The Company Law Reform Bill: Auditors' Liability and Audit Quality

1. Liability Limitation Agreements - what will be fair and reasonable?

The audit profession has been campaigning heavily for the reform of section 310 Companies Act 1985 and the replacement of joint and several liability (which has exposed auditors to 100% of the damages even when only 1% at fault) with "full proportionate liability", and the statutory right to negotiate liability limits with their audit clients; from a commercial perspective, it was also argued that a cap on auditor liability would increase market competition because it would lead to:

• A reduction in barriers to entry and growth facing smaller audit firms
• The maintenance of competition between larger audit firms including non-audit work
• Less risk of collapse of one of the Big Four

In the 1990s the Law Commission and the DTI concluded that it would be inappropriate to consider the introduction of full proportionate liability for auditors in isolation from a comprehensive reform on the law of negligence but the issue of limiting auditors' liability has continued to be hotly debated.

Part 16, chapter 6 of the Bill is therefore a welcome development for the audit profession as it makes it possible for auditors to limit their liability by agreement with a company on an annual basis, but the agreement will not be effective if it is not "fair and reasonable", i.e. any attempt to limit liability must be proportionate to the auditor's fault.

Clause 518(1) states:

"A "liability limitation agreement" is an agreement that purports to limit the amount of a liability owed to a company by its auditor in respect of any negligence, default, breach of duty or breach of trust, occurring in the course of the audit of accounts for a financial year specified in the Agreement, of which the auditor may be guilty in relation to the company."

Clause 519(4) states:

"'The principal terms of an agreement are terms specifying, or relevant to the determination of:

(a) the kind (or kinds) of acts or omissions covered,

(b) the financial year in relation to which acts or omissions are covered, or

(c) the amount to which the auditor's liability is limited"

Whilst the limitation does not specifically introduce a cap, reference to "the amount to which the auditor's liability is limited" may be seen to encourage the setting of a financial cap. That said, according to clause 520 (1), a liability limitation agreement will not be effective to limit an auditor's liability if the limitation would result in the company recovering an amount that was less than "fair and reasonable in all the circumstances having regard to the auditor's responsibilities, the auditor's contractual obligations and the standards expected of an auditor". Therein lies the rub for auditors.

The proposed legislation specifically states that liability limitation agreements are not subject to certain provisions in the Unfair Contract Terms Act (1977) although clause 520(2) states, "a liability limitation agreement that purports to limit the auditor's liability to less than the amount mentioned in sub-section (1) shall have effect as if it limited his liability to that amount"; accordingly, if a Court determines that a liability limitation agreement would limit the auditor's liability to an excessive degree, the agreement will have effect as if it had limited liability to the amount that the Court determines is fair and reasonable; there is, therefore, very considerable scope for uncertainty as to the extent to which the Court will uphold any liability limitation agreement; the Court will examine all the circumstances including the extent of the damage which has been suffered by the company, and the relative culpability of the auditors, with the benefit of hindsight. The negotiation of a liability limitation agreement will, no doubt, become a matter of routine as part of the annual audit engagement but the amount of protection afforded to the auditor will be impossible to predict with certainty; many eyes will be eagerly focussed, assuming the proposed reforms become law, on the first occasion a liability limitation agreement is analysed by the Court.

In summary, although auditors will be able to agree a financial exposure limit with the company to apply to the annual audit, the Courts will have the power to override any such agreement if they consider that it would operate unfairly. Hence, auditors face uncertainty as to whether any such agreement will be enforceable unless and until a claim is pursued and determined by a Court.

Throughout the consultation process the audit profession argued that one of the barriers to competition was the cost and difficulty in obtaining professional indemnity insurance and that hefty premiums were recouped in increased audit fees. The Minister for Industry, Alun Michael, has said he expects to see audit fees reduce following the proposal in the Bill but whether this happens in practice and whether there is any resultant impact on the cost of professional indemnity insurance remains to be seen.

2. Criminal offences in connection with an auditor's report

Throughout the consultation process, the threat of imprisonment loomed in circumstances where an auditor "knowingly or recklessly" causes a report to include anything which is misleading, false or deceptive, or to not include a statement of a problem with the accounts. The audit profession will be relieved to learn that the penalty is now reduced to an unlimited fine rather than a prison sentence.

Concerns continue to be expressed, however, as to the use of the words "knowingly or recklessly", with many fearing it will lead to the audit profession becoming much more risk averse; it was pointed out with considerable force by many firms that an auditor who makes an honest, but misguided, judgement during the course of an audit could face criminal prosecution. Alun Michael feels that there has been some misunderstanding about what was meant by "reckless", and there have been assurances that the test for recklessness will be very high and that honest errors would not result in the auditor in question being penalised; further clarification of this issue as the Bill progresses would doubtless be much welcomed by the audit profession; otherwise, whether honest mistakes are penalised is something that only time will tell.

3. The "senior statutory auditor"

Further provisions to improve transparency and strengthen the quality of audit reports are embodied in clause 480 which provides that regulations may be made in future requiring auditors to publish audit engagement letters including details of the services provided by the auditors and the remuneration received, and clauses 491 and 492 of the Bill which require the "senior statutory auditor" to sign the audit report; this requirement anticipates standards to be issued by the European Commission and will constitute a significant reputational inducement for the individuals concerned to satisfy themselves that the audits to which they publicly put their names are properly conducted. It is insignificant, however, in overall liability terms as the Bill provides (clause 492(3)) that the senior statutory auditor is not exposed to any additional civil liability merely by having signed the audit report.

4. Third party claims

The Government has decided not to codify any statement of the auditors' duty of care, as expressed by the House of Lords in Caparo Industries Plc v. Dickman [1990], but the Bill does, at clause 366, restate the auditors' duty to express an opinion as to whether the accounts give a "true and fair view" of the company's financial position.

Auditors remain reliant, therefore, on the judiciary to determine the circumstances in which damages for economic loss can be recovered by those who allege they have relied on audited accounts to their detriment. There remains concern that the common perception is that a company's auditors and their deep pocketed insurers will be a frequent target for claimants who are prone to inflate their claims in the hope of forcing a settlement based on damage limitation in terms of the size of the claim and protecting the reputation of the auditor in question.

In conclusion, those who have campaigned for many years for reform to the law on auditors' liability will understandably be pleased that change is coming; much thought will be given in the meantime by auditors, their insurers, and their advisors as to the approach to be taken (from both legal and commercial perspectives) to negotiating liability limitation agreements with their audit clients. The ramifications for the audit market will become clear over time; otherwise auditors will have to continue to rely on the Court for protection from unmeritorious claims by third parties who allege that they have relied to their detriment on negligent audit reports.

Further information

For an article summarising the provisions of the Bill as a whole click here. The article contains links to the Bill itself and related materials.

In April 2005 the Companies (Audit, Investigations and Community Enterprise) Act 2004 made various changes to the Companies Act 1985 designed to improve the quality of financial reporting by UK companies and the independence of auditors. For details of the main provisions of this Act and related changes see our article published in December 2003 (when the Act was in draft form), 'The UK'S answer to Sarbanes-Oxley: Proposed changes to accounting and auditing practices in the UK ': click here.

In August 2004 the Office of Fair Trading published a report concluding that allowing auditors to cap their liability would not improve competition in the audit market. For further information see our article published in August 2004, 'Reform of law on auditors' liability: OFT report concludes that cap would not improve competition': click here.

For further information on the liability of auditors for statutory accounts see our article, 'Audit opinion letters to include disclaimer of liability to third parties?' published in January 2003, click here.