The Changing Landscape of Auditor Litigation and Its Implication for Audit Quality

Stretching back to Central Bank v. First Interstate, [1] a series of Supreme Court opinions have limited shareholders’ ability to bring claims under Rule 10b-5 against auditors. Prior literature has noted the changes in auditor liability and questioned whether the current law provides auditors with efficient incentives (e.g., Park, 2017; Coffee, 2006; Partnoy, 2001). However, our paper, The Changing Landscape of Auditor Litigation and Its Implications for Audit Quality, is the first to provide empirical evidence that recent court opinions have led to declines in Rule 10b-5 liability exposure and have implications for audit quality.

We begin our analysis by collecting, as best possible, all federal class action lawsuits brought against auditors from 1996 through June 2016—the most comprehensive sample of any academic research to date. We find that indicators of litigation risk under federal securities laws have significantly decreased. For example, the number of lawsuits has declined. Although roughly ten percent of federal securities class actions name an auditor defendant over the full sample period from 1996 to 2016, this figure declines to roughly 5 percent in each of the past five years. In multivariate regressions, we test the decline formally and show that the likelihood that the auditor is sued in a federal class action following a restatement has declined.

Further, the percentage of Rule 10b-5 claims that are dismissed has increased monotonically over each three-year period from 1996 to 2013: 23% (1996-1998), 35% (1999-2001), 48% (2002-2004), 59% (2005-2007), 62% (2008-2010), and 69% (2011-2013). Consistent with the increase in dismissal rates, auditors’ settlement payouts have fallen—both in terms of dollar value and as a percentage of the total settlement value paid by all defendants. In light of this decline in Rule 10b-5 exposure, we note that some other claims—notably, those under Section 11 of the Securities Act—have begun to play a larger role in auditor liability.

One explanation for the changing pattern of litigation is that recent Supreme Court cases have limited the application of Rule 10b-5 against private parties. For example, in 2007 and 2011, respectively, the court’s rulings in Tellabs v. Makor and Janus v. First Derivative had potentially far-reaching effects for auditor liability under Rule 10b-5. In Tellabs, the Supreme Court attempted to resolve differences in pleading standards across the country. In Janus, the Supreme Court attempted to resolve intra-country differences in liability for secondary actors such as auditors.

To offer sharper tests and potentially causal evidence, we use the differential legal effects of Tellabs and Janus to compare litigation outcomes in the circuit courts most likely to be affected by the court decisions (the “treatment” groups) relative to outcomes in the circuits that were not affected (the “control” groups). Our tests provide evidence that the change in liability standards led to substantive changes in litigation practices and outcomes in the affected circuits. In particular, we find that (i) auditor settlements decreased in the circuit courts in which the risk of liability under Rule 10b-5 declined, and (ii) courts were less likely to reject motions to dismiss Rule 10b-5 claims in the circuits in which the risk of liability under Rule 10b-5 increased.

The change in liability under Rule 10b-5 plausibly implies a change in audit quality. To test that conjecture, we evaluate changes in audit quality following each court case, where audit quality is measured as earnings response coefficients (ERCs) for quarterly earnings surprises and by the occurrence of restatements. After both Tellabs and Janus, we find that audit quality, as measured by these proxies, decreased in the circuits where it became more difficult to bring Rule 10b-5 claims against auditors. By contrast, after Tellabs, audit quality increased in the circuits where it became easier to bring Rule 10b-5 claims against auditors.

Our evidence on the decline in Rule 10b-5 liability has implications for the incentive effects of litigation risk for auditors. Significant prior literature suggests that litigation risk influences auditor behavior and affects financial reporting outcomes (e.g., Simunic, 1980; Lys and Watts, 1994; Lennox and Li, 2012). Although we hesitate to claim that auditor liability in general has significantly declined—after all, changes in public enforcement and in other sources of legal liability may counteract the decline in Rule 10b-5 liability exposure—we believe we document an important trend in auditor liability.

The complete paper is available for download here.

Endnotes

1Central Bank of Denver, N.A. v. First Interstate Bank of Denver N.A., 511 U.S. 164 (1994).(go back)