Knocking on reform's door

Any hope auditors had of legal reform to allow them to cap their liability was scuppered by the Department of Trade and Industry last week. Nicholas Heaton explains, however, that the door to reform could be reopened in the future

Last week, the Department of Trade and Industry ruled out reforming the law relating to auditors' liability in the Companies Bill, now being considered by the House of Commons. The law, contained in section 310 of the Companies Act 1985, stops a company from agreeing to limit an auditor's liability to it in relation to company audits.

Auditors had hoped, following sustained lobbying and a recent DTI consultation paper, that changes allowing them to cap their liability to a company might be introduced. The chance of reform to the law in this area has been put back, possibly until after the next general election.

The government's refusal to allow auditors to agree caps on their liability to companies is not out of sympathy, however, with the international climate.

There is no prospect at this time of similar reforms in the US. And in Europe, even Germany, one of the few countries that currently does cap auditors' liability to companies at EUR4m (£2.7m), is considering reforming its law to raise the level of the cap, perhaps substantially.

Competition enhancing

Announcing its decision, the DTI has, however, left the door open for reform in the future. The DTI says it will consider any proposal that can be demonstrated significantly to enhance competition and improve quality in the audit market.

Interestingly, the DTI's statement itself suggested one possible basis for reform - that auditors should be permitted to agree contractually to limit their liability on a proportionate basis. Currently, auditors are jointly and severally liable, with any other party that is also liable for the same loss caused by the faulty audit, such as directors or other professional advisers. This means that the injured party may recover its loss in full from any of those liable, regardless of the degree to which that party's fault contributed to the loss. Although a defendant can claim a contribution from anyone else who is also liable, the risk of being unable to recover is the defendant's. Auditors have long complained that this system unfairly results in their being pursued for the entire loss suffered by a company because others, such as directors, who might bear a greater responsibility for the loss, do not have the assets to meet the claim. Proportionate liability means the defendant is liable only for that proportion of the damage for which they are judged to be responsible.

Auditors have in the past said that proportionate liability is what they really want, and that a cap on liability was second choice. It is surprising, however, that the government is now suggesting proportionate liability might be the answer because the DTI's consultation paper, published in December 2003, specifically ruled out its introduction.

Joint and several liability is central to the current English law of negligence and the introduction of proportionate liability would have amounted to a major reform, which the government did not think it right to consider in the context of the audit industry alone.

Auditors will, no doubt, point to the introduction of proportionate liability in Australia in respect of claims for economic loss and property damage arising from misleading or deceptive conduct. These provisions, which came into force on 1 July this year, do provide Australian auditors with proportionate liability but it is not just limited to claims against auditors and it is the result of a more general review of the law.

The idea floated by the DTI would not involve a reform of the general law of negligence because it is proposed that proportionate liability could be implemented for auditors through their contracts with companies.

The DTI has invited auditors, businesses and investors to consider whether such arrangements are practical or desirable. Although complicated, contractual provisions that achieve this should be possible, and indeed some accountants already include proportionate liability clauses in engagement letters for non-audit work.

The real question is whether they are desirable and whether they can be shown to enhance competition and improve quality in the audit market.

Just as joint and several liability can sometimes be unfair on a defendant, proportionate liability can be unfair on a claimant. Under a system of proportionate liability, if more than one person is responsible for a loss, the claimant must sue each one or choose which to pursue. And if one of the parties is unable to pay, the claimant goes uncompensated for part of the loss. This, however, is a risk inherent in any form of cap and, auditors would argue, is no reason for them to pay more than their fair share of the loss.

More difficult is the question of whether limiting liability on a proportionate basis would enhance competition. The Office of Fair Trading published a report in July on the effect of allowing auditors to negotiate liability caps with clients, which concluded that allowing caps would be neutral from a competition perspective. Auditors clearly have some work to do to show that reform would significantly enhance competition.

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