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Practice Points

September 28, 2016

Illinois Supreme Court Affirms Accountant, Not Client, Is Holder of Privilege

In 2015, the Illinois Supreme Court revisited the issue of who holds the privilege over materials that are covered by the accountant’s privilege. In Illinois, the accountant’s privilege is a creation of statute that states “[a] licensed CPA shall not be required by any court to divulge information or evidence which has been obtained by him in his confidential capacity as a licensed or registered CPA.” 225 ILCS 450/27. In Brunton v. Kruger, the Illinois Supreme Court confirmed that the accountant is the holder of the privilege, rather than his or her client. 32 N.E.2d 567, 576 (Ill. 2015).

This decision has a significant impact on malpractice suits brought against accountants by their clients. Generally, the plaintiff will want access to all of the accountant’s work papers and provide them to their expert for the expert to render an opinion on whether the standard of care was breached. While it’s possible that these papers are unnecessary for the expert to render an opinion, it would be easier—and more compelling—if they had access to all of the accounting documents. Now, in Illinois, the accountant can claim the privilege and withhold production of their work papers as long as an exception does not apply. Thus, Brunton can serve as a shield from the production of highly relevant information in accounting-malpractice actions. Notably, in the context of actions based on failing to adequately perform an audit, the privilege would apply to all work papers of the accountant.

The operative inquiry to determine whether the privilege covers a given document or communication is whether the accountant obtained the information or evidence in his or her confidential capacity. The statute does not put any limitation on the scope of the materials that are covered by the privilege, whether they be work papers, communications, or other materials. Prior case law has only created two exceptions to this rule: (1) documents relating to the preparation of a client’s tax returns; or (2) information provided to an accountant relating the current or final account of a probate court proceeding. See in re 1985 Grand Jury No. 746, 530 N.E.2d 453 (Ill. 1988); In re Estate of Berger, 520 N.E.2d 690 (Ill. App. Ct. 1987). If neither of these exceptions applies, and the information was obtained in his or her confidential capacity as a licensed accountant, then the accountant can claim the privilege.

Keywords: professional services liability litigation, accounting malpractice, accountant’s privilege, discovery

Alexander I. Passo, Patterson Law Firm, LLC, Chicago, IL


September 28, 2016

Effectively Handling Experts

In nearly all accounting and legal-malpractice actions, the retention of an expert is necessary. Consequently, counsel should begin their search for a potential expert nearly at the outset in these types of cases. However, before retaining an expert, it is critical to perform adequate due diligence on the potential expert’s credentials and testimonial history. After retention, counsel should tread lightly when communicating about the case with the expert. Otherwise, these communications can potentially be discovered by opposing counsel and used to attack the credibility of the expert’s opinion.

  • Vetting: Before disclosing any information to the expert, a conflict check should be performed. After clearance, ask the expert whether he or she has ever been disqualified in a matter either by conflict or by Daubert challenge. Obtain the expert’s CV and inquire about the result of each matter that the expert was retained in as an expert and provided testimony. Avoid retaining an expert whose past retention in matters indicates a bias. Review the articles the expert has authored in the past to determine whether any of them run contrary to the position in your matter. When interviewing the expert, evaluate whether he or she communicates well and is persuasive.
  • File Review: After retaining the expert, send the expert the entire case file (excluding attorney-client information and work product). If you provide the expert an incomplete file to review for the purpose of rendering an opinion, you risk a cross-examination focused on an incomplete review by the expert of all the facts while the expert was rendering its opinion.
  • Neutral Written Communications: Refrain from drafting any emails or letters in which you make conclusory statements about the legal issues or facts in the case. These communications in some jurisdictions are discoverable. By using neutral language, you will eliminate the risk that your conclusions compromised the expert’s independent judgment. Moreover, it eliminates the possibility of violating your state analog of Model Rule of Professional Conduct 3.4(b), which prohibits attorneys from counseling or assisting a witness to testify falsely.
  • Protect Draft Reports: The Federal Rules of Civil Procedure currently shield draft expert reports from discovery by characterizing the drafts as work product. However, there are three exceptions, which are: (1) compensation of the expert; (2) facts or data that the attorney provided the expert and from which the expert considered when forming its opinion; or (3) assumptions the attorney provided the expert from which the expert relied upon when forming its opinion. Fed. R. Civ. Pro. 26(b)(4)(B)–(C). Tread lightly when communicating with experts in relation to their draft reports, and refrain from assisting your expert in editing. If you extensively assist in the drafting of the report, you risk your communications with the expert being discoverable. See Gerke v. Travelers Cas. Ins. Co., 289 F.R.D. 316 (D. Org. 2013) (“Communications between a lawyer and the lawyer’s testifying expert are subject to discovery when the record reveals the lawyer may have commandeered the expert’s function or used the expert as a conduit for his or her own theories.”); see also, U.S. ex rel. Wall v. Vista Hospice Care, No. 3:07-cv-604-M, 2016 U.S. Dist. LEXIS 99480 (N.D. Tex. Mar. 22, 2016) (Ordering production of any portions of draft expert reports authored by counsel); Bingham v. Baycare Health Sys., No. 8:14-cv-73-T-23JSS, 2016 U.S. Dist. LEXIS 127933 (M.D. Fla. Sept. 20, 2016). Gerke technicallypredates the amendment of Rule 26 that shields expert drafts from discovery, and since then, courts have declined to follow its holding. See U.S. CFTC v. Newell, 301 F.R.D. 348 (N.D. Ill. 2014). Nevertheless, the law on this issue is unclear and it would be prudent to avoid assisting experts in drafting their reports.

Keywords: professional services liability litigation, experts, discovery, work product privilege

Alexander I. Passo, Patterson Law Firm, LLC, Chicago, IL


June 30, 2016

SEC Renews Focus on Non-GAAP Financial Measures

In periodic reports filed with the Securities Exchange Commission (SEC), companies may elect to supplement their publicly disclosed financial measures prepared using Generally Accepted Accounting Principles (GAAP) with other non-GAAP measures that a company believes will better inform investors of the company’s performance. The SEC has signaled in the past few months a keen interest in policing the use of non-GAAP financial measures. In a December 2015 speech, SEC Chair Mary Jo White acknowledged the value of non-GAAP measures but emphasized that the topic “deserves close attention, both to make sure that our current rules are being followed and to ask whether they are sufficiently robust in light of current market practices.” Mary Jo White, Keynote Address at the 2015 AICPA National Conference: “Maintaining High‑Quality, Reliable Financial Reporting: A Shared and Weighty Responsibility” (Dec. 9, 2015). Following Chair White’s speech, the agency released in May 2016 new Compliance & Disclosure Interpretations (C&DIs) revising and clarifying the agency’s interpretations of the rules and regulations governing the use of non-GAAP financial measures.

As defined by SEC regulations, a non-GAAP financial measure is a numerical measure of a company’s historical or future financial performance, financial position, or cash flows that includes or excludes amounts from the most directly comparable GAAP measure. See Regulation G, 17 C.F.R. § 244.101(a)(1). Although non-GAAP measures may in certain circumstances better educate investors of a company’s true value, the SEC grew concerned about the potential for abuse and thus adopted Regulation G in 2003 to regulate the use of these measures.

Under Regulation G, which the SEC adopted as part of its implementation of the Sarbanes-Oxley Act, registered companies that publicly release non-GAAP measures must include a presentation of (1) the most directly comparable GAAP financial measure, and (2) a reconciliation of the differences between the non-GAAP measures released with the comparable GAAP measure. See id. § 244.100(a). Regulation G applies to all non-GAAP financial measures that are publicly disclosed in print, orally, telephonically, by webcast or broadcast, or through other similar means. Additionally, in filings before the SEC, registered companies must include, among other things, statements (1) explaining the reasons why the company believes its use of non-GAAP measure provides useful information to investors, and (2) disclosing the additional purposes for which the company uses the non-GAAP measures. See Regulation S‑K, 17 C.F.R. § 229.10(e)(1)(i)(C)–(D).

The SEC’s new May 2016 C&DIs add to this regulatory framework by providing, among other things, additional guidance on the prominence that may be attached to non-GAAP measures relative to comparable GAAP measures. The C&DIs provide specific illustrations of disclosures that would cause a non-GAAP measure to be more prominent than a comparable GAAP measure. For instance, the SEC made clear in the C&DIs that it would consider a non-GAAP measure more prominent, and therefore in violation of SEC regulations, where the company omits comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures, or where the company presents a non-GAAP measure using a style of presentation that emphasizes the non-GAAP measure over the GAAP measure.

In her December 2016 speech, Chair White cautioned companies that use non-GAAP measures to consider questions such as:

Why are you using the non-GAAP measure, and how does it provide investors with useful information? Are you giving non-GAAP measures no greater prominence than the GAAP measures, as required under the rules? Are your explanations of how you are using the non-GAAP measures—and why they are useful for your investors—accurate and complete, drafted without boilerplate? Are there appropriate controls over the calculation of non-GAAP measures?

In light of the SEC’s focus on non-GAAP measures and the likelihood of future enforcement actions, companies should give serious consideration to the questions raised by Chair White and review the new C&DIs to ensure compliance. Companies should take note of the enforcement risks associated with the use of non-GAAP measures, as the SEC’s attention to non-GAAP measures may have significant implications for directors of public companies. In particular, in the same December 2016 speech, Chair White singled out members of audit committees, admonishing them to “take seriously their reporting to shareholders, a critical responsibility on which the SEC is closely focused,” and to be vigilant in “adequately review[ing] how management . . . is using non-GAAP measures.”


June 30, 2016

The Second Circuit Clarifies Liability Standard for Audit Opinions

The Second Circuit’s recent decision in In re Puda Coal Securities Inc. Litigation, No. 15-2100 (2d Cir. May 20, 2016), clarified an important question regarding auditors’ liability in applying Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 135 S. Ct. 1318 (2015), the Supreme Court’s decision limiting the circumstances in which a statement of opinion can be actionable under section 11 of the Securities Act of 1933. The first question courts applying Omnicare must confront is whether or not the statements at issue are statements of opinion or are statements of fact. In Puda, the Second Circuit summarily affirmed the district court’s decision recognizing that auditors’ reports are statements of opinion, not statements of fact that would subject auditors to liability under the Securities Act of 1933 or the Securities Exchange Act of 1934. Under Omnicare, such statements of opinion are actionable only if there is evidence the auditor provided an audit opinion it did not believe or that contains a misleading statement of fact or omits material facts.

Puda Coal Inc. was a coal company based in China and publicly traded in the United States. The company conducted its operations exclusively through Shanxi Puda Coal Group Co., 90 percent of which was indirectly owned by Puda. In 2009, Puda’s chairman Ming Zhao, and his brother Yao Zhao, orchestrated the fraudulent transfer of Puda’s entire interest in Shanxi to Ming Zhao personally, which left Puda without any revenue-generating assets. They further arranged for the transfer of 49 percent of the ownership of Shanxi to a state-owned private equity fund. Although the transfers were reflected in shareholder meeting minutes and reported to the Chinese government, Puda’s financial statements for 2009 and 2010 continued to show that Puda maintained a 90 percent interest in Shanxi.

Puda’s auditing firm, Moore Stephens Hong Kong, audited Puda’s 2009 and 2010 financial statements, providing unqualified audit opinions. Moore Stephens and the investors in Puda did not discover the Zhao brothers’ scheme until 2011 when a research report revealed the fraudulent transfers. Puda investors filed a securities class action claiming that, in providing unqualified audit reports on Puda’s financial statements, Moore Stephens violated section 11 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934. Section 11 imposes liability for parts of a registration statement prepared by an expert, such as an auditor’s report, but does not require scienter. Section 10(b) and the related Rule 10b-5 prohibit making an untrue statement of material fact or omitting a material fact necessary to make the statement not misleading in connection with the purchase or sale of a security. Unlike section 11, a plaintiff who brings a claim under section 10(b) must allege scienter.

In granting summary judgment to Moore Stephens, U.S. District Court Judge Katherine B. Forrest concluded that Omnicare applied to both a section 10(b) and section 11 claim, and that to be actionable the opinion statements in question must be both objectively and subjectively false; the statements must not only be false at the time they were made, the auditor must also not honestly believe the statements. According to the district court, “audit statements, such as the clean audit opinions presented by the Auditors in this case, are statements of opinion to which the subjective falsity requirement applies.” In re Puda Coal Sec. Inc., Litig., 30 F. Supp. 3d 230, 259 (S.D.N.Y. 2014). Finding no evidence that Moore Stephens disbelieved its own audit opinions, the court had little trouble ruling against the plaintiffs. The Second Circuit agreed. The panel made clear that “[a]udit reports, labeled ‘opinions’ and involving considerable subjective judgment, are statements of opinion” and subject to the Omnicare standard.

In re Puda Coal Securities Inc. Litigation builds on Omnicare to provide attorneys representing auditors a clear tool with which to defend against section 10 or section 11 claims predicated on alleged false statements contained in audit reports. Conclusory allegations that an audit opinion turned out to be wrong are not sufficient. Absent sufficient factual allegations that reasonably call into question that an auditor knew the statements were false, disbelieved their own opinions, or omitted material facts, such claims are unlikely to survive scrutiny.

Keywords: auditor liability, audit reports, false statements, statements of opinion, Omnicare, Section 10(b), Section 11

James Thomas, Arthur Luk, and Said Saba, Arnold & Porter, Washington, D.C.


March 31, 2016

Administrative Errors Are Legal-Malpractice Traps for the Unwary

Missing deadlines, drafting errors, and failing to know or apply substantive law are not the only mistakes that give rise to legal-malpractice claims. Administrative errors, seemingly innocuous at the time made, can have disastrous legal-malpractice consequences. Not only can these administrative errors give rise to claims in and of themselves, they can also muddy the facts, giving credence to what would otherwise be meritless claims.

Sloppy intake procedures often give rise to claims arising from conflicts of interest. For example, if the client is not defined or is inaccurately defined, a future conflicts search may not detect the problem. Similarly, if adverse parties are not identified, conflicts search will be incomplete. Many attorneys forget to update their intake memoranda when parties are added to an ongoing litigation matter—leaving open the possibility that such parties will not show up on future conflicts-search reports.

Other intake problems arise when the file-opening documents do not include evidence that a conflict check was performed. Should a conflict of interest later arise, plaintiff’s counsel will likely exploit the lack of documentation by suggesting to the jury that the attorney failed to perform the check because he or she knew one existed, and simply took the matter anyway, the clients’ rights be damned. Even if untrue, jurors expect attorneys to document their files, and the lack of documentation of a conflicts check may be detrimental to the law firm’s case.

Likewise, while the Model Rules do not require attorneys to send engagement letters, doing so is certainly a best practice. When sent, however, they must be done properly. They must clearly define the scope of the engagement, as well as matters that our outside the scope of the engagement. They must also clearly identify the clients, and, when appropriate, non-clients. They must also have consistent and complete statements concerning any conflict waivers to which the parties have agreed.

Moreover, once sent, it is imperative that attorneys remember to update and amend engagement letters as the matter progresses to the extent the scope of representation changes. Failing to do so gives a plaintiff’s attorney room to argue that the attorney expanded the scope of engagement as to a second matter without documenting it; therefore, the lack of an engagement agreement for matter three does not have any bearing on whether an attorney-client relationship did, in fact, exist for matter three.

Anytime a non-client exhibits any conduct that suggests he or she may believe an attorney is representing the non-client’s interests, the attorney must immediately disabuse the non-client of any such notion. That communication should be in writing. Even if others are witnesses to such communications, jurors expect lawyers to document important communications. The lack of a writing can be detrimental to any defense based on an attorney’s disavowal of an attorney-client relationship.

Billing issues also may give rise to numerous legal-malpractice claims. For example, when a non-client pays the bill of a client, and the firm accepts the payment without disclaimer, the non-client may have a basis to argue that it believed it had an attorney-client relationship with the attorney. Likewise, when an attorney represents one corporate entity, but in narrative billing entries references “conference call with clients” as shorthand for “conference call with Mr. White, CEO, and Mr. Black, EVP,” he leaves open the possibility that Messrs. White and Black could claim that the attorney was representing the interests of them, as opposed to the corporate entity. Similarly, references to work outside the scope of the engagement, such as “advise client re financial issues,” “advise client re potential tax implications,” or “advise client re business matter,” can expand the scope of the lawyers’ representation to matters typically falling outside the attorney’s responsibility.

Finally, the failure to send a letter terminating representation at the conclusion of representation can give rise to future disputes as to whether the attorney’s duties to the client to address future issues had ceased. Similarly, later actions and statements that are inconsistent with the termination of the representation can re-commence the attorney’s duty to protect the client’s interests.

Due to these risks, attorneys should ensure that administrative matters are given sufficient attention and consideration to prevent minor errors from snowballing into major legal-malpractice claims.

Keywords: litigation, professional services liability, attorney liability, legal malpractice, administrative errors, billing errors, engagement letters, intake procedures

Carey L. Menasco, Liskow & Lewis, APLC, New Orleans, LA


March 31, 2016

Best Practices for Avoiding Attorney Liability to Non-Clients

Traditionally, the attorney-client relationship requires an express agreement between the attorney and client. However, an attorney-client relationship may be inferred or implied from the “totality of the circumstances,” including a course of conduct, communications between the parties, and a putative client’s reasonable expectations. Therefore, when an attorney deals with a non-represented party, an attorney-client relationship can arise without the attorney’s knowledge, intent, or consent. In those circumstances, the attorney often is not representing the interests of that party, and very well may be taking actions that are contrary tothat party’s interests. Such situations are rife with legal-malpractice exposure.

The risk of developing an unintended attorney-client relationship occurs most frequently in transactional matters, where one party has counsel and the other does not. The other party may believe he or she does not need counsel because his or her interests are similarly aligned. Other risk factors include circumstances where a non-client will derive benefits from the contemplated transaction, such as working-interest owners or joint-venture partners. Likewise, unintended attorney-client relationships can arise when there is a lack of clarity concerning whether the attorney represents an entity or its managers or constituents.

Any doubt concerning the existence of an attorney-client relationship will likely be resolved in favor of the putative client. Defending such matters can be particularly difficult, because if the jury finds an attorney-client relationship, the attorney then, by definition, was acting with a conflict of interest—by preferring the interests of one client over another. Jurors are often incensed by attorneys who act with a conflict of interest, and in some cases, have significantly inflated damage awards due to their outrage.

There are several measures an attorney can and should take to prevent unintended attorney-client relationships. They include:

1. The Engagement Letter. This document, delivered at the outset of the relationship, should define who the attorney represents, and, when necessary, who the attorney does not represent. In the case of the entity representation, Rule 1.13(f) of the Model Rules of Professional Conduct requires the attorney to make clear that he or she represents the organization rather than its agents or employees, when their interests diverge. While such a letter probably will not be shared with non-clients, it provides contemporaneous documentation of who the lawyer intended and understood his or her client to be.

2. The Declination Letter. When an attorney turns down a representation, or the potential client decides not to hire the attorney, the attorney should send a letter confirming that the attorney has not accepted any responsibility for the matter. Nonetheless, the attorney may need to advise the non-client of any pending deadlines or limitations issues in that same letter.

3. The Disengagement Letter. At the end of an attorney-client relationship, the attorney should send a letter confirming that the matter has been concluded and the attorney no longer has responsibility for protecting the client’s interests in future matters.

4. The “I Am Not Your Lawyer” Letter. If at any time a non-client says something or takes action that suggests he or she may believe that he or she has an attorney-client relationship, the attorney should immediately advise the non-client in writing that the non-client is mistaken. Contemporaneous written communications are the best policy, and can head off future disputes and uncertainties. Attorneys should take extra caution when communicating with unrepresented non-clients, and send “I Am Not Your Lawyer” letters whenever there is any chance that the non-represented party may have some misunderstanding concerning the attorneys’ duties and obligations.

The above-described communications do not have to be adversarial or unpleasant. In fact, they can be short and polite statements, provided they make clear that the attorney represents only the interests of the client, and not the non-client. Attorneys should use the protective measures described above consistently in their practices.

Keywords: litigation, professional services liability, attorney liability, non-clients, legal malpractice

Carey L. Menasco, Liskow & Lewis, APLC, New Orleans, LA


December 30, 2015

PCAOB Adopts Rules Requiring New Disclosures for Audit Firms

Beginning in 2017, accounting firms participating in audits of issuers will be required to make additional disclosures, according to new rules released by the Public Company Accounting Oversight Board (PCAOB) this month. Rules 3210 and 3211 will require public accounting firms to file Form AP for each issuer audit, which discloses both the name of the engagement partner and the level of participation of any other accounting firm that participated in the audit. This information will be available in a searchable database on the PCAOB’s website. According to the PCAOB, the new rules promote “transparency about the partner and firms involved” in issuer audits and will “provide more specific data points in the mix of information that can be used when evaluating audit quality and hence credibility of financial reporting.” See PCAOB, Release No. 2015-008, Improving the Transparency of Audits: Rules to Require Disclosure of Certain Audit Participants On a New PCAOB Form and Related Amendments to Auditing Standards 15 (Dec. 15, 2015); News Release, PCAOB, PCAOB Adopts Rules Requiring Disclosure of the Engagement Partner and Other Accounting Firms Participating in an Audit (Dec. 15, 2015).

Form AP
The new rules require public accounting firms to disclose for each issuer audit a Form AP that provides two types of information previously not made publicly available:

1. the name of the engagement partner, and

2. the participation in an audit of any “other accounting firms” (defined as any registered public accounting firm other than the firm filing the Form AP or any other person or entity that opines on the compliance of any entity’s financial statements within an applicable financial reporting framework)

With respect to “other accounting firms,” the rules require varying amounts of information depending on the degree to which the other firms participated in the audit. For any other accounting firm participating in five percent or more of an audit’s total hours, the responsible firm must disclose the name, city, state, and/or country of the other accounting firm, and the percentage of total hours attributable to that firm. For other accounting firms contributing participation of less than five percent of an audit’s total hours, the responsible firm must only disclose the total number of those other accounting firms and the aggregate percentage of total audit hours contributed by those other accounting firms.

Deadlines for filing the new Form AP are triggered by the date an auditor’s report is first included in a document filed with the Securities Exchange Commission. Typically, an accounting firm will have 35 days before the Form AP disclosures must be filed. In the case of initial public offerings, disclosures must be made within 10 days after the auditor’s report is first included in a document filed with the SEC.

Disclosure of the names of individual engagement partners will become effective for auditor’s reports issued on or after January 31, 2017, or three months after SEC approval of the final rules, whichever is later, and disclosure of other accounting firms will apply to auditor’s reports issued on or after June 30, 2017.

As the PCAOB noted in its rulemaking release, during the six-year development of the PCAOB’s new rules, some commenters raised concerns that requiring disclosure of the names of engagement partners would subject engagement partners to increased liability under the federal securities laws.

For example, section 11 of the Securities Act imposes liability on participants in a securities offering, including accountants, who are named as having prepared or certified any part of a registration statement or a report used in connection with the registration statement. During the PCAOB’s rulemaking, some questioned whether requiring disclosure of the names of engagement partners would increase those individuals’ liability under section 11. The PCAOB believes that it addressed this concern by requiring disclosure in a separate form that is not automatically incorporated by reference in an auditor’s report, and thus not incorporated by reference into a registration statement. See PCAOB, Release No. 2015-008, at 31. Whether this separation limits liability, however, remains to be seen.

Moreover, the PCAOB’s rulemaking release recognizes that “commenters expressed mixed views on the potential for liability under Exchange Act Section 10(b),” the act’s anti-fraud provision, and Rule 10b-5 promulgated thereunder. The PCAOB’s rulemaking release acknowledges that “the ultimate resolution of Section 10(b) liability is outside of [the PCAOB’s] control.” In addition to risks of liability under the federal securities laws, there may be an increased likelihood of the named engagement partner or disclosed “other accounting firms” to be added as defendants in the context of accounting negligence actions.

Accordingly, attorneys advising public accounting firms and individual engagement partners should be aware of the potential issues that may arise as a result of the PCAOB’s new required disclosures. In particular, public accounting firms (and the attorneys advising them) should ensure their clients understand the requirements of the new rules and begin to put in place robust compliance procedures to meet those requirements, including procedures designed to enhance information flow with other participating accounting firms.

Keywords: professional services liability litigation, PCAOB, Form AP, accounting firm disclosures

James W. Thomas Jr., Arthur Luk, and Lindsay Vance Smith, Arnold & Porter LLP, Washington, D.C.


December 30, 2015

Recent SEC Enforcement Actions Reinforce Focus on Independence Violations

The SEC recently suspended two accounting firms and five accountants associated with those firms from practicing before the Securities Exchange Commission (SEC). According to the SEC’s orders instituting settled administrative proceedings, the firms and accountants, which consented to the orders without admitting or denying the SEC’s findings, violated or caused violations of federal securities laws and engaged in improper professional conduct because they performed deficient audits and sub-standard engagement quality reviews (EQRs), backdated and falsified audit documentation, and violated the SEC’s rules requiring independence of audit firms and PCAOB standards regarding EQRs. These actions reiterate the SEC’s ongoing focus on independence and confirm that audit firms should continue to closely analyze potential conflicts that could compromise the independence of their audits.

The enforcement actions involve two Florida-based accounting firms and their affiliated partners: Messineo & Co., a small firm that is majority owned by Peter Messineo, that merged briefly in 2012 with DKM Certified Public Accountants, Inc., another small firm owned in part by Charles Klein.

Before the merger, Messineo served as the CFO of two companies (identified in the orders as Issuer A and Issuer B) who were clients of DKM. Messineo also owned stock in the companies. Although Messineo resigned as CFO of the companies prior to the merger, both companies later retained DKM to conduct audits of their businesses for the time during which Messineo was CFO. The SEC found that Messineo “caused DKM not to be independent” because as “a partner and shareholder of DKM—[he] was the [former] CFO of Issuer A and Issuer B during the audit period and in a position to influence DKM’s audit and interim reviews.” Order at 14, In the Matter of Messineo, SEC Administrative Proceeding No. 3-16993 (Dec. 10, 2015). As a result, the SEC concluded that Messineo’s conduct violated Regulation S-X Rule 20-1(c)(2) concerning independence with respect to employment relationships.

The SEC found that Messineo and his firm further violated the independence rules by allowing an employee of Messineo & Co., Richard Confessore, to perform EQRs of audits conducted by DKM for Issuer A and Issuer B during the period Messineo was still CFO of those companies. Order, In the Matter of Richard Confessore, CPA, SEC Administrative Proceeding No. 3-16995; see also PCAOB Auditing Standard No. 7, Engagement Quality Review at ¶ 2 (explaining that the objective of an engagement quality reviewer “is to perform an evaluation of the significant judgments made by the engagement team and the related conclusions reached in forming the overall conclusion on the engagement”) and ¶ 6 (“The engagement quality reviewer must be independent of the company, perform the engagement quality review with integrity, and maintain objectivity in performing the review.”). In addition, Messineo supervised Confessore in performing an audit of another company, Issuer C, for the time period that Confessore had served as CFO of that company. The SEC also found two other Messineo employees engaged in improper professional conduct in violation of SEC Rule 102(e): (1) Joseph Mohr, who (a) falsely held himself out as a CPA despite having failed to renew his registration, and (b) backdated records of EQRs at the request of (2) firm senior accountant Robin Bigalke.

The SEC permanently barred Messineo and his firm from appearing or practicing before the SEC, and it suspended Mohr, Bigalke, and Confessore from appearing or practicing before the SEC for at least four, three, and two years, respectively.

Furthermore, the SEC found that Charles Klein, the DKM engagement partner for the audits of Issuer A and Issuer B, caused DKM to not be independent of Issuers A and B because of (i) Confessore’s employment by Messineo, (ii) Messineo’s role as the issuers’ CFO during the audit periods, and (iii) Klein’s knowledge that Messineo owned stock in the issuers. The SEC suspended DKM and Klein for at least two years.

The SEC’s enforcement actions reiterate its ongoing focus both on audit failures and on conduct that jeopardizes the independence of audits. Attorneys counseling firms auditing public companies should continue to advise rigorous attention to PCAOB standards and SEC independence rules, by, for example, ensuring the timely conduct of EQRs and adherence to restrictions on holding financial interests in audit clients to avoid conflicts that might give rise to similar enforcement actions. As these recent actions emphasize, closely held audit firms in smaller markets and their relationships with clients pose risks of impairing independence, particularly where there is lateral movement of partners between firms. In such situations, firms should analyze not only the current financial interest of new partners but also prior positions to avoid potential or apparent conflicts that might otherwise compromise the independence of the firm and subject the firm to SEC sanctions.

Keywords: professional services liability litigation, SEC, accounting, auditing, independence

James W. Thomas Jr., Arthur Luk, and Lindsay Vance Smith, Arnold & Porter LLP, Washington, D.C.


November 23, 2015

Know Your Bench Strength

While more seasoned lawyers may be sought out based on their individual reputation, younger attorneys will more often be known by association with their firm. Wherever your firm is well regarded, you will commonly be asked about your firm’s bench strength in a particular area of substantive law—and often, it will be a field completely unrelated to your practice area.

A typical comment will go something like this: “Oh, so you’re at Quarles & Brady? I’ve heard of them. Do they do any patent litigation?” How you answer this question could determine whether the next comment changes the subject or opens a client-development opportunity.

If you don’t know your firm’s bench strength, your answer will likely be vague or noncommittal—and therefore unhelpful. Answers such as “I think we do” or “I’d have to check our website” may make it appear as if you are unsure of the services your firm offers, uninformed about practice groups other than your own, or even uninterested in the broader work of your firm. And even if none of these is true, your questioner will walk away without the information she was looking for.

At the same time, many young lawyers fall into the opposite trap: over-committing. Resist the temptation to tout your firm’s excellence in every field under the sun. While such praise may be well deserved, offering it without knowing its accuracy could lead to client disappointment or worse down the road.

Instead, do the work necessary to respond to such questions from a position of knowledge and confidence:

  • Regularly review the portion of your firm’s website describing your firm’s general service areas and subspecialties.
  • Review communications from your marketing team describing recent firm successes across a variety of practice areas. (If your marketing team doesn’t produce such communications, encourage them to do so.)
  • Perhaps most importantly, find opportunities to get to know colleagues outside your practice group and talk to them about the work they’re doing. These personal connections will enhance your ability to describe various practice areas when asked.

The goal of these efforts is not to memorize every last subspecialty your firm offers—that would be impossible—but to have a working knowledge of your firm’s strengths. When you use this knowledge to cross-sell effectively, everybody wins.

Keywords: litigation, professional liability, marketing, bench strength, networking, cross-selling

James Goldschmidt, Quarles & Brady, LLP, Milwaukee, WI


November 23, 2015

Increase Your Exposure Through Community Involvement

At the outset of their careers, one challenge that lawyers face is achieving the name recognition that eventually will come with accomplishments in the legal sphere. In those early days, one of the best ways to increase your exposure—both to fellow attorneys and to potential clients—is through meaningful community involvement.

The first and best reason to be involved in your community is, of course, because it benefits those around you. But that doesn’t have to be a one-way street. Getting involved will also broaden the sphere of business and community leaders who interact with you personally. Many of your first client opportunities will come from those who know you first as a person, not as a lawyer, so diversifying those personal relationships is key.

One significant way to accomplish this is to seek a board position with a local non-profit organization. Such organizations are many and varied, spanning causes as diverse as literacy, hunger, poverty, the environment, cultural issues, and human rights. Regardless of whether your community is large or small, urban or suburban, all communities benefit from the presence of non-profits, and those non-profits will rarely turn down the enthusiasm of a bright young person who wants to help and brings legal skills to the table for free. Your fellow board members will come from varied backgrounds in business, education, philanthropy, and the arts, increasing your exposure to these elements of your community and their exposure to you.

Another excellent opportunity for community involvement is through your local bar associations, particularly at the city and federal district levels. These bar associations typically mirror larger ones at the state or national levels, but frequently provide younger attorneys with hands-on committee experience and even leadership positions early in their careers. Local bar associations also provide the most direct contact with local judges you are likely to receive outside the context of a litigated case. Most importantly, these associations invariably immerse their members in the most pressing legal issues facing the community.

Finally, most if not all communities have created opportunities for lawyers to offer pro bono legal assistance to populations in need. While these populations may vary from community to community and from institution to institution, all share the need for assistance that only your training and experience can provide. Whether you are a solo practitioner or employed by a major law firm, contributing pro bono service lifts up your community while elevating your legal skills and exposure in the process. For these reasons, even those at firms with robust internal pro bono programs should consider engaging with their community in this way.

In pursuing any or all of these forms of community involvement, you will find that your sense of fulfillment is primary, and any professional implications secondary. No other form of professional development is so effective and so enjoyable, too.

Keywords: litigation, professional liability, marketing, pro bono, community involvement, networking, cross-selling

James Goldschmidt, Quarles & Brady, LLP, Milwaukee, WI


August 31, 2015

Party in Privity Barred by Collateral Estoppel from Establishing Causation Element of Legal Malpractice Claim

Confirming the principle that a plaintiff should not get a second bite at the proverbial apple, an Ohio district court recently dismissed a plaintiff’s legal-malpractice action on grounds that it was barred by the prior decision in the underlying litigation under the doctrine of collateral estoppel. See Scherer v. Wiles, No. 2:12-cv-1101, 2015 U.S. Dist. LEXIS 96892 (S.D. Ohio July 24, 2015).

In Scherer, the plaintiff was one of several beneficiaries to a family trust. However, when the beneficiaries failed to provide the documents and information necessary to prepare a final trust accounting, the trustee filed suit against them. The beneficiaries counterclaimed against the trustee for breach of fiduciary duty, and the trustee responded with a claim against Scherer for conversion of trust assets.

During discovery, Scherer and the beneficiaries refused to produce documents and were held to be “in blatant violation of the discovery process.” In addition, Scherer’s attorney made improper objections during a deposition, and the court imposed discovery sanctions, including the exclusion of certain testimony pertaining to the trustee’s conversion claim against Scherer.

After trial in 2007, the court found that Scherer had in fact misappropriated $6.2 million of trust assets over seven years. The unauthorized transactions were the same transactions for which Scherer was barred from providing rebuttal evidence due to the discovery sanctions. The court therefore entered judgment against Scherer for $6.2 million. The court also dismissed Scherer and the beneficiaries’ counterclaims against the trustee challenging the trustee’s accounting.

On appeal, the appellate court upheld dismissal of Scherer’s counterclaim but remanded for trial of the other beneficiaries’ counterclaims. After trial in 2011, the court found the counterclaims meritless and confirmed the $6.2 million judgment against Scherer.

Thereafter, Scherer brought a legal-malpractice claim against his attorney in the trust case, alleging that the attorney’s negligence during the discovery process led to the discovery sanctions that precluded the testimony necessary to rebut the trustee’s conversion claim. The attorney argued that collateral estoppel barred Scherer from proving the causation element of his claims—i.e., that but for the attorney’s conduct, Scherer would have prevailed in the trust litigation.

In Ohio, collateral estoppel applies when: (1) the fact or issue was actually and directly litigated in the prior action; (2) the fact or issue was passed upon and determined by a court of competent jurisdiction; and (3) the party against whom collateral estoppel is asserted was a party in privity with a party to the prior action. Daubenmire v. City of Columbus, 507 F.3d 383, 389 (6th Cir. 2007).

The district court found that the mere fact that Scherer lost the underlying trial did not preclude him from relitigating the adverse judgment as part of the case-within-a-case component of his legal-malpractice claim. Rather, there was a question of fact concerning whether the attorney’s negligence contributed to the adverse judgment at trial.

Nevertheless, because the beneficiaries’ counterclaims (which were identical to Scherer’s) were tried and dismissed in 2011, and there was no argument that the malpractice of Scherer’s attorney could have negatively affected the factual or legal findings in that later proceeding, the facts and issues fully litigated in the 2011 trial had preclusive effect as to the causation element of Scherer’s malpractice claim. Thus, the court held that collateral estoppel barred the plaintiff “from arguing that but for [his attorney’s] negligence, he would have prevailed on his counterclaims or defeated the $6.2 million judgment.”

Even though Scherer was not a party to the 2011 action, the court expressly found that he was in privity with the other beneficiaries because he actively participated in that action and had a common interest in the outcome of that proceeding. The court noted that, under Ohio law, which applies a modern rule of privity, exact identity of the parties is not required. Instead, “[a]s a general matter, privity ‘is merely a word used to say that the relationship between the one who is a party on the record and another is close enough to include that other within the res judicata.’” Id. at *56 (citing Brown v. City of Dayton, 730 N.E.2d 958, 962 (Ohio 2000)). “[A] mutuality of interest, including identity of desired result,” can be sufficient for privity purposes. Id.

The Scherer decision, and others like it, confirms that collateral estoppel may be a viable defense to a legal malpractice claim when the underlying issues have been fully and fairly litigated. Further, in jurisdictions applying the modern rule of privity, collateral estoppel may extend to non-parties, provided that their interests are sufficiently aligned to parties in the underlying litigation.

Carey L. Menasco, Liskow & Lewis, APLC, New Orleans, LA


July 15, 2015

PCAOB Seeks Public Comment on 28 Proposed Indicators of Audit Quality

The Public Company Accounting Oversight Board (PCAOB) is seeking public comment on 28 quantitative factors for evaluating audit quality. The PCAOB views the proposal of the potential “audit quality indicators” as furthering the goal of “improv[ing] the ability of persons to evaluate the quality of audits in which they are involved or on which they rely and to enhance discussions among interested parties; use of the indicatory may also stimulate competition by audit firms based on quality.” PCAOB Release No. 2015-005, July 1, 2015, at 4. The PCAOB envisions that potential users of the quantitative information include audit committees, which are responsible for hiring and interacting with audit firms; investors, who make investment decisions based on audited financial statements and are sometimes asked to ratify the choice of an outside auditor; and regulators, who are responsible for enforcement and policy-making. The PCAOB anticipates that such quantitative data will provide a tool to evaluate the strengths and weaknesses of an audit process, help distinguish auditors from one another, and recognize and reward audit quality when it is present.

The 28 proposed audit quality indicators focus on audit professionals, audit process, and audit results. The information for 19 of the factors will come from audit firms themselves, while public sources or audit committee member surveys will provide the information for nine of the factors.

The proposed audit quality indicators are:

  • Staffing Leverage
  • Partner Workload
  • Manager and Staff Workload
  • Technical Accounting and Auditing Resources
  • Persons with Specialized Skill and Knowledge
  • Experience of Audit Personnel
  • Industry Expertise of Audit Personnel
  • Turnover of Audit Personnel
  • Amount of Audit Work Centralized at Service Centers
  • Training Hours per Audit Professional
  • Audit Hours and Risk Areas
  • Allocation of Audit Hours to Phases of the Audit
  • Results of Independent Survey of Firm Personnel
  • Quality Ratings and Compensation
  • Audit Fees, Effort, and Client Risk
  • Compliance with Independence Requirements
  • Investment in Infrastructure Supporting Audit Quality
  • Audit Firms’ Internal Quality Review Results
  • PCAOB Inspection Results
  • Technical Competency Testing
  • Frequency and Impact of Financial Statement Restatements for Errors
  • Fraud and other Financial Reporting Misconduct
  • Inferring Audit Quality from Measures of Financial Reporting Quality
  • Timely Reporting of Internal Control Weaknesses
  • Timely Reporting of Going Concern Issues
  • Results of Independent Surveys of Audit Committee Members
  • Trends in PCAOB and SEC Enforcement Proceedings
  • Trends in Private Litigation

The list of audit quality indicators raises a number of questions on which audit firms or audit committees might wish to comment. For example, is the list comprehensive, duplicative, or over-inclusive? How are the various indicators to be calculated? Should the same list of indicators be used for both larger and smaller firms, and can it be adapted to evaluate global audits involving more than one auditor? To what extent is the data called for by the indicators already broken out in audit firms’ operating systems? For data that is engagement-based, how should the “engagement” be defined? How, when, and to whom should the information about the indicators be delivered? Can a single set of indicators be tailored to a company’s unique circumstances, and does evaluating this data risk spreading audit committees’ attention too thin?

The PCAOB’s release (No. 2015-005) regarding the proposed audit-quality indicators includes some of these questions, and many others, as well as more detailed explanations regarding the potential use and calculation of the quantitative data.

The PCAOB seeks comments by 5 p.m. Eastern time on September 29, 2015. Written comments should be sent to the Office of the Secretary, Public Company Accounting Oversight Board, 1666 K Street, N.W., Washington, D.C. 20006-2803, or by email to comments@pcaobus.org or through the board’s website at www.pcaobus.org. Comments should refer to PCAOB Rulemaking Docket Matter No. 041 in the subject or reference line.

Dylan Black, Bradley Arant Boult Cummings LLP, Birmingham, AL


May 9, 2015

New York Embraces "Likely to Succeed" Standard for Appeals

The New York Court of Appeals, in a case of first impression, recently recognized the “likely to succeed” standard in appeals of an underlying case leading up to the commencement of an attorney malpractice action. Grace v. Law, 2014 WL 53253632014, N.Y. Slip Op. 07089 (N.Y. Oct. 21, 2014). In short, prior to commencing a legal malpractice action, a party who is likely to succeed on appeal of the underlying action should file an appeal so that the appellate courts are given the opportunity to correct a trial court mistake and essentially vindicate the attorney’s representation. Yet, under the standard set forth in Grace v. Law, if the client is not likely to succeed on appeal, he or she can file a legal malpractice action without first pursuing an appeal of the underlying action.

In Grace, the plaintiff began receiving treatment for an eye condition with a specific ophthalmologist at a Veterans Administration (VA) clinic. In June 2003, the VA canceled an appointment and did not reschedule the plaintiff until August 2004. At that 2004 appointment, the plaintiff was diagnosed with glaucoma and subsequently became blind in one eye. The plaintiff alleged that had the glaucoma been diagnosed at his initial appointment, his blindness would have been prevented. In June 2006, the plaintiff retained a law firm to commence a medical malpractice lawsuit against the VA; he was then referred to a second firm to continue the suit. The second firm learned that the doctor was not a VA employee but an independent contractor, and it referred the case back to the original firm due to a conflict of interest. The plaintiff eventually amended his complaint to name the correct employer, but the court dismissed the claims against the doctor and new defendant as time-barred.

The plaintiff then sued both firms for legal malpractice for failing to timely sue the doctor and his correct employer. The firms argued that because the plaintiff had not appealed the dismissal of his medical malpractice action, he could not maintain the legal malpractice claim. The defendants argued that the plaintiff was estopped from commencing the legal malpractice action and moved for summary judgment on this issue. The trial court denied their motions.

The New York Court of Appeals recognized that previous lower court decisions “generally stand for the proposition that an attorney should be given the opportunity to vindicate him or herself on appeal of an underlying action prior to being subjected to a legal malpractice suit.” However, the court decided that there should be an exception to the general rule, pointing to decisions from other jurisdictions. To apply the “likely to succeed” standard, courts will determine whether a client can commence a legal malpractice action without taking an appeal in the underlying action based on the likelihood of success of that underlying appeal. The court opined that this standard was the “most efficient and fair to all parties.” Furthermore, because courts are routinely required to analyze whether the plaintiff would have been successful on the merits (i.e., a “case within a case”), the new standard aligned with typical analysis in malpractice actions.

In Grace, the court determined that the defendants failed to establish that the plaintiff was likely to succeed on appeal and affirmed the denial of summary judgment. The upshot of this new standard is that claimants will no longer be required to exhaust the appeal process for cases with little chance of success prior to suing for malpractice. One such example would be a decision involving a claim clearly barred by the statute of limitations. To make use of this defense in circumstances where an appeal could be meritorious, defendants will now need to provide sufficient evidence to show that the plaintiff would have been successful on the underlying appeal. But this approach poses difficulties. For one, it requires the client or subsequent malpractice counsel to make fundamental assumptions on how an appellate court would rule. This approach seems rooted in uncertainty leading many practitioners to follow the safest practice, which is to take an appeal as a matter of course before filing the malpractice lawsuit.

Keywords: litigation, professional services liability, New York, legal malpractice, likely to succeed, appeal

Saleel V. Sabnis, Goldberg Segalla, LLP, Philadelphia, PA


March 2, 2015

Recent SEC Publications Address Cybersecurity

In a February 3, 2015 press release, the Securities and Exchange Commission (SEC) announced its publication of a risk alert and an investor bulletin addressing cybersecurity risks at brokerage and advisory firms. These publications provide tips to investors, and also may be useful for broker-dealers and investment advisors to consider in addressing cybersecurity issues at their firms.

According to SEC Chair Mary Jo White, “[c]ybersecurity threats know no boundaries. That’s why assessing the readiness of market participants and providing investors with information on how to better protect their online investment accounts from cyber threats has been and will continue to be an important focus of the SEC . . . Through our engagement with other government agencies as well as with the industry and educating the investing public, we can all work together to reduce the risk of cyber attacks.”

The risk alert, from the SEC’s Office of Compliance Inspections and Examinations, contains information based on examinations of more than 100 broker-dealers and investment advisers. The risk alert provides information on how these various firms:

  • identify cybersecurity risks;
  • establish cybersecurity policies, procedures, and oversight processes;
  • protect their networks and information;
  • identify and address risks associated with remote access to client information, funds transfer requests, and third-party vendors;
  • detect unauthorized activity.

Some of the examined firms’ procedures to address cybersecurity threats that the risk alert highlights include conducting firm-wide inventorying, cataloguing, or mapping of their technology resources, conducting periodic audits to ensure compliance with written information-security policies, and having a written policy to address how to determine whether the firm is responsible for client losses associated with cyber incidents. The risk alert also notes that many of the examined firms identify best practices through both formal and informal information-sharing networks, such as the Financial Services Information Sharing and Analysis Center (FS-ISAC). Underlining the importance of assessing and protecting against cybersecurity threats, the risk alert notes that 88 percent of the broker-dealers and 74 percent of the advisers included in the examination stated that they have experienced cyber-attacks directly or through one or more of their vendors, the majority of which related to malware and fraudulent emails.

The Investor Bulletin, issued by the SEC’s Office of Investor Education and Advocacy, provides key suggestions to help investors protect online investment accounts, including:

  • pick a “strong” password
  • use two-step verification
  • exercise caution when using public networks and wireless connections

According to Office of Investor Education and advocacy director Lori J. Schock, “[t]his bulletin provides everyday investors with a set of useful tips to help protect themselves from cyber-criminals and online fraud.”

Such practical information may prove useful to many firms in assessing how to shape and implement their own cybersecurity policies and procedures.

Keywords: litigation, cybersecurity, professional services liability, SEC

James Thomas and Laura D'Allaird, Arnold & Porter LLP, Washington, D.C.


March 2, 2015

PPCAOB Provides Observations in Broker-Dealer Audits Subject to New Standards

On January 28, 2015, the Public Company Accounting Oversight Board (PCAOB) issued a release providing observations from its interim inspections of five audit and attestation engagements of registered public accounting firms for brokers and dealers. The selected 2014 engagements were required to be conducted for the first time in accordance with PCAOB standards. The PCAOB expressed concern that it found deficiencies in all five of the audits and four of the five attestation engagements included in its initial inspections, observing auditors may not be sufficiently familiar with recent amendments to SEC Rule 17a-5 and the PCAOB standards applicable to their audit and attestation engagements of brokers and dealers. The PCAOB issued the release to provide insight from these initial inspections for auditors. To this end, the PCAOB also recommended that firms auditing broker-dealers review the Staff Guidance for Auditors of SEC-Registered Brokers and Dealers issued by the PCAOB on June 26, 2014.

The Dodd-Frank Act amended the Sarbanes-Oxley Act to, among other things, authorize the PCAOB to oversee the audits of broker-dealers registered with the Securities and Exchange Commission (SEC). The SEC in turn amended Exchange Act Rule 17a-5 to require that audits of broker-dealers be conducted in accordance with PCAOB standards. The requirement to follow PCAOB standards, which differ in some respects from prior applicable standards, became effective for broker-dealer annual reports with fiscal years ending on or after June 1, 2014.

Process and Findings
The PCAOB stated that it focused its inspections on (1) areas relevant to the amended Rule 17a-5, (2) topics that are unique to audits and other engagements for broker-dealers subject to PCAOB standards, including, for example, Auditing Standard No. 7 (Engagement Quality Review), Attestation Standard No. 1 (Examination Engagements Regarding Compliance Reports of Brokers and Dealers), and Attestation Standard No. 2 (Review Engagements Regarding Exemption Reports of Brokers and Dealers), and (3) deficiencies that the PCAOB had noted in past inspections of audits of broker-dealers.

The deficiencies identified by these most recent inspections included audit procedures relating to supplemental information that accompanies broker-dealer financial statements. Specifically, the PCAOB noted that auditors did not sufficiently evaluate whether the broker-dealers’ computations of net capital and customer reserves, including both form and content, complied with the Customer Protection and Exchange Act Rules 15c3-1 and 15c3-3. The PCAOB also provided observations regarding procedures related to financial-statement audits covering revenue recognition, risk of material misstatement due to fraud, financial statement presentation and disclosures, related party transactions, reliance on records and reports, and fair value estimates. The PCAOB also identified deficiencies with audit documentation, engagement-quality review, and auditor reports. With respect to attestation engagements, the board noted deficiencies in engagement procedures, such as failing to perform tests of controls, as well as deficiencies in review reports, such as an auditor-review report that covered a period of time beyond that which the broker-dealer’s statements covered in its exemption report.


For 2015, the PCAOB plans to inspect about 75 firms and portions of approximately 115 audit and attestation engagements required to be conducted pursuant to PCAOB standards. According to the board’s release, it will issue future reports describing significant observations from those inspections. Given the PCAOB’s authority to oversee broker-dealer audits, the board’s release is a useful reminder for accounting professionals performing audit and attestation engagements of broker-dealers to adequately familiarize themselves with the applicable PCAOB standards.

Keywords: litigation, professional services liability, PCAOB, broker-dealer

James Thomas and Laura D'Allaird, Arnold & Porter LLP, Washington, D.C.


February 26, 2015

PA Court Holds Legal-Malpractice Claims Barred by Collateral Estoppel

Illustrating the cautionary principles that (1) an attorney should avoid dabbling in practice areas with which he or she is unfamiliar and (2) prior litigation positions can have serious future consequences, a Pennsylvania district court recently dismissed a plaintiff’s legal-malpractice action on grounds that it was barred by a prior decision of a U.S. Bankruptcy Court under the doctrine of collateral estoppel. See Roach v. Verterano, No. 14-947, 2015 U.S. Dist. LEXIS 18745 (W.D. Pa. Feb. 17, 2015).

In Roach, the plaintiff hired the defendant and his law firm to assist her with the filing of Chapter 7 bankruptcy proceedings for the plaintiff, individually, and for her company, GRL Packaging, LLC. The defendant wrongly advised the plaintiff that the debt owed by GRL would be discharged and that the plaintiff could continue to operate her business even after the Chapter 7 bankruptcy petitions had been filed. Relying on this incorrect advice, the plaintiff continued to operate GRL and used funds in the business account to pay creditors and to pay for her own living expenses.

Months later, at the meeting of creditors, the U.S. Trustee learned about the defendant’s mistaken advice to the plaintiff. The Trustee informed both the plaintiff and her attorney that “it was illegal to continue to operate a corporation after filing [] Chapter 7” and directed the plaintiff to immediately turn over all corporate assets, cease doing business, and provide an accurate accounting. The defendant admitted that he was at fault in advising the plaintiff to file a Chapter 7 for her business, and he promised to pay for damage done as a result of his error.

Thereafter, the plaintiff ceased doing business in GRL and began to establish a new corporation to conduct her business. The defendant, however, advised the plaintiff that she could not transfer any assets of GRL to the new company, and allegedly advised her to continue operating GRL because he was going to file a motion to dismiss the GRL bankruptcy case. The defendant filed a motion to dismiss the case, but then later withdrew that motion, presumably because the Trustee’s opposing argument, that the plaintiff failed to establish any legal cause warranting dismissal, had merit.

Subsequently, one of plaintiff’s creditors filed a complaint seeking to deny the plaintiff individually a discharge of her debts because she intended to hinder, delay, or defraud her creditors and because she transferred corporate assets post-petition. The plaintiff defended the denial-of-discharge action by claiming that she was not in bad faith and did not have the requisite intent because she had simply relied on the advice of her attorney. Rejecting the plaintiff’s argument, the bankruptcy court held that the plaintiff’s reliance on her attorney’s advice was unreasonable after the Trustee had expressly instructed her to cease doing business and to turn over all corporate assets. Thus, her reliance on the defendant’s bad advice could not negate her intent.

Following that decision, the plaintiff filed suit against her attorney for professional negligence and breach of contract. Her attorney sought dismissal of all claims on grounds that the plaintiff was collaterally estopped from proving causation of any damages due to the bankruptcy court’s decision that the plaintiff herself intended to hinder, delay, or defraud her creditors, and that plaintiff could not rely on the defendant’s advice in making the post-petition transfers of assets that ultimately led to her denial of discharge.

The district court agreed with the defendant and dismissed all claims, holding that under the doctrine of collateral estoppel, the plaintiff could not “now seek to prove that something other than [her own] conduct was the proximate cause of her nondischarge. To hold otherwise would allow Plaintiffs to relitigate factual issues already resolved by the Bankruptcy Court, namely, whether Plaintiff Roach’s reliance on Attorney Verterano was in good faith and whether Plaintiff acted fraudulently or innocently relied on her incompetent attorney.”  

The Roach decision, and others like it, have interesting legal implications for plaintiffs who find themselves in the undesirable position of having relied on the bad advice of counsel, and who thereafter try to salvage what remains of their cases. It seems that the plaintiff in Roach may have been better off not objecting to the motion to deny discharge, given the risk that an adverse ruling that the plaintiff was not entitled to rely on advice of counsel could negatively impact any future malpractice claim. However, had the plaintiff chosen that strategy, she may have been faced in the legal-malpractice action with the argument that she failed to mitigate her damages. Both options have substantial risks, and neither is appealing.

And, while the district court dismissed malpractice claims against the attorney in Roach, the decision nevertheless serves as an important reminder to all attorneys that they should not dabble in practice areas with which they are unfamiliar, given the substantial risk of malpractice exposure.

Carey L. Menasco, Liskow & Lewis, APLC, New Orleans, LA


February 25, 2015

Malpractice Action Allows Discovery of Underlying Matter after Suit Settles

The U.S. District Court in New Jersey recently addressed an important question that arises frequently in the legal-malpractice universe: What is discoverable in a malpractice action when the case in which the malpractice allegedly occurred settles before trial? In Smith v. Dezao, No. 2:13-cv-72, 2015 U.S. Dist. LEXIS 8423 (D.N.J. Jan. 26, 2015), the district court explored whether allowing discovery of the underlying matter was necessary to fully evaluate the merits of the “suit within the suit” after the underlying suit had settled.

Dezao involved a tragic accident in Mexico in 2006, where Andrew Smith, the son of Nancy and Harold Smith (plaintiffs in the underlying case), died after falling down an elevator shaft in a Cancun resort. Shawn Smith, Andrew’s brother, observed Andrew in the elevator shaft and heard his cries for help after the fall. Mr. and Mrs. Smith claimed that they informed their attorneys that Shawn had observed Andrew’s fall. However, when the Smiths’ attorneys filed suit against the resort, they did not file any claims on behalf of Shawn Smith.

In 2010, over four years after the accident, the Smiths’ attorneys attempted to add Shawn Smith as a plaintiff to the underlying action. The court in that action denied the motion on futility grounds, reasoning that the two-year statute of limitations from the 2006 accident had run. Mr. and Mrs. Smith fired their attorneys soon after this decision, and their new attorneys settled the wrongful-death case before trial in 2012.

Plaintiff Shawn Smith filed the instant malpractice action against his former attorneys in 2013, for failure to file his claim for negligent infliction of emotional distress within the proper time period. As part of their defense, the defendants asserted the comparative negligence of the decedent, Andrew Smith. They asked the court to allow discovery into the underlying dispute, even though it had settled, to investigate Andrew Smith’s alleged alcohol consumption on the night of the accident.

The plaintiff opposed allowing this discovery pursuant to the “suit within a suit” analysis. In a “suit within a suit” analysis, a party in a legal-malpractice case presents the evidence that would have been submitted at trial if the alleged malpractice had not occurred. See, e.g., Gautam v. De Luca, 215 N.J. Super. 388, 521 A.2d 1343 (1987). Although the issue of Andrew Smith’s alleged alcohol consumption had been raised in the underlying suit, it had not been established as fact in the underlying suit. The plaintiffs argued that the defendants should be barred from further discovery on this issue, arguing that they should not be allowed to “conduct additional discovery in an effort to establish new facts on liability issues or comparative negligence arguments which were not established in the underlying action.”

The district court noted that the plaintiff ignored recent judicial criticism that the “suit within a suit” analysis can be both inaccurate and unfair, as the parties to the later-filed legal-malpractice action often do not have the same access to evidence as in the underlying suit, and the evidence grows stale. See, e.g., Garcia v. Kozlov, Seaton, Romanini & Brooks, P.C., 179 N.J. 343, 845 A.2d 602 (2004). According to the district court, the “suit within a suit” method also raises serious concerns for cases like this one, where the underlying suit settles before trial.

The Dezao court ultimately held that evidence regarding Andrew Smith’s potential intoxication on the night of the accident was discoverable. Because there had been no trial in the underlying suit, it was impossible to know what evidence would have been presented at trial; in any event, the issue of his intoxication was not fully explored in the underlying suit given the settlement. Because there was no trial, the parties could not be “bound by the same evidence that would have been presented in the underlying action . . . because no evidence was presented in the underlying case.” The court held that to “achieve a fair trial, unfettered discovery within the bounds of Federal Rule of Civil Procedure 26 should proceed.”

Further, the court also reasoned that, under New Jersey law, any damages attributable to the defendants could be diminished by Andrew Smith’s comparative negligence on the night of the accident. See, e.g., Portee v. Jaffee, 84 N.J. 88, 417 A.2d 521 (1980). Thus, discovery on this issue was held to be not only relevant but also necessary to the “just outcome of this case given the comparative negligence defense.”

Dezao makes clear that parties to a malpractice action are not barred from obtaining full and complete discovery of the facts concerning the underlying case in circumstances, such as pretrial settlement, where discovery in the underlying case is not completed.

Mandie E. Landry, Liskow & Lewis, New Orleans, LA


January 15, 2015

Another Court Finds Privilege Applies to Firm In-House Counsel Communications

The issue of whether a law firm may assert the attorney-client privilege concerning communications between lawyers at the firm and law firm in-house counsel in a later dispute with a client is a hotly contested one. Recent appellate decisions from around the country have rejected the holding of earlier cases that found a “fiduciary exception” to the privilege and ordered communications with in-house counsel produced to the clients. See Crimson Trace Corp. v. David Wright & Tremaine LLP, 326 P.3d 1181 (2014); RFF Family Partnership, LP v. Burns & Levinson, LLP, 991 NE2d 1066 (2013).

A new California opinion is the latest to reject the “fiduciary” or “current client” exception and uphold the privilege. In Edwards Wildman Palmer v. Superior Court, 180 Cal.Rptr.3d 620 (2014), the court held that California law did not recognize a fiduciary exception to the privilege, and that courts are not free to create new exceptions to the law governing privilege. “[I]n the absence of a statutory exception, the Firm’s ethical duties to its client do not trump assertion of the privilege here.” That holding contradicts several long-standing federal district court cases in California purported to apply California law.

In that case, the plaintiff in a legal-malpractice case sought production of internal communications between lawyers at the firm and the firm’s in-house counsel concerning the underlying matter that took place while the firm was still representing the plaintiff. The plaintiff objected that the privilege was inapplicable when “’a law firm is attorney to both an outside client and itself.’” The court rejected that argument, finding that allowing attorneys to seek privileged advice concerning current clients does not necessarily create adversity between the law firm and its client. “As a practical matter, it is not a foregone conclusion that an attorney’s consultation with in-house counsel with regard to a client dispute will always be disloyal to the client.” The client and the attorney have the same interests in ensuring that the attorney complies with his or her ethical obligations. Further, the court noted, the existence of the privilege does not affect the lawyer’s ethical obligations of disclosure to the client. “Should an attorney’s consultation with in-house counsel reveal that the attorney, or the firm, has committed malpractice, the attorney or firm would be obliged to report the malpractice to the client, although the confidential communication itself [between the lawyer and in-house counsel] would remain privileged.”

Echoing other courts who have considered this issue, the California court focused on the factors needed to demonstrate that an attorney-client relationship exists between lawyers at the firm and in-house counsel. Citing RFF, the court identified four prerequisites that must be established: 1) The law firm must have designated an attorney or attorneys within the firm to serve as in-house counsel; 2) in regard to a particular client dispute, the in-house counsel must not have performed any work on that client matter or on substantially related matters; 3) in-house counsel’s time spent must not have been billed to the client; and 4) the communications between the lawyers and in-house counsel must have been made in confidence and kept confidential. Applying these factors, the court found that certain of the communications designated as privileged by the law firm were not within the scope of the privilege, because the lawyer involved had not been “deputized” as in-house counsel until after the dispute arose and had actually worked on the client matter.

Palmer is the first California state-court opinion to address the issue of attorney-client privilege within law firm, and joins what appears to be an emerging consensus by courts protecting the ability of law firms to obtain privileged legal advice concerning current client matters.  

Merri A. Baldwin, Rogers Joseph O'Donnell, P.C., San Francisco, CA


November 19, 2014

FL Jury Rejects Allegations of "Special Relationship" With Insurance Broker

On October 30, 2014, a Florida jury wholly rejected the plaintiff’s argument that it had a “special relationship” with its insurance broker that triggered an enhanced duty of care under Florida law. Tiara Condominium Ass’n, Inc. v. Marsh USA Inc., Case No. 08-80254-CIV-HURLEY (S.D. Fla. Oct. 30, 2014). The plaintiff, Tiara Condominium Association, had hired Marsh, USA to place insurance to cover its 43-story tower, which was then devastated by two back-to-back hurricanes in September of 2004. After resolving its coverage claims against the insurance company, Tiara sued Marsh, alleging that it had suffered $35 million in uncompensated damages.

Although Florida law recognizes that an insurance broker owes a fiduciary duty of care to the insured, it also follows the general rule that insurance professionals do not have any duty to provide advice regarding insurance coverage needs to their clients. See, e.g., Wachovia Ins. Serv., Inc. v. Toomey, 994 So.2d 980, 987 (Fla. 2008) (broker owes fiduciary duty); Tiara Condominium Ass’n, Inc. v. Marsh, USA, Inc., 991 F.Supp.2d 1271, 1280-81 (S.D. Fla. 2014) (citing general rule that broker does not have any duty to advise clients as to their insurance needs or on the availability of particular coverage, and citing supporting cases).

A narrow exception to this general rule arises if the plaintiff can establish that a “special relationship” existed between the parties, creating enhanced duties for the broker and establishing a higher standard of care. Tiara Condominium, 991 F.Supp.2d at 1281-82(citing cases). Despite acknowledging that there was not “any Florida case directly on point,” the District Court for the Southern District of Florida denied Marsh’s motion for summary judgment on the plaintiff’s fiduciary-duty claim, holding that the jury would have to determine whether Tiara and Marsh had a special relationship. Judge Hurley noted that the “evidence of a long-term relationship” between the parties and the plaintiff’s claims of heavy reliance on Marsh’s expertise would be factors for the jury to consider. Judge Hurley concluded that the jury must decide whether Marsh had an enhanced duty “to provide reasonable and prudent recommendations on the optimal amount of coverage needed to best protect the interests of the insured.”

After a six-day trial, the jury directly rejected Tiara’s argument that it had a special relationship with Marsh or any enhanced duties beyond those traditionally imposed by Florida law. The jury never reached the issue of damages because it found that Marsh had fully complied with the standard of care under Florida law. As a result, there is still no Florida authority finding a special relationship between an insurance broker and its client, or imposing any heightened duties when procuring insurance coverage.

Keywords: litigation, professional services liability, insurance broker, fiduciary duty, special relationship

Joshua Maggard, Quarles & Brady LLP, Milwaukee, WI


November 19, 2014

NY Courts Clarify Continuous Representation in Legal Malpractice Actions

In New York, the statute of limitations for legal malpractice is three years, and a cause of action accrues on the date when the malpractice was committed, regardless of the date on which the malpractice is actually discovered. See CPLR 214 [6]; Town of Amherst v. Weiss, 120 A.D.3d 1550, 993 N.Y.S.2d 396, 398 (N.Y.A.D. 4th Dept. 2014) (citing cases).

However, New York also recognizes the continuous-representation doctrine, which tolls the three-year limitations period whenever there is (1) “clear indicia of an ongoing, continuous, developing, and dependent relationship between” the attorney and client and (2) the continued relationship includes an attempt by the attorney “to rectify an alleged act of malpractice.” Town of Amherst, 993 N.Y.S.2d at 398 (citing cases). The doctrine is frequently asserted by plaintiffs when there has been a gap in representation after the initial alleged malpractice, but there was no formal termination of the relationship. During the past year, several New York decisions have clarified the scope and impact of the doctrine.

First, a plaintiff may obtain summary judgment by establishing that the law firm never formally disengaged but instead continued to take steps to address its prior malpractice. For example, in Red Zone LLC v. Cadwalader, Wickersham & Taft LLP, 118 A.D.3d 581, 590 (N.Y.A.D. 1st Dept. June 19, 2014), the Supreme Court, Appellate Division affirmed the trial court’s grant of summary judgment to the plaintiff. The plaintiff argued that the law firm had negligently drafted an agreement that was intended to cap a third party’s fees at $2 million during the course of a separate transaction. This agreement was drafted in 2005, which would have made the plaintiff’s claims untimely, but the law firm continued to provide legal advice to the plaintiff during the separate transaction and related litigation in 2007 through 2010. Although the plaintiff was represented by other counsel during this separate transaction and litigation, the court found that the defendant’s advice was intended to rectify its earlier malpractice, and that the continuous-representation doctrine applied to claims based on that 2005 agreement. The court also found that the “gap” in legal representation between 2005 and 2007 provided no basis for finding that the attorney/client relationship had ended, because “there was simply no need to consult defendant during that time, and defendant never communicated to plaintiff that its prior representation had ended.” Id. (citing cases).

Second, courts may determine that whether the continuous-representation doctrine applies presents a question of fact for the jury. For example, in Town of Amherst v. Paul D. Weiss, Esq., 120 A.D.3d 1550, 993 N.Y.S.2d 396 (N.Y.A.D. 4th Dep. Sept. 26, 2014), the Supreme Court, Appellate Division reversed the trial court’s decision to grant summary judgment to the defendant law firm, holding that it was an issue of fact as to whether the statute of limitations had been tolled. The parties agreed that the alleged malpractice occurred on June 26, 2001, and that the action was brought after the three-year statute of limitations had expired. However, the appellate court reversed because there were triable issues of fact as to whether defendants had been retained for separate and distinct legal proceedings, or instead “ongoing and developing phases of the [same] litigation.” Id. at 400 (citing cases). Although the defendant correctly argued that the continuous representation doctrine requires “continuing trust and confidence” between the parties, the court held that there were triable issues of fact as to whether the plaintiff ever lost such trust and confidence. Likewise, in Grace v. Law, ___N.E.3d ___, 2014 WL 5325363 (N.Y. Ct. App. Oct. 21, 2014), the court found that a triable issue of fact existed because “it is unclear when the Law defendants’ representation of plaintiff ended.”

Third,the continuous-representation doctrine requires more than simply “a continuing, general, professional relationship,” and instead tolls the statute of limitations only where the “continuous representation pertains specifically to the matter in which the attorney committed the alleged malpractice.” Deep v. Boies, ___N.Y.S.2d ___, 2014 WL 5365931 (N.Y.A.D. 3 Dept. Oct. 23, 2014) (citing cases). The plaintiff contended that the defendants had committed legal malpractice by misappropriating the plaintiff’s file-sharing software while serving as his counsel with regard to transactions developing and marketing the software. Although this alleged misappropriation occurred on June 25, 2002, the plaintiff did not bring suit until October 28, 2005, after the three-year limitations period had expired. The plaintiff argued that the statute was tolled because the defendants’ legal services during related copyright litigation was part of a “continuing, interconnected representation” by the defendants. The trial court disagreed, and the appellate court affirmed, holding that the copyright litigation was unrelated to the alleged malpractice, and that the plaintiff failed to establish the “existence of an ‘interconnected’ attorney-client relationship that was related to its representation of him on the copyright claim.” Id. at *2 (citing cases).

Based on the above authority, attorneys should consistently and carefully document the scope of their legal representation, including clear confirmation that the relationship has ended when the underlying matter is resolved.

Keywords: litigation, professional services liability, legal malpractice, statutes of limitations, continuous representation doctrine

Joshua Maggard, Quarles & Brady LLP, Milwaukee, WI


October 24, 2014

Broker-Dealer Audits: PCAOB Finds Room for Improvement

The Public Company Accounting Oversight Board (PCAOB) recently issued its third progress report regarding its inspection of broker-dealer audits and it again found a high number of independence violations and audit deficiencies. Although the number of findings was slightly lower than those reported in its previous progress report, the PCAOB still expressed concerns regarding both the nature and number of deficiencies.

In its findings, the PCAOB noted deficiencies related to both the financial-statement audits and the audit of customer protection and net-capital rules. With respect to the financial-statement audits, the PCAOB noted the following material deficiencies:

  • Revenue Recognition—The extent of testing for material classes of revenue transactions was insufficient, and the substantive analytical procedures performed by the firm failed to provide the intended level of assurance;
  • Reliance on Records and Reports—Firms failed to perform substantive audit procedures or test controls on information provided by service organizations and/or it failed to perform tests on broker-dealer records used in the tests of controls or substantive tests;
  • Risk of Material Statements Due to Fraud—Firms failed to sufficiently identify and assess the risks of material misstatement due to fraud, the responses to the assessed risks of material misstatements due to fraud such as management overrides, and the responses to fraud risk related to revenue recognition.

With respect to the customer-protection-rule and the net-capital-rule deficiencies, the PCAOB indicated in its report that almost half the audits revealed a deficiency associated with the report on material inadequacies. Mainly, it found that firms were not performing sufficient procedures to determine whether broker-dealers were complying with their stated exemption from the customer-protection rule. In some cases, the firms relied solely on an inquiry to the broker-dealer without making any affirmative determination.

Another important finding of the PCAOB is that 21 of 90 audits selected for inspection failed to satisfy independence requirements. The requirements for auditor independence are mandated by Securities and Exchange Commission (SEC) Rule 17a-5 and, as the PCAOB pointed out, differ from the independence requirements of the American Institute of Certified Public Accountants (AICPA). Interestingly, the PCAOB found that 19 of the audits that failed to satisfy independence requirements were performed by auditors that audited broker-dealers, but did not conduct audits on issuers. The PCAOB stated that “Apparent independence violations have been, and will continue to be, reported to the SEC as such violations may have implications to the broker’s or dealer’s compliance with the requirements of Securities Exchange Act of 1934 (‘Exchange Act’) Rule 17a-5 (‘Rule 17a-5’).”

The PCAOB also pointed out that 100 percent of the audits of those auditors which had only one broker-dealer client, revealed deficiencies. It noted, however, that those firms that also audited issuers had a lower number of deficiencies, while those firms that audited more than 100 broker-dealers and audited issuers had a significantly lower number of deficiencies.

Based on the findings from its third progress report, the PCAOB clearly believes that there is room for significant improvement. Therefore, it is recommending that firms review agreements for services performed for broker-dealers to ensure that they do not violate the SEC independence requirements; that they provide training to ensure that all personnel are aware of the SEC independence requirements; and that they initiate quality-control procedures to ensure compliance with the SEC requirements. As for audit deficiencies, the PCAOB is recommending that firms provide guidance and training to its employees related to the areas noted in the progress report as well as creating supervisory policies to ensure that adequate attention is being placed on the highlighted areas by partners and supervisory personnel. Finally, the PCAOB is recommending that all firms review its “Staff Guidance for Auditors of SEC-Registered Brokers and Dealers” dated June 26, 2014, for specific guidance on preparing broker-dealer audits.

Keywords: litigation, professional services liability, PCAOB, broker-dealer, independence

Greg Amoroso and Amanda Powell, Sutherland Asbill & Brennan, LLP, Atlanta, GA


October 24, 2014

AICPA Overhauling Code of Professional Conduct to Streamline Navigation

As of December 15, 2014, the American Institute of Certified Public Accountants (AICPA) is overhauling the Code of Professional Conduct to streamline navigation of the ethics standards. The overhauled Code of Professional Conduct achieves this goal in several ways. First, the code is divided into three parts: Part 1 provides the rules for members in public practice; Part 2 provides the rules for members in business; and Part 3 provides the rules for all other members. Second, each part of the Code of Professional Conduct is further subdivided by topic and subtopic. Third, previous ethics rulings have been codified, and non-authoritative guidance is included at the end of the applicable standard in boxed text.

The AICPA’s reorganization offers a one-stop shopping experience for members with questions on ethics matters. For instance, if a member in public practice wanted to know whether an affiliate impaired independence, he or she would navigate to Part 1 for public members, where he or she would find the independence rule and relevant interpretations.

While the principal goal of the AICPA’s overhaul of the Code of Professional Conduct was reorganization, the new Code of Professional Conduct does include some substantive changes. The substantive changes to the code are discussed in the explanation to the April 15, 2013, exposure draft that proposed the reorganization of the Code of Professional Conduct. The most significant substantive change is the addition of two conceptual frameworks—one applicable to members in public practice and one applicable to members in business—designed to provide guidance to members facing ethics issues. Inclusion of the conceptual frameworks recognizes that members will encounter myriad situations in which the code does not provide guidance. Under the conceptual frameworks, members use a threats and safeguards matrix to identify threats to compliance with the code and to determine whether safeguards exist that eliminate the threat to an acceptable level. The effective date for the conceptual frameworks is December 15, 2015—one year later than the effective date for the general overhaul of the Code of Professional Conduct.

The Professional Ethics Executive Committee has more information regarding the streamlined Code of Professional Conduct at their website, including comment letters received in response to the exposure draft and a summary of comments and analysis.

Keywords: litigation, professional services liability, professional conduct, AICPA, ethics

Kurt Lentz, Sutherland Asbill & Brennan, LLP, Atlanta, GA


October 24, 2014

Collectability Is Affirmative Defense; Emotional Distress Damages May Be Available in Legal-Malpractice Cases

The Washington Supreme Court recently decided two issues of first impression in legal-malpractice cases: (1) the uncollectibility of a judgment in the underlying case is an affirmative defense that must be pleaded and proved by the defendant-attorney; and, (2) the plaintiff may recover emotional distress damages for attorney negligence only when significant emotional distress is foreseeable due to the particularly egregious (or intentional) conduct of an attorney or the sensitive or personal nature of the representation thereby excluding this recovery in a typical legal-malpractice case. Schmidt v. Coogan, __ P.3d __, 2014 WL 5088862 (Wash. 2014) (October 9, 2014).

When plaintiff Schmidt slipped and fell in a grocery store, she retained attorney Coogan to represent her in a claim for damages. Days before the statute of limitations ran, attorney Coogan filed suit, naming the wrong defendant. Later attempts to correct the error failed, and the trial court dismissed the case as barred by the statute of limitations. Schmidt then sued her attorney for legal malpractice. The case was tried to verdict in favor of Schmidt. On appeal, defendant Coogan argued that the plaintiff had the burden to prove that any judgment she would have gotten in the underlying case would have been collectible, and plaintiff Schmidt argued that general damages are available in legal-malpractice claims.

A bare majority of the Washington Supreme Court held that the uncollectibility of a judgment in the underlying case is an affirmative defense as to which the defendant-attorney bears the burden of pleading and proof in a legal-malpractice case. The court rejected the argument that collectibility is an element of the plaintiff’s case, holding that the plaintiff need not prove that a judgment in the underlying case was or would have been collectible to meet his or her burden of proof on damages and proximate cause. Rather, the defendant-attorney must plead and prove that the judgment was uncollectible to mitigate or eliminate damages in the malpractice case.

The court based its holding on policy. It reasoned that the traditional approach requiring the plaintiff to prove collectibility rests on the premise in tort cases that plaintiffs (1) may recover only the amount that will make them whole; and (2) must prove damages and proximate cause as essential elements of their tort cause of action. Six policy concerns led the court to reject the traditional approach: (1) by placing the burden of proof on the plaintiff, the traditional approach presumes an underlying judgment to be uncollectible when the record may be silent, unfairly burdening the wronged client; (2) the attorney may be in a better position than the client to establish uncollectibility because the attorney investigated the underlying claim closer to the time of the event; (3) the traditional approach inserts evidence of liability insurance into every legal-malpractice claim where evidence rules and case law generally prohibit such evidence whereas requiring the defendant-attorney to show uncollectibility limits introduction of liability-insurance evidence to a subset of cases where the attorney raises uncollectibility as an affirmative defense; (4) delay between the injury in the underlying case and the legal-malpractice case may hinder the client’s ability to gather evidence of collectability and the attorney’s negligence creates the delay; (5) placing the burden on the plaintiff-client unfairly harms the client because judgments in Washington are valid for 10 years and may be renewed; changing fortunes may make a judgment that initially is uncollectible against the underlying tortfeasor collectible over time; and (6) the fiduciary relationship between attorney and client favors placing the burden on the defendant-attorney.

Addressing another issue of first impression in Washington, the Schmidt court held that a legal-malpractice plaintiff may recover emotional-distress damages for attorney negligence when significant emotional distress “is foreseeable due to the particularly egregious (or intentional) conduct of an attorney or the sensitive or personal nature of the representation.” Either attorney conduct or the nature of the representation may support a claim for emotional-distress damages; both are not required. The court reached its holding by considering existing Washington law, the rule in other jurisdictions, and the emphasis on foreseeability in the Restatement (Third) of the Law Governing Lawyers § 53 (2000). While the holding expands Washington law regarding damages for emotional distress in limited cases in the legal-malpractice context, the typical legal-malpractice case resulting in pecuniary loss that causes emotional upset will not support a claim for emotional-distress damages.

Indeed, the Schmidt court concluded that the facts failed to support an award of general damages for emotional distress. The plaintiff, who had worked for a time in Coogan’s law firm, alleged that attorney Coogan harassed, intimidated, and belittled her when she raised the problem of the statute of limitations before it expired. Neither the attorney’s conduct nor the relationship between the parties that extended beyond a simple attorney-client relationship was sufficient to warrant emotional-distress damages under the rule the court fashioned.

Practice Note: Under Washington law, defendant-attorneys would do well to plead uncollectibility as an affirmative defense and to be prepared to defend claims for emotional-distress damages in legal-malpractice cases.

Keywords: litigation, professional services liability, legal malpractice, uncollectibility, emotional distress

Susan K. McIntosh and Roy A. Umlauf, Forsberg & Umlauf, P.S., Seattle, WA


July 18, 2014

GA Bank Directors and Officers Protected by Business-Judgment Rule

In a landmark ruling for officers and directors of Georgia’s financial institutions, the Supreme Court of Georgia held in FDIC v. Loudermilk, S14Q0454 (Ga. July 11, 2014), that directors and officers of banks are protected by the business-judgment rule, which affords directors and officers a presumption of good faith and ordinary care in the performance of their duties.

The standard of liability has been litigated heavily by the Federal Deposit Insurance Corporation (FDIC) acting as receiver for various failed banks in Georgia. Director and officer defendants argued that Georgia’s business-judgment rule bars claims for ordinary negligence, and the FDIC responded that the business-judgment rule either does not exist or does not apply. The federal district courts generally sided with the defendants, relying on decisions from intermediate state courts for interpretation of Georgia law. Other judges disagreed. Recognizing the potential ambiguity, one federal district court and the Eleventh Circuit sought guidance from the Georgia Supreme Court.

In a lengthy and unanimous decision, the court described the business-judgment rule as a “settled part of our common law in Georgia” and emphasized that “[i]f an officer or director has honestly exercised ‘judgment’ with respect to a business matter—that is, if her decision was made in a deliberative way, was reasonably informed by due diligence, and was made in good faith—the wisdom of the judgment cannot ordinarily be questioned in court.”

Moreover, the court held “the business judgment rule applies equally at common law to corporate officers and directors generally and to bank officers and directors.” Though the court did not thoroughly review the statutes applicable to corporate officers and directors, the court did state “the Corporation Code seems to leave room for the sort of business judgment rule acknowledged at common law in the decisions of this Court.”

The court did not accept all of the defendants’ arguments. Notably, the court distinguished between two types of ordinary-negligence claims: 1) claims that allege ordinary negligence in the wisdom of the decisions made by defendants; and 2) claims that allege ordinary negligence in the process by which those decisions were made. The court held that the first category of claims, but not the second, are wholly barred by the business-judgment rule.

Even in this latter category of claims focusing on the decision-making process, the court held that “officers and directors are presumed to have acted in good faith and to have exercised ordinary care. Although this presumption may be rebutted, the plaintiff [here the FDIC] bears the burden of putting forward proof sufficient to rebut it.”

The court held that the standard of ordinary care is “less demanding” for bank officers and directors than in most business circumstances: “In other words, bank officers and directors are only expected to exercise the same diligence and care as would be exercised by ‘ordinarily prudent’ officers and directors of a similarly situated bank.” They are not expected to exercise the same degree of care as one would in operating their daily business.

The court also emphasized the importance of O.C.G.A. § 7-1-490(a), which states that bank directors and officers “shall be entitled to rely upon information, opinions, reports, or statements, including financial statements and other financial data” prepared or presented by bank employees, counsel, accountants, and other experts and professionals. The court held that this statute “conclusively presumes that it is reasonable for an officer or director to rely upon certain information as a part of the diligence with which the standard of ordinary care is concerned. . . . If an officer or director relies in good faith on information described in subsection (a), the reasonableness of his reliance cannot be questioned in court.”

The Loudermilk decision enumerates a number of key defenses for bank directors and officers, but it remains to be seen whether those defense can be raised effectively in motions to dismiss or motions for summary judgment. The federal district courts may have to engage in a more searching review of the FDIC’s claims to determine which claims meet the process-oriented definition carved out in Loudermilk.

Keywords: litigation, professional liability, FDIC, business judgment rule, Eleventh Circuit, Georgia, directors and officers

W. Scott Sorrels, Patricia Gorham, Gabriel A. Mendel, Yvonne M. Williams-Wass, and Maia Cogen, Sutherland Asbill & Brennan LLP, Atlanta, GA


July 7, 2014

The Latest on the SEC's "Operation Broken Gate" Initiative

On September 30, 2013, the U.S. Securities and Exchange Commission (SEC) announced “Operation Broken Gate,” a plan to renew its focus on holding “gatekeepers”—including auditors and legal counsel—accountable for conduct facilitating fraud and for material misstatements in the financial reporting of publicly registered companies. The SEC’s initiative draws inspiration from the New York City Police Department’s “Broken Window” policy of the 1990s, focusing on both major and minor infractions as a means of deterring future misconduct.

Announcing the “Broken Gate” initiative, SEC Chairwoman Mary Jo White promised to “prob[e] the quality of audits and determin[e] whether the auditors missed or ignored red flags; whether they have proper documentation; and, whether they followed their professional standards.” White explained that the SEC will focus not only on intentional fraud and misconduct, but also on “violations such as control failures, negligence-based offenses, and even violations of prophylactic rules with no intent requirement.” Since “Operation Broken Gate” was announced, however, the SEC has brought a series of actions against both lawyers and auditors who are alleged to have failed to maintain the level of competence required by professional standards.

The first three cases that the SEC brought in connection with “Operation Broken Gate” involved outside auditors who allegedly failed to comply with Public Company Accounting Oversight Board (PCAOB) standards in conducting their audits by demonstrating a clear “lack of competence” in auditing SEC-registered companies.

In In the Matter of John Kinross-Kennedy, CPA, Adm. Proc. File No. 3-15536 (filed Sept. 30, 2013), for example, the SEC alleged that John Kinross-Kennedy falsely reported that six of his audits were conducted according to PCAOB standards. Although he performed audits for 23 different public companies, the SEC alleged that Kinross-Kennedy lacked basic accounting knowledge and skill as evidenced by his unfamiliarity with PCAOB requirements and recent changes in GAAP. The SEC also alleged that Kinross-Kennedy used outdated audit templates and checklists and disclosure requirements from nonpublic commercial businesses to guide his review.

In the related case of In the Matter of Wilfred W. Hanson, CPA, Adm. Proc. File No. 3-15537 (filed Sept. 30, 2013), the SEC alleged that Wilfred Hanson, who served as the engagement quality review partner for five of the six reviews conducted by Kinross-Kennedy, failed to comply with PCAOB standards because he was untrained in PCAOB standards and had not participated in public-company financial reporting in the last 19 years.

Finally, in In the Matter of Malcolm L. Pollard, CPA, Adm. Proc. File No. 3-15535 (filed Sept. 30, 2013), the SEC alleged that Malcolm Pollard falsely reported that audits for three companies done by his firm met PCAOB guidelines when in fact they did not, because Pollard failed to conduct engagement quality reviews and did not prepare or retain adequate audit documentation. All three of these individuals settled with the SEC, and each is barred from practicing as an accountant on behalf of any publicly traded company or SEC-regulated entity in the future.

In another high-profile case,In the Matter of Laird Daniels, CPA, Adm. Proc. File No. 3-15825 (filed Apr. 8, 2014), the SEC charged Laird Daniels, an internal accountant for CVS, with a number of securities-law violations involving the company’s improper valuation of drugstores it acquired in 2008. Daniels allegedly orchestrated an improper accounting adjustment and provided incomplete and inaccurate information to outside auditors and valuation experts. Daniels settled with the SEC, agreeing to both a permanent suspension from practicing as an accountant before the SEC and a $75,000 fine.

In a recent case involving a lawyer, In the Matter of David H. Frederickson, Esq., Adm. Proc. File No. 3-15676 (filed Jan. 14, 2014), the SEC charged David H. Frederickson with aiding and abetting a fictitious investment scheme. The SEC alleged that Frederickson served as an escrow agent for two fictitious investments and falsely represented to investors that their money was “secured by collateral over which Mr. Frederickson held a power of attorney.” Frederickson settled the charges and agreed to a permanent suspension from practicing as an attorney before the SEC.

In light of these enforcement actions, accountants and lawyers should expect continued scrutiny from the SEC. As Chairwoman White warned during her October 9, 2013, speech: “Cases against delinquent gatekeepers remind them, and the industry, of the important responsibilities that gatekeepers share with us to protect investors.”

Keywords: litigation, professional liability, gatekeeper, enforcement, auditor, attorneys

Jonathan Walsh and Stephanie Morris, Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY


May 29, 2014

Lawyers, Jurors, and Social Media: Best Practices

Attention lawyers: Do not “friend” a juror or potential juror on Facebook, request to “follow” a juror on Twitter or Instagram, send a “connect” request to a juror’s LinkedIn profile, or sign up for the RSS feed for a juror’s blog. These types of “access requests,” or requests to a juror for nonpublic information on the Internet, could cause a lawyer to face disciplinary action.

On April 24, 2014, the American Bar Association’s Standing Committee on Ethics and Professional Responsibility issued a formal written opinion outlining the ethical prohibitions and obligations regarding reviewing jurors’ Internet presence, most often in the form of jurors’ various social-media platforms. The opinion states that a lawyer may not request access to information that a juror posted on the Internet, equating sending an access request to the type of ex parte communication prohibited by Model Rule 3.5(b). A lawyer may, however, review a juror’s online public information that can be accessed without a request, even if the social-media site notifies the juror that the lawyer has accessed his or her social media.

If a lawyer reviewing jurors’ public social-media accounts finds evidence of criminal or fraudulent juror misconduct related to the proceeding, the lawyer has an affirmative duty under Model Rule 3.3 to take remedial measures, which may include disclosure to the tribunal. A lawyer, however, is not required to report all misconduct; a juror’s “innocuous postings” in violation of a court order, for example, may not “rise to the level of criminal or fraudulent conduct.” A lawyer must consult applicable law to determine whether the conduct meets the criminal or fraudulent threshold, but the committee suggests that the applicable law may treat juror conduct materially violating a court order as criminal contempt, thereby triggering the lawyer’s duty to take remedial action.

What are jurors posting on the Internet that might trigger a lawyer’s duty of remedial action? Consider these real-life examples:

  • A jury foreman posts about drinking during jury duty.
  • A juror “Facebook friends” the defendant.
  • A juror exchanges Facebook messages with a witness whom she knew before trial telling the witness, “You really explained things so great!!”
  • A juror posts on Facebook: “I guess all I need to know is GUILTY. lol.”
  • A juror used Facebook to poll her friends as to what the verdict should be.

In addition to discovering juror misconduct, a lawyer should use jurors’ public online information for research purposes. Even when limited to public information, a juror’s Internet footprint provides valuable information about a potential juror or jury. For instance, Google search results or a public Facebook profile may tell a lawyer about undisclosed relationships with parties or witnesses through a juror’s online network, the juror’s organization and political affiliations, or a juror’s occupation and schooling. Facebook and Twitter posts may provide a more a subtle inlet into a juror’s opinions and experiences, some of which may be relevant to jury service.

The committee leaves open a tangential but essential question: Considering the potential value in reviewing jurors’ Internet presence in the jury-selection process, does a lawyer have a duty to search for public information on the Internet?

The committee notes that it “does not take a position on whether the standard of care for competent lawyer performance requires using Internet research to locate information about jurors that is relevant to the jury selection process.” Cases and bar associations have tackled this issue and are footnoted in the opinion. A Missouri court, for instance, held that a “lawyer must use reasonable efforts to find potential juror’s litigation history in . . . Missouri’s automated case management system.” The New Hampshire Bar Association issued an opinion stating that lawyers “have a general duty to be aware of social media as a source of potentially useful information in litigation, to be competent to obtain that information . . . , and to know how to make effective use of that information in litigation.” Similarly, the Association of the Bar of New York City issued an opinion stating that “the standards of competence and diligence may require doing everything reasonably possible to learn about jurors who will sit in the judgment on a case.”

While the committee hedges the question on what a lawyer’s duty is regarding a juror’s Internet presence, an ethically mindful lawyer will realize that social media is now part of the advocacy process. Lawyers cannot protect themselves by avoiding a juror’s Internet presence altogether.

Amanda R. Powell, Sutherland Asbill & Brennan LLP, Atlanta, GA


March 6, 2014

Are We Headed Toward "Basic Writ Small"?

The U.S. Supreme Court heard oral argument on March 5, 2014 in the closely watched Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317, which places in the Court’s crosshairs the continued viability of the fraud-on-the-market presumption of reliance first articulated by the Supreme Court in Basic Inc. v. Levinson. 485 U.S. 224 (1988). The fraud-on-the-market presumption of reliance posits that an investor’s reliance on any public misrepresentations may be presumed because publicly available information is reflected in the market price of stocks traded on efficient, well-developed markets. This presumption has been a driving force behind securities-fraud class actions since its inception. The Supreme Court’s decision therefore has the potential to fundamentally change the future of securities-fraud class actions.

Halliburton is asking the Supreme Court to overrule Basic, or to modify it so that plaintiffs would have to prove that an alleged misrepresentation affected a company’s stock price before gaining the benefit of the presumption. Alternatively, Halliburton asks that Basic’s fraud-on-the-market theory be pared down to require plaintiffs to prove that an alleged misrepresentation actually affected a company’s stock price before the fraud-on-the-market presumption can be invoked, or that defendants have a chance to rebut the presumption at the class-certification stage.

Halliburton’s argument comes on the heels of the Supreme Court’s 2013 decision in Amgen Inc. v. Connecticut Ret. Plans & Trust Funds, 133 S. Ct. 1184 (2013), in which four justices took the opportunity to question the continuing vitality of the fraud-on-the-market presumption in dissenting and concurring opinions. Even the majority opinion in Amgen recognized that modern economic research undercuts the premise of the fraud-on-the-market presumption: Market efficiency is no longer believed to be a binary, yes-or-no question. Rather, differences in efficiency can exist within a single market.

At oral argument, the Court did not focus on whether Basic should be overturned because it rests on an arguably faulty economic theory, despite the intimations in Amgen. Instead, the Court focused on a compromise position based on an argument that law professors made in an amicus curiae brief. The professors argued that the plaintiffs should provide event studies analyzing whether a defendant’s alleged misrepresentation affected its stock price at the class-certification stage. Justice Kennedy, who referred to the professors’ position as a “midway position,” asked both the Halliburton and respondent about the professors’ approach of requiring an event study at the class-certification stage, and Justice Scalia asked the respondent what the effect of adopting “Basic writ small” would be. At the close of argument, Justice Breyer, perhaps showing his hand, asked Halliburton whether the defendants are currently precluded from presenting an event study at the class-certification stage to rebut fraud-on-the-market’s presumption of reliance, to which Halliburton responded, “[y]es Hour Honor, that’s precisely what the Fifth Circuit held in this case.”

Interestingly, the solicitor general, when asked by Justice Kennedy what consequences implementing the “midway position” might bring, responded that “focusing only on the effect or lack of effect on—the particular stock . . . would be a net gain to plaintiffs, because plaintiffs already have to prove price impact at the end of the day.” This indication of support from the solicitor general was likely a welcome arrow in the quiver of those justices in favor of the law professors’ position.

If the Court’s focus on the “midway position” is any indication, the Court is not prepared to overturn Basic, but seems willing to require plaintiffs to provide event studies tying a defendant’s misrepresentation to a price impact on their stock at the class-certification stage. The significance of such a holding is manifest because, as Halliburton pointed out, nearly 75 percent of class-certification motions are granted in securities cases, and only 7 percent of cases make it to the summary-judgment stage after certification is granted. Were the Court to adopt “Basic writ small,” as coined by Justice Scalia, plaintiffs would no longer be able to avail themselves of Basic’s presumption without showing that a defendant’s alleged misrepresentation actually affected stock price, which would lead to fewer classes being certified and settled before price impact could be analyzed.

Keywords: professional liability litigation, securities fraud, fraud on the market, class certification, Supreme Court

Kurt Lentz and Sam Casey, Sutherland Asbill & Brennan, LLP, Atlanta, GA


February 27, 2014

Legislation Proposed to Reform Professional-Malpractice Claims

Currently before the New Jersey legislature is Assembly Bill No. A1254, which seeks to shorten, from six years to two years, the period within which a party may bring a professional-malpractice claim. Under New Jersey law, legal-malpractice claims are presently governed by the six-year statute-of-limitations period provided by N.J. Stat. Ann. § 2A:14-1, which encompasses all actions involving tortious injury to the rights of another. See McGrogan v. Till, 167 N.J. 414, 425–26 (N.J. 2001). The proposed amendment would provide an exception to the six-year statute for professional-malpractice claims against attorneys and other licensed professionals.

If adopted, the amendment would bring New Jersey in line with other states in the Northeast. For example, Delaware and New York have three-year statutory periods for legal-malpractice claims while Pennsylvania has a two-year period for legal-malpractice claims arising in tort and a four-year period for malpractice claims arising in contract. See Del. Code Ann. tit. 10, § 8106; N.Y. C.P.L.R. 214(6); 42 Pa. Cons. Stat. Ann. §§ 5524(3) and 5525. In contrast, California and Louisiana have a one-year limitations period. See Cal. Civ. Proc. § 340.6 (excluding fraud); La. Rev. Stat. Ann. § 9:5605.

In addition to revising the applicable statutory period, the proposed bill also seeks to legislatively overrule Saffer v. Willoughby, 143 N.J. 256 (N.J. 1996), in which the New Jersey Supreme Court held that successful legal-malpractice plaintiffs are permitted to collect their attorney fees. As presently drafted, Assembly Bill No. A1254 provides that “[a]ttorneys’ fees shall not be awarded in any action subject to the limitations period in this subsection, except where authorized by statute or the New Jersey Rules of Court.” Commentators believe that the effort to slash the recovery of attorney fees may ultimately raise as much opposition from the bill’s detractors as the provision proposing to shorten the statute-of-limitations period.

Similar reform efforts in New Jersey have been rejected. Just two years ago, an identical piece of legislation was introduced only to fall short of acquiring the necessary votes for enactment. Gen. Assemb. A2553, 215th Leg. (N.J. 2012).

This controversial bill is likely to garner much attention in the current legislative session due to the fact that it places the New Jersey State Bar Association, which has expressed its public support for the measure, in direct opposition to the New Jersey Association for Justice, which represents plaintiffs’ attorneys and vehemently opposes the proposed legislation.

According to the New Jersey State Bar Association, if enacted, the legislation would eliminate two of the primary sources that make New Jersey among the most expensive states in the region to obtain malpractice policies. Legislative Alert: Professional Malpractice Legislation, New Jersey State Bar Association. In contrast, the New Jersey Association for Justice claims that the “reduction in the statute of limitations presently in place will harm consumers by limiting their ability to discover malpractice” and victims of legal malpractice will be prevented from being made whole due to their inability to collect attorney fees. Position Paper from the New Jersey Association for Justice (on file with author). Ultimately, the likelihood of the bill’s success may hinge on whether the amendment is perceived—by New Jersey constituents and legislators alike—to inure for the benefit of licensed professionals at the expense of the consumer.

Keywords: professional liability litigation, statute of limitations, professional malpractice, attorney fees

Tyler D. Trew and Shannon S. Holtzman, Liskow & Lewis, APLC, New Orleans, LA


February 27, 2014

Stern Does Not Preclude Bank. Court's Resolution of Certain Claims

The Fifth Circuit recently considered the effect of the landmark decision of the U.S. Supreme Court in Stern v. Marshall, 131 S. Ct. 2594 (2011), on malpractice counterclaims in bankruptcy. In Frazin v. Haynes & Boone, L.L.P. (In re Frazin), 732 F.3d 313 (5th Cir. 2013), the Fifth Circuit held that a debtor’s state-law malpractice and breach-of-fiduciary-duty counterclaims filed in response to the fee applications of approved special counsel fall outside the ambit of Stern v. Marshall, such that a bankruptcy court may enter a final judgment on such claims.

The now infamous (among bankruptcy practitioners) counterclaim in Stern arose from a dispute between Vickie Lynn Marshall, better known by her stage name, Anna Nicole Smith, and her former son-in-law over the estate of her late husband. After Smith filed bankruptcy, her former son-in-law filed a proof of claim in her case, alleging that Smith had defamed him. Smith counterclaimed, alleging tortious interference with a gift. The bankruptcy court ruled in Smith’s favor, awarding $425 million in damages.The Supreme Court, however, held that Smith’s counterclaim was not constitutionally a “core” proceeding under 28 U.S.C. § 157(b).

The statutory list of core matters over which Congress has granted bankruptcy courts the authority to enter final judgments includes “counterclaims by the estate against persons filing claims against the estate.” 28 U.S.C. § 157(b)(C). Despite this plain language, the Supreme Court in Stern held that bankruptcy judges, because they are not Article III judges, lack the constitutional authority to enter a final judgment on a narrow subset of counterclaims—state-law counterclaims that are not resolved in ruling on a creditor’s proof of claim.

In Frazin, the Fifth Circuit illuminated one way a state-law counterclaim may be “resolved in ruling on a creditor’s proof of claim.” Frazin, the debtor, obtained bankruptcy-court approval to employ special counsel to represent him in a breach-of-contract lawsuit outside his bankruptcy case. After obtaining a $3.2 million judgment in Frazin’s favor, special counsel filed fee applications with the bankruptcy court. Frazin objected to the fee applications and counterclaimed for legal malpractice and breach of fiduciary duty. The bankruptcy court overruled Frazin’s objections and approved the fees. After trial, the bankruptcy court entered final judgment against Frazin on the malpractice and breach-of-fiduciary-duty claims. The district court affirmed. Frazin, 732 F.3d at 316–17. Frazin appealed, arguing that Stern precluded the bankruptcy court from entering a final judgment on his counterclaims because, like the counterclaim at issue in Stern, Frazin’s counterclaims were not constitutionally “core” bankruptcy proceedings.

Relying on Stern, the Fifth Circuit in Frazin noted that the Supreme Court’s “concern for separation of powers and the independence of the judiciary” applied equally to Frazin’s fee application counterclaims as to Smith’s counterclaim to the proof of claim. Frazin, 732 F.3d at 319. The Fifth Circuit concluded, however, that Frazin’s counterclaim was “necessarily decided by the bankruptcy court in the process of ruling on the fee applications and thus fell constitutionally within the bankruptcy court’s jurisdiction.”

The Fifth Circuit considers a bankruptcy court’s award of fees to a professional as interrelated to a malpractice claim in light of 11 U.S.C. § 330. Section 330 provides bankruptcy courts the authority to award fees “based on a consideration of the benefit and the necessity” of the services rendered to the debtor as well as “the nature, the extent, and value of such services.” 11 U.S.C. § 330(a)(3),(a)(4)(B). Thus, to award fees, a bankruptcy court must first determine that the benefit and the value of the attorney’s services are sufficient to warrant payment of the fee amount requested. Frazin’s counterclaims asserted the same conduct as his objections to the fee applications. By awarding the fees to Frazin’s special counsel, the bankruptcy court necessarily considered and rejected Frazin’s malpractice claim as well as his objections grounded in the same allegations. Thus, Frazin’s counterclaims were “not ‘independent of federal bankruptcy law’ but [were] ‘necessarily resolvable’ by a ruling on the [ ] fee applications.”Frazin, 732 F.3d at 322 (quoting Stern, 131 S. Ct. at 2611).

Although not a perfect analogy, in bankruptcy, a fee application is similar to a proof of claim, as both seek payment from a debtor’s bankruptcy estate and a debtor may object to the amount sought. Section 330 provides bankruptcy judges authority to “resolve” malpractice actions through the fee-application process. Practitioners who find themselves serving as special counsel to debtors or bankruptcy trustees should therefore not assume that a bankruptcy judge will not have the power to enter a final judgment against them on state-law malpractice counterclaims brought in response to their fee applications post-Stern.

Moreover, debtors should not lie in wait to raise potential malpractice claims. Not only does Frazin exercise the authority of district-court Article III judges to enter final judgments on malpractice claims raised after the bankruptcy court approves fees, but prior Fifth Circuit jurisprudence likewise precludes state-court judges from ruling on such belated claims on grounds of res judicata. See Osherow v. Ernst & Young, L.L.P. (In re Intelogic Trace, Inc.), 200 F.3d 382 (5th Cir. 2000).

Keywords: professional liability litigation, bankruptcy, Article III, separation of powers, fee applications, malpractice

Lacey E. Rochester and Carey L. Menasco, Liskow & Lewis, New Orleans, LA


January 23, 2014

Georgia Supreme Court to Address Business-Judgment Rule

In an unexpected turn of events, two federal courts have recently certified questions to the Georgia Supreme Court that will impact the ability of officers and directors of Georgia financial institutions to rely on the business-judgment rule, which affords a presumption of good faith and thus absolves officers and directors of personal liability absent a showing that they engaged in fraud, bad faith, or an abuse of discretion. For years, officers and directors of Georgia financial institutions have asserted the protection of the business-judgment rule in support of motions to dismiss allegations of simple negligence. Georgia federal courts have agreed, often citing a pair of non-banking Georgia Court of Appeals decisions that provide business-judgment rule protection for officers and directors of all Georgia corporations. Thus, when the Federal Deposit Insurance Corporation (FDIC) as the receiver for a failed bank sues the bank’s former officers and directors to recoup damages allegedly resulting from a bank’s failure, the business-judgment rule would, as a matter of law, foreclose the FDIC’s ability to base its claim on ordinary negligence, leaving the FDIC with the more significant hurdle of satisfying the gross-negligence standard. Two sets of certified questions threaten the viability of the business-judgment rule as a defense to FDIC actions.

The first of the two cases arose out of the failure of Integrity Bank in Alpharetta, Georgia. When the defendant bank officers and directors moved to dismiss the FDIC’s claim of ordinary negligence relying on Flexible Products Co. v. Ervast, 284 Ga. App. 178, 182, 643 S.E.2d 560, 564–65 (2007), andBrock Built, LLC v. Blake, 300 Ga. App. 816, 821–22, 686 S.E.2d 425, 430–31 (2009), Judge Steve C. Jones, following precedent within the district, held that the FDIC was barred from asserting claims for ordinary negligence in professional-liability suits against bank officers and directors and granted the defendants’ motion. FDIC v. Skow, No. 1:11-cv-0111-SCJ, 2012 WL 8503168, at *8 (N.D. Ga. Feb. 27, 2012).

The FDIC appealed the district court’s decision. On December 23, 2013, the Eleventh Circuit issued an opinion concluding that application of the business-judgment rule to bank officers and directors “might contradict the plain language” of O.C.G.A. § 7-1-490(a), which provides: “Directors and officers of a bank or trust company shall discharge the duties of their respective positions in good faith and with that diligence, care, and skill which ordinarily prudent men would exercise under similar circumstances in like positions.” FDIC v. Skow, No. 12-15878, 2013 WL 6726918, at *2 (11th Cir. Dec. 23, 2013). The Eleventh Circuit certified the following two questions to the Georgia Supreme Court:

1) Does a bank director or officer violate the standard of care established by O.C.G.A. § 7-1-490 when he acts in good faith but fails to act with “ordinary diligence,” as that term is defined in O.C.G.A. § 51-1-2?

2) In a case like this one, applying Georgia’s business judgment rule, can the bank officer or director defendants be held individually liable if they, in fact as alleged, are shown to have been ordinarily negligent or to have breached a fiduciary duty, based on ordinary negligence in performing professional duties?

Id. at *3. The questions have been placed on the Georgia Supreme Court docket and are currently scheduled for argument in April 2014.

In the second case, decided in November 2013, Judge Thomas W. Thrash Jr. in the Northern District of Georgia issued an opinion in which he “respectfully disagree[d]” with the decisions issued by other judges in the Northern District of Georgia and denied the former bank officers and directors’ motion to dismiss the FDIC’s claim of ordinary negligence. FDIC v. Loudermilk, No. 1:12-cv-4156-TWT, 2013 WL 6178463, at *4 (N.D. Ga. Nov. 25, 2013).

Judge Thrash held that the “ordinary prudent men” standard imposed on bank officers and directors in O.C.G.A. § 7-1-490 appears to be in tension with Georgia’s business-judgment rule,which forecloses personal liability for directors and officers arising from ordinary negligence claims. Judge Thrash certified to the Georgia Supreme Court the “unsettled question of law of whether the business judgment rule should supplant the standard of care required of bank officers and directors by O.C.G.A. § 7-1-490 in a suit brought by the FDIC as receiver.” Id. at *12. The question is currently on the Georgia Supreme Court’s docket and is set for oral arguments in March 2014.

The outcome of the certified questions will determine whether the business-judgment rule is available to officers and directors of financial institutions in Georgia and has the potential to impact the availability of the rule to officers and directors generally.

Keywords: litigation, professional liability, FDIC, business judgment rule, Eleventh Circuit, Georgia, directors and officers

W. Scott Sorrels, Gabriel A. Mendel, Yvonne M. Williams-Wass, and Maia Cogen, Sutherland Asbill & Brennan LLP, in Atlanta, GA


January 17, 2014

Attorney Retained by Title Insurer Owes No Duty of Care to Nonclient Title Insurer

In a case of first impression, the Washington Supreme Court held that a title insurer is neither a client of the attorney retained to represent its insured nor the intended beneficiary of the attorney-client relationship. Consequently, the attorney owed no duty of care to the insurer even where (1) the interests of the client insured and the insurer aligned and (2) the attorney had an obligation to keep the insurer informed about the case. The insurer lacked standing to sue the attorney for legal malpractice. Stewart Title Guar. Co. v. Sterling Sav. Bank, 178 Wash. 2d 561, 311 P.3d 1 (Wash. Oct. 3, 2013).

Stewart Title Guaranty Co. sued the attorney it hired to defend its insured, Sterling Savings Bank, for legal malpractice. The underlying case involved enforcement of a mechanic’s lien on property on which Sterling made a construction loan. As a condition of the loan, Sterling required a first-priority security interest in the property. Stewart Title negligently failed to inspect the property before the loan closed. Construction had already begun, giving the builder a statutory mechanic’s lien interest in the property that took priority over Sterling’s interest.

A payment dispute arose and the builder sued Sterling to foreclose its mechanic’s lien. Stewart Title hired defense counsel to defend Sterling in the lien foreclosure action. The attorneys determined that the mechanic’s lien took priority over Sterling’s security interest. The parties quickly settled the foreclosure action. Stewart Title fired the law firm, contending the attorneys should have argued Sterling was equitably subrogated to the mechanic’s lien it paid and therefore had priority over that lien after all. Subsequent counsel made the equitable subrogation argument. The trial court held the parties were bound by their earlier stipulation.

Stewart Title sued the law firm for legal malpractice alleging it should have raised the equitable subrogation defense before stipulating that the builder’s mechanic’s lien had priority over Sterling’s security interest. The law firm raised two arguments in its motion for summary-judgment dismissal: (1) Its client was the insured lender, Sterling, and not the title insurer; therefore, the law firm owed no duty to the nonclient title insurer that would support a malpractice claim against the firm; and, (2) the equitable subrogation defense would fail under the facts of the underlying case. The trial court ruled the law firm owed a duty of care to Stewart Title, but dismissed the case, finding no breach of that duty related to the equitable-subrogation defense.

On direct review, the Washington Supreme Court held that the law firm’s duty ran only to insured Sterling, and it owed no duty of care to Stewart Title, a nonclient. The court framed the issue as follows: “whether an attorney hired by a title insurer to represent its insured owed a duty to the nonclient insurer and, hence, whether that insurer can sue the lawyer for negligently representing the insured during the defense.” 178 Wash. 2d at *566, 311 P.3d at **4, slip op. at 6.

The court analyzed the case under Washington’s case law for determining whether an attorney owes a duty of care to nonclient third parties that would give rise to a legal-malpractice claim. In Trask v. Butler, 123 Wash. 2d 835, 872 P.2d 1080 (1994), the court adopted a multifactor balancing test to make that determination. Under Trask, the first factor is a threshold question: the extent to which the transaction was intended to benefit the plaintiff (i.e., the nonclient third party suing the attorney). If the nonclient is not the intended beneficiary of the transaction to which the attorney’s advice pertained, no further inquiry need be made. The attorney owed no duty to the nonclient Sterling.

The court also reasoned that the Rules of Professional Conduct prohibit an attorney from contracting away his or her professional duty not to permit a third party payor to direct or regulate the lawyer’s professional judgment in rendering legal services.

Practice Note: The Washington court has not previously expressly addressed whether it would adopt the rationale of the tripartite-relationship cases. Washington joins the jurisdictions that do not allow an insurer to bring a legal-malpractice suit against defense counsel it retains to defend an insured. The court recognized that other jurisdictions and the Restatement (Third) of the Law Governing Lawyers § 51 cmt. g (2000) reached different conclusions.

Keywords: litigation, professional liability, duty of care, legal malpractice, insurance

Susan K. McIntosh and Roy A. Umlauf, Forsberg & Umlauf, P.S., in Seattle, WA


December 24, 2013

PCAOB Proposes Amendments to Audit Report Standards

The Public Company Accounting Oversight Board (PCAOB) recently held public hearings regarding proposed amendments to its standards that would require (i) the disclosure of the name of the engagement partner in the audit report and the PCAOB’s Annual Report Form (Form 2) and (ii) the disclosure in the audit report of the names of other independent public accounting firms and other persons that took part in the audit. See Press Release, PCAOB, PCAOB Reproposes Amendments to Improve Transparency by Requiring Disclosure of the Engagement Partner and Certain Participants in the Audit (Dec. 4, 2012). These proposed changes followed an original proposal by the PCAOB in 2009 that would have required the signature of the engagement partner in addition to the signature of the accounting firm in the audit report issued in connection with audits of public companies. See Concept Release on Requiring the Engagement Partner to Sign the Audit Report (July 28, 2009). After receiving numerous comments regarding the suggested signature requirement, the PCAOB revised the proposal to require only the addition of the following sentence in the audit report: “The engagement partner responsible for the audit for the [period] ended [date] was [name].” PCAOB Release No. 2011-007 (Oct. 11, 2011) at 11–12. The proposal would also require accounting firms to include the name of the engagement partner in the Form 2 that registered firms file with the PCAOB on an annual basis.

In reissuing these proposed changes, the PCAOB cited comments from investors, investor advocates, and academics who asserted that the identification of the engagement partner in the audit report would improve audit quality by increasing the engagement partner’s sense of personal accountability for the audit opinion and the work performed. The PCAOB also cited commentary from accounting firms who argued that engagement partners already feel a strong sense of responsibility for the audits they perform and that identifying partners by name would only serve to increase the partners’ exposure to litigation.

The PCAOB was cognizant of these arguments when making the proposal in 2011, and asked for additional comments regarding the impact of the proposed changes on auditor liability under section 10(b) of the Exchange Act and section 11 of the Securities Act. The PCAOB cited Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2302 (2011), which limited section 10(b) liability to the person making the allegedly false and misleading statement or the entity with ultimate authority over the statement. The Janus ruling arguably would shield individual auditors from liability for audit reports issued by their firms. Similarly, section 11 liability only applies to those who have consented as “having prepared or certified” any part of a registration statement or report used in a registration. Individual accountants who have not filed consents pursuant to section 7 of the Securities Act may not be deemed to have consented to having prepared or certified the audit report used in the registration.

The PCAOB also proposed to identify in the audit report the names of other independent public accounting firms and other persons not employed by the auditor that took part in the most recent period’s audit. PCAOB Release No. 2011-007 at 18–19. The PCAOB recognized that audit firms increasingly rely on other firms to perform specific audit procedures or to provide other information in connection with financial-statement audits. The proposed rule would require that the audit report specify the name, location, and extent of participation in the audit of other independent public-accounting firms when the auditor assumes responsibility for or supervises the work performed. In the event that the auditor divides responsibility with another firm for the audit of the financial statements of one or more subsidiaries, divisions, components, or investments included in the financial statements of the company, the proposed rule would require the disclosure of the name and location of the other firm.

As was the case with the 2009 proposed rule, there were a number of comments submitted to the PCAOB regarding the 2011 proposed changes. Accounting firms again asserted that the identification of the engagement partners in audit reports would invite plaintiffs to sue individual partners in securities litigation cases. While the Janus decision would appear to limit liability to the accounting firm that had authority to issue the audit report, accounting firms noted that the case law under Janus was still evolving and thus it was not clear whether an engagement partner who is cited in the audit report would be immune from personal liability. Moreover, the Janus decision would not prevent plaintiffs from asserting section 10(b) claims against an engagement partner, who previous to the proposed rule change would have been unknown to investors. The accounting firms also asserted that the Securities and Exchange Commission had not taken a position regarding whether individual partners identified in audit reports would be required to file consent forms pursuant to section 7. Thus, it was also unclear whether individual partners would be deemed to have consented to having prepared or certified any part of the registration statement or any report used in a registration for section 11 purposes. Finally, accounting firms raised a concern that disclosing the names of other accounting firms that took part in the audit would subject those firms to liability, citing the decision in Munoz v. China Expert Tech., Inc., 2011 U.S. Dist. LEXIS 128539 (S.D.N.Y. Nov. 4, 2011), which held that there was a genuine issue of fact whether a U.S. affiliate of a Hong Kong accounting firm “made” the statements in the Hong Kong firm’s audit report.

Jonathan J. Walsh and Alyssa Astiz, Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY


December 24, 2013

The Pitfalls of E-Discovery

Given the dramatic increase in the number of cases involving electronically stored information (ESI), lawyers must be diligent about meeting their legal obligations with regard to the proper collection, production, and review of ESI. A lawyer’s failure during the discovery process to preserve, protect, or produce a client’s ESI, whether advertent or inadvertent, can result in court sanctions, adverse-inference instructions, or even malpractice claims by former clients.

Courts have levied a variety of sanctions when counsel has failed to issue litigation holds in a timely manner or failed to monitor clients’ compliance with litigation holds. See, e.g., Pension Comm. of Univ. of Montreal Pension Plan, et al. v. Banc of Am. Secs., LLC, 685 F. Supp. 2d 456, 463 (S.D.N.Y. 2010) (counsel’s failure to instruct clients not to destroy relevant documents resulted in an adverse-inference instruction that relevant documents were presumed to have been destroyed); Day v. LSI Corp., No. Civ 11-186-TUC-CKJ, 2012 WL 6674434 (D. Ariz. Dec. 20, 2012) (court entered a partial judgment for the plaintiff because the defendant failed to a put a timely litigation hold in place); Apple Inc. v. Samsung Elecs. Co., Ltd.,888 F. Supp. 2d 976, 999 (N. D. Cal. 2012) (both parties granted mirror adverse-inference instructions that relevant documents were destroyed after each failed to institute litigation holds when their duty to preserve arose).

Similar penalties can result from the failure to produce documents that have been collected. In Coquina Invs. v. Rothstein and TD Bank N.A., No 10-60786-Civ., 2012 WL 3202273 (S.D. Fla. Aug. 3, 2012), plaintiff Coquina Investments sued TD Bank for aiding and abetting codefendant Scott Rothstein’s Ponzi scheme on the grounds that TD Bank knew of or should have known of Rothstein’s fraud. Post-trial, Coquina filed a motion for sanctions against TD Bank and its counsel, Greenberg Traurig, for, among other things, failing to produce an accurate version of the customer-due-diligence (CDD) form for the Rothstein accounts. The original CDD had a header running across the top that read “HIGH RISK” in red ink, but it was produced in black and white without a header. Additionally, the document produced to Coquina did not contain certain embedded information that indicated when TD Bank employees saved, reviewed, or edited the CDD during the relevant time period. The Greenberg lawyers maintained that these production errors were inadvertent and that Coquina suffered no prejudice from the errors. The district court disagreed and sanctioned the firm, finding that the failure to produce the CDD in a manner that preserved the document’s qualities was negligent and deprived Coquina of a full opportunity to use the document’s information at trial.

Counsel can also find themselves the subject of malpractice lawsuits for errors made during the discovery process. In 2011, J-M Manufacturing Co., Inc. sued its outside counsel, McDermott, Will & Emery, after the McDermott firm inadvertently produced to the federal government thousands of documents protected by attorney-client privilege. See J-M Manufacturing Co., Inc. v. McDermott, Will & Emery, No. BC462832, (Cal. Super. Ct., L.A. Cty). Similarly, in August 2013, technology company Devon IT filed a legal-malpractice action against its former counsel Mitts Law LLC for failing to adequately supervise and compensate the contract attorneys and outside vendors involved in the discovery process. Devon claimed that the Mitts firm mismanaged the fees paid to them for e-discovery services, causing the contract attorneys and vendors to stop work prematurely, which in turn caused Devon to settle its federal suit against IBM for substantially less than its claims were worth. Devon IT Inc. et al v. Mitts Milavec LLC et al., No.130603102, (Ct. Com. Pl., Phila. Cty).

Jonathan J. Walsh, Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY


October 22, 2013

Dismissal of Legal-Malpractice Claims Against DLA Piper Affirmed

Confirming the well-established principles that expert testimony is usually required to establish the duty of care in legal-malpractice cases and that causation is often the plaintiff’s Achilles heel, the Second Circuit recently affirmed the district court’s summary-judgment dismissal of legal-malpractice claims against DLA Piper. See In re Joseph DelGreco & Co., Inc., No. 12-4524, 2013 U.S. App. LEXIS 19572 (2d Cir. Sept. 25, 2013).

In DelGreco, the plaintiff company had retained DLA Piper to represent it in a transaction to create an ongoing supplier/distributor relationship between DelGreco and Eastwest, a Taiwan-based corporation. The transaction consisted of various agreements, including a promissory note from DelGreco to Eastwest, a security agreement, and a manufacturing-and-licensing agreement. The promissory note required an interest payment of $767.12 at the time of closing, which DelGreco did not pay. DLA did not specifically notify DelGreco in writing that it was supposed to make this payment. This missed payment formed the foundation of several of the plaintiff’s malpractice claims against the firm.

The relationship between DelGreco and Eastwest soured, and Eastwest filed suit against DelGreco. DLA Piper assisted DelGreco in the defense of those claims, but later withdrew due to nonpayment of legal fees. Eastwest obtained a judgment against DelGreco for $4.7 million, and DelGreco then filed suit against DLA Piper alleging 13 acts of legal malpractice, including that the failure to make the first interest payment caused Eastwest to declare default and that DLA improperly withdrew from its representation.

For 11 of the claims, DelGreco failed to present expert opinion establishing the standard of care that DLP Piper was required, but failed, to meet. The court found that plaintiff’s claims were not “so egregious” as to make any alleged breach of the standard of care obvious to a reasonable juror such that expert testimony was unnecessary, and therefore granted DLA Piper’s motion for summary judgment dismissing those claims. The court also found that DelGreco’s own substantial breaches, not DLA’s conduct, proximately caused Eastwest to declare default and DelGreco’s resulting damages.

DelGreco presented expert testimony for its remaining two claims of malpractice, i.e., that DLA Piper (i) should have ensured that DelGreco made the first interest payment and (ii) should have provided a copy of the various agreements to DelGreco at closing. The district court concluded that the expert testimony was sufficient to establish conduct falling short of the applicable standard of care. Nevertheless, the district court dismissed these claims because neither of these breaches could have proximately caused the plaintiff’s damages. Again, DelGreco’s own substantial breaches of its agreements with Eastwest caused its damages.

On appeal, the Second Circuit agreed that DelGreco’s own substantial breaches proximately caused its damages, not any alleged legal malpractice of DLA Piper. Moreover, the plaintiff’s failure to present expert testimony as to the applicable standard of care was fatal to all of its claims. The Second Circuit therefore affirmed the dismissal of the plaintiff’s legal-malpractice claims of DLA Piper.

Carey L. Menasco, Liskow & Lewis, APLC, New Orleans, LA


October 22, 2013

Miss. High Court Affirms Liability Judgment, Reverses Damage Award

The Mississippi Supreme Court, sitting en banc, affirmed a liability judgment in a legal-malpractice case against Baker & McKenzie, LLP, and one of its partners, but reversed a more than $103 million damages award and sent the matter back to the trial court for a new trial on causation and damages.

In Baker & McKenzie, LLP v. S. Lavon Evans, Jr., plaintiff Evans asserted that he had lost access to two drilling rigs, his companies’ largest assets, after “a storm of liens and suits by vendors” launched against him and his companies. Evans asserted that his legal troubles arose as a result of agreements he executed based on advice and recommendations from Baker & McKenzie, which he believed to be his lawyers.

Baker & McKenzie had an engagement letter with Evans and another entity for services related to responding to a Mississippi subpoena. The firm argued that its representation of Evans was limited to that work. Evans, however, alleged that he had looked to the firm for advice on many other matters. Evans said that the firm had provided him with the guidance he had sought and did not say until later that it was not representing him.

The case was tried to a jury in Jones County, Mississippi, in late 2010. The jury returned a verdict of $103 million in actual damages against Baker & McKenzie and one of its partners, and awarded $150,000 in punitive damages and about $12.6 million in attorney fees.

On appeal, the en banc Mississippi Supreme Court concluded that Evans had presented “substantial” evidence to support the jury’s liability finding. But the court held that the trial court had erred by failing to permit the jury to allocate fault to each of the parties, by submitting a peremptory jury instruction on liability that did not contain qualifying language and that represented an improper indemnity instruction, and by failing to make a requisite finding before submitting a question on punitive damages.

Accordingly, the Mississippi Supreme Court affirmed the trial court’s judgment on liability, but reversed the judgment concerning damages and remanded to the trial court for a new trial on proximate cause and damages.

Keywords: litigation, professional liability, legal malpractice, causation, damages, comparative fault, jury charge, jury instructions

Gavin R. Villareal, Baker Botts LLP, Austin, TX


October 17, 2013

Could the End Be Near for the Fraud-on-the-Market Theory?

The fraud-on-the-market presumption of reliance in securities-fraud cases, as first articulated by the Supreme Court in Basic Inc. v. Levinson, 485 U.S. 224, 247 (1988), has faced increased scrutiny in recent years. The presumption of reliance is based on the assumption that publicly available information is reflected in the market price of stocks traded in efficient markets. The most recent challenge to Basic comes by way of a petition for writ of certiorari filed by Halliburton on September 9, 2013, asking the Supreme Court to overrule Basic, or modify it so that plaintiffs would have to prove that an alleged misrepresentation affected a company’s stock price before gaining the benefit of the presumption. Halliburton Co. v. Erica P. John Fund, Inc., 2013 U.S. Briefs 317 (Sept. 9, 2013). If the Supreme Court grants Halliburton’s petition, it will mark Halliburton’s second time before the Court, having already unsuccessfully argued to the Court that plaintiffs in securities class actions must prove loss causation prior to class certification.

Halliburton’s petition for certiorari follows closely on the heels of the Supreme Court’s decision earlier in 2013 in Amgen Inc. v. Connecticut Retirement Plans & Trust Funds, 133 S. Ct. 1184 (2013). In Amgen, four justices took the opportunity to question the continuing vitality of the fraud-on-the-market presumption, in dissenting and concurring opinions. Justice Scalia criticized Basic as having no basis in statutory or common law. Justice Thomas, joined by Justice Kennedy, similarly questioned the presumption. Justice Alito posited that reconsideration of the presumption may be appropriate. Even the majority opinion in Amgen recognized that modern economic research undercuts the premise of the fraud-on-the-market presumption—market efficiency is no longer believed to be a binary, yes-or-no question; rather, differences in efficiency can exist within a single market.

Seizing on these doubts, Halliburton filed its petition for certiorari asking the Supreme Court to overrule Basic after the Fifth Circuit affirmed the district court’s certification of a securities class action against Halliburton. Halliburton argues that its case is the perfect vehicle for reexamining the fraud-on-the-market presumption of reliance because the alleged misrepresentations at issue did not cause a price impact on Halliburton’s stock. Halliburton offers three reasons Basic should be overruled.

First, continuing where the dissenting and concurring opinions in Amgen left off, Halliburton argues that Basic is premised on the outdated and faulty economic theory that the market price of shares traded on well-developed markets reflects all publicly available information. Halliburton points to academic critiques of Basic that have been mounting since its inception and notes that the consensus is that the fraud-on-the-market presumption is untenable.

Next, Halliburton argues that because an unsound economic theory underlies the fraud-on-the-market presumption federal courts have struggled to apply Basic, leading to inconsistent results, and that rather than subjecting themselves to the same confusion faced by their federal peers, state courts have eschewed adoption of the fraud-on-the-market presumption altogether.

Finally, Halliburton argues that Basic’s fraud-on-the-market presumption is inconsistent with recent Supreme Court precedent relating to class certification that requires plaintiffs to present evidentiary proof that common issues of the class predominate over individual ones.

Halliburton posits that “[i]f expert testimony and economic models are insufficient to show that common issues truly predominate, a bare presumption that all agree is unrelated to actual common reliance cannot coexist with Rule 23.”

Halliburton argues in the alternative that Basic’s fraud-on-the-market theory should, at the very least, be pared down to require plaintiffs to prove that an alleged misrepresentation actually affected a company’s stock price before the fraud-on-the-market presumption could be invoked.

Given the doubt cast on the presumption by the dissenting and concurring opinions in Amgen, Halliburton’s petition is one to keep a close eye on.

Keywords: litigation, professional liability, fraud-on-the-market, securities fraud, reliance

Kurt Lentz, Sutherland Asbill & Brennan LLP, Atlanta, GA


July 15, 2013

Escrow Agents Have No Duty, Right to Extracontractual Investigation

A Florida appellate court recently held that an escrow agent neither has the duty nor the right to inquire into payment instructions submitted under an escrow agreement that does not require such investigation. In SO5 501, LLC v. Metro Dade Title Co., 109 So. 3d 1192 (Fla. 3d DCA March 27, 2013), a purchaser of a pre-construction unit in a condominium brought suit against an escrow agent for gross negligence and breach of fiduciary duty. The buyer deposited 10 percent of the purchase price of a condo. The buyer failed to deposit the required additional 10 percent, and as a result, the developer informed the escrow agent that the buyer had defaulted and therefore the developer was entitled to retain a portion of the deposit.

The buyer brought suit, claiming that it had an oral agreement with the developer that it need not deposit the additional 10 percent, and that the escrow agent had an obligation to “verify the representations made by the developer before complying with the written directives it received from the developer instructing it to disburse the [b]uyer’s deposit.” The court observed that the escrow agent “was contractually required to disburse the [b]uyer’s deposit to the developer” once the developer had represented that the buyer had defaulted. The court stated that the contractual obligation was triggered once the developer sent a letter advising the escrow agent that the buyer had defaulted. Further, the court stated that “the escrow agent did not have the responsibility nor the right to inquire into directions to pay made by the developer.”

The court affirmed the trial court’s grant of judgment on the pleadings to the escrow agent. The court held that under the escrow agreement, the escrow agent’s duties were limited to following the escrow instructions. Further, the court held that under the escrow agreement, the escrow agent is “expressly relieved from any duty or obligation to investigate the veracity of the developer's disbursement instructions.” Therefore, when an escrow agent disburses funds as instructed by a developer, the escrow agent cannot breach its fiduciary duty, nor be grossly negligent, if it disburses the funds in the manner instructed by the developer and required by the escrow agreement.

This opinion is important for professional-liability practitioners in that attorneys and title agents both often serve as escrow agents in construction purchases or other transactions. This decision bolsters the argument that a court must look solely at the language of the applicable escrow agreement to determine the duties owed by an escrow agent to the principals.

Jeffrey M. James and Stephen J. Bagge, Banker Lopez Gassler P.A., Tampa, Florida


April 24, 2013

PCAOB Expands Enforcement Presence in New York Region

The Public Company Accounting Oversight Board (PCAOB), on February 4, 2013, indicated a new focus of its enforcement program in the New York region. The PCAOB announced the creation of a new position within its Division of Enforcement and Investigations (DEI): New York Office regional associate director. Filling the new position will be C. Ian Anderson, former senior trial counsel in the Miami office of the SEC Division of Enforcement.

To date, the DEI has been a relatively small component of the PCAOB’s total activity. The PCAOB 2013 Budget by Program Area reflects a budget of $21 million for the DEI, compared to $127 million for the Division of Registration and Inspections. It has been centrally located and staffed in the PCAOB’s Washington, D.C., headquarters. The hiring of Anderson represents a significant new step for the PCAOB’s enforcement regime and suggests a potential increase in enforcement activity in the New York area.

This new hiring may also signal an increase in the PCAOB’s enforcement activity related to its jurisdiction over broker-dealer audits. The Dodd-Frank legislation gave the PCAOB authority over the audits of broker-dealers, and the board’s first inspections of broker-dealers commenced in August 2011. According to the PCAOB Report on the Progress of the Interim Inspection Program Related to Audits of Brokers and Dealers, PCAOB Rel. No. 2012-005 (Aug. 20, 2012), the board found audit deficiencies in all of the audits the PCAOB inspected. In a keynote address during a conference last fall, one PCAOB board member referred to these results as “disturbing.”

The maturation of the PCAOB’s inspection program for broker-dealer audits will invariably lead to an increased enforcement focus in this area. Given New York’s status as the hub of broker-dealer activity, it is likely that any serious enforcement focus will be centered in the PCAOB’s New York Regional Office, which will now be led by Anderson.

Veronica E. Rendón and Bret A. Finkelstein, Arnold & Porter LLP, New York, NY


April 18, 2013

Federal Jurisdiction over Patent Legal-Malpractice Claims Rejected

In its recent decision in Gunn v. Minton, 133 S. Ct. 1059 (2013), the U.S. Supreme Court held that legal-malpractice claims, even if arising from underlying issues of patent law, belong in state court.

The Court granted certiorari to clarify the scope of exclusive federal jurisdiction—pursuant to 28 U.S.C. § 1338—for claims “arising under” federal patent, copyright, and trademark law. The leading cases from the Federal Circuit had held that legal-malpractice claims involving underlying patent matters fall to the exclusive jurisdiction of the federal courts under section 1338. See Air Measurement Tech., Inc. v. Akin Gump Strauss Hauer & Feld, L.L.P., 504 F.3d 1262 (Fed. Cir. 2007); Immunocept, L.L.C. v. Fulbright & Jaworski, L.L.P., 504 F.3d 1281 (Fed. Cir. 2007). The Texas Supreme Court, in Minton v. Gunn, 355 S.W.3d 634 (Tex. 2011), had followed the Federal Circuit’s lead and declined to exercise jurisdiction over a malpractice claim centering on issues of patent law.

The Supreme Court reversed and, by implication, overruled the Federal Circuit’s precedent in Air Measurement and Immunocept. The Court began by reaffirming the test for “arising under” jurisdiction; the federal issue must be: (1) necessarily raised; (2) actually disputed; (3) substantial; and (4) capable of resolution in federal court without disrupting the balance of state and federal courts established by Congress. Gunn, 133 S. Ct. at 1065 (citing Grable & Sons Metal Prods., Inc. v. Darue Eng’g & Mfg., 545 U.S. 308, 314 (2005)). All four requirements must be met for a federal court to exercise “arising under” jurisdiction over a state-law claim.

In the case of Minton’s legal-malpractice claim, the Court found that the first two prongs of Grable were met: (i) The underlying “case within a case” necessarily raised issues of patent law; and (ii) the parties actually disputed those issues. The Court, however, held that resolving a patent issue in evaluating the “case within a case” did not raise a “substantial” federal issue, and the claim thus failed the third Grable prong. The Court noted that, in assesing the “substantial” prong of Grable, “it is not enough that the federal issue be significant to the particular parties in the immediate suit,” it must be important “to the federal system as a whole.” Id. at 1066. The Court found that state-court determinations of patent issues in legal-malpractice claims—which are rooted in the hypothetical “case within a case”—were unlikely to have a substantial effect on the development of uniform federal patent law. It followed that Minton’s malpractice claim also failed the fourth Grable requirement and federal jurisdiction would upset the state-federal balance. States have a “special responsibility” for regulating their licensed professions, and the Court explained that Congress did not intend to bar state courts from applying those regulations “simply because they require resolution of a hypothetical patent issue.” Id. at 1068.

The Court held that Minton’s legal-malpractice claim did not arise under federal patent law and it was proper for the Texas state courts to decide the case. The Court went one step further, though, and stated: “[W]e are comfortable concluding that state legal malpractice claims based on underlying patent matters will rarely, if ever, arise under federal patent law for purposes of § 1338(a).” Id. at 1065.

Read a pre-argument discussion of this case.

Keywords: professional liability litigation, legal malpractice; patents; federal jurisdiction; exclusivity; preemption; litigation; attorneys; Supreme Court

Hunter Allen, Baker Botts L.L.P., Dallas, TX


February 19, 2013

Subject-Matter Waiver Does Not Apply to Extrajudicial Disclosures

The Illinois Supreme Court has declined to apply the subject-matter-waiver doctrine to extrajudicial disclosures that were not made to gain an advantage in litigation. The issue arose in a dispute between two groups of partners in a limited partnership that owns retail shopping centers. The plaintiffs (minority limited partners) sued the defendants (who controlled the general partner and a majority of the limited partnership interests), alleging that the defendants had breached fiduciary and contractual duties owed to the minority limited partners. In discovery, the plaintiffs learned that in the negotiations that led up to the transaction through which the defendants acquired their interests, various defendants had disclosed the substance of privileged legal advice they had received from their own counsel to other defendants. The plaintiffs argued that this selective disclosure of privileged communications constituted a waiver of the attorney-client privilege over all other privileged communications concerning the same subject matter. The trial court agreed and ordered disclosure, and the Illinois Appellate Court affirmed.

Read the full case note.

Linton J. Childs , Sidley Austin LLP, Chicago, IL


February 19, 2013

Strong Incentives for CEOs and CFOs to Ensure Houses Are in Order

In SEC v. Baker, the U.S. District Court for the Western District of Texas (Sparks, J.) held that section 304 of the Sarbanes-Oxley Act requires CEOs and CFOs to pay back certain incentive-based and other compensation to an issuer that files a restatement due to misconduct, even when it was not the CEO’s or the CFO’s misconduct that gave rise to the need restate a prior filing. Baker is one of the first decisions to have examined whether section 304 may be enforced against a CEO or a CFO who is not himself or herself accused of wrongdoing, and it is the first decision to consider whether such enforcement violates the Constitution or the Civil Asset Forfeiture Reform Act (CAFRA).

Read the full case note.

Robert A. Stolworthy Jr., Arnold & Porter LLP, Washington, D.C.


December 3, 2012

Federal Jurisdiction over Patent-Based Malpractice Claims in Question

On November 26, 2012, the U.S. Supreme Court heard argument in a case that will decide whether state-law malpractice claims arising from the handling of underlying patent matters fall within the exclusive jurisdiction of the federal courts.

Under 28 U.S.C. § 1338, all claims “arising under” federal patent, copyright, or trademark law fall to the exclusive jurisdiction of federal courts and are appealed to the Federal Circuit. The Federal Circuit has held that legal-malpractice claims, even though brought under state-law causes of action, arise under federal law if they center on underlying patent matters. It follows that such claims must be brought in federal court. In Minton v. Gunn, 355 S.W.3d 634 (Tex. 2011), the Texas Supreme Court adopted the Federal Circuit’s rule: It dismissed the appeal of a patent-based legal- malpractice claim, holding that the Texas courts lacked jurisdiction over the claim. The U.S. Supreme Court granted certiorari to determine the scope of “arising under” jurisdiction as it applies to legal-malpractice claims.

In January 2000, Vernon Minton filed a patent-infringement action against the National Association of Securities Dealers, Inc. (NASD) in the Eastern District of Texas. The trial court granted summary judgment of invalidity in favor of NASD because Minton’s invention had been the subject of a commercial lease more than one year prior to filing his patent application—thus, his patent was invalid under the on-sale bar of 35 U.S.C. § 102(b). Minton’s attorneys did not argue, in response to NASD’s motion for summary judgment, that the lease should be excepted from the section 102(b) on-sale bar because it had the primary purpose of testing or developing the product, known as the experimental-use exception. Minton’s subsequent counsel unsuccessfully briefed and argued the experimental-use exception in a motion for reconsideration. On appeal, the Federal Circuit affirmed the trial court’s grant of summary judgment.

On August 25, 2004, Minton brought a state-law malpractice claim against his attorneys. The attorney-defendants moved for summary judgment, arguing that Minton failed to show causation because the experimental-use doctrine did not apply to the commercial lease at issue. The trial court agreed, granted summary judgment, and Minton appealed.

While Minton’s legal-malpractice claims were on appeal, the Federal Circuit decided two cases holding that federal courts have exclusive jurisdiction over legal-malpractice claims involving underlying patent matters. See Air Measurement Tech., Inc. v. Akin Gump Strauss Hauer & Feld, L.L.P., 504 F.3d 1262 (Fed. Cir. 2007); Immunocept, L.L.C. v. Fulbright & Jaworski, L.L.P., 504 F.3d 1281 (Fed. Cir. 2007). As a result, Minton argued that the state court lacked subject-matter jurisdiction over his (failed) claims. The Fort Worth Court of Appeals rejected the Federal Circuit’s jurisdictional formulation as contrary to the Supreme Court’s holding in Grable & Sons Metal Prods., Inc. v. Darue Eng’g & Mfg., 545 U.S. 308, 314 (2005), which provided that a federal question exists when the federal issue is (1) “actually disputed and substantial” and (2) does not disturb the balance of federal and state judicial responsibilities. Id. at 314. The court of appeals held that the federal issue—whether Minton’s case would have actually been saved by the experimental-use doctrine (or, the case within the case)—was not substantial because the question of whether there was evidence supporting experimental use was predominantly one of fact, with little or no precedential value. The court also held that the exercise of federal jurisdiction would disturb the balance of federalism by removing from the state courts one of their traditional domains: legal malpractice. The court of appeals retained jurisdiction and affirmed the case on its merits.

The Texas Supreme Court reversed. In a 5–3 decision, the majority strictly applied the Federal Circuit’s jurisdictional formulation, finding that legal-malpractice claims involving issues of patent law “arise under” federal patent law and fall to the exclusive jurisdiction of the federal courts.

Now the Supreme Court will finally decide the issue. The attorney-defendant’s petition for a writ of certiorari argued that the Federal Circuit’s formulation ignores consideration of specific factors enumerated in Grable: whether the federal issue is “disputed and substantial” and whether federal jurisdiction disturbs the balance between the courts. The Supreme Court granted the writ, consolidating Gunn alongside four other “arising under” cases, to clarify the scope of section 1338’s jurisdictional scope.

Keywords: professional liability litigation, legal malpractice; patents; federal jurisdiction; exclusivity; preemption; litigation; attorneys; Supreme Court

Hunter Allen, Baker Botts L.L.P., Dallas, TX


November 20, 2012

An Analysis of the Most Recent SEC Reinstatements

A review of the reinstatements the Securities and Exchange Commission (SEC) has granted to individuals suspended under Rule 102(e) over the last five years shows that applicants must wait over two years before obtaining reinstatement. Under Rule 102(e), the commission can “censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission . . . to have engaged in unethical or improper professional conduct.” While not the commission’s exclusive enforcement action against accountants and attorneys, Rule 102(e) proceedings are one of the most common proceedings brought by the commission against these professionals.

The SEC often settles administrative proceedings brought against accountants and attorneys under Rule 102(e) by issuing an order that denies the accountant or attorney the right to appear or practice before the commission with the right to request reinstatement after a certain number of years. In effect, this form of settlement constitutes a suspension for an agreed-upon number of years. In practice, however, an individual who applies for reinstatement at the end of his or her suspension period should not expect to be reinstated expeditiously.

A review of the 45 reinstatements that the SEC has approved since 2007 shows that the commission takes an average of two years and nine months to grant reinstatement. (See chart.) While some part of the delay may be attributed to the timing of the individual’s application for reinstatement, the requirements for reinstatement, many of which cannot be fulfilled until the completion of the suspension period, and the SEC’s own timetable for review of reinstatement applications ensure that individuals who apply for reinstatement will have a substantial waiting time before a decision on their reinstatement application. Indeed, most settled orders require the accountant seeking reinstatement to demonstrate that his or her state CPA license is current and all other disciplinary issues have been resolved with the applicable state boards of accountancy, which in most cases cannot accomplished until the end of the SEC suspension period.

Individuals who are considering an offer of settlement that includes some time period before allowing for an application for reinstatement should take into account the additional time required for the reinstatement process.

Keywords: professional liability litigation, Rule 102(e), SEC Reinstatement

— Jonathan J. Walsh, Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY


November 20, 2012

PCAOB Privilege Applies to Communications about Inspections

Discovery requests to accounting firms for materials relating to Public Company Accounting Oversight Board (PCAOB) inspections of their audits have become more frequent. These materials can include, for example, communications by the audit firm to the PCAOB inspectors regarding the audit, oral and written responses to questions from the PCAOB inspectors, responses to PCAOB inspection comments, and internal communications regarding the PCAOB’s inspection, questions, and comments. Section 105(b)(5)(A) of the Sarbanes-Oxley Act of 2002 affords a privilege to “documents or information prepared or received by or specifically for” the PCAOB. Audit firms, together with the Center for Audit Quality, have contended that if litigants can compel production of materials related to the PCAOB’s confidential inspection process notwithstanding this privilege, open and constructive engagement between the PCAOB and accounting firms could be chilled by the threat of increased civil litigation. Further, the statutory framework carefully crafted by Congress to improve the quality of public-company audits could be frustrated. Their arguments have met with varying degrees of success in the limited number of cases addressing this issue.

Two district courts have reached differing conclusions on the scope of this privilege, one recently upholding the applicability of the PCAOB privilege to an audit firm’s internal documents relating to the firm’s response to PCAOB inspectors and inspection reports. Bennett v. Sprint Nextel Corp., Case No. 11-9014-MC-W-ODS, 2012 U.S. Dist. LEXIS 145902 (W.D. Mo. Oct. 10, 2012).

Bennett, a securities-fraud class action, involved allegations that Sprint falsely reported its quarterly and annual financial results over the time period relevant to the class action. The plaintiffs subpoenaed from KPMG, Sprint’s auditor, documents related to the PCAOB’s inspection of KPMG as it related to KPMG’s audit of Sprint’s financial statements.

KPMG invoked the “PCAOB privilege,” which reads as follows:

[A]ll documents and information prepared or received by or specifically for the Board, . . . in connection with an inspection under section 104 or with an investigation under this section, shall be confidential and privileged as an evidentiary matter (and shall not be subject to civil discovery or other legal process) in any proceeding in any Federal or State court or administrative agency, and shall be exempt from disclosure, in the hands of an agency or establishment of the Federal Government, under the Freedom of Information Act [5 U.S.C. § 552a], or otherwise, unless and until presented in connection with a public proceeding or released in accordance with subsection (c).

15 U.S.C. § 7215(b)(5)(A).

Until Bennett, only one other decision had squarely addressed the applicability of this privilege; that court had held that the privilege attaches only to materials actually provided by the accounting firm to the PCAOB, and not to internal documents or communications used to prepare such materials (including, for example, draft responses). See Silverman v. Motorola, Inc., No. 07-C-4507, 2010 U.S. Dist. LEXIS 81671, *12 and *16 (June 29, 2010). Silverman thus interpreted narrowly the applicability of the privilege for materials “prepared or received by or specifically for the Board,” reasoning that the statutory language “did not create a blanket privilege regarding the PCAOB inspection process” and that “[i]f Congress [had] intended the privilege to protect all materials related to the inspection, the text of the statute would reflect that intention.”

Bennett expressly rejected the Silverman rationale, and held that internal communications discussing confidential questions or comments by the board or reflecting the development of responses to board inquiries or comments are protected. “All of these communications are specifically for the Board because absent the inspection, these documents and communications would not exist.” Bennett, 2012 U.S. Dist. LEXIS 145902 at *12.

Bennett went on to hold, however, that substantive information prepared by KPMG for Sprint that was also used to respond to PCAOB inquiries would not be privileged under this statute.

[T]he privilege does not extend to documents from the underlying transaction or work that is the subject of the investigation as such documents are not prepared for the Board. When those underlying documents are given to the Board, the fact they were delivered is privileged, but the documents themselves are not.

Bennett also held that the PCAOB privilege attaches to materials in the possession of the audit firm, not just the PCAOB, and that merely notifying an audit client that the audits of its financial statements will be inspected does not waive the privilege.

Keywords: professional liability litigation, PCAOB, PCAOB privilege

Amelia Toy Rudolph, Sutherland Asbill & Brennan LLP, Atlanta, GA


November 20, 2012

PCAOB Adopts Standard to Enhance Audit Communications

On August 15, 2012, the Public Company Accounting Oversight Board (PCAOB) adopted Auditing Standard No. 16, Communications with Audit Committees. The new standard requires new and more specific communications between the auditor and the audit committee regarding documentation of the auditor’s engagement, planning and conducting the audit, and reporting the results. The new standard is designed to foster “constructive dialogue between the auditor and the audit committee about significant audit and financial statement matters.” Two-way communication throughout the audit is the goal.

The new standard requires the auditor to establish with the audit committee—not just with the client, as under AU sec. 310—an understanding of the terms of the audit engagement. These include the objective of the audit and the respective responsibilities of the auditor and of management. That understanding must now be recorded in an engagement letter, executed by the appropriate person on behalf of the company and delivered to the audit committee annually, and not merely documented in the working papers as before.

The new standard requires the auditor to ask the audit committee whether it is aware of any “violations or possible violations of laws or regulations.” This requirement enhances the existing rule that the auditor must question the audit committee regarding matters important to the identification and assessment of risks of material misstatement and fraud.

The new standard also addresses the timing and the substance of the auditor’s communications with the audit committee. Now, while the auditor must complete the required communications “in a timely manner,” these communications must take place before issuing the audit report. The auditor must communicate with the audit committee about the company’s accounting policies, practices, and estimates; the auditor’s evaluation of the quality of the company’s financial reporting; information related to unusual transactions, including the business rationale for such transactions; and the auditor’s views regarding significant accounting or auditing matters.

Auditing Standard No. 16 also requires the auditor to provide the audit committee with information about significant aspects of the audit. These include an overview of the audit strategy, any significant risks identified, and any significant changes to the planned audit strategy. The auditor must also communicate to the audit committee regarding any specialized skill or knowledge needed in the audit; the auditor’s plans for using the company’s internal auditors or other company personnel; and, if significant parts of the audit will be performed by others, the basis for determining that the auditor can still serve as principal auditor.

The new standard also addresses communications about the result of the audit. The auditor should communicate to the audit committee about significant or critical accounting policies and practices, critical accounting estimates, and significant unusual transactions. In addition, the standard requires the auditor to communicate any concerns about management’s anticipated application of issued-but-not-yet-effective accounting pronouncements; difficult or contentious matters on which the auditor consulted outside the engagement team; the auditor’s going-concern evaluation; any departures from the auditor’s standard report; and any other matters that are significant to the oversight of the company’s financial-reporting process, including complaints or concerns about accounting or auditing matters that have come to the auditor’s attention.

Auditing Standard No. 16 supercedes AU sec. 380, Communication with Audit Committees, and AU sec. 310, Appointment of the Independent Auditor. Subject to SEC approval, the new standard will be effective for public company audits for fiscal years beginning on or after December 15, 2012.

Keywords: professional liability litigation, PCAOB, Auditing Standard No. 16

Dylan C. Black, Bradley Arant Boult Cummings LLP, in Birmingham, AL


October 30, 2012

SOX Shields Auditor Responses but Not Underlying Documents

Documents that an auditor prepares for the Public Company Accounting Oversight Board (PCAOB), or that are prepared by or received by the PCAOB, are privileged under a provision of the Sarbanes-Oxley Act (SOX), but substantive information the auditor prepares for its audit client and uses to respond to a PCAOB inquiry may not be privileged, according to the U.S. District Court for the Western District of Missouri.

Bennett v. Sprint Nextel Corp. (No. 11-9014-MC-W-ODS, W.D. Mo.) is a putative class action in which the plaintiffs asserted fraud claims in connection with Sprint’s merger with Nextel. Non-party KPMG LLP performed accounting work for Sprint in connection with this transaction. In July 2006, the PCAOB began an inspection of KPMG. The investigation encompassed KPMG’s procedures and testing during the Sprint audits.

The plaintiffs issued a subpoena to KPMG requesting the firm produce documents for use in the class-action lawsuit. The trial court ordered KPMG to produce its entire set of work papers reflecting KPMG’s audits and reviews of Sprint’s financial statements. KPMG withheld from its production 468 documents related to the PCAOB investigation for which it asserted privilege under SOX.

Section 105(b)(5)(A) of SOX provides:

[A]ll document and information prepared or received by or specifically for the Board, and deliberations of the Board and its employees and agents, in connection with an inspection under section 104 or with an investigation under this section, shall be confidential and privileged as an evidentiary matter (and shall not be subject to civil discovery or other legal process) in any proceeding in any Federal or State court or administrative agency, and shall be exempt from disclosure . . . under the Freedom of Information Act. . . .

Class plaintiffs challenged KPMG’s assertion of this privilege. The district court rejected the plaintiffs’ contention that this privilege only covers documents in the hands of the PCAOB and not in the hands of third parties. The court also rejected the plaintiffs’ claim that the “Board,” as mentioned in the statutory language, means only the appointed PCAOB members and not their staff. The court also held that the privilege extended to KPMG’s internal communications that related to the PCAOB investigation.

The court concluded that a majority of the withheld documents fell within the first category of privilege, as “documents and information prepared or received by or specifically for the Board.” The court was careful to exclude, however, “any substantive information, documents, spreadsheets, or forms that were compiled specifically for Sprint, but [were] nevertheless used to respond to the Board’s inquiries. . . .” The court found none of the documents fell within the “deliberations” portion of the privilege. The court also found that the class plaintiffs had failed to meet their burden to establish that KPMG had waived the privilege.

Keywords: litigation, discovery, Sarbanes Oxley, PCAOB, privilege, audit, auditor, investigation, class actions

Gavin R. Villareal, Baker Botts L.L.P., Austin, TX


June 13, 2012

Accounting Allegations on the Rise in Securities Class Actions

The number of securities class-action cases that involve allegations of accounting fraud is on the rise again, thanks to a large number of accounting restatements and an increase in market volatility last year, according to a new report from Cornerstone Research.

According to Cornerstone, class actions that included accounting allegations increased in 2011 to 70, up 52 percent from a four-year low of 46 in 2010. Cases including accounting allegations represented 37 percent (70) of all 188 class actions filed in 2011, compared to 26 percent (46) of 176 class actions filed in 2010. More than 60 percent of cases with accounting allegations also included complaints about internal control weaknesses.

This increase can be attributed in part to the number of Chinese reverse-merger filings in 2011, which are significantly more likely to involve restatements of financial statements and, as a result, include alleged violations of generally accepted accounting principles (GAAP).

U.S. class actions related to accounting fraud have generally been declining since the Sarbanes-Oxley Act of 2002 required companies to put in more controls over financial reporting, according to industry experts.

A relatively small number of these cases include auditor defendants or auditing allegations. For the period 2006–2011, only eight initial filings included auditing allegations. Auditing allegations were added in eleven cases, and dropped in three, leaving 16 amended complaints including auditing allegations (compared to 71 including GAAP allegations). In that same period only 16 amended complaints (compared to 71 amended complaints naming company accounting personnel) included auditor defendants, according to Cornerstone.

A summary of the report’s findings can be found here.

Keywords: litigation, professional liability, accounting, fraud, cornerstone, class actions, internal controls, Sarbanes Oxley, audit, auditor, GAAP, GAAS

Amy June, Bingham McCutchen LLP, Palo Alto, CA


June 13, 2012

Deloitte Settles Bear Stearns Investor Suit

On June 11, 2012, it was announced that Deloitte & Touche LLP will pay only $19.9 million to settle claims by The Bear Stearns Cos. investors, a fraction of the $275 million settlement amount to be paid by Bear Stearns, announced on June 6.

The lawsuit, filed in federal court in the Southern District of New York, claims that Bear Stearns and its auditor, Deloitte, misled investors about the bank’s financial health in the years leading up to its collapse. In particular, Deloitte allegedly ignored Bear Stearns’ risky investments and mortgage underwriting and securitization practices, which the plaintiffs claimed contributed to the bank’s downfall in 2008.

The plaintiffs claimed that Bear Stearns had a strategy of generating large numbers of risky mortgages to securitize and sell, and then maintained billions of dollars of these assets on its own books. They claim that, as its auditor, Deloitte “deliberately or recklessly” ignored “red flags” of deficient internal controls, and issued deficient audit reports. In particular, they claim that Deloitte’s 2007 audit failed to address the impact of the escalating housing crisis on the bank’s finances, and that Deloitte should have been more aware of the fact that Bear Stearns’s mortgage-related valuation models did not take account of increasing mortgage-loan defaults. They also claimed that the housing downturn was not reflected in Bear Stearns’s projections for the value of financial instruments, another alleged red flag according to the plaintiffs.

The case is In re: Bear Stearns Cos. Inc. Securities, Derivative and ERISA Ligiation, case number 1:08-md-01963 in the U.S. District Court for the Southern District of New York.

Keywords: litigation, professional liability, Deloitte, audit, auditor, housing market, Bear Stearns, settlement

Amy June, Bingham McCutchen LLP, Palo Alto, CA


June 13, 2012

Ernst & Young Dismissed From IndyMac Securities-Fraud Case

On June 8, 2012, Ernst & Young was dismissed from shareholder litigation against IndyMac Bancorp, Inc. when U.S. District Judge George Wu in Los Angeles concluded that Ernst & Young had not committed securities fraud, based on the facts of the case.

Ernst & Young was IndyMac’s auditor during the 2006 and 2007 fiscal years. In their complaint, shareholders claimed that Ernst & Young committed securities fraud in the course of those audits by, among other things, failing to include a “going concern” warning in their audit opinion about IndyMac’s financial survival as of Dec. 31, 2007.

In its defense, Ernst & Young argued that the plaintiffs had borrowed from related cases to add facts to their allegations, but that none of those alleged facts involved Ernst & Young.

“In the end, the Court would observe (as has EY) that, despite providing numerous accounts of IndyMac insiders attesting to wrongdoing within the company and laying blame at the feet of co-defendants Michael Perry and A. Scott Keys, the . . . complaint provides zero witnesses attributing any particular knowledge of, or misdeeds of, EY,” Wu wrote.

Ernst & Young spokesman Charlie Perkins issued a statement: “We are very pleased with Judge Wu’s ruling in this case.”

Keywords: litigation, professional liability, Ernst & Young, audit, auditor, IndyMac, fraud

Amy June, Bingham McCutchen LLP, Palo Alto, CA


June 13, 2012

New York Court Rejects Nonpecuniary Damages for Legal Malpractice

On May 31, 2012, the New York Court of Appeals ruled that nonpecuniary damages are not available in an action for attorney malpractice.

Thomas Dombrowski hired attorney Raymond Bulson to represent him on sexual-assault charges in New York. Dombrowski was convicted after a jury trial. He moved to vacate his conviction, complaining that Bulson had not effectively represented him at trial, such as by failing to investigate or present evidence concerning an allegedly meritorious defense, failing to interview certain potential witnesses, and failing to cross-examine the victim regarding discrepancies in her testimony. The trial court denied his motion. Dombrowski then sought habeas relief from the U.S. District Court for the Western District of New York. After an evidentiary hearing, the federal court granted the habeas petition, ruling that errors by Dombrowski’s counsel made it difficult for the jury to make a reliable assessment of the “critical issue” of the victim’s credibility. Dombrowski was not re-prosecuted and the indictment against him was dismissed.

Dombrowski subsequently sued Bulson, his attorney, for malpractice. Among other damages, Dombrowski sought nonpecuniary damages for the loss of liberty (he was imprisoned for five years) and other losses that were the direct result of his conviction. The trial court granted summary judgment for Bulson. The Appellate Division (Fourth Department) reinstated the portion of Dombrowski’s complaint seeking nonpecuniary damages, holding that while such damages are unavailable in a civil malpractice claim, an individual who had been wrongfully convicted as a result of attorney malpractice in a criminal matter could recover for loss of liberty and related harm.

The New York Court of Appeals reversed. In reaching its decision, the court found that the policy concerns of permitting recovery of such damages outweighed the potential benefit:

Allowing this type of recovery would have, at best, negative and, at worst, devastating consequences for the criminal justice system. Most significantly, such a ruling could have a chilling effect on the willingness of the already strapped defense bar to represent indigent accused. Further, it would put attorneys in the position of having an incentive not to participate in post-conviction efforts to overturn wrongful convictions.

The case is Dombrowski v. Bulson, 2012 WL 1946592 (N.Y.), Slip Op. 04203 (May 31, 2012).

Keywords: litigation, professional liability, legal malpractice, nonpecuniary damages, New York, Dombrowski, Bulson

Gavin R. Villareal, Baker Botts L.L.P., Austin, TX


April 13, 2012

Refco Firms Can't Avoid Claims Stemming from Bankruptcy

On April 9, 2012, the special master, Daniel J. Capra, in In Re: Refco Securities Litigation (Case No. 1:07-md-1902) recommended that most of the allegations supporting a single claim of malpractice against Shulte Roth, who acted as legal counsel to the Sphinx Funds, should proceed in the litigation. The liquidators for the Sphinx Ltd. Funds alleged that Schulte Roth may have drafted conflicting provisions in the hedge funds’ government documents, and that the firm didn’t properly advise them about bankruptcy-law provisions that had an impact on their decision making when deciding whether to let investors cash out as the Refco fraud was unraveling. Among other things, the special master found that the Sphinx Funds had raised a fact question about whether Schulte Roth’s failure to inform them about the bankruptcy-law provisions was legal malpractice, and that it did not matter that Schulte Roth had withdrawn from representing the funds before the redemption took place. He also rejected Schulte Roth’s argument that the fact that Gibson Dunn & Crutcher LLP continued to represent the Sphinx Funds after Schulte Roth withdrew cut off the chain of causation.

Only two weeks earlier, on March 24, 2012, Judge Jed S. Rakoff ruled that Mayer Brown LLP, primary counsel for Refco Inc. until Refco’s October 2005 collapse, must face claims that it reviewed and prepared public documents for shady Refco transactions that were designed to conceal its terrible financial condition. The special master recommended dismissing a claim for aiding and abetting fraud that sought to recover assets placed with Refco before Mayer Brown’s alleged wrongdoing, as well as claims for interference with contract and aiding breach of fiduciary duty and conversion. But, he also found that assets placed with Refco after Mayer Brown’s alleged wrongdoing could give rise to a claim for assisting the fraud because the Sphinx Funds would not have continued to make deposits if it knew the truth about Refco. In a one-page ruling on March 24, Judge Rakoff adopted all of those findings in full.

Full coverage can be found on Law 360.

Keywords: litigation, professional liability, malpractice, fraud, breach of fiduciary duty, Mayer Brown, Refco, Shulte Roth, bankruptcy

Amy June, Bingham McCutchen LLP, Palo Alto, CA


April 4, 2012

Prosecutorial Misconduct Revealed in Sen. Stevens Corruption Scandal

On March 15, 2012, special prosecutor Henry “Hank” Schuelke III released a 525-page report, revealing that two Justice Department prosecutors intentionally hid evidence that may have exculpated the late Sen. Ted Stevens. Stevens died in a plane crash in Alaska in 2010.

A jury convicted Stevens on public-corruption charges in 2008; but, before Stevens was sentenced, Attorney General Eric Holder requested to dismiss the indictment on allegations of prosecutorial misconduct.

U.S. District Judge Emmet Sullivan tasked Schuelke with the investigation, which ultimately concluded that “[t]he investigation and prosecution of [Stevens] were permeated by the systematic concealment of significant exculpatory evidence which would have independently corroborated [Stevens’] defense and his testimony, and seriously damaged the testimony and credibility of the government’s key witness.” Specifically, the undisclosed information involved (1) witness Rocky Williams, whose testimony would have supported Stevens’s position that services were paid for and (2) the credibility of the government’s main witness, who was involved in an unrelated prostitution case.

The investigated prosecutors—William Welch II, Brenda Morris, Edward Sullivan, Joseph Bottini, and James Goeke—were cooperative. A sixth prosecutor, Nicholas Marsh, committed suicide in 2010. The report was finalized in November, but kept under seal to provide the prosecutors with an opportunity to respond.

According to the report, prosecutors Bottini and Goeke bore most of the blame for withholding important information. In their lengthy responses, Bottini and Goeke admitted that mistakes may have been made, but that no misconduct was intentional. Counsel for Bottini and Goeke claim that the evidence tends to prove that Bottini and Goeke were actually pushing to disclose the information. Goeke’s lead counsel stated that “the idea that [Goeke] is being held intentionally responsible for discovery violations is in itself a miscarriage of justice.”

Stevens’s defense lawyers claim the report reveals “the worst misconduct we’ve seen in a generation by prosecutors at the Department of Justice.” Cleared prosecutors have also expressed support for the report’s findings. Schuelke notably states that the evidence does not support criminal contempt charges against any prosecutors.

Soon after the report was released, Sen. Lisa Murkowski (R-Alaska) announced new legislation aimed at preventing this type of prosecutorial misconduct. This new legislation, the Fairness in Disclosure Act of 2012, would require prosecutors to timely disclose any favorable information or face sanctions. Sen. Patrick Leahy (D-Vt.), chairman of the Judiciary Committee, has announced plans to hold a hearing with Schuelke prior to April recess. The Justice Department is expected to release an internal ethics investigation by the Office of Professional Management.

Consequence for evidence suppression is not limited to public lawyers. In the private-law context, litigators must be mindful of their professional responsibilities. In California, “[a lawyer] shall not suppress any evidence that the [lawyer] or the [lawyer's] client has a legal obligation to reveal or to produce.” CRPC 5-220. ABA Model Rule 1.6 similarly prohibits lawyers from suppressing evidence, with one caveat: Absent appropriate discovery/subpoena, lawyers are under no obligation to volunteer evidence harmful to their client's position. Lawyers must defer to the specificity of the subpoena/discovery request to determine whether there is a clear obligation to produce harmful evidence.

ABA Model Rule 3.4(a) also prohibits lawyers from unlawfully obstructing another party's access to evidence (or potential evidence) or counseling/assisting another party to do so. In many federal courts, both parties must disclose information "relevant to disputed facts alleged with particularity in the pleadings." FRCP 26(a)(1).

The Stevens investigation reminds us that both public and private lawyers have disclosure obligations under the professional-responsibility rules.

Related coverage:



Keywords: litigation, professional liability, prosecutorial misconduct, department of justice, mismanagement, misconduct, corruption, scandal, disclosure, senator, senate, legislation, investigation

Taneen Jafarkhani, Bingham McCutchen LLP, San Francisco, CA


April 3, 2012

Grant Thornton Faces Aiding-and-Abetting Allegations

On March 26, 2012, U.S. District Judge Jed S. Rakoff backed Special Master Daniel J. Capra’s December 16, 2011, report recommending that the motion to dismiss brought by defendants Grant Thornton LLP and Mark Ramler be granted in part and denied in part. The case at issue is Krys et al. v. Sugrue et al., No. 08-CV-3065, in the U.S. District Court for the Southern District of New York, and the multi-district litigation is In re Refco Securities Litigation, No. 07-MDL-1902, in the same court.

The plaintiffs, the liquidators for the SPhinX Ltd. funds, brought actions against Grant Thornton, Refco's outside auditor, for aiding and abetting fraud, aiding and abetting breach of fiduciary duty, and aiding and abetting conversion. The plaintiffs allege that Grant Thornton aided and abetted Refco's improper co-mingling of SPhinX funds assets in unprotected, non-regulated accounts at Refco Capital Markets, Ltd. (RCM). These assets were upstreamed to fund Refco operations of its affiliates and then ultimately lost when Refco’s precarious financial position was made public. The plaintiffs claim they lost $263 million when Refco collapsed in 2005.

The plaintiffs allege that Grant Thornton knew about Refco’s scheme to defraud its customers because it knew that Refco needed to use the funds at RCM to prop itself up, it knew that RCM was unregulated, and it knew that after the 2004 leveraged buyout it would be impossible for RCM to pay back the money it had upstreamed. The plaintiffs allege that Grant Thornton aided and abetted the scheme by issuing unqualified, clean audit opinions in connection with RCM's stand-alone statements, and improperly reported the RCM upstreaming as loans to customers. Relying on Grant Thornton’s audits, the plaintiffs kept their assets with Refco and continued to deposit more cash.

The special master found that the plaintiffs adequately pled knowledge on Grant Thornton’s part because it knew that RCM was an unregulated entity and its own reports indicate that it knew that RCM was making substantial transfers to affiliates, which were far greater than its profits. The plaintiffs also adequately pled that Grant Thornton, by issuing unqualified, clean audit opinions of RCM, substantially assisted a primary wrong. Further, the special master found that the plaintiffs did not adequately allege that Grant Thornton proximately caused them to retain assets at Refco because if Refco’s true financial state had been known, the excess cash would still have been lost due to RCM’s inability to pay its customers back. However, the special master found that the plaintiffs adequately alleged that if they had known of Refco’s true financial condition, they would not have continued to deposit excess cash with Refco. Accordingly, the special master recommended that the motion to dismiss the aiding-and-abetting claim against Grant Thornton should be denied with respect to those assets the plaintiffs deposited with Refco after Grant Thornton’s issuance of its first clean auditing opinion, but that the motion be granted for the deposits made before this wrongdoing. The special master also recommended granting the motion to dismiss the aiding-and-abetting-breach-of-fiduciary-duty and aiding-and-abetting-conversion claims with prejudice because the plaintiffs did not adequately allege scienter.

Keywords: litigation, professional liability, Grant Thornton, Refco, aided and abetted, co-mingling, unqualified audit opinions

Monica A. Hernandez, Bingham McCutchen LLP, Palo Alto, CA


April 3, 2012

Debate over Auditor Independence and Audit Firm Rotation Heats Up

There has been a lot of discussion and debate lately about issues of auditor independence and, particularly, the possibility of mandatory auditor rotation.

The Public Company Accounting Oversight Board  (PCAOB) issued a concept release on enhancing auditor independence on August 16, 2011. Following this, on March 21 and 22, 2012, the PCAOB recently hosted a public meeting of over 40 panelists to discuss ways to enhance auditor independence, objectivity, and professional skepticism, including mandatory audit firm rotation. Many of the panelists were among the more than 600 people who submitted comment letters on the concept release (more than 90 percent of the letters opposed mandatory audit firm rotation). They explored a range of topics, including the perceived benefits and costs of mandatory audit firm rotation and audit firm concentration. While the discussion focused on mandatory firm rotation, some board members sought input from panelists on alternatives that might improve audit quality. The comment period for the concept release was recently extended through April 22, 2012.

The archived webcast and panelists’ written testimonies are available on the PCAOB’s website.  

Meanwhile, Congress entered into the debate with a draft bill that would block the PCAOB’s mandatory auditor rotation requirement. Members of Congress then asked questions of PCAOB Chairman James Doty on March 28, 2012, as the topic of mandatory audit firm rotation was debated during a discussion of accounting and auditing issues in front of the House Subcommittee on Capital Markets and Government Sponsored Enterprises. Representative Scot Garrett, R-N.J., the chairman of the subcommittee, opened the hearing by stating his concern that the PCAOB was overstepping its mandate by considering the issue of mandatory audit firm rotation. PCAOB Chairman James Doty made the case that Sarbanes-Oxley gives the board authority of auditor independence issues, subject to SEC approval. But he also told the congressional panel that the agency has not decided whether to require companies to rotate their auditors, but he promised to do an appropriate cost-benefit analysis if the rule moves forward.

Keywords: litigation, professional liability, auditor rotation, pcaob, congress, auditor independence

Amy June, Bingham McCutchen LLP, Palo Alto, CA


April 3, 2012

2nd Cir.: Part of NY Conduct Rule Violates First Amendment

On March 5, 2012, the U.S. Court of Appeals for the Second Circuit held in Hayes v. State of New York Attorney Grievance Committee of the Eighth Judicial District, 10-1587-cv, that part of Rule 7.4 of the New York Rules of Professional Conduct violates the First Amendment and is unconstitutionally vague as applied to Mr. Hayes, the plaintiff-appellant. Rule 7.4 requires attorneys who state they are certified as a specialist in a particular area of the law to make a prescribed disclaimer statement. The statement must identify the certifying ABA-approved organization and prominently make the following disclosure: “[1] The [name of the private certifying organization] is not affiliated with any governmental authority[,] [2] Certification is not a requirement for the practice of law in the State of New York and [3] does not necessarily indicate greater competence than other attorneys experienced in this field of law.”

Read the full case note.

Keywords: litigation, professional liability, NY Rules of Professional Conduct, Second Circuit, Grievance Committee, attorney advertisement, certification

Monica A. Hernandez, Bingham McCutchen LLP, Palo Alto, CA


February 27, 2012

The Reemergence of the Virginia Bankshares Alleged Misstatement

Recently, in Fait v. Regions Financial Corp., 655 F.3d 105 (2d Cir. 2011), the Second Circuit considered whether statements about goodwill and loan-loss reserves in a registration statement and prospectus can give rise to liability under sections 11 and 12 of the Securities Act of 1933. The court’s conclusion—(i) that the statements in question were statements of opinion and (ii) that a statement of opinion is actionable under sections 11 and 12 only if the complaint alleges that the speaker did not truly hold the opinion at the time it was issued—could have a far-reaching impact on the way courts evaluate securities claims predicated on alleged misrepresentations in a company’s financial statements.

In April 2008, the plaintiffs acquired securities in a subsidiary of Regions Financial Corp. pursuant to a registration statement and prospectus that incorporated by reference Regions’s 2007 Form 10-K. The Form 10-K reported $11.5 billion in goodwill ($6.6 billion of which was attributed to a recent acquisition) and loan-loss reserves of $555 million. The 10-K also included an audit opinion in which Ernst & Young, Regions’s independent public accountant, certified that Regions’s 2007 financial results were presented in accordance with generally accepted accounting principles (GAAP). Less than a year later, with the housing and residential real-estate markets collapsing around it, Regions announced a $6 billion charge for impairment of goodwill and doubled its loan-loss reserves to $1.15 billion. Following the announcement, Regions’s stock price fell and the plaintiffs brought suit.

The complaint, which asserted claims under sections 11 and 12 of the Securities Act against Regions and Ernst & Young, among others, alleged that the offering documents pursuant to which plaintiffs acquired securities were false and misleading because they overstated Regions’s goodwill and underestimated its loan-loss reserves. The defendants moved to dismiss on the ground that the challenged statements were matters of opinion, which were not actionable because the complaint failed to allege that the speaker did not truly hold the opinions at the time they were issued. The district court granted the motion and the plaintiffs appealed.

The Second Circuit began its analysis by recognizing that, under Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991) and the cases applying it, an alleged misstatement of opinion (as distinguished from an alleged misstatement of fact) can give rise to a claim under sections 11 and 12 of the Securities Act only if the complaint alleges both objective falsity (i.e., that the opinion was empirically false with respect to the underlying subject matter) and subjective falsity (i.e., that the speaker disbelieved the opinion at the time it was offered).

The court then considered whether the misstatements alleged in the complaint were misstatements of fact or misstatements of opinion. It observed that, under GAAP, goodwill is the amount by which the “purchase price” of an acquired asset exceeds the “fair value” of that asset and the liabilities assumed. While “purchase price” can be measured objectively, the “fair value” of an asset depends upon the particular valuation methodology and assumptions employed, making it an inherently subjective figure. According to the court, the same is true of loan-loss reserves, which represent management’s judgment about what portions of amounts due on loans might not be collectible. Estimating loan-loss reserves, like estimating goodwill, “is inherently subjective” and will vary “depending on a variety of predictable and unpredictable circumstances.” Id.at 113. In light of these observations, the court concluded that the statements alleged in the complaint about goodwill and loan-loss reserves were statements of opinion. Because the plaintiffs failed to allege that the statements were not only objectively false but also subjectively false, the Second Circuit, applying Virginia Bankshares, affirmed the district court’s judgment dismissing the complaint.

Regions could have significant implications for the way courts analyze securities cases in which the misstatements giving rise to suit appear in a company’s financial statements. Viewed through the Regions lens, many components of financial statements qualify as “opinions” because they consist of estimates, have estimates embedded within them, or otherwise reflect management’s judgment. For example, statements about contingent legal liabilities, tax and litigation reserves, sales returns and allowances, and allowances for doubtful accounts are in essence opinions about future events, making them subject to the same analysis applied to goodwill and loan-loss reserves in Regions.

The Second Circuit’s searching analysis in Regions shines a spotlight on the importance of examining the nature of the alleged misstatement. After Regions, courts may be more inclined to parse misstatement claims, especially those arising out of financial statements or an auditor’s report on financial statements, by first breaking the alleged misstatement into its constituent parts and determining whether it is actually an opinion. At its core, Regions discredits the notion that a securities claim—even one brought under “strict liability” statutes like sections 11 and 12 of the Securities Act that do not require a showing of scienter—lies whenever a figure in a financial statement turns out to be incorrect. In addition, a proper Regions-type exegesis of alleged misstatements may lead to a more fine-tuned analysis of whether alleged market losses were caused by those misstatements. An alleged corrective disclosure that does not speak to the subjective falsity of an opinion statement should, under the logic of Regions, be suspect.

Keywords: professional liability litigation, securities litigation, goodwill, loan loss reserves, financial statement, auditor

Michael S. Flynn and Seth Caffrey, Davis Polk and Wardwell LLP, New York, NY


February 27, 2012

NJ Supreme Court Limits Third-Party Liability of Professionals

Construing its version of the Uniform Accountancy Act, the New Jersey Supreme Court rejected a $38 million judgment against KPMG LLP. Cast Art Industries, LLC v. KPMG LLP, 2012 WL 489229 (N.J. Feb. 16, 2012). The court held that an auditor could not be held liable to a third party who claims to rely on audited financial statements unless the auditor had knowledge—at the time the auditor-client relationship began—that the third party would rely on its reports. “An auditor is entitled to know at the outset the scope of the work it is being requested to perform and the concomitant risk it is being asked to assume.” Id. at *11.

The case arose out of a merger in which the acquiring company alleged negligence in the audit report on the acquired company’s financial statements. The plaintiff complained that the auditor was aware of the merger, participated in a conference call with the acquirer, and agreed to make its audit report and work papers available to the acquirer’s auditor for limited agreed-upon purposes.

Noting the paucity of relevant decisional law construing the model act, the New Jersey law applied traditional statutory construction analysis, concluding that the legislature intended to limit the expansive foreseeability theory of third-party professional liability previously adopted by the New Jersey Supreme Court in Rosenblum v. Adler, 93 N.J. 324 (1983), and “to restrict the potential scope of an accountant’s liability.” Cast Art, 2012 WL 489229, *9. In so doing, the justices overturned the Appellate Division's holding that, under the Accountant Liability Act, an auditor’s knowledge that a third party is relying on the audited financial statements at any time during its engagement with the client exposes it to liability. To be held accountable to a third party, the auditor must know at the outset of the engagement that a third party will rely on the work.

Patricia A. Gorham, Sutherland, Asbill & Brennan, LLP, Atlanta, GA


February 24, 2012

Penn. Pro Se Helpers Not Ethically Compelled to Disclose Involvement

The Pennsylvania Bar Association Committee on Legal Ethics and Professional Responsibility along with the Philadelphia Bar Association Professional Guidance Committee recently issued advisory Joint Formal Opinion 2011-100 on “Representing Clients in Limited Scope Engagements.”

Given the recent economy, it is not uncommon for lawyers to extend services for part of a transaction or proceeding on a pro bono or reduced-fee basis. This is often referred to as “discrete task representation,” “limited scope engagement,” or “unbundling” of legal services. “Ghostwriting” is when such representation involves drafting or revising pleadings for submission to a tribunal.

In response to the increasing number of limited representation, the opinion addresses whether in connection with a limited-scope engagement, a lawyer who is assisting a litigant in a court proceeding is obliged under the Pennsylvania Rules of Professional Conduct to disclose to the tribunal his or her engagement in the matter. In short, the answer in Pennsylvania is no.

The committees found that despite Rule 3.3 on candor toward the tribunal and Rule 8.4 barring “dishonesty, fraud, deceit or misrepresentation,” or Rule 11 of the Federal Rules of Civil Procedure requiring signed pleadings, these rules did not impose a requirement of disclosure. Rules regarding truthfulness in statements or fairness in dealing with unrepresented parties generally applied to specific situations outside of a limited-scope engagement.

Rather, the opinion found that requiring a lawyer to always disclose his or her involvement would frustrate and practically negate the purpose of Rule 1.2, which explicitly allowed limited-scope engagements. The committees did, however, advise that under Rule 1.2(c), reasonableness of the limitation and informed consent by the client were imperative.

The opinion also emphasizes that lawyers entering a limited engagement must still remember that he or she is engaged in a full attorney-client relationship, therefore triggering all of the obligations that are inherent in such complete representation. Under the Pennsylvania Rules of Professional Conduct, these include, but are not limited to, duties of:

• competent representation (Rule 1.1)

• diligence (Rule 1.2)

• communication (Rule 1.4)

• representation agreements (Rule 1.5)

• confidentiality (Rules 1.6 and 1.9)

• avoidance of conflicts of interest (Rules 1.7, 1.8, 1.9, 1.10, 1.11, 1.12)

Amongst the committees’ findings, the opinion reports the following totals from other jurisdictions:

• Eleven, including the American Bar Association, concluded that disclosure to a tribunal is not required.

• Eighteen concluded that at least some disclosure is required.

• Thirteen have found that disclosure is required where the aid provided to a litigant is “substantial” or “extensive.”

• Three have held that disclosure of assistance is always mandatory.

• Two require disclosure of the fact of legal assistance but not the identity of the provider.

These findings and the applicable ethical rules from those jurisdictions are listed in Appendix A to the opinion. Pertinent court rules regarding unbundled services and court-annexed limited-service programs from other jurisdictions are included in Appendix B.

Appendix A of Opinion 2011-100.

Appendix B of Opinion 2011-100.

Karen Lu, Bingham McCutchen LLP, Palo Alto, CA


February 24, 2012

$2.6 Million Award Against Former Toyota In-House Counsel Upheld

The Ninth Circuit recently upheld a $2.6 million arbitration award against former in-house counsel, Dimitrios P. Biller, of Toyota Motor Sales (TMS), who allegedly leaked confidential documents that he claimed showed the company covering up evidence in rollover-accident litigation.

In 2007, Biller, who worked on products-liability matters for TMS, presented his former employer with various claims related to TMS’s alleged unethical discovery practices. Upon settling these claims, Biller signed a severance agreement to which he agreed to (1) give a broad release of his claims relating to his employment with and separation from TMS, (2) protect and not disclose Toyota’s confidential information as defined by the agreement, (3) return all of Toyota’s confidential information, and (4) not copy Toyota’s confidential information.

After leaving TMS, Biller started Litigation, Discovery & Trial Consulting, a business that provided seminars on various legal topics. On the company website, Biller used information about his work on TMS’s products-liability litigation. TMS believed this to be confidential information and in violation of attorney-client privilege. As required by the severance agreement, the parties went to arbitration where TMS submitted claims for breach of contract, conversion, and statutory computer fraud. Biller claimed and cross-claimed various intentional tort and RICO violations against TMS.

After several rounds of briefing and hearings, the JAMS arbitrator concluded that Biller was liable to TMS on all of its claims, and that under the severance agreement, TMS was entitled to injunctive relief, $100,000 in punitive damages, and $2.5 million in liquidated damages. Biller was injunctively prohibited from disclosing TMS’s confidential information, and was required to destroy and return to TMS all confidential information in his possession.

In confirming the final arbitration award, the Ninth Circuit rejected Biller’s claim that the district court improperly denied his motion for contempt. Biller had argued that TMS improperly collected and retained five documents in violation of the permanent injunction when TMS reviewed and deleted certain documents from Biller’s computer files after obtaining the award.

The three-judge panel also rejected Biller’s claim that the arbitrator failed to address his affirmative defenses of unclean hands and equitable estoppel. Under California law, the unclean hands defense applies when there is equity of relationship between the parties, and specifically if unclean hands affected the transaction at issue. The Ninth Circuit found that the arbitrator implicitly addressed Biller’s unclean-hands defense by pointing out that in light of the lack of justification for Biller’s unprecedented ethical violations, the equities of the parties’ relationship precluded assertion of the defense.

As for his equitable-estoppel defense, Biller claimed that TMS falsely represented to him that he had to remove TMS’s confidential information from his company website under Rule 1.6(a) of the ABA Model Rules. Rule 1.6(a) provides that

A lawyer shall not reveal information relating to the representation of a client unless the client gives informed consent, the disclosure is impliedly authorized in order to carry out the representation or the disclosure is permitted by paragraph (b).

Rule 1.6(b)(5) contains an exception that permits the lawyer

to establish a claim or defense . . .  in a controversy between the lawyer and the client, to established a defense to a . . .  civil claim against the lawyer based upon conduct in which the client was involved, or to respond to allegations in any proceeding concerning the lawyer’s representation of the client.

The panel expressed its confusion as to how Biller thought ABA Model Rule 1.6 was relevant to the issues at hand, but nonetheless found that the arbitrator implicitly rejected Biller’s equitable-estoppel defense by concluding that his disclosures were beyond what TMS permitted. The Ninth Circuit found Biller’s reliance on Rule 1.6(a) was misplaced, and that Biller was well aware of his ethical duty to TMS and that nothing justified breach of that duty.

Karen Lu, Bingham McCutchen LLP, Palo Alto, CA


July 28, 2011

Commission on Ethics Seeks Comments on Online Client Development Tools

On June 29, 2011, the ABA Commission on Ethics 20/20 released for public comment its initial proposals relating to lawyers’ use of technology-based client development tools, recommending amendments to the rules regarding attorney advertising (Model Rule 7.2), duties to prospective clients (Model Rule 1.18), and direct contact with prospective clients (Model Rule 7.3). 

The Commission concluded that “no new restrictions are necessary in this area, but that lawyers would benefit from more guidance on how to use new client-development tools in a manner that is consistent with the profession’s core values.” 

For example, the proposed rules would clarify when electronic communication gives rise to a prospective client-lawyer relationship and would amend Model Rule 1.18(a) to read, “A person who communicates with a lawyer about the possibility of forming a client-lawyer relationship and has a reasonable expectation that the lawyer is willing to consider forming a client-lawyer relationship with respect to a matter is a prospective client.” 

A proposed added comment would emphasize the fact-sensitive nature of the creation of a prospective client relationship:

    For example, if a lawyer’s website encourages a website visitor to submit a personal inquiry about a proposed representation and the website fails to include any cautionary language, the person submitting the information could become a prospective client.  In contrast, if a website offers only information about the lawyer or the lawyer’s firm, including the lawyer’s contact information, this information alone is typically insufficient to create a reasonable expectation that the lawyer is willing to consider forming a client-lawyer relationship. 

Model Rule 1.18, Proposed Comment 3.

The Commission also proposed amendments to the comments to Model Rule 7.2 to clarify what kinds of Internet-based client development tools attorneys may use without violating the ethical prohibition against paying others for a recommendation: “[A] lawyer may pay others for generating client leads, such as Internet-based client leads, as long as the person does not recommend the lawyer and any payment is consistent with Rule 1.5(e) (division of fees) and Rule 5.4 (professional independents of the lawyer).” Model Rule 7.2, Proposed Comment 5.  The Commission’s intent is to make clear that lawyers can take advantage of such Internet services as “pay-per-click” and “pay-per-lead,” so long as the marketing method does not violate the lawyer’s professional obligations. ABA Commission Report at 5.

The proposed amendments would add a comment to Model Rule 7.3 to clarify what constitutes a “solicitation.”

    A solicitation is a targeted communication initiated by the lawyer that is directed to a specific potential client and that offers to provide, or can reasonably be understood as offering to provide, legal services.  In contrast, a lawyer’s communication typically does not constitute a solicitation if it is directed to the general public, such as through a billboard, an Internet banner advertisement, a website or a television commercial, or if it is in response to a request for information or is automatically generated in response to Internet searches.

Model Rule 7.3, Proposed Comment 1.

The complete text of the proposed amendments and the Commission’s Report may be found on the ABA’s website. The Commission will submit its proposals to the ABA House of Delegates in May 2012 for deliberation at the ABA Annual Meeting in August 2012. In the meantime, comments to these initial proposals are due August 31, 2011.

—Amelia Toy Rudolph, Sutherland Asbill & Brennan LLP, Atlanta, GA


July 28, 2011

PCAOB Issues Concept Release on Alternatives for Auditorís Reporting Model

On June 21, 2011, the Public Company Accounting Oversight Board (PCAOB) issued a concept release discussing alternatives for changing the auditor’s reporting model to increase the transparency of financial reporting and its usefulness to the investing public.  

The current auditor’s reporting model requires a description of the nature of the audit and an opinion on whether or not the company’s financial statements fairly present the financial position, results of operations, and cash flows of the company in accordance with the applicable financial reporting requirements. The current model “has been commonly described as a pass/fail model because the auditor opines on whether the financial statements are fairly presented (pass) or not (fail).” PCAOB Release No. 2011-003, June 21, 2011.

The current model, however, fails to require auditor disclosure of other relevant and significant information about the audit and the company’s financial condition. The PCAOB concept release proposes possible enhancements in the auditor’s reporting model to give the investing public more insight into the company’s financial statements or other relevant information outside the financial statements. These alternatives include:

  • supplement to auditor’s report providing additional information about the audit and the company’s financial statements (Auditor’s Discussion and Analysis)
  • mandatory and expanded use of emphasis paragraphs in the auditor’s report
  • auditor reporting on other relevant information outside the financial statements
  • clarification of language in the standard auditor’s report

According to PCAOB, the proposed changes are not designed to change the fundamental role of the auditor but rather “are focused primarily on enhancing communication to investors through improving the content of the auditor’s report.” Id. However, “depending on the nature and extent of additional information to be communicated by the auditor . . . new auditing requirements and coordination with the Securities and Exchange Commission . . . would likely be necessary.” Id. Additionally, the scope of current audit procedures might be increased, thereby requiring new auditing standards.

PCAOB chairman James R. Doty states that “[t]he concept release . . . represents a significant step for investor protection in response to the financial crisis, and a first step toward a holistic consideration of reforms designed to foster the relevance, transparency and reliability of the audit process.”

PCAOB requests comments on the concept release by September 30, 2011. Comments may be submitted by email or through the board’s website. Comments may be submitted by mail to the Office of the Secretary, PCAOB, 1666 K Street, N.W., Washington, DC 20006-2803. All comments should refer to PCAOB Rulemaking Docket Matter No. 34 in the subject or reference line. PCAOB will convene a public roundtable to discuss the proposals in the third quarter of 2011.  

—James A. Brown, Liskow & Lewis, PLC, New Orleans, LA


May 20, 2011

Extending the Statute of Limitations on Professional Malpractice Claims in Georgia

In the recent case of Newell Recycling of Atlanta, Inc. v. Jordan Jones & Goulding, the Supreme Court of Georgia held that a claim of professional malpractice arising out of a written agreement with an engineering firm was subject to a six-year statute of limitations instead of the four-year limitations period historically applied to professional malpractice claims. The plaintiff had engaged the defendant, a professional engineering firm, to design a specialized building. Their agreement was evidenced by a “Draft Scope of Work,” certain letters, and an agreement to prepare a concrete platform. The platform failed in May of 2000, and the plaintiff sued the engineering firm for breach of contract and professional malpractice in August of 2004—more than four years later. At issue in this appeal was whether the plaintiff’s claims were time-barred pursuant to O.C.G.A. § 9-3-25, which provides a four-year limitations period for all actions upon oral or implied contracts, or whether the claims were timely pursuant O.C.G.A. § 9-3-24, which provides a six-year limitations period for actions upon written contracts.

The plaintiff argued that the six-year statute of limitations applied, citing the Draft Scope of Work, letters, and agreement to build a platform as the written contract that gave rise to its claims. The defendant argued that the plaintiff’s claims arose from an implied contract, were subject to the four-year limitations period, and were therefore time-barred. The Georgia Court of Appeals agreed, but for different reasons, apparently applying what it interpreted as a hard and fast rule that the four-year limitations period always governs professional malpractice claims—even those premised on the breach of a written contract.

The Georgia Supreme Court reversed, holding that the six-year limitations period applied and that the claims were timely. The court reasoned that by its terms, the four-year limitations period applied only to breach actions based solely on an implied promise or an express oral promise.

Scott F. Bertschi and Theresa Y. Kananen, Arnall Golden Gregory, LLP


May 20, 2011

Ohio Federal Court Upholds "Loss Prevention Privilege" to Prevent Discovery in Legal Malpractice Action

In Tattletale, the magistrate refused to compel a law firm to produce certain documents in a legal malpractice action, holding that internal “loss prevention” communications among attorneys at the defendant law firm were protected by the attorney-client privilege.

Specifically, Tattletale Alarm Systems sued the law firm of Calfee, Halter & Griswold alleging that the firm failed to timely pay the maintenance fee for a patent held by Tattletale. Tattletale moved to compel the production of approximately 300 documents withheld by the defendant firm on the basis of the attorney-client privilege. The defendant contended that these documents were privileged because they reflected loss prevention communications, which occurred after the defendant became aware that Tattletale might assert a malpractice claim. Tattletale argued that some of these communications occurred prior to the firm’s termination of its representation of Tattletale and, therefore, could not be privileged.

The court rejected Tattletale’s argument, starting with the proposition that one attorney in a firm can seek legal advice from another attorney in that same firm and, thus, form an attorney-client relationship under which the privilege would normally attach. Accordingly, the court addressed whether an exception to the attorney-client privilege applied when the advice sought regarded an existing client of the firm. The court noted that, under Ohio law, exceptions to the attorney-client privilege generally fall into one of three broad categories: (1) communications not worthy of protection, such as those involved in the crime-fraud exception; (2) communications not necessary to support the policy rationale underlying the privilege, namely the need for lawyers to have full and complete information before rendering advice; and (3) communications that are necessary for a party to prove her case. Ultimately, the court rejected the proposition that loss prevention communications fell within any of these categories.

Scott F. Bertschi, Arnall Golden Gregory, LLP, Atlanta, GA


May 20, 2011

Third Circuit Rejects Fraud-Created-the-Market Theory

In an August 2010 opinion, the Third Circuit, in the process of affirming the district court’s denial of class certification in a securities fraud class action, rejected the fraud-created-the-market theory. See Malack v. BDO Seidman, LLP, 617 F.3d 743 (3d Cir. 2010). The fraud-created-the-market theory enables a plaintiff in a § 10(b) private damages action to establish that he or she presumptively relied upon the misstatements at issue because a fraudulent scheme resulted in securities being brought to market that were otherwise unmarketable. The securities could be unmarketable because they were not legally or economically viable, or because the securities would not have been on the market at the price and interest rate at which they were issued in the absence of fraud.

The Third Circuit held that the fraud-created-the-market theory lacked a basis in any of the traditionally accepted grounds for triggering an evidentiary presumption. The court therefore declined to recognize a presumption of reliance based upon the theory.

First, the theory was not grounded in common sense because none of the entities involved in the issuance of a security could be reasonably relied upon to prevent fraud. The court noted that such an approach would require the issuers of a security to make decisions “that are at least burdensome and at most economically irrational.” Moreover, the SEC could not be reasonably relied upon to prevent fraud, because the SEC merely confirms that the issuer adequately disclosed information pertaining to the security as opposed to evaluating the merit of a particular security. As a result, disclosure of adverse information may have lowered the price of a security, but it would not have prevented that security from going to market.

Nilofer Umar, Sidley Austin LLP, Chicago, IL


May 20, 2011

Sixth Circuit Applies Imputation Rule to Dismiss Professional Negligence Claim

The Sixth Circuit Court of Appeals affirmed the dismissal of a professional negligence claim brought by the Trustee in bankruptcy for a group of companies collectively known as Venture, an automotive-parts supplier that had filed for Chapter 11 bankruptcy, against Deloitte & Touche LLP, Venture’s former independent auditor. Venture’s CEO, Larry Winget, had entered Venture into a series of improper transactions with companies that were wholly owned or controlled by Winget, and the Sixth Circuit held that under Michigan’s “sole-actor” rule, Winget’s knowledge of those transactions could be imputed to Venture, preventing Venture from relying on Deloitte’s audits. The Sixth Circuit also held that the Trustee’s claim that Deloitte aided and abetted the Winget’s breach of his fiduciary duty was barred by Michigan’s residual three-year statute of limitations for tort claims.

The Trustee’s complaint alleged that Deloitte, in conducting audits of Venture beginning in 1987, had become aware of Winget’s impropriety and knew that Venture’s financial statements were materially misleading in their failure to disclose the nature of Winget’s related-party transactions. As a result, the Trustee claimed, Deloitte’s audits were not in accordance with Generally Accepted Auditing Standards, and were the proximate cause of Venture’s financial situation and eventual bankruptcy. The Trustee alleged that if Deloitte had properly performed its audits, then someone at Venture, or Venture’s creditors, would have learned about the related-party transactions and stopped Winget from engaging in the transactions.

Deloitte moved to dismiss the Trustee’s complaint. Deloitte argued the Trustee could not state a claim for professional negligence because the complaint did not properly allege that Venture relied on Deloitte’s audits and that the Trustee’s aiding-and-abetting claim was barred by the statute of limitations. The bankruptcy judge issued a recommendation to the federal district court that the Trustee’s professional negligence and aiding and abetting claims be dismissed. The district court accepted the bankruptcy judge’s recommendation, and the Trustee appealed.

—Ian M. Ross, Sidley Austin LLP, Chicago, IL


October 21, 2010

New York High Court Reaffirms In Pari Delicto Doctrine

The New York Court of Appeals has reaffirmed that principles of in pari delicto and imputation bar a corporation from shifting responsibility for the fraudulent acts of its own insiders to third parties, including auditors and other third party professionals. Kirschner v. KPMG LLP, et al., ___ N.E.3d ___, 2010 WL 4116609 (N.Y. Oct. 21, 2010) [PDF]. Kirschner v. KPMG was brought by the litigation trustee for Refco, Inc., seeking to recover from Refco’s outside accounting firms and other third parties that allegedly participated in or failed to detect fraud perpetrated by Refco insiders. Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP was brought as a derivative suit by AIG shareholders seeking to recover from PwC for its allegedly negligent failure to detect fraud perpetrated by AIG insiders. The United States Court of Appeals for the Second Circuit (in Kirschner) and the Delaware Supreme Court (in AIG) certified questions concerning the adverse interest exception to imputation and the scope and application of the in pari delicto doctrine.

In a 4-3 opinion authored by Judge Read, the Court of Appeals first confirmed that existing principles of in pari delicto and imputation apply. The court explained that in pari delicto "mandates that the courts will not intercede to resolve a dispute between two wrongdoers," and reaffirmed that this doctrine operates to bar the claims of willful wrongdoers without regard to whether the other party’s wrongdoing was negligent or willful. Turning to imputation, the court reiterated that agency law requires imputation "even where the agent . . . commits fraud," explaining that "[t]he crucial distinction is between conduct that defrauds the corporation and conduct that defrauds others for the corporation’s benefit." The court rejected plaintiffs’ argument that, under the Second Circuit’s decision in In re CBI Holding Co., 529 F.3d 432 (2d Cir. 2008), the adverse interest exception turns primarily on the intent of the agent. Accordingly, the court affirmed the narrow scope of the adverse insider exception, noting that it is typically reserved for instances only of "outright theft or looting or embezzlement."

The court also declined to follow the approach of the New Jersey and Pennsylvania Supreme Courts, which have carved out exceptions to in pari delicto when outside auditors or other professionals are alleged to share some blame for an insider’s fraud. The court questioned the soundness of the public policy arguments underlying those decisions and noted that any potential benefits that might result from those exceptions were only "speculative." Accordingly, the court concluded that the interests identified by those courts and urged by the plaintiffs in the two cases are insufficient to "outweigh the important public policies that undergird" the court’s tradition of robust and predictable application of in pari delicto and imputation.

Erin Murphy, King & Spalding, Washington, D.C.


Keywords: auditor liability, in pari delicto, AIG, Refco


Texas Supreme Court Reaffirms Limits on Auditors' Liability to Third Parties


In a unanimous opinion issued July 2, 2010, the Texas Supreme Court issued its most definitive statement in two decades regarding the limited scope of professional liability to non-clients and, in an issue of first impression, rejected a “holder claim.” Grant Thornton LLP v. Prospect High Income Fund, No. 06-0975 (Tex. July 2, 2010). The lawsuit was brought against accounting firm Grant Thornton by four investment funds managed by Highland Capital Management. The Court articulated the limited scope of professional liability to non-clients for negligent misrepresentation and fraud under Texas law.

The lawsuit was brought by hedge funds that bought high-yield junk bonds issued by Epic Resorts, a vacation timeshare operator. After timely paying interest for two years, Epic chose not to make an interest payment after its principal lender withdrew critical financing. The plaintiff funds subsequently drove Epic into bankruptcy in 2001. In 2002, the funds sued Grant Thornton, which had issued audit reports on Epic’s financial statements for the periods ending December 31, 1999 and December 31, 2000. The funds alleged that Grant Thornton had misrepresented the status of an escrow account that Epic maintained at U.S. Trust, the trustee under the indenture that defined Epic’s obligations to bondholders.

Embracing the Restatement approach, the Court reaffirmed that Texas law limits liability for negligent misrepresentation to “situations in which the professional who provides the information is aware of the nonclient and intends that the nonclient rely on the information. Unless a plaintiff falls within this scope of liability, a defendant cannot be found liable for negligent misrepresentation.” Liability for fraud is also limited, requiring evidence that the auditor had “reason to expect” that a non-client would rely, that the claimant’s reliance is “especially likely and justifiable,” and that the transaction sued upon is the type the defendant contemplated. The Court held that liability could not be premised on Grant Thornton’s “general knowledge that investors might purchase Epic bonds.” 

The Court also rejected “holder claims”—not claims that the funds bought or sold securities based on the audit reports, but instead that they refrained from selling bonds that they had previously purchased. The Texas Supreme Court had never considered whether holder claims were viable under Texas law. The Court concluded that “to the extent they are viable, [holder claims] must involve a direct communication between the plaintiff and defendant.” Because it was undisputed that there had been no direct communication between the funds and Grant Thornton, the Court rejected the asserted holder claims.

The Court’s opinion also addresses two important issues regarding reliance. Most of the funds’ bond purchases occurred after March 2001, when its investment manager learned that Epic had lost the financing critical to its operations. The Court held that if the funds relied on the 1999 or 2000 audits reports in making these purchases, that reliance would not have been justifiable in light of the funds’ knowledge. As the Court concluded, the funds “could not have justifiably relied on the audit report as to purchases made after they knew the corporation was at risk of financial ruin.”

The Court also rejected the funds’ vicarious reliance theory. The funds admitted that they never saw or relied upon a negative assurance statement that Grant Thornton provided to Epic in 2000. The funds argued that U.S. Trust relied on that statement and that they could substitute U.S. Trust’s reliance for their own because U.S. Trust was the bondholders’ agent. Rejecting this argument, the Court held that if that were true, U.S. Trust’s knowledge (that the escrow account was not in place) also must be imputed to bondholders. The Court held that the bondholders “may not substitute their escrow agent’s reliance for their own without also being bound by its knowledge.”


—Samara Kline, Baker Botts L.L.P., Dallas.


Keywords: auditor liability, negligent misrepresentation, holder claims


Top SEC Officials Speak at Los Angeles Securities Regulation Seminar


On October 30, 2009, the Los Angeles County Bar Association sponsored the forty-second annual Securities Regulation Seminar to address recent trends and developments in securities laws. The seminar included several panels of scholars, leading private practitioners, and senior officials from the Securities and Exchange Commission (SEC), the United States Attorney’s Office, and the California Department of Corporations. Michael C. Kelley of the Los Angeles office of Sidley Austin LLP moderated a panel on the Changing Face of Securities Litigation.


ABA Urges FASB Not to Adopt Exposure Draft

On August 5, 2008, the ABA presented its formal comments to the Financial Accounting Standards Board (FASB) exposure draft entitled, "Disclosure of Certain Loss Contingencies: An Amendment of FASB Statements 5 and 141(R)." The Exposure Draft has the potential to affect significantly lawyers' responses to audit inquiry letters, which are auditors' requests for information on loss contingencies regarding pending or threatened litigation. The Exposure Draft would change both the basic disclosure threshold and the content of the required disclosures, protocols for which have been in place since the mid-1970s. In its comment letter, the ABA expresses a number of serious concerns regarding the Exposure Draft, including that it further erodes the protections of the attorney-client privilege and work product doctrine during the audit process, and urges FASB not to adopt the proposed amendment.


U.S. Supreme Court Curbs Securities Lawsuits Against Secondary Actors

On January 15, 2008, the United States Supreme Court held that investors suing business partners of an issuer must plead and ultimately prove actual reliance to state a claim under Section 10(b) of the Securities Exchange Act of 1934, rejecting so-called “scheme liability.” Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al., – U.S. –, No. 06-43 (Jan. 15, 2008). In a 5-3 decision authored by Justice Kennedy, the Court held that the secondary actors’ alleged conduct in Stoneridge was not actionable because the investors could not have relied on the secondary actors’ allegedly deceptive conduct because it was not disclosed to the market.

Supreme Court Hears Argument on Expanding Professional Liability in Securities Fraud Case

While reading the tea leaves in any oral argument can be perilous, the Supreme Court appears likely to reject a major expansion of professional liability in private securities fraud cases. Eight members of the U.S. Supreme Court recently heard oral argument in Stoneridge Investment Partners, LLC v. Scientific Atlanta, Inc., et al. (No. 06-43). (Justice Breyer recused himself.) The question before the Court is whether Section 10(b) of the Securities Exchange Act, and the SEC’s implementing regulation, Rule 10b-5, provide a private cause of action against cable-box equipment vendors that (1) did not make any misrepresentations to the market and (2) did not have any duty to disclose. The petitioner’s attorney advanced the theory that the vendors were liable under the applicable securities laws for using a “deceptive device” in connection with the purchase or sale of a security. Specifically, the petitioner’s attorney alleged that the vendors had participated in a fraudulent scheme to create “fictitious advertising revenue” for another company, Charter Communications, to report to that company’s investors.

UPDATE—Oral Argument: October 9, 2007

Stoneridge Investment Partners, LLC, brought a securities fraud class action against Charter Communications' vendors Scientific Atlanta and Motorola, alleging a scheme in which Charter contracted with the vendors to purchase set-top cable boxes at higher-than-normal prices and sell advertising at higher-than-normal rates. These transactions served to artificially inflate Charter's stock price. The United States District Court for the Eastern District of Missouri held that Stoneridge's claim was foreclosed by the Supreme Court's decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), in which the Court determined that mere "aiders and abettors" of fraud cannot be held liable. The Eighth Circuit affirmed. Thus, the issue before the Supreme Court is whether a party may be held liable for fraud where it made no misleading public statements (or omissions), and had no duty to do make disclosures, but engaged in transactions with a public corporation designed to artificially enhance the public corporation's financial statements. How the Supreme Court decides this case may set a new standard for determining whether third parties can be held liable for investor- related fraud.


Here we have a rare US Supreme Court case addressing professional liability issues (and general securities issues). It concerns whether shareholders of companies that commit securities fraud should be able to sue investment banks, lawyers, and others that allegedly aided and abetted in the fraud under Central Bank. The case is Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. The key available briefing is below. The Stonebridge case is set for oral argument in early October 2007.


Court Rules Two Patent-Related Legal Malpractice Actions Must Be Litigated in Federal Court

Two recent decisions of the United States Court of Appeals for the Federal Circuit hold that the federal courts have exclusive jurisdiction under 28 U.S.C. § 1338 over state legal malpractice actions involving patent infringement and patent scope. See Air Measurement Technologies, Inc. v. Akin Gump, 2007 U.S. App. LEXIS 24098(Fed Cir. Oct. 15, 2007); Immunocept, LLC v. Fulbright & Jaworski, LLP, 2007 U.S. App. LEXIS 24095 (Fed Cir. Oct. 15, 2007).

In Akin Gump, Air Measurement Technologies (“AMT”), a patent holder, filed suit against Akin Gump, its attorneys, for legal malpractice and other various state law claims. AMT alleged the attorneys’ errors in litigating the underlying patent infringement suits forced them to settle the prior litigation for merely $10 million, far below the market value of the patents. The Federal Circuit Court found that Section 1338, providing exclusive federal court jurisdiction over actions arising under Acts of Congress relating to patents, applies because determination of patent infringement is the necessary “suit within a suit” proximate cause element of the malpractice claim. The court found, therefore, removal appropriate because it was based on a contested question of patent law intended for resolution in federal court.

In the sister Fulbright & Jaworski case, Immunocept, the patent holder, sued Fulbright, the attorneys hired to secure patent protection, in federal court for legal malpractice. Immunocept alleged the attorneys’ drafted a patent claim too narrowly, providing inadequate patent protection and resulting in lost profits for the patent holder. The Federal Circuit Court found that Section 1338 applies because determination of claim scope, as the first step of a patent infringement analysis, is a substantial question of patent law. After finding jurisdiction, the court then found the claim barred by the statute of limitations.

These two cases add to the Federal Circuit’s Section 1338 jurisprudence concerning cases involving state legal malpractice cases. Now, malpractice claims involving patent infringement and patent scope, in addition to patent validity, enforceability, and interpretation of patent applications, require federal determination of a substantial question of patent law.

Effects of the Federal Circuit Court rulings were soon felt in California. On October 17, 2007, merely two days after the Akin Gump and Fulbright & Jaworski cases were decided, a patent infringement case pending in a California state court was removed to the United States District Court for the Northern District of California. Berger v. Seyfarth Shaw, 5:07-cv-05279-PVT.

Submitted by John Hong, associate attorney awaiting bar results, Long & Levit, LLP, San Francisco, CA


Tennessee Case Raises Questions Concerning Solicitation of Potential Clients

On October 26, 2004, Simpson Strong-Tie Company, Inc. (“Simpson”) disclosed the following in a filing with the SEC:

The Company was recently informed of a consumer alert issued on October 21, 2004, by the fraud division of the office of Contra Costa County, California, District Attorney, regarding the corrosion of some types of connectors and fasteners when used with some types of pressure treated wood. A local television news program reported on this matter the same day. The Company sujects its products to extensive testing, including their use with pressure treated wood. The Company publishes its conclusions and guidance in its catalogues and on its website (see www.strongtie.com/info). Based on its test results to date, the Company believes that if its products are appropriately selected and properly installed in accordance with the Company’s guidance, they may be reliably used in appropriate applicationa with pressure treated wood.

In January of 2006, Simpson became aware of the following advertisement which Stewart Estes and Donnell (the “law firm”) had placed in The Nashville Tennessean:

If your deck was built after January 1, 2004 with galvanized screws manufactured by Phillips Fastener Products, Simpson Strong-Tie or Grip-Rite, you may have certain legal rights and be entitled to monetary compensation, and repair or replacement of your deck. Please call if you would like an attorney to investigate whether you have a potential claim.

Joyce Cope
424 Church Street, Suite 1401
Nashville, Tennessee 37219-2392
Phone: (615) 244-6538

Simpson subsequently filed suit against the law firm in the United States District Court for the Middle District of Tennessee [Docket # 3-06-CV-00094].

The complaint asserted a claim for defamation and other claims. The law firm filed a motion for judgment on the pleadings, asserting that its advertisement was protected by the litigation privilege. The District Court then certified the following question to the Supreme Court of Tennessee: Does the litigation privilege apply to communication made preliminary to a proposed judicial proceeding, where such communications are directed a recipients unconnected with the proceeding in hopes of soliciting them to become parties to it?

Briefs have been submitted, and copies of the briefs are available from this website.

Oral argument was held in the Tennessee Supreme Court in June 2007.


Texas Ethics Committee Rules That Law Firms May Not Mark Up Fees of “Non-firm Lawyers,” Including Temporary Lawyers

In a move that may have significant consequences for the temporary legal staffing industry, the Professional Ethics Committee for the State Bar of Texas (the “Committee”) has set new guidelines for law firms to follow when billing clients for legal services performed by a lawyer who is not an associate, partner, or shareholder of the law firm. Opinion No. 577 explains that the proper billing treatment depends on whether the lawyer is considered to be “in” the law firm for purposes of the Texas Disciplinary Rules of Professional Conduct (the “Rules”). The categories recognized by the Committee are: (1) “other firm lawyers,” such as of counsel attorneys or other part-time lawyers, who are considered to be “in” the law firm for purposes of billing disclosures and (2) “non-firm lawyers,” such as local counsel or lawyers hired on a temporary basis, who are not considered to be “in” the law firm.


Deep East Texas Self-Insurance Fund v. Cunningham Lindsay Claims Management, Inc. et al.

Cause 51,556-A, County Court at Law No. 2, Smith County, Texas

Prevailing plaintiff who sought to satisfy judgment pursuant to a high-low agreement challenges the attorneys’ fees and expenses incurred by defense counsel because those fees and expenses were deducted from the amount paid by defendants’ insurer under an “eroding” policy, thus reducing the plaintiff’s recovery. Plaintiffs alleged that to the extent that the law firm obtained money from the insurance company by submitting unreasonable, excessive and/or fraudulent bills for fees, then such funds should be paid to the Plaintiffs.