An empirical investigation of the impact of Central Bank of Denver on securities disclosure-related auditor litigation risk

Auditor litigation risk is one of the quality control mechanisms that facilitates a high quantity and quality of corporate disclosure. The objective of this study was to investigate, using the legal economics paradigm (Coase, 1960) and the Cooter-Rubinfeld model of litigant behavior (1989), the change in the legal regime for auditor liability on April 19, 1994, with the Central Bank decision by the United States Supreme Court. It is hypothesized that Central Bank, in eliminating the "aiding and abetting" theory of legal liability previously implied from Section 10(b) of the Securities Exchange Act of 1934, reduced auditor litigation risk. The rationale for the hypothesis is that this liability theory was targeted to auditors but not companies and their management.; The Securities and Exchange Commission has advocated legislatively overturning the Central Bank decision. Congress has not acted, possibly because of the lack of empirical evidence demonstrating that the decision had a significant impact. Contemporary issues in auditor liability, like the Central Bank decision, have necessarily been avoided by empirical researchers. The reason for this avoidance is that empirical researchers have been unable to collect a large sample of recent litigation observations.; Using the new PACER (Public Access to Court Electronic Records) system, 423 recent securities disclosure-related lawsuits filed in the United States District Courts from April 20, 1992, through April 19, 1995, were examined. To measure the impact of the Central Bank decision, eleven other factors believed to influence the probability of naming the auditor a defendant were also analyzed. From these candidates, a multiple logistic regression model with four independent variables was constructed.; As hypothesized, the proportion of securities disclosure lawsuits with auditor defendants declined significantly in the immediate post-Central Bank period. Other factors found in this study to be significantly associated with auditor defendants included bankruptcy of the defendant company, the length of the class period, and the restatement of previously issued audited annual financial statements where a credible explanation for the restatement, other than a tacit admission of an error or irregularity, was lacking.