Solving The Problem of Unlimited Auditors Liability
23 April 2007 Talia Zubli
Talia Zubli of DLA Piper explains the dangers associated with litigation in the accountancy profession.
The collapse of Arthur Anderson in 2002 in the wake of the Enron scandal demonstrated the enormous impact that litigation can have on global accountancy practices. The spectacle of this collapse has given rise to the concern that, if repeated, the 'big four' could become the 'big three', leading to a practical reduction in choice to a point where finding an independent adviser might become effectively impossible.
This has been compounded by a concern that mid-tier firms in many instances may not be able to be effective substitutes for a 'big four' practice, especially where, for example, international reach or specialist technical experience is required.
It is therefore no surprise that the last few years have seen increased support for greater protection for auditors from catastrophic litigation in a market where major audit firms risk being treated as 'deep pockets' and a reliable place to turn for compensation when a company hits trouble. Experience shows that there is often an expectation on the part of investors that they will be compensated by the company's audit firm because liability is joint and several as between a company and its auditors.
International businesses are already struggling with the limited choice of firms available for audit and other advisory work, not only as a result of the demise of Arthur Anderson but also as a result of a number of mergers of medium sized audit firms.
In addition, the extra-territorial reach of US Sarbanes-Oxley regulations, which commonly now preclude auditors of the largest international corporations from supplying non-audit services such as expert witness support to their audit clients and vice versa, means that the number of conflicts and potential conflicts are ever-increasing.
In an attempt to deal with these issues and in order to try to allow the 'big four' to survive cataclysmic litigation, the UK Companies Act 2006 has granted auditors the ability to limit their liability to clients. Concern about the same issues has led to the European Commission publishing a working paper (entitled Consultation on Auditors' Liability and its impact on the European Capital Markets) in order to consult on the limitation of auditors' liability.
The working paper makes it clear that it is not an issue of if but when and what type of auditors' limitation of liability will be introduced on a Europe-wide basis, despite objections from investor groups, which have always been opposed to the introduction of such limitation of liability, perceiving it as likely to lead to reduced diligence in the conduct of audits.
This is reflected in recent comments from one of the UK's largest institutional shareholders that unlimited auditor liability was 'a reasonable proposition in an increasingly litigious world'.
Investors also perceive a serious risk to quality and confidence in the audit where there is a limit to liability. However, accountancy practices are entitled to limit their liability in respect of non-audit work so the concept of limitation of liability is not a foreign one to many of their clients, who would presumably be astute to point out any perceived consequence of a diminution in the quality of service provided.
THE COMPANIES ACT
The solution in the companies act is probably the best compromise between investor and auditor concerns. The act allows auditors to negotiate a contractual proportionate limit of liability with their clients in order to limit their liability to the damage suffered by the claimant. This means that auditors are responsible for their errors but not for the failings of others.
The problem with joint and several liability is that statutory auditors could be fully liable for the misconduct of a company, in particular if that company becomes insolvent, irrespective of the auditors' degree of involvement or fault.
Other European Member States that have taken matters into their own hands are Germany, Austria, Belgium, Greece and Slovenia, which all limit liability to a monetary cap. The UK government is against deals that set an arbitrary monetary cap on liabilities and the Act has in been drafted in such a way as to prevent this.
EUROPEAN COMMISSION SUGGESTIONS
The European Commission sees unlimited liability as a barrier to the international audit market and since liability regimes vary considerably between member states, there may be a danger of 'forum shopping' as a result. The European Commission is suggesting four different options for auditors' limitation of liability.
The first is a single monetary cap at EU level. Monetary caps in Austria, Belgium and Germany were developed purely for domestic cases in order to improve access to insurance cover and differ from each other considerably. A Europe-wide cap would mean harmonising the liability regimes, and finding the appropriate level would be very challenging.
There are also the obvious difficulties in a 'one-size-fits-all' approach for all 27 Member States, where there are such differing levels of economic development, and account will need to be taken of new entrants such as Romania and Bulgaria. A Europe-wide cap would also have to work for all audit bands including mid-tier audit firms, which might be disadvantaged if a high cap was set.
The second option is a monetary cap depending on the company's size. This would be a transparent approach and would take into account that statutory audit liability risk is higher in certain industries and differs for small listed companies compared to larger or 'blue-chip' companies. However, a mid-tier audit firm might still have difficulty covering the collapse of a large company.
A third option is a cap based on a multiple of audit fees charged. Again, this is a transparent option and would bring to the forefront the risk and reward calculation on the part of the auditors. This would certainly be an effective protection against catastrophic claims.
The final option is proportionate liability. The European Commission envisages that proportionate liability could be implemented in one of two ways – allowing courts to award damages corresponding with the auditor's degree of fault, or allowing proportionate solutions to be negotiated between the company and its auditors and enshrined in contractual arrangements.
In such a situation, where the amount agreed is not in accordance with what is considered to be fair and reasonable, the national court would be able to set the fair amount. Comments on the proposals are to be provided to the European Commission by 15 March 2007.
Time will tell if the UK has got it right, and what the European Commission will decide, but these are positive steps in avoiding future meltdown as a result of catastrophic litigation which – in the long run – serves to benefit no one.