Investors rely on corporate auditors to keep impartial watch on the accounting practices of the companies they invest in. Historically, investors have not been shy about launching litigation when they believed auditors did not do enough to stop their clients from cooking the books or engaging in other financial improprieties.
But new research shows that lawsuits against auditors for accounting violations have fallen over the past 20 years, and it’s not because accountants have become so much better at their craft or companies more honest.
“The number of lawsuits per year has declined, dismissals have increased, and settlements in recent years have declined,” conclude the authors of a new research paper. “Our study asks why.”
The number of lawsuits specifically about Rule 10b-5, the antifraud regulation created under the Securities Exchange Act of 1934, dropped from 487 in the year 2001 to 80 in 2014. Another example: Some 70 percent of auditors in 1996 were likely to settle claims with some sort of cash payment. By 2016 the percentage of paid settlements had dropped to a little over 30 percent.
“Reducing the bite, the risk of litigation, is not necessarily a good thing because now it will make investors more wary of engaging in the capital markets.”
Two Supreme Court decisions, although not the only reasons, appear to have made a difference, according to the researchers. The rulings in Tellabs v. Makor (2007) and Janus v. First Derivative (2011) have effectively narrowed liability standards, requiring plaintiffs such as institutional investors to prove that auditors knew, or should have known, their clients’ financial statements contained errors.
In both decisions, Rule 10b-5 lost its bite. Investors are at a disadvantage.
The Changing Landscape of Auditor Liability is the first research to capture changes in federal auditor liability over the past two decades before and after Tellabs and Janus. Its authors are Harvard Business School professor Suraj Srinivasan, Stanford Law School professor Colleen Honigsberg, and Shivaram Rajgopal of Columbia Business School.
We asked Srinivasan, the Philip J. Stomberg Professor of Business Administration, to explain.
Martha Lagace: What is the context for the research you are doing?
Suraj Srinivasan: Auditors play a key role in capital markets because investors rely on information produced by companies. As we have seen when big scandals happen, like Enron and WorldCom, the weak link often turns out to be auditors. Managers are mostly truth-tellers but have incentives to embellish and sometimes commit fraud. So we rely on auditors to mitigate that problem.
Auditors’ incentive to do a good job is to maintain their reputation. Investors trust that they will provide effective monitoring, and auditors exist because of that trust. But the audit firms are large organizations and the work is complex. Mistakes happen and cause us to lose that trust.
The complement to reputational incentives is the litigation system. The US is somewhat unique in having a strong class-action litigation system through which investors can hold companies accountable after the fact when there is a problem. For investors, this is how they can partly remedy the harm. Oftentimes the remedy is not just money but that the company has to do something differently like improve their governance and change their board. The same goes for auditors.
With risk of litigation there’s a deterrent effect. If you know that I can sue you then you are less likely to commit a violation in the first place. That’s even more important here because the work of auditors is basically a black box. Even though investors are the ones who most benefit from the auditors’ work, they don’t get to see how it takes place. And that is why they need to rely on these somewhat blunt tools of litigation after the fact to create that incentive for auditors to do a good job.
So that’s the context. In capital markets, auditors play a huge role. When we have a financial crisis, there are often calls asking, “Where was the auditor?” “Where was Arthur Andersen during the Enron fraud?” That is why litigation as an accountability mechanism becomes an issue.
Lagace: Why did you follow up on Tellabs and Janus?
Srinivasan: When there are big changes like Supreme Court decisions it becomes important to assess whether they have changed the landscape or not. These two lawsuits are important for their implications for our economy and capital markets. In legal practice there was a sense that these rulings changed the landscape and were more to the advantage of the corporations and detrimental to investors. There was a sense that pleading standards have risen.
The cases have made it harder for investors to prove scienter, meaning that auditors knew there was a violation. We decided to assess whether and how things have changed over time from 1996 to 2017 and let the data give us the answer.
Lagace: What do the data show?
Srinivasan: Dismissals are going up, settlement amounts are going down, and fewer lawsuits are being filed.
Essentially, the ability of a class (group of investors) to bring a suit has been weakened. This matters because the way US investors hold corporations and agents of corporations accountable is through class-action lawsuits. Investors that sue most often as lead plaintiff are institutional investors. The bar has been raised, possibly to an extent where even meritorious lawsuits are not being brought, though that is hard to establish empirically.
“The bottom line from our study is that the balance has moved away from investors and towards auditors.”
A restatement of financials means that the company accepts that there was a mistake made. Our tests show that previously when there have been serious restatements of financials, those mistakes would lead to a certain number of lawsuits being filed and a certain settlement amount from them. The settlement amount is a proxy for whether there was a serious problem or not. If it was a trivial mistake, the company is unlikely to settle for a significant amount. They might still settle for something just to get rid of the problem.
What we find even in cases of significant restatements is that fewer lawsuits are being filed and the settlement amounts are smaller. And that financial reporting quality has fallen in places where it has become harder to sue.
The rulings of Tellabs and Janus have made it easier for auditors to argue, “We didn’t know the company lied to us.” How do investors prove that auditors didn’t ask the right questions or should have known the company was lying? Since Tellabs and Janus, it has become much harder to prove.
Filing a lawsuit and pursuing it is costly for the plaintiffs and attorneys. So if they know the chances of winning and of settlement are low, then they are not even going to bother trying.
Lagace: Where does this leave auditing as a profession?
Srinivasan: Auditors are in an interesting position. They rely on management teams in a lot of ways, but they also have an adversarial relationship. They verify that companies follow generally accepted accounting principles and by doing so they check on the validity of financial reports produced by the management team.
Making it harder to sue auditors actually might make auditors’ job harder, because if auditors have a lower risk of getting sued, they are going to potentially incorporate that lower risk into their own behaviors, consciously or not, and reduce their extent of vigilance when they are auditing their clients. Of course, auditors might deny that litigation risk is what motivates them to uphold quality. The profession has high standards of conduct and their reputation matters. Professional standards are usually upheld, but we know in case after case of reporting fraud that professional standards are not infallible. You still need this external accountability mechanism.
Lagace: What do your findings mean for the health of US capital markets?
Srinivasan: Companies from around the world seek to list in US capital markets and investors from around the world invest in US listed companies because the US legal regime offers a high level of investor protection. High quality auditing is a big part of this protection. When our investor protections standards go up, our capital markets become more attractive to global investors and companies. It’s a tradeoff, though. You don’t want to impose undue burdens on companies because that will deter one from listing and auditors from doing audits on companies that list in the US. On the other hand, if standards are too low then investors are not protected. There has to be a balance.
That balance is essentially a political and societal balance. The bottom line from our study is that the balance has moved away from investors and toward auditors. We hope our evidence helps provide some of the information we need to strike that balance.
Where is the trend heading? Hard to tell. But if the balance shifts too much away from investor protection it makes for weaker capital markets.
“We have some of the strongest capital markets because we have we have some of the strongest legal enforcement.”
Lagace: What can investors do? And what’s at stake?
Srinivasan: Federal laws are one aspect of our governance system. We can strengthen other aspects. One source of investor protection is the Public Company Accounting Oversight Board (PCAOB). One can make the case that the monitoring of auditors has greatly increased since the PCAOB was created after the Sarbanes Oxley Act of 2002.
There is also evidence that audit committees have improved their ability and willingness to monitor auditors. Investors can ask for and insist on strong audit committees of the board and pay more attention to what an audit committee does.
Investors can also engage with the Securities and Exchange Commission (SEC) and Congress to espouse their point of view. Lobbying for that through a coalition such as the Council for Institutional Investors (CII) can help.
We are a nation of laws. And we can have individual freedoms because we enforce our laws. If we reduce the impact of laws, we actually might not be improving society, because our individual freedoms are encumbered by laws. Which is exactly the issue here. Companies are free and auditors are free to do whatever they want except violate the laws. So reducing the bite, the risk of litigation, is not necessarily a good thing. There are countries with very lax laws and lax law enforcement, and there is a lot of evidence that their capital markets are some of the weakest in the world. We have some of the strongest capital markets because we have some of the strongest legal enforcement.
Sure, we need a balance. Companies have argued that they are subject to a lot of frivolous litigation. Raising the bar higher is a good thing then, to reduce waste of resources spent in litigation. But just reducing investor protections is a recipe for weakened capital markets.
Investor coalitions and individual large investors themselves understand this goal. Enlightened regulators and corporate leaders realize this as well and strive to strike a balance. Companies are benefitted when more investors are in the capital markets. It is not a one-way street. When you improve investor protection, it’s not hurting companies. If you help companies, it’s not hurting investors. You need checks and balances. The trust we have in our system—we shouldn’t weaken it. That actually will end up hurting us.
About the Author
Martha Lagace is a writer based in the Boston area.
[Image: guvendemir]
Related Reading:
What Are the Real Lessons of the Wells Fargo Case?
Counting Up the Effects of Sarbanes-Oxley
Corrupting Silence: Companies Must Speak Up Against Bribes
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