Liability Limitation Agreements (LLAs) were introduced under the Companies Act 2006 to address concerns that the audit market could be seriously damaged by the collapse of one of the remaining large international audit firms. Unfortunately, the requirement for shareholder approval appears to have caused a degree of paralysis, as firms wait to see what their competitors are doing.
Ambiguity in the 2006 Act has not helped the situation, as it has been left to the courts to determine whether or not agreed limitations will be enforceable, thus adding to the uncertainty. In this article Jane Howard and Ross Goodrich consider some of the issues which have led to the current state of affairs and offer some thoughts on possible solutions.
The Companies Act 2006 provides that companies may enter into LLAs to limit an auditor’s liability to it for negligence, default or breach of duty or trust in relation to the audit of the company’s accounts. LLAs will only be effective to limit an auditor’s liability to such an amount as is “fair and reasonable in all circumstances of the case”. It is immaterial how an LLA is framed. In particular, the limit on the amount of an auditor’s liability need not be a sum of money or a formula specified in the agreement. This provision has ostensibly opened the way for methods of liability limitation beyond mere proportionality. This goes beyond what was originally intended and has created uncertainty as to what may, in a given case, be deemed to be “fair and reasonable in all the circumstances”.
The Financial Reporting Council (FRC) final guidance on LLAs, which was published on 30 June 2008, sought to clarify matters. The guidance outlined the principal changes brought about by the 2006 Act and noted that in theory, contractual limits could be set in a number of different ways:
(a) a proportionate liability approach, where the auditor’s liability is limited to the extent that the auditor was responsible for the loss
(b) by reference to the “fair and reasonable” test
(c) a cap on liability expressed as a monetary amount or by an agreed formula, and
(d) a combination of some or all of the above.
The guidance made clear that the institutional investors canvassed would only accept LLAs which sought to limit liability “proportionately”, with the “fair and reasonable” and “capping” approaches only to be considered in exceptional circumstances. Furthermore, other entities have expressed misgivings at any form of liability limitation. In its submission to the FRC on 14 March 2008, the International Corporate Governance Network noted that it found difficulty in supporting either a proportionality and/or a “fair and reasonable” limitation when there were a number of questions outstanding regarding the legal meaning and practical interpretation and implementation of these terms. It is this latter point more than anything else that has created the current uncertainty and with anecdotal evidence suggesting that many firms are understandably adopting a “wait and see” approach rather than taking the plunge, it is difficult to determine what the future holds for LLAs.
This state of affairs is unfortunate for the profession as a whole, since LLAs can offer firms real benefits in what is likely to become an increasingly litigious environment. Whilst limitations on liability have become widely accepted in relation to nonstatutory audit work, the Achilles heel of the 2006 Act is arguably the requirement that LLAs be approved by the company. Directors may fear that they would be acting in breach of duty in recommending LLAs to shareholders. However, there are a number of good arguments that can be raised to justify LLAs, at the very least on a proportionality basis, and there is nothing stopping auditors from using them in their dialogue with clients. Some suggested arguments that might help counter concerns include:
- The advent of LLAs has come about after years of extensive consultation with the auditing profession, the investment community and other interested parties; LLAs are the result of a long and reasoned debate
- It is in the interests of the business community to reduce the prospect of major accounting firms being forced to leave the market as a result of a catastrophic claim. If this were to occur, the choice in the market would be more limited.
- Depending upon the circumstances, the widespread adoption of LLAs across the board (in due course) may well benefit the company as the auditor could be more likely to have the ability to pay out on more than one claim (should there be an unfortunate series of claims at any one time)
- In the event of a catastrophic claim (which could well exceed an auditor’s available resources) the company would be unlikely to recover the entirety of its losses from that tne source in any event
- Limitations on liability are well established and accepted in other areas of work undertaken by the larger accountancy firms, for example, in due diligence and tax work
- Similarly, other suppliers of services will often seek to limit their liability as part of their contractual arrangements
- Proportionate liability is fair and just. Absent such a regime, auditors face the prospect of potentially having to meet 100% of a loss in circumstances where their conduct was but one (possibly a minor) contributory factor
- A proportionality approach could use wording approved by the FRC (following extensive consultation with all sections of the business community). A number of leading industry groups have already publicly indicated that their members may well support the introduction of proportionate liability in the majority of circumstances
- Under the 2006 Act, auditors are only able to limit their liability to the extent that any limitations are “fair and reasonable” in the particular circumstances. If they are not, a company would have the ability to ask the court to vary the agreement so as to achieve “a fair and reasonable” result in the event that claims were to be made
- Given that LLAs have to be re-approved annually for each audit, they could actually have a positive effect on dialogue and provide a natural basis for discussing audit quality and satisfaction issues annually
- In certain instances, it may be arguable that an LLA is an essential element of the arrangements under which the company is able to secure the appointment of auditors who the company believes are particularly well suited to audit a company’s affairs by virtue of, for example, specialist industry expertise, geographic coverage and knowledge of a business.
There are clearly a number of good reasons for audit firms to seek to enter into LLAs. If firms are awaiting further guidance/clarification from the FRC, they may have a while to wait as the FRC has already indicated that it does not expect to review the impact and content of its June 2008 guidance until the second half of 2010. We also know that under s535 of the 2006 Act, the government has reserved the right to legislate, by means of statutory instrument, with a view to preventing adverse effects on competition. However, the government has indicated that it does not intend to make such regulations immediately. Therefore, if individual firms and the audit profession generally are to benefit from LLAs they may need to give serious consideration to taking the plunge. The key question is when - any takers?