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									                                                                              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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