Audit Litigation Risk Down, but Not Out

Audit firms have enjoyed a respite from litigation the past few years, but legal experts believe it may only be a period of calm between storms.

A recent report from Cornerstone Research says class-action lawsuits alleging accounting improprieties rose in 2014 after two of the lightest years in the past decade. While only a tiny fraction of those class-action filings are directed at audit firms, an increase in accounting-related claims today suggests that audit firms may appear back on the radar as targets of allegations after some reprieve, experts say.

“Anecdotally, yes, litigation is off or lessened against the accounting firms,” says Patricia Gorham, a partner at law firm Sutherland Asbill & Brennan. “I think that is pretty much across the board the past couple of years.” Experts point to a variety of reasons why accounting firms have faced less litigation, along with reasons they expect it to pick up again over the next few years.

Data from Audit Analytics on litigation more broadly shows that the six largest audit firms fielded only 28 new cases in 2014, down from 46 in 2013 and 61 in 2012. For the first quarter of 2015, however, audit firms have already seen 13 new lawsuits, nearly half the number filed for all of last year.

“If you look at litigation against audit firms, it is for the most part driven by certain waves of issues,” says Emre Carr, a director at Berkeley Research Group. “It is true that last year was slower than previous years, but what kinds of events are shaping these trends, and where will the next big wave come from?”

Litigation reform measures dating back to 1995, along with various court cases interpreting the law, have made filing class-actions lawsuits against audit firms more difficult, says Tammy Bieber, a partner with law firm Thompson Hine. “The Private Securities Litigation Reform Act was supposed to get rid of frivolous class actions,” she says. “In the circuit courts, it’s a higher pleading standard. That has probably made a difference in litigation. To survive a motion to dismiss, you have to allege a lot more than you did before.”

“If you look at litigation against audit firms, it is, for the most part, driven by certain waves of issues. It is true that last year was slower than previous years, but what kinds of events are shaping these trends, and where will the next big wave come from?”
Emre Carr, Director, Berkeley Research Group

The Sarbanes-Oxley Act has made a difference as well, says Barry Epstein, a principal at forensic accounting firm Epstein + Nach. “We all made a lot of noise about Sarbanes-Oxley in terms of the work it required,” he says. “In fact, it has reduced the rate of occurrence of those things that in the past have led to litigation.”

Two factors in particular, says Bieber, have reduced litigation against auditors under SOX. First, the requirement for CEOs and CFOs to certify financial statements has forced companies to take their financial reporting more seriously, she says, and inspections by the Public Company Accounting Oversight Board have driven improvement to audit quality.

Litigation also has trailed off as cases brought in the wake of the financial crisis have worked their way through the courts, says Veronica Rendon, co-chair of the securities enforcement and litigation practice at Arnold & Porter. “The litigation that came out of the financial crisis was very focused on residential mortgage-backed securities,” she says. “The auditors kept their noses clean in that regard. That was not a prime target area for auditor liability.”

What Happens Next

EY’s recent settlement with the New York attorney general’s office over the Lehman Brothers meltdown may even be the last of the major cases arising from the financial crisis, Epstein says. “All these things go in a cycle,” he says. “We are way beyond the last crisis and too early for the next crisis, so there’s not a lot to blame the auditors for right now.”

Rebounding stock markets after the financial crisis and recession also contributed to diminishing litigation, says Roberta Karmel, a professor at Brooklyn Law School. “Cases follow the market,” she says. “When markets are going up, investors have no reason to sue.”

The Securities and Exchange Commission is stepping up its enforcement efforts on accounting and auditing issues, going after “gatekeepers,” or those who are considered important in guarding against fraud and financial misstatements. That likely will lead to an increase in litigation, says Todd Cipperman, founder of Cipperman Compliance Services. “Why plaintiff’s lawyers do what they do is often a mystery, but to a large extent they follow enforcement trends,” he says. “It gives them a leg to stand on. And we are seeing an uptick on the enforcement side recently.”

ACCOUNTING LITIGATION

Below Cornerstone Research compares class-action filings and settlements for accounting v. non-accounting cases from 2013 through 2014.


Note: In 2013 the majority of the total settlement value for non-accounting cases is represented by one large settlement. Without this case, the total value for non-accounting cases is $1,171.7 million, and the median and average are $15.5 million and $56.6 million, respectively. Settlement dollars adjusted for inflation; 2014 dollar equivalent figures used.
Source: Cornerstone Research.

Courtney Saleski, an attorney at law firm DLA Piper, concurs that an increase in enforcement means an increase in litigation is likely to follow. “Anytime you see the regulators acting, the plaintiff’s bar is watching,” she says. “They will file follow-ons.”

Epstein says auditors to some extent have been protected by the “cumulative beneficial impact” of SOX and litigation reform. But he notes the PCAOB still delivers harsh inspection findings to all the largest firms. “The PCAOB has been rather scathing in its observations on the number of audit failures they see,” he says. “But there’s no harm done if the financials are not wrong. You don’t get sued for a bad audit unless they are also bad financial statements that people relied on to their detriment. Auditors have been more lucky than smart.”

Carr says it’s clear auditors have changed the way they operate over the last 10 to 15 years. “There’s so much more scrutiny and so much more publicity on how audit firms operate,” he says. “That has had an impact on their behavior.”

The jury is still out, however, on whether that translates to truly better or more effective auditing, which might make the firms more resilient to the effects of litigation.

“When new regulations come out, they are always thought of with hindsight on what failed before,” Carr says. “They are usually capable of addressing yesterday’s problems, but not necessarily all that effective at solving today’s problems. I’m not sure the firms can avoid litigation from some unexpected area of the financial markets.”