Auditors Shielded by Fraud Laws

Changes made by the Supreme Court and Congress in the mid-1990s to shield accountants and lawyers from having to pay investors for massive frauds perpetrated by their clients will make it much harder for victims of the Enron Corp. scandal to recoup their losses, legal experts say.

“The legal risk to auditors and lawyers is way down from a decade ago, and the number of earnings restatements has gone way up,” said Columbia University law professor John C. Coffee.

These days, the prime perpetrators of a fraud still can be held fully liable for the losses suffered by innocent investors, but outsiders who gave their official blessing to a questionable scheme are more protected from legal exposure. And even if they are found liable for the fraud, they will not be required to cover the full loss.

Lionel Glancy, a plaintiffs’ lawyer in Los Angeles, said the law is now tilted too far in favor of protecting the “secondary actors” in a corporate fraud.

“The effect of these changes is to significantly decrease the ability of investors to recover their losses,” Glancy said. “It seems as though you are more likely to go to jail for stealing three packs of cigarettes than for causing an investment scheme that results in $100 million in damages.”

Just a decade ago, however, accountants, lawyers and investment advisors complained the law was tilted unfairly against them.

Then, the government and plaintiffs lawyers cast a wide net and sought to hold liable all the key participants in a financial fraud. When dozens of savings and loans institutions crashed in the late 1980s, the accountants and lawyers who were involved in their shaky deals were sued along with the owners of the thrifts.

In some instances, they ended up paying for most of the losses because, by the time of a court judgment, the promoter of an investment fraud typically would be bankrupt.

Determined to change the law, accountants pressed their case in the courts and Congress. They succeeded on several fronts.

In 1993, the Supreme Court shielded outside accountants, lawyers and investment bankers from being sued under the federal anti-racketeering law, known as RICO.

Only the senior managers, not the outside advisors, can be held liable for a fraud, the justices said in Reves vs. Ernest & Young. The RICO ruling took away from plaintiffs’ lawyers a powerful weapon that they had used to win big settlements from auditors and law firms.

The same year, the high court unanimously said federal thrift regulators may not try to recover money from a law firm that did work for a bankrupt S&L; to repay depositors (O’Melveny & Myers vs. FDIC).

A year later, the court overturned nearly 50 years of precedent and ruled accountants and lawyers cannot be held liable for “aiding and abetting” a fraud perpetrated by others.

The justices, by a 5-4 vote, reinterpreted the Securities Exchange Act of 1934 to conclude it meant to punish only those who directly deceive investors, not those who aided their effort.

Leaders of the accounting profession praised the ruling (Central Bank of Denver vs. First Interstate) and said it would “curb the abuses” of the securities laws. However, a leading plaintiff lawyer called it a “very dark day” for investors.

Meanwhile, leaders of California’s high-tech firms had joined accountants and corporate executives in urging Congress to erect new barriers to lawsuits. They said aggressive plaintiffs’ lawyers were going to court whenever their firms’ stock price dipped, regardless of whether the companies had engaged in deception.

In 1995, Congress overrode a veto by President Clinton and passed the Private Securities Litigation Reform Act. It allowed judges to throw out suits at the initial stage if they did not “state with particularity” the facts that would prove a fraud.

Plaintiffs lawyers said they often could not know those “particular facts” until they were cleared to investigate a case and examine the company’s files.

The new law also shielded auditors by requiring the plaintiffs to prove they were not just reckless or negligent, but had an “intent to defraud” the public.

Moreover, even if they were found liable in fraud cases, the auditors were told they would have to pay only their fair share of the loss, not all the losses that went unpaid.

Clinton said he feared the bill would bar legitimate lawsuits as well as frivolous claims, and he predicted “innocent people will be shafted” in financial frauds.

On the day the bill became law, an official of Public Citizen, the consumer groupfounded by Ralph Nader, predicted the new barriers to lawsuits would lead to a “slow but mounting financial crime wave.”

Experts in securities law differ on whether the recent wave of accounting debacles can be blamed on the changes in the law.

“You could point to three or four factors behind it,” said Coffee, the Columbia law professor, referring to what he called “an epidemic of accounting irregularities.”

Accountants are less likely to be sued now, and their firms are also making additional money serving as consultants to the same corporations that they are auditing, Coffee said.

Enron and its top officers are already facing dozens of lawsuits from shareholders and others. In addition, Enron’s accounting firm, Andersen, is the subject of several civil suits.