Dec. 12 (Bloomberg) -- The biggest U.S. accounting firms, including Ernst & Young LLP and KPMG LLP, have been pressing Congress for more than a decade to protect them from liability lawsuits. Now they're taking matters into their own hands, drawing fire from government regulators and investors.

The firms are shielding themselves from financial damages over corporate scandals by requiring companies they audit to limit their right to sue. These waivers of punitive damages and jury-trial rights are tucked into audit contracts, often unnoticed by investors and corporate boards.

Five federal banking agencies say the provisions may lead to less rigorous audits, and are preparing to bar large banks from agreeing to them. Shareholders, including public-employee pension funds in Ohio and Florida, say the agreements may presage a push by the firms to curb investors' right to sue.

``If there are liability caps on corporations, why shouldn't there be liability caps on shareholders?'' says Lynn Turner, former chief accountant for the U.S. Securities and Exchange Commission. ``That will be next.''

Turner is also former chairman of the audit committee at Sun Microsystems Inc., which in September became the first company to disclose that its audit contract -- with Ernst & Young, the second biggest U.S. accounting firm -- requires it to submit disputes to arbitration and give up its right to punitive damages.

Deloitte & Touche LLP, the largest U.S. firm, PricewaterhouseCoopers LLP and KPMG have varying liability limits in their audit contracts. ``Since they couldn't win the litigation reform they wanted, they've been putting these in engagement letters,'' says Arthur Bowman, whose Atlanta-based newsletter, Bowman FirstAlert, chronicles the accounting industry.

Shareholder Suits

The contract waivers also apply to trustees who take over a company in bankruptcy, and to derivative suits filed by shareholders, says Herbert Milstein, a securities lawyer at Cohen, Milstein, Hausfeld & Toll in Washington.

Client suits against auditors have become more frequent in the wake of the corporate scandals at Enron Corp., WorldCom Inc. and other companies. New York-based Cendant Corp. and Birmingham, Alabama-based HealthSouth Corp. have sued Ernst & Young, for example, in connection with accounting missteps.

While Ernst & Young says the liability waiver is a standard part of its engagement contracts, the extent of the practice is unknown because the agreements are confidential.

``It is important to note that these clauses do not in any way relate to an investor's ability to seek damages,'' says Ernst & Young spokesman Ken Kerrigan.

`Applicable Rules'

``We believe our engagement letters comply with applicable rules,'' says Steven Silber, a spokesman for Pricewaterhouse. Tom Fitzgerald, a spokesman for KPMG, and Deborah Harrington, a spokeswoman for Deloitte, declined to comment.

While Congress gave accounting firms some protection in a 1995 law that scaled back securities lawsuits, the 2002 Sarbanes- Oxley corporate-governance law ``increased a little bit'' the potential for holding an audit firm liable, says Milstein. ``Once more, the auditing firms are more concerned,'' he says.

A large verdict could put a firm out of business and disrupt the capital markets, industry executives say, because only four major firms remain since the 2002 collapse of Arthur Andersen LLP in the wake of the Enron scandal. Bowman says 80 percent of all publicly traded U.S. companies use one of the four firms, all of which are based in New York.

In a Dec. 1 speech in Washington, Ernst & Young Chief Executive James Turley called on the government to protect the firms from the type of ``litigation risk'' that could destroy them.

`Catastrophic Risk'

``We in the profession understand and accept that there are legal liability risks inherent in the public accounting business,'' Turley said. ``It goes with the territory. This is a debate about uninsurable, catastrophic risk -- in a word, sustainability.''

The prohibition on allowing banks to agree to waivers is being prepared by the Federal Financial Institutions Examination Council, which is made up of the Federal Reserve Board, the Federal Deposit Insurance Corp., the National Credit Union Administration, the Office of the Comptroller of the Currency and the Office of Thrift Supervision.

The four accounting firms and their Washington-based trade association, the American Institute of Certified Public Accountants, filed letters in June opposing the banking regulators' proposal as unnecessary regulation. The trade group's letter predicted higher auditing costs for financial institutions and ``fewer audit firms willing to provide such audit services'' if the rule is approved. The final rules are likely to be announced early next year.

Complaining to Regulators

Investors such as the AFL-CIO and the Council of Institutional Investors, a Washington-based association of pension funds, have complained about the waivers to the Securities and Exchange Commission and the Public Company Accounting Oversight Board, the five-member group that regulates the accounting profession. At issue is whether the waivers violate SEC rules designed to prevent auditors from being too close to their clients.

``These provisions are in the self-interest of the accounting industry, but they are very much not in the interest of shareholders,'' says Michael Garland, a New York-based investment official at the AFL-CIO, the nation's largest labor organization.

``They are in conflict with the spirit, if not the letter, of existing auditor-independence regulation,'' says Garland, whose office works with union-sponsored investment plans that manage $400 billion in assets.

Auditor Independence

The SEC's auditor-independence rules, which prohibit companies from indemnifying their auditors in civil suits, don't address waivers in auditing contracts. Spokesmen for the commission and the accounting regulator say they are studying the issue.

The accounting firms aren't backing down. Their trade association issued a draft opinion in September endorsing punitive-damage waivers and mediation requirements. The group requires its members to follow the guidance in its opinions unless they are subject to other regulations with tougher standards. The accounting trade group hopes to offer final guidance in January, says Lisa Snyder, director of its professional ethics division.

Cynthia Richson, corporate governance officer of the $68 billion Ohio Public Employees Retirement System in Columbus, says the fund withheld its vote to approve Ernst & Young as Sun Microsystems auditor after learning of the waiver in the contract. The possibility of a lawsuit plays an important role in ensuring high-quality audits, she says.

`Checks and Balances'

``In a critical system of checks and balances, you're taking away one of the most significant checks, and you're doing it quietly,'' Richson says of the waivers.

The Florida State Board of Administration, which invests more than $130 billion, also withheld its vote on Ernst & Young's appointment, says Mike McCauley, the Tallahassee-based board's director of investment services and communications. The waivers are ``a significant issue, and we're going to monitor it going forward,'' he says.

To contact the reporter on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net.

Last Updated: December 12, 2005 00:18 EST