Could the Lawyers Kill the Auditors?

Center for Audit Quality, worrying about bankruptcies of firms, asks Treasury to step in with litigation rule reforms.

With public-company auditing firms facing a rash of lawsuits with the potential to bankrupt them, the Center for Audit Quality is urging the U.S. Treasury Department to help out the accountancies by improving the government’s handling of catastrophic risks and costly litigation.

According to a letter the group sent to the Treasury Advisory Committee last week, the six biggest audit firms faced 90 lawsuits as of March 21, 2008, with claims ranging from $100 million to $10 billion. “It could take only one or two cases where settlement is not reached to threaten a firm’s existence,” wrote Cynthia Fornelli, executive director of the CAQ.

The CAQ, which describes itself as an autonomous public-policy organization serving investors, auditors, and the capital markets, urged the Treasury Department to consider a recent recommendation from the European Commission, that liability risk be limited though a contract with the audit client, creating a cap on liabilities, or adopting “proportionate liability.”

Fornelli also suggested that Treasury consider capping appeals bonds to make it easier for audit firms to appeal cases with large damages. She also suggested that the committee consider creating a way for large firms to obtain liability insurance. This could be based on a similar government insurance model that banks use. Finally, Fornelli said that bankruptcy defenses should be stronger and that in cases where an audit client was just as negligent as an auditor, they should not be able to sue the audit firm.

Protection of audit firms facing big litigation risks is an important issue because only four large auditors exist and experts fear that the lack of competition is bad for quality. Therefore, the CAQ is hoping to “reduce the barriers to growth” of smaller firms so that the industry will become more effective.

Moral hazard is always a worry, and Fornelli acknowledged that limiting the risks of lawsuits should not come at the expense of audit quality itself.

“We do not advocate that these reforms be used to give audit firms a ‘free pass’ for substandard audits,” she wrote.

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