Catastrophe Bonds for Auditors -- An Idea that Refuses to Stay Dead

Our teen-ager just finished a great school course, “Monsters In Literature.” The class read about all manner of scary creatures, the most gruesome being those who, once roused, were hardest to kill off.

In the antagonistic drama about the impact on the global capital markets of the impending collapse of the large-company audit function, the role of doctor Frankenstein goes to George Washington University law professor Lawrence Cunningham.

Cunningham has proposed an alternative to liability caps – here.

With the large firms showing no sign of the communication and strategic skills needed in the unfriendly American political and regulatory environment, Cunningham suggests instead that they issue high-interest “catastrophe bonds” – whose principal would be callable to cover massive litigation awards. His analogy is to the now-familiar “cat bonds,” that fund against damages from hurricanes, floods and other natural disasters.

Developing events have driven stakes through the hearts of other unworkable salvage proposals: Mandatory auditor rotation was only ever tried in Italy, where the collapse of Parmalat put an end to the export of that idea. The prospect of global scale competitors for the Big Four has been quashed by the Bankest verdict against BDO’s Seidman firm in Miami and the pending one-two against Grants of Parmalat and Refco.

Not that it’s wrong for Cunningham to be skeptical of the large firms’ case for liability caps, as they continue to resist calls for financial transparency. But he misses the broader public policy issue. The non-trivial likelihood of a disruptive “worst case scenario” is broader than the cost to its partners of the next firm’s failure – it’s about the reverberations in the capital markets caused by the cascading failure of the entire franchise. 

Trouble is, the weaknesses in the firms’ messages do not make viable the alternatives. Although the critique of Cunningham’s proposal by insurance expert Kevin LaCroix – here -- should have laid its ghost almost two years ago, it still stirs. So a brief comparison on the basics of insurability is in order:

Diversity: The essence of real insurance is the spreading of risks – whether life insurance for a broad population or hurricane bonds across the broad geography of the Caribbean. No life underwriter would survive that served only insureds from a single hospital ward of the terminally ill. Just so, the concentrated and homogeneous Big Four audit market is exposed to every major financial collapse anywhere in the world.  

Predictability: Dangerous as it is, the annual hurricane season is measurably limited by the calendar. And exposed as is its geographic region, there are no hurricanes in Paris or Chicago. Effective modeling gives a confidence level in the expected volume and severity of claims.

By contrast, the Big Four’s risks extend across every one of their clients large enough to generate a billion-dollar claim. And the presence of globally-recognized names in their litigation inventory illustrates the pervasive nature of their exposures. Models of frequency and severity are simply ineffective to measure and set prices for the extremes of unpredictable events arising out of human malfeasance.

Independence of Cause and Impact: Mother Nature does not generate hurricanes in order to trigger claims against available insurance or cat bonds. The flood takes out the bridge, whether it is insured or not. But Cunningham goes astray in his assertion that auditor cat bonds would not “attract suits against auditors because they fund only catastrophic losses, upwards of $500 million.”

Large sums not incentives to the plaintiffs’ bar? Did anyone ask them whether money talks or not! American class action lawyers have never shied from auditor liability cases on a multi-billion dollar scale, and the existence of a ten-figure honey pot would be well publicized and irresistible – both commercially and as a matter of the lawyers’ ethical obligation to provide zealous advocacy to their clients.

Still, the most telling evidence that auditor cat bonds have no pulse is that in recent years the smart guys in financial services, who had left no source of securitization unexplored, have taken a pass.

Put another way, if the idea were viable, the bankers and insurers would have been there by now. The combination of greed and ingenuity that transformed portfolios of subprime mortgages and other doubtful debt into the multi-layered mountains of toxic financial waste spread across the capital markets was readily transferable. To extend that creative venality to the cobbling up of an auditor cat bond needed only to breathe the life of profits into the body on the laboratory table. And it hasn’t happened. 

It is of passing interest that in Bram Stoker’s 1897 original, the eponymous Count Dracula was actually able to live and move about in the daylight. But as US Supreme Court Justice Oliver Wendell Holmes put it in a more elegant context, “sunshine is the best disinfectant.” So illuminated, the idea of catastrophe bonds for auditors deserves its place, tightly closed up in a box with the lid nailed shut.

Comments

[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.