Introduction
The globalization of business and the accounting standards that apply to business mean it is time to re-visit the decades-old Joint Policy Statement (Joint Policy).1
The Canadian Institute of Chartered Accountants (CICA) recently announced that international accounting principles will replace Canadian generally accepted accounting principles (GAAP), perhaps as early as 2008.2 In addition, the Ontario Securities Act 3 Canada Business Corporations Act 4 and Ontario Business Corporations Act 5 have recently been changed to permit U.S. GAAP reporting for inter-listed companies. Canadian lawyers who represent businesses are routinely asked to respond to audit enquiries from their cross-border clients, and in particular, their U.S. clients. The frequency of U.S. audit enquiries will only increase with the globalization of business and accounting standards. However, the Joint Policy sets the parameters for Canadian lawyers’ responses to only Canadian audit enquiries.
How then should Canadian counsel respond to U.S. audit enquiries in a way that will be most helpful to their American clients for U.S. financial reporting purposes? At the same time, what are Canadian counsel’s professional responsibilities in responding to U.S. audit enquiries? What limitations on the scope and use of their audit responses should Canadian counsel express?
This article analyzes these and other emerging professional issues, drawing on both the Joint Policy and the ABA Statement.6 A sample form of audit response for external Canadian counsel (Sample Response), incorporating the best practices discussed here, is available on the side bar.7
Discussion of Best Practices
A Canadian client’s audit enquiry typically asks the law firm to provide information relating to "claims" and "possible claims" as defined in the Joint Policy. An enquiry letter from an American client 8 typically references the ABA Statement and asks the lawyer to provide information relating to "pending or threatened litigation," and "unasserted claims or assessments," which are “loss contingencies” as defined under Statement of Financial Accounting Standards No. 5 9 (FAS 5).
Even though Canadian and American accounting standards differ, and the Joint Policy and ABA Statement differ, there are many more commonalities than differences when Canadian lawyers are called on to respond to U.S. audit enquiries.
1. What does the U.S.enquiry ask the lawyer to address?
U.S. audit enquiries 10 typically ask the law firm to provide to the client’s auditors:
- details relating to pending or threatened litigation, including (i) a description of the nature of each matter, (ii) the progress of each matter to date, (iii) how the client has responded or intends to respond (for example, to contest the case vigorously or to seek an out-of-court settlement), (iv) an evaluation of the likelihood of an unfavourable outcome, and (v) an estimate, if one can be
made, of the amount or range of potential loss; and
- with respect to unasserted possible claims or assessments “considered by management to be probable of assertion and which, if asserted, would have at least a reasonable possibility of an unfavourable outcome”, any explanation necessary to supplement the information provided by management in the letter,11 including an explanation of those matters on which the lawyer’s views may differ from management’s stated in the letter.
The U.S. term, “pending or threatened litigation,” is analogous to the Canadian term “claim”. It means that a potential claimant has manifested to the client an awareness of and present intention to assert a possible claim or assessment, unless the likelihood of litigation is considered “remote.”12
The U.S. term, ”unasserted possible claim or assessment,” is analogous to the Canadian term “possible claim.” It means there has been no manifestation by a potential claimant of an awareness of, and present intention to assert, the possible claim or assessment. According to the ABA Statement,13 the client should request its lawyer to furnish information to the auditor only if the client has determined that (i) it is probable that a possible claim will be asserted, (ii) if asserted, there is a reasonable possibility that the outcome will be unfavourable, and (iii) the resulting liability would be material to the financial condition of the client.
U.S. audit enquiries typically address only loss, not gain, contingencies. Accordingly, they are concerned with litigation or claims only against, but not by, the client. Canadian audit enquiries address both gains and losses and therefore litigation or claims against or by the client.
2. What matters should the audit response address?
Consistent with the Joint Policy, the ABA Statement provides that when properly requested by the client,14 it is appropriate for the lawyer to provide information to the auditor on (i) overtly pending or threatened litigation, whether or not specified by the client, and (ii) unasserted claims or assessments that the client has specifically identified and on which the client has specifically requested comment to the auditor.15
The information that lawyers may properly give to the auditor about these matters include, to the extent appropriate, an identification of the proceedings or matter, the stage of proceedings, the claims asserted, and the position taken by the client.
In a U.S. audit enquiry, the responding lawyer would normally refrain from expressing a judgment as to outcome except in those relatively few clear cases where it appears to the lawyer that an unfavourable outcome is either “probable”16 or “remote”.17 The ABA Statement anticipates that in most situations an unfavourable outcome will be neither “probable” nor “remote” as defined.18 The ABA Statement also cautions that this standard applies with even more force in determining whether the assertion of a claim not yet asserted is “probable.”
Where an unfavourable outcome is not viewed to be remote, the lawyer may also be asked to estimate the potential amount or range of loss in dollar terms. However, the ABA Statement takes the position that the amount or range of potential loss will normally be inherently impossible to ascertain with any degree of certainty.19 In most cases, therefore, the lawyer will not be able to provide any such estimate to the auditor. The considerations bearing upon the difficulty in estimating loss (or range of loss) where pending litigation is concerned are obviously even more compelling in the case of unasserted possible claims.
3. What if the client omits unasserted claims or assessments from the enquiry?
On this issue, the Joint Policy and the ABA Statement are completely consistent with each other. Lawyers have a professional obligation to their client 20 to maintain the confidentiality of all lawyer-client communications and preserve solicitor-client privilege. If the client’s enquiry letter omits possible claims, under no circumstances should the lawyer’s response identify for the auditor any possible claims that the client has omitted.21 The lawyer should confirm neither the completeness of management’s list of unasserted possible claims, nor the accuracy of management’s representation concerning disclosure of all unasserted possible claims.22 These issues should be dealt with between lawyer and client.
However, as both the Joint Policy and the ABA Statement acknowledge, lawyers do have a professional obligation to bring to their clients’ attention the existence of possible claims that have been omitted and to ensure that clients are aware of their own responsibility to bring those possible claims to the attention of their auditor. It is the client who ultimately determines whether or not disclosure of an unasserted possible claim is required in its financial statements.23 Neither the Joint Policy nor the ABA Statement requires the lawyer to make any determination of what should be disclosed in the client’s financial statements; only a determination of what the client should disclose to the auditor.
4. Should the Canadian lawyer give the requested undertaking about future advice to the client on unasserted possible claims?
U.S. audit enquiries typically ask lawyers to confirm that under certain circumstances they will advise their clients about the clients’ obligation to make “disclosure” of unasserted possible claims or assessments in the context of financial statement presentation.24 The intended disclosure is whether the client must or should bring the unasserted possible claim to the attention of its auditor; not whether the client must or should disclose the unasserted possible claim in its financial statements.25 The ABA Statement refers to the requested confirmation from lawyers as the “Undertaking.” Under the Joint Policy, no such undertaking is currently requested by, or given to, Canadian auditors by Canadian lawyers.
The ABA recommends this language for the undertaking:26
…[T]his will confirm as correct the Company's understanding as set forth in its audit inquiry letter to us that whenever, in the course of performing legal services for the Company with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, we have formed a professional conclusion that the Company must disclose or consider disclosure concerning such possible claim or assessment, we, as a matter of professional responsibility to the Company, will so advise the Company and will consult with the Company concerning the question of such Disclosure and the applicable requirements of Statement of Financial Accounting Standards No. 5.
For U.S. lawyers, the undertaking has been the source of some confusion and a great deal of commentary. In fact, the ABA’s Second Report is devoted almost entirely to the issue.
What does the undertaking mean? The Second Report makes several important points on its scope.
First, the undertaking requires only that the lawyer not dismiss an unasserted possible claim without consideration, if, in providing legal services to the client, the lawyer in fact realizes there is an unasserted possible claim and recognizes that it may call for financial disclosure.27
Second, once that threshold condition is met, the undertaking requires the lawyer to consider whether he or she can form a conclusion, as a lawyer, (i.e. a “professional conclusion”) that (i) it is probable the possible claim will be asserted, (ii) if asserted, there is a reasonable possibility that the outcome will be unfavourable to the client, and (iii) the resulting liability would be material to the financial condition of the client.28
Third, if the lawyer has formed that conclusion, then his or her primary obligations are to: (i) bring the existence of the unasserted possible claim to the attention of a responsible officer or employee of the client (for example, in-house counsel), (ii) be satisfied that the client is generally aware of the disclosure requirements of FAS 5 with respect to unasserted possible claims and assessments, and (iii) ensure that the client understands the lawyer’s view that the possible claim is one which the client must disclose, or must consider disclosing, to its auditor.29
The ABA has made it clear that the undertaking does not require the lawyer to make determinations of what should be included in the client’s financial statements or to undertake an interpretation of FAS 5 or other accounting requirements as it may apply to a particular unasserted possible claim.30
Lastly, quite apart from issues of financial statement presentation, lawyers may have a role in advising clients about timely public disclosure of unasserted possible claims for press releases, securities reporting, and third party disclosure to lenders, for example. The undertaking is not intended to affect that role.31
Should the Canadian lawyer give such an undertaking in the audit response? The short answer for most Canadian lawyers will be “no”, and in most cases, the undertaking should be strongly resisted. Why?
First and foremost, the undertaking is prospective (“will” advise and “will” consult). Giving such an undertaking does not make sense from either the lawyer’s or the auditor’s perspective where the Canadian lawyer has only a limited retainer from the U.S. client.32 Going forward, however, Canadian lawyers may well find themselves in a different position as a result of changes in financial reporting standards for inter-listed companies, and as a result of the anticipated adoption of international accounting standards in place of Canadian GAAP.
Secondly, the ABA Statement makes it clear that no U.S. lawyer is obligated to enter into such an understanding with his or her client; nor is the lawyer obliged to confirm to auditors that such an understanding exists. In fact, the ABA Statement goes on to say: “If no such undertaking by the lawyer is seriously intended, it would be entirely wrong for the lawyer to do either.”33
Whether or not a Canadian lawyer chooses to give the undertaking, he or she is not qualified to advise the client on U.S. financial statement disclosure or FAS 5. The lawyer should therefore expressly disclaim that responsibility, so there is no misunderstanding as to the nature of the advice the lawyer can give.34
5. What are best practices to ensure proper client consent?
While the audit enquiry letter will have been signed by the client, that alone does not constitute consent to the disclosure of a confidence or the evaluation of a claim.35 To ensure client consent, the safest course is to have the draft audit response reviewed by the U.S. client before releasing it to the auditor.36 Going forward, the best practice is to encourage the client to have the lawyer prepare, or assist the client in the preparation of, the description and evaluation of claims and possible claims,37 even before the client issues the enquiry letter. This would be a useful practice to adopt even with Canadian clients.
6. What are best practices to preserve privilege?
In a previous EPIIgram 38 concerns about waiver of solicitor-client privilege under Canadian law were canvassed. These concerns apply with even more force in the American context.39 For example, an adverse party in the U.S. may assert that an evaluation of potential liability is an admission.40 Accordingly, to preserve privilege, each response to a U.S. audit enquiry should contain appropriate language, including an express statement that the client does not intend to waive privilege.41
Canadian lawyers should be aware of a further point on this issue. Canadian auditors may ask the client for a written representation that the client has disclosed to the auditor all outstanding claims and possible claims, whether or not discussed with the law firm.42
In Canada, such a representation does not typically appear in the audit enquiry itself. However, U.S. auditors may go further and ask for that representation in the audit enquiry. It typically appears as follows:43
We have represented to our auditors that there have been disclosed by Management to them all unasserted possible claims that you have advised are probable of assertion and must be disclosed in accordance with Statement of Financial Accounting Standards No. 5 in the financial statements currently under examination. [or]
We have represented to our auditors that there are no unasserted possible claims that you have advised are probable of assertion and must be disclosed in accordance with Statement of Financial Accounting Standards No. 5 in the financial statements currently under examination.
In the ABA’s view, this particular language could constitute a waiver by the client of its privilege. The ABA therefore counsels lawyers to err on the side of caution by including an express disclaimer in their response. Accordingly, if that representation appears in the client’s audit enquiry, the Canadian lawyer should include an appropriate disclaimer in the response, based on the recommended ABA text:44
Please be advised that it would be inappropriate for us to respond to a general inquiry related to the existence of unasserted possible claims or assessments involving the Corporation. We can only furnish information concerning those unasserted possible claims or assessments upon which the Corporation has specifically requested, in writing, that we comment. Nor can we comment upon the adequacy of the Corporation’s listing, if any, of unasserted possible claims or assessments or its assertions concerning the advice, if any, about the need to disclose unasserted possible claims or assessments.
7. What limitations on the scope and use of the response should be expressed?
The illustrative forms of response in both the Joint Policy and the ABA Statement incorporate by reference certain limitations on the scope and use of the response.45 Since responses to U.S. audit enquiries cannot be made strictly in accordance with either policy statement, Canadian lawyers should expressly incorporate the necessary limitations in their response. To set the parameters of the response, the definitions of both “claims” and “possible claims” should incorporate (i) a knowledge qualifier, defining knowledge as the current actual knowledge of lawyers in the firm who have performed services for the client in the relevant fiscal period46 and (ii) the element of substantive time and attention.47
Both the Joint Policy and the ABA Statement recognize that it may be in the client’s interest to protect information contained in the lawyer’s response against unnecessary further disclosure or use beyond its intended purpose of informing the auditors.48 This limitation is incorporated in the Sample Response.
Both the Joint Policy and the ABA Statement contemplate that the lawyer’s response will not be quoted from or referred to in the client’s financial statements or in any third party dealings without the law firm’s prior written consent.49 However, the ABA Statement goes further. It not only requires prior consent from the lawyer but also requires reasonable notice to the lawyer where, for example, disclosure is required by the court process or in defence of the audit. Canadian lawyers may wish to incorporate this limitation in responding to a U.S. enquiry so they have an opportunity to consult with their client.50
8. To whom should the response be addressed?
While Canadian audit responses are required to be addressed to the client with a copy to the auditors,51 American audit responses are typically addressed to the auditors with a copy to the client. Because the response will get into the hands of the auditor at the direction of the client, nothing turns on the addressee. The Sample Response is addressed to the auditor, as directed by the client.
Summary of Best Practices
- Provide “information” in your audit response only on:
- overtly pending or threatened litigation, whether or not specified by the client, and
- unasserted claims or assessments that the client has specifically identified and on which the client has specifically requested comment.
- The “information” you provide should include only an identification of the proceedings or matter, stage of proceedings, the claims asserted, and the position taken by the client. “Information” does not generally include a judgment as to outcome or an estimate of the potential amount or range of loss.
- If your client’s enquiry letter omits unasserted possible claims, do not identify any of them in your response.
- Instead, advise your client of them and make sure that the client is aware of its responsibility to bring them to the auditor’s attention and to make appropriate disclosure in the financial statements.
- Similarly, do not confirm for the auditor the completeness of management’s list of all unasserted possible claims or the accuracy of management’s representation to the auditor concerning disclosure of all unasserted possible claims. Again, advise your client.
- Expressly disclaim any responsibility to advise the client respecting financial disclosure in accordance with U.S. standards.
- Forward a draft of the audit response to your client before releasing it to the auditor.
- Going forward, encourage your client to have you prepare, or assist in the preparation of, the description and evaluation of claims and possible claims (including materiality thresholds and exclusions) before the client issues the enquiry letter.
- Take care to preserve privilege. Incorporate the recommended language to preserve privilege, including an express statement to the effect that the client does not intend to waive privilege.
Comments
If you have any comments on these issues, please click here.
By Marlene Kane and Robert Scavone
McMillan Binch Mendelsohn LLP (Toronto Office)
Notes
1 Joint Policy Statement of January 1978 approved by The Canadian Bar Association and the Canadian Institute of Chartered Accountants.
2 Accounting Standards in Canada: Future Directions - Draft Strategic Plan issued by the Accounting Standards Board March 2005 with invitation to comment by July 31, 2005. The CICA's Auditing and Assurance Standards Board (AASB) issued a more recent invitation to comment on its proposed new standard-setting approach for the period April 1, 2006-March 31, 2009. The proposed new approach envisions the convergence of Canadian Auditing standards with the International Standards on Auditing (ISAs) of the International Auditing and Assurance Standards Board (IAASB) in the medium term.
3 Ontario Regulation 72/04 made under the Securities Act (Ontario) amending Regulation 1015, R.R.O 1990; and National Instrument 52-107 of the Canadian Securities Administrators, Part 4.
4 Regulations amending the Canada Business Corporations Regulations, 2001 - Sections 70 and 71. 5 Ontario Regulation 246/05, sections 40 and 41.
6 The ABA Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information (“Statement of Policy”), Commentary to the Statement of Policy (“Commentary”), First Report of the Committee on Audit Inquiry Responses Regarding Initial Implementation of the Statement of Policy, the Second Report of the Committee on Audit Inquiry Responses Regarding Initial Implementation of the Statement of Policy (the “Second Report”), Report of the Subcommittee on Audit Inquiry Responses (“Subcommittee Report”), and the Third Report of the Committee on Law and Accounting (the “ABA Third Report”), are collectively referred to in this article as the “ABA Statement.”
7 To compare the Sample Response to the typical response by a U.S. lawyer, see Illustrative Form of Letter for Use by Outside Practitioner or Law Firm, Appendix A to Commentary at pages 20-21. 8 See Illustrative Form of Letter of Audit Inquiry, Statement of Policy, pages 29 and 30.
9 Statement of Financial Accounting Standards No. 5 of the Financial Accounting Standards Board in the U.S. 10 See Illustrative Form of Letter of Audit Inquiry, Statement of Policy, pages 29 and 30.
11 Management’s information would include: (1) the nature of the matter, (2) how management intends to respond if the claim is asserted, and (3) an evaluation of the likelihood of an unfavourable outcome and an estimate, if one can be made, of the amount or range of potential loss. 12 Statement of Policy, Paragraph 5 “Loss Contingencies” at pages 6-8.
13 Statement of Policy, Paragraph 5 “Loss Contingencies” at page 7. 14 See the discussion following on “What are best practices to ensure proper client consent?”
15 For a full discussion, see Statement of Policy, Paragraph 5 “Loss Contingencies”, pages 6-8, Commentary, pages 13-18 (particularly pages 16 and 17) and First Report. It would be inappropriate for the lawyer to be asked to furnish information where it appears that (a) the client that been required to specify unasserted possible claims without regard to this standard, or (b) the client has been required to specify all or substantially all unasserted possible claims as to which legal advice may have been obtained: Statement of Policy, page 7. 16 An unfavourable outcome for the client is probable if the prospects of the claimant not succeeding are judged to be extremely doubtful and the prospects for success by the client in its defence are judged to be slight: Statement of Policy, page 8.
17 An unfavourable outcome is remote if the prospects for the client not succeeding in its defence are judged to be extremely doubtful and the prospects of success by the claimant are judged to be slight. If the lawyer is able to make an informed judgment, he or she may in appropriate circumstances communicate to the auditor his or her view that an unfavourable outcome is “probable” or “remote”, applying the above meanings; Statement of Policy, page 8. 18 See Commentary, pages 13-18, which reviews the relevant provisions of FAS 5. For purposes of the lawyer’s response, an unfavourable outcome will be “probable” only if the chances of the client prevailing appear slight and of the claimant losing appear extremely doubtful. It will be “remote” when the client’s chances of losing appear slight and of not winning appear extremely doubtful.
19 Therefore, under the ABA Statement it is appropriate for the lawyer to provide an estimate of the amount or range of potential loss (if the outcome should be unfavourable) only if he or she believes that the probability of inaccuracy of the estimate of the amount or range of potential loss is slight.
20 The auditor is legally independent, and not an agent, of the client.
21 See First Report, “Unasserted Claims or Assessments,” at pages 23-27. See also the discussion under “What are best practices to preserve privilege?”
22 See paragraph 14 of the Joint Policy Statement under “Possible Claims Omitted From The Enquiry Letter” and page 7 of the ABA Statement. It is not for the lawyer to make a determination on the need for the disclosure to be made in the client’s financial statements. That determination is to be made by the client, subject to review by the auditor.
23 See paragraph 15 of the Joint Policy Statement under “Possible Claims Omitted From The Enquiry Letter” and the Second Report.
24 Statement of Policy, Paragraph 6 “Lawyer’s Professional Responsibility” at pages 8 and 9; and Commentary, page 18.
25 It is the client who makes the ultimate determination whether or not the claim must be disclosed in its financial statements under the requirements of FAS 5, relying on its auditor for interpretation of FAS 5: see Second Report, page 37 26 Third Report, page 44.
27 It does not mean that the lawyer must go out of his or her way to search out information about unasserted possible claims or that even that he will recognize those claims which may call for financial statement disclosure: Second Report, page 33 at para.1.
28 Second Report, page 33 at para.3. 29 The lawyer has no further responsibility with respect to the client’s consideration of, and conclusions in respect of, disclosure of the unasserted possible claim unless the lawyer has advised the client that as a matter of law the unasserted possible claim must be disclosed: Second Report, page 35 at para.4.
30 Second Report, pages 36 and 37 at para.2. 31 Second Report, page 36 at para.1.
32 The ABA Statement acknowledges that even for U.S. lawyers, the undertaking “may not make sense for the lawyer retained to act in a limited capacity, such as special counsel in a lawsuit or other matter, where there is no expectation on the part of either the client or the lawyer that a relationship will be maintained following its disposition”: Second Report, page 35 at para.6. However, there is one situation in which the ABA Statement takes the position the Undertaking should definitely be given. That is where the response also includes a disclaimer about responding to general, rather than specific, enquiries on unasserted possible claims: See the discussion in the Third Report.
33 Second Report, page 32. 34 See Sample Response to U.S. Client Enquiry Letter.
35 For a full discussion, see Statement of Policy, pages 5 and 6 at Paragraph 1 “Client Consent to Response, ” Commentary at page 10, and Subcommittee Report. 36 The Subcommittee Report, issued subsequently, “strongly encourages” lawyers to have their draft audit responses reviewed by clients before releasing them to the auditors: page 42.
37 The Joint Policy suggests that clients may wish to discuss description and evaluation with their lawyers before preparing the audit enquiry: see paragraph 10.
38 October, 2001 39 Third Report.
40 Statement of Policy, Paragraph 1, page 6. 41 See the language suggested by the October 2001 EPIIgram and the other excellent suggestions put forward there to address these concerns. Not that a recent decision of the Ontario Divisional Court has held that when a client disclosed privileged documents to their auditor for the purposes of the audit, privilege was waived as a result, but only to the extent necessary to enable the auditor to carry out its function: Philip Services Corp., (Receiver of) v. Ontario Securities Commission [2005] O.J. No. 4418 (Div. Ct.), rev’g, 27 O.S.C.B. 10003 (OSC).
42 Section 6560 CICA Official Pronouncements paragraph 19.
43 See the Illustrative Form of Letter of Audit Inquiry at page 29 of the ABA Statement.
44 Third Report, page 43. 45 “This response is limited by and in accordance with the ABA Statement of policy Regarding Lawyer’s Responses to Auditors’ Request for Information. The limitation set forth in such Statement of the scope and the use of this response is specifically incorporate herein by reference….”
46 See also the definition of “records” in the sample response.
47 The Joint Policy incorporates the concept of ‘substantial time and attention”, while the ABA Statement incorporates “substantive attention.”
48 See Joint Policy, paragraph 23 and illustrative from of response. See ABA Statement, paragraph 7 and Illustrative Form.
49 See para. 7, ABA Statement and Joint Policy prescribed response letter.
50 Statement of Policy, Paragraph 7, “Limitation on Use of Responses” at page 9; Commentary, page 19. 51 See Joint Policy Statement: paragraph 5.
