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An accountant’s liability describes the legal liability assumed while performing professional duties. An accountant is liable for a client’s accounting misstatements. This risk of being responsible for fraud or misstatement forces accountants to be knowledgeable and employ all applicable accounting standards.

An accountant who is negligible in their examination of a company can face legal charges from either the company, investors, or creditors that rely on the accountant’s work. The accountant could also be responsible for the financial losses incurred from any incorrect representation of a company’s books. This possible negative scenario often leads to accountants taking out professional liability insurance.

Whether providing services as an accountant or auditor, a certified public accountant (CPA) owes a duty of care to the client and third parties who foreseeably rely on the accountant’s work. Accountants can be sued for negligence or malpractice in the performance of their duties, and for fraud.

Liability to clients

CPAs have an obligation to their clients to exercise due professional care. With an engagement letter, it provides the client and other third parties with rights of recovery. Therefore, if the CPAs are not performing within the agreement set forth in the contract this will be considered a breach of contract. The clients may also claim negligence against the CPAs if the work was performed but contained errors or was not done professionally. This is considered a tort action.

In order to recover from an auditor under common law negligence theory, the client must prove:

• Duty of care
• Breach of Duty
• Losses
• Causation

CPAs may defend against a breach of contract if they can prove that the client’s loss occurred because of factors other than negligence by the auditors. If the auditor proves the loss resulted from causes other than the auditor’s negligence, a client may be accused of contributory negligence. If a state follows the doctrine of contributory negligence, the auditor may eliminate their liability to the client based on contributory negligence by the client. Many states do not follow this doctrine. Most states permit a jury to assess the fault and apply the correct percentage of fault to the parties involved. This is called comparative negligence.

Rosenblum (foreseeable user) approach

The “reasonably foreseeable” approach which was created due to Rosenblum v. Adler. This method is very liberal and broad in terms of scope, unlike the privity approach. This system holds an auditor liable to all third parties that rely on financial statements.

Restatement of Torts (foreseen user) approach

The “foreseen” or “Restatement Standard” approach was established by the American Law Institute’s (ALI) Second Restatement of Law of Torts. With this approach the auditor is liable to all third parties in which their reliance is foreseen even if the auditor doesn’t know the third party. This approach came about due to Rusch Factors, Inc. v. Levin. In this case, the CPA was found accountable for ordinary negligence to the third party who had not been specifically identified but the CPA was aware that the financial statements were to be used by this party.

Ultramares (known user) approach

In order for the court to decide if the auditor’s duty actually extended to the third party, for ordinary negligence, there are four legal approaches each state could follow. First is the Privity approach, which states the auditor is liable to a third party if an existence of a contract is in existence. This approach was established in Ultramares Corporation v. Touche and is the most limiting approach in respect to scope. Ultramares occurred in 1933 where the defendant CPA distributed an unqualified opinion on the balance sheet of a company. In addition to the CPAs estimations, Ultramares wrote out several loans to the company shortly before the company declared bankruptcy. Ultramares sued the CPA for ordinary negligence. The New York Court of Appeals ruled that CPAs are held accountable for ordinary negligence to their clients and third parties who identify themselves as users of the CPAs reports.

Liability to third parties

Not all suits brought to an auditor are from a direct client. Third parties can also sue an auditor for fraud, in which case a contract (privity) is necessary. In order for a third party to prevail in a case, there are a number of things they must prove. First, the third party must prove that the auditor had a duty to exercise due care. Second, the third party must prove that the auditor breached that duty knowingly. Third, the third party must prove that the auditor’s breach was the direct reason for the loss. Finally, the third party must prove that they suffered an actual loss.

Statutory liability

Statutory law consists of written laws created by legislative bodies. Lawsuits brought against auditors based on statutory provisions differ from those under common law. Common law theories of liability may evolve or change over time, and interpretation and application may differ between jurisdictions, while statutory law is constrained to a greater degree by the text of the underlying statute.

Communications between an accountant and his client are, likewise, confidential; and, in some, but not all, states, are treated as privileged and may not be disclosed without the client’s permission. However, in many cases, they still may be disclosed under court order. THIS IS NOT THE SAME AS AN ATTORNEY/CLIENT PRIVILEGE. There is also a limited privilege for certain non criminal tax matters and work papers.

The Securities Act of 1933. Criminality under this act relates to the fiduciary duty of auditors acting in a professional capacity for publicly held companies. Before any business can register to sell stock, an audit of financial records and other legal disclosures must be performed by a CPA. In order to avoid criminal liability under the Securities Act, the auditor must report any fraud or other criminal activity to the company’s board or the SEC, in cases of severe financial crimes.

With regard to the sale of unregistered securities, it is not uncommon for an accountant to become involved in the business opportunity of a client and assume a role as a partner or salesperson of investment vehicles.

However, when this happens, it is an invitation for disaster, and the opportunity for bad endings expands exponentially. So, any relationship beyond the accountant/client one should be approached with great care.

As a small firm or sole practitioner, you may not have the resources in place that a large firm has or have a corporate lawyer to protect you. Common sense and experience are going to be your best defenses against criminal exposure. If a client seems shady or asks you to do something unethical, there’s no law saying you have to work for them. Keep in mind you can still be considered civilly negligent if irregularities escape your attention.

You can also avoid problems at the outset by drafting engagement letters for each client that clearly outline your duties, responsibilities and legal obligations. For added protection, most accountants carry liability insurance. Aside from a general liability policy any business owner should have, look into an Errors and Omissions policy or accounting crime insurance.

When reconciling accounts or preparing financial statements uncovers inaccuracies or suspicious activity, ask questions to determine if it’s just an oversight that’s easily rectified or an attempt to misrepresent income. Reluctance to provide requested information or avoidance of sensitive conversations may indicate the need to reevaluate your relationship with your client.

When you suspect your client is breaking the law and placing you in jeopardy, your first instinct may be to ask another accountant for advice. Be aware they also have a duty to report crimes, and they’re not bound by any sort of confidentiality. The same goes for family members or friends, who also might be drawn into legal trouble by having knowledge of a crime.

Your best defense is talking to a lawyer who handles criminal financial matters. They can advise you about how to proceed in order to minimize your legal exposure, and anything you tell them is completely confidential.

Looking the other way when a client is involved in shady activities will do more than just affect your professional reputation; it could cost you your professional certification or worse, your freedom.

As the accountant or auditor of record, you must be aware of financial crimes of your clients. Knowing what to look for and how to mitigate potential pitfalls will keep you in good stead with regulators and out of disastrous criminal proceedings.

“No potential legal hazard has so surprised and alarmed the public accounting profession as the spectre of criminal liability.” So wrote accounting scholars Paul Hooper and John Page in 1984. The exposure of accountants to the risk of criminal penalties is expanding.

In general, most criminal liability actions against accountants were brought under the federal securities laws, most notably under Sec. 24 of the 1933 Act and Sec. 32(a) of the 1934 Act. The Federal Mail Fraud Statute also is a principal source of criminal liability for auditors. Lately, the accounting profession is  concerned with suits brought under the Racketeer Influenced and Corrupt Organizations Act (RICO).

Both Secs. 24 (33 Act) and 32 (34 Act) make willful violations of any provision, rule, or regulation of the respective acts a crime. However, unlike Sec. 24, Sec. 32 uses the word “knowingly” in conjunction with “willfully.” Whether the two words are to be construed as synonymous is the subject of debate. However, regardless of whether these two terms are interpreted independently or together, it appears well settled that in a prosecution under either section, a specific intent on the part of the defendant to violate the law need not be shown. In a prosecution under the “willfully knowing” standard of Sec. 32(a), an evil purpose on the part of the defendant must usually be established.

Case law under the criminal provisions of the federal securities laws reveals a tendency toward increasing criminal liability for accountants. In United States v. Benjamin,10 the United States Court of Appeals for the Second Circuit held that an accountant cannot “shut his eyes” in the presence of fraud. Benjamin involved a prosecution against a certified public accountant who, after preparing pro forma statements relating to his client’s financial status, falsely reported that certain assets existed, when no procedures for verification or examination had been used. Responding to the argument that the evidence adduced at trial was insufficient to establish the defendant’s criminal state of mind, Judge

Friendly held that: The government may meet its burden by proving that a defendant closed his eyes to facts he had a duty to see… or recklessly stated as facts things of which he was ignorant .. . Congress .. . could have intended that men holding themselves out as members of .. . ancient professions should be able to escape criminal liability on a plea of ignorance when they have shut their eyes to what was plainly to be seen, or have represented a knowledge they knew they did not possess.

Supreme Court Standard 503, Lawyer-Client Privilege, says a client has a privilege to refuse to disclose, and to prevent others from disclosing, confidential communications made for the purpose of facilitating the provision of legal services to the client. The communications can be:

• Between the client or the clients representative and his or her lawyer or the client’s lawyer’s representative.
• Between the client’s lawyer and that lawyer’s representative.
• Made by the client and his or her lawyer representing another in a matter of common interest.
• Between representatives of the client.
• Between lawyers representing the client.

An attorney owes her client the duty to provide competent and diligent representation.

An attorney must know well-settled principles of law applicable to a case and discover what law can be found through a reasonable amount of research.

An attorney’s competence and diligence are judged against those of a reasonably competent general practitioner of ordinary skill, experience, and capacity, ups the attorney holds herself out as being expert in some area of law, in which case she is held to the higher standard of care expected of a reasonably competent expert practitioner in that area of the law.

Restatement Rule Section 552(2) of the Restatement (Second) of Torts extends the “Ultra mares Rule,” holding that accountants are also liable to third parties

• For whose benefit and guidance, the accountant intends to supply the information or knows that the recipient intends to supply it; or
• Whom the account intends the information to influence of knows that the recipient so intends.

Reasonably Foreseeable Users: A minority of courts hold accountants liable to any user whose reliance on the accountant’s report was reasonably foreseeable to the accountant at the time she prepared the report.

Due Diligence Defense: An accountant can avoid Section 11 liability if he can show that, after reasonable investigation, he had reasonable grounds to believe, and did believe, that the financial statements were true and complete at the time the accountant made them.

A case for applying attorney-client privilege to accountants can be made when

• An attorney-client relationship exists.
• An accountant is retained by the attorney.
• The accountant renders services that abet the provision of legal services.
• The parties do not waive the privilege.

Diversified standard, the attorney client privilege applies to an employees communications if

• The communication was made to get legal advice.
• The employee making the communication did so at the direction of his or her corporate superior.
• The superior made the request so the corporation could get legal advice.
• The subject of the communication is within the scope of the employees corporate duties.
• The communication was not shared with anyone other than those who, because of the corporate structure, needed to know its contents.

The Statute

The I.R.C. extends “the same common law protections of confidentiality . . . to a communication between a taxpayer and any federally-authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.” Remarkably, however, the privilege does not apply to the preparation of a tax return. That, of course, raises the question of what exactly it covers.

The privilege extends only to tax advice, which has been defined as advice given by a federally-authorized tax practitioner within the scope of their authority under 31 U.S.C.A. § 330. In this respect, it is important for practitioners to distinguish between the tax advice covered by the privilege, and general business or financial planning advice which is not covered by the privilege. Importantly, the privilege is not available where it is needed most: it cannot be used in a criminal proceeding. Nor can it be used in state court proceedings (such as a divorce or civil suit). It can only be asserted in a noncriminal tax proceeding before the IRS or in a noncriminal tax proceeding in federal court.

Exceptions

Even where it otherwise applies, there are two notable exceptions to this privilege. First, there is a crime-fraud exception. Where communication is made in furtherance of a crime or fraud, the communication may not be privileged. Another notable exception to the privilege is statutory. Under I.R.C. § 7525(b), any written communication “in connection with the promotion of the direct or indirect participation of the person in any tax shelter” is not privileged.

Statutory liability is a legal term meaning that someone can be held responsible for a specific action or omission because of a related law that is not open to interpretation. This is a generic term that can apply to any field, not just finance. Within the world of finance, it may apply to real estate transactions, stockholder obligations, or the behavior of a board member.

Statutory law consists of written laws created by legislative bodies. Lawsuits brought against auditors based on statutory provisions differ from those under common law. Common law theories of liability may evolve or change over time, and interpretation and application may differ between jurisdictions, while statutory law is constrained to a greater degree by the text of the underlying statute.

Types of Statutory Liability

The legal responsibilities of a company or individual can extend to a number of different types of statutory liabilities. Here are just a few examples.

Employee benefits liability: Companies can be held accountable should they fail to meet federal laws regarding employee benefits, such as health insurance.

Professional liability: A company that offers professional services (such as accountants, financial advisors, or lawyers) may be held liable should it be deemed they provided inadequate or erroneous advice or services.

Vehicle liability: Companies can be held responsible for property damage and medical bills should a company vehicle cause an accident.

Medical malpractice liability: Providers of healthcare services face malpractice liability should their omission or negligent act cause harm to a patient.

Media liability: Companies that violate media or advertising laws face potential lawsuits filed on behalf of the damaged party. An example of this would be a lawsuit for copyright infringement.

United States

The two most important laws relating to auditors’ liability are the Securities Act of 1933 and the Securities Exchange Act of 1934. CPAs must also be concerned with the application of the Racketeer Influenced and Corrupt Organizations Act (RICO) and with each state’s blue sky laws (which regulate the issuance and trading of securities within a certain state).

The Securities Act of 1933 requires a company to register with the Securities and Exchange Commission (SEC). In order to complete registration, the company must include audited financial statements and numerous other disclosures. If the registration statement was to be found materially misstated, both the company and its auditors may be held liable. Those who initially purchase a security offered for sale are the only ones protected by the 1933 Act. These security purchasers, known as the plaintiffs, only need to prove a loss was constant and that the registration statement was misleading. They do not need to prove that they relied upon the registration or that the auditors were negligent. In order for an auditor to avoid liability, they must provide proof that the audit was performed with due diligence, the plaintiff’s losses were not caused by misstated financial statements, the plaintiffs knew of the misstatement at the time the securities were purchased, or the statute of limitations had expired (one year after the discovery of the misstatement, but no more than three years after the security was offered to the public). The due diligence defense is the defense that most auditors raise, even though it is difficult for auditors to prove their innocence. The standing precedent on interpretation of due diligence is Escott v. BarChris Construction Corporation, decided in 1968.

The Securities Exchange Act of 1934 requires all companies under SEC jurisdiction to file an annual audit and have quarterly review of financial statements. While the 1933 Act creates liability only to those investors involved in the initial distribution of public offerings, the 1934 Act increases that responsibility to subsequent purchasers and sellers of the stock. This act provides absolute protection to original and subsequent purchasers and sellers of securities. These plaintiffs must prove that:

• There was a substantial loss.
• The financial statements were misleading.
• They relied upon the financial statements.

According to Ernst & Ernst v. Hochfelder, plaintiffs must show proof of scienter (the intent to deceive, manipulate, or defraud). In order to avoid liability, auditors must prove they are normally able to establish “good faith” unless they have been guilty of gross negligence or fraud. In addition, the auditors may rely on causation, meaning that the losses experienced by the plaintiffs were caused by factors other than the auditor’s behavior.

Racketeer Influenced and Corrupt Organization Act

In 1970, Congress established the Racketeer Influenced and Corrupt Organizations Act (RICO). This act was established as a means of making sure that CPAs who may have been involved with any illegal mob or racketeering activity were brought to justice. The RICO Act allows for triple damages in civil cases that were brought under the act. This later became an issue of liability in Reves vs. Ernst & Young. This was a significant court case, in that, the court decided that for accountants to be liable for damages of a company under this act, they must have participated in the operation or management of the organization. This also led to the Private Securities Litigation Reform Act which essentially eliminated securities fraud as a civil action under RICO unless prior conviction.

Criminal liability under the Securities Acts

The Continental Vending case (also known as United States v. Simon) has set the precedent of severe charges for accountants. In this case, the U.S. court of appeals convicted three CPAs of gross negligence. Although the CPAs had proof to establish that they complied with U.S. generally accepted accounting principles and the U.S. generally accepted accounting standards, Mano states that the district court judge instructed the jury that mere compliance with professional accounting standards was not a complete defense. This led to the conviction of the three CPAs, who were later pardoned by President Richard Nixon.

As the accounting standards and principles evolve, it is essential for those in regulation, of litigation and in the accounting profession to be aware of the principles and the potential risks affiliated with the system concerning liability. The Securities and Exchange Commission (SEC) along with the Public Company Accounting Oversight Board (PCAOB) have implemented consequences for those who are involved in auditing fraud and any other illegal or unethical behavior in the field. In 1995, the SEC established the Private Securities Litigation Reform Act which in essence mandated auditors to have even stricter guidelines as they pertains to any fraudulent or misleading behavior of their clients. This act simply states that the auditors must promptly report any illegal acts of its clients to the company’s board of directors and if severe enough, to the SEC. According to the guidelines of this Act, auditors are relieved of sanctions if they report required information about clients to the SEC in a timely manner.

All organizations in all industries have exposure to potential liabilities that may arise from investigations or court cases brought by regulatory bodies for alleged breach of statute. Statutory liability policies can cover liabilities that arise out of unintentional violations under a range of New Zealand laws. Some of those statutes include:

• Consumer Guarantees Act
• Building Act
• Fair Trading Act
• Health and Safety in Employment Act 1992 and amendments

Employment Regulations

The U.S. Department of Labor (DOL) administers and enforces more than 180 federal laws. These mandates and the regulations that implement them cover many workplace activities for about 150 million workers and 10 million workplaces.

Following is a brief description of many of DOL’s principal statutes most commonly applicable to businesses, job seekers, workers, retirees, contractors and grantees. This brief summary is intended to acquaint you with the major labor laws and not to offer a detailed exposition. For authoritative information and references to fuller descriptions on these laws, you should consult the statutes and regulations themselves.

Workers’ Compensation

If you worked for a private company or a state government, you should contact the workers’ compensation program for the state in which you lived or worked. The U.S. Department of Labor’s Office of Workers’ Compensation Programs does not have a role in the administration or oversight of state workers’ compensation programs.

The Longshore and Harbor Workers’ Compensation Act, administered by The Office of Workers Compensation Programs (OWCP), provides for compensation and medical care to certain maritime employees (including a longshore worker or other person in longshore operations, and any harbor worker, including a ship repairer, shipbuilder, and shipbreaker) and to qualified dependent survivors of such employees who are disabled or die due to injuries that occur on the navigable waters of the United States, or in adjoining areas customarily used in loading, unloading, repairing or building a vessel.

Workplace Safety and Health

The Occupational Safety and Health (OSH) Act is administered by the Occupational Safety and Health Administration (OSHA). Safety and health conditions in most private industries are regulated by OSHA or OSHA-approved state programs, which also cover public sector employers. Employers covered by the OSH Act must comply with OSHA’s regulations and safety and health standards. Employers also have a general duty under the OSH Act to provide their employees with work and a workplace free from recognized, serious hazards. OSHA enforces the law through workplace inspections and investigations. Compliance assistance and other cooperative programs are also available.

Wages and Hours

The Fair Labor Standards Act prescribes standards for wages and overtime pay, which affect most private and public employment. The act is administered by the Wage and Hour Division. It requires employers to pay covered employees who are not otherwise exempt at least the federal minimum wage and overtime pay of one-and-one-half-times the regular rate of pay. For nonagricultural operations, it restricts the hours that children under age 16 can work and forbids the employment of children under age 18 in certain jobs deemed too dangerous. For agricultural operations, it prohibits the employment of children under age 16 during school hours and in certain jobs deemed too dangerous.

The Wage and Hour Division also enforces the labor standards provisions of the Immigration and Nationality Act that apply to aliens authorized to work in the U.S. under certain nonimmigrant visa programs (H-1B, H-1B1, H-1C, H2A).

Employee Protection

Most labor and public safety laws and many environmental laws mandate whistleblower protections for employees who complain about violations of the law by their employers. Remedies can include job reinstatement and payment of back wages. OSHA enforces the whistleblower protections in most laws.

Unions and their Members

The Labor-Management Reporting and Disclosure Act of 1959 (also known as the Landrum-Griffin Act) deals with the relationship between a union and its members. It protects union funds and promotes union democracy by requiring labor organizations to file annual financial reports, by requiring union officials, employers, and labor consultants to file reports regarding certain labor relations practices, and by establishing standards for the election of union officers. The act is administered by the Office of Labor-Management Standards.

Employee Benefit Security

The Employee Retirement Income Security Act (ERISA) regulates employers who offer pension or welfare benefit plans for their employees. Title I of ERISA is administered by the Employee Benefits Security Administration (EBSA) and imposes a wide range of fiduciary, disclosure and reporting requirements on fiduciaries of pension and welfare benefit plans and on others having dealings with these plans. These provisions preempt many similar state laws. Under Title IV, certain employers and plan administrators must fund an insurance system to protect certain kinds of retirement benefits, with premiums paid to the federal government’s Pension Benefit Guaranty Corporation. EBSA also administers reporting requirements for continuation of health-care provisions, required under the Comprehensive Omnibus Budget Reconciliation Act of 1985 (COBRA) and the health care portability requirements on group plans under the Health Insurance Portability and Accountability Act (HIPAA).

Environmental Regulations

United States environmental law concerns legal standards to protect human health and improve the natural environment of the United States. While subject to criticism at home and abroad on issues of protection, enforcement, and over-regulation, the country remains an important source of environmental legal expertise and experience.

The United States Congress has enacted federal statutes intended to address pollution control and remediation, including for example the Clean Air Act (air pollution), the Clean Water Act (water pollution), and the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA, or Superfund) (contaminated site cleanup). There are also federal laws governing natural resources use and biodiversity which are strongly influenced by environmental principles, including the Endangered Species Act, National Forest Management Act, and Coastal Zone Management Act. The National Environmental Policy Act, governing environmental impact review in actions undertaken or approved by the U.S. federal government, may implicate all of these areas.

Federalism in the United States has played a role in the shape of national environmental legislation. Many federal environmental laws employ cooperative federalism mechanisms – many federal regulatory programs are administered in coordination with the U.S. states. Furthermore, the states generally have enacted their own laws to cover areas not preempted by federal law. This includes areas where Congress had acted in limited fashion (e.g., state site cleanup laws to handle sites outside Superfund) and where Congress has left regulation primarily to the states (e.g., water resources law).

The history of environmental law in the US can be traced back to early roots in common law doctrines, for example, the law of nuisance and the public trust doctrine. The first environmental statute was the Rivers and Harbors Act of 1899, which has been largely superseded by the Clean Water Act (CWA). However, most current major environmental statutes, such as the federal statutes listed above, were passed in the time spanning the late 1960s through the early 1980s. Prior to the passage of these statutes, most federal environmental laws were not nearly as comprehensive.

Silent Spring, a 1962 book by Rachel Carson, is frequently credited as launching the environmental movement in the United States. The book documented the effects of pesticides, especially DDT, on birds and other wildlife. Among the most significant environmental disasters of the 1960s was the 1969 Santa Barbara oil spill, which generated considerable public outrage as Congress was considering several major pieces of environmental legislation. (See Environmental movement in the United States.)

One lawsuit that has been widely recognized as one of the earliest environmental cases is Scenic Hudson Preservation Conference v. Federal Power Commission, decided in 1965 by the Second Circuit Court of Appeals, prior to passage of the major federal environmental statutes. The case helped halt the construction of a power plant on Storm King Mountain in New York State. The case has been described as giving birth to environmental litigation and helping create the legal doctrine of standing to bring environmental claims. The Scenic Hudson case also is said to have helped inspire the passage of the National Environmental Policy Act (NEPA), and the creation of such environmental advocacy groups as the Natural Resources Defense Council.

Environmental protection

Water

EI duPont de Nemours & Co. v. Train, 430 U.S. 112 (1977)

Friends of the Earth, Inc. v. Laidlaw Environmental Services, Inc. (2000)

Rapanos v. United States, 547 U.S. 715 (2006)

County of Maui v. Hawaii Wildlife Fund (2020)

Air pollution

Union Elec. Co. v. EPA, 427 U.S. 246 (1976)

Chevron USA v. Natural Resources Defense Council, 467 U.S. 837 (1984)

Massachusetts v. Environmental Protection Agency, 549 U.S. 497 (2007)

Rule 144, promulgated by the SEC under the 1933 Act, permits, under limited circumstances, the public resale of restricted and controlled securities without registration. In addition to restrictions on the minimum length of time for which such securities must be held and the maximum volume permitted to be sold, the issuer must agree to the sale. If certain requirements are met, Form 144 must be filed with the SEC. Often, the issuer requires that a legal opinion be given indicating that the resale complies with the rule. The amount of securities sold during any subsequent 3-month period generally does not exceed any of the following limitations:

• 1% of the stock outstanding
• The average weekly reported volume of trading in the securities on all national securities exchanges for the preceding 4 weeks
• The average weekly volume of trading of the securities reported through the consolidated transactions reporting system (nasdaq)

Notice of resale is provided to the SEC if the amount of securities sold in reliance on Rule 144 in any 3-month period exceeds 5,000 shares or if they have an aggregate sales price in excess of $50,000. After one year, Rule 144(k) allows for the permanent removal of the restriction except as to ‘insiders’. In cases of mergers, buyouts, or takeovers, owners of securities who had previously filed Form 144 and still wish to sell restricted and controlled securities must refile Form 144 once the merger, buyout, or takeover has been completed.

SIFMA, the Securities Industry and Financial Markets Association, issued “SIFMA Guidance: Procedures, Covenants, and Remedies in Light of Revised Rule 144” after revisions were made to Rule 144.

Rule 144A

Rule 144 is not to be confused with Rule 144A. Rule 144A, adopted in April 1990, provides a safe harbor from the registration requirements of the Securities Act of 1933 for certain private (as opposed to public) resales of restricted securities to qualified institutional buyers. Rule 144A has become the principal safe harbor on which non-U.S. companies rely when accessing the U.S. capital markets.

Regulation S

Regulation S is a “safe harbor” that defines when an offering of securities is deemed to be executed in another country and therefore not be subject to the registration requirement under Section 5 of the 1933 Act. The regulation includes two safe harbor provisions: an issuer safe harbor and a resale safe harbor. In each case, the regulation demands that offers and sales of the securities be made outside the United States and that no offering participant (which includes the issuer, the banks assisting with the offer, and their respective affiliates) engage in “directed selling efforts”. In the case of issuers for whose securities there is substantial U.S. market interest, the regulation also requires that no offers and sales be made to U.S. persons (including U.S. persons physically located outside the United States).

Section 5 of the 1933 Act is meant primarily as protection for United States investors. As such, the U.S. Securities and Exchange Commission had only weakly enforced regulation of foreign transactions, and had only limited Constitutional authority to regulate foreign transactions. This law applies to its own unique definition of United States person.

Civil liability; Sections 11 and 12

Violation of the registration requirements can lead to near-strict civil liability for the issuer, underwriters, directors, officers, and accountants under §§ 11, 12(a)(1), or 12(a)(2) of the 1933 Act. However, in practice the liability is typically covered by directors and officers’ liability insurance or indemnification clauses 4.

To have “standing” to sue under Section 11 of the 1933 Act, such as in a class action, a plaintiff must be able to prove that he can “trace” his shares to the registration statement and offering in question, as to which there is alleged a material misstatement or omission. In the absence of an ability to actually trace his shares, such as when securities issued at multiple times are held by the Depository Trust Company in a fungible bulk and physical tracing of particular shares may be impossible, the plaintiff may be barred from pursuing his claim for lack of standing.

Additional liability may be imposed under the Securities Exchange Act of 1934 (Rule 10b-5) against the “maker” of the alleged misrepresentation in certain circumstances.

The Securities Act of 1933, also known as the 1933 Act, the Securities Act, the Truth in Securities Act, the Federal Securities Act, and the ’33 Act, was enacted by the United States Congress on May 27, 1933, during the Great Depression and after the stock market crash of 1929. It is an integral part of United States securities regulation. It is legislated pursuant to the Interstate Commerce Clause of the Constitution.

The Securities Act of 1933 was created and passed into law to protect investors after the stock market crash of 1929. The legislation had two main goals: to ensure more transparency in financial statements so investors could make informed decisions about investments; and to establish laws against misrepresentation and fraudulent activities in the securities markets.

It requires every offer or sale of securities that uses the means and instrumentalities of interstate commerce to be registered with the SEC pursuant to the 1933 Act, unless an exemption from registration exists under the law. The term “means and instrumentalities of interstate commerce” is extremely broad and it is virtually impossible to avoid the operation of the statute by attempting to offer or sell a security without using an “instrumentality” of interstate commerce. Any use of a telephone, for example, or the mails would probably be enough to subject the transaction to the statute.

The act also known as the “Truth in Securities” law, the 1933 Act, and the Federal Securities Act requires that investors receive financial information from securities being offered for public sale. This means that prior to going public, companies have to submit information that is readily available to investors.

Purpose

The primary purpose of the ’33 Act is to ensure that buyers of securities receive complete and accurate information before they invest in securities. Unlike state blue sky laws, which impose merit reviews, the ’33 Act embraces a disclosure philosophy, meaning that in theory, it is not illegal to sell a bad investment, as long as all the facts are accurately disclosed. A company that is required to register under the ’33 act must create a registration statement, which includes a prospectus, with copious information about the security, the company, the business, including audited financial statements. The company, the underwriter and other individuals signing the registration statement are strictly liable for any inaccurate statements in the document. This extremely high level of liability exposure drives an enormous effort, known as “due diligence”, to ensure that the document is complete and accurate. The law bolsters and helps to maintain investor confidence which in turn supports the stock market.

Registration process

Unless they qualify for an exemption, securities offered or sold to a United States Person must be registered by filing a registration statement with the SEC. Although the law is written to require registration of securities, it is more useful as a practical matter to consider the requirement to be that of registering offers and sales. If person A registers a sale of securities to person B, and then person B seeks to resell those securities, person B must still either file a registration statement or find an available exemption.

The prospectus, which is the document through which an issuer’s securities are marketed to a potential investor, is included as part of the registration statement. The SEC prescribes the relevant forms on which an issuer’s securities must be registered. The law describes required disclosures in Schedule A and Schedule B; however, in 1982, the SEC created Regulation S-K to consolidate duplicate information into an “integrated disclosure system”. Among other things, registration forms call for:

• A description of the securities to be offered for sale.
• Information about the management of the issuer.
• Information about the securities (if other than common stock).
• Financial statements certified by independent accountants.

Exemptions

Not all offerings of securities must be registered with the SEC. Section 3(a) outlines various classes of exempt securities, and Section 3(b) allows the SEC to write rules exempting securities if the agency determines that registration is not needed due to “the small amount involved or the limited character of the public offering”.:398 Section (4)(a)(2) exempts “transactions by an issuer not involving any public offering”[14] which has historically created confusion due to the lack of a specific definition of “public offering”; the Supreme Court provided clarification in SEC v. Ralston Purina Co.:357

Some exemptions from the registration requirements include:

• Private offerings to a specific type or limited number of persons or institutions;
• Offerings of limited size;
• Intrastate offerings; and
• Securities of municipal, state, and federal governments.

Regardless of whether securities must be registered, the 1933 Act makes it illegal to commit fraud in conjunction with the offer or sale of securities. A defrauded investor can sue for recovery under the 1933 Act.

The Securities Exchange Act of 1934 (SEA) created to govern securities transactions on the secondary market, after issue, ensuring greater financial transparency and accuracy and less fraud or manipulation.

The Securities Exchange Act of 1934 (also called the Exchange Act, ’34 Act, or 1934 Act) (Pub.L. 73–291, 48 Stat. 881, enacted June 6, 1934, codified at 15 U.S.C. § 78a et seq.) is a law governing the secondary trading of securities (stocks, bonds, and debentures) in the United States of America. A landmark of wide-ranging legislation, the Act of ’34 and related statutes form the basis of regulation of the financial markets and their participants in the United States. The 1934 Act also established the Securities and Exchange Commission (SEC), the agency primarily responsible for enforcement of United States federal securities law.

Companies raise billions of dollars by issuing securities in what is known as the primary market. Contrasted with the Securities Act of 1933, which regulates these original issues, the Securities Exchange Act of 1934 regulates the secondary trading of those securities between persons often unrelated to the issuer, frequently through brokers or dealers. Trillions of dollars are made and lost each year through trading in the secondary market.

Securities associations

The ’34 Act also regulates broker-dealers without a status for trading securities. A telecommunications infrastructure has developed to provide for trading without a physical location. Previously these brokers would find stock prices through newspaper printings and conduct trades verbally by telephone. Today, a digital information network connects these brokers. This system is called NASDAQ, standing for the National Association of Securities Dealers Automated Quotation System.

Securities exchanges

One area subject to the ’34 Act’s regulation is the physical place where securities (stocks, bonds, notes of debenture) are exchanged. Here, agents of the exchange, or specialists, act as middlemen for the competing interests in the buying and selling of securities. An important function of the specialist is to inject liquidity and price continuity into the market. Some of the more well known exchanges include the New York Stock Exchange, the NASDAQ and the NYSE American.

Self-regulatory organizations (SRO)

In 1938 the Exchange Act was amended by the Maloney Act, which authorized the formation and registration of national securities associations. These groups would supervise the conduct of their members subject to the oversight of the SEC. The Maloney Act led to the creation of the National Association of Securities Dealers, Inc. the NASD, which is a Self-Regulatory Organization (or SRO). The NASD had primary responsibility for oversight of brokers and brokerage firms, and later, the NASDAQ stock market. In 1996 the SEC criticized the NASD for putting its interests as the operator of NASDAQ ahead of its responsibilities as the regulator, and the organization was split in two, one entity regulating the brokers and firms, the other regulating the NASDAQ market. In 2007, the NASD merged with the NYSE (which had already taken over the AMEX), and the Financial Industry Regulatory Authority (FINRA) was created.

Issuers

While the ’33 Act recognizes that timely information about the issuer is vital to effective pricing of securities, the ’33 Act’s disclosure requirement (the registration statement and prospectus) is a one-time affair. The ’34 Act extends this requirement to securities traded in the secondary market. Provided that the company has more than a certain number of shareholders and has a certain amount of assets (500 shareholders, above $10 million in assets, per Act sections 12, 13, and 15), the ’34 Act requires that issuers regularly file company information with the SEC on certain forms (the annual 10-K filing and the quarterly 10-Q filing). The filed reports are available to the public via EDGAR. If something material happens with the company (change of CEO, change of auditing firm, destruction of a significant number of company assets), the SEC requires that the company issue within 4 business days an 8-K filing that reflects these changed conditions (see Regulation FD). With these regularly required filings, buyers are better able to assess the worth of the company, and buy and sell the stock according to that information.

History of the Securities Exchange Act of 1934

The SEA of 1934 was enacted by Franklin D. Roosevelt’s administration as a response to the widely held belief that irresponsible financial practices were one of the chief causes of the 1929 stock market crash. The SEA of 1934 followed the Securities Act of 1933, which required corporations to make public certain financial information, including stock sales and distribution.

Other regulatory measures put forth by the Roosevelt administration include the Public Utility Holding Company Act of 1935, the Trust Indenture Act of 1934, the Investment Advisers Act of 1940, and the Investment Company Act of 1940. They all came in the wake of a financial environment in which the commerce of securities was subject to little regulation, and controlling interests of corporations were amassed by relatively few investors without public knowledge.

Exemptions from reporting because of national security

Section 13(b)(3)(A) of the Securities Exchange Act of 1934 provides that “with respect to matters concerning the national security of the United States,” the President or the head of an Executive Branch agency may exempt companies from certain critical legal obligations. These obligations include keeping accurate “books, records, and accounts” and maintaining “a system of internal accounting controls sufficient” to ensure the propriety of financial transactions and the preparation of financial statements in compliance with “generally accepted accounting principles.”

On May 5, 2006, in a notice in the Federal Register, President Bush delegated authority under this section to John Negroponte, the Director of National Intelligence. Administration officials told Business Week that they believe this is the first time a President has ever delegated the authority to someone outside the Oval Office.

To revoke a Subchapter S election/small business election that was made on Form 2553, submit a statement of revocation to the service center where you file your annual return.

The statement should state:

• The corporation revokes the election made under Section 1362(a)
• Name of the shareholders
• Address of the shareholders
• Taxpayer identification number of the shareholders
• The number of shares of stock owned by the shareholders
• The date (or dates) on which the stock was acquired
• The date on which the shareholder’s taxable year ends
• The name of the S corporation
• The S corporation’s EIN
• The election to which the shareholders revokes
• The statement must be signed by the shareholders under penalties of perjury
• Signature and consent of shareholders who collectively own more than 50% of the number of issued and outstanding stock of the corporation, (whether voting or non-voting)
• Indication of the effective date of the revocation (or prospective date)
• Signature of person authorized to sign return

Due Date of Revocation:

• If revoking effective the first day of the tax year, the revocation is due by the 16th day of the third month of the tax year,
• If revoking effective any day other than the first day of the tax year, the revocation must be received by IRS by the requested effective date.
• For example, the S corporation is on a December 31 tax year ending and requests a revocation effective January 1, the revocation is due March 15.
• The S corporation is on a December 31 tax year ending and requests a revocation effective February 14, the revocation is due February 14.

Revoking the S election

To voluntarily terminate its S status, a corporation may file a revocation for any of its tax years, including the first tax year for which the election is effective (Sec. 1362(d)(1)(A)).

The revocation is made by a corporation in the form of a statement filed with the IRS Service Center where the corporation properly filed its S election, Form 2553, Election by a Small Business Corporation. The statement should be signed by a person authorized to sign Form 1120S, U.S. Income Tax Return for an S Corporation, (i.e., a corporate officer) and must provide (Regs. Sec. 1.1362-6(a)(3)):

• The number of shares of stock, including nonvoting stock, outstanding at the time the revocation is made.
• That the corporation is revoking its election under Sec. 1362(a) to be taxed as an S corporation.
• The effective date of the revocation, if it is to be a prospective revocation.

Basis measures the amount that the property’s owner is treated as having invested in the property. At the start of the investment, this is the property’s cost. But in the S corporation context, basis can become a moving target as a shareholder’s investment in the company changes. Unlike with C corporation stock basis, which stays the same each year, annual income, distributions and loans can all affect an S corporation shareholder’s basis, in sometimes surprising ways.

Calculating the S corporation shareholder’s basis correctly is important because it measures the amount the shareholder can withdraw or receive from the S corporation without realizing income or gain. The shareholder’s basis should reflect the shareholder’s economic investment in the corporation. Basis adjustments should be made at the end of each taxable year, taking into account income, distributions and deductions and losses in the right order.

Importance of Stock Basis

It is important that a shareholder know his/her stock basis when:

• The S corporation makes a non-dividend distribution to the shareholder.

In order for the shareholder to determine whether the distribution is non-taxable they need to demonstrate they have adequate stock basis.

• The S corporation allocates a loss and/or deduction item to the shareholder.

In order for the shareholder to claim a loss, they need to demonstrate they have adequate stock and/or debt basis.

• The shareholder disposes of their stock.

As with any asset, including S corporation stock, when the asset is sold or disposed of, basis needs to be established in order to reflect the proper gain or loss on the disposition.

Since shareholder stock basis in an S corporation changes every year, it must be computed every year.

Computing Stock Basis

In computing stock basis, the shareholder starts with their initial capital contribution to the S corporation or the initial cost of the stock they purchased (the same as a C corporation). That amount is then increased and/or decreased based on the pass-through amounts from the S corporation. An income item will increase stock basis while a loss, deduction, or distribution will decrease stock basis.

Debt must meet two requirements to qualify as S corporation basis. First, the debt must run directly from the shareholder to the S corporation. Second, under Regs. Sec. 1.1366-2(a)(2), the indebtedness must be bona fide. Whether indebtedness to a shareholder is bona fide is determined under general federal tax principles and depends upon all the facts and circumstances.

The IRS adopted these “bona fide debt” provisions on July 23, 2014, when it issued final regulations providing guidance regarding basis for S corporation loans (T.D. 9682). Rather than adopt a judicial doctrine of an “actual economic outlay” that leaves the shareholder “poorer in a material sense,” the regulations adopted provisions for determining whether a shareholder is entitled to debt basis under Sec. 1366(d)(1)(B).

Regs. Sec. 1.166-1(c) defines a bona fide debt as arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money. Courts have looked to the intent of the parties at the time the loan is made to verify a debtor-creditor relationship. The shareholder must have a real expectation of repayment and intent to enforce collection efforts against the S corporation in the event of a default on the loan.

Items of Adjustment

A good way to explain stock basis to clients is to compare it to a checking account. Basis is deposits and earnings less withdrawals. Like a bank account, more cannot come out than goes in basis can never go negative. Since basis begins when the company stock is acquired, basis should be tracked from day one. Updating basis each year is a straightforward process, and it can be calculated manually or by using tax preparation software. The extra few minutes it takes to update basis annually are well worth the headaches they will save down the road.

Initial basis is generally the cash paid for the S corporation shares, property contributed to the corporation, carryover basis if gifted stock, stepped-up basis if inherited stock, or basis of C corporation stock at the time of S conversion. Common basis increases include capital contributions, ordinary income, investment income and gains; common decreases include Sec. 179 deductions, charitable contributions, non-deductible expenses and distributions.

Basis adjustments are normally calculated at the end of the corporation’s taxable year. First, they are increased by income items; then decreased by distributions; and, finally, decreased by deduction and loss items. The order is important because, if basis is positive before distributions but would be negative if all deduction items were subtracted (however, again, basis cannot be negative), then the excess loss is suspended rather than the excess distributions being taxable.

Reconstructing Basis

Reconstructing basis is not difficult procedurally. The difficult part is tracking down all company Schedules K-1 and capital contribution records since the stock was acquired (often the day the company opened its doors). Re-creating basis for a company that opened last year is easy. Taking on the task for a company that opened in 1965 is not easy, but it may be necessary. Once all records are gathered, the process requires accumulating annual increases and decreases from inception to the present year. Retaining supporting documentation is necessary in case of an IRS inquiry.

 If a company has been tracking basis, that doesn’t necessarily mean the numbers are correct. Basis schedule for a company that had the wrong capital contribution entered for the initial year, even though the schedule had been updated annually. The calculation had been reviewed annually for changes and continuity, but when the company decided to make a large distribution, the basis schedule indicated the distribution was taxable, and in this situation a taxable distribution didn’t make sense. The age-old adage of “garbage in, garbage out” holds true for basis schedules.