Auditor liability

Images of handcuffed CEOs have become commonplace in the US media. To many it is a sign that shareholder-driven litigation is working. But audit firms are getting nervous, reports Christian Doherty

This summer saw another major fraud trial. One of the BDO network of firms, BDO Seidman, suffered a guilty verdict for failing to identify a major fraud at Banco Espirito Santo. A Florida court hit BDO Seidman with a US$521m fine in July. The case is still being appealed, but it is clear the suit has made US auditors nervous.

To those in the profession this illustrates a real danger to audit in the US. To Sam Wholley, MD of Baker Tilly International in Boston, there is a serious level of concern among all US firms. 'I have no doubt the case will have an impact. It doesn't matter where you're located, so it's a concern to everyone. And it's not going away.'

And Wholley points to the fact that, since the collapse of Andersen in 2002, competition and choice in the audit market has worsened. 'It has to be said that competition is good for the client and the economy and the networks,' he says. 'There's a lot of business out there and we're all doing well from it, and there's no doubt it will hurt the profession if another firm goes under.'

However, Wholley's view is not shared by many outside the audit profession. Essentially, the attitude among US regulators and investor groups seems to be that the current legal situation ('screw up and we'll sue you heavily') in the US means that auditors are encouraged to self regulate and make sure they do not fall foul of the courts.

Glen DeValerio is a corporate lawyer at Boston firm Berman DeValerio Pease Tabacco Burt & Pucillo. He has fought many cases on this issue and says the current burden of proof required to prosecute auditors successfully in fraud cases is so high that a liability cap is unnecessary. 'In the US just because there's a false financial statement made, or a restatement, that's not sufficient to name the auditor as liable,' DeValerio says. 'What the plaintiff has to do is establish at the beginning of the lawsuit, before anything else is heard, that it was more than just a blown audit; there was clear wrongdoing. So the standard for establishing liability is high. You can't just name the auditor and you get a great big recovery settlement by any means.'

DeValerio says that the principle of proportionality is also there. 'If the lawyers can establish the auditor should have spotted the wrongdoing, and it's a major error, then the plaintiff is still only entitled to their proportionate share of auditor's wrongdoing. So if the jury decides the auditor is only 20% liable, then that's all you get. So there are lots of checks and balances against wild recovery. But it is fair and it's not just some arbitrary cap; it's only in the most egregious cases.'

Meanwhile, US investors and consumer advocates say that, in fact, claims against auditors have fallen recently, evidence that the threat of litigation is working. There is also the contention that no auditor has ever gone out of business thanks to securities litigation. So while the profession is painting uncapped liability as a major threat, Congress, the Securities and Exchange Commission (SEC) and other regulators in the US are far less concerned.

One audit partner at a US firm was blunt in his assessment. 'The mood in the US about capping liability is generally driven by the mood of big business,' he says. 'If the Fortune 500 screams at Congress, then they might react. Or if someone thinks they can make points in an election by proposing something, then it gets attention. Right now it isn't on anybody's list of important issues, so it isn't getting a lot of attention.'

In DeValerio's view, there is only one way auditors will see a liability cap put in place: 'This issue is being pushed only by the auditor's lobby in the US, and they have an interest in the Republican side of the house. If the Republicans get a strong majority in Congress there would be a reasonable chance they could accomplish it. But if it remains a Democratic majority in the house, or a close split, the likelihood is very slight.'

So all eyes are on the Presidential race next November. With the Democrats heavily tipped to take back the White House, US auditors might be waiting a while before they see this resolved.

Europe: the state of play

Across the Atlantic, the EU is taking this seriously and is pushing for reform and convergence. Charlie McCreevy, the European Commissioner responsible for the stability of the financial markets, has already floated the idea of capping liabilities in order to avoid another collapse or further erosion of choice.

Currently, the Department for Business, Enterprise and Regulatory Reform (formerly the Department of Trade and Industry) is taking the lead on this issue in the UK. It has set out four possible formulas for working out auditors' liability. They are:

• a fixed monetary limit for auditor liability at pan-European level through EU legislation
• a limit based on the equity capitalisation of the client company
• a limit based on a multiple of the auditor's fees
• the principle of 'proportionate liability', where auditors are liable for damages which were caused by their own errors, and excluding client errors.

In the UK, audit liability is reaching further up the agenda of both firms and regulators. Jeremy Newman, managing partner at BDO Stoy Hayward, says the UK is leading the way in establishing a system whereby auditor liability is fairly handled. 'In Europe we're well ahead of the US on this issue, and in the UK I'd say we're well ahead of Europe on it,' he says. 'The Companies Act, which comes into force at the end of the year, does have some provision for an element of audit liability limitation, and that's a good thing.'

Under the Companies Act, the UK is pioneering a separate system whereby the auditor can agree a limit on liability with its individual clients. This would be subject to shareholder approval, but could offer a blueprint for consensual liability caps to suit all parties.

John Davies, ACCA's head of business law, says there will need to be stakeholder buy-in for the new rules to have a lasting impact. 'The UK's new rules offer auditors the opportunity to limit their liability on whatever basis is set out in the agreement - this will be able to include proportionate liability, but it could also include any other basis, such as a fixed cap, provided that it is “reasonable”,' he says. 'But the key to whether this option becomes widely used will be the stance of shareholders, especially institutional shareholders. Since every limitation agreement will require the assent of shareholders, they will effectively have a veto on this matter, whether the auditors like it or not.'

'There's currently a working party discussing this and they should report before the end of 2007,' Newman confirms. 'I think this is largely about limiting auditors' liabilities on a proportionate basis. And if that comes in then it may well end up as a court-mandated issue where the legal process will decide what liability the auditor should bear.'

As for the rest of Europe, the issue is also working its way into the boardrooms and thinktanks. The EU's stance at present is that there is a need for reform, but given the fractured nature of individual states' current systems, there is a lot of work to be done to harmonise the issue across EU members. But there is a recognition that simply throwing auditors on the mercy of the courts is more cure and less prevention.

What is clear is that should Europe come up with a single standard that helps competition and ensures that audit firms are adequately protected from catastrophic liability, then more pressure will be brought to bear on the US to follow this route. Watch this space.

Christian Doherty is a freelance journalist.