CHAPTER 1

LEGAL PROCESS OVERVIEW AND TORTS

I. INTRODUCTION TO HISTORY OF LEGAL DEVELOPMENT

    Welcome to Volume 3 of the Rigos CPA Review. This volume covers all the legal and taxation concepts tested on the Regulation portion of the AICPA Uniform CPA examination. The Rigos text distributes these topics over 9 chapters of learning modules. Each module has 3 sections, which address subjects that are common and/or are combined in exam questions. The business law topics will only be tested via multiple-choice questions in 2004.

II. HISTORY OF THE AMERICAN LEGAL SYSTEM

    Law may be defined as that body of rules that can be enforced through legal procedures. This section of the preface to the text covers the historical development of our legal system. Greek, Roman and English law have all contributed to the current U.S. legal system. Certain elements common to all types of legal actions are discussed to gain a foundation for the subjects covered later in detail.

    A. Early Development

        1. The Greek Merchant Empire: Homer, Aristotle, and other ancient authors tell of a hundred independent Greek city states which banded together to create a merchant trading empire.

            a. Trading Procedures Formalized: Rudimentary legal forms and trading procedures developed to facilitate the commercial success of the trading Empire. Accompanying the commercial achievements was the development of a rich society that was a pioneer in the modern intellectual-legal development process.

            b. Individual Justice and Freedom: Greece has long been revered as the "cradle" of Western civilization and Athens is the birthplace. The Golden Greek philosophers dealt extensively with the concept of individual justice and personal freedom. This was the birthplace of trial by a jury of one's peers. Parties represented themselves in a courtroom; there were no paid advocates.

        2. The Roman System: The Roman Empire in around 450 B.C. emerged as the successor to the Greek philosophers. Rome -- the Eternal City -- colonized what was then the known civilized world. Rome's influence quickly spread through most of present-day Europe.

            a. Military Campaigns: Caesar books IV and V recount the campaigns into Gaul and Normandy to conquer and spread the Roman legal system and Latin written language. The papal or canon legal equitable procedures began in the first century. This was the genesis of equity. This period also saw the birth of double-entry bookkeeping.

            b. Property and Contracts Foundation: Property conveyancing documents and the law of contracts were perfected. In the third century B.C. a class of jurists made law their professional specialty.

            c. Legal Professionals: This was the birth of the group of advocates allowed to speak on behalf of a client. The ability to spellbind a judge or a jury was developed and perfected by Cicero and other orators.

            d. Justinian Code and Digest Corpus: In the fifth century, the Justinian Code was compiled. The Digest Corpus Juris Civilis was the first systematic categorization of the law and the predecessor to the modern English reporting system. When Rome fell, there was a temporary dark age in the advancement of modern civilization. A distant island north of Europe led us forward.

    B. English Common Law

        1. Anglo-Saxon and Norman Influence: In the fifth and sixth centuries Low German tribes invaded the island of England and established the Anglo-Saxon Crown. Anglo-Saxons continued as the ruling power of Britain until the Norman invasion in 1066. William the Conqueror set about colonizing the island and installing a dispute resolution system that became common to all the municipalities of England.

        2. Industrial Revolution and British Colonization: Between the 13th and the 18th centuries, the English laws developed to a rather sophisticated level of organizational excellence. The Industrial Revolution provided many opportunities. Fortunately, the British merchants early adopted proper accounting systems; the economic empire flourished and expanded. It was English savvy aided by a superior naval empire which established and civilized much of the modern world.

        3. Common Law Development: Civil court rules and procedures were perfected. Equity developed through the Chancellory, which expanded Roman canon law. The English barrister-solicitor distinction has become blurred in the American advocacy system. The principles of consistency and predictability have been retained.

    C. Modern American Legal System

        1. English Origin: The English common law and judicial dispute resolution system was adopted with very few changes by the framers of our 1776 Declaration of Independence. British court procedures, which had proven a durable way to resolve civil disputes, were retained.

            a. Checks and Balances: The American founding fathers adopted a national constitution which established a system of broad principles. Federal government power was made subject to a checks and balances system among the executive, two-house legislative and independent judicial branches. The U.S. Supreme Court became the final arbiter of disputes and the rule of law.

            b. State Rights: Federal power was limited by giving the states broad jurisdictional rights. This includes the responsibility for initiating and enforcing their own statutory framework and legal procedures. Disputes between citizens of a state should be decided by that state's court system.

            c. Jury Trial: Citizens have a right to a jury trial of 12 citizens. American law is therefore a close cousin to the British system.

        2. Bill of Rights: The first constitutional amendments were passed in 1791.

            a. Individual Personal Freedom: They were intended to grant the individual maximum personal political, economic, and religious freedom.

            b. Due Process of Law: The government must observe due process of law in dealing with citizens. The protections in the Bill of Rights have been greatly expanded by interpretations from the judicial branch.

            c. Private Ownership of Resources: The American founding fathers also intended to instill a policy favoring private ownership of resources and freedom of political expression. Subsequent constitutional amendments have added other individual freedoms and rights.

III. COMMON LEGAL CONCEPTS

    A. Monetary and Equitable Relief

        1. Monetary Damages: The British Crown established the King's Bench or Court in the thirteenth century. The King's Court could only provide a remedy expressed in money. Often this proved to be inadequate and/or inequitable, therefore a right of appeal to the King's Chancellor developed. Since the Chancellory was staffed by churchmen educated in canon law, they based their decisions upon Roman canon law principles of equity.

        2. Equitable Remedies: At common law there were many cases where a plain, adequate or complete monetary remedy at law was not possible. The equitable forum operated by the Chancellory had the power of the Church of England to enforce its decisions; it grew at such a rate that the King's Court began to lose influence. A merger of the two adjudication processes occurred; now in both England and the United States a judge can order a legal and/or equitable remedy. Equitable remedies include non-monetary relief such as specific performance and injunctions.

    B. "Stare Decisis" or Precedent

    "Stare decisis" or precedent is often referred to as a judicial source of law. Legal consistency and therefore predictability are of primary importance to any system of law enforcement. The doctrine of precedent has helped shape a unified body of legal principles.

        1. Concept: When a court in a particular jurisdiction has made a decision regarding the application of a given legal principle to a given fact pattern a precedent is established. In every similar subsequent decision by the same court in the same jurisdiction, the same conclusion should result. The judge is supposed to follow the precedent of the previously decided cases. The precedence set by higher courts are to be followed by courts at a lower level.

        2. Advantages: This doctrine promotes a body of controlling principles that can be categorized and annotated. The outcome of commercial transactions thus becomes subject to prediction.

    C. Statutory Law

        1. National Model or Uniform Statutes: The American Bar Association (ABA), through the American Law Institute (ALI) and the National Conference of Commissioners on Uniform State Laws has drafted a number of model or uniform statutes and codes. Most CPA exam questions cover either a federal statute or the state variety of the ALI's model statute. Such statutes as the Uniform Commercial Code (UCC), Revised Model Business Corporation Act (RMBCA), Uniform Partnership Act (UPA) are often adopted by a state without significant changes.

        2. State Statutes Control: The citizens elect state representatives and instill in them the power to create statutory laws which control parties, activities and transactions within the state. This includes constitutions, treaties, statutes, and ordinances passed by legislative bodies. Most of the controlling commercially-oriented laws are thus state statutes. Such a statute would apply to a contract executed in the state or damages which occur in the state.

        3. Statutory Law Powers: Statutory law supersedes and overrides common law if there is a different treatment. In addition, a statute fills in the blanks where the parties fail to specify the treatment of an item.

    D. Parties and Procedures

    There are two parties to every legal action; a plaintiff (P) and a defendant (D).

        1. Plaintiff (P): The P brings the lawsuit against D and chooses the cause of action or legal theory of recovery. But, the P also has the burden of proof to meet each and every required element of their cause of action. The general rule is that P must produce a quantum of evidence at trial that meets a mere preponderance standard. This means that the evidence showing on every required element must more likely than not favor the P (51+%).

        2. Defendant (D): The D is the party being sued. To win the case, the D only has to prevail on one essential element of P's case. But if the D counterclaims against P, they assume the burden of proof on each element in that cause of action.

IV. FEDERAL CRIMINAL LAW

    Criminal law is not tested on the CPA exam except in a few narrow subjects listed below. However, it is an area you can discuss for possible discretionary points. The government is the P. A citizen must convince the US attorney, or appropriate regulatory agency that they should charge the D with a violation of the statute. A federal statute defines the elements of the proscribed act, the degree of offense, and penalty range the judge must impose.

    To convict a defendant, the Government must present evidence beyond a reasonable doubt (90+%). This is a higher burden than the civil mere preponderance standard. The CPA exam tests three federal criminal areas as follows:

    A. 1933 and 1934 Securities and Exchange Commission Acts

    These statutes have fraud provisions which authorize criminal sanctions of up to five years imprisonment and $10,000 fine. To sustain such a penalty against a CPA, the government must show a willful and knowing falsification or omitted material facts in a registration statement or prospectus. Further, the CPA must have had actual knowledge of the misrepresen­tation or omission. This willful intention requirement must go beyond negligence or carelessness.

    B. Federal Criminal Activities

    Racketeers Influenced and Corrupt Organizations Act (RICO) is intended to curb inroads by organized crime into legitimate businesses. The civil penalties include triple damages. Criminal penalties are also possible for violations of the Foreign Corrupt Practices Act.

    C. Internal Revenue Service (IRS) Regulations

    Criminal taxation penalties may apply to a CPA's tax practice in extreme circumstances. Up to five years imprisonment and up to $100,000 fine per individual or $500,000 per corporation return can be imposed under authority of Internal Revenue Code (IRC) sections 7201 through 7216. Included are offenses that are generally considered to go beyond negligence. Willful attempt to evade tax and willful failure to pay over are of primary significance. Willful failure to file, fraudulent statements, withholding exemption certificates, failing to obey a summons, and interference with the administration of internal revenue laws are all subject to potential criminal penalties.

V. STATE CRIMINAL STATUTES

    State criminal statutes are not usually directly tested on the CPA exam, but a probative discussion may get the candidate discretionary grading points on an essay question. The P is the state attorney general or a county prosecutor. Possible areas include:

    A. "Blue Sky" Securities Fraud

    State "blue sky" laws control a sale of securities within one state. Fraudulent security offerings which have no value other than "blue sky" are prohibited. A state agency regulates such sales. Such statutes usually provide that criminal and civil penalties may apply to a CPA who is associated with fraudulent offerings. This may include a CPA's opinion on materially false financial statements included in a prospectus, offering circular or other documents connected with a security offering.

    B. Theft or Larceny

    Theft or larceny is defined in most states statutes as the obtaining or exerting control over another's property by color or aid of deception. Exam fact patterns include a dishonest CPA, agent or employee, negotiable instrument defense, or stolen collateral in a secured transaction question. The degree and penal institution sentence range a court can impose is defined in the statute. First degree theft often requires the value of the stolen items to exceed $1,500 or that the stolen item be taken by force or fear. Below $250 in value is usually theft in the third degree. Notice that this is a criminal action to be undertaken by the public prosecutor. A victim may also sue the thief seeking replevin of the stolen good and/or damages.

    C. State Criminal Conspiracy

    Conspiracy is defined as “a willful agreement by three or more people to engage in or cause the performance of a crime.” The crime usually requires a substantial step be taken to strongly corroborate the actor's criminal purpose. This crime might apply to a CPA who gets too close to illegal conduct.

    D. Other Accounting Related Statutes

    Most states have enacted statutes with potential criminal liability to CPAs for such offenses as willfully making or certifying to fraudulent or false financial statements. If such a statement is used to obtain credit or property, the willful intent may be imputed. Again, the facts and circumstances must be generally considered to go beyond negligence.

VI. INTRODUCTION TO TORTS

    A. Definition

    A "tort" is a civil wrong.

        1. Privity not Required: While the law of contracts governs the agreements reached between specific parties with privity, tort actions address breaches of obligations due third parties and society. Privity is not usually required for P to bring a tort-based lawsuit.

        2. Focus on Elements: The CPA exam testing emphasis is focused on the elements of the tort.

    B. Joint and Several Liability

    If two or more Ds cause indivisible harm by their tortious conduct each is jointly and severally liable for the full amount of the damages. The injured party may seek a full recovery of all damage from any one of the Ds (even if they were only 10% at wrong).

VII. FRAUD OR MISREPRESENTATION -- FIRD

    Misrepresentation, deceit or fraud in the inducement occurs when a person is mislead by a false statement which causes P to suffer damages. Fraud appears in exam questions covering the subjects of contracts, sales, negotiable instruments, agency, corpora­tions, and accountant's liability. The required four elements are abbreviated by the memory ladder/acronym FIRD.

    A. False Statement

    False statement of a material fact made by D with actual or constructive knowledge of its falsity.

        1. Materiality: The importance of the fact to P determines the materiality.

        2. Non-Facts: Opinion, puffing or sales talk, general value or quality do not usually rise to the level of a misstatement of fact. Detailed, specific allegations are more likely to be considered material facts than general assertions and words such as "good value" or "great opportunity."

    B. Intention

    Intention by D that P act upon and be mislead by the false statement. This intention to deceive or defraud is frequently referred to on the CPA exam as "scienter." Scienter may be imputed in the right fact pattern on the basis that a person intends the natural and probable consequences of a grossly or wantonly negligent act. This may apply where there is a reckless disregard for the truth. This element - intention - is the principle difference between fraud and negligence.

    C. Reliance

    Reliance by P which was justifiable.

        1. "In Fact": Did the P in fact rely upon the D's statement?

        2. Reasonable Person Test: Would a reasonable person under similar facts and circumstances have relied on the D's statement. A P who makes their own investigation may have trouble meeting this element.

    D. Damages

    Damages sustained by the P must be material. The majority of states follow the "benefit of the bargain" rule (awarding the dollar result the P would have received had his expectation been met) as opposed to the "out-of-pocket" minority view (actual detriment incurred). Damages can't be too speculative. Fraud is never presumed under the common law, and the burden of proof is on P.

    E. Clear, Cogent and Convincing Evidence

    Because a holding of fraud in a court decision reflects adversely upon a D's integrity and character, the quantum of evidence proof which P must demon­strate is clear, cogent, and convincing. This means the evidence must be more than a mere preponderance (51%) - which is the usual civil standard, but less than beyond a reasonable doubt (90%) - which is the usual criminal standard.

VIII. FRAUDULENT CONCEALMENT

    A. Act of Omission

    Fraudulent concealment is an act of omission rather than commission such as in express misrepresentation. Liability is imposed on a seller for failing to disclose to the purchaser a defective condition that is serious or substantially reduces the value of the property. This may override the common law rule of "caveat emptor" (let the buyer beware). A frequent fact pattern is that the D said nothing but had actual knowledge of an omission or defect that would injure the P or materially effect the property's value. Restatement of Torts 551(1) imposes the same liability on such a seller as though he had repre­sented the nonexistence of the matter that he concealed.

    B. Duty to Speak

    If the matter is material, the law may impose a legal duty to speak and make minimal disclosures. Knowledge of a hidden or latent defect may create this duty. A CPA must make financial statement disclosure of a pending law suit in excess of net worth.

    C. Damages

    Because there is no statement, it may be difficult to prove express "scienter." Thus, damages must generally be more significant than in fraud.

    D. Remedies

    The requested remedy is normally to rescind the transaction. This returns the parties to their pre-bargain position. Some states allow money damages in an amount that the property value without the defect would have exceeded the actual value.

IX. NEGLIGENCE -- ABCD+C

    Negligence is a major exam question area. Often the setting is a CPA's negli­gence where the action may be termed negligent misrepresentation. Other areas covered less frequently include negligent conduct by a corporate Board of Directors, employee/agents, or a trustee of a trust. The five required elements are abbreviated by the acronym ABCD+C.

    A. A Legal Duty

    A legal duty of D to use reasonable "due" care to protect others from risk or conform to recognized standards of conduct. The question is whether the D acted as a reasonably prudent person under the circumstances. The standards of conduct applied will depend upon the D's skill or work category. A professional such as a CPA is held to the standard of a reasonable CPA. Expert opinion testimony regarding the relevant standards of performance establish the duty criteria for the jury.

    B. Breach

    Breach of duty or failure to conform to the required "reasonable" standard. This is a question for the trier of fact. Breach may be shown by direct evidence of specific acts or omissions or by circumstantial evidence. The decision may examine the conduct and weigh the likelihood and severity of potential injury against the cost of making it perfectly safe. The doctrine of "res ipsa loquitur" imputes liability where the event causing the damages would not ordinarily occur in the absence of someone's negligence and the opera­tive instrumentality was under the D's control.

    C. Causation

    Causation relationship between the D's conduct and the resulting damages. The P must rely on the D's performance and make two showings.

        1. But For Test: First, that "but for" the D's lack of care, the damages would not have resulted. This is also called "cause in fact."

        2. Proximate Cause: Second, that the legal principle of "proxi­mate or legal cause" is met. The D's negligence must be a "substantial factor" in causing the P's injuries and normal reactions to D's negligence are included. A proximate cause cannot be too remote or indirect, and the causal chain cannot be broken by new unforeseen independent causes which intervene unexpectedly. One exam question covered a fact pattern in which the client changed the numbers on a financial statement which had been certified by the CPA. The bank was suing the CPA firm because of a small, negligent omission in their audit procedure. The client's wrongful action was an unforseeable intervening cause sufficient to break the casual chain and thus superseded the accoun­tant's negligence.

    D. Damages

    Damages must be present and material. Nominal damages are not sufficient. It must have been foreseeable by a reasonable person in the position of the D that such harm would flow from the negligent conduct. Consequential damages, such as lost profits, may be recovered if it was foreseeable they would occur as a consequence of the negligent conduct. CPA exam questions have posed facts where the magnitude of the damages was not foreseeable, such as the loss of a large contract profit flowing from a telegram that was not delivered. P's evidence burden is a mere preponderance.

    E. Comparative Negligence

    Comparative negligence is a partial defense that is allowed in most states. Some states call this doctrine contributory negligence or contributory fault. A P must also exercise due care to avoid injury to himself. If P is also negligent, the court will diminish the damages in proportion to the percen­tage attributable to the P's fault. Suppose a CPA firm performed an audit upon which the bank partially relied. The bank also made its own independent credit investigation before making the loan and also failed to discover the irregularity. The bank's recovery will not be 100 percent of their loss. If the bank were 25 percent comparatively negligent, they would recover only 75 percent of their loss from the auditor.

X. STRICT LIABILITY

    A. Abnormally Dangerous

    One who engages in an abnormally dangerous business activity is subject to liability even though reasonable care has been exercised to prevent such harm. A seller and/or manufacturer of an item that is inherently dangerous is strictly liable if the defective product reached the consumer without substantial change in the condition in which it was sold. The P does not have to prove negligence. This category includes poisons, explosives, flammable liquids, aerial crop dusting, blasting, power tools and food or drink. Also included in this category is an owner of an animal with vicious or dangerous propensities. (See Chapter 3.1 for more details)

    B. Design or Manufacturing Defects

    A design defect involves products that are improperly planned while a manufacturing defect involves products that are properly designed but not made according to plan. Strict liability is imposed on design defects because it is usually impossible for P to prove the D's negligence.

    C. Privity Not Required

    Usually privity of contract is necessary for a buyer to sue a seller. However, in the situation of the manufactured goods, the item may have passed through many hands. Privity is deemed to be adequate in product liability cases if the seller reasonably could have foreseen that this type of consumer would be injured by the good.

    D. Worker's Compensation

    Strict liability is imposed on employers under worker's compensation for employee injuries sustained while acting in the course of employment. Exceptions to coverage are injuries intentionally self-inflicted or received in the course of committing a crime. (See Chapter 6.3 for details)

XI. CONVERSION

    The wrongful exercise of dominion and control over another person's property is a tort. The tort feasor may also be guilty of the criminal offense of theft. The dollar amount determines the degree (first, second, or third degree theft). Conversion exam question settings include secured transactions, negoti­able instruments, and agency.

XII. INTERFERENCE WITH CONTRACT OR BUSINESS EXPECTANCY

    There have been a few multiple-choice questions from this area. The factual settings include a competitor interfering with an employer/employee contract, interference with a principal/agent relationship and a CPA interfering between an attorney and his client.

    A. Elements of the Tort

    The ALI's Restatement 2d of Torts 766 specifies that the intentional third-party interference with a valid contractual relations or business expectancy constitutes an actionable tort. A person has a right to pursue valid contractual and business expectancies unmolested by wrongful and officious intermeddling. The interferer must have knowledge of the relationship or expectancy; thus unintentional or indirect interference are not usually actionable. There must be damages. Calbom v. Knudtzon, 65 Wa. 2d 157, 396 P. 2d 148 (1964) held that a CPA, who convinced the client to fire an attorney that the CPA disliked, was liable for the fee the attorney would have earned on the engagement.

    B. Privilege

    The D's interference with a valid contractual relationship may be privileged. The burden of showing privilege for interference rests with the interferer. The basic test is whether, under the facts and circumstances of the particular case, the interferer's conduct is justifiable. Some of the privileges which have been legally recognized include legitimate business competition, the giving of requested advice and a financial interest in the contract.

XIII. DEFAMATION

    Defamation has been occasionally questioned on the exam. The three required elements are (1) a false statement (2) publicized to a third person (3) with the wrong­ful intention to expose any person to public hatred, contempt, or ridicule.

    A. Types

    "Slander" is spoken defamation, while "libel" is printed or written defamation. Defamation "per se" applies if the P is injured in his trade or business. A "per se" violation entitles P to substantial damages without proof of pecuniary loss. Defamation against a public figure requires malice.

    B. Immunities and Defenses

    Statements made in judicial or legislative proceedings are given an absolute privileged immunity against suit. While truth is an absolute defense, a private P does not have a burden to show falsity; it is presumed from a clearly defamatory statement.

    C. Exam Questions

    Exam questions have included outrageous, unsupported statements made by a CPA firm in a newspaper article about their competitors. The statements reflected upon the P's integrity of character and competency to practice public accounting.

XIV. TRESPASS AND PRIVILEGE

    Trespass is the entering or remaining on land of another without permission or a valid legal privilege. A privilege excusing trespass is allowed if the entry is necessary, such as preventing an imminent public disaster. A trespasser in fresh pursuit of stolen chattels is also allowed a privilege. Likewise, a creditor executing upon a valid security agreement has a limited privilege. The entering must be reasonable under the circumstances as to time and extent, and not involve a breach of the peace. This use of excess force during the repossession process is not allowed.