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Panel Seeks Cap on Liability Of Accounting Firms
By David Reilly
The Wall Street Journal
Thursday, November 30, 2006

Congress should consider curtailing the liability accounting firms face from auditing public companies either by capping their potential courtroom damages or by creating special protections for some auditing activities, according to a report due today from a committee weighing the competitiveness of U.S. capital markets.

The report, from the Committee on Capital Markets Regulation, is also calling for U.S. authorities to curb contentious audit requirements related to checks on companies' internal controls as called for by the Sarbanes-Oxley Act.

A cap on auditor liability is a long-sought goal of the accounting industry, which argues that an outsize court award following a corporate blowup could lead to the collapse of a big firm, imperiling global capital markets. In its report, the committee noted that such protections already exist in many European countries.

The committee didn't offer a detailed recommendation on how a cap would work. "There are many possible approaches, and we're not picking one or another," said Hal S. Scott, a Harvard Law School professor and a founding member of the committee. "What we're saying is that there's a problem here that needs fixing."

That problem, the report says, leads to higher costs that erode U.S. competitiveness even if a major accounting firm doesn't fail because of a court award. "Auditors may have incentives to engage in 'defensive auditing,' just as doctors faced with potential financial ruin from medical malpractice cases practice 'defensive medicine,' " the report said.

But investors have long balked at the idea that auditors are deserving of special protections, a view that hardened in the wake of the accounting firms' failure to catch corporate scandals earlier this decade. In addition, no major audit firm has gone out of business because of a big court award in recent times. Arthur Andersen LLP's demise was the result of a criminal conviction, later overturned on appeal.

While many accountants are sympathetic to the idea of caps, they question whether they are a practical solution. "You don't want to drive any more of the firms out of business," said Donald Nicolaisen, a former chief accountant of the Securities and Exchange Commission who is also a retired partner of PricewaterhouseCoopers LLP. "But it's more in the execution of how you'd make it happen, and I don't know how workable that is. You certainly don't want to give the firms a free pass."

When it comes to Sarbanes-Oxley, and in particular its requirements related to checks on companies' internal controls, the committee didn't call for "statutory changes" to the law, which has been assailed by companies, in particular small enterprises, as imposing overly burdensome costs. Nor did the report say that small companies with market values of less than $75 million should be exempt from internal-controls rules.

But the committee said the SEC should continue to exempt these small companies from complying with the rules until they can be made more cost-effective. If that doesn't occur, the report said, the SEC should ask Congress to change the law so auditors aren't required to sign off on the effectiveness of these companies' controls.

The committee's report also calls for a relaxation of the requirement that auditors test the effectiveness of all controls annually. But it rejected the idea that auditors could simply sign off on the design of internal controls, rather than their effectiveness.

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