Litigation cases are expensive for audit firms whether they win or lose because they result in monetary losses, take up the time of audit firm members, and can hurt the reputation of the audit firm. In fact, audit firms report that practice protection costs, such as insurance, legal fees, and litigation settlements, are the second-highest costs faced by audit firms, behind only employee compensation costs. When auditors agree to perform audits, they purport to be experts in assessing the fairness of financial statements on which the public relies. In conducting most audits, auditors use great care, perform professionally, issue appropriate opinions, and serve the interests of the public. In short, most audits are conducted in a quality manner. Even so, audit firms continue to experience high levels of litigation. Reasons for this include the following:
- Liability doctrines that include joint and several liability statutes permitting a plaintiff to recover the full amount of a settlement from an external audit firm, even though that firm is found to be only partially responsible for the loss (often referred to as the deep-pocket theory, meaning we sue those who can pay)
- Class action suits and associated user awareness of the possibilities and rewards of litigation
- Contingent-fee-based compensation for law firms, especially in class action suits
- The misunderstanding by some users of financial statement that an unqualified audit opinion represents an insurance policy against investment losses
Liability Doctrines
Auditors may be subject to either joint and several liability or proportionate liability. Joint and several liability concepts are designed to protect users who suffer losses because of misplaced reliance on materially misstated financial statements. Users suffer real losses, but sometimes those primarily responsible for the losses, such as management, do not have the monetary resources to compensate users. Under joint and several liability, users suffering a loss are able to recover full damages from any defendant, including an audit firm, regardless of the level of fault of the party. For example, if a jury decided that management was 80% at fault and the auditor was 20% at fault, the damages would be apportioned 80% to management and 20% to auditors. Unfortunately, in many lawsuits involving auditors, the client is in bankruptcy, management has few monetary resources, and the auditor is the only party left with adequate resources to pay the damages.
Joint and several liability then apportions the damages over the remaining defendants in proportion to the relative damages. Under joint and several liability, if management has no resources and there are no other defendants, 100% of the damages are then apportioned to the audit firm. In federal suits, Congress has limited the extent of joint and several liability damages to actual percentage of responsibility (if auditors are found liable for less than 50% of damages).
In 1995, Congress passed the Private Securities Litigation Reform Act (PSLRA), which is designed to curb frivolous securities class action lawsuits brought under federal securities laws against companies whose stock performs below expectations. Under this Act, liability is proportional rather than joint and several, unless the violation is willful that is, unless the auditor knowingly participated in a fraud. In some situations, a defendant may have to cover some of the obligation of another defendant who is unable to pay his or her share. Under proportionate liability, a defendant must pay a proportionate share of the damage, depending on the degree of fault determined by the judge or jury. Because the PSLRA applies only to lawsuits brought in federal courts, many lawyers filed their cases in state courts. This loophole was closed by the Securities Litigation Uniform Standards Act of 1998, which says, “Any covered class action brought into any state court involving a covered security...shall be removable to the federal district court for the district in which the action is pending.” The 1998 Act is designed to require potential plaintiffs to adhere to the spirit, as well as the letter, of the PLSRA Act of 1995.
Class Action Lawsuits
Class action lawsuits are designed to prevent multiple lawsuits that might result in inconsistent judgments and to encourage litigation when no individual plaintiff has a claim large enough to justify the expense of litigation. These types of lawsuits are especially appropriate for securities litigation because they enable a number of shareholders to combine claims that they could not afford to litigate individually. Often in these cases, the lawyers are working on a contingent fee basis and will work very diligently to identify every potential member of the class. Damages to audit firms in such cases can be extremely large, thus the fees for the lawyers are also usually quite large.
Contingent-Fee Compensation for Lawyers
Contingent fees for lawyers have evolved in our society to allow individuals who cannot afford high-priced lawyers to seek compensation for their damages. Lawyers take contingent-fee cases with an agreement that a client who loses a case owes the lawyer nothing; however, if the case is won, the lawyer receives an agreed-upon portion (usually one-third to one-half) of the damages awarded. This arrangement protects the underprivileged and encourages lawsuits by a wide variety of parties. The plaintiffs have little to lose, while the lawyers have a large incentive to successfully pursue such cases.
Audits Viewed as an Insurance Policy: The Expectations Gap
As you know from your readings, an audit report accompanying a financial statement is not a guarantee that an investment in the audited company is free of risk. Unfortunately, some investors mistakenly view the unqualified auditreport as an insurance policy against any and all losses from a risky investment. When they do suffer losses, these investors believe that they should be able to recover their losses from the auditor. This misperception has elements of an “expectations gap,” whereby shareholders believe that they are entitled to recover losses on investments for which the auditor provided an unqualified opinion on the financial statements. This misperception, coupled with joint and several liability, class action lawsuits, and contingent-fee compensation for lawyers, encourages large lawsuits against auditors, even for cases in which the auditor is only partially at fault or is not at fault.
Auditors may be subject to either joint and several liability or proportionate liability. Joint and several liability concepts are designed to protect users who suffer losses because of misplaced reliance on materially misstated financial statements. Users suffer real losses, but sometimes those primarily responsible for the losses, such as management, do not have the monetary resources to compensate users. Under joint and several liability, users suffering a loss are able to recover full damages from any defendant, including an audit firm, regardless of the level of fault of the party. For example, if a jury decided that management was 80% at fault and the auditor was 20% at fault, the damages would be apportioned 80% to management and 20% to auditors. Unfortunately, in many lawsuits involving auditors, the client is in bankruptcy, management has few monetary resources, and the auditor is the only party left with adequate resources to pay the damages.
Joint and several liability then apportions the damages over the remaining defendants in proportion to the relative damages. Under joint and several liability, if management has no resources and there are no other defendants, 100% of the damages are then apportioned to the audit firm. In federal suits, Congress has limited the extent of joint and several liability damages to actual percentage of responsibility (if auditors are found liable for less than 50% of damages).
In 1995, Congress passed the Private Securities Litigation Reform Act (PSLRA), which is designed to curb frivolous securities class action lawsuits brought under federal securities laws against companies whose stock performs below expectations. Under this Act, liability is proportional rather than joint and several, unless the violation is willful that is, unless the auditor knowingly participated in a fraud. In some situations, a defendant may have to cover some of the obligation of another defendant who is unable to pay his or her share. Under proportionate liability, a defendant must pay a proportionate share of the damage, depending on the degree of fault determined by the judge or jury. Because the PSLRA applies only to lawsuits brought in federal courts, many lawyers filed their cases in state courts. This loophole was closed by the Securities Litigation Uniform Standards Act of 1998, which says, “Any covered class action brought into any state court involving a covered security...shall be removable to the federal district court for the district in which the action is pending.” The 1998 Act is designed to require potential plaintiffs to adhere to the spirit, as well as the letter, of the PLSRA Act of 1995.
Class Action Lawsuits
Class action lawsuits are designed to prevent multiple lawsuits that might result in inconsistent judgments and to encourage litigation when no individual plaintiff has a claim large enough to justify the expense of litigation. These types of lawsuits are especially appropriate for securities litigation because they enable a number of shareholders to combine claims that they could not afford to litigate individually. Often in these cases, the lawyers are working on a contingent fee basis and will work very diligently to identify every potential member of the class. Damages to audit firms in such cases can be extremely large, thus the fees for the lawyers are also usually quite large.
Contingent-Fee Compensation for Lawyers
Contingent fees for lawyers have evolved in our society to allow individuals who cannot afford high-priced lawyers to seek compensation for their damages. Lawyers take contingent-fee cases with an agreement that a client who loses a case owes the lawyer nothing; however, if the case is won, the lawyer receives an agreed-upon portion (usually one-third to one-half) of the damages awarded. This arrangement protects the underprivileged and encourages lawsuits by a wide variety of parties. The plaintiffs have little to lose, while the lawyers have a large incentive to successfully pursue such cases.
Audits Viewed as an Insurance Policy: The Expectations Gap
As you know from your readings, an audit report accompanying a financial statement is not a guarantee that an investment in the audited company is free of risk. Unfortunately, some investors mistakenly view the unqualified auditreport as an insurance policy against any and all losses from a risky investment. When they do suffer losses, these investors believe that they should be able to recover their losses from the auditor. This misperception has elements of an “expectations gap,” whereby shareholders believe that they are entitled to recover losses on investments for which the auditor provided an unqualified opinion on the financial statements. This misperception, coupled with joint and several liability, class action lawsuits, and contingent-fee compensation for lawyers, encourages large lawsuits against auditors, even for cases in which the auditor is only partially at fault or is not at fault.
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