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Another
Business for the Big Five
In one of the stranger bits of
accounting that the Big Five engages in, we have the
auditing of overseas factories in order to tell if they
are treating their workers in a human manner and are
paying them a living wage. PricewaterhouseCoopers is the
largest accounting firm analyzing this data, they do
over 6,000 of these audits a year for among other
companies. Nike, and they have recently been charged by Dara O’Rourke, an M. I. T. professor with having a
corporate bias. Included in the rap on Pricewaterhouse
is the fact that they have a tendency to overlooks
carcinogenic chemicals that the workers were exposed to,
80 hour work weeks that they were obliged to put in,
falsified timecards that tended to underestimate the
hours put in by employees and missing health and safety
features that were intended to protect workers from
external problems.
These audits have become increasingly important to
consumer groups as they have become more interested in
analyzing the human side of the manufacturing business.
Colleges have also become intensely interested in the
process in order to insure that improprieties do not
occur in the manufacture of their own branded
merchandise which is often produced in the Pacific Rim.
Student groups have now started criticizing the audit
entire audit process as a self fulfilling for the
Universities and corporations.
The New York Times on 9/28/2000 in an article by Steven
Greenhouse said that “Professor O’Rourke, who has
inspected more than 100 Asian factories for the World
Bank and various United Nations organizations, called on
universities and companies to demand more rigorous
monitoring efforts. He criticized Pricewaterhouse
inspectors for failing to identify that workers in a
garment factory in Seoul, South Korea, used a spot
remover containing benzene, a carcinogen. When he
visited a factory outside Jakarta, Indonesia, he found
that the firm’s inspectors had overlooked the same
problem during an earlier inspection. He also faulted
the firm’s monitors for not noting that the labor union
at a Shanghai garment factory was, like most Chinese
unions, controlled by management. And he criticized the
inspectors for failing to note that little information
was given on chemicals used in the factory and that some
workers did not wear proper gloves, masks or whose while
doing dangerous tasks or handling dangerous materials.”
Most of the people that read the report by O’Rourke were
taken somewhat aback by the report and indicated that
they were previously unaware of a pro-management bias by
Pricewaterhouse in this type of study. But some
indicated that the accounting giant was not being paid
to create bad publicity occur for their own clients.
Thus, most of those contacted thought the process to be
much needed but of little real benefit when the very
outcome that the client fears the most, being labeled a
sweatshop producer was being determined by their own
accounting firm who they were paying. Hardly the kinds
of conflicts that are likely to build consumer
confidence.
And In Addition
Auditor’s New Duty to Blow the Whistle on Its Client
WHEN CONGRESS voted to override President Clinton's veto
of the Private Securities Litigation Reform
Act of 1995 last December, the passage of the act
was viewed as a major victory, not only for companies
deluged with class action claims, but also for
accounting firms who had been favorite targets for
plaintiffs seeking damages for violations of the federal
securities laws.
One of the main attractions in the act for
accountants and other professionals
was Congress's substitution of a proportionate liability
standard for the previous Joint and several liability
litigation. that auditors and others had faced in
securities enacted a provision amending
However, Congress also enacted a provision amending the
Exchange Act that imposed on auditors a duty to "blow
the whistle" on illegal acts that they discover in
connection with the audit of client’s financial
statements - a duty previously found not to exist by
many courts examining the boundaries of an auditor's
liability under the Exchange Act.
'The new act requires accountants to include in their
audits "procedures designed to Provide reasonable
assurance of detecting illegal acts that would have a
direct and material effect on the determination of
financial statement
amounts."'
DUTY TO INFORM MANAGEMENT
Perhaps more important, the act requires auditors who
detect such illegal acts to inform the client's
management and ensure that the audit committee is
adequately informed unless the illegal acts are "clearly
inconsequential." If management fails to take
appropriate action and the auditor determines that the
illegal acts will have a material effect on the issuer's
financial statements, the auditor must report the
information to his client's board of directors.
The company must then inform the SEC not later
than one business day after receipt of the report and
must give the auditor a copy of the notice to the SEC;
failing such action by the company, the auditor must
itself report to the SEC within one business day.
The statute supplies a carrot-and stick approach with
regard to the consequences: the auditor who blows the
whistle on the client will enjoy the protection of a
safe arbor from liability in a private action for any
"finding, t expressed in a report" rendered conclusion,
or statement willfully to the SEC, whereas an auditor
found to have isolated" the statute by falling to make
the disclosures required under the act will be liable
for civil penalties-'
The House sponsor of this provision, then Representative
Ron Wyden, D-Ore., proclaimed on the floor of the House
that the fraud reporting requirement would telegraph to
corporate management that they "cannot have an auditor
In their pocket's This statement was undoubtedly a
source of astonishment among auditors who have
traditionally been truly independent and more than any
other profession have been responsible for preventing
fraudulent or even negligently prepared financial
statements from being circulated to investors.
Indeed, auditors have navigated through the
Shoals of relents who perpetrated frauds both on the
investing public and upon the auditors themselves - with
the added collateral consequence of "posing auditors to
liability as deep-pocket targets of opportunity for
investors
seeking to make themselves whole after the fraud has
made the company judgment. proof.
GAAS Requirements
Before the adoption of the act, art independent
auditor's responsibilities were governed by generally
accepted auditing standards (GAAS) pursuant to SEC
regulations* and case law under 910(b) of the Exchange
Act. Under
the relevant auditing standards, particularly SAS 53 and
54, as interpreted
in the American institute of Certified Public
Accountants' (AICPA) Codification of Statements on
Auditing Standards, auditors were - and are - required
to conduct audits with a degree of professional
skepticism, having in mind the possibility of fraud, but
were not otherwise responsible for identifying illegal
acts as such, under the theory that it is possible to
defraud auditors and,
under SAS 54, a fraud audit was beyond the auditors' normal scope of
Investigational
However, if an auditor determined that financial
statements were fraudulent, GALAS required that the
auditor "insist that the financial statements be revised
and, If they are not, express a qualified or an adverse
opinion on the financial statements, disclosing all
substantive reasons for his opinion."" f the auditor
found that, after applying extended procedures, he was
"unable to conclude whether possible Irregularities
may materially affect the financial statements," SAS
53 required the auditor to disclaim or quality an
opinion on the financial statements and communicate his
findings to the audit committee or the board of
directors.
If the client then refused to accept the auditor's
report as modified, the position of the A[CPA was that
the auditor should resign. 12 SAS 53 did not impose a
duty to "blow the whistle" on fraud, and, in fact,
expressed an ethical obligation on the part of the
auditor to remain silent, subject to a qualified
exception where the client was required to report a
change of auditor to the SEC on Form 8-K.
Auditor' Liability Under Rule 10b-5
Under
the law as It existed before the act, courts had not
spoken with one voice as to whether auditors were
obliged to report illegal acts directly to third
parties, such as the
SEC, at least
where the auditor had not completed the audit or signed
the auditor's report.
In a line of cases, courts had held that auditors
sued under an aiding-and
abetting theory of liability (now extinct following
the Supreme Court decision In
Central Bank of
Denver, N.A. v. First Interstate Bank of Denver, et
al.,14) were not liable for
a failure to
blow the whistle on their Clients unless some positive
duty existed In law to disclose the fraud to parties not
in privity with the auditors.
As Judge Easterbrook of the Seventh Circuit noted In
Dileo v. Ernst &
Young,14 in situations where such a duty did exist,
such as when an accountant actually were to certify
financial statements with knowledge that such statements
were materially misleading, the auditor would be liable
as a primary violator.17 Declining to recognize a duty
on the part of auditors otherwise to search out and
report illegal acts, Judge Easterbrook wrote; Such a
duty would prevent the client from reposing in the
accountant the trust that is essential to air accurate
audit. Firms
would withhold documents, allow auditors to see but not
copy, and otherwise emulate the CIA, if they feared that
access might lead to destructive disclosure - for even
air honest firm may fear that one of its accountant's
many auditors would misunderstand the situation and
.bring the tocsin needlessly
with great loss to the firm."
However, decisions in the Eleventh and Ninth Circuits
did impose a duty on auditors to report fraud concerns
which the auditors had knowledge - even in cases where
fraud did riot have a material effect on the
financial statements.
In Rudolph v. Arthur Andersen & Co., sustaining a complaint under both
primary and secondary liability theories, the Eleventh
Circuit held that an auditor could be liable even where
the statements made in a private placement offering were
true when made.
In Rudolph,
Arthur Andersen had prepare,(] audit reports that were included in an
offering memo for a private placement, While the
statements were true at the time of the offering, the
plaintiffs alleged that the principal of the company
later diverted funds from a research and development
project initially included in the offering, and the
auditors later did not cure any misapprehension as to
the condition of the partnership caused by the
executive's diversion of funds.
The plaintiffs' continued reliance in
Rudotph upon
Arthur Andersen's statements was held to be sufficient
to support cause of action against the auditor for both
primary and secondary liability.
A Primary Violation
The court first reasoned that this omission to disclose
a misleading statement amounted to a primary violation
of Rule 10b.5 where the silent party was under a duty to
disclose. The court then found such a duty, pronouncing
that standing by while one's good name is being used to
perpetrate a fraud is inherently misleading, It is not
unreasonable to expect an accountant, who stands in a
"special relationship of trust vis-a-vis the public" ,
and whose "duty is to safeguard the Public interest," .
to disclose fraud in this type of circumstance, where
the accountant's information is obviously superior to
that of the investor, the cost to the accountant of
revealing the information minimal, and the cost to the
investors of the information remaining secret
potentially enormous.
The judicially created duty of whistle-blowing achieved
perhaps its most extreme form in American
Continental Corp./ Lincoln Savings and Loan
Litigation.21 In
ACC, the
accounting firm of
Touché Ross undertook an engagement in the middle
of a public offering on behalf of John Keating and
Lincoln Savings and Loan, replacing a previous auditor
that had disagreed with ACC's proposed booking of a gain
on a transaction.
Under circumstances that the district court found
to suggest "opinion shopping" by ACC, the court
determined that issues of fact existed as to whether
Touché Ross possessed "reckless scienter" concerning the
auditor’s awareness of the improper financial reporting
at ACC.
At the time, the
ACC court
pushed the boundaries of an independent auditor's
liability to unprecedented limits " Touché Ross had
never completed its audit, had never issued an audit
report and was not named in ally registration statement,
prospectus or other document required to be filed with
the SEC, other than the form 8-K reporting the change in
auditor. Nevertheless, the court found that silence in
the face of fraud could constitute "substantial
assistance," thereby supporting liability.
Citing Rudolph. the district court held:
This court holds that an independent
public accountant who knows of or recklessly disregards
a client's fraud, may be held liable or aiding
and abetting that fraud here the auditor provides
services which constitute substantial
assistance. Whether an audit has been completed
is not necessarily determinative ')I whether the
assistance is "substantial " If an an-auditor is aware
that an ongoing fraud is a real possibility, he or she
may not act as an advocate for its wrongdoing client.
Nor may the auditor stand by, knowing of a fraud, and
withhold damaging in-formation from the SEC and federal
bank regulators.
Even after the Supreme Court struck down aider-and-a
abettor liability in
Central Bank,
the judicially expressed duty of disclosure continued to
have life in the world of primary liability. In such
cases as in re
ZZZZ Best.
There, the court denied the auditor's motion for
summary judgment on the ground that the auditor had a
continuing duty either to withdraw a quarterly financial
report or to bring the mis-staternents or omissions in
that report to the attention of either the board o'
directors, the government, or investors,
ZZZZ Best allowed a claim for primary liability to proceed, focusing
on the public's reliance upon previously reported
financial information.
Statutory Duty
Whatever
doubt may previously have existed as to whether an
independent auditor had a duty to expose a fraud is now
resolved by the act.
Although
Central Bank has written secondary liability out of
the statute, primary liability still haunts auditors,
albeit subject to the act's new restrictive standards,
not to mention the possibility of civil prosecution by
the SEC.I.
The act poses several Hobson’s choices for the
auditor.
Although the auditing profession, including the AICPA,
publicly supported Representative Wyden's language,
under the theory that the statute merely codified
existing SAS standards, a comparison of the 8-K
reporting requirements with the language of the act
suggests that the act may expand somewhat upon the
substance of what previously was required to be
reported, and certainly accelerates the process, with
the duty of disclosure placed squarely on the auditor if
the company fails to do so.
Thus, the auditor is now forced to choose between
the threat of civil penalties from the SEC on the one
hand and the consequences of a mistaken report, If the
auditor were to determine after making such a report
that the effect of the illegal act were not material
after all, the share value and reputation of the issuer
would have been impacted needlessly.
Equally serious is the ethical dilemma imposed by
the act. As
the Auditing Standards Board recently observed in its
draft of new proposed standards, which would require an
auditor to Specifically assess the risk of material
misstatement due to fraud,"20 the interplay between the
act and the auditor's ethical responsibility to its
client is not free of tension:
The disclosure of fraud to parties other than the
client's senior management and its audit committee
ordinarily is not part of the auditor's responsibility,
and ordinarily would be precluded by the auditor's
ethical or legal obligations of confidentiality unless
the matter is reflected in the auditor's report .30
One need only recall Judge Easterbrook's forecast
of the chill that whistle-blowing will inevitably
introduce into the relationship between the auditor and
its client to see that one very distinct consequence of
the act may, therefore, be a greater instinct on the
part of an issuer's management to withhold information
from its auditor.
A Second dilemma for the auditor is one of
judgment.
How is an auditor to know whether air illegal act's
effect on the financial statements is "clearly
inconsequential," thereby obviating the duty to make a
report to management?
Or what of the issue of whether under paragraph
10A(b)(2) the effect on the financial statements is
"material," thereby requiring the auditor to report
management's lack of remedial action to the board of
directors?
These issues are classical issues of fact, likely
in most cases to survive pretrial motion practice, tying
up the auditor in expensive litigation in instances
where hindsight shows that the effect of a fraudulent
accounting practice was more or less substantial than
the auditor's judgment originally forecast,
Conclusion
The
independent auditor has always experienced an inherent
tension between the duty to be independent on the one
hand and to serve the issuer on the other.
That tension has been resolved by statute in
favor of independence, but just how that tension will
play itself out in the context of the “whistle blowing"
requirement re mains to be seen.
Certainly courts should hesitate to impose
liability upon accountants who, far from Willfully
violating the act, exercise their professional judgment
as to the materiality of an illegal act in gray areas.
The unhappy alternative would arise if courts
instead were to apply the act in the same, sweeping
manner as, for example the court in
Rudolph did in construing the reach of
_0(b). Auditors will then be
placed in the impossible position of acting not merely
as detectives, obliged to seek out and report illegal
acts, but clairvoyants, open to liability for a failure
to report acts that seem prospectively to pose no
material consequence to the financial statements of the
issuer.
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