We are now litigating against a large accounting firm, and wondering if a similar phenomenon -- structuring a business for reasons other than business success -- is at work. The accounting industry has been subjected to increasingly stringent regulatory standards, evolving out of Enron and other debacles. Yet the evidence suggests that the quasi-franchise structure the Big Four and other global accounting firms have adopted can make it quite difficult to assert and maintain effective controls over far-flung accounting practices around the world.

The global accounting firms are not structured as traditional corporations, with absolute lines of control and authority running to the top of the organization. Rather, they are generally membership organizations, where the country firms delegate certain governance powers to a central authority, in return for the right to practice under a global brand. The central authority taxes the member firms for its costs, uses partners coming up through the country firm ranks to staff its global positions, and maintains the ultimate power to eject a member firm for failure to maintain professional standards.

Such a structure implies that the authority of the governing entity is not nearly as absolute as in a traditional corporation. For example, the global chief executive cannot fire a subordinate country head at will. That power rests with the country practice. Although a country practice risks ejection if it resists the central authority, that can be an unwieldy sanction, much like an atomic bomb no one wants to drop. From a central governance point of view, the result can feel much like trying to drive a car from the back seat. You can eventually get there by threatening to sack the driver, but can easily crash along the way before the message gets through. 

Why suffer such an unwieldy governance structure, when the reputation and legal risks to the entire organization of missteps can be so high, as Arthur Andersen made clear? We do not know the answer, but from our perch as litigators, it appears that liability control has something to do with it.

The major accounting firms are global enterprises with multi-billion dollar revenues. They are global brands, and their "seals of approval" on financial statements make them juicy litigation targets when things go wrong. As our legal rules now stand, were they to structure themselves as integrated firms, without "fire walls" protecting country practices from each others' liabilities, they might well be rolling the dice with each Fortune 500 audit opinion they sign.

Our legal system has developed extensive rules on what does and does not constitute a securities fraud or an improper business practice. But once wrongdoing is found, the courts can be cavalier in their assessments of how much guilty parties should pay. They are particularly concerned about getting the initial determination of guilt right. Thereafter, the courts have been perfectly happy to let the guilty shoulder the entire burden of compensating the injured for whatever damages can be proven.

An improper accounting opinion or other improprieties in the audit can cause sizeable investor-trading losses eclipsing the fees earned from the improper audit. The current legal regime could expose the entire balance sheet of an integrated global accounting firm to bankrupting damages resulting from the failure of one large multi-national company.

An international firm's balkanized structure may limit such catastrophic risks, but can result in sub-standard performance. Our current system of broad damages assessments does not necessarily get us the results we want -- higher quality audits. To fix the problem, sensible limits on the damages (including punitive damages) chargeable to an accounting firm from an improper opinion would have to be put in place, geared to the revenues earned from the engagement. Such limits could well yield stronger audit performance by fostering more effective governance structures.

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CHARLES J. HECHT and MITCHELL BERNS practice law with Hecht & Associates, P.C. in New York.  Mr. Berns is a former director of the Office of Supervision of the Federal Housing Finance Board.  Prior to entering private practice, Mr. Hecht was with the Division of Corporate Finance of the Securities and Exchange Commission.