1 Auditor Liability Reform in UK and US: Who benefits? Tim Bush (Hermes) Stella Fearnley (Portsmouth Business School) Shyam Sunder (Yale School of Management)

2 Motivation for paper Major differences between US and UK regimes (Bush 2005) Strong moves towards global standards in accounting and auditing Growing drive from the profession for global liability limitation LLPs & joint & several reform in US, 1990s LLPs in UK 2000 and Companies Act 2006 limits liability Considering wider implications of changes for the profession and users

3 US developments Federal securities laws since 1933, decision usefulness reporting model Securities Acts focus on protection of markets i.e. buying and selling shares; Class actions for share price falls Contract law at state level Original joint and several liability with burden of proof on defence who bear own costs regardless of outcome But had to prove recklessness or intent (Hochfelder, 1976) i.e. more than negligence

4 US developments 1991 onwards: states allowed LLPs, firms able to protect partners assets Audit firms writing private restrictive clauses in engagement letters stop contract law cases at state level (jury trial and punitive damages) (Now PCAOB independence concern) Genuine concerns about merit-less class actions where cheaper to settle because of defence costs Auditors appointed by management (until SOX) and report to directors. Shareholders cannot sack directors

5 US developments 1995 PSLRA and 1998 SLUSA brought proportionate liability, except for criminality & fines for meritless cases Presidential veto: quid pro quo improvements to audit quality suggested by Treadway in 1987 (illegal acts, related party transactions, going concern, report breaches) No evidence of improvements to audit quality Suggestions (Zeff, 2003, Francis and Krishnam, 2002, Coffee and others) moral hazard undermined audit quality but no conclusive causal link

6 UK before 2000 Company law controls corporate and auditor responsibilities; liability limitation banned since 1929 Duty of care to shareholders but Caparo 1990 limits rights to sue to shareholders as a group Almost no liability to 3 rd parties unless proximity can be proved No class actions on share price falls Sue for negligience for loss in company; most claims from liquidators Losers pays other side’s costs

7 UK before Companies act allowed incorporation –only KPMG had limited take-up. Was price too high? Reform of Joint and several rejected by Law Commission in 1996 but possibility of allowing proportionate liability by contract mooted Key argument was only 6 firms LLPs allowed from 2000

8 UK present position UK and US Government scared of market disruption by KPMG tax scandal and UK Equitable Life case (Look at Table 3) Too big to fail and who caused that? Companies Act 2006 allows limitation by contract subject to shareholders agreement. Criminalises reckless or knowing misreporting, including omissions, also naming partners on audit reports, nothing onerous except criminalisation which may cause defensive auditing. CA 2006 brings possibility of derivative actions agaisnt directors but not auditors (shareholders sue company and company sues directors)

9 Implications of all this Stewardship - decision usefulness major issue – different purpose for accounts Who can sue for what is major issue In different governance and liability regimes can reform be the same? Risk passing from firms to regulators and audit committees and liability reform Should high income carry risk (table 3)? Should we allow firms to become globally bomb proof with legal control only possible at country level? Regulators more concerned about losing a firm UK FRC has working group reviewing it

10 Possible outcomes If audit wasn’t compulsory, price and quality would find its own level In compulsory environment liability limitation reduces value of audit to investors – pay less and value service less Increased regulation, brought on by previous poor auditor performance, devalues profession How much though has been given to the implications of liability reform in changing environment – more concern about risk of loss of a firm What are firms offering up? More information about litigation costs and risk/reward Now some thinking about whether whole model is broken because of excessive regulation