SEC Pushes To Gut Accounting Fraud Liability

The first line of defense against big business fraud are the accounting firms that big businesses hire to reassure shareholders that their books are honest.  

Now, Conrad Hewitt, the Security and Exchange Commission's chief accountant, and the European Commission, the executive branch arm of the E.U. think "the big audit firms should be given legal protection against claims."  Treasury Secretary Hank Paulson and the Committee on Capital Markets Regulation are also involved in the U.S. effort. The adminisration may plan to try to get around Congressional opposition to the plan by issuing regulations or audit standards that would change audit firm liability.

This is a very bad idea.

Among the proposals (as reported by tax research firm RIA) are:

• Establishing a monetary cap on liability.
• Establishing a monetary cap on liability based on the market capitalization of the audit firm.
• Establishing a monetary cap on liability based on a multiple of the fees charged by the audit firm.
• Establishing proportional liability, where the audit firm's liability would be limited to the role it played in damages.

The first three options are unprecedented and fundamentally unsound.  Even the most striden tort reformers, who seek to limit liability for things like medical malpractice, never seek to limit compensatory damages, only pain and suffering and punitive damages, not compensation for out of pocket losses.

The last option seems to make sense on its face, but, in practice, the firm's liability and the liability of its accounting firm for accounting fraud are usually inseparable.  While there are rare instances where a corporation actively hides things from its auditing firm so that there is no way it could have discovered the fraud, more often, the auditing firm should have known what was going on and either gave a questionable practice a rubber stamp, or was negligent.  In effect, there was a conspiracy of malfeasance.

Basically, he argues that liability will make big auditing firms go under.  Accounting companies have somehow managed to make billions and stay in business since at least the invention of securities laws in the 1930s, but somehow, they can't do that anymore.

The obvious response is, that if they are doing that shoddy a job and getting too cozy with management allowing fraud to go on, that they deserve to go under.  In the same way, an insurance company that fails to set aside proper reserves for disasters and claims deserves to go under.

Who Are Audit Companies?

When an accounting firm audits a company's books they are representing to the public that they the company's books are set up according to standard accounting rules and that they have kicked the tires of the important underlying facts to make sure that the numbers aren't made up.  When a big corporation cooks its books, the senior executives, the corporation, and the accounting firm that said everything was fine are all on the hook to investors.

One of the biggest accounting firms in the country, Arthur Anderson, went under in the wake of the Enron scandal beacause they were too cozy with the company, instead of aggressively looking out for shareholder interests.  In the wake of the tech bust accounting fraud scandals, Congress tightened rules on accounting firms to discourage those kinds of relationships.

A proposal like this would be basically an invitation for auditors to act laxly in assuring the accuracy of corporate books, which could undermine the very basis of the capital markets.  It would invite a return to the fraudulent approaches that helped create the tech bust in the first place.

Most big accounting firms are basically consulting firms that use auditing as a hook to build relationships with big businesses.  Fine.  Nothing prevents big accounting firms from splitting up into audit firms and consulting firms, with the audit firms alone bearing the risk of a bad audit.

But, limiting liability when an audit firm has failed in its basic mission is grossly inappropriate.  If they want to manage their liability, they can buy professional malpractice insurance against it at Lloyds of London.  

If it costs more for audit companies to budget for the risk of liability, so what?  Attorneys who write opinion letters on tax and security issues routinely charge far more than the hourly cost of doing so, because they know that they are liable in large amounts if they screw up.  Auditors should do the same.