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German Working Papers in Law and Economics
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Volume 2004

AUTHOR:
Hans-Bernd Schäfer

TITLE:
Efficient Third Party Liability of Auditors in Tort Law and in Contract Law

SUGGESTED CITATION:
Hans-Bernd Schäfer (2004) "Efficient Third Party Liability of Auditors in Tort Law and in Contract Law", German Working Papers in Law and Economics: Vol. 2004: Article 9.
http://www.bepress.com/gwp/default/vol2004/iss1/art9


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ABSTRACT:

A wrong audit can cause damages to shareholders in secondary markets or to buyers of firms or shares in primary markets. This happens especially if outside investors base their decision on the audit and buy overpriced company shares. Liability of auditors is liability for pure economic loss. The main point of this paper is to give normative guidelines for the problem of whether or not the victim should be compensated for such losses. It proposes liability for disloyal and gross negligent behavior if a wrong audit caused damages in the secondary market. It proposes liability for simple negligence, if the audit was made for the primary market. The legal forms of auditor’s liability and of liability of experts in general differ widely across countries. Under tort law most legal orders restrict or even exclude liability for pure financial loss. In contract law pure economic losses are generally compensated in case of simple negligence. In some legal orders the plaintiff can base his claim either on tort law or on contract law or on both. Some countries (Germany) have a broad scope of (implicit) contract law, which covers case groups, which in other countries (Britain) are treated under tort law. Our main concern is however not the legal form but a proposal for two liability rules, one based on simple negligence, one based on gross negligence. In principle these rules can be embedded in contract law, tort law or both. If damages caused by a wrong audit are recoverable under an implied contract between auditor and shareholder, the auditor is usually liable for simple negligence. In that case he has negligently violated a contractual duty to the shareholder, even though the explicit contract was between him and the corporation. If however, these damages are only recoverable under tort law, simple negligence will not lead to compensation because they are pure economic losses and because most legal orders restrict or exclude liability for pure economic loss in tort. For such damages, most legal orders grant compensation under tort law only if it is proven that the tortfeasor was willful, disloyal, reckless or grossly negligent . In most cases, this excludes compensation. The economic literature on civil liability for economic loss has underlined the rationale for such restrictions. However, this literature remains silent with respect to the borderline between contract law and tort law. There is general agreement that pure economic loss has to be compensated under contract law as the cost of this protection is internalized in the contract. If a wrong audit and a wrong and published balance sheet causes a pure financial loss to a shareholder, should this be regarded as a violation of contractual duties between the auditor and the shareholder, or just as a tort? In civil law countries, this question is decisive for whether the plaintiff receives compensation or not. As judges lack the competence to introduce liability for pure economic loss in tort law, they can expand liability by expanding the scope of contract law to the respective group of cases. We argue that this question should be answered in the affirmative, if the victim has an ex-ante willingness to pay for the costs associated with performing such a duty. In Common Law countries such restrictions do not exist. Judges can impose a rule of simple or gross negligence in tort law or in contract law, depending on what they regard as reasonable. It should be made clear, however that our argument is purely consequentialist as it reinterprets the problem of whether a certain victim’s interest should be protected under contract or under tort only on the basis of their respective effects in terms of the injurers’ equilibrium level of precaution. Contractual (or quasi-contractual) liability is called upon only as a way to remedy the lack of protection of purely economic interest under tort law in some jurisdictions. We argue that a wrong audit that causes damages to shareholders in secondary markets should generally be regarded as a tort case and compensation be restricted. We also argue that a rule of gross negligence or of gross violation of professional standards in tort law can avoid the problems of underdeterrence as well as of overdeterrence in the compensation of pure financial loss in tort. However, we also argue that a wrong audit should lead to contractual liability for simple negligence, if it was made to prepare the sale in a primary market, (f.i.an initial public offering). Under this condition we argue that the economic rationale for restricting compensation for pure financial loss is not given. The paper first analyses the social value of an audit. Then several liability rules with precise and vague levels of professional care are treated with respect to their incentive effects. This leads to the proposal of a rule of gross negligence in tort law. In the last part we analyse the special conditions, under which the legal order should assume a contract with protective consequences for buyers of company shares, which leads to liability for simple negligence. The legal form of a contract with protective consequences for third parties (Vertrag mit Schutzwirkung für Dritte) is borrowed from German dogmatic scholarship, but may be interesting in this respect for an international audience as well. This article draws from the literature on pure financial losses and from the literature on precise and vague negligence norms as well as from the literature on the tort contract boundary . The article does however not discuss the problem of joint and several liability and the strategic problems involved, which have been broadly discussed in the literature. The victim of a wrong audit might have a claim against the inside investor, the management, the firm and/or the auditor. This causes strategic interactions, which influence the level of care of all actors as well as the price of auditing . These problems have been extensively dealt with in the literature and are left out here completely. The focus is exclusively on the question, under which conditions the victim should be highly protected by contract law or get a lower level of protection under tort law. The problem of auditors´ liability arises, given that the auditor certifies a financial report such as a balance sheet of a company. First, the auditor might cause damage to his contractual partner, the company and the company claims damages. The base of this claim is the contract with the auditor. Second, the auditor testifies a financial report and a balance sheet, which inside owners use for preparing a transaction, when they sell the company or shares to new owners or if a firm goes public in an initial public offering. By the auditors’ overvaluation of the corporation, the buyer suffers a loss. Here typically asymmetric information between buyer and seller of the firm exists. The audit is made to reduce this asymmetry. Third, the auditor certifies a balance sheet, in which the net worth of the company is overvalued. This leads to an overvaluation of shares at the stock market until the bad company news reaches the market by other channels of information. Therefore, outside shareholders suffer losses. Here asymmetric information between buyers and sellers typically do not exist. We concentrate on the second and the third constellation, when the victims of such losses have no direct and explicit contractual relation with the auditor. We argue that liability in the second case should be stricter than in the third case. The rationale for this is found in the literature on pure economic loss in torts. The basic argument is that pure economic losses contain a redistributive component. Therefore, the victims’ loss is lower than the total societal loss, which might lead to overcompensation and overdeterrence of victims. The main purpose of this article is to show why this argument holds for the third, but not for the second constellation. We first analyze the case in which the auditor’s mistake leads to an overvaluation of shares at the stock market such that shareholders might suffer losses, a case which in recent years and months has occurred in many countries. As usual in the law and economics literature the legal remedies are analyzed from a viewpoint of optimal deterrence. We first analyze the auditors’ liability to shareholders and then proceed to the special case, in which the auditors’ expertise is exclusively used for preparing the transfer of ownership from an inside to an outside investor and in which the buyers suffer a loss because the assets were overvalued. Throughout the article we assume that auditors as well as shareholders are risk neutral and maximize expected income.




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