Ethical and liability risks in auditor response letters.

• Author: Allen, John W.

Your client writes a letter, asking you to send to its auditor information about certain types of loss contingencies, such as litigation and unasserted claims. As you draft a response, you are entering a minefield, thick with issues relating to waiver of privilege, terms of art such as "probable" and "remote," risk of disclosure to litigation opponents, and the only "treaty" affecting most domestic U.S. lawyers. Missteps bring severe consequences.

When preparing responses to auditors' requests for information, the lawyer must also understand the general principles of Statement of Financial Accounting Standards No. 5 ("FAS No. 5") and the American Bar Association's Statement of Policy Regarding Lawyers' Responses to Auditors' Requests for Information ("ABA statement of policy," or the "treaty"). By following some simple guidelines for preparing these responses, most of the "mines" can be avoided.

The same pitfalls also expose such responses to discovery. The reported decisions are far from unanimous in regard to attempts to subpoena or require production of these litigation evaluations. Appropriate language in the lawyer's response to the auditor reduces the risk of disclosure.

Compliance with the treaty requires careful adherence to a multistep process. Although not mandatory, a written policy is recommended.

Differing Duties of Auditor and Lawyer

The auditor's duty is to the reader of the client's financial reports and is public in nature, for the purpose of stating an opinion on whether they present fairly the financial position and results of operations of the client. Pursuant to FAS No. 5, the auditor must account for (possibly accrue or disclose) loss contingencies (litigation, and unasserted claims and assessments) which are within the lawyer's special knowledge because of legal services rendered to the mutual client. The auditor requests the client to ask the lawyer for information intended to assist the auditor in properly accounting for those loss contingencies.

The lawyer's duty is to the client and is private in nature. The lawyer represents or advises the client in some defined capacity--for example, general counsel, litigation only, specific litigation only, or specific nonlitigation matters only. In responding to the client's request, the lawyer must give the information the auditor needs to form an opinion regarding the client's financial reports, but neither the lawyer nor the client intends to waive the attorney-client privilege or the attorney work-product privilege by disclosing protected information to a third party, the auditor. To preserve these important privileges, the lawyer must respond within the scope of, and incorporate the limitations on, the response delineated by the treaty.

An obvious tension results from the differences between the duties of the auditor and the lawyer. Each must meet a different professional Standard of care. By recognizing the divergent roles and duties of the lawyer and the auditor, the lawyer will more likely be successful in reaching an appropriate resolution of issues that arise in the context of responding to auditors' inquiries.

FAS No. 5: Accounting for Contingencies

FAS No. 5 establishes standards of accrual and disclosure of loss contingencies, followed by accountants in auditing and opining on financial reports. FAS No. 5 defines "loss contingency" as "an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur." Examples of loss contingencies include litigation, claims arising from product warranties, potential assessments of fines or penalties by regulatory agencies, self-insurance risks, collectibility of receivables, letters of credit, and guarantees of indebtedness. In the typical request letter, the auditor (through the client) requests information from the lawyer about two general classifications of loss contingencies: 1) pending or threatened litigation Or other proceedings, and 2) unasserted claims and assessments. (Standard form of "Auditor-Provided Client's Request to Lawyer" is at the end of this article.)

Accrual. The primary purpose of the auditor's inquiry to the lawyer is to determine whether accrual or disclosure of a material loss contingency is required. Accrual of a liability results in a reduction of net income and net worth. On the other hand, disclosure of the liability usually occurs in a footnote to the financial statement; even though it may not reduce net income or net worth, it is still undesirable. Such accruals and disclosures can have adverse effects upon investors, lenders, and creditors. At the extreme, the auditor may conclude there are materially adverse effects upon the client's business, and refuse to issue a "clean" audit opinion.

Accrual is required if information available before issuance of the financial statements indicates that it is probable that an asset is impaired or a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. A loss is "probable" under FAS No. 5 if it is "likely to occur."

FAS No. 5 provides two other classifications of the likelihood that the future event or events will confirm the loss. First, "reasonably possible" is defined as more than remote but less than likely. Second, "remote" is defined as slight. The auditor will request information from the lawyer about the following factors, in order to assess whether a material loss contingency is "probable:"

1) The nature of the litigation, claim, or assessment;

2) The history of the matter or progress of the litigation;

3) The lawyer's opinion about the likelihood of an unfavorable outcome;

4) The company's experience with previous similar contingencies; and

5) How the company's management intends to respond to the matter.

Disclosure. If the conditions requiring accrual of a material loss contingency are not met, the auditor must then determine whether disclosure of the loss contingency is required as a footnote in the financial statements. Disclosure is required if there exists a "reasonable possibility" of loss or additional loss beyond the amounts already accrued; however, no disclosure of an unasserted claim or assessment should be made unless the potential claimant has manifested an awareness of the claim or it is probable that the claim will be asserted and an unfavorable outcome is reasonably possible.

ABA Statement of Policy

The treaty (1) is not a required format for the lawyer's response to the auditor's inquiry, but it is foolish not to seek its protection. Before writing a response to the auditor's inquiry, the lawyer should review the treaty and its supporting works. (2) The treaty incorporates into the lawyer's response the understanding between the ABA and the American Institute of Certified Public Accountants (AICPA) about the limitations on the lawyer's response. A lawyer gains the protection of the treaty by using the model response letter set forth in the treaty. (See Sample Lawyer's Response to Auditor at the end of this article.)

1991 Opinion Accord. The treaty is not changed or otherwise affected by the 1991 Third-Party Legal Opinion Report (sometimes called the "Silverado report"), which includes the Legal Opinion Accord of the ABA Section of Business Law. (3)

Loss-contingencies Limitations. The treaty recognizes limitations on loss contingencies about which the lawyer can furnish information to the auditor. First, the two general types of loss contingencies about which lawyers may have information are: 1) pending and threatened litigation and other proceedings; and 2) unasserted claims and assessments. Second, the lawyer is limited to responding to those matters which involve loss contingencies to which the lawyer has devoted substantive attention in the form of legal consultation or legal representation. Third, the lawyer should respond only with respect to material loss contingencies. The auditor should state an objective standard of materiality, such as a dollar amount, in the request to the lawyer; if there is none, the lawyer may wish to consult with the auditor about the standard.

Evaluation Limitations. The treaty also recognizes limitations on the information furnished by the lawyer to the auditor. The treaty states that no evaluation of the probability of loss should be provided to the lawyer unless an unfavorable outcome is either: 1) "probable," which means "the prospects of the claimant not succeeding are judged to be extremely doubtful and the prospects for success by the client in its defense are judged to be slight;" or 2) "remote," which means "the prospects for the client not succeeding in its defense are judged to be extremely doubtful and the prospects of success by the claimant are judged to be slight."

It is critical to note that FAS No. 5 and the treaty define "probable" differently. The FAS No. 5 definition embodies a much lower threshold of likelihood, but lawyers are governed by the higher threshold of the treaty. Thus, unless the likelihood of an unfavorable outcome is "probable" as defined in the treaty, the lawyer should not...