Lawyers are giving new scrutiny to requests by auditors for information on the status of clients' contingent liabilities, the so-called “audit response” letters or “audit letters.”

For the past 30 years, the accounting and legal professions have relied on the “treaty” worked out by the American Bar Association and the American Institute of Certified Public Accountants.

Under the “treaty,” lawyers, accountants and clients entered into a three-way dance with prescribed steps for each, so that accountants could document that appropriate financial statement disclosures were made concerning pending litigation and unasserted claims, without lawyers breaching their obligations to maintain client confidences.

The steps are as follows: The accountants send a letter to the client, asking the client to ask the lawyer to describe certain loss contingencies for which the attorney has been engaged. The client sends the attorney a letter telling the attorney to provide such information to the accountant. The attorney sends the accountant a letter, in effect, stating that if there was something that the client should have told the accountant, the lawyer told the client to tell the accountant.

The accountants are then able to complete an audit with some comfort that loss contingencies are appropriately disclosed. The attorney and client are able to avoid a detailed disclosure that might result in a waiver of attorney client privilege or a breach by the attorney of a client confidence.

As always, the devil is in the details with this arrangement. Recent developments have attorneys questioning whether their duties have changed.

The “treaty” is premised on specific definitions of what must be included as an entry in the financial statements, what must be disclosed in financial statement footnotes, and what lies outside either of those categories. But the treaty may no longer be the sole authority regarding audit letters.

Under SEC Rule 13b2-2, which was created in response to the Sarbanes Oxley Act, it is illegal for anyone to “mislead” an auditor in the preparation of financial statements. The breadth of the rule is such that even accidentally misleading an auditor could be a violation.

At the same time, the SEC has increased its use of its “cease and desist” order authority under Section 21C of the Securities Exchange Act. That section provides:

“If the Commission finds. . .that any person is violating, has violated, or is about to violate any provision of this title, or any rule or regulation thereunder, the Commission may. ..enter an order requiring [any] person that is, was, or would be a cause of the violation, due to an act or omission the person knew or should have known would contribute to such violation, to cease and desist from committing or causing such violation and any future violation of the same provision, rule, or regulation.”

The SEC is able to impose cease and desist orders with the benefit of hindsight, and since the standard for such orders is whether the person “caused” a violation, the good faith or intent of the party “causing” a violation is not a defense.

In consequence, an attorney who provides an audit letter that “misleads” an auditor might “cause” a violation of Rule 13b2-2, exposing the attorney to cease and desist sanctions.

Arguably, an audit letter that conforms to the “treaty” is not misleading to an auditor, in that the limitations on the information provided by the attorney are known and understood by both the attorney and the accountant.

It is not hard to imagine, however, a circumstance in which a client conceals from an auditor a matter the attorney has advised the client to disclose, and a dispute arises over whether the attorney had an expanded duty to prevent the auditor from being misled by the client

Bruce Dravis is a partner at Downey Brand LLP, operating primarily in the firm's Sacramento and Roseville offices, specializing in corporate, securities and business law. His column appears in The Daily Journal on the third Monday of each month.