Who Got Sued

As the accounting profession adjusts to state and federal legal reform--such as the Private Securities Litigation Reform Act of 1995--it is important to consider what we know from past litigation against auditors. This article discusses research on more than 1,000 instances of litigation against 20 or so large audit firms. Publicly held clients made up about 65% of the cases; however, all types of clients, actions and jurisdictions were represented in the overall sample, which covered litigation over the last three decades. The evidence had some surprises; it coincided with some but not all beliefs widely held in the accounting profession. THE MATTER OF MERITS A key question in studying lawsuits against auditors is, "Do the merits of the suits matter? " This question raises one of the most contentious debates among advocates and opponents of legal reform. For example, the 1992 Big 6 statement of position argued that the accounting profession was the victim of a significant amount of nonmeritorious litigation. The evidence supported this argument. Research found that between 40% and 50% of all lawsuits against large accounting firms resulted in one of two outcomes: Either the court dismissed the case against the auditors or the case was settled with the auditors paying nothing to the plaintiffs. Since both outcomes are consistent With weak claims, the evidence indicated that the merits of nearly half of the cases filed were too weak to stand up in court. Opponents of reform counter that this evidence showed the legal system can get rid of weak claims so the system does not need changing. Additional evidence, however, supported a related argument made by the accounting profession. Defending against weak claims under the Securities Exchange Act of 1934 has been difficult, time-consuming and financially burdensome. Based on the data, it took an average of 3.7 years to conclude a suit that resulted either in charges being dismissed or auditors making no payments to plaintiffs. Using a common defense attorney gauge of costs of $1 million per year per lawsuit, this translates into average costs of $3.7 million to defend against a weak claim. WHO PAID? In contrast to the widespread publicity often given to large payments by auditors, the evidence revealed that auditors were not, on average, major contributors to settlements. The client and its affiliates-officers, directors and professional advisers, such as underwriters-generally contributed more than auditors. The payment data showed that auditors most often contributed 10% or less of the total. And they tended to pay nothing or paid much less than others even when total payments to plaintiffs were relatively large. For example, in only 8% of lawsuits did the auditors contribute more than 50% of the settlement and pay more than $5 million to plaintiffs. THE IMPORTANCE OF BANKRUPTCY Does auditor litigation tend to involve bankrupt or financially distressed clients? The answer is yes. Research based on the large sample of lawsuits against auditors found that between 30% and 40% of suits were filed on clients about to be or already in bankruptcy However, the evidence is slightly different when the question is changed to: Are auditors always sued when clients fail? To answer this required a sample of bankrupt companies. We looked at 655 public companies that had declared bankruptcy between 1972 and 1992. In the sample, we found slightly under 20% had litigation against the auditors. Lawsuits against auditors were more likely to come from larger bankrupt clients (median assets for companies with auditor litigation were $244 million compared with $39 million for companies without any financial reporting litigation) and from those reporting net income in the last financial statements before they filed for bankruptcy or before lawsuits were filed. Surprisingly, bankruptcy did not, on average, precipitate litigation against auditors. …