September 13, 2007
Cunningham & LaCroix on How to Save Accounting Firms
Posted by David Zaring

Accounting firms may face catastrophic liability if they certify the returns give unqualified audit opinions before another Enron-style collapse.  And yet we don't have many big accounting firms left, and perhaps we would prefer not to lose another.  What to do?  Cap auditor liability?  Insure?  Seek ex-post bailouts?  Larry Cunningham proposes that the accountancies issue catastrophe bonds in this paper, and debates the issue with Kevin LaCroix of the D&O Diary here (permalink apparently unavailable UPDATE: link also here).  A taste, and please excuse the occasional brackets where I added explanatory materials - all errors mine:


Reducing [catastrophic] risk by putting legal caps on auditor damages is a hard political sell—Members of Congress find it difficult explaining to American investors why these firms should enjoy such a privilege and any choice of cap levels could seem arbitrary....

I consider cat bonds because they: (a) could add resources to meet claims that threaten to destroy audit firms or the industry; (b) avoid political obstacles facing both caps and financial statement insurance; and (c) highlight informational problems in the policy debate on caps....

[I]t is possible to see informational problems [about the nature of the risk for accountancies] as a sort of market failure supporting regulatory intervention. Yet the information is within firms’ control and they can decide whether to use it in the political arena, in markets, or not at all. Notably, using this data [necessary to assess the risks of significant auditor liability] in the political arena to support caps creates incentives to overstate risk whereas using it in the marketplace to sell cat bonds creates incentives to understate risk


[T]he whole value of a capital market based solution [like cat bonds] is to avoid the cyclicality and volatility of the insurance marketplace, but the capital markets for these kinds of bonds could be subject to the own cyclicality. Indeed, during a time of significant losses, there may be little or no market interest in bonds of this kind, just as when insurer losses mount insurance can be scarce or unavailable. For that reason, I am uncertain whether the availability of this type of capital market alternative, even if the other barriers could overcome, would in the end remedy the concerns for which an alternative to the traditional insurance marketplace was sought.

As they say, both check it out and download it while it is hot.

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