Contractual Limitations on the Auditor's Liability: An Uneasy Combination of Law and Accounting

Date01 July 2009
Published date01 July 2009
AuthorP. E. Morris
Contractual Limitations on the Auditor’s Liability: An
Uneasy Combination of Law and Accounting
P. E. Morris
Operativeas from 6 April 2008, sections 532^538 of the Companies Act200 6 createa new liabi-
lity limitation regime in contractual relationships between audit ¢rms a nd companies in relation
to the statutoryaudit function which overturns an almost eighty yearsold fundamental principle
of company law.This new regime is the product of continui ng pressure by the audit profession
for liability reform and concern by Government regarding the market structure for audit ser-
vices.Thi s commentary critically evaluates the regimefrom law and accounting perspectives. It
concludes by re£ecting on its longer term implications for audit quality, perceptions of the audit
profession and the evolution of a future research agenda.
The Companies Act 2006 enjoys the dubious distinction of being the lengthiest
piece of legislation ever enacted at Westminster. Comprising thirteen hundred
sections, sixteen schedules and spanning seven hundred and sixty pages of the
statute book, those parts of theAct which represent reform measures have taken,
commencing with the initial activities of the Company Law Review working
parties and culminating with operational implementation of most of it by 2008,
overte nyears to bring tocompletion. Lurking in the midst of this vast legislative
scheme for the conduct of corporate business are a group of self-contained, inno-
vative provisions which deal with the bilateral contractual relationship between
audit ¢rms and companies in relation to performance of the statutory audit.
essence they create a permissive regime whereby the parties may enter into liabi-
lity limitation agreements (LLAs) which impose restrictions on the auditor’s lia-
bility for negligence, default, breach of dutyor breach of trust during the course
of the statutoryaudit. The e¡ect of this is to overturn a fundamental principle of
company law enshrined in successive companies’ legislation for almost eighty
years which precluded the company from relieving the auditor from liability for
these breachesof duty.The original rationale for this principle, ¢rst established in
1928 in relation to directors and other o⁄cers and extended to auditors in 1929,
Independent Researcher.Thanks are due to Philip Lawton of the Law School at the University of
Lancaster for helpful advice during preparation of this commentary. Needless to say responsibility
for all views expressed herein, unless otherwise indicated, rest with the author.
1 Sections 532^538 of the Companies Act 2006. All references to statutory provisions are to the
Companies Act 2006 unless otherwise stated.
r2009 The Author.Journal Compilation r200 9 The Modern LawReview Limited.
Published by BlackwellPublishing, 9600 Garsington Road,Oxford OX4 2DQ,UK and 350 Main Street, Malden, MA 02148, USA
(2009) 72(4) 607^627
was concern regarding the practice employed by the draftsmen of companies
articles of association of inserting extensive exclusion clauses in them relieving
directors, o⁄cers and auditors from liability for a wide range of legal wrongs
including negligence and breach of contract. Despite judicial approval of these
standardform terms
they were regardedas abusive and justifying comprehensive
statutory prohibition.
The background to this reform is one of a continuing and forceful campaign
by the accountancy profession
calling for reform of the system of joint and sev-
eral liability in negligence claims against them as partnerships which, they assert,
transforms them into classic deep pocket defendants’ with indemnity insurance
cover and liable for the total amount of loss cause d even though other parties
(typically senior corporate management) are in practice equally if not more
culpable.While the main thrust of this campaign has been in the context of third
party negligence litigation against audit ¢rms, it has includedas a featurepressure
to liberalise the long established prohibition on agreements which delimit the
audit ¢rm’s bilateral contractual and negligence liability to its corporate client.
The ideal reform option pursued by the accountancy profession remains a shift
towards proportionate liabili ty, embracing both bilateral and th ird party dimen-
sions, whereby the audit ¢rm’s responsibility is closely tied to its contribution to
the losses caused; it regards this as fairer and more rational than the traditional
joint and several l iabilit y regime which in the afterm ath of a corporate collapse
results in practice it being targeted as the sole defendant with su⁄cient resources
to meet claims.
The campaign is £awed by absence of convincing empirical evidence on the
incide nce and outcome of neglige nce litigation against audit ¢ rms.
There is
admittedly speci¢c evidence of huge damages claims in negligence by third par-
but this falls considerably short of the oft and still repeated claim that the
auditing profession is beset by a liability crisis; indeed such evidence as there is,
at least inthe United Kingdomcontext, suggests that litigation against audit¢rms
2Re Brazilian Rubber Plantation and Estates Ltd [1911] 1 Ch 425; and Re City Equitable Fire Insurance
[1925] 1 Ch 40 7.
3 Report of the Company Law Amendment Committee 1925^26 Cmd 2657 (The Greene Com-
mittee) paras 46^47 and 75. A full account of this historical dimension can be found in: C. J.
Napier,‘Intersections of Law and Accountancy: Unlimited Auditors’ Liability in the United
Kingdom’ (1998)23 Accounting, Organizationsand Society 105.
4 On which see generally: R. Mednick and J.J. Peck,‘Proportionality: A Much Needed Solution to
the Accountants’ Legal Liability Crisis’ (1993-94) 28 ValparaisoUniversity Law Review 867;J. Freed-
man and V.Fi nch,‘Limited LiabilityPartnerships: Have AccountantsSewn Up The‘‘Deep Pock-
ets’’ Debate?’ [1999] JBL 387; and G.Ward,‘Auditors’Liability i n the UK:The Case for Reform’
(1999) 10 Criti cal Perspecti ves on Account ing 387.
5 J. Cousins A. Mitchell and P. Sikka,‘Auditor Liability:The Other Side of the Debate’ (1999) 10
CriticalPerspectiveson Accounting283; and A Mitchell, HC DebVol 450,Cols 1070^1071(19October
6 London Economics and R. Ewart, Study on the Economic Aspects of Auditors’ Liability Regimes
(MARKT/2005/24F): Final Report to EC-DG Internal Markets and Services (September 2006)
revealing that the largest EU audit ¢rms face eleven claims ranging between US $200milion-
$1billion and ¢ve claims in excess of $1billion leading to a signi ¢cant risk of loss of one of the
Big Four audit¢rms and ¢nding that liability limitation can reduce the risk ofa potentially cata-
strophic claim (atxxi^xx iii).In the UK audit ¢rms face six claims or potential claims of in excess
of Euro 250 mi llion (at 116).
Limitations on Auditor’s Liability
608 r2009 The Author.Journal Compilation r2009 The Modern Law Review Limited.
(2009) 72(4) 607^62 7

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