Auditor Class Actions Go Global As U.S. Suits Dwindle

March 21, 2013 by Dena Aubin

Class actions against the world’s largest corporate auditing firms are spreading globally as governments bolster investor protection laws in countries where the Big Four firms have previously not faced substantial legal risks.

Even as class action lawsuits dwindle in the United States, as a result of court rulings and legislation, the number of countries allowing these kinds of suits has grown to more than 20, including recent additions Italy, Poland and Mexico.

The biggest class action settlement in Australia came last year in a $203-million case that named audit firm PwC as one of the defendants. It paid about a third of the sum.

Ernst & Young last year paid about $118 million in Canada’s largest class action settlement against an auditor.

For the Big Four—PwC, Ernst & Young, KPMG and Deloitte—the offshore expansion of class actions presents a big risk.

These firms check the books of most of the world’s largest corporations. When accounting scandals erupt—and they regularly do—shareholders with losses on their investments typically seek legal recourse. Those able to sue as a class frequently target deep-pocketed audit firms.

“The average investor or common man truly does not have access to a means by which they can sue a Big Four auditor,” said Andrea Kim, a partner at Houston law firm Diamond McCarthy, who represents plaintiffs in lawsuits against auditors.

“Class actions give you a bigger chance of affordable representation against a behemoth like a Big Four,” she said.

The firms had collective auditing revenues of nearly $50 billion in 2012, according to the International Accounting Bulletin. They have worked hard over the years in the courts and through lobbying to shield themselves from legal liability, with considerable success in the United States.

But they have also followed their multinational clients into new, developing markets where legal, accounting and regulatory systems are often weak, if not corrupt. Auditing problems and perils have followed.

The spread of class actions worldwide reflects efforts by some governments to shore up consumer and investor rights. Such laws help hold auditors accountable, said a lawyer at the Council of Institutional Investors, a nonprofit U.S. group that supports good corporate governance.

“External auditors should be subject to robust oversight and genuine accountability,” said Jeff Mahoney, the group’s general counsel, calling securities class actions “an important supplement to regulatory activity.”

Representatives for Deloitte, Ernst & Young, KPMG and PwC declined comment.

In the past, the firms have said that class action damages can be catastrophic if the firms are held liable for investor losses that dwarf the fees earned by auditors. The potential size of damages often forces auditors to settle lawsuits out of court, even if they have strong defenses, the firms have said.

Structure Shields Firms

The Big Four are structured as networks of legally separate affiliates, typically one in each country, so that when one national practice is sued, the others in the network and the parent in the United States are protected.

This business model allows the firms to market themselves as global organizations, but insulates individual components of their networks from collateral legal and financial damage.

For example, PwC’ U.S. affiliate in 2004 won dismissal of a lawsuit against it in U.S. District Court in Manhattan alleging negligence in audits performed by PwC affiliates in Peru for the troubled bank Nuevo Mundo. The bank ended up being liquidated.

Still, a massive settlement could be a fatal blow to a national unit, according to academics and market specialists.

In Britain, for example, consulting firm London Economics concluded in 2006 that the biggest legal hit that could be absorbed by a Big Four UK firm was $324 million (255 million euros) to $685 million (540 million euros), depending on the firm.

The Big Four over the years have asked for liability relief, saying they lack the capital or insurance coverage to withstand the largest claims, forcing them to settle out of court.

More than 20 countries now have legal rules allowing class actions. That is up from just three—the United States, Canada and Australia— in the late 1990s, according to a 2011 report by Stanford Law School Professor Deborah Hensler.

Countries that now permit class actions include Brazil, South Africa, Taiwan, Portugal and Chile. Mexico began allowing class actions last year. India is considering doing the same as it undertakes reforms following a 2009 accounting scandal at Satyam Computer Services, a leading technology outsourcer, which devastated the company’s investors.

Canada and Australia

The two big class action cases that put the auditors on notice last year were in Canada and Australia.

In Canada, Ernst & Young last year agreed to pay about $118 million (C$117 million) to settle claims of substandard audits at Chinese forestry company Sino-Forest, which collapsed amid fraud allegations. It was by far the largest settlement ever by an auditor in Canada.

E&Y said in a statement that it is “hopeful the settlement in Sino-Forest will be approved,” but declined further comment with a final court ruling pending.

The Sino-Forest case was part of a wave of class-action lawsuits alleging misleading accounting at China-based companies that were listed on U.S. exchanges.

Investors, mostly in the United States, have suffered big losses since 2010 from accounting scandals at China-based companies, many of which were audited by the Big Four.

While U.S. courts let plaintiffs sue Chinese companies, pursuing such cases can be tricky due to language barriers and difficulty in getting evidence out of China.

The rise in class actions in Australia can be partly attributed to the growth of business ventures that provide funding for such lawsuits.

In the Australian case, PwC and its client Centro Retail, an Australian shopping center giant now known as Federation Centres, last year agreed to pay about $203 million (A$200 million) to shareholders who had sued over misleading accounting. PwC paid about a third of the total.

A spokesperson for PwC declined comment.

The rise in class actions in Australia can be partly attributed to the growth of business ventures that provide funding for such lawsuits. Like many countries outside the United States, Australia requires the losing side in a lawsuit to pay the opponent’s legal expense, raising litigation costs.

IMF (Australia), a litigation funding company, has helped to finance a number of lawsuits against auditors, including the Centro case and a 2009 class action against KPMG over the failed MFS Premium Income Fund.

“There is no doubt that litigation funding has led to an increase in audit litigation in Australia and elsewhere,” said Hugh McLernon, managing director for IMF.

U.S. Cases Subside

The United States is the largest market for the major accounting and audit firms and it was long home to the largest legal claims against them, as well. That has changed, despite shareholder advocates’ warnings that the threat of potential legal action makes audit firms do a better job.

Court rulings—especially a 2008 U.S. Supreme Court decision in Stoneridge Investment Partners v Scientific-Atlanta— have made it harder to sue a company’s outside auditors for misleading accounting.

Top audit firms were named as defendants in just two of the U.S. federal securities class actions filed last year, or about 1 percent of the cases, according to NERA Economic Consulting. By contrast, auditors were defendants in nearly 7 percent of cases between 2005 and 2009.

Big Four auditors were hit with a spate of U.S. lawsuits over their failure to flag risks at troubled banks ahead of the 2008-2009 financial crisis, but most of these cases were dismissed or settled for small amounts.

“When cases are lost (or don’t even go to court), another enforcement tool is lost that just might have influenced the behavior of these firms,” said Anthony Catanach, accounting professor at Villanova University.

The Big Four audit all but two of the companies in the benchmark U.S. S&P 500 index, according to research firm Audit Analytics. In Britain, the four audit more than 90 percent of the FTSE 350 index, covering the biggest companies on the London Stock Exchange, said the UK Competition Commission.

Once known as the Big Eight, the top-tier auditing industry shrank to five firms by 1998 through mergers; then to four with Arthur Andersen’s implosion in the 2002 Enron scandal.

Class actions are not the only growing international legal threat to the firms. Regulators and liquidators for bankrupt companies have also been bringing lawsuits on behalf of investors, resulting in big settlements.

Potential losses are so large that commercial insurers no longer provide affordable liability insurance to the Big Four. They are now self-insured through “captives,” or insurance firms owned by the global audit networks and funded with premiums paid by member firms. Yet the captives have limited capital and cannot cover the full risks faced by audit firms, according to a 2006 study by London Economics.

“Class action litigation can drive up costs to the breaking point fairly quickly,” said Ed Nusbaum, head of 6th-largest audit firm, Grant Thornton International.

“The U.S. firms have adjusted for this, but as class actions move around the world, there’s a huge risk,” he told Reuters.

(Editing by Kevin Drawbaugh, Claudia Parsons and Leslie Gevirtz)