Huge damage awards against accountants continue to make headlines. Why are they so high? The authors provide the background to answer this question and explain what is being done to have them reduced.

News releases describing huge damage payments by accountant defendants have been fast and furious. The club of accountants who suffered judgments over $200 million in 1992 includes the following:

* Ernst & Young agreed to pay $400 million to various government agencies to settle claims relating to its audits of savings and loan institutions.

* Coopers & Lybrand was found jointly liable to debenture holders of Miniscribe for that company's false financial statements. The jury awarded an additional $200 million in punitive damages on top of $28.7 million in compensatory damages. After settling that case for an estimated $45 million prior to appeal, Coopers then paid $95 million more to settle additional claims arising out of the same audit.

* In a verdict the trial judge later overturned because the damage award was irrational, an Arizona jury awarded $338 million against Price Waterhouse to a purchaser that had bought Standard Charter Bank in asserted reliance on false financial statements and had ultimately sold the bank at a $123 million loss.

* Laventhal & Horwath, meanwhile, did not even make it to 1992, having closed its doors in 1991 in the face of litigation claims exceeding $2 billion.

These headline grabbing payments may create a skewed impression about the usual scale of damages against accountants. For example, in 1991 the Big Six accounting firms on average paid approximately three cents per dollar claimed to settle Federal securities law claims against them, an amount undoubtedly smaller than the cost of litigating to final judgment. Nevertheless, these huge damage awards have stoked plaintiffs' willingness to sue accountants, driven up settlement costs, detonated insurance premiums that were already exploding, and inspired droves of accountants to abandon audit work in favor of less high-risk lines of business.

Even a single damage award of this magnitude can devastate a firm's condition. The huge litigation costs and risks of performing audit work have become inescapable. In each year of the 1990's, the Big Six accounting firms have together spent more than $400 million in settlements, judgments, and legal fees. They are not alone A 1992 AICPA survey indicated the number of claims against accountants other than the Big Six increased by 67% between 1987 and 1991.

By its nature, the audit function exposes accountants to huge potential liabilities. The near universality of audited financial statements ensures an accountant will be in the neighborhood virtually every time a business disaster occurs. More often than not, the accountant delivered an unqualified report on the company's financial statements sufficiently in advance of the disaster that it was not predicted, but sufficiently close in time that a resourceful plaintiffs' counsel aided by hindsight can identify harbingers of what was to come in contemporaneous company documents. Because business disasters frequently come on the heels of management misjudgments, negligence, or even wrongdoing, and because they always cause tremendous losses to investors and creditors, major lawsuits by plaintiffs' counsel who can generate powerful incentives for settlements (and sometime achieve huge verdicts) are no surprise.

The auditor for a company that has suffered business reversals has walked into a hornet's nest of potential exposure. There is no correspondence, of course, between the amount of damages to which an accountant is exposed and the amount of the audit fee. In the Standard Charter Bank action against Price Water-house, for example, the jury's verdict was more than 2,400 times larger than the $140,000 audit fee for the 1986 audit. That kind of disproportionate exposure bespeaks a line of business that would ordinarily be characterized as high risk.

Much attention has been paid to the legal and business strategies for limiting or avoiding auditor liability when the financial fortunes of an audited entity turn sour, and much more can be said on that score. It is also useful, though, to take the painful analytical step of assuming the auditor is found liable for negligence or fraud in the audit, and to consider some of the issues that arise in measuring damages from the accountant's wrongdoing.

The Uncertain Linkage Between Accountants' Wrongdoing and Plaintiffs' Loss

Assume an accounting firm has acted with negligence or fraud in its audit work or its provision of an unqualified report on misleading financial statements for a company that later suffered financial reversals. Should a lender or investor who entered a transaction when the inaccurate information was in the marketplace and then lost money after the reversals occurred and the prior inaccuracies were revealed be entitled to recover damages from the auditor? The correct answer ought to be, not necessarily. As courts have increasingly come to recognize, plaintiffs should have to jump through two separate hoops before obtaining damages from even a negligent or fraudulent accountant.

First, the plaintiff must establish the loan or investment would not have been made, or would have been made only at a materially different price, if the accurate information had been disclosed at the time of the transaction. Where plaintiffs were sophisticated investors who performed their own due diligence before acting, or did not read the financial statements and cannot claim "fraud on the market" because the transaction was a private one, they may be unable to show that accurate disclosure of the undisclosed facts would have altered their behavior. The same would be true if they were indifferent to certain aspects of a company's performance in entering the transaction--for example, because they discerned value from some other aspect of the company or were exclusively interested in tax losses.

Even if plaintiffs can demonstrate they would not have extended credit or invested in the company had they known the truth, an award of damages from the accountant should not necessarily follow. An illustration from an old case will demonstrate why. In that case, a purchaser bought a company's stock in undisputed reliance on a fraudulently misleading financial statement. Shortly after the purchase, the company lost its largest customer for reasons unrelated to the misstatements. After determining the company's failure had stemmed from the loss of the customer, the court rightly declined to award damages based on the fraudulently misleading financial statements. Though the plaintiff would not have bought the stock but for the misleading financials, the fraud had not caused the plaintiff's loss.

The level of court sophistication and rigor in addressing whether accountants' errors caused the loss has varied widely in recent years. Some courts have shown little inclination to impose a full second inquiry before awarding damages, once satisfied the plaintiff would not have entered a particular transaction if appraised of the facts. Others have recognized the losses associated with a downturn in company fortunes can have a broad array of causes. These causes often arise from business risks the plaintiffs knowingly took when entering their inherently speculative transactions, and at least sometimes have little or nothing to do with the aspects of the company's condition that were misstated in the audited financial statements.

In the Arizona case against Price Water-house, it should have been difficult for the jury to saddle Price Waterhouse with full causal responsibility for the loss of value of the bank that plaintiffs had purchased. Since that loss of value resulted in large measure from the post-transaction collapse of real estate and junk bond prices that affected the entire banking industry and was independent of any asserted wrongdoing by any auditor.

Because the relationship between errors in a financial statement and damages to a plaintiff after a downturn is not linear, even the simplest-seeming application of the measures of damages applicable to findings of accountant liability should have the benefit of rigorous scrutiny before a huge number is attached to the plaintiffs recovery.

The Measures of Compensatory Damages for Accountant Wrongdoing

Assuming liability has been established, the measures of compensatory damages applicable to a finding of accountant negligence or fraud will not usually depend on whether the wrongdoing involved negligence or fraud, or on whether the finding of liability is based on the Federal securities laws or on state statutory or common laws. The primary and most common measure of damages for an investor is the out-of-pocket measure, calculated by determining the difference between the actual purchase price of the security or other investment interest and its fair value at time of purchase (i.e., the value the marketplace would have given it if the true facts were known). By its nature, this calculation must be made by hindsight and speculation, since there is no ready measure for what the asset purchased or sold would have been worth if the inaccurate information had been corrected.

For many years, the tendency has been to measure the price-inflating effect of the misleading information by reference to what happened when the inaccuracy was revealed. Thus, plaintiffs have long focused on the difference between the market price of a security just before the inaccurate information was corrected and that same security's price after the market received and was able to digest the correction. This "misinformation premium" has been asserted to correspond with the amount by which the security's value was inflated by the misinformation at the time of purchase. Plaintiffs representing a large number or class of purchasers or sellers have typically sought to calculate damages based on the product of the "misinformation premium" and the number of shares traded in the period when the inaccurate information was in circulation.

As this theory of damages has evolved, a cottage industry has developed of market analysts who understand and can describe the shortcomings of such an approach. These analysts may point out, for example, that the correction of previously inaccurate information often comes in conjunction with other bad news about the company or its industry that can have a major independent effect on the stock price movement. Corrections of information that might have had little or no effect on the price of an investment in 1993, when the company's fortunes were uncertain and believed to have substantial upside potential, may be devastating to the stock price in 1994 when the company is teetering on the edge of failure. The notion that the price movement after release of inaccurate information must correspond with the value differential at the time of the original transaction has been rightly exploded as inconsistent with common sense.

The determination of how much damage any individual investor truly suffered should be equally subject to a rigorous reality check. Investors frequently ride the ups and downs of a stock's price once they have purchased it, not selling at high points to recognize profits or at low points to minimize losses even if material good or had news has caused this move. However, if the company has issued a correction of prior inaccurate information, the investor is deemed to have "sold" the stock for damages purposes. Most courts have held that an investor's decision not to sell stock after learning of a prior material nondisclosure has no effect on his or her entitlement to damages, even if the stock later bounces up in price. The theory underlying this view is that the "misinformation premium" was accurately reflected in the immediate downward movement of the stock price, and that any later upturns could still be smaller than they would have been if not for the disclosures of the earlier inaccuracy. As a result, the courts hypothesize a fictional sale at the price after the information has been digested, which fixes the amount of damages, plus a contemporaneous repurchase in which the investor bore the risks and can enjoy the benefit of later improved performance.

As many market analysts will explain, individual investors frequently cannot be said to have truly been damaged by release of a correction of inaccurate information. If the correction is unaccompanied by other bad news, the stock frequently rebounds. If it is included in a package of bad news, the damage associated with the corrective disclosure may be insignificant compared to the effect of the bad news. When the damage claim is expanded from a single investor to a larger group or class, the multiplicative approach to damages becomes even more dubious. Only a limited fraction of the total shares bought during the time of the inaccurate information will still be held at the time of the correction, and those shares will have been bought at such a wide range of prices that the mechanical application of the "misinformation premium" to all of them could not be expected to conform with the group's actual collective injury.

Many similar difficulties exist if the plaintiff is not an investor but a creditor that extended funds based on false information. Even if the undisclosed information is sufficiently "material" to support a finding of liability, that means only that a hypothetical reasonable lender would have considered it important. Any particular lender might have still entered the same transaction, at most perhaps exacting only modestly more rigorous terms, had the information been disclosed. A rational theory, of damages might consider the difference between any different terms the lender would have exacted in the face of full disclosure (higher interest charges, stronger security interests, etc.) and the terms actually imposed.

Rescissionary Damages

An alternative theory of damages used in some cases is the "rescissionary" measure, in which the court constructively unwinds the transaction that was based on false information, giving each party back what it conveyed. This measure of damages may be appropriate, for example, when a lender demonstrates it would never have extended credit but for the misstatements of financial condition, and the events materially altering the borrower's creditworthiness stemmed directly from the fraudulently undisclosed adverse information.

Courts often instruct the jury on out-of-pocket and rescissionary measures of damages, so either measure is available if the other does not add up. Before rescissionary damages will be allowed, however, it must be shown that the plaintiff made a clear choice between seeking to undo the transaction and trying to make the best of it. A plaintiff that did not renounce the transaction immediately after learning about the false information will not be entitled to recover under this theory. Rescissionary damages are available against accountants even though it is theoretically incongruous to have accountants pay for constructively undoing a transaction to which they were not parties.

The Problem of Joint and Several Liability

One of the greatest damages risks an accounting farm faces is the risk of having to pay all damages that result from a false financial statement as opposed to merely paying for the share that corresponds with its share of responsibility. Although contribution claims against asserted joint tortfeasors are available under most state tort laws and have recently been reaffirmed by the Supreme Court to be available under the Federal securities laws, the existence of an effective right of contribution depends on the reachability of a party from whom contribution can be sought. In each of the cases involving huge judgments against accountants that were listed earlier, the audited company had become bankrupt or otherwise unable to answer a judgment against it. As a result, the accounting firm got disproportionately stuck.

There has rarely been a case in which a plaintiff credibly contended an outside auditor was more at fault for falsity in financial statements than the audited company and its internal management. Accountants' worst sin in almost any case has been their failure to detect wrongdoing by others. Unfortunately, a fraud claim by a disappointed investor or incompletely secured lender against a bankrupt company is virtually valueless in most cases. Holders of securities claims rank no higher under the Bankruptcy Code than holders of the equity securities on which those claims were based and rarely receive anything more than such pittances, if any, as are left for all equity holders after other debtors have been satisfied. Unsecured lenders often rank no higher than trade creditors. Although plaintiffs sometimes see money to be recovered from the company's directors and officers, claims against those limited resource individuals typically reach no further than settlements obtained from their insurance carriers, and sometimes not even that far if the carrier did not insure against fraud. That leaves the accountants.

Under the law of nearly every state, accountants found even partially liable for fraud or even for negligence, if the the state's law permits such actions, can be required to pay the entire amount of damages if the other culpable parties cannot be reached. While the unfairness of imposing this unshared liability based on only partial fault has been long recognized, legislatures have generally considered it preferable to leaving a victim of the accountant's fraud or negligence only partially compensated.

Attempts at Reform

Relieving defendants from the obligation to pay full damages for only partial liability has been a principal aim of tort reform in recent years. The special report, In the Public Interest, issued in March 1993 by the Public Oversight Board (POB) of the SEC Practice Section of the AICPA, was the direct result of that body's analysis of the impact of litigation on the accounting profession. First among the over 20 recommendations in the special report to improve the financial reporting process was the following:

Financial responsibility among those involved in a financial failure or in fraudulent financial reporting should be allocated in proportion to responsibility for losses suffered. Accordingly, "separate and proportionate" liability legislation applicable to both Federal and state claims should be enacted by Congress.

In June 1993, the AICPA issued a white paper endorsing the POB's recommendations and adding additional steps the AICPA intends to take to improve financial reporting and further tort reform prospects. With regard to rationalizing the liability system the paper states: "The system of joint and seven liability should be replaced with proportionate liability except in cases of 'knowing fraud.'"

After a series of Senate hearings in the summer of 1993, Senator Christopher J. Dodd (D-Conn.), chairman of the Senate Securities Subcommittee, expressed his intent to introduce litigation reform legislation. Observing that "the securities litigation system is not working as it should and needs improvement," Senator Dodd added that instead of relying on the threat of enormous monetary judgments under joint and several liability to ensure accountants arc doing their job, "a stronger and more direct disciplinary system" should be considered. This might or might not be an improvement; some accounting firms that have faced SEC investigations have suggested that fear of the SEC's ultimate sanction power to suspend their authorization to do business has forced them to settle even charges they believed to be meritless.

There have been successes in tort reform at the state level. A significant number of states have legislated some form of "proportionality" rule for addressing the effect of plaintiffs' settlements with other defendants. Under this approach, the jury determines the proportionate responsibility of defendants who have settled as well as that of the accountant, and the accountant has no obligation to pay any share attributable to the settled defendants irrespective of whether the plaintiff received less in that settlement than the jury would have awarded. Some states have gone further, placing the plaintiff additionally at risk for any proportionate liability attributable to a defendant the plaintiff failed to sue when it could have done so.

Nobody should expect that accountant's exposure to huge damages will be altered anytime soon. Although Senator Dodd has expressed some interest in proceeding with limiting the damages payable by 10b-5 defendants in most cases to each defendant's proportionate share of fault, tort reform has not been a major legislative or White House priority in this administration. Even passage of a Federal bill would merely steer plaintiffs to emphasizing their common law claims of negligence and fraud under state law.

Meanwhile, courts have tended to resolve doubts in interpreting proportionality statutes by resorting to the principles of maximizing recovery to wronged plaintiffs and resisting adoption of rules that discourage settlement. Neither courts nor legislatures have shown much interest in leaving plaintiffs incompletely compensated when the primary wrongdoer is unreachably insolvent. Unless lawmakers become convinced that the accountants' liability crisis has done more harm in endangering the audit function than good in fostering more careful and scrupulously independent auditing (a matter about which man), for assertedly populist reasons, appear to remain unconvinced) the rules permitting monstrous compensatory damage recoveries against accountants when the audited company has disappeared are not likely to change.

The Specter of Punitive Damages

The mere mention of punitive damages can send shudders through the most resolute accountant defendants. When the jury returned its verdict in the Miniscribe trial, it not only awarded that company's subordinated debenture holders (just one of many groups injured by the company's failure) $28.7 million in compensatory damages against a group of defendants including Coopers & Lybrand, but also imposed $200 million more in punitive damages against Coopers alone. When such essentially unrestricted damages are added to already huge potential recoveries against accountants, the consequences can be overwhelming.

In truth, however, such verdicts are rare. Plaintiffs who establish liability under the Federal securities laws are not entitled to recover punitive damages. The Supreme Court further weakened the capacity to recover extra damages under Federal law in the spring of 1993, when it declared accountants will not ordinarily be reachable for the automatic treble damages of the RICO statute by virtue of their audits of false financials, even if they are found to have committed fraud.

Under state statutory and common laws, imposition of punitive damages ordinarily requires a finding of willfulness much stronger than could be said to follow naturally from jurors' mere inference of accountant fraud based on a negligent or reckless mistake. Accountants rarely can be asserted in a credible way to have acted with that kind of willful intent to mislead in their auditing and accounting work. Neither the amount of the audit fee nor any other benefit of the audit representation is enough in ordinary circumstances to give accountants a strong incentive to participate in knowing and willful frauds.

In each of the past three years, the Supreme Court has flirted with the constitutional question surrounding the imposition of disproportionate and standardless punitive damages. The right case for a broad pronouncement has not yet been presented. Nevertheless, the Court has already unmistakably indicated that although it is unwilling to eliminate punitive damages altogether, there are limits to the level of damages that can be awarded without raising constitutional concerns. Trial judges have been applying their personal views about these limits (without necessarily basing them on the constitution) for years. This is undoubtedly a major reason why Coopers & Lybrand was able to settle the Miniscribe judgment for less than one quarter of the jury's total verdict against it.

The Future of Damage Awards

Between 1987 and 1991, 96% of the nation's firms with more than 50 accountants reported an increase in the number and amount of the claims asserted against them. The huge claims may have crested as the litigation over savings and loan failures has matured, but complaints seeking large dollar recoveries remain likely to continue. A recent survey of CPA firms indicated that 79% have responded to the current liability environment by limiting their services, and some entities are finding it more difficult to engage the auditor of their choice. An increasing number of firms are employing risk management techniques in their client selection process, although most entities can still find firms willing to audit their financial statements.

Besides the irrationality of some applications of damages theories to auditors, the basic predicament fueling the damages explosion appears to be the much-discussed expectations gap. The courts have all recited their recognition that accountants are not guarantors or insurers against market loss, but many judges and juries still appear sometimes to disbelieve that an accountant doing a good job could have failed to unearth client misstatements or see a business disaster coming. Accounting firms have been working hard to close the gap between what they think they are doing and what others may think they are doing, but resistance is high.

Accounting firms and their professional associations are vigorously seeking to limit their exposure to an excessive liability burden. In part, this effort has stressed advocacy of the adoption or reaffirmation of rules (such as a strict privity requirement for negligence actions or rigorous pleading requirements for commencing fraud actions) that limit accountants' substantive liability. It has also included efforts to restrict or eliminate punitive damages, limit payment obligations beyond the share specifically allocable to the accountants, and tighten requirements for proving actual causation of damages. Accountants have also made significant strides in reducing plaintiffs' incentive to sue them, in part by developing the reputation of resisting easy settlements to show the plaintiffs' bar that it will not be economical to sue accountants reflexively after every business disaster.

In some measure, the hidden public costs of imposing huge damage awards on accounting firms are only beginning to creep into the national consciousness. It will be some time longer before the public can rely on judges and juries to consider those costs. Until then, so long as accountants are nearby when the bad news is announced and so long as plaintiffs unquestionably lose big money from that bad news, the specter of an occasional huge damage award will not go away.

John S. Kiernan, Esq., is a litigation partner in the New York office of Debevoise & Plimpton. Lisa Lovinger Lewin, Esq., is an associate in the same office.