Balancing Act.

Don't get caught holding the wrong set of books.

As CPAs expand their scope of services to include more tax, consulting and business services and less attest-related services, they risk unwittingly taking on a fiduciary duty. Add to this the courts' expanding views of the nature of fiduciary relationships and the risk becomes downright hazardous. Keeping abreast of the nature of fiduciary duties and some circumstances where courts have determined that CPAs had a fiduciary responsibility to their clients will help you stay out of hot water.

TRUST-LIKE

Literally, fiduciary means "trust-like." Attorneys long have acknowledged a fiduciary duty toward their clients and that duty is their underpinning for ethical rules on confidentiality, loyalty, competence, diligence, the responsibility to keep clients informed, and the duty to protect client's rights to make decisions. Speaking on attorneys' fiduciary duties, former U.S. Supreme Court Justice Benjamin Cardozo observed:

"Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of the courts of equity when petitioned to undermine the rule of undivided loyalty by the 'disintegrating erosion' of particular exceptions. ...Only thus has the level of conduct for fiduciaries been kept at a higher level than that trodden by the crowd." [Meinhard v. Salmon, 249 N.Y. 458 464 (1928)].

Because attorneys are aware of their own fiduciary relationship with clients, a plaintiffs' attorney's first instinct might be to attribute a fiduciary relationship to CPAs and their clients, too, even though the CPA never intended such a relationship, nor believed it to exist.

IMPLICATIONS OF FIDUCIARY DUTY

Plaintiffs' attorneys are sometimes eager to establish that a fiduciary duty exists between a CPA and client because of the following legal advantages for their side:

* Expert testimony may not be required as it is to prove the breach of the standard of care for negligence.

* Existence of a fiduciary duty shifts the burden to the defendant to prove that conduct was above reproach.

* The defense of comparative or contributory negligence is not available to the defendant because the case is not grounded in negligence.

* Extraordinary remedies are available for breach of fiduciary duty, including disgorgement of fees and profits. Proof of causation of damages may not be required where the client seeks disgorgement of fees and profits.

* The statute of limitations may be extended, or a fiduciary breach may be subject to a longer limitation period.

THE NATURE OF CPA-CLIENT RELATIONSHIPS

The traditional CPA-client relationship requiring independence was usually not considered a fiduciary one. Courts have generally held that independence is fundamentally inconsistent with status as a fiduciary. However, as CPAs expand their scope of services into non-attest arenas, fiduciary relationships might follow.

CPAs have long understood a fiduciary relationship to exist when they acted as trustees for their clients or managed property entrusted to them. Currently, SB 1881 calls for the Department of Consumer Affairs in California to conduct a study on the potential licensing and regulation of persons acting in the capacity of professional fiduciaries. The bill specifies that the study shall be conducted in conjunction with certain persons, including one member of CalCPA. Thus, the authors of SB 1881 also recognize that CPAs can and do act in a fiduciary capacity.

But what of the CPA who unintentionally and unknowingly assumes a fiduciary relationship with their clients? Such a relationship actually exists whenever a client justifiably reposes trust and confidence in an accountant to act in the client's interest. Following are several examples of instances in which the courts found CPAs to have a fiduciary duty.

In Cafritz v. Corporation Audit Co. [60 F. Supp. 627 (1945)], the court held that the defendants, Robins & Corp. Audit Co., had a fiduciary duty toward the plaintiff because the plaintiff had entrusted substantial control over a portion of his business to them. The court also indicated that the defendants' fiduciary duty included a responsibility to account for property and money entrusted to them.

In Stainton v. Tarantino [637 F. Supp. 1051, 1066 (E.D. Pa., 1986)], the defendant, Thomas Tarantino, was a CPA, attorney and business partner in several real estate partnerships with the plaintiffs. The court held that the defendant was a fiduciary, not because of his status as an attorney, since he did not act as the business' attorney, nor because of Tarantino's status as a CPA (the plaintiffs failed to prove they surrendered substantial control over some portion of their business affairs to Tarantino) but because Tarantino was the plaintiffs' business partner.

In Dominguez v. Brackey Enterprises Inc. [756 S.W. 2d. 788 (1988)], Joe Dominguez was a CPA who rendered tax services and business advice to Brackey Enterprises Inc. Dominguez advised his clients to invest in SWIS, a seafood broker, and also introduced the Brackney brothers to SWIS' president. Following the brothers' investment in SWIS, Brackey Enterprises lost more than $50,000. The court found a fiduciary relationship between Dominguez and his clients. In the words of the court, "Where a party is accustomed to being guided by the judgment or advice of another in legal and accounting matters relating to income taxation, and there exists a long association in a business relationship, as well as a personal friendship, the first party is justified in placing confidence in the belief that the other party will act in his best interest."

The finding in Dominguez is contrary to the finding in Adler v. Bloom, et al. [L.A. Superior Santa Monica (Feb. 4, 1999)] where the plaintiff claimed his accountant advised him not to sell certain shares of stock to pay taxes owed to the IRS. Plaintiff subsequently incurred penalties and interest for nonpayment of taxes and lost money on the eventual sale of the stock some months later. The defendant accountant denied ever advising the client not to pay taxes and claimed plaintiff was solely responsible for his investment decisions. The court granted defendant's motion for a nonsuit on plaintiff's breach of fiduciary claim.

Although courts generally have held that accountants have no fiduciary duty to users of audited financial statements, an auditor recently was sued for breach of fiduciary duty by the audit client itself. In Stern Stewart & Co. v. KPMG Peat Marwick [N.Y. (1997)], a New York judge assessed damages to a client based on the existence of a fiduciary relationship between KPMG and its audit client, Stern Stewart. Stern Stewart, a consulting company, sued KPMG and three former employees alleging that the former employees stole trade secrets and engaged in unfair competition. Stern Stewart claimed that when the former employees joined KPMG, they helped KPMG develop a performance measurement tool for incentive compensation schemes, in direct competition with Stern Stewart. Although the judge dismissed those charges for lack of evidence, the judge did rule that KPMG had breached its fiduciary responsibility to its client. The judge said that there are special obligations placed on accountants to engage in conflict chec ks and to take actions to avoid injuring existing clients.

CPAs also may be found liable for damages even when they are not directly engaged in a breach of fiduciary duty themselves. For example, numerous lawsuits have been brought against attorneys and accountants in various savings and loan failures, in which the plaintiffs alleged that the CPAs knowingly assisted in breaches of other parties' fiduciary duties.

CONFLICTS OF INTEREST

As these cases illustrate, CPAs may be particularly susceptible to fiduciary-related liability if clients can demonstrate that their CPAs had a conflict of interest. An increasingly common scenario unfolds as follows: A CPA enters into a business arrangement with a client and has some power to make decisions that affect the outcome of the investment. Initially the CPA and client have a mutuality of interests, obtained with full consent of the client. However, circumstances later develop that allow the CPA to make a decision that provides self-benefit at the client's expense. The client then cries "foul" and seeks redress by complaining that the CPA had entered into a conflict of interest. The CPA believes the conflict of interest was allowed because the client consented to the business arrangement.

Even though Rule 201 of the AICPA Code of Professional Conduct allows an exception to the prohibition against conflicts of interest when all parties consent, it is not clear, in the preceding scenario that the client agreed to anything other than a mutuality of interests. If a court were to rule that agreeing to the mutuality of interests is tantamount to such consent, it is still possible that such consent will not nullify a fiduciary duty. Also it will not protect the CPA from damages resulting from breach of fiduciary duty, since conflicts of interest are foreseeable when one enters into business arrangements with others. Thus, the court could find a breach of fiduciary duty and resulting damages against the CPA, even though the CPA felt protected against conflict of interest charges.

PROTECT YOURSELF

When a fiduciary responsibility is found to exist, the fiduciary owes the client duties of good faith, loyalty, due care, honesty and communication. Plaintiffs' attorneys have several advantages if they are able to establish the existence of a fiduciary relationship, as explained above, including the fact that the burden of proof then shifts to the CPA to prove fulfillment of the fiduciary duty, which may be a daunting task.

CPAs may be able to escape an unintended fiduciary liability through well-worded engagement letters or contracts. Such client-CPA understandings should specify the engagement in detail, including any limitations or qualifications, and should not guarantee results, either explicitly or implicitly. They should include a denial of fiduciary responsibility provision, unless both parties intend a fiduciary relationship. (See sidebar, Page 14.)

KNOW WHEN YOU'RE A FIDUCIARY

Sometimes a CPA intentionally assumes a fiduciary relationship with a client, for example, when agreeing to act as a trustee. The CPA then willingly takes on the related responsibilities. CPAs need to be fully aware that failure to fulfill these fiduciary duties may result in legal liability, even if the client was partly at fault, or the client failed to take reasonable steps to mitigate the damage. The accountant may be held liable for damages simply because the client's assets lost value and the loss was somehow caused by the accountant.

Sometimes, however, accountants assume fiduciary duties toward clients unintentionally, and may be making themselves vulnerable to a higher standard of care than they realized. For example, the cases previously cited should alert CPAs to be particularly cautious in the following situations:

* The client entrusts substantial control over a portion of its business to the CPA.

* The CPA and the client are business partners and the CPA has authority to make business decisions in the joint endeavor.

* The client is accustomed to being guided by the CPA's judgment and advice (including tax services and business advice) and the nature of the relationship (business and social friendship) justifies the clients placing unusual reliance on the CPA's advice.

* The client is an attest client and the CPA's actions, outside the attest arena, may harm the client.

To protect yourself from the consequences of unintended fiduciary relationships, you should keep updated on judiciary trends, and you should be especially careful when drafting understandings with your clients.

Mary Beth Armstrong CPA, PhD, is a professor of accounting at Cal Poly State University, San Luis Obispo. She has served on CalCPA's Professional Conduct Committee. She is the author and instructor of a professional ethics review course offered by the Education Foundation.

Janice Carr CPA, PhD is an associate professor of accounting at Cal Poly State University, San Luis Obispo. She currently serves as co-chair of CalCPA's Accounting Education Committee and as a California representative on the AICPA Council.

Effective Engagement Letters Define Expectations

The engagement letter has evolved from a general practice management tool to a necessity for accounting firms and sole practitioners alike. Although the content of an engagement letter may vary depending on the specific type of engagement, the purpose of every engagement letter is to define and include the expectations that a CPA and a client have of each other. The engagement letter does, in fact, open channels of communication between you and your client. More important, it documents this communication.

You can reap a number of benefits by creating thorough yet straightforward letters for new engagements, repeat engagements and, especially, changed engagements. Primarily, the engagement letter fosters a clear understanding of both your responsibilities and those of your client. By setting out this understanding, you will minimize your chances of facing litigation, because the engagement letter will leave little or no room for misunderstanding - a common cause of lawsuits. If you do find yourself in the middle of a lawsuit, then the engagement letter will serve as documented proof of the duties that were outlined for the engagement. Finally, a well-constructed engagement letter also provides an opportunity to explore other potential business with your client. Down the road your client may want you to provide a service that is outside the parameters of the engagement letter. In that case, you should amend the original engagement letter and seek additional fees to accommodate the added service.

Excerpted from the 2001 edition of CPA's Guide to Effective Engagement Letters, by Ron Klein, Ric Rosario and Suzanne M. Holl (Harcourt Professional Publishing).