In this edition of our Accountants' Liability Update we look ahead a few months to April 2008 when auditors will be allowed to limit their potential liability to audit clients and we consider the affect of this for auditors, third parties and professional indemnity insurers as well as whether these newly implemented Companies Act provisions will satisfy any future EU proposals. In a bid to promote greater transparency, we highlight that the ICAEW will now be holding most of their disciplinary hearings in public and we also consider the recent Market Participants Group Final Report on Audit Choice. Finally, we look at two recent decisions concerning auditors' liability.
Taking A Gaze At LLAs
As from 6 April 2008 auditors will be allowed to reach "Liability Limitation Agreements" (LLAs) limiting the amount of their liability to their audit clients.
For reasons outlined here this should be of particular interest to those involved in claims against auditors, including their professional indemnity insurers and their co-defendants. As also explained, there may be circumstances where an auditor's liability is in effect unlimited despite that auditor having reached an LLA.
At What Level Might An Auditor's Liability Be Limited?
Auditors and their clients are not restricted in the manner in which liability can be limited so (by way of example) this could be a cap based on a monetary amount or a formula; a limit that is simply stated to be 'fair and reasonable'; or proportionate liability (or a combination of such limits). A limit will be effective so long as it is 'fair and reasonable in all the circumstances of the case' and it has been approved by a shareholders' resolution. However and importantly, if an LLA purports to limit liability to an amount that is less than what is "fair and reasonable", the agreement will still be effective - it will take effect as if it limited the auditor's liability to such an amount.
Helpfully for auditors, when assessing what is a "fair and reasonable" limitation of liability a Court cannot take into account the fact that others who may be responsible for a company's losses (for example directors or other professional advisers) are in financial difficulties or even insolvent.
Currently auditors can be jointly and severally liable. That means auditors can be liable for all recoverable losses regardless of the responsibility of others for such losses. Whilst auditors can seek an indemnity or contribution from others,much depends on the financial standing of the other parties. However, with auditors soon being able to agree proportionate liability, the amount for which auditors might be liable would be limited to take into account the responsibility of any other party, regardless of that party's financial standing.
Auditors And Third Parties
In addition to helping auditors who are sued by their audit clients, LLAs may also assist auditors in relation to claims by third parties, such as investors, banks and directors. Whilst the circumstances in which auditors may be liable to such third parties are reasonably narrow, and will depend on the facts, auditors can and do face such liabilities. If an auditor does owe a duty of care to a third party, the auditor could in the future contend that it's liability should be limited to the amount of its LLA. This follows from the fact that LLAs will have to be disclosed in audited companies' accounts. As such an LLA should have come to the attention of the third party. Although the law is not settled on whether an exclusion clause in a contract can be effective against a third party, it can be reasonably argued that LLAs can further protect an auditor.
Unlimited liability despite LLAs?
There are some situations where, despite LLAs, auditors may still encounter unlimited liability:-
- Since LLAs only apply to single financial years it is possible that a company may have reached LLAs for audit work for some financial years but not for others. As a consequence, claims in relation to some audit years may not be the subject of liability limitations.This could give rise to difficulties for auditors where, for example, an auditor fails to detect fraud over a number of years but only some of the audit years are the subject of LLAs. Liability for losses arising in respect of work for one audit year may be limited, however liability for losses arising in respect of another audit year may not be. Depending on the facts, it may be that all losses can be claimed in respect of the unlimited liability work, negating the effect of any LLA.
- Audit firms often also carry out non-audit work for their audit clients. For example, they may be retained in relation to tax, accounting or management consultancy work. Firms carrying out such non-audit work continue to be entitled to reach agreements limiting liability for that work, so long as any limitation meets the requirement of reasonableness under the Unfair Contract Terms Act 1977. However, if firms do not have such limits, because they have not negotiated limits or because the limits fall foul of UCTA 1977, this could lead to difficulties. For example, an auditor may have an LLA in respect of audit work but if that auditor also previously prepared the accounts, any liability in respect of that accountancy work may be unlimited.This could lead to unlimited liability by the back door.
LLAs - The Way Forward
In the future, professional indemnity insurers may well want to see that accountants proposing for insurance have previously agreed LLAs and are intending to try to agree LLAs, as well as disclaiming liability to third parties for audit work and limiting liability for nonaudit work.
Our view is that auditors should try and reach LLAs since agreements will result in some limit, even if the negotiated agreement is subsequently deemed to have been too low a limit. Sensibly auditors might try and agree an LLA whereby their liability is to be proportionate as well as a fixed or capped limit. In most circumstances it should be considered that proportionate liability is fair and reasonable, with the result that that aspect of the LLA will be retained in any substituted LLA. That in itself would be an improvement from the current position of joint and several liability. In addition, if a fixed or capped limit can be agreed this will provide some ceiling on liability if it is a fair and reasonable amount.
On 17 December 2007 the Financial Reporting Council published, for consultation, draft guidance on LLAs. This can be found at http://www.frc.org.uk. It is intended that such guidance will explain what is and is not allowed; set out some factors relevant to the consideration of whether there might be an LLA; explain what matters should be covered in an LLA and provide specimen clauses; and explain the process for obtaining shareholder approval. Consultation is to run until 14 March 2008 with the intention being that guidance will then be published in the first half of 2008.
Reform Of Auditors' Liability In Europe
At our Auditors' Liability seminar last year, we highlighted the possibility that provisions contained in the Companies Act 2006 which allow companies to limit the liability of their auditors could be made redundant following a public consultation launched by the European Commission. The consultation in question dealt with "harmonisation" and the possible need to reform the laws relating to auditors' liability in the 27 EU States.
More recently, following the results of the consultation at the end of last year, Charlie McCreevy, the European Commissioner for Internal Market and Services, has stated that he intends to put forward a Recommendation, in the first quarter of 2008, to Member States asking them to limit auditor liability. Mr McCreevy went on to confirm that there would be no specific implementation guidelines by which liability is limited as this will be for each Member State to decide. He has said that existing solutions such as a liability cap, proportionate liability or a contractual arrangement between the auditor and the audited firm would all seem adequate means to deal with this issue but that liability would not be limited in cases involving wilful misconduct by auditors.
Aside from whether terms of art such as "wilful misconduct" will be an issue in implementation for the various Member States, it appears those States which presently allow for some form of limitation for auditors (or mandatory caps in some States) will not be required to change existing law. Since the Companies Act 2006 allows individual companies to negotiate agreements with their auditors to limit liability subject to shareholder approval, but does not specify whether such an agreement must be a fixed amount (or how this would be calculated) or on a proportionate basis, it therefore appears that the newly implemented Companies Act provisions will satisfy any future EU proposals.
ICAEW To Hold Disciplinary Hearings In Public
As part of a commitment to greater transparency, the Institute of Chartered Accountants of England & Wales ("ICAEW") is to hold most disciplinary hearings in public with effect from 1 January 2008. The chair of the tribunal will have the power to exclude the media and the public from all or part of any particular hearing. The first public case was heard last month.
The Association of Chartered Certified Accounts (ACCA) has been able to hold disciplinary hearings in public since at least 1996 and since 2001 all of ACCA's hearings must be held in public unless there are issues of moral, public order or national security, a private hearing is necessary to protect juveniles or the private life of individuals or publicity would prejudice the interests of natural justice. The Institute of Chartered Accountants in Ireland has also been in the forefront, as it first held a public disciplinary hearing in 1999. The Chartered Institute of Public Finance and Accountancy ("CIPFA") followed with its first public hearing in August 2001 and The Chartered Institute of Management Accountants ("CIMA") followed in February 2003.
This leaves the Institute of Chartered Accountants of Scotland ("ICAS"), the world's first professional body of accountants, as the only member of the Consultancy Committee of Accountancy Bodies which holds proceedings in private. ICAS has said that until it has the power to compel attendance from witnesses who are not ICAS members, it will not hold hearings in public for fear that witnesses would not attend.
Market Participants Group Final Report On Audit Choice Published
The Market Participants Group ("The Group") was established in October 2006 to provide advice to the Financial Reporting Council ("FRC") on possible actions that companies, investors and audit firms could take to mitigate the risks arising from the market for audit services to public interest entities in the UK.
In April 2007 The Group's interim report and provisional recommendations for consultation were published. Since that report The Group has consulted and deliberated over the 15 provisional recommendations which it had suggested in order to enhance the efficiency of the audit market and in doing so to mitigate risks associated with a firm, and particularly one of the "Big-Four" firms, leaving the market
On 16 October 2007 the FRC published its final report which included its final recommendations which are aimed at:
- Increasing the feasibility of investment in the supply of audit services to public interest entities by existing non Big-Four firms or new firms;
- Reducing the perceived risks to directors of selecting a non Big- Four firm;
- Improving the accountability of boards for their auditor selection decisions;
- Improving choice from within the Big-Four;
- Reducing the risk of firms leaving the market without good reason;
- Reducing uncertainty and disruption costs in the event of a firm leaving the market.
The Group's final 15 recommendations can be found at http://www.frc.org.uk/press/pub1420.html
MAN Nutzfahrzeuge AG -v Freightliner Limited 
The decision in MAN Nutzfahrzeuge AG -v Freightliner Limited  EWCA Civ 910 was the first ruling by the Court of Appeal upon auditors' liabilities for some years, and it serves as a useful reminder of the judicial stance and the principles governing this area of law as well as providing some comfort to auditors.
MAN Nutzfahrzeuge AG ("MAN") acquired ERF (a truck manufacturer) in early 2000 via a share purchase agreement from Western Star Truck Holdings Ltd ("Western Star"), who had in turn been acquired by Freightliner Limited ("Freightliner"), which took on its liabilities. It subsequently became clear that, since approximately the middle of 1997, ERF's accounts had been manipulated by its financial controller, and ERF's true financial position had been fraudulently concealed.
MAN brought proceedings against Freightliner to recover damages and claimed that there had been (a) a fraudulent misrepresentation by Western Star in respect of the warranties and representations given and (b) deceit, following the representations made by the financial controller.
First Instance Decision
The Court determined that MAN had been induced to enter the agreement to purchase ERF by the fraudulent statements made by the financial controller on behalf of Western Star.
Freightliner issued Part 20 proceedings against ERF's UK based accountants, Ernst & Young ("E&Y"), contending that E&Y had been negligent in the audit of ERF's accounts and in carrying out the due diligence exercise. It was further contended that, but for E&Y's negligence, the manipulation of the accounts by the financial controller would have been detected and the sale would not have proceeded. The Part 20 claims were rejected by the Court at first instance. The Court held that E&Y did not owe Western Star/Freightliner a duty of care to protect it from a loss of the kind it was seeking to recover. Freightliner appealed.
Court of Appeal
The issue considered by the Court of Appeal was whether E&Y had a special audit duty to Western Star in respect of the representations made by the financial controller when he met with MAN as to the accuracy of ERF accounts.
Giving Judgment, Chadwick LJ held that E&Y did not owe a special duty, for two main reasons:
- there was no basis to challenge the lower Court's finding that it was not foreseeable by E&Y that Western Star (and the financial controller on behalf of Western Star) would make any representations as to the accuracy of ERF's accounts that went beyond representations contained in the share purchase agreement. In short, there was no reason for E&Y to conclude that Western Star would allow a position to arise in which it was exposed to liability for representation made by the financial controller; and
- that even if it had been foreseeable, an additional element was still necessary. It was impossible to hold that E&Y assumed responsibility for the use of the information by Western Star which E&Y had provided. Chadwick LJ stated "to hold that the auditors assumed responsibility for the use which a dishonest employee of the audited company might make of the accounts in the context of the parent company's negotiations for the sale of the company would, I think, be to impose on them a liability greater than they could reasonably have thought they were undertaking".
In reaching this decision, it seems that, in the Court of Appeal's view, the key question is no longer whether, in addition to knowing that the recipient would rely, the auditor had to have intended such reliance. Earlier cases left the position on the question of whether intention had to be shown unclear. In several cases intention had been rejected as a requirement. The decision appears to confirm that there must be some indication from the auditor to the recipient that the auditor's statement can be relied upon by the recipient for its particular purpose. Therefore, any auditors wishing to reduce their possible exposure to a third party should be careful not to give such indication to a third party. Such disclaimers of responsibility to third parties have been used by auditors, particularly since the decision in Royal Bank of Scotland -v- Bannerman Johnstone MacLay . The decision may, however, leave auditors open to risk in a situation where accounts are provided to a parent company when it is known that the parent company is intending to rely on the accuracy of the accounts in the pursuance of a third party sale which is then made and in respect of which the parent company is likely to provide warranties and make representations as to the accuracy of the accounts. In such circumstances auditors would be advised to expressly disclaim responsibility to any third party.
STOP PRESS: The House of Lords has rejected an application by Freightliner for permission to appeal the decision of the Court of Appeal.
Stone and Rolls Ltd (In Liquidation) v Moore Stephens 
In Stone and Rolls Ltd (In Liquidation) v Moore Stephens  EWHC 1826 the defendant auditors failed, at least for now, in their attempt to strike out the claim against them by relying on the ex turpi causa maxim, a legal principle which prevents a claim being pursued when it arises from a claimant's own illegal, or immoral, acts.
Stone & Rolls Ltd ("S & R") and Mr S, the individual who owned, controlled and managed S & R, engaged in a series of fraudulent transactions in respect of letters of credit through which they managed to defraud the lending bank of US$90m. Most of this was passed on immediately to third parties who were in on the fraud. At an earlier trial, S & R and Mr S had been found liable for fraud to the bank.
As a result S & R went into liquidation and could not meet the judgment against it. The liquidator then brought the claim against Moore Stephens, alleging that if it had not negligently audited S & R between 1996 and 1998, the fraud would have come to light and S & R would not now be liable to the banks to repay the monies that had been fraudulently obtained and then dissipated.
However, because S & R had only dissipated monies to which it was never entitled in the first place, it had arguably suffered no real loss; the claim was really about the indirect recovery by the bank of any money that S & R manages to recover from its former auditors. The total amount claimed was US$173.6m.
The Court had to decide the following important questions:
" Was Mr S's knowledge of the fraud to be attributed to S & R (i.e. should the two be treated as one and the same because Mr S was the controlling mind and owner of S & R).
" Should the ex turpi causa maxim apply in this case to prevent S & R claiming against the auditors when that claim was founded on their own fraudulent actions.
"Attribution of knowledge"
On the first point, the High Court Judge found that, although as a general principle where an officer or employee of a company is committing a fraud upon the company itself then the knowledge of his own fraud is not the knowledge of the company, in the circumstances of this case, S & R would be attributed with Mr S's knowledge. That finding turned on the nature of the close relationship between S & R and Mr S; this meant that S & R was in a real sense also a perpetrator of the fraud, rather than the primary, or even the secondary, victim of it.
The Judge found that it would be "artificial": a) not to fix S & R with the knowledge of Mr S's wrongdoing and b) to describe S & R even as a secondary victim of the fraud.
Does ex turpi causa apply?
The law of ex turpi causa is relatively undeveloped, despite some very old authorities that the Judge admitted he had struggled to reconcile. The Judge made a number of points in reaching his conclusion as to whether ex turpi causa could be relied on to prevent the claim being brought by S & R.
- The Judge held that ex turpi causa could, in theory, apply to a company as well as an individual.
- The claim to which the ex turpi causa maxim is to be applied, must satisfy the "reliance test", that is to say the claim must be "founded on" or "arise from" an illegal act by the claimant.
- The Judge confirmed that auditors owed no duty to prevent fraud; that was the duty of the company itself. However, by applying the "conscience of the ordinary citizen" test, he concluded that there was nothing so repugnant in S & R pursuing the claim such as would justify applying the ex turpi causa maxim to bar the claim altogether.
- In reaching the conclusion above, the Judge relied on the fact that the "very duty" for which the auditors were employed, although not as wide as a duty to detect fraud, did encompass a duty to conduct the audit in a manner which would have brought the fraud to light, and therefore led to its prevention, if the audit had not been negligently performed (as was assumed for the purposes of the strike out application only).
Therefore, the Judge found that the ex turpi causa maxim could not be used to bar the progress of the liquidator's claim. The Judge did, however, comment that it could have been used to prevent a similar claim by Mr S.
As it currently stands the decision is clearly unhelpful for auditors (and their insurers), since it shows that companies engaged in fraud may not be prevented from pursuing recovery actions against auditors arising from such companies' own fraudulent actions. The decision of the Judge was influenced by his desire to reach an overall "fair" conclusion and be specificially refered to deriving comfort from the fact that the recovery (if any) by S & R could be reduced at trial by way of contributory negligence to reflect its responsibility for the loss, rather than barring the pursuit of the claim altogether.
We understand that an appeal is now being pursued and the hearing is set for 10 March 2008. It will be interesting to see how the Court of Appeal deals with the issue.
As an aside, the Court did strike out a large claim (US$81m) for compound interest claimed as special damages, confirming the general rule that such interest is not recoverable.
The case has also given rise to general concerns amongst accountants since it is an early example of a case funded not by the claimant, but by an unrelated, commercial third party funder. The advent of third party funding increases the likelihood of claims being made against accountants and other professionals.
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.