Auditors get their wish but the market could miss out

The law, then, remains that companies cannot agree to limit an auditor’s liability to them in relation to statutory audits. But the government itself has suggested one possible solution: that auditors make their liability to their clients proportionate.

Proportionate liability means a defendant is liable only for the proportion of the damage for which they are judged responsible.

Auditors have said in the past that proportionate liability is what they really want, but this was not thoughtthought to be an option because the DTI’s consultation paper had specifically ruled it out.

Auditors can point to the introduction of proportionate liability in Australia for claims for economic loss and property damage arising from misleading or deceptive conduct.

The provisions came into force on 1 July this year and allow Australian auditors to offer proportionate liability. However, the Australian example is not just limited to claims against auditors – it has resulted from a more general review of the law.

The government’s suggestion would not involve a reform of the general law of negligence because it is proposing that auditors implement proportionate liability through their contracts with their audit clients.

The real issue is whether proportionate liability can significantly enhance competition and improve quality in the audit market.

One argument against proportionate liability is that if more than one person is responsible for a loss, the claimant must sue all of them; and if one of the defendants can’t pay up, the claimant goes uncompensated for that part of the loss.

But the risk of a claimant not getting full compensation is inherent in any form of cap. Auditors can justifiably argue that partial compensation is not a good reason for making auditors stump up more than their fair share of the loss.

If liability has to be limited, then proportionate liability is a fairer basis for limiting it than most other available methods. Investor groups such as the Association of British Insurers are reported as supporting the idea of proportionate liability.

But whether limiting liability on a proportionate basis will enhance competition in the audit market is a more difficult question to tackle. Those who support liability caps argue that their introduction would guard against a decline in competition by protecting auditors from catastrophic claims that might bring down one of the big firms and by encouraging them not to withdraw from the market because of the risks they face.

It is also argued that capping liability would allow medium-sized audit firms to enter the market for large audits, thus increasing competition. But an Office of Fair Trading report concluded that exposure to large claims was not what kept mid-sized firms out of the market, that the big firms showed no sign of withdrawing, and that reputational damage rather than legal liability was more likely to cause the collapse of a big firm.

The OFT’s report, which was prepared in a very short time, has been heavily criticised for failing to take account of the difficulties faced by the bigger firms in obtaining professional indemnity insurance for audit work and so underestimating their exposure and the deterrent it poses to mid-sized firms looking to enter the market.

While it is hard to see how a cap based on proportionate liability could reduce competition, the OFT did not seem to think that caps in general would increase it. Auditors have some more persuading to do to show such caps will greatly enhance competition, as the government says they must.

  • Nicholas Heaton, partner at the international law firm Lovells.

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