Two Regulators Move On Auditor Liability

Banking regulators have finished their advisory to financial institutions warning against agreements to auditor liability, while that debate is now starting to simmer at the Public Company Accounting Oversight Board.

The Federal Financial Institutions Examination Council—an interagency body that sets standards for financial institutions—made only one departure from its original position in advising banks and thrifts to steer clear of auditors’ efforts to negotiate protections into audit engagements.

The Council agreed to “take under advisement” whether financial institutions may waive their right to seek punitive damages from auditors. A spokesperson for the Federal Reserve, one of the agencies represented by FFIEC, said the Council hadn’t gotten the feedback it hoped for from the Securities and Exchange Commission and the PCAOB about whether any agreement on punitive damages would constitute an unsafe or unsound practice.

Dyckman

Matthew Dyckman, a partner with law firm Thacher Proffitt & Wood, said the accounting industry put up “a heavy volume of critical comments,” to the Council’s proposed advisory, but Council members “stuck to their guns and adopted the advisory largely as proposed.”

Deloitte & Touche, for example, complained that the proposal undermines basic notions about freedom to enter into contracts. “Sophisticated commercial entities of equal bargaining strength are capable of negotiating to allocate the risk of economic loss inherent in any commercial transaction, and the allocation of risk agreed to by those parties should be respected,” the firm wrote.

Deloitte also pointed out that the proposal itself acknowledges “a large majority” of engagement letters do not contain the liability limits the Council opposes. “This fact suggests that auditors and financial institutions are able to contract for these provisions freely, and have decided to use such provisions only in limited circumstances,” the letter says.

Richson

Cynthia Richson, corporate governance officer for the Ohio Public Employees Retirement System (OPERS), said the advisory in final form is “weaker” than the initial proposal, “and that’s disappointing to us as investors.”

While the banking regulators’ measure is not applicable to most public companies—the guidance is primarily relevant to financial services firms—it does raise questions about how auditor liability secured via engagement letters affects the audit process or outcome for public companies. The PCAOB’s Standing Advisory Group debated the issue at its most recent meeting just last week, suggesting the Board is investigating whether it should write a new rule addressing auditor liability.

Richson, a member of the advisory group, says she considers auditor liability an impairment to auditor independence, and believes the PCAOB needs to establish rules around such protections.

Robert Kueppers, national managing partner for Deloitte and a member of the advisory panel, says that as a practical matter auditors’ judgment isn’t influenced by any liability protections that might exist on an engagement, since so many other regulatory and licensure duties loom larger. “It’s No. 14 on the list of things our people worry about as they conduct themselves,” he says.

Richson says auditor liability protection is defended because of the small number of major firms that provide auditor work, a position she called a “red herring.” She cites a Stanford University review that found only five legal actions against audit firms, suggesting the firms are not being inundated by frivolous claims.

Instead, Richson told the SAG gathering, she worries that audit firms may seek protections because of concerns they’ve developed about legal actions related to tax work—a fear, she says, that should be treated as entirely unrelated to liability concerns in audit engagements.

Lynn Turner, managing director of research for Glass, Lewis & Co., said he can’t understand why audit committees—which are charged to represent shareholders—would agree to protect auditors from legal action. “What is the public interest in having these types of agreements?” he said. “Why would I carve out a special class of people and give them protection that I wouldn’t give other vendors?”

Damon Silvers, legal counsel for the AFL-CIO, says the limited number of large audit firms and the legal requirement to buy audit services leave issuers with few choices, but they often have no choice other than to sign a liability waiver. “There aren’t a great deal of market forces at work here,” he says.

Barbara Roper, director of investor protection for the Consumer Federation of America, said after the meeting that regulators need more information about when, where and how frequently audit firms seek liability protections before any rule-making could proceed. She suggested audit firms should have such data readily available simply by assembling their engagement letters.

Separately, another auditor liability debate is unfolding inside the American Institute of Certified Public Accountants, where the group’s Peer Ethics Executive Committee is studying auditor liability, but only as it relates to an auditor’s independence, not the soundness of financial statements.

Lisa Snyder, director of the AICPA’s professional ethics division, said the committee is still working on its rule and hopes to have some guidance ready for discussion by May.