Pushing the limits

A new UK reform bill is set to remove existing limits on auditor liability, forcing company and auditor to come to an agreement themselves. Nicholas Heaton and Andrew Wigston report

The Company Law Reform Bill, which had its second reading in the House of Commons on 6 June 2006, is the result of a fundamental review of the UK company law framework. One significant change that the bill will bring about is to remove the longstanding bar on auditors limiting their liability to the companies they audit, which is currently contained in Section 310 of the Companies Act 1985. What will auditors be able to do in future to limit their liability? And how will the new regime compare with the law in other key jurisdictions?

Although the bill is still making its way through Parliament, a broad agreement has been reached on the clauses that allow auditors to limit their liability, so significant change to this part of the legislation is unlikely. In the new regime, attempts to limit an auditor’s liability will be void unless they comply with the bill. The bill permits a ‘liability-limitation agreement’ between a company and its auditor if it is approved by shareholders and applies to only one financial year. The bill imposes no restrictions on the methods that can be used to limit the auditor’s liability.

The most likely approach will be to fix a limit by reference to a specified amount or a formula (e.g. a multiple of fees) or to agree proportionate liability. If proportionate liability is agreed, the auditor will only be liable to the extent that he or she is responsible for the damage suffered, taking into account the fault of others. This freedom is subject to three criteria: the consent of shareholders must be obtained; any limit on liability must be fair and reasonable; and the Government will have the power to regulate what may or may not be agreed.

The role of the shareholders

The need for shareholder consent is likely to be a significant practical control on the ability of auditors to limit liability, but it remains to be seen how willing shareholders will be to agree these limits and what approach they will find most acceptable. It seems inevitable that there will be a period of uncertainty once the bill comes into force, but that some form of common approach is likely to emerge over time, at least within different parts of the audit market.

The role of the court

Any limit on liability that an auditor manages to agree will still only be effective to limit liability to such amount as is “fair and reasonable in all the circumstances of the case”. This reasonableness test is not the same as the familiar test contained in the Unfair Contract Terms Act 1977 (UCTA), which governs attempts to limit liability by other professionals (including accountants when not carrying out statutory audits). It differs in a number of respects. Under UCTA, if the court finds that an exclusion clause is not fair and reasonable, the clause will be void, leaving the professional without any protection. Under the bill, if the court considers that the auditor’s liability is limited to an amount that is less than fair and reasonable, the agreement will nevertheless be effective to limit liability to what the court thinks is a fair and reasonable amount. Auditors will, therefore, have a clear advantage over other professionals in that they will not have to run the risk of having no protection if they agree limits that are found to be too low.

In another difference from UCTA, when the court considers what is a fair and reasonable amount, it can take into account circumstances arising after the liability limitation agreement was made. The court will not, however, be able to take into account circumstances arising after the damage has been suffered, or anything relating to whether a claimant will be able to recover from a third party. The emphasis under the bill, therefore, can be seen to be whether the result of the liability limitation agreements is fair and reasonable, rather than whether the bargain struck by the parties was reasonable at the time, as is the case under UCTA.

The role of the Government

At the last minute, during the House of Lords stages of the bill, despite years of consultation to find the best approach, the Government inserted a power into the bill, allowing it to make regulations dictating what can and cannot be agreed. If the Government does not like any practices that develop, it will have the ability to reduce the freedom the bill gives.

It appears that this move was taken because of fears in some quarters that if very high caps on liability became the norm for the audits of big companies, this might make it even more difficult for medium-sized audit firms to compete for this work. The Government has said that it does not expect competition in the audit market to be affected so does not intend to make any regulations at present. However, competition in the UK audit market is under scrutiny and a change of mind is possible. Also, there is nothing in the bill that limits any regulations to dealing with competition issues. This raises the possibility of the debate on how auditors should be allowed to limit their liability being reopened in the future.

The international landscape

Australia is also currently reforming its rules about the liability of auditors (and other professionals). The first reform was the 2004 introduction of proportionate liability for all claims for economic loss. This removed joint and several liability, with the result that tortfeasors are liable only for the share of any damage for which they are judged responsible. This brought Australian auditors a degree of protection that many UK auditors would have happily settled for. Australia is now going further and individual states are introducing schemes that cap auditors’ and other professionals’ liability. These schemes will operate in addition to the proportionate liability regime and in conjunction with compulsory insurance up to the level of the cap. New South Wales has already introduced a scheme for auditors that caps their liability at 10 times the audit fee for substantial audits, subject to a maximum of A$20m (£8m).

In Germany, there is a statutory cap of €1m (£680,000) on an auditor’s liability, rising to €4m (£2.7m) in the case of a quoted company. These caps do not apply for deliberate breaches of duty. The German government proposed an increase in these caps in 2003, but this has not progressed since. At the other extreme are France and the US. In France, the auditor’s duty arises in tort and cannot be limited by contract or otherwise. In the US, auditors cannot limit liability for their own negligence and, in the wake of corporate collapses and the introduction of the Sarbanes-Oxley Act, reform of auditors’ liability is not on the agenda. As far as EU jurisdictions are concerned, reform is still under consideration. The EU Statutory Audit Directive, which comes into force later this month, requires the Commission to report on auditor liability by the end of the year.

UK auditors should be satisfied with the new rules on liability limitation. They will have a wide freedom to agree limitations and, even if a limit is found not to be fair and reasonable, the agreement will not be void. In some ways auditors will have more effective protection than other professionals. From an international perspective, although the new UK regime will not be as favourable as those in Australia and Germany, a reasonable degree of protection will be possible and an appropriate balance struck between company and auditor.

Nicholas Heaton is a partner and Andrew Wigston is a solicitor at Lovells