Exam II Flashcards
What is the standard of evidence in a civil liability case?
Preponderance of the evidence (which essentially means that it was more likely than not that something occurred in a certain way)
What is the standard of evidence in a criminal case?
Beyond a reasonable doubt
What sources of law can the plaintiff sue under in a civil liability case?
- Common law
- Statutory law
What is common law?
- Written opinions of prior courts within a state (called legal precedent)
- Each state has its own common law
What is statutory law?
- Written, legislated
- Refers to written statutes established by Congress at the federal level and by state legislatures at the state level
Are more cases tried under SA ‘33 or SEA ‘34?
SEA ‘34 (Securities Exchange Act of 1934)
What four potential parties can sue under common law?
(1) Client (management of company)
(2) 3rd Party Primary Beneficiary
(3) 3rd Party Foreseen Beneficiary
(4) Foreseeable 3rd Party
What are three sources of potential liability for an auditor? Expand.
(1) Ordinary negligence (lack of reasonable care)
(2) Gross negligence (lack of even min. care)
(3) Fraud (intentional misrepresentation of material fact)
Give an example of ordinary negligence.
Violate GAAP/GAAS
Give an example of gross negligence.
- Reckless departure from GAAP/GAAS
- Audit staff checks off procedures he/she didn’t actually do
- Audit partner moves work down the line to save on costs but staff not experienced enough to do it right
Give an example of fraud.
Deceive user of F/S, and as a result they suffer financial damage.
What are the two ways fraud plays out in practice? Give an example for each.
(1) “Aiding and abetting” - Global Crossings - capacity swaps perpetrated by the independent auditors
(2) “Knew or should’ve known” - Sunbeam - auditors knew about channel stuffing and bill and hold - auditors should’ve known have restructuring accruals
What does burden of proof vary by?
- By Source of Law
- By Jurisidiction
What is the auditor’s primary defense to the deficient conduct argument?
Due Diligence Defense
What are the names of the three key criminal liability cases?
1) National Student Marketing (US v. Natelli)
2) ESM Government Securities (ESM v. Alex Grant Co.)
3) US vs. Arthur Andersen
What happened in the criminal National Student Marketing case (co. wrongdoing; auditor conviction)?
- Co. overstated A/R and revenues (did so by hiring college students to stuff mailboxes with consumer products with order form; students received huge discounts if they used order forms; but co. significantly overstated #order forms actually executed)
- Auditor convicted for criminal liability for certifying Nat’l Student Marketing Co. financial statements with material A/R disclosure omisions
What happened in the criminal ESM v. Alexander Grant Co. case (co. wrongdoing; auditor conviction)?
- Co. repeatedly resold same block of securities
- Co. told AG partner about a fraud the prior year and partner agreed to say nothing for $100,000
- Partner was sentenced to 12 years in prison when this was uncovered
Why did the USA v. AA case become criminal?
- DOJ won case from SEC
- Became criminal b/c AA announced “doc shredding” and AA had entered into a consent decree with the SEC after Waste Management to “not violate laws anymore”
Under common law, who does the burden of proof fall on?
- Plaintiff (needs to prove damage or loss, misstated F/S, reliance on F/S, deficient auditor conduct)
Under common law, what is the auditor’s minimum basis for liability to the client?
- Ordinary negligence
Under common law, what is the auditor’s minimum basis for liability to the primary beneficiary?
- Ordinary negligence
Under common law, what is the auditor’s minimum basis for liability to foreseen third parties
- Restatement of Torts v. NY Rule
Under common law, what is the auditor’s minimum basis for liability to foreseeable third parties?
- Fraud (majority view)
- Ordinary neg. (minority view in Mississippi and Wisconsin)
What is the distinction among “restatement-majority,” “restatement-minority,” and “credit alliance” states?
- Majority states: requires that auditor knew recipient would “use” report to influence plaintiff
- Minority states: adds that auditor knew recipient would “rely” on report
- Credit Alliance states: adds that evidence “links” the auditor and plaintif
Under statutory law, what is the auditor’s minimum basis for liability under sec. 11 to the plaintiff?
- Ordinary negligence
Under statutory law, what is the auditor’s minimum basis for liability under sec. 10b to the plaintiff?
- Gross negligence or fraud
Under statutory law, what is the auditor’s minimum basis for liability under sec. 18 to the plaintiff?
- Gross negligence
Under statutory law sec. 11, what’s the burden of proof on the plaintiff? On the defendant?
- Plaintiff: damage, F/S misstated
- Defendant: lack reliance or due diligience
What does the auditor need to do to prove due diligence?
- Enter evidence showing he/she followed all 10 auditing standards
Under statutory law sec. 10b, what’s the burden of proof on the plaintiff? On the defendant?
- Plaintiff: damage, F/S misstated, reliance, deficient conduct
- Defendant: none
Under statutory law sec. 18, what’s the burden of proof on the plaintiff? On the defendant?
- Plaintiff: damage, F/S misstated, reliance
- Defendant: due diligence
Do many securities class action suits go to trial?
- No, few go to trial
- Most are settled outside of court
What did the Private Securities Litigation Reform Act of 1995 introduce?
Proportionate liability
In settlements, how much do auditors generally pay?
- Less than 30% of settlement fee
Why is the Big 4’s ability to pay settlement fees low?
- B/c can’t float stock
- Total Big 4 partner capital is likely less than $2 billion
What are the six key issues in litigation support services?
1) Business valuation
2) Forensic accounting
3) Tax laws
4) Damage calculations
5) Accounting principles (GAAP)
6) Auditor performance (GAAS)
What are the three key tasks in litigation support services?
1) Arbitrator or mediator
2) Court master
3) Expert witness
What are the three key deliverables in litigation support services?
1) Report
2) Deposition testimony
3) Trial testimony
What’s an independent auditor’s responsibility for a client’s accounting under rule 203 (accounting principles)?
- …shall not express an opinion that the F/S are presented in conformity with GAAP …if the statements depart from principles promulgated by bodies designated by Council…
What’s an independent auditor’s responsibility for the auditor’s auditing under rule 202 (compliance with standards)?
- …shall comply with standards promulgated by bodies designated by Council…
Most suits against auditors under the SA ‘33 are brought under what?
Section 11
Summarize SA’33 Section 11.
- Intended to protect potential investors by imposing liability on anyone who makes untrue statements or omits material facts in connection with a registration statement.
An auditor’s liability under the SEA ‘34 derives typically from his involvement with Forms 10K and 10Q. Most suits brought against auditors under the SEA ‘34 relate to either what 2 sections?
- Section 10(b)
- Section 18
Summarize SEA ‘34 Section 10(b).
- Antifraud provision
- Protects purchasers and sellers of securities from manipulation and deception by an auditor or any other person
Summarize SEA ‘34 Rule 10b-5.
- Antifraud provision
- Protects purchasers and sellers of securities from manipulation and deception by an auditor or any other person
Summarize SEA ‘34 Section 18.
- Disclosure provision
- Protects purchasers and sellers from false and misleading statements
What is the rule of Daubert?
The Daubert standard provides a rule of evidence regarding the admissibility of expert witnesses’ testimony during United States federal legal proceedings
What is the origin of the rule of Daubert?
- Derives from Daubert v. Merrell Dow Pharmaceuticals
What happened in Daubert v. Merrell Dow Pharmaceuticals?
- Judge threw out expert testimony b/c he reached unsound conclusion based on unsound “methodological reliability”
AICPA Statement on Standards for Consulting Services
What are general standards that the AICPA requires of auditors to follow?
- Professional competence
- Due professional care
- Planning and supervision
- Sufficient relevant data
AICPA Statement on Standards for Consulting Services
What are additional standards (peculiar to consulting/litigation services) that the AICPA requires of auditors to follow?
- Client interest (“accomplish objectives…while maintaining integrity and objectivity”)
- Understanding w/ client (“establish written or oral understanding”)
- Communication with client (“inform client of conflicts of interest, significant reservations concerning scope or benefits of the engagement, significant engagement findings”)
What does Rule 702 govern?
Governs testimony of experts
In reference to Rule 702, how can auditors satisfy the “sufficient fact,” “reliable principles,” and “reliability applied” standards”?
- Take selected F/S accounts
- Lay out key audit procedures next to accounts
- Lay out assertion auditor trying to get at
- Lay out selected evidence (w/p with Bates stamps)
- Need to establish methodological reliability at the end
What are the four components of the testimony pyramid?
1) Source Data, Facts & Assumptions
2) Data Reliability Tests and Analysis
3) Accepted Methodology, Reliability Applied
4) Admissible Opinions
In answering the question “how do market cap declines map to rule 10b-5 damages,” what is a major case we reference?
Case of Oracle Systems Corp.
What is regulation S-X?
SEC’s accounting interpretation of securities laws
In the case of Oracle, what happened on March 27, 1990?
- Oracle announce 3Q1990 earnings of $0.18 per share
- Equal to earnings in 3Q1989
- Due in part to an accounting glitch
- Missed earnings forecast of $0.25
In the case of Oracle, what was the market’s reaction on March 28, 1990 to Oracle’s neg. announcement the day before?
- 28% stock price decline at opening bell
- 31% decline at closing bell
- Record NASDAQ daily volume of 21 million shares
A week after Oracle’s neg. announcement, what happened?
- Investors filed 10b-5 class actions and derivative suits
- Complaint was that Oracle inflated prior reported revenues and earnings
- Defendants were Oracle, managers, and auditors
In the Oracle 10b-5 class actions and derivative suits, what was the key question?
What is the extent of damage?
To estimate the extent of damages in the Oracle case, what are two approaches you can take?
1) Wait for a correction
2) Consensus earnings estimate
To estimate the extent of damages in the Oracle case, what is the rationale behind waiting for a correction?
- Informed investors will correct price to equilibrium
To estimate the extent of damages in the Oracle case, how long would it take to wait for a correction?
- Heavily traded stocks: a few days (Oracle)
- Thinly traded stocks: a few weeks
- 3/28/90 dropped from $25.375 to $17.50
- 3/29 to 4/2/90 recovered to $19
- 8.6% gain
To estimate the extent of damages in the Oracle case, how would you calculate the crash component and the true value if you waited for a correction?
“Wait for a Correction”
- Crash Component = (Recovery price per share less crash price) * shares outstanding
- True Value = Recovery price per share * shares outstanding
To estimate the extent of damages in the Oracle case, what is the rationale behind using consensus earnings estimates?
- Informed financial analysts will estimate equilibrium earnings (estimate = analysts expected earnings * PE ratio)
What was the estimated value of the Oracle stock using the consensus earnings estimate approach?
- 25 analysts median earnings forecast = $0.92
- Times 7 competitors avg PE ratio = $20.94
- Equals estimated value of stock of $19.26
To estimate the extent of damages in the Oracle case, how would you calculate the crash component and the true value if you followed the consensus earnings estimate approach?
“Consensus Earnings Estimate”
- Crash Component = (estimated value less crash price) * shares outstanding
- True Value = estimated value * shares outstanding
What method did the plaintiffs invoke in the Oracle case?
- Backwards induction
What is backwards induction?
- To est. damages as the difference between the true value and the inflated value
What do we call the difference b/w the true value and the inflated value?
- Inflation band
Define true value.
Share price “with” fully revealed accounting info
Define inflated value.
Share price “absent” fully revealed accounting info
In the Oracle case, what was the key question that the defendant’s attorneys asked?
Is this a reasonable measure of the inflation band?
What is the problem with backward induction?
Market reaction to the news too extreme (does not reflect actual company value)
What is the cause of inflation band overstatements?
- The share price following the announcement P(c) carries extraneous info that is unrelated to true value
How would one calculate true value?
- True value = P(c) + Crash Component
where P(c) is the post announcement market price
In answering the question “how do GAAP violations map to rule 10b-5 actions and negotiated damage settlements,” what is a major case we reference?
Case of Waste Management
In the 1960s, who handled waste disposal prior to Waste Management coming onto the scene?
- Local companies
In evaluating Waste Management, what were the three things analysts focused on?
1) Inorganic pop to environmental liabilities
2) Inorganic pop to revenue
3) Inorganic pop to earnings
How was WM able to pop revenue and earnings in its earlier years?
- Revenues and earnings popped every year due to rollups and acquisitions (stock acquisitions so no CF to be taxed)
What were the four economic shocks in the waste disposal industry?
1) 1994 US Supreme Court decision
2) National Hazardous Waste Market
3) National Low Level Radioactive Waste Market
4) US Trash Recycling
Expand on the 1995 US Supreme Court decision that shocked the waste disposal industry.
- outlawed municipal flow control laws
- municipalities can’t designate within border dump cites
- decision increased average load travels
- national per/ton dump price decreased from $85.25 in ‘88 to $36.48 in ‘98
How did WM respond to the shock of the 1995 US Supreme Court Decision?
- Tried to convert this economic shock to an adverse influence
- Attempted to hedge by getting into 3 other industries
Expand on the following economic shock to the waste disposal industry:
National Hazardous Waste Market
- relaxed hazardous waste definitions/clean up regulations
- improved technologies
- effect on industry was 5% decline in revenues from ‘93’-‘98
Expand on the following economic shock to the waste disposal industry:
National Low Level Radioactive Waste Market
- improved process and compaction technologies
- effect on industry was 14% decline in revenues from ‘93-‘98
Expand on the following economic shock to the waste disposal industry:
US Trash Recycling
- US Trash Recycling gained market share
Give two examples of how WM responded to the economic shocks to the waste disposal industry.
1) Geography: the netting issue
- netted gains on disposal of discontinued (e.g. Modulaire) operations against exposure on under-accrued reserves (e.g. environmental liabilities)
2) Reversal of field entries (250 profit centers) at corporate
- increased salvage values on trucks
- increased useful lives on containers
What did WM announce on 10/10/97?
- Announced that 3Q1997 results will not meet analyst expectations
What happened on 10/30/97 and what was the impact on WM’s market cap?
- WM announced that Ronald LeMay, Chairman & CEO resigned
- $5billion market cap decline
In the WM case, what were the plaintiff’s likely to cite from analysts’ reports?
- WM operated outside of GAAP (Smith Barney)
In the WM case, where were the defendant’s likely to cite from analysts’ reports?
- ROE is actually higher (CS First Boston)
- Limited CF effect (<$25million) (Merrill Lynch, CS First Boston, Salomon)
In an effort to remove “crash components” from plaintiff’s damage estimates and, more importantly, from jury awards, the 1995 Private Securities Litigation Reform act imposes what?
- Imposes a 90-day “lookback” period that imposes the period which true value is to be calculated:
“…the mean trading price of that security during the 90 day period beginning on the date on which the info correcting the misstatement or omission that is the basis for the action is disseminated to the market.”
In answering the question “how do GAAS violations map to rule 10b-5 actions,” what is a major case we reference?
Case of Datronic Equipment Income Funds
How did PwC win in the Datronic Funds case?
PwC argument
- Client violated partnership agreement so there should be a liability on the right hand side of B/S (related to damages of people who would sue) but there wasn’t
- PwC demoed that a loss was not “reasonably probable” meaning there shouldn’t be a footnote in which case no liability either
Expand on the deposition testimony
- Objective is to find inconsistencies in the deposition
- Person being deposed volunteers no information (say the bare minimum)
What does the auditor need to display in the cross examination?
- Need to display seamless behavior
- Need to show you are trying to help the other side understand
- Demo cooperation
- Impart onto jury that this stuff is simple
What does the court master do?
- Reads all docs and goes to trial as consultant to judge
Do non-public clients typically sue under common law or statutory law?
Common law
Do public clients typically sue under common law or statutory law?
Statutory law
What does RICO stand for?
Racketeer Influence Corrupt Organizations Act of 1970
One of the issues in litigation support services is business valuation. Give an example of a case related to business valuation. Expand.
- Case: Tyson and IBP
- Tyson acquired IBP then found MAC (material adverse change)
- IBP had overstated its value using a subsidiary, DFG
- Delaware court ruled for a clawback on the purchase price (revalued DFG and Tyson only had to pay new valuation)
One of the issues in litigation support services is forensic accounting. Give an example of a case related to forensic accounting. Expand.
- Case: Cablevision and Dish Network
- CV and Dish entered joint venture to broadcast CV shows in foreign countries
- Dish paid CV a bundled fee per subscriber
- CV was supposed to spend $500M on a satellite for Dish
- Dish realized it was overpaying and wanted to exit the contract, claiming CV hadn’t spend $ on satellite
- Came down to how/where overhead was charge
- CV settled fro $1.667B
One of the issues in litigation support services is damage calculations. What is a prominent case related to damage calculations?
Oracle Systems Corp.
One of the issues in litigation support services is accounting principles (GAAP). What is a prominent case related to accounting principles (GAAP)?
Waste Management
One of the issues in litigation support services is auditor performance (GAAS). What is a prominent case related to auditor performance (GAAS)?
Datronics Income Funds
What is the goal of mediation?
- Initially saber rattling
- Goal is to ID accounting holes to prevent a court battle
What are the two parts of a trial testimony?
- Direct Testimony
- Cross Examination
What happens during the direct testimony?
- Questioned by own side
friendly, know all questions beforehand
What happens during the cross-examination?
- Questioned by opposition
- Goal is to show seamless behavior, show you are trying to explain and cooperate
What would happen to you in court if you were an expert witness and you testified without methodological reliability?
Daubertized
In the WM case, what was the beginning point of the trough and the ending point of the trough?
- Beg. 10/30/97 when WM announces that Ronald LeMay, Chairman & CEO, resigns
- End 2/24/98 when WM releases restated ‘92-‘97 financial statements
What was the largest restatement of all time?
WM (2/3 of balance sheet was written off on 2/24/98)
What was WM management’s explanation to their restatement?
Rationalization part of Fraud Triangle:
1) Challenges to maintaining rapid growth and expanding into new markets
2) Overly optimistic expectations that drove aggressive accounting
3) By far, industry’s most aggressive depreciation accounting
* BOTTOM LINE: could not justify any accounting methods so they just explained why they did it
What was the ultimate ruling in the WM case in response to the defendant’s argument for using the date of restatement over the date of the CEO’s resignation to calculate damages?
- Stock price only increased b/c WM was bought by another company
- Ruling: market didn’t care about the restatement, just the CEO’s resignation ($5B market cap decline)
What did Datronics do?
- Datronics acquired and leased high- and low- tech equipment, particularly in heavily populated states (CA, IL, FL)
What was stated in the Datronics Funds’ partnership agreements?
- People invested in their funds and the partnership agreement stated that investors would get audit opinion and a “special report” about expenses every year
- No one ever got the expense report though
In the Datronics case, what did the General Partner do?
- Embezzled $24M
- Company couldn’t pay its expenses in a period and went bankrupt
In the Datronics case, who did the investors sue?
- Sued PwC auditors stating they never got the special expense report per the partnership agreement
What is the theory of the Datronics case?
Defend what you did, not what you didn’t do
What happened in the case of General Mills? Were they guilty of anything?
- SEC attempted to take action against an innocent public co. (very difficult to prove you didn’t do something)
How does General Mills management see the company?
- Nothing to do with accounting:
1) 3 Temperature Channels
2) MEQs: Millions of Equivalent Cases Shipped
3) Trade Spending (20% of gross revenues)
What were General Mills’ three temperature channels?
1) Frozen (e.g. ice cream)
2) Refrigerated (e.g. Pillsbury)
3) Dry (e.g. cereal)
Of General Mills’ three temperature channels, which had the higher margin?
- Higher margin on refrigerated
- Highest margin for dry products
- B/c less packaging required and lower moving and storage costs as you moved from frozen to refrigerated to dry
What are MEQs?
- Millions of Equivalent Cases shipped
- Metric to predict revenues, equalizes products
- Reports distributed to top of co. every morning about MEQs
What did the SEC allege General Mills of?
- “Loading” …the shipment by General Mills of product to customers…ahead of current reporting period consumption or demand
What was the result of the General Mills investigation?
- Commissioners voted NOT to take action b/c GM complies with industry standards for disclosures
- GM channel stuffs and tells the public it is part of the business model and makes products cheaper for consumers
