GPSolo Magazine - September 2004
Intellectual Property Law
Responding to Audit Inquiry Letters After the Sarbanes-Oxley Act
A udit inquiry letters typically ask the same questions year after year. The first question asks you to list and describe all litigation, claims, and assessments, excluding unasserted ones, above some stated threshold of materiality. Most auditors also expressly ask for an evaluation of the likelihood and magnitude of an unfavorable outcome.
The second question asks you to list all unasserted claims and assessments considered to be probable of assertion that, if asserted, have a reasonable possibility of an unfavorable outcome. This is tricky. An unasserted claim may not even be known to the potential claimant. Your client hardly wants to put a footnote into its financial statements that calls attention to an unasserted claim. In fact, your client may be so paranoid about the possible unasserted claim that he or she does not even want you to mention it to the auditor. Remember, too, that there is no auditor-client privilege like the one clients enjoy with their lawyers. And finally, bear in mind that third parties will be reading the auditor’s report on the financial statements and will rely upon it, just as the auditor wishes to rely upon you.
The American Institute of Certified Public Accountants and the American Bar Association developed the “Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information” (the ABA-AICPA Treaty). Every lawyer who is called upon to prepare an answer to an audit inquiry letter should be familiar with it. The treaty applies in every case, whether the client is public or private.
The Sarbanes-Oxley Act (SOXA) applies to public, not private, companies. However, it is not likely that the revolution in standards of behavior that SOXA was intended to bring about will be limited to public companies. Conduct that Congress has endorsed will probably become the de facto standard of good conduct and best practices for lawyers and auditors, particularly if a judge or jury is asked to evaluate the lawyer’s or accountant’s behavior.
Section 303 of SOXA makes it unlawful for any person “acting under the direction” of a public company to “take any action to fraudulently influence, coerce, manipulate, or mislead” an auditor for the purpose of rendering the company’s financial statements materially misleading. The Securities and Exchange Commission has enacted rules in furtherance of Section 303 and has made it clear that the word “fraudulently” modifies “influence” but does not modify any of the other actions listed in Section 303.
What is the basic idea? Lawyers may properly respond to an auditor’s request for information concerning loss contingencies, as provided in the ABA-AICPA Treaty. The treaty seeks to balance the auditor’s need to know with the client’s entitlement to the attorney-client privilege. The lawyer reveals what he or she can, and, with respect to unasserted claims that the lawyer must keep confidential, the lawyer agrees to consult with the client about the application of relevant accounting literature to the determination of whether the unasserted matter calls for disclosure as a loss contingency. Loss contingencies include overtly threatened and pending litigation.
To the extent appropriate, a lawyer can indentify:
• the proceedings or matter,
• the stage of the proceedings,
• the claim(s) asserted, and
• the position taken by the client.
A lawyer should refrain from expressing judgments as to the outcome of the case or proceeding except in those relatively few clear cases where it appears that an unfavorable outcome is either probable or remote.
What if it appears that an unfavorable outcome is probable or remote? The rare case. If a lawyer can conclude that an unfavorable outcome is either probable or remote, the lawyer may communicate that view to the auditor. This should be done only after discussing with the client the potential legal consequences of the evaluation.
What if it appears that an unfavorable outcome is not probable or remote? The usual case. Where a lawyer does not conclude that an unfavorable outcome is either probable or remote, the lawyer need not and should not express a view.
What about saying, “We have not formed an opinion”? Such a statement might be characterized as misleading if the lawyer has in fact provided the client with a recent evaluation of the case. Appropriate language for the audit letter might say that because the lawyer has not formed an opinion that an unfavorable outcome is either probable or remote, the lawyer “declines to express an opinion” or simply “expresses no opinion” as to the likely outcome.
What about saying, “The case is in its early stages”? That comment is unnecessary under the treaty and potentially troublesome. The early stage of discovery is not a reason to be silent in the rare case where the lawyer has determined that an unfavorable outcome is either probable or remote. Similarly, the fact that substantial discovery has been undertaken does not suggest that a lawyer should express a judgment, unless the judgment is that an unfavorable outcome is either probable or remote.
What if the lawyer is asked about the amount of damages? The lawyer may do so only if he or she believes that the probability of inaccuracy of the estimate of the amount or range of potential loss is slight. In the vast majority of cases, the lawyer will not be able to meet this standard and should not express a view.
What if the lawyer is asked to speak to the auditor directly? This is a dangerous thing to do, especially in light of Sarbanes-Oxley’s express prohibitions against misleading auditors. There are no different rules applicable to oral communications with the auditor, and for that reason such communications, to the extent that they would be covered by the treaty if they were in writing, are to be particularly avoided. Oral communications present a danger of loss of the attorney-client privilege and make it difficult for the lawyer to argue that what is said is governed by the rules of the treaty.
When should the lawyer expect the client to “specifically identify” an unasserted possible claim? Where there has been no manifestation by a potential claimant of an awareness of and present intention to assert a possible claim or assessment, the client should request that the lawyer furnish the information to the auditor only if the client has determined that it is probable that a possible claim will be asserted, that there is a reasonable possibility that the outcome will be unfavorable, and that the resulting liability would be material to the financial condition of the client.
What if the auditor asks about all unasserted possible claims? It is not proper for the auditor to ask the lawyer to furnish information in response to an inquiry letter or supplement thereto if it appears that (a) the client has been required to specify unasserted possible claims without regard to the standard suggested above, or (b) the client has been required to specify all or substantially all unasserted possible claims as to which legal advice may have been obtained. In either case, such a request would be in substance a general inquiry and would be inconsistent with the intent of the treaty.
Dean F. Hanley is a partner in the Boston office of Foley Hoag LLP. He can be reached at email@example.com.
for more information about the Section of Intellectual Property Law
- This article is an abridged and edited version of one that originally appeared on page 10 of IPL Newsletter, Winter 2004 (22:2).
- For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.
- Website: www.abanet.org/intelprop/.
- Periodicals: IPL Chair’s Bulletin, a monthly update of Section activities and timely intellectual property issues; IPL Newsletter, a quarterly newsletter with current developments and Section news; Annual Report, a comprehensive summary of committee activities.
- Books and Other Recent Publications: Pamphlet series intended for clients, including Marketing Your Invention, Submitting an Idea, What Is a Patent?, What is a Trademark?, and What Is a Copyright? Extensive course materials in connection with CLE programs are also available.