Auditor Liability Limitation Agreements

This helpsheet has been issued by ICAEW’s Technical Advisory Service to help ICAEW members understand the background to, and purpose of, auditor liability limitation agreements (LLAs) and the procedures that need to be followed. This helpsheet covers the requirements for companies registered under the Companies Act 2006; it does not address the specific requirements of other types of entities. In these circumstances, members need to check whether LLAs are permitted in such audits and, if so, much of the helpsheet will be relevant with changes of wording needed as necessary.

Members may also wish to refer to the following related guidance and helpsheet:

• FRC Guidance on Auditor Liability Limitation Agreements
• ICAEW guidance on Auditors' Limited Liability Agreements
• Engagement letters and privacy notices
• TECH 01/03 AAF (Revised) The audit report and auditors' duty of care to third parties

When a company fails or there has been a fraud or, for example, there has been a change in ownership and the new owners believe that the assets have been overstated in the audited accounts, there will sometimes be a claim made against the auditor on the grounds that they gave a true and fair audit opinion when they should not have done, and should be made to pay compensation for the company’s (i.e. shareholders’) losses.

It is a reasonable principle that auditors should be held liable for the consequences of their own actions. Unfortunately, due to a combination of factors, this is not what was happening in the audit market.

• First, a tendency to sue based on perceived ability to pay, rather than degree of fault, has become more widespread and auditors are required to have professional indemnity insurance, when others involved in the financial reporting process are not.
• Second, the principle of joint and several liability entrenched in UK law allows someone who is only partly responsible for a loss to be pursued for the whole loss if other parties are unable to pay.

There has been a fraud at an audit client and legal claims have been made against several parties. The court has found that an employee is 80% responsible on the grounds that they actually perpetrated the fraud, a software company is 10% responsible because a control supposedly in place did not work and the auditors are 10% responsible for failing to spot the fraud after the event. It is possible for the employee to have few assets and the software company to have gone out of business, so the auditor is presented with the bill for 100% of the damages.

The auditor has been held liable not only for the consequences of their own actions, but those of everyone else too.

There are practical consequences: everyone ends up paying for the actions of a few through higher insurance premiums and increased audit fees and, particularly at the larger end of the audit market, it has become almost impossible to get enough insurance to cover the size of potential claims. There is the real possibility of a joint-and-several claim taking auditors out of the market completely, making the existing lack of choice in some areas even more of an issue and deterring others from entering that market.

For these reasons, ICAEW has long held reasonable liability limitation to be in the best interests of efficient markets, shareholders and companies, as well as auditors, and the government has been persuaded of the case.

The default position is that an auditor’s liability is unlimited. The Companies Act 2006 sections 532 to 538, however, permit the optional limitation of liability by contract between the auditor and the company. Such contracts only govern the position in the event of the company making a claim against the auditor; they do not address claims by third parties.

To be valid in law, any terms in an auditor liability limitation agreement are subject to:

• Member approval annually (for private companies this can be via written resolution); and
• The courts considering that the terms are ‘fair and reasonable in all the circumstances of the case’.

Whilst these safeguards are there to ensure that no one tries to remove liability completely, they inevitably lead to complications. Firstly, the member approval requirement raises some concerns as to what rationale directors can use to allow them to recommend such agreements to their members for approval.

Secondly, the legislation is drafted to allow any means of limitation to be included in a liability limitation agreement, examples being proportionality, a fixed monetary cap, or a cap linked to, say, a multiple of audit fees. However, any agreement is subject to challenge in the courts and if the courts consider the terms not to be ‘fair and reasonable in all the circumstances of the case’, they can substitute alternatives.

The FRC has produced Guidance on Auditor Liability Limitation Agreements aimed at directors, which is also relevant for auditors. It seeks to address a number of issues by:

• summarising what the law permits and requires;
• explaining what matters an agreement should cover;
• providing specimen clauses;
• noting the views of a number of institutional shareholders, who have indicated that they would be likely only to approve those based on proportionality;
• explaining the process to be followed for obtaining shareholder approval; and
• setting out some of the factors that will be relevant when assessing the case for an auditor liability limitation agreement.

Before using the example wording for liability limitation agreements, it is recommended that the full guidance be read as it is an invaluable source for practitioners to explain to clients why such agreements are necessary and the process to follow.

ICAEW sought legal opinion on auditor liability limitation agreements, as discussed in the ICAEW guidance on Auditors' Limited Liability Agreements, which may be of use in discussions with clients who are concerned about the effect on their own position.

It principally addresses a concern that directors recommending liability limitation agreements to shareholders might face increased liability themselves, as they could be in breach of their fiduciary duty to act in the interests of the shareholders. The opinion confirms that, provided the directors lay before the members the information they need to make an informed decision, it should not give rise to, in its own right, an increase in their liability. Directors should, however, consider the fairness of such an agreement, the availability of other terms elsewhere and the undesirability of changing auditors too often.

Where a company and auditor have entered into an auditor liability limitation agreement, regulation 8 of The Companies (Disclosure of Auditor Remuneration and Liability Limitation Agreements) Regulations 2008 (SI 2008/489) requires the following to be disclosed in a note to the company’s annual accounts:

(a) its principal terms; and
(b) the date of the resolution approving the agreement or the agreement’s principal terms, or, in the case of a private company, the date of the resolution waiving the need for such approval.

The annual accounts in which such disclosure needs to be made are those for the financial year to which the agreement relates, unless the agreement was entered into too late for it to be reasonably practicable for the disclosure to be made in such accounts. Where the agreement was entered into too late, the disclosure must be made in a note to the company’s next set of accounts.

ICAEW members, affiliates, ICAEW students and staff in eligible firms with member firm access can discuss their specific situation with the Technical Advisory Service on +44 (0)1908 248 250 or via webchat.