60-day public exposure period for comments on the agreement ended in june 1989. After the FTC reviews the comments it received, it will decide whether to make the proposed agreement final. At this time, there is no way of knowing when an announcement will be made.

This article explores the scope of professional services referred to in the agreement and considers factors that must be evaluated by the CPA before: 1) accepting commissions; 2) accepting contingent fees; or 3) paying or accepting referral fees. Factors that must be considered include:

* Legality of these services under applicable state law; and

* Possible exclusions under accountants' malpractice insurance.

The text of the proposed agreement was published in the AICPA's semi- monthly newsletter, The CPA Letter, of September 23, 1988. Commissions, Contingent Fees, and Referral Fees Referred to in the Agreement

The proposed agreement permits a CPA to accept commissions or contingent fees from clients for whom no "attest services" are performed. Those services are defined in ORDER I of the agreement as: 1) any audit; 2) any review of a financial statement; 3) any compilation of a financial statement when the CPA expects, or reasonably might expect, that a third party will use the compilation and the CPA does not disclose a lack of independence; and 4) any examination of a prospective financial statement. A practitioner would be allowed to pay or accept referral fees for all services. However, the AICPA is not precluded from requiring a CPA to disclose any commissions or referral fees.

Nature of Commissions

Commissions paid to a CPA for recommending or referring a person to the products or services of others could involve the following:

* Commissions from the sale of computer hardware or software;

* Commissions from the sale of securities;

* Commissions from the sale of real estate; or

* Commissions from the sale of insurance.

A CPA who acts as a sales agent to receive such commissions could be liable to the purchaser for express or implied warranties. When involved in selling securities, real estate, or insurance, the practitioner must be sure that proper licensing requirements have been met.

Under the proposed agreement, the AICPA is not precluded from requiring the practitioner who has accepted a commission to disclose this fact. The AICPA can continue to provide that failure to disclose a commission is a breach of the CPA's fiduciary duty. Acceptance of Contingent Fees

According to the proposed consent agreement, a CPA could no longer be prohibited by the AICPA from accepting disclosed contingent fees from "non-attest" clients where the fee is determined based on a percentage of cost savings derived from the findings of management advisory services (MAS) performed by the CPA. In effect, any kind of engagement for a "non-attest" client can be on a contingent fee basis. Payment or Acceptance of Referral Fees

The proposed agreement permits no restrictions on the payment or acceptance of disclosed referral fees. State Regulation

The AICPA is not the only organization involved in regulating the accounting profession. State governments, state boards of public accountancy, and state CPA societies are involved in the "watchdogging" process as well. Many state jurisdictions still forbid a CPA's association with the commissions, contingent fees, and referral fees that would be permitted under the proposed AICPA-FTC agreement.

States that have statutory code sections specifically prohibiting a CPA's involvement with such services are the exceptions to the rule. However, almost every state board has rules included in their "Code of Ethics" prohibiting such involvement. Exhibit I is a summary of all jurisdictions and their respective positions with regard to statutes or board rules on commissions, contingent fees, or referral fees.

NASBA Model Code

Statutes and state board rules addressing commissions and contingent fees generally do not follow the text in the Model Code adopted by the National Association of State Boards of Accountancy. Model Code rules on commissions and contingent fees are as follows:

"Rule 103. A licensee who receives or agrees to receive other compensation with respect to services or products recommended, referred or sold by him to another person shall, no later than the making of such recommendation, referral or sale, make the following disclosures to such other person in writing: (a) if the other person is a client, the nature, source and amount of all such other compensation; and (b) if the other person is not a client, the nature and source only of any such other compensation received from a third party. The disclosure required by this Rule shall be made regardless of the amount of the other compensation involved. This Rule does not apply to payments received from the sale of all, or a material part, of an accounting practice, or to retirement payments to persons formerly engaged in the practice of public accountancy."

"Rule 104. A licensee shall not pay a commission to a third party to obtain a client unless, prior to being engaged by such client, the licensee discloses to the client in writing the fact and the amount of such commission. This Rule does not apply to payments made by a licensee for the purchase of all, or a material part, of an accounting practice, or to retirement payments to persons formerly engaged in the practice of public accountancy."

State Governments

California, Florida, Nevada and Oregon have specific statutory laws prohibiting certain subject activities permitted by the proposed agreement. All 50 states plus the District of Columbia, Guam, Puerto Rico and the Virgin Islands have code sections establishing their respective state boards and granting these boards the power to promulgate binding rules of professional conduct.

Practitioners in California, Florida, Nevada and Oregon should be hesitant to violate their state laws on commissions and contingent fees. Several Supreme Court cases have established the precedent that state regulation of a profession may not be impaired by federal antitrust legislation. Both Parker v. Brown, 317 U.S. 341 (1943) and Bates v. State Bar of Arizona, 433 U.S. 350 (1977) indicate that "state action" can be exempt from the Sherman Antitrust Act.

State Boards of Public Accountancy

All jurisdictions have board rules prohibiting both commissions and contingent fees in their codes except Maryland, Nevada, Oklahoma, South Dakota, Texas, Virgin Islands, and Wisconsin. The Nevada Board includes no rule prohibiting contingent fees. The Boards of Maryland, Oklahoma, South Dakota, Texas, the Virgin Islands, and Wisconsin do not specifically prohibit commissions or contingent fees. Finally, New York has a rule which specifically prohibits referral fees.

Some state board rules may not qualify for immunity from federal antitrust legislation as do state laws. A 1979 court case, United States v. Texas State Board of Public Accountancy, 592 F.2d 919 (5th Cir.), cert. denied, 100 S. Ct. 262, determined that a state board rule banning competitive bidding was deemed a violation of the Sherman Act. The state board rule was not viewed as "state action."

There is always an element of uncertainty as to how a court might rule at a given time. Any CPA who chooses to challenge state board rules on commissions, contingent fees, or referral fees may invite state board disciplinary action and incur major legal expenditures pursuant to a legal battle with the state board.

A recent state board declaratory ruling highlights the potential danger facing a practitioner who follows the proposed AICPA-FTC agreement without first determining the position of the state board having jurisdiction. The conclusion of the North Carolina State Board regarding a CPA who acts as a representative for a software owner and distributor was that such action is a violation of the state board rule prohibiting commissions. This declaratory ruling was entered on November 18, 1988.

AICPA and State CPA Societies

The proposed agreement indicates the AICPA's recognition that legal enforcement of the subject rules is unlikely in light of certain legal precedents. A 1978 Supreme Court case, U.S. v. National Society of Professional Engineers, 435 U.S. 679 (1978), helped establish such precedents. In this case, the Justice Department brought a civil injunctive suit under the Sherman Act against the engineering society. The suit opposed the society's anti-competitive bidding rule claiming the rule to be unlawful restraint of trade. The Supreme Court agreed, denying the society's "rule of reason" defense as well as their immunity from the Sherman Act" defense. The AICPA, in 1972, was forced to delete the competitive bidding rule from its ethics code after a legal battle with the Antitrust Division of the Department of Justice. Most assuredly, state CPA society rules would not stand up in court as "state action" exempted under the Sherman Act.

It is worthwhile to note that ORDER II of the proposed agreement provides that the AICPA may solicit action by any federal, state, or local government entity. It is further stated that the AICPA may suspend or terminate the membership of a CPA if the member's certificate or license is suspended or cancelled as a disciplinary measure by a governmental entity. Also, AICPA membership can be suspended or cancelled based on actions taken by the SEC or IRS against a CPA member as outlined in the proposed agreement. Therefore, the proposed agreement leaves the AICPA with some indirect enforcement powers with regard to covered services.

Accountants' Liability Insurance

Accountants' professional liability insurance policies generally are limited to covering professional services in the insureds' professional capacity as accountants. In 1985, an appeals court in North Carolina upheld a trial court's judgment that the professional liability insurer for a CPA firm was not liable to the insured where the CPA firm provided services outside the realm of their professional capacity as accountants. In this case, Mastrom, Inc. v. Continental Casualty Co., 337 S.E. 2d 162 (NC Ct. App. 1985), seven clients of the Mastrom accounting firm brought suit against Mastrom's directors for fraudulently inducing them to invest in the unsecured notes of Thermal Belt Air Service (TBAS). TBAS subsequently became bankrupt. The Continental Casualty Co. refused to defend Mastrom because the sale of unsecured notes by Mastrom was not covered as professional accounting services. The appeals court agreed.

In 1986, a New York CPA firm was sued for fraud because of acceptance of undisclosed commissions for the sale of certain tax-sheltered limited partnerships. The CPA firm settled by repaying the commissions when its insurance carrier refused coverage. The firm then sued their carrier for breach of contract asking for damages amounting to commissions paid and counsel fees. The case, George Muhlstock & Co. v. American Home Assurance Co., 502 N.Y.S.2d 174 (N.Y. 1986), resulted in the court's conclusion that the commission-related activities of the CPA firm were outside the covered professional accounting services and, therefore, not the responsibility of the insurance carrier. In essence, the accounting firm was deemed to be offering brokerage services instead of accounting services. The court relied on the New York Board's (Education Department Board of Regents) interpretation of what constituted public accountancy in their decision.

Specific Exclusions

Many insurance companies will specifically exclude coverage for services performed by the CPA for a client for which the CPA receives a commission or contingent fee. Exhibit 2 is a partial accountant malpractice policy specimen containing specific exclusions for commission-related and/ or contingent fee-related services. In light of the proposed agreement, such exclusions will probably become the norm.

Costs of Coverage

Where liability increases, its related coverage and cost naturally increase. Because practitioners would extend their liability by involvement with commissions, contingent fees, or referral fees, insurance coverage would likely need to be revised to specifically include such activities. If obtainable, such insurance coverage would certainly be costly.


Practitioners should carefully evaluate their individual circumstances before accepting commissions, contingent fees, or paying or accepting referral fees covered by the proposed AICPA-FTC agreement. This evaluation should involve the CPA's review of state laws as well as accounting board rules of the state having jurisdiction to ascertain the legality of such arrangements. A few practitioners will find that in their jurisdictions there is no conflict with the proposed agreement regarding these matters. However, such jurisdictions are certainly the exception.

CPAs who assume that their state jurisdiction will not attempt to enforce statutes or board rules banning commissions, contingent fees, or referral fees in light of the proposed agreement, may do so to their detriment. State action has previously been declared "exempt" from the constraints of federal antitrust legislation in certain court cases. Thus, any practitioner who chooses to violate state statutes or board rules assumes risks including the following:

* State or state board disciplinary action (suspension or termination of certificate or license);

* Suspension or termination of AICPA membership (based on disciplinary actions taken by state); and

* Major legal costs pursuant to a legal battle with the particular state or state board.

To reduce these risks, the CPA may request a declaratory ruling from the appropriate jurisdiction as to a particular proposed activity. Even if a practitioner receives a favorable ruling approving of the proposed activity involving commissions, contingent fees, or referral fees, malpractice insurance coverage for such an activity would be unlikely. Most CPAs could ill-afford to engage in such services without first making sure of adequate insurance protection.

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