Auditors’ liability limitation agreements

Sections 532 to 538 of the Companies Act 2006 come into force on 6 April 2008, following which auditors will be permitted for the first time to limit their liability for audit work by entering into an agreement with their audit client (a liability limitation agreement or LLA). Already some companies may have been asked by their auditors to enter into such agreement; others are likely to be asked soon.

Section 534 defines a liability limitation agreement as “an agreement that purports to limit the amount of a liability owed to a company by its auditor in respect of any negligence, default, breach of duty or breach of trust occurring in the course of an audit of accounts, of which the auditor may be guilty in relation to the company.”

Crucially, however, the Act does not prescribe how an LLA should be framed. In particular, “the limit on the amount of the auditor’s liability need not be a sum of money, or a formula, specified in the agreement”. Terms of an LLA that attempt to limit auditors’ liability are not subject to a reasonableness test under the Unfair Contract Terms Act 1977. As a result, companies and auditors have freedom to agree the terms of an LLA, including freedom to limit the auditors’ liability by reference to a fixed cap, proportionate liability, or any other means, subject to the following:

• An LLA must specify the financial year to which it relates and must not apply in respect of acts and omissions in the audit of accounts for more than one financial year (s535).
• The agreement must be approved by a resolution of the company’s members (s536). If members’ approval is sought before the agreement has been entered into, at least its “principal terms” must be approved – i.e. the kind or kinds of acts or omissions covered; the financial year to which the agreement will relate; and the limit of liability. If approval is sought after the agreement has been entered into, the whole agreement must be approved.
• Any limit on the amount of the auditors’ liability is only effective to the extent that it is not less than such amount as the court considers fair and reasonable in all the circumstances. This means that although an LLA can limit the auditors’ liability to any amount, if the court considers the limit to be lower than is fair and reasonable, it can substitute its own amount. The LLA then takes effect “as if it limited [the auditor’s] liability to that amount”, and otherwise remains effective. Auditors will therefore continue to be protected by the LLA in the event that the court subsequently decides that the agreed limit is too low. In deciding what is a fair and reasonable amount, the court must have regard to the auditor’s responsibilities, the nature and purpose of the auditor’s contractual obligations to the company and the professional standards expected of him /her. No account is to be taken of matters arising after the loss and damage in question has been incurred, or matters (whenever arising) affecting the possibility of recovering compensation from other persons liable in respect of the same loss or damage – in other words, the court should ignore any factors that could make it difficult or impossible for the company to recover damages from other actual or potential defendants who have, for example, contractually limited their liability, gone insolvent or left the jurisdiction.
• Quoted companies will need to take account of the views of bodies that represent institutional shareholders, such as the ABI and NAPF: they have already indicated that they support proportionate liability, but that, unless there are compelling reasons, their members should reject LLAs that attempt to limit auditors’ liability in other ways (such as a fixed cap). In their 2008 shareholder voting guidelines, published last month, PIRC indicated that in principle they oppose all forms of LLAs, and that “voting recommendations will be decided on a case by case basis”.
• A company’s directors will need to satisfy themselves that it is in the best interests of their company to enter into an LLA. In doing so, they are entitled to take account of the potentially adverse consequences for the company of an audit firm being ruined by a catastrophic claim.

In December last year the Financial Reporting Council’s Working Group on Auditor Liability Limitation Agreements published a consultation paper and draft guidance, including suggested clauses designed to limit auditors’ liability to an amount proportionate to the degree of their fault as compared to other wrongdoers. A copy of the draft guidance can be accessed here. We understand that, in view of the scope and complexity of the comments submitted by companies, investors, lawyers and accountants, the final guidance will not be published until June 2008.

As the draft guidance says, it seems likely that shareholders will normally be asked to approve an LLA (or its principal terms if it has not yet been entered into) at the AGM held during the financial year to which it relates. So, for example, an LLA for the financial year ending 31 December 2009 would be approved at the AGM earlier in 2009. If this approach is adopted, companies and auditors may wish to negotiate the audit engagement terms early in the relevant financial year so that agreement on those issues is reached before the LLA is put to shareholders at the AGM. Companies with a calendar year end may already have been approached by their auditors (or may be approached shortly) about entering into an LLA in respect of the current financial year, perhaps based on the clauses set out in the draft guidance, in which case they will need to consider whether it is possible to deal with the issue in time for their 2008 AGM.

All companies will need to consider carefully the arguments for and against entering into an LLA, and the implications of the terms proposed. Quoted companies, in particular, are likely to monitor others’ AGM notices to see when shareholder approval is being sought for an LLA, and on what terms, and market practice is therefore likely to emerge over the next year or so. Similarly, auditors (and their professional indemnity insurers) will be paying close attention to developments. Everyone will also be awaiting the first occasion when an LLA is tested in court – although this likely to be several years from now.