Roars on Auditor Liability
Amid revolutionary proposals to renovate US financial regulation, auditing firms continue to push for caps on their liability for bothced audits. In a report to the Treasury Department’s Committee on the Auditing Profession, the profession’s lobbying affiliate, Center for Audit Quality, collates pending cases against large firms to dramatize their campaign.
They report 90 pending cases asserting aggregate damages exceeding $140 billion, with a third of the cases seeking more than $1 billion apiece and 7 alleging more than $10 billion. The firms say these claims, altogether, support their view that their liability exposure is unfair to them and dangerous for the financial system. The only solution, they urge, is having Congress set statutory dollar caps on claims against them, along with exclusive federal jurisdiction over these cases using a light standard of liability, scienter instead of negligence.
The profession is making its pitch in comment letters on the Advisory Committee’s draft reports on the state of the auditing profession. The reports include extensive recommendations for reform, including a shift to exclusive federal jurisdiction for these claims. They stop way short of any discussion of capping auditor liability by legislative fiat. The firms cite their trade group’s data to support their plea, saying that “the threat of catastrophic litigation risks is real” and “unique” to the auditing profession and requires protective federal legislation.
True, auditors do face liability that sometimes can be measured according to the decline of a firm client’s market capitalization and that decline is beyond the firm’s control. That could kill a firm and disrupt global financial markets. And, often, the net social loss from audit failure may be relatively low, at least when losses to one group of shareholders are offset by gains to another group of shareholders.
But the audit is fully within the firm’s control and there are losses to one group of shareholders that an effective audit would prevent. Further, although the profession’s data may look threatening at first glance, all the figures are worst-case scenarios. Also, the data look at what auditors stand to lose in litigation rather than what they gained or stood to gain from rendering ineffective audits, whether negligently or otherwise.
This debate can appear to be an either-or proposition, to cap or not to cap, but is there any other approach to this nettlesome problem? I propose a simpler, market-based idea that has commanded considerable interest among market participants but to which the firms have given scant public attention.
The firms would issue bonds in debt markets to provide a backstop against the big judgment. Paying a high interest rate to reflect risk, the bonds would be repaid at maturity if no big claims arose but principal would be released to cover massive judgments if they did. This would protect share owners against losses from incorrect accounting without bankrupting an audit firm.
Although not without limitations (explored by Kevin LaCroix, an expert in the field), these bonds should appeal to investors and regulators. Similar bonds have been used since the mid-1990s to provide funding against catastrophic hazards of natural disasters, like hurricanes and floods. Buyers of such “cat bonds” enjoy an investment vehicle that adds portfolio diversification and, with a high interest rate, a good risk-adjusted return. No regulatory approval is needed and no legislative hunches or political jockeying occurs.
Insurers of audit firms keep the business they now have writing policies, as these bonds would cover losses that current coverage does not reach. Investment banks would help design and sell the bonds and assemble and analyze information about risk.
Benefits are considerable. Risks of bankrupting a firm are reduced dramatically. The political hot potato of capping auditor liability goes away. Investors would begin to see auditors as partners in promoting reliable accounting rather than as deep pocket guarantors against unreliable reporting. Incentives arise to encourage capital market monitoring of auditors. The bonds don’t attract suits against auditors because they fund only catastrophic losses, upwards of $500 million.
Cat bonds are a practical, cost-effective solution to the risk that another large auditing firm could disappear and leave few ways to supply this important function. Certainly, to take seriously any proposal to cap liability, or even move to exclusive federal jurisdiction and standards, Congress and the public first should ask about this idea.
After all, at present, proponents of caps and federal standards, especially audit firms, have incentives not only to ignore the gains to auditors from acquiescent auditing, but to overstate liability risks. With cat bonds, those same people would have an incentive to understate risks when selling the bonds to capital market investors. Making cat bonds a serious point of public policy debate would help reveal the true stakes.