Auditor Settlements of Securities Class Actions

Some corporate law scholars have concluded that auditors do not have sufficient legal incentive to detect securities fraud and should be governed by a strict liability standard. This study assesses this argument by examining a dataset of 554 class actions alleging an accounting restatement filed from 1996 through 2007. Because some but not all of these restatement cases named an auditor defendant, it is possible to analyze whether variables such as the liability standard affect both the decision to name an auditor defendant as well as the outcome of the case. Despite the narrowing of auditor liability under Rule 10b-5, auditors are still often named as defendants and pay substantial settlements in Rule 10b-5 cases. A more restrictive liability standard is associated with a modest reduction in the rate at which auditors are named as defendants and the rate at which auditor cases end in settlement. If a Rule 10b-5 case against an auditor is strong enough to result in a settlement, the legal standard does not affect the size of the settlement. The auditor's payment is correlated with nonlegal factors such as whether the issuer is bankrupt and the issuer's market capitalization. These results are best explained by the tendency of judges to read narrow liability provisions broadly in cases where the size and impact of the alleged fraud are significant. The evidence thus does not support the conclusion that a strict liability standard is necessary to generate sufficient incentives for auditors to detect substantial frauds.