Consulting liabilities.

CPAs should be aware of standards and statutes if they are to avoid lawsuits.

There has been an explosion in the number of lawsuits against CPAs, consultants among them. It's more important than ever for practitioners to be aware of the potential risks they face in each engagement and how to address them.

Professional liability cases frequently turn on the adherence to professional standards. The degree of skill and care required of a professional is a question of fact for a jury. Evidence of compliance with the governing professional standards can be used to show the practitioner performed at a legaily expected level. So it is vital for CPA consultants to know about new standards and how they affect them (see the sidebar on page 89). In addition, CPAs should know about possible dangers in consulting engagements and how to mount a defense against them in court.

LEGAL RISKS

Evolving client needs have meant increased client service opportunities for CPA consuitants. However, they also have meant increased exposure to-possible client or third-party lawsuits. Typical claims include breach of contract, negligence, fraud, negligent misrepresentation and breach of juduciary duty. Less frequent charges (but significant ones because they have the potential to trigger massive class action claims) are made for securities fraud and violations of the Racketeer Influenced and Corrupt Organizations Act.

Breach of contract. This is the most common claim against consultants. The plaintiff must show the consultant failed to perform material terms under an agreement (either written or verbal) and that the claimant suffered direct damages because of the breach.

Negligence. This is another common claim. It requires proof of a duty owed to the claimant and that the consultant's breach of that duty caused the claimant losses or damages. If a duty exists, the courts generally determine whether the consultant has satisfied it by considering

* Compliance with governing standards from the American Institute of CPAs, the Financial Accounting Standards Board and the Securities and Exchange Commission.

* The consultant's internal manuals and standards.

* Prior case law.

* The consultant's representations and statements in the engagement letter.

* The level of conduct expected from a reasonable person possessing skill in the particular field in question.

Fraud. This is a somewhat less common claim against practitioners because fraud is an intentional tort that is more difficult to prove. Fraud requires proof the consultant knowingly (or in reckless disregard of the truth) made a false statement or omission of a material fact that was intended to induce reliance and that it did actually induce good faith reliance, which caused damages. Fraud claims are potent weapons in the arsenal against consultants because they trigger punitive damages, which can be huge.

Negligent misrepresentation. This is a relatively new claim against consultants. The claimant must prove the consultant supplied false information as guidance to others in business, who justifiably relied on it and suffered a loss as a result. It must be proved the consultant failed to exercise reasonable care or competence in obtaining or communicating the information. This claim is a hybrid of negligence and fraud but, unlike fraud, it doesn't require proof of intentional misconduct on the part of the consultant.

Breach of fiduciary duty. This claim requires proof of a fiduciary duty established by a contract or special facts and circumstances surrounding the engagement. Fiduciaries owe duties of good faith, loyalty and honesty.

Federal securities laws. Numerous provisions of the federal securities laws expose consultants to liability and their detailed analysis is beyond the scope of this article. (For more information, see "What Every Accountant Should Know About Securities Law," JofA, Aug. 92, page 109.) Usually, these claims are made when services are provided to publicly held companies or for business transactions that are deemed to involve securities.

RICO. Under this complex federal law, consultants can be labeled racketeers if it's proved they engaged in illegal acts. RICO claims are enormously expensive to litigate and difficult to prove, but successful RICO cases allow for treble damages and attorney's fees.

PRACTICAL DEFENSES

The first line of defense against consultant liability claims is adherence to practice fundamentals, which can preclude or resolve claims before they are made. Some of these fundamentals are

* Clear and precise understanding or engagement letters. Scrutiny of these documents is guaranteed in practitioner liability cases, and CPAs will be held accountable for what they do and don't say. However, absence of documentation can be used against a consultant unfortunate enough to be sued. If an engagement's scope changes, the prior understanding should be modified in writing. This can help eliminate problems when a client's expectations change or when a novel application develops unexpected new requirements.

* Thoroughly prepared and maintained workpapers. These are paramount to a good defense. Sloppy, incomplete and inadequate workpapers are a plaintiff attorney's primary target in cases against consultants. Every page will be reviewed.

* Frequent and candid communication. This is imperative both among the consulting staff and between consultant and client. Clients are less likely to sue if they are kept informed and involved and if they understand and consent to the services that are performed.

* Fidelity to professional standards. Generally, compliance with governing professional standards discharges any duty of care. But compliance with professional standards doesn't provide absolute immunization from liability. Courts sometimes hold that professional standards alone are inadequate and, thus, have imposed a higher standard of care. When no precise standards exist, or when guidelines are inconsistent or contradictory, a prudent practitioner ought to document in the workpapers the work performed, why it was performed and which guidelines were relied on to perform the work.

* Due diligence and a reasonable ground for belief. This must be based on sufficient relevant data and reasonable investigation. All should be documented in workpapers.

* Devotion to excellent planning, staffing and procedure. Inexperienced staff members' work frequently is examined in consuitant liability cases to challenge adequacy of supervision and adherence to the established work plan.

UNDERSTANDINGS WITH CUINTS

A good foundation for a consulting engagement is a documented understanding with the client. This may be in the form of an accepted proposal letter, a confirmation letter, an engagement letter or a file memorandum documenting an oral understanding. The practitioner should consider several factors in reaching an appropriate understanding with the client:

* Engagement objectives.

* Nature of the services to be performed.

* Engagement scope, including areas of client operations to be addressed and limitations or constraints, if any.

* Respective roles, responsibilities and relationships of practitioners, the client and other parties to the engagement.

* The anticipated engagement approach, including major tasks and activities to be performed and, if appropriate, methods to be used.

* The manner in which the engagement status and results are to be communicated (deliverables).

* Work -schedule-'(to help control who is to do what, by-when-and under what conditions).

* Fee arrangements.

Written agreements with clients can be safeguards if used properly by the practitioner. Agreements should specify the engagement in detail, including any limitations or qualifications, and should not guarantee results either explicitly or implicitly. Sales language should be avoided. Words that connote perfection, such as expert, tend to elevate expectations and performance standards to a level that can't always be reached.

As a practical matter, a written understanding's language may be of paramount importance in defending liability claims. It not only defines the CPA's role but it also usually precludes liability if written agreements contain warnings, risk factors, disclaimers and the source of assumptions used. A limitation commonly used in understandings is that, in the event of a dispute, damages will not exceed the total paid for the consulting services under the engagement and a claim for the amount paid would be the client's exclusive remedy. Other limiting terms expressly exclude liability for any lost profits, consequential damages or any claim or demand against the client by any other party. Still others expressly exclude any claim of reliance on prior oral or written representations that may have been made. And, sometimes, written understandings require arbitration or create their own statutes of limitations so neither the client nor the consultant can sue more than one year after a claim.

There are, of course, a host of business reasons not to include such liability limitations in a written understanding for a particular engagement, and it should be recognized that their enforceability varies among the jurisdictions. Still, many firms include them.

LEGAL DEFENSES

Here are some of the technical legal defenses that can be raised to preclude or limit consultant liability:

* Statutes of limitations to avoid stale claims. Time periods for asserting claims vary among jurisdictions, but generally they're between two and six years for negligence, contract and other state law claims. Most federal securities laws expressly impose a short statute of limitations and court rulings interpreting statutes without limitation periods have similarly required claims to be brought within a year of claim discovery and in no more than three years from the transaction.

* Privily. A consultant's primary care is to the client; however, depending on the circumstances and jurisdiction, third parties, such as creditors or investors, also may be owed a duty. Under the traditional view of privily, consultants aren't liable to third parties for ordinary negligence. This theory has been evolving, however, and many states allow recovery by third parties that are actually foreseeable or even reasonably foreseeable. The privily defense is unavailable in fraud cases.

* Warnings, limitations and disclaimers. The examples previously described are becoming more important as courts recognize them as acceptable reasons for precluding liability.

* Contributory negligence and comparative fault. These defenses may avoid or limit liability for negligence or negligent misrepresentation because the claimant knew or participated in the challenged conduct. This defense can't be used in fraud claims.

* No duty to "characterize." Some claims are based on the consultants' failure to explain the meaning or significance of their findings or conclusions, but many courts have found no further obligation to characterize or explain if complete statements, information or data are supplied.

* No fraud by hindsight. Courts frequently rule that, when unforeseen events occur after an engagement, there is no liability based on hindsight.

* Aiding and abetting challenges. Under this theory, consultants face liability for knowingly assisting another person's legal violations. The good news for practitioners is that courts are becoming reluctant to impose this liability on professionals if the evidence shows they merely performed professional services or routine tasks.

* Specific statutory defenses. Claims for statutory violations often have statutory defenses. For instance, under section 11 of the Securities Act of 1933, a consultant's liability can be limited exclusively to that portion of the registration statement on which the consultant has expertise. The section also contains a due diligence defense under which a consultant can show that reasonable care was exercised and an express negative causation defense if the practitioner can show that the damages were caused by something other than the consultant's conduct.

BE ALERT

Consulting services continue to grow and represent an increasing percentage of CPA firms' gross revenues. CPA consultants often are creative entrepreneurs with the vision for new opportunities and cuttingedge service to clients. These new opportunities can be lucrative, but they often bring new and substantial risks. In addition to potential damages, consultants are vulnerable to expensive legal costs for defending liability cases and to intangible costs (such as damaged reputations, self-doubt and time and attention taken from revenuegenerating practice). Prudent consultants must plan their engagements with a full understanding of the potential liabilities.