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July 15, 2008


Lawrence Cunningham

To paraphrase another literary figure, this report of auditor cat bond death may be exaggerated. After all, shouldn’t practical issues like these be resolved in a negotiation over a product prototype rather than by intellectual declaration? How can one know whether the bonds can be sold without having tried to sell them? Surely, not all financial inventions have been made already.

There is a practical political point here: at least in the US, if auditing firms wish to persuade US legislators to enact permanent statutory liability caps, they should be prepared to demonstrate that they have exhausted other avenues to handle their business model. At least for some legislators, that will require more than analytical destruction of an abstract idea and hard evidence that there are no private market solutions to their problems.

Also, it may be true that cat bonds, as such, “miss[] the broader public policy issue,” but please note that I’ve written extensively about that too, including through articles investigating financial statement insurance. As one example, see my article, Too Big to Fail: Moral Hazard in Auditing and the Need to Restructure the Industry Before it Unravels, published in Columbia Law Review in 2006. This emphasizes an immediate public policy point: the huge stakes of a failed auditing firm may, even now, be tempting auditor laxity.

Jim Peterson

Professor Cunningham -- Thanks for your response -- in an environment where constructive dialog is not easy to find, it's most welcome.

On the market's views on auditor cat bonds, a curious student looking for a good project might usefully survey the major players in insurance and "contingency capital": Have they indeed considered the subject, and if so, what explains their indifference? We could all be better informed.

As for liability caps, it is past time to acknowledge that, with the overwhelming gap between the large firms' limited partners' capital and their $100+ billion litigation exposure, neither monetary nor proportionate caps are politically achievable at limits low enough to address survivability. Besotted as the firms' leadership may be with caps, more comprehensive re-engineering is essential; devotion to a one-dimensional "solution" is a waste of time and energy.

Finally, the Andersen experience shows that while "too big to fail" may apply to Fannie Mae and Freddie Mac, the Big Four are "too frail to survive", especially when the regulators are on record as lacking any tools to prevent their collapse -- which is only one large judgment away.

Keith Tracey

From a practical industry perspective, it is a reasonable presumption that cat bonds for large accounting firms have been, and are currently, not possible to construct. The reasons are as explained by Kevin LaCroix, principally the relationship between event, notification, claim and final resolution and the data questions. The former makes the term of the investment difficult and the latter introduces considerable pricing uncertainty.Certainly the existence of the bonds would pose a question about the patterns observable in past data and the conclusions to be drawn about the exposure.

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