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Dec 1994

Liability of accountants under the Federal securities laws.

by Augenbraun, Barry S.

    Abstract- Most accountants believe that they can never be liable under the Federal securities laws because their practice do not involve securities. However, the comprehensive definition of securities indicated in the statutes and the pertinent case law has left many accountants in the middle of liability lawsuits they did not imagine themselves being threatened with. Securities laws apply not only to traditional instruments such as common stock, stock options and debentures but also to limited partnerships, real estate syndications, notes issues by companies and oil drilling leases. One of the provisions that accountants should take note is Sec. 5 of the Securities Act of 1933, which hold them accountable to investors who use their financial statement as basis for purchasing securities. On the other hand, Sec. 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 prohibit deceptive devices. Sample cases involving securities are discussed.

Many accountants think they don't have to worry about liability under the Federal securities laws because they don't practice in that area. However, because the definition of securities is so broad, many times they are involved without realizing it. The author provides some background on this troublesome and complex field of the law. And while a recent Supreme Court case appears to be a victory for accountants, he explains why it may be short lived.

"I never get involved in stock offerings in my practice--why do I have to worry about the securities laws?"

"I used to do some work with real estate developers, helping to obtain financing, working on setting up units for ownership of commercial office buildings--but I never got involved in any public company work."

"I know what a prospectus is--you will never see our name in one."

To many accountants, the world of securities law and attendant liabilities seems remote. Yet the broad definition of "securities" reflected in the statutes and the applicable case law has resulted in many accountants finding themselves measured by a standard of liability they never believed had any bearing on their activities.

What is a Security?

The definition of "security" under the Federal securities laws is extremely broad, and the courts have substantially expanded the scope of the definition. Conventional instruments, such as common stock, stock options, debentures, etc., obviously fall within the reach of the securities laws. However, limited partnerships, real estate syndications, notes issued by commercial and industrial companies, investments in citrus groves, and oil drilling leases have all been found to be securities, with attendant liability for those who are in any way connected with the transactions in which they were issued and sold. In its most recent review of the issue, the Supreme Court did little to narrow the scope of the definition, holding that demand notes issued by a membership farmers' cooperative were "securities" within the meaning of the law, even though the law exempts any note that has a maturity not exceeding nine months Reves v. Ernst & Young, 494 U.S. 1092 (1990).

Accordingly, almost any transaction that results in investment by more than a few people is likely to engage the Federal securities laws, whether the underlying transaction involves real estate, oil and gas leases, or investments in conventional business operations. Even the sale of an entire business can constitute a sale of securities that can become subject to the Federal securities laws.

The Securities Act of 1933

The most straightforward application of the Federal securities laws arises in connection with issuances of securities that are registered with the SEC pursuant to Sec. 5 of the Securities Act of 1933, as amended (the 1933 Act). With the filing of a registration statement in which the auditor allows his or her report to appear, the auditor assumes a liability to purchasers of the securities for "any untrue statement of a material fact or omission to state a material fact required to be stated...or necessary to make the statements...not misleading" with respect to the financial statements on which he or she reported (Sec. 11).

This is an extremely exacting standard of liability. Unlike the normal case where the plaintiff has the burden of proving some wrongdoing, in the case of a registration statement claim, the burden is shifted: once the plaintiff has established that the financial statements reported on were false or misleading in some material respect, the accountant must then prove that he or she conducted a reasonable investigation and had reasonable grounds for his or her belief in the accuracy of the statements made Sec. 11 (b) (3) (b). In one of the few cases to proceed to trial against an accounting firm under Sec. 11 of the 1933 Act, the Court undertook a detailed analysis of the audit steps undertaken by the accounting firm, the information available to it at the time of the audit, the reasonable conclusions it should have drawn from that information--and imposed liability for material misstatements in the financial statements with respect to accounts receivable and net income Escott v. Barchris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968). Because liability is imposed under Sec. 11 only in connection with financial statements the accountant has either prepared or certified in a report, courts have generally not found liability under Sec. 11 for unaudited interim financial statements contained in a prospectus Grimm v. Whitney-Fidalgo Seafoods, Inc., 458 F. Supp. 5 (S.D.N.Y. 1978).

Liability as a "Seller" of Securities

Another section of the 1933 Act imposes liability on any person who offers or sells a security in violation of the registration provisions of Sec. 5 of the 1933 Act. Under this provision of the law, those engaged in an offer or sale of securities that should be registered with the SEC, who either mistakenly or purposely failed to file the necessary registration statement and sold the securities, have liability to the purchasers. While some early cases attempted to impose liability on accountants who were involved in an offering of securities when the promoter failed to file properly with the SEC, a 1988 decision of the Supreme Court has resolved many concerns relating to that issue. In Pinter v. Dahl, 486 U.S. 622 (1988), the Court held that liability is only imposed on those who actually assist in the offer or sale. Lawyers, accountants, and other professionals who simply provide normal professional services in connection with an offering, are not liable for violation of the registration provisions of the 1933 Act if it turns out a registration statement should have been filed.

Sec. 10(b) of the 1934 Act and Rule 10b-5

By far the largest body of litigation under the Federal securities laws arises under Sec. 10(b) of the Securities Exchange Act of 1934, as amended (the 1934 Act), and Rule 10b-5 adopted by the SEC under Sec. 10(b). Sec. 10(b) of the 1934 Act prohibits the use of any "manipulative or deceptive device or contrivance" in violation of rules established by the SEC. Rule 10b-5 provides as follows:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange:

1. To employ any device, scheme, or artifice to defraud,

2. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

3. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Liability under Sec. 10(b) and Rule 10b-5 can be imposed whenever there is a purchase or sale of a security, even when the securities are sold privately, and even if the security is not publicly traded.

The case law and commentary under Rule 10b-5 are enormous. Some of the major issues that affect liability of accountants under Rule 10b-5 are discussed below.

Pleading and Proof of Scienter

In a 1975 case involving an accounting firm, the Supreme Court made clear Rule 10b-5 is a fraud statute, and mere negligence cannot give rise to liability. Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). A plaintiff seeking to recover must plead and prove the accounting firm acted with scienter, usually defined as malice, knowledge, or intent.

Initial reaction on the part of the profession to the Hochfelder decision was enthusiastic, since it was widely believed plaintiffs would not be able to meet the scienter standard. While accounting firms may, from time to time, depart from professional standards and fail to live up to the high demands of their calling, it was believed that only in the rare case would a plaintiff be able to establish the accounting firm acted with malice, knowledge, or intent. Unfortunately, those initial expectations were quickly disabused by the resourcefulness of the plaintiffs' bar, which found numerous ways of escalating claims that appear to be mere negligence to claims that met the scienter standard.

A principal technique has been pleading that the accounting firm acted with recklessness. Although the Supreme Court had left open the question of whether reckless behavior met the scienter standard, virtually all Circuit Courts of Appeal have concluded that a pleading of recklessness satisfies this standard. While the definition varies from circuit to circuit, an example of the standard is that followed in the Seventh and Ninth Circuits:

Reckless conduct may be defined as a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it Sundstrand Corp. v. Sun Chem. Corp, 553 F.2d 1033, 1044-45 (7th Cir. 1977) cert. denied, 434 U.S. 875 (1977); Hollinger v. Titan Capital Corp., 914 F.2d 1564 (9th Cir. 1990).

Liability as "Aider and Abettor"

Until the decision of the U.S. Supreme Court in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. (April 19, 1994), a common technique used to implicate accountants in claims of violation of Rule 10b-5 was a claim of aiding and abetting the violation of others. It was routine in cases involving accounting firms for plaintiffs to plead both a direct violation by the firm of the statute and rule, and that the firm aided and abetted the violation of others.

In the Central Bank decision, the Supreme Court held that since the Federal securities laws did not specifically provide for a claim of aiding and abetting, the courts had no power to create such a claim. The decision came as a surprise to many, since most lower courts had recognized that a claim can be stated for aiding and abetting a violation of Federal securities laws when the plaintiff established that a violation was committed by some other defendant and a party had knowledge of the violation and took some action in furtherance of the violation Woodward v. Metro Bank of Dallas, 522 F.2d 84 (5th Cir. 1975).

The most aggressive use of the aiding and abetting doctrine had been the claim that the failure of the accountants to blow the whistle on their client during the course of performing services constituted aiding and abetting the violation of others. In the most extreme application of this doctrine, a court held that the mere use of the name of the accounting firm in connection with a fraudulent offering memorandum, even when the accountant had not yet performed any services, could constitute aiding and abetting the violation of law of the principal wrongdoers:

These facts may be sufficient to create a duty to disclose in Peat Marwick. Investors can reasonably be expected to assume that an accounting firm would not consent to the use of its name on reports and offering memoranda it knew were fraudulent. Thus, it may be reasonable to expect an accountant to disclose fraud in this type of situation, where the accountant's information is superior and the cost to the accountant of disclosure is minimal Roberts v. Peat Marwick Mitchell & Co., 857 F.2d 646 (9th Cir. 1988).

Other courts reacted with horror to this extreme extension of liability. In Latigo Ventures v. Laventhol & Horwath, 876 F.2d 1322 (7th Cir. 1989), the Court of Appeals made it clear that it would not accept any theory of liability that would result in a claim against an accounting firm even before the firm issued its audit report:

All that remains is a claim that accountants who participate in or even are merely aware of a fraud by a client have a duty under Rule 10b-5 and the common law of Illinois to broadcast that fraud to anyone who might buy the client's stock. This theory of whistle-blower liability or financial good Samaritanism severs accountants' liability from the making of representations. Under it Laventhol & Horwath would be liable to the plaintiffs even if it had never issued an audit report. Rule 10b-5 does not reach frauds that involve no misrepresentations or misleading omissions....

It is not the law that whenever an accountant discovers that his client is in financial trouble he must blow that whistle on the client for the protection of investors--so that Laventhol & Horwath should have taken out an advertisement in the Wall Street Journal stating that it had just discovered that its client Xonics, Inc. was losing money, rather than waiting to report this in the next audit report. That would be an extreme theory of accountants' liability, and it is one we decline to embrace....

The Central Bank decision has been criticized by the plaintiffs' bar and, more importantly, by the SEC. The general counsel of the SEC has indicated the decision could adversely affect the enforcement activities of the SEC, and it is likely the SEC will recommend legislation to change the decision. At its last session, legislation was introduced in Congress to address some of the harsher results of securities law liability (The Private Securities Litigation Reform Act of 1994: S. 1976; the AICPA and major accounting firms support this legislation). It is possible the SEC and others will attempt to use the bill as a vehicle for reversing the Central Bank decision. Until legislation is adopted addressing the issue of aiding and abetting liability, it is likely lawyers for plaintiffs will seek to expand the scope of direct liability of accountants under Rule 10b-5.


Since a claim under Rule 10b-5 is a fraud claim, the plaintiff must establish that he or she actually relied on the financial statements. Despite that clear legal mandate, courts have been extremely liberal to plaintiffs in allowing them to establish reliance on the basis of minimal contact. For example, in Herzfeld v. Laventhol, Krekstein, Horwath & Horwath, 378 F. Supp. 112, aff'd 540 F.2d 27 (2d Cir. 1976), the plaintiff acknowledged he never read the final audit report issued by the accounting firm that contained a qualification regarding collectibility of accounts receivable. Because the plaintiff testified he had read an earlier draft of the financial statement, and the net income figure in the final financial statement was the same as that in the draft, the court found sufficient evidence of reliance. It is doubtful a court looking at the same facts today would be similarly generous to a plaintiff.

However, following the decision of the Supreme Court in Basic Inc. v. Levinson, 485 U.S. 224 (1988), plaintiffs have been allowed to avoid the need to demonstrate that they read and relied on a financial statement when they can point to reliance on the integrity of the market. Under this doctrine, which the Supreme Court applied in the case of a widely traded New York Stock Exchange listed company, the dissemination of false and misleading information into the marketplace for securities is presumed to have an impact on investors, and they need not establish reliance on the actual document alleged to be false and misleading. While this doctrine would appear to be so dangerously broad as to eliminate all need for proof of reliance, most courts have limited the fraud on the market doctrine to cases of widely traded publicly held securities. Attempts to apply the doctrine to circumstances where there was no existing trading market, such as the issuance of new municipal bonds or sales of a small over-the-counter stock, have generally been rejected by the courts.


The plaintiff in any fraud or negligence case must prove the errors in the financial statements were in fact the cause of his or her losses. In an important case that dealt with this issue under state law, the bankruptcy trustee for Auto-Train sued the accounting firm alleging numerous errors in connection with the financial statements and arguing that the company would have been in a position to cure some of its problems had it obtained better information with respect to its true financial status. While the jury awarded a sizeable verdict for the plaintiff, the Court of Appeals reversed on the grounds that there was no causal connection between the alleged deficiencies in the audits and the financial problems that ultimately resulted in the failure of the company. The company failed because of market forces and management deficiencies, not because the financial statements were false and misleading Drabkin v. Alexander Grant & Co., 905 F.2d 453 (D.C. Cir. 1990) cert. denied, 498 U.S. 999 (1990).

Liability for Forecasts And Projections

One of the most actively litigated issues in accountants' liability under the Federal securities laws in recent years has been liability for forecasts and projections. During the 1980s, an enormous number of limited partnerships and syndications were offered to investors, based on proposed investments in hotels, retirement centers, commercial real estate, oil and gas leases, motion picture production rights, and condominium units. In most cases, the offerings to investors included projections or forecasts of future results, generally accompanied by disclaimers of opinion from an accounting firm in the forms mandated by applicable AICPA literature. Early cases dealing with these projections and forecasts frequently found they could give rise to liability as statement of opinion see, for example, Eisenberg v. Gagnon, 766 F.2d 770 (3rd Cir., 1985). In recent cases, however, courts have become more sensitive to the apparent unfairness in permitting investors to claim damages when projections are not met, in the face of an accountant's report that specifically disclaimed any assurance the projections would be realized In re Convergent Technologies Sec. Litig., 948 F.2d 507, 515 (9th Cir. 1992); Kushner v. DBG Property Investors Inc., CCH Fed. Sec. L. Rep. 97,251 (S.D.N.Y. 1992).

Recognizing that a claim of fraud against a professional can be severely damaging even when it ultimately fails, some courts demand a high level of specificity of any claim of fraud against an accounting firm. That is true in the Second Circuit, which encompasses New York and Connecticut. There, a plaintiff who alleges a violation of Rule 10b-5 against an accounting firm must specify the items of the financial statements or projections that are false and misleading, the specific actions or omissions of the accounting firm, and specific facts that demonstrate a high likelihood they acted with the intent to deceive or defraud O'Brien v. National Property Analysts Partners, 936 F.2d 674 (2d Cir. 1991). Other jurisdictions, however, are less demanding in their adherence to the Federal rule of particularity, and permit pleadings with far less in the way of detail In re U.S. Healthcare Inc. Sec. Litig., 122 F.R.D. 467 (E.D. Pa. 1988).

Let the Accountant Beware

While the Federal securities laws may seem unrelated to the activities of most practitioners, many accountants have come to learn of their broad application and exacting standards of liability. In today's litigious environment, accountants must hold themselves to the highest professional standards when engaged in services that may fall within the scope of these laws.

Barry S. Augenbraun, Esq., is Executive Vice-President and General Counsel of Home Shopping Network, Inc. He has been involved with accounting-related issues for over 20 years, including as general counsel for a national accounting firm.

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