Testing the water

Very few companies have actually entered into limitation of liability
agreements (LLAs) with their auditors despite being able to agree a contractual
limit on their liability with a company whose accounts they are auditing. In
addition, it seems increasingly unlikely that the changes introduced under the
Companies Act 2006 will be sufficient to deliver the wider public policy
objectives of alleviating concerns relating to auditor concentration risk and
enhancing competition within the UK audit market.

Legal background
The limitation must be fair and reasonable in the particular circumstances. A
separate agreement is required for each year’s audit and each agreement must be
approved by the company’s shareholders. In the case of a private company, its
shareholders can agree to waive the requirement for approval.

The act does not restrict the manner in which liability can be limited so, in
principle, the contractual limits can be set in a number of different ways, for
example:

• a limit based on the auditor’s proportionate share of the responsibility
for any loss;

• purely by reference to a “fair and reasonable” test;

• a financial cap on liability, expressed either as a monetary amount or
calculated on the basis of an agreed formula; or

• a combination of some or all of the above.

The art of persuasion
Audit firms are finding it difficult to persuade their clients to consider an
LLA, while the publicity surrounding the SEC’s decision to prohibit UK companies
registered with it from entering into LLAs has made the task harder.

The difficulty arises in persuading directors of the benefits to their
individual company in signing up to an agreement and that this is consistent
with their statutory duties to promote the best interests of the company. This
is despite the guidance issued by the FRC on them, which suggests a number of
reasons why companies and their directors might conclude that it is appropriate
for a company to enter into an LLA.

Bigger fish to fry
The lack of agreements is particularly acute among smaller firms. The reasons
for this go beyond publicity issues and the reluctance of clients to contemplate
LLAs, especially with a weak economy.

For smaller firms carrying out audit work, the increasing regulatory burden
imposed on them (primarily in relation to quality assurance and continuing
professional development) is a far bigger concern than the perceived risk of a
claim arising from an audit. Increased regulation has also had an impact on the
number of firms undertaking audit work with the number of registered audit firms
in the UK falling by more than 25% between 2003 and 2008.

The overall decrease can partly be explained by the increase in the audit
threshold, resulting in a lower number of companies requiring an audit. However,
for those firms who only undertake a few audits a year, the business case for
them retaining their audit registrations is under increasing scrutiny.

Significantly, limiting an auditor’s liability on a proportionate basis
provides no certainty in advance (either for the auditor or the company) as to
what the auditor’s liability will be if a claim arises. The extent of the
auditor’s liability will depend on the circumstances of the case and ultimately
it will be left to the courts to decide the share of the loss for which it would
be just and equitable to hold the auditor liable.

Consequently, although the mid-tier firms are more supportive of LLAs based
on proportionality as opposed to financial caps, the degree to which they can
protect a Big Four firm from a catastrophic claim is questionable. The fear
among smaller firms is that if financial caps were introduced, they may be at a
level that they cannot match.

Breaking into the big leagues
Unless the contractual limits for LLAs are structured in such a way as to
provide firms outside the Big Four with greater clarity and certainty as to
their potential liability to companies in respect of audit work, LLAs in
isolation are unlikely to be effective in boosting competition in the UK audit
market. While the “deep pockets” of the Big Four undoubtedly creates a
significant barrier to entry for the mid-tier and smaller firms in trying to
break into the audit market for listed and large private companies, the equally
important issue is whether firms outside the Big Four have the requisite
expertise to audit higher risk entities. This is questionable, particularly in
relation to financial sector institutions.

If government and legislators are to be successful in boosting competition in
the audit market, they will need to look again at the voluntary (rather than
obligatory) nature of LLAs. They will also need to consider how firms outside
the Big Four can genuinely be expected to obtain the requisite experience to
enable them to audit larger and high risk companies without carrying out joint
audits alongside the Big Four. In the meantime, the fear of what would happen to
investor confidence in financial corporate reporting if one of the Big Four were
struck by a catastrophic claim remains and auditors, for the most part, remain
in the unenviable position of being insurers of last resort.

Until these issues are addressed it seems that smaller firms will be in no
hurry to push for larger and higher risk audit work.

James Herbert is a partner and head of the corporate and commercial
department at regional law firm Thomson Snell & Passmore