Choosing Gatekeepers: The Financial Statement Insurance Alternative to Auditor Liability

Abstract

Positioned in a lively current debate concerning how to design auditor incentives to optimize financial statement auditing, this Article presents the more ambitious financial statement insurance alternative. This breaks from the existing securities regulation framework to draw directly on insurance markets and law. Based on upon an evaluation of major structural and policy-related features of the concept, the assessment prescribes a framework to permit companies, on an experimental-basis and with investor approval, to use financial statement insurance as an optional alternative to the existing model of financial statement auditing backed by auditor liability.

The financial statement insurance concept, pioneered by New York University Accounting Professor Joshua Ronen, promises considerable advantages compared to traditional financial statement auditing. As with any proposal, however, it presents challenges. This Article expands the model first sketched by Dr. Ronen, extending and interpreting it to examine its efficacy, attempting to show how certain limitations can be overcome.

A chief challenge is relating state insurance law, the default applicable to insurance policies including FSI, to federal securities regulation. A general method is to develop for financial statement insurance the functional equivalent of the U.S. Trust Indenture Act of 1939 applicable to contracts governing public debt securities. This would allow substantial freedom of contract in policy terms, governed by state law, while mandating certain specific terms and establishing minimum federal parameters for others. Most other hurdles arising from the interplay between state insurance law and federal securities regulation can be overcome using disclosure, while more uncertain are issues associated with preserving insurer solvency if financial statement insurance is placed at the center of the public-company financial reporting system.

Keywords: gatekeepers, financial statement insurance, auditor liability, accountants' liability, securities regulation, liability insurance, directors' and officers' insurance, D&O insurance, title insurance, corporate governance, financial reporting, outside auditor

JEL Classification: M49, G22, G38