Liability limitation: seeing red

When businesses negotiate terms and conditions with professional services
firms, such as accountants, the service provider will usually look to limit its
exposure to the risk of huge claims arising from its work.

Tax specialists, in particular, have looked to limit the risk of litigation
surrounding their advice, following some huge lawsuits in the US.

So far, the law in the UK has stopped auditors from contractually limiting
their level of exposure to claims, but that is about to change.

From 6 April 2008, as a result of the Companies Act, the law will change to
allow auditors to calculate and seek agreements with clients to limit their
liability.

Auditors have sought this ability for years, and the issue was brought into
sharp focus following the collapse of Enron and its auditor Andersen. This has
proved controversial, as losing a litigation case was not what caused Andersen
to collapse. Yet the fear of another large audit firm going to the wall and the
potentially devastating impact that would have on the market has forced the
government’s hand.

Limited liability agreements will soon be a fact of life for businesses
requiring an audit.

‘They will have auditors knocking on their door soon,’ warns Tony Bromell,
head of accounting markets and ethics at the ICAEW.

So, what should companies expect from the new arrangements? How should
discussions be handled? And what power does a company really have to ensure that
the terms of the deal are acceptable to its shareholders?

Ready to kick off

Bromell says firms will soon start asking their clients about how to
formulate limited liability. And, in some cases, tentative discussions have
already begun. Reports have already surfaced of discussions between BP, Tomkins
and their respective auditors.

‘The subject can be broached at any time now, but it cannot be signed until
after 6 April,’ says Bromell.

But some think that it is premature to have any meaningful negotiations at
this time. Ernst & Young senior partner Gerald Russell warns against
starting formal negotiations too early. He argues that, with guidance from
financial regulator the Financial Reporting Council on the topic not due until
the end of the year, no real decisions or deals should be struck until the
guidance, issued in a consultative format, is absorbed and understood.

Bromell believes that the guidance from the FRC will not be too prescriptive,
leaving options open for both auditors and their clients. However, this could
cause its own problems.

Proportionality or cap?

The key issue identified for the accounting profession, and its clients, to
consider is whether to agree to a proportional limit on liability, or a monetary
cap.

Giles Murphy, head of audit and assurance at Smith & Williamson, explains
that caps are commonplace elsewhere, but audit will probably be a different
matter.’ It seems the whole idea of caps has caused a bit of a stir,’ says
Murphy.

Caps have been heavily criticised, with some arguing that they would only be
used by firms looking to abdicate their financial responsibility for a botched
job. Murphy says that, for finance directors in particular, the audit is about
the quality of verification, and how efficiently it is undertaken.

Some firms, says Murphy, would argue that a cap does not impact on quality or
efficiency, but the next question would be where to set the limit. Would you
choose an auditor because it offered the highest cap? How does that guarantee,
or suggest, the level of quality of the audit?

Murphy thinks firms could only argue that a cap avoids the ‘Armageddon’
situation faced by Andersen, even though litigation did not kill the firm. It
would also avoid the ‘deep pocket situation’, he argues, reducing the likelihood
that other firms within an accounting network would be forced to cover the
damages of another member firm.

Jane Howard, a partner at professional indemnity firm Reynolds Porter
Chamberlain, believes most firms will

look to a form of proportionality, as opposed to caps, when discussing plans
with audit clients.

But strangely, the markets did not expect there to be a choice until
recently. For the reasons above, and others, firms were not expected to be given
a choice of limitation by cap. But late changes to legislation permitted the
choice.

Signing the contract

Market forces could be key to the way contracts are formed, and in which
format. Russell says that the market should not force auditors to win
assignments by setting high caps or a high proportion of liability. Auditors
that try to win clients on this basis would be ‘unprofessional’, in his opinion.

James Barbour, director of accounting and auditing at ICAS, says that FRC’s
guidelines should bring stability to the way in which agreements are structured.
That way, both parties don’t get into a position whereby agreement cannot be
reached, the auditor quits on that basis and then the client cannot find another
auditor to take up the work.

‘If a business turns down a standard agreement, it wouldn’t be easy to go to
[other auditors] if the terms were quite standard,’ adds Barbour. Each company
and every audit is different, so he still expects agreements to require
tailoring.

S&W’s Murphy says businesses should also bear in mind that service
providers tend to face more risk from other service lines, such as tax, and that
could influence the level at which audit liability is set at.

Reputational risk is a bigger issue for auditors, and limited liability does
not protect against that. But businesses should expect some haggling, Murphy
adds, and we may even see some tenders change hands because of it.

The greatest priority for the business, however, is audit quality and
maintaining a healthy relationship with its audit firm, which should be
considered before ditching a trusted provider.

While there is not a ‘wealth of knowledge’ on market practice yet, Murphy
wonders whether discussions will be any different to that on other services,
despite audit’s uniqueness.

Reynolds Porter Chamberlain’s Howard agrees that guidelines issued by the
watchdog will be critical, as both sides will have access to their
recommendations, so she believes nothing concrete will be agreed between any two
parties until they have been revealed.

Caps, Howard believes, could set off a backlash from clients, as it gives
clients the ‘whip hand’.

‘Clients will be in a good position,’ says Howard. ‘Caps will be slow to come
in’.

But, ominously, she adds that at least one mid-tier firm is putting together
proposals for proportionality and cap agreements. ‘They’re dipping their toe in
the water on that.’

Howard suggests the auditors will have some power, as she concedes there is
the potential for auditors to drop a client if there is disagreement over
liability proposals.

Crowd pleaser

One of the most profound issues that businesses, and their auditors, face is
convincing stakeholders that the agreement struck is fair and reasonable.
Shareholders will vote to agree on the deal as part of their AGM
responsibilities.

Reappointing auditors goes by without any fuss 999 times out of 1,000, but
will shareholders be as benign on limited liability? They have become much more
active around directors’ remuneration.

Advisers suggest that engaging shareholders with the process as early as
possible is vital to get them onside. ‘If you’re a public company you want to
make sure [shareholders] will approve it. I would expect institutional investors
to be sounded out on this,’ said Bromell.

‘We’re moving into a new area,’ says Russell. ‘Companies will have to
second-guess. When you put things to individual shareholders as you do in an AGM
they can do what they like, so business has to educate. Sensible companies will
sound out shareholders but you can’t cover all of them.

Guidelines, when issued, will lead to accepted norms, says Russell, which
should ease this part of the process.

Tactics

DO – begin discussions with your auditor on liability
agreements

DON’T – sign any definitive agreements until guidelines have
been issued.

Limited liability only comes into effect from 6 April 2008 anyway

ENGAGE – shareholders, who will vote on the agreement you
have reached with your audit firm. So involve major stakeholders throughout the
process to avoid an embarrassing AGM, and an auditor that reconsiders its
position

PROPORTIONALITY – is expected to be the most popular form of
liability limitation, but the law allows for caps, and this may suit you and
your auditor better

AVOID – firms trying to win work by offering a high cap. It
should set off alarm bells – focus on quality instead

WATCH – the market, see what competitors do, read
Accountancy Age for the detail on deals struck

TAILOR – the deal to suit your company and its situation.
Guidelines and norms are there to help but not to tie down companies.
Proportionality, cap or even multiples of fees? You decide.