Liability of auditors for fraud faces court test

By Jean Eaglesham in New York

The legal liability of auditors for detecting corporate fraud is set to be tested in a New York court, potentially increasing the Big Four accountants’ exposure to multibillion-dollar shareholder claims for malpractice.

The New York Court of Appeals will on Tuesday be asked to rule on a key legal defence for auditors against such claims that has been deployed in two high-profile cases.

The first is a lawsuit brought on behalf of shareholders in AIG against PwC, the bailed-out insurer’s auditor. The second case relates to protracted litigation by the bankruptcy trustee of Refco Inc, the failed futures broker, seeking damages from a number of the firm’s professional advisers, including its auditor, Grant Thornton.

In both cases, the appeals court will be asked to decide whether auditors can rely on the legal doctrine of in pari delicto – “in equal fault” – to reject claims for frauds allegedly committed by company insiders.

The doctrine prevents someone from recovering damages from a defendant if they themselves are also at fault. The argument centres on whether shareholders, as owners of the company, can thus be deemed at fault for frauds committed within the company and barred from suing auditors for not spotting them.

“This case has huge implications for the auditing industry as well as shareholder derivative litigation,” said Stuart Grant of Grant & Eisenhofer, the law firm acting for the AIG shareholders.

“What auditors are asking for is a ‘get-out-of-jail-free’ card that they can play every time their corporate client [the shareholder] sues them for failing to detect fraud by a corporate manager. But detecting that kind of fraud is exactly what the client hired them to do.”

PwC declined to comment on the ongoing litigation, as did Grant Thornton.

The PwC case is being closely watched by the accounting industry. The American Institute of Certified Public Accountants and the Center for Audit Quality have filed briefs supporting the accountancy firm’s arguments.

PwC has also hired a top legal counsel, engaging Paul Clement, the former US solicitor general who is now a partner at King & Spalding, to argue its case.

The lawsuit against PwC, brought by the Teachers’ Retirement System of Louisiana, was dismissed in trial court on the basis of the equal fault doctrine but the issue was referred by the Delaware Supreme Court to the New York appeals court to clarify the New York state law on the issue.

The ruling by the New York appeals court will be binding in that state only. But “because so many of the companies and aud-itors are based in New York, it’s very significant”, Mr Grant said.

Copyright The Financial Times Limited 2010.