Director and Auditor Liability
A consultative document issued by the Department of Trade and Industry
Comments from ACCA
March 2004
Executive Summary
We welcome this consultation exercise as a very timely review of a matter of major importance to the corporate and professional sectors. While the issue under review is of concern to companies and firms of all sizes, it would, in our view, be particularly damaging to both sectors and the UK economy as a whole if there were any further reduction in the number of audit firms capable of providing audit services to listed companies.
We agree that directors and auditors, all of whom occupy positions of trust and responsibility and owe duties of skill and care, should be accountable for their work. Where directors and auditors are proved to have been negligent in carrying out their duties, those who have suffered as a direct result should be entitled to bring civil actions against them.
In determining liability, however, there must be a close correlation in law between officer fault and consequent loss. Auditors and boards should be responsible for their own actions but, more often than not, more than one party will be responsible in a situation of economic loss and it is, as a matter of principle, unreasonable for the whole of the financial responsibility to be attributable to a single party where more than one party is responsible.
A debate on the most appropriate basis for determining the liability of directors and auditors should take into account a wider context than just the positions of those two groups. There is a wider constituency of players whose roles and responsibilities with respect to financial statements need to be considered in the light of determining where final financial responsibility for loss should lie. Analysts, for example, are highly influential in valuing companies for investment purposes ¿ their contribution to shaping investor expectations and reactions should not be ignored. Audit committees, too, will hopefully evolve to become a vital link in the process of ensuring that published accounts are true and fair and that the audit process can be carried out unhindered. We believe, accordingly, that there is scope for a holistic approach to be taken towards minimising the risk of investor loss through misrepresentation of the company's financial position. More generally, we would argue that the UK needs to be careful to guard against encouraging the development of a litigious climate in which investors regard all business loss as potentially actionable. This can only serve to discourage the use of judgement and inflate insurance costs.
We believe that directors and prospective directors, for understandable reasons, are concerned about the possibility of attracting personal liability. The implications for director liability are likely to increase if the scope of directors' duties is expanded as recommended by the Company Law Review (CLR). The implications may be much higher if the directors of listed companies take on civil liability in respect of the contents of their companies' accounts under the draft Transparency Directive. But we suspect that a more general issue in relation to directors' liability is proper understanding, on the part of individual directors, of their statutory and common law responsibilities. We believe that the CLR's recommendations in this respect should be implemented as soon as is practicable.
With respect to the liability of auditors, we recognise that the courts have, over the years, been concerned to avoid imposing on auditors too wide a duty of care and also to restrict the circumstances in which damages for economic loss can be claimed. Further, we appreciate that Parliament has acted in the recent past to allow firms of auditors to make substantial changes to the personal exposure of their individual members via the introduction of the Limited Liability Partnership (LLP).
We consider, however, that the current law, which is based on the principle of joint and several liability, imposes a contingent burden on auditors which can be entirely disproportionate. Under this rule, which applies to partnerships and LLPs alike, claimants can choose to pursue the auditor for the whole of their claimed loss, not necessarily because they think that the auditor is primarily responsible for that loss but because they estimate that the auditor, or his insurers, is most likely to be able to pay. Professional advisers are particularly vulnerable to this practice. While the operation of the joint and several liability rule maximises the prospects of recovery for an innocent claimant, it does not, in principle, ensure a fair allocation of financial responsibility as between the parties involved.
Where an auditor is found to have been negligent in his audit work, this finding is absolute and can serve to attach to him responsibility for meeting the whole of the loss claimed, which may be out of all proportion to the reward which the auditor received for the work and also to the level of his insurance cover.
We are disappointed that the consultation paper excludes consideration of the merits of proportionate liability as a more radical solution to the issue of auditor's liability than the alternatives discussed in the paper. Proportionate liability would, in our view, simplify the existing law on liability by making it clear at the outset of proceedings that, if found negligent, a party will only be held liable to the extent of his perceived share of responsibility for the loss caused. It would mean that, where more than one party was responsible for loss caused to a claimant, no single negligent party could be held responsible for meeting the whole of the claim. We would support the undertaking of a detailed review of the merits of this solution in the light of legal changes which are taking place and have already taken place in other jurisdictions.
The law currently acknowledges, via the concept of contributory negligence, that, in determining the level of damages to be awarded against a negligent defendant, actions of the claimant which may have contributed to the loss claimed should be taken into account. This is a reasonable tool for use by the courts but it should be strengthened. It is currently accepted that, where a company is the claimant, and its management failures are relevant to the issue of negligence, those failures are to be treated as fault for the purposes of a defence of contributory negligence. It should be made clear that the law should recognise for this purpose the failure of directors to provide the assistance to and co-operation with the auditor which statute law requires of them. In order to maximise its effectiveness in this context, we recommend that the provision in clause 8 of the Companies (Audit, Investigations and Community Enterprise) Bill should be re-presented so as to make it clear that the responsibility of the directors is to volunteer material information to the auditor, not merely to disclose whether or not they have done so.
We would support the amendment of the Companies Act to allow auditors and their clients to agree between them a contractual limit to the former's liability to the latter. But any such agreement must be entirely voluntary and the shareholders, as the addressees of the audit report, should approve it formally, ideally at the same time as the auditors are appointed. Shareholders would appreciate guidance on how limitations should be considered and agreed, but this should be a matter for the proposed Standards Board or the Auditing Practices Board, rather than statute.
Our responses to specific questions posed in the consultation paper are set out in the following pages.
Responses to Specific Questions
Should investors be able to claim against officers, and why? (Q1)
1 It is right that a company's members should be entitled to look to the company's directors and auditors for redress if they suffer financial loss as the direct result of the negligence of those parties. As long as directors are appointed by the members to act as agents of the company, the members should be entitled to expect the directors to fulfil their duties to the company. Rights of redress must be available where these duties are breached. The auditors for their part are appointed by the company's members to provide them with an expert, independent opinion on the directors' accounts of their stewardship of the company and so the auditor too should be accountable to the members for his audit opinion.
2 It would not, however, be wise to broaden the current scope of either duty of care so as to give a right of action to individual investors. Both directors and auditors are appointed on a collective basis and so the right of redress should be framed on a similar basis. The duties of directors, in particular, are expressly framed so as to require them to work in the best interests of the company as a whole, which may cover the interests of some members but not all members, and may also encompass the interests of parties other than shareholders. It would therefore be illogical to suggest that shareholders alone have interests which must be served by the directors.
3 The law must be careful to avoid allowing a situation to develop where frivolous and groundless actions were encouraged. This would be unhelpful from an insurance cost point of view and also from the perspective of encouraging competent individuals to become directors and auditors. The Higgs Report called for a substantial expansion in the range of individuals who offer themselves for NED posts; if this aim is to be achieved, directors must know the extent of their liability and, in particular, must be confident that honest business judgements which they make will not be examined by the courts. In the case of auditors, there is, we consider, a serious risk that the supply of audit services to the market, both generally and in specific sectors, will be curtailed if firms conclude that the levels of risk they face have increased to levels where the potential dangers outweigh the rewards.
4 Investors must always accept that with investment comes risk. While it is right that directors and auditors should be liable for breach of their duties, negligence should remain strictly defined and investors should not be led to believe that all losses are or could be recoverable from officers.
Should potential investors be able to claim (Q2)?
5 To allow ¿potential' investors to claim against the officers would require substantial reform to the law of negligence, which the DTI says - in respect of the issue of proportionate liability - it is not prepared to do at present. In the case of large investors, they will in any case carry out their own due diligence tests prior to making investment decisions and will make their decisions on that basis.
6 In this connection we would express our concern at the potential implications, for directors if not auditors too, of the draft EU Transparency Directive, article 7 of which would appear to suggest that a listed company's directors could in future be subject to actions under the civil law in respect of the content of their company's interim and financial reports. Given the market-orientated nature of these reports, we are concerned that there is potential in this development for the scope of the duty of care to be widened to encompass a duty of care to persons who invest or disinvest on the basis of the contents of annual or interim accounts. An extension of the duty of care of this extent would have very serious consequences and should be resisted.
Should an ability to claim in respect of annual accounts be extended to any other group? (Q3)
7 No. The accounts and the audit report are prepared for specific purposes and addressees, and there is no cause to change this.
Should there be statutory criteria to determine whether an auditor owes a duty of care to a particular person? (Q4)
8 A statutory statement of the persons to whom the auditor owes a duty of care would certainly create certainty for auditors, their clients and third parties. The principles established by Caparo are, in our view, sufficiently clear to enable this to be done. Whether it should be done in respect of auditors alone, in isolation from all other parties who owe duties of care under the law of negligence, would be matter for the Department to decide. Any decision of this kind will also need to be made in the light of any framework principles which emerge from the revised Eighth Directive.
Should any action for recompense be against the directors, auditors or both? (Q5)
9 Liability should be linked to the responsibility of all parties for any loss caused. It is rare for only one party to be so responsible.
The basis of assessment of loss (Q6(a) and (b))
10 A claimant should be entitled to present a claim for the total economic loss he claims to have suffered as the result of the conduct complained of. It should be for the courts to determine the correct basis to apply in the light of the circumstances of the particular case.
Implications of overall liability limits (Q7(a) and (b))
11 The implications of overall limits for third parties would depend on the basis on which any limit was imposed. A contractual limit would bind the two contracting parties but would not bind third parties. A statutory limit would bind all parties.
If the company brings an action against officers on a particular matter, then no individual member should be entitled to do likewise. If the company declines to do so, however, that should not prevent personal rights being enforced or derivative actions being sought. Third party rights should not be affected by the company's actions.
Extension of auditor's duty of care (Q8)
12 As the duty of the auditor is understood post- Caparo, the auditor may already assume a duty of care to one or more third parties provided certain conditions are met. This understanding has been used by the courts to attribute a duty of care to the auditor in the ADT and Bannerman cases. In current circumstances, we do not believe that it would be reasonable to extend the auditor's duty of care further than this. It will be recalled that the CLR reviewed this matter and concluded that extending the range of persons to whom the auditor owes a duty of care to include, for example, prospective creditors and investors would not be justifiable. Any extensions in the auditor's duty of care as presently understood would have to be based on an extension of the core purpose of the audit, which is, currently, to provide shareholders with an opinion on the truth and fairness of the annual accounts. In the light of current and future developments in financial and non-financial reporting, we would be supportive of an evolution of the overall function of the auditor but consider that such an initiative would need to be accompanied or preceded by an acceptable resolution of the liability issue.
(Qs 9 and 10 are not applicable)
D&O Insurance (Q11)
13 Given the context of steep rises in the cost of all forms of insurance, the cost of D&O insurance appears to us to have been relatively stable in recent years. There are, however, a number of factors which could have a substantial impact on D&O costs. We have referred above to the possible implications for directors' civil liability, and hence insurance costs, of the draft EU Transparency Directive. Then there are the expanded responsibilities which are envisaged for directors in the DTI's company law white paper. Also, recent years appear to have seen an increase in the number of wrongful trading actions brought against directors, probably because of the recognition of conditional fee agreements. We expect the number of wrongful trading actions to increase further as the result of the abolition of Crown preference. These factors suggest to us that the market will have to react by increasing the cost of cover.
14 Another issue which must be taken into account in considering the cost of insurance is the excess payment conditions which apply to policies. These can be so high as to reduce the benefit to officers of having the insurance in the first place.
Insurance for directors (Q12)
15 The issue of what companies should do as regards their own insurance is a question for them and the market.
Are liability issues affecting the recruitment of able NEDs? (Q13)
16 We believe that NEDs and prospective NEDs are right to be concerned about their exposure to liability. The main factor involved here, though, is the increased level of expectations of them which arise from projected changes in the law and also from changes in corporate governance guidance.
17 Research carried out by KPMG in 2002 suggested that 40% of NEDs felt that they did not have sufficient knowledge of non-financial indicators which could have a material impact on the future business performance of their companies. 70% did not have any training on crisis management or on how to identify early warning signals of business failure. The latter point is of course particularly concerning because of its civil liability implications.
18 The KPMG survey suggested that there is a pressing need for NEDs to receive more training in order to be able to perform their roles effectively. This has subsequently been echoed in the Higgs report. It is evident that if NEDs are unsure about what is expected of them they will not be in a position to perform their roles properly and will therefore be a liability risk to themselves and their colleagues. Companies and directors can therefore address liability concerns through a commitment to education and training. (ACCA has embarked on a series of NED training courses, which have proved very successful). In addition, though, it is vital that, in the proposed codification of directors' duties, directors' honest business judgements are respected. This, more than anything, will serve to assuage NEDs' fears about liability.
Should companies be permitted to indemnify NEDs? (Q14)
19 UK law treats executives and non-executives as having equal status and collective responsibility for board decisions. While we support the trend for NEDs to be expected to bring a particular perspective to the board room, it would not be appropriate for NEDs to be given favourable treatment with regard to indemnity.
Does the length of court proceedings add to directors' concern about liability (Q15)?
20 Yes, in that it affects the length of run-off insurance which directors are expected to have post-retirement.
Does s727 CA 85 allow the courts sufficient scope to grant interim relief? (Q16)
21 The present arrangements are sufficient. Interim relief can only be given in front of a jury.
Which of the three given reform options should the Government adopt? (Q17)
22 Of the three options presented in the paper, we would favour following Option B, viz adopting specific recommendations made by the Company Law Review with regard to s310 and s727 CA 85.
Aspects of the CLR proposals (Q18(a) and (b))
23 We believe that a more radical reform of s310 would be preferable to merely limiting its application to directors' ¿general' duties, which would risk causing confusion.
We would not support the proposal to allow companies to indemnify a director in advance against legal costs without trying to establish beforehand his prospects of success.
Aspects of the US model of director liability (Q19(a-c))
24 As stated above, UK law must make clear that honest business judgements are to be respected. Provided that this remains the case, we do not think that there is anything to gain from express adoption of the US ¿business judgement' rule.
Barriers to entry to, and expansion of, the audit market (Q20)
25 At the lower end, there are no substantive barriers to entry to the audit market. That being said, the abolition of the mandatory annual audit for all small companies will reduce the range of companies which will require audit services and this may well cause a significant reduction in the number of firms which maintain their audit registrations. This risks having a detrimental effect on the availability and cost of audit services to the SME sector, and to specialised entities such as small charities and clubs, pensions schemes, solicitors and estate agents.
26 At the top end of the market, there is, effectively, very restricted competition. 96% of FTSE 350 companies are audited by Big 4 firms. This concentration is not helped by the pressure exerted on companies by institutional investors to appoint as their auditors one or other of the Big 4 firms. This pressure inhibits the ability of mid-tier firms to attract listed company business and thereby to expand their experience and to inject more competition into the top end of the market. In making this point, though, we have to acknowledge that the financial risk of auditing FTSE companies, together with resource and logistical factors, also act as material deterrents to mid-tier firms entering this market.
Is the only way to maintain competition to legislate, e.g. by reforming s310 of the Companies Act? If not, why not? (Q21)
27 We would support reform of s310 as one means of stimulating competition within the audit market. But we do not see this as being the principal objective of reform. Ultimately, other factors will determine whether mid-tier firms do more work with listed companies.
Cost of insurance cover (Q23)
28 The increasing cost of all forms of insurance is an issue for businesses of all kinds. Auditors, and other types of professional adviser, are not exempt from this. The cost and availability of indemnity insurance is certainly an issue for practising accountants, particularly for the large firms which conduct the audit of large and listed companies but also at the smaller end of the market too. While the cost of PII cover has certainly risen dramatically in recent years we should say that new competition in the market appears currently to be having a beneficial effect on the cost of cover to consumers. We would also say that, in our experience as a regulator and professional body, the instances of members being refused cover absolutely are comparatively rare, and when they do occur they are usually associated with outstanding disciplinary matters.
Effects of existing liability law on recruitment and retention (Q24)
29 ACCA has received testimony which suggests that the risks associated with partnership status are perceived by some accountants at least as being greater than the potentially increased rewards of that status. This testimony has come both from the perspective of accountants who have been invited to become partners as well as from firms themselves which have experienced difficulty in persuading individuals who they deem suitable to become partners. Even if this evidence is not indicative of a generalised attitude towards risk across the whole of the profession, any significant reluctance on the part of individual accountants to accept exposure to personal liability is likely to cause longer-term difficulties to smaller professional firms in particular. The introduction of the LLP is of some help in this regard, but the LLP was introduced principally with the circumstances of larger firms in mind. Also, the LLP is of limited assistance since unlimited exposure still applies to any single LLP ¿partner' who owes a duty of care to any of the firm's clients.
Defensive auditing (Q25)
30 There is already a trend towards defensive auditing, encouraged by a fear of litigation as well as downward pressure on fees and restrictions on non-audit services. We would also make the point that US-influenced audit standards are heavily influenced by the ¿tick box' approach which has the aim of demonstrating that the auditor has not been negligent. In our view, this reduces the essential technical quality of an audit.
Given that no audit firm has yet collapsed as the result of a successful claim against it in the UK , how real is the threat to the largest firms? (Q26)
31 We consider that the question as posed is complacent. The scale of outstanding claims against large firms is well known. If those claims are successful they would be large enough to put the firms concerned out of business.
The chances of success of these claims cannot of course be estimated with any certainty at this stage. But no firm will ever be strong enough to withstand a very large claim, and insurance cover will be of no help to it. We consider that the risk that one of the Big 4 firms could collapse is a realistic proposition and the DTI should regard it as such. Should that happen, the competition implications would need to be considered. Those large firms which remained would be likely to adopt a very aggressive risk-averse strategy.
While the implications of the current liability regime are very serious for both large firms and large companies, the current review should also be mindful of the implications of unlimited liability claims for smaller firms.
Do you favour minimal law reform? (Q27)
32 The present situation is in need of attention. This view was supported by the CLR.
Do you favour simply allowing auditors to limit their liability contractually (with or without benchmark statutory rules)? (Q28 & Q29)
33 Contractual capping would not, in our view, be a complete or an ideal solution to the liability problem. The practical likelihood of shareholders agreeing to allow a limitation of their auditor's liability, and the practical difficulties of agreeing on a formula to suit both sides, are obvious obstacles to the widespread adoption of bi-lateral capping. And if a resolution to approve a cap was carried by large or institutional shareholders with the majority of members voting against, there may be a suggestion that the interests of minority shareholders have been prejudiced. Rather than seeking agreement in advance to the capping of the auditor's liability before the audit has been carried out, we would prefer it if the determination of an auditor's liability to a client was made by reference to the scope of his duty and his actual responsibility for the shareholder loss he had caused.
34 Notwithstanding the shortcomings of contractual caps, however, we do not believe that the law should prevent auditor and client agreeing between themselves on a limit to the former's liability. If the two sides are able to come to a free and informed decision on restricting the scope of the auditor's liability, they should be allowed to do so, subject to certain safeguards.
35 With regard to possible benchmark rules, we agree that shareholders might find it helpful for there to be some guidance on what level of capping might be the norm or appropriate to their circumstances. But we do not believe that such rules should be set down in statute. It would be more suitable, in our view, if they were set by a body such as the proposed Standards Board or the Auditing Practices Board.
36 With regard to the substance of any benchmark rules, any formula will always have its drawbacks. Setting the cap as a multiple of the audit fee or the auditor's turnover would bear no direct relation to the scale of the potential loss to plaintiffs. Setting the cap at monetary levels, e.g. £500m for Big 4 firms and £100m for second tier firms, would be arbitrary and of limited practical use to smaller firms. An alternative method would be to set the cap by reference to a firm's professional indemnity (PI) cover (although shareholders may still only be interested in a cap which covered their foreseeable losses, regardless of the firm's PI cover). The PII link is, in fact, authorised by the auditing bodies for use by their members in respect of non-audit engagement and resulting claims against them, for example tax-related claims.
37 The process of setting benchmark rules should take into account that the legal scope of the audit is similar irrespective of the circumstances of the client. The rules should be framed in such a way as to be fair and applicable to all audits and should not be framed with the circumstances of only the Big 4 firms and their clients in mind.
38 Ideally, we would prefer a more comprehensive solution to the liability issue. The consultation paper suggests that the introduction of full proportionate liability, which we consider would have the virtue of providing a fair and logical basis for determining responsibility for financial loss, would be impossible in isolation from the reform of the law of negligence generally. We appreciate that there is currently no branch of the law of negligence which applies specifically to auditors, and that the implications of reform for all aspects of the duty of care will need to be understood. We are aware that, in the past, the DTI and the Law Commission have argued that proportionate liability would be undesirable in that it would inevitably lead to an innocent plaintiff being unable to recover full compensation for his loss if the only party having the resources to pay up, viz the insured auditor, is allowed to benefit from restricted liability.
39 This concern, though, does not sit easily with the DTI's apparent readiness to contemplate options which could have a similar effect. We would also ask why it is wrong for an innocent plaintiff not to be entitled to recover his whole claim and at the same time right that a concurrent wrongdoer should be expected to meet the whole of a claim even though other parties may have been instrumental in causing the loss complained of. We would stress that, under a system of proportionate liability, where the auditor (or other adviser) was uniquely at fault and wholly to blame for the loss caused, he would be solely responsible for meeting the plaintiff's claim. In such cases, there would be no change from the present system. The reasonable advantage of a system of proportionate liability would lie in the fact that auditors, and their insurers, were not made to pay for the mistakes of others as well as themselves.
40 Other comparable jurisdictions have been able to legislate to incorporate the concept of proportionate liability into the law of tort. Given these developments, we consider that it would be in the UK 's commercial interests to give renewed consideration to the advantages of adopting a proportionate approach to the liability issue.
Is the existing law on contributory fault and negligence adequate or is specific provision required? (Q30)
41 Under the law on contributory negligence, the amount of damages awarded against a defendant can only be reduced:
- by reference to the plaintiff's share in the responsibility for the damage caused to him
and
- then only if the plaintiff is negligent in circumstances where he ought reasonably to have foreseen the danger to his interests and still failed to act to defend himself.
42 The auditor is appointed by the company's members and reports only to them. The purpose of the audit report, after Caparo, is to report to the shareholders as a body on how the directors have fulfilled their functions. The members of the company are not, in any case, involved in the preparation of the company's accounts - this is the sole responsibility of the company's directors. However, even though the company's shareholders are not responsible for the functions of management, it has been held, in Barings v PwC , that the management functions of the directors can be assigned to the company for the purposes of contributory fault, thereby reducing the company's claim against the auditor.
43 A company's members qua members are not party to the preparation or approval of the accounts. These functions rest solely with the directors by statute. It is arguable, therefore, whether, in relation to the audit process, the members (as distinct from the directors) can be expected to be in a position to take action to ¿reasonably protect their interests' and thereby avoid committing contributory fault.
44 In order to strengthen the law on contributory negligence and to avoid any doubt on the matter, we consider that the law should be clear that failure on the part of the directors to comply with their statutory responsibilities with regard to the audit process should be attributable to the company for this purpose. This should be the case with respect to directors' duties under s389A(1) of the Companies Act 1985 and also the proposed new duties under clause 8 of the Companies (Audit, Investigation and Community Enterprise) Bill currently before Parliament. With respect to the latter, we believe the effect of the clause would be strengthened if the clause were to give a positive duty on directors to volunteer relevant information to the auditors ¿ this was, we believe, the recommendation of the CLR. As it stands, clause 8 creates an obligation, and a corresponding offence, only in respect to the disclosure by directors of whether or not they have volunteered information to the auditor.
45 However, even if directors do provide an auditor with all the assistance and information to which he is entitled under the law, the auditor may still, of course, perform his audit negligently and, consequently, become liable to the company for its loss. In such a case there will be no question of contributory fault and the auditor will be rightly liable. But it is evident that directors' statutory responsibilities with respect to the audit process are laid down in law precisely in order to put the auditor in a position where he can do his job properly.
If those responsibilities are not fulfilled, it will follow that the auditor may not be able to carry out his assignment as well as he otherwise might. This factor should be reflected in any assessment by the courts of the auditor's alleged negligence and the contributory responsibility of the directors for that negligence.
46 Related to the above point is that any determination of the auditor's responsibility for shareholder loss must take into account the scope of the auditor's responsibility for detecting and reporting fraud. The audit process is not intended to uncover all frauds which might have been perpetrated by management but, rather, to give the auditor a reasonable expectation of identifying frauds and errors which are material to the financial statements.
Arrangements for disclosure and/or shareholder consent (Q31)
47 Should a provision be introduced for auditors and their corporate clients to agree on a cap on the former's liability, then it is the shareholders, not the directors, who should give the necessary approval for it. Delegation to the directors of the scope of shareholders' recourse to the auditors is not the same as delegating to the board authority to fix the auditors' remuneration and should not be capable of such delegation. Approval of limitation should be considered and determined in advance, on the appointment of the auditors at the AGM. Where auditors are not appointed at the AGM, an EGM should be convened to give the necessary approval. Disclosure of the amount of the agreed liability cap should be made in the audit report and in the company's accounts.