Liability of accountants.by Brodsky, Edward
The court emphasized that the accountants were absolved from Rule 10b- 5 liability because, they complied with the rules of their own profession, which is all they were expected to do. Thus, whatever responsibility management may have had to disclose the company's internal control problems in the circumstances, the auditors' duty was to report the problems to management, which they did.
The Monroe decision is unique because, instead of focusing on Federal and state securities laws in determining whether the audit was conducted properly, the opinion is stated in terms of whether the auditor, in this case Deloitte & Touche, needed to do more than comply with professional standards established by the profession's own governing body, the American Institute of Certified Public Accountants ("AICPA").
In Monroe, Deloitte performed an audit of Hughes Homes, Inc. and discovered that the company had certain internal control problems which were then reported in a letter to management. Deloitte's audit report was subsequently included in a public debenture offering of the company. Two months later, Hughes management responded to Deloitte's letter about the internal controls issue.
Subsequently, Hughes publicly disclosed serious financial problems, stating that its financial statements would likely include a disclaimer of opinion by Deloitte resulting from Hughes' potential inability to continue as a going concern and the lack of supporting documentation to explain significant year-end adjustments resulting from deficiencies in its internal control and accounting systems. Soon thereafter, Hughes ceased operations and plaintiffs, who had purchased debentures in the public offering, lost their investment.
Plaintiffs sued Deloitte, among others, claiming that the auditors acted recklessly in failing to disclose information relating to Hughes' internal control problems in violation of Rule 10b-5 and Oregon state law. Additionally, plaintiffs claimed that in issuing its audit, Deloitte failed to disclose the internal control issue and neglected to make its findings available to the underwriters in the public offering. Finally, plaintiffs asserted that the internal control problems constituted "material weaknesses" which should have warranted a "going concern" qualification from Deloitte.
Deloitte's motion for summary judgment was granted by the court. Although recognizing that the parties raised several complex questions under the securities law, the court simply found that Deloitte could not have acted "recklessly" within the meaning of Rule 10b-5 because plaintiffs failed "to identify a single misrepresentation or omission in defendant's . . . audit reports" furnished to the public. Specifically, the court ruled that the internal control problems were properly identified by Deloitte in its letter to management and that is all the accountants were required to do on that issue. The court further found that Deloitte had no obligation to the investors to inform them of the internal control problems either through the audit report or by issuing a "going concern" qualification reporting the internal control problems as "material weaknesses" that may have effected the entity's continued existence.
If accountants conduct an audit in accordance with AICPA rules, it is difficult to see how they could have the necessary degree of scienter for 10b-5 liability and, under the circumstances, summary judgment - rather than requiring the accountants to suffer the expense and uncertainty of a trial - permits the judicial system to rid itself of meritless securities fraud suits directed at the deep pocket of independent accounting firms.
Unfortunately, not all courts subscribe to the view that accountants who have complied with professional standards should not be burdened with Rule 10b-5 claims.
GAAP Not Always Enough
For example, in Herzfeld v. Laventhol Krekstein Horwath & Horwath, the District Court for the Southern District of New York held that compliance with generally accepted accounting principles (GAAP) is not the proper focus in determining auditor liability under Rule 10b-5. While in Monroe the problem was more a generally accepted auditing standards (GAAS) issue, compliance with GAAP is a requirement of professional standards. Also, in the case of Herzfeld, the Court may have been somewhat imprecise in its use of GAAP. Under Herzfeld, the Court went on to conclude that AICPA rules are "esoteric accounting norms, comprehensible only to the initiate" and the issue is not whether GAAP has been followed, but whether the accountants, under an unspecified standard, disclosed all material information about their client's financial condition in their audit report. The Court's rationale was that auditors have a "special duty" of candor to investors which is not necessarily satisfied by conforming their conduct with GAAP.
Further support for the contrary view is found m United States v. Simon, where the Court of Appeals for the Second Circuit held that compliance with GAAP is not "a complete defense" to a charge of criminal fraud against an auditor under the Securities Act of 1934. The Court said that while such evidence may be highly persuasive, it is not conclusive.
But with no standards to follow other than GAAP and GAAS, accountants are in a difficult, if not impossible, position to determine what, if anything, should be disclosed beyond those requirements. By comparison, the Monroe analysis adds a measure of predictability to the potential liability of accountants under the securities laws to which all professional persons should be entitled. By using professional standards to absolve the auditor from liability in Monroe, the court effectively held that conformance with AICPA standards is consistent with the required disclosure under the securities laws. This, has the salutary effect of giving the accountants, who have not consciously participated in a scheme to defraud, a level of comfort in their work to the extent that they will be immunized from liability if they have complied with stated professional standards.
Thus, in Monroe, arguing that it was not required to disclose the company's internal control problem to the investing public, Deloitte cited AU Sec. 320 of the AICPA Professional Standards which governed the auditors' evaluation of internal controls at the time the audit was performed. That guideline indicated that existing internal controls should be examined "as a basis for reliance thereon and for the determination of the resultant extent of tests to which auditing procedures are to be restricted." The court properly interpreted this section as a direction to the auditor to examine internal controls solely "to determine the scope of the audit - i.e., poor internal controls is sic a signal to conduct a more thorough audit, whereas good controls signal a less searching audit." Accordingly, the court found that the auditors' measure of internal controls is exclusively for the guidance of the accountants, not the public, and thus need not be disclosed in the audit report.
Similarly, although plaintiffs complained the auditor should have required management to implement the suggestions for better controls before allowing the audit to be used in the debenture offering, the relevant section of professional standards (AU Sec. 711.10) only requires the auditors to read the prospectus and ask management whether there have been any material events that might have affected the outcome of the audit. Because neither party disputed that Deloitte had complied with this guideline, the court correctly found that Deloitte could not be held liable under the theory advanced by plaintiffs.
As indicated above, the plaintiffs in Monroe also alleged that the internal control problems identified by Deloitte should have triggered a "going concern" qualification from Deloitte. To support its claim, plaintiff had its expert, another accountant, submit an affidavit stating that "in his professional judgment" the internal control problems were significant enough to qualify as "material weaknesses" within the company.
In rebuttal, Deloitte contended that under professional standards, the internal control problems were merely matters that should be identified and reported to management, but need not be included in the audit report. In defense of its position, Deloitte relied on the section of professional standards (AU Sec. 340) on going-concern problems which set forth a list of factors an auditor should weigh in determining an entity's ability to continue as a going concern, and noted that the list does not include "poor internal controls."
The Court Agreed with Deloitte
The court agreed with Deloitte on this issue, implicitly recognizing that the AICPA standards referred to are merely guidelines which are subject to different interpretations by different auditors. The court indicated that although the internal control problems were not included in the audit report, Deloitte did not act recklessly in applying this guideline and reaching its conclusion. Accordingly, the Court refused to impose liability, holding that a difference of professional opinion . . . fails to satisfy a claim for securities fraud . . ."
Nonetheless, it should be noted, that while the auditors are not always obligated under GAAS to inform the stockholders of problems with the internal control system, accountants may not simply "keep a blind eye to all wrong-doing while walking through a client's corporate headquarters" (Adams v. Standard Knitting Mills, Inc.). Indeed, liability may be imposed to the extent that the auditors intentionally or recklessly disregard the generally accepted, standard body of accounting knowledge. In Adams, however, the court refused to impose liability against the independent accountants on this ground because the plaintiff could not prove scienter in failing to disclose a flaw in the client's computer system that caused the internal control problems.
This rule set forth in Monroe should also be distinguished from the rule in a different context that auditors may not simply ignore potential internal control problems to the detriment of the client. For instance, in Robe Wooler Co. v. Fidelity Bank, auditors performing unaudited financial statement services for a client failed to inform the client of a potential problem with its internal control system. This enabled an employee of the client to deposit 94 company checks into her personal bank account. When the client brought an action for conversion against the bank which cashed the checks, the bank impleaded the auditors for negligently failing to warn the client of the internal control problem.
The Superior Court of Pennsylvania imposed liability on the accountants in that case. The court that ruled absent specific language in the engagement agreement relieving the auditors from negligent acts, auditors must be held to a duty of care equivalent to that which reasonably prudent, skillful accountants would use under the circumstances." According to the court, this level of skill included to report to the client suspicious circumstances concerning the internal control system.
A Favorable Decision
The Monroe opinion is obviously a favorable one for accountants. Not only does this opinion speak in terms with which accountants are conversant, it also can be used as a preventive measure which informs the auditors that if they follow AICPA standards in conducting their audit, they will not, except in the most extraordinary cases, be subjected to civil liability under the securities laws. Thus, where a plaintiff in a Rule 10b-5 case alleges a material misstatement or omission from an audit report by accountants, the decision in Monroe could be utilized as an approach for disposing of cases seeking to impose liability on accountants in cases in which professional standards have been followed.
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