UK: Limiting Auditors´ Liability: The Sky Is No Longer The Limit

Last Updated: 16 April 2008
Article by Frances Brown, Natasha Lewis and Iain Redford

Firms of auditors around the country will be breathing a huge sigh of relief next month. From 6 April, under new rules introduced by the Companies Act 2006 ("Act"), auditors will be able to limit their liability for negligence, default, breach of duty or breach of trust, in relation to audit work carried out for their corporate clients. Whilst this is undoubtedly a policy decision on behalf of the Government, following intense lobbying by the accountancy profession, the outcome is a sensible one as the collapse of another major accountancy firm would have dire consequences for the financial services industry.

Conditions

Not surprisingly, auditors will need to jump through certain 'hoops' to ensure that their liability is limited. These are:

  • An agreement (snappily entitled a 'Liability Limitation Agreement') will be required between the auditor and the company in respect of each year's audit. Practically speaking this is unlikely to be too onerous as it could be part of the engagement letter;
  • In addition, in the case of public companies, the 'Liability Limitation Agreement' must be approved by the shareholders at a general meeting - no doubt the requisite resolution will become another AGM standing item. Shareholders in private companies may resolve to waive the requirement for approval; and
  • The 'Liability Limitation Agreement' may only limit the auditor's liability to an amount that is "fair and reasonable in all the circumstances" having regard to the auditor's responsibilities, the nature and purpose of the auditor's contractual obligations to its client and the professional standards expected of an auditor.

A working group of the Financial Reporting Council ("FRC"), the independent regulator responsible for promoting confidence in corporate reporting and governance, is currently developing guidance on the process of shareholder approval and a guide to the "principal terms" to be included in such agreements. The draft guidance can be viewed at www.frc.org.uk/about/auditorliability.cfm and has been under public consultation until 14 March. This intervention by the FRC is welcome as the Act only provides a general indication as to the principal terms of such agreements.

What is fair and reasonable?

This is the six million dollar question and those seeking certainty in the short term are likely to be disappointed. The Act does not provide an easy answer (see below) and the FRC makes it clear in its guidance that it will not define the parameters of a "fair and reasonable" limit. Instead, the FRC has confirmed that the issue of whether a limitation is fair and reasonable is to be assessed on a case by case basis and that, in any event, the ultimate decision will lie with the courts. Some auditors may be less than enamoured by this - the reason being that if the Court considers that the contractual limit was less than what is "fair and reasonable", the Court can substitute a higher limit. This applies even if the limit has been approved by shareholders. Admittedly, it will be a brave judge who chooses to do this but it could happen so where does one start in assessing what will be 'fair and reasonable'?

Looking back, the Government's original intention was to allow auditors to limit their liability by means of proportionality, meaning that the auditor would be liable only for the portion of the loss relating to the auditor's degree of responsibility for the loss suffered by the company. The Act, however, has been drafted to allow greater flexibility and it will be open for auditors to seek to limit their liability in other ways, such as:

  • by a fixed cap (which would be a fixed monetary figure based on the size of the audited company, or a cap calculated in accordance with an agreed method such as a multiple of the audit fees charged by the auditor to the company);
  • solely by reference to the "fair and reasonable test";
  • or a combination of a fixed cap and proportionate liability.

The reality, however, is that proportionality is likely to be key in determining market practice. It is safe to assume that most firms will wish to seek a cap where they can and in assessing whether that cap represents a "fair and reasonable" limit a Court is likely to consider whether it is an amount that reflects the auditor's proportion of responsibility for the loss suffered.

Furthermore, the NAPF (National Association of Pension Funds) published its new corporate governance policy and voting guidelines in November 2007 and suggested that 'proportionate liability' should be voted for unless there are compelling reasons for not using this approach.

Final thoughts

Clearly it will be some time before market practice develops and, in the meantime, pragmatism and common sense will hopefully prevail on the part of the auditors endeavouring to limit their liability - after all they will not wish to risk a judicial challenge. No doubt the providers of auditor's professional indemnity insurance policies will also take a keen interest. What is certain is that auditors will (sensibly) wish to take advantage of the new rules as quickly as possible and corporates can expect a flurry of engagement letters to arrive after the Easter break with new limitation provisions. CFOs and finance directors of quoted companies will be able, to a certain extent, to rely on the investor community in ensuring the scope of limitations is sensible. In the case of private companies, however, directors will have to, at least initially, make their own assessments and it may well be prudent to seek further guidance including legal advice.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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