Abstract
One of the prevailing explanations of the corporate scandals of the Enron era and the recent financial crisis is the failure of professional gatekeepers—such as auditors, corporate lawyers, and securities analysts—to detect and disrupt corporate misconduct. The alleged solution to this failure—typically proposed and justified on consequentialist grounds—is to impose legal liability on professionals. The purpose of this paper is to critically examine the normative foundations of gatekeeper liability. In the course of this paper, I shall defend the claim that gatekeeper liability may be morally objectionable not only on grounds of fairness but also on consequentialist grounds. The expected contribution of this paper is threefold. First, it systematizes the framing and moral justification of gatekeeping duties. Second, it calls into question the normative underpinnings for targeting intermediaries instead of primary wrongdoers. Third, it anticipates some negative (and often overlooked) results of gatekeeping strategies in the accounting profession, specifically in the realm of clientele selection, the expectation gap, and auditor compensation.
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Notes
As of January 2013 in the United States, 28 states have enacted social hosting laws, which hold party hosts liable for the property damages and personal injuries that any of their intoxicated guests cause to an innocent third person and/or property. National Institute on Alcohol Abuse and Alcoholism (2013). http://alcoholpolicy.niaaa.nih.gov/Prohibitions_Against_Hosting_Underage_Drinking_Parties.html.
Technically, gatekeeper liability is a genre of collateral liability but in what follows, I shall use “collateral liability”, “gatekeeper liability”, and “secondary liability” interchangeably.
Another gatekeeper’s failure, by credit rating agencies, explains the most recent financial crisis given the role of CRAs in developing structured financial products and downgrading sovereign debt. Credit rating agencies also failed as gatekeepers in the Enron’s collapse. Until four days before Enron declared bankruptcy its debt was still rated as investment grade by the major credit rating agencies (Payne 2014).
“Non-ideal theory” is defined negatively, as either a complement or a rejection of an ideal theory (Rawls 1971; Simmons 2010). Ideal theories typically make some idealizing assumptions intended to simplify a complex problem (for example, the theory may assume that every member of a society will fully comply with such society’s principles of justice). The assumption underlying gatekeeper liability is that direct deterrence—the ideal theory—does not work effectively.
In the U.S.A., when providing professional services, accountants may incur common law liabilities for negligence and fraud, and liabilities for the violation of federal and state statutes. In addition to common law liability, accountants have statutory law liability to third parties under the Securities Exchange Act of 1934 and the Securities Act of 1933. I cannot do justice to the history of legal liability in the accounting profession in the U.S.A. here but see Fischel (1981), Goldberg (1988), and Coates (2007).
Privity is a doctrine in contract law according to which an agreement between two parties A and B cannot confer rights on C or impose obligations arising under it on C or any other except A and B. Only the parties to the contract should be allowed to enforce their rights and claim for compensation. See Lilienthal (1887).
For example, accountants have a legal duty to report any illegal act of their clients to the company’s board of directors and the SEC (Private Securities Litigation Reform Act). Whistleblowing is not just a purely preventive role because it entails some punishment as well, as it reveals damaging information about attempted misconduct.
The Code of Professional Conduct (Article 203) establishes that auditors may depart from GAAP to prevent financial statements from being misleading. The leading case is a 1969 criminal court case, Continental Vending (United States v. Simon) in which three auditors were found guilty of fraud for certifying their client’s annual report, which disclosed just enough to arguably comply with GAAP but concealed critical information to understanding the firm’s financial standing (the firm soon went bankrupt). If literal compliance with GAAP creates a fraudulent or materially misleading impression in the minds of shareholders, according to the courts, the auditors should be held liable (Zeff 2007; Duska et al. 2011).
Or, one may argue, it is not that the implication really goes the other way: while “ought implies can” may just mean that one has an obligation to do A only if one can do A; “can implies ought” may mean that one ought to do A if one can do A and A is in some way morally praiseworthy. In either case, the claim is that gatekeepers have an obligation to frustrate bad behavior if they can. I am grateful to Ed Hartman for pressing this point.
Boatright explains why the design of a comprehensive system of deterrence should take into account not only the cost and effectiveness of each means of deterrence but also how the selected means interact with each other as part of a whole system. It is possible, he suggests, that some responsibilities are too costly: “For example, if banks avoid risk by requiring significant additional information about a client's operations, or if some companies decline to deal with banks because of the information they require, then an unnecessary cost may be imposed on the economy.” (2007, p. 626) I thank an anonymous reviewer for pressing this point.
Elsewhere, I have discussed the related question of whether these professional roles are consistent with the traditional ideals and identity of the accounting profession (Warren and Alzola 2009).
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111 - 203, 124 Stat. 1376 (2010) 929O.
Gatekeeper obligations are dependent on primary obligations not to wrong others in the first place. Gatekeeper responsibilities arise out of failures to discharge such primary responsibilities. Such primary responsibilities offer reasons to honor remedial responsibilities and shape the extent and scope of remedial responsibilities. Repairing injuries wrongly done is a second best way to comply with one’s duties not to do harm wrongly in the first place.
Moreover, there is no penalty imposed on the firm resulting from the individual partner’s or manager’s misconduct because the civil law principle of respondeat superior does not apply in the accounting profession (Goldberg 1988) and the SEC has been reluctant to proceed against firms (Franco 2011). That is, the individual partner and the audit manager do not face serious risk of individualized sanctions. In addition, according to Coffee, the AICPA “lacks any real enforcement staff.” (2001, p. 47).
The Sarbanes–Oxley Act ended the accounting profession’s long tradition of self-regulation and peer review with the creation of the Public Company Accounting Oversight Board to oversee auditors of public companies—including periodic inspections—and to set auditing standards (Coates 2007).
In response to these concerns, the European Commission has issued a “Recommendation Concerning the Limitation of the Civil Liability of Auditors” which holds a proportionality principle: a limitation of the liability to the contribution of the audit firm to the damage suffered by the plaintiff. See “Study on the Economic Impact of Auditors’ Liability Regimes.” Available at http://ec.europa.eu/internal_market/auditing/docs/liability/auditors-final-report_en.pdf.
Note. Negligence—Social Host Liability—Social Hosts Not Liable For Accidents Caused By Intoxicated Guests, Harvard Law Review, Dec. (1988), 102(2), 553.
My argument is not inconsistent with the claim that the professional roles ought to shift. Part of the problem with the current arrangement may be precisely that client firms have too great a tendency to think of their auditors as cooperative colleagues rather than cops on the beat. A young student who decides to pursue a career as an accountant or as a professor is not thinking that his or her job will be the job of a police officer. Maybe he or she should. And maybe many of us who see ourselves as academicians rather than cops on the beat are simply wrong (For a story about university professors as gatekeepers, see Bhasin (2011).
Daniel Goelzer, a Board Member at the PCAOB, says that the evidence collected at the PCAOB indicates that some small public firms “are finding it harder to engage or retain a Big 4 audit firm.” “Sarbanes–Oxley and the Post-Enron Environment: Auditor Oversight” Available at http://pcaobus.org/News/Speech/Pages/08022005_GoelzerSOXAuditorOversight.aspx.
The expression “expectation gap” comes from the 1978 AICPA’s Cohen Commission report, which concluded “a gap exists between the performance of auditors and the expectations of users of financial statements.” (Evans 1978).
At this juncture, it might be helpful to examine some differences between corporate attorneys and auditors. The competent accountant may act as a gatekeeper given his or her non-adversarial role. But the lawyer cannot. Previous to Sarbanes–Oxley, the counsel’s role was zealous advocacy for his or her client (Daley and Karmel 1975). The attorney’s loyalty was then to the client and not to investors. Lawyers had no independent certification role, unlike auditors. And they were subject to a duty of confidentiality that is quite different from the auditor’s. Yet, after Sarbanes–Oxley, lawyers have a duty to monitor the client, to report wrongdoing to senior management and corporate boards, and to withdraw if the client refuses to comply with the law. Even if a particular transaction is perfectly legitimate, it can be fraudulent if its primary purpose or effect is to mislead investors. Hence, as in the case of accountants and social hosts, gatekeeper regimes will necessarily change, for better or worse, the nature of the attorney-client relationship. See Coffee (2006).
Kraakman (1986) disagrees. He believes that gatekeepers must be punished for failure rather than paid for success because their cooperation is non-verifiable, in the sense that we can only observe ex-post whether gatekeepers failed to prevent misconduct ex-ante. However, when private enforcers can make easily observable enforcement contributions, recruiting private enforcers can rely on rewards (e.g. legal immunity).
An earlier version of this essay was presented at IESE Business School in Barcelona in June 28, 2014 and at colloquia at ESSEC Business School in Paris in May 27, 2015. I have benefited from the input of both audiences. Written comments of Ed Hartman, Domenec Mele, Silvia Romero, and two anonymous reviewers enabled me to make a number of improvements in preparing the final version. I am also grateful to Fordham University for fellowship support during the period I was working on this paper.
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Alzola, M. Beware of the Watchdog: Rethinking the Normative Justification of Gatekeeper Liability. J Bus Ethics 140, 705–721 (2017). https://doi.org/10.1007/s10551-017-3460-3
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DOI: https://doi.org/10.1007/s10551-017-3460-3