Another Business for the Big Five

In one of the stranger bits of accounting that the Big Five engages in, we have the auditing of overseas factories in order to tell if they are treating their workers in a human manner and are paying them a living wage. PricewaterhouseCoopers is the largest accounting firm analyzing this data, they do over 6,000 of these audits a year for among other companies. Nike, and they have recently been charged by Dara O’Rourke, an M. I. T. professor with having a corporate bias. Included in the rap on Pricewaterhouse is the fact that they have a tendency to overlooks carcinogenic chemicals that the workers were exposed to, 80 hour work weeks that they were obliged to put in, falsified timecards that tended to underestimate the hours put in by employees and missing health and safety features that were intended to protect workers from external problems.

These audits have become increasingly important to consumer groups as they have become more interested in analyzing the human side of the manufacturing business. Colleges have also become intensely interested in the process in order to insure that improprieties do not occur in the manufacture of their own branded merchandise which is often produced in the Pacific Rim. Student groups have now started criticizing the audit entire audit process as a self fulfilling for the Universities and corporations.

The New York Times on 9/28/2000 in an article by Steven Greenhouse said that “Professor O’Rourke, who has inspected more than 100 Asian factories for the World Bank and various United Nations organizations, called on universities and companies to demand more rigorous monitoring efforts. He criticized Pricewaterhouse inspectors for failing to identify that workers in a garment factory in Seoul, South Korea, used a spot remover containing benzene, a carcinogen. When he visited a factory outside Jakarta, Indonesia, he found that the firm’s inspectors had overlooked the same problem during an earlier inspection. He also faulted the firm’s monitors for not noting that the labor union at a Shanghai garment factory was, like most Chinese unions, controlled by management. And he criticized the inspectors for failing to note that little information was given on chemicals used in the factory and that some workers did not wear proper gloves, masks or whose while doing dangerous tasks or handling dangerous materials.”

Most of the people that read the report by O’Rourke were taken somewhat aback by the report and indicated that they were previously unaware of a pro-management bias by Pricewaterhouse in this type of study. But some indicated that the accounting giant was not being paid to create bad publicity occur for their own clients. Thus, most of those contacted thought the process to be much needed but of little real benefit when the very outcome that the client fears the most, being labeled a sweatshop producer was being determined by their own accounting firm who they were paying. Hardly the kinds of conflicts that are likely to build consumer confidence.

And In Addition

Auditor’s New Duty to Blow the Whistle on Its Client

WHEN CONGRESS voted to override President Clinton’s veto of the Private Securities Litigation Reform Act of 1995 last December, the passage of the act was viewed as a major victory, not only for companies deluged with class action claims, but also for accounting firms who had been favorite targets for plaintiffs seeking damages for violations of the federal securities laws. One of the main attractions in the act for accountants and other professionals

was Congress’s substitution of a proportionate liability standard for the previous Joint and several liability litigation. that auditors and others had faced in securities enacted a provision amending

However, Congress also enacted a provision amending the Exchange Act that imposed on auditors a duty to “blow the whistle” on illegal acts that they discover in connection with the audit of client’s financial statements – a duty previously found not to exist by many courts examining the boundaries of an auditor’s liability under the Exchange Act.

‘The new act requires accountants to include in their audits “procedures designed to Provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts.”‘


Perhaps more important, the act requires auditors who detect such illegal acts to inform the client’s management and ensure that the audit committee is adequately informed unless the illegal acts are “clearly inconsequential.” If management fails to take appropriate action and the auditor determines that the illegal acts will have a material effect on the issuer’s financial statements, the auditor must report the information to his client’s board of directors. The company must then inform the SEC not later than one business day after receipt of the report and must give the auditor a copy of the notice to the SEC; failing such action by the company, the auditor must itself report to the SEC within one business day.

The statute supplies a carrot-and stick approach with regard to the consequences: the auditor who blows the whistle on the client will enjoy the protection of a safe arbor from liability in a private action for any “finding, t expressed in a report” rendered conclusion, or statement willfully to the SEC, whereas an auditor found to have isolated” the statute by falling to make the disclosures required under the act will be liable for civil penalties-‘

The House sponsor of this provision, then Representative Ron Wyden, D-Ore., proclaimed on the floor of the House that the fraud reporting requirement would telegraph to corporate management that they “cannot have an auditor In their pocket’s This statement was undoubtedly a source of astonishment among auditors who have traditionally been truly independent and more than any other profession have been responsible for preventing fraudulent or even negligently prepared financial statements from being circulated to investors. Indeed, auditors have navigated through the Shoals of relents who perpetrated frauds both on the investing public and upon the auditors themselves – with the added collateral consequence of “posing auditors to liability as deep-pocket targets of opportunity for investors seeking to make themselves whole after the fraud has made the company judgment. proof.

GAAS Requirements

Before the adoption of the act, art independent auditor’s responsibilities were governed by generally accepted auditing standards (GAAS) pursuant to SEC regulations* and case law under 910(b) of the Exchange Act. Under the relevant auditing standards, particularly SAS 53 and 54, as interpreted in the American institute of Certified Public Accountants’ (AICPA) Codification of Statements on Auditing Standards, auditors were – and are – required to conduct audits with a degree of professional skepticism, having in mind the possibility of fraud, but were not otherwise responsible for identifying illegal acts as such, under the theory that it is possible to defraud auditors and, under SAS 54, a fraud audit was beyond the auditors’ normal scope of Investigational

However, if an auditor determined that financial statements were fraudulent, GALAS required that the auditor “insist that the financial statements be revised and, If they are not, express a qualified or an adverse opinion on the financial statements, disclosing all substantive reasons for his opinion.”” f the auditor found that, after applying extended procedures, he was “unable to conclude whether possible Irregularities may materially affect the financial statements,” SAS 53 required the auditor to disclaim or quality an opinion on the financial statements and communicate his findings to the audit committee or the board of directors.

If the client then refused to accept the auditor’s report as modified, the position of the A[CPA was that the auditor should resign. 12 SAS 53 did not impose a duty to “blow the whistle” on fraud, and, in fact, expressed an ethical obligation on the part of the auditor to remain silent, subject to a qualified exception where the client was required to report a change of auditor to the SEC on Form 8-K.

Auditor’ Liability Under Rule 10b-5

Under the law as It existed before the act, courts had not spoken with one voice as to whether auditors were obliged to report illegal acts directly to third parties, such as the SEC, at least where the auditor had not completed the audit or signed the auditor’s report. In a line of cases, courts had held that auditors sued under an aiding-and abetting theory of liability (now extinct following the Supreme Court decision In Central Bank of Denver, N.A. v. First Interstate Bank of Denver, et al.,14) were not liable for a failure to blow the whistle on their Clients unless some positive duty existed In law to disclose the fraud to parties not in privity with the auditors.

As Judge Easterbrook of the Seventh Circuit noted In Dileo v. Ernst & Young,14 in situations where such a duty did exist, such as when an accountant actually were to certify financial statements with knowledge that such statements were materially misleading, the auditor would be liable as a primary violator.17 Declining to recognize a duty on the part of auditors otherwise to search out and report illegal acts, Judge Easterbrook wrote; Such a duty would prevent the client from reposing in the accountant the trust that is essential to air accurate audit. Firms would withhold documents, allow auditors to see but not copy, and otherwise emulate the CIA, if they feared that access might lead to destructive disclosure – for even air honest firm may fear that one of its accountant’s many auditors would misunderstand the situation and .bring the tocsin needlessly with great loss to the firm.”

However, decisions in the Eleventh and Ninth Circuits did impose a duty on auditors to report fraud concerns which the auditors had knowledge – even in cases where fraud did riot have a material effect on the financial statements. In Rudolph v. Arthur Andersen & Co., sustaining a complaint under both primary and secondary liability theories, the Eleventh Circuit held that an auditor could be liable even where the statements made in a private placement offering were true when made.

In Rudolph, Arthur Andersen had prepare,(] audit reports that were included in an offering memo for a private placement, While the statements were true at the time of the offering, the plaintiffs alleged that the principal of the company later diverted funds from a research and development project initially included in the offering, and the auditors later did not cure any misapprehension as to the condition of the partnership caused by the executive’s diversion of funds. The plaintiffs’ continued reliance in Rudotph upon Arthur Andersen’s statements was held to be sufficient to support cause of action against the auditor for both primary and secondary liability.

A Primary Violation

The court first reasoned that this omission to disclose a misleading statement amounted to a primary violation of Rule 10b.5 where the silent party was under a duty to disclose. The court then found such a duty, pronouncing that standing by while one’s good name is being used to perpetrate a fraud is inherently misleading, It is not unreasonable to expect an accountant, who stands in a “special relationship of trust vis-a-vis the public” , and whose “duty is to safeguard the Public interest,” . to disclose fraud in this type of circumstance, where the accountant’s information is obviously superior to that of the investor, the cost to the accountant of revealing the information minimal, and the cost to the investors of the information remaining secret potentially enormous.

The judicially created duty of whistle-blowing achieved perhaps its most extreme form in American Continental Corp./ Lincoln Savings and Loan Litigation.21 In ACC, the accounting firm of Touché Ross undertook an engagement in the middle of a public offering on behalf of John Keating and Lincoln Savings and Loan, replacing a previous auditor that had disagreed with ACC’s proposed booking of a gain on a transaction. Under circumstances that the district court found to suggest “opinion shopping” by ACC, the court determined that issues of fact existed as to whether Touché Ross possessed “reckless scienter” concerning the auditor’s awareness of the improper financial reporting at ACC.

At the time, the ACC court pushed the boundaries of an independent auditor’s liability to unprecedented limits ” Touché Ross had never completed its audit, had never issued an audit report and was not named in ally registration statement, prospectus or other document required to be filed with the SEC, other than the form 8-K reporting the change in auditor. Nevertheless, the court found that silence in the face of fraud could constitute “substantial assistance,” thereby supporting liability. Citing Rudolph. the district court held:

This court holds that an independent public accountant who knows of or recklessly disregards a client’s fraud, may be held liable or aiding and abetting that fraud here the auditor provides services which constitute substantial assistance. Whether an audit has been completed is not necessarily determinative ‘)I whether the assistance is “substantial ” If an an-auditor is aware that an ongoing fraud is a real possibility, he or she may not act as an advocate for its wrongdoing client. Nor may the auditor stand by, knowing of a fraud, and withhold damaging in-formation from the SEC and federal bank regulators.

Even after the Supreme Court struck down aider-and-a abettor liability in Central Bank, the judicially expressed duty of disclosure continued to have life in the world of primary liability. In such cases as in re ZZZZ Best. There, the court denied the auditor’s motion for summary judgment on the ground that the auditor had a continuing duty either to withdraw a quarterly financial report or to bring the mis-staternents or omissions in that report to the attention of either the board o’ directors, the government, or investors, ZZZZ Best allowed a claim for primary liability to proceed, focusing on the public’s reliance upon previously reported financial information.

Statutory Duty

Whatever doubt may previously have existed as to whether an independent auditor had a duty to expose a fraud is now resolved by the act. Although Central Bank has written secondary liability out of the statute, primary liability still haunts auditors, albeit subject to the act’s new restrictive standards, not to mention the possibility of civil prosecution by the SEC.I.

The act poses several Hobson’s choices for the auditor. Although the auditing profession, including the AICPA, publicly supported Representative Wyden’s language, under the theory that the statute merely codified existing SAS standards, a comparison of the 8-K reporting requirements with the language of the act suggests that the act may expand somewhat upon the substance of what previously was required to be reported, and certainly accelerates the process, with the duty of disclosure placed squarely on the auditor if the company fails to do so.

Thus, the auditor is now forced to choose between the threat of civil penalties from the SEC on the one hand and the consequences of a mistaken report, If the auditor were to determine after making such a report that the effect of the illegal act were not material after all, the share value and reputation of the issuer would have been impacted needlessly.

Equally serious is the ethical dilemma imposed by the act. As the Auditing Standards Board recently observed in its draft of new proposed standards, which would require an auditor to Specifically assess the risk of material misstatement due to fraud,”20 the interplay between the act and the auditor’s ethical responsibility to its client is not free of tension:

The disclosure of fraud to parties other than the client’s senior management and its audit committee ordinarily is not part of the auditor’s responsibility, and ordinarily would be precluded by the auditor’s ethical or legal obligations of confidentiality unless the matter is reflected in the auditor’s report .30

One need only recall Judge Easterbrook’s forecast of the chill that whistle-blowing will inevitably introduce into the relationship between the auditor and its client to see that one very distinct consequence of the act may, therefore, be a greater instinct on the part of an issuer’s management to withhold information from its auditor.

A Second dilemma for the auditor is one of judgment. How is an auditor to know whether air illegal act’s effect on the financial statements is “clearly inconsequential,” thereby obviating the duty to make a report to management? Or what of the issue of whether under paragraph 10A(b)(2) the effect on the financial statements is “material,” thereby requiring the auditor to report management’s lack of remedial action to the board of directors?

These issues are classical issues of fact, likely in most cases to survive pretrial motion practice, tying up the auditor in expensive litigation in instances where hindsight shows that the effect of a fraudulent accounting practice was more or less substantial than the auditor’s judgment originally forecast,


The independent auditor has always experienced an inherent tension between the duty to be independent on the one hand and to serve the issuer on the other. That tension has been resolved by statute in favor of independence, but just how that tension will play itself out in the context of the “whistle blowing” requirement re mains to be seen.

Certainly courts should hesitate to impose liability upon accountants who, far from Willfully violating the act, exercise their professional judgment as to the materiality of an illegal act in gray areas. The unhappy alternative would arise if courts instead were to apply the act in the same, sweeping manner as, for example the court in Rudolph did in construing the reach of _0(b). Auditors will then be placed in the impossible position of acting not merely as detectives, obliged to seek out and report illegal acts, but clairvoyants, open to liability for a failure to report acts that seem prospectively to pose no material consequence to the financial statements of the issuer.