Professional Negligence Special Report: Out for the count
16 February 2009
It is common for deteriorating economic conditions to result in increased litigation against professionals.
A claim against a party with deep pockets is more tempting in difficult trading conditions and may be an option that certain classes of person, notably trustees and liquidators, cannot ignore. A recession in the wake of global financial market turmoil – along with a sustained liquidity crisis and asset price collapse – is likely to give rise to claims in connection with a range of accountants’ activities.
Audits and asset valuations are the most obvious areas of risk. The profession has devoted considerable attention to the risks and uncertainties associated with the valuation of certain investments, which for balance-sheet purposes has become very difficult, particularly for those required to be measured at ‘fair value’ or where there has been a cessation in trading of investments marked to market. This is a wide-ranging and significant issue for the auditing of financial institutions and possibly other entities.
The liquidity crisis has wider auditing implications for business in general.
Where the provision of credit or renewal of financing is impeded, risk assessment may be significantly affected, with potential implications for ‘going concern’ assumptions. All this has implications for the disclosure of risk in directors’ and auditors’ reports. The dangers of being perceived as too closely aligned with the interests of management in such a context become more acute.
Losses in the financial sector and the rapid contamination of the real economy by the financial crisis will inevitably mean close scrutiny of audits and asset valuations, mainly in the aftermath of corporate failures and extraordinary write-downs.
It is also likely that financial misstatement and fraud (or the posthumous detection of them) will increase and with this the potential exposure of auditors to those who place reliance on their work.
Other areas of practice may also face a rise in claims. Candidates include accountants in private client wealth management who failed to foresee the collapse in value of classes of investment previously perceived as safe, as well as tax planning specialists in years to come should HM Revenue & Customs scrutinise and challenge tax avoidance schemes even more proactively as the pressure grows on government finances. There is also a general risk of accountancy firms facing pressure to focus on areas of work outside of their core expertise and consequently failing to advise clients appropriately.
But although the volume of claims may rise, will these claims be successful? Hopefully not, at least for the better risk-managed practices.
One feature of the liability claims landscape that differs from previous recessions is the availability of conditional fee arrangements and various mechanisms for managing the risk of unsuccessful litigation. It is not clear whether these will result in more claims being taken to trial than in previous recessions but they may encourage a greater number of proceedings to be issued.
More claims against accountants will certainly be intimated, so a rise in notifications, including ‘blanket notifications’, to professional indemnity insurers is inevitable. In the wake of the Court of Appeal decision in Kidsons (2007), we may see close scrutiny by insurers of the language used in blanket notifications.
One trend that predates the financial crisis and looks unlikely to be reversed by it is the pursuit of very high-value claims where crippling damages are sought that are out of all proportion to the amounts paid to the accountants and which, if awarded, would swiftly empty even the deepest pockets. It is not clear what mega-litigation involving accountants may arise, even from the write-downs and insolvencies so far.
One can, however, contemplate the English courts making significant case law in the areas of contributory negligence, causation and scope of duty in seeking to avoid finding disproportionate liability against accountants.
It will be interesting to see to what extent auditing practices are able to avail themselves of liability caps in light of Sections 534-536 of the Companies Act 2006, which came into force in April last year. The limitation agreements permitted by the act must be authorised by the companies’ shareholders and the provisions can only apply for one financial year, meaning they will need to be renegotiated annually.
One can see the attraction to auditors of such agreements increasing in times of recession but diminishing inversely to shareholders. Any limitation will only be effective to the extent that it is “fair and reasonable in all the circumstances”. What this means has yet to be tested. Such agreements will not in any event cap auditors’ liabilities to third parties who might, one way or the other, place reliance on their work.
There is an increase in precautionary notifications from institutions remote from the epicentre of the financial crisis and that increase will continue as the recession deepens. Notwithstanding the balanced approach of the English courts, no one should be complacent. A litigation shockwave may take time to spread but it is no doubt on the way.
Matt Andrews is a partner and Barnaby Winckler a solicitor in the professional indemnity team at Kennedys