Investor Lawsuits Against Auditors Are Falling, and That’s Bad News for Capital Markets

Investors rely on corporate auditors to keep impartial watch on the accounting practices of the companies they invest in. Historically, investors have not been shy about launching litigation when they believed auditors did not do enough to stop their clients from cooking the books or engaging in other financial improprieties.

But new research shows that lawsuits against auditors for accounting violations have fallen over the past 20 years, and it’s not because accountants have become so much better at their craft or companies more honest.

“The number of lawsuits per year has declined, dismissals have increased, and settlements in recent years have declined,” conclude the authors of a new research paper. “Our study asks why.”

The number of lawsuits specifically about Rule 10b-5, the antifraud regulation created under the Securities Exchange Act of 1934, dropped from 487 in the year 2001 to 80 in 2014. Another example: Some 70 percent of auditors in 1996 were likely to settle claims with some sort of cash payment. By 2016 the percentage of paid settlements had dropped to a little over 30 percent.

Two Supreme Court decisions, although not the only reasons, appear to have made a difference, according to the researchers. The rulings in Tellabs v. Makor (2007) and Janus v. First Derivative (2011) have effectively narrowed liability standards, requiring plaintiffs such as institutional investors to prove that auditors knew, or should have known, their clients’ financial statements contained errors.

In both decisions, Rule 10b-5 lost its bite. Investors are at a disadvantage.

Companies from around the world seek to list in US capital markets and investors from around the world invest in US listed companies because the US legal regime offers a high level of investor protection. High quality auditing is a big part of this protection. When our investor protections standards go up, our capital markets become more attractive to global investors and companies. It’s a tradeoff, though. You don’t want to impose undue burdens on companies because that will deter one from listing and auditors from doing audits on companies that list in the US. On the other hand, if standards are too low then investors are not protected. There has to be a balance.

That balance is essentially a political and societal balance. The bottom line from our study is that the balance has moved away from investors and toward auditors. We hope our evidence helps provide some of the information we need to strike that balance.

Where is the trend heading? Hard to tell. But if the balance shifts too much away from investor protection it makes for weaker capital markets.

Federal laws are one aspect of our governance system. We can strengthen other aspects. One source of investor protection is the Public Company Accounting Oversight Board (PCAOB). One can make the case that the monitoring of auditors has greatly increased since the PCAOB was created after the Sarbanes Oxley Act of 2002.

There is also evidence that audit committees have improved their ability and willingness to monitor auditors. Investors can ask for and insist on strong audit committees of the board and pay more attention to what an audit committee does.

Investors can also engage with the Securities and Exchange Commission (SEC) and Congress to espouse their point of view. Lobbying for that through a coalition such as the Council for Institutional Investors (CII) can help.

We are a nation of laws. And we can have individual freedoms because we enforce our laws. If we reduce the impact of laws, we actually might not be improving society, because our individual freedoms are encumbered by laws. Which is exactly the issue here. Companies are free and auditors are free to do whatever they want except violate the laws. So reducing the bite, the risk of litigation, is not necessarily a good thing. There are countries with very lax laws and lax law enforcement, and there is a lot of evidence that their capital markets are some of the weakest in the world. We have some of the strongest capital markets because we have some of the strongest legal enforcement.

Sure, we need a balance. Companies have argued that they are subject to a lot of frivolous litigation. Raising the bar higher is a good thing then, to reduce waste of resources spent in litigation. But just reducing investor protections is a recipe for weakened capital markets.

Investor coalitions and individual large investors themselves understand this goal. Enlightened regulators and corporate leaders realize this as well and strive to strike a balance. Companies are benefited when more investors are in the capital markets. It is not a one-way street. When you improve investor protection, it’s not hurting companies. If you help companies, it’s not hurting investors. You need checks and balances. The trust we have in our system—we shouldn’t weaken it. That actually will end up hurting us.

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