Can investors seek accountability for accountants?

As allegations of misconduct continue to swirl around Arthur Andersen in the wake of the Enron debacle, it seems likely that individual investors will regard the pronouncements of accounting firms more skeptically in the future. Specifically, they may wonder whether the financial statements they relied on in making their stock purchases were prepared carefully and honestly. If their investments go south, these individuals may well seek redress in court.

But is it possible for third parties who relied on accountant-approved financial reports to recover damages? What are the elements of a successful claim?

"The top issue is always whether it was foreseeable that a certain party would rely on this professional's advice," said Jeffrey Wagner, a Chicago attorney who has handled accounting negligence cases. "I think nowadays, with more people investing, and especially after Enron, juries will want to say that accountants have a duty to the public at large, as well as to their clients."

Careful discovery and use of expert witnesses is crucial in this often esoteric field, said veterans of this type of litigation. And deciding whether to pursue the claim in federal or in state court is often a key decision.

As in other professional negligence cases, industry standards are a starting point for investigating a possible claim. The Securities and Exchange Commission (SEC) has statutory authority to establish accounting and reporting standards for publicly held companies. Throughout its history, however, the SEC's policy has been to rely on the private sector for this function, specifically such entities as the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA).

"It's easy for people who don't specialize in this field to be confused by all the different standards," warned Robert Berliner, a former chair of the Professional Ethics Committee of the New York State Society of Certified Public Accountants.

The crucial rules to review, he said, are:

* Generally Accepted Accounting Principles (GAAP). Issued by the FASB, these rules apply to the preparation of routine financial reports, such as the 10-K and 10-Q statements that publicly traded corporations must file with the SEC. This information winds up in the annual reports that many market investors review before buying shares.

* Generally Accepted Auditing Standards (GAAS). These standards are prepared by a committee of the AICPA and apply to specific types of audits of a company's books.

* SEC regulations. Despite its policy of delegation, "the SEC does retain its oversight authority, and sometimes exercises it," Berliner said. For instance, the commission's Rule 10(b)-5, which prohibits making fraudulent misrepresentations in connection with any sale of publicly traded stock, has been used in accounting negligence cases.

Legislation currently under consideration in Congress in the wake of the Enron mess may affect accounting standards in the future. The House of Representatives passed a bill April 24 that would empower the SEC to set up a new five-member government panel to wield much of the authority currently delegated to the FASB. Of course, litigation concerning past accounting malfeasance would be governed by the rules that were in force when the services at issue were provided.

Who can sue?

Historically, accountants were liable only to individuals or company clients, and third parties who had relied on the accountants' seal of approval were out of luck. Most states have substantially relaxed this requirement of contractual "privity" in recent years, but it persists in some, so checking the most recent case law is important, experts say.

"California used to have a fairly expansive approach, where if the reliance by the third party was reasonably foreseeable, the plaintiff could win," said Arnold Schwartz, a Los Angeles trial attorney. But that changed, he said, with Bily v. Arthur Young. (834 P. 2d 745 (1992).) In that case, the state high court held that an accountant's liability for general negligence in conducting an audit of its client's financial statements is confined to the client. Third parties now have to go the extra mile of proving negligent misrepresentation, which requires a showing of dishonesty rather than merely one of carelessness. New York also has a relatively restrictive rule, while New Jersey and Wisconsin are more plaintiff-friendly.

Several states have not ruled definitively on this question, but the U.S. Supreme Court weighed in when it ruled in U.S. v. Arthur Young & Co. The case involved whether the Internal Revenue Service could gain access to an accountant's work product. The Court said, "By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public." (465 U.S. 805,817-18(1984).)

Federal or state?

Whether to proceed with an accounting negligence claim under federal or under state law depends on the circumstances, said Les Livingstone, a former Coopers & Lybrand partner who now testifies as an expert witness in accounting cases. Some years ago, plaintiffs favored federal court because they were able to conduct more extensive discovery, which is often crucial in these cases, he said.

But in 1995, Congress passed the Private Securities Litigation Reform Act, which imposed a variety of new restrictions on shareholder suits, including limits on what records plaintiffs can obtain through discovery. Currently, many state rules of civil procedure offer more latitude to plaintiffs, Livingstone said.

Also, individuals seeking redress under federal securities laws typically have to show "scienter," or bad faith, to prevail, said Berliner. Mere violations of GAAP or GAAS are not enough; rather, plaintiffs must show that the accounting firm either deliberately misrepresented crucial facts or acted with reckless disregard as to the accuracy of its reports or audits. That can be difficult to prove, given the complex and sometimes ambiguous nature of the accounting profession's standards, Berliner said.

Plaintiffs who file in state court should be prepared for defense efforts to remove the case to federal court. In Toumajian v. Frailey, a business owner sued his accounting firm in state court for negligence in administration of a pension plan. The defendant argued for removal on the ground that the claim was preempted by ERISA. But the Ninth Circuit held that the federal statute preempts only claims in which plan beneficiaries seek to obtain benefits or enforce their rights. It does not block state law claims for professional negligence. (135 E3d 648 (9th Cir. 1998).)

One advantage of suing under federal law would be the possibility of obtaining treble damages under the RICO act. Congress, as part of its response to Enron's collapse, is considering whether to clarify how this powerful law applies to accountants and other financial professionals.

If the plaintiff lives in a state that takes a restrictive view of liability to third parties, federal securities law may offer a better chance of victory, Schwartz said. And if both the company and its accounting firm are defendants, it may make sense to consolidate all claims into one federal case.

The massive class action suit brought against Arthur Andersen, Enron, and many other defendants is pending in a U.S. district court in Houston. (Newby v. Enron, No. H-01-3624 (S.D. Tex. filed Apr. 8, 2002).) The plaintiffs' complaint, which runs more than 500 pages, is available at www.milberg.com.

What to look for

Early retention of accounting experts is crucial, say lawyers in this field. Schwartz said attorneys should have their experts review the documentary work product of the defendant firm, including all correspondence between client and accountants. (Unlike a lawyer's work product, that produced by accountants is not covered by privilege.) In a particularly complex case, it may be a good idea to have the expert sit in during depositions, he added.

During case investigation, the lawyer should look for any conflict of interest between the accounting firm and the company for which it performed services, such as a business partner relationship or even whether senior partners of the accounting firm hold large amounts of their client's stock.

"The whole point of the independent accounting firm is that they're supposed to provide an objective assessment of what's going on," said Wagner. "A conflict of interest is easier for a jury to understand" than some of the more complex issues relating to compliance with GAAP or GAAS. Also, any evidence of insider trading is extremely valuable, particularly if the accountants were selling their shares while giving a clean bill of health to the company for public consumption.

If the case relies entirely on negligence, as opposed to willful misrepresentation, experts said, the plaintiff lawyer should be as specific as possible about what standards were violated. A primer for defense lawyers in these cases (available on the Internet at www.morganlewis.com) advises counsel to zero in on "an absence of particulars" in plaintiffs' complaints. It also urges defense attorneys to stress "intervening causes" for inaccurate reports, such as third-party defaults or changes in accounting rules, as well as "the relatively small magnitude of the error relative to overall revenues" of the client.

While Washington policy-makers continue to debate how to prevent future Enrons, private citizens and their lawyers may do the most to hold the accounting profession accountable.