(1) What are the various types of damages available in a breach of.docx

(1) What are the various types of damages available in a breach
of contract case. Please explain when each type of damages
may apply (provide a few examples).
(2) Describe the horizontal and vertical restraints of trade that
violate Section 1 of the Sherman Act.
(3) Explain the three theories of liability under which an
accountant/accounting firm may be liable to third parties for a
claim based on negligence. Which is the strictest and least
strictest theory?
CH51
“By certifying the public reports that collectively depict a
corporation’s financial status, the independent auditor assumes
a public respon-sibility transcending any employment
relationship with the client.”
—Justice Burger
United States v. Arthur Young & Co.
465 U.S. 805, 104 S.Ct. 1495, 1984 U.S. Lexis 43 (1984)
Introduction to Accountants’ Duties and Liability
Although accountants provide a wide variety of services to
corporations and other businesses, their primary functions are
(1) auditing financial statements and
rendering opinions about those audits. Accountants also prepare
unaudited financial statements for clients, render tax advice,
prepare tax forms, and provide consulting and other services to

clients.
Audits generate the majority of litigation against accountants.
Lawsuits against accountants are based on the common law
(e.g., breach of contract, misrepresen-tation, negligence), or on
violation of certain statutes (particularly federal securi-ties
laws). Accountants can be held liable both to clients and to
third parties. This chapter examines the legal liability of
accountants.
Public Accounting
The term accountant applies to persons who perform a variety of
services, includ-ing bookkeepers and tax preparers. The term
certified public accountant (CPA) applies to accountants who
meet certain educational requirements, pass the CPA
examination, and have a certain number of years of auditing
experience. A person who is not certified is generally referred
to as a public accountant.
Limited Liability Partnership (LLP)
Most public accounting firms are organized and operated as
limited liabilitypartnerships (LLPs). In this form of partnership,
all the partners are limited part-ners who lose only their capital
contribution in the LLP if the LLP fails. The lim-ited partners
are not personally liable for the debts and obligations of the
LLP (see Exhibit 51.1). A limited partner whose negligent or
intentional conduct causesinjury is personally liable for his or
her own conduct.
Accounting
Debt or

obligation
Firm
Third
owed
(Limited
Liability Party
Partnership)
Capital investment
Accountant
Accountant
Accountant
Accountant
Partner
Partner
Partner
Partner
Liability limited
to capital

contribution
No personal liability
for partnership’s
debts and obligations
In our complex society the accountant’s certificate and the
lawyer’s opinion can be instruments for inflicting pecuniary
loss more potent than the chisel or the crowbar.
Justice Blackman
Dissenting Opinion, Ernst & Ernst v. Hochfelder 425 U.S. 185,
96 S.Ct. 1375, 1976 U.S. Lexis 2 (1976)
certified public accountant (CPA)
An accountant who has met certain educational requirements,
has passed the CPA examination, and has had a certain number
of years of auditing experience.
limited liability partnership (LLP)
A special form of partnership in which all partners are limited
partners.
Exhibit 51.1 ACCOUNTING
FIRM LLP
PART XI Accounting Profession

Example Suppose Alicia, Min-Wei, Holly, Won Suk, and
Florence, each a certified public accountant (CPA), form an
LLP called “Min-Wei Florence, LLP.” While working on an
audit for Min-Wei Florence LLP’s client Microhard
Corporation, Holly commits accounting malpractice
(negligence) and fails to detect an ac-counting fraud at
Microhard. Because of the fraud, Microhard goes bankrupt and
its shareholders lose their entire investment. In this case, the
shareholders of Microhard Corporation can sue and recover
against Holly, the negligent party, and against Min-Wei
Florence LLP. As limited partners, Alicia, Min-Wei, Won Suk,
and Florence can lose their capital contribution in Min-Wei
Florence LLP but are not personally liable for the losses
suffered by Microhard’s shareholders. Holly loses her capital in
the LLP and is also personally liable to the shareholders of
Micro-hard Corporation because she was the negligent party.
Accounting Standards and Principles
Certified public accountants must comply with two uniform
standards of profes-sional conduct: (1) generally accepted
accounting principles (GAAPs) and (2) generally accepted
auditing standards (GAASs). Both are discussed in the fol-
lowing paragraphs.
generally accepted account-ing principles (GAAPs)
Standards for the preparation and presentation of financial
statements.
WEB EXERCISE

For a description of generally ac-cepted accounting principles
(GAAPs), go to www.fasab.gov/accepted.html.
WEB EXERCISE
Go to the IFRS website at www.ifrs.org. Click on “Global
convergence” and read the article.
generally accepted auditing standards (GAASs)
Standards for the methods and procedures that must be used to
conduct audits.
WEB EXERCISE
For a description of generally ac-cepted auditing standards
(GAASs), go to
www.aicpa.org/download/members/div/auditstd/AU-00150.pdf.
audit
A verification of a company’s books and records pursuant to
federal se-curities laws, state laws, and stock exchange rules
that must be per-formed by an independent CPA.
Generally Accepted Accounting Principles
Generally Accepted Accounting Principles (GAAPs) are
standards for the prepa-ration and presentation of financial
statements.1 These principles set forth rules for how
corporations and accounting firms present their income,
expenses, as-sets, and liabilities on the corporation’s financial
statements. There are more than 150 “pronouncements” that

comprise these principles. GAAPs establish uniform principles
for reporting financial statements and financial transactions.
The Fi-nancial Accounting Standards Board (FASB), an
organization created by the ac-counting profession, issues new
GAAP rules and amends existing rules. GAAP applies mainly to
U.S. companies.
Most companies in other counties abide by International
Financial Report-ing Standards (IFRSs). These principles are
promulgated by the International Accounting Standards Board
(IASB), which is located in London, England. TheIFRSs differ
in some respects from GAAPs. As U.S. companies become more
global, and as foreign companies increase their business in the
United States, the International Financial Reporting Standards
are replacing GAAPs.
Generally Accepted Auditing Standards
Generally Accepted Auditing Standards (GAASs) specify the
methods and proce-dures that are to be used by public
accountants when conducting external audits of company
financial statements.2 The standards are set by the American
Instituteof Certified Public Accountants (AICPA). GAASs
contain general standards ofproficiency, independence, and
professional care. They also establish standards for conducting
fieldwork and require that sufficient evidence be obtained to
afford a reasonable basis for issuing an opinion regarding the
financial statements under audit. Compliance with audit
standards provides a measure of audit quality.
Audit
Audit can be defined as a verification of a company’s books and
records. Pursuantto federal securities laws, state laws, and stock
exchange rules, an audit must be performed by an independent
CPA. The CPA must review the company’s financial records,

check their accuracy, and otherwise investigate the financial
position of the company.
CHAPTER 51 Accountants’ Duties and Liability 851
The auditor must also (1) conduct a sampling of inventory to
verify the fig-ures contained in the client’s financial statements
and (2) verify information from third parties (e.g., contracts,
bank accounts, real estate, and accounts receiv-able). An
accountant’s failure to follow GAASs when conducting audits
consti-tutes negligence.
Auditor’s Opinions
After an audit is complete, the auditor usually renders an
opinion about how fairly the financial statements of the client
company represent the company’s financial position, results of
operations, and change in cash flows. The auditor’sopinion may
beunqualified,qualified, oradverse. Alternatively, the auditor
mayoffer a disclaimer of opinion. Most auditors give
unqualified opinions. The various types of opinions are the
following:
Unqualified opinion. An unqualified opinion represents an
auditor’s findingthat the company’s financial statements fairly
represent the company’s finan-cial position, the results of its
operations, and the change in cash flows for the period under
audit, in conformity with generally accepted accounting prin-
ciples (GAAPs). This is the most favorable opinion an auditor
can give.
Qualified opinion. A qualified opinion states that the
financial statementsare fairly represented except for, or subject
to, a departure from GAAPs, a change in accounting principles,

or a material uncertainty. The exception, de-parture, or
uncertainty is noted in the auditor’s opinion.
Adverse opinion. An adverse opinion determines that the
financial state-ments do not fairly represent the company’s
financial position, results of opera-tions, or change in cash
flows in conformity with GAAPs. This type of opinion is
usually issued when an auditor determines that a company has
materially misstated certain items on its financial statements.
Disclaimer of Opinion
A disclaimer of opinion expresses the auditor’s inability to draw
a conclusion about the accuracy of the company’s financial
records. This disclaimer is gen-erally issued when the auditor
lacks sufficient information about the financial records to issue
an overall opinion.
The issuance of other than an unqualified opinion can have
substantial ad-verse effects on the company audited. A company
that receives an opinion other than an unqualified opinion may
not be able to sell its securities to the public, merge with
another company, or obtain loans from banks. The Securities
and Exchange Commission (SEC) has warned publicly held
companies against “shop-ping” for accountants to obtain a
favorable opinion.
Accountants’ Liability to Their Clients
Accountants are employed by their clients to perform certain
accounting ser-vices. Under the common law, accountants may
be found liable to the clients who hire them under several legal
theories, including breach of contract, fraud, and negligence.

auditor’s opinion
An opinion of an auditor about how fairly the financial
statements of the client company represent the company’s
financial position, results of operations, and change in cash
flows.
unqualified opinion
An auditor’s opinion that the com-pany’s financial statements
fairly represent the company’s financial position, the results of
its opera-tions, and the change in cash flows for the period
under audit, in con-formity with generally accepted ac-counting
principles (GAAPs).
qualified opinion
An auditor’s opinion that the financial statements are fairly rep-
resented except for, or subject to, a departure from GAAPs, a
change in accounting principles, or a material uncertainty.
adverse opinion
An auditor’s opinion that the fi-nancial statements do not fairly
represent the company’s financial position, results of
operations, or change in cash flows in conformity with GAAPs.
disclaimer of opinion
An auditor’s opinion expressing the auditor’s inability to draw a
conclu-sion about the accuracy of the com-pany’s financial
records.

Liability to Clients: Breach of Contract
The terms of an engagement are specified when an accountant
and a client enter into a contract for the provision of accounting
services by the accountant. An accountant who fails to perform
may be sued for damages caused by the breachof contract.
Generally, the courts consider damages to be the expenses the
clientincurs in securing another accountant to perform the
needed services as well as
engagement
A formal entrance into a contract between a client and an
accountant.
any fines or penalties incurred by the client for missed
deadlines, lost opportuni-ties, and such.
Rather fail with honor than succeed with fraud.
Sophocles (497 bce–406 bce)
Liability to Clients: Fraud
Where an accountant has been found liable for actual or

constructive fraud, the client may bring a civil lawsuit and
recover any damages proximately caused by that fraud. Punitive
damages may be awarded in cases of actual fraud. Actualfraud
is defined as intentional misrepresentation or omission of a
material factthat is relied on by the client and causes the client
damage. Such cases are rare.
Constructive fraud occurs when an accountant acts with
“reckless disregard”for the truth or the consequences of his or
her actions. This type of fraud is some-times categorized as
gross negligence.
accounting malpractice (negligence)
Negligence where the accountant breaches the duty of
reasonable care, knowledge, skill, and judgment that he or she
owes to a client when providing auditing and other ac-counting
services to the client.
Liability to Clients: Accounting Malpractice (Negligence)
Accountants owe a duty to use reasonable care, knowledge,
skill, and judgment when providing auditing and other
accounting services to a client. In other words, an accountant’s
actions are measured against those of a “reasonable accountant”
in similar circumstances. The development of GAAPs, GAASs,
and other uniform accounting standards has generally made this
a national standard. An accountant who fails to meet this

standard may be sued for negligence (also called
accountingmalpractice).
Example An accountant does not comply with GAASs when
conducting an audit and thereby fails to uncover a fraud or
embezzlement by an employee of the company being audited.
This accountant can be sued for damages arising from this
negligence.
Violations of GAAPs or GAASs, or IFRSs, if applicable, are
prima facie evi-dence of negligence, although compliance does
not automatically relieve the ac-countant of such liability.
Accountants can also be held liable for their negligence in
preparing unaudited financial statements. If an audit turns up a
suspicious transaction or entry, the accountant is under a duty
to investigate it and to inform the client of the results of the
investigation.
Accountants’ Liability to Third Parties
Many lawsuits against accountants involve liability of
accountants to third par-ties. The plaintiffs are third parties
(e.g., shareholders, bondholders, trade credi-tors, and banks)
who relied on information supplied by the auditor. There are
three major rules of liability that a state can adopt in
determining whether an accountant is liable in negligence to
third parties:
The Ultramares doctrine
Section 552 of the Restatement (Second) of Torts
The foreseeability standard

These rules are discussed in the paragraphs that follow.
Liability to Third Parties: Ultramares Doctrine
The landmark case that initially defined the liability of
accountants for their neg-ligence to third parties was Ultramares
Corporation v. Touche.3 In that case, Touche Niven & Co.
(Touche), a national firm of certified public accountants, was
employed by Fred Stern & Co. (Stern) to conduct an audit of the
company’s financial statements. Touche was negligent in
conducting the audit and did not uncover over $700,000 of
accounts receivable that were based on fictitious sales
and other suspicious activities. Touche rendered an unqualified
opinion and pro-vided 32 copies of the audited financial
statements to Stern. Stern gave one copy to Ultramares
Corporation (Ultramares). Ultramares made a loan to Stern on
the basis of the information contained in the audited statements.
When Stern failed to repay the loan, Ultramares brought a
negligence action against Touche.
In his now-famous opinion, Judge Cardozo held that an
accountant could not be held liable for negligence unless the
plaintiff was in either privity of contract or a privity-like
relationship with the accountant. Judge Cardozo wrote,
If liability for negligence exists, a thoughtless slip or blunder,
the failure to detect a theft or forgery beneath the cover of
deceptive entries may expose accountants to a liability in an
indeterminate amount for an indetermi-nate time to an
indeterminate class. The hazards of a business conducted on
these terms are so extreme as to enkindle doubt whether a flaw
may not exist in the implication of a duty that exposes to these

consequences.
Under the Ultramaresdoctrine, a privity of contract relationship
would occur in which a client employed an accountant to
prepare financial statements to be used by a third party for a
specific purpose. For example, if (1) a client employs an
accountant to prepare audited financial statements to be used by
the client to secure a bank loan and (2) the accountant is made
aware of this special purpose, the accountant is liable for any
damages incurred by the bank because of a negli-gently
prepared report.
In the following case, the court held that a privity-like
relationship was re-quired to find accountants liable for
negligence to third-party plaintiffs.
Ultramares doctrine

A rule stating that an accountant is liable only for negligence to
third parties who are in privity of contract or in a privity-like
relationship with the accountant. It provides a narrow standard
for holding accountants li-able to third parties for negligence.
CASE 51.1STATE COURT CASE Ultramares Doctrine
Credit Alliance Corporation v. Arthur Andersen& Company
65 N.Y.2d 536, 493 N.Y.S.2d 435, 1985 N.Y. Lexis 15157
Court of Appeals of New York
“The facts as alleged by plaintiffs fail to demonstrate the
existence of a relationship between the parties sufficiently
approaching privity.”
—Jason, Judge
Facts
L.B. Smith, Inc., of Virginia (Smith) was a Virginia corporation
engaged in the business of selling, leas-ing, and servicing heavy
construction equipment. It was a capital-intensive business that
regularly required debt financing. Arthur Andersen & Co.
(Andersen), a large national firm of certified public
accountants, was employed to audit Smith’s finan-cial
statements. Andersen audited Smith’s financial statements for
two years. During that period of time, Andersen issued
unqualified opinions concerning Smith’s financial statements.
Without Andersen’s knowledge, Smith gave copies of its

audited financial statements to Credit Alliance Corporation
(Credit
Alliance). Credit Alliance, relying on these finan-cial
statements, extended more than $15 million of credit to Smith to
finance the purchase of capi-tal equipment through installment
sales and leasing arrangements.
The audited financial statements overstated Smith’s assets, net
worth, and general financial position. In performing the audits,
Andersen was negligent and failed to conduct investigations in
accordance with generally accepted auditing stan-dards.
Because of this negligence, Andersen failed to discover Smith’s
precarious financial condition. The next year, Smith filed a
petition for bankruptcy. Smith defaulted on obligations owed
Credit Alliance in an amount exceeding $8.8 million. Credit
Alli-ance brought this action against Andersen for negli-gence.
The trial court denied Andersen’s motion to dismiss. The
appellate division affirmed. Andersen appealed.
(case continues)
Issue
Is Andersen liable under the Ultramares doctrine?
Language of the Court
Upon examination of Ultramares, certain cri-teria may be
gleaned. Before accountants may be held liable in negligence to
noncontractual parties who rely to their detriment on inac-
curate financial reports, certain prerequisites must be satisfied,
(1) the accountants must have been aware that the financial
reports were to be used for a particular purpose or purposes, (2)

in the furtherance of which a known party or parties was
intended to rely, and (3) there must have been some conduct on
the part of the accountants linking them to that party or parties,
which evinces the accountants’ understanding of that party or
parties’ reliance. In the appeal we decide to-day, application of
the foregoing principles presents little difficulty. The facts as
alleged by plaintiffs fail to demonstrate the existence of a
relationship between the parties suffi-ciently approaching
privity. While the allega-tions in the complaint state that Smith
sought to induce plaintiffs to extend credit, no claim is made
that Andersen was being employed to
prepare the reports with that particular pur-pose in mind.
Decision
The court of appeals held that an accountant is only liable for
negligence to third parties who are in a privity-like relationship
with the accountant. In ap-plying this rule, the court held that
Arthur Andersen
Co., the accountants, were not liable to plaintiff third-party
Credit Alliance Corporation. The court dismissed Credit
Alliance’s cause of action for negli-gence against defendant
Andersen.
Note
In this case, the court went beyond the privity re-quirement
established by Ultramares and extended the liability of
accountants for negligence to parties who are in a privity-like
arrangement with the ac-countant. Some states follow this
expanded rule, while other states follow the strict Ultramares
doctrine.

Ethics Questions
What does the Ultramares doctrine provide? Do you think that
accountants favor the Ultramares doctrine? Why or why not?
What rule was estab-lished by the Credit Alliance case? Did the
accoun-tants’ breach any ethical duty in this case?
Section 552 of the Restatement (Second) of Torts
A rule stating that an accountant is liable only for negligence to
third parties who are members ofa limited class of intended
users of the client’s financial statements. It provides a broader
standard for holding accountants liable to third parties for
negligence than does the Ultramares doctrine.
Liability to Third Parties: Section 552 of the Restatement
(Second) of Torts
Section 552 of the Restatement (Second) of Tortsprovides a
broader middle-ground approach for holding accountants liable
to third parties for negligence than does the Ultramares
doctrine. Under the Restatement standard, an accoun-tant is
liable for his or her negligence to any member of a limited class

of in-tended users for whose benefit the accountant has been
employed to preparethe client’s financial statements or to whom
the accountant knows the client will supply copies of the
financial statements. In other words, the accountant does not
have to know the specific name of the third party. The majority
of states have adopted this standard, which is worded as
follows:
Section 552. Information Negligently Supplied for the Guidance
of Others.
1. One who, in the course of his business, profession or
employment, or in any other transaction in which he has a
pecuniary interest, sup-plies false information for the guidance
of others in their business transactions, is subject to liability for
pecuniary loss caused to them by their justifiable reliance upon
the information, if he fails to exer-cise reasonable care or
competence in obtaining or communicating the information.
2. Except as stated in Subsection (3), the liability stated in
Subsection
(1) is limited to loss suffered
a. by the person or one of a limited group of persons for whose
benefit and guidance he intends to supply the information or
knows that the recipient intends to supply it; and
through reliance upon it in a transaction that he intends the
infor-mation to influence or knows that the recipient so intends
or in a substantially similar transaction.
The liability of one who is under a public duty to give the
informa-tion extends to loss suffered by any of the class of

persons for whose benefit the duty is created, in any of the
transactions in which it is intended to protect them.
Example A client company needs an accountant to prepare
audited financial state-ments to be used for the purpose of
obtaining investors for the company. The company employs an
accounting firm to conduct the audit and prepare the fi-nancial
statements. The accountant is notified that the financial
statements will be provided to potential investors. The
accountant agrees to conduct the audit of the company and
prepare financial statements to be used for this purpose. The
accountant is negligent in conducting the audit and preparing
the financial statements by not discovering that the company
has significantly overstated its earnings. The company provides
copies of the audited financial statements to po-tential
investors, who rely on the financial statements and invest in the
company. The company fails and the investors lose their
investments. In this example, the accountant is liable to the
investors—a limited class of intended users—who relied on the
information in the financial statements, purchased securities of
the company, and were injured thereby. The accountant is liable
even though the ac-countant does not know the specific
identities of the investors.
In the following case, the court applied a Section 552 rule in
deciding whether an accountant could be held liable for
negligence to third-party nonclients.
CASE 51.2STATE COURT CASE Accountants’ Liability to a
Third Party

Cast Art Industries, LLC v. KPMG LLP
36 A.3d 1049, 2012 N.J. Lexis 152 (2012)
Supreme Court of New Jersey
“KPMG was not told that a nonclient would be rely-ing on its
work.”
—Wefing, Judge
Facts
Papel Giftware produced and sold collectible figu-rines and
giftware. KPMG LLP, certified public ac-countants, had audited
Papel’s financial statements for many years and produced
audited financial state-ments with unqualified opinions. KPMG
issued the financial statements for the year in question.
Cast Art Industries, LLC, was in the same line of business as
Papel. Cast Art became interested in ac-quiring Papel and hired
attorneys, investment bank-ers, and accountants to advise it in
connection with the proposed transaction. Cast Art obtained
copies of Papel’s audited financial statements and had its ac-
countants review the financial statements and KPMG’s audit
papers. Three months later, Cast Art decided to acquire Papel
and obtained a $22 million loan from
PNC Bank to fund the transaction. Major shareholders of Cast
Art gave their personal guarantees to the bank for $3 million if
the loan was not repaid.
Shortly after the merger was finalized, Cast Art began to
experience difficulty in collecting some of Papel’s accounts
receivable. After conducting an investigation, Cast Art learned

that the financial statements prepared by Papel were inaccurate
in several ways. Papel recognized revenue from sales when
goods were shipped and invoices sent, not when payment was
received. In addition, Papel rou-tinely booked revenue from
goods that had not yet been shipped and would often not close
its books for a month so that it could include revenue that was
earned in the following month. Cast Art knew at the time of the
merger that Papel was carrying a signifi-cant amount of debt.
The surviving corporation from the merger was unable to
generate sufficient revenue to carry its debt load and produce
new goods, and it eventually failed.
(case continues)
Cast Art and its shareholders sued KPMG, al-leging that KPMG
had been negligent in auditing Papel’s financial statements and
that KMPG was therefore liable for their losses. KPMG asserted
that it was not liable to the plaintiff nonclients based on the
New Jersey Accountant Liability Act (Act), a state statute that
adopted the rules of Sec-tion 552 of the Restatement (Second)
of Torts. KPMG argued that, because Cast Art had not re-tained
it to audit Papel, Cast Art was not its client, and KPMG did not
know at the time it performed the audits that Papel and Cast Art
were contem-plating a merger or that Cast Art would be rely-ing
on KPMG’s auditing work, and that therefore the plaintiffs’
claims were barred by the act. KPMG asserted that the
company’s large debt and a de-crease in sales caused its failure.
The trial court held that KPMG was liable and awarded damages
of $38 million to the plaintiffs. The appellate court upheld the
verdict. KPMG appealed to the supreme court of New Jersey.
KPMG did not know, when it agreed to per-form the audit, that
its work could play a role in a subsequent merger. An auditor is
entitled to know at the outset the scope of the work it is being

requested to perform and the concomitant risk it is being asked
to assume. KPMG was not told that a nonclient would be relying
on its work. The statute requires agreement, not mere
awareness, on the part of the accountant to the planned use of
his work product. Because Cast Art failed to es-tablish that
KPMG knew at the time of the engagement by the client or
thereafter agreed that Cast Art could rely on its work in pro-
ceeding with the merger, Cast Art failed to satisfy the requisite
elements of the statute, and KPMG was entitled to judgment. In
light of this conclusion, the remaining issues raised by the
parties are moot and need not be addressed.
Issue
Is KPMG liable to the plaintiff–third parties for ac-counting
malpractice?
Language of the Court
To forestall indeterminate liability, subsec-tion (2) of Section
552 limits the scope of po-tential liability to those persons, or
classes of persons, whom the accountant knows and intends will
rely on his opinion, or whom he knows his client intends will so
rely. Clearly,
Decision
The supreme court of New Jersey held that KPMG was not
liable to the nonclient third-party plaintiffs and ordered the case

dismissed.
Ethics Questions
What does Section 552 of the Restatement (Second)of Torts
require for an accountant to be held liablefor negligence to
nonclients? Is this a more reason-able rule than the Ultramares
doctrine?
foreseeability standard
A rule stating that an accountant is liable for negligence to third
par-ties who are foreseeable users of the client’s financial
statements. It provides the broadest standard for holding
accountants liable to third parties for negligence.
Liability to Third Parties: Foreseeability Standard
A few states have adopted a broad rule known as the
foreseeability standard for holding accountants liable to third

parties for negligence. Under this standard, an accountant is
liable to any foreseeable user of the client’s financial
statements. The accountant’s liability does not depend on his or
her knowledge of the identity of either the user or the intended
class of users.
Example A corporation makes a tender offer for the shares of a
target corporation whose financial statements have been audited
by a CPA. If the CPA prepared the financial statements
negligently and the tender offeror relied on them to purchase
the target corporation, the accountant is liable for injuries
suffered by the tender offeror.
CONCEPT SUMMARY
ACCOUNTANTS’ NEGLIGENCE LIABILITY TO THIRD
PARTIES
Legal Theory
To Whom Liable?
Ultramares doctrine
Any person in privity of contract or a privity-like relationship
with the
accountant.
Section 552 of the Restatement
Any member of a limited class of intended users for whose
benefit the ac-
(Second) of Torts
countant has been employed to prepare the client’s financial
statements or

whom the accountant knows will be supplied copies of the
client’s financial
statements.
Foreseeability standard
Any foreseeable user of the client’s financial statements.
Liability to Third Parties: Fraud
If an accountant engages in actual or constructive fraud, a third
party that relies on the accountant’s fraud and is injured thereby
may bring a tort action against the accountant to recover
damages.
Example Salvo Retailers, Inc. (Salvo) applies for a bank loan,
but the bank requires audited financial statements of the
company before making the loan. Salvo hires a CPA to do the
audit, and the CPA falsifies the financial position of the
company. The bank extends the loan to Salvo, and the loan is
not repaid. The bank can re-cover its losses from the CPA who
committed fraud.
Liability to Third Parties: Breach of Contract
Third parties usually cannot sue accountants for breach of
contract because the third parties are merely incidental
beneficiaries who do not acquire any rights under the
accountant–client contract. That is, they are not in privity of
contract with the accountants.
Example An accountant contracts to perform an audit for Kim

Manufacturing Com-pany (Kim) but then fails to do so. A
supplier to Kim cannot sue the accountant because the supplier
is not in privity of contract with the accountant.
Securities Law Violations
Accountants can be held liable for violating various federal and
state securities laws. This section examines the civil and
criminal liability of accountants under these statutes.
Section 11(a) of the Securities Act of 1933
The Securities Act of 1933 requires that, before a corporation or
another business sells securities to the public, the issuer must
file a registration statement with the Securities and Exchange
Commission (SEC). Accountants are often employed to prepare
and certify financial statements that are included in the
registration statements filed with the SEC. Accountants are
considered experts, and the finan-cial statements they prepare
are considered an expertised portion of the registra-tion
statement.

privity of contract
The state of two specified parties being in a contract.
Section 11(a) of the Securities Act of 1933
A section of the Securities Act of 1933 that imposes civil
liability on accountants and others for
making misstatements or omissions of material facts in a
registration statement or (2) failing to find such misstatements
or omissions.
due diligence defense
A defense an accountant can assert and, if proven, avoids
liability under Section 11(a).
Section 11(a) of the Securities Act of 1933 imposes civil
liability on accoun-tants and others for (1) making
misstatements or omissions of material facts in a registration
statement or (2) failing to find such misstatements or
omissions.4 Ac-countants can be held liable for fraud or
negligence under Section 11(a) if the fi-nancial statements they
prepare for a registration statement contain such errors.
Accountants can, however, assert a due diligence defense to

liability. An ac-countant avoids liability if he or she had, after
reasonable investigation, reason-able grounds to believe and did
believe, at the time the registration statement became effective,
that the statements made therein were true and there was no
omission of a material fact that would make the statements
misleading.
Example While conducting an audit, accountants fail to detect a
fraud in the fi-nancial statements. The accountants’ unqualified
opinion is included in the reg-istration statement and prospectus
for the offering. An investor purchases the securities and suffers
a loss when the fraud is uncovered. The investor can sue the
makers of the misrepresentations for fraud and the accountants
for negligence.
The plaintiff may recover the difference between the price he or
she paid for the security and the value of the security at the
time of the lawsuit (or at the time the security was sold, if it
was sold prior to the lawsuit). The plaintiff does not have to
prove that he or she relied on the misstatement or omission.
Privity of contract is irrelevant.
Section 10(b) of the Securi-ties Exchange Act of 1934
A section of the Securities Exchange Act of 1934 that prohibits
any manipulative or deceptive practice in connection with the
purchase or sale of a security.
Rule 10b-5
A rule adopted by the SEC to clarify the reach of Section 10(b)
against deceptive and fraudulent activities in the purchase and
sale of securities.

Section 10(b) of the Securities Exchange Act of 1934
Section 10(b) of the Securities Exchange Act of 1934 prohibits
any manipula-tive or deceptive practice in connection with the
purchase or sale of any security.5 Pursuant to its authority
under Section 10(b), the SEC promulgated Rule 10b-5. This rule
makes it unlawful for any person, by the use or means or
instrumental-ity of interstate commerce, to employ any device
or artifice to defraud; to make misstatements or omissions of
material fact; or to engage in any act, practice, or course of
conduct that would operate as a fraud or deceit on any person in
con-nection with the purchase or sale of any security.6
The scope of these antifraud provisions is quite broad, and the
courts have im-plied a civil private cause of action. Thus,
plaintiffs injured by a violation of these provisions can sue the
offending party for monetary damages. Only purchasers and
sellers of securities can sue under Section 10(b) and Rule 10b-5.
Privity of contract is irrelevant.
Accountants are often defendants in Section 10(b) and Rule
10b-5 actions. The U.S. Supreme Court has held that only
intentional conduct and recklessness of accoun-tants and others,
but not ordinary negligence, violates Section 10(b) and Rule
10b-5.7
Section 18(a) of the Securi-
ties Exchange Act of 1934
A section of the Securities Exchange

Act of 1934 that imposes civil liabil-
ity on any person who makes false
or misleading statements in any ap-
plication, report, or document filed
with the SEC.
Section 18(a) of the Securities Exchange Act of 1934
Section 18(a) of the Securities Exchange Act of 1934 imposes
civil liability onany person who makes false or misleading
statements of material fact in any ap-plication, report, or
document filed with the SEC.8 Accountants often file reports
and other documents with the SEC on behalf of clients; thus
they can be found liable for violating this section.
Like Section 10(b), Section 18(a) requires a showing of fraud or
reckless con-duct on the part of the defendant. Thus, the
plaintiffs in a Section 18(a) action must prove that they relied
on the misleading statement and that it affected the price of the
security. Negligence is not actionable.
There are two ways an accountant or another defendant can
defeat the impo-sition of liability under Section 18(a). First, the
defendant can show that he or
she acted in good faith. Second, he or she can show that the
plaintiff had knowl-edge of the false or misleading statement
when the securities were purchased or sold.

Private Securities Litigation Reform Act of 1995
The Private Securities Litigation Reform Act of 1995, a federal
statute, changed the liability of accountants and other securities
professionals in the following ways:
The act imposes pleading and procedural requirements that
make it more dif-ficult for plaintiffs to bring class action
securities lawsuits.
The act replaces joint and several liability of defendants (where
one party of sev-eral at-fault parties could be made to pay all of
a judgment) with proportionateliability. This new rule limits a
defendant’s liability to his or herproportion-ate degree of fault.
Thus, the act relieves accountants from being the “deeppocket”
defendant except up to their degree of fault. The only exception
to this rule—where joint and several liability is still imposed—
is if the defendant acted knowingly.9
Example Consider a case involving plaintiffs who are victims of
a securities fraud perpetrated by a firm, and they suffer $1
million in damages. If the accountants for the firm are found to
be 25 percent liable, the accountants are required to pay only
their proportionate share in damages—$250,000. If the
accountants know-ingly participated in the fraud, however, they
would be jointly and severally liable for the entire $1 million in
damages.
The following ethics feature discusses an accountant’s duty to
report a client’s illegal activity.

proportionate liability
A rule that limits a defendant’s liability to his or her
proportionate degree of fault.
Section 10A of the Securities Exchange Act of 1934
A law that imposes a duty on audi-tors to detect and report
illegal acts committed by their clients.
Ethics
Accountants’ Duty to Report a Client’s Illegal Activity
In the course of conducting an audit of a client company’s

financial statements, an accountant could uncover informa-tion
about the client’s illegal activities. In 1995, Congress added
Section 10A of the Securities Exchange Act of
1934.10 Section 10A imposes duties on auditors to detect and
report illegal acts committed by their clients. Under Section
10A, an illegal act is defined as an “act or omis-sion that
violates any law, or any rule or regulation having the force of
law.” Section 10A imposes the following report-ing
requirements on accountants:
Unless an illegal act is “clearly inconsequential,” the auditor
must inform the client’s management and audit committee of the
illegal act.
If management fails to take timely and appropriate remedial
action, the auditor must report the illegal act to the client’s full
board of directors if (a) the illegal
act will have a material effect on the client’s financial
statements and (b) the auditor expects to issue a non-standard
audit report or intends to resign from the audit engagement.
Once the auditor reports the illegal act to the board of directors,
the board of directors must inform the Securi-ties and Exchange
Commission (SEC) of the auditor’s conclusion within one
business day; if the client fails to do so, the auditor must notify
the SEC the next busi-ness day.
Ethics Questions What prompted Congress to add Section 10A
to the Securities Exchange Act? Should accountants report the
unethical conduct of their clients that is not considered illegal
conduct? Why or why not?

Criminal Liability of Accountants
Many statutes impose criminal penalties on accountants who
violate their provi-sions. These criminal statutes are discussed
in the following paragraphs.
Section 24 of the Securities Act of 1933
A section of the Securities Act of 1933 that makes it a criminal
offense for any person to (1) will-fully make any untrue
statement of material fact in a registration statement filed with
the SEC,
omit any material fact necessary to ensure that the statements
made in the registration statement are not misleading, or (3)
willfully violate any other provision of the Securities Act of
1933 or rule or regulation adopted thereunder.
Section 32(a) of the Securi-
ties Exchange Act of 1934
A section of the Securities Exchange
Act of 1934 that makes it a crimi-
nal offense for any person willfully
and knowingly to make or cause to
be made any false or misleading
statement in any application, report,

or other document required to be
filed with the SEC pursuant to the
Securities Exchange Act of 1934
or any rule or regulation adopted
thereunder.
Criminal Liability: Section 24 of the Securities Act of 1933
Section 24 of the Securities Act of 1933 makes it a criminal
offense for any per-son to (1) willfully make any untrue
statement of material fact in a registration statement filed with
the SEC, (2) omit any material fact necessary to ensure that the
statements made in the registration statement are not
misleading, or (3) will-fully violate any other provision of the
Securities Act of 1933 or rule or regulation adopted thereunder.
Because accountants prepare the financial reports included in
the registration statements, they are subject to criminal liability
for violating this section. Penalties for a violation of this statute
include fines, imprisonment, or both.11
Criminal Liability: Section 32(a) of the Securities Exchange Act
of 1934
Section 32(a) of the Securities Exchange Act of 1934 makes it a
criminal offensefor any person willfully and knowingly to make
or cause to be made any false or misleading statement in any
application, report, or other document required to be filed with
the SEC pursuant to the Securities Exchange Act of 1934 or any
rule or regulation adopted thereunder. Because accountants
often file reports and documents with the SEC on behalf of
clients, they are subject to this rule. Insider trading also falls

within the parameters of this section.
On conviction under Section 32(a), an individual may be fined,
imprisoned, or both. A corporation or another entity may be
fined. A person cannot be impris-oned under Section 32(a)
unless he or she had knowledge of the rule or regulation
violated.12
If the SEC finds evidence of fraud or other willful violation of
federal securi-ties laws or other federal law (e.g., mail and wire
fraud statutes), the matter may be referred to the U.S.
Department of Justice, with a recommendation that the
suspected offending party be criminally prosecuted. The
Department of Justice determines whether criminal charges will
be brought.
Tax Reform Act of 1976
An act that imposes criminal liability on accountants and others
who pre-pare federal tax returns if they
willfully understate a client’s tax liability, (2) negligently
understate the tax liability, or (3) aid or assist in the preparation
of a false tax return.
Racketeer Influenced and Corrupt Organizations Act (RICO)
A federal act that provides for both criminal and civil penalties
for secu-rities fraud.
Criminal Liability: Tax Preparation

The Tax Reform Act of 1976 imposes criminal liability on
accountants and others who prepare federal tax returns and
commit wrongdoing.13 The act specifically imposes the
following penalties: (1) fines for the willful understatement of a
cli-ent’s tax liability, (2) fines for the negligent understatement
of a client’s tax liabil-ity, and (3) fines and imprisonment for an
individual and imprisonment and fines for a corporation for
aiding and assisting in the preparation of a false tax return.
Accountants who have violated these provisions can be enjoined
from further federal income tax practice.
Criminal Liability: Racketeer Influenced and Corrupt
Organizations Act
Accountants and other professionals can be named as defendants
in lawsuits that assert violations of the Racketeer Influenced
and Corrupt Organizations Act(RICO).14Securities fraud falls
under the definition of racketeering activity, sothe government
often brings a RICO allegation in conjunction with a securities
fraud allegation.
Persons injured by a RICO violation can bring a private civil
action against the violator and recover treble (triple) damages.
But to bring a private civil RICO action based on securities
fraud, the defendant has to have first been criminally convicted
in connection with the securities fraud.15 A third-party
independent contractor (e.g., an outside accountant) must have
participated in the operation or management of the enterprise to
be liable for civil RICO.16
Criminal Liability: State Securities Laws
Most states have enacted securities laws, many of which are

patterned after fed-eral securities laws. State securities laws
provide for a variety of civil and criminal penalties for
violations of these laws. Many states have enacted all or part of
the Uniform Securities Act, a model act promulgated by the
National Conference ofCommissioners on Uniform State Laws.
Section 101 of the Uniform SecuritiesAct makes it a criminal
offense for accountants and others to willfully falsify fi-nancial
statements and other reports.
Sarbanes-Oxley Act
During the late 1990s and early 2000s, many corporations in the
United States engaged in fraudulent accounting in order to
report inflated earnings or to con-ceal losses. Many public
accounting firms that were hired to audit the financial
statements of these companies failed to detect fraudulent
accounting practices.
In response, Congress enacted the federal Sarbanes-Oxley Act
of 2002 (also called SOX).17 SOX imposes new rules that affect
public accountants. The goals of these rules are to improve
financial reporting, eliminate conflicts of interest, and provide
government oversight of accounting and audit services. Several
ma-jor features of the act that apply to accountants are
discussed in the following paragraphs.
Public Company Accounting Oversight Board (PCAOB)
The act creates the Public Company Accounting Oversight
Board (PCAOB), which consists of five financially literate
members who are appointed by the SEC for five-year terms.
Two of the members must be CPAs, and three must not be
CPAs. The SEC has oversight and enforcement authority over
the board. The board has the authority to adopt rules concerning

auditing, accounting quality control, independence, and ethics
of public companies and public accountants.
Public Accounting Firms Must Register with the PCAOB
To audit a public company, a public accounting firm must
register with the board. Registered accounting firms that audit
more than 100 public companies annually are subject to
inspection and review by the board once a year; all other public
accounting firms must be audited by the board every three
years. The board may discipline public accountants and
accounting firms and order sanctions for in-tentional or reckless
conduct, including suspending or revoking registration with the
board, placing temporary limitations on activities, and assessing
civil money penalties.
Audit and Nonaudit Services
The act makes it unlawful for a registered public accounting
firm to provide si-multaneously audit and certain nonaudit
services to a public company. If a public accounting firm audits
a public company, the accounting firm may not provide the
following nonaudit services to the client: (1) bookkeeping
services;
Sarbanes-Oxley Act of 2002 (SOX)
A federal act that imposes signifi-cant rules for the regulation

of the accounting profession.
financial information systems; (3) appraisal or valuation
services; (4) inter-nal audit services; (5) management functions;
(6) human resources services;
broker, dealer, or investment services; (8) investment banking
services;
legal services; or (10) any other services determined by the
board. A certified public accounting firm may provide tax
services to audit clients if such tax ser-vices are preapproved by
the audit committee of the client.
WEB EXERCISE
Visit the website of the PublicCompany Accounting
OversightBoard (PCAOB) at www.pcaobus.org. What is the
mission of this board?
Audit Report Sign-Off
Each audit by a certified public accounting firm is assigned an
audit partner of the firm to supervise the audit and approve the
audit report. The act requires that a second partner of the
accounting firm review and approve audit reports prepared by
the firm. All audit papers must be retained for at least seven
years. The lead audit partner and reviewing partner must rotate
off an audit every five years.

Certain Employment Prohibited
Any person who is employed by a public accounting firm that
audits a client can-not be employed by that client as the chief
executive officer (CEO), chief finan-cial officer (CFO),
controller, chief accounting officer, or equivalent position for a
period of one year following the audit.
Like a gun that fires at the muzzle and kicks over at the breach,
a cheating transaction hurts the cheater as much as the man
cheated.
Henry Ward Beecher Proverbs from Plymouth Pulpit (1887)
Audit Committee
The act requires that public corporations have an audit
committee that is com-posed of independent members of the
board of directors. These are outside board members who are
not employed by the corporation and do not receive
compensation other than for directors’ duties from the
corporation. The audit committee must have at least one
member who is a financial expert by either education or
experience. The audit committee is responsible for the appoint-
ment of accounting firms to audit the company and the oversight
of such public accounting firms.
CONCEPT SUMMARY

PROVISIONS OF THE SARBANES-OXLEY ACT
Creates the Public Company Accounting Oversight Board
(PCAOB)
Requires public accounting firms to register with the PCAOB
Separates audit services and certain nonaudit services provided
by accountants to clients
Requires an audit partner of the accounting firm to supervise an
audit and approve an audit report prepared by the firm and
requires a second partner of the accounting firm to review and
approve the audit report
Prohibits employment of an accountant by a previous audit
client for certain positions for a period of one year following
the audit
Requires a public company to have an audit committee
composed of independent members of the board of directors that
employs and oversees a public accounting firm
Accountants’ Privilege and Work Papers
In the course of conducting audits and providing other services
to clients, accoun-tants obtain information about their clients
and prepare work papers. Sometimes clients are sued in court,
and the court seeks information about the client from the
accountant. The following paragraphs discuss the law that
applies to these matters.

Accountant–Client Privilege
Sometimes clients of accountants are sued in court. About 20
states have enacted statues that create an accountant–client
privilege. In these states, an accountant cannot be called as a
witness against a client in a court action. The majority of the
states follow the common law, which provides that an
accountant may be called at court to testify against his or her
client.
The U.S. Supreme Court has held that there is no accountant–
client privilege under federal law.18 Therefore, an accountant
could be called as a witness in cases involving federal securities
laws, federal mail or wire fraud, federal RICO, or other federal
criminal statutes.
accountant–client privilege
A state law providing that an ac-countant cannot be called as a
witness against a client in a court action.
Accountants’ Work Papers
Accountants often generate substantial internal work papers as
they perform their services. These papers often include plans
for conducting audits, work as-signments, notes regarding the
collection of data, evidence about the testing of accounts, notes
concerning the client’s internal controls, notes reconciling the
accountant’s report and the client’s records, research,

comments, memorandums, explanations, opinions, and
information regarding the affairs of the client.
Some state statutes provide work product immunity, which
means an accoun-tant’s work papers cannot be discovered in a
court case against the accountant’sclient. Most states do not
provide this protection, and an accountant’s work pa-pers can
be discovered. Federal law allows for discovery of an
accountant’s work papers in a federal case against the
accountant’s client.
Key Terms and Concepts
Accountant (849)
Foreseeability standard
Proportionate liability
Accountant–client
(856)
(859)
privilege (863)
Fraud (852)
Public accountant
Accountant’s work
Generally Accepted
(849)
papers (863)
Accounting Principles
Public Company
Accounting malpractice
(GAAPs) (850)
Accounting Oversight

(negligence) (852)
Generally Accepted
Board (PCAOB) (861)
Actual fraud (852)
Auditing Standards
Qualified opinion (851)
Adverse opinion (851)
(GAASs) (850)
Racketeer Influenced and
American Institute
International Accounting
Corrupt Organizations
of Certified Public
Standards Board
Act (RICO) (860)
Accountants (AICPA)
(IASB) (850)
Registration statement
(850)
International Financial
(857)
Audit (850)
Reporting Standards
Rule 10b-5 (858)
Audit committee (862)
(IFRSs) (850)
Sarbanes-Oxley Act of
Auditor’s opinion (851)
Joint and several liability
2002 (SOX) (861)
Breach of contract (851)
(859)
Section 10A of the
Certified public
Limited liability
Securities Exchange

accountant (CPA) (849)
partnership (LLP) (849)
Act of 1934 (859)
Constructive fraud (852)
Private Securities
Section 10(b) of the
Disclaimer of opinion
Litigation Reform Act
Securities Exchange
(851)
of 1995 (859)
Act of 1934 (858)
Due diligence defense (858)
Privity of contract (857)
Section 11(a) of the
Engagement (851)
Privity-like relationship
Securities Act of 1933
Expertised portion (857)
(854)
(858)
work product immunity
A state law providing that an ac-countant’s work papers cannot
be used against a client in a court action.

Securities Exchange
Act of 1934 (858)
Section 24 of the Securities
Act of 1933 (860)
Securities Exchange
Act of 1934 (860)
Section 101 of the Uniform
Securities Act (861)
Section 552 of the
Restatement (Second)
of Torts (854)
Tax Reform Act of 1976 (860)
Ultramares Corporation v. Touche (852)

Ultramares doctrine (853)Unaudited financial
statements (852) Uniform Securities Act
(861)
Unqualified opinion (851) Work product immunity
(863)
Critical Legal Thinking Cases
51.1 Accountant’s Liability to a Third Party BrandonApparel
Group, Inc. (Brandon), made and sold cloth-ing and licensed the
making and selling of clothing in exchange for a percentage of
the licensees’ sales rev-enues. Brandon began borrowing money
from Johnson Bank and in two years owed the bank $10 million.
George Korbakes & Company, LLP (GKCO) was the au-ditor of
Brandon during the period at issue in this case. When Brandon
was seeking an additional loan from the bank, Brandon
instructed GKCO to give the bank the audit report that GKCO
had just completed, which GKCO gave to Johnson Bank.
The audit report summarized Brandon’s financial re-sults for
the year and revealed that Brandon had serious problems. But
the audit report contained several errors. First, the audit report
classified a $1 million lawsuit Brandon had brought against a
third party as an asset, but it was in fact only a contingency that
should not have been listed as an asset. Second, Brandon’s sales
were inflated by 50 percent because sales of a licensee were
treated as if they were Brandon’s sales. However, footnotes in
the audit report indicated that Brandon might not prevail in the
lawsuit and that Brandon’s sales included those of a licensee.

After receiving the audit report, Johnson Bank made further
loans to Brandon. Brandon did not repay John-son Bank the new
money it borrowed. Johnson Bank sued GKCO, alleging that
GKCO committed the tort of negligent misrepresentation and
was therefore liable for the money lost by the bank as a result of
the errors in the audit report prepared by GKCO. Is GKCO, the
auditor of Brandon, liable to Johnson Bank for negli-gent
misrepresentation under Section 552 of the Re-statement
(Second) of Torts? Johnson Bank v. George Korbakes &
Company, LLP, 472 F.3d 439, 2006 U.S.App. Lexis 31058
(United States Court of Appeals for the Seventh Circuit, 2006)
51.2 Auditor’s Liability to Third Party Michael H.Clott was
chairman and chief executive officer of First American
Mortgage Company, Inc. (FAMCO), which originated loans and
sold the loans to investors, in-cluding E. F. Hutton Mortgage
Corp. (Hutton). FAMCO employed Ernst & Whinney, a national
CPA firm, to con-duct audits of its financial statements. Hutton
received a copy of the financial statements with an unqualified
certification by Ernst & Whinney. Hutton bought more than
$100 million of loans from FAMCO. As a result of massive
fraudulent activity by Clott, which was unde-tected by Ernst &
Whinney during its audit, many of the loans purchased by
Hutton proved to be worthless. Ernst & Whinney had no
knowledge of Clott’s activi-ties. Hutton’s own negligence
contributed to most of the losses it suffered. Hutton sued Ernst
& Whinney for
fraud and negligence. Is Ernst & Whinney liable? E. F.Hutton
Mortgage Corporation v. Pappas, 690 F.Supp.1465, 1988 U.S.
Dist. Lexis 6444 (United States District Court for the District of
Maryland)
51.3 Accountant’s Liability to Third Party GiantStores

Corporation (Giant) hired Touche Ross & Co. (Touche), a
national CPA firm, to conduct audits of the company’s financial
statements for two years. Touche gave an unqualified opinion
for both years. Touche was unaware of any specific use of the
audited statements by Giant. After receiving copies of these
audited finan-cial statements from Giant, Harry and Barry
-Rosenblum (Rosenblums) sold their retail catalog showroom
business to Giant in exchange for 80,000 shares of Giant stock.
One year later, a major fraud was uncovered at Giant that
caused its bankruptcy. Because of the bankruptcy, the stock that
the Rosenblums received became worth-less. In conducting
Giant’s audits, Touche had failed to uncover that Giant did not
own certain assets that appeared on its financial statements and
that Giant had omitted substantial amounts of accounts payable
from its records. The Rosenblums sued Touche for ac-counting
malpractice. Is Touche liable for accounting malpractice under
any of the three negligence theories discussed in this chapter?
H. Rosenblum, Inc. v. Adler, 461 A.2d 138,1983 N.J. Lexis
2717 (Supreme Court of New Jersey)
51.4Ultramares Doctrine Texscan Corporation(Texscan) was a
corporation located in Phoenix, Arizona. The company was
audited by Coopers & Lybrand (Coopers), a national CPA firm
that prepared audited financial statements for the company. The
Lindner Fund, Inc., and the Lindner Dividend Fund, Inc. (Lind-
ner Funds), were mutual funds that invested in secu-rities of
companies. After receiving and reviewing the audited financial
statements of Texscan, Lindner Funds purchased securities in
the company. Thereafter, Tex-scan suffered financial
difficulties, and Lindner Funds suffered substantial losses on its
investment. Lindner Funds sued Coopers, alleging that Coopers
was negli-gent in conducting the audit and preparing Texscan’s
financial statements. Can Coopers be held liable to Lindner
Funds for accounting malpractice under the Ultramares doctrine,
Section 552 of the Restatement (Second) of Torts, or the

foreseeability standard? Lind-ner Fund v. Abney, 770 S.W.2d
437, 1989 Mo. App.Lexis 490 (Court of Appeals of Missouri)
51.5 Section 10(b) The Firestone Group, Ltd. (Fire-stone), a
company engaged in real estate development, entered into a
contract to sell nursing homes it owned to a buyer. The buyer
paid a $30,000 deposit to Firestone
and promised to pay the remainder of the $28 million purchase
price in the future. The profit on the sale, if consummated,
would have been $2 million.
To raise capital, Firestone planned on issuing $7.5 million of
securities to investors. Firestone hired Laventhol, Krekstein,
Horwath & Horwath (Laventhol), a national CPA firm, to audit
the company for the fis-cal year. When Laventhol proposed to
record the profit from the sale of the nursing homes as
unrealized gross profit, Firestone threatened to withdraw its
account from Laventhol. Thereafter, Laventhol decided to rec-
ognize $235,000 as profit and to record the balance of
$1,795,000 as “deferred gross profit.” This was done even
though, during the course of the audit, Laventhol learned that
there was no corporate resolution approv-ing the sale, the sale
transaction was not recorded in the minutes of the corporation,
and the buyer had a net worth of only $10,000. Laventhol also
failed to verify the enforceability of the contracts.
Gerald M. Herzfeld and other investors received cop-ies of the
audited financial statements and invested in the securities
issued by Firestone. Later, when the buyer did not purchase the
nursing homes, Firestone declared bankruptcy. Herzfeld and the

other investors
lost most of their investment. Herzfeld sued Laventhol for
securities fraud, in violation of Section 10(b) of the Securities
Exchange Act of 1934. Is Laventhol liable? Herzfeld v.
Laventhol, Krekstein, Horwath & Horwath,540 F.2d 27, 1976
U.S. App. Lexis 8008 (United States Court of Appeals for the
Second Circuit)
51.6 Accountant–Client Privilege For five years,Chaple, an
accountant licensed by the state of Georgia, provided
accounting services to Roberts and several corporations in
which Roberts was an officer and share-holder (collectively
called Roberts). During this period, Roberts provided Chaple
with confidential information with the expectation that this
information would not be disclosed to third parties. Georgia
statutes provide for an accountant–client privilege. When the
IRS began inves-tigating Roberts, Chaple, voluntarily and
without being subject to a subpoena, released some of this
confidential information about Roberts to the Internal Revenue
Ser-vice (IRS). Roberts sued Chaple, seeking an injunction to
prevent further disclosure, requesting return of all in-formation
in Chaple’s possession, and seeking monetary damages. Who
wins? Roberts v. Chaple, 369 S.E.2d 482, 1988 Ga. App. Lexis
554 (Court of Appeals of Georgia)
Ethics Cases
51.7 Ethics Case The archdiocese ofMiami established a
health and welfare plan to provide medical coverage for its
employees.
The archdiocese purchased a stop-loss insurance pol-icy from

Lloyd’s of London (Lloyd’s), which provided insurance against
losses that exceeded the basic cover-age of the plan. The
archdiocese employed Coopers & Lybrand (Coopers), a national
firm of CPAs, to audit the health plan every year for 12 years.
The audit program required Coopers to obtain a copy of the
current stop-loss policy and record any changes. After two
years, Coopers neither obtained a copy of the policy nor
verified the existence of the Lloyd’s insur-ance. Nevertheless,
Coopers repeatedly represented to the trustees of the
archdiocese that the Lloyd’s insur-ance policy was in effect, but
in fact it had been can-celed. During this period of time, Dennis
McGee, an employee of the archdiocese, had embezzled funds
that were to be used to pay premiums on the Lloyd’s policy. The
archdiocese sued Coopers for accounting malprac-tice and
sought to recover the funds stolen by McGee. Did Coopers act
ethically in this case? Is Coopers liable?
Coopers & Lybrand v. Trustees of the Archdiocese
of Miami, 536 So.2d 278, 1988 Fla. App. Lexis 5348(Court of
Appeal of Florida)
51.8 Ethics Case Milton Mende purchased the StarMidas Mining
Co., Inc., for $6,500. This Nevada corpo-ration was a shell
corporation with no assets. Mende changed the name of the
corporation to American Eq-uities Corporation (American
Equities) and hired Ber-nard Howard to prepare certain
accounting reports so that the company could issue securities to
the public. In preparing the financial accounts, Howard (1)
made no examination of American Equities’ books; (2) falsely
included an asset of more than $700,000 on the books, which
was a dormant mining company that had been through
insolvency proceedings; (3) included in the profit and loss
statement companies that Howard knew American Equities did
not own; and (4) recklessly stated as facts things of which he

was ignorant. Did Howard act unethically? The United States
sued Howard for crimi-nal conspiracy in violation of federal
securities laws. Is Howard criminally liable? United States v.
Howard, 328 F.2d 854, 1964 U.S. App. Lexis 6343 (United
States Court of Appeals for the Second Circuit)
Notes
GAAPs are official standards promulgated by the Finan-cial
Accounting Standards Board (FASB) and predecessor
accounting ruling bodies. GAAPs also include unofficial
pronouncements, interpretations, research studies, and
textbooks.
GAASs are issued by the Auditing Standards Committee of the
American Institute of Certified Public Accountants (AICPA).
255 N.Y. 170, 174 N.E. 441, 1931 N.Y. Lexis 660 (Court of
Appeals of New York).
15 U.S.C. Section 77k(a).
15 U.S.C. Section 78j(b).
17 C.F.R. Section 240.10b-5.
Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375,1976
U.S. Lexis 2 (Supreme Court of the United States).
Ch46
While competition cannot be created by statutory enactment, it
can in large measure be revived by changing the laws and

forbidding the practices that killed it, and by enacting laws that
will give it heart and occasion again. We can arrest and prevent
monopoly.”
—Woodrow Wilson
former president of the United States
Speech, August 7, 1912
Introduction to Antitrust Lawand Unfair Trade Practices
The U.S. economic system was built on the theory of freedom of
competition. After the Civil War, however, the U.S. economy
changed from a rural and agricul-tural economy to an
industrialized and urban one. Many large industrial trusts were
formed during this period. These arrangements resulted in a
series of mo-nopolies in basic industries such as oil and gas,
sugar, cotton, and whiskey.
Because the common law could not deal effectively with these
monopolies, Congress enacted a comprehensive system of
antitrust laws to limit anticompeti-tive behavior. Almost all
industries, businesses, and professions operating in the United
States were affected. Although many states have also enacted
antitrust laws, most actions in this area are brought under
federal law.
This chapter discusses federal and state antitrust laws.
Federal Antitrust Law
Federal antitrust law comprises several major statutes that
prohibit certain anti-competitive and monopolistic practices.
The federal antitrust statutes are broadly drafted to reflect the

government’s enforcement policy and to allow it to respond to
economic, business, and technological changes. Federal
antitrust laws provide for both government and private lawsuits.
The following feature describes the major federal antitrust
statutes.
People of the same trade seldom meet together, even for
merriment and diversion, but that the conversation ends in a
conspiracy against the public, or in some contrivance to raise
prices.
Adam Smith
The Wealth of Nations (1776)
antitrust laws
A series of laws enacted to limit anticompetitive behavior in
almost all industries, businesses, and professions operating in
the United States.
Landmark Law
Federal Antitrust Statutes
After the Civil War, the United States became a leader of the

Industrial Revolution. Behemoth companies and trusts were
established. The most powerful of these were
John D. Rockefeller’s Standard Oil Company, Andrew
Carnegie’s Carnegie Steel, Cornelius Vanderbilt’s New York
Central Railroad System, and J. P. Morgan’s banking house.
These corporations dominated their respective industries, many
obtaining monopoly power. For example, the Rockefeller oil
trust controlled 90 percent of the country’s oil refining
capacity. Mergers and monopolization of industries were
rampant.
During the late 1800s and early 1900s, Congress en-acted a
series of antitrust laws aimed at curbing abusive
and monopoly practices by business. During this time,
Congress enacted the following federal statutes:
The Sherman Antitrust Act2 (or) is a federal statute, enacted in
1890, that makes certain restraints of trade and monopolistic
acts illegal.
The Clayton Antitrust Act3 (or Clayton Act) is a federal statute,
enacted in 1914, that regulates mergers and prohibits certain
exclusive dealing arrangements.
The Federal Trade Commission Act (FTC Act)4 is a federal
statute, enacted in 1914, that prohibits unfair methods of
competition.
The Robinson-Patman Act5 is a federal statute, enacted in 1930,
that prohibits price discrimination.
PART IX Government Regulation
Each of these important statutes is discussed in this chapter.

WEB EXERCISE
Go to www.usdoj.gov/atr/overview.html and read the U.S.
Justice Department’s overview of the Antitrust Division.
Government Actions
The federal government is authorized to bring government
actions to enforce fed-eral antitrust laws. Government
enforcement of federal antitrust laws is divided between the
Antitrust Division of the Department of Justice and the Bureau
ofCompetition of the Federal Trade Commission. The Sherman
Act is the onlymajor antitrust act that includes criminal
sanctions. Intent is the prerequisite for criminal liability under
this act. Penalties for individuals include fines and prison
terms; corporations may be fined.
The government may seek civil damages, including treble
damages, for viola-tions of antitrust laws.6 Broad remedial
powers allow the courts to order a number of civil remedies,
including orders for divestiture of assets, cancellation of con-
tracts, liquidation of businesses, licensing of patents, and such.
Private parties cannot intervene in public antitrust actions
brought by the government.

Section 4 of the Clayton Act
A section stating that anyone injured in his or her business or
property by the defendant’s violation of any federal antitrust
law (except the Federal Trade Commission Act) may bring a
private civil action and recover from the defendant treble
damages plus reasonable costs and attorney’s fees.
treble damages
Damages that may be awarded in a successful civil antitrust
lawsuit, in an amount that is triple the amount of actual
damages.
Private Actions
Section 4 of the Clayton Act permits any person who suffers
antitrust injury in hisor her “business or property” to bring a
private civil action against the offenders.7 Consumers who have
to pay higher prices because of an antitrust violation have
recourse under this provision. To recover damages, plaintiffs
must prove that they suffered antitrust injuries caused by the
prohibited act.
Successful plaintiffs may recover treble damages (i.e., triple the
amount of the actual damages), plus reasonable costs and
attorney’s fees. Damages may be calculated as lost profits, an
increase in the cost of doing business, or a decrease in the value
of tangible or intangible property caused by the antitrust
violation. This rule applies to all violations of the Sherman Act,
the Clayton Act, and the Robinson-Patman Act. Only actual
damages—not treble damages—may be re-covered for violations

of the FTC Act. A private plaintiff has four years from the date
on which an antitrust injury occurred to bring a private civil
treble-damages action. Only damages incurred during this four-
year period are recoverable. This statute is tolled (i.e., does not
run) during a suit by the government.
government judgment
A judgment obtained by the
-government against a defendant for an antitrust violation that
may be used as prima facie evidence of liability in a private
civil treble-damages action.
Effect of a Government Judgment
A government judgment obtained against a defendant for an
antitrust violation may be used as prima facie evidence of
liability in a private civil treble-damages action. Antitrust
defendants often opt to settle government-brought antitrust ac-
tions by entering a plea of nolo contendere in a criminal action
or a consentdecree in a government civil action. These pleas
usually subject the defendant topenalty without an admission of
guilt or liability.
Section 16 of the Clayton Act permits the government or a
private plaintiffto obtain an injunction against anticompetitive
behavior that violates antitrust laws.8 Only the FTC can obtain
an injunction under the FTC Act.

Section 1 of the Sherman Act
A section that prohibits contracts, combinations, and
conspiracies in restraint of trade.
Restraints of Trade: Section 1of the Sherman Act
In 1890, Congress enacted the Sherman Act in order to outlaw
anticompetitive behavior. The Sherman Act has been called the
“Magna Carta of free enterprise.”9 Section 1 of the Sherman
Act is intended to prohibit certain concerted anticom-petitive
activities. It provides:
Every contract, combination in the form of trust or otherwise, or
conspir-acy, in restraint of trade or commerce among the
several states, or with
CHAPTER 46 Antitrust Law and Unfair Trade Practices 763
foreign nations, is hereby declared to be illegal. Every person
who shall make any contract or engage in any combination or
conspiracy hereby declared to be illegal shall be deemed guilty
of a felony.10
In other words, Section 1 outlaws contracts, combinations, and
conspiracies in restraint of trade. Thus, it applies to unlawful
conduct by two or more parties. The agreement may be written,
oral, or inferred from the conduct of the parties.
The U.S. Supreme Court has developed two different tests for
determining the lawfulness of a restraint. These two tests—the

rule of reason and the per se rule— are discussed in the
following paragraphs.
Rule of Reason
If Section 1 of the Sherman Act were read literally, it would
prohibit almost all contracts. In the landmark case Standard Oil
Company of New Jersey v. UnitedStates,11the Supreme Court
adopted therule of reasonstandard for analyzingSection 1 cases.
This rule holds that only unreasonable restraints of trade violate
Section 1 of the Sherman Act. Reasonable restraints are lawful.
The courts exam-ine the following factors in applying the rule
of reason to a particular case:
The pro- and anticompetitive effects of the challenged restraint
The competitive structure of the industry
The firm’s market share and power
The history and duration of the restraint
Other relevant factors
Critical Legal Thinking
What are the purposes of antitrust law? Has antitrust law been
enforced more vigorously at different times in history? How
vigorously is it enforced today?

rule of reason
A rule stating that only -unreasonable restraints of trade violate
Section 1 of the Sherman Act. The court must examine the pro-
and anticompeti-tive effects of a challenged restraint.
Per se Rule
The Supreme Court adopted the per serule, which is applicable
to restraints of trade that are considered inherently
anticompetitive. No balancing of pro- and anticompetitive
effects is necessary in such cases: Such a restraint is automati-
cally in violation of Section 1 of the Sherman Act. When a
restraint is character-ized as a per se violation, no defenses or
justifications for the restraint will save it, and no further
evidence need be considered. Restraints that are not
characterized as per se violations are examined using the rule of
reason.
per se rule
A rule that is applicable to restraints of trade considered
inherently anticompetitive. Once this determi-nation is made
about a restraint of trade, the court will not permit any defenses
or justifications to save it.

CONCEPT SUMMARY
RESTRAINTS OF TRADE: SECTION 1 OF THE SHERMAN
ACT
Rule
Description
Rule of reason
Requires a balancing of pro- and anticompetitive effects of the
challenged restraint.
-Restraints that are found to be unreasonable are unlawful and
violate Section 1 of the
-Sherman Act. Restraints that are found to be reasonable are
lawful and do not violate
-Section 1 of the Sherman Act.
Per se rule
Applies to restraints that are inherently anticompetitive. No
justification for the restraint
is permitted. Such restraints automatically violate Section 1 of
the Sherman Act.
Horizontal Restraints of Trade
A horizontal restraint of trade occurs when two or more
competitors at the samelevel of distribution enter into a
contract, combination, or conspiracy to restraintrade (see
Exhibit 46.1). Many horizontal restraints fall under the per se

rule; others are examined under the rule of reason. The most
common forms of hori-zontal restraint are discussed in the
following paragraphs.
horizontal restraint of trade A restraint of trade that occurs
when two or more competitors at the same level of distribution
enter into a contract, combination, or -conspiracy to restrain
trade.
Exhibit 46.1 HORIZONTAL
RESTRAINT OF TRADE
price fixing
A restraint of trade that occurs when competitors in the same
line of business agree to set the price of the goods or services
they sell, rais-ing, depressing, fixing, pegging, or stabilizing the
price of a commodity or service.
Competitor

Agreement
Competitor
No. 1
to restrain trade
No. 2
Price Fixing
Horizontal price fixing occurs when competitors in the same
line of business agree to set the price of goods or services they
sell. Price fixing is defined as rais-ing, depressing, fixing,
pegging, or stabilizing the price of a commodity or service.
Illegal price fixing includes setting minimum or maximum
prices or fixing the quantity of a product or service to be
produced or provided. Although most price fixing agreements

occur between sellers, an agreement among buyers to agree to
the price they will pay for goods or services is also price fixing.
The plaintiff bears the burden of proving a price fixing
agreement.
Price fixing is a per se violation of Section 1 of the Sherman
Act. No defenses or justifications of any kind—such as “the
price fixing helps consumers or pro-tects competitors from
ruinous competition”—can prevent the per se rule from
applying.
Example If the three largest automobile manufacturers agreed
among themselves what prices to charge automobile dealers for
this year’s models, they would be engaging in sellers’ illegal
per se price fixing.
Example If the three largest automobile manufacturers agreed
among themselves what price they would pay to purchase tires
from tire manufactures, they would be engaging in buyers’
illegal per se price fixing.
The following feature discusses a per se horizontal restraint of
trade.
Ethics
High-Tech Companies Settle Antitrust Charges
Adobe Systems Inc., Apple Inc., Google Inc., Intel Corpora-
tion, Intuit Inc., Lucasfilm Ltd., and Pixar (defendants) are
high-tech companies with principal places of business in the
San Francisco–Silicon Valley area of California. In a free labor

market, these companies would compete for high-tech talent to
hire as employees. One way of doing so is by cold calling,
which includes communicating directly with and soliciting
current employees of other companies either orally, in writing,
by telephone, or electronically.
After receiving complaints from certain high-tech em-ployees,
the U.S. Department of Justice (DOJ) investigated alleged
anticompetitive behavior by the defendant compa-nies. The
charges were that the defendants had entered into
nonsolicitation agreements among themselves not to cold-call
employees of the other companies in order
to prevent a bidding war for the best talent in the area, thus
depressing salaries of the effected employees. The defendants
were accused of memorializing agreements in CEO-to-CEO e-
mails and other documents, including “Do Not Call” lists,
putting each firm’s high-tech employees off limits to other
defendants.
After receiving documents produced by the defendants and
interviewing witnesses, the DOJ concluded that the defendants
reached anticompetitive agreements that elimi-nated a
significant form of competition that deprived em-ployees from
receiving competitively important information and access to
better job opportunities. The DOJ concluded that the
nonsolicitation agreements disrupted normal price setting for
labor and held that the defendants had entered into agreements
that were naked horizontal restraints of trade and thus per se
violations of Section 1 of the Sher-man Act.
After substantial investigation, the DOJ filed complaints in
federal court against the defendants for conspiracy to violate
antitrust laws. Eventually, the DOJ and the defen-dants settled
the case by agreeing to stipulated judgments whereby the
defendants were enjoined from attempting to enter into,
maintaining or enforcing any agreement with any other person
or company, or in any way refraining from soliciting, cold-
calling, recruiting, or otherwise competing for employees of any

other person or company. In reaching this agreement, the
defendants were not required to admit
CHAPTER 46 Antitrust Law and Unfair Trade Practices 765
to any wrongdoing or violation of the law. United States
v.Adobe Systems Inc. and United States v. Lucasfilm, Inc.,2011
U.S. Dist. Lexis 83756 (United States District Court for the
District of Columbia, 2011)
Ethics Questions Why did the DOJ and the defendants enter
into a settlement rather than go to trial? Was it proper for the
government to agree to allow the defendants to not admit to any
wrongdoing?
Division of Markets
Competitors who agree that each will serve only a designated
portion of the mar-ket are engaging in a division of markets (or
market sharing), which is a per se violation of Section 1 of the
Sherman Act. Each market segment is considered a small
monopoly served only by its designated “owner.” Horizontal
market shar-ing arrangements include division by geographical
territories, customers, and products.
Example Three national breweries agree among themselves that
each one will be assigned one-third of the country as its
geographical “territory,” and each agrees not to sell beer in the
other two companies’ territories. This arrangement is a perse
illegal geographical division of markets.

Example Three largest sellers of media software agree that each
can sell media software to only one designated media software
purchaser and not to any other media software purchasers. This
arrangement is a per se illegal product division of markets.
division of markets (market sharing)
A restraint of trade in which compet-itors agree that each will
serve only a designated portion of the market.
Group Boycotts
A group boycott (or refusal to deal) occurs when two or more
competitors at one level of distribution agree not to deal with
others at a different level of -distribution. A group boycott
could be a group boycott by sellers or a group
boycott- by purchasers.
If a group of sellers agrees not to sell their products to a certain
buyer, they would be engaging in a group boycott by sellers.
Example A group of high-fashion clothes designers and sellers
agree not to sell their clothes to a certain discount retailer, such
as Walmart. This is a group boy-cott by sellers (see Exhibit
46.2).

Seller
Agreement
Seller
Competitor
Competitor
No. 1
not to deal
No. 2
with a customer

Boycotted
Customer
group boycott (refusal to deal)
A restraint of trade in which two or more competitors at one
level of distribution agree not to deal with others at another
level of distribution.
Exhibit 46.2 GROUP

BOYCOTT BY SELLERS
If a group of purchasers agrees not to purchase a product from a
certain seller, they would be engaging in a group boycott by
purchasers.
Example A group of rental car companies agree not to purchase
Chrysler automo-biles for their fleets. This is a group boycott
by purchasers (see Exhibit 46.3).
Exhibit 46.3 GROUP
BOYCOTT BY
PURCHASERS
Boycotted
Supplier
Purchaser
Agreement
Purchaser
Competitor

Competitor
No. 1
not to deal
No. 2
with a supplier
The courts have found that most group boycotts are per se
illegal. If not found to be per se illegal, a group boycott will be
examined using the rule of reason. Nevertheless, most group
boycotts are found to be illegal.
Other Horizontal Agreements
Some horizontal agreements entered into by competitors at the
same level of

distribution-—including trade association activities and rules,
exchange of non-price information, participation in joint
ventures, and the like—are examined using the rule of reason.
Reasonable restraints are lawful; unreasonable restraints violate
Section 1 of the Sherman Act.
vertical restraint of trade
A restraint of trade that occurs when two or more parties on
differentlevels of distribution enter into acontract, combination,
or conspiracy to restrain trade.
Exhibit 46.4 VERTICAL
RESTRAINT- OF TRADE
resale price maintenance (vertical price fixing)
A per se violation of Section 1 of the Sherman Act that occurs
when a party at one level of distribution enters into an
agreement with a party at another level to adhere to a price
schedule that either sets or stabilizes prices.

Vertical Restraints of Trade
A vertical restraint of trade occurs when two or more parties on
different levelsof distribution enter into a contract,
combination, or conspiracy to restrain trade(see Exhibit 46.4).
The Supreme Court has applied both the per se rule and the rule
of reason in determining the legality of vertical restraints of
trade under Section 1 of the Sherman Act. The most common
forms of vertical restraint are discussed in the following
paragraphs.
Supplier
Agreement to
restrain trade
Retailer
Resale Price Maintenance
Resale price maintenance (or vertical price fixing) occurs when
a party at onelevel of distribution enters into an agreement with

a party at another level to ad-here to a price schedule that either
sets or stabilizes prices.
CHAPTER 46 Antitrust Law and Unfair Trade Practices
767
The setting of minimum resale prices is a per se violation of
Section 1.12
Example Camera Corporation manufactures a high-end digital
camera and sets a minimum price below which the camera
cannot be sold by retailers to consumers(e.g., the cameras
cannot be sold for less than $1,000 to consumers by retailers).
This constitutes per se illegal minimum resale price
maintenance.
The setting of maximum resale prices is examined using the rule
of reason to determine whether it violates Section 1.13
Example Digital Corporation produces a digital device on which
it has a patent. Digital Corporation sets a maximum price above
which the device cannot be sold by retailers to consumers (e.g.,
the cameras cannot be sold for more than $500 to consumers by
retailers). This conduct will be examined using the rule of
reason and most likely will be found to be lawful.
Nonprice Vertical Restraints
The legality of nonprice vertical restraints of trade under
Section 1 of the Sher-man Act is examined by using the rule of
reason. A nonprice vertical restraint is unlawful under this
analysis if its anticompetitive effects outweigh its procompeti-
tive effects. Nonprice vertical restraints include situations in
which a manufac-turer assigns exclusive territories to retail
dealers or limits the number of dealers that may be located in a

certain territory.
The following U.S. Supreme Court case involves the issue of
defining concerted action for Sherman Act Section 1 purposes.
nonprice vertical restraints
A restraint of trade that is unlawful under Section 1 of the
Sherman Act if its anticompetitive effects out-weigh their
procompetitive effects.
CASE 46.1U.S. SUPREME COURT CASE Contract,
Combination, or Conspiracy
American Needle, Inc. v. National Football League
560 U.S. 183, 130 S.Ct. 2201, 2010 U.S. Lexis 4166 (2010)
Supreme Court of the United States
“Section 1 applies only to concerted action that restrains trade.”
—Stevens, Justice
Facts
The National Football League (NFL) is an unin-corporated
association that includes 32 separately owned professional
football teams. Each team has its own name, colors, logo,

trademarks, and other intellectual property. Rather than sell
their sports memorabilia individually, the teams formed Na-
tional Football League Properties (NFLP) to mar-ket caps,
jerseys, and other sports memorabilia for all of the teams. Until
2000, NFLP granted nonex-clusive licenses to a number of
vendors, includ-ing American Needle, Inc. In December 2000,
the teams voted to authorize NFLP to grant exclusive licenses.
NFLP granted Reebok International Ltd. an exclusive 10-year
license to manufacture and sell trademarked caps and other
memorabilia for all 32 NFL teams.
American Needle sued the NFL, the teams, and NFLP, alleging
that the defendants engaged in an illegal contract, combination,
or conspiracy, in violation of Section 1 of the Sherman Act. The
defendants argued that they were a single economic enterprise
and there-fore incapable of the alleged conduct. The U.S.
district court held that the defendants were a single entity and
granted summary judgment for the defendants. The U.S. court of
appeals affirmed the judgment. The case was appealed to the
U.S. Supreme Court.
Issue
Are the NFL, the NFL teams, and the NFLP separate legal
entities, capable of engaging in a contract, com-bination, or
conspiracy, as defined by Section 1 of the Sherman Act?
Language of the U.S. Supreme Court
Section 1 applies only to concerted action that restrains trade.
Directly relevant to this case, the teams compete in the market
for
(case continues)
768

intellectual property. To a firm making hats,
Decision
the Saints and the Colts are two potentially
The U.S. Supreme Court held that the NFL, the in-
competing suppliers of valuable trademarks.
dividual teams, and the NFLP were separate entities
Decisions by NFL teams to license their sepa-
capable of engaging in concerted activity, in violation
rately owned trademarks collectively and to
of Section 1 of the Sherman Act. The Supreme Court
only one vendor are decisions that deprive
remanded the case for further proceedings.
the marketplace of independent centers of de-
cision making, and therefore of actual or po-
Ethics Questions
tential competition. For that reason, decisions

Do you think that the defendants’ conduct violated
by the NFLP regarding the teams’ separately
owned intellectual property constitute con-
Section1 of the Sherman Act? Do you think there
certed action.
was any unethical conduct in this case?
unilateral refusal to deal
A unilateral choice by one party not to deal with another party.
This does not violate Section 1 of the Sherman Act because
there is not concerted action.

Unilateral Refusal to Deal
The U.S. Supreme Court has held that a firm can unilaterally
choose not to deal with
another party without being liable under Section 1 of the
Sherman Act. A unilateral-
refusal to deal is not a violation of Section 1 because there is no
concerted action
with others. This rule was announced in United States v.
Colgate & Co.14 and is
therefore often referred to as the Colgate doctrine.
Example If Louis Vuitton, a maker of expensive women’s
clothing, shoes, hand-bags, and accessories, refuses to sell its
merchandise to Walmart stores, this is a lawful unilateral
refusal to deal.
conscious parallelism
A doctrine stating that, if two or more firms act the same but no
concerted action is shown, there is no violation of Section 1 of
the Sherman Act.

Noerr doctrine
A doctrine statingthat that two or more persons can petition the
executive, legislative, or judicial branch of the government or
admin-istrative agencies to enact laws or take other action
without violating antitrust laws.
Conscious Parallelism
Sometimes two or more firms act the same but have done so
individually. If two or more firms act the same but no concerted
action is shown, there is no violation of Section 1 of the
Sherman Act. This doctrine is often referred to as
consciousparallelism. Thus, if two competing manufacturers of
a similar product both sepa-rately reach an independent decision
not to deal with a retailer, there is no viola-tion of Section 1 of
the Sherman Act. The key is that each of the manufacturers
acted on its own.
Example If Louis Vuitton, Gucci, and Chanel, makers of
expensive women’s cloth-ing, shoes, handbags, and accessories,
each independently makes a decision not to sell their products
to Walmart, this is lawful conscious parallelism. There is no
violation of Section 1 of the Sherman Act because the parties
did not agree with one another in making their decisions.
Noerr Doctrine
The Noerrdoctrine holds that two or more persons may petition
the executive, legislative, or judicial branch of the government
or administrative agencies to enact laws or to take other action
without violating antitrust laws. The rationale behind this

doctrine is that the right to petition the government has
precedence because it is guaranteed by the Bill of Rights.15
Example General Motors and Ford collectively petition
Congress to pass a law that would limit the importation of
foreign automobiles into the United States. This is lawful
activity under the Noerr doctrine.
CHAPTER 46 Antitrust Law and Unfair Trade Practices769
Monopolization: Section 2 of the Sherman Act
By definition, monopolies have the ability to affect the prices of
goods and ser-vices. Section 2 of the Sherman Act was enacted
in response to widespread con-cern about the power generated
by this type of anticompetitive activity. Section 2 of the
Sherman Act prohibits the act of monopolization. It states:
Every person who shall monopolize, or attempt to monopolize,
or combine or conspire with any other person or persons, to
monopolize any part of the trade or commerce among the
several States, or with foreign nations, shall be deemed guilty
of a felony.16
Proving that a defendant is in violation of Section 2 means
proving that the defen-dant (1) in the relevant market (2)
possesses monopoly power and (3) engaged in a willful act of
monopolization to acquire or maintain that power. These three
elements are discussed in the following paragraphs.
Section 2 of the Sherman Act

A section that prohibits monopoliza-tion and attempts or
conspiracies to monopolize trade.
1. Relevant Market
Identifying the relevant market for a Section 2 action requires
defining the rel-evant product or service market and
geographical market. The definition of the relevant market often
determines whether the defendant has monopoly power.
Consequently, this determination is often litigated.
The relevant product or service market generally includes
substitute products or services that are reasonably
interchangeable with the defendant’s products or services.
Defendants often try to make their market share seem smaller by
argu-ing for a broad definition of the product or service market.
Plaintiffs, on the other hand, usually argue for a narrow
definition.
Example If the government sued the Anheuser-Busch
Corporation InBev, which is the largest beer producer in the
United States, for violating Section 2 of the Sher-man Act, the
government would argue that the relevant product market is
beer sales. Anheuser-Busch, on the other hand, would argue that
the relevant product market is sales of all alcoholic beverages
or even of all drinkable beverages.
The relevant geographical market is usually defined as the area
in which the defendant and its competitors sell the product or
service. This may be a national, regional, state, or local area,
depending on the circumstances.
Examples If the government sued The Coca-Cola Company for
violating Section 2 of the Sherman Act, the relevant
geographical market would be the nation. If the largest owner of

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