Say No To Auditor Liability Caps

I have consistently disagreed with the Big 4’s claim that auditor liability caps are necessary to avoid losing one of the remaning firms to catastrophic litigation.
I have lamented the fact that the auditors don’t get sued often enough for my tastes and, when they do, they often settle.
I’ve also said that they don’t deserve our pity, as they are less than transparent regarding their true financial capacity to address ongoing litigation.
While cruising around the news sites and blogs today, I ran acoss the site for the US Treasury’s Advisory Committee on the Auditing Profession.
“The Treasury Department established the Advisory Committee on the Auditing Profession to examine the sustainability of a strong and vibrant auditing profession.

The inaugural meeting was in October of 2007. Their third meeting was held on February 4th, 2008. One of the speakers was John P. Coffey, the Co-Managing Partner of Bernstein Litowitz Berger & Grossmann LLP, a fifty lawyer firm with its principal offices in New York and San Diego.

I was glad to see Mr. Coffey agrees with what I have been saying on this blog all last year.
It is with this perspective that I address one of the questions the Committee is
considering, namely, whether there ought to be a cap on auditor liability. I respectfully submit
that the case for such a cap has not been made…
…the fact that, in today’s environment, auditors are rarely named as defendants in these actions. In a three-year period immediately before the PSLRA was enacted – April 1992 through April 1995 – auditors were named as defendants in 81 of 446 private securities class actions filed, for an average of 27 suits per year, or 18% of all private securities class actions.
As the reforms of the PSLRA and the concomitant jurisprudence took hold, that number dropped precipitously. Auditors were named as defendants in only five suits in 2005, and only two cases in each of 2006 and 2007.
The number for 2007 is especially telling because approximately one out of every eleven companies with U.S.-listed securities – almost 1200 companies in all – filed financial restatements in 2007 to correct material accounting errors. Further, an analysis of securities actions filed in 2006 and 2007 demonstrates a significant decline in the number of cases alleging GAAP violations, appearing to suggest “a movement away from the focus in recent years on the validity of financial results and accounting treatment.”

Analysis of settlement payments by audit firms as a result of the cases filed during the recent “corporate crime wave” further confirms that claims of catastrophic liability exposure are exaggerated. Despite several multi-billion dollar scandals involving false financial statements of client companies, audit firms avoided suffering any serious blow, let alone any catastrophic threat. Our survey of settlements indicates that, if audit firms paid at all, it was typically a fraction of what other market actors paid. (A statement we frequently hear in settlement discussions is that Big Four firms will not pay a settlement that is more than 10% of what the issuer audit client paid.)
…The failure to assess reasonably the supposed litigation risk to audit firms is coupled with another material defect in the case for a cap on auditor liability: the absence of any meaningful exposition of the financial wherewithal of these firms to pay a potentially large verdict.
Notwithstanding their plea to be treated more leniently than other market actors, audit firms do not publicly disclose their financial status like issuers or investment banks, and it is not possible to assess whether the claim of vulnerability to “catastrophic liability” has merit…
Another important piece of any analysis of an audit firm’s financial vulnerability is an
assessment of available insurance. Here, too,
the essential facts remained obscured. Audit firms have not been sufficiently forthcoming on matters such as the amount of coverage from classic insurance underwriters or their efforts to self-insure. As for the latter, audit firms appear reluctant to explain why more of the cash they chose to distribute to partners year-in and year-out cannot be set aside in reserve for the litigation charge they seem so assured is coming.
In making a plea for special treatment based on what they claim is financial peril, it is incumbent on the audit firms to be forthcoming about their true financial capacity to withstand a “mega judgment.” They have not to date, and appear unwilling to do so in future. That alone should end the discussion.
4 replies
  1. Independent Accountant
    Independent Accountant says:

    You go girl! I have opposed CPA liability caps for decades. I think the 1995 Litigation Reform Act should be repealed. Right on!

  2. Krupo
    Krupo says:

    I believe the joint and several liability issue is the problem, if I recall the legal concepts I picked up in in university correctly.

    You do an audit for a $100,000 fee, and then the company fails and you’re sued for $500,000,000. The risk/reward hook seems a bit off, no?

    The big issue being, what if you *did* in fact do a proper audit, but a judge or jury nevertheless decides to find you at fault, and your legal system allows them to go after the full value of said failed company?

    This risk would explain, of course, why firms would chose to settle rather than risk losing a major case, no?

    Of course, contingency funds (to cover your deductible) and insurance should in theory suffice, but how many insurance companies would want to cover such a large risk?

    Or is there something – aside from the firms being understandably skittish about revealing their reserves – that I’m missing here?

    I wonder how much of a difference there is between the Canadian and US legal situations?

Trackbacks & Pingbacks

  1. […] But the pace, so far, is slow due to the sheer numbers and the increased difficulty under PSLRA of bringing them. […]

  2. […] Four are “too big to fail” and for “national security reasons” we need to cap litigation.    Tell this to the millions of investors who lost their retirement savings or the US taxpayers […]

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