Risk Management & Liability Guidebook

Table of Contents | Editorial Board

PART I - INSURANCE

1. THE MARKET

The accountants’ professional liability market has undergone continuous change, activity and growth since 1992 due to overwhelming competition among the various insurers. There are more companies than ever offering accountants’ professional liability insurance affording accounting firms a wide range of pricing and coverage options. While price is important, it is only one factor to consider. More important are the insurer's quality of service and claims handling. All too often, accountants who purchase insurance solely on the basis of premium find their savings illusory once they report a claim.

A. AVAILABLE POLICIES

The following list sets forth the majority of companies providing professional liability policies for the accounting profession:

• A/pls+
• Accountants Liability
• Assurance Corporation (ALAC)
• American Home Assurance Co.
• American Society of Accountants (ASA)
• AVRECO, Inc. (offering Lloyds of London policies)
• CAMICO Mutual Insurance Company
• CNA Insurance Company
• Coregis/Westport
• CPA Mutual Insurance Co.
• Garden State Indemnity Co.
• Golden Eagle Insurance Company
• Hartford Insurance Co.
• Interstate Insurance Company
• SAFECO Insurance
• Travelers Group
• Zurich-American Insurance Company

B. CRITIQUE OF AVAILABLE PROGRAMS

A/pls+ has proactive loss prevention and claims handling and is extremely selective in its underwriting. It also offers profit sharing distributions to its insureds. Accordingly, it can offer lower costs to its insured firms over the long-term. Rated "A" by A. M. Best

American Home, a subsidiary of AIG, has been offering accountants professional liability longer than any other insurance company, although it is no longer aggressive in pursuing this market. American Home currently offers coverage of up to $15 million. Rated "A++" by A. M. Best.

American Society of Accountants (ASA) targets CPA firm with one to five professionals. ASA is wholly committed to loss prevention. Its program is rated B++ by A.M. Best.

AVRECO, Inc. is an insurance agency that provides coverage through underwriters at Lloyds of London on a non-admitted basis. The policy is broadly written but contains a large number of exclusions. It is geared toward smaller firms. AVRECO provides no loss prevention services.

CAMICO Mutual Insurance Company offers a policy which is designed for a wide range of accounting firms. CAMICO targets small to mid-sized firms located in California and other western and mid-western states and actively promotes loss prevention activities including seminars and newsletters.

CNA is the AICPA-endorsed insurer and offers coverage on two levels: a basic policy for small firms and a broad policy for larger firms. CNA tends to price its policies aggressively and offers broad policy terms. Rated AA@ by A. M. Best.

Coregis/Westport was formerly the insurer for the AICPA endorsed program. It was recently purchased by G.E. Capital Corp. greatly enhancing its financial stability. A. M. Best AA++@ rated.

CPA Mutual is a risk retention group and, therefore, is not rated by A.M. Best. CPA Mutual has a program in which insureds may get lower premiums in the form of dividends. CPA Mutual, like A/pls+, advocates loss prevention.

Garden State Indemnity Co. only offers policies in New Jersey. Its policy has broadly written exclusions and is designed for smaller firms with limited practices. No loss prevention services are offered. Garden State has a NA-3 A.M. Best rating (not enough information to rate).

Golden Eagle Insurance Company offers its policies in California and Arizona. Although Golden Eagle offers no loss prevention services, it does provide discounts to firms that participate in loss prevention activities. It has an A.M. Best rating of C++.

Hartford Insurance Co. has only recently begun to offer accountants liability insurance and the parameters of its program are still unknown.

Interstate is a subsidiary of Fireman’s Fund and is A. M. Best AA@ rated. It is aggressive on pricing and offers many coverage enhancements.

SAFECO Insurance offers a policy which is designed for smaller accounting firms. Its target is firms having no more than twenty-five professionals. SAFECO publishes a loss prevention newsletter and provides hotline support. It is rated A++ by A.M. Best.

Travelers Group seeks to insure firms with up to fifty professionals. Its policy is well written and should appeal to small and mid-size firms. Travelers does not provide loss prevention services but it takes an applicant’s loss prevention efforts into account when underwriting and pricing.

Zurich American is a financially strong company which has taken over the professional liability program previously offered by Home Insurance Co. It is rated AA++@ by A. M. Best.

2. BUYING INSURANCE

A. WHAT LIMITS?

Deciding on what limits to obtain, more often than not, is an emotional decision, as opposed to a scientific one. There are generally two schools of thought that apply to this process:

Buy As Much Coverage As You Can Afford - When insurance premiums sky-rocketed in the late 1980s, most firms maintained relatively low limits of liability because the cost for higher limits coverage was prohibitive. In the current competitive climate, most firms are in a position to purchase higher limits since the premiums have decreased. In many instances, firms are obtaining more coverage for a lower premium than they paid in the early 1980s. Purchasing as much coverage as you can affords a greater comfort level and Asleep at night@ insurance.

Buy The Most You Have To - Many firms fear that high limits may attract lawsuits; they are afraid that if they have higher limits, plaintiff attorneys may automatically include them in suits in an attempt to obtain proceeds from the firm's policy. These firms tend to purchase what they determine to be the minimum that they need to protect themselves. Other factors that must be considered when deciding the appropriate limits of liability are as follows:

Split Limits - Some insurers offer a per claim limit with a larger limit as an aggregate for the policy period (i.e. $1,000,000/$3,000,000 provides $1,000,000 per claim, $3,000,000 in the aggregate for all claims pertaining to the policy period). When firms purchase an aggregate they are covered up to the Aper claim@ limit for each claim; however, they are also covered up to the maximum aggregate limit for more than a single claim. This coverage is more attractive for those firms who, in the past, have had more than one claim per policy year.

Defense Inside Limit - Defense costs are usually (but not always) within the limit of liability and, therefore, reduce the amount of available coverage. In New York, the extent to which defense costs may be charged against policy limits is limited by Regulation 107. A few insurers offer policies with defense costs in addition to the policy's limit of liability. This option is available at a higher premium than Defense Inside Limit. Defense costs include legal fees and associated expenses. They do not include indemnity (i.e. judgment or settlement) payments.

B. WHAT DEDUCTIBLE TO SELECT?

Deciding what deductible to select entails a philosophy similar to the decision to buy Aas much coverage as you can afford.@ Therefore, a firm should choose the highest possible deductible that allows its owners to still be able to "sleep at night." Of course, the choice of deductible is limited to an amount the insurer will authorize after a review of the firm profile. This is because insurer will frequently pay out claims in full with its own funds in order to expedite a settlement and then look to the firm to collect the deductible obligation; and no insurer wishes to be left Aholding the bag@ if the firm is not able to pay the deductible. In addition to selecting the amount of the deductible, there are three types of deductibles that are available:

Per Claim Deductible - the deductible applies to each and every claim. This is the most common form of deductible.

Annual Aggregate Deductible - The amount of the deductible is capped during the policy period and applies to single or multiple claims. Only a few insurers offer annual aggregate deductibles.

Loss Only Deductible/Dollar One Defense - The deductible only applies to indemnity payments. This is always provided with Defense Outside coverage (see above) and may be offered by some insurers for an additional premium with Defense Inside coverage.

C. FACTORS TO CONSIDER WHEN PURCHASING INSURANCE

There are many decisions that have to be made when purchasing professional liability insurance. The following items should be considered.

Claims Handling - It is important to ascertain the insurer's reputation for handling insureds’ claims. Does it have experienced claims representatives on staff? How much defense work does it do in-house? How closely does it work with the insured in defending claims? Companies vary in their attitudes towards claims. Some look at the terms and conditions of coverage and are quick to disclaim liability for claims that are excluded or outside of the scope of coverage. Other companies make great efforts to afford coverage with respect to claims falling in those gray areas in the policy language in an effort to avoid disputes with their own insureds. In recent years, some plaintiff's attorneys have taken what should have been regular malpractice claims and have purposely worded their complaints to allege fraud instead of negligence to entice insurers to disclaim both coverage and defense costs. The strategy is to force the defendant to settle a smaller case quickly rather than incur large legal bills. Some insurers will provide defense until fraud is proven, while others will not. Therefore, it is important to try to ascertain the coverage philosophy of the insurer before purchasing insurance.

Policy Coverage - How broad/comprehensive are the coverages offered? Remember, a policy is only valuable to the extent that it covers the scope of practice offered by the insured firm. The scope of coverage does differ significantly making it critical to review both the policy's definition of professional services and its exclusions.

Exclusions - Does the policy exclude a service offered by your firm? You may be able to modify the exclusion for an additional premium or find a competitor's policy of similar quality without the exclusion.

Insurers Financial Ratings - The financial strength of an insurer is important as insurance will only be valuable if the insurer is solvent when a claim arises. Moreover, insurers in a weak financial position may be prone to disclaim claims against their insureds. A.M. Best is a good guide but should not be the only benchmark. A knowledgeable insurance broker should be able to give you greater insight into the strength and stability of each company being considered.

Available Limits - Are the limits offered appropriate for the needs of the firm?

Price - Is the price reasonable vis-à-vis other carriers and the coverages offered? Price is often negotiable but beware of a deal too good to be true.

Responsiveness - Consideration must be given not only to the insurer selected, but also to the broker you are using. As a rule, you should work with a broker who specializes in professional liability.

Risk Management - Many companies offer loss prevention services. Some insurers place greater emphasis on this aspect of practice than others. In this regard, it should be remembered that only a portion of the cost of a claim is covered by insurance. Insurance policies do not cover lost time spent in defending a claim.

Over the past ten years, the number of insurers offering professional liability insurance to accounting firms has increased dramatically. Therefore, firms now have a wide selection of insurers to choose from. Firms should consider the above-listed factors in selecting their insurance coverage. Because of the large number of factors, accounting firms should consider utilizing the services of an independent broker who specializes in accountants= professional liability insurance and who is familiar with the markets and coverages available. While certain cost advantages may be achieved by purchasing insurance directly from the insurer, those choosing this route may not be able to discern the shortcomings of a particular policy and may sacrifice some bargaining power.

D. HOW TO COMPLETE THE APPLICATION

In most cases, the application is the only way for the insurance company to learn about your firm. It, therefore, behooves each firm to be as complete and as accurate as possible. Supplements should be included to explain any circumstances about the firm's practice that may warrant concern by the insurer. The application becomes part of the policy and, therefore, it is critical that the application be completed in full and reviewed by every partner/principal of the firm. Every effort should be made to be accurate, while putting the firm in the best possible light. Because applications usually take many hours to complete, some firms may be tempted to take shortcuts. Such temptations should be resisted. In addition, some firms may leave out requested information or exaggerate data in an attempt to depict themselves in a favorable manner. It is important that firms be as accurate and forthcoming as possible because insurers can rescind coverage under certain circumstances should a claim arise if representations in the application are not accurate or do not fully present the risks posed by their practices. Thus, the best policy is to disclose all adverse factors, but try to explain why those factors should not present an unacceptable risk. In this connection, firms should not hesitate to supplement their responses with additional information.

E. WHAT IS NEGOTIABLE?

Price, policy coverage, limits of liability and deductibles are all negotiable items. Keep in mind that all insurance companies must operate within certain guidelines; however, these guidelines do permit some degree of flexibility. Your broker, who should be knowledgeable about these issues, is the best person to assist you in your negotiations.

Price is one of the most negotiable features of a quote. All insurers utilize a formula to derive the price for their policies. Usually, there is a high degree of flexibility built into these formulae so that the underwriters can exercise discretion to alter their price depending on various characteristics of the firm and competitive factors. Therefore, firms seeking to lower their insurance costs should obtain quotes from several insurers as well as make every effort to present their firm as favorably as possible to the insurer.

Generally, insurers try to determine the inherent risks in the types of services offered by the firm, the level of training offered to the firm’s staff, the internal quality controls used by the firm, the quality of the firm’s clientele and the extent to which the firm uses engagement letters and other loss prevention measures. If the firm has had any claims, full explanations of the circumstances leading up to the claim and what efforts the firm has made to prevent similar claims in the future should be set forth. In today’s competitive market place, insurers are offering greater coverages than in the past. Your broker should be familiar with what is being offered and should advise you regarding additional coverages available to your firm. For example, most insurers will eliminate exclusions in the policy for an additional premium charge, or modify exclusions, depending on the nature of the firm’s practice. In addition, some insurers are willing to work with their insureds and to permit their insureds to select their own defense counsel.

3. UNDERWRITING CONSIDERATIONS

A. SCOPE OF PRACTICE

One of the primary areas of consideration by insurers on deciding whether to accept or decline a particular risk is the scope of practice of the applicant. Insurers in the last few years have become particularly sophisticated in asking firms to provide practice profile information. While most insurers are still primarily concerned with the delivery of audit services (particularly, to publicly traded companies), they are also concerned, as a result of recent litigation, with accounting services, tax services, fiduciary services, securities activities, personal financial planning, management advisory services, business investment advice and any other non-customary services provided by the firm. Of great concern to most insurers is a firm's position with respect to the Year 2,000 Issues. Firms that are trying to assist their client in becoming Year 2,000 Compliant may find few insurers willing to insure them. Becoming less of a concern are services performed for financial institutions.

Most of the insurer application forms and their many supplements create headaches for the majority of firms. However, the opportunity to differentiate your firm from a similar risk by utilizing the application form is critical to the underwriter's acceptance of your risk and the terms and cost of coverage. Accordingly, accounting firms should utilize the insurer's application form to explain their expertise in each area in which they practice. The liberal use of addenda to describe the firm's training, supervision and quality controls in each area will also enhance its insurability.

The two largest areas producing claims for insurers in terms of frequency and severity emanate from both audit and tax services. In fact, almost 70% of insurers' claims emanate from audit and tax services. One of the other areas which has continued to provide insurers with problems is the continually expanding scope of management advisory services performed by CPA firms. In the last ten years, this area has become a particularly dynamic growth area for accountants resulting in the creation of a plethora of services not before or historically offered by accounting firms. Traditionally, the insurance industry viewed management advisory services (MAS) as effectively relating only to the technology and computer area. However, MAS in the last ten years, has expanded to include litigation support services, personnel management and general management consulting.

One of the growing areas of concern in light of numerous losses, is the provision of services for a client in which the firm has an equity or financial interest. Insurers are naturally concerned that this will lead to conflicts and compromise the independence and objectivity required of a CPA firm. In addition, there is the potential risk of an increased moral hazard due to the direct financial rewards as a result of the equity interest. Accordingly, it is critical that CPA firms recognize the importance of analyzing the services that they provide and explaining these to insurers in the most concise way, as this will have a distinct impact on the insurer's desire and ability to provide coverage and provide it at an effective cost!

B. PRIOR CLAIMS

Another of the critical sections within the application form is the area of prior claims information. A prior claims history provides insurers with a benchmark against which they decide whether the risk being submitted falls within the highly desirable, moderately desirable or less desirable category. Statistically, insurers are able to prove that a firm which has a significant frequency exposure ( i.e. reports a number of claims within a defined time period) will ultimately experience a significant claim. The purpose of the underwriting exercise is to ensure that the rate being charged is commensurate with the risk being accepted. Clearly, a firm that has had either a number of claims or one or more serious claims will indicate to the insurer a less than desirable statistical probability that the firm will become a repeat offender. As a result, insurers scrutinize the prior claims history both from a reporting and payment standpoint.

From the prior claims history, an insurer is able to determine what kind of problems the firm has suffered in the past and whether the firm has made any attempt to correct these problems from an internal management standpoint. As an example, failure to utilize engagement letters where clear evidence would show that the utilization of engagement letters would have prevented the claim, will create, in the insurer's mind, a less than desirable exposure.  Insurers are not as concerned with a single paid claim, whether it be significant or not, as the reason for purchasing the insurance is to take care of this situation. However, insurers will carefully review any and all prior claims experience in order to ensure that the firm has:

• Learned from its experiences in the past and has taken steps to mitigate its future exposure;
• Does not continue to create a greater than acceptable risk level; and
• Is likely to continue to present a more desirable risk profile for the future.

C. QUALITY CONTROL SYSTEMS

Throughout the underwriting process, critical to an underwriter's review of the CPA firm will be its ability to mitigate and control risks. Throughout the application form, a number of questions will be asked concerning the utilization of engagement letters, independent internal review of audit work papers, the firm's submission to the peer review process and the results of such reviews, and internal procedures where client funds are managed. The insurer will be looking to identify whether the firm is complying with the elements of quality control recommended by the AICPA. As with any business, it is important that the CPA firm follow a work plan which has been devised and approved to ensure that work is being performed in a professional manner. Insurers view quality control as creating a standard against which they are capable of measuring risk. While the AICPA will continue to set standards, these standards are the minimum level at which insurers expect their insureds to perform.

The majority of claims emanate from the insured firm's failure to follow its own quality control procedures. Accordingly, utilization of internal reviews as a way of ensuring compliance with quality control procedures are critical to the mitigation of risk from the insurer's standpoint. As an external control, insurers are also extremely concerned with the results of a firm's peer review. Accordingly, firms that perform audit services for public companies and are required to undergo peer review every three years are requested to provide a copy of their peer review report, together with the recommendations made by the reviews. In this way, insurers are able to ascertain whether the recommendations contained in the report have been complied with, thus providing clear evidence of the firm's commitment to mitigate risk and to prevent potential claims from arising.

It should be noted that even firms with exceptional quality control procedures will occasionally be sued. However, it is critical to the CPA's firm's ability to defend itself that a proper recognizable procedure be in place and that the firm's work papers adequately reflect the work performed. The insurer's ability to verify the applicant's contention regarding its work product is contingent upon the work product adequately reflecting the implementation of quality control procedures. While quality control is not a panacea, the utilization of quality control, together with an active and well-supported risk management program, will have an impact on an insurer's view of the risk presented by an applicant.

D. SUITS FOR FEES

Insurers first became concerned with CPA firms' suing their clients for unpaid fees as early as the late 1970s. As anyone who has sued a client is aware, a suit for fees in almost all circumstances results in a counterclaim for failure to provide the professional service and advice the client expected or was entitled to. Ultimately, fee suits have the effect of creating a litigious situation - one in which the client has the upper hand -as the CPA firm must now defend itself and its work product against almost unrealistic standards. Accordingly, wherever possible, suits for fees should be avoided. In fact, some insurers recommend that suits for fees should be avoided altogether!

In order to do this, a CPA firm must institute strict control procedures regarding its billing and fee collection. In addition, the utilization of resignation letters can be critical with respect to potential ongoing liabilities. Where the application form reveals a history of fee suits, the insurer, if it decides to offer a quotation, will be looking to determine whether the CPA firm has policies in place regarding the payment of fees and the monitoring of overdue accounts. Such policies should cover - (a) engagement letter forms addressing the payment of fees; (b) collecting payments in advance; (c) suspending services for delinquent clients; (d) collecting interest on past due notices; and (e) obtaining promissory notes for unpaid balances.

Wherever possible, CPA firms should not sue their client for unpaid fees without analyzing the professional services performed for the client and the likelihood of a counterclaim being made and possibly being sustained. Where possible, before a suit is instituted, an independent party should review the file to ascertain the likelihood of whether the client could sustain a claim. No one likes to perform services for which they will not be reimbursed; however, past fees must be viewed in context of a lawsuit, particularly in light of the time and effort to be expanded by the firm in defending a counterclaim.

Evidence of frequent suits for fees will deter insurers from providing a competitive quote or, in most situations, any quote. Clearly, every insurer will be concerned with the applicant's ability to manage its practice, as insurers view the inability to control client receivables as an indication of the ability to control remainder of the firm's practice. Suits for fees are discussed more fully in Section II.12 hereof.

E. OTHER 

Throughout the application and underwriting process, the underwriter seeks to evaluate each applicant in terms of a list of risk factors which it has identified from its past claims experience to create a rating base (or pricing formula) based upon those criteria. As a result, every CPA firm must understand that most application forms seek to assess the firm's risk in terms of a number of factors that the insurer can evaluate and understand. Viewed in this context, it is not difficult to understand why an insurer may not be capable of evaluating and understanding the difference between the services performed by one CPA firm and those performed by another. Clearly, the mere completion of an application form does not provide this. As a result, CPA firms are encouraged to also provide a narrative explaining its internal auditing controls and how those controls are designed to minimize the firm's exposure to liability risks.

4. TAIL AND PRIOR ACTS COVERAGE

Because accountants professional liability policies are written on a "claims made" form, in the event a firm's policy were canceled, it would effectively be left with no coverage if a claim were subsequently asserted against it following the termination date of the policy. This contrasts with the traditional Aoccurrence@ policy form (traditionally used in general liability policies), which keys coverage to when the actual service which created the claim was performed. As an example, if a firm's policy was in force from January 1, 1996 to January 1, 1997 on a claims-made basis, then any claim which is reported during that policy period would be covered by that policy regardless of when the firm's services had been performed. Under an occurrence policy, the policy which was actually in force at the time the services were provided, (e.g., five years ago) would be the policy that would apply. To prevent a lack of coverage in the event of a cancellation or non-renewal, every claims-made policy provides for an extended reporting period option or tail coverage. This is critical, as it determines a firm's ability to protect itself in the event that the insurer either wishes to leave this particular line of coverage or does not renew the firm's policy.

Thus, professional liability coverage consists of two components - work in progress and prior acts exposures. The longer a firm is in practice, the larger the prior acts component becomes. Insurers promulgate their rates based upon a rate-step factor. Each year when the policy renews, the firm's rate moves up a step until it reaches the insurer's maximum rate. If a firm commenced practice on January 1, 1998, there would be no basis to bring a claim against the firm on the policy's inception date since the firm had not previously performed any work. Accordingly, an insurer would rate a firm newly commencing practice very differently from firms which had been in practice for a number of years. As the new firm continues to develop business, when it comes to renew its policy in January, 1999, the insurer would move the rate from a rate-step 1 (or $1.00) to a rate-step 2 (or $1.35). This recognizes that the new policy is not only picking up the work which will be performed in the next twelve months, but also the exposure emanating from the work which was performed in the previous twelve months. This is a significant component of the underwriting methodology utilized by insurers as it enables insurers to monitor which exposures they are actually insuring. As a result, insurers will appear to offer extremely attractive terms to firms that have newly entered practice versus those that have been in existence for a number of years. Thus, insurers merely move their rating methodology to coincide with the increased exposure which they are assuming. Ultimately (usually seven to eight years), the firm will reach the fully mature rate required by the insurer to take care of the prior acts exposure being assumed.

In short, whenever a firm receives a quotation from an insurer which appears highly attractive, it should determine whether:

• The coverage as presented provides full prior acts coverage and does not contain any limiting endorsements with respect to the time period within which the firm's professional services will be covered in the event of a claim (also known as a "retroactive limitation clause" endorsement).
• The tail or extended reporting period option under the coverage being offered provides a number of options - 1, 3, 6 years or even unlimited - thus ensuring that all prior acts exposure will be adequately covered in the event the policy is canceled or non-renewed. Wherever possible, this option should be available "both ways" (i.e. whether the firm or the insurer wish to cancel or non-renew the policy).

Finally, another area where prior acts and tail coverage is extremely important is in the event of a merger or acquisition. On such occasions, a CPA firm should consult with its insurance representative as to how and whether it can insure the liabilities of the entity it is acquiring.

5. DUTY TO NOTIFY

All accountants' professional liability policies include a requirement that the insured firm notify its insurer in the event that it receives (or is served with) a demand, notice, summons or other process. Most insurers require that this notice be given immediately (and in writing). The requirement for immediate notice permits two key services to be triggered by the insurer:

*The recording of the claim for the purpose of identifying the insurer's duty to cover the claim under the policy then in effect; and

*The appointment of legal counsel whose involvement may help to diffuse the volatility of the situation through an independent and detached review of the circumstances surrounding the claim.

For the purposes of most professional liability policies, a Aclaim@ may arise in two different ways:

*An actual demand, notice, summons or other process seeking compensation for the alleged failure of the firm to provide the professional services expected or required by the plaintiff; and

*The CPA firm becomes aware of circumstances which could reasonably be expected to give rise to a claim either because an error is discovered or because the client or a third-party has incurred damages which can be traced back to the firm's actions.

The reporting of such Acircumstances,@ in most policies, has the effect of assuring that if a subsequent demand is received by the firm, the insurer will consider notice to have been given under the policy which was in force at the time the circumstance was reported. As an example, the firm becomes aware that one of its clients may suffer a tax penalty as a result of its failure to list certain deductible items in a prior tax return. While there may be potential remedies to this problem (such as filing an amended return), in the event that such remedial efforts are unsuccessful, the client will suffer a loss for which the firm may be held liable. Although no "claim", i.e. demand, has been made, clearly the firm has a potential liability. By reporting this situation as a "circumstance" which may subsequently give rise to a claim, the insurer "assigns" this matter to the policy in force at the time the original notice was received.

This has two benefits:

*If a subsequent claim does arise, the firm has already provided notice; and

*Early involvement of the firm's insurer may help mitigate the potential exposure.

Before giving notice of a claim or circumstance, a CPA firm should review its policy carefully with respect to where notice should be sent. In the event of any confusion, the firm's insurance representative should be contacted. Not all insurers treat notice of Acircumstances@ as a notice of a claim. Because this feature is highly advantageous to the insured firm, it is prudent to inquire whether the insurer's policy includes an Aawareness provision@ before the policy is purchased.

6. DUTY TO COOPERATE

Every insured accounting firm has a duty to cooperate with its insurer. This duty arises out of specific provisions in the firm's policy (i.e., the "cooperation clause"), as well as from the legally implied duty to act in good faith. The duty to cooperate applies both to the defense of claims covered by the firm's insurance, as well as to assisting the insurer in determining whether, and to what extent, there is coverage for the claim.

The first of these duties requires that the insured firm work with defense counsel and provide that counsel with such information and documents as might be necessary or helpful in order to defend the firm against the claim. It also requires the members and employees of the firm to meet with defense counsel to convey and explain this information, and to prepare for oral examinations before trial (also referred to as "depositions" or "EBT's"), and for their trial testimony. It also requires that they attend their depositions and appear for trial. A failure to so cooperate would be a breach of the insurance contract, providing the insurer with a basis for disclaiming liability.

The insured firm's second duty of cooperation requires the insured firm to supply information to its insurer. This is to enable the insurer to evaluate the claim so that the insurer can effect an appropriate resolution of the claim. It also enables the insurer to determine whether, and to what extent, coverage pertains to the claim.

For the most part, information pertaining to the claim will be sent to the insurer by defense counsel who will periodically report developments relating to the claim. While such reports are customary, the insured firm not only has the right to receive copies of such reports, it also has the right to review those reports before they are transmitted, as defense counsel, while generally selected and paid by the insurer, owes his or her primary duty of loyalty to the firm.

In order to determine whether it has a duty to cover a given claim, the insurer may seek certain information from the insured firm. While much of the information that the insurer may need for this purpose may have already been supplied by the firm to defense counsel, the insurer should seek this information directly from the insured firm, as defense counsel will not normally get involved in coverage issues between the insurer and the insured firm. Nevertheless, the firm may simply authorize defense counsel to pass such information on to the insurer.

Although the insured firm has a duty to cooperate with the insurer in supplying this information, such requests for information should be handled with great care, as an inappropriate disclosure could prompt the insurer to disclaim liability. Accordingly, it is advisable for accounting firms to seek the advice of counsel before responding to such requests. Although nothing prohibits defense counsel designated by the insurer from supplying this advice, many attorneys asked to defend claims on behalf of insured firms will be reluctant to become involved in a dispute (or potential dispute) between an insured firm and its insurer.

7. COVERAGE DISPUTES

An accounting firm's insurer is only required to defend and indemnify an insured's firm with respect to those claims that are covered by its policy. Thus, an insurer would not be required to provide coverage for claims that were brought outside the policy period or were encompassed by one of the "exclusions" within the policy.

When a claim is brought to the attention of an insurer, it has a duty to investigate whether there is coverage for that claim under the policy. In a great many cases, the insurer will simply not be able to make this determination from a review of the complaint and, in some cases, this determination cannot even be made based upon information available to the insured firm. When the insurer's duty to cover a claim is not clear, the insurer has a duty to provide the insured firm with a defense until such time as the coverage issues become clear which, in many cases, may not happen until the case has been concluded.

A. RESERVATION OF RIGHTS LETTERS

Because an insurer who provides a defense to a claim may be deemed to have waived its right to later disclaim liability for the claims, insurers have adopted the practice of writing to their insureds immediately following the submission of a claim, advising the insured of certain provisions within the insurance policy which may form the basis of a later disclaimer of liability by the insurer. Such letters (commonly referred to as "reservation of rights" letters because the insurer reserves its right to disclaim liability) generally have an ominous tone, as they strongly imply that the insurer will not cover the claim. While they are clearly intended to convey that warning, only a small percentage of cases in which such letters are sent are actually disclaimed. In most cases, the insurer goes on to both provide a defense to the claim, and to pay the entire settlement amount other than the insured firm's deductible amount. Nevertheless, insured firms that receive such letters should discuss them with their counsel, as the very fact that the insurer sent the letter may provide the insured firm with additional rights to control the defense of the claim.

B. DISCLAIMER LETTERS

Occasionally, it will be clear at the outset that a claim is outside of the scope of the policy, in which event the insurer will decline to defend the claim and will notify the insured firm that it is disclaiming responsibility for the claim. Although such letters are relatively rare, they require immediate action, as the insured firm must make arrangements to defend the claim and must consider whether it wishes to contest the insurer's decision to disclaim. Thus, the insured firm must immediately contact its counsel and take action.

C. RESERVATION OF RIGHTS AGREEMENTS

Rather than simply send a "reservation of rights" letter, insurers will occasionally seek to enter into an agreement with the insured firm. In this agreement, the insurer will reserve its right to later disclaim on certain bases. In return, the insurer will agree to provide the insured with a defense of the matter. In this way, the insurer will seek to avoid having the insured take over the defense of the matter. From the insured firm's perspective, it secures the defense of its claim without having to resort to court action in order to compel the insurer to fund the defense of its claim.

D. SELECTION OF DEFENSE COUNSEL

Most insurance policies for small and mid-size accounting firms require the insurer to provide a defense to covered claims. This is in contrast to policies written for the large firms, which place the duty of defending claims in the hands of the insured firm. Even where the insurer has the duty to defend claims, the insured may have the right to select counsel and to control the defense of the claim if the insurer reserves its right to disclaim liability of the claim. Selection of defense counsel and control of the claim are important rights, especially where there is a serious possibility that the insured firm may be called upon to pay all or a significant part of any final resolution of the claim.

Because of the importance of controlling the defense of claims, certain insurers will permit some insured firms, principally those with large deductible obligations, to select defense counsel. In some cases, this right can be obtained through the payment of an additional premium.

E. DECLARATORY JUDGMENT ACTIONS

Because the law provides that the duty to defend is broader than the duty to indemnify, most insurers will provide a defense of a claim even though they believe that they have no responsibility to indemnify the insured against any resulting judgment or settlement (or major part thereof). Should an insurer wrongfully refuse to defend the claim, it could be held responsible not only for the defense costs, but also for any resulting liability incurred by the insured. It is for this reason that early disclaimers of liability are relatively rare.

An insurer that does choose to provide a defense to a claim believed to be outside of the scope of the insured firm's policy may seek to have a court rule as to its responsibility with respect to a claim as a means of limiting its defense and indemnity obligations. This is done through a "declaratory judgment" (or "DJ") action. A DJ action is a separate case from the plaintiff's claim against the insured firm. In fact, if there is a material overlap in the issues in the two cases, the court will not entertain the DJ action, so as not to prejudice the insured firm's position in the liability case.

In a DJ action, the insurer and the insured firms will employ their own separate coverage counsel. Although the defense counsel may serve as the insured firm's counsel in a DJ action, this is generally not done. Defense counsel, however, may not represent the insurer in the DJ action.

8. INSURANCE REGULATION

Insurance is a highly regulated industry for the simple reason that a purchaser of an insurance policy pays for the policy in advance, not knowing until much later whether and to what extent the insurer will provide coverage. As such, it is an industry designed for abuse. It is for this reason that it is highly regulated in every state. Such regulations concern which insurers shall be licensed (or admitted) to sell their policies within the state, the capital requirements of insurance companies (which is usually a function of volume of premiums collected), the terms of policies deemed to provide acceptable levels of coverage, and prohibitions against unethical practices and false advertising. Set forth below are some of the aspects of insurance regulation that impact the accountants= liability insurance market.

A. ADMITTED, NON-ADMITTED/SURPLUS LINES CARRIERS

Throughout the insurance industry, there are numerous operating formats which can be utilized by an insurer to underwrite risks. One of the available choices is whether they are prepared to provide coverage on an admitted or non-admitted surplus lines basis. Simplistically, admitted companies are those which have been authorized and licensed to do business in a given state and have been reviewed by the state's insurance department. Admitted insurers are required to file both their policy wordings and rates and act in compliance with their filings under the risk of financial or other penalties by the state insurance department. They are also subject to the state guaranty funds in the event of their insolvency or bankruptcy. Wherever possible, and where the risk permits, a CPA firm should seek to obtain coverage from an "admitted" insurer. In addition to the review and regulation by the state's insurance department, admitted companies are also reviewed by the many independent rating agencies, e.g. A.M. Best, Standard & Poor's and Moody's. In this way, a firm has a means of measuring the financial security of its insurer as promulgated by these rating agencies.

As an example, consider the following rating system utilized by A.M. Best. Insurers rated A++ (XV) by A.M. Best are considered financially superior. The class designation (XV) denotes that the insurer has $2 billion or more in reported policyholder surplus plus conditional reserves. By contrast, an insurer rated C- would be considered marginal.

To permit flexibility in underwriting risks, the insurance industry also utilizes "non-admitted" or "surplus lines" companies. Non-admitted companies are those which are not licensed to carry on business in a particular jurisdiction. However, many states publish Awhite lists@ which list non-admitted insurers whom the insurance department considers acceptable for difficult-to-place risks.

Surplus lines companies are utilized to provide coverage where there is no admitted insurer available to provide the coverage requested. As a result, surplus lines insurers can be more flexible; however, in most states, in order to place its business with a surplus lines insurer, a purchaser must obtain (a) declinations of coverage from a specified number of insurers and (b) an affidavit completed by the placing broker regarding those declarations of coverage. In addition, most insurance departments require the payment of a surplus lines tax where a surplus lines insurer is utilized. Since the market for professional liability coverage is very competitive for all but the very large CPA firms, there is little reason why most CPA firms should not obtain their coverage from an admitted insurer. A well-run risk retention group or similar entity owned by accountants themselves may also be a good alternative for some firms.

B. REGULATION OF POLICY TERMS

Most policy terms (certainly within the admitted market) are required to be filed and approved by the state's insurance department. The regulation of policy terms is an attempt to ensure that basic policy provisions are provided to a firm when purchasing a policy. While clearly there are numerous differences between the various policies offered, the provision and regulation of policy forms ensures that a CPA firm will obtain a minimum level of coverage which the insurer and the insurance department find necessary in order for an insurer to be able to provide its product to a particular client base.

C. REGULATION OF CAPITAL AND SURPLUS

Each year, insurers are required to file with the state insurance department a statement which outlines their capital and surplus position. It also identifies the placement of admitted and non-admitted reinsurance which has an effect upon the capital and surplus position of the company. In addition, these filings permit the various state insurance departments to monitor the financial health and solvency of the various insurance companies operating within their states. These annual filings are also utilized in independent reviews performed by the various independent rating agencies to monitor the ongoing health and success of the insurance companies.

D. REGULATION 107

Regulation 107 issued by the New York State Department of Insurance provides for defense offsets against the policy limit, which effectively has the result of providing additional coverage to the insured firm with respect to a claim made against it in the event that the stated limit of liability is eroded by defense costs. Thus, this regulation provides a measure of protection for the insured in the event that a claim is ultimately settled where a significant portion of the policy's limit has been utilized purely for defense and the insured could be faced with making the actual settlement payment personally.

In New York State, Regulation 107 provides:

• Where the policy is below $1,000,000, defense costs are provided in addition to the policy limit and the deductible is not subject to defense costs; and
• Where the policy limit is $1,000,000 or greater, then only 50% of the policy limit may be utilized for defense costs. This 50% rule also applies to the deductible.

 

PART II - RISK MANAGEMENT

1. CLIENT SELECTION

A. IMPORTANCE OF SCREENING

High risk clients and engagements increase the liability exposures of even the most careful accounting firms where an attempt will be made to (i) blame the firm for any misstatements which are found in a client's financial statements or (ii) hold the firm liable for substantial losses suffered by various persons who allegedly "relied" on the misstated financials, including the client itself, and the client's shareholders, lenders and trade creditors. In order to reduce these litigation exposures, it is imperative that accounting firms carefully screen out high risk clients and engagements which clearly "spell trouble" for the firm. Unfortunately, such clients and engagements cannot be "dealt with" by simply charging higher fees because, if litigation ensues, defense costs and damage exposure will almost certainly greatly (many times, by a factor of 100) exceed the fees (including any premium) previously charged the client.

Walking away from an engagement is not an easy decision, but taking on a high-risk engagement can lead not only to liability but to professional discipline and sometimes even to criminal indictment.

B. "PROBLEM" CLIENTS AND ENGAGEMENTS

While it is not possible to catalog all "problem" clients and engagements, the following are common examples of situations which should be avoided or, at least, approached with significant caution and a realistic assessment of the risks:

Unsavory Clients. Avoid clients that have previously engaged in improper or illegal activities. If caught, such clients often try to pin the blame on the accountant, especially where tax liability is involved. "My accountant told me to do it that way" is one of the more common refrains of clients who cannot be trusted. If other accounting firms have declined to service the prospective client, determine why those firms turned away the client.

Clients With Financial Problems. Firms should always be wary before taking on a client which is already in financial distress or has a "going concern" problem. Even if such a client was "doomed" to fail before the firm accepted the engagement, a significant possibility exists that the firm will be held responsible in future litigation for any failure by the client.

Clients With Poor Internal Controls. Be cautious when accepting an engagement for a client which has poor internal controls or where management is lax in enforcing internal controls in place. The likelihood that a client's financial statements will be materially misstated greatly increases if its books and records are unreliable, or its internal accounting group is poorly trained, unreliable or understaffed. Such clients are also vulnerable to client-employee thefts for which accounting firms are routinely blamed.

Clients Which Lack Internal Stability. Be cautious when accepting work for a client which lacks internal stability, especially if there is frequent turnover in its important managerial positions. Such firms have a high failure rate, leaving bank loans unpaid.

Clients With Uncertain Futures. Think twice before accepting an engagement if the prospective client's major products are either difficult to market or only in the "start-up" phase. Unfortunately, the financial outlook for such clients is highly uncertain and it is possible that the firm will be at least partially blamed for the client's ultimate failure.

Clients Which Frequently Change Or Sue Accountants. Prospective clients which have a history of changing accounting firms, refusing to pay professional fees or suing accountants obviously "spell trouble" from the beginning.

Clients Shopping For An Accountant. CPA firms should be suspicious when a prospective client seeks assurances concerning the proper accounting treatment for a material transaction prior to its engagement of the firm. The client may be improperly "shopping" for a firm willing to endorse a questionable approach in return for payment of fees.

Clients Involved In Substantial Litigation. Avoid clients which are already embroiled in significant litigation or government investigations, the outcome of which could have an adverse effect on their financial viability or ability to attract and retain new business and customers.

Clients Engaged in Material Related-Party Transactions. Be suspicious of clients which participate in material related-party transactions. By making appropriate inquiries, the firm should satisfy itself that the existence and terms of all such transactions have been fully disclosed and that such transactions are not a part of a series of illegal acts or a scheme to falsify financial data.

Clients Requiring Expertise Not Possessed By The Firm. A CPA firm should not accept engagements if it does not have the personnel or skills to properly perform the required work. Special consideration should be given to whether the firm is qualified to perform high risk engagements, such as audits of financial institutions and construction companies. Such consideration also applies to audits of pension plans and entities receiving government grants or contracts. Both of these areas have highly specialized accounting and auditing issues that come under regular scrutiny by Federal and State agencies. These agencies feed into the professional discipline apparatus of state CPA regulators, the AICPA and state CPA societies. At a minimum, their investigations can trigger the need to make damaging disclosures on insurance applications. While it is always difficult for a firm to turn away business, the risks associated with taking on work the firm is not qualified to handle are too great.

Clients That Are Unable Or Unwilling To Pay Fair Prices. Avoid engagements for unreasonably low fees. While it is sometimes tempting to initially perform services for a very low fee in order to attract an important new client, the temptation to cut back on procedures required by GAAS or other applicable standards to avoid losing money on the engagement is too great. If litigation arises from low budget engagements, disclosure of the firm's failure to perform all required procedures in order to save money may be devastating. Even if the firm complied with applicable professional standards, a jury may infer from the engagement's low fee that corners were cut by the firm.

Client Engagements that "Feel Wrong". Experienced CPAs commonly have the ability to sense when something is amiss with an existing or prospective client, even though the CPA cannot point to specific evidence. All too often, this professional intuition proves correct. If something about a prospective engagement feels wrong, it may be best to walk away.

C. CLIENT-IN-TAKE PROCEDURES

To avoid overly risky clients and engagements, CPA firms should establish formal screening procedures which must be followed before a new client or new engagement is accepted. Among other things, accounting firms should develop a written checklist which incorporates the risk factors listed above, as well as other risks identified by the firm. Using that checklist, the firm's management (or a committee appointed by management) should carefully review each prospective client or new engagement, and determine whether the litigation risks to the firm outweigh the expected financial benefits.

In order to make an informed decision concerning new client acceptance, the firm should obtain and review all available information. For example, the firm should read any public filings by the "client", check the public press and make inquiries of knowledgeable third parties to learn as much as possible about the prospective client and its management.

In addition, the firm should make detailed inquiries of the predecessor accountants before accepting a new client. Such inquiries should be specifically directed to such matters as management's integrity, any disagreements between the predecessor and management with respect to GAAP, GAAS or other significant matters, and the reasons why the prospective client is seeking to change accountants. As part of the foregoing, the firm should also review its predecessor's workpapers before taking on the new matter.

Absent unusual circumstances, an accounting firm should refuse to accept any new client which refuses to authorize the predecessor accountants to communicate with the new accountant or to make its work papers available to the successor accountant. Clients that have had disputes with their prior accountants will often make disparaging remarks about their prior accountants in an effort to discourage contact with the prior accountant. Such remarks should not dissuade a firm from communicating with the prior accountants and should be considered when evaluating the acceptability of the client.

D. CONFLICT OF INTEREST ISSUES

Before taking on a new client or engagement, a firm should make sure that no "conflict of interest" exists. This subject is discussed in detail in Section 10 below.

E.  INDEPENDENCE ISSUES

Before taking on new work which requires that it be "independent" of the client (e.g., auditing or other verification or attest services), a CPA firm should carefully consider whether any facts exist which would impair its independence or create an appearance that independence is lacking. Generally, questions involving "independence" can be resolved by consulting the AICPA's Code of Professional Conduct and related interpretations and ethics rulings.

Among other things, the AICPA's "independence" rulings provide that to be independent, an accountant must NOT:

Assume the role of employee or of management. For example, the accountant should not consummate transactions, have custody of client assets, or exercise authority on behalf of the client. The client must prepare the source documents for its transactions in sufficient detail to identify clearly the nature and amount of such transactions. The accountant should not make changes in such basic data without the concurrence of the client.

Have any loan to or from the client or any officer, director, or principal stockholder of the client, except for a limited number of "permitted" loans (e.g., certain loans from financial institution clients).

Be in threatened or actual positions of material adverse interests with the client or its management by reason of threatened or actual litigation. Because of the complexity and diversity of the situations of adverse interests which may arise (especially in cases of "threatened" litigation) CPA firms should obtain further guidance on this matter by consulting with legal counsel and reviewing applicable AICPA "guidelines" concerning the effect of litigation on "independence".

Allow an individual to participate in an engagement if during the period of the professional engagement or at the time of expressing an opinion a firm member or employee participating in the engagement has a close relative with a financial interest in the enterprise that was material to the close relative and of which the individual participating in the engagement has knowledge.

The AICPA has also addressed (among others) the following "independence" related issues: (i) former practitioners and firm independence, (ii) honorary directorships and trusteeship of not-for-profit organizations, (iii) the effect on independence of financial interests in non-clients having investor or investee relationships with an accountant's client, (iv) the meaning of certain independence terminology and the effect of family relationships on independence, (v) the effect on independence of relationships with entities included in the governmental financial statements, (vi) independence and attest engagements, (vii) contingent fees and (viii) commissions and referral fees.

The SEC has established its own "independence" requirements (see Rule 2-01 of Regulation S-X) which CPA firms must satisfy if their engagements are subject to the Commission's rules and regulations. In some instances, these rules are more stringent than those imposed by the AICPA or the various State Boards of Accountancy. Among other matters, the SEC rules address the effect on independence of:

The accountant's performance of EDP and bookkeeping services for the client;

Various financial interests held by the accountant in the client;

Failure by the client to pay the accountant's fees

Family relationships between the accountant and the client; and

Business relationships between the accountant and the client.

Although independence issues in the context of financial statements filed with the SEC have been assumed by the Independence Standards Board (AISB@), the ISB, as an interim measure, has adopted all of the SEC independence rulings and interpretations.

Since some regulatory agencies other than the SEC (e.g., the FDIC) also maintain their own independence rules, CPA firms should ascertain that all applicable independence standards have been complied with whenever a client is subject to an agency's jurisdiction.

F. CLIENT REFUSALS AND NON-ENGAGEMENT LETTERS

When a CPA firm decides not to accept a prospective client for any reason (e.g., excessive risk, conflict of interest or independence problem), it should consider sending the person or entity a formal rejection letter. Otherwise, if the contemplated service (e.g., the preparation of tax returns) is not performed by others on a timely basis, the "client" may attempt to hold the firm that refused the work liable for any damages or penalties which flowed from non-performance of the service in question. While the use of rejection letter is clearly a matter of judgment, they deserve serious consideration in cases in which the client is facing imminent financial statement or tax return filing deadlines.

G.  CLIENT PRUNING AND DISENGAGEMENT LETTERS

Occasionally, CPA firms should disengage existing clients if they begin to take on one or more of the risk characteristics set forth in Part B. above. To facilitate the identification of overly risky clients, firms should periodically review their client roster using a "checklist" similar to the list previously proposed for accepting new clients.

A CPA firm should also drop an existing client if an unreconcilable "conflict" or "independence" problem arises which did not exist when the client was initially accepted.

Whenever a CPA firm withdraws from an engagement, it should send the client a formal resignation letter. Among other things, this letter should apprise the client of all pending deadlines (e.g., tax filing dates) so that the client cannot blame the firm if required action is not taken on a timely basis.

2. ENGAGEMENT LETTERS

A. IMPORTANCE

Accounting firms are frequently sued for having failed to perform services or rendered advice which their client alleges they agreed (or were expected) to render. Accordingly, the profession has long encouraged its members to use engagement letters to establish a clear understanding of the services to be performed, and to define the responsibilities between them and the client.

The use of engagement letters by accountants is based on the premise, as noted in professional standards, that an accountant should reach an understanding with the client concerning the engagement and communicate this understanding orally or in writing. Various references to reaching such an understanding appear throughout professional standards and other professional literature. The AICPA Code of Professional Conduct, however, does not require written engagement letters.

Over the years, and especially in these litigious times, engagement letters have been used with greater frequency, and have evolved to include language addressing topics related to the engagement, such as statements about the limitations of the services provided, particularly in the case of audit, attestation, and accounting and review services. It is even more important to fix the terms of a firm's engagement where the services to be rendered are of a non-standardized nature, such as in consulting engagements. Engagement letters have also been used to establish an understanding of fee and billing arrangements.

(1) Fundamental Guidelines

According to a variety of commentators, each engagement letter should contain the following information, and address the following subjects:

• Addressee
• Identification of the financial statement and/or work to be performed
• A statement that no work other than that identified will be performed; and that work performed will be updated unless specifically agreed to in writing
• Description of principal services to be provided
• Additional services ancillary to the main purpose of the engagement
• Identification and explanation of unique terminology
• The limitations of the firm's services and responsibilities
• The responsibilities of the client, including the client's assistance
• The basis upon which the firm's fees are to be charged
• Resolution of disputes
• Client's acknowledgment of the terms of the engagement

(2) Descriptive Guidelines

At the outset, an engagement letter should specify the type of services to be performed by the accounting firm. For example, by setting out the parameters of an engagement as a compilation, an accounting firm may prevent the client from later establishing that the firm undertook to review or audit a set of financial statements, without an expressly identified step-up in service.

In addition, an engagement letter should also describe the nature of the services to be performed. This is particularly important in specialized engagements such as those in which the accountant performs agreed-upon procedures or consulting services. The specific procedures to be performed can either be listed in the engagement letter itself or set forth in an accompanying schedule. Some accounting firms even refer to the appropriate professional literature governing the engagement or the procedures to be performed. By so specifying what services will be performed, the firm can minimize potential litigation, and may prevent client disputes based upon a misunderstanding of the scope of services to be provided.

In order to avoid a misunderstanding with the client regarding the benefits to be derived from the firm's services, the engagement letter should mention the limitations of the specified services. These limitations generally should mirror the applicable professional standards and include the limited ability of the firm's services to unearth frauds and client employee defalcations. Of course, it is not practical to mention all items not covered by a firm's services in the engagement letter. But, if a client specifically identifies certain items it expects to be covered in an engagement, an accounting firm should consider language in the engagement letter identifying the limiting factors associated with its engagement.

It is also important that the engagement letters specify the client's responsibilities. If the client agrees to provide any workpapers, confirmations or other documents, locate documents selected for testing, or assist the firm in any other way, these responsibilities should also be itemized in the engagement letter. It is also useful to specify the timing of the client's responsibilities and a warning that the client's failure to adhere to that schedule will necessarily cause a delay in the firm's performance of its engagement.

Regardless whether an accounting firm's charges are based on the time expended in performing its engagement or upon a fixed-fee arrangement, the engagement letter should specifically set forth the fee arrangement, as well as any limitations or contingencies associated with the arrangement. All too often, firms encounter difficulties recovering uncollected fees when the fee arrangement is not explicitly articulated. In this regard, the engagement letter should specify when payments are due. If interim invoices are to be sent, the engagement letter should also specify that the firm reserves the right to suspend its services or terminate the engagement if the client does not pay its invoices on a timely basis. In addition, the engagement letter should provide that if the firm terminates its services due to nonpayment of its fees, it shall be deemed to have earned that portion of its total fees represented by its accrued time charges, irrespective of whether it has completed its engagement.

B. STANDARD ENGAGEMENT LETTER FORMATS

(1) Audit/Review/Compilation

Although there are several references to engagement letters in the authoritative literature of the accounting profession; neither the profession nor its regulators require that a firm enter into an engagement letter with its clients. Instead, engagement letters are only recommended for the protection of accounting firms so as to prevent misunderstandings with their clients. Nevertheless, the fact that the authoritative literature of the profession does encourage the use of engagement letters places a greater legal burden upon accounting firms to reach a clear understanding with their clients as to the scope of their services and assumed responsibilities.

The auditing section of the AICPA's Professional Standards is virtually silent on the subject of engagement letters, referring only to specified elements, accounts or items, reports on internal control and reviews of interim information. In fact, it offers no examples of engagement letters.

In contrast, the standards are explicit about the use of engagement letters for accounting and review services, perhaps because the risk of misunderstanding in this area is greater. Accounting and review ("AR") Section 100.08 says, "The accountant should establish an understanding with the entity, preferably in writing, regarding the services to be performed." Examples of engagement letters for both compilations and reviews services appear in AR Sections 100.53 and 100.54.

Although it is not an authoritative source, the AICPA Audit and Accounting Manual ("AAM") provides helpful advice on engagement letters. The AAM contains an excellent discussion of matters the engagement letter should address, as well as illustrative forms of letters appropriate for audits, compilations and reviews in various circumstances. The manual also suggests that an accounting firm need not issue the letter more than once a year and that one letter may cover a variety of services.

The key points to consider including in audit engagement letters are as follows:

Purpose of letter: This letter will confirm our understanding of the arrangements for our audit of the financial statements of [company name] for the year ended [date].

Engagement purpose: We will audit the company's balance sheet at [date], and the related statements of income, retained earnings and cash flows for the year then ended. In all circumstances, our responsibility for this engagement will be limited to this period. The purpose of our engagement will be to express an opinion on the fairness of presentation of these financial statements in conformity with generally accepted accounting principles [or other comprehensive bases of accounting].

This paragraph should limit the accountant's responsibility to a specified interval, a provision that may discourage a claim related to work allegedly or actually performed at another time. This paragraph also can describe the engagement's fundamental purpose. While this may seem elementary, it sets a logical stage for the contents to follow. Although a firm may undertake to perform an audit of its client's financial statements, it should not agree to issue an unqualified report as problems may subsequently be encountered which might preclude the issuance of a report, creating the possibility that the client might contend that the failure to issue a report (much less an unqualified report) constitutes a breach of contract and thereby precludes the firm from collecting its unpaid fees.

Responsibilities: The accuracy and completeness of the financial statements, including the related footnotes, are the responsibility of the company's management. Management also is responsible for selecting sound accounting principles, and for maintaining an adequate internal control structure. Our responsibility is to express an opinion on the financial statements based on our audit.

This section should explicitly recognize all the client's and auditor's major responsibilities. As the AAM manual points out, such definitions are especially important for write-up work leading to the preparation of financial statements for a small, non-public client. Should an accounting firm offer advice about a choice among alternative accounting principles, it is essential that the client acknowledge its responsibility for the selection decision.

Standards applicable to engagements: We will conduct our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. The term reasonable assurance implies a risk that material monetary misstatements may remain undetected and precludes our guaranteeing the accuracy and completeness of the financial statements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audit will provide a reasonable basis for our opinion.

The paragraph that concerns applicable standards is, of course, based on the standard auditor's report set forth in SAS No. 58. The additional reference to detection risk alerts the client to the possibility that material misstatements will not be discovered due to the audit process's inherent limitations. In this same regard, it may be helpful to point out that the "reasonable assurance" provided by an audit opinion is clearly less than a guarantee as to the material accuracy of the client's financial statements.

Audit procedures: Our procedures will include obtaining an understanding of the company's internal control structure and testing those controls to the extent we believe necessary. We also will physically examine the fixed assets and inventories [if applicable], and will confirm receivables, certain other assets and liabilities by corresponding with selected customers, suppliers, attorneys and banks. In addition, we will read the other information included in the annual report to stockholders and consider its consistency with the financial statements.

Management representations: At the conclusion of our audit, we will request from you a letter attesting to the completeness and truthfulness of representations and disclosures made to us during the course of our work.

The audit procedures sections address the firm's responsibility for obtaining an understanding of the internal control structure, underscoring for the client the importance of the controls for audit purposes. It also refers (albeit obliquely) to the management's discussion and analysis section and other financial information appearing in documents in which the audited financial statements are published. Once client personnel understand the requirements of AU Section 550, they may be particularly careful to avoid inconsistencies between the "other information" and the client's financial statements.

Scope restrictions: If you are aware of any restrictions that might limit the scope of our testing, we ask that you bring them to our attention as soon as possible. Such restrictions, if significant, may preclude us from issuing an unqualified opinion.

A paragraph on scope restrictions can impress on the client the importance of early notification to the auditor so the work can proceed smoothly without a significant fee increase. It also points out the seriousness of significant restrictions and may discourage the client from imposing any such limits.

Responsibility for detecting fraud: Generally accepted auditing standards require us to design our audit to detect errors and irregularities that would have a material effect on the financial statements. However, since we will not examine all the transactions that occurred during the preceding year, our audit cannot provide absolute assurance that such errors and irregularities, including fraud or defalcations, will be detected. We will inform you of irregularities that come to our attention during the course of the audit unless they are clearly inconsequential.

By far the most serious liability exposures arising out of audit engagements are based upon an accounting firm's failure to uncover a client-employee defalcation or a management fraud. Accordingly, it is particularly critical for every audit engagement to contain a strongly worded caveat concerning the possibility that a defalcation or fraud perpetrated by client employees might not be detected by a properly performed audit.

While such caveats do warn clients as to the limitation of an audit and have even been relied upon by some courts in finding accounting firms not to be responsible for client-employee defalcations, they are not an impenetrable shield against such claims. This is because most courts tend to construe narrowly all disclaimers of liability. Some courts further take the position that such disclaimers only avoid liability where the engagement has been properly performed and provide no protection where the accounting firm has failed to comply with professional standards.

Responsibility for detecting illegal acts: In performing our audit, we will be aware of the possibility that illegal acts have occurred. We will design our audit to detect illegal acts that have a direct and material effect on the financial statements. Again, we will inform you of violations of government laws and regulations that come to our attention unless they are inconsequential.

Under the provisions of the Private Securities Litigation Reform Act of 1995, accounting firms auditing public companies which become aware of the possibility that an illegal act (whether or not material) has occurred have a duty to determine whether it is likely that one has occurred, determine its possible effect on the financial statements and report it to the client. If the client fails to take remedial action the auditor must then determine whether the illegal act has a material effect on the financial statements of the client. If the auditor determines that the failure to take action is reasonably expected to warrant departure from a standard report of the auditor, when made, or warrant resignation from the audit engagement, that fact has to be reported to the board of directors as soon as practicable. If such a report is given to the Board, the Board then has one business day after receipt of the report to inform the SEC by notice that the report has been received and furnish the auditor with a copy of the notice sent to the SEC. If the auditor fails to receive a copy of that notice, the auditor must then furnish a copy of its report to the SEC not later than one business day following its failure to receive a copy of the SEC notice from the Board. Accordingly, accounting firms must apprise their clients as well as their audit staffs of this requirement, lest the firm itself incur liability for failing to carry out this mandate.

Report on internal control deficiencies and management letter: In connection with our obtaining an understanding of the company's internal control structure, should we encounter any reportable conditions, we will so notify you along with our recommendations for correcting them. (Reportable conditions represent significant deficiencies in the design or operation of the internal control structure, which could adversely affect the organization's ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statements.) In addition, we will advise you of any opportunities to improve the effectiveness or economy of operations that we observe during our field work. We will deliver a letter describing these matters to you at the conclusion of our audit.

This paragraph offers assurance that any reportable conditions encountered will be reported to the appropriate level so that the necessary improvements may be implemented. It also advises the client that one of the benefits of an audit is advice regarding improvements to the client's internal controls. While advice on internal control weaknesses need not be in writing, it is clearly advisable to create a record of the advice given to the client as the number of suits based upon an alleged failure to warn of internal control weaknesses is clearly growing.

Identification of intended recipients: We will be pleased to deliver to you the 4 copies of our audit report you require. We understand you intend to distribute copies of the company's financial statements, with our audit report attached, to [names of third-party recipients].

A paragraph identifying the audit report's intended recipients should be used only after gaining an understanding of your state's privity law, which defines CPA liability to non-client third-parties, such as banks or other client creditors. This paragraph may, depending on the jurisdiction, increase or limit the firm's liability for negligence to potential users. In states, such as New York, New Jersey and Connecticut, such a paragraph would be highly material (and possibly, detrimental) to the determination whether the non-client financial statement user enjoys privity with the accountant. In other states, this paragraph may limit the ability of non-listed parties to sue the accountant for negligence, (see "Protecting the Privity Defense" in the next section.)

Printer's proofs: If you intend to publish or otherwise reproduce the financial statements and make reference to our firm, you agree to furnish us with printer's proofs for our review and approval before printing. You also agree to provide us with a copy of the final reproduced material for our approval before you distribute it.

The Audit and Accounting Manual advises accounting firms to request printer's proofs of statements to guard against condensation of the financial statements, omission of footnotes, erroneous layouts and misstatements of figures that might occur in narratives or statistical tables. It also provides the firm with an appreciation of the extent of reliance upon its reports.

Tax services: At your request, we will prepare [or review] the company's federal and state [identify states] income tax returns for the year ended [date]. [These returns, we understand, will be prepared by the controller.] In addition, we will be pleased to advise you concerning any income tax matters you bring to our attention, including the tax effects of proposed transactions or changes in business policies.

It is usually a good idea to also insert language disclaiming responsibility for volunteering tax advice or a duty to update tax advice previously provided to the client. In addition, in order to avoid responsibility for casually given advice or advice that may have been given by a staff accountant employed by the firm, it is recommended that engagement letters also contain language emphasizing the complex nature of tax issues and that the client may only rely upon oral advice at its own peril.

Engagement staffing: You may expect a staff senior from our firm and three assistant auditors to be present in your office during the course of our field work. [For continuing engagements:] To promote continuity, we will make every reasonable effort to assign the same audit personnel from previous years to the current examination.

Client assistance: We understand that your accounting personnel will assist our staff by locating vouchers, contracts, minutes and other documentation necessary to complete our tests. In addition, we anticipate they will help us through the timely preparation of analyses and schedules. [The auditor may wish to attach a list of such schedules.]

It is usually helpful to augment this language by an additional sentence warning that if the client fails to carry out these duties or to provide the information on schedule, the firm may not be able to complete its engagement on schedule and that the cost of the firm's work will likely exceed previous estimates.

Fees: We will base our fees on the amount of time required at the different levels of responsibility, plus travel and other out-of-pocket costs. Assuming adequacy of records and internal controls, and the assistance of your personnel, we estimate that our fee for all services will be [specify amount]. We will notify you immediately of any circumstances we encounter that materially affect that figure.

Billing: We will bill you for our services monthly; invoices are payable on presentation. Unpaid fee balances will bear interest at [percent] per annum.

This language should be expanded to include a statement that if payment of invoices is not made in a timely manner the firm reserves the right to suspend or terminate its services; and if the firm elects to terminate the engagement it shall be compensated for its accrued time charges and out-pocket expenses irrespective of whether a report has been rendered.

Timing: We anticipate the following timetable for the performance of our audit and delivery of requested reports and will promptly notify you of any necessary changes:

[Date] We will begin our field work.

[Date] We will observe the physical inventory.

[Date] You agree to provide us with a year end trial balance.

[Date] We will complete our field work.

[Date] We will deliver our audit [and other] reports as well as your tax returns.

[Date] We will deliver our report on your internal control structure.

Appreciation: We appreciate your confidence in retaining our firm to perform these services and are happy to have this opportunity to serve you.

Request for client signature: If this letter correctly expresses your understanding, please sign the enclosed copy and return it to us at your earliest convenience. If you have further questions concerning the engagement, including any of the detailed contents of this letter, or questions about additional services we might provide, do not hesitate to call me.

A concluding paragraph with an acceptance statement is crucial. The client representative must acknowledge that the letter constitutes a contract and agree that he or she has read and understands its terms. Accordingly, it is helpful to go over the terms of the letter with the client to assure the client's understanding. In this way the client will not be able to later assert that he or she never understood the limitations of the firm's engagement and only signed it to permit the firm to proceed with the engagement.

Sincerely yours,

[Partner's name]

Acceptance

The terms of this letter constitute our contract. I have read it and fully understand its terms and provisions.

Accepted by:

Title:

Date:

(2) Modifications for Tax and Consulting Engagements

It is interesting to note that the term engagement letter does not even appear in either the tax practice or the consulting services sections of the Professional Standards. Yet, the same legal liability issues apply to these services; and misunderstandings may arise on any engagement, regardless of type. A properly structured model audit engagement letter can be adapted to any situation. For example, a letter for consulting work would refer to the AICPA's Statements on Standards for Consulting Services. For financial projections, the engagement letter may incorporate a summary of the procedures used to test management's assumptions.

Many accountants are reluctant to utilize engagement letters for individual tax return preparation services. These engagements are typically small, generating fees of only a few hundred dollars each. In addition, they generally are viewed as being relatively harmless, with little liability exposure. Such services, however, give rise to roughly 30% of all claims against small to mid-sized accounting firm. Most of such claims can be avoided by obtaining a clear understanding with the client as to the scope and limitations of the firm's services.

Other factors which tend to increase the importance of engagement letters in tax return preparation engagements are (1) increased Congressional and IRS-mandated record keeping requirements, (ii) efforts to turn tax preparers into an IRS enforcement agents, (iii) the complexity of ever-changing tax laws and increased compliance and (iv) penalty provisions directed at the taxpayer (as well as the tax preparer).

One simple way to obtain an engagement letter on small individual tax engagements is to bind the letter into the tax workbook that is given to each client. Many accountants use such workbooks as a way to help their clients pull together their W-2 forms, receipts, and other documents that will be needed when the return is prepared. On the cover of the booklet, the accountant can include a space for the client to sign below the following wording:

The undersigned(s) hereby confirm(s) that the information provided herein is true and complete to the best of (his, her, their) knowledge and accept(s) the terms of the engagement letter contained herein.

The firm then simply has to insist that each client sign the cover of the booklet before the firm starts work on the client's return.

C. SPECIAL CLAUSES IN ENGAGEMENT LETTERS

(1) The CPA'S Right to Withdraw

In the process of performing an engagement, changes may occur or facts may come to light that lead an accounting firm to arrive at conclusions adverse to the client's position. The firm may even be asked to take positions with which it may disagree. Information previously unavailable or unknown to the firm may make continued service to the client inappropriate. Whatever the issue, the firm should reserve in writing the right to withdraw from and terminate the engagement by stating, for example:

Should information become known that would make our continued involvement in this engagement inappropriate as set forth in the professional standards that govern the accounting profession, or otherwise we reserve the right to withdraw from this engagement.

(2) Specific Fee Issues

Many engagements last longer than a year. Consequently, engagement letters often state that the firm's fees are subject to change. By stating this, the firm is not bound to the original rate structure if additional work is performed, for example, a year or more after the initial agreement. This situation can be addressed in a brief statement such as the following:

Our hourly rates are subject to change from time to time. We will advise you immediately if our rates are being adjusted.

Fee disputes are no-win situations for accounting firms as most firms end up not being paid and if they take legal action to collect their unpaid fees, they are usually greeted with a malpractice counter-claim. For these reasons, the best policy is to make every effort to obtain payment in advance or at least as the work is being performed. In order to encourage the prompt payment of fees, the following language is suggested for inclusion in engagement letters.

Invoices will be presented monthly and are due on presentation. Invoices for which payment is not received within 30 days of invoice date shall accrue interest at the rate of 1.5 percent (or the highest rate allowable by law) per month compounded late charge. We reserve the right to halt further services until payment is received on past due invoices. If we should be requested to issue a report, we require that we be paid in full prior to such issuance for all work performed to date (or for all work to date and the estimated time and expenses through such report).

In a further effort to prevent disputes about fees, an accounting firm can include relevant statements in the engagement letter, such as in the following examples:

In the event that you disagree with or question any amount due under an invoice, you agree that you shall communicate such disagreement to us in writing within thirty (30) days of the invoice date. Any claim not made with that period shall be deemed waived.

In the event that collection procedures are required, you agree to pay all expenses of collection and all attorneys' fees and costs actually incurred by our firm in connection with such collection, whether or not suit is filed thereon. If litigation is required regarding collection of the account, we will be paid our hourly rates for all time actually expended by our firm in connection with such action.

(3) Provisions for Limiting a Firm's Liability

Some of the larger accounting firms have begun including provisions in their engagement letters requiring their clients to release them from liability and to indemnify them in the event that they are sued by a third-party for misstatements in financial statements which were caused by false representations made to the firm by members of client's management. While the SEC has objected to this type of provision (based upon the appearance that the accounting firm's independence has been impaired), there is no reason why such a clause should not be included in engagement letters for non-SEC engagements. This type of provision can be especially effective where the client's management does not own a majority interest in the client enterprise. In such a case, if there is a claim by the client, the firm will have a basis for legal recourse. The following statement is an example of such a provision:

You agree to indemnify and hold our firm, its partners, and employees harmless from any and all liabilities, costs, and expenses relating to this engagement, and expenses (and those of our legal counsel) incurred by reason of any action taken or committed to be taken by us in good faith. In no event will our firm be liable for incidental or consequential damages even if we have been advised of the possibility of such damages.

An accountant can also limit its liability exposure by including a provision requiring that all claims with respect to services be asserted within a specified period of time, such as one year from the date the subject services were performed. This type of provision will protect the firm from a substantial portion of claims arising out of defalcations as well as frivolous counter-claims in the event that the firm is required to sue a client for unpaid professional fees. While such limitations are not always honored by the courts, they can serve to deter potential claims.

(4) Alternative Dispute Resolution

Many firms and malpractice insurers feel that one way to control the high costs of defending liability claims is to require the use of alternative dispute resolution ("ADR") methods. Under such a program, any claims that a client brings against an accounting firm must be mediated and/or arbitrated rather than tried in a court of law. Firms should consider adding a provision to their engagement letters requiring the parties to mediate and/or arbitrate all claims relating to the services covered by the engagement letter. The provision may even be expanded to cover any prior services which the firm has rendered for the client. A firm should always obtain its insurance carrier's permission before including any ADR language in its engagement letters, as some insurers take the position that these clauses compromise their ability to defend claims.

If an accounting firm wishes to utilize any of the preceding clauses to limit its liability, it is important that the client take note of the clauses before signing and returning the engagement letter. Otherwise, there is a danger that the courts may be unwilling to enforce the provisions. This means the accounting firm should either point out such clauses to the client when the engagement letter is delivered or should type such clauses in bold print and/or capital letters so that they will stand out from the remainder of the engagement letter.

(5) The Accountant As Witness

In recent years, accountants frequently have been drawn into litigation involving their clients, not as defendants, but as witnesses. As a result, an accountant may be asked to retrieve and produce copies of its client's records and to give testimony in a deposition or trial. Occasionally, accountants are requested to provide information to regulatory authorities such as the Federal Deposit Insurance Corporation or the SEC. Whenever an accounting firm is drawn into a legal proceeding, there is always a possibility that the firm itself may be named as a party in the litigation. Therefore, any accountant placed in this position must retain counsel and carefully review the documentation that has been requested as well as the likely questions to be asked of the firm's personnel. This is both time-consuming and expensive. Unfortunately, the accountant has little or no basis for being compensated for such expenses other than the statutory witness fee, which does not even begin to cover actual costs. Accordingly, an accounting firm might consider including a clause in its engagement letters providing that any time it is requested or required to provide information about the engagement or the client in a legal proceeding in which the firm (or any of its employees) is not a party, the efforts in responding will be deemed to be a part of the original engagement. The firm will therefore be entitled to compensation for time and out-of-pocket expenses (including legal fees) incurred in responding to such requests.

D. ENGAGEMENT LETTER PROCEDURES

(1) Timely Issuance of Engagement Letters

Accountants should maintain standard forms of engagement letters on their word processors so that an engagement letter can be issued to a client at the commencement of each engagement with little or no delay. As a practical matter, if a firm delays in delivering an engagement letter, the client will feel no great urgency to sign and return it. If an accounting firm wishes to receive the signed letter before it starts performing services for the client, it must move quickly in generating the appropriate engagement letter.

(2) Client Signature

Some accountants are reluctant to begin using engagement letters for long-standing clients. They fear that such clients might be offended by being asked to formalize their agreement after having operated on "trust" for so many years. This is largely an irrational fear as no client has any legitimate basis for refusing to acknowledge the terms of the engagement (which is an appropriate matter for discussion); and any client that simply objects to putting the terms of an engagement in writing may not be a client worth having.

Occasionally, an accountant may get a client who balks at signing an engagement letter. The accountant should be prepared to explain the importance of engagement letters to such a client. Some suggested responses to clients who are reluctant to sign engagement letters are listed below:

a. The engagement letter is intended to help the client fully understand exactly what the accounting firm is doing. It lists any limitations of those services so that the client will not allow important functions to fall between the cracks.

b. The use of engagement letters has become a standard professional practice. Accountants may be criticized for unprofessional conduct by failing to utilize engagement letters.

c. Insurance companies strongly urge accountants to utilize engagement letters in all of their engagements. Some even refuse to provide coverage to accountants that do not follow this practice.

While it is always preferable to have a signed engagement letter, even an unsigned letter will go a long way to reducing an accountant's exposure to liability claims. This is because it presents some (if not conclusive) evidence of the terms of the firm's engagement. Therefore, a firm can gain significant advantage simply by sending an engagement letter to the client.

Accountants should keep a record of all engagement letters sent to their clients and should be prepared to follow up if a client does not promptly sign and return the letter. In most cases, a firm should not proceed with an engagement until it has received a copy of the engagement letter signed by the client.

When a firm fails to receive a signed letter back from a client, it can write a follow-up letter that informs the client that an engagement letter was previously sent (with a copy enclosed) and that no response has been received. The follow-up letter should go on to state that because it is important that the firm proceed with the engagement, the firm will assume that the client accepts the terms set forth therein unless it promptly notifies the firm to the contrary. In this way, if the client does not object, it will be "estopped" from contesting that he or she did not agree to the terms set forth in the engagement letter. This technique will place the firm in virtually the same position as if it had received a signed engagement letter. The firm, however, will probably not be able to utilize any mediation or arbitration clause contained in the engagement letter, because the courts generally require a signed agreement in order to enforce such provisions. In addition, this approach should not be used for agreed-upon procedures engagements. The firm should insist on receiving a signed engagement letter before beginning such an engagement.

Many accountants have adopted the practice of including provisions in their engagement letters that cover each annual engagement unless subsequently modified. These firms receive a letter in the first year of a client relationship and do not require a new letter in each subsequent year. While this is a legally permissible practice, it is not advisable. This is because a client's operations change over the years as does the scope of an accountant's engagement. Since virtually all accountants today utilize computers as a part of their daily routine, the generation of engagement letters only requires a few minutes of the accountant's time. Moreover, requiring a new letter each year forces the accountant to focus on the scope of services that he or she will be providing and to reflect upon the potential liability exposure the firm faces in performing that engagement.

(3) Rejection Letters

An accountant will occasionally turn down a new client for one of any number of reasons. When this occurs, the accountant should consider informing the rejected client in writing to look elsewhere for its accounting services. Such a letter will prevent the would-be client from subsequently blaming the firm for the client's failure to file tax returns, provide creditors with timely financial statement reports or perform some other required service. Rejection letters should also warn that any advice that the accountant may have given in the course of the client acceptance interview should not be relied upon as it was offered without an investigation of the underlying facts and without an opportunity to refer to authoritative literature.

3. PROTECTING THE PRIVITY DEFENSE

A. BACKGROUND

One of the more significant issues in the area of accountant's liability is whether a non-client such as a lender, trade creditor or investor, may sue an accountant for professional negligence. The issue was first addressed by the New York State Court of Appeals in 1931 in Ultramares v. Touche Ross. The Court in that case recognized that the risk to the profession of exposure to claims from anyone who could conceivably rely upon a financial statement, as to which a CPA firm has expressed an opinion, was potentially enormous. Accordingly, the Court determined to limit liability for professional negligence to only those in contractual privity with the firm or in a relationship closely approximating that of privity. Ultramares expressly noted that the privity defense would be applicable only to negligence claims and not to claims where the firm's level of misconduct would support a claim of fraud.

The privity standard was followed by the courts in other states that addressed the issue until the 1960's when certain courts began to question the continued propriety of the defense. Since then, three standards have evolved as the courts continue to grapple with the issue: (i) privity, (ii) foreseeability and (iii) the Restatement of Torts standards.

B. STANDARDS OF LIABILITY TO NON-CLIENTS FOR NEGLIGENCE

(1) Privity Standard. Since the Ultramares decision, courts adopting the privity approach have refined the concept to further define the contours of an accountant's liability to third-parties. In Credit Alliance Corp. v. Arthur Andersen & Co., the New York Court of Appeals held that a non-client party could not hold accountants liable for negligence unless three prerequisites are met:

"(1) the accountants must have been aware that the financial reports were to be used for a particular purpose or purposes; (2) in the furtherance of which a known party or parties was intended to rely; and (3) there must have been some conduct on the part of the accountants linking them to that party or parties, which evinces the accountants' understanding of that party or parties reliance."

The third prong of this test raises the question of the nature and extent of the "conduct on the part of the accountants" linking them to the third-party which would be sufficient to meet the test. This issue was later addressed by the Court of Appeals in Security Pacific v. Peat Marwick, where the only linking "conduct" was a single telephone conversation between the accountant and the lender, initiated by the lender in which the lender announced its intended reliance and made certain inquiries regarding the audit then in progress. The Court held that this was not sufficient to establish the necessary link and dismissed the claim. Sixteen states now follow the privity standard based either on case law or statute.

(2) Foreseeability Standard. The foreseeability standard, which is the least restrictive approach, permits claims to be asserted against a CPA firm by all reasonably foreseeable third-persons who might rely on reports prepared by it. This standard abandons any notion of privity and exposes accountants to potential negligence liability to a spectrum of potential claimants, limited only by the requirement that the claimant fall within a class of potential claimants who might reasonably be expected to rely on the financial statement in question. Only two states, Wisconsin and Mississippi, currently follow this approach. Significantly, New Jersey which had been the first state to adopt the foreseeability standard, statutorily reversed itself and adopted a privity standard similar to that of New York. The New Jersey privity standard is made more rigid in the case of banks, where to impose potential liability, it is specifically required that the accountant acknowledge the bank's intended reliance and the client's knowledge of that reliance in writing.

(3) Restatement Standard. The Restatement standard, representing a middle ground between the restrictive privity standard and the broad foreseeability approach, has been adopted by 22 states. It provides that liability is limited to loss suffered "(a) by the person or one of a limited group of persons for whose benefit and guidance he intends to supply the information or knows that the recipient intends to supply it; and (b) through reliance upon it in a transaction that he intends the information to influence or knows that the recipient so intends or in a substantially similar transaction." Thus, the Restatement approach does not require that the accountant be aware of a particular person's reliance, but rather permits liability if the person is part of a "limited group" of persons (whether or not specifically identified to the accountant) who the accountant intends or expects to be influenced by the information supplied. Unlike the Credit Alliance privity test, the accountant need not be affirmatively linked to the claimant by its own specific conduct. California, also previously a "foreseeability" state, adopted the Restatement standard in Bily v. Arthur Young & Co. in connection with negligent misrepresentation claims.

C. THE IMPORTANCE OF THE PRIVITY DEFENSE

By limiting the range of potential plaintiffs, the privity defense protects accountants from liability for negligence in numerous situations. In appropriate factual circumstances, the privity defense can be used to dismiss claims brought by banks, trade creditors or investors claiming to have relied on the financial statements of an accountant's client. Moreover, since the applicability of the defense can often be determined on a motion to dismiss based upon the legal insufficiency of a complaint or after preliminary factual development addressed to the issue of privity, claims can be eliminated at an early stage in the legal proceedings and, accordingly, with a lesser investment of time and money than in cases where the defense is not available. The Restatement defense, although available in fewer situations than the privity defense, is similarly a useful tool in appropriate circumstances for eliminating negligence claims at an early stage in the proceedings.

D. ATTEMPTS TO COMPROMISE THE DEFENSE

Given the potential significance of the privity defense, it is not surprising that sophisticated third-parties will attempt to create circumstances that will permit them to claim that they have satisfied the criteria of privity and can overcome the defense. In some instances, those circumstances may be consciously built into the underlying transaction as, for example, when an acquisition agreement provides for the accountant to directly deliver to the purchaser audited financial statements of the seller. In other situations, attempts may be made to establish the requisite link with the accountant through telephone calls or letters or combinations thereof. Indeed, some potential third-party claimants, such as banks and other institutional creditors, have adopted procedures whereby they regularly notify their borrower's accountants of their intended reliance upon the accountants' report. Some will even ask the accountants to acknowledge in writing that they are aware of the third-party's reliance on the accountants' report.

E. RESPONDING TO REQUESTS TO ACKNOWLEDGE RELIANCE

Since the privity defense may be employed to protect accountants against a wide variety of potential claims and claimants, accountants should be careful to preserve the defense in as many situations as possible. Clients, however, may attempt to pressure an accounting firm to respond to inquiries by third- parties to facilitate the clients' credit or other transactions. Obviously, therefore, a CPA firm's decision regarding whether and how to respond to inquiries or otherwise involve itself in circumstances which may cause a loss of the defense implicate business considerations, including client relations, apart from potential prospective litigation. Moreover, the courts have not spelled out with great precision exactly how the privity defense may be overcome in the many contexts in which the issue may arise. Further, even apart from whether a particular state fits within one of the broad categories of privity, the Restatement or foreseeability standard, different states apply the same standard differently and individual judges within a particular state may differ as to the outcome in specific situations. That said, however, a few basic principles ought to be followed.

As a general matter, direct contact with third-parties even by telephone should be avoided. Alternatively, recognizing that the risk of exposure of potential liability to third-parties may exceed the rewards of continuing a particular engagement, an accounting firm may determine to resign the engagement. In the event, however, an accounting firm determines that it does wish to respond, careful consideration should be given to the nature of the response, including whether the communication will be deemed to satisfy the privity criteria and, if so, whether qualifications might appropriately be included in the response. Illustratively, the accountant might specifically draw the third-party's attention to the inherent limitations of the auditing process, the inherent risk that material errors or irregularities, if they exist, will not be detected, the possibility that the financial statements may be stale, or the fact that the audit was not planned or conducted for the benefit of the third-party and that inquiries and procedures should be undertaken by the third-party to satisfy itself in connection with its particular needs. Finally, given the potential significance of the loss of the privity defense, an accounting firm may wish to consult with legal counsel to discuss an appropriate response under the particular circumstances.

F. DEVELOPING THE NO-RELIANCE DEFENSE

In the event an accountant chooses to respond to a third-party's inquiry, a carefully prepared response may assist in the establishment of a defense that the third-party could not have reasonably relied on the accountant's report. For example, a response that explicitly points out the limitations of a compilation or review may make clear that reliance for a particular purpose may be unwarranted. It might further be pointed out that the report in question was not prepared for the user's intended purpose. Further, if, for example, a prospective lender were particularly interested in a financial statement item such as accounts receivable or inventory, it may be recommended that the third-party undertake additional due diligence steps to satisfy itself.

G. MEETINGS WITH CREDITORS

As noted above, the precise conduct which may be deemed sufficient to satisfy the privity standard is not clear and there may be instances where meeting with creditors is desirable. However, where accountants want to avoid privity, meetings with creditors must be viewed with extreme caution since it may later be argued that assurances provided at such a meeting, particularly where coupled with other "linking" conduct on the part of the accountant, satisfy the privity standard. Consideration should also be given to the fact that the precise content of oral communications is often the subject of later dispute and significant qualifications or limitations orally expressed may later not be "remembered" by a party claiming to rely on an accountant.

H. AVOIDING THIRD-PARTY BENEFICIARY STATUS

Separate from the concept of privity, and although rarely used, an accountant may be liable to a third-party under the theory of third-party beneficiary. To establish a third-party beneficiary claim, a third-party must show that it was the intended (as opposed to incidental) beneficiary of a contract between the accountant and its client. Thus, a contract (for example, an engagement letter) which states that an audit report will be prepared for the specific use of a designated third-party may establish a third-party beneficiary claim. The third-party beneficiary concept, unlike the privity standard (as applied in Credit Alliance), can only be created at the time of contract. Accordingly, it would be advisable, if possible, to eliminate such a contract reference to a specific third-party and engage only to prepare the report for the firm's client.

4. DOCUMENT RETENTION POLICIES

The accounting profession, by necessity, generates volumes of paper in connection with the performance of client engagements. Given today's litigation climate and a business climate favoring paperwork reduction, the question therefore arises whether accountants are under any clearly defined duty to maintain and retain working papers and client records. Despite all the focus in professional liability literature on the nature of an accountant's potential for liability in traditional and non-traditional engagements, liability to non-clients, and the like, there is little information available to assist accounting firms on the issues associated with document retention.

While the point at which a legal duty arises to retain documents that might otherwise be discarded is highly fact particular, most decisions in this area tend toward the point at which a reasonable person in the position of the accountant would believe that the records may be relevant either to a dispute or an investigation. Such notice may come through media reports as well as specific communications. Prudence suggests both prior thought to how information discarding should be stopped and ready access to legal advice in making that decision.

A. GENERAL

(1) Types of Documents Covered

The first issue in determining an appropriate document retention policy is the identification of the actual documents which may be accumulated in the average accounting practice. This section is intended to address what ordinarily constitute client files and records. These generally include the documents generated by an accounting firm in the course of performing professional services for clients. Subsequently, the documents that may come to later be relevant in a litigation are engagement workpapers, tax return preparation files, research and consulting files, and the like.

Most accountants do not realize that document retention issues that may arise during litigation, or otherwise, may also encompass several categories of documents that are not "ordinarily" considered part of a client's files. The potential for reducing adverse litigation consequences through a document retention policy might not be realized because of the existence of these other records of client services. The following is a partial checklist of documents to be considered part of a client file:

• budgets, time summaries and/or daily time records;
• workpapers, including interim workpapers;
• indexes to workpapers;
• reports, and/or opinions relating to the client;
• correspondence files;
• continuing audit files or permanent files;
• billing records;
• memoranda and notes including:
  • exit meeting notes,
  • engagement reports,
  • interview notes,
  • senior's memoranda,
  • partner's memoranda,
  • research memoranda,
  • review notes,
  • second partner's review;
• audit plans, audit programs and other planning documents;
• appraiser's reports;
• peer review reports;
  
• audit check lists;
  
• engagement letters;
  
• organizational charts;
  
• handwritten notes;
  
• abstracts of company documents;
  
• financial statements, including drafts;
  
• flow charts;
  
• management letters and reports;
  
• internal control questionnaires;
  
• interoffice reporting packages;
  
• lead schedules;
  
• representation letters;
  
• manuals (and all supplements), including:
  
  • audit handbooks,
    
  • audit partner lists,
    
  • audit manual bulletins,
    
  • training materials,
    
  • accounting manuals,
    
  • reference manuals;
    
• personnel evaluations; and
  
• SEC letters of comment, replies thereto and other documents relating thereto.

A perusal of the foregoing list reveals that there are many types of records that typically may be considered part of a client file which reflect or materially relate to professional services rendered to clients. These documents would include: personal calendars and diaries; daily time records; work-in-process records; client billing, disbursements, and payment records; personal correspondence; firm manuals; and personnel files. Although these materials are not usually included physically in the files maintained for clients, the careful practitioner should not discard them prematurely -- such records (with the possible exception of peer review reports and employee evaluation) are relevant and discoverable in a professional liability litigation. Indeed, items such as calendars and billing records may prove the most useful tool for refreshing someone's recollection as to work performed or meetings attended, especially when an accountant's adversary is promoting a different version of history.

(2) Relevant Considerations

The primary impact on client file retention is economic. Accountants face ever-increasing costs to retain client files. These costs include: storage space; maintaining security for files; organizing, indexing and cataloging stored files; transporting files to and from storage; and equipment to organize files, such as file shelving. Emerging technologies, including microfiche, electronic and magnetized storage media, have not developed to the point of providing cost-effective solutions to the retention dilemma; however, their cost is coming down quickly.

As a practical matter, the retention of working papers and client records may become useful, and sometimes necessary, for the client. In this regard, retention of working papers may be required for the preparation of SEC reports, tax returns, and reports to other government agencies. Whether legally required or not, historical working papers invariably are indispensable in IRS tax return audits, or other governmental investigations into the affairs of a client.

B. SUGGESTED POLICY

(1) Standard Retention

A firm's ability to best protect itself in a professional liability litigation begins long before litigation is even contemplated -- it begins during the engagement itself with the actual preparation of an engagement letter, which then is followed by the creation and maintenance of working papers and other client records in further support of the actual engagement. Although the conventional wisdom is that accountants should keep their files for a "reasonable" period of time (a concept addressed below), there is growing, but definitely minority, school of thought that, in view of the presently hostile litigation environment, accountants should not maintain client files for an unnecessarily long time, if at all. The reasoning behind this thinking is that because the plaintiff in any malpractice claim has the burden of proving an accountant's negligence, client files only make it easier for the plaintiff to prove its case. In addition, advocates of short retention schedules claim that the destruction of old files pursuant to a reasonable and "good faith" document retention policy may deter an unscrupulous plaintiff (or plaintiff's counsel) from bringing a claim in the hope of discovering some basis for liability in the firm's records.

Advocates of the position that client files should be maintained for only a short time tend to rely on examples of cases where plaintiffs were able to prove their claims only because of evidence obtained from an accountant's own working papers. Those who believe client files should be discarded sooner define a "reasonable" period of retention as being as little as one year after termination of the relationship with the client.

The vast majority of professionals (and their legal counsel) are of the view that the premature destruction of client files may leave an accountant defenseless against a claim for malpractice. These professionals argue that it is not possible to make a generalized prediction about whether a good or bad litigation result will follow from the fact that client records are kept or not.

The professionals who favor longer retention periods certainly do not advocate that client files be maintained in "complete" form and for an indefinite period of time. The general consensus is that files should only contain documents that are in "final" form. These professionals also believe that client files should be discarded after the applicable statute of limitations reasonably can be expected to have expired. As a general rule, the longest statute of limitations in some states for claims by clients against accountants is fifteen (15) years, and the shortest in other states is three (3) years. A typical limitations is perhaps six (6) years, which corresponds to the longest statute of limitations in New York and several other states.

In this age of advanced technology, one option considered by some accountants is to retain client documents in perpetuity via electronic storage on microfilm or fiche, or via computerized document imaging. These technologies, while expensive, are rapidly decreasing in cost due to Internet related and other advances. At this time, storage in perpetuity is not recommended.

Once a decision is made to retain client documents for a period of time and when destruction will occur, it is important that this policy be memorialized in writing, and that the policy be consistently followed. Inconsistent destruction of documents only enables plaintiffs to suggest that the accountant is hiding some misdeed.

(2) The Accounting Standards

The AICPA's professional standards deal with the issue of client records in an indirect and objective manner. Statement on Auditing Standards No. 96, titled "Working Papers," provides:

The auditor should prepare and maintain working papers, the form and content of which should be designed to meet the circumstances of a particular engagement.

Although the time requirements for maintaining audit working papers is not addressed with any degree of specificity in the professional literature, the articulated functions that audit working papers are intended to serve may provide some guidance for the practitioner. Under SAS 96, the "purposes" of audit working papers include:

a. Providing "principal support" for the audit report;
b. demonstrating that work has been adequately planned and supervised;
c. Evidencing the auditor's understanding of the audit client's internal control structure and to substantiate the nature, timing, and extent of substantive testing performed; and
d. Establishing that the auditor obtained "sufficient competent evidential matter" to support the audit report.

These purposes tend to suggest that working papers (and the client records that support them) should be maintained for a sufficient period of time in order to enable the accountant, if challenged, to defend a position taken during an audit. Again, however, these purposes are not helpful in defining the amount of time client records should be maintained.

The professional standards further mirror SAS's indirect and objective test and contain only the following language about the retention of audit working papers:

The auditor should adopt reasonable procedures for safe custody of his working papers and should retain them for a period sufficient to meet the needs of his practice and to satisfy any pertinent legal requirement of record retention.

Historical working papers also may serve as a continuing source of information for succeeding audits and succeeding auditors. Regarding the appropriate professional behavior governing the transition between predecessor and successor accountants, the professional standards provide the following:

The successor auditor should request the client to authorize the predecessor to allow a review of the predecessor's working papers. It is customary in such circumstances for the predecessor auditor to make himself available to the successor auditor for consultation and to make available for review certain of his working papers. The predecessor and successor auditors should agree on those working papers that are going to be made available for review and those that may be copied. Ordinarily, the predecessor should permit the successor to review working papers relating to matters of continuing accountant significance, such as the working paper analysis of balance sheet accounts, both current and non-current, and those relating to contingencies. Valid business reasons, however, may lead the predecessor auditor to decide not to allow a review of his working papers.

Separately, regarding the retention of client tax records, the general interpretation of Treasury Regulation '31.6001-1(e) is that such records should be retained for the current year plus three years.

Finally, although it is not authoritative literature, according to the AICPA's Guide to "Managing Your Practice," the recommended document retention period for client files should track the particular state statute of limitations period where the firm is in practice. As noted above, these limitations periods may run as long as fifteen years, and as short as three years. In addition, practical consideration should by given to whether the firm conducts business in more than one state. If that is the case, the longest state's limitations period should govern the entire firm's retention -- as a practical matter, attempts to use different retention periods can become logistically difficult.

(3) Legal Duty to Maintain Records

With the exception of the GAO regulations pertaining to audits of government-funded entities (which calls for a three year retention period), accountants are under no express legal duty to maintain client files. Likewise, there is no express legal duty to maintain working papers for any length of time. Although there exist numerous statutes and regulations directed to the owners and operators of businesses generally, there is no law to suggest that practitioners providing accounting services to a business are bound by a particular statute or regulations.

The following is a useful bibliography of reference that an accountant may wish to consider when dealing with document retention issues as they relate to state or federal statutes and/or regulations:

a. Office of the Federal Register, Guide to Record Retention Requirements in the Code of Federal Regulation, published with annual supplements;
b. Skupsky, Legal Requirements for Business Records: Federal and State (1988); and
c. Hancock, Guide to Records Retention, (1986).

The broadest formulation of statutes dealing with business records retention are the Federal Paperwork Reduction Act of 1980 and the Uniform Preservation of Private Records Act of 1985. Interpreting these statutes, one author has suggested that there is a "presumption" that businesses must retain records for a minimum of three years. The Uniform Preservation of Private Records Act has been adopted in exact, or modified, form in Colorado, Georgia, Illinois, Maryland, New Hampshire, Oklahoma, and Texas.

When, in the context of either a professional liability litigation or other litigation involving a client, an accountant destroys or discards client files, the accountant may face serious and adverse legal consequences if the destruction occurs in bad faith. Although the court decisions addressing these consequences are numerous, and by necessity tend to focus on the unique facts and circumstances present in a particular case, there are six significant legal risks a practitioner may face if document destruction occurs in bad faith.

a. The imposition of criminal sanctions, fines, or penalties for obstruction of justice, spoliation of evidence or hindering law enforcement investigation. Of course, these penalties generally can arise when there is an ongoing governmental investigation into the affairs of an entity for which the accountant is providing professional services.
b. Entry of an order citing contempt of court for failure to comply with subpoena.
c. Entry of a court-ordered judgment by default for a plaintiff in a civil case and the assessment of money damages against the professional. This harsh remedy does require extreme bad faith, and conduct tantamount to the destruction of evidence, by the party destroying documents.
d. Award of discovery sanctions, including costs and attorneys' fees incurred by an opposing litigant related to the discovery, investigation, and remedial action required as a result of the document destruction.
e. Jury instruction that an adverse inference can be drawn to the effect that destroyed documents would either have favored the plaintiff or harmed the legal position of the defendant, for purposes for rendering a verdict. One court has held that the destruction of business records, which the owner should have "appreciated" would be relevant to "reasonably foreseeable litigation" was enough to justify an "adverse inference" in the litigation. This holding occurred despite the fact that the documents at issue were destroyed "years before the commencement of litigation" pursuant to a "good faith" policy adopted and implemented in the ordinary course of business.
f. A party wrongfully destroying documents may, in some states, face independent civil liability for the tort of spoliation of evidence.

(4) Document Retention Policies

The safest way for a professional to defend against a claim that documents have been destroyed in bad faith is the adoption and implementation of a reasonable document retention policy. There generally are as many different formulae for what should be contained in a document retention policy as there are lawyers drafting them. Some of the key ingredients to an effective retention policy are: a clear definition of which documents will be permanently retained and which will not; the duration of retention; under what circumstances must the documents be retained; and what procedures may apply if the documents may be relevant to a litigation that subsequently may arise.

Moreover, although there appears to be no published authority on the topic, an accountant may consider including language defining issues pertaining to document retention in a client engagement letter. As a practical matter, if a client wants documents retained for a longer period than ordinary for the accountant, it is possible that the client will be willing to share in the expense of retaining the documents. Some risks with this approach are that the client may be viewed as having undue control over the affairs of the accountant, and organizational difficulties (and the risk of mistaken destruction) associated with retaining one client's documents for longer than another client's documents.

C. SPECIAL RETENTION ISSUES

(1) Confidentiality of Client Records

One issue that often arises in connection with the production of client files involves the confidentiality of client records. Most states do not recognize an unqualified "accountant-client" privilege that immunizes accountant-client communications from disclosure. However, a federal privilege exists for tax practice except in limited circumstances related to corporate tax shelter advice. Generally, accountants assert the position that they are not permitted to make disclosures of client records unless either the client consents, or appropriate legal process issues compelling the production. Specifically, Rule 301 of the AICPA's Code of Professional Conduct provides that "[a] member in public practice shall not disclose any confidential client information ..." unless one of the two exceptions noted above applies.

Document requests proffered in the course of litigation invariably seek "confidential information" -- some examples are tax return information; financial statements and reports; engagement letters and work performed for related clients like affiliates and corporate representatives; billing and time records reflecting work performed for affiliates and corporate representatives; and communications between the accountant and "governmental agencies" (including the SEC). Therefore, accountants, bound by the strictures of AICPA Rule 301, are presented with a dilemma when demanded to produce this sort of documentation -- protect the client or protect thyself.

To avoid the need and cost of litigating motions regarding the production of these documents to non-clients who are suing an accountant, and at the same time to comply with AICPA Rule 301, it should be argued that it is incumbent upon the plaintiff to obtain authorizations from the client allowing the accountant to make disclosures in response to a document request. Most often, the plaintiff will not have obtained this authorization, and lacking such authorization, this exception to Rule 301 does not apply.

Absent the client's consent, AICPA Rule 301 only permits the accountant to make the sought after disclosures in the face of appropriate legal process compelling the production, such as a subpoena or other court order. Depending on the particular facts and circumstances present in a case, the accountant can argue that the professional standards and concerns for client confidentiality require that the court should strike a particular document request because the information sought is irrelevant and immaterial to a plaintiff's suit against the accountant.

Separately, accountants involved in tax engagements should be mindful of Section 7216 of the Internal Revenue Code ("IRC"), which contains a provision similar to AICPA Rule 301. Section 7216 of the IRC sets forth the circumstances in which tax preparers may produce tax returns or materials related to their preparation. Section 7216, in part, provides that any tax preparer who discloses tax returns, or related information, in a manner proscribed by the statute "shall be guilty of a misdemeanor, and, upon conviction thereof, shall be fined not more than $1,000, or imprisoned not more than one year, or both, together with the costs or prosecution." Just like AICPA Rule 301, however, Section 7216 of the IRC does not apply: (1) if the client/taxpayer consents to the disclosure of tax related information; or (2) appropriate legal process issues compelling the production. Notwithstanding the latter exception, the 1998 amendments to the IRC create a privilege in tax data obtained while a CPA represents his or her client in a tax court proceeding.

(2) Firm Records

Although the focus of records retention almost always centers on client files for the practical reason that they may impact actual or potential litigation, firms should consider the implementation of a retention policy to govern internal, or firm, records. These documents may be necessary for investigative purposes, or, as discussed in the next subsection, if problems arise with former employees. Certain general records of the accounting firm should, according to the AICPA's Guide to Managing Your Practice, be retained permanently, while others can be discarded after shorter periods. The following list contains a useful guide to the retention of firm records, although the actual periods of retention should be established based upon careful consideration of the firm's particular needs.

a. Documents To Be Retained Permanently

• Accounting records
  
• General ledger
  
• Payroll records (journals, ledgers, Permanent W-2s, 940s, 941s, etc.)
  
• Journal voucher
  
• Cash receipts and disbursements journals
  
• Depreciation schedules
• Administration records
  
• Partnership or corporate records, including local, state and federal licenses, annual reports, capital stock and bond ledger, canceled stock and bond certificates, articles of incorporation, bylaws, and minutes from partner meetings or stockholder and director meetings
  
• Legal correspondence, including those pertaining to copyrights, permits, and bills of sale
• Property records, including blueprints, appraisals, and permits
  
• Annual financial reports
  
• Firm tax returns, annual statements and workpapers--operating offices and consolidated
  
• Current legal documents
  
• Partnership agreements or corporate documents
  
• Special contracts
  
• Non-current legal documents
• Partnership agreements or corporate documents--superseded

b. Documents To Be Retained For 10 Years

• Accounting records
  
• Accounts receivable
  
• Accounts payable
  
• Clients' invoices
  
• Data transmittal (In central processing system)
  
• Expense reports
  
• Time reports
  
• Other changes to client's voucher
  
• Bill draft
  
• Voucher check copies
  
• Canceled checks, bank statements, and deposit slips
  
• Interoffice client charges
  
• Client coding form--masters
  
• Payroll data and authorization
  
• Correspondence
  
• Billed accounts receivable aged trial balance
  
• Client unbilled receivables ledger
  
• Unbilled accounts receivable status
  
• Employee time analysis
  
• Analysis of billing adjustments
  
• Client charges and billing report
  
• Administration records
  
• Accident reports and claims
  
• Equipment records
  
• Warranties and service agreements
  
• User's manuals
  
• Insurance documents, including policies, reports, claims, and coverage information
  
• Leases and contracts
  
• Monthly or periodic financial reports
  
• Supplemental accounting data
  
• Daily cash reports, remittance advices and bank deposit slips
  
• Vendors' invoices and petty cash slips
• Miscellaneous
  
• Firm meeting files (annual and special meetings)
  
• Attendance records
  
• New business reports
  
• Interoffice correspondence
  
• Bulletins to clients, firm executives and staff
• Firm publications, including promotional and recruiting brochures, personnel guide and client newsletter
  

(3) Employment Files/Personnel Records

Potential litigation against accountants is not limited to clients. The number of internal, "personnel-related" administrative actions and related litigation against accounting firms, and all business entities, continues to skyrocket. Appropriate employee file retention thus becomes imperative. According to the AICPA's Guide to Managing Your Practice employee files should be retained for approximately seven (7) years after the employee's termination. The only documents to be kept permanently are employment applications, and, where applicable, employment contracts. The following list is useful in considering the types of employment records that should be kept for the seven year period.

Documents to be Retained for Seven Years

• Personnel: Post-employment
  
• Counseling records
  
• Disability benefits
  
• Discrimination charges
  
• Education, training and CPE records
  
• Employee medical history
  
• INS I-Q forms, Complies with Immigration Reform & Control Act
  
• Performance reviews
  
• Salary rates and changes
  
• Personnel: pre-employment
  
• Position applications, resumes, tests, or other job advertisements and replies relating to employees
  
• Position applications, resumes or other job advertisements and replies relating to non-employees
  
• Promotion, demotion, layoff, or discharge of an employee

(4) Firm Manuals and Checklists

Firm manuals and checklists are also favorite targets in litigation. The accounting profession is constantly revising its audit, review and compilation standards. A firm's manuals and practice aids should therefore be updated on a periodic basis. When a manual or set of procedures is updated, the previous version should be kept in case a liability claim arises relating to a year that the old manual covers. These old manuals should be kept as long as related client workpapers are kept.

Courts are beginning to address whether these manuals and practice guides are protected from disclosure to an adversary as trade secrets. At least one state court in New York has held that audit programs do constitute trade secrets, and need not be turned over to an adversary during a litigation. Accountants should be vigilant in attempting to protect the potential trade secret status of their self-written practice manuals. This effort is helped by not publicizing the contents of such manuals to clients or even other professionals.

5. ACCESS TO WORKING PAPERS

A. INTRODUCTION

In responding to requests or demands by clients or others for access to working papers, an accounting firm must consider the effect of its response upon its professional liability exposure. Although it is not realistic to suggest that a firm consult with its attorney each time a request for access to its working papers is made, accounting firms must be able to recognize those circumstances when such consultation is appropriate and wise. To do so, each firm should be aware of certain principles and concepts which impact upon its rights and obligations vis-a-vis its clients and others.

As recognized in Statement on Auditing Standards No. 41 and in various state statutes, working papers are the property of the firm. This right of ownership permits the accounting firm to deny requests for access to its working papers in the absence of a subpoena, search warrant, court order or other legally enforceable right on the part of the requesting party. The firm's ownership rights are, however, subject to certain ethical limitations arising from the confidential relationship between the firm and its client. The firm's professional obligation to maintain the confidential nature of client communications, although itself subject to certain exceptions, has been embodied in statutes regulating the profession in most states. Indeed, a number of states recognize that certain communications between an auditor and a client are privileged in certain contexts. The existence of these ethical (and in some states, legal) limitations on the firm's ownership rights with respect to working papers, necessitate careful consideration by the firm of any request or demand for working papers.

Another concept which must be considered, particularly in the context of requests by clients for access to working papers, is that they should not be regarded or maintained as a substitute for, or part of, the client's accounting records. To the extent this concept is disregarded and the firm's files become a depository for client records, the firm will have only limited ability to protect such documents from review by present or former clients and others in the future. Although it is not unusual for accountants to maintain documents such as voluminous computerized inventory runs, depreciation schedules for property, plant and equipment and accounts receivable aging analyses which are generated by the client, in doing so the firm must remember that in some states, client access to such documents is not only allowed, but mandated by statute or regulation.

Additionally, although it is recognized in SAS No. 41 that an auditor's working papers may serve as a useful reference source for the client, allowing access to original working papers, particularly during the course of an audit, creates the risk of physical alteration. Further, to the extent that client review of an auditor's working papers, originals or copies, would reveal the particulars of the audit process utilized, it would weaken the effectiveness of that process, and increase the risk of irregularities through circumvention.

Fostering good client relationships, extending professional courtesies and minimizing costs and expenses are often cited as reasons for allowing access to an auditor's working papers. While these are appropriate business goals, the resultant increase in professional risk must be recognized and carefully considered by the auditor.

B. CLIENT REQUESTS

In responding to client requests for access to working papers, an accounting firm should consider:

•  Who among the client's personnel is making the request;
•  Why is the request being made; and
•  Which working papers are being requested.

With respect to the identity of the individual making the request, the firm should consider whether that person, or a person in his or her position, customarily has access to the client information set forth on the requested working papers. The firm should also consider whether the duties and responsibilities of that individual, or a similarly situated individual, are such that it is reasonable that he or she would need the information requested to do his job.

With respect to why the request is being made, the firm should consider whether the requested information is reasonably available to the requesting individual from elsewhere within the client organization and if so, why the requesting individual has not obtained the document from such internal sources. The firm should also consider whether the requested information is reasonably necessary for the stated purpose.

Finally, the firm should consider the scope of the request and the content of the working papers being sought. Requests by the client for access to all working papers or to all working papers in a specific audit area should be considered with a high level of skepticism. Requests for working papers which reveal audit or other verification processes to the degree that it would enable the client to circumvent the audit process should be considered with a particularly high level of skepticism. By comparison, requests for a limited number of specific working papers which merely summarize, reorganize, or recapitulate client information, and which do not reveal audit approach or procedures should be considered with more emphasis on the identity of the requesting individual and the stated reason for the request.

C. REQUESTS BY SUCCESSOR AUDITORS

Although Statement on Auditing Standards No. 84 provides guidance on communications between predecessor and successor auditors, with respect to working papers, it states only that it is "customary" for the predecessor to make "certain" of its working papers available, which would "ordinarily" relate to matters of continuing accounting significance. This guidance is subject to the caveat that "valid reasons" may exist to not allow a review of working papers by a successor auditor.

In responding to such a request, the predecessor auditor should request authorization in writing from the former client to make the working papers available to a specifically named successor auditor that has accepted the engagement. In addition, the firm should insist that the client authorize it to make any and all disclosures of matters learned in the course of the firm's engagements on behalf of the client. The successor auditor should be requested to confirm to the predecessor auditor that the engagement has been accepted.

Among the myriad of reasons which a predecessor audit firm may consider as a basis for refusing access to its working papers are the circumstances of its termination, withdrawal or non-engagement, the non-payment of fees, and the threat or pendency of litigation or investigations involving the client or the firm.

If the predecessor firm concludes that it is appropriate to make certain of its working papers available and obtains both the necessary client authorization and an acknowledgment from the successor audit firm that it has accepted the engagement, the firm should carefully review its working papers prior to their being made available and exclude proprietary information and other documents with no continued accounting significance such as its audit programs, audit plans, checklists and audit memoranda. The firm should document which working papers are made available for review by the successor auditor and obtain the written acknowledgment of the successor auditor to the list. If copies of certain of the working papers made available for review are provided to the successor auditor, a control set of those copies should be made and retained by the firm.

SAS No. 84 which was adopted in 1997 adds a new feature not included in its predecessor, SAS No. 7. That feature is two letters, one from the management of the former client and one from the successor auditor, which expressly agree that the review by the successor auditor of the predecessor auditor's workpapers is solely for the purposes of enabling the successor to determine whether it wishes to accept the engagement and to help plan its audit of the client's financial statements. In fact, the suggested form of letter from the successor auditor covenants that the successor will not render any advice or opinion regarding the predecessor's compliance with professional standards nor will it advise or participate in any claim against the predecessor. In fact, the successor is not even permitted to disclose the predecessor auditor's workpapers to the client. This procedure was devised by the large accounting firms in the early 1990s and is now recognized as "not inappropriate" in the authoritative auditing literature.

D. REQUESTS BY OTHERS

Occasionally auditors receive requests to review working papers from prospective or existing creditors of, or investors in, a client, or from regulatory organizations or government authorities making preliminary or informal inquiries with respect to a client. Initially, an accounting firm must not accede to such a request without notifying and obtaining authorization from the client. Moreover, even if such authorization is obtained, by acceding to such requests, the firm may well increase its own professional risk. Accordingly, should the client provide the necessary authorization, or indicate that it is prepared to do so, the firm should consult with its own counsel to evaluate the likely increase in professional liability risk, to determine whether to accept the increased risk, and to ascertain whether there are mechanisms available to mitigate the risk. Frequently, agreements can be reached with the requesting party which would limit or eliminate the firm's increased exposure to professional liability risks. Although agreements with a client or former client providing some form of indemnification or other protection may also be considered under such circumstances, they are usually less effective in determining the firm's prospective risk than agreements with the requesting party, and such agreements with an existing client may impair the firm's independence.

Should a firm accede to such a request to review its working papers, the authorization from the client should be in writing, specifically identifying the purpose of the review, the requesting party who will be conducting the review, and the working papers authorized to be made available.

Requests for review of working papers may also be received from government agencies or professional organizations which relate to the auditor rather than (or in addition to) the client. The American Institute of Certified Public Accountants and most state regulatory organizations have recognized that allowing access to working papers in response to such an inquiry does not constitute an ethical violation by the firm, and that neither client authorization nor client notification is required (although it is recommended that the client be notified). While most accountant-client privilege statutes include exceptions relating to responses to governmental and regulatory requests, the recent revisions to the IRC creating a privilege for tax advice may provide a basis for not providing tax information. The firm should consult with its own counsel upon receipt of such a request, however, to ascertain the impact, if any, of the state statutes which may be applicable, as well as to assess the professional risk arising from the circumstances giving rise to the request.

E. SUBPOENAS

Although government agencies, administrative law judges, hearing examiners, private attorneys, arbitrators and others have the statutory authority to issue subpoenas under certain circumstances, an auditor receiving a subpoena should consider it as the equivalent of a court order. Upon receipt of a subpoena, the auditor should contact his own counsel immediately to discuss an appropriate response. The auditor should not contact directly the person or entity issuing the subpoena without first having the subpoena reviewed by his own counsel and being advised as to how to respond.

Frequently, the individuals or organizations issuing the subpoenas will include broadly-stated descriptions of the documents being sought. Such descriptions are often the result of an over-abundance of caution or a lack of information about, or experience with the types of documents being sought. An auditor's attorney will frequently be able to narrow the scope of the subpoena and to make the timing and other logistics of the response less burdensome, more efficient, and less expensive through negotiation with the issuing party. He may also be able to negotiate an agreement which preserves the confidentiality of the working papers being produced by limiting the purposes for which they can be used and the individuals who will have access to such working papers.

Most importantly, if the firm's attorney is unable to negotiate an acceptable narrowing of the scope of a subpoena which is overly broad, or otherwise ease the burden of responding to the subpoena to a reasonable level, he or she can seek a protective order from the court or other governing authority.

6. PRACTICE ACQUISITIONS

A. INTRODUCTION

The expansion of an accounting practice through merger with, or acquisition of, another accounting firm or the admission of individual partners with a portfolio of clients or particular skills and expertise can provide many benefits. In many instances, however, the eager pursuit of these benefits causes potential dangers to be overlooked. Often, the desire to expand a client base, or to penetrate a new market, or to expand the offered range of services obscures the significance of professional skills, work habits, quality control and integrity. Similarly, analyses of billings and realization rates may leave little time for careful consideration of professional complaints, claims and insurance coverage. Perhaps most importantly, the haste with which many of these transactions are consummated does not afford adequate time to negotiate an acquisition agreement which addresses and resolves critical issues.

The very motivations for this type of transaction are the genesis of increased levels of professional risk. For example, expansion of a firm's client base will often bring higher risk clients operating in unfamiliar industries, requiring services which the existing firm has little experience in providing. Similarly, a desire to absorb overhead through staff expansion will often bring individuals whose professional credentials are weak, whose work ethic is poor, or whose values are questionable.

Although a degree of risk is inherent in all such transactions, it must be identified and evaluated before the transaction is consummated, so that appropriate steps can be taken to minimize and control subsequent exposure. Due diligence is a necessity. It should encompass far more than a financial analysis of assets, liabilities and earnings potential. The quality of personnel, control procedures, and clients must also be evaluated, along with insurance coverage and claims potential. This is particularly true with respect to lateral partners as they are essentially unknown quantities that are likely to be allowed to work under the firm's banner with little or no supervision. This reason alone explains why some of the most serious liability cases ever brought against accounting firms arose out of recently acquired practices.

B. DUE DILIGENCE

Appropriate due diligence should include, at a minimum, an investigation of:

Professionals, including their education, prior experience, professional standing, productivity, and personal claims experience;

Quality Control Processes, including new client investigation procedures, review procedures, management information systems, firm manuals, personnel policies, time management systems, independence assurance procedures, audit risk and professional risk assessment practices, and peer review reports;

Potential and Actual Claims, including identifying past and pending litigation, determining which clients and personnel were involved, assessing claimed weaknesses in performance, reviewing relevant communications with issuers and insurance agents, identifying high risk clients, identifying clients for which independence may be lost due to the practice combination, analyzing practice by nature of service and industry, reviewing lists of recently departed partners and their clients, reviewing lists of former clients and understanding the reasons for their change of accountants;

Clientele, including the breakdown of the clients by industry and type of service provided, those clients with delinquent accounts, those deemed to present a high risk exposure by reason of (i) the nature of the services provided, (ii) the extent to which third-parties have relied, and are likely to rely, upon the firm's reports, (iii) the complexities of the professional issues involved in servicing the client's needs (iv) the integrity of the client and/or its management, and (v) the financial stability of the client.

Respective Insurance Coverage, including the effect of the proposed acquisition on both your coverage and the to-be- acquired practice's coverage, the availability and cost of the coverage, and the coverage terms with respect to retentions or deductibles, policy amounts, and selection of counsel.

Although the acquiring firm can use its personnel to perform many aspects of this due diligence, it should consider retaining attorneys, investigators or other professionals to perform discreet tasks.

C. ACQUISITION AGREEMENTS

Properly performed due diligence will identify many of the risks inherent in the acquisition of an accounting practice. In order to minimize those risks or mitigate subsequent exposure, a written agreement must be prepared which both identities and addresses the issues created by the likely risks. It is essential that both parties be represented by counsel, preferably with experience in representing accountants as well as with business combinations. An attorney who understands the nature of the practice will be better able to assist in risk assessment and fashion mechanisms to address those risks.

Among the matters which should be addressed in such an agreement are the following:

• The legal form of the transaction, e.g. merger, purchase of assets, admission to partnership, formation of new entity;
• The consideration flowing from each party to the other, including specific identification of assets to be acquired and liabilities assumed and not assumed;
• Representations of the respective parties as to critical elements of their practices;
• Identification of key individuals and their intended positions in the management of the surviving or new business;
• Purchase of insurance tail coverage;
• Control and movement of client-related files such as working papers and business records such as personnel files and billing files;
• Indemnification provisions;
• Communications with clients and others regarding the transaction;
• Withdrawal provisions; and
• Compensation and equity allocated to new firm members.

The decisions made with respect to each of these matters can either increase or decrease professional risk. The accounting firm and its attorney should analyze each element of the proposed transaction with the effect upon professional risk in mind, so that informed decisions can be made, with the possible consequences reasonably understood by all.

D. POST-ACQUISITION ACTIVITIES

Having expended a considerable effort to investigate and negotiate a practice acquisition, it is ironic that the success or failure of such an endeavor over a longer term may be dependent upon the efforts of the surviving or new entity to integrate newcomers. The key to effective integration is planning. The professional requirements of the firm must be communicated to those joining the firm as quickly and thoroughly as possible. The needs of the newcomers must also be anticipated. Particular individuals in the firm should be assigned integration responsibilities and they, in turn, must coordinate their efforts to assure a smooth transition.

Among the most critical elements of the integration process are communicating and explaining the firm's quality control standards and practices. Matters such as new client acceptance procedures, independence procedures, required audit programs, check lists, forms and format, training requirements, personnel assignments, consultation and supervision practices, and expected professional development should all be addressed.

7. PARTNERS LEAVING THE FIRM

The issues of ensuring that a departing partner cooperates in handing over client papers and proprietary documents, cooperates in transitioning clients to others in the firm, and compensates the firm for losses caused to the firm by the partner after departure are best addressed in the partnership agreement executed by the individual when he or she becomes a partner.

The mechanism for helping to ensure a smooth transition can be as simple as establishing a policy which defines proprietary and confidential information, requiring two to six months advance notice of any resignation from the partnership, and paying out monies owed the departing partner over a period of time, which can be used as leverage to encourage compliance with firm policies and to satisfy losses and damages which occur after the partner's departure.

A. CLIENT PAPERS

Client files should be maintained in a standard format and under a standard filing system, with new files logged into a data base as they are created, and signed out to individuals on the data base, which can be accessed by all staff. When it becomes known that a partner will be leaving, one or more partners should be assigned to transition the work of that partner to others in the firm, making sure all the files are collected, and making sure that each affected client is contacted and advised of the change. A termination check list can be developed to insure each element of the transition is addressed. Firm policy incorporated into the partnership agreement should also clearly state that clients are deemed to be firm assets and that client files are proprietary to the firm, may not be disclosed to anyone outside the firm, and must be returned at the time of departure from the firm.

If a firm partner seeks to take firm clients upon his or her withdrawal from the firm, the firm may not turn over any client files without the express written consent of the client. Even if the client consents, the firm's client files are the property of the firm and the firm is under no obligation to turn over such files to the departing partner, although the firm may have an ethical obligation to provide the client with copies of those portions of its files which may be deemed to be client records. The firm, however, should either retain its original workpapers or a copy, or make satisfactory arrangements to assure access to any workpapers that are turned over to a withdrawing partner. In this way the firm will be in a position to defend itself in the event of litigation or a regulatory or disciplinary proceeding relating to the firm's services on behalf of the client is instituted.

While, as a technical matter, the departing member has no right to obtain copies of the client's files (much less the original documents), if the departing partner is compensating the firm for the right to continue to service the clients, the question of who shall bear the cost of copying the files is more a question of bargaining than of who has the right to hold the firm's workpapers.

D. PROPRIETARY DOCUMENTS

Confidentiality requirements for proprietary firm information are best addressed in a firm policy manual which sets out the policy for all partners and employees of the firm. The policy can identify documents, or the type of documents, deemed to be proprietary to the firm, and spell out the restrictions on disclosure of the documents, or any part of the documents, to anyone outside the firm. The partnership agreement should specifically refer to the policy manual and incorporate it by reference, making it part of the partnership contract. Proprietary documents such as manuals and procedural guides can also be labeled as proprietary and confidential, and contain warning statements on the front covers and/or on the first page stating that neither the document nor its contents may be disclosed to anyone who is not an employee or partner of the firm. Some firms also number the manuals and keep a record of the person assigned that manual or document, with any departing partner or employee being required to return the assigned manual as part of the departure procedure.

B. COOPERATION

A substantial transition period facilitates cooperation and gives the firm an opportunity to acclimate a new partner to the accounts of the withdrawing partner before his or her departure. Client files can be located and reassigned, the client can be contacted and told of the change, and the departing partner remains on the premises to answer questions and brief his or her successors.

With respect to cooperation after departure, a provision can and should be added to the partnership agreement requiring the partner to agree that if his or her interest in the partnership is terminated, he or she will devote reasonable time and services to the Partnership as determined to be necessary by the managing partner or his or her delegate, and that the partner will be compensated at a rate to be negotiated. Such obligation is usually a condition to the withdrawing partner's right to recover his or her firm capital or other separation payments.

C. INDEMNIFICATION

The partnership agreement can contain obligations requiring terminated partners to pay the firm damages for improperly removing, copying or using any files, business records, confidential information, trade secrets or other property of the partnership, or otherwise causing the partnership financial loss or damage, with the damages to be as reasonably determined by the firm's management.

If payment of the departing partner's capital account and share of accounts receivable and work in process are paid out in equal installments over an extended period, such as 60 or 120 months, the partnership agreement can provide that the firm may apply to the satisfaction of such damages all payments otherwise payable, or to become payable to the departing partner, and that any payments may be deferred until all the damages are assessed and satisfied. If the deferred payments are insufficient to satisfy the damages assessed, the partner is required to pay the balance with interest at a stated rate over a period of five years from the date of notice of the deficiency, unless the firm's management agrees to other terms. It should also be stated that these provisions do not limit the firm's legal remedies.

E. PAYMENT FOR RIGHTS TO SERVICE CLIENTS

The law varies from state to state on what non-compete provisions are permissible, and an agreement to pay for clients a partner takes with him or her has been deemed to constitute a covenant not to compete in some states. It will therefore be necessary to consult state laws on covenants not to compete to determine what is permissible. It is also important to note that in order to be enforceable, a covenant not to compete must be applicable to all partners of a firm. Unless a provision is equally enforceable against all partners, it is enforceable against none. Therefore, the partnership will have to examine the law in each state where it has partners and develop a client compensation (non-compete) provision which is enforceable in all such states.

In general, client compensation provisions which are limited to clients served by the former partner are likely to be upheld in almost all jurisdictions, as these limitations are normally deemed to be reasonable to protect a legitimate, protectable "employer" interest, without placing an undue restriction on free trade, or preventing an ex-partner from being able to earn a living.

Smaller firms may also be able to extend the non-solicitation to all clients of the firm, not just the clients served by the terminated partner, or to provide for territorial restrictions on all competition.

In order to be enforceable, the restriction on solicitation should also be limited as to time, generally not more than two years, and to services performed by the firm.

An example of a restrictive covenant is as follows:

"If, without the specific consent of the Board of Directors, a partner at, prior to, or within eighteen (18) months after his termination from the Partnership directly or indirectly solicits or obtains for himself, or for an entity with which he is or becomes associated, engagements to perform, or if he or an entity with which he is associated does perform, accounting, auditing, tax and/or management consulting services, or related services, for a client for whom or for which the partner provided services while a partner of the Partnership, or causes such a client of the Partnership to terminate that relationship, the said partner shall compensate the Partnership for any engagements lost by the Partnership an amount equal to one and one-half times the fees charged by the Partnership during the last full fiscal year during which the client was a client of the Partnership."

The amount of the specified compensation and the period over which this amount is to be paid will also likely be reviewed for reasonableness; and the greater the amount and the shorter the period of payment, the less likely the provision will survive court scrutiny. Total amounts should not exceed 150% of average or actual annual client revenues. Such provisions should also include a clause stating that in the event the court finds the provision unenforceable, the parties desire that the court reform the provision in such a way that it will not be deemed an unreasonable restriction. Such a clause not only will provide greater assurance as to the provision's viability but it will also discourage challenges by the withdrawing partner as it will severely decrease the possibility that the departing partner, can avoid altogether compensating the firm for the client which her or she wishes to take.

F. ARBITRATION

Another tool which should be considered as a method of dealing with problems arising after the departure of a partner is to require that all disputes which arise under the partnership agreement be submitted to arbitration. If an arbitration clause is included in the partnership agreement, the following factors should be considered:

• How much discovery will be allowed;
• Who will bear the costs;
• What procedural rules will apply;
• Will time limits be imposed for filing a complaint;
• Where will the arbitration take place;
• How are the arbitrators to be chosen; and
• How is confidentiality to be preserved.

In summary, problems with departing partners are best contained by clearly defining confidentiality, fiduciary and non-compete responsibilities and the associated penalties for noncompliance in the partnership agreement; building in a required transition period with set procedures; deferring payouts to provide leverage if problems arise; and providing for arbitration to resolve any disputes.

8. LLCs/LLPs AND PCs

A. THE DANGERS TO BE AVOIDED

Traditionally, accounting firms have organized themselves as general partnerships. Partners, however, are personally responsible for the debts and liabilities of the partnership, with the result that a partner or even an employee of the firm can cause one or more of the firm's owners to incur substantial liabilities. While this possibility is not unreasonable in a small firm where the character and competence of the firm's partners and employees are well known to all of the firm's owners, it is wholly unrealistic in even a moderately large practice. It is for this reason that accounting societies across the country during the past 10 years lobbied hard for statutes permitting professional firms to freely organize themselves in limited liability entities.

New York has long had a professional corporation ("PC") statute which permits professionals to operate in a corporate format. This statute, however, requires that owners remain personally liable for damages which are caused through their own acts or through the acts of persons operating under their supervision. Unlike similar statutes in other states, the owners of a New York PC are not personally liable for the commercial obligations of the PC, such as bank loans and rent obligations.

While the New York PC statute is relatively protective, it is also relatively limited as to its membership, as it does not permit CPAs who are not licensed in the state to become members. Thus, it is not well-suited for a multi-state firm. It is for this reason that the New York State Society of CPAs, like other state CPA societies, pushed for the adoption of an LLC/LLP statute which was enacted in mid 1994.

B. COMPARING PCs, LLCs AND LLPs

Although CPA firms now have a choice of three limited liability entities to use as an organizational form, the choice is not particularly difficult. This is true for CPA firms operating both within and outside of New York.

The first decision that a firm will have to confront is whether to adopt a limited liability format or simply continue as a general partnership. For firms with ten or more owners, this should be an easy choice; a limited liability format will give the firm's partners additional protection for their personal assets at little or no additional expense (in the form of franchise taxes). The only downside is that certain owners (who perform engagement review services) will potentially face personal liability exposure in a disproportionately large percentage of engagements. While this is likely to make review partners uncomfortable, the additional risk is slight, if not non-existent. This is because the vast majority of plaintiffs are loathe to chase after the personal assets of a CPA firm owner. This is particularly true if there are only one or two partners who are personally exposed. Thus, it can be argued that by choosing a limited liability format, the personal liability exposure of a review partner is actually diminished. In addition, the statute provides for personal liability of a partner only for "any negligent or wrongful act or misconduct committed by him or her or by any person under his or her direct supervision and control." Accordingly, a review partner may well be able to successfully argue that he or she is not liable for work performed in an audit since it was not conducted under his or her direct supervision or control.

For small CPA firms the advantages of a limited liability format becomes marginal where professional liability is concerned. This is because of the higher likelihood that several if not all of the firm's owners may have been involved in the engagement that gave rise to a claim, either as the partner-in-charge, the review partner, or simply as someone who was consulted on the matter. Where most of the firm's partners are likely to be personally exposed in any event, it may be better to opt for free and open collegiality by not becoming a limited liability entity.

If a firm chooses to become a limited liability entity, its choice is likely to be an LLP. This is especially true in the States of New York and Minnesota where LLP partners are protected from commercial liabilities as well as professional liabilities. In these states, the benefits of the commercial liability protection alone may outweigh any costs of becoming an LLP. These benefits are discussed further below. Among the advantages of an LLP are the following:

• It is easy to form;
• It requires little change to the firm's operations;
• Its limited liability protection is relatively broad;
• Virtually every state permits operation as an LLP; and
• Partnership taxation is assured.

Among the disadvantages of the LLP format are the following:

• There are still approximately ten states that have not adopted this operating format, with the result that in those states limited liability protection is unavailable;
• In some states, including New York, non-CPAs may generally not have firm ownership interests; and
• LLPs in only a few states provide protection against commercial liabilities.

Occasionally, a CPA firm may opt to become an LLC, rather than an LLP. There are at least three reasons which might motivate this choice. The first is that the firm may operate in a state which is yet to adopt an LLP statute. This is largely a temporary reason, as the likelihood is high that all states will ultimately adopt this format. Secondly, The LLC format provides protection against commercial as well as professional liabilities. This too may only be true on a short-term basis, as many states that have adopted LLP legislation are looking to amend their statutes to provide this additional feature as have New York and Minnesota. The third reason is that the regulatory bodies may not permit non-CPAs to hold ownership interests in an LLP, but may allow such persons to have ownership in an LLC. While these positions are also likely to change over the next few years, such changes are more difficult to predict.

LLCs, however, do have some serious disadvantages, which include the following:

• LLCs have a markedly different organizational structure from partnerships and may require the firm to change its organization;
• The cost of organizing as an LLC will be greater than organizing as an LLP; and
• While only three states have not passed LLC statutes, there are still several states that have not modified their accountancy laws to permit accounting firms to be organized as LLCs.

Of the three limited liability formats, the PC is the least attractive. This is because all PC statutes were adopted decades ago at a time when it was not generally believed that professionals should have protection from ruinous liability. Accordingly, roughly half of the PC statutes offer little (or only limited) protection for firm owners against professional liability claims. Moreover, most PC statutes do not permit professionals licensed in other states to be members of a PC organized under the state's PC statute, making PCs wholly inappropriate for a multi-state firm. Lastly, partnership taxation can only be achieved by qualifying as an S corporation, which is cumbersome, at best. 

There is only one good reason why a CPA firm should be a PC; that is because the firm is already a PC and the tax consequences of changing to an LLP format are too great. As a corporation, a CPA firm organized as a PC would have to liquidate to become an LLP. This would cause the firm's owners to recognize income represented by the firm's receivables WIP and goodwill. Even this obstacle can be minimized if the conversion is done at the beginning of a calendar year, as the chances are great that all income from receivables and work in process (but not goodwill) would be recognized over the course of a year in any event.

C. ORGANIZING A LIMITED LIABILITY ENTITY

Organizing an LLP is a relatively easy process. The firm's partners must simply agree to amend their partnership agreement to become an LLP and to change the firm's name to add "LLP" at the end. Next, they must file a declaration with the state's regulatory authorities (usually, the state's board of accountancy and, in New York, with the Secretary of State's office). In some states, including New York, the firm must place an advertisement in two newspapers for six weeks and file the newspapers' certifications with the state's regulatory authorities. The whole process is rather simple and inexpensive and requires little or no change in the firm's organizational documents.

Converting into an LLC is somewhat more complicated, as an LLC must have a set of articles of organization and an operating agreement, which documents roughly correspond to a set of corporate articles of incorporation and by-laws. Thus, at the very least, forming an LLC will require the firm's organizational documents to be redrafted. This may require the firm to change its management structure or the provisions regarding dissolution if a partner withdraws. Such issues take time to work out to everyone's satisfaction, with the result that the conversion to an LLC usually takes several weeks, if not months.

Once these issues are resolved, the formation of an LLC is very similar to forming an LLP as described above.

D. PROTECTION AGAINST COMMERCIAL LIABILITIES

The LLP statutes of New York and Minnesota currently contain provisions protecting LLP owners from personal liability for their firm's commercial obligations unless they elect otherwise. It is anticipated that many other states will amend their LLP laws to include similar provisions. This raises the following questions:

• Why would a CPA firm wish to opt out of this type of protection?
• What types of liabilities would individual firm members wish to accept?
• What is the best way of dealing with these issues?
  

For the most part, a CPA firm will seek the LLP format in order to afford maximum protection for its partners against personal liability. Thus, waiving protection against certain types of commercial obligations will likely require a good reason. There are three classes of obligations which are likely to present good reasons. The first is rental obligations. Many landlords simply will not lease space to a professional firm unless the firm's partners agree to be personally responsible for the firm's leasehold obligations. While this requirement could be satisfied by having each partner sign a personal guarantee, this could raise additional problems as partners join, withdraw or retire from the firm. In order to assure uniformity of treatment it may be preferable to simply opt to make all partners personally liable so long as they remain partners of the firm. Moreover, this will preclude a partner from preventing the firm from entering into a new lease.

A second type of commercial obligation for which the firm's partners may wish to accept personal responsibility are bank loans. Because of the highly seasonal nature of accounting practices, most accounting firms maintain some form of bank financing arrangement. Like landlords, banks also frequently require their professional firm customers to provide personal guarantees of each of the firm's partners. Accordingly, for the same reasons that an LLP may wish to expose its partners to personal liability for real estate obligations, it may also wish to expose them to the firm's financing obligations. In fact, a firm is more likely to encounter a hold-out partner in a bank financing than it is on a lease transaction.

The third group of commercial obligations for which a firm may wish its partners to be personally liable are liabilities to retiring and/or withdrawing partners. This issue can be handled either by making specific obligations run to the firm's partners (rather than to the firm) or by simply exempting these obligations from the personal liability provision of the LLP statute. This is a complex issue and each firm will have to consider it in terms of the firm's individual members and their respective financial positions.

A firm wishing to accept one of more types of commercial obligations for its partners need not simply do so on a blanket basis. Indeed, the best method would be to authorize the firm's management committee to make amendments to its organizational certificate from time to time as the need arises. In this way, the firm will remain flexible and important firm transactions cannot be blocked by a dissenting partner. This issue can also be addressed by allowing such amendments to be authorized by less than all members of the firm.

E. PROTECTING HIGH-EXPOSURE PARTNERS

As noted above, there are likely to be certain partners in every accounting firm who are likely to be involved in a disproportionately large number of engagements or in a disproportionately large number of high-risk engagements. Such persons are likely to include review partners and members of the firm's management and quality control committees. This raises the question of how and to what extent can the firm protect such partners for their personal liability exposure. While there are severe limitations, there are ways to offer some additional protections to these individuals.

Most CPAs faced with this issue first consider a form of cross-indemnity arrangements, whereby all firm members will indemnify any partner who is held personally liable for a professional liability claim. This technique simply does not work, as those personal guarantees become assets of the liable partner and can be enforced by the plaintiff. In fact, the liable partner could probable cut a deal with the plaintiff whereby his assets would not be attached in return for an assignment of the personal guarantees of his partners. In this way, every partner but the one actually responsible for the claim would be called upon to pay.

One possible way of dealing with this issue is to have the guarantees run in favor of the spouses or children of the partners. In this way, the plaintiff would not have a right to attach the guarantees of the other partners. This type of arrangement is also flawed as, unless the guarantees were made non-assignable, the affected partner could simply have his or her spouse assign the guarantees to the plaintiff in return for amnesty. Just as important, some partners may not have a spouse and many partners might be reluctant to give a guarantee to another partner's spouse.

 In all probability, members of the firm's management committee will not be personally liable for malpractice claims unless they actually become involved in the engagement which gave rise to the claim. That is because the statute speaks in terms of persons who supervised the work of the individuals whose actions were negligent. Management committee members normally only set and implement firm policies, and do not supervise the performance of engagements. As long as they limit themselves to these activities, they are not likely to be found to be personally liable for firm liabilities.

Review and quality control partners, on the other hand,

do become involved in the performance of firm engagements. They, too, however, can be protected if they limit themselves to reviewing and advising the engagement partners and do not deal directly with the engagement teams. Moreover, if the firm's organizational documents describe their functions as purely advisory, permitting the engagement partner to reject their advice with the consent of the management committee, there is a good chance that they will only be exposed for their own negligence. While they will still be involved in a disproportionate number of firm engagements, they will not have responsibility for staff negligence.

F. MULTI-STATE PRACTICES

Firms that operate in more than one state must not only consider the laws in their state of organization, but also those of the other states in which they practice. This means that they must check to see that all states recognize the form of limited liability entity in which they have been organized, whether the accountancy laws of all such states permit organization in that form, and whether the laws of the state in which they are formed permit CPAs licensed in another state to be members of the firm.

Paramount among these considerations is whether CPAs licensed in other states may be members of the firm. If not, it may require the firm to organize itself in a state whose laws pose no such restriction. The next most important concern is whether CPAs can practice in the chosen form in all states in which the firm practices. In most cases, this criterion will dictate the use of the LLP format.

In the case of the very large firms, there is also the possibility that interests in PCs and LLCs will be deemed a security whose sale must be registered with the SEC and state securities regulators.

9. PERSONAL ASSET PROTECTION

For partners in accounting firms, the issue of personal asset protection is the issue of protecting those assets from creditors of the firm in the event personal liability requires the filing of personal bankruptcy.

Section 541 of the Bankruptcy Code provides that upon filing bankruptcy, the debtor's estate for purposes of the bankruptcy proceeding will be comprised of all legal and equitable interests of the debtor as of the filing date of the bankruptcy petition, except as otherwise exempted by the Code or excluded from the reach of creditors by applicable non-bankruptcy law. Therefore, in order to determine what assets can be protected from inclusion in the bankruptcy estate, it is necessary to look at both the U.S. Bankruptcy Code and the relevant state laws.

For example, whether or not assets held in joint tenancies, trusts, profit sharing plans and retirement plans are excluded from the debtor's estate will depend upon whether non-bankruptcy laws (usually state laws) prohibit access to the assets by creditors.

A. JOINT TENANCIES

Section 522(b)(2)(B) of the Code permits the debtor to exclude from the estate any interest in property in which the debtor, immediately before the commencement of the case, had an interest as a tenant by the entirety or joint tenant which is exempt from process under applicable non-bankruptcy law; i.e., state laws on joint tenancies.

Generally, a joint tenant may convey or encumber his or her interest in the joint tenancy property, subject only to the right of survivorship. Therefore, this alienable interest will be included in the estate unless the property is exempt under another provision, such as the homestead exemption.

A tenant "by the entirety" however, cannot dispose of any interest in the property without the consent of the spouse; nor may he or she subject the property to payment of his or her individual debts. This means that a creditor cannot attach assets held in this form of ownership and the entire property will pass to the survivor. Whether an estate by the entirety (usually, an undivided interest in real property held by a husband and wife) has been created depends upon state law.

Thirteen states, including California, Connecticut, Iowa, Minnesota and Washington, have deemed the tenant by the entirety form of ownership to be archaic and have abolished it by statute. However, twenty-five states (including New York) still recognize it. Most of these twenty-five states do not permit creditors of one spouse to reach the property, although some states (including New York) do permit access. For example, Delaware, the District of Columbia, Florida, Michigan, Missouri, Pennsylvania and Virginia, do not permit creditors to reach the property; Tennessee permits only the survivorship interest to be reached; New Jersey permits creditors to reach the property, with the creditor becoming a tenant in common with the non-debtor spouse; and New York allows creditors to reach the property subject only to the right of survivorship.

It should also be noted that some states, including Florida, Michigan, Pennsylvania and Virginia permit interests in personal property (such as securities, cars, jewelry, etc.), as well as interests in realty, to be held in the form of tenancies by the entirety, with the result that in these states a wide variety of assets can be effectively shielded from creditors.

B. HOMESTEAD EXEMPTIONS

The Bankruptcy Code allows a person to exempt real property up to $15,000, or elect to use an exemption provided by state law. Some states prohibit an individual from electing the federal exemption, making the state exemption exclusive.

Examples of state exemptions include:

California	$30,000, $45,000 if member of family unit,$75,000 if debtor or spouse is 65 or older or mentally disabled.
District of Columbia	None.
Florida	No monetary limit, however, exemption limited to residence and 160 acres of rural land or residence on one-half acre of urban land (exclusive).
Georgia	$5,000 (exclusive)
Illinois	$7,500
Michigan	$10,000
New Jersey	None
New York	$10,000, $20,000 if both spouses (exclusive)
Pennsylvania	None
Texas	No monetary limit, however, limited to an urban home on not more than one acre, a rural home for a family on not more than 200 acres, or a rural home for an individual on not more than 100 acres.

C. TRANSFERS OF ASSETS

Transfers of assets to family members or to trusts or partnerships can also be used to protect assets, but these methods of protection necessarily involve tax consequences, estate planning considerations, personal circumstances involving issues of loss of control, and permanent divestiture of economic benefit, and would therefore best be considered in consultation with the individual's personal tax, legal and financial advisors.

The principal issue in determining the validity of a transfer of assets to one or more family members, or to trusts or partnerships in which family members are the primary beneficiaries, is whether the transfers could be set aside under state fraudulent conveyance statutes. These statutes typically provide that a transfer can be set aside if the intent is to hinder or delay present, and in many states, future creditors. Fraudulent intent is usually established by inference based upon such factors as reservation of rights and control by the transferor, inadequacy of consideration, a transfer while insolvent or with knowledge of a creditor's claim, a transfer of all of the transferor's property, and a transfer to a relative.

In general, it is better to transfer assets before significant claims are asserted, although it should be noted that creditors may not be prepared to spend the time and money necessary to set aside a transfer.

(1) Direct Transfer of Assets to Spouse or Family Members. An outright transfer, apart from tax and estate planning issues, is simple and straightforward, but results in loss of control and of direct economic benefit from the assets.

(2) Transfers of Assets to Trusts. Under Section 541(c)(1) of the Code, property held in trust for the debtor becomes part of the debtors estate; however, under Section 541(c)(2), "A restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable non-bankruptcy law is enforceable in a case under this title". It is therefore possible to protect assets by transferring them to a trust controlled by a spouse or to a third party for the benefit of the spouse and children. A Bermuda Trust is another possibility. Under the laws of Bermuda and certain other jurisdictions, it is possible to create a trust for the benefit of various individuals, including the transferor of the assets (the "settlor" of the trust), so long as the settlor cannot direct the specific distributions. The trustee will have to be a Bermuda bank, or similar institution, or an individual residing in Bermuda, although it is permissible to appoint a "protector" (who can be a United States citizen) to instruct the Bermuda trustee on specific distributions. The settlor may also have a limited power of appointment with respect to the trust corpus in favor of specific individuals. It is also possible to have a limited partnership with a Bermuda trust, in which the settlor is the general partner owning a one percent interest, who can manage the assets, and with the Bermuda trust owning a 99 percent limited partnership interest, which will be protected from creditors.

Some persons seeking to shelter their assets from creditors (and taxes) use offshore trusts or combinations of such trusts to hold significant assets. Some of these arrangements do not rely upon legal protections, but are rather designed to conceal the transferor's interest in the transferred assets or to pose the specter of endless litigation so as to discourage creditors from pursuing them.

D. PENSION PLANS, 401(k) PLANS AND IRAS

(1) Pension and Profit Sharing Plans. The Supreme Court held in 1992 (Patterson v. Shumate, 504 US 753, 112 S. Ct. 2242), that a debtor's interest in an ERISA-qualified plan may be excluded from the property of the bankruptcy estate under Section 541(c)(2) on the grounds that the exclusion of property held in trust for the debtor subject to a restriction on transfer of a beneficial interest of the debtor enforceable under applicable non-bankruptcy law includes restrictions under state and federal non-bankruptcy law, such as ERISA's anti-alienation provision. Therefore, a debtor's interest in a pension or profit sharing plan that qualifies as a state spendthrift trust or as an ERISA-qualified plan will be excluded from the property of the debtor's estate.

The elements of a spendthrift trust in a majority of jurisdictions are that it cannot be established by the settlor for his own benefit; it must contain an anti-alienation provision; and the beneficiary of the trust cannot control the trust assets. In order for a pension plan to meet these criteria, there should be mandatory participation in the plan, loans should be prohibited or substantially restricted, and distributions should be prohibited until the beneficiary reaches normal retirement age, or is involuntarily terminated.

It is also important that investment direction should be in the hands of a trustee such as a bank, without participant involvement, and that plan committees be composed of non-partners, such as administrative staff, or perhaps some partners with a majority of employees.

The burden of mandatory participation by new partners can be addressed by making the new partners ineligible to participate in the plan until after they have been a partner for five years, at which time participation becomes mandatory, with contributions increasing based upon years as a partner (one percent the first year, two percent the second year, etc.).

The governing law is usually determined to be the law of the state where the plan is created, particularly if that is the same state the plan provides is to be the governing law state.

(2) 401(k) Plans. Because 401(k) Plans are ERISA qualified plans, they are now exempt from the debtor's estate under the holding in the 1992 Supreme Court case discussed above.

(3) IRAs. Many states, including New York, Michigan and Texas, exempt IRAs from the bankruptcy estate by statute, although California does not. The new Roth IRA, which is covered by a different section of the Internal Revenue Code than traditional IRAs, may not yet have statutory protection in some states. Unless there is such statutory protection, an IRA will be included in the estate as it is voluntary as to participation and amount of contributions, permits withdrawals, provides for settlor control over investment of the assets, and can be paid out to the settlor at any time upon demand.

In conclusion, although the advent of the limited liability partnership may have significantly decreased the threat of creditor access to the personal assets of partners to satisfy obligations of a CPA firm, the law has yet to be tested, the protection does not apply to nonprofessional business obligations of the firm in some states, and individual members still remain liable for their own malpractice. It may therefore continue to be advisable to work with one's personal tax, legal and financial advisors to protect personal assets from creditors. It is also still necessary for firms to set up pension and profit sharing plans which protect the participants interests from access by creditors.

10. CONFLICTS OF INTERESTS

A. INTRODUCTION

Although Article IV of the Principles of the Code of Professional Conduct of the American Institute of Certified Public Accountants addresses both independence and freedom from conflicts of interest, they are distinct concepts.

Article IV states:

A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services.

While both concepts encompass the careful preservation of objectivity, they are not subsets of one another. Independence and freedom from conflicts of interest are the subject of separate Rules of the Code of Professional Conduct of the American Institute of Certified Public Accountants, and the potential consequences of a loss of independence and of the existence of a conflict of interest may be very different. While a loss of independence precludes the auditor from providing attestation services, the existence of a conflict of interest may not prohibit the performance of professional services, including attestation services, with proper disclosure to and consent of the client.

B. AICPA RULE 102

Although it provides little pragmatic guidance, Rule 102 of the AICPA Code of Professional Responsibility provides emphatically that "[i]n the performance of any professional service, an member . . . shall be free of conflicts of interest . . ." Interpretation 102-2 does not define "conflict of interest", but provides that one may occur "if a member performs a professional service for a client or employer and the member of his or her firm has a significant relationship with another person, entity, product, or service that could be viewed as impairing the member's objectivity." The use of the word "significant," although excluding some relationships from the ambit of the Rule, must be considered conjunction with the remaining segment of the Interpretation. Thus, it should be recognized that any relationship which could be viewed as impairing the member's objectivity will likely be considered as significant. While impairment of objectivity is itself judgmental, the focus of the interpretation is not a subjective determination as to whether such impairment exists, but rather a seemingly objective one of whether the relationship "could be viewed" as impairing objectivity.

C. DISCLOSURE AND CONSENT

Although there are countless sets of circumstances which could be viewed as impairing objectivity, and little guidance available to assist the practitioner in assessing those circumstances, avoiding the consequences of a mistaken assessment is less complicated. Interpretation 102-2 provides:

"If the significant relationship is disclosed to and consent is obtained from such client, employer, or other appropriate parties, the rule shall not operate to prohibit the performance of the professional's service."

The interpretation that states both disclosure and consent are required. The disclosure should be complete and clear. Although there is no requirement that the disclosure be made in writing, or that it be documented in writing if made orally, the existence of such documentation will reduce professional risk under most circumstances. The consent of the client should also be documented, and if possible, acknowledged in writing by the client.

In making such disclosures, consideration must be given to Rule 301 which requires that confidential client information not be disclosed.

D. LEGAL SIGNIFICANCE

Conflicts of interest have two primary legal effects: they can often form the bases for a plaintiff's claim that an oversight on the part of a CPA was fraud and not simple negligence, and they provide prima facie evidence of a breach of fiduciary duty.

(1) Fraud Implications

As more states move toward limiting the exposure of accounting firms to non-clients for negligence in the performance of professional services, plaintiffs are resorting increasingly to the assertion of fraud claims to avoid summary dismissal of their cases. To sustain a fraud claim, a plaintiff must prove, among other elements, that the accounting firm acted with scienter -- meaning either knowingly and intentionally, or recklessly (i.e. without concern for the damages which its actions might cause).

To meet this burden, plaintiffs often attempt to demonstrate that a defendant accounting firm had a motive for its actions or inactions, and that what might appear to be a simple oversight was really a case of the accounting firm's knowingly placing its own interest ahead of its client's interest. The presence of a conflict of interest would, under these circumstances, be relevant to the issue of scienter and would increase the risk of an adverse determination.

(2) Fiduciary Liability

The variety of professional services offered by accounting firms to their clients has grown dramatically during the last decade. A broad array of consulting services, particularly those involving computerized management information and accounting systems and litigation support, have been added to the menu of traditional accounting, attestation and tax services at many accounting firms.

Although the legal relationship between an accounting firm and its client is contractual, the nature of the services provided by an accounting firm will often further define and/or affect that relationship. Thus, the expansion of the services offered has broadened the possible legal consequences to the accounting firm and its client. When the performance of each services requires or results in the client placing a high degree of trust in and reliance upon the accounting firm, a fiduciary relationship may arise.

While the independence requirements for attestation services is the antithesis of a fiduciary relationship, independence is not required for tax, consulting and other engagements. Should a fiduciary relationship exist, the accounting firm will be required to act solely for the benefit of the client, subject only to legal and ethical limitations.

Under such circumstances, the accounting firm will be bound to advise the client in accordance with the client's best interests, and to subordinate its own interests to those of the client. If the services provided are in some measure deficient and the accounting firm's actions or advice served its own interests rather than those of its client, then the accounting firm may be found to have breached this duty. The presence of a conflict of interest may provide a basis for inferring that the deficient services were the result of the conflict. Although not necessarily conclusive, the combination of a fiduciary relationship, a deficiency in service, and a conflict of interest reaches a threshold upon which liability may be found to exist.

As a fiduciary, the CPA will be legally bound to advise the client in accordance with the client's best interests and to subordinate his own interests to those of the client. If the CPA has not only given bad (or less than perfect) advice and that advice served his own interests, then the CPA could be held to have breached this duty. As in the case of fraud claims, the plaintiff need not necessarily have a better than even chance of proving that the CPA did, in fact, subordinate the client's interests to his own; he need only be able to convince the court that the jury would reasonably infer that the improvident advice was given in substantial measure due to the conflict, thereby creating the need to have the case resolved by the jury. Once this threshold is passed, the case is doomed to trial by jury unless it is settled.

11. THIRD-PARTY FEES AND COMMISSIONS

A. ETHICAL RESTRICTIONS

Both New York State and the accounting profession impose restrictions on commissions and referral fees. Until recently, New York State, the AICPA and the State Society prohibited these arrangements on the basis of a perceived conflict of interest. While the AICPA has amended its rule in recent years, approximately one half of the states still to view referral fees and commissions as arrangements which impair the objectivity and independence of financial advisors and accountants. New Jersey is among the 28 states that now allow commissions and referral fees.

The Rules of the New York Board of Regents, which regulates the accounting profession, promulgated under authority of the New York Education Law, specifically prohibit the receipt of commissions and referral fees even though it has liberalized its rules on contingent fees. The Regents Rule under Section 29.1 on commissions is as follows:

(b) Unprofessional conduct in the practice of any profession licensed or certified pursuant to Title VIII of the Education Law shall include . . . (3) Directly or indirectly offering, giving, soliciting, or receiving or agreeing to receive, any fee or other consideration to or from a third party for the referral of a patient or client or in connection with the performance of professional services.

N.Y. Comp. Codes R. & Regs. tit. VIII, ' 29.1(b)(3)(1994). Violations of the Regents Rules can result in sanctions, including the loss of an accountant's license.

CPA's who are members of the State Society risk expulsion from membership if they violate the State Society's Rule 503, which states: A member shall not pay a commission to obtain a client, nor shall he accept a commission for a referral to a client of products or services. New York State Society of Certified Pub. Accts., Code of Ethics, 2 Accountancy L. Rep. (CCH) Rule 503.

The AICPA's recent relaxation of its rule on referral fees and commissions in some instances does not represent departure from the basic concern over conflicts of interest. Effective August 9, 1990 AICPA ET ' 503 was amended and Section A now states:

A member in public practice shall not for a commission recommend or refer to a client any product or service, or for a commission recommend or refer any product or service to be supplied by a client, or receive a commission, when the member or the member's firm also performs for that client (a) an audit or review of a financial statement, or (b) a compilation of a financial statement when the member expects, or reasonably might expect, that a third party will use the financial statement and the member's compilation report does not disclose a lack of independence, or (c) an examination of prospective financial information. This prohibition applies during the period in which the member is engaged to perform any of the services listed above and the period covered by any historical financial statements involved in such listed services.

While this language clearly permits some commission payments and referral fees to be taken in situations not enumerated in Section A, under all circumstances disclosure of the payments is essential. Section B requires:

A member in public practice who is not prohibited by this rule from performing services for or receiving a commission and who is paid or expects to be paid a commission shall disclose that fact to any person or entity to whom the member recommends or refers a product or service to which the commission relates.

This disclosure requirement is applied to referral fees in Rule 503(C). Even where permitted, the acceptance of commissions may create problems where fiduciary liability is involved. The profession has not sought to answer this dilemma.

B. IMPACT ON INSURANCE COVERAGE

Many of the liability policies available to accounting firms expressly exclude coverage on a transaction that involves payment of a commission or fee. An example of typical exclusionary language is as follows, drawn from the policy of an insurer that, until recently, was one of the most widely written in New York:

This policy does not apply . . . to any claim arising out of services performed for any client which any Insured also received a commission, fee, reciprocity or revenue for the sale or promotion of securities, tax shelters, computer hardware/software or real estate, or other investments.

The claims office of most professional liability insurers may view a transaction falling in this exclusionary framework as one that justifies a disclaimer of coverage. Several exclusions usually apply to investment advice, including that arising in connection with portfolio or trust account management, and opinions made by the Insured firm in connection with the performance or non-performance of securities, tax shelters, real estate or other investments. Even an insurer whose philosophy is less aggressive about disclaiming coverage will be inclined to see a complaint alleging investment advice and a commission payment as ripe for disclaimer.

Plaintiff's lawyers who are unfamiliar with this policy exclusion may frame the allegations of the complaint in a way that invokes this exclusion most strongly. (Rather than focusing on negligent accounting or tax advice, the complaint will focus on fraud and undisclosed commissions.) Thus, the accountant may find that the worst possible situation arises. The accountant must both defend the suit at his or her own expense and pay any judgment. This result is not automatic for all exclusions under the policy. Usually, since the duty of the insurer to defend is very broad (relative to the duty to indemnify) an insurer may extend a defense, but reserve its rights (in what insurers call a "reservation of rights" letter) to avoid liability on a claim if there is a finding that the defendant's liability falls under an exclusion to the policy. The odds of an insurer's losing in a declaratory judgment action to enforce the policy is usually strong and usually a compelling factor in the claims department's thinking. However, investment advice with commission payments are very often viewed as strong facts for the insurer. Indeed, at least one case has held that an accounting firm which received a commission for advising its client to invest in a tax shelter was acting as a securities broker and not as an accountant and, therefore, such actions were not covered by the firm's liability policy.

Even if the firm's insurer extends a defense, a finding supporting one or more exclusions related to investment advice is a serious risk.

C. EFFECTS ON LITIGATION

Transactions in which accountants receive fees or commissions for referral of clients give important and sometimes compelling arguments to the plaintiff's attorney in the event litigation over the transaction ensues. Even advice only tangentially related to the commission or fee can be tainted in the minds of jurors.

The plaintiff's attorney will argue that the defendants enriched themselves by taking secret commissions from the promoters. More often than not, the plaintiff will deny any knowledge of the commissions (and, in fact, it appears often they are not told). Even where the commission is disclosed, the plaintiff will often testify that statements were made misrepresenting the nature or meaning of the commission. Defendant's accounting practices will be characterized across the board as deceptive. Defendants will also be accused of a scheme to obtain the utmost trust of the plaintiff by exploiting his or her fiduciary role as accountant and financial planner while putting all types of individuals into the same kind of investment, whether suitable or not, so as to profit at their expense in the deals.

It should be remembered that most jurors have a high opinion of members of the accounting profession and are usually willing to presume that they acted honestly and in the interests of their clients. This presumption, however, can be overcome where it can be shown that the accountant had ulterior motives, such as the possibility of enhancing his or her income through the receipt of a commission or finders fee. Thus, the very existence of such payments will likely have an enormous impact on a juror's perception of the case.

The accountant's advice in terms of investments may also be linked to other protective statutes. The Martin Act is the New York legislation on securities transactions. Although the Martin Act will not give rise to a private right to sue for damages, under some circumstances sale of investment interests under circumstances of concealment and breach of fiduciary duty would, if proven, be a crime pursuant to Penal Law '' 190.60 and 190.65.

There is also increasing litigation over a broad consumer protection statute in New York under General Business Law section 349. The question under the statute is whether a reasonable consumer would have been misled by the practice being sued upon. The accountant's client, as plaintiff, will likely argue that he should be entitled to recovery under the statute because he or she was a consumer relying on his fiduciary to advise him in a competent and independent manner. The jury may agree that the client would be misled by the accountant's concealing his commission or fee (which the plaintiff's attorney will surely characterize as a "kickback") and personal financial involvement in successful sales of investments.

Section 349 is not receiving a friendly reception from lower courts. Like RICO it has the prospect of appearing in all types of litigation where the legislature did not expect to find it. But there is a growing effort by plaintiffs= attorneys to exploit the statute because proof of violation may be easier than proof of claims for fraud or negligence and the winning plaintiff can recover attorneys fees.

D. FIRM POLICIES

As long a the Board of Regents and the State Society rules remain unchanged, the best risk management policy is to prohibit all fees and commissions as they relate to current clients of the firm. Violation of firm policy in this regard should be a basis for termination. Where fees are involved for referral of non-clients (and that are not related to rendition of professional services), a written disclosure of the payment should be made. Where a person involved in this type of transaction is not a client it is also an important to obtain written acknowledgment that no accountant-client relationship exists.

A more difficult problem arises when an accountant owns a business entity (usually a corporation) that receives the commission payments or fees. However, the best risk management decision still is to prohibit this arrangement as well. The Board of Regents rule prohibits Adirect or indirect referral transactions, including not just receiving commissions, but offering, giving, soliciting . . . or agreeing to receive them.

12. SUITS FOR FEES

A. THE DANGER

The accounting profession has learned the hard way that suits for fees are not a particularly profitable undertaking as all too frequently they precipitate counterclaims for malpractice which are not only expensive to litigate but which occasionally result in severe adverse judgments against the accounting firm.

The frequency of this phenomenon is easy to understand. Once a CPA firm commences a legal action against a client, the client generally only has two choices: compromise the claim or hire a lawyer to defend the matter. Naturally, no client (no matter how tight-fisted) wants to be known as unwilling to pay its rightful debts. Thus, there is a great tendency on the part of a client that has been sued for professional fees to claim that the services were defective and/or overpriced. Moreover, if the client can make up a good enough story it might even be able to convince its attorney to take the case on a contingency, saving it from having to "throw good money after bad," a prospect which is undoubtedly appealing to someone who doesn't like to pay professional fees.

To be sure, any attorney hired to defend a suit for fees is going to explore the possibility of asserting a malpractice counter-claim. This is in part due to the fact that the law of New York provides that a client need not pay for defective professional services. More importantly, however, most litigators appreciate that a "good offense is the best defense." Also, professional liability claims are exceedingly fact intensive, making them expensive to litigate, and this raises the prospect that the CPA firm will not be able to achieve a net recovery even if the malpractice counterclaim is without merit. Thus, the malpractice counter suit can effectively nullify the benefits of the suit for fees under almost any circumstances.

B. SUIT AVOIDANCE

The best way to deal with dead beat clients is to take prophylactic measures to make sure that no client is able to run up a large unpaid bill. Among the methods that can be used to this end are the following:

(1) Clearly specify the amount of and/or basis for computing the fees to be earned in an engagement letter that is sent to and signed by the client. In this way, the client will have no basis for arguing about the amount of the fee. If the estimated fee is likely to be exceeded, immediately approach the client and have the client sign a letter amending the amount of the fee.

(2) Include in the engagement letter a sentence reserving your right to suspend or terminate services to the client if interim bills are not paid timely, and specifying that if services are terminated, the CPA firm is entitled to payment for all time accrued through the date of termination, irrespective of whether the engagement (or any discrete part hereof) has been completed.

(3) Each time the client fails to make an interim payment, suspend services and notify the client of that fact and the matters that require immediate attention.

(4) If the client has financial problems, negotiate a payout arrangement in which the client acknowledges its debt and the fact that the firm's services were acceptable in all respects in addition to specifying the payout schedule. This agreement should also provide for acceleration of the amount owing if any installment is not paid. It is also preferable that the amount to be paid is evidenced by promissory notes for which a judgment can be more easily obtained.

C. MAKING THE DECISION TO SUE

The decision to bring a suit for unpaid fees should never be lightly undertaken. Indeed, such suits should never be instituted without the express permission of the firm's management committee and after consultation with legal counsel and the firm's professional liability insurer. In making this determination, the firm should consider the following:

(1) Is there enough involved to justify the cost of a litigation, bearing in mind that the cost of litigation today is very expensive, so that suits to collect relatively small amounts are generally unfeasible.

(2) Why has the client refused to pay? If the client simply has no funds with which to pay, then there is little reason to sue because even if the suit is successful, the likelihood of a recovery could still be remote. On the other hand, if the client has not paid because he is simply trying to take advantage of the firm, then other factors must be considered.

(3) Has the client ever voiced dissatisfaction with the firm's performance? If so, it is inconceivable that a suit for fees will not be answered by a counterclaim. If not, there is still a possibility of a counterclaim.

(4) Has the client experienced any economic reversals or disappointments that might, in one way or another, be attributed to the actions or omissions of the firm? In this regard, lost opportunities should also be considered. In answering this question the firm should seek to be as creative as possible, as the client's counsel will likely be exercising his or her imagination in an effort to dream up a basis for a counterclaim.

Only if all of these questions can be answered satisfactorily should the firm proceed with suit for fees.

13. ADDRESSING DIFFICULT SITUATIONS

A. CAUGHT IN BETWEEN FEUDING CLIENTS

Accounting firms occasionally face involvement in serious disputes between two or more of their clients. For example, various owners of a business which retained a firm might be engaged in a bitter struggle for control of the business. In such circumstances, the firm's goal must be to avoid becoming the target of one or more of the feuding clients in any ensuing litigation. Avoiding entanglement in such litigation, depending on the situation, may include remaining neutral or representing only one of the parties. When neutrality is appropriate, it requires a consistent appearance of impartiality. Accordingly, requests for documents should be viewed with caution and consideration should be given (subject to confidentiality restrictions) to providing both sides with equal access. In some circumstances, to avoid the appearance of partiality or other criticism, documents should be produced only pursuant to a lawfully issued subpoena.

In some circumstances, "neutrality" may increase, rather than lessen, the chances of being targeted in litigation between feuding clients. Emotions often run high in these situations and a client's sense of being "abandoned" by a once close and trusted advisor may lead to vindictiveness. Indeed, marital and business separations tend to be highly charged affairs in which anyone deemed to be a "friend" of the enemy becomes an enemy. Since it is not always easy to know which litigation avoidance strategy is best, accountants should immediately seek the advice of legal counsel when litigation develops between two or more of their clients.

B. DISCOVERING CLIENT FRAUD

Two basic issues arise in connection with the discovery of fraud: (a) the extent to which an accounting firm is responsible for detecting client fraud and (b) the nature of the firm's duty in the event fraud is discovered. Both subjects present potentially difficult problems for accounting firms problems laden with the possibility of litigation.

The basic standard of auditor conduct in connection with fraud is set forth in AU Section 316 (SAS 82) which was issued by the AICPA in 1997. While SAS 82 was not intended to expand the auditor's responsibilities in this area, it does increase a firm's liability potential for not detecting fraud by reason of its more explicit guidance which can be used to measure the efforts of the firm in trying to detect fraud.

The question of an auditor's duty to detect and report fraud has been hotly debated for the past two decades. In 1987, in response to Congressional criticism the Auditing Standards Board (AASB) adopted SAS No. 53 which significantly expanded an auditor's duty to detect fraud. While SAS 53 stopped short of requiring auditors to detect all material fraud, it clearly placed upon auditors a duty to plan their auditors so as to detect fraud that has a material impact on the client's financial statements. Not surprisingly, SAS 53 did not bring a halt to financial fraud and in the early 1990s the ASB again set out to enhance audit performance by providing further guidance to CPAs with respect to fraud. While SAS 82 does not change the basic responsibilities of an auditor, it does provide a great deal of detail as to how an auditor should look for fraud, what should be recorded in the auditor's workpapers and what reports should be made. In this latter regard, SAS 82 also takes into consideration the passage of the whistle blower provisions now found in Section 10A of the Securities Exchange Act of 1934 which were adopted as a part of the Securities Litigation Reform Act of 1995. SAS 82 also uses the term fraud in contrast to SAS 53 which used the term irregularities.

SAS 82, like SAS 53, requires auditors to plan their audits to detect fraud. Specifically, it divides fraud into two categories: financial reporting fraud and misappropriations of client assets. It then goes on to discuss these species of fraud in terms of the factors that prompt them, the signs that evidence them and the audit measures that can be taken to combat or deter them. With respect to the audit planning stage, the auditor is required to assess the possibilities of these types of fraud. Unlike an audit risk assessment, this process does not seek to assign a score to the level of risk, which can be short-cut by simply concluding that the risk is at maximum level. Instead, what is important is this process is focusing on the various risk factors which should be continually reassessed as the audit process proceeds and as audit evidence (including further risk signs) is gathered and considered. Thus, the assessment of the risk of fraud is deemed to be both a continuing and a cumulative process.

SAS 82 is highly detailed, listing dozens of potential signs of fraud and the types of signs associated with various types of fraud (see paragraphs 16-18). These signs are to be recorded as they are encountered; and the auditor is required to consider what additional or differing audit procedures should be used in the face of those signs. Paragraph 29 and 30 provide a sampling of extended auditing procedures that might be utilized in the face of growing signs of fraud. There is an important point in this process that is left unstated; namely, that where fraud exists, the chances are high that the auditor encountered increasing signs of fraud as the audit progressed. Under such circumstances, one would expect to find that audit procedures were extended and/or modified as the audit progressed. If no such additions or modifications are noted in the workpapers, there is a serious danger that the auditor failed to comply with SAS 82.

SAS 82 not only admonishes the auditor to consider the cumulative impact of signs of fraud and to extend audit procedures to obtain sufficient assurance that such signs do not evidence fraud, but also to reassess all work previously performed if any fraud is uncovered. In essence, having discovered fraud by one or more client employees, the auditor must now go back and check further all other matters touched upon by the wrongdoers to make sure those transactions were not also tainted.

SAS 82 also contains additional guidance with respect to the reporting of fraudulent acts. If the matter is immaterial to the financial statements and does not involve members of senior management of the client, they may be reported to the client's management at a level higher than that of the persons believed to be involved. On the other hand, if the fraud involves a member of the client's senior management or has a material effect on the client's financial statements, the auditor must report it to the client's audit committee or board of directors. If the fraud involves an SEC reporting company, the auditor must also comply with the reporting requirements under Section 10A of the Securities Exchange Act of 1934.

While SAS 82 allows the auditor discretion as to when the firm should resign a client, the AICPA has counseled that an auditor who has significant concerns about the integrity of the client's management or otherwise concludes that it is not possible to address the level of fraud risk in the engagement, should consider withdrawing from the engagement. In this connection, the AICPA has published a practice aid entitled, "Considering Fraud in a Financial Statement Audit: Practical Guidance for Applying SAS No. 82."

C. DISCOVERING ILLEGAL ACTS BY THE CLIENT

Difficult issues are also presented in connection with an auditor's responsibility to discover illegal acts that its client may have committed, as well as what to do if the auditor believes illegal acts have been committed by the client. AU Section 317 (SAS 54) generally establishes the auditor's obligations with respect to "illegal acts" by clients. In addition, the Private Securities Litigation Reform Act of 1995 imposes further requirements in the case of SEC reporting companies.

The term "illegal acts", as defined in SAS 54, refers to violations of law or government regulations by the client or persons acting on the client's behalf. The responsibility of the auditor to detect and report misstatements resulting from illegal acts having a direct and material effect on the financial statement is the same as that for errors and irregularities as described in AU Section 316 (SAS 53).

When the auditor becomes aware of information concerning a possible illegal act which could have "a material indirect effect on the financial statements", but does not obtain sufficient information from the client to resolve the matter, it should:

• Consult with the client's legal counsel or other specialists about the application of relevant laws and regulations to the circumstances and the possible effects on the financial statements; and
• Apply additional procedures, if necessary , to obtain further understanding of the nature of the acts.

hen the auditor concludes that an illegal act, which could have "a material indirect effect on the financial statements", has or is likely to have occurred, the auditor should consider the effect of that act on the financial statements as well as the implications for other aspects of the audit, particularly the reliability of representations of management.

The provisions in AU Section 317 dealing with the auditor's obligation to communicate to others its knowledge of illegal acts which have "a material indirect effect on the financial statements" and the effect of such knowledge on its audit report are essentially the same as the provisions in AU 316 which deal with notification and reporting matters.

The recently enacted "Private Securities Litigation Reform Act of 1995" specifically addresses the responsibilities of auditors in connection with services rendered on behalf of public companies as to illegal acts (defined as "as act or omission that violates any law, or any rule or regulation having the force of law") that may have been committed by a client. Among other things, the new legislation restates the existing GAAS requirement that auditors must design their procedures to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts.

Moreover, under the new legislation, if the accounting firm detects or otherwise becomes aware of information during the conduct of its audit indicating that an illegal act (whether or not perceived to have a material effect on the client's financial statements) has or may have occurred, the firm must determine whether it is likely that an illegal act has occurred and, if such a likelihood is found to exist, determine and consider the possible effect of the illegal act on the client's financial statements, including any contingent monetary effects, such as fines, penalties and damages. Consistent with GAAS, as soon as practicable, the auditor must also inform the appropriate level of management at the client of the matter and assure that the audit committee (or the board of directors in the absence of an audit committee) is adequately informed with respect to the illegal act, unless it is clearly inconsequential.

The new law further provides that if, after determining that the client's audit committee is adequately informed with respect to the illegal act involved, the auditor concludes that (i) the illegal act has a material effect on the client's financial statements, (ii) senior management has not taken, and the board of directors has not caused senior management to take, timely and appropriate remedial actions with respect to the illegal act and (iii) the failure to take remedial action is reasonably expected to warrant departure from a standard report of the auditor, when made, or warrant resignation from the audit engagement, the firm must, as soon as practicable, directly report its conclusions to the client's board of directors. A public company board of directors receiving such a report must notify the SEC of the report not later than one business day after receiving it and provide the firm with a copy of the notice sent to the SEC. If the firm does not receive a copy of the notice to the SEC, it must furnish the SEC with a copy of its report (within one business day). This is required even if the auditor elects to resign the engagement.

While increasing the profession's whistle-blowing responsibility, the new statute expressly insulates audit firms from any liability for anything contained in the requisite report. On the other hand, a wilful failure by the accounting firm to comply with the applicable reporting requirements may lead to adverse action by the SEC, including the imposition of civil penalties and other relief. Moreover, it may be argued that accounting firms are entitled to no protection for even a negligent failure to provide the required reports which could form the basis of a civil damage claim brought by the client or one or more of its shareholders.

D. DISCOVERING ERRORS IN PRIOR ENGAGEMENTS

Another sensitive area for auditors arises out of the discovery of errors in prior engagements. In this regard, AU Section 561 (SAS No. 1) sets forth the appropriate procedures where an auditor, subsequent to the date of its report, becomes aware of facts that existed at that date which would have affected its report had it then been aware of such facts. These requirements are briefly summarized below.

Most critically, if the auditor believes that there are persons currently relying or likely to rely on the prior financial statements who would attach importance to the newly discovered information, it should advise the client to disclose such facts and their impact on the financial statements to all users of the financials.

If the client refuses to disclose the error to all appropriate persons, the firm should apprise each member of the client's board of directors of the situation. If the board also refuses to make the required disclosures, the firm should then notify its client, all known users of the financials (to the extent practicable) and all regulatory agencies with jurisdiction over client that the firm's report can no longer be relied upon. The notifications to the regulatory agencies should be accompanied by a request that the agency take whatever steps it may deem appropriate to accomplish the necessary disclosures.  

Since a reasonable possibility exists that the client will sue the firm if it unilaterally discloses prior "errors" to the outside world, the accountant should first consult with legal counsel before making any such disclosures. In this regard, the firm should also seek legal advice concerning the possible application of (i) state statutes regarding the confidentiality of auditor-client communications and (ii) the confidentiality rule in the AICPA's Code of Professional Conduct.

In addition, an accounting firm should seek legal advice if it contemplates issuing a "revised" report with respect to errors in previously issued financial statements. Since potential plaintiffs will probably consider a "revised" report to be an admission of error by the firm, counsel should explore whether an amendment to a prior report is absolutely necessary.

SSARS No. 1 (and Interpretation 4 thereof) states that an accounting firm may wish to consider the guidance in AU Section 561 in determining an appropriate course of action when, subsequent to the date of the report on financial statements it previously compiled or reviewed, it becomes aware of facts that existed at that date which would have caused it to believe that information supplied by the client was incorrect, incomplete or otherwise unsatisfactory. When determining its "appropriate course of action", the firm should give due consideration to the different objectives of compilation, review and audit engagements.

E. EVALUATIONS IN BUSINESS BUY-OUTS

Accountants should recognize that engagements in which they are hired to provide a valuation of assets (or liabilities) for use in a business buy-out or other disposition of a business entail significant risks. For example, if the "buy-sell" (or other) agreement which outlines the transaction is ambiguous concerning how the firm should compile or verify financial data, the possibility exists that one of the parties will sue the firm claiming it got the "short end of the stick" because the firm incorrectly "determined" the value of the business or its assets. Accordingly, the firm should only accept such an engagement if the underlying agreement clearly establishes the scope of the firm's responsibilities and is not open to differing interpretations. For example, a firm should not accept an engagement relating to the acquisition or disposition of a business which calls for it to perform services beyond its areas of expertise. To further protect itself from litigation, the firm should also consider obtaining appropriate releases from liability and indemnification agreements from all parties involved in the transaction.

In the course of any such engagement, the firm is likely to run into issues of interpretation or critical estimates as to which prior actions of the parties will provide no precedent. In such cases, the firm should not exercise its own Solominic judgment, but instead should consult with all interested parties. If they cannot agree, the firm's report should be presented with dual computations with notes explaining the affect of each such issue. In this way, the firm's neutrality may be maintained and the possibility of its being drawn into a litigation can be minimized. The accountant's goal is to be recognized as the objective advisor by all parties and the advocate of none, which can be extremely difficult to accomplish. If during the course of employment it becomes evident that one or more parties is concerned with the accountant's objectivity, it may be wise for the accountant to suggest that each party retain the services of its own accountant.

As further precaution, the firm should include in its engagement letter that any time and legal expenses it may incur in the course of the engagement, including appearing as a witness in an EBT or trial, will be compensated by the parties.

F. DISAGREEMENTS WITH CLIENTS RE: AUDIT AND ACCOUNTING ISSUES

Occasionally, an accounting firm and management of a client may disagree over matters such as (i) the application of accounting principles to the client's specific transactions and events, (ii) the basis for management's judgments about accounting estimates, (iii) the scope of the firm's audit, (iv) disclosures to be included in the client's financial statements and (iv) the wording of the auditor's report. While the firm should remain open-minded to all reasonable approaches suggested by the client when differences arise, it should never endorse a position it knows is wrong or accede to a client's wishes out of fear that it will lose the client's business. If the firm yields to its client's position in inappropriate circumstances, it will assume litigation risks which will a outweigh any short-term benefits obtained by accommodating the client.

Pursuant to AU Section 380 (SAS 61), an auditor should discuss with the client's audit committee any "disagreements" with management, whether or not satisfactorily resolved, about matters that individually or in the aggregate could be significant to the client's financial statements or the auditor's report. Indeed, the Public Oversight Board strongly suggests that even issues of preferability between two accepted treatments should be brought to the attention of the client's audit committee.

Among other required disclosures, AU Section 380 also provides that an audit firm must advise its client's audit committee of any "serious difficulties" it has encountered in dealing with management relating to its performance of the audit. Such "difficulties" may include, among other things, (i) unreasonable delays by management in permitting the commencement of the audit or in providing requested information, (ii) establishment by management of an unreasonable timetable, (iii) unavailability of client personnel during the audit and (iv) the failure of client personnel to complete client-prepared schedules on a timely basis. Although AU Section 380 does not mandate that reports by an auditor to a client's audit committee be in writing, written reports are generally preferable to oral communications. In addition, under the federal securities laws, a "disagreement" between an auditor and its client must be reported on a Form 8-K when the auditor is terminated or resigns.

G. REQUESTS FOR CONSENT TO REPRODUCE REPORTS

Often accounting firms are asked to consent to reproduction of a prior audit report in a registration statement to be filed with the SEC. Significantly, when an auditor provides such consent, it is potentially liable under the Securities Act of 1933 for any material misstatements or omissions in the re-issued financials or auditor's report, as of the effective date of the registration statement. Moreover, if sued under that statute, the accountant will be required to show that it had "after reasonable investigation, reasonable ground to believe and did believe...that the statements therein were true...". Accordingly, in the event the firm consents to the republication of a prior audit report, it should generally extend its subsequent events work all the way from the date of the report to the actual "effective" date of the registration statement.

It is important to remember that absent a written agreement to do so, an audit firm is under no obligation to consent to the republication of a previously issued report even if the client is willing to compensate the firm for its efforts in assuring itself that nothing has happened to cast doubt on the accuracy of the report. This is particularly critical for small firms whose clients later effect a public offering or are acquired by a public company and the prior financial statements are required to be included in a document filed with the SEC. Although it is conceivable that the client in such circumstances may contend that the firm has an implied duty to consent to the republication of its report, to date no court has held that such a duty exists.

H. DISAGREEMENTS AMONG MEMBERS OF ENGAGEMENT TEAM

It is critical that all accounting firm partners and staff members be encouraged to freely express their opinions concerning the proper application of professional standards and, if necessary, disagree with personnel higher in the "chain of command". Unfortunately, many firms have experienced litigation difficulties because junior staff persons who properly identified problems missed by others were too intimidated by their seniors to press the matter or because partners and managers "brushed off" important concerns raised by less experienced personnel.

When personnel assigned to an engagement disagree, such differences of opinion can usually be satisfactorily resolved between the individuals. However, since differences between team members occasionally cannot be reconciled without intervention by others, firms should have established procedures for resolving disputed issues. For example, a disagreement between a member of an audit team and an independent reviewer can often be resolved by the firm's or office's coordinator for accounting and auditing matters.

Such procedures can be critical in a subsequent litigation when a disgruntled former staff member testifies that he or she reported a "suspicious matter" to the audit manager who declined to investigate it or that the partner-in-charge of the audit refused to make an adjustment to the client's inventory reserve which the former employee had recommended. Such testimony can be devastating to the defense of a malpractice action unless it can be shown that the former employee failed to avail himself of the firm's internal dispute resolution procedures. More importantly, those procedures will go a long way toward making sure that the appropriate professional judgments are made.

 

PART III - DAMAGE CONTROL

Every CPA firm should implement procedures for responding to the perceived or actual threat of a liability claim. In this context the threat may manifest itself by certain fact patterns that are likely to give rise to demands for compensation by clients or third-parties. This list is not meant to be an exclusive itemization of high risk situations, but one or more of the following circumstances are likely to be precursors of liability claims.

• Tax authorities assess the client.
• An embezzlement has resulted in loss to the client.
• A staff person on the original engagement team has been found to have created a serious risk management problem on an unrelated engagement, possibly leading to termination.
• Discovery of an error related to the original engagement.
• The client has been placed in bankruptcy.
• The client has been sued (or threatened with suit) because of financial statement errors.
• The client has threatened to sue or demanded money in compensation for a claimed error on the firm's part.
• The client has asked why a specific problem was not foreseen, addressed or avoided by a member of the engagement team or the firm, and the problem's financial ramifications may be substantial to the client.
• The client is being terminated by the firm.
• The client is embroiled in litigation or is being investigated by a government or self-regulating agency and a subpoena has been issued (or will be issued) for the firm's workpapers.
• A dispute involving financial matters has erupted between two clients of the firm.

The last three items are less serious but can still be treated as warning signs that damage control measures should be considered.

1. WHEN & HOW TO SEEK OUTSIDE ADVICE

You cannot seek outside advice too soon. When a potential suit or claim manifests itself, immediate steps should be taken to obtain objective professional input on formulating a firm response. Reluctance to consult outsiders because of a concern for the fees that may be involved is usually false economy.

The two primary sources of assistance are attorneys who practice in the area of accountant liability litigation (as long as they do not exclusively or primarily do plaintiffs' work), and accountants with a substantial history in assisting in the defense of these types of claims. The issues related to accounting malpractice (and often, securities law violations) are highly specific. Attorneys or other accountants who have general litigation experience, even in the context of commercial litigation, may not have the necessary working familiarity with important legal doctrines and accounting concepts to provide cost-effective assistance. Since securities fraud and accounting malpractice claims are frequently found together, experience in both fields is when with the threatened claim arises from a public or private securities transaction.

A third source of assistance is the firm's professional liability carrier. However, there must be no threat that the claim will fall under a policy exclusion or otherwise not be covered under the policy. The carrier will have a potentially serious conflict of interest in such situations. Outside counsel should not only be asked about evaluation and defense of a claim, but also rights and obligations the firm has under its professional liability policy.

2. IMPORTANCE OF DAMAGE CONTROL

Early consultation with an outsider will likely contribute to substantial savings in fees later if the claim results in litigation. Preparing for a defense and controlling damage early is likely to reduce exposure as well as litigation costs going forward. It will also tend to minimize the amount of effort that the firm itself will have to expend in defusing the situation.

It is important to seek objective advice early. In-house evaluations of exposure and risk will be conducted by people with personal relationships and financial interests that may, even with the best of intentions, skew the analysis. In addition, if negotiations are undertaken to try to resolve threatened claims early, an independent negotiator with experience in the field of accountant malpractice litigation will have more credibility with prospective claimants and their advisors.

Failure to seek outside assistance may lead to missed opportunities to preserve important evidence or failure to adopt a realistic negotiation strategy. Another harmful consequence may be the making of admissions that may actually make the case more difficult to resolve. The implementation of damage control procedures will limit the circumstances under which a member of the firm makes inappropriate admissions of fault or liability. While obvious errors may have to be acknowledged under some circumstances, in most cases fault is not clear. The premature or incorrect acknowledgment of error can have devastating consequences to the defense of a claim. Furthermore, the firm's professional liability policy may provide that the insured may not to admit wrongdoing without forfeiting coverage.

Until the firm's outside consultants and the damage control team have had a chance to evaluate the exposure represented by the claim, admissions of liability should be prohibited.

3. DAMAGE CONTROL TEAM

A. COMPOSITION

In order to implement a damage control strategy and to be able to respond quickly to a potential claim, each CPA firm should designate a damage control team to oversee the handling of actual and threatened litigation. At least one partner (or shareholder) and manager-level person should be assigned to the team. The senior team member or members need to command respect in the firm to act on behalf of the partnership or professional corporation. The team should be composed of members who have technical expertise required by the particular claim. Team members should include persons with an understanding of the insurance and litigation support issues that are related to the claim. The team need not be large. One of the team's primary tasks is to assist the outside counsel or other representatives and that task will be the primary factor determining team size.

The damage control team should not include the members of the original engagement team. While their input is extremely important in analyzing the claim and responding to litigation, their objectivity is difficult to maintain and assess. Moreover, their decision making functions cannot be freed of the emotional stake they will usually have in the defense of a claim attacking their professional competence or honesty.

B. FUNCTIONS

The team's primary task is to determine in specific terms the exposure the firm has with respect to the claim. That determination must be made with the firm's outside counsel or representatives. The assignment must begin with the assembly and review of documents that concern the engagement under scrutiny, including but not limited to workpapers and reports. If errors have been made, they must be identified. What injuries have been suffered (in terms of amount) and by whom is also an important part of the evaluative process. In sum, in approaching this initial assignment the team must evaluate the strength of each potential claimant's case as to each of the elements of a prima facie claim.

The team must also evaluate the liability insurance coverage that may be available to the firm. If coverage exists, or it is possible the claim is covered, the team must put the carrier on notice promptly as its policy requires.

The evaluation process must involve identification of other persons who contributed to the claimant's injury, if any. Negotiations to settle the claim at an early stage may be successful if others who are responsible for the losses suffered are called upon to contribute their share. If litigation ensues, the firm should consider the advantages and disadvantages of making these third-parties participants in the litigation.

In the event of litigation, the damage control team members will be well-positioned to turn their attention to litigation support functions. That includes responding to discovery demands of opposing parties and helping counsel formulate discovery demands on behalf of the firm.

4. RESPONDING TO PERCEIVED OR THREATENED CLAIMS

An important early step should be an assessment of ways in which the claimant's injuries can be reduced. The possibilities are quite varied. By way of example, the firm may notify the client that a report on financial statements is flawed and require the client to notify recipients of the financial statements that reliance is no longer possible. In tax situations, the filing of an amended return or belated election may substantially reduce the potential injury to the client.

Relevant documents, including workpapers, should be secured. The damage control team should promptly address the issues and complete the tasks itemized above. Settlement possibilities should be evaluated. Notification to the firm's insurer should be made immediately if it has been determined that it is appropriate to do so. This is particularly true if settlement is deemed advantageous, as no insurer will contribute to any settlement unless it has approved that settlement in advance.

When settlement is possible at early stages, it is important to reach out to others who the claimant (or the firm) may view as being partly responsible for the damages suffered. There are two reasons for this. As mentioned above, contribution to a settlement by others may facilitate a resolution with less money begin paid by the firm. In addition, if the plaintiff negotiates piecemeal, the potential defendants can gain valuable information by comparing notes about what the claimant has told them and negotiating positions the claimant has taken or abandoned.

Be alert to tactical considerations that have nothing to do with the merits of a threatened claim. Legal advisors for clients who have suffered losses often do not know or understand the practice of accountancy. Frequently, litigation is threatened when no expert on accounting malpractice issues has been consulted by the plaintiff. In fact, a successor accountant who has no litigation support experience may not be able to effectively evaluate the merits of a proposed claim. In fact, a successor accountant may have obtained the client's business by emphasizing differences in how they would have approached a particular issue and opining that a different approach is malpractice simply because it was different.

Where the firm's liability exposure does not seem to be substantial, an aggressive and in part educating response to the attorney for the prospective plaintiff may make a lawsuit look less appealing. Attorneys unfamiliar with accounting malpractice litigation may think an accounting firm and its insurer will pay large amounts in settlement before a suit is filed (or before discovery is completed) just to avoid embarrassment, publicity or the costs of defending an action. This impression is wrong (unless damages are minimal) and should be corrected as promptly as possible when the merits of a case appear to be weak. Indeed, most insurers will insist upon a thorough evaluation of every claim before authorizing its settlement.

After a threat has been made, if suit is not promptly commenced, do not overlook a chance to use requests for cooperation from successor accountants as a lever to get outstanding fees paid. From time to time, this will result in negotiations for reduced fees, which may be coupled with an exchange of releases. When it happens, the release is worth far more than any compromise in the fee.

5. WORKPAPERS

At the heart of every malpractice case against a CPA firm is the firm's own workpapers. Even though workpapers are intended to enable the firm to prove that it performed its engagement in a professional manner, all too often they end up revealing gaps in procedures and audit evidence and thus sow the seeds for liability. Accordingly, even if a firm regularly reviews and cleans up its workpapers at the end of each engagement, if a liability exposure presents itself, it is absolutely critical to have the firm's workpapers reviewed by someone (preferably someone not associated with the firm) with significant expertise in the type of engagement under scrutiny. Oftentimes corrective action can be taken at this stage that can greatly minimize the firm's ultimate liability exposure.

A. LOCATING AND SECURING

The first step in this process is to locate and secure all of the firm's files with respect to the subject client, and in particular, the engagements believed to be a potential source of liability. In this regard, it should be appreciated that plaintiffs' document demands are rarely limited to the files pertaining to the engagements in which liability claims are grounded. More times than not, the plaintiffs' counsel will wish to see prior and subsequent year's work to see if they were handled differently. They will also demand the files of other contemporaneous engagements for the client to see if something may have been learned by the firm in those engagements which should have been considered in the subject engagements. The accounting firm should marshall all files of the client not only because the plaintiff is likely to use a broad scope of discovery, but also because files from one engagement often are misfiled or used in connection with other engagements, making it impossible to secure all of the files of the subject engagement without searching all files.

The firm should also review the personal files of all persons working on the subject engagements. Frequently staff accountants (particularly junior ones) will make copies of memo, checklists or even client documents for their own files so that they will be available to guide them in the conduct of future engagements. While such diligence is to be admired, it is a dangerous practice from a liability perspective, as it has the potential of providing conflicting evidence of testimony that may have been previously given without the benefit of those documents.

All documents pertaining to the subject client should then be secured and placed into the custody of a responsible person at the firm or with the firm's legal counsel. In doing so, care should be taken to identify the source of each document.

B. PRUNING AND REJOINING

If a legal action has not been commenced against the firm and the firm's documents have not been subpoenaed, the firm may safely prune its files of unnecessary and superfluous materials. In this regard, it should be appreciated that every document holds the potential for additional discovery efforts, efforts which will only increase the length and expense of the ensuing litigation.

In particular, firms should consider disposing of multiple copies of the same document, and documents that previously should have been disposed of under the firm's document retention policy. Such disposition should take place under the supervision of the partner in charge of the client, as there is a high likelihood that any disposition of client files in the period immediately preceding a lawsuit is likely to be the subject of inquiry and it is best that such questions be handled by an experienced person. Once a litigation has been commenced against the firm, or the firm or one of its employees or partners has been subpoenaed to produce documents, no documents can be destroyed. To do so could subject the firm to judicial sanctions and unfavorable media exposure. If the firm is a defendant in a civil damage action, the jury will be instructed by the court that it can consider that act of destruction in assessing the credibility of the evidence and in a majority of the cases, the averse inferences drawn by the jury are more harmful that the destroyed documents themselves. In addition, under the Private Securities Litigation Reform Act of 1995, a plaintiff in a class action securities case can ask the court for sanctions if it can be established that documents were willfully destroyed after a party (to the litigation) had actual notice of the complaint.

Frequently, a review of the firm's records will reveal that certain procedures were not recorded in the workpapers. In many cases, this does not mean that the procedures were not performed, but simply that they were never recorded. It is always possible to supplement the firm's workpapers to record those procedures. Preferably, this should be done by the person who performed the procedures. Any such supplements should be dated currently so as not to misconstrue the supplemental nature of the workpaper. While it is questionable whether workpapers which are not generated contemporaneously with the work are admissible, they may nevertheless be sufficient to convince the plaintiff's attorney that further inquiry into the procedures so recorded is not likely to be fruitful.

6. DEALING WITH PRESENT AND FORMER PARTNERS AND EMPLOYEES

A. INDIVIDUAL OR JOINT DEFENSES

It is not uncommon in accountants' malpractice cases for the plaintiff to name as defendants the individual accountants who worked on the matter(s) that gave rise to the claim and, in some cases, all of the defendant accounting firm's partners are so named. This raises the question as to how the defense of the matter is to be handled. In the vast majority of cases, it will be advisable to have all firm partners and employees (both present and past) defended jointly. This will eliminate the possibility that the firm (which is generally responsible for the acts of all its employees and partners) will incur liability because of information or testimony provided by one of its own.

Sometimes it is not possible to have all former and past employees defended by counsel for the insured firm. This may happen where the interests of such parties is so divergent that counsel cannot simultaneously represent all such parties. This is likely to happen where one or more of the firm's employees is alleged to have acted intentionally. In such cases those persons with diverging interests must be given their own counsel. This is not a particularly happy choice for the firm or its insurer who must not only bear the cost of an additional legal counsel but also because the inability to mount a unified defense could adversely affect the firm's defensive efforts.

It is important to bear in mind that when an attorney represents multiple parties in a lawsuit, he or she has a duty, if requested, to disclose information learned during the course of his engagement to other clients within the join representation arrangement. Accordingly, if there is information that is relevant to the case and which the firm does not wish to have disclosed to its former employees or partners, the firm should carefully consider whether its failure to disclose that information to its counsel will jeopardize the firm's defense. If so, it may not be feasible to have such persons be jointly represented by the firm's defense counsel.

The firm should also consider the character of its former partners and employees. If they were expelled from the firm for discreditable acts, this will undoubtedly come out in the discovery process and the firm's decision to join forces with such persons (even against a common enemy) may adversely affect the firm's image and credibility before the jury. Accordingly, the firm must also consider whether association with such a person outweighs the advantages of presenting a unified defense. Under such circumstances, separate but coordinated defenses may be preferable.

B. REPAIRING SEVERED RELATIONS

Occasionally, persons who formerly worked for the firm will be named as a defendant, along with the firm, and in some cases their departure may not have been on a friendly basis. Although this situation can make for awkward moments, it is nevertheless important for the parties to put their former differences aside and to join together in a common defense. If the separation had grown out of work done on the engagement(s) which gave rise to the claim, this may not be possible.

If a former partner or employee is named as an additional defendant, it is important to contact such person(s) immediately in an effort to have them joint the firm's defense. A failure to do so will only confirm the hard feelings that may have previously existed and will make a joint defense all the more difficult. While it is possible to have the firm's defense counsel make this contact, it is far more effective if the initial contact comes from the firm itself. Otherwise, it may be taken as a sign that the bitter feelings that accompanied the separation still persist, making cooperation between the parties difficult despite their common interest in defeating the lawsuit.

Once the initial relationships are reestablished, it may be better to allow defense counsel to work with former partners and employees so that the possibility of reopening old wounds will be minimized. Defense counsel, however, should be careful to treat former partners and employees as equals in the defense efforts, even though the firm has the primary liability exposure and the firm and its liability insurer will be funding the joint defense. A failure to treat such persons as equals will breed suspicion and could lead to a fracture of the defense efforts which an astute plaintiff's counsel might be able to exploit.

For the most part, it will be helpful to assure the former partners and employees who are being jointly defended that they should not incur any personal liability if the case is resolved within the limits of the firm's liability policy. Such assurances will not be possible where the former partners or employees acted improperly; however, in those circumstances, a joint defense may not be possible. This approach is usually better than trying to achieve cooperation based upon fear that they will be held liable if they don't cooperate. Former partners and employees caught in these situations tend to feel isolated and alone and heightening their fears could cause them to panic which, in turn, could cause them to seek a settlement with the plaintiff under which they would cooperate with the plaintiff in exchange for a release. Since the plaintiff probably never expected to recover from the personal assets of such persons, this type of settlement is usually available unless the would-be settler's actions lie at the heart of the lawsuit.

7. DEALING WITH THE PRESS

One of the unfortunate side effects of a malpractice action is the adverse publicity that may be generated. For the most part, the press has become so bored by professional malpractice claims that it rarely bothers to report them unless (a) the firm itself has a high profile, (b) the other parties have a high profile, (c) the subject matter of the case is exciting or notorious or (d) plaintiff's counsel makes a habit of trying his or her cases in the press. Accordingly, dealing with the press will not likely be a problem faced by most CPAs. For those few who must, it is likely to be a distinctly unpleasant experience.

Make no mistake, when the subject of the press' inquiry is a malpractice claim against your firm, the reporter making the inquiry is not your friend and no matter how nice and charming you may be, the resulting story is not going to be positive. Accordingly, if you are contacted by a reporter about a claim against your firm, the response should be short and courteous. You should not try to explain the case or why you believe the firm did no wrong. This will only provide the reporter with more facts and make the story 20 inches long with a two column headline instead of three inches long with a one column heading. The best policy is to simply explain that the firm does not believe in trying cases in the press and will present its position in court at the appropriate time and that based upon the facts available to the firm, the case is without merit.

A reporter receiving such a reply will likely try to probe further and ask why the firm believes the case to be without merit and what facts does the firm know. The reporter may even ask you to respond to specific statements that others have made to him. Don't be baited into responding and don't assume that any such statements were, in fact, made to the reporter. (Yes, reporters do those things). If necessary, remind the reporter that one of the qualities of a good reporter is that he must listen carefully and he obviously wasn't listening when you told him that the firm doesn't argue its legal matters in the press.

Of paramount importance is not providing the reporter with additional information that will lead him to other facts or sources. Remember, you want this article to be as short as possible and to only appear once. You do not want the matter to turn into a series that is followed daily or periodically over the course of the proceeding.

Even if the plaintiff is an individual whom the press loves to hate, it is a mistake to think that the press will write an article that is favorable to your firm. Even if you are right about the press' bias, you still have to remember that your firm is the defendant in the case and no matter how despicable the plaintiff, the very fact that your firm is associated with such a person will have an adverse impact. Moreover, you may fall into the trap of disclosing "confidential" matters concerning the client and only add to the firm's problems by becoming the subject of a libel charge or disciplinary proceeding.

It is generally a good idea to designate one person within the firm to be its spokesperson. All other firm members and employees should simply refer any inquiries to that person. It is generally not a good idea to simply turn over the job of dealing with the press to the firm's attorney, as attorneys revel in publicity and may only keep the story going in the press. Remember, even though O.J. Simpson may have won his trial and his lawyers clearly prevailed in the press, he is still an outcast following these victories. His attorneys, on the other hand, are now authors of best-selling books.

8. USE OF BAD FAITH CLAIMS TO SECURE INSURER COOPERATION

When an insurer has reserved its right to avoid liability under the policy in the event of an adverse verdict (or other adverse fact finding), but has still agreed to defend the action, a time will come when the insurer's cooperation in resolving the case can be-Cor must be-Csecured or encouraged by the specter of litigation with the firm (the insured) alleging that the insurer wrongfully failed to honor its policy, a charge which can result in the insurer's having to cover a verdict in excess of the limits of the firm's policy. Such claims are generally referred to as "bad faith" claims.

The firm's "bad faith" strategy should be implemented as soon as it receives a reservation of rights letter. Independent counsel (i.e. not counsel appointed by the insurer) should be retained to monitor the litigation and to advise the firm on the reasonableness of the insurer's conduct. A point may come when the firm's independent coverage counsel must demand (on behalf of the firm) that the insurer take some action. The specific purpose of the demand is to put the insurer on notice that the firm will sue the insurer for its bad faith refusal to honor its obligations under the policy. The demand makes it clear the insured does not intend to waive its rights under the policy.

This situation is most often confronted in the context of settlement proposals. Take as an example a case in which the plaintiff seeks damages $2 million, but the firm's professional liability policy is for only $1 million. The plaintiff, however, may offer to settle for the amount of the policy and waive the possibility of recovering damages above that amount. This happens more often than not, as few plaintiffs are particularly anxious to pursue the personal assets of professionals. If the offer is accepted, the insured has no further exposure. If the offer is rejected the insured faces a possibility that the jury may decide the plaintiff is entitled to $2 million (or even more), leaving the insured firm to pay the amount in excess of its insurance. Under these circumstances the firm's desire will almost always be to settle. The insurer, however, has no greater risk from trying the case than from settling, as the policy limits cap the insurer's liability. Thus, by steadfastly refusing to settle, the insurer is, in effect, gambling with the firm's credit that the jury returns a verdict for $2 million and there is usually some chance the jury will decide the plaintiff is entitled to less than $1 million, or even to nothing. Of course the insurer will have to pay attorneys' fees to try the case, but usually those costs are not material to settlement when the potential savings are greater. Moreover, under most policies even those fees are charged against the policy's limits. Thus, from the insurer's perspective, there is little reason to settle.

This conflict has been addressed before by the courts, which uniformly hold that the insurer has a duty to exercise good faith in trying to settle all such claims. Indeed, the law of New York requires the insurer to consider not only the insurer's interests, but also the interests of the insured in evaluating the plaintiffs' settlement proposal. The contract of insurance imposes on the insurer the obligation to manage its defense of the insured in good faith. The term "good faith" in this context means the insurer must evaluate the seriousness of the claim against the insured (and the reasonableness of a settlement demand) as if the insurer would be responsible for the entire amount of any eventual judgment itself. In short, the insurer cannot gamble with the insured's money in order to possibly save some of its own. Should the insurer fail to exercise such good faith, the firm may assert a "bad faith" claim against the insurer for the entire judgment rendered against the firm, without reference to the policy limits.

The facts of the case as developed in pretrial discovery need not be conclusive and there will usually be evidence presented at trial which favors the defense. But the greater the possible damages, and the greater chance of a plaintiff's verdict, the more readily is bad faith inferable from a refusal by the insurer to settle for an amount within the policy limits. Where the financial risk is considerably greater for the insured than for the insurer, even a judgment modestly in excess of the limits of the policy can ruin a small practice financially. Thus, at or near the conclusion of discovery, if settlement is possible within the limits of coverage, the insured must be prepared to make a demand that the case be settled for the amount offered by the plaintiff's lawyer.

9. SELECTION OF DEFENSE COUNSEL

The insured should attempt, if at all possible, to appoint, or participate in the selection of, defense counsel. Options available to the insured will be a function of the provisions of the professional liability policy itself and whether the insurer has a conflict of interest with the insured. In some cases, professional liability policies give the insured the right to select counsel (with the insurer's reasonable input) or give the insurer the right to select counsel, largely as a matter of its own discretion. Even if the policy gives the insurer the power to select counsel, if the insurer has reserved its rights to avoid indemnifying the insured at the end of the case, New York law grants the insured the right to select defense counsel (again with the insurer's reasonable approval).

Often an insurer, in opening a file on a new claim, will routinely appoint as defense counsel an attorney of its choice from its panel of approved attorneys. The counsel will be on its panel for several reasons. First panel counsel are usually experienced in this area of law and have functioned adequately as defense counsel in the past. Secondly, they also frequently have a business relationship with the insurer and have agreed to handle cases at reduced rates in return for a volume of work. Nevertheless, the attorney designated by the insurer will be the attorney for the firm, and will owe the firm his undivided loyalty notwithstanding the fact that he may be economically dependent upon the insurer. Indeed, panel counsel may even represent the insured firm in a coverage dispute with the insurer (although this would be a dubious choice), but may not represent the insurer in such a dispute.

In the event of a latent or potential conflict between the insurer and the firm, it is usually important for the firm's defense counsel to be Aneutral@ in a business sense. The defense attorney has a duty of loyalty to the insured, but the presence of an ongoing business relationship is a factor the firm will often want to eliminate from the equation.

10. IMPACT OF RESERVATION OF RIGHTS LETTERS

A reservation of rights letter is customarily sent by the insurer at the start of a lawsuit or notice of the claim to the insurer (or promptly after facts are disclosed triggering the possibility of a verdict that falls outside the scope of coverage). The purpose of the letter is to put the insured on notice that coverage may not be complete with respect to the claim.

A reservation of rights letter will extend a defense to the insured but serve notice that the insured may be without coverage for some or all of the claims asserted in a lawsuit. For example, if the jury were to find that the insured was not negligent, but had committed fraud, a reservation of rights letter that recites the fraud exclusion under the policy will allow the insurer to avoid paying the amount of the damages awarded to the plaintiff.

11. RESPONDING TO INSURER REQUESTS FOR INFORMATION

In the event of a claim, the insurer will likely seek information about the claim, its background and the insured firm. Such requests generally have two motivations. First the insurer must obtain information so that it can properly evaluate, defend and resolve the claim. An insured firm's failure to provide such information is likely to be deemed as a failure to cooperate with the defense of the claim, which will provide the insurer with a basis for disclaiming liability. Second, the insurer may be seeking information that will support a disclaimer, such as information that the insured firm was aware or should have been reasonably aware of the claim prior to the inception of the firm's policy. Because an insurer's request for information may be motivated by the latter reason, it is critical that any such requests be properly reviewed before the information is turned over to the insurer.

Before taking any action it is important to understand the role of defense counsel. Unless the insured firm has bargained for and obtained the right to select defense counsel or the insurer has reserved its right to disclaim coverage, the overwhelming likelihood is that the insurance company would have appointed one of its "panel counsel" to defend the claim. Although such counsel is appointed, "controlled" and paid by the insurer, he or she owes his or her entire loyalty to the insured defendant and may not make any disclosures to the insurer without the knowledge and consent of the insureds. Indeed, some courts have held that it is altogether improper for an insurer to even ask defense counsel to supply it with information relating to a coverage issue, and virtually all courts have ruled that it is unethical for defense counsel to supply any such information unless the insureds have authorized its disclosure. Correspondingly, prudent defense counsel will normally seek express approval for any disclosures it may make to the insurer.

For the foregoing reasons, if a request for information is made by an insurer to the insured firm, there is a strong presumption that such request is likely to seek information bearing on a coverage issue. Accordingly, accounting firms faced with such requests would be prudent to discuss these requests with an independent counsel retained to advise them on policy coverage issues. In fact, most defense counsel will be exceedingly reluctant to even become involved with potential coverage issues, even though there is no legal restriction in most states against defense counsel's representation of an insured in a coverage matter.

Before responding to an insurer's request for information the insured firm should carefully review its policy as well as any reservation of rights letter it may have received from the insurer in an effort to ascertain what bases for disclaiming the insurer might be pursuing through its request for information. Such questions should be discussed with the insured's coverage counsel to ascertain how the courts have treated disclaimers on the same grounds. Although a potential disclaimer can never be good news for an insured CPA firm, it is not necessarily bad news. This is because the very possibility that an insurer might disclaim liability is often an impetus to causing the plaintiff to reduce its demands and to accept a modest settlement offer. Secondly, depending on the basis of the proposed disclaimers, the insurer may not even be legally entitled to raise the disclaimer issue until after the underlying case has been settled. Thus, it is essential that each potential basis for disclaiming liability be thoroughly reviewed before responding to an insurer's request for information.

Although the insurer will ultimately be able to establish its right to information pertaining to a wide variety of coverage questions, when and how that information is supplied could be important.