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SEC loses in trial against auditor Price Waterhouse.

The accounting profession now has reason to believe that the complexities of auditing and accounting issues can be thoroughly understood by a Court or perhaps even a jury. In a recent victory in the Southern District of New York, Price Waterhouse (PW) successfully defended allegations of audit fraud brought by the Securities and Exchange Commission (SEC or Commission) in a bench trial.

In Securities and Exchange Commission v. Price Waterhouse,(1) the SEC sought broad injunctive relief against PW for violating the antifraud provisions of the Securities Act of 1933 (Securities Act), the Securities Exchange Act of 1934 (Exchange Act) and for aiding and abetting such violations in connection with PW's audit of the financial statements of AM International, Inc. (AMI) for the fiscal year ended July 31, 1980.(2)

While not a jury trial involving a private plaintiff suing for civil damages, PW's ability to defend its audit at trial is most impressive. Significantly, the Court rejected the expertise of the SEC on virtually all contested accounting or auditing issues. Such rejection is unusual as courts frequently give at least some weight to the SEC's expertise. This failure will be a sobering fact to the SEC in its crusade against financial fraud involving accountants or auditors.

The Case Behind the Trial

The facts presented to the Court indicated that beginning in 1976, new management expanded AMI's operations through acquisitions and product development at a substantial cost to the company. By fiscal year end July 31, 1980, the company experienced operating pre-tax losses that were overcome through special tax credits and non-recurring items. PW issued an unqualified audit opinion on AMI's financial statements, and management described in AMI's annual report a quarter-to-quarter improvement in performance and stated that AMI's turbulent times were well in the past.

Unfortunately, AMI's fortunes declined and new management took over in February 1981. PW reported the following month that since the July 31, 1980, audit, approximately $25 million in adjustments needed to be made and financial statements could not be issued in September or October 1981 because of financial difficulties.

The July 31, 1980, Audit

The SEC alleged PW had misrepresented in its audit report that AMI's financial statements were prepared consistent with GAAP and that PW's examination of such statements was consistent with GAAS.The SEC further alleged PW assisted AMI in misrepresenting AMI's financial position to support the contention that the company was experiencing a financial turnaround. Such allegations went to the heart of the audit and asserted defects in seven principal areas: (1) treatment of leases as sales; (2) transactions as direct financings; (3) understatement of allowance for doubtful accounts; (4) irregularities in accounting changes; (5) examination of intercompany accounts; (6) disclosure of accounting changes; and (7) concessions to management to book a lesser amount of adjustments.(3)

In an impressive analysis of accounting literature and expert testimony, the Court considered each of these areas and rejected the SEC's allegations that PW had engaged in fraud. The Court's 59-page discussion should be required reading for every accountant and auditor as it amply demonstrates that the Court was most capable of adjudicating these issues.

In its discussion, the Court noted that despite the fact that PW had expanded the scope of its audit due to AMI's increase in operations and poor internal controls, AMI did not pay PW for such expanded audit work as the audit fees had been negotiated and fixed by agreement. The Court focused on this situation and cited the engagement partner's trial testimony that he instructed "PW personnel to perform whatever hours were necessary to carry out a thorough examination without regard to fees."(4)

The Court emphasized this fact in concluding that PW did not have a motive to engage in any fraudulent conduct, i.e., it did not shortcut its examination to keep its audit work within the agreed-upon fee. Rather, PW went beyond its fee arrangement to ensure that its audit was professional and, in fact, lost money on the audit.

High Threshold Of Liability

The Court adopted a rule of liability in a SEC injunctive action most favorable to the accounting profession:(5)

"The SEC must prove that the accounting practices were so deficient that the audit amounted to no audit at all...or 'an egregious refusal to see the obvious, or to investigate the doubtful'...or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts."

Under this rule, in order to give rise to any liability, an audit would have to be so substandard that no reasonable accountant would have made the same decision. The Court held there must be an extreme departure from a standard of care that requires more than a misapplication of auditing standards or accounting principles. In applying this Rule to PW, particularly in light of PW's expert testimony, the Court held that, "at best," the Commission merely proved that reasonable accountants might reach different conclusions regarding complex accounting issues and that no finding of fraud or recklessness could rationally be made under such circumstances.

PW's experts obviously outperformed the Commission's experts and the Court even stated most pointedly that PW's experts "were more credible, persuasive and reasonable in their analysis and conclusions."(6)

No Inference of Fraud

The SEC contended that PW's conduct permitted an inference of fraud/scienter because PW was so concerned in maintaining AMI as an audit client that it would engage in fraud or misconduct. But citing the Seventh Circuit authority in DiLeo v. Ernst & Young,(7) Judge Sprizzo rejected such client pressure as providing any inference:(8)

"It is highly improbable that an accountant would risk surrendering a valuable reputation for honesty and careful work by participating in a fraud merely to obtain increased fees... The Court therefore declines the Commission's invitation to look with a jaundiced eye at each accounting decision made during a complex audit merely because of an accountant's economic motivation in maintaining an ongoing relationship with a client."

Judge Sprizzo similarly rejected as "frivolous" the Commission's argument that PW had an investment in AMI because it performed audit work for which it was not compensated:(9)

"It defies economic reality to suggest that a professional firm which extends a discount or does not bill its full fee for its "learning curve" in order to retain and accommodate a client has compromised its independence merely because it may colloquially refer to that circumstance as "an investment" in the client. Indeed, this argument reflects the Commission's general approach to this case, i.e., to seize and grasp any fact to support any argument, however irrational, to justify its claim of fraud. The Court can only conclude that in this case, fraud, like evil, exist principally in the eye of the beholder."

This holding is most responsive to the accounting profession's growing frustration in responding to audit fraud allegations--what benefit did the auditors receive to engage in the egregious fraudulent conduct? Most auditors remember the long hours, the time deadlines, the client demands, preparation of detailed work papers and myriad tasks to comply with the professional standards--if that was fraud, where was their payoff? The Court was crystal clear that these client pressures will not constitute an inference of fraud.(10)


The Court's analysis and understanding of audit field accounting principles and client relationships should be applauded by the accounting profession. The profession had begun to doubt whether the judiciary could understand and analyze substantive and technical issues, but Price Waterhouse is an impressive demonstration that such issues not only can be understood at trial but can be presented in a manner to persuade the trier of fact.

PW's victory may be so overwhelming that the SEC may hesitate to bring any more injunctive actions that raise substantive audit or accounting issues against accountants. The 12-year time gap between the audit and the Court's decision--or even the five-year time gap between the audit and filing of the complaint--mitigated against any injunction. In light of these delays, the SEC may resort to its own administrative forum to proceed against accountants under Rule 2(e) of its own Rules of Practice or possibly even under its new cease and desist powers under recent amendments to the Securities Act and Exchange Act.(12)


1 No. 85 C 4787, slip op. (S.D.N.Y. June 29, 1992). The SEC filed its complaint on June 20, 1985, against PW, the audit engagement partner, the partner responsible for audit procedures in Chicago, the senior audit manager and seven employees of American International, Inc. Five employees settled with the SEC and two employees were dismissed by stipulation, but PW and its personnel litigated the complaint for seven years and obtained a judgment 12 years after the audit. PW had moved to dismiss and for summary judgment, but Judge Sprizzo denied both of these motions.

2 The SEC's antifraud allegations were pursuant to Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5. The SEC's aiding and abetting allegations involved these provisions as well as the periodic reporting requirements, such as Form 10K, under Section 13(a) of the Exchange Act and Rules 13a-1 and 12b-20. The request for an injunction was pursuant to Section 20(b) of the Securities Act and Section 21(d) of the Exchange Act.

3 One observation is that the SEC should have focused its litigation on one or two areas rather than taking the "shotgun" approach. Once the SEC failed to carry its burden in any area, it raised a doubt whether the SEC had carried the burden in other areas.

4 Slip op. at 14.

5 Slip op. at 80-81. The SEC's legal theory was that PW was reckless in its audit and accounting work, and that such recklessness met the scienter requirement of Section 17(a)(1) of the Securities Act and Section 10(b) and Rule 10b-5 of the Exchange Act. The Court held that the SEC failed to prove such scienter (recklessness) during the trial.

6 Slip op. at 82.

7 901 F.2d 624, 629 (7th Cir.), cert. denied, 111 S.Ct. 347 (1990).

8 Slip op. at 85-86.

9 Slip op. at 86. Judge Sprizzo stated thatt the "credible testimony indicates that an unqualified opinion was rendered after reasonable investigation and extensive discussions with company officials and among PW personnel." The Judge also stated that after observing the engagement partner's testimony and gaining "some insight into his personality, the Court finds the suggestion that he 'capitulated to management's pressure' highly unlikely." Slip op. at 84. These statements should fortify auditors in countering a client's pressure for a particular result.

10 Slip op. at 84-88.

11 The victory may also encourage the industry to "fight back" against abusive lawsuits as also reflected by Coopers & Lybrand's recent counterclaim against its former client, Phar-Mor Inc., alleging that management-alleged fraudulent conduct prevented Coopers & Lybrand from conducting a proper audit. See Coopers & Lybrand Bring Countersuit Against Phar-Mor Over Firm's Problems," The Wall Street Journal (August 20, 1992).

12 See Section 8A of the Securities Act and Section 21C of the Exchange Act which were part of the amendments affected by the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. These provisions authorize the SEC to enter a ppermanent cease and desist order against any person in an administrative proceeding. See also Ferrrara, Ferrigno and Darlund, "Hardball! The SEC's New Arsenal of Enforcement Weapons," 47 Bus. Law. 33, 56-65 (Nov. 1991).

Quinton F. Seamons focuses his practice on the requirements of the federal securities laws in the corporate, broker/dealer, investment banking and investment advisory areas and in litigation and arbitration. He was a member of the staff of the Securities and Exchange Commission (SEC) in Washington, D.C., from 1971 to 1976, where he served in the Division of Market Regulation and on the executive staff as legal counsel to the SEC.
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Title Annotation:Guest Column
Author:Seamons, Quinton F.
Publication:The National Public Accountant
Date:Mar 1, 1993
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