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The liability crisis in the United States: impact on the accounting profession.

In recognition of the growing litigation crisis in the United States, the six largest accounting firms recently issued a historic joint statement of position titled The Liability Crisis in the United States: Impact on the Accounting Profession.

Below is a resolution by the board of directors of the American Institute of CPAs urging tort reform, commending the work being done at the state level to reduce the threat posed by unwarranted liability and endorsing the joint statement. The statement itself begins on the facing page.



WHEREAS: The AICPA, on behalf of the entire accounting profession, has been seeking judicial and legislative reforms responsive to the liability crisis affecting the United States; and

WHEREAS: Unwarranted litigation affects new business ventures in their efforts to raise capital and also impacts local, national and global businesses; and

WHEREAS: The cost of litigation ultimately is passed on to the general public; and

WHEREAS: The accounting profession as a whole faces thousands of lawsuits claiming many billions of dollars in damages, far exceeding its proportionate share of responsibility; and

WHEREAS: In 1991, the six largest firms spent $477 million on legal matters--9% of their domestic auditing and accounting revenues and an 18% increase over 1990 litigation costs; and

WHEREAS: Litigation claims against other firms rose by two-thirds between 1987 and 1991 and 40% are "going bare" in light of the cost of liability insurance; and

WHEREAS: A growing number of firms are avoiding "high-risk" audit clients and even whole industries and some small firms are dropping public clients or abandoning their auditing practices altogether; therefore

BE IT RESOLVED: That the board of directors of the American Institute of CPAs endorses the position paper issued by the six largest accounting firms, The Liability Crisis in the United States: Impact on the Accounting Profession. The board believes the paper fairly reflects the nature of the litigation crisis in this country and appropriately emphasizes that in seeking litigation reform the profession is not attempting to avoid responsibility where accountants have breached their duty; and

BE IT FURTHER RESOLVED: That the AICPA believes reform of the federal securities laws is essential to curb unwarranted litigation and would be an important first step toward instituting broader liability reforms; and

BE IT FURTHER RESOLVED: That the AICPA also commends the work being done at the state level to reform state liability laws through legislative and judicial initiatives and to remove harmful regulatory and professional restrictions. The profession's ability to meet public expectations would be greatly enhanced by exploring all possible alternatives for reducing the threat unwarranted liability poses to the entire profession.


The following statement was signed by J. Michael Cook, chairman and chief executive officer, Deloitte & Touche; Eugene M. Freedman, chairman, Coopers & Lybrand; Ray J. Groves, chairman, Ernst & Young; Jon C. Madonna, chairman and chief executive, KPMG Peat Marwick; Shaun F. O'Malley, chairman and senior partner, Price Waterhouse; and Lawrence A. Weinbach, managing partner and chief executive, Arthur Andersen & Co.

The tort liability system in the United States is out of control. It is no longer a balanced system that provides reasonable compensation to victims by the responsible parties. Instead, it functions primarily as a risk transfer scheme in which marginally culpable or even innocent defendants too often must agree to coerced settlements in order to avoid the threat of even higher liability, pay judgments totally out of proportion to their degree of fault and incur substantial legal expenses to defend against unwarranted lawsuits.

The flaws in the liability system are taking a severe toll on the accounting profession. If these flaws are not corrected and the tort system continues on its present inequitable course, the consequences could prove fatal to accounting firms of all sizes. But a liability system seriously lacking in logic, fairness and balance is not just the accounting profession's crisis. It is a business crisis and a national crisis.

This position statement describes these matters in more detail, as well as needed reforms that the American Institute of CPAs and the six largest accounting firms are advocating. In seeking these reforms, the firms are not attempting to avoid liability where they are culpable. Rather, the firms seek equitable treatment that will permit them and the public accounting profession to continue to make an important contribution to the U.S. economy.


The present liability system has produced an epidemic of litigation that is spreading throughout the accounting profession and the business community. It is threatening the independent audit function and the financial reporting system, the strength of U.S. capital markets and the competitiveness of the U.S. economy.

The principal causes of the accounting profession's liability problems are unwarranted litigation and coerced settlements. The present system makes it both easy and financially rewarding to file claims regardless of the merits of the case. As former Securities and Exchange Commissioner Philip Lochner recently pointed out in the Wall Street Journal, Plaintiffs may simply be seeking to recoup losses from a poor investment decision by going after the most convenient "deep pocket"--the auditor ("Black Days for Accounting Firms," Wall Street Journal, May 22, 1992, page AIO. Reprinted in JofA, Aug. 92, page 105). In too many cases, moreover, claims are filed with the sole intent of taking advantage of the system to force defendants to settle.

The doctrine of joint and several liability makes each defendant fully liable for all assessed damages in a case, regardless of the degree of fault. In practical terms this means that, even with no evidence of culpability, a company's independent auditors are almost certain to be named in any action filed against that company alleging financial fraud for no reason other than the auditors' perceived deep pockets or because they are the only potential defendant that is still solvent. A particularly egregious example of the abuses encouraged by joint and several liability is the common practice of plaintiffs' attorneys settling with the prime wrongdoers, who don't have a defense or money, at a fraction of what these parties should pay. The attorneys then pursue the case against the deep pocket professionals, who as a result of joint and several liability are exposed

* LIABILITY CRISIS for 100% of the damages even if found to be only 1% at fault.

Other elements in the system also act as incentives for unwarranted litigation leading to forced settlements. For example, American judicial rules make no effective provision for recovery of legal costs by prevailing defendants, even if the plaintiff's case is meritless. In addition, judicial restrictions on the types of cases in which punitive damages may be awarded have been significantly relaxed in recent years, making solvent professional and business defendants a prime target. The prospect of having to pay all damages as a consequence of joint and several liability, the high costs of defense and possible punitive damages are persuasive factors in coercing settlements.

Abusive and unwarranted litigation is a problem not just for the accounting profession but also for business and the economy generally. A small group of attorneys is reaping millions of dollars by bringing federal securities fraud claims (under SEC rule lob-5) against public companies whose only crime has been a fluctuation in their stock price. These attorneys use the threat of enormous legal costs, a lengthy and disruptive discovery process, protracted litigation and damage to reputation to force large settlements.

The CEO of a high-tech company that has been the target of 13 specious rule lob-5 suits calls these actions "legalized extortion" and their effects go far beyond the "payoffs" demanded. These meritless suits siphon off funds needed for research and development, capital investment, growth and expansion. They divert management's time, talent and energy from the principal mission of running the business. They send liability insurance premiums skyrocketing. Ultimately the direct and indirect costs of these suits are borne by shareholders, along with employees, customers and all of a company's stakeholders.

Joint and several liability encourages the inclusion of deep pocket defendants such as independent accountants, lawyers, directors and underwriters in these suits in order to increase the prospect and size of settlements. Prohibitive legal costs, the unpredictable outcome of a jury trial and the risk of being liable for the full damages compel even blameless defendants to race each other to the settlement table. And they do this despite the realization that, to the uninformed public, "agreeing" to settle is seen as an admission of wrongdoing.

A survey by the six largest accounting firms of the cases against them involving lob-5 claims that were concluded in fiscal year 1991 showed that (i) the average claim subjecting the accounting firm to joint and several liability was for $85 million; (ii) the average settlement by the firm was $2.7 million, suggesting there might have been little or no merit to the original claim against the accountant; yet (iii) the average legal cost per claim was $3.5 million. It is not surprising that an accounting firm would agree to settle a case for less than what it had already spent in legal fees and, therefore, avoid the risk of liability of over 20 times the settlement by a jury that may be hostile to a business with deep pockets. However, controlling risk by settling when you did nothing wrong becomes a very expensive strategy for "winning" the liability game.

* LIABILITY CRISIS surveyed are "going bare," largely because liability insurance is simply too expensive (according to a 1992 AICPA survey of accounting firms, excluding the six largest).

For the largest firms, the increase in insurance premiums was dramatically higher than that reported by the smaller firms, coupled with drastically reduced policy limits. Deductibles also have risen dramatically and now exceed $25 million for a first loss. The higher rate of increase in liability insurance for the largest firms generally reflects the larger proportion of audit work for publicly held companies, thereby subjecting them to a greater liability risk.

IMPACT ON CORPORATE ACCOUNTABILITY AND ECONOMIC COMPETITIVENESS The heavy financial burden placed on accounting firms by runaway litigation affects business and the economy in two major ways:

* Through the actual and threatened failure of accounting firms.

* Through the "survival tactics" firms are forced to employ.

In 1990, Laventhol & Horwath, the seventh-largest firm, collapsed--the largest bankruptcy for a professional organization in U.S. history--necessitating that its former partners agree to pay $48 million to avoid personal bankruptcy. While other factors contributed to the firm's demise, the overriding reason was the weight of its liability burden. According to former CEO Robert Levine, L&H, like other accounting firms, was included as a defendant because of the perception of being a deep pocket rather than deficiencies in the performance of its professional responsibilities. "It wasn't the litigation we would lose that was the problem," he asserted. "It was the cost of winning that caused the greatest part of our financial distress."

The consequences of L&H's failure reverberated throughout the capital markets. Audits in process were interrupted. New auditors had to be found, with the inevitable time lag that occurs for start-up. Special rules had to be adopted by the SEC to deal with public companies whose prior year financial statements reported on by L&H had to be reissued in connection with public offerings and periodic public filings. Companies whose financial statements were audited by L&H were placed under a cloud through no fault of their own.

Furthermore, the failure undermined confidence in the ability of the profession to carry out its public obligations by creating concerns about the financial viability of other firms. It also created a deep sense of apprehension throughout the accounting profession that has only grown worse. During 1992, another prominent firm, Pannell Kerr Foster, closed or sold about 90% of its offices and opted to reorganize its offices as individual professional corporations. Accounting Today quoted a former PKF partner who indicated that liability was one of the reasons for this massive restructuring.

The magnitude of the six largest accounting firms' liability-related costs, as well as the size of some highly publicized judgments and settlements, has fueled speculation about their survival. This is not surprising. A grim precedent has been set, and without decisive action the liability crisis will grow worse and the six firms' collective liability burden, enormous as it is, will increase.

This potential long-term threat to the survival of the six firms has serious implications for the independent audit function, the financial reporting system and the capital markets. As a group, the six largest accounting firms audit all but a handful of the country's largest and most prominent public companies in every category:

* 494 of the Fortune 500 industrials.

* 97 of the Fortune 100 fastest-growing companies.

* 99 of the Fortune 100 largest commercial banks.

* 92 of the top 100 defense contractors.

* 195 of the 200 largest insurance companies.

In each of these categories, at least one of the six firms audits more than 20% of the companies. According to figures from Who Audits America, the six firms audit 90% (4,748 of 5,266) of the publicly traded companies in the United States with annual sales of $1 million or more (Who Audits America, 25th ed., Data Financial Press, Menlo Park, California, June 1991, pages 393-396.)

The detrimental effects on auditing, financial reporting and our capital markets are already very much in evidence. They are a natural consequence of the risky and uncertain practice environment which the litigation epidemic has created not only for the six largest firms but also for the entire accounting profession.



One obvious effect is what the media has called the "tort tax"--that is, the increased cost of goods and services caused by runaway litigation. To quote SEC Chairman Richard C. Breeden, "Accounting firms, in particular, pay substantial and increasing costs to litigate and settle securities cases. At some point, these increasing litigation costs will increase the cost of audit services and tend to reduce access to our national securities markets" (letter from Chairman Breeden to Congressman John D. Dingell [D-Mich], May 5, 1992). If companies must pay higher costs for services provided both by auditors and by underwriters, attorneys and other frequent deep pocket defendants, it will be more expensive for them to raise needed capital. Opportunities for investors will be reduced, and U.S. businesses will be placed at a competitive disadvantage vis-a-vis companies in countries with more rational liability systems--virtually every other country in the world.


The liability burden cannot be measured only in dollars and cents. Other effects are less easy to detect, but are no less costly. For example, groups targeted by frequent litigation now practice risk reduction as a matter of professional survival. Doctors, for instance, are avoiding such fields as gynecology and obstetrics. The result is a scarcity of practitioners in crucial specialties.

Accountants are also practicing risk reduction. The six largest firms are attempting to reduce the threat of litigation by avoiding what are considered high-risk audit clients and even entire industries. High-risk categories include financial institutions, insurance companies and real estate investment firms. Also considered high risk are high technology and midsized companies, and private companies making initial public offerings (IPOs). These companies are a ready target of baseless rule lob-5 suits because their stock prices tend to be volatile. Unfortunately, they are also the companies that most need quality professional services, are a key source of innovation and jobs and play a crucial role in keeping this country competitive.

Risk avoidance is not confined to only the largest accounting firms. Smaller and mediumsized firms are dropping their public clients or abandoning their audit practices altogether. A recent survey of California CPA firms showed that only 53% are willing to undertake audit work. This creates serious problems for smaller companies (and their shareholders) that need viable alternatives to the major firms. Additionally, the survey showed that 32% of the reporting CPA firms are discontinuing audits in what they consider as highrisk sectors. Another survey by Johnson & Higgins found that 56% of the midsized firms surveyed will not do business with clients involved in industries they consider high risk.


Another troubling effect of the litigation explosion on the accounting profession, its clients and the public is one that cuts across all industries and services. The litigious practice environment is making it increasingly difficult to attract and retain the most qualified individuals at every level. The Atlantic Monthly has reported that fewer top business students are choosing to go to public accounting firms to do audit work because, among other things, they perceive it as risky.

It is likely that the most serious impact on recruitment and retention of qualified people is yet to be felt, since widespread media and public attention have only recently begun to focus on the accounting profession's liability plight. Recruiters from the six largest firms report that they are encountering more awareness, more questions and more apprehension about the liability risk on college campuses across the country. Transforming public accounting from a secure and respected career to one in which becoming a partner carries with it the threat of personal financial ruin is no way to ensure the profession's ability to meet its responsibilities to investors and the public.


To restore equity and sanity to the liability system and to provide reasonable assurance that the public accounting profession will be able to continue to meet its public obligations requires substantive reform of both federal and state liability laws.


While other serious problems must also be addressed, the principal cause of unwarranted

* LIABILITY CRISIS litigation against the profession is joint and several liability, which governs the vast majority of actions brought against accountants at the federal and state levels.

In arguing for an end to joint and several liability, the profession is in no way attempting to evade financial responsibility in cases where accountants are culpable. The profession is merely asking for fairness--the replacement of joint and several liability with a proportionate liability standard that assesses damages against each defendant based on that defendant's degree of fault. SEC Chairman Breeden recently acknowledged that joint and several liability can lead to unfair results by forcing marginal defendants to settle even weak claims. He has also expressed support for reducing the coercive "effect of allegations of joint and several liability in cases of relatively remote connection by the party to the principal wrongdoing" (letter from SEC Chairman Breeden to Senator Terry Sanford [D-N.C.], June 12, 1992).

Proportionate liability would help restore balance and equity to the liability system by discouraging specious suits and giving blameless defendants the incentive to prove their cases in court rather than settle. By creating overwhelming pressure on innocent defendants to settle, joint and several liability gives plaintiffs' lawyers a strong incentive to bring as many cases as possible without regard to the relative merits, to include as many defendants as possible without regard to their degree of fault and to settle these cases at a fraction of the alleged damages. Thus, victims of real fraud receive no more (on average 5% to 15% of their alleged damages) than so-called professional plaintiffs and speculators trying to recoup investment losses. On the other hand, the lawyers bringing these suits typically receive 30% of the settlements plus expenses. If plaintiffs' lawyers were not able to use the threat of joint and several liability to compel innocent defendants to settle meritless cases, they would have to focus all of their efforts on meritorious claims. That, in turn, would result in more appropriate awards for true victims.


The six largest firms have joined with the AICPA and concerned businesses in calling for federal securities reform to curb unwarranted litigation brought under rule lob-5. Proposed remedies include replacing joint and several liability with proportionate liability and requiring that the plaintiff pay a prevailing defendant's legal fees if the court determines that the suit was meritless.

Curbing baseless rule lob-5 actions will, however, ease but not solve the liability problem. Of the total cases pending against the six largest firms in 1991, only 30% contained lob-5 claims. Of that 30%, less than 10% were exclusively lob-5 claims.

The greatest liability exposure resides in the states. Reform of state liability laws affecting accountants is of critical importance to the future viability of the profession. The lob-5 effort, if successful, will certainly serve as an important precedent for further reform. Beyond proportionate liability, reasonable limitations on punitive damages, as well as disincentives to filing meritless claims, ought to be enacted. Reforms could be accomplished either through federal preemption or state-by-state modification of their statutes governing legal liability. The accounting profession will continue to participate in various state liability reform initiatives.

No less important is the need for the accounting profession to remove legislative, regulatory and professional restrictions on the forms of organization that may be used by accounting firms. Accountants must be free to practice in any form of organization permitted by state law, including limited liability organizations. The accounting profession is not seeking special treatment. Public accountants seek to practice only in forms of organization that are available to the vast majority of American businesses. Such changes will not relieve culpable individuals of legal responsibility for their own actions but simply end the current inequity of full personal liability on all partners for all judgments against their firms resulting from the actions of others. The six largest firms will continue to aggressively pursue needed state-level liability reform.

The six largest firms are exploring all possible alternatives for reducing the threat that liability poses to their ability to meet their public obligations and to their survival. In this pursuit, the firms cannot support any legislative or regulatory proposal that increases the responsibilities of the profession unless these increased responsibilities are accompanied by meaningful and comprehensive liability reform. The firms will support initiatives at both the federal and state levels that will restore balance to the current system of justice.
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Author:Weinbach, Lawrence A.
Publication:Journal of Accountancy
Date:Nov 1, 1992
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