The European Union has just published the results of its public consultation on the possible reform of auditor liability rules in the EU. Jane Howard and consider the implications for UK firms.

In January 2007, the EU’s Directorate General for Internal Market and Services launched a public consultation on possible reform of auditor liability rules in the EU. The results of the consultation process have just been announced. Interestingly, only 85 organisations participated in that process, and only one firm of lawyers.

The consultation paper invited views on four possible options for reforming audit liability:

  • a fixed monetary cap at European level
  • a cap based on the size of the audited company
  • a cap based on a multiple of the audit fees
  • the principle of proportionate liability.

The results show that the audit profession unanimously supports an EU initiative. 70% of the audit firms who responded favoured limiting audit liability by means of a cap, agreed by reference to audit fees. 57% favoured proportionality, with 50% supporting a combination of proportionality plus a cap based on audit fees.

The published results of the consultation process reveal (perhaps not altogether unsurprisingly) slight differences of approach between the Big 4 and mid-tier audit firms.

Both the Big 4 and mid-tier firms seem to agree that the introduction of proportionate liability would not be sufficient to avoid the collapse of an audit firm or network. Further, both come out in support of a combination of proportionality and a fixed cap. However, the Big 4 are reported as preferring a cap based on the “characteristics” of the company being audited, whereas mid-tier firms would prefer a cap based on audit fees.

Outside the audit profession, views seemed to vary. Most investors, and banking and securities regulators, were against any kind of EU reform. However, the position of banks and companies was less clear cut. Companies incorporated in the UK considered (in common with RPC) that any action at EU level should not be inconsistent with the new provisions introduced by the Companies Act 2006, and that any limitation on audit liability should be based on the contract between the company and the audit firm, as approved by the majority of shareholders. However, if there are to be EUwide limits on auditors’ liability, it is clear that amongst non-audit organisations, proportionality is the much preferred option (with 61% of the non-audit organisations supporting it). Of those who are against any EU initiative, the majority consider that proportionate liability would be the only acceptable option if the Commission wishes to move forward. Perhaps most significantly, only 18% of those outside the audit profession would support a cap based on audit fees (mid-tier firms’ preferred way forward).

UK implications

What impact might these findings have on the negotiations of the liability limitation agreements permitted by the Companies Act 2006? S534(1) Companies Act 2006 states that:

“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, of which the auditor may be guilty in relation to the company.”

There has been much debate amongst academics, auditors, lawyers and others (including the Institute of Chartered Accountants and the Financial Reporting Council (FRC)) as to the nature of the liability agreements which s534 now permits. In particular, when it was published, there was a concern that the wording of the Company Law Reform Bill allowed auditors to cap their liability, but did not allow the principle of proportionality to be enshrined in audit engagement letters.

When these concerns were expressed to the Government, the response (apparently) was what has become s535(4), which provides that:

“Subject to the preceding provisions of this section, it is immaterial how a liability limitation agreement is framed. In particular, the limit on the amount of the auditor’s liability need not be a sum of money, or a formula, specified in the agreement.”

Certainly, the view amongst the accountancy profession is that it will be open to shareholders to agree to limit liability auditor’s liability by reference to either or both a cap and the principle of proportionality. However, even if this is the case as a matter of legal interpretation of s534, it remains to be seen what provisions (i) audit firms will seek and (ii) shareholders will agree. In other words, what is likely to be the outcome of what the EU has called “the essential choice: cap or proportionality?”

It became clear during the EU consultation process that audit firms perceived that the introduction of proportionality clauses alone would not remove the risk of so-called catastrophic claims. To protect against that eventuality, a fixed cap on liability would be needed.

That being the case, it is conceivable that, in negotiating liability agreements, audit firms will seek to agree terms introducing proportionality, together with a “long-stop” cap on liability to safeguard against catastrophic claims.

The precise detail of the approaches taken may differ depending upon the size of the audit firm concerned, as stated above. Will audit firms seek to agree caps by reference to audit fees or the size of the audit client? According to some recent press reports, firms have already begun to negotiate liability caps with their clients, in some cases, amounting to ten times the audit fee. If the responses to the EU consultation process are anything to go by, most audit clients would prefer proportionality and, amongst those who countenanced the idea of fixed liability at all, caps based on audit fees received less support than those based on the size of the company being audited.

Another issue on which the consultation process invited views was whether proportionate liability should be implemented by means of: 

  • Member States changing their laws to allow courts to award damages only for that portion of loss corresponding to auditor’s degree of fault (in other words, proportionate liability by statute).
  • Member States allowing proportionate liability between the company and its auditors to be negotiated in contractual arrangements (in other words, proportionate liability by contract). It was interesting to note that some of those who responded to the consultation process said that allowing proportionate liability by contract would only be a partial solution. They commented that the cap limitation would probably only be binding on the parties to the contract, leaving the auditor with unlimited liability exposure to claims from third parties. Whether or not this is true is likely to be a matter of some debate in the courts. No doubt the audit firms will want to argue that the limits on their liability should also bind non-clients, it being seemingly unfair for an auditor’s (capped) liability to its client to be less than to its non-client. Hopefully, the risk of claims by third parties has been diminished in any event since the use of Bannerman disclaimers became commonplace.
  • Quite apart from the legal issues which will have to be teased out in due course, it remains to be seen how market practice will develop. The FRC is coming under a degree of pressure to produce guidance and draft standard wording for inclusion in standard audit engagement letters. 

The process by which such wording is produced will be important. Given the FRC represents a range of interested parties (including investors), there are those who say that audit firms and company directors may experience difficulties in securing agreement to limited liability wording which goes beyond that which it recommends as standard practice. Now is the time for lobbying!