Auditors’ Liabilities Update David Schmitz of Ten Old Square, Lincoln’s Inn
A review of the basics
The auditor’s role
1.
“It is the auditors' function to ensure, so far as possible, that the financial information as to the company's affairs prepared by the directors accurately reflects the company's position in order, first, to protect the company itself from the consequences of undetected errors or, possibly, wrongdoing (by, for instance, declaring dividends out of capital) and, secondly, to provide shareholders with reliable intelligence for the purpose of enabling them to scrutinise the conduct of the company's affairs and to exercise their collective powers to reward or control or remove those to whom that conduct has been confided.” Caparo v Dickman [1990] 2 AC 605, 626, per Lord Oliver.
Proving breach of duty
2.
As in other negligence cases of professional negligence, the test is whether the auditor fell below the standard that is to be expected of the reasonable practitioner. The auditor’s adherence or non-adherence to the standards
mentioned below will be of the utmost importance, as will evidence as to prevailing practice. Expert evidence on both of these is essential, but it is for the court to determine whether or not the defendant was in breach of duty in the particular case. As in cases involving other professionals, the Court will occasionally disregard evidence of prevailing practice, if it considers that practice to be too loose. “The Court has to be satisfied that the exponents of the body of opinion relied upon can demonstrate that such opinion has a logical basis. In particular, in cases involving, as they often do, the weighing of risks against benefits, the judge before accepting a body of opinion as being responsible, reasonable or respectable, will need to be satisfied that, in forming their views, the experts have directed their minds to the question of comparative risks and benefits and have reached a defensible conclusion on the matter.” Bolitho v City and Hackney Health Authority [1998] AC 232, 241-2. Applied to the auditors’ profession in PlanAssure PAC v Gaelic Inns Pte Ltd [2007] 4 SLR 513, 537 (Singapore Court of Appeal).
Sources of the duty
3.
An auditor’s duties are “founded in contract and the extent of the duties undertaken by contract must be interpreted in the light of the relevant statutory provisions and the relevant auditing standards. The duties are duties of reasonable care in carrying out the audit of the company’s accounts.” Stone & Rolls Ltd. v Moore Stephens [2009] 4 All ER 431, 441 paragraph 19 per Lord Phillips.
There is a tortuous as well as a contractual duty of care.
Statutory provisions
4.
The relevant statutory provisions defining an auditor’s duties were contained in the Companies Act 1985 Section 237 and are now contained in the Companies Acts 2006 Section 498. Note: it will often be appropriate to cite both old and new provisions because many cases are still likely to concern breaches of the older provisions.
5.
Section 498 of the 2006 Act reads in part: (1) A company's auditor, in preparing his report, must carry out such investigations as will enable him to form an opinion as to— (a) whether adequate accounting records have been kept by the company and returns adequate for their audit have been received from branches not visited by him, and (b) whether the company's individual accounts 1 are in agreement with the accounting records and returns, and (c) in the case of a quoted company, whether the auditable part of the company's directors' remuneration report is in agreement with the accounting records and returns. (2) If the auditor is of the opinion— (a) that adequate accounting records have not been kept, or that returns adequate for their audit have not been received from branches not visited by him, or (b) that the company's individual accounts are not in agreement with the accounting records and returns, or (c) in the case of a quoted company, that the auditable part of its directors' remuneration report is not in agreement with the accounting records and returns, the auditor shall state that fact in his report.
6.
Note that Section 507 of the 2006 Act creates a new criminal offence of knowingly or recklessly causing an auditor’ report to include anything which is misleading, false or deceptive in a material particular or to omit certain specified matters.
Contract
7.
The contract will establish the nature of the task for which the auditor is engaged, in particular whether the engagement is to perform an audit with all of the responsibilities which that entails, and whether the audit is for purposes which are additional to those described above. It can also entitle and oblige the auditor to adopt particular policies in conducting the audit, though this will not free the auditor from liability in negligence if those policies are defective or inappropriate. Note, it is not possible to require an auditor to refrain from enquiries which it would be negligent for him not to make, but it is now possible for the contract to restrict the auditor’s liability for negligence generally. This principle, however, is subject to severe limits. See below.
8.
It is an implicit requirement that prevailing auditing standards will be observed. For audits carried out after 15th December 2004 these standards will be the International Standards on Auditing ((ISAs) issued by the International Auditing and Standards Board. This is because all professional bodies governing accountants have adopted them and because every audit performed for the purposes of the requirements of the Companies Acts is required to be performed by a member of one of those professional bodies. It is also implicit that an auditor will observe the Practice Notes and Bulletins of the Auditing Practices Board.
1
ie the accounts of that company as opposed to those of a group of which it forms part.
Auditing standards and principles developed in caselaw
9.
For a summary of the principal provisions of the ISAs, see Jackson & Powell on Professional Negligence, 6th edition paragraphs 17-051 to 16-052. The ISAs for the UK and Ireland are available at http://www.frc.org.uk/apb/publications/isa/dec2004.cfm
10
The latest edition of the ISA 200 (effective 15th June 2006, is entitled “Objective and General Principles Governing an Audit of Financial Statements”. It provides, among other things, that: 2.
The objective of an audit of financial statements is to enable the auditor
to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. The phrases used to express the auditor’s opinion are “give a true and fair view” or “present fairly, in all material respects,” which are equivalent terms. 2-1.
The “applicable financial reporting framework” comprises those
requirements of accounting standards, law and regulations applicable to the entity that determine the form and content of its financial statements. Note that on the question of what an “applicable financial reporting framework” and therefore on what an auditor ought or ought not to accept: “As to the proper treatment of [statements of accounting practice], the approach of both counsel was the same and I accept this approach. While they are not conclusive, so that a departure from their terms necessarily involves a breach of the duty of care, and they are not as the explanatory foreword makes clear, rigid rules, they are very strong evidence as to what is the proper standard which should be adopted and unless there
is some justification, a departure from this will be regarded as constituting a breach of duty. It appears to me important that this should be the position because third parties in reading the accounts are entitled to assume that they have been drawn up in accordance with the approved practice unless there is some indication in the accounts which clearly state that this is not the case. SSAP No 2, the relevant practice, is so far as material in these terms.” Lloyd Cheyham & Co. v Littlejohn & Co. [1987] BCLC 303, 313 (Woolf J)
11.
ISA 200 also provides: 8.
An audit in accordance with ISAs (UK and Ireland) is designed to
provide reasonable assurance that the financial statements taken as a whole are free from material misstatement. Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable assurance relates to the whole audit process. 9.
An auditor cannot obtain absolute assurance because there are
inherent limitations in an audit that affect the auditor’s ability to detect material misstatements. These limitations result from factors such as: ● The use of testing. ●The inherent limitations of internal control (for example, the possibility of management override or collusion). ●The fact that most audit evidence is persuasive rather than conclusive. ● The impracticality of examining all items within a class of transactions or account balance. ●The possibility of collusion or misrepresentation for fraudulent purposes.
9-1. The view given in financial statements is itself based on a combination of fact and judgment and, consequently, cannot be characterized as either 'absolute' or 'correct'. A degree of imprecision is inevitable in the preparation of all but the simplest of financial statements because of inherent uncertainties and the need to use judgment in making accounting estimates and selecting appropriate accounting policies. 10.
Also, the work undertaken by the auditor to form an audit opinion is
permeated by judgment, in particular regarding: (a) The gathering of audit evidence, for example, in deciding the nature, timing, and extent of audit procedures; and (b) The drawing of conclusions based on the audit evidence gathered, for example, assessing the reasonableness of the estimates made by management in preparing the financial statements.
12.
In other words, an audit does not warrant the accuracy of the accounts. It merely indicates that the risk of their being inaccurate has been reduced to acceptable limits.
13.
ISA 240 deals with the auditor’s responsibility to consider the possibility of fraud. Note the risk factors which are identified in Appendix 1 thereto and which are grouped under the headings of incentives/pressures (e.g. the company being under pressure), opportunities (e.g. a number of transactions with connected persons) and attitudes/rationalizations (e.g. a domineering management). Of fundamental importance is:
24. The auditor should maintain an attitude of professional skepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, notwithstanding the auditor’s past experience with the entity about the honesty and integrity of management and those charged with its governance.
14.
Note that an auditor should plan the investigations and procedures which he will undertake. “First, there must be a proper inquiry to ascertain the company’s system. This would include ascertaining such features as indicate the strength and weaknesses of the system and hence its reliability. Second, there must be appraisal of it in that a person of sufficient auditing competence should make a decision as to the extent, if any, that the auditors can properly rely upon it. Third, there must be a testing of its operation. All these essentials may call for revision in the course of the audit. For example, because of the result of testing it might be necessary to make a decision in the course of the testing to extend the testing or even not to rely on the system.” Pacific Acceptance Corp Ltd. v Forsyth (1970) 92 W.N. (N.S.W.) 29. 87-8 (cited in Jackson & Powell at 17-056)
15.
Note Jackson & Powell at paragraph 17-058 where the authors list various checks which it is prudent to make with regard to particular items in the accounts. For example, an auditor must satisfy himself that securities exist and are in safe and proper custody, that work in progress relates to the accounting period in question, that there is support for the assessment of stock in trade, that proper provision is made for the risk that debtor might default and that the system for recording cash transactions is satisfactory.
16.
Note finally on this section, that although the adage that an auditor is a watchdog, not a bloodhound (Re Kingston Cotton Mill Co (No 2) [1896] 2 Ch
279) is still used and although the distinction is still observed between those situations which ought to excite suspicion (where full probing is called for) and cases which do not excite suspicion, these rules of thumb are of less use now than are the standards referred to above.
To whom does the auditor owe a duty?
17.
The leading authority is of course Caparo v Dickman [1990] 2 AC 605, which held that in the absence of special circumstances, the auditor owes a duty only to the shareholders as a body and that he does not generally owe any duty to the shareholders individually or to persons who might, on the strength of the report, buy shares in the company or give credit to the company. The auditor moreover does not generally owe a duty to the existing creditors of the company.
Exceptions to this principle
18.
The exceptions have been described in Caparo as being governed by a socalled “three-fold test.� Under this test, an auditor or other person who supplies information which is then passed on to a third party who relies upon it will be liable to the third party if (1) it is foreseeable that the third party will rely upon the information and suffer damage if it is wrong; (2) there is a relationship of proximity between the parties; and (3) it is fair and reasonable that the law should impose a duty of a given scope on the maker of the statement.
19.
In Customs & Excise Commissioners v Barclays Bank [2006] 4 All ER 456, the House of Lords preferred a test based upon whether or not the maker of the statement had assumed a responsibility to the third party for the statement, but with a strong caveat. See particularly Lord Hoffman: “There is a tendency, which has been remarked upon by many judges, for phrases like 'proximate', 'fair, just and reasonable' and 'assumption of responsibility' to be used as slogans rather than practical guides to whether a duty should exist or not. These phrases are often illuminating but discrimination is needed to identify the factual situations in which they provide useful guidance. For example, in a case in which A provides information to C which he knows will be relied upon by D, it is useful to ask whether A assumed responsibility to D (see Hedley Byrne & Co Ltd v Heller & Partners Ltd [1964] AC 465); ... Likewise, in a case in which A provides information on behalf of B to C for the purpose of being relied upon by C, it is useful to ask whether A assumed responsibility to C for the information or was only discharging his duty to B (see Williams v Natural Life Health Foods Ltd [1998] 2 All ER 577). Or in a case in which A provided information to B for the purpose of enabling him to make one kind of decision, it may be useful to ask whether he assumed responsibility for its use for a different kind of decision (see Caparo Industries plc v Dickman [1990] 2 AC 605). In these cases in which the loss has been caused by the claimant's reliance on information provided by the defendant, it is critical to decide whether the defendant (rather than someone else) assumed responsibility for the accuracy of the information to the claimant (rather than to someone else) or for its use by the claimant for one purpose (rather than another). The answer does not depend upon what the defendant intended but, as in the case of contractual liability, upon what would reasonably be inferred from his conduct against the background of all the circumstances of the case. The purpose of the inquiry is to establish whether there was, in relation to the loss in question, the necessary relationship (or 'proximity') between the parties and ... the existence of that relationship and the foreseeability of economic loss will make it unnecessary to undertake any further inquiry into whether it would be fair, just and reasonable to impose liability.... It is equally true to say that a sufficient relationship will be held to exist when it is fair, just and reasonable to do so. Because the question of whether a defendant has assumed responsibility is a legal inference to be drawn from his conduct against the background of all the circumstances of the case, it is by no means a simple question of fact. Questions of fairness and policy will enter into the decision and it may be more useful to try to identify these questions than
simply to bandy terms like 'assumption of responsibility' and 'fair, just and reasonable'.”
20.
Returning now to the case of auditors, they may in some circumstances be held liable to some third parties (ie to persons other than the company’s shareholders as a body) for some statements in respect of some heads of damage. Six relevant factors have been identified by Sir Brian Neill in BCCI (Overseas) Ltd. v Price Waterhouse (No. 2) [1998] PNLR 564 and Peach Publishing Ltd. v Slater & Co. [1998] PNLR 364. They are summarised in Jackson & Powell at paragraph 17-030. (1)
The purpose for which the statement was made – ie was it made for the purpose (express or to be implied from the circumstances) of being communicated to the person (not the company) who relied upon it.
(2)
The purpose of the onward communication – ie whether for information only or for the purpose of the person receiving it acting upon it in the way that he has.
(3)
The relationship between the company and the party acting on the information. Did the relationship make it likely that that the company would pass the statement on to the other party and that the other party would act on it? An auditor of another company in the same group as the company being audited may find it easy to prove that it was intended that he should act on the information contained in the audit. Similarly, where the auditors are also the accountants of a company which operates as a quasi partnership, this may be found to operate on the footing (when they advise the company) that the individual shareholders in such a company
would rely on the auditor’s report for the purpose of deciding whether to guarantee the company’s debts. (4)
The size of any class to which the statement is communicated – the large the class the harder it is to establish a duty.
(5)
The auditor’s state of knowledge. If he knew or reasonably should have known the purpose for which the statement was made in the first place and the purpose for which it was to be communicated to the person relying on it and that that person would rely upon it.
(6)
Whether it was reasonable for the claimant to rely on the statement and whether the claimant actually did rely upon it. Here, the sophistication of the claimant and the likelihood that he would rely on the statement without further enquiry are relevant.
Other matters relevant to liability
21.
As in other fields of professional negligence, it is necessary to enquire into questions such as causation, remoteness, foreseeability and the nature of the damage for which the professional was supposed to save the claimant harmless.
Recent Cases
22.
On the ability of a person other than the company to sue an auditor for a negligent report see Man Nutzfahrzeuge v Freightliner Ltd. [2008] BCLC 22. Greatly simplified, the facts were that the predecessor in title of the Defendant sold a subsidiary company to the predecessor in title of the Claimant. The
subsidiary had a fraudulent financial controller who had falsified the accounts. The subsidiary’s auditors approved the accounts and in respect of the accounts for one of the years in question, the accountant knew that the parent company would be showing these to the purchaser for the purposes of the purchaser’s due diligence procedures. On the facts of the case, the parent company (ie the vendor of the subsidiary) was held liable to the purchaser company, not because of the falsity of the accounts, but because of the fact that the financial controller, during the negotiations, had fraudulently said that the accounts were accurate. 2 On the vendor company’s claim against the auditors for damages to indemnify it for the liabilities incurred as a result of the controller’s fraudulent statements, HELD that the vendor’s claim would fail because, although there was an assumption of responsibility by the auditor for negligence in the preparation of the accounts and although that responsibility extended, on the facts of the case, to liabilities resulting from the falsity of the accounts themselves, no responsibility had been undertaken for damages resulting from fraudulent statements made by another person (ie the controller) about those accounts.
23.
For examples of where courts have held that auditors have been negligent for failing to detect fraud, see the following two cases from Singapore which, though they are fact sensitive and therefore of limited use for the purpose of precedent, nonetheless give useful indications of the sorts of things which auditors should be alert to detect.
2
The reason why the vendor was not liable for the falsity in the accounts themselves was that they were protected by a limitation of action clause which protected them from suit after one year, except for fraud and the vendor company was untainted by any fraud in connection with them, the company’s liability being confined to vicarious liability for the fraudulent statements which the controller had made about
24.
In JSI Shipping v Teofoongwonglcloong [2007] 4 SLR 460 auditors failed to notice that a director was concealing the misappropriation of money by misstating his remuneration. His supposed remuneration was much greater than that of the other directors and his entitlement was neither evidenced by an employment contract nor otherwise independently verified. The appeal court, overturning the judge at first instance, HELD that the failure to seek such verification was negligent, notwithstanding that another director had signed the accounts in draft and notwithstanding further that an analysis of the accounts showed that they were internally consistent. As to the first point, the auditors ought not to have relied upon the signature without first warning that director that his signature would be relied upon as verification of the entitlement to remuneration, and as to the second point: “Analytical reviews and variance comparisons must be assessed in relation to their subsequent verification against sufficient and appropriate audit evidence as figures cannot simply by “analysed” or “compared” in isolation.”
25.
In PlanAssure PAC v Gaelic Inns Pte Ltd. [2007] SLR 513 auditors were held negligent for failing to detect a “teeming and lading” scheme operated by the group finance manager, whereby she misappropriated cash and made up the resulting shortfall by banking subsequent receipts. The auditors were HELD to have been negligent because of their failure to investigate an increase in “uncredited lodgements” in the company’s accounts, it being (as the auditors’ knew) unusual and against the company’s policies for the company to delay the banking of its receipts.
26.
In Rushmer v Smith (QBD, Jack J) unreported, 30/1/2009, a guarantor of the debts of a one-man company claimed an indemnity from an auditor when the company subsequently failed and the loan was called in. The claimant’s complaint was that the auditor had negligently certified accounts showing that the company was profitable when it was not, and that if the claimant had known the true position, he would have wound the company up before the liabilities under the guarantee had increased substantially. HELD The claim failed on the facts because C had not relied upon the report. However, even if the claim had not failed on the facts, it would have failed on the law because the claimant’s loss as guarantor merely reflected the loss which the company had sustained as a result of the negligent audit (ie continuing to incur trading losses which it would have avoided had it known the true position earlier). The claim therefore failed because of the principle in Johnson v Gore Wood [2002] 2 AC 1 which provides that where a wrong results in loss to a company, other persons cannot claim for their own losses which are merely reflective of a loss which the company has incurred. 3
Stone & Rolls Ltd. (in Liquidation) v Moore Stephens House of Lords
27.
In this case, it was alleged that auditors were negligent in failing to detect that the company was operating a fraud, whereby the company was receiving money from banks pursuant to shipping documents which related to fictitious commodity trading. The company had been set up for the purposes of the fraud
3
The most common example occurs where a wrong affects the value of a company’s assets. In such a case, the company has a claim but the shareholders cannot claim for the consequent reduction in the values of their shares.
and it had a single director and shareholder, who was the chief instigator of the fraud. The Claimant bank advanced money which was lost because they company had paid it out to the participants in the fraud. The Claimant obtained judgment against the company and the director for deceit. The company went into insolvent liquidation and the liquidator brought a claim against the auditors for negligence. The auditors applied to strike out the action and although it was conceded for the purposes of the application that the auditors owed a duty to the company to carry out the audit with reasonable care and that the auditors had been in breach of that duty HELD by a 3:2 majority (affirming the decision of the Court of appeal which had reversed the decision at first instance) the action must be struck out. The reasons were: (1)
Because the company’s sole directing mind and will was a fraudsman, the company was liable directly to the Claimant and not merely vicariously. It was therefore villain, not victim. Accordingly, applying the rule ex turpi causa non oritur actio the company was not entitled to make a claim against the auditors because in doing so it would have to plead and prove its own wrongful conduct.
(2)
Per Lord Phillips, the auditor owed no duty to a company which was set up for the purpose of perpetrating a fraud. An auditor, whose duties are to the shareholders as a body to convey information to them, cannot owe such a duty where the shareholders are embodied in a single individual who knows everything because he has done everything. Moreover, his duty cannot extend so far as to protect a company from losses which have
been incurred because of the actions of an individual who has been the company’s sole mind and will.
28.
In his dissenting speech, Lord Scott said that there was a substantial difference between the position of a solvent company and an insolvent one: because the ex turpi causa rule was meant to give effect to the principle of public policy that one should not be permitted to profit from ones own wrong and that principle would not be offended if the company’s defrauded creditors, rather than its fraudulent shareholders were to profit from the action. Lord Mance, the other dissenter, did not take this precise point because in his view a liquidator could not find himself in a better position than the company was in pre-liquidation [para 264]. He relied instead [from paragraph 265] on the fact that the company was insolvent at the date of the audit and that therefore the persons who stood to lose from further losses incurred by the company would be the creditors. The public policy objection to the action should therefore disappear. Moreover, because auditors of an insolvent company are obliged to report irregularities to the authorities, it is not an answer to say that the claim can simply be dismissed as being based upon a failure to report matters to a person who knew everything because he had done everything. The persons now interested in the performance by the auditor of his duties were no longer the shareholders but the creditors.
29.
Lord Walker said of Lord Mance’s comments however [paragraph 191] that any attempt to make the matter turn on the identity of the persons who stand to lose if the company loses must fail as an attempt to attenuate the rule in Caparo
(under which only the company can claim and the individual shareholders and the creditors cannot).
Stone & Rolls: What remains to be decided
30.
Because the case turned entirely upon the fact that the company was solely owned and solely controlled by the fraudsman, it remains uncertain whether or not the same decision would be reached where some, but not all, of the shareholders are innocent. The Courts are likely to be sympathetic to claims by companies some of whose shareholders are innocent. However, there are difficulties in finding in favour of such companies. Thus, after observing that the company would be able to recover if all of the shareholders were innocent of the fraud, Lord Phillips observed: [61] ... The position becomes unclear, however, if some of the shareholders were complicit in the directing mind and will's misconduct. Lord Mance states that in such circumstances some process designed to achieve the ends of justice would 'without doubt' prevent the fraudulent shareholders from profiting from their dishonesty. Lord Mance may well be right, but it is not apparent to me that the law provides a mechanism for achieving this. What would seem to be involved would be a lifting of the veil of incorporation in order to ensure that shareholders who were complicit in the illegal manner of operating the company would not be able to share in the recovery from the directing mind and will. This would, I believe, be without precedent. [62] The situation becomes more complicated when one considers a claim against auditors, such as that with which this appeal is concerned, by a company that has independent shareholders. Here the argument is that auditors should not be entitled to pray in aid the very illegality that their breach of duty has permitted to occur. The same problem arises where some of the shareholders are complicit in the fraud being perpetrated on the banks by the directing mind and will. But more intractable is the problem of contributory negligence. The duty owed by the auditors to the company is a duty of care. It would not seem just for a company to make a full recovery of damages against auditors for the benefit of banks which have themselves negligently failed to carry out appropriate 'due diligence' before advancing monies to the company. [Counsel for the company] recognised this, for he opened his case by
submitting that any apparent unfairness in holding Moore Stephens liable to S&R would be met by contribution under the Law Reform (Contributory Negligence) Act 1945. But it is not easy to see how the Act would apply. Moore Stephens's liabilities would reflect S&R's liabilities to the banks and the damages paid by Moore Stephens would be paid, indirectly, to the banks. Lack of care on the part of the banks in their dealings with S&R ought to be taken into account for the purposes of contributory negligence. Yet such lack of care could not be prayed in aid by S&R in answer to claims framed by the banks in deceit—Standard Chartered Bank v Pakistan National Shipping Corp (No 2) [2003] 1 AC 959. Nor is there any obvious mechanism by which such lack of care could be relied upon by Moore Stephens in answer to the claim brought by S&R. [63] My Lords, I would not think it right to hold as a matter of general principle that ex turpi causa does not apply to a claim by a company against its auditors for failing to detect that the company has been operating fraudulently unless it were demonstrated how the difficulties to which I have referred could be resolved. There has been no such demonstration in this case.
Limitation of Liability
31.
Under section 310 of the Companies Act 1985 any provision which purported to exempt an auditor from (or indemnify him against) liability for negligence, default or breach of duty that would otherwise be due to the company was deemed void. This provision is retained in Section 532 of the Companies Act 2006.
32.
However, Section 534 creates an exception by making it possible for an auditor to limit liability by a “liability limitation agreement� with the company, provided that certain conditions are observed, namely, that its terms comply with the requirements of Section 535 and that it be authorized by the company under Section 536.
535 Terms of liability limitation agreement (1) A liability limitation agreement— (a) must not apply in respect of acts or omissions occurring in the course of the audit of accounts for more than one financial year, and (b) must specify the financial year in relation to which it applies. (2) The Secretary of State may by regulations— (a) require liability limitation agreements to contain specified provisions or provisions of a specified description; (b) prohibit liability limitation agreements from containing specified provisions or provisions of a specified description. “Specified” here means specified in the regulations. (3) Without prejudice to the generality of the power conferred by subsection (2), that power may be exercised with a view to preventing adverse effects on competition. (4) Subject to the preceding provisions of this section, it is immaterial how a liability limitation agreement is 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. As of now, no regulations have been prescribed.
33.
Under Section 536, a private company may, by resolution, waive the need to authorize the agreement, or it may approve the “principal terms” in advance of the agreement being made (these being the financial year to which the agreement is to apply, the kinds of acts or omissions covered and the limitation to which the auditor’s liability is subject) or it may approve the agreement after it has been made. In the case of a public company, the principal terms may be approved in advance or the agreement may be approved after it has been made. Authorisation is effected by a resolution in the case of a private company and by a resolution in general meeting in the case of a public company.
34
Section 537, restricts the effectiveness of a liability limitation agreement.
537 Effect of liability limitation agreement (1) A liability limitation agreement is not effective to limit the auditor's liability to less than such amount as is fair and reasonable in all the circumstances of the case having regard (in particular) to—
(a) the auditor's responsibilities under this Part, (b) the nature and purpose of the auditor's contractual obligations to the company, and (c) the professional standards expected of him. (2) A liability limitation agreement that purports to limit the auditor's liability to less than the amount mentioned in subsection (1) shall have effect as if it limited his liability to that amount. (3) In determining what is fair and reasonable in all the circumstances of the case no account is to be taken of— (a) matters arising after the loss or damage in question has been incurred, or (b) matters (whenever arising) affecting the possibility of recovering compensation from other persons liable in respect of the same loss or damage.
35.
Note in particular from this section that the auditor will not be punished if he seeks to limit his liability beyond that which is fair and reasonable. In such a case, the court will correct the agreement rather than strike it out. Note also the obligation on the court to ignore the insolvency of other persons who may have caused the loss. The effect appears to be that the court may not increase the burden on the auditor beyond that which it is fair for him to assume simply on the ground that only the auditor or his insurer can satisfy the claim.
36.
There have not yet been any cases under this section, and there are not likely to be any for some time, owing to its recent commencement.
Relief from liability.
37.
Note that under Section 1157 the Court has retained the power to relieve an auditor from liability if it considers that he acted honestly and reasonably and that in all the circumstances it considers that he ought fairly to be excused in whole or in part from his liability on such terms as it thinks fit.
The New Disciplinary Rules under AADB (Accountancy and Actuarial Discipline Board)
38.
These were brought into effect on 26th February 2010 and are available via http://www.frc.org.uk/aadb/publications/
39.
They are known as the “Amended Accountancy Scheme” and apply to those investigations, hearings and decisions on discipline, which are made under the aegis of the AADB and which relate to accountants. The function of the AADB is to deal with those cases which raise or appear to raise important issues affecting the public interest. 4 Matters of lesser interest are dealt with under the aegis of the relevant professional body such as, for example, the Institute of Public Accountants. The AADB itself is a body which carries out some of the functions of the Financial Reporting Council (“FRC”) which is the industry regulator.
40.
As a supervising body, the AABD is subject to Schedule 10 of the Companies Act 2006. Paragraphs 16 and 24 require, in the case of matters of public interest relating to statutory audits of companies, that supervising bodies make arrangements for investigations, hearings and the taking of decisions about disciplinary action which among other things ensure “that the carrying out of those investigations, the holding of those hearings and the taking of those decisions are done independently of the body.” Some of the changes in the rules are made in order to comply with these requirements.
4
In its feedback of October 2009 on consultation responses received with regard to the proposed rule changes, the AADM observed that it had conducted only twelve investigations in the five years of its existence.
41.
The principal changes are as follows: (1)
There is a new test which governs the decision of whether or not an investigation by the AABD should result in a hearing before a disciplinary tribunal. Under rule 4 (3) it is provided that such a hearing should follow if it is determined by the Executive Counsel (ie a legally qualified officer who is appointed to that office by the Nominations Committee of the FRC) that there is a realistic prospect that a Tribunal will make an Adverse Finding against a Member or a Member Firm and that a hearing is desirable in the public interest. From the consultation documents it appears that this is regarded as equivalent to the principle adopted by prosecuting authorities which requires a prospect of conviction which is greater than 50 per cent.
(2)
A new office of Convener is established. The holder of that office is appointed by the nominations committee of the FRC and his function is to appoint the members of a disciplinary tribunal.
(3)
There is a new power in the AABD to conduct preliminary enquiries before making a decision to investigate. This was thought necessary in order to promote the effectiveness of investigations, but also in order to spare practitioners the disruption of a full investigation where this is unnecessary. Because the various professional bodies which participate in the AABD also have the power to conduct investigations, there is an agreed protocol which governs the exercise of this new jurisdiction.
(4)
The rules have now adopted the principle in Baxendale-Walker v The Law Society [2007] 3 All ER 330 that a regulatory body should not normally be liable for the costs of disciplinary proceedings which it
loses, provided that the proceedings were properly brought. It is accordingly provided in Rule 7 (9) that “The Tribunal’s discretion to award costs to a Member or Member Firm concerned shall be restricted to circumstances where the Tribunal finds that no reasonable person would have referred or pursued a Formal Complaint under the terms of this Scheme.” (5)
Rule 9 (8) abolishes the tribunal chairman’s casting vote, except in matters of procedure and prohibits abstentions on any issue.
One final point is that the AABD initially wished to expand the definition of professional misconduct so as to include breaches of rules and even non-binding guidelines. During the consultation it was persuaded to retain the existing definition (“any Member’s or Member Firm's conduct in the course of his or its professional, business or financial activities (including as a partner, member, director or employee in or of any organisation or as an individual), which falls short of the standards reasonably to be expected of a Member or Member Firm.”) The fear had been that any broadening of the definition could lead to vexatious complaints. Note, however, that Rule 4 (4) continues to provide that “In considering the question of whether the conduct of a Member or Member Firm may have fallen short of the standards reasonably to be expected of him or it, regard shall be had in particular to any law, whether statutory or otherwise, or regulation of any sort, and to any charter, bye-law, rule, regulation or guidance which applies to him or it.” © David Schmitz 2011.
The author would like to express his gratitude to Mr. Rupert D’Cruz of Littleton Chambers for his permission to make use of the notes prepared by him for use in connection with his lecture for Central Law Training in 2009.