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Modern Audit - Boynton_Modern Auditing 8e_Solution Manual
Modern Audit - Boynton_Modern Auditing 8e_Solution Manual
CHAPTER 4 AUDITOR'S LEGAL LIABILITY Learning Check 4-1. a. Privity of contract refers to the contractual relationship that exists between two contracting parties. A CPA firms is in privity with their client by nature of a contractual relationship with the client. The courts have given the benefits of privity to some third party beneficiaries of an audit, such as a creditor named in an engagement letter. Under common law, if the audit firm does not comply with their obligations to the client, resulting in damages, the client may sue and recover its losses by proving that the audit firm was negligent in performing its duties under the contract. The same rights extend to third party beneficiaries that are given the benefits of privity by the courts. b. An auditor may breach a contract by (1) issuing a standard audit report when the audit has not been made in accordance with GAAS, (2) not delivering the audit report before the agreed-upon date, and (3) violating the client's confidential relationship. c. A tort action may be attributable to ordinary negligence, gross negligence, or fraud. 4-2. a. Under common law the two classes of third parties are primary beneficiaries and other beneficiaries. b. The auditor may be held liable by both classes of third parties for fraud and gross negligence. The auditor may be held liable for ordinary negligence by primary beneficiaries. 4-3. Foreseen parties are a person or one of a limited group of persons for whose benefit or guidance the preparer intends to supply the information and who suffer a loss through reliance upon it in a transaction or similar transactions that the information is intended to influence. For example, if the client plans to use the audit report to obtain a bank loan, all banks who use the report are foreseen parties. Foreseeable parties are any parties that are not foreseen. They include all creditors, stockholders, and present and future investors who suffer a loss by relying on the accountant's representation. 4-4. Ultramares limited the accountant's liability for ordinary negligence to parties who are in privity of contract with the accountant (i.e., primary beneficiaries). The case did not emancipate the accountant from the consequences of fraud, and it concluded that gross negligence may constitute fraud. Rusch Factors held that accountants should be liable for ordinary negligence to actually foreseen and limited classes of persons, even if not named or identified. Rosenblum vs Adler held that accountants could be sued for ordinary negligence by foreseeable parties. Credit Alliance restored a "near privity rule" in New York state by establishing three criteria for determining whether a plaintiff can bring a claim for ordinary negligence: (1) plaintiff relied on auditor's report, (2) auditor knew plaintiff would rely, and (3) the auditor, through some actions on his or her own part, evidenced understanding of the plaintiff's intended reliance. Bily ended the foreseeability standard in California, and established that (1) the auditor owes no general duty of care regarding the conduct of an audit to persons other than the client and (2) the auditor's liability to third parties for negligent misrepresentation through a faulty audit report is the same as that under the Restatement (Second) of Torts. 4-5. a. The accountant's primary defenses against charges of negligence in tort actions are due care and contributory negligence. b. The Restatement (Second) of Torts defines contributory negligence as "(Conduct on the part of the plaintiff which falls below the standard to which he (she) should conform his (her) own protection, and which is a legally contributing cause co-operating with the negligence of the defendant in bringing about the plaintiff's harm." c. Contributory negligence only represents a valid defense when it directly contributes to the accountant's failure to perform. 4-6. a. Suits may be brought under the 1933 Act by any person purchasing or otherwise acquiring the securities. b. The basis for action under the 1933 Act is that the financial statements contain an untrue statement of a material fact or omit a material fact necessary to make the statements not misleading. 4-7. The responsibilities of the parties in a 1933 Act suit are Plaintiff May be any person acquiring securities described in the registration statement, whether or not he or she is a client of the auditor. Must base the claim on an alleged material false or misleading financial statement contained in the registration statement. Does not have to prove reliance on the false or misleading statement or that the loss suffered was the proximate result of the statement if purchase was made before the issuance of an income statement covering a period of at least twelve months following the effective date of the registration statement. Does not have to prove that the auditors were negligent or fraudulent in certifying the financial statements involved. Defendant Has the burden of establishing freedom from negligence by proving that he or she had made a reasonable investigation and accordingly had reasonable ground to believe, and did believe, that the statements certified were true at the date of the statements and as of the time the registration statement became effective. Must establish, by way of defense, that the plaintiff's loss resulted in whole or in part from causes other than the false or misleading statements. 4-8. The issue in BarChris was whether the defendant accountants had performed a proper S-1 Review (a subsequent events review). The court concluded that a proper review was not made and ruled that the accounting firm had not established a due diligence defense, stating that The firm’s audit program was in conformity with GAAS but the senior did not meet the firm’s own standards when carrying out the audit program. The senior's review was useless because it failed to discover a material change for the worse in Bar Chris's financial position that required disclosure to prevent the balance sheet from being misleading. The senior did not meet the standards of the profession because he did not take some of the steps prescribed in the written program. The senior did not spend an adequate amount of time on a task of this magnitude and, most important of all, he was too easily satisfied with glib answers. There were enough danger signals in the materials examined to require some further investigation. 4-9. a. Plaintiffs under the 1934 Act may be any person buying or selling the securities. b. The bases for action are basically the same as under the 1933 Act, -- the claim on an alleged material false or misleading financial statement 4-10. Rule 10b-5 states that it is unlawful to Employ any device, scheme, or artifice to defraud. Make any untrue statement of a material fact or 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. 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. 4-11. Under both sections of the 1934 Act, the plaintiff must prove (a) the existence of a material false or misleading statement, and (b) reliance on such statement and damage resulting from such reliance. Under Section 18 the plaintiff does not have to prove the auditor acted fraudulently, but under Section 10, Rule 10b-5 such proof is required. The defendant under Section 18 must prove he or she acted in good faith and had no knowledge of the false or misleading statement. 4-12. a. The basis of the Hochfelder case was that the auditor's negligence had aided and abetted the president's fraudulent actions relative to an escrow account, and that the auditor was therefore liable under Rule 10b-5. b. This decision means the auditor is not liable to unnamed third parties for ordinary negligence under this rule. 4-13. a. The jury in Fund of Funds found the defendant accountants guilty of (1) aiding and abetting violations of securities laws (Rule 10b-5), (2) common law fraud, and (3) breach of contract. The jury also found that the requisite of scienter had been met through the accountants' recklessness. b. The critical issue in Continental Vending was whether the fairness of the financial statements should be based on GAAP. The judge ruled that the "critical test" was whether the balance sheet fairly presented financial position without reference to GAAP. The accountants were found to be guilty of criminal liability under the 1934 Act. 4-14. a. Proportionate liability is when a defendant is liable based on the defendant’s percentage of responsibility. In order for a defendant to obtain the benefits of proportionate liability it must be found that the defendant did not knowingly commit a violation of the law. b. Previously auditors were jointly and severally for all damage that might be assessed. For example, if both management and the auditor were found guilty and management was bankrupt, then the auditor could be liable for all the damages. Proportionate liability limits the auditor’s liability to the proportion that the auditor was held liable (plus the auditor could be liable for any uncollectible amount up to 50% of the auditor’s initial share). 4-15. Following is a list of ways that the Private Securities Reform Act of 1995 (Reform Act) will potentially change auditor’s legal liability. The Reform Act: Places a cap on damages that would potentially reduce the maximum amount that auditor’s could be liable for. Requires plaintiffs to pay defendant’s reasonable attorney’s fees and expenses directly related to litigation found by the court to be frivolous and unwarranted. This may make it unlikely that auditor’s will be sued for deep pockets if the suit is found to bee frivolous and unwarranted. Provides for a stay of discovery during the period a motion to dismiss is pending, thereby reducing a cost that often forces innocent parties to settle frivolous class action suits. Limits punitive damages by eliminating securities fraud as a basis for bringing action under the Racketeer Influenced and Corrupt Organization Act which provides for treble damages. The limit on punitive damages will directly reduce the cost of damages to auditors. Places limits on the rights of third parties to sue by limiting the number of times a plaintiff can be a lead plaintiff to no more than five class actions in any three-year period and by imposing stricter pleading standards to be met by plaintiffs. This limits the number of individuals that may sue auditors and reduces the likelihood of suit by “professional plaintiffs.” Changes the manner in which the court appoints lead plaintiffs in class actions to favor institutional investors likely to have the largest financial state in the relief sought and to mitigate the “race to the courthouse by professional plaintiffs” who hold minimal ownership interests. This also limits the number of individuals that may sue auditors and reduces the likelihood of suit by “professional plaintiffs.” 4-16. The Reform Act imposed new reporting requirements on auditors of public companies who detect or otherwise become aware of illegal acts by issuers of securities. If an auditor concludes that an illegal act has a material effect on the financial statements, that senior management has not taken appropriate action, and the failure warrants a departure from a standard report or a resignation from the engagement, the auditor should report these conclusions directly to the board of directors. The board should then notify the SEC within one day. If the board does not file a timely report with the SEC, the auditor should make a report to the SEC. The Reform Act explicitly states that the auditor will not be held liable in a private action for any finding, conclusions, or statements made in such reports. 4-17. a. Following is a list of key changes for auditors as a result of the Sarbanes – Oxley Act of 2002. A number of non-attest services are prohibited for auditors of public companies. The Act gave the PCAOB authority to establish auditing standards, quality control standards, and independence standards for auditors of public companies. b. Following is a list of key changes for auditors as a result of the Sarbanes – Oxley Act of 2002. Section 302 requires a public company’s CEO and CFO to prepare a statement to accompany the audit report to certify the appropriateness of the financial statements and disclosures. Section 303 makes it unlawful for any officer or director of an issuer to take any action to fraudulently influence, coerce, manipulate, or mislead any auditor. Section 305 requires the CEO and CFO of a company that restates financial statements due to “material noncompliance” with financial reporting requirements to “reimburse the company for any bonus or other incentive-based or equity-based compensation received” during the 12 months following the issuance or filing of the noncompliant document and “any profits realized from the sale of securities of the issuer” during that period. Title VIII of the Act, the Corporate and Criminal Fraud Accountability Act of 2002: Makes it is a felony to “knowingly” destroy or create documents to “impede, obstruct or influence” any existing or contemplated federal investigation. Requires auditors required to maintain “all audit or review work papers” for five years. Extends the statute of limitations on securities fraud claims to the earlier of five years from the fraud, or two years after the fraud was discovered. Extends “whistleblower protection” to employees of public companies and their auditors that would prohibit the employer from taking certain actions against employees who lawfully disclose private employer information to, among others, parties in a judicial proceeding involving a fraud claim. Whistleblowers are also granted a remedy of special damages and attorney’s fees. Creates a new crime for securities fraud that has penalties of fines and up to 10 years imprisonment. Title IX of the Act enhances penalties for a variety of white-collar crimes. 4-18. a. RICO was originally drafted to curtail inroads of organized crime into legitimate business. However, RICO has been extended to losses suffered from fraudulent securities offerings and failures of legitimate businesses. b. A plaintiff victimized by a "pattern of racketeering activity" may sue for treble damages and attorneys' fees. In addition, a plaintiff may sue when he or she cannot satisfy the requirements for bringing suit under the antifraud provisions of the federal securities acts. c. A CPA may be involved in a RICO suit due to an audit failure. In such cases, it is usually alleged that the CPA either (1) knew or should have known that the financial statements were materially misstated or (2) recklessly ignored indications of fraud by management. To be liable, there must be some "scienter" or actual knowledge of the fraud. In addition, based on the Reves v. Ernst & Young decision, RICO requires some participation in the operation or management of the enterprise itself. 4-19. To avoid litigation, the auditor should Use engagement letters for all professional services. Make a thorough investigation of prospective clients. Emphasize quality of service rather than growth. Comply fully with professional pronouncements. Recognize the limitations of professional pronouncements. Establish and maintain high standards of quality control. Exercise caution in engagements involving clients in financial difficulty. Comprehensive Questions 4-20. (Estimated time - 20 minutes) City is likely to prevail against Winston based on constructive fraud. To establish a cause of action for constructive fraud, City must prove that: Winston made a materially false statement of fact. Winston lacked a reasonable ground for belief that the statement was true. Constructive fraud may be inferred from evidence of gross negligence or recklessness. Winston intended another to rely on the false statement. City justifiably relied on the false statement. Such reliance resulted in damages or injury. Under the facts of this case, Winston is likely to be liable to City based on constructive fraud. Winston made a materially false statement of fact by rendering an unqualified opinion on Bell's financial statements. Winston lacked a reasonable ground for belief that the financial statements were fairly presented by recklessly departing from the standards of due care in that it failed to investigate other embezzlements, despite having knowledge of at least one embezzlement, and did not notify Bell's management of the matter. Winston intended that others rely on the audited financial statements. City justifiably relied on the audited financial statements in deciding to loan Astor $600,000 and damages resulted evidenced by Astor's default on the City loan. City is not likely to prevail against Winston based on negligence. In order to establish a cause of action for negligence against Winston, City must prove that: Winston owed a legal duty to protect City. Winston breached that legal duty by failing to perform the audit with the due care or competence expected of members of the profession. City suffered actual losses or damages. Winston's failure to exercise due care proximately caused City to suffer damages. The facts of this case establish that Winston was negligent by not detecting the overstatement of accounts receivable because of its inadvertent failure to follow its audit program. However, Winston will not be liable to City for negligence because Winston owed no duty to City. This is the case because Winston was not in privity of contract with City, and the financial statements were neither audited by Winston for the primary benefit of City, nor was City within a known and intended class of third party beneficiaries who were to receive the audited financial statements. 4-21. (Estimated time - 20 minutes) The facts reveal negligence on Field's part in that it did not follow its own audit program nor did it make a proper investigation into the many irregularities and suspicious circumstances. Compliance with GAAP is of some evidentiary value to Field if it in fact complied with the principles set forth therein. However, the courts do not invariably accept GAAP as the conclusive test to disprove negligence. Furthermore, even if assuming GAAP were followed literally, GAAS certainly were not under the facts stated. Field will undoubtedly rely upon the privity defense to avoid liability to Slade, a third party to the Field-Tyler contract. However, most jurisdictions recognize the standing of a third party beneficiary to sue. Therefore, Slade would assert such status. In a majority of jurisdictions Slade would be regarded as a third party beneficiary if it is within a known and intended class of beneficiaries. Other jurisdictions have gone even further in recognizing a duty is owed to those whom the CPA should reasonably foresee as recipients of the financial statements for authorized business purposes. There are insufficient facts to determine whether Field knew that Tyler intended to use the audited financial statements to secure credit from Slade. Therefore, it is not possible to determine whether the privity defense will bar recovery. Fraud does not require that the party suing be in privity of contract with the defendant. However, the most significant problem in proceeding based upon fraud is that fraud requires a knowledge of falsity (scienter) or a recognized substitute therefor. Based upon the facts, Field did not actually know of management's fraud. However, it may be guilty of conduct which may be deemed to be a reckless disregard for the truth. The courts also resort to the constructive fraud theory where the facts are compelling, i.e., a shutting of one's eyes to the obvious. Sometimes, the conduct is labeled gross negligence, and an inference of fraud may be drawn from this by the trier of fact. 4-22. (Estimated time - 20 minutes) a. Privity is an early common law concept that was adopted by the courts to prevent third parties from bringing a legal action based upon a contract to which they were not parties. William was in privity of contract with Perfect, its audit client, but William had no contractual relationship with Capitol despite Capitol's reliance upon the statements audited by William. Moreover, Capitol gave no consideration to William. Therefore, under strict application of the privity rule, Capitol lacks the standing to sue for breach of contract or negligence since Capitol is not in direct contractual relationship with William. Privity has been the subject of much critical reevaluation, and the courts have frequently narrowed or rejected it. However, in a landmark opinion (Ultramares), privity was retained to some extent in an action against a CPA firm based partially upon negligence. Some court decisions, however, have directly overruled the privity defense in actions against CPAs, particularly when the third party was contemplated as a user of the financial statements, as in this case. b. The first major exception to the privity requirement is fraud. Although a CPA may generally avoid liability for ordinary negligence based upon privity, where the action is for fraud, an injured third party has the requisite standing to sue. However, in order to recover based on fraud, the third party (Capitol) must prove scienter or guilty knowledge on the part of the CPA The second exception to the privity defense is constructive fraud. Constructive fraud is generally defined as a false representation of a material fact with lack of reasonable ground for belief and with an expectation of reliance by another, and, in fact, there is reasonable reliance resulting in damage. Constructive fraud may also be inferred from evidence of gross negligence or recklessness, although they are not necessarily constructive fraud in and of themselves. The dividing line between what actions will meet the scienter requirement for actual fraud and what is necessary to evoke the constructive fraud doctrine is not clear. The third exception to the privity defense is gross negligence. Gross negligence represents an extreme, flagrant, or reckless departure from standards of due care. For example, a knowing failure to follow GAAS on a material matter might be held by a jury to be gross negligence. The jury might then find that the defendant's conduct was so gross as to satisfy the scienter requirement. In addition to fraud and its various offshoots, one may avoid the privity barrier if it can be established by the third party that it was the party that the contract was intended to benefit. Thus, if a third party plaintiff suing a CPA can establish that the audit was for his benefit, then the injured third party may have standing to sue. He or she is a third party beneficiary of the contract and privity will not bar him or her from recovery. Recovery under this theory has been significantly expanded. It has recently been held that liability extends to those in a fixed, definable, and contemplated group whose conduct is to be governed by the contract's performance. 4-23. (Estimated time - 25 minutes) 1. True. The offering was filed with the SEC and was public. 2. True. This is the essence of the 1933 Act. The effect of the Securities Act of 1933 is to give to third parties who purchase registered securities similar rights against the auditor as are possessed by the client under law. 3. True. Plaintiffs can show that the financial statements omitted material facts necessary to prevent the statements from being misleading. Investors need not prove that they relied on the statements, however. The burden is on the auditors to demonstrate that the losses were not the result of omissions in the financial statements. 4. True. Accountants have no liability if they can show that their work was adequate to support their opinion (the "due diligence" defense). 5. True. One defense available to the accountants is to demonstrate that the losses of the inventories were due to causes other than errors or omissions in the financial statements. 6. True. Any action must be filed within three years after the securities have been offered to the public and within one year after the discovery of the error or omission has been made. 7. False. That is not the function of the SEC. The SEC does not pass judgment on the merit of securities, nor does it defend accountants. 8. False. The fact that the financial statements are management’s responsibility is not a defense if the auditor know of loans and collateral that were not disclosed. 4-24. (Estimated time - 20 minutes) Crea will not be liable to the purchasers of the common stock. Although an offering of securities made pursuant to Regulation D is exempt from the registration requirements of the Securities Act of 1933, the antifraud provisions of the federal securities acts continue to apply. In order to establish a cause of action under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, the purchasers generally must show that: Crea made a material misrepresentation or omission in connection with the purchase or sale of a security; Crea acted with some element of scienter (intentional or willful conduct); Crea's wrongful conduct was material; the purchasers relied on Crea's wrongful conduct; and, that there was a sufficient causal connection between the purchasers loss and Crea's wrongful conduct. Under the facts of this case, Crea's inadvertent failure to exercise due care, which resulted in Crea's not detecting the president's embezzlement, will not be sufficient to satisfy the scienter element because such conduct amounts merely to negligence. Therefore, Crea will not be liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. Crea is likely to be held liable to Safe Bank based on Crea's negligence despite the fact that Safe is not in privity of contract with Crea. In general, a CPA will not be liable for negligence to creditors if its auditor's report was primarily for the benefit of the client, for use in the development of the client's business, and only incidentally or collaterally for the use of those to whom the client might show the financial statements. However, a CPA is generally liable for ordinary negligence to third parties if the audit report is for the identified third party's primary benefit. In order to establish Crea's negligence, Safe must show that: Crea had a legal duty to protect Safe from unreasonable risk; Crea failed to perform the audit with the due care or competence expected of members of its profession; there was a causal relationship between Safe's loss and Crea's failure to exercise due care; actual damage or loss resulting from Crea's failure to exercise due care. On the facts of this case, Crea will be liable based on negligence since the audited financial statement reports were for the primary benefit of Sale, an identified third party, and Crea failed to exercise due care in detecting the president's embezzlement, which resulted in Safe's loss, i.e., Dark's default in repaying the loan to Safe. 4.30 (Estimated time - 20 minutes) Part I a. Yes. Section 32(a) of the Securities Exchange Act of 1934 provides that any person who "willfully" violates a substantive provision of the 1934 act or any person who "willfully and knowingly" makes, or causes to be made, false or misleading statements in reports required to be filed with the SEC shall be subject to criminal sanctions. The elements of the government's case would be (1) falsity, that is, the false information included in the Form 10-K; (2) of a "material" fact, satisfied here based on the fact; and (3) criminal intent,' as evidenced by the acceptance of the additional $20,000 fee by Danforth as payment for not mentioning the CD in the report. To prove criminal intent, it need only be established that Danforth rendered the opinion knowing that the financial statements were false. b. Yes. The fact that Danforth can establish that no one was damaged will not be a valid defense to the criminal action. The reason is that such damage is not an element of proof in criminal proceedings. Part II Yes. Danforth would be found liable to the bank. According to the facts, the bank made the loan to Blair in reliance on the audit report and financial statements. Danforth's failure to disclose the subsequently discovered information to the bank, constituted a common law fraud. Danforth had a duty to correct the financial statements, which he knew to be in error and which he knew the bank would rely upon. 'The necessary fraudulent intent of the auditor may be inferred where, as here, the auditor sits by silently while others rely on his original representations. Danforth's performance of his audit in accordance with GAAS did not relieve him of his responsibility to disclose to the bank the fact that the CD was erroneously included in the financial statements. The auditor owes such a duty to third parties, the breach of which constitutes an intentional misrepresentation rather than mere negligence. Cases 4-26. (Estimated time - 25 minutes) Part I a. No. Peters will not prevail. The facts do not involve liability in the sale of registered securities nor liability for reports filed with the SEC. Because the stock transaction involved interstate commerce, Peter's claim may be based on Section 17 (the antifraud provision) of the Securities Act of 1933 and Rule 1Ob-5 under the Securities Exchange Act of 1934. In either case, he will have to show fraud on the part of Doe, or a manipulative device or scheme, in connection with the sale of a security under the 1933 act or the purchase or sale of a security under the 1934 act. If this can be shown, an implied civil damage remedy is available to Peters against Doe. (Note - Section 17 is not discussed in the chapter.) Although Doe was negligent, the United States Supreme Court, in the Hochfelder case, held that a violation of Rule 10b-5 requires scienter, something greater than mere negligence. Unless the violation of GAAS involves intent, or gross negligence, Doe would not be held in violation of Rule 10b-5. Similarly, Peters might claim a remedy against Doe for violation of Section 17 of the 1933 Securities Act. The Supreme Court, in the Aaron case, held no scienter is required in certain Section 17 cases brought by the SEC, but it appears that private actions, such as the one by Peters, would be subject to provisions similar to those in Rule 10b-5. b. No. Peters will not prevail based upon his state common law action either. At common law, privity is required before an accountant can be held liable to users of the financial statements, absent fraud. Doe was not in privity of contract with Peters, nor does the question indicate that Doe was even aware that Peters would rely on the financial statements. Part II Yes. Ira will prevail and recover damages from Baker. He will base his action on Section 11 of the Securities Act of 1933. Section 11 imposes liability on experts, including accountants, whose opinions appear in a registration statement. The experts are liable to all those who in reliance on their opinions purchase securities in a public offering under the 1933 act. Ira does not have to prove Baker was negligent in auditing Able. All he need allege and prove is that there is a material false statement or omission of a material fact in the registration statement. The only defense that Baker may assert is that it exercised the degree of care that would be exercised by certified public accountants in similar circumstances. This is commonly referred to as the "due diligence" defense. Negligence by Baker is therefore a violation of Section II, and makes Baker liable to Ira for his damages. Suggested Solution to Professional Simulations Chapter #4 (Estimated time - 30 to 45 minutes) Communication Situation To: Audit File Re: Liability for Negligence Under Common Law and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. From: CPA Candidate 1. The elements necessary to establish negligence are: A legal duty to protect the plaintiff (Musk) from unreasonable risk. A failure by the defendant (Apple) to perform or report on an engagement with the due care or competence expected of members of its profession. A causal relationship, i.e., that the failure to exercise due care resulted in the plaintiffs loss. Actual damage or loss resulting from the failure to exercise due care. 2. The elements necessary to establish a violation of Rule 10b-5 include: A material misstatement or omission. The material misstatement or omission made by the defendant (Apple) with knowledge (scienter). Reckless disregard for the truth may constitute scienter. Justifiable reliance on the misstatement or omission. The reliance being in connection with the purchase or sale of a security. 3. Apple is not in privity of contract with Musk because there is no direct contractual relationship between them. Therefore, in the absence of other factors, Apple would not be liable to Musk for Apple's alleged negligence based on the Ultramares decision. However, the privity defense would not protect Apple if Musk could prove that Apple had committed actual or constructive fraud (that is, Apple owes a duty to all persons, including third persons, to practice its profession in a non-fraudulent manner).
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