The Companies Bill is generally thought to be a positive development in redressing the balance of liability between auditors and clients but Ed Vinales asks what issues firms will face when implementing its changes
The Companies Bill, which received royal assent on 8 November, contains a key section for accountancy firms, which overrides the existing prohibition on auditors limiting their liability through the introduction of new agreements. As a piece of legislation, this is generally thought to be a positive development that goes some way to redressing the balance of liability between an auditor's duty and the corporate responsibilities of clients.
However, participants at a recent Post roundtable believed these new agreements were somewhat marred by the government's underlying intention to protect the financial market from the knockout blow that would ensue should another major accountancy firm go bust. They argued that it would take several months - if not years - of litigation to unravel the intended objectives and test the wording.
Hosted in conjunction with Kennedys law firm, guests at the roundtable sought to determine whether the changes proposed provide any real potential for protection, given the large degree of uncertainty that surrounds these new liability limitation agreements.
Matt Andrews, partner at Kennedys, said: "The Bill is a sea change from the law as it has been since 1929. Until now, there has been a prohibition on auditors limiting their liabilities with reference to audits. It seems to have grown out of the concern that followed Enron when Anderson's collapsed."
He explained that auditors have traditionally been the "whipping boys" for claims of this nature, particularly in relation to allegations of fraud, and that if one of the 'big four' accountancy firms was to collapse it would have a disastrous impact on the financial markets as a whole.
"However, does the Bill give auditors any meaningful protection?" asked Mr Andrews. "The language is so uncertain that litigation is inevitable to set the climate for how the limitations of liability are going to work.
"My main concern with the limitation of liability provisions is that in one of the leading auditors' negligence cases, Barings, it was made clear that it was an auditor's responsibility to discover fraud. It is well-established that if you fail to discover fraud then you are liable for the damages that flow from that fraud. That consequence must be contrasted to a negligence situation where there can be other causation but, with fraud, if you don't uncover it you are on hook for the lot until the fraud is found and stopped."
Clive Weeks, partner at BDO Stoy Hayward, agreed, adding that there was so much doubt surrounding this section of the Bill that firms could not yet tell how it would work out. "If you imagine a situation where a fraud of £250m is discovered and the liability cap has been agreed at £125m, what will a judge say? It seems to me that the law develops case by case and judges decide based on what they think is fair and reasonable."
Mark Harwood, partner at Baker Tilly, added: "The introduction of this legislation serves to preserve the status quo vis-a-vis the market dominance of the big four because liability levels in our market are likely to be driven by what they agree with their clients. In agreeing liability levels and drafting letters of engagement, we will have one eye on risk and the other on the commercial position."
He said that firms such as his own would have to bear in mind what their competitors were doing, "and that includes the big four in certain sectors of market. The largest firms will agree limitation of liability at such a high level that the impact on the medium-tier firms would be minimal".
Edward Maddison, director at ASL International, pointed out: "The other problem area is what sort of limitations are you going to go for - will it be proportionality or cap?"
"Where do you pitch it?" asked Mr Andrews. "The Bill doesn't say you must do one or the other; it doesn't prescribe how you do it. You could say we will be liable for 30%, or three times audit fees, or to the limit of our professional indemnity insurance - not that insurers would like that."
Brenda Leeds, executive director at insurance and risk management specialist Lockton, said: "It is rare for people to ask accountants how much PI insurance they buy, although it has been common practice in construction and other professions. This is changing, however, and I'd be interested to know the feedback from accountant firms as to their clients' reaction on disclosing how much they buy in relation to a liability cap."
Mr Andrews commented that it was difficult to see how you could legally agree a level at the time of signing the audit. "In a sense, what you might be asking for is a resolution of the company on the limitation of liability agreement the day before you sign the audit," he said.
The insurance panellists were asked at what stage PI insurers would address the issue - in the underwriting or a few years down the line when a case hits the courts? Clare Norton, claims manager for the professional liability division of Markel International, responded: "While there remains a high degree of uncertainty as to how the courts will approach the 'fair and reasonable' test, it is difficult to be definitive as to the effect it will have on claims, and hence, should have on underwriting.
"It seems likely that the courts will be less comfortable with a financial cap where the effect of that would be to leave a gap in recovery for claimants. The instinct would be to fill that gap if possible."
She agreed that it was likely to be several years before the outcome was known but added: "Insurers will ask for more information and look at agreements firms are coming to. Whether it makes a difference in the immediate future remains to be seen."
Mr Maddison added: "The traditional claims that insurers deal with daily are not going to be affected that much by these agreements. It's on upper level claims, which aren't insured anyway."
Ms Norton agreed: "It depends where you are writing. If it is primary layers, it's not going to be so relevant. On higher excess, it's likely to become more significant."
Ms Leeds then added: "The caps in liability will cover the next 12 months' audit but the impact on the insurer will be in four or five years when any claim arising out of that audit is settled. In the interim, as a broker, I would say that the approach to limitation agreements is an indicator to insurers of a firm's attitude to risk management."
So will accountancy firms set specific limited liability agreements for each audit or will they have a blanket limit? Mr Harwood said that Baker Tilly has not got as far as thinking about that yet. "I suspect we'll have a range of parameters that we'll adapt to different types of audit, depending on size of client and the perceived level of risk as well as what we can negotiate.
"However, there is also a commercial angle - what would be acceptable in the market? Since the big four are effectively self-insured and operate a portfolio approach to risk, they may choose to apply one liability limit for all audits. If so, this is likely to be quite a high number. If other firms seek to agree levels on a client-by-client basis then we would look to follow suit but it really is too early to determine exactly how individual firms or the market as a whole will react."
Peter Ellingham, partner at Kennedys, commented that it would be interesting to see what level of case is first to reach the courts. "Will a test case be for £35,000, against a small high-street accountant, or a £7bn fraud test case against one of the big four? To a small practitioner, which has audited a family company for 12 years, a £100,000 cap is proportionally bigger than a £1m cap for the big four. At first sight, a £100,000 cap seems low but in the context of an auditor turning over £70,000 a year it may be disproportionate."
Panellists were then asked whether it would be more attractive to a PI underwriter if a firm had an institutional limitation of liability. "It depends on the sector of industry because expectation should vary as the caps are likely to be at a high level," responded Ms Leeds. "If you consider a large firm, then you are looking at their processes. In the mid-tier, you expect it to be far more proactive on negotiation. At the smaller end, we might expect to factor a cap on their fees."
Asked whether the Companies Act would prompt audit firms to buy higher levels of cover, she responded: "It depends on what the context is and on availability. With the larger firms there is a finite availability and we have pretty much reached that. Small to medium-sized enterprise businesses could be forced to buy more cover or lose the audit. It depends on their clients' perception of the audit's value - fees aren't that large."
Mr Andrews then played devil's advocate by asking whether liability limitation agreements would promote lazy auditing. Mr Harwood firmly denied this but said that the limitation of liability raises other questions regarding the value people place on audit. "There is an argument that if there is a limitation of liability then investors may value the audit less," he said.
So have there been any parallel situations to the proposed 'fair and reasonable' test where a judge has stepped in and declared a contractual agreement between two parties unacceptable? "In terms of decisions involving accountants, the 'win/lose' graph has shown a downward trend in recent years, although it has come back a bit from the bottom," responded Mr Ellingham. "There have been some high-profile duty-of-care decisions where accountants have gone for a strike-out and failed, which have then been held up to say there was a duty of care. So perhaps the Act will provide a chance for more confidence and a high-profile decision in accountants' favour, to bring the trend of the graph back up."
Mr Andrews added: "The law is desperately uncertain as to what the merits are of taking a strike-out at an early stage. That confusion creates a problem that is as much about limitation of cost, which is a big issue for accountants and their insurers. Maybe the existence of a limitation of liability agreement, even untested, will have the effect of expectation management on claims. This will at least encourage people to come together to have a sensible discussion as to where things are going to go."
Responding to a question on whether further guidance on the issue can be expected, Mr Weeks said: "BDO was involved in consulting on parts of the Act, although we don't yet have enough information to advise our clients. The uncertainty that we have all expressed must mean that it looks unsatisfactory at the moment. I strongly suspect it will ultimately be tested by litigation."
Commenting further on this lack of clarity, Mr Ellingham said: "It's all very political. For once we have seen a government looking to bring in legislation intended to help the accountancy profession, which contrasts with the government's more restrictive approach to, say, tax avoidance arrangements."
Adding to the political argument, Mr Andrews said: "There is nothing like this in Sarbanes-Oxley, which has made acting as an accountant or auditor in the US more onerous. Was one of the drivers an attempt to entice more big business to the UK, to make it more attractive to do business here?"
Mr Harwood said: "When liability limitation was first applied to non-audit work, there was a period of time when it was a matter of commercial debate with clients concerning the application of a cap. For example, some banks would argue against caps for certain types of corporate finance work and would shop around until they found a firm that would guarantee not to cap their liability.
"Some accounting firms did not stand firm on the liability cap and gave in to pressure. Over time, the position with respect to liability caps settled down and the same sort of situation may well apply with the audit liability limit. In the short-term, there may be commercial challenges in agreeing appropriate liability levels."
Bearing in mind these uncertainties, what is the best advice on how to deal with liability limitation agreements? Mr Ellingham advised: "Speak to clients and find out what they would accept. Negotiate on that and work out an agreement. Seek your insurer's views on what they consider acceptable. If there is a divergence of views between client and insurer, you may need to find a middle ground."
Mr Weeks responded with disappointment to the fact that under the Act, auditors now have to personally sign audit reports in the knowledge that their names can be made public. He said it was equally displeasing that a criminal offence had been created. "These are undesirable developments but in reality it doesn't make a practical difference to the way these things work. We are accountable internally and it is unfortunate that accountability has been extended to the public domain," he said.
Mr Maddison ended the discussion with a final cautionary remark: "It has been suggested that the unlimited fine is a substitution to unlimited liability - and, of course, that is not insurable."
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