Guidance Proposed on Limiting Auditor Liability

A very significant event will occur on April 6, 2008. The UK Companies Act will come into force; and with it there will be provisions allowing outside auditors of financial statements to negotiate limits on their liability with client companies. The liability limiting agreements must be fair and reasonable; and a separate agreement would be required for each year’s audit, and each one must be approved by the company’s shareholders. In light of this development, the Financial Reporting Council, the UK audit oversight body, has proposed guidance on the use of agreements to limit the liability of auditors of public companies.

Among other things, the draft guidance sets out some of the factors that will be relevant when assessing the case for an agreement and explains what matters should be covered in an agreement. It also provides specimen clauses for inclusion in agreements. The draft guidance does not identify a preferred approach, but simply sets out the available options.

The key principle of the Companies Act is that any arrangement to limit liability must be fair and reasonable in the particular circumstances. This means that a court can override any contractual limits agreed to by the company and the auditors if it considers that they are less than fair and reasonable. The court may reach this conclusion notwithstanding the fact that the agreement was approved by the company’s shareholders.

Although the question of what is a fair and reasonable limit on the auditor's liability will ultimately be for the courts, the Companies Act sets out a number of factors that should be taken into consideration, such as the nature and purpose of the auditor's contractual obligations to the company and the professional standards expected of the auditor.

Also, the Act does not restrict the manner in which liability can be limited, which means that the limits could be set in a number of different ways. For example, a limit could be based on the auditor’s proportionate share of the responsibility for any loss. Under this approach, explained the FRC, the company would agree that if there is someone other than the auditor who is also liable to the company for all or part of the same loss, the auditor's liability would be limited to the extent to which the auditor was responsible for that loss. The agreement could also put a cap on the outside auditor’s liability, expressed either as a monetary amount or calculated on the basis of an agreed formula.

Even if the final guidance does indicate which options are most likely to be acceptable, noted the FRC, the guidance will not and cannot give firm assurances as to whether particular arrangements will ultimately be considered fair and reasonable. That is because every agreement will need to be assessed in the context of the specific circumstances. That judgment would be made by the courts in the event of a dispute, and cannot be defined in advance.

The proposed guidance advises companies and auditors to consider how any liability limiting agreement interrelates to the audit engagement letter. One option is for the principal terms to be part of the audit engagement letter. Another option is to have a separate agreement which just deals with the limitation of the auditor’s liability, cross-referencing to the audit engagement letter.

Companies and auditors will also need to consider whether there are any provisions in the audit engagement letter that would have the effect of limiting the auditor's liability in other ways, such as a limit on the period in which claims can be brought.