Strategic Analysis of Securities Litigation against Independent Auditors

Article excerpt

INTRODUCTION

In 1992 the world's six largest accounting firms asserted that the accounting profession faced a liability crisis characterized by "unwarranted litigation and coerced settlements" (Arthur Andersen et al. 1992, 1). Of particular concern to Arthur Andersen et al. were securities class-action lawsuits, which they cited as the source of 30 percent of all lawsuits against auditors (1992, 6) and which account for more than one-half of accounting firms' settlement payments (Mednick and Peck 1994, 896). In 1994 the Advisory Panel on Auditor Independence asserted that litigation against auditors "has had a damaging and costly impact on the profession--and on the public it serves" (1994, 29). Such concerns prompted leaders of the accounting profession to campaign for legislative reform to curb "abusive" securities fraud lawsuits (O'Malley 1993; Simonetti and Andrews 1994). The culmination of this campaign was the passage of The Private Securities Litigation Reform Act of 1995 (PSLRA), designed to "reduce the number of frivolous class-action securities lawsuits" (Journal of Accountancy 1996, 13). However, a study recently released by PricewaterhouseCoopers reports that the number of securities class-action lawsuits filed each year has remained virtually unchanged since the passage of the PSLRA, and that the number of complaints alleging accounting irregularities has almost doubled since 1995 (Dooley 2001).

In response to recent calls for academic research on issues related to accountant's liability (Elliott 1993; Kinney 1994; Palmrose 1997; Cloyd et al. 1998), this paper analyzes a game-theoretic model of securities litigation and settlement under present institutional arrangements in the United States. This analysis addresses two questions. First, what factors explain the outcomes of securities lawsuits against independent auditors in the U.S.? These outcomes include protracted and costly pretrial litigation, a high proportion of cases that are settled before trial, and settlement amounts that are often a relatively small proportion of the claimed damages. Second, what (if any) strategies exist that accounting firms might employ to deter unwarranted securities litigation, coerced settlements, and other outcomes as cited above that are objectionable to them?

Recent papers in the accounting literature utilize game-theoretic models to examine the effects on audit quality or effort of differences in legal regimes, such as joint and several vs. proportionate liability (Narayanan 1994; Chan and Pae 1998; Hillegeist 1999), strict vs. "vague" negligence (Schwartz 1997; Radhakrishnan 1999; Zhang and Thoman 1999), and the U.S. and British systems of allocating legal costs (Boritz and Zhang 1997; Smith and Tidrick 1997). This paper differs from these prior papers in that our objective is to understand the factors that influence the outcomes of securities litigation against independent auditors under the legal regime that currently prevails in the U.S. We believe that such an understanding provides a stronger foundation for research that examines the effects of differences in legal regimes on auditor behavior. For example, our model demonstrates that the incentives of the plaintiffs' attorney have a major influence on the outcome of securities litigation against independent auditors. Yet, none of the eight papers cited earlier in this paragraph properly specify the incentives faced by plaintiff's attorneys; in fact, all of these papers except Narayanan (1994) incorrectly assume that the plaintiff (usually the investor) is the primary decision maker on the plaintiff's side of a securities lawsuit.

In addition, the models examined by Narayanan (1994), Schwartz (1997), Chan and Pae (1998), Radhakrishnan (1999), and Hillegeist (1999) all assume that audit litigation cases are tried, despite pervasive evidence that most securities class-actions in the U. …