I’ve become interested in the proposal to require auditing firms to disclose the names of engagement partners, and other firms, involved in an audit of a public company. Though I can’t pretend to have waded through all the comments that have been submitted on this issue, I gather one of the concerns is that disclosure will increase potential liability under Section 10(b). I actually think that it will and it won’t, and as someone who feels that auditors should be held to more stringent standards than the law currently allows, I have mixed feelings about the proposal.

[More under the jump]

To begin, I am in favor of the proposal that the names of different firms be disclosed.

PCAOB has expressed its concern that prestigious firms may outsource audit functions to firms with less expertise and hide that fact; disclosure of the names of the firms involved in a particular audit will discourage this practice.

I actually come at the problem from the opposite direction. Sometimes, companies that have nominally foreign headquarters but who conduct operations in the US use a relatively small, local branch of a big name auditing firm to submit an audit report, when much of the substantive work was performed by the American branch. But when plaintiffs bring a lawsuit based on a false audit report, courts typically hold that unless the plaintiffs can allege facts (pre-discovery) demonstrating the American branch’s involvement, the American will be treated as a separate entity from the smaller foreign branch, and only the foreign branch will be kept in the lawsuit. When I was in practice, I used to joke that these courts are exactly the kind of people who wouldn’t be able to tell Clark Kent and Superman apart – look, he’s wearing glasses, so he must be a totally different person!

Disclosure of the participating firms may serve multiple functions. First, simply as a general matter, American branches won’t be able to disclaim responsibility for audits conducted by foreign branches when in fact the substantive work was done here. Second, to the extent there are Janus issues with holding the non-signatory American firm liable for a false report, disclosure might either itself count as an endorsement by the American firm of the audit results, or at least give plaintiffs a basis for showing that the American firm had control over the audit report, and therefore should get discovery into whether the American firm was a Janus “speaker.” Finally, disclosure of the American firm’s involvement may provide ammunition for a Section 20(a) claim against the American firm, if Section 10(b) standards can’t be met (at the pleading stage).

That said, I have mixed feelings about the proposal to disclose the name of the engagement partner.

As I discussed in my article, Slouching Towards Monell, there is a great deal of uncertainty regarding the standards for attributing scienter to an entity under Section 10(b). When it comes to issuers, courts tend to focus solely on the scienter of the highest level officers and directors, without regard to whether lower level employees intentionally manipulated the issuer into making false statements. When it comes to secondary actors, however – like auditors – courts are much more likely to conduct a holistic inquiry of the behavior of the firm as a whole. Indeed, in the context of auditor liability – and only auditor liability – the Second Circuit held that organizational intent exists “where a large entity, firm, institution, or corporation is acting in a manner that easily can be foreseen to result in harm.” AUSA Life Ins. Co. v. Ernst & Young, 206 F.3d 202 (2d Cir. 2000).

I think there are a few reasons that courts adhere to the issuer/auditor distinction for scienter purposes (as I talk about in Slouching) but one reason not discussed in that piece is, I think, salience. The audit firm signs the audit report as an entity – not as an individual on the entity’s behalf. That invites courts to inquire into the entity’s overall conduct, and allows plaintiffs to plead scienter by reference to information available to the entity as a whole.  I fear that if audits are pegged to a particular person, courts will start demanding not merely evidence of entity misconduct, but individual partner misconduct – which, at the pleading stage, pre-discovery, is a standard plaintiffs will find very difficult to meet.