Auditor liability limitation agreements – about to become a reality?

United Kingdom

On 6 April this year it became possible for the first time for auditors to limit their liability for audit work by entering into an agreement with their audit client (a liability limitation agreement or LLA). On the next occasion when a company discusses with an audit firm their proposed terms of engagement, the auditors may well request an LLA. Some companies may already have started such discussions; others are likely to do so in the next few months.

An LLA will be effective only to the extent that it does not limit the auditors’ liability to less than the amount that a court considers fair and reasonable in all the circumstances. But the law does not prescribe what form an LLA should take or how the limit should be framed. Contractual limits can therefore be set in a number of different ways, such as:

  • a limit based on the auditor’s proportionate share of the responsibility for any loss (proportionate liability)
  • a limit purely by reference to the ‘fair and reasonable’ test
  • a specified sum of money or sum calculated by reference to a formula, such as a multiple of the audit fee (a fixed cap).

In most cases, audit firms are likely to seek proportionate liability, although sometimes a fixed cap (e.g. a multiple of the audit fee) may be sought in addition or as an alternative.

An LLA can apply only to a single financial year, and must be approved by the board and shareholders of each company to which it relates. It is 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. For listed companies with a calendar year end, the first LLA could therefore relate to the 2009 calendar year and be put to shareholders at the 2009 AGM.

Few, if any, LLAs have been entered into to date, because specimen clauses and guidance published by the Financial Reporting Council (FRC) were only finalised at the end of June this year, too late for the 2008 AGM season. Most audit firms are likely to propose LLAs that broadly reflect the specimen clauses.

Directors of quoted companies will need to take account of the views of significant shareholders and their representative bodies. The Institutional Shareholders’ Committee (which includes representatives from the ABI and NAPF) supports proportionate liability but is opposed to fixed caps. Directors of all companies will need to consider carefully whether, taking into account all the circumstances, and the potential advantages and disadvantages (both direct and indirect), it is in the best interests of their company to enter into an LLA, and what the terms should be.

The approach that companies should take will be determined largely by the position of the Big Four firms, which should become clear over the next year or so.

The FRC guidance and specimen clauses

In 2007 the FRC undertook to produce some specimen clauses designed to be used as the basis for agreeing an LLA. Draft clauses, together with guidance on the new regime, were published for consultation last December but, because of the large number of comments made by companies and lawyers, the clauses and guidance could not be finalised before the 2008 AGM season. (Click here for the Law-Now article that we published on 4 April, just before the new regime came into force.)

At the end of June this year the FRC published the final version of the specimen clauses and related guidance (which can be found by clicking here). Among other things, the guidance covers:

  • What is permissible under the Act
  • Some of the reasons for and against entering into an LLA, and other factors that may be relevant
  • What should be covered in a LLA
  • The process that must be followed to implement a LLA, including specimen resolutions to approve an LLA
  • Additional considerations for, and the process to be followed by, private companies
  • Specimen clauses for inclusion in an LLA. Drafting is provided for the following different types of limitation, which can be applied singly or in some combination:

- Proportionate liability - limiting the auditor’s liability to such amount as is just and equitable, having regard to the extent to which the auditor and others (including the company itself and directors and employees whose negligence is attributed to the company) are to blame for the company’s loss.


- Liability limited to whatever amount the court decides is fair and reasonable.


- Liability limited to a monetary amount which is either stated in the LLA or to be calculated in some way - e.g. as a multiple of the audit fees.

The Guidance does not recommend which type of limitation should be adopted: it is up to companies and their auditors to decide which (if any) is most appropriate to their circumstances.

Views of institutional shareholders

Quoted companies will need to take account of the views of the bodies that represent institutional shareholders, such as the ABI and the NAPF. On 30 June 2008 the Institutional Shareholders' Committee (which includes representatives from the ABI and NAPF) published a statement on what their members are likely to expect from companies seeking shareholder approval for an LLA. A copy of the statement can be found by clicking here. In broad terms it states that:

  • Investors are “generally willing to support agreements providing for proportional liability or those providing for liability to be at the level that is fair and reasonable". LLAs that include an element of a fixed cap are not appropriate.
  • Companies should recognise that they are not obliged to enter into LLAs if they are not suitable.
  • Investors should be consulted at an early stage about the proposed terms of the LLA.
  • Investors are unlikely to support LLAs after the audit work for the year has been completed.
  • Companies should explain to investors how they have used discussions with the auditors to obtain assurance that audit quality will be preserved and enhanced, and to secure benefits that counter-balance the disadvantage to the company of entering into an LLA.
  • Shareholders will not want to see their preference for proportionate liability agreed at holding company level undermined by other forms of agreement lower down the group structure.
  • Companies will particularly need to justify to shareholders any disadvantageous departure from the specimen clauses produced by the FRC.

Briefing note for audit committees

We have produced a briefing note for audit committees and directors generally about the new regime. It gives further detail about the matters referred to above and, in particular, discusses in more detail the arguments for and against a company entering into an LLA, in whatever form. Please contact one of the authors below if you would like a copy.