Audit opinion letters to include disclaimer of liability to third parties?

United Kingdom
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.


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]