A law of uncertainty
| by Peter Hayden 11 Feb 2006 Topic: Audit, Business law |
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Peter Hayden reports on the new Company Law Reform Bill and predicts challenges ahead for auditors For those who regard auditors as “deep pockets” who should be held responsible for any failing in the company that they audit, 2005 was not a good year. In late September, Equitable Life was forced into an embarrassing climb-down and to drop its claims against Ernst & Young. Then in October, in the other large “deep pocket” claim, the liquidator of BCCI dropped its claims against the Bank of England. It may be that these cases will serve as salutary lessons to those seeking to bring claims against auditors, although whether they stem the trend that has developed over recent years remains to be seen. New challenges present themselves for UK auditors in 2006. The Company Law Reform Bill was introduced in the House of Lords on 1 November 2005. It seeks to make a number of changes, although some of the more significant changes for auditors can only be identified by a careful reading of the Bill. In particular, as far as the resigning auditor is concerned, some of the requirements relating to the preparation and filing of resignation statements will be changed when the Bill replaces the Companies Act 1985 (CA). The fact that changes are being made should not be surprising because it is generally accepted that Section 394 CA does not operate as well as it might. In particular, the research that has been carried out (1) suggests that resignation statements are uncommon and, even when such statements are made, they tend to be relatively uninformative and unhelpful to the members and creditors of the company whom they are intended to assist. The increasing focus on corporate governance has now reached this area and steps are being taken with a view to improving the frequency and quality of resignation statements. However, this area was carefully considered by the Audit Quality Forum, which concluded in its February 2005 report that the current law was generally satisfactory. Whilst the failings of Section 394 CA are recognised by both parties, the Audit Quality Forum and the UK’s Department of Trade and Industry have different ideas about the best way to tackle them. The key change in Section 507 of the Bill relates to the basis on which the court should judge the auditor’s conduct when filing a resignation statement. Section 507(4) of the Bill requires the court to consider whether the auditor is “abusing the rights conferred by Section 506”. This form of wording is less prescriptive than that contained in Section 394(6) CA and is presumably intended to give the court more flexibility and discretion. Section 509 of the Bill also provides for a copy of the resignation statement to be sent to the appropriate authority (the recognised supervisory body which has issued the auditor’s authorisation). Where the audit appointment being terminated concerns a listed company, or where there is a major public interest in the company’s financial condition, the RSB concerned will have to pass the information it receives on the auditor’s ceasing to hold office to the Financial Reporting Council (FRC). Better guidance The requirements to file the statements should be welcomed. They will introduce an element of supervision that has previously been lacking and enable a better picture to be built up of the circumstances in which resignation statements are prepared and the contents of those statements. This should assist in the future development of policy and enable better guidance to be provided to auditors on complying with their obligations. However, these positives need to be considered in light of the changes to the basis on which the auditor’s conduct will be judged, which are less welcome and likely to cause considerable difficulty, at least until a body of case law has been developed to clarify matters. The key reason why resignation statements have either not been filed, or have contained limited information, is largely due to the concerns that auditors have had about being drawn into potential lengthy and expensive litigation with their former client. This is exactly what happened in the leading case on Section 394 CA, Jarvis Plc & Ors v PricewaterhouseCoopers (2000) (2). The company applied to court to prevent PwC filing its resignation statement with the registrar. The proceedings took a considerable time to resolve and, by the time the proceedings had been resolved, the resignation statement was out of date. Whilst the application to court was being made, the contents of the resignation statement were prevented from coming to the attention of members and creditors at the appropriate time. The difficulty with the new wording contained in the Bill is that it is likely to exacerbate the reluctance of auditors to prepare and file informative resignation statements rather than encourage them. One of the key reasons the Audit Quality Forum believed that the law in this area should not be changed was that there was an existing body of case law relating to Section 394 CA and the law was at least relatively clear. By changing the law, the case law will be lost. This difficulty is further compounded by the new test set out in the Bill, which may give the court more flexibility but at the same time is unclear. Section 394 CA requires the court to consider whether the auditor is “using the statement to secure needless publicity for defamatory matter”. The test is based on the auditor’s motive and the threshold is placed at a relatively high level. Not only must the company show that material in the statement is defamatory - following the guidance given in the Jarvis case - it must also prove bad faith on the part of the auditor. As noted above, Section 507(4) of the Bill requires the court to consider whether the auditor is “abusing the rights conferred by Section 506”. This wording gives rise to a number of potential difficulties. Section 506 of the Bill does not really give the auditor rights, it imposes an obligation on the auditor to file a resignation statement. More fundamental though is what “abusing” means. It arguably requires much less than the bad faith required by Section 394 CA. By possibly lowering the threshold (or at least introducing considerable uncertainty as to the threshold level), the Bill is likely to discourage auditors from preparing more open and informative statements. It is disappointing that the provisions of the Bill are likely to make the position more difficult for auditors and fail to address the need for members and creditors to be provided with timely and useful information on the condition of the company. The real difficulty in this area is the amount of time that it takes for applications to be heard by the court. If applications were dealt with swiftly, the incentive for companies to abuse the law to delay the resignation statement being filed would disappear. Serious consideration should be given as to how the procedure for dealing with these applications can be improved so that the wheels of justice turn a bit quicker.
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