Accountants Liability Update

In this edition of our Accountants' Liability Update we

look ahead a few months to April 2008 when auditors will be

allowed to limit their potential liability to audit clients and

we consider the affect of this for auditors, third parties and

professional indemnity insurers as well as whether these newly

implemented Companies Act provisions will satisfy any future EU

proposals. In a bid to promote greater transparency, we

highlight that the ICAEW will now be holding most of their

disciplinary hearings in public and we also consider the recent

Market Participants Group Final Report on Audit Choice.

Finally, we look at two recent decisions concerning

auditors' liability.

Taking A Gaze At LLAs

As from 6 April 2008 auditors will be allowed to reach

"Liability Limitation Agreements" (LLAs) limiting the

amount of their liability to their audit clients.

For reasons outlined here this should be of particular

interest to those involved in claims against auditors,

including their professional indemnity insurers and their

co-defendants. As also explained, there may be circumstances

where an auditor's liability is in effect unlimited despite

that auditor having reached an LLA.

At What Level Might An Auditor's Liability Be

Limited?

Auditors and their clients are not restricted in the manner

in which liability can be limited so (by way of example) this

could be a cap based on a monetary amount or a formula; a limit

that is simply stated to be 'fair and reasonable'; or

proportionate liability (or a combination of such limits). A

limit will be effective so long as it is 'fair and

reasonable in all the circumstances of the case' and it has

been approved by a shareholders' resolution. However and

importantly, if an LLA purports to limit liability to an amount

that is less than what is "fair and reasonable", the

agreement will still be effective - it will take effect as if

it limited the auditor's liability to such an amount.

Helpfully for auditors, when assessing what is a "fair

and reasonable" limitation of liability a Court cannot

take into account the fact that others who may be responsible

for a company's losses (for example directors or other

professional advisers) are in financial difficulties or even

insolvent.

Currently auditors can be jointly and severally liable. That

means auditors can be liable for all recoverable losses

regardless of the responsibility of others for such losses.

Whilst auditors can seek an indemnity or contribution from

others,much depends on the financial standing of the other

parties. However, with auditors soon being able to agree

proportionate liability, the amount for which auditors might be

liable would be limited to take into account the responsibility

of any other party, regardless of that party's financial

standing.

Auditors And Third Parties

In addition to helping auditors who are sued by their audit

clients, LLAs may also assist auditors in relation to claims by

third parties, such as investors, banks and directors. Whilst

the circumstances in which auditors may be liable to such third

parties are reasonably narrow, and will depend on the facts,

auditors can and do face such liabilities. If an auditor does

owe a duty of care to a third party, the auditor could in the

future contend that it's liability should be limited to the

amount of its LLA. This follows from the fact that LLAs will

have to be disclosed in audited companies' accounts. As

such an LLA should have come to the attention of the third

party. Although the law is not settled on whether an exclusion

clause in a contract can be effective against a third party, it

can be reasonably argued that LLAs can further protect an

auditor.

Unlimited liability despite LLAs?

There are some situations where, despite LLAs, auditors may

still encounter unlimited liability:-

Since LLAs only apply to single financial years it is

possible that a company may have reached LLAs for audit work

for some financial years but not for others. As a

consequence, claims in relation to some audit years may not

be the subject of liability limitations.This could give rise

to difficulties for auditors where, for example, an auditor

fails to detect fraud over a number of years but only some of

the audit years are the subject of LLAs. Liability for losses

arising in respect of work for one audit year may be limited,

however liability for losses arising in respect of another

audit year may not be. Depending on the facts, it may be that

all losses can be claimed in respect of the unlimited

liability work, negating the effect of any LLA.

Audit firms often also carry out non-audit work for their

audit clients. For example, they may be retained in relation

to tax, accounting or management consultancy work. Firms

carrying out such non-audit work continue to be entitled to

reach agreements limiting liability for that work, so long as

any limitation meets the requirement of reasonableness under

the Unfair Contract Terms Act 1977. However, if firms do not

have such limits, because they have not negotiated limits or

because the limits fall foul of UCTA 1977, this could lead to

difficulties. For example, an auditor may have an LLA in

respect of audit work but if that auditor also previously

prepared the accounts, any liability in respect of that

accountancy work may be unlimited.This could lead to

unlimited liability by the back door.

LLAs - The Way Forward

In the future, professional indemnity insurers may well want

to see that accountants proposing for insurance have previously

agreed LLAs and are intending to try to agree LLAs, as well as

disclaiming liability to third parties for audit work and

limiting liability for nonaudit work.

Our view is that auditors should try and reach LLAs since

agreements will result in some limit, even if the negotiated

agreement is subsequently deemed to have been too low a limit.

Sensibly auditors might try and agree an LLA whereby their

liability is to be proportionate as well as a fixed or capped

limit. In most circumstances it should be considered that

proportionate liability is fair and reasonable, with the result

that that aspect of the LLA will be retained in any substituted

LLA. That in itself would be an improvement from the current

position of joint and several liability. In addition, if a

fixed or capped limit can be agreed this will provide some

ceiling on liability if it is a fair and reasonable amount.

On 17 December 2007 the Financial Reporting Council

published, for...