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Efficient Third Party Liability of Auditors in Tort Law and in Contract Law

Hans-Bernd Schäfer

No 2003-1-1074, German Working Papers in Law and Economics from Berkeley Electronic Press

Abstract: A wrong audit can cause damages to shareholders. This happens especially if outside shareholders base their investment decision on the audit and buy overpriced company shares. If such damages are recoverable under an implied contract between auditor and shareholder, the auditor is usually liable for simple negligence. In that case he has negligently violated a contractual duty to the shareholder, even though the explicit contract was between him and the corporation. If however these damages are only recoverable under tort law, simple negligence will not lead to compensation because they are pure economic losses and because most legal orders restrict or exclude liability for pure economic loss. For such damages, most legal orders grant compensation under tort law only if it is proven that the tortfeasor was willful, disloyal, reckless or grossly negligent . In most cases this excludes compensation. The economic literature on civil liability for economic loss has underlined the rationale for such restrictions. However, this literature remains silent with respect to the borderline between contract law and tort law. There is a general agreement that pure economic loss has to be compensated under contract law as the cost of this protection is internalized in the contract. If a wrong audit and a wrong and published balance sheet causes a pure financial loss to a shareholder, should this be regarded as a violation of contractual duties between the auditor and the shareholder, or just as a tort? Obviously, in most cases this question is decisive for whether the plaintiff receives compensation or not. We argue that this question should be answered in the affirmative, if the victim has an ex-ante willingness to pay for the costs associated with performing such a duty. In this article we argue that a wrong audit that causes damages to shareholders should generally be strictly regarded as a tort case. We also argue that a rule of gross negligence or of gross violation of professional standards in tort law can avoid the problems of underdeterrence as well as of overdeterrence in the compensation of pure financial loss in tort. However, we also argue that a wrong audit should lead to contractual liability, if it was made to prepare the sale of a company or parts of it from inside investors to outside investors or to prepare an initial public offering. Under this condition we argue that the economic rationale for restricting compensation for pure financial loss is not given. The paper first analyses the social value of an audit. Then several liability rules with precise and vague levels of professional care are treated with respect to their incentive effects. This leads to the proposal of a rule of gross negligence in tort law. In the last part we analyse the special conditions, under which the legal order should assume a contract with protective consequences for buyers of company shares, which leads to liability for simple negligence. The legal form of a contract with protective consequences for third parties (Vertrag mit Schutzwirkung für Dritte) is borrowed from German dogmatic scholarship, but may be interesting in this respect for an international audience as well. This article draws from the literature on pure financial losses and from the literature on precise and vague negligence norms as well as from the literature on the tort contract boundary . The article does however not discuss the problem of joint and several liability and the strategic problems involved, which have been broadly discussed in the literature. The victim of a wrong audit might have a claim against the inside investor, the management, the firm and/or the auditor. This causes strategic interactions, which influence the level of care of all actors as well as the price of auditing . These problems have been extensively dealt with in the literature and are left out here completely. The focus is exclusively on the question, under which conditions the victim should be highly protected by contract law or get a lower level of protection under tort law.

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