Investors' Recovery Friction and Auditor Liability Rules

Abstract

This paper examines investor welfare under two different liability regimes for holding auditors liable for investor losses, the due care and the strict liability regimes. In both regimes, the investor pays the expected legal liability cost to the auditor, and a portion of any subsequent damages awarded by the court is retained by the lawyer as a contingent fee, which is called the recovery friction. This study finds that the presence of the recovery friction leads to second-best efforts by the auditor and the manager. Investor welfare in the due care regime is higher than in the strict liability regime because the expected litigation cost for the investor is lower. Investor welfare is higher in the due care regime than in the strict liability regime even when audit effort in the due care regime is lower than audit effort in the strict liability regime.