A troubling proposal, being considered by a Treasury Department advisory committee, would place a cap on auditor liability to shareholders in securities class-action cases. A cap is needed, the argument goes, because some mega class action might bankrupt one of the remaining audit firms. A cap is a decidedly bad idea, however, because our securities laws already afford auditors ample protections; audit firms have not been forthcoming about their finances and insurance capacity; and given the lessons of the recent corporate accounting scandals, any policy that makes certified public accountants less accountable to investors is bad policy.
The specter of a litigation Armageddon for audit firms is overblown and ignores the Private Securities Litigation Reform Act of 1995. That law was enacted after intense lobbying by auditors and others to address perceived threats and abuses posed by private securities actions. The PSLRA sharply curtailed risks for defendants by, for example, setting very stringent pleading standards and imposing a proportionate fault regime that sharply limits the potential liability of defendants (which is particularly good for auditors, who can almost always argue that venal company officers lied to them). The PSLRA was intended to weed out frivolous securities cases, and it did. Nearly 40% of these cases are now thrown out at the pleading stage, and that does not count cases never filed by virtue of the PSLRA's deterrent value. Auditors in particular are much less likely to be sued. Before the PSLRA, auditors were sued in about 20% of all securities class actions; that has now dropped to a handful each year. And analysis of settlement payments as a result of cases filed during the recent corporate crime wave further confirms that claims of catastrophic liability exposure are exaggerated. Despite several multibillion-dollar scandals involving false financial statements of client companies, audit firms avoided suffering any serious blow, let alone a catastrophic threat. If audit firms paid at all, it was typically a fraction of what other market actors paid.
The failure to assess the litigation risk to audit firms reasonably is coupled with another problem: the absence of meaningful disclosure of the ability of these firms to pay a large verdict. Audit firms do not publicly disclose their financial status like securities issuers or investment banks, and also obscure their actual insurance capacity. Thus, it is not possible to assess whether the claim of vulnerability to catastrophic liability has merit. What is discernable suggests that the finances of the Big Four accounting firms are quite robust. Audit fees have increased significantly each year since the passage of Sarbanes-Oxley in 2002 which is ironic, given that SOX was passed in response to corporate scandals that were possible only because too many auditors were not doing their jobs in the 1990s.
We should not forget what happened the last time the audit profession got comfortable with the idea that its litigation exposure was circumscribed. That view was one of the apparent takeaways from enactment of the PSLRA that with heightened pleading standards, discovery stays, proportionate fault and other obstacles to investor redress, accounting firms could cut corners on audit staffing, become more pliable to management and disregard the obligation of professional skepticism. The results can be summed up in a few words: WorldCom, Enron, HealthSouth, Tyco, Cendant, etc. What we learned was that if audit firms perceive that the cost for a blown audit has gone down, there will inevitably be more blown audits. This experience is too painful a lesson for investors to suffer a second time.
There is one change to the securities litigation landscape that would reduce the liability exposure of audit firms and, at the same time, give defrauded investors a fairer chance to recoup losses caused by corporate wrongdoers: undo what the Supreme Court did in its recent Stoneridge decision (Stoneridge Investment Partners vs. Scientific-Atlanta Inc. and Motorola Inc.) and restore scheme liability. This would enable investors to seek redress not just from auditors who were reckless in failing to uncover a company's fraud, but also from third parties who participated in deceptive conduct intended to mislead the investing market and in many instances the audit firm about a company's finances. Unfortunately, the Stoneridge decision has made the world less safe for auditors in at least two ways. Because the decision essentially immunizes third parties that engage in deceptive conduct even for lying to auditors it has eliminated them from assignment of any blame under the PSLRA's proportionate liability paradigm. Guess who is left behind to share the percentage of fault that might otherwise go to those bad actors? The audit firm that was reckless in not discovering that it was being lied to. Also, by immunizing those smart enough to tell their lies to auditors in private, the Stoneridge decision makes it likely that more lies will be told to auditors in the future. That certainly will not make the auditor's job any easier.
Before any proposal to ease up on auditors gets more traction, it is important to ask the key question: Should accountants be held less accountable? The answer is self-evident. Artificially limiting auditor liability would diminish incentives to push back on overreaching management, reduce auditor accountability and reduce audit quality. This would, in turn, harm our capital markets, because it would undermine the most precious and fragile commodity we have investor confidence in the accuracy and transparency of financial statements. To sum up the merits of a cap on auditor liability in two words: Not smart.
John P. Sean Coffey is co-managing partner of Bernstein Litowitz Berger & Grossmann LLP, a New York-based securities litigation law firm, representing pension funds and other institutional investors.