This is the first of a two-part series looking at how state security and tort laws can affect auditors.
Auditors generally don’t need a deep understanding of the intricacies of state securities laws. But they should have a working knowledge of some of the legal theories and risks involved when working with a client offering securities outside the scope of SEC registration.
State securities laws are also referred to as “Blue Sky” laws. The term originated from a U.S. Supreme Court opinion in a 1917 case titled Hall v. Geiger-Jones Co., 242 U.S. 539 (1917). In that case, the court upheld the right of individual states to regulate the offer, sale, and purchase of securities. The opinion referred to fraudulent investments as “speculative schemes which have no more basis than so many feet of ‘blue sky.’”
Much has been written about the legal and financial risks associated with auditing a publicly traded company raising capital through securities offerings subject to the registration requirements of the SEC. But the related risks associated with auditing a privately held entity engaged in private placement offerings that are exempt from SEC registration but subject to state securities laws have received scant attention.
Both existing and prospective audit clients may seek to raise capital through securities offerings, whether offered privately or publicly. While most securities offerings are not fraudulent investment schemes, allegations of fraud can arise when investors incur losses in connection with the purchase of securities.
All 50 states have their own securities laws and regulators. These laws govern the offering of securities that are exempt from the SEC’s registration and reporting requirements. The laws are complex and vary substantially by jurisdiction. Many private placement offerings are subject to state registration and qualification. For those offerings that are not subject to state registration and qualification, there may still be state notice filing requirements and fees.
Professional liability claims
Many professional liability claims made against auditors of companies engaged in private placement offerings allege that the auditor failed to detect and disclose a financial irregularity or fraud. A common assertion is that this directly or indirectly defrauded the market in violation of state securities laws, resulting in losses to investors.
In addition to the usual allegations of negligence and breach of the engagement agreement, these claims often seek exemplary damages for the alleged violation of state securities or other statutory laws. They involve large damages, extensive fraudulent conduct by clients, and sympathetic plaintiffs.
Here’s a hypothetical scenario to help explain the type of situation to look out for:
A development-stage company seeks to raise capital through a private placement offering. Depending on the type of offering, audited financial statements may or may not be required under federal and state securities laws. Company management seeks out an auditor well known in the region where the offering will originate, with the intent of including the auditor’s report in the offering materials. The underlying assets involve mineral rights, real estate, biotechnology research and development, or, in more recent years, virtual currencies. The securities are marketed to a limited but highly targeted group of individuals. Often the company or senior management has been involved in prior private placement offerings.
In some of these cases, what equates to a Ponzi scheme is used to pay off early investors to build support for future offerings. In other fraudulent scenarios, senior management may engage in outright theft through a variety of other types of schemes. A controlling person or persons orchestrate the fraud over an extended period. Information requested by auditors is typically delayed, incomplete, and inaccurate.
Several years after the initial private offering, the company declares bankruptcy, and a liquidator is assigned to recover assets on behalf of creditors and shareholders. Lawsuits are filed against both management and their professional service providers, starting with law and accounting firms. Criminal charges against firm management receive extensive press coverage, which also notes the civil cases naming the professional service firms.
Claimed damages exceed both the remaining assets and the collective insurance coverage of all the defendants. Faced with millions of dollars in defense costs, substantial lost time, reputational damage, sympathetic plaintiffs who lost their life savings in the scheme, and state tort laws that may leave the CPA firm facing a large exposure in excess of its insurance coverage, the case settles for millions of dollars prior to trial.
Engagement acceptance and continuance
For CPA firms performing audit services, avoiding exposure to potential claims arising from alleged securities fraud is first and foremost an engagement acceptance and continuance consideration. The integrity and experience of client management and the qualifications and industry experience of CPA firm personnel are important factors.
When an existing or prospective audit client is planning a securities offering that they have concluded is exempt from the registration requirements of the SEC, the engagement warrants closer scrutiny. This is also recommended when an auditor is asked to consent to include a previously issued report in related private offering materials.
Determining how state securities laws apply requires specialized expertise. While it is not an auditor’s responsibility to determine if a client is complying with state securities laws in connection with a private offering of securities, noncompliance can elevate the risk of regulatory enforcement and lawsuits filed against the client by investors. Significant time and expense can be incurred by the auditor in responding to regulatory investigations of clients. Investor lawsuits can also ensnare auditors. Depending on the jurisdiction in which the lawsuit is filed (generally governed by law of the states where the securities offering was made), significant damages may be recoverable from the CPA firm.
Auditors need not become experts in state securities laws as part of the engagement acceptance and continuance process. However, if a client or prospective client is planning a private placement offering or is asking the auditor to consent to include a previously issued audit report in related private offering materials, consider consulting with qualified legal counsel before moving forward.
The second part in this series discusses state tort laws, and how they impact professional liability risks for auditors.