German Working Papers in Law and Economics

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1 German Working Papers in Law and Economics Voume 2003 Paper 21 Efficient Third Party Liabiity of Auditors in Tort Law and in Contract Law Hans-Bernd Schäfer University of Hamburg, Germany Copyright c 2003 by the authors. A rights reserved.

2 Efficient Third Party Liabiity of Auditors in Tort Law and in Contract Law Abstract A wrong audit can cause damages to sharehoders. This happens especiay if outside sharehoders base their investment decision on the audit and buy overpriced company shares. If such damages are recoverabe under an impied contract between auditor and sharehoder, the auditor is usuay iabe for simpe negigence. In that case he has negigenty vioated a contractua duty to the sharehoder, even though the epicit contract was between him and the corporation. If however these damages are ony recoverabe under tort aw, simpe negigence wi not ead to compensation because they are pure economic osses and because most ega orders restrict or ecude iabiity for pure economic oss. For such damages, most ega orders grant compensation under tort aw ony if it is proven that the tortfeasor was wifu, disoya, reckess or grossy negigent. In most cases this ecudes compensation. The economic iterature on civi iabiity for economic oss has underined the rationae for such restrictions. However, this iterature remains sient with respect to the borderine between contract aw and tort aw. There is a genera agreement that pure economic oss has to be compensated under contract aw as the cost of this protection is internaized in the contract. If a wrong audit and a wrong and pubished baance sheet causes a pure financia oss to a sharehoder, shoud this be regarded as a vioation of contractua duties between the auditor and the sharehoder, or just as a tort? Obviousy, in most cases this question is decisive for whether the paintiff receives compensation or not. We argue that this question shoud be answered in the affirmative, if the victim has an e-ante wiingness to pay for the costs associated with performing such a duty. In this artice we argue that a wrong audit that causes damages to sharehoders shoud generay be stricty regarded as a tort case. We aso argue that a rue of gross negigence or of gross vioation of professiona standards in tort aw can avoid the probems of underdeterrence as we as of overdeterrence in the compensation of pure financia oss in tort. However, we aso argue that a wrong audit shoud ead to contractua iabiity, if it was made to prepare the sae of a company or parts of it from inside investors to outside investors or to prepare an initia pubic offering. Under this condition we argue that the economic rationae for restricting compensation for pure financia oss is not given. The paper first anayses the socia vaue of an audit. Then severa iabiity rues with precise and vague eves of professiona care are treated with respect to their incentive effects. This eads to the proposa of a rue of gross negigence in tort aw. In the ast part we anayse the specia conditions, under which the ega order shoud assume a contract with protective consequences for buyers of company shares, which eads to iabiity for simpe negigence. The ega form of a contract with protective consequences for third parties (Vertrag mit Schutzwirkung für Dritte) is borrowed from German dogmatic schoarship, but may be interesting in this

3 respect for an internationa audience as we. This artice draws from the iterature on pure financia osses and from the iterature on precise and vague negigence norms as we as from the iterature on the tort contract boundary. The artice does however not discuss the probem of joint and severa iabiity and the strategic probems invoved, which have been broady discussed in the iterature. The victim of a wrong audit might have a caim against the inside investor, the management, the firm and/or the auditor. This causes strategic interactions, which infuence the eve of care of a actors as we as the price of auditing. These probems have been etensivey deat with in the iterature and are eft out here competey. The focus is ecusivey on the question, under which conditions the victim shoud be highy protected by contract aw or get a ower eve of protection under tort aw.

4 Schäfer: Efficient Third Party Liabiity of Auditors in Tort Law and 1 Hans-Bernd Schäfer Efficient Third Party Liabiity of Auditors in Tort Law and in Contract Law A. Introduction A wrong audit can cause damages to sharehoders. This happens especiay if outside sharehoders base their investment decision on the audit and buy overpriced company shares. If such damages are recoverabe under an impied contract between auditor and sharehoder, the auditor is usuay iabe for simpe negigence. In that case he has negigenty vioated a contractua duty to the sharehoder, even though the epicit contract was between him and the corporation. If however these damages are ony recoverabe under tort aw, simpe negigence wi not ead to compensation because they are pure economic osses and because most ega orders restrictor ecud e iabiity for pure economic oss. For such damages, most ega orders grant compensation under tort aw ony if it is proven that the tortfeasor was wifu, disoya, reckess or grossy negigent 1. In most cases this ecudes compensation. The economic iterature on civi iabiity for economic oss has underined the rationae for such restrictions. However, this iterature remains sient with respect to the borderine between contract aw and tort aw. There is a genera agreement that pure economic oss has to be compensated under contract aw as the cost of this protection is internaized in the contract. If a wrong audit and a wrong and pubished baance sheet causes a pure financia oss to a sharehoder, shoud this be regarded as a vioation of contractua duties between the auditor and the sharehoder, or just as a tort? Obviousy, in most cases this question is decisive for whether the paintiff receives compensation or not. We argue that this question shoud be answered in the affirmative, if the victim has an e-ante wiingness to pay for the costs associated with performing such a duty. In this artice we argue that a wrong audit that causes damages to sharehoders shoud generay be stricty regarded as a tort case. We aso argue that a rue of gross negigence or of gross vioation of professiona standards in tort aw can avoid the probems of underdeterrence as we as of overdeterrence in the compensation of pure financia oss in tort. However, we aso argue that a wrong audit shoud ead to contractua iabiity, if it was made to prepare the sae of a company or parts of it from inside investors to outside investors or to prepare an initia pubic offering. Under this condition we argue that the economic rationae for restricting compensation for pure financia oss is not given. The paper first anayses the socia vaue of an audit. Then severa iabiity rues with precise and vague eves of professiona care are treated with respect to their incentive effects. This eads to the proposa of a rue of gross negigence in tort aw. In the ast part we anayse the specia conditions, under which the ega order shoud assume a contract with protective consequences for buyers of company shares, which eads to iabiity for simpe negigence. The ega form of a contract with protective consequences for third parties (Vertrag mit Schutzwirkung für Dritte) is borrowed from German dogmatic schoarship, but may be interesting in this respect for an internationa audience as we. This artice draws from the iterature on pure financia osses 2 and from the iterature on precise and vague negigence norms 3 as we as from the iterature on the tort contract boundary 4. The artice 1 For surveys on the compensation of pure economic oss in tort see E. Banakas, Civi Liabiity for Pure Economic Loss, Kuver Law Internationa, London et a., F. Parisi, Liabiity for Pure Financia Loss: Revisiting the Economic Foundations of a Lega Doctrine, George Mason University Schoo of Law, Law and Economics Research Paper, 2001, 01-21; E. Siverstein, On Recovery in Tort for Pure Economic Loss, 32 University of Michigan Law Review, (1999) pp. 404; E. Banakas (ed.) Civi Liabiity for Pure Financia Loss, Kuwer Law Internationa, London.The Hague-Boston, (1996), W. Bishop, Economic Loss in Tort, 2 1 Produced by bepress.com, 2011

5 2 German Working Papers in Law and Economics Vo. 2003, Paper 21 does however not discuss the probem of joint and severa iabiity and the strategic probems invoved, which have been broady discussed in the iterature. The victim of a wrong audit might have a caim against the inside investor, the management, the firm and/or the auditor. This causes strategic interactions, which infuence the eve of care of a actors as we as the price of auditing 5. These probems have been etensivey deat with in the iterature and are eft out here competey. The focus is ecusivey on the question, under which conditions the victim shoud be highy protected by contract aw or get a ower eve of protection under tort aw. B. The optima eve of care of an auditor The probem of auditors iabiity arises, given that the auditor certifies a financia report such as a baance sheet of a company. First, the auditor might cause damage to his contractua partner, the company and the company caims damages. The base of this caim is the contract with the auditor. Second, the auditor testifies a financia report and a baance sheet, which inside owners use for preparing a transaction, when they se the company or shares to new owners or if a firm goes pubic in an initia pubic offering. By the auditors overvauation of the corporation, the buyer suffers a oss. Here typicay asymmetric information between buyer and seer of the firm eists. The audit is made to reduce this asymmetry. Third, the auditor certifies a baance sheet, in which the net worth of the company is overvaued. This eads to an overvauation of shares at the stock market unti the bad company news reaches the market by other channes of information. Therefore, outside sharehoders suffer osses. Here asymmetric information between buyers and seers typicay do not eist. We concentrate on the second and the third consteation, when the victims of such osses have no direct and epicit contractua reation with the auditor. The question then arises, whether the victims shoud be protected by the contract between the auditor and the management of the firm or whether they shoud be restricted to a tort caim. We argue that iabiity in the second case shoud be stricter than in the third case. The rationae for this is found in the iterature on pure economic oss in torts. The basic argument is that pure economic osses contain a redistributive component. Oford Journa of Lega Studies (1982) 1-29.V. Godberg, Recovery for Pure Economic Loss in Tort foowing the Eon Vades Oi Spi, 23 Journa of Lega Studies (1991) pp.; M. Rizzo, A Theory of the Economic Loss Probem in the Law of Torts, 11 Journa of Lega Studies, 1982, see R. Crasswe and J.E. Cafee, Deterrence and uncertain Lega Standards, Journa of Law, Economics and Organisation, Vo.2 no , pp.281; see aso R. Schwartz, Auditors Liabiity, Vague Due Care, and Auditing Standards, Review of Quantitative Finance and Accounting, 11 (1998); , and Raf Ewert, Auditor Liabiity and the Precision of Auditing Standards, op. cit. Fn P.H. Rubin, torts and the Tort-Contract boundary in Product Liabiity, in F. Buckey (ed.), the Fa and Rise of Freedom of Contract, Duke University Press, 1999, Victor P. Godberg, "A Reeamination of 'Ganzer v. Shepard': Surveyors on the Tort-Contract Boundary", Vo. 3, Theoretica Inquiries in Law (Onine Edition): No. 2, Artice 6 (2002). 5 For a review of the strategic iterature on accounting see R. Ewert, Auditor Liabiity and the Precision of Auditing Standards, JITE (1999), Vo.155, pp See aso S.A. Hiegeist, Financia Reporting and Auditing Under Aternative Damage Apportionment Rues, The Accounting Review, Vo. 74, No. 3, pp ; Chi-Wen Jevons Lee, Zhaoyang Gu, Low Baing Lega Liabiity and Auditor Independence, The Accounting Review, Vo. 73, No , pp , R.R. King, R. Schwartz, An Eperimenta Investigation of Auditors Liabiity: Impications for Socia Wefare and Eporation of Deviations from Theoretica Predictions, The Accounting Review, Vo. 95, 2000, pp

6 Schäfer: Efficient Third Party Liabiity of Auditors in Tort Law and 3 Therefore, the victims oss is ower than the tota societa oss, which might ead to overcompensation and overdeterrence of victims. The main purpose of this artice is to show why this argument hods for the third, but not for the second consteation. We first anayze the case in which the auditor s mistake eads to an overvauation of shares at the stock market such that sharehoders might suffer osses, a case which in recent years and months has occurred in many countries. As usua in the aw and economics iterature the ega remedies are anayzed from a viewpoint of optima deterrence. We first anayze the auditors iabiity to sharehoders and then proceed to the specia case, in which the auditors epertise is ecusivey used for preparing the transfer of ownership from an inside to an outside investor and in which the buyers suffer a oss because the assets were overvaued. Throughout the artice we assume that auditors as we as sharehoders are risk neutra and maimize epected income. I. The case of an information efficient capita market, the true yied parameter is known for every period We begin the anaysis with determining the efficient eve of care of an auditor or in other words the efficient eve of costs (=*) for auditing a company s report or baance sheet. Thereafter it is asked, which iabiity regime and which scope of iabiity provides incentives to reach this eve. We anayze a stock isted company, in which one share represents one unit of capita. Let the net yied per period per share and per unit of capita be a and et the opportunity cost interest rate of capita be r. Then the net profit per period is a-r. The yied (a) is regarded as a parameter whose vaue might be either high or ow. For simpicity s sake the parameter can have ony two possibe vaues, which are common knowedge to sharehoders, management and auditors. Depending on the conditions of the market as we as on technica productivity the parameter can take either a high or a ow vaue in each period. a { a, a h } If the capita market is information efficient in the strong sense the true parameter is known to the market and refected in the market price. The market price is the discounted vaue of a future yied parameters. Consequenty auditing cannot improve any decisions of sharehoders or the management. Therefore mandatory auditing of annua reports, baance sheets and cash fow cacuation is a mere waste as it creates additiona costs to the sharehoders without causing any benefits. Information efficient stock markets do not need mandatory auditing. Neither is there a rationae for any iabiity vis-à-vis stockhoders, because by assumption auditors cannot cause osses to sharehoders, regardess of the auditor s eve of care. II. The yied parameter is known ony for the first period To rea informationa assumptions assume that the eact vaue of the yied parameter for the first period is common knowedge at the beginning of the first period. But for a future periods the parameter is not known and cannot be reveaed, neither by the management nor by anybody ese. There eists ony a probabiity distribution. In other words, one knows the near future with certainty, whereas the distant future is uncertain. 3 Produced by bepress.com, 2011

7 4 German Working Papers in Law and Economics Vo. 2003, Paper 21 In this case the price of one share (p) in period 1 is p=a h +R if the yied parameter is high during the first period. R is a constant term, which refects the discounted vaue of epected earnings in the periods 2 to infinity. If the yied parameter is ow in the first period, two possibiities arise. First, a >r. In that case the price for the share is p=a +R Second, if ra, sharehoders are interested that the management shifts the capita to aternative uses outside the firm such that the yied is r. This asset shifting shoud be repeated in any future period, whenever a=a <r. This aso incudes the possibiity of permanent iquidation of the firm, if r>r. This shifting requires that capita is not firm specific and can be transferred without a cost to productive uses outside the firm. Throughout this artice we assume that this is possibe, because the basic argument sti hods if ony fractions of the capita can be put to a different use outside the firm as a reaction to ow yied within the firm. < Therefore, if the management acts in the sharehoders interest, if the capita market is information efficient and if the parameter (a) is ow an immediate reaocation of resources takes pace. This generates a yied of r a, compared to the situation, in which the capita stock is used inside the firm. The auditor can neither promote nor prevent this yied. III. The Yied Parameter is Not Known. We now anayze a situation, in which the yied parameter for a particuar period is uncertain at the beginning of the period, but reveas itsef at no cost at the end of the period. The epected yied for any period is now the sum of the yied parameters, weighted with probabiities. Let the probabiities that the yied parameters are ow and high in the first period be w and (1-w). The epected yied (ey) for the first period is then. ( 1) a = wa + (1 w) a h For the second and a other periods we again add the constant term R to get the share price. The share price at the beginning of the first period is then (2) p = wa + (1 w) Ra h + The uncertainty refected in this equation can have two reasons. Either nobody, neither sharehoders nor management, know the true parameter or the management knows the true parameter, but conceas it successfuy from the sharehoders. The management might for instance know that the company just burns money, and needs restructuring or even iquidation (a=a ) incuding dismissa of the management, but keeps this as a secret by fabricating positive news. Paradigmatic for such management behavior are the Hozmann bankruptcy 6 in Germany or the Enron scanda 7 in the USA. In both cases the management misinformed sharehoders and was for some time- abe to keep share vaues up. In this case capita is used inside the firm even if at the 6 Business Week onine, January 28, Wet am Sonntag, August 28,

8 Schäfer: Efficient Third Party Liabiity of Auditors in Tort Law and 5 end of the period- it is reveaed to sharehoders that the yied parameter is ow and that a oss of r was caused which coud have been avoided. a If the management knows the true vaue of the parameter at the beginning of the period and is oya to sharehoders, it wi shift resources to uses outside the firm. If sharehoders know this the share price wi by the amount of w(r-a )- be higher than in equation (2). Equation (2) therefore presupposes that either the true parameter is not known to the management or that it is known to the management but not to the sharehoders and that the management acts disoya to sharehoders by neither informing them and nor shifting resources to uses outside the firm and continues burning of money. Under these assumptions the screening by an auditor can ead to a sociay vauabe information 8. Auditors often have a broader knowedge than managers about the genera conditions of the market. They might for instance. see that a patent is vaueess even though it is not yet epired or that housing prices in East Germany are ikey to be depressed for a onger period, or that some of the main debtors of the company are cose to bankruptcy etc.. Or they can just see and make pubic what an disoya management tries to concea from the sharehoders. In these cases their work can hep to avoid further unproductive investment and osses. We assume now that the auditor acts at the beginning of a period, that his effort might ead to a reveation of the true parameter for this period, and if so that this forces the management to stop osses by shifting resources to aternative use. Throughout this artice we use the foowing sequence of actions and events. 1. At the beginning of the period the productivity parameter is unknown to sharehoders. 2. The audit is made. The auditor either finds or does not find the true productivity parameter. The audit is pubished for the use of outside investors. 3. If the auditor finds that the true parameter is ow (a=a ), this eads the management to shift resources to uses outside the firm. 4. If the audit does not revea the true parameter, it reveas itsef to the sharehoders without cost at the end of the period. The events 1.,2.,3. are a at the beginning of the period, the event 4. is at the end of the period. The company receives the yied (a h, a or r). To keep the anaysis simpe it is assumed, that the auditors effort cannot revea the yied parameters for any future period t>1. The vaue of the firm per share is therefore aways the epected yied of the first period, which is party dependent on the auditors effort pus a fied term R as the discounted net income of a other periods. We can now cacuate the optima effort eve, which is set equa to the optima cost eve () of the auditor. The search costs of the auditor are (per share). If inspite of his search the auditor does not find the true parameter vaue these costs are born by the sharehoder and consequenty the price of the share is reduced to. ( 3) p = wa + (1 w)a h + R = a + R 8 A sociay productive information aows for an improvement of resource aocation, whereas a sociay unprod uctive information does not have this capacity. A sociay unproductive information can sti be privatey vauabe, if it eads to a foreknowedge which can be used for a mere transfer of weath, without improving the aocation of resources. See J. Hirscheifer, 5 Produced by bepress.com, 2011

9 6 German Working Papers in Law and Economics Vo. 2003, Paper 21 If the auditor finds the true vaue of the parameter three consteations can arise. The true vaue is high and immediatey pubicized, then the share price increases 9 to ( 4) p = a h + R The auditor finds that the parameter is ow. If it is ow but sti higher than r, the opportunity cost of capita, the share price reduces to ( 5) p = a + R In this case the auditor has reveaed the true vaue of the firm and found that it is ower than epected. But this does not ead to any improved aocation of resources. For a buyer of a company or a buyer of shares this might be a very profitabe information. But sociay this information is not productive as it does not ead to an efficiency gain. If the auditor finds that the parameter is ow and ower than r, an immediate reaocation of resources takes pace to uses outside the firm. The future burning of money is prevented by the activity of the auditor. In that case the vaue of the firm is ( 6) p = r - + R In this case the auditor s work eads to a net efficiency gain of (r-a )-. We can now cacuate the optima costs of the auditor s effort. We assume that the probabiity that the auditor s search eads to the reveation of the true parameter is q=q(). Consequenty the probabiity that the true parameter is not found is 1-q(). This function has the foowing properties: q=0 if =0, q (0,1] if >0, q ()>0 q ()<0, and q 1,if 10. We now anayze the case in which the auditor s effort can ead to an efficiency gain, that is the case in which the ow yied parameter is ower than the opportunity costs of capita a < r. The epected efficiency gain (eg) of the auditor s work is then the probabiity that the true parameter is detected mutipied with the prior probabiity that this parameter is ow and beow the opportunity costs of capita (r) in the first period mutipied with the efficiency gain that is made possibe in this case minus the costs of auditing. ( 7) eg = q()w(r a) For the first order condition we get q ()w(r a ) 01 or = (8) q () = 1 w(r a ) 9 It increases ony if the costs of auditing are reativey sma compared to the price increase due to the reveation the fact that the true parameter is high An eampe for such a function is q = tan. 6

10 Schäfer: Efficient Third Party Liabiity of Auditors in Tort Law and 7 This is the Learned Hand formua for the optima search costs of the auditor. It determines a unique optima eve of costs (*). Consequenty the auditor acts negigenty as ong as his costs are beow this eve. The epected socia oss (SL) of negigent behavior of the auditor is then the difference between the socia gain of auditing if the effort eve () is optima minus the socia gain if it is not optima. SL = (9) [ q(*) q() ] w(r a ) ( * ) C. Consequences of iabiity rues We can now anayze different tort iabiity rues which give the sharehoder a caim against the negigent auditor. The foowing rues are anayzed. (1) Fu iabiity and partia iabiity (on the European continent better known as difference principe or Differenzprinzip ) under negigence, if the eve of due care is precisey defined. It is shown that these rues ead to overcompensation of sharehoders, but not to overdeterrence. (2) Liabiity under negigence, if the eve of due care is not precisey defined and the auditor knows ony a probabiity distribution of the due eve of care. It is shown that this rue eads to overcompensation and to overdeterrence if overcompensation is sufficienty high. (3) Fu iabiity under gross negigence or under an obvious vioation of professiona standards. It is shown, that this rue eads to overcompensation, but that the probems of overdeterrence are reduced under this rue. I. Fu iabiity under negigence, if the eve of care is precisey defined 1. The cost minimizing auditor This rue gives every sharehoder who suffers the oss (p-a ) at the end of the period a tort caim against the negigent auditor, who faied to detect the true vaue of the yied parameter at the beginning of the period. We assume that courts fi a due eve of care which is equa to the efficient eve of care. Negigence is then defined by the condition <*. Under this rue the tota costs of the auditor are TC, the epected iabiity costs are and the costs of auditing are + if < * TC = if * Obviousy the auditor does not choose an > *. he aso must choose * as his private cost minimum, because whenever he reduces by some arbitrary amount beow * to save costs, the resuting epected damage compensation must be higher than the costs saved. We now show that whenever he makes a choice in the range [ 0, *] 7 Produced by bepress.com, 2011

11 8 German Working Papers in Law and Economics Vo. 2003, Paper 21 * is the cost, which minimizes the sum tota of and q()w(r-a ), the epected socia gain from auditing. Therefore any reduction of beow the vaue of * eads to an increase of this sum that is to a socia oss. The epected socia oss (SL) from reaching a cost eve beow * is then [ q()w(r a ) ] = [ q(*) q() ] w(r a ) ( * ) ( 10) SL = q(*)w(r a ) * We show that the private oss from choosing an <* is arger than the socia oss for every. That is a sufficient condition for the iabiity rue to give incentives to reach *. In the case of fu iabiity the sharehoder receives a damage compensation which is the difference between the price at the beginning of the period (p) and the price at the end of the period a, that is (p-a ). If the auditor acts negigenty (<*) and sti finds the true vaue of the parameter with probabiity q(), he wi in spite of his negigence- not cause any oss. This ecudes iabiity. The epected iabiity costs pus auditing costs (TC) of the auditor are then for any <*. (11) TC = [ 1 q() ] w(p (a + R) + = [ 1 q() ] w(a a ) The term (1-q() denotes the probabiity that the auditor does not find the true vaue of the parameter with a cost eve of. The epected private osses for the auditor (PL) of reducing the care eve beow the efficient eve by the amount of *- are the tota costs at the care eve <* minus the efficient costs of auditing, which if spent woud ecude iabiity. (12) PL = [ 1 q() ] w[ a a ] ( * ) Aso, <*. Here the term *- denotes the reduction of auditing costs from the efficient eve to a eve beow the efficient eve and the other term denotes the resuting epected iabiity. If one compares these private osses with the socia osses from deviating from the optima effort eve one sees that these private osses are greater for any cost reduction beow the eve of *. The reason is that we assumed that a > r and that (1-q())>(q(*)-q()) (Compare the epected private oss in (12) with the epression for the epected socia oss in (9)). Therefore the private oss for the auditor from choosing a cost eve which is beow the efficient cost eve * is bigger than the socia oss. Consequenty the private cost minimum is *. The ratio of private oss to socia oss of not reaching the optima and due eve of care is bigger than 1. (13) PL PS = [ 1 q() ] w[ a a + R] [ q(*) q() ] w[ r a ] ( * ) ( * ) > 1 Sharehoders are overcompensated under this rue as is often the case with pure economic oss in which damage compensation is arger than osses inficted to the society. The quota of [ 1 q() ] w [ a a ] + R overcompensation is given by the term > 1 q(*) q() w r a [ ] [ ] The private osses of the auditor from reducing costs to a eve beow * are therefore higher than the socia osses for any eve of. As socia osses of reducing the effort eve beow the optima 8

12 Schäfer: Efficient Third Party Liabiity of Auditors in Tort Law and 9 eve (*) are higher than the cost reductions (*-), this proves that any cost reduction to a eve beow * increases tota private costs, i.e. auditing costs pus iabiity costs for the auditor. And the auditor has an incentive to reach the optima effort eve. Therefore, even though damage compensation a a is higher than the tota socia damages (r-a ) in case a damage occurs, this does not ead to overdeterrence as ong as the eve of due care is precisey defined and efficient. 2. The share price if sharehoders know the consequences of the iabiity rue We can now aso cacuate the share price at the beginning of the period before the auditor gives his audit. If iabiity has the above properties, the sharehoders wi assume that auditors work efficienty and that they can prevent unnecessary osses in case the yied parameter is ow. They aso foresee that iabiity is just a threat and wi not actuay happen and that therefore the epected iabiity costs wi be zero. The e ante price (p), given the iabiity rue is then = + h + + h + (14) p q(*)(wr (1 w)a ) (1 q(*)) [ wa (1 w)a ] * R This price is higher than the price with which we worked above, by assuming that the sharehoders beieve that the work of auditors is useess for them. Consequenty in case of a iabiity aso the damage award (p-a ) is higher. Therefore the fact, that this rue eads to overcompensation and efficient incentives aso prevais for the price in (13). II. Partia iabiity under negigence, if the eve of care is precisey defined 1. The difference principe Under partia iabiity the damage award is the difference between the weath of the victim with and without the negigent act. This rue, known in Continenta Europe as the difference principe, (Differenzprinzip in German, 249 BGB) woud not ead to a fu compensation (p-a ) of the sharehoder by the auditor. To carify this principe with respect to auditor s iabiity we have to distinguish between three different cases. (1) The buyer buys the shares before the beginning of period 1 and sti keeps them after the end of period 1. The auditor fais negigenty to discover and pubish the ow yied parameter at the beginning of period 1. At the end of period 1 the market reveas that the parameter is ow (a ). The buyer suffers a oss of p-a +R= a a Under the difference principe the sharehoder woud however not be entited to recover this oss. The defendant coud argue that if he had been diigent and eercised due care and informed the pubic propery at the beginning of the period, the vaue of the shares woud have dropped from p to r+r and that he has caused ony the damage r-a. This resuted from the fact that the auditors did not cause the management to shift resources to uses outside the firm where they coud yied the opportunity costs of capita. To my knowedge this defense according to the difference principe woud be accepted in most ega orders. Damage compensation in this case woud therefore resut not in fu iabiity (p-a +R), but in partia iabiity (r+r-a +R=r-a r ). It is aso noteworthy that in genera the difference principe appies ony, if the defendant shows that even without negigent behavior a certain damage woud have occurred with certainty. The difference principe is however not appicabe with respect to probabiities. If the defendant has reached a cost eve of auditing of <* he cannot argue that even if he had reached the due eve of 9 Produced by bepress.com, 2011

13 10 German Working Papers in Law and Economics Vo. 2003, Paper 21 care (*), the same damage might have occurred but with a ower probabiity. And he cannot argue that therefore the damage award shoud therefore be reduced to the damage (r-a ) mutipied with the probabiity differentia of the damage probabiity with and without the due eve of care. At east this defense seems not to be possibe within Germany, where the difference principe is part of the Civi Code and generay accepted by jurisdiction 11. We wi therefore interpret partia iabiity based on the difference principe as a rue which reduces iabiity if a fu proof can be given that some of the damages woud have occurred anyway, even if the defendant had reached the due eve of care. This means that if the sharehoder has bought the shares before period 1 and sti hods them after the end of that period- the tota costs of the auditor under this rue wi be (1 q())w(r a ) + if < * TC = otherwise. In that case the tota private costs of the auditor of deviating from the efficient eve of care is the sum of auditing and iabiity costs if <* minus the costs eading to the efficient eve of auditing *. (15) PL = (1 q())w(r a ) ( * ) Is there overdeterrence in this case as under a rue of fu iabiity? The sharehoder receives a compensation equa to the socia damage of r-a. The auditor cannot reduce his tota costs by reducing his costs of care beow the due eve of care. This is due to the fact, that in case damage is paid, compensation is equa to the socia oss. But the fact that the auditor cannot argue that the damage might have occurred even in the case of due diigence, however with a ower probabiity sti makes the epected private oss of deviating from the optima cost eve of care arger than the epected socia oss for every eve of care <*(compare (15) with (9)). (2)The buyer buys the shares after the beginning of period 1and keeps them unti after the end of period 1. In this case the buyer buys at price p in period 1. The auditor faied to find and make pubic that the yied parameter is ow. The buyer keeps the share unti after the true parameter is reveaed to the market at the end of period 1 and suffers a oss of p-(a +R)= a a. Now the use of partia iabiity under the difference principe does not ead to any reduction of the damage award. Had the auditor not acted negigenty and had he found the true parameter, the drop in share prices by (p-(r+r)) woud have happened before the buy. Therefore, the defendant cannot argue that if he had acted diigenty the paintiff woud have suffered a oss of (p-(r+r)) anyway which woud reduce the damage award to (r-a ). The difference principe eads to fu iabiity and therefore from a socia point of view- to overcompensation. The tota epected costs given that the sharehoder bought the shares after the beginning of period 1 is then 11 In the case of Landwehrkana in Berin the German Supreme Court BGH hed the state of Berin iabe for not ceaning the Landwehrkana, an inner city cana, more than once in a year. The faiure to reach a higher eve of care ed to fu compensation of a shipowner whose ship propeer was damaged by foating fith. The fact that with more frequent ceaning the same damage might have ocurred but with a ower probabiity did not ead to any reduction of the damage award. (BGHZ, Landwehrkana..). 10

14 Schäfer: Efficient Third Party Liabiity of Auditors in Tort Law and 11 (16) [ 1 q() ] w(a a + R) +,if < * TC = otherwise. (3)the buyer ses the share after the beginning and before the end of period 1. Here the buyer ses shares at an overvaued price, because the auditor has faied to detect and pubicize that the company is worth ess than the market vauation. This resembes the case of an art coector who buys a painting at a high price, which is based on the epertise of an art epert, who negigenty overooked that the painting was a fake. The art coector reses the painting at a high price and ony the second buyer discovers the fake and suffers the oss. To this sharehoder the negigence of the auditor has caused a gain of a r under the difference principe. Had the auditor not negigenty faied to detect the true parameter, the sharehoder woud have suffered an equivaent oss. As this oss was avoided, the auditor has caused a gain to the sharehoder. From an economic poicy point of view this gain shoud be disgorged to the auditor according to the mitigation principe. But this is a practica impossibiity. Therefore under the difference principe the private gains caused by the negigent behavior of the auditor are not disgorged, but the private osses of those who buy the shares within period 1 have to be fuy compensated, which again eads to overcompensation. 2. Tota epected damage compensation under the difference principe We can now cacuate the epected damage compensation under the difference principe. For this we assume that every sharehoder who hods shares after period 1 has a constant probabiity of having bought the shares in period 1 () or before period 1 ( 1 ). The epected tota cost for the tortfeasor (TC), damage compensation pus costs of auditing () is then = + + if < (17) TC [(1 q())w(a a )] (1 )[(1 q())w(r a )] * The epected private oss of the tortfeasor (PL) of reaching a cost eve beow the efficient cost eve is then TC-* or (18) PL = PL = [(1 q())w(a a )] + (1 ) [(1 q())w(r a )] [ 1 q() ] w[ (a a ) + (1 )(r a )] ( * ) ( * ) The ratio Q between the private and the Socia oss is then (19) Q() = PL SL = [ 1 q() ] w[ (a a ) + (1 )(r a )] [ q(*) q() ] w[ r a ] ( * ) ( * ) > It can easiy be seen that this ratio is aso arger than one as ong as a > a and that the private costs of the auditor of deviating from the efficient cost eve * are arger than the socia osses caused by this deviation. Thus overcompensation is inevitabe even under partia iabiity. However, as ony the socia oss is compensated, if the sharehoder has bought his shares before period 1, the distance from socia osses to auditor s private osses is smaer than under fu iabiity Produced by bepress.com, 2011

15 12 German Working Papers in Law and Economics Vo. 2003, Paper 21 It is aso easy to see that overcompensation does not ead to overdeterrence under partia iabiity, if the due costs of care are precisey defined at *. For the same reasons as epained under fu iabiity the cost minimum must be the efficient and due eve of care. III. Overcompensation and overdeterrence under negigence, if the due eve of care is unknown e-ante In this section we anayze the effect of overcompensation on deterrence if the due eve of care is not precisey known e ante, neither to courts nor to tortfeasors 12. Ony during the judicia procedure, when the parties present the facts of the case and when the tortfeasor epains what he has done to reduce damages and when the paintiff epains what coud have been done the due eve of care is fied e post. This is a reaistic assumption for most of the cases. An e ante precise eve of care is to be found more often in reguatory aw where eperts can fi it beyond ega procedure. It is aso to be found in those tort areas, in which a ong accummuation of high court decisions has ed to a precise rue. However in dynamic fieds with changing technoogies this is not to be epected and the due eve of care is most ikey known ony as a probabiity distribution when the tortfeasor decides on his eve of care. We change assumptions as epained by the foowing graph. Fig.1 Costs of care 0 h Here is the cost of care. denotes a ower threshod eve of care for which negigence can be regarded as being obvious for an outside observer ike a judge. If and a damage is caused, courts wi assume negigence and iabiity resuts with certainty. If h it is equay obvious that the due eve of care was reached and courts wi aways accept this eve or a higher eve as sufficient to ecude iabiity. It is assumed that tortfeasors know these threshod eves defined by the courts and therefore know a eves of care which ecude iabiity with certainty and a eves of care which wi ead to iabiity with certainty. Between and h the tortfeasor attaches a probabiity that he is hed negigent to each possibe care eve. Denote this probabiity vaue with F=F(). F has the foowing properties. 12 For an anaytica eposition without bounds for the range of the distribution function F. see R. Crasswe and J.E. Cafee, Deterrence and uncertain Lega Standards, Journa of Law, Economics and Organisation, Vo.2 no , pp.281, See aso R. Schwartz, Auditors Liabiity, Vague Due Care, and Auditing Standards, Review of Quantitative Finance and Accounting, 11 (1998); , and Raf Ewert, Auditor Liabiity and the Precision of Auditing Standards, op. cit. Fn

16 Schäfer: Efficient Third Party Liabiity of Auditors in Tort Law and 13 (20) F() [ 0,1] F() = 1if F() = 0 if F () < 0 if (, ) h h To be abe to anayze the effect of overcompensation, we assume that damage compensation is by a factor m (m>1) higher than the socia damages for a eves of < h. In equation (13) and (19) this ratio is shown for fu and partia iabiity under the difference principe. From this equations it aso foows that m can change with, but that it is aways arger than 1. However to avoid more compicated terms it is further assumed that m is a parameter (m>1). We make the further assumption, that the efficient eve of care (*) is between and h. This is the most pausibe assumption, if one assumes that the courts try to hit the efficient eve of care when they fi the due eve of care but for ack of information sometimes hit to the right and sometimes to the eft of *. The tortfeasor minimizes his epected costs. Assume that 0. Then his costs are md+, where D refects the damage compensation. In this range at every an increase of must decrease tota costs, as by assumption the eve of care is then smaer than the optima eve and any eads to a higher reduction in damages D and an even higher reduction in damage compensation m D, as m>1. The cost minimum in this range is therefore at. Assume now that is increased by a sma vaue at, then again tota costs must decrease, as by assumption the eve of care is then sti ower than the optima eve and the resuting reduction in damage compensation m D is higher than the increase in at. Furthermore aso the probabiity of being negigent decreases beow 1 which eads to a further reduction of the epected damage compensation. Consequenty cannot be a cost minimum. If there eists a cost minimum it must be at a higher eve of than. If h tota costs of the tortfeasor are, as it is certain that the due eve of care is reached. Consequenty the cost minimum in this range is h. The cost minimum for a vaues of must therefore be at at a eve higher than, and the highest possibe cost minimum is h. In the range < tota epected costs of the tortfeasor (TC) are h TC = F()mD() +. Differentiation with respect to yieds the first order condition TC = m F ()D() + D ()F() + 1, with F < 0,D < 0,D() > 0, F().0 [ ] 0 = > It is now easy to see that ony by chance the tortfeasor gets incentives to reach the efficient eve of of care, if (21) 1 F (*)D(*) + D (*)F(*) = m This depends on whether at * the joint effect of an increase of the costs of care on the probabiity of iabiity and on the damages just outweighs this increase. Otherwise the cost minimum is reached at some eve of * in the interior of the range or at = h. The resut is therefore either over- or undertederrence, if the standard of due care is known ony as a probabiity distribution. It is aso easy to see that with an m high enough the vaue of 1/m must be higher than the vaue of the eft hand side. That means that the equaity can ony be reached at a an >* and that therefore overdeterrence resuts. 13 Produced by bepress.com, 2011

17 14 German Working Papers in Law and Economics Vo. 2003, Paper 21 Proposition 1. If the eve of due care is imprecise e ante within a range and if the efficient eve of care is within this range, there eists an m>1 for which overcompensation in a negigence regime must resut in overdeterrence. The same resuts for any number bigger than m. Overdeterrence of auditors is therefore a ikey outcome under a rue of simpe negigence, if -the purey redistributive component of iabiity is high enough and -it is not possibe to define e ante cear and efficient rues of behaviour whose observation ead to an escape from iabiity and whose vioation triggers iabiity with certainty. It is however questionabe whether a compe task as auditing, which incudes among other things asset vauation, can be efficienty prescribed by cear rues of behaviour and due care. However the probem of overdeterrence might sti be soved or at east aeviated by a negigence concept of gross negigence. C. Gross Negigence as a method to reduce overdeterrence. For a soution or at east aeviation to this probem we present a concept of gross negigence or gross vioation of professiona standards, that shoud trigger iabiity instead of norma negigence. To do this we have first to take a coser ook at the distribution function F(). This function is defined over the interva [, h ]. Its vaue is 1 at the ower bound and 0 at the upper bound of this interva. The ega interpretation of the upper bound is that at these costs of care it is obvious that the tortfeasor was not negigent. The ega interpretation of the ower bound is that it is obvious that the tortfeasor was negigent. F() is continuous and F ()<0, F() (0,1) everywhere in the interior of the interva. Now assume that the ega system imposes a restriction on the court decision. This restriction is a rue which fies an upper bound g which is stricty smaer than h. Liabiity is then ecuded with certainty, if g < h is reached, even if it is not obvious that the tortfeasor was not negigent. With an g < h we now get a new distribution function whose vaue is 1 at = and whose vaue is 0 at = g < h. Let this function be G () and et it aso be of the same type as F(). Then we assume as a consequence: (22) () F() (,, g (23) G () < F () if (, ]. G < if ( ] This is iustrated by the foowing graph in whgich G and F are inear functions g 14

18 Schäfer: Efficient Third Party Liabiity of Auditors in Tort Law and 15 Fig. 2 1 F() G() g h Here the absoute vaues of G() and of G () are stricty smaer than the vaues of F() and F () for any [, g ] We beieve that this is a reasonabe consequence aso for other types of functions with the properties of G() and F() given as in (21) and (22). The function G() is interpreted as a definition of gross negigence. Under this definition the tortfeasor is iabe in damages if it is obvious that his eve of care was too ow. But he can escape iabiity at a reativey ow eve of care at which it is not obvious that he was not negigent. We now ask, whether it is possibe to find an g and thereby define a range of gross negigence, which eads to efficient incentives for the tortfeasor, even in the case of overcompensation. For this purpose we now regard g as a variabe, which can run from to h.this eads to a distribution function with the foowing properties. (24) G = 1if = G = 0 if = g G (0,1) if (, g ) In the atter case we aso get G G(, < 0,G g g ) > 0 The tota cost function for the tortfeasor in the range between and g is then (25) TC = G(,g )md() + For the first order conditions one gets 15 Produced by bepress.com, 2011

19 16 German Working Papers in Law and Economics Vo. 2003, Paper 21 (26) TC = m G [ (, )D() + D ()G(, )] TC = mg (,g)d() = 0 g g g g + 1 = 0 It is now possibe to ask for the sociay optima upper bound g * of the distribution function G(). We ask which g minimizes the tota epected costs of the tortfeasor, given an optima eve of care (=*). 1 (27) TC = [ G (*,g)d(*) + D (*)G(*, g) ] = m This yieds an g = g *. Proof: Assume as a starting point that m and g are high enough to ead to an 1 overdeterrence at g i.e. TC = [ G (*,g)d(*) + D (*)G(*, g) ] >. Now reduce the vaue m of g continuousy towards. That reduces the vaues of G>0 and of G g <0. G g must decrease beow a imits, as G g - if g. This resuts because the vaue of G drops from 1 at G( ) to 0 at G( g ). Consequenty the first derivative of the function within this range, which is aways negative must decrease beow a imits. The range of the function then becomes smaer and approaches 0. The vaue of the function must aways run from 1 to zero within this range, however sma the range is. This must decrease the vaue of the derivative beow a imits. As D(*) is positive and constant, there must therefore eist an g = g * at which 1 [ G (*,g)d(*) + D (*)G(*, g) ] =. Assume now that the ega system chooses the range m [,g *] over which the distribution function is defined. Then the tortfeasor minimizes his tota costs when he chooses a care eve which is equa to the sociay optima care eve. Proposition 2: Assume overcompensation for pure financia oss eads to overdeterrence under a eve of due care which is known e ante ony as a distribution function F() with a ower and an upper bound for the range of the function. Then there eists another distribution function G() with the same ower bound and a smaer upper bound of its range, which induces the optima eve of care. Such a distribution function can be caed Gross Negigence or in the case of auditors Gross Vioation of Professiona Standards. If courts stick to such a standard, when granting compensation for pure financia osses, it is guaranteed that overcompensation does not systematicay ead to overdeterrence. Of course the informationa requirements for such a gross negigence standard can often not be met by the courts. If a concept of gross vioation of standards is used, it might be to a i.e. g too cose to (the eve of obvious negigence) and then even ead to underdeterrence. Or it might be too cose to simpe negigence, i.e. g too cose to h, eading sti to overdeterrence just as under a norma egigence standard. How often this happens, is dependent on the informationa eve of courts and cannot be anaysed here. But the systematic bias of overdeterrence as a resut of overcompensation disappears, if the above concept of gross negigence is introduced. In this contet it is noteworthy that the German supreme court (BGH) has in various decisions on the iabiity of eperts for pure financia damages used a standard of gross negigence to trigger tort iabiity. Basicay the BGB (Bürgeriches Gesetzbuch) restricts iabiity for pure financia oss in tort to those cases in which the tortfeasor acts intentionay (vorsätzich) and under vioation of boni mores (Sittenwidrigkeit), 826 BGB. This very restrictive rue for the compensation of pure financia damages was somewhat reaed by jurisdiction. In severa court decisions the BGH rued 16

20 Schäfer: Efficient Third Party Liabiity of Auditors in Tort Law and 17 that gross negigence is sufficient for the court to assume both a vioation of boni mores and intentionaity 13. This deveopment was not accepted without critique within the ega profession 14. It is seen as a deviation from the concept of intentionaity for which the court in a civi aw country acks authority and as a sient introduction of gross negigence in a domain, which the egisator wanted in principe to ecude from iabiity. On the other hand it must be seen, that the very restrictive wording of 826 BGB which practicay ecudes iabiity ecept for cases of proven disoyaty of the epert eads to efficiency osses. This oss is ever increasing over time as those professions which process and market information are becoming more and more important for the functioning of markets and especiay the capita market. The jurisdiction of the supreme court shoud therefore be wecomed from an economic perspective. And it shoud be etended and generay used in cases of auditor s iabiity in tort. D. The tort-contract boundary Our anaysis woud be of itte vaue if it were restricted to tort aw. The caimant has aways the possibiity to base his caim either on tort aw or on contract aw or on both. This is especiay the case in the German civi aw system (Anspruchskonkurrenz). With respect to the compensation of pure financia osses the difference between tort and contract is of fundamenta importance, as in contract the usua restrictions to compensate pure financia osses do not eist. If within a contract an epert such as an auditor negigenty deivers a wrong epertise and thereby causes a damage to the partner he is iabe for the pure financia oss 15. This is the genera contractua defaut rue for consequentia damages in Germany and in a major countries. If for instance an epert negigenty overvaues a house in his epertise, which his contractua partner buys at a too high price, the epert is iabe under contract aw, even though he escapes iabiity under tort aw. The fact that this has ony ed to a redistribution of weath between the seer and the buyer of the house has no consequence in contract aw. In a contract the partner has a wiingness to pay the epert his costs of care and his epected iabiity costs to such an etent that the sum tota of his private damages from a wrong epertise and these costs are minimized. The contractua partner gets the iabiity he pays in the price of the epertise and his wiingness to pay is reated to the avoidance of private osses. Consequenty, the probem of sorting out pure financia osses from compensation does in genera not eist in contract aw. The due eve of care is ceary oriented to the avoidance of private osses and not of socia osses. These costs are transactions costs which aow the transfer of resources to the highest vaued user. The question here is, whether the sharehoder has a contractua caim against the auditor. The auditor s contract is not with the sharehoders but with the corporation. An epicit contract does therefore not eist. This however does not ecude contractua iabiity, as a ega orders have deveoped concepts and routines that ead to a contractua caim under an impicit contract or a quasi-contract. It seems however that in Germany the scope of contractua iabiity is arger than in Common Law Countries. In Germany the concept of a contract whose protective effects are etended to third parties eists on which a contractua caim can be based in such cases (Vertrag mit Schutzwirkung für Dritte). Some authors 16 have proposed a iabiity concept sui generis, based on simpe negigence, for the iabiity of eperts whose ega consequences can however be taken either from contract aw or from tort aw. There eist different ega forms which have as a consequence, that the caim can be based on contract aw even if the caimant has no epicit 13 BGH MW 1975, 559; BGH 1991, 3283=WM 1991, 2043 ff. 14 See C.-W..Canaris, Die Reichweite der Epertenhaftung gegenüber Dritten, ZHR, 163, (1999), 206 ff. 15 In Germany contractua iabiity of the auditor is capped. 323, 2 HGB 16 See C.-W..Canaris, Die Reichweite der Epertenhaftung gegenüber Dritten, ZHR, 163, (1999), 206 ff. 17 Produced by bepress.com, 2011

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