Accounting & Tax

Days in Court

Would principles-based accounting slow the pace of securities litigation, or make it explode? (A Exclusive)
Alix StuartSeptember 1, 2006

Ask those on either side of the securities-litigation fence about principles-based accounting and you get two different views.

If there were no hard and fast rules, it would make it harder to bring accounting cases, since “most of them turn on what was the rule and did they follow it or not,” says Bruce Carton, vice president of Institutional Shareholder Services’s securities class-action services unit.

Skadden, Arps, Slate, Meagher & Flom partner Ed Yodowitz, a defense attorney for corporations and auditors, disagrees. A lack of rules “doesn’t mean plaintiffs’ attorneys will have no basis; they’re going to assert a different basis,” he says.

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Since there is no telling in advance which side is right, experts say there are several options that could help quell the fears. One is for Congress or the Securities and Exchange Commission to craft a federal version of the Delaware business-judgment law, in which directors are indemnified for bad decisions as long as they made them in good faith. This type of safe harbor, which was among the major recommendations of the SEC’s Advisory Committee on Smaller Public Companies in its April report, would “protect well-intentioned preparers from regulatory or legal action when the process is appropriately followed.” The focus would be on how companies got a judgment rather than the judgment itself.

While a safe harbor could be a viable solution — SEC acting chief accountant Scott Taub has publicly said the SEC would at least consider it — many are skeptical that would happen. “I don’t see Congress writing any kind of law that says if noble business executives have done their best, they’re not going to be subject to lawsuits,” says Lyondell Chemical controller Charles Hall. And privately, SEC insiders express concern that whatever methods are given safe harbor will become de facto rules, negating the whole system.

As a preventive measure, Yodowitz suggests expert panels could review and screen accounting lawsuits for frivolity before they could be filed. Such panels have been filtering medical-malpractice suits in some states since the early 1990s, and the state of Louisiana set up one for accountants back in 1997. In general, potential defendants have the chance to choose an attorney to lead the panel, as well as one of the three experts on the panel. The plaintiff chooses another expert, and the two experts choose a third. A recent study of Massachusetts medical cases by a local paper (the Milford Daily News) found that panels rejected about 95 percent of the potential suits between 2003 and 2006.

Less attractive, but perhaps easier to implement, would be for states to set caps on the liability a company or accounting firm could face. Still, the change to principles-based accounting would inherently involve the risk of more lawsuits. “There’s no surefire inoculation from frivolous lawsuits,” says Michael Young, a New York–based attorney at Wilkie, Farr and Gallagher who is also a member of the Financial Accounting Standards Advisory Committee. “It is a principle of American jurisprudence that everyone should get his day in court.”