Litigation: auditors get the blame

Deputy Labour leader Harriet Harman was reported recently commenting on a
possible challenge to the now infamous pension entitlement of Sir Fred Goodwin,
as saying that whatever the strict legal position in a Court of law, public
opinion expected a different outcome.

The idea of this gap between what the public expects and what the law
actually provides will be a familiar one to auditors and from recent reports of
the evidence to the Treasury Select Committee investigation into the banking
crisis, it is not confined to the minds of the public. Politicians, academics
and investor groups have all lined up in recent months to question what the
auditors were doing and why they did not signal greater warnings about the
sustainability of the business model and profits driving many financial
institutions.

One answer, of course, is that this is not the auditors’ job but in the
current climate it seems unlikely that accountants, and particularly auditors,
are going to avoid claims on that basis alone. But even if this is the
environment in which they are going to be called to account, does it necessarily
mean an increase in claims, what types of claims are these likely to be and are
they going to be serious ones?

It is useful to distinguish between exposure arising specifically in relation
to damaged financial institutions and the more general exposure arising from the
fact that we look to be facing the biggest recession in over 30 years.

Financial Institutions

At its most basic, the result of the financial crisis for many financial
institutions has been a massive write-down in the value of assets, decreased
earnings, a fall in the value of stock and with it the destruction of
shareholder value and goodwill.

In many cases, this followed unqualified audit opinions on accounts prepared
on the basis that the company would remain a going concern.

Leaving aside for now questions about what the directors of a particular
company (or its regulator) knew and understood about the complex financial
products it was selling and their associated risks, it will of course be asked
what the auditor understood about them, as well as the internal control
environment that sought to manage the risks and helped inform the scope of the
audit.

It is easy to see how, in the present context, an auditor could be quizzed
(with the benefit of hindsight) about how they gained reasonable assurance
around the valuations placed by the company on its assets and liabilities and
whether the evidence upon which that assurance was based was sufficient. Given
the uncertainty likely to exist around such assessments, another area of risk is
the amount and transparency of disclosure in the accounts around these
valuations and assumptions.

These and the assessment of going concern are all quintessentially matters of
audit judgment, to be based (as much of the relevant ‘guidance’ states) on the
specific facts and circumstances of each case. It is going to be interesting to
see at what point prospective claimants seek to call these judgments into
account.

In terms of bringing home a successful claim, alleging audit failure earlier
than the 2007 year end runs the risk of running against the tide of a still
rising market.

On the other hand, by the time of the 2008 year end, the tide had gone out
and it will certainly be more difficult to prove that any negligence by the
auditors concealed the true position or was the cause of any loss.

Either way, documentation on the audit file of the principal judgments and
how they were reached will inevitably be brought into focus. It is a fact of
life that almost any audit can be criticised second time round with the benefit
of 20/20 hindsight.

Recession-led claims

Distinct from the exposure to claims by financial institutions is the
exposure arising from the general upswing in claims in recessionary times. This
has less to do with a genuine belief in audit failure and more to do with the
prospect of recovering money from perceived deep-pocketed defendants.

Accountants or auditors whose work or opinion is used to support or promote
what turned out to be failed investment opportunities may well get drawn into
negligence actions by increasingly angry investor/shareholder groups.

In the case of either insolvency or discovery of fraud (both on the increase,
as in any recession, and not just in the financial services sector), the
insurance-backed professional adviser is often the only prospect of compensation
and therefore attracts claims.

This is likely to be matched by increased regulatory scrutiny of companies
into which auditors will get drawn, with particular attention currently being
paid by US and other regulators to issues such as asset impairment,
restatements, revenue recognition and off-balance sheet financing, as well as
the application of the Foreign Corrupt Practices Act.

In the final analysis, there is likely to be an increase in claims against
accountants, both by financial institutions and generally.

Some of them will undoubtedly be large and high-profile as claimants attempt
to leverage their position (and the reputation of the defendant) in achieving a
favourable settlement. But an increase in the incidence and size of claims does
not necessarily mean an increase in good claims ­ often, quite the opposite.

It remains to be seen whether prospective litigants, including those intent
on seeking a quick recovery from reputation-busting allegations, will be able to
join the legal and factual dots between audit failure and the allegedly
foreseeable consequences of that failure.

Given the scale and speed of the collapse in the markets, and the number of
people caught out by it, apportioning blame and proving a recoverable loss will
be far from easy.

Practical advice

An environment in which increased claims are almost inevitable is a good time
to revisit the procedures and protocols for handling them, particularly where
there is likely also to be an increase in parallel regulatory, disciplinary and
civil proceedings.

Re-emphasising the importance of early reporting of potential problems is a
good start.

The first signal is often a request by a third party (the client, a
regulator or an unconnected third party) for documents or information,
including from interviews with potential witnesses.

Dealing with the immediate request while at the same time finding out and
assessing the risk of the underlying issues is difficult. It is important to
control the creation of documents and transcripts of evidence which may then
have to be disclosed in subsequent proceedings.

The early identification and preservation of relevant documents (especially
electronic) and establishing the story of key individuals before they have to
tell it to someone else, is therefore essential. Doing all this in a way that
protects legal professional privilege in the communications between the
team-members investigating the matter is crucial.

Matthew Lawson is a partner in the commercial dispute
resolution team at Mayer Brown International LLP