In proportion

Official guidance is currently being developed to help companies and their
auditors contractually agree a degree of limited auditor liability. However,
institutional investor groups have made it clear that, for listed companies at
least, one of the options included in the draft guidance will not be deemed
acceptable.

The draft guidance in question has been developed by the Financial Reporting
Council and is based on the Companies Act 2006, which makes it possible for
contractual agreements to limit auditor liability to be entered into from April
this year. It explains that there are a number of options available for
companies and auditors:
• A limit based on the auditor’s proportionate share of the responsibility for
any loss;
• A limit set purely by reference to a “fair and reasonable” test, as decided by
the courts;
• A monetary cap (a set figure or an amount based on some formula, such as a
multiple of audit fees); or
• A combination of some or all of these options.
Shareholders must vote in favour of any such contracts if they are to be valid.

Investor dissent
Although all the options outlined by the FRC are allowable by law, institutional
investors have long opposed the idea of a fixed monetary cap. The Association of
British Insurers has now said that it will issue “red top” alerts when listed
companies seek shareholder approval for contracts to limit liability using fixed
monetary caps. Such alerts are designed to flag up to investors situations which
the ABI does not consider best practice in terms of corporate governance.

The ABI is not alone in its views. The National Association of Pension Funds’
voting guideline, issued in November 2007, says: “Investors should consider
voting against resolutions which propose any form of liability limitation other
than proportional liability unless there are compelling reasons why that is not
appropriate…”

Michael McKersie, the ABI’s assistant director of investment affairs,
stresses that his organisation does not oppose reform of joint and several
liability. “Joint and several causes difficulties for those with deep pockets,
such as auditors,” he says. However, it does oppose the fixed monetary cap
option. “A fixed cap will bear little or no relation to the damage that could
potentially be done by auditors,” McKersie says. “It is an arbitrary amount. But
we are happy to contemplate proportionality. Proportionality is the right
conceptual approach, though it is quite complex.”

The audit profession appears to accept that proportionate liability will be
the option that works in practice, at least for listed companies. “When a
company has to put a resolution to its shareholders, if it knows a fixed cap
will be turned down and proportionality accepted, that’s the way it will work,”
says Ernst & Young partner Gerald Russell. “The legislation has allowed caps
because not all companies are the same. Ernst & Young agreed a cap with its
own auditors a long time ago. But I think with big listed companies, caps are
unlikely to prevail.”

Far from ideal
This isn’t to say that all parts of the audit profession think agreements based
on proportionality are ideal. As Russell points out, a major firm could still go
bust if on the receiving end of a catastrophic claim. “From a professional point
of view, it’s a bit of a shame [that proportionality will prevail], because
proportionality is fine, but it could bust a firm,” Russell says. “That’s not in
anyone’s interest.”

However, mid-tier firms seem likely to oppose fixed caps. This is because
they would probably be unable to agree caps as large as those agreed by Big Four
auditors, thus making themselves potentially less attractive to clients.

Jeremy Newman, managing partner at BDO, is opposed to fixed monetary caps. He
feels that most interested parties accept agreements based on proportionality as
the way forward. He would like the FRC’s final guidance to give a clear steer on
the types of agreement that would be most appropriate for particular situations
or clients. “You would hear applause from the investment community, major
accounting firms and I think from corporates, because they would be clear what
was regarded as acceptable practice,” he says. “There is a danger that given
ambiguous guidance, people will be scared to do anything.”

A consensus does seem to be emerging that the FRC’s final guidance should
come out in favour of proportionality as the preferred basis for agreements
between listed companies and their auditors.

The ABI’s McKersie says, “All interested parties, certainly in the area we
look at ­ quoted companies ­ would welcome a clear indication that a
proportionate approach is deemed to be the acceptable basis that companies can
reasonably rely on shareholders supporting.”

E&Y’s Russell agrees: “If we know that institutional shareholders are
only going for one option [for plcs], then it would be better to have one
option. It will save endless individual negotiation if everybody can just pick
up the suggested agreement.”