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July 08, 2008
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.
Posted by Lawrence Cunningham at July 8, 2008 09:24 AM
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Comments
This is a very interesting idea, and worth exploration on the academic and policy levels. I would add a couple of technical points.
First, the analogy to natural "cat" bonds is limited in that natural cats are subject to a degree of risk modeling. There are a number of firms that model these things, and thus the risks are somewhat quantifiable. Even so, due to tax and regulatory restrictions, natural bonds are typically issued offshore, and they constitute a small but growing fraction of the capital that supports natural cat risk. Moreover, it has taken this market over a decade to develop. Other asset classes in securitization (i.e., credit cards, mortgages, etc.) also require a long "gestation" period before they become popular with investors. Thus, the securitization of auditor risk would not be an overnight, clean cut solution even if the tax and regulatory issues are cleared away overnight.
Second, we still have to answer the question: why would capital market investors invest in the bonds when insurers won't underwrite the risk? If the answer is that they are given a "premium" return, then would not an equivalent in insurance premium suffice to entice insurers. The yields on junk bonds can exceed the equity cost of capital of many firms, and so securitization, depending on how it is price, can exceed comparable insurance premium rates. If the problem is that capital markets can diffuse the risk to many participants, then we could see a consortium of insurers and reinsurers try to solve the problem as well. In any event, the details of pricing will be a major obstacle. The pricing will be greatly affected by the tax and regulatory restrictions and ambiguities.
The benefits of diversification and additional capital brought to bear on the risk are great, but there has to be a financial raison d'etre to the scheme. Securitization makes sense because there is a cost of capital advantage. This means that if the insurance industry is flush with capital, as it is now, then traditional insurance might be cheaper than securitization. This was the problem encountered when natural cat bonds were being developed in the 1990s, and the reason why natural bonds were slow to take off. As the market hardens, the advantages of securitization becomes more compelling as securitization is simply another form of capital.
If the details can be worked out to feasiblity, then this could be a piece of the puzzle in how to allocate auditor risk. May the risks can be layered among insurers, reinsurers and capital markets. There are other alternative risk transfer techniques that can be explored as well, such as an XOL auction with possibility of government involvement. This last possibility was discussed in the aftermath of the 9/11 attacks to address terrorism risk. Speaking of which, we could also see a TRIA type of private-public insurance partnership. Lots to think about.
Nice blog post, Larry.
Posted by: Robert Rhee at July 9, 2008 02:21 PM
Rob,
Thanks very much for such a thoughtful and sophisticated analysis. It is very helpful indeed to anyone interested in the subject.
I can only add that I would advise the large auditing firms to explore precisely these challenges and questions and let the public know the results.
It seems important for them to pursue the proposal to feasibility, as well as all other reasonable avenues, before neutral observers, including me, can take credibly their asserted inability to handle their business model without statutory caps on liability for audit failures.
After all, though this proposal may be complex and difficult, it may be less so than designing and administering a workable statutory standard, method or formula for caps.
Again, thanks truly, for these powerfully insightful points.
Posted by: Lawrence Cunningham at July 9, 2008 07:33 PM
As sympathetic as we should all be to the lack of substance in the public debate about the challenge of auditor survivability, all reasonable ideas are welcome and should be aired thoroughly. Welcome as is the idea, however, there are some serious issues with auditor cat bonds -- which I discuss in a post today on my own blog -- www.jamesrpeterson.com. With thanks for the contribution to the debate....
Posted by: Jim Peterson at July 15, 2008 03:22 PM
Jim,
Thanks for the reference, to which I've offered a comment in turn.
Posted by: Lawrence Cunningham at July 15, 2008 04:16 PM
