A bit of a liability

Last week, the government took a huge step towards bringing in measures that
auditors believe will reduce the risk of another big accountancy firm
collapsing.

In an update to parliament before its summer break, minister of state for
industry Alun Michael introduced a series of draft clauses that allow auditors
to negotiate their liability with clients, seemingly bringing to an end a
long-running and sometimes bitter battle between the profession and investors.
It looked, bar the shouting, as though the auditors had won this battle hands
down.

But there may still be a twist in the tale, with auditors seemingly getting
more than they were asking for and investors unlikely to give up without a
fight.

The substantial update, covering several areas of the bill, made no mention
of the sudden change of heart from investors, which saw several key
shareholders’ representatives argue against the introduction of proportionate
liability.

Michael said that draft clauses relating to the ‘balanced package of reforms’
mentioned in the March consultation document were being published, which
included ‘legislation to allow shareholders to agree limitations to the
liability of auditors’.

Investors will be disappointed to learn that their views have largely been
ignored by the government. A stinging attack on the move to reduce auditors’
exposure to catastrophic claims was made, earlier this year, by groups such as
the Association of British Insurers, the Investment Management Association, the
National Association of Pension Funds and, in particular, investment house
Morley Fund Management.

Morley, with the backing of several of these organisations, argued furiously
that the time was not yet right for auditors to be able to limit their liability
further. Regulatory changes in the UK and Europe, and especially the recent
introduction of international standards on auditing, threatened audit quality,
reduced auditor exposure and risked bringing an end to the ‘true and fair’
audit, it said.

Yet these concerns seem to have been discounted by the DTI when formulating
its response to the March document. Investors are still mulling over the
consequences of the announcement but initial disappointment could soon turn to
anger once the proposals are scrutinised.

The government has signalled its intention to enshrine in legislation rulings
on auditor responsibility that emerged from the Caparo Industries plc v Dickman
case in 1990. The House of Lords ruling said auditors ‘do not, in general, have
a duty of care to individual shareholders or potential shareholders in a company
whose accounts they audited’. The proposals to do this had initially come from
the investment community but as an alternative to proportionate liability, not
as an accompaniment.

Worse still, the draft clauses that were put in to allow auditors to limit
their liability seem to have sidestepped the issue of proportionality
completely. The wording relates to limiting liability to an amount that is ‘fair
and reasonable’ but nowhere is the auditor’s proportionate responsibility in
relation to other parties mentioned.

In fact, some lawyers have argued that the proposals put forward more closely
resemble that of a liability cap, an idea that was rejected by the government
last year.

‘What is set out in the draft clauses is, in fact, something much more
liberal than was expected,’ says John Trotter, head of the professional
negligence team at law firm Lovells. ‘It is not what is generally understood as
proportionate liability. It allows companies and auditors a great deal of
freedom to agree limits on the auditor’s liability to the company. The check is
that if this is lower than what is fair and reasonable it will not be
effective.’

Parts of clause Q65 seem to encourage the setting of a monetary limit. When
defining the ‘principal terms’ of a liability limitation agreement, the clause
states that alongside the kinds of acts covered and the period for which it is
covered, ‘the amount to which the auditor’s liability is limited’ should also be
set.

One investor says that the company has its legal team poring over the
documentation as they also felt that the clause omitted the issue of
proportionality.

KPMG’s head of regulatory affairs, Neil Lerner, disagreed that the clause
defined a liability cap but did admit that some improvements to the wording of
the proposals could be made.

‘I do not see it as a monetary cap,’ says Lerner. ‘But whether it absolutely
achieves proportionality is something we can take legal advice on.’

Lerner, however, says he remains ‘concerned about the criminal offence
clause’ which he believes sets the bar too low for prosecution and could see
innocent auditors in jail. As things stand, auditors who ‘knowingly or
recklessly’ give an incorrect audit opinion could face time behind bars.

With the proposals out for consultation, Lerner believes there is still time
to make changes to the legislation on this particular subject, which he believes
would only require ‘tweaking’.

This view, as well as being shared by many others in the audit profession, is
also backed by lawyers, with Lovells using past history to support its point of
view.

‘The concern here for auditors is what will be meant by recklessness,’ says
Trotter. ‘If the same definition is applied by the courts with this offence as
for other offences, this will be a worryingly low threshold and would amount
generally to a judgement on whether the auditor acted reasonably, with a
criminal penalty depending on the answers to that question.’