Beware: Watchdog function can result in liability risk
The civilized man has a moral obligation to be skeptical, to demand the credentials of all statements that claim to be facts.
– Bergan Evans (1904-1978)
While it is unclear who originated the phrase “public watchdog” in describing the function of auditors, one of the most common attributions in recent articles and commentaries is the U.S. Supreme Court opinion in United States v. Arthur Young, 465 U.S. 805 (1984), wherein the Court noted that:
“The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as the investing public. This ‘public watchdog’ function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.” 465 U.S. 817-818.
Although recent examples of auditor liability for failure to discharge this obligation abound, auditors are sometimes faced with highly complex issues and, as discovered by Andy Accountant, efforts to fulfill the public watchdog function can also give rise to litigation and potential liability.
Andy audited the financial statements of Universal Widget, Inc. (UWI) since its inception in 1997. In August 2001, Andy’s practice was acquired by another firm, but the new firm agreed to audit UWI’s financial statements for the year ended Dec. 31, 2001.
In prior years, UWI’s president and other related parties loaned funds to UWI. In exchange, UWI paid significant interest and issued warrants to the lenders that allowed them to acquire UWI stock at the existing market value.
The warrants contained an unusual provision that neither the number of shares that could be acquired, nor the price per share, would change in the event of a reverse stock split.
In November 2001, UWI’s board and shareholders representing a majority of UWI’s outstanding stock approved a
200-to-1 reverse stock split. Thereafter, the related parties exercised their warrants.
The result of the transaction was to increase the related parties’ ownership of UWI from 70 percent to 99 percent at a cost that was 200 times less than the cost of the transaction if the stock had been purchased at its post-reverse price.
Although Andy was aware of the anti-dilutive warrant provision and enactment of the reverse when audit planning began, he had been assured that the legality of the reverse had been addressed by UWI’s legal counsel and was not a concern.
Immediately after the initial planning meeting, Andy’s partner, Experienced Ed, took over the audit due to Andy’s temporary suspension from practice before the SEC.
Fieldwork on the audit proceeded, and review partner Observant Al began his examination of the work papers on March 26, 2002, five days before UWI’s March 31, 2002, Form 10-K filing deadline.
The next day, Al advised Ed and quality control partner Careful Carl of his concern that the reverse might constitute an illegal act. On March 28, 2002, Al and Ed informed UWI’s president of this concern and requested clarification from UWI’s attorney that the reverse was a legal transaction.
UWI’s response to the inquiry was agitated and, in its request for an automatic extension of the filing deadline, UWI made numerous factual assertions about the audit process that suggested the filing delay was the result of its auditors’ failure to address various issues in a timely manner.
Andy’s firm contested UWI’s factual assertions and, as the relationship with UWI continued to deteriorate, engaged legal counsel to assist them in addressing the legal issues presented by the reverse.
While Andy’s firm initially requested a legal opinion that arguably included subjective elements upon which UWI’s counsel could not opine, UWI refused to negotiate regarding the scope of the legal opinion and sent a letter indirectly accusing Andy’s firm of asking it to alter legal documents, issue false or misleading public filings and coerce its legal counsel to issue a legal opinion that was not usual or customary.
As a result, Andy’s firm resigned just four days before UWI’s Form 10-K extension deadline.
While UWI engaged a new auditor within days of the resignation, and the 2001 audit was completed in June, UWI’s stock was delisted as a result of its late Form 10-K filing.
Despite the fact that UWI rescinded the anti-dilution provision in the warrants prior to the completion of the 2001 audit, UWI filed suit against Andy’s firm alleging that it deviated from professional standards in accepting the engagement, planning and staffing the audit, conducting initial and subsequent reviews and withdrawing from the engagement.
In addition to costs and expenses, the lawsuit sought to recover millions of dollars in alleged lost profits.
The case was ultimately tried, and a defense verdict was issued. While the court was concerned about the possibility of Andy’s firm being overly sensitive and noted that it would have been better if the issues regarding the reverse had been identified and addressed earlier in the audit process, it found that Andy’s firm:
- Had a legal obligation to have a review process that was designed to detect oversights and questionable issues
- Had a legal obligation to confirm the legality of the reverse
- Did not act negligently by seeking to resolve issues detected during the review process
Although terminating an audit engagement shortly before a significant deadline presents significant litigation risk, Andy’s firm acted appropriately in requiring UWI to adequately address the legality of the reverse.
Andy’s firm also helped ensure a defense verdict by engaging legal counsel to assist them in addressing a legal issue that was beyond their ability to evaluate and by establishing a record of their good faith efforts to resolve the issue with UWI prior to resigning.
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