Auditor and director liability - statement in full

The House will be aware that, between December 2003 and March 2004, the Government consulted widely on the case for reform of the law on director and auditor liability. Over 120 responses to the consultation were received from investors; companies, both large and small; auditors; legal advisers; industry bodies; academia; and the general public. I am grateful to all those who took the time and trouble to contribute.

In the light of the consultation responses the Office of Fair Trading was asked to undertake a study of the potential impact on competition in the audit market of a cap on auditor liability. I am grateful to them for completing and publishing this so quickly.

Directors

It is essential for British competitiveness that we have a diverse pool of high-quality individuals willing to become directors, and that directors are willing to take informed and rational risks. But it is also important that directors act in accordance with their duties, and that negligent directors can be held to account by their companies. The courts have in recent years imposed a much more demanding standard of care, skill and diligence on directors. This has been a very welcome development.

The consultation built on the recommendations both of the Company Law Review and of Sir Derek Higgs’ study on non-executive directors. It identified two particular concerns:

• exposure to liabilities arising from legal action against directors by third parties. The sharp rise in the number of class actions by groups of shareholders in the US has made this a particular concern for directors of British companies with a US listing;

• the cost of lengthy Court proceedings. Companies are currently permitted to indemnify a director against the cost of defending legal proceedings, but only when judgment has been given in the director’s favour or he has been acquitted. For many directors, such indemnification comes too late and the prospect provides cold comfort.

The consultation indicated these issues are affecting the recruitment and behaviour of directors. I therefore intend to introduce a balanced and proportionate package of reforms, by tabling amendments to the Companies (Audit, Investigations and Community Enterprise) Bill at its Commons Committee stage. The proposals will in particular introduce two important relaxations of the current prohibition on companies exempting their directors from, or indemnifying them against, liability:

• they will permit, but not require, companies to indemnify directors in respect of proceedings brought by third parties (covering both legal costs and the financial costs of any adverse judgement, except for the legal costs of unsuccessful defence of criminal proceedings, fines imposed in criminal proceedings and penalties imposed by regulatory bodies such as the Financial Services Authority);

• they will permit, but not require, companies to pay directors’ defence costs as they are incurred, even if the action is brought by the company itself. The director would still be liable to pay any damages awarded to the company and to repay his defence costs to the company if his defence were unsuccessful (except where the company chooses to indemnify the director in respect of his legal costs in civil proceedings brought by third parties).

The Government amendments will also remove an arguable loophole under which a company in the same group may currently provide an indemnity to a director that would be unlawful if it was provided directly by the company of which the individual was a director.

The amendments will also require disclosure in the directors’ report by companies that indemnify directors. Shareholders will also have the right to inspect any indemnification agreement. Companies that do not indemnify directors will not have to make any disclosure.

Auditors

The consultation also covered the position of auditors.

The Government wishes to see a competitive and high-quality market for audit services, shareholders using high quality and reliable information, and an adequate system of redress for when things go wrong. There must also be an appropriate degree of transparency and accountability for the audit process.

The Government is actively pursuing this agenda. The Bill already extends the powers of auditors to obtain information, and contains new provisions for each director to confirm there is no relevant audit information of which he is aware but the company’s auditors are unaware.

There are also a number of initiatives to improve the quality of the audit and other information provided to shareholders. For example:

• the recommendations of the Review chaired by Sir Robert Smith mean that in listed companies there will shortly be enhanced audit committee reporting to shareholders, including better information on key audit judgements;

• the Auditing Practices Board, a subsidiary of the Financial Reporting Council, has published for comment draft new ethical standards relating to the independence of auditors which are expected to be finalised this autumn;

• the Financial Reporting Council has established an Audit Inspection Unit which has begun independent reviews of the effectiveness of the audit procedures of the four largest audit firms;

• the audit regulatory activities of the professional accountancy bodies are now subject to independent oversight by the Professional Oversight Board for Accountancy, a subsidiary of the Financial Reporting Council;

• a new Accountancy Investigation and Discipline Board has been established, as a subsidiary of the Financial Reporting Council, in order to investigate public interest cases of alleged breaches of professional standards by auditors and it has commenced its first investigation;

• the Financial Reporting Council has recently set up a group under Douglas Flint to review the current guidance on internal risk control;

• we are also considering carefully the responses to our recent consultation on the Operating and Financial Review.

In line with the Company Law Review’s recommendations, and as supported in the consultation, I have decided not to bring forward amendments to the current Bill to extend an auditor’s duty of care.

The consultation showed a wide variety of views both as to whether reform of the law on liability of auditors was needed, and if so what form it should take. Some investors also had concerns about whether the audit process was serving them sufficiently well. It was also a matter of concern that the leaders of some of our largest companies were worried their choice of auditor was limited.

I have considered carefully whether there is a case for a change in the law on auditor liability. I am grateful to the Office of Fair Trading for looking at the competition implications of enabling shareholders to agree in advance a maximum amount for which the auditor would be liable. In the light of the consultation responses, and the OFT’s advice that introducing a cap would not significantly enhance competition, I have concluded against proposing changes to the law on this.

The Government remains committed to improving the operation of the audit market and will continue to consider any proposals, including the possibility of limiting liability on a proportionate basis by contract, which can be demonstrated significantly to enhance competition, and to improve quality, in the audit market. The Government intends to look closely at this option and actively calls upon auditors, business, and investors to work together to examine whether proposals for a system of proportionate liability via contract are practical and/or desirable.

However no change to the law on financial liability could protect one of an auditor’s greatest assets – its reputation. That responsibility rests with the professionalism of auditors themselves.

Department of Trade & Industry
7 September 2004