By James Hamilton, J.D., LL.M.
In an effort to increase the number of global audit firms, and preserve the existing ones, the European Commission has proposed limitations on auditor liability. This effort is in response to the increasing trend of litigation and the lack of sufficient insurance coverage in the sector. The proposal is also designed to ensure that enough audit firms are available to carry out the audits of public companies in the European Union. Studies have shown that liability risks for audit firms act as a barrier for mid-tier audit firms entering the market for the audit of listed companies at the international level.
Internal Market Commissioner Charlie McCreevy declared untenable the specter of unlimited auditor liability. Current conditions prevent the entry of new players in the international audit market, he said, as well as threaten existing audit firms. Left alone, noted the commissioner, the combination of high concentration and limited choice of audit firms could lead to damaging consequences for the capital markets.
The Commission’s initiative arises out of a mandate in the Directive on Statutory Audit to examine the issues of auditor liability and present recommendations. Ultimately, EU members must decide on the proper method of limiting auditor liability. There is no common view on which option to favor. At present, only 7 out of 27 EU members have limited liability for auditors. Of these, some, such as Germany, have chosen a cap on liability, while others have proportionate liability. No EU-wide Directive on auditor liability is being contemplated at this time.
The Commission proposes a number of non-exclusive methods to reduce liability. There could be a cap on auditor liability, which has the advantage of making liability risk exposure predictable, as well as improving insurance coverage for auditors. Another possibility is to define auditor liability in proportion to the firm’s actual level of responsibility. Auditors would no longer be jointly and severally liable with companies.
However, proportionate liability might not be enough to protect auditors against excessive claims, since it does not limit absolutely the magnitude of such claims. Concomitantly, it would not improve the insurability of audit firms as much as a cap would. Yet another option would be to limit the risk exposure for auditors by carving-out certain risky tasks from the audit activity under international standards, in effect creating a safe harbor. One problem with this option is that auditors would strive to work within the boundaries of any such safe harbor.
At the same time, the Commission has set forth key principles to be followed by EU members when they select an audit liability oiption. One principle is that the limitation of liability should not apply in the case of intentional misconduct on the part of the auditor. Another principle is that a limitation would be inefficient if it does not also cover third parties. Finally, damaged parties have the right to be fairly compensated.
The Commission emphasized that major audit networks will not receive immunity against audit failure. Even after audit liability measures are put in place, audit firms will continue to pay compensation to damaged parties that can still be very high in many cases.
The report noted that, in the US, the Private Securities Litigation Reform Act eliminated joint and several liability for auditors and replaced it with a form of proportionate liability. However, the Commission noted that the US system offers less protection for auditors than they currently enjoy in the EU because it includes the possibility of awarding punitive damages and allows not only shareholders but a much wider range of investors to sue companies and their auditors.
There is currently a wide public debate in the US about whether there is a need to even cap auditors' liability. The US Chamber of Commerce has called for a better definition of the limits of an auditor’s responsibility and ways to permit companies and auditors to agree to reasonable limits on an auditor's liability.
In late 2006, the Treasury Committee on Capital Markets Regulation considered in its report whether Congress should be invited to explore whether there is still a sustainable and competitive audit market. The Committee suggested a cap based on a multiple of audit fees as a possible reform to be considered by Congress.