Lawyers and accountants can substantially reduce the risk of errors and omissions claims through the thoughtful use of engagement letters. Lawyers in most states must have an engagement letter to receive a contingent fee; accountants must have an engagement letter to conduct an audit. Engagement letters are invaluable, and claims professionals should examine their clients’ engagement letters closely to help evaluate claims.
Rules, Jurisdiction, and Governing Law
Various state and federal laws and rules impact lawyers’ and accountants’ engagement letters. For example, the Securities and Exchange Commission, the Internal Revenue Service, and the Public Company Accounting Oversight Board may all impact a professional’s work. The state laws that govern engagement letters can be critical, as well. Accountants’ engagement letters are substantially impacted by standards issued by the American Institute of Certified Public Accountants (AICPA), which are often mirrored, at least in part, by state law. The American Bar Association’s Model Rules do not govern lawyers anywhere except that they are often replicated quite closely in states’ rules.
An engagement letter should clearly set forth which state’s laws will govern the engagement. If a dispute arises, the parties will then know what rules will govern. Most professionals prefer to be governed by the law of the state in which their firm maintains its primary location. On the other hand, some states (like New York or Delaware) have particularly well-defined laws regarding malpractice issues that might speed the resolution of a dispute.
Some states find it unethical for a law firm to require arbitration in their engagement letters, while other states do not. Some states may enforce arbitration requirements, while others may not. All of the Big Four accounting firms routinely use arbitration clauses in their engagement letters and their use by law firms seems increasingly common.
On the other hand, many defendants do not prefer arbitration and would rather the dispute be decided by the court system in their jurisdiction. Arbitration provides confidentiality, the assumption of a quicker and less expensive process, and, oftentimes, a more sophisticated trier of fact. Those who oppose arbitration argue that it results in significant expense, places limitations on the discovery process, makes appeals unavailable; and tends to result in “split the baby” decisions that disregard defense motions. These considerations should be contemplated when deciding whether or not to utilize an arbitration clause.
Shortening the Statute of Limitations
In many jurisdictions, accountants have included language shortening the statute of limitations in their engagement letters. The theory is that parties should be allowed to contract as they please. We don’t see much evidence of attorneys utilizing such a provision. While unenforceable in some jurisdictions, it might still deter a client from filing a claim. However, some states might determine that a lawyer is in breach of an ethical rule for even attempting to shorten the statute of limitations.
Description of Services
Accountants and lawyers both frequently err by using an “off the rack” engagement letter that does not specifically describe the services provided. For example, an accountant who describes her services as “preparation of 2022 tax returns” could get in trouble by not specifying what state returns are to be prepared. Ensuing state tax problems for unpaid filings can be massive.
Lawyers can fall into similar traps. For example, a lawyer whose engagement letter says that the representation will include “any and all claims arising from the accident,” may only intend to be covering auto insurance claims. If a product liability statute of limitations falls by the wayside, substantial malpractice litigation can result.
It is important for both accountants and lawyers to be detailed in their descriptions of their services, which will result in fewer misunderstandings and claims. Specificity in the engagement letter also forces the professional to better plan the engagement while helping the client better understand the process. The letter should set forth the client’s obligations as well as the major steps anticipated in the process.
Fees and Conflicts
Attorneys’ ethical rules typically require that the fees be reasonable and that some fee arrangements be specifically set forth in writing. The rules on accounting fees are less stringent, but many states and the AICPA have specific provisions that prohibit undisclosed commissions. A detailed description of fee provisions helps prevent disputes and litigation.
Attorney conflict rules are usually more explicit than accountant conflict rules. Both lawyers and accountants often include conflict waivers in their initial engagement letters. The ethical rules for a particular engagement and the independence rules for auditors must be considered before utilizing and drafting a waiver. Inadequate conflict disclosure can result in loss of the statute of limitations defense and bring on punitive damages.
Indemnification, Exculpation, Damage Limitation
AICPA guidance should be carefully considered when indemnification, exculpation, or damage limitation language is included in an accounting engagement letter. State law often permits such language, and such disclosures can be quite useful in limiting or barring claims altogether. Some states have specific requirements as to the size of the font, the location of the provision, and the reasonableness of such provisions.
Indemnification, exculpation, and damage limitation is less common in lawyers’ engagement letters and may be prohibited by state ethical rules.
Negotiated Modifications
A professional’s engagement letter is only as good as the modifications negotiated once it is presented to a client. Large clients often have their own engagement letters, which may treat a lawyer or an accountant as a simple vendor. This leaves a professional service firm to balance risk and reward, and firms need a process whereby those balances are examined. Engagement partners are highly motivated to bring in the work and may not have a clear view of the risk. Some firms create a matrix of provisions that can be modified without management’s prior approval. Lots of mistakes are made when two conflicting engagement letters are simply combined. Some insurance carriers provide advice as engagement terms are negotiated.
In the end, understanding the important terms in an engagement letter, as well as the pitfalls that may accompany them, will help you evaluate a claim, take care of your insured, and protect your bottom line.