Auditor's liability

 On 3 November 2005 the government issued the Company Law 
Reform Bill.  This contains important amendments to the law 
on limitation of liability by auditors and introduces a new 
criminal offence in relation to audit reports.  This part 
of the Bill responds to the audit profession's call for the 
ability to limit their liability to prevent the 
next "Andersen".  It derives from a consultation process 
that has been ongoing for several years and builds on part 
of a White Paper issued in March 2005 and draft clauses 
published in July 2005. 

The key points in relation to auditors are as follows:

• The Bill allows auditors to limit their liability. 
 Auditors will for the first time be free to agree limits 
on their liability to companies in respect of statutory 
audits.  Any limit on liability must be agreed with the 
company.  It must also be approved by shareholders each 
year.  
 An agreement limiting the liability of an auditor will 
not be effective to limit liability to less than what is 
fair and reasonable in all circumstances having regard to 
the auditors' responsibilities, professional standards and 
contractual obligations. 
 The Bill expressly provides that the effect of failing 
this "fair and reasonable" test will not be that the clause 
is invalid. Instead the limit set will be what is 
considered fair and reasonable.  This gives auditors a 
significant advantage as they will not run the risk of 
having no protection if the original agreement went too far 
in limiting liability.  Generally if a clause limiting 
liability is considered unreasonable it will fail 
altogether and the court will not rewrite the parties' 
agreements to make it effective.  This is a change from the 
earlier draft clauses.
 The draft Bill gives auditors the freedom to set limits 
on their liability by reference to a fixed amount (a cap) 
or by whatever other criteria they think appropriate.  This 
gives auditors much more freedom than was suggested by the 
White Paper, which had said that the legislation would only 
permit auditors to agree proportionate liability with 
companies.  Introducing proportionate liability would have 
allowed auditors to limit the amount for which they are 
liable to a level that the court determines to be just and 
equitable in the light of the relative responsibility of 
the auditor and any other defendants.  Although it would 
still be open to auditors to agree proportionate liability 
with the company, the Bill does not restrict them to this 
and allows monetary caps.   

• A new criminal offence
 The bill introduces a new criminal offence for auditors 
of knowingly or recklessly causing an auditor's report on 
company accounts to include any matter that is misleading, 
false or deceptive in a material particular.  This will 
apply to individuals only, not firms.   In a change from 
earlier draft clauses, the penalty for the offence has 
been  reduced to a fine.  As a result, the risk of auditors 
being imprisoned for this  offence has been removed.
 Auditors will remain concerned that the offence can be 
committed through "reckless" behaviour.  The concept of 
recklessness potentially causes difficulty when applied in 
the context of an audit, which always involves an element 
of risk.  If the same definition of recklessness is applied 
by the courts to this offence as to others, this will be a 
worryingly low threshold and could amount to a judgment on 
whether the auditor acted "reasonably".  The concern is 
that an honest mistake could attract a criminal penalty. 

• Shareholders (100 together or holding 5% of the voting 
rights) have been given the right to require the company to 
publish on its website statements on any matter relating to 
the audit or the circumstances of an auditor leaving 
office.  The company must pass these to the auditor but 
there is no obligation on the auditor to answer any 
questions put. 

• A company audit must be signed (where the auditor is a 
firm) by a person authorised to sign on its behalf and the 
senior statutory auditor (pursuant to the relevant 
standards).  It is provided that the senior statutory 
auditor will not be subject to any additional civil 
liability as a result of doing so. 

• The position with regard to audit resignation statements 
is amended.  Previously (under s. 394 of the Companies Act 
1985) the court could only prevent the statement from being 
sent to the members if the auditor was seeking needless 
publicity for defamatory material.  Now it can do so in 
wider circumstances were the auditor is abusing the rights 
given to it.  Summary The clauses allowing auditors to 
limit their liability are a very helpful development for 
the audit profession.  They have also received the bonus of 
being allowed to cap their liability and not just agree 
proportionate liability. Moreover, by providing that 
agreements limiting liability below a fair and reasonable 
level do not fail, but are effective to limit liability to 
a fair and reasonable level,  auditors are put in a better 
position than all other professionals in relation to 
liability caps (and in a better position than accountants 
for their non-audit work).  Auditors will be disappointed 
that their intense lobbying over the wide scope of the new 
criminal offence has not changed the definition of the 
offence but will be relieved to see the potential penalty 
reduced from imprisonment to a fine.     

For further information or comment please contact:

John Trotter, Partner and head of Lovells professional 
negligence team 0207 296 2606/john.trotter@lovells.com

Nicholas Heaton, Partner, Lovells professional negligence 
team0202 296 5919/nicholas.heaton@lovells.com
 
Kate Horsfield, PR Manager, Lovells020 7296 
2675/kate.horsfield@lovells.com