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Governments are considering ways to shelter accounting firms from ruinous lawsuits

Financial Times: Governments are considering ways to shelter accounting firms from ruinous lawsuits

 

By Adrian Michaels and Andrew Parker

May 21, 2004

Posted 22 May 04

 

Parmalat, Hollinger, Royal Dutch/Shell, Nortel -the long wave of corporate scandal that began with Enron rolls on across the world, producing a flood of lawsuits from unhappy investors who want compensation from organisations they deem responsible for the destruction of wealth.

 

It is not just companies themselves that are being targeted; accountants are also on trial. Apart from numerous investor lawsuits where auditors are accused of wrongdoing in the audit of their clients’ financial statements, regulators are pursuing accounting firms in the US, the UK and Italy.

 

In such circumstances it might seem bizarre for governments to be talking about protecting auditors from huge legal claims. Yet the UK government is close to proposing that accounting firms be allowed to reach agreements with audit clients that would shield them from ruinous negligence claims. Such a move could pave the way for reform in other European Union member states and will be closely watched in the US.

 

Behind such initiatives lies some furious lobbying by the so-called Big Four global accounting firms: Deloitte, Ernst & Young, KPMG and PwC. These are all that are left after consolidation from what were eight large firms 20 years ago. Andersen, once the world’s largest accounting firm, was destroyed in 2002 by the US Department of Justice for its work as Enron’s auditor.

 

The remaining firms claim that if one of their number were to be brought down by legal action, the repercussions for the accounting industry and the rest of the corporate world would be serious. The Big Four between them audit well over 90 per cent of the world’s largest listed companies and it is acknowledged that the firms offer companies too few choices.

 

“Consolidation of the accountancy profession following the demise of Arthur Andersen has created a precarious situation,” says KPMG’s UK business. “The collapse of another large firm would create a crisis of confidence in the capital markets and a further undermining of the audit profession, and hit hard the economic stability achieved for the UK economy.”

 

But in other quarters there is fierce opposition to special treatment for audit firms that might limit their liability. Many lawyers fighting class-action lawsuits against accounting firms, and some groups representing large investors, believe it would not serve the interests of shareholders in companies where audits have been questioned.

 

Meanwhile, a consensus is emerging that auditors should exercise more judgment, which could leave them open to greater liability problems in future. The call for greater judgment is part of efforts to improve financial reporting models used by companies and thereby give investors more sophisticated information.

 

In the UK as well as the EU as a whole, there are plans to require directors to give information about prospects of companies as well as historical data in annual reports. Concern about the inadequacies of financial reporting has also put the issue of auditor liability on the US agenda. The Big Four have been less vocal about pressing for reform in the US because their standing was so badly damaged by alleged failures in the corporate scandals.

 

But when the American Assembly, a leading forum on public policy, last year held a gathering of people from industry, financial services and the accounting profession, auditor liability was considered as part of wider discussion about the future of accountancy.

 

Senior accounting standard-setters and regulators from across the financial services industry participated but took no part in signing off on the group’s final report. Roderick Hills, a former chairman of the Securities and Exchange Commission, was one of the conference leaders. Some media, including the Financial Times, participated in the discussions.

 

“The balance sheet of the future will be a more flexible instrument, able to adapt to a wide variety of industries and circumstances,” says the group’s report. “It will include a variety of non financial information, and should encompass a wider array of numbers so that users recognise when management and auditors are making judgments on transactions and asset valuations.” The report goes on: “If auditors are allowed, even required, to use more judgment . . . regulators must bring a greater degree of rationality to the issue of auditor liability.”

 

Robert Herz, chairman of the Financial Accounting Standards Board, which writes US financial reporting rules, implies that much has to change. “What the capital markets want, need and desire is a very strong, independent, objective and knowledgeable auditing profession,” he says. “The real question is how do we get there from where we are now and is auditor liability part of that?”

 

William Lerach, a celebrated US class-action lawyer who has brought many suits against auditors on behalf of investors, takes a strong line. “If limiting the liability of securities professionals is supposed to result in benefits for investors, there is no empirical evidence to support it,” he says.

 

Accountants say their businesses are being unfairly punished and can hardly survive lawsuit inflation. The number and level of pay-outs from legal settlements – no one dare risk a jury’s deciding how much should be paid for fear of instant bankruptcy – have in general been rising steeply in recent years.

 

In 1992, E&Y’s US business paid $400m to settle potential claims arising out of its audits of failed savings and loan institutions. Though not private litigation, the size of the settlement with the US government placed E&Y alongside the $650m penalty paid in 1988 by Michael Milken’s notorious Drexel Burnham Lambert in an insider trading scandal.

 

Some other settlements since then have been nearly as hair-raising. In 1999 E&Y’s US business paid shareholders $335m in a dispute over its work at Cendant. In 2002, while Andersen was in the midst of the Enron crisis, its US business agreed to pay $217m to resolve litigation related to its audits of the Baptist Foundation of Arizona, which collapsed in 1999.

 

In the UK, E&Y has used its own plight to make the case for auditor liability reform with the government. E&Y’s UK business says it could be destroyed if a £2.5bn negligence claim by Equitable Life, the troubled insurer, succeeds.

 

The Big Four claim the litigation threat is deterring new recruits to the profession. Their businesses are organised as country-specific private partnerships that have significant but limited capital. It is estimated that the Big Four have $5bn-$10bn between them worldwide.

 

They have set up their own insurance arrangements because of their struggle to buy cover. They self-insure through their own captive vehicles, and buy extra cover from reinsurers. However, such arrangements are unlikely to deal with the size of potential legal claims. E&Y’s UK business had £200m of capital, according to its 2003 annual report. E&Y’s captive insurer provides the UK business with $40m of cover through reinsurers for the biggest claims, down from $50m in 2003.

 

Even if E&Y’s partners increased their capital contributions, they could not cope with the £2.5bn claim by Equitable Life. E&Y’s UK business also says it has no guarantees that fellow partnerships outside Britain would rescue it if a claim exceeded its insurance cover.

 

Certainly the loss of another big accounting firm would create immense problems for business. The Sarbanes-Oxley Act, passed in the US in 2002, banned auditors from offering their clients a range of non-audit work such as consultancy or legal advice. Heightened wariness from company boards has also caused the voluntary scrapping of other work such as tax advice.

 

A large company might now have one of the Big Four as its auditor, another as its tax adviser and a third as consultant.

 

In a survey last year by the US General Accounting Office, the investigative arm of Congress, 84 per cent of more than 150 corporate respondents indicated a preference for more accounting firms. But they wanted firms with a global capability and said they would not choose a firm outside the Big Four should they be forced to change auditor.

 

In the UK, the Big Four have talked up the possibility of quitting audit work because of the spectre of catastrophic negligence claims. Such action is unlikely, but they also warn that high-risk companies, such as some in the financial services sector, could struggle to secure them as auditors. nsurprisingly, lawyers are incensed by the possibility of auditors being given greater protection from legal claims. Melvin Weiss, one of the most successful plaintiff lawyers in the US – who is vilified by corporate opponents – says it is the very threat of liability that prods the auditors into doing their job properly in the first place.

 

“I find it stunning that, in the face of the corporate wrongdoing that we have all experienced, all the companies and the firms are saying that you have to get rid of litigation,” he says.

 

Mr Weiss also disagrees that settlements have become more costly. He points to what he sees as the comparatively low $125m that KPMG’s US business agreed to pay in March to settle allegations over its audits at Rite Aid, the US drugstore chain. Many legal analysts point out the last objective of Mr Weiss would be to bankrupt an accounting firm. Why kill the goose that lays the golden eggs?

 

Regulators generally do not seek to put groups out of business through the size of monetary penalties, though the Andersen case indicated they could do so in the case of serious misconduct. Donald Nicolaisen, the SEC’s chief accountant, says: “There’s no firm too big to fail. It’s up to the firms themselves to improve their quality … Either they’re in it for the long haul or it’s not inconceivable that another firm could fail. I certainly don’t hope that.”

 

Some influential investor groups are also opposed to auditor liability reform in the short term. The Association of British Insurers questions the validity of the Big Four’s claim that one or more of them could be destroyed by legal claims.

 

The ABI says: “If there are concerns that these firms could collapse in the face of claims against them, this would suggest either systemic professional failure or that these firms are insufficiently capitalised given the potential liabilities they face.”

 

The ABI and the National Association of Pension Funds, another large UK investor group, want an investigation by regulators into the Big Four’s dominance of audits of leading listed companies. The ABI says the “oligopolistic” audit market is not competitive, and if accounting firms were free to reach agreements with clients on their exposure to legal claims, it could result in the Big Four insisting on common audit fees and liability conditions.

 

In the face of such opposition, the British government is close to proposing that auditors be allowed to reach agreements with clients on the limit to their liability in the event of legal claims alleging negligence.

 

The Big Four privately hope that action by the UK to limit auditor liability could encourage other EU countries to follow suit. They were disappointed that Frits Bolkestein, the European commissioner responsible for accounting matters, voiced opposition to auditor liability reform last year. The European Commission also promised a study on the issue last year, but it has yet to start.

 

However, Mr Bolkestein stands down as EU internal market commissioner at the end of October, and could be replaced by someone who is more sympathetic to the accountants.

 

In the US, the American Assembly’s suggested approach to auditor liability would be for the new US accountancy regulator – the Public Company Accounting Oversight Board – to credit firms for doing good work and proving their internal environment and controls are sound. That could earn them a measure of liability protection in future.

 

But no one in the US is suggesting that anything be done in the near term to cap the amount that auditors could have to pay following a legal claim. Mr Nicolaisen of the SEC says: “There may be a time when liability reform is appropriate [in the US]. This is not the time. It is really the firms that are going to have to offer something that is helpful to investors that extends beyond what they are offering today.”

 

Some countries have already put in place measures to protect auditors from ruinous litigation.

 

Australia is introducing an ambitious reform in the wake of its biggest business failure – the collapse of HIH, the insurer. It is establishing a proportionate liability regime in which a court will decide what percentage of blame for any financial losses is carried by the auditor, and will award damages accordingly. This regime exists already in some US states.

 

Australia previously had, like the UK, the principle of joint and several liability enshrined in law.

 

Under this principle, auditors are exposed to unlimited liability for their mistakes, even if they were less at fault than the directors of the company they had been auditing.

 

If they could choose, many auditors would opt for the reform promised in Australia, following concerns about lack of affordable insurance cover for big and medium-sized accounting firms. But auditors would also settle for a specific limit on their liability.

 

Austria and Germany have set fixed caps on liability to shield auditors from big legal claims. The liability limit in Greece is based on a multiple of fees secured by an accounting firm with an audit client.

 

Denmark, Luxembourg, the Netherlands and Spain allow auditors to reach contractual agreements with clients on their liability limit.

 

The UK government refused to consider a proportionate liability regime when it published a consultation document in December on possible measures to give auditors protection against catastrophic legal claims. This was because it would involve a root-and-branch overhaul of negligence law.

 

Instead, the government used its consultation to collect views on less ambitious measures that would still give significant protection to auditors:

 

* Give auditors the right to reach agreements with clients to limit their liability. That would involve repealing existing legislation prohibiting such agreements. The reform would enable auditors to negotiate a ceiling on their liability in any legal action by a company over defective work.

 

* Building on the first option, new rules would determine the extent to which auditors could limit their liability in agreements with clients. The limit could be based on a multiple of audit fees, or calculated on a multiple of total fees, because auditors often secure lucrative tax work on top of a client’s audit. Alternatively, it could set the limit at a multiple of an accounting firm’s turnover.

 

* Put a cap on liability, based on an arbitrary level. The UK government suggests it could be £500m ($890m) for each of the Big Four.

 

Following the public consultation, the government is close to proposing that auditors be allowed to reach agreements with clients that would limit their liability. Although no final decisions have been taken on reform, ministers are likely to require that such agreements be approved by shareholders.

 

The government is also likely to ask the regulator to devise a formula ensuring that an agreement between an auditor and a client did not result in a very low limit on the accounting firm’s liability. For example, the regulator could stipulate that the minimum level of liability must be based on a high multiple of audit fees.

 

The Financial Services Authority, the chief UK financial regulator, could be disappointed by the government’s likely reform because it favours a proportionate liability regime. “We do not believe that a convincing case has been made for allowing auditors to limit their liability contractually,” it says.

 

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