The CPA Journal: The Task Force on Accountants' Legal Liability was born in 1985, a child of the "insurance crisis," and quickly came of fighting age to join in the battle for reform of accountants' legal liability, part of a war that expanded rapidly in the highly litigious environment of the 1980s. Unfortunately, there is every reason to expect that the conflicts in the courtroom will continue in the 1990s. Recent allegations of inadequacies in audits of the S&L industry, with billions of dollars involved, have cast a pall over the whole profession. Is the accountant better prepared for the skirmishes and battles yet to be fought? Are the trenches dug and the weapons clean and well oiled?

Bob, would you please set the stage for our readers? What were the conditions in the mid-1980s that gave rise to the AICPA Accountants' Liability Task Force?

Robert Mednick: The number and size of lawsuits against accountants were increasing at an alarming rate. Accountants were, like many others, being swept along in a wave of lawsuits. In the years from 1975 to 1985 the number of lawsuits filed annually in the U.S. District Courts increased from 117,000 to 273,600.

In many of those lawsuits, somehow the courts and juries found someone to compensate an injured party for their loss. Plaintiffs had become very clever in finding the now well-known "deep pocket" to make the injured whole. Remember, in many jurisdictions, joint and several liability principles operated. Under those principles, each negligent party can be held liable for the total damages suffered, even though it was deemed responsible for only a small portion of the loss. Invariably, those with the "deepest pockets" paid, particularly in the financial rubble of a bankrupt company. The accounting profession has kept its pockets well lined as a protection to the public through the use of insurance. This has in many cases, I suppose, worked to our detriment.

The irony is that accountants weren't necessarily being sued by those directly hurt. Often, litigation was initiated by lawyers seeking a contingent fee. The so-called "plaintiffs' bar" watches developments with a keen eye, and will file a suit as soon as word of a large business failure hits the street. To be first in line increases an attorney's participation in damage awards or settlements stemming from an accountant's misdeed.

On top of this, the bubble burst on insurance companies, whose poor loss versus premium experience had been masked by high earnings on investments. The huge awards by courts and high pre-trial settlements had to be paid, and the growing uncertainty over litigation risk further added to the insurers' burdens. For the first time the accounting firms below the very large ones felt the pinch, not necessarily in the courtroom, but in the higher premiums and, even worse, cancellation notices from their insurance companies.

Something had to be done.

CPAJ: The AICPA joined in the fray by forming the Task Force (originally a Special Committee on Accountants' Legal Liability) to explore responsible ways of reducing accountants' exposure and to recommend specific action for AICPA and state CPA societies. Realistically, what could a committee of a professional organization do to bring reason to the process?

RM: It is important to remember that we were not the only profession or group upset. Lawyers themselves, engineers, architects, doctors, manufacturers, financial institutions, state and local governments, not- for-profit organizations, and insurance companies, to name more than a few, were all very concerned with what was happening.

Thus, the AICPA committee joined with others to formulate a plan of attack. Coalitions were formed, such as the American Tort Reform Association, to marshall resources and aggressively reverse the tide.

CPAJ: What did these groups agree to do?

RM: Tort reform became a priority of all members of these coalitions. Proportionate liability in one form or another had to displace the obvious inequities of the joint and several concept. And, from the perspective of the accountant, privity requirements needed to be preserved and expanded.

CPAJ: Because tort reform must be fought primarily at the state level, did it require battles in each state?

RM: Yes, it required extensive educational and legislative efforts in substantially all state capitals. Many state CPA societies quickly accepted the challenge and have been very active, in some cases taking leading roles in drafting legislation, giving speeches, publishing articles, and generally keeping the issue before the press and state legislatures.

CPAJ: What was the AICPA doing?

RM: The Task Force has first and foremost supplied the state societies with the resources and tools to educate legislators and influence public opinion at the grass roots level. Reform in Louisiana will come only when Louisianians convince the local legislators of the need. I can't do it from Chicago and the AICPA can't do it from New York. However, we can and have provided those on the firing line with model legislation, speeches and articles, position papers, a legislation evaluation service and testimony for pertinent legislative hearings, among other things.

CPAJ: Here we are, in the 1990s, some five years after the crisis and the formation of the Task Force. Are we making progress?

RM: Absolutely. Look at the summary of State Tort Reform successes. (Exhibit 1.) It shows the accomplishments over the 1986-1989 period. Ten states abolished joint and several liability, 21 others reduced exposure to some extent, and three states enacted privity legislation. Furthermore, we have seen favorable court decisions with respect to third-party liability for negligence in another nine states. That ain't bad!

In addition, thanks to the efforts of all--the AICPA, the state societies, and the various coalitions--we have made significant progress at the awareness level. Lawyers who represent accountants have volunteered the view that the efforts are paying off in the attitudes reflected in courtrooms. It's also showing up in the settlements negotiated on courthouse steps. We have even had a number of favorable jury decisions. Tort reform education impacts juries as well as judges and legislators.

CPAJ: What kind of modifications are being made to the Joint and Several Liability statutes short of absolute proportionate liability?

RM: Generally, modifications are being made to eliminate the extreme cases where a party adjudicated negligent to a minor degree is obliged to pay the bulk of damages. As an example, a statute might provide that a defendant who is less than 50% at fault is responsible for only its own several share of the loss or up to twice that amount. Or, it might provide that the joint and several liability will run only to economic damages, not to such things such as awards for pain and suffering. This latter provision is not of much help to accountants, who rarely are held liable for other than economic loss.

CPAJ: I understand why all defendants favor proportional liability or paying only your fair share. How's the privity situation shaping up?

RM: Privity is different from general tort reform. Tort reform depends on state legislatures enacting laws that, for instance, provide that damages be assessed in virtually all litigation on a proportionate basis. Each party found to be at fault pays its share, and not more. The privity issue is much more accountant-specific. We seek to preserve an established principle that an accountant in particular can be held responsible only to third parties which he or she knows and understands are using audited or reviewed financial statements for a particular purpose, and with whom he or she has had some direct contact.

CPAJ: Is the privity standard a matter of statute or judicial precedence?

RM: The principle was first enunciated by Judge Cardozo, sitting on the New York Court of Appeals, in Ultramares v. Touche over 50 years ago and reaffirmed by that court in Credit Alliance v. Arthur Andersen in 1985. However, while it continues to be followed in many states, a few state courts have abandoned or seriously modified the rule, potentially exposing accountants in those states to liability for negligence to an unlimited number of unknown third parties with whom the accountant has no contractual or other relationship. It is primarily in those states that the Task Force recommended attempts to shore up the privity standard through legislation. Model legislation to help state societies achieve this goal was developed by the Task Force in early 1986.

CPAJ: What principle or rule do the jurisdictons that don't follow privity employ?

RM: The extreme position is known as the "foreseeability standard." Under this standard, accountants can be held liable to any third-party whose reliance was, in hindsight, foreseeable. For example, in one case a trade supplier with whom an accountant had no contact, claimed to have extended credit on the basis of summarized financial information included in a credit agency report and brought suit on the basis that such usage was foreseeable by the accountant. A middle ground is what has become known as the Restatement standard. While the accountant must have knowledge of a third-party's intended use of the report, or that the third-party is part of a limited group of intended users, there is no requirement for the direct contact between the accountant and the third-party, such as exists in privity states.

CPAJ: Let me quote from a recent article in the Commercial Lending Newsletter of Robert Morris Associates, the banking group. Brad Korell, a senior lender for the National Bank of Commerce, Lincoln, Nebraska, is quoted as saying the whole matter of privity is "very irritating." He says accountants are well aware that their work is not only important but that it is also relied on by others besides the client for whom it is prepared. To take the position that a written notice from a financial institution is going to impose a discipline on an accountant's work makes a mockery of the process. What is your reaction to that statement?

RM: It's not that we are trying to avoid our legitimate responsibilities. We are trying to put reasonable limitations on our exposure. Excessive liability creates an incentive for accountants to restrict the free flow of commercial information which is so important to our free enterprise system. When someone wishes to rely on an accountant's report for a significant business decision, it is only fair that the accountant have knowledge of the intended reliance. Then all parties can undertake the due diligence and other steps necessary to see that the investment or othe decision is made under the right conditions. privity is not a shirking of responsibility; it creates a stable environment for the accountant to provide the marketplace with his or her valuable services.

CPAJ: Before we get on to another topic, would you please summarize the accomplishments of the Task Force in tort reform and privity conservation on which we can build during the 1990s?

RM: Here we go.

* During the insurance crisis period we testified before Congress on the impact of rising costs and diminishing availability of coverage to the accounting profession as well as the underlying causes for this condition.

* We assisted state societies by developing speeches, model legislation, and testimony to operate at the grass roots level of tort reform. I have already described the results.

* We assisted states in evaluating tort reform legislation that was drafted. During this period, dozens of bills were being introduced, some better than others.

* We gave guidance to state societies and practitioners on incorporation of professionals, alternative methods of resolving disputes--e.g., arbitration and mediation--and other related matters intended to protect against increasing liability.

* We joined others in speaking out against the contingent fee system for plaintiffs' lawyers. (A recent Forbes article points out that, on average, 70% of the awards to the injured never make it to those actually injured. Between legal fees and other costs, only 30% goes to compensate the aggrieved party.)

* We also are raising the liability concern of the profession in the halls of Congress and, while tort reform at the federal level will be a long-term project, have been successful in getting favorable bills introduced in both Houses.

* Finally, we have encouraged the AICPA to file amicus curiae (friend of the court) briefs in particular lawsuits against accountants which appear to threaten the entire profession with new or additional liability exposure. These briefs bring to the attention of the court the broad policy and historical perspectives on accountants' legal liability to aid the court in reaching its decision. They have been very effective in a number of instances.

CPAJ: More than half the states have legislated some level of reform in the very important area of joint and several liability. Are the troops still in the field? Is the battle still being fought?

RM: Yes. The Task Force is still active. There are major state legislatures that have not yet seen the light--Pennsylvania, Massachusetts, the Carolinas, to name a few. Furthermore, there are other tort reform issues that may be ready for an assault, such as punitive damages and statutes of limitations. However, it's in the hands of practitioners and others in the individual states to continue the effort.

Incidentally, the Task Force has put together a Tort Reform manual for state societies and others interested in the reform movement. It includes all of the efforts of four years' work and is available for the asking.

CPAJ: We have been talking for almost an hour and yet the word RICO reform has not come up. Is your task force involved with it?

RM: Not directly. The AICPA has played a leadership role in RICO reform efforts, but that initiative is under the supervision of the AICPA's Washington office and its Government Affairs Committee. RICO is a federal criminal statute, and we have focused primarily on helping state societies influence and achieve state tort reform. However, as with tort reform, many groups in addition to accountants are clamoring for relief. The securities industry, banks, manufacturers, labor unions and others all thought success was at hand when the House first passed reform legislation in 1986. Unfortunately, the Senate voted it down by a narrow margin, and we are still waiting for our victory. In my opinion, there is a good chance it will pass next year. RICO reform is supported by the American Bar Association, the SEC, the Justice Department, and the American Ciivil Liberties Union, among others. It is just a matter of time.

The problem is that most everyone agrees reform is in order, but the specific elements of possible reform are so varied that much debate continues to occur. Thomas Jefferson may have been sensible when he said that passing laws should not be made easy. But perhaps it should be easier to correct a bad law or a law that has led to abuse or a result not originally intended.

CPAJ: Are there any new initiatives on the legal liability front?

RM: We are just beginning a program of education for the judiciary. Believe it or not, judges also have continuing professional development needs and requirements. They all attend institutes such as the National College of State Court Judges which are an important means of staying abreast of relevant developments in a complex and increasingly technological world. In this respect, our Task Force is just beginning to develop programs for use in such institutes to provide a better understanding of audits and financial statements--both their objectives and their limitations.

CPAJ: In the matter of commissions and contingent fees, one of the factors that the CPA must consider is the increased exposure to legal liability. What do you see happening with commissions and contingent fees if the FTC agreement is signed?

RM: Frankly, I'm not certain what will occur if and when the FTC agreement is finalized. In fact, I could argue either side of the subject. Some believe that state boards and legislatures will actually enact new regulations and legislation in an effort to avoid a liberalization of existing restrictions. Others believe that most states will go along with the settlement and permit commissions and contingent fees, except for audit clients. Unfortunately, rules will vary from state to state. With 50 states we no doubt could have many variations in what is allowed and what is not. The administration of such a situation for a multi-office accounting firm will become a nightmare.

CPAJ: I understand that some accounting and auditing firms carry no malpractice insurance. What advice would you have to the small practitioner in this regard?

RM: I don't believe that this lack of insurance is in the public interest. Unfortunately, it has been primarily brought on by the lack of availability stemming from the litigation crisis of this past decade. For the services of a CPA to have value, there must be sufficient assets backing up the process, so if someone is injured by a CPA's actions, the injured can be made whole. While CPAs without insurance coverage may be very careful about what they do, we are all human.

CPAJ: What advice to you have for the CPA who is asked by his or her client to issue a "reliance letter?" It could mean the difference between losing and keeping the client.

RM: First, some background. The trend toward third-parties seeking reliance letters stems from the privity precedent and statutes in certain states. In effect, third-parties are seeking to establish privity. Without such a letter the third-party has the burden in litigation of establishing not only that he or she has relied on the accountant's report, but also that the auditor knew of the reliance and acceded to it.

What should the accountant do? Well, I can think of a five-step program to follow:

1. Don't just acknowledge a third-party's intended reliance. Seek a representation from the third-party that other due diligence has been performed, or, if this is not practical, state in the letter that the performance of other due diligence has been assumed.

2. Only acknowledge intended reliance as opposed to actual reliance. It is up to the third-party to establish actual reliance if the need arises.

3. Be sure to express the inherent limitations of the audit process.

4. Note that the report speaks as of a specific point in time, that no procedures subsequent to the date of the report have been performed, and most importantly, that the procedures performed as part of the audit may not be adequate or appropriate for the purpose of the third-party's reliance in the particular situation.

5. State as precisely as possible the proposed purpose of the third- party's reliance, avoiding any acknowledgement of general after-the-fact reliance.

CPAJ: Are we as a profession doing better work than we used to do? Do you see an improvement in quality which should lead to less liability?

RM: No one individual, organization or professional is perfect, but I do feel that there has been significant improvement. It is very difficult to prove, and certainly the increasing number of lawsuits doesn't necessarily support that feeling. However, the lawsuit pipeline takes a long time for matters to pass through. And the mere existence of a suit does not mean an audit was deficient, particularly in today's litigious society and search for deep pocket defendants. Unfortunately, critics are too quick to equate a business failure with an audit failure, and hindsight is always 20/20. But on the whole, I believe the people entering the profession today are as qualified as ever, and the nature and extent of controls and safeguards established to assure the quality of practice have been strengthened considerably during the past decade.

CPAJ: Do you see public accounting firms being able to practice in the form of limited liability corporations? And with outside capital?

RM: This issue is again one that will need to be tackled on a state by state basis. To achieve uniformity among all the states is a virtual impossibility. Right now, practicing as a professional corporation (P.C.) does give some protection for local practitioners in many states. Usually a shareholder would be liable only for his or her individual acts and not those of other shareholders. The problem is that the protection is seldom afforded to foreign corporations, i.e., those incorporated in another state. Therefore, P.C. laws do not benefit the larger, multi-office firms. As far as capital investment by people not active in the business, I think many other matters have to come home to roost before we deal with that. Let's wait and see how this matter fares in Great Britain.

CPAJ: Is the profession heading in two directions, the large firms one way and the rest another way?

RM: In some ways that is true. For instance, audits of multi-national businesses are very different from those of most small- and medium-sized companies. But on issues such as liability, all accountants are fighting the battle side by side. Everyone can rally behind the common cause of bringing fairness back into our legal system. If we are not successful, then the plaintiffs' bar will price us all--big and small-- out of the marketplace.

CPAJ: We need to act as a united profession, concerned with the users of our services. When we do that, all will benefit--the big and the small. With that warning, I hope we have been of help to our readers in updating how the legal issues are evolving. Thank you, Bob, for your insights and for your continuing commitment to liability reform. We have made progress, and it should continue, thanks to you and others on your Task Force.

Robert Mednick, CPA, is a partner of Arthur Andersen & Co., Chicago, II. He is Chairperson of the AICPA Task Force on Accountant's Legal Liability and a member of the AICPA Special Committee on Governance and Structure. He is a past member of the AICPA Board of Directors, the Auditing Standards Board, the Financial Accounting Standard's Advisory Council, the AICPA Committee on SEC Regulations, the AICPA Mission Committee, and the Committee on Accounting Principles of the Illinois CPA Society.

James L. Craig, Jr., Managing editor of The CPA Journal, interviewed Robert Mednick to discuss this important and contentious matter.