Liability of Accountants

Article excerpt

n accounting firm does not violate the Federal securities laws by failing in its audit report to disclose the internal control problems of its client that it knew about and reported to management, according to the decision of the United States District Court for the District of Oregon in Monroe v. Hughes. Fed. Sec. L. Rep. (CCH) 96,621 (District Court of Oregon, Civil No. 90-152-MAI Dec. 9, 11)1. The court said that the firm had followed professional standards, its audit report contained no false or misleading statements, and the firm did not participate in the fraud which the company allegedly perpetrated on investors.

The court emphasized that the accountants were absolved from Rule 10b-5 liability because, they complied with the rules of their own profession, which is all they were expected to do. Thus, whatever responsibility management may have had to disclose the company's internal control problems in the circumstances, the auditors' duty was to report the problems to management, which they did.

The Monroe decision is unique because, instead of focusing on Federal and state securities laws in determining whether the audit was conducted properly, the opinion is stated in terms of whether the auditor, in this case Deloitte & Touche, needed to do more than comply with professional standards established by the profession's own governing body, the American Institute of Certified Public Accountants ("AICPA").

In Monroe, Deloitte performed an audit of Hughes Homes, Inc. and discovered that the company had certain internal control problems which were then reported in a letter to management. Deloitte's audit report was subsequently included in a public debenture offering of the company. Two months later, Hughes management responded to Deloitte's letter about the internal controls issue.

Subsequently, Hughes publicly disclosed serious financial problems, stating that its financial statements would likely include a disclaimer of opinion by Deloitte resulting from Hughes' potential inability to continue as a going concern and the lack of supporting documentation to explain significant year-end adjustments resulting from deficiencies in its internal control and accounting systems. Soon thereafter, Hughes ceased operations and plaintiffs, who had purchased debentures in the public offering, lost their investment.

Plaintiffs sued Deloitte, among others, claiming that the auditors acted recklessly in failing to disclose information relating to Hughes' internal control problems in violation of Rule 10b-5 and Oregon state law. Additionally, plaintiffs claimed that in issuing its audit, Deloitte failed to disclose the internal control issue and neglected to make its findings available to the underwriters in the public offering. Finally, plaintiffs asserted that the internal control problems constituted "material weaknesses" which should have warranted a "going concern" qualification from Deloitte.

Deloitte's motion for summary judgment was granted by the court. Although recognizing that the parties raised several complex questions under the securities law, the court simply found that Deloitte could not have acted "recklessly" within the meaning of Rule 10b-5 because plaintiffs failed "to identify a single misrepresentation or omission in defendant's ... audit reports" furnished to the public. Specifically, the court ruled that the internal control problems were properly identified by Deloitte in its letter to management and that is all the accountants were required to do on that issue. The court further found that Deloitte had no obligation to the investors to inform them of the internal control problems either through the audit report or by issuing a "going concern" qualification reporting the internal control problems as "material weaknesses" that may have efected the entity's continued existence.

If accountants conduct an audit in accordance with AICPA rules, it is difficult to see how they could have the necessary degree of scienter for 10b-5 liability by and, under the circumstances, summary judgment--rather than requiring the accountants to suffer the expense and uncertainty of a trial-permits the judicial system to rid itself of meritless securities fraud suits directed at the deep pocket of independent accounting firms. …