Cap in hand

With the Company Law Reform Bill in the Lords, it seems auditors may be awarded their longsought-after limited liability. Nicholas Heaton reports

Auditors have long pressed to be allowed to limit their liability to the companies they audit, and it now seems that when the Company Law Reform Bill becomes law they will achieve that goal. The bill is currently being debated by the House of Lords, some amendments to the relevant clause have been proposed so there may yet be further twists in this long-running saga.

Auditors are currently prevented from limiting their liability to the companies they audit by Section 310 of the Companies Act 1985, which renders void any provision exempting an auditor from liability in relation to the company or indemnifying an auditor. The calls for auditors to be permitted to limit their liability grew following the collapse of Andersen. It was argued that auditors needed to be able to protect themselves from enormous claims that could destroy them, in order to ensure that there was effective competition in the audit market for listed companies. This argument was rejected by the Office of Fair Trading when it concluded in a report published in July 2004 that allowing auditors to cap liability could distort competition. Consequently, the Department of Trade and Industry indicated it would only consider proposals for reform if they would enhance competition and audit quality.

In March 2005, the Government proposed that auditors should be allowed to agree limits on their liability to the companies they audit on the basis of proportionate liability. This would allow the auditor to limit its liability to an amount that the court determines is just and equitable considering the relative extent of the auditor’s responsibility for the damage suffered. It was, therefore, a surprise that when the draft Company Law Reform Bill was published in July 2005, it allowed auditors to agree a limit to their liability by reference to a fixed amount or cap.

The scheme of the bill is that provisions limiting the liability of an auditor are void unless they meet certain requirements. A liability limitation agreement will be effective only if approved by shareholders or, in the case of a private company, if shareholders waiver approval. The agreement may only take effect for one year and may be terminated by shareholder resolution, but only in respect of future acts or omissions. Crucially, a liability limitation agreement will not be effective to limit an auditor’s liability to less than such amount as is fair and reasonable in all the circumstances of the case. The bill sets out its own test of what is fair and reasonable and the familiar Unfair Contract Terms Act 1977 (UCTA) “reasonableness” test, which governs limitation on liability for negligence for other professionals, is excluded.

Fair and reasonable

In the bill as published, what amounts to a fair and reasonable amount is to be determined with express regard to auditors’ responsibilities under the bill, the nature and purpose of the auditor’s contractual obligations and the professional standards for auditors. Amendments have been proposed to either remove the reference to these specific factors or at least make it clear that they are not the only factors to be considered. Although the test in the bill is similar to the UCTA reasonableness test, unlike that test it does not specify the time at which the reasonableness of the limitation should be tested: once the claim has arisen or at the time the liability limitation agreement was entered into. What once seemed fair and reasonable can seem very different a few years later when a claim has arisen. Amendments have been put forward that would make this clear by specifying that the test is to be applied at the time the agreement was made and with regard to the circumstances known at that time.

Fallback position

One aspect of the test in the bill that is very different from the UCTA reasonableness test is the consequence of the limitation not being fair and reasonable. Under the bill, if a liability limitation agreement purports to limit the auditor’s liability to less than what is fair and reasonable, it will nevertheless have effect as if it did limit liability to the amount that would be fair and reasonable. In contrast, if the clause fails the UCTA reasonableness test, the provision is entirely ineffective, leaving the professional with no protection. In this respect, auditors are being given an advantage not given to other professionals, or indeed accountants carrying out non-audit work. This difference may play an important part in claims against auditors, as a claimant will be unable simply to dismiss an unreasonable limitation of liability and proceed as if there was none, but will have to reckon on there being some limitation, albeit a reasonable one.

Cap or proportionate liability?

A liability limitation agreement is defined in the bill as an agreement that purports to limit the “amount” of the liability owed to a company by its auditor. The principal terms of such an agreement are said to include the “amount” to which the auditor’s liability is limited. It is clear, therefore, that under the bill, liability can be limited to a fixed amount. Indeed, it is arguable that the bill does not allow an auditor to agree proportionate liability, as this does not involve fixing an “amount”. It seems most unlikely that the intention is to prevent the parties agreeing proportionate liability given the history of these provisions, and amendments have been proposed that would make it clear that proportionate liability could also be agreed.

In practice, the key restraint on whether an auditor will be able to limit its liability and, if so, in what way, will be what the auditor is able to agree with the directors and get approved by the shareholders in advance. As other professionals have found, it is not always easy to persuade clients to accept limits on liability. Auditors may find it is easier to convince shareholders and, if necessary, the court, that proportionate liability, rather than a fixed cap, is a fair and reasonable approach. It would also give them much of the protection they seek against catastrophic large claims.

Whatever practice eventually develops between auditors and their clients in relation to liability limitation agreements, the fact that they will be permitted will be a very significant development for the audit profession.

Nicholas Heaton is a partner at Lovells