Verdict Levels Playing Field for Accounting Firms

Journal of Accountancy, February 2000 | Go to article overview

Verdict Levels Playing Field for Accounting Firms


The jury's verdict in a federal trial has made it harder to hold accounting firms disproportionately liable for damages when they fail to discover accounting irregularities during an audit. The trial, based on a $37 million lawsuit brought against BDO Seidman LLP by shareholders of a pharmaceutical firm it had audited, was the first, under a 1995 federal tort reform law, to be decided by a jury. Previously, such cases often were decided on the basis of joint and several liability, a legal principle adopted to ensure plaintiffs are fully compensated for their damages.

Critics of joint and several liability have pointed out that juries, in attempting to compensate plaintiffs in cases like this one, sometimes unfairly burden "deep-pocketed" accounting firm defendants with a greater share of damages than they caused, simply because they are better able to pay for it than their often bankrupt codefendants, who committed the fraud.

The ground-breaking verdict in favor of BDO was made possible by legislation passed four years ago. Until this case, that law had not been invoked at trial because it generally takes so long for liability cases to complete the pre-trial investigation process and because most cases are settled. In fact, among the more than 700 cases filed following the enactment of the Private Securities Litigation Reform Act of 1995, the BDO case was the first to go to a jury trial. Thus, it has broad implications for cases yet to be tried.

Veteran observers expect other accounting firms, named as defendants in similar actions, may now assume bolder positions in settlement negotiations. "Look at the Cendant case," said one, in reference to the suit that resulted when the travel and real-estate giant, formed by the merger of HFS, Inc., and CUC International, found out after the merger that $500 million of revenue on CUC's books had been falsified, but not detected as such, during E&Y's audit of CUC--a fact which, when revealed, dealt a serious blow to the company's market value and its investors' portfolios.

In December, E&Y agreed to pay Cendant shareholders $335 million as a result of these accounting irregularities. It is fair to ask whether, in the future, accounting firms will seize upon the favorable jury verdict in the suit against BDO to argue that, in similar cases, they shouldn't be paying anything at all--let alone such excessive amounts.

In fact, the last two years have seen such a surge in reported instances of accounting irregularities that SEC Chairman Arthur Levitt instituted a campaign to ensure that audit committees and auditors worked together more effectively to improve the quality of financial reporting.

The BDO lawsuit, brought in 1997 by shareholders of Health Management, Inc. (HMI), a pharmaceutical sales company formerly headquartered in Holbrook, N.Y., alleged that HMI's CEO, CFO and other employees had knowingly committed fraud, and that BDO, its auditor, had knowingly and recklessly failed to detect it during a 1995 audit. Ultimately, the CEO was sentenced to nine years in jail, and the plaintiff shareholders settled with several other defendants, leaving BDO as the only nonindividual defendant.

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Verdict Levels Playing Field for Accounting Firms
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