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Punitive damages: a storm over the accounting profession.

The accounting profession's liability problems continue to dominate the American Institute of CPAs agenda. Although these problems involve many different legal issues, one receiving increasing attention is punitive damages. Several recent rulings awarded large punitive damage verdicts against CPA firms.

In February of this year, Coopers & Lybrand faced a punitive damage verdict of $200 million. The judgment was awarded in Texas, a state known for its liberal punitive damage awards against corporate defendants. Although the verdict ultimately was dismissed in connection with settlement of the case for an undisclosed sum, it illustrates how these judgments and the mere threat of them create an untenable atmosphere for the profession.

WHAT ARE PUNITIVE DAMAGES?

Punitive damages are fines awarded in civil cases after the injured party's need for compensation has been fully established. While awarding noncompensatory punitive damages can help deter and punish extreme misconduct, the current methods for awarding them often impose penalties randomly and capriciously. Unfortunately, the specter of unlimited punitive damages encourages parties to try cases needlessly or demand unreasonable settlements, thereby delaying justice and impeding the swift award of compensatory damages to the affected injured victims.

Once very rare, punitive damage awards, while certainly not the norm, are becoming quite common. Studies show a dramatic increase in these awards in both commercial and personal injury cases. A 1987 study by the Institute of Civil Justice examined 24,000 jury trials in Cook County, Illinois, and found the average punitive damage award increased, in inflation-adjusted dollars, from $43,000 in 1965-69 to $729,000 in 1980-84, a jump of 1,600%. Furthermore, since 95% of tort cases settle before trial, the real impact is the effect they have on out-of-court settlements.

The Coopers & Lybrand case demonstrates these problems quite clearly. The case (U.S. National Bank of Galveston v. Coopers & Lybrand) arose from actions of the former chairman of Miniscribe, Inc., a manufacturer of computer disk drives. The chairman was accused of deceiving investors about the company's financial condition by inflating net income for several years using falsified corporate records. The plaintiffs in the action, investors who had bought about $18 million in Miniscribe bonds sold in 1987, were awarded $20 million in actual damages and $530 million in punitive damages. Of these amounts, $4 million in compensatory and $200 million in punitive damages were levied against Coopers & Lybrand, based on allegations the firm had conducted faulty audits and had signed off on a prospectus that contained fraudulent financial statements. Coopers vigorously contested the actions. In fact, the trial court judge later actually set aside the verdict as "contrary to the great weight of the evidence" in connection with the settlement of the matter.

Although the case was settled, it still exemplifies the problems with punitive damage cases. In Texas, juries are given little guidance on how best to calculate an appropriate award. Also there are neither protections requiring proof by a clear and convincing standard nor separate trials on punitive damage issues. Hence, a punitive damage award 50 times the size of the compensatory damage award, as with Coopers & Lybrand's liability in Miniscribe, becomes possible. The jury is given unlimited discretion to decide not only whether and when such damages should be awarded but also how large an award is appropriate. In essence, the punitive damage law allows private plaintiffs to use the civil litigation process as a vehicle for the demand and collection of sizable windfalls beyond their actual losses. For whatever reason, although the plaintiffs in Miniscribe were made whole through compensatory damages, an enormous punitive damage award against the CPA firm was deemed appropriate and necessary.

While Miniscribe is one of the most egregious examples of multimillion-dollar verdicts against CPA firms, other cases abound. For instance, in September 1990, in In Re FPI Securities Litigation, Ernst & Young was ordered to pay $10 million in punitive damages to investors who participated in syndicated partnerships. formed to buy and sell tropical plants. The jury found the investors relied on fraudulent financial forecasts reviewed by Ernst & Young. The award was granted even though the firm was unaware of the scheme. Instead, the jury found the firm, as auditor of FPI Investments, should have known of the fraud. Although the amount was not as outrageous as the one in Miniscribe, the result is equally absurd since it was based on unintentional conduct. In another instance, a $12 million punitive damage award was entered against a Texas CPA firm in a case involving allegedly defamatory statements contained in a diagnostic review of a hotel.

THE AICPA RESPONSE

Although some of these awards were vacated or reduced on appeal, their unpredictability affects the entire litigation process. CPAs' liability exposure becomes extremely difficult to evaluate. Since defendants are incapable of accurately predicting either the likelihood that punitive damages will be awarded or their amount, plaintiffs can force an unreasonable settlement before trial. These problems affect not only the larger firms but also smaller firms and sole practitioners.

As a result, the AICPA accountants' legal liability subcommittee decided the only choice was to become active in punitive damage reform. In 1989, the subcommittee worked with the American Tort Reform Association (ATRA), an advocacy group based in Washington, D.C., to develop punitive damage legislation based on the U.S. Supreme Court decision in Pacific Mutual Life Insurance Company v. Haslip. In Haslip, the Supreme Court decided the due process clause of the Fourteenth Amendment should limit jurors' discretion in setting punitive damage amounts. The Haslip decision recognized that in most states juries are given little or no guidance in determining whether punitive damage awards are warranted in the first place. ATRA's model legislation was designed to provide that guidance. It contains provisions requiring claimants seeking punitive damages to establish by clear and convincing evidence that any harm done was the result of intentional or malicious misconduct involving a conscious intent to cause injury. It also requires punitive dam* age issues to be considered only in a separate proceeding after compensatory damages are awarded. In addition, the legislation limits punitive damages to $200,000 or the claimant's compensatory damages award, whichever is greater. Finally, it calls for court review of these awards to ensure they are reasonable in amount and rational in light of their purpose, and lists various factors for the court to consider.

In December 1989, the AICPA subcommittee wrote to state CPA societies to advise them of the subcommittee's general support of ATRA's legislative reform. The letter also discussed additional legislative provisions the subcommittee developed that are of particular relevance to the accounting profession. For instance, the AICPA's own model legislation specifically seeks reform of punitive damage awards involving vicarious liability issues. In some jurisdictions, juries may still impose punitive damages on a CPA firm even though an employee committed the negligent conduct justifying that award. Often, all that is required for employer liability is that the employee act within the scope of his or her duties and in furtherance of the employer's interest, even if the employer was prudent in employee hiring and supervision. CPA firms are especially vulnerable to punitive damage awards based on employee actions because of the nature of accounting services. As a result, the AICPA model legislation requires that a firm's governing body expressly authorize the employee's negligent conduct before the firm can be held liable for related punitive damages.

In addition, like the ATRA model bill, the AICPA model legislation recommends a dollar limit on punitive damage awards, although the AICPA model is tied to the defendant's actual or expected gain from the wrong. The specified measure limits punitive damage awards to twice the actual or expected gain, such as the amount of an audit fee. The ATRA bill, although different, acknowledges this measure as a criterion to be considered when determining the award size.

The subcommittee recommended these two more stringent standards because, among other things, firms' potential for disaster is exacerbated by the nature of professional partnerships that put at risk all personal assets of each partner despite his or her total lack of complicity in torts committed by isolated individuals. For obvious reasons, passing legislation based on either the AICPA or ATRA proposals would provide the accounting profession with invaluable assistance in its battle against punitive damage abuses. Reform legislation that contains any of these suggestions would alleviate some of the problems created by cases such as Miniscribe and FPI Investments. Had such legislation existed in the states where they were tried, the case results would have been different.

LEGISLATIVE ACTIVITY

The subcommittee's position paper and ATRA's model bill, together with punitive damage reform activity independent of these initiatives, resulted in reforms in some 25 states. The legislative initiatives vary widely, from outright abolition to tighter definitions of the kinds of conduct that merit such awards. In some cases, higher standards of proof are required, such as the necessity that plaintiffs prove all material allegations by clear and convincing evidence. Several states also attempted to set punitive damage caps, although some of them were overturned on state constitutional grounds.

Several state CPA societies have been active in this effort. For instance, in Maryland, a punitive damage bill with a vicarious liability standard similar to the Institute's was considered by the state legislature. The Maryland statute also required a plaintiff to prove by clear and convincing evidence that the harm was the result of actual malice or fraud before punitive damages could be awarded and required a separate trial on punitive damages issues. Although the bill failed to obtain passage by one vote in 1992, the Maryland Association of CPAs is optimistic and believes the bill will be resubmitted next year.

Clearly, the effort to reform punitive damage law will be a protracted one. However, the job gets easier every day as more people understand the issues. Just last February, the president sent the Access Justice Act of 1992 to Congress to enact major reforms in the civil justice system. The act addresses the problem created by the explosion in civil lawsuits and the tremendous cost they impose on small businesses, professionals, industries and government at all levels. It was developed in connection with a report issued by the President's Council on Competitiveness, which also contains a model state punitive damage act to assist with state judicial system reforms.

AN IMPORTANT ISSUE FOR CPAs

Accountants' liability problems are of major import for the profession. Concerns about possible legal ramifications affect many decisions for CPAs, from hiring to taking on a new client. It's important for the profession to respond to problems in the legal system and to participate in their solution.

EXECUTIVE SUMMARY

* SEVERAL RECENT rulings awarded large punitive damage verdicts against CPA firms.

* PUNITIVE DAMAGES are awarded in civil cases after the injured party's need for Compensation is fully established. While these awards can help deter and punish extreme misconduct, current award methods often impose penalties capriciously. This encourages parties to try cases needlessly or demand unreasonable settlements, delaying justice and impeding the swift award of compensatory damages to victims.

* THE AICPA DECIDED its only choice was to become active in punitive damage reform. It has worked with the American Tort Reform Association to develop model punitive damage legislation that attempts to give juries guidance in making punitive damage awards.

* AICPA MODEL LEGISLATION seeks reform of punitive damage awards when vicarious liability issues are involved. It requires that a firm's governing body expressly authorize an employee's negligent conduct before the firm can be held liable for related punitive damages. It also recommends a dollar limit on punitive damage awards.

* VARIOUS EFFORTS resulted in reforms in some 25 states.

HOW TO TAKE PART IN THE INSTITUTE'S WORK

The Institute will continue to be active in this and other efforts to ensure the legal system fairly resolves disputes involving accountants and auditors. CPAs who have any interest in pursuing legislative reform in their states should contact the Institute's assistant general counsel, Paul Geoghan, at (212) 575-6385.
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Article Details
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Author:Geoghan, Paul
Publication:Journal of Accountancy
Date:Jul 1, 1992
Words:1992
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