Killer Caps

From the moment Treasury Secretary Henry Paulson created the Committee on Capital Markets Regulation, an independent, bipartisan committee to study the competitiveness of U.S. capital markets in September 2006, the Big Four accounting firms had the committee's members in their sights. Haunted by the memory of the Arthur Andersen collapse, their goal was to secure a recommendation for an audit liability cap.

Less than three months later, the Big Four got their wish when the committee, which includes the CEOs of Pricewaterhouse?? 1/2 Coopers and Deloitte & Touche, released its interim report in November. The report unequivocally supported the Big Four's proposal and acknowledged the pressures that have plagued auditors in the post-Enron era.

"Auditors may have incentives to engage in 'defensive auditing,' just as doctors faced with potential financial ruin from medical malpractice cases practice 'defensive medicine,'" the report states.

It's precisely this defensive auditing that has strained relationships between auditors and general counsel. There was a time in the recent past when auditors and general counsel lived in relative harmony, but Congress' enactment of SOX and the erosion of attorney-client privilege have contributed to a growing tension between in-house counsel and accountants.

"The relationship between GCs and auditors has been tarnished as auditors continue to push for information to the point where it seems as if they are asking general counsel to waive privilege as a matter of course," says Firoz Dattu, managing director of the General Counsel Roundtable.

But whatever the pros and cons of an audit liability cap, it's hard to find anyone who believes that a cap will ameliorate the tension. Ironically, the reason for that may be that the accounting firms have been careful to limit just what it is they're asking for.

Liability Caps

"The only thing we're serious about is a catastrophic liability cap that offers some protection from firm killer-type cases, the kind that would produce judgments that are far in excess of our capital," says Robert Kueppers, deputy CEO of Deloitte & Touche USA.

The notion of such judgments is not just hypothetical. A recent study by Chicago-based Aon Corp. cited 20 claims worth more than $1 billion against U.S. auditors as of September 2005.

As it turns out, the committee's 135-page report specifically cites the need "to avoid catastrophic loss and its consequences" as the purpose of an audit liability cap.

According to Harvard Law School professor Hal Scott, a founding member of the committee--which also includes Tom Russo, CLO of Lehman Brothers, and Ira Millstein, partner at Weil, Gotshal & Manges--the collapse of a major accounting firm could threaten global markets.

"Avoiding the collapse of one of the major accounting firms is the main justification for a cap," he says.

As Kueppers sees it, such a collapse could have a cascading effect.

"If one of us goes, I don't know if the other three will survive," he says. "But even if that doesn't happen, the notion of going to only three firms is too scary because the level of competition remaining will not serve the public interest."

Kueppers also claims that insurance is unavailable for catastrophic claims and points out that the liability is borne entirely by private capital because accounting firms are not allowed to go public. Finally, he maintains that accounting firms are at a disadvantage in taking major cases to trial because the risks are too great.

Still, critics of a cap say the arguments in its favor amount to nothing less than fear mongering.

Protected Status

To begin with, the critics maintain that no outsized judgment has ever led to the collapse of a large accounting firm. Arthur Andersen, they note, failed because of a criminal conviction (later overturned on appeal). That won't happen again, they say, because the government would not risk the failure of any of the Big Four.

Indeed, KPMG paid $456 million in August 2005 as part of a deferred prosecution agreement after admitting the firm sold illegal tax shelters to help wealthy clients avoid taxes. KPMG will avoid criminal indictment if it abides by the agreement.

"The Big Four are effectively immune to criminal prosecution, which means they're untouchable in the sense that you can't put them out of business," says Sean Coffey, a partner at New York-based Bernstein Litowitz Berger & Grossmann, which has sued several accounting firms. "Now they want provisions that reduce their costs for failing to catch fraud. It's mind-boggling and contrary to all the lessons we've learned in the past few years."

And according to a study released in September by the European Commission, the cost of settlements, judgments and legal fees has risen to 14.2 percent of revenue in 2004 from 7.7 percent in 1999 for U.S. auditors. The study also notes, however, that revenues have been accelerating in the double digits in the past few years. In addition, the Stanford Law School Securities Class Action Clearinghouse reports that there were only five class actions against auditors in 2005, down from 14 in 2002.

For his part, Kueppers maintains a catastrophic liability cap will not impact the quality of audits. "If you do a poor job and someone sues you for $100 million, it still won't be good for the firm of the partners involved," he argues.

Looking at it from general counsel's perspective, he also says that a catastrophic liability cap won't impact auditors' relationships with management.

Status Quo

"The availability or non-availability of a $10 billion claim will not change behavior in the front lines," Kueppers says. "Those types of claims are outside the periphery of practitioners day in and day out. They are more a matter for accounting firm executives like myself."

Dattu is of the same mind.

"It would be an upside surprise if a cap on liability had much of an effect on relations between corporate counsel and auditors," he says. "Any cap that's imposed will still leave the accounting partners with a fair amount of change coming out of their pockets."

The fact remains, however, that a cap is still a distant prospect. It's unlikely that the newly minted Democratic Congress will have much sympathy for auditors. Meanwhile, Kueppers puts the onus of improving relations with in-house counsel squarely on the auditors.

"It has been a mistake for auditors not to deal with the ramped-up auditing requirements by relieving the tension that has built up across the spectrum of client management, in which one key position is certainly general counsel," he says. "Relieving the tension means we can work more effectively, and unless we work more effectively, we can't do our best."

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Julius Melnitzer

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