Audit Firms Push (Again) for Liability Caps

Audit firms are making their case to the Treasury Department to provide public policy recommendations that would relieve what the audit firms describe as a risky, unfair exposure to legal damages.

In an extensive, first-of-its-kind report to Treasury’s Advisory Committee on the Auditing Profession, the Center for Audit Quality says that as of mid-March, the six largest audit firms were fending off 90 cases brought by shareholders or bankruptcy trustees.

While the potential damage from those 90 cases can’t be precisely measured because plaintiffs’ demands aren’t always stated upfront, the CAQ says the claims against audit firms total more than $140 billion. Nearly one-third of those cases involve potential liability exposures of at least $1 billion, and seven cases involve exposures greater than $10 billion, the CAQ says.

The Treasury Department’s advisory committee published a first draft report in May offering recommendations to fortify the auditing profession, and an addendum a few weeks later that addressed more controversial audit firm issues. That addendum did propose revising the contents of an audit report and perhaps having an engagement partner sign the report, but the ideas fell well short of a cap on liability claims should audits be dragged into court over failed audits.

The CAQ says audit firms, for the sake of healthy capital markets, need litigation reform. “The committee should use the data made available by the firms, including data regarding outstanding litigation claims, to supports its conclusion that the threat of catastrophic litigation risks is real and to recommend that policymakers and regulators act in response,” the center wrote in a comment letter to the advisory committee.

Audit firms face liability exposure that is “dramatically more onerous” than any other type of business, the CAQ contends. Shareholders or bankruptcy trustees sometimes seek damages against auditors for the entire decline in value of a business whose financial statements the audit firm audited.

The plaintiffs’ logic, the CAQ says, is the decline in value would not have occurred if not for flawed financial statements or undetected management fraud. Cases often invoke both federal and state laws that ultimately tie damages to the loss suffered by the company, “something wholly outside the auditor’s control,” the CAQ report says.

Fornelli

“We’re talking about striking a balance,” says Cindy Fornelli, executive director of the CAQ. She stresses that the center is perfectly content with holding individual auditors, or even audit firms, liable for clear cases of wrongdoing. But, she adds, “If you have a questionable audit, should it take out the entire firm? I would answer no. That’s not good for the marketplace.”

Bob Kueppers, deputy CEO of Deloitte & Touche and chairman of the executive committee at the CAQ, says audit firms are not trying to shirk their responsibility to do good audit work or shed excess costs. “It really is the catastrophic problem we’re trying to avoid,” he says. “Once we’re faced with a $1 billion or $5 billion judgment, there seem to be no solutions that would avoid failure of a major firm.”

WELCOME REFORM

Below are excerpts of two letters to the Treasury Department's Advisory Committee on the Auditing Profession, discussing liability for audit firms.

We welcome the Committee’s recognition that liability reform is necessary to maintain the viability of the auditing profession, and is critical to U.S. capital markets’ competitiveness. As Mr. Gerdts noted in his testimony, “[v]irtually every study of the accounting profession in recent years has recognized that the major firms performing public-company audits face the very substantial risk of a catastrophic event ... and a significant component of [that risk] is the current U.S. litigation regime under which auditing firms operate.” As the Draft Report itself states, “civil litigation was the risk most often cited by witnesses before the Committee.” Moreover, this exposure not only threatens the viability of the largest firms, it also “deters small and mid-sized firms from expanding their public company audit business or entering the market in the first place.” By limiting audit firm choice, liability risk actually undermines competition and therefore audit quality.

As Mr. Nally observed in his testimony, “solutions aimed at insulating the auditing profession from some of the consequences of the U.S. litigation system miss the point that the system itself should be examined. ... [M]uch of the litigation risk for accounting firms stems from the firms’ recurring role as defendants in securities class action litigation.” While the Committee’s recommendation appears specific to auditor liability, a recommendation regarding jurisdiction and a uniform standard of care should address “whether the U.S. securities litigation system efficiently accomplishes the goals of compensation and deterrence.”

—PricewaterhouseCoopers

June 30, 2008

The Committee has received a great deal of input on catastrophic litigation risk. Many diverse parties have expressed concerns regarding the risks posed to markets and investors, the inability of firms to take cases to trial in light of the size of the claims, the impact on personnel retention, the uninsurability of firms relative to catastrophic claims, the impact of litigation risk on profession concentration and competition, and the impact on the competitive and leadership position of the United States in a dynamic global market.

Notwithstanding the considerable evidence before the Committee regarding the seriousness of this risk, the Structure and Finance Subcommittee appears unable to agree amongst its members on relatively modest and incremental reforms recently under their consideration. Furthermore, while the Concentration and Competition Subcommittee has advanced a proposal that may have a salutary effect in certain situations, it would not directly address catastrophic litigation risk—the “mega-claims” that threaten the future of private sector public company auditing in the United States.

We urge the full Committee to address this issue. We note the challenging comment of Committee Co-Chair Nicolaisen at the June 3, 2008 meeting, “If litigation catastrophic risk by itself is an important topic to the Committee, then the Committee members should speak up to that, because at the subcommittee level there has not been an ability to identify what that solution would be.”

As the Committee considers modifications to its Draft Report, we encourage its members to utilize the considerable record that has been put before the Committee and to speak out in support of recommendations regarding catastrophic litigation risk.

—Ernst & Young

June 27, 2008

Source

U.S. Dept. of the Treasury.

The failure of another major audit firm would bring chaos to Corporate America. The remaining three large firms could not absorb the extra client load, primarily because the new clients would cause conflicts of interest with the firms’ existing clients. At the same time, most smaller audit firms could not pick up the slack either, since audits in the Sarbanes-Oxley era are now so extensive and sophisticated.

What Happens Next

The CAQ recommends the Treasury Department committee look at approaches under consideration in the European Union, where regulators are mulling contractual limits on liability, caps on liability, or adopting provisions for apportioning liability to audit firms among others who may be responsible for a failure.

Investor advocates declined to discuss the CAQ data directly with Compliance Week. One investor advocate, however, says the data is inadequate because it only reflects what plaintiffs generally have sought in litigation, rather than what audit firms ultimately have paid—which presumably is less.

Johnson

Dennis Johnson, a portfolio manager for the California Public Employees’ Retirement System, says the Treasury Department committee should abandon its idea that claims against audit firms should be heard in federal court rather than state court. “CalPERS believes that federal jurisdiction over the public company auditing profession would weaken plaintiffs’ rights and remedies,” Johnson wrote in a comment letter to the committee.

Lawrence Cunningham, a law professor at George Washington University who has studied auditor liability, agrees the CAQ information doesn’t provide the kind of insight Congress would need to act. “It’s difficult to decide from this data that we need to change from this, that, or another thing,” he says. “All this data is expressly presented as the worst-case situation.”

The concept of proportionate liability under consideration in the EU already exists in the United States, granted by the Private Securities Litigation Reform Act, according to Adam Pritchard, a law professor at the University of Michigan. Most claims against audit firms, however, are settled long before they reach a jury, where liability would be apportioned; the risk of loss is too big a gamble for firms to take, Pritchard says.

Pritchard

Pritchard says debate should focus on the “social loss” to investors as the result of a public company failure. He contends stock prices preceding a meltdown do not reflect the real value of an entity that is on the verge of collapse.

“Someone has paid too much for their stock when they purchased it, but someone sold the stock for too much,” he says. “There’s some wealth transfer among shareholders going on, but that all comes out in the wash. Sometimes I’m the winner; sometimes I’m the loser for things of this nature. The social loss is close to zero.”

As such, “the damage measure should be fixed for the audit firms and the companies,” Pritchard says. “The damages are well in excess of what we could reasonably think the damages to be.”

The CAQ study also reveals that audit firms generally do not prepare and audit their own financial statements in accordance with Generally Accepted Accounting Principles. They’re not required to do so, and the Treasury Department committee has sparred over whether they should call for such a policy change. The CAQ says audit firms should not be required to produce such reports, because they are not public companies seeking public capital.

Cunningham

Cunningham argues financial statements would shed a great deal more light on the question of whether audit firms are exposed to excessive risk as a result of litigation.

“It’s really difficult to think about rewards versus risks, and the relation of that to audit quality and financial statement reliability, without having some sense of the financial position of audit firms,” Cunningham says. “I don’t see fierce opposition to the proposal to require them to prepare audited GAAP financial statements to file with the [Public Company Accounting Oversight Board], even if they remain confidential with the PCAOB. There’s such sweet irony there.”