On 5 December it was reported in the
Financial Times that
PricewaterhouseCoopers (PWC) is to change the wording of its
standard audit opinion letter to include an express disclaimer of
liability to third parties who may rely on the audited accounts. It
is believed that PWC is the first major firm of accountants to
include such a disclaimer in its audit opinion letter, although
given the enthusiasm of disaffected investors, lenders and others
for going after the deep pockets of accountants, it might seem
surprising that such disclaimers are not already standard in the
industry. So what lies behind PWC's decision?
Liability of auditors for statutory
accounts
Most companies are required by the Companies Act
1985 (the Act) to prepare accounts on an annual basis comprising
(at least) a profit and loss account for the past year and a
balance sheet showing the company's assets and liabilities at the
year end. A company's directors are responsible for preparing and
approving accounts that give a true and fair view of the profit or
loss during the year, and the state of affairs of the company at
the year end. The auditors must make a report to the company's
members giving an opinion on whether the directors have done so,
and whether the accounts have been properly prepared in accordance
with the Act.
The primary source of an auditor's duties is
contractual. The audit engagement letter creates a contract between
the audit firm and the company, and will set out (amongst other
things) the scope of the audit to be carried out. In addition, the
auditor usually assumes a tortious duty of care to the client
company, which normally coincides with its contractual duty.
Accountants' engagement letters in connection with
particular transactions or advice usually include limitations on
the accountants' liability in contract and tort to the contracting
party, as well as restrictions on the way in which the advice and
opinions may be used and the third parties to whom they may be
disclosed. These limitations and restrictions are in practice the
most effective way of limiting liability to third parties.
As accountants are required by statute to produce
reports on companies' accounts which will necessarily be seen by
third parties, and used by them for a variety of different
purposes, the issue of accountants' liability for such reports is
critical. As a matter of public policy, Parliament has decided that
auditors should not be able to exclude or limit their liability to
the company itself for negligence or other breach of duty: this is
reflected in section 310 of the Act. However, liability of auditors
to third parties (such as existing shareholders, potential
investors, banks and other creditors) has been left for
determination by the Courts. Generally, they have tried to limit
the extent to which auditors may be held liable in tort to third
parties, for the reasons explained by Lord Bridge in the leading
case of Caparo Industries plc v Dickman [1990] 1 All ER
568:
"Where [as a result of a
statutory obligation] a statement is put into more or less general
circulation and may foreseeably be relied on by strangers to the
maker of the statement for any one of a variety of different
purposes which the maker of the statement has no specific reason to
anticipate, to hold the maker of the statement to be under a duty
of care in respect of the accuracy of the statement to all and
sundry for any purpose for which they may choose to rely on it is
not only to subject him to 'liability in an indeterminate amount
for an indeterminate time to an indeterminate class', it is also to
confer on the world at large a quite unwarranted entitlement to
appropriate for their own purposes the benefit of the expert
knowledge or professional expertise attributed to the maker of the
statement."
Nevertheless, the Courts have accepted that in certain
circumstances auditors can be held to have assumed a duty of care
to third parties.
In Caparo, the House of Lords clarified
that the auditors' statutory duty is owed to the members as a body,
to enable them to exercise class rights in general meeting (for
example, to approve or disapprove the election or re-election of
directors, or the appointment or reappointment of the auditors),
but not to individual shareholders or the public at large who may
rely on the accounts when deciding whether or not to invest in the
company. However, the existence of this statutory duty does not
preclude the existence of a duty of care in tort, which will be
found where all of the following ingredients are present:
- the damage suffered by the third party was reasonably
foreseeable;
- there is a relationship of sufficient proximity between the
auditors and the third party; and
- it is fair, just and reasonable in the circumstances for the
law to impose a duty of care.
It is apparent from the cases which have followed
Caparo that whether or not a duty of care will be found to
exist in any particular case will be determined principally by the
facts in that case; previous decisions may not always offer much
guidance. As a result, auditors have had to be wary about their
potential liability to third parties. The ICAEW's 1994 paper on
'Managing the professional liability of accountants' warns
accountants that "it would be prudent to assume that a duty of care
will exist in a situation where the accountant knows of the
existence of a third party whom he reasonably expects to receive
and rely on the accountant's work for a particular transaction or
purpose and to whom damage will be caused if the work has been done
negligently. The danger of a duty being imposed will be increased
where that third party has no other source of advice and where the
purpose of the accountant's work is to induce the third party to
take the particular action he has taken".
Some comfort for auditors who are sued in tort by
banks who have lent money to a company in reliance on statutory
accounts was provided by the decision of the High Court in Al
Saudi Banque v Clarke Pixley [1990] Ch.313 (the judgment of
Millet J subsequently being approved by the House of Lords in
Caparo). In that case, the auditors were held not liable
to the group of lending banks: the Court pointed out that the banks
had played no part in appointing the auditors, who had no statutory
duty to report to them; and the auditors did not supply a copy of
their report to the banks, or to the company with the intention or
in the knowledge that it would be supplied to the banks. However,
the case also illustrates that liability will depend on the
particular facts in each case: where these differ in any material
respect from the situation in Al Saudi Banque a different
conclusion could conceivably be reached.
Effectiveness of Disclaimers
It is evident from case law that a disclaimer which
is sufficiently clear and prominent is usually effective to exclude
liability even if the damage is reasonably foreseeable and there is
a relationship of sufficient proximity. Put another way, such a
disclaimer should be enough to prevent the maker of the statement
from being taken to have assumed responsibility to the third party.
Disclaimers of this type are used to enable companies to carry on
their business without being exposed to unacceptable levels of
uninsurable risk.
Attempts to exclude or limit liability for
negligence by means of a contractual term (such as in an engagement
letter) or a notice (such as in an audit opinion letter which is
reproduced in the accounts) are subject to a test of reasonableness
under section 2(2) of the Unfair Contract Terms Act 1977 (UCTA
1977). Whether or not a disclaimer of an auditor's liability for
negligence in giving an opinion on the accounts is reasonable will
depend on all the circumstances: factors of particular importance
will include the 'nature and quality' of the auditor's negligence,
the comparative resources of the parties, the availability of
insurance, the nature of the transaction, the scale of potential
loss and the fees paid.
Although auditors may well include in their audit
engagement letters restrictions on the persons to whom the company
may provide the audit report or for what purpose, they have not to
date included in their audit opinion letters a disclaimer of
liability to third parties, even though neither the Act nor
auditing standards prohibit it. Reasons for this probably
include:
- a belief that it is better to rely on the courts to determine
liability on a case by case basis, based on the principles in
Caparo and the cases following it. It may even be felt
that the inclusion of a disclaimer of liability to a particular
class of persons could in some circumstances be more of a hindrance
than a help: it could establish the foreseeability of particular
damage, or a relationship of proximity to that class, but could
nevertheless be held void for unreasonableness;
- pressure from clients: since clients expect the audited
accounts to provide third parties with some assurance as to the
'accuracy' of the company's accounts, they may well feel that a
disclaimer of liability to third parties undermines this assurance;
and
- reluctance to provide an excuse to increase the potential
liability of auditors through legislation. In their interim report
published in March 2000, the Company Law Review Steering Group
recommended that section 310 of the Act should be amended to allow
auditors - subject to the approval of the company's shareholders -
to limit their liability in contract to the company or the
shareholders in their audit engagement contract, and that auditors
should be expressly permitted to limit their liability in tort to
third parties (with such limitations being presumed to be
reasonable for the purposes of UCTA 1977 provided they go no
further than certain guidelines to be agreed after public
consultation). This proposal was designed to counter-balance both
the increasing amount of information which the auditors are
required to review and the Steering Group's proposal to set out in
statute an extended range of persons to whom auditors would be
deemed to owe a duty of care - namely existing shareholders and
creditors, those who become shareholders or creditors in reliance
on the accounts, and possibly employees.
However, in their final report in June 2001, the
Steering Group changed its mind and withdrew the proposal for a
statutory extension of auditors' duty of care, in view of the
objections which were made to it, but continued to recommend that
auditors should be able, subject to shareholder approval, to limit
their liability to the company contractually and in tort to third
parties. Clearly auditors would like to see this amendment
introduced.
The first part of the government's White Paper on
Modernising Company Law, published in July this year, did not deal
with the "difficult question of auditor liability"; instead the
government stated that it would announce its response to the
question in due course.
Royal Bank of Scotland plc v Bannerman Johnstone
Maclay (a firm) (The Times, 23rd July, 2002)
According to PWC, the decision to change the form
of their audit opinion letter was prompted by the ruling in July
this year of the Scottish Outer House (equivalent to the English
High Court) in this case. The ruling was made in a preliminary
hearing to decide whether or not the Bank's claims should be
allowed to proceed to a full trial. Bannerman Johnstone Maclay were
auditors of a plant hire company which borrowed money from the Bank
and then went into receivership. The Bank alleged that the auditors
had owed them a duty of care, which had been breached when the
accounts were negligently audited, causing loss to the Bank. In
response, the auditors contended that the Bank's claim should be
struck out on the grounds that it failed to establish a
relationship of sufficient proximity between the auditors and the
Bank.
In ruling that the Bank's claims should be admitted
to full trial, the Outer House held that it was at least arguable
that in the present circumstances a relationship of sufficient
proximity could be established. The Court considered that the
following factors might assist the Bank in establishing such a
relationship:
- the auditors knew that RBS was a shareholder and substantial
creditor of the company, as well as its principal banker;
- the company had a close relationship with the auditors, and one
employee of the firm was seconded to the company to work as its
financial controller;
- the company's business was very cash-dependent and it relied
heavily on funds being available on overdraft from the Bank;
- in order to satisfy themselves that the company would be able
to continue as a going concern for the next 12 months (required for
the audit opinion), the auditors must have been aware of the
existence of the overdraft and its terms. These terms included an
obligation on the company to provide the Bank with copies of the
monthly management accounts and the audited annual accounts;
- the auditors must have known that the Bank would use the
audited accounts to check the validity of the management accounts
and thus to decide whether or not to continue lending to the
company; and
- despite knowing that under the terms of the overdraft facility
the audited accounts would be supplied by the company to the Bank,
and the Bank would rely on them in making its lending decisions,
the auditors had not disclaimed liability to the Bank (even though
it was open to them to have done so).
Contrary to the arguments put forward by the
auditors, it was not necessary for the Bank to show that the
auditors intended the Bank to rely on the accounts for a
particular purpose; it was enough that the auditors knew that the
Bank was likely to do so. In deciding the latter point, the Court
followed a clear line of authority that no such intention is
required.
As it is a preliminary ruling, the decision of the
Outer House in Bannerman cannot be taken as changing the
law as to when auditors may be held to have assumed a duty of care
to third parties. Indeed if the case goes to full trial it may well
be that the auditors will be held on the facts not to be liable to
the Bank. Instead, the real significance of the case lies in the
importance attached by the Court to the fact that the auditors had
not included a disclaimer. Although judgments of the Scottish Court
of Session are not binding in the English courts, they can be of
persuasive authority. In view of this, it would be surprising if
most major firms of auditors were not at least to consider
including a disclaimer as a matter of course in all their audit
opinions, or at least those given where the auditors know that it
is likely that a third party will rely on the accounts for a
particular purpose.
Consequences
PWC's standard audit opinion letter will now
include the following sentence:
"We do not, in giving this opinion, accept or
assume responsibility for any other purpose or to any other person
to whom this report is shown or in to whose hands it may come save
where expressly agreed by our prior consent in writing."
It is believed that other large accounting firms
are considering adopting similar wording. Other consequences are
likely to include:
- lenders wishing to rely on statutory accounts for a particular
purpose may have to negotiate with the borrower's auditors as to
the terms on which the auditors are prepared to allow the lender to
rely on the company's accounts - in particular, the extent to which
the auditors' liability will be limited or excluded. The same is
likely to be true for other third parties wishing to rely on
statutory accounts for their own particular purposes;
- auditors may charge fees to third parties who wish expressly to
rely on the audited accounts. Environmental consultants, for
example, often charge non-clients who wish to rely on a report that
was prepared for a client: where the consultant's overall exposure
to liability for the report will not be increased (due, for
example, to caps being imposed on liability, or existing insurance
cover), the level of the fee is usually a 'nominal' one to cover
the 'administrative cost' to the consultant. If the consultant's
exposure is likely to be increased, however, the fee may reflect
the cost to the consultant of obtaining additional insurance. In
the case of auditors, in the absence of a disclaimer the
Bannerman case suggests that auditors' exposure to
liability for negligence is likely to be increased in circumstances
where auditors know that a third party is likely to rely on the
accounts for a particular purpose. It is therefore possible that
insurance premiums could rise for auditors who do not as a matter
of course include a disclaimer in their audit opinion letters;
- on the other hand, audit clients with sufficient bargaining
power may try to insist that the disclaimer be taken out;
- future parts of the White Paper on Modernising Company Law may
follow the recommendation of the Company Law Steering Group that
auditors be permitted, subject to shareholder approval, to limit
their liability to the company contractually and in tort to third
parties; and
- until the proposed changes to section 310 come into force, it
is likely that there will be more challenges made by third parties
under UCTA 1977 to the reasonableness of disclaimers and other
restrictions on auditors' liability.
For further information please contact Peter
Bateman (Corporate Professional Support Lawyer) by telephone on +44
(0)20 7367 3145 or by e-mail at [email protected]