AABA

Auditor liability remains a contested issue. It matters to shareholders and others relying upon audited financial statements because it affects the extent to which they may be able to seek damages from negligent auditors. As company audits are carried out by commercial organisations, the extent of auditor liability matters to accountancy firms because it affects the extent of audit effort and their current and future profitability. A low liability threshold to a range of indeterminate parties may persuade auditors to abandon company audits. Conversely, a restrictive scope of liability may dilute auditor incentives to deliver good audits and can, in the process, undermine confidence in corporate governance. Issues about auditor liability matter to the state because as the ultimate sponsor of capitalism it is keen to secure a particular kind of social order and persuade people to believe that capitalism is not corrupt and that there are independent watchdogs to ensure that companies provide honest and trustworthy accounts. Such a system assumes that auditors have incentives to be vigilant and effective because failure to do so would leave them open to lawsuits and claims from injured stakeholders.

In market economies, there are no state guaranteed monopolies for mathematicians, scientists, engineers, designers or electronic experts, but accountancy firms enjoy the state guaranteed monopoly of external financial audits. As the creator and underwriter of this monopoly, the state is expected to provide the rules and principles of auditor liability. However, the policies of the state are formed by competing politics and ideologies, which gives auditing firms advantages as they can mobilise considerable financial, political and media resources to advance their arguments. As a result, developments in auditor liability have been complex and often contradictory to the extent that auditors do not seem to be accountable to stakeholders and injured stakeholders are rarely in a position to sue negligent auditors. Indeed, it seems that auditing firms are engaged in a ‘race to the bottom’ and keen to severely restrict their liability. At the time of writing (August 2004), major firms are pressing the UK government to ‘cap’ their liabilities and further restrict the redress available to injured stakeholders (UK Department of Trade and Industry, 2003). How we got here is best understood through a brief review of the auditor liability debate in the UK.

The Companies Act 1948 gave accountants belonging to a select few trade associations (e.g. the Institute of Chartered Accountants in EnglandWales) the monopoly of the state controlled market of external audits. The quid pro quo was that in return accountancy firm partners would have ‘joint and several’ liability i.e. they would be liable for each other’s negligence and omissions. The framework gave partners incentives to police each other’s work with the knowledge that negligence of one partner would have serious financial consequences for others. Auditing firms were forbidden to trade as limited liability companies as this weakened the incentives for good audits. Such an arrangement was welcomed by accountancy firms and their patrons (Napier, 1998), and also turned out to be an economic boon as on the back of ‘joint and several’ liability accountancy firms became giant multinational businesses. &

Nevertheless, in accordance with the contemporary corporate culture of minimising obligations, accountancy firms have sought to change the 1948 social bargain by demanding liability concessions (Gwilliam, 1988). Since the 1970s, major auditing firms have portrayed themselves as unfair victims of lawsuits (Likierman, 1989) even though relatively few cases involving alleged auditor negligence reached the courts. For example, between 1968 and 1988, only two cases alleging negligent audits reached the

courts. In both cases, the plaintiffs failed (Gwilliam, 1988). In response to their lobbying, the UK law was changed and the Companies Act 1989 (consolidated into the Companies Act 1985) permitted auditing firms to trade as limited liability companies. In the UK, the right to trade through a limited liability company has been accompanied by an obligation to publish audited financial statements. However, major accountancy firms were unwilling to form limited liability companies because “the obligation on [auditing firms trading as] companies to publish their accounts is perceived as a considerable drawback” (The Accountant, September 1991, p. 2) and that “firms have always stood out against revealing any financial information except their annual fee income” (Accountancy, April 1994, p. 26). Major firms were also reluctant to give-up considerable tax benefits associated with the partnership structures (Accountancy, April 1994, p. 26; February 1998, p. 14). Consequently, very few major firms formed limited liability companies and [1] and voluntarily continued to trade as partnerships.

Section 310 of the Companies Act 1985 (originally introduced in 1929) prohibits any ‘capping’ of auditor liability in respect of the opinions given under the Act. In response to pressures from the auditing industry, a state-sponsored study (Likierman, 1989) recommended that subject to shareholder approval companies and their auditors should be able to agree a limit on auditors’ potential negligence liability. There were no proposals for enhacing auditor accountability to stakeholders. The government’s response was to introduce Section 137 of the Companies Act 1989 (which became Section 310(3)(a) of the Companies Act 1985), enabling companies to buy insurance to cover their auditor’s liability, should they so wish. However, hardly any company is known to have taken advantage of this legal provision.

The House of Lords judgement in Caparo Industries plc v Dickman & Others [1990] 1 All ER HL 568, further restricted auditor liability. It stated that generally auditors owed a ‘duty of care’ to the company (as a legal person) appointing them rather than to any individual shareholder. The Law Lords decided that the audit report was prepared to enable shareholders to exercise their rights as members of the company (e.g. vote at annual general meeting), and not to enable them to make any investment decisions. The judgement narrowed the circumstances under which auditors could be successfully sued for breach of a ‘duty of care’. Subsequently, the courts applied the Caparo principle to cases such as McNaughton (James) Paper Group Limited v Hicks Anderson & Co. [1991 1 All ER 134 and [1990] BCC 891 and Berg Sons & Co. Limited & Others v Adams & Others [1992] BCC 661, and did not award any damages against auditors, even where they were considered to be negligent, on the ground that they did not owe a ‘duty of care’ to third parties. Thus the general legal position is that in the absence of exceptional circumstances auditors do not owe a ‘duty of care’ to any individual shareholder, creditor or any other stakeholder.

In ADT v Binder Hamlyn [1996] BCC 808, it was held that auditors may be liable to third parties where “the purpose of audit work has been widened so that it is no longer confined to the statutory one … and the auditor in all the circumstances ought to have regarded himself as carrying out the audit for the plaintiff’s purpose as well the company’s”. Such circumstances are extremely rare. Thus the general position under English law is that in the absence of exceptional circumstances auditors do not owe a ‘duty of care’ to any individual shareholder, creditor or any other stakeholder. In the event of auditor negligence usually only the company can properly act as plaintiff, with no automatic liability to individual shareholders, or any party which may be relying upon audited accounts to make investment decisions All claims against auditors are subject to three formidable tests: foreseeability of loss suffered by the plaintiff, proximity between claimant and defendant, that it just and reasonable to impose liability. Consequently, there is little or no “evidence suggesting that the courts in the

have made, or are liable to make, excessive damages awards against auditors” (UK Office of Fair Trading, 2004, para. 1.2)

Despite the favourable case law, auditing firms have continued to make demands. In the early 1990s, they claimed that lawsuits from alleged audit failures at the Bank of Credit and Commerce International (BCCI), British and Commonwealth, Maxwell, Polly Peck, Levitt Group of Companies and Atlantic Computers threatened their existence. Such a campaign did not acknowledge that the actual settlements, whether through the courts or otherwise tend to be a fairly small proportion of the original claims, or that most of lawsuits are from liquidators (usually another major accountancy firm) who tend to be the major beneficiaries from such lawsuits (Cousins et al., 1998, 1999). Ordinary stakeholders receive little or nothing.

Following a report by the Law Commission (UK Law Commission, 1993), the

accepted the principle of ‘contributory negligence’, which is a form of ‘modified proportional liability’. This permits auditors to defend themselves by arguing that others (e.g. directors, bankers) contributed to their negligence and the loss suffered by the plaintiffs, and should therefore bear a fair share of the damages. The UK courts accepted the principle of ‘contributory negligence’, as evidenced by the House of Lords judgement in Banque Bruxelles Lambert S.A. v Eagle Star Insurance Co. Ltd [1997] AC 191 and have applied it to absolve one of the Barings’ auditors from liability (see Barings PLC v Coopers & Lybrand [1997] 1 BCLC 427) whilst the damages against another were severely reduced (In Barings plc (in liquidation) v Coopers & Lybrand; Chancery Division 11 June 2003).

The auditing industry’s ultimate aim is to use the state to shield it from the consequences of its own failures. So it continued with its campaign for more liability concessions even though the ICAEW acknowledged that the principle of ‘contributory negligence’ has a “dramatic effect on limiting the consequences of negligence” (The Accountant, August 1996, p. 11). The then Big Eight accountancy firms produced a joint report (they were in it altogether weren't they) claiming that liability related costs were eating up 8% of the accounting and auditing revenues[2] (Big Eight, 1994). The government responded by inviting the Law Commission (UK Department of Trade and Industry, 1996) to conduct a feasibility study on the possibility of replacing partners’ joint and several liability with full proportional liability and/or a ‘cap’ on auditor liability. The Law Commission rejected the concept of ‘full proportional liability’ and considered it to be against the public interest. It added that “we regard the policy objections to joint and several liability to be at worst unproven and, at best, insufficiently convincing to merit a departure from the principle” (p. 35). The Law Commission also rejected the call for a ‘cap’ on auditor liability by concluding that “we can find no principled arguments for a ‘capping’ system” [and that it] “cuts across a principle that a wrongdoer should compensate the plaintiff for loss caused by its tort or breach of contract ...... [and that it] would put the plaintiff at a disadvantage, since the cap would represent the upper limit in negotiations for a limit” (pp. 48-49).

By 1994, some UK auditing firms began to consider the possibility of forming “offshore” Limited Liability Partnerships (LLPs) to shield their partners’ assets from negligence lawsuits (Accountancy, December 1994, p. 23). Such possibilities were encouraged by developments in the US where LLPs initially started as tax avoidance vehicles but were soon crafted as organisations that could limit the liability of professionals (Alberta Law Review, 1998). In general, LLPs shielded individual partners from personal liability claims against the firm arising from any future malpractice by other partners of the firm. The general rule was that the liability claims would be met by the assets of the firm and any applicable liability insurance, followed by the assets of the partner responsible for the action/inaction creating the liability. Thus the assets of the other partners were protected even though they shared in the profit/loss, goodwill and reputation generated by all partners. Following the success of securing LLPs, accounting firms used their resources to run television commercials, lobby policymakers and build alliances with other occupational groups (e.g. lawyers) to demand further liability concessions (King and Schwartz, 1997; Goldwasser, 1997; Financial Times, 13 July 1995, p. 10). Despite a Presidential veto[3], the Private Securities Litigation Reform Act of 1995 provided protection to auditors (and other professionals) by providing forms of proportionate liability[4] and by enacting barriers which made class-action litigation more difficult (Boyle and Knopf, 1996).

In 1995, the UK based firms of Ernst & Young and Price Waterhouse were considering registering as LLPs and identified Jersey emerging as a favourite location (Financial Times, 8 December 1995, p. 1 and 15; The Times, 14 December 1995, p. 30). Just before the UK Law Commission finalised its report (on 29 December 1995) rejecting full proportional liability and a ‘cap’, Price Waterhouse and Ernst & Young spent £1 million to draft a LLP Bill, awarding themselves considerable protection from lawsuits with no public regulation or accountability requirements. The firms feared that their preferred “law would not hold water in the UK courts” (The Accountant, November 1998, p. 5). So they asked Jersey (part of the Channel Islands) to enact the Bill (Hansard, House of Commons Debates, 23 May 2000, col. 901).

The key idea of the 62 page Jersey Bill was that LLPs would be a separate legal person distinct from the individual partners and its status would not be affected by any change in the composition of the partnership. Individual partners would not be personally liable for the liabilities of the LLP unless they actually caused the loss in the course of their work. The Bill required LLPs to have a registered office address in Jersey, but did not require them to have any agent or partner operating from there. LLPs were required to file an annual return (on 1st January each year) consisting of the name and address of the partners only. They did not need to file audited accounts. The registered office needed to hold a copy of the partnership agreements, but this would only be available to partners and not to the general public. Firms registering as LLPs could sell audits, but did not have a dedicated regulator. LLPs registered in Jersey did not need any minimal capital and were to be exempt from all corporate/income taxes. Jersey government hoped to supplement its revenues by levying £10,000 for an initial LLP registration and £5,000 annually thereafter (The Accountant, August 1996, p. 1; Accountancy Age, 26 April 1997, p. 4).

The government of Jersey duly promised to ‘fast track’ the Bill (Accountancy, September 1996, p. 29), but it ran into considerable opposition as it was suspected that major firms were using Jersey as a lever to squeeze liability concessions from the UK government (see Christensen and Hampton, 1999; Hampton and Christensen, 1999a, 1999b; Sikka, 2003). It led to “one of the most turbulent political debates in living memory” (Financial Times, 26 September 1996, p. 7). The Jersey LLP Bill finally became law in September 1998.

Accountancy firms openly said that if the UK government failed to give them equivalent concessions they would relocate their operations, with the consequent loss of jobs and economic activity. Their campaign was joined by 25 other professional groups who also saw this as an opportunity to secure liability concessions (Financial Times, 17 April 1996, p. 8). The prospect of possible migration of accountancy firms (and other businesses) to Jersey alarmed the UK government and it promised equivalent legislation “within a week” (Financial Times, 28 June 1996, p. 22; 24 July 1996, p. 9) and then “at the earliest opportunity” (Hansard, House of Commons Debates, 7 November 1996, col. 617) and eventually enacted the Limited Liability Partnerships Act 2000, which came into existence on 6 April 2001.

The legislation enabled accountancy firms to form LLPs in the UK, limit the liability of partners and enjoy tax concessions associated with partnerships. However, it required LLPs to publish audited financial statements. Ernst & Young senior partner added that

“It was the work that Ernst & Young and Price Waterhouse undertook with the Jersey government …… that concentrated the mind of UK ministers on the structure of professional partnerships. ……The idea that two of the biggest accountancy firms plus, conceivably, legal, architectural and engineering and other partnerships, might take flight and register offshore looked like a real threat …… I have no doubt whatsoever that ourselves and Price Waterhouse drove it onto the government’s agenda because of the Jersey idea” (Accountancy Age, 29 March 2001, p. 22).

Today, all major accountancy firms are registered as LLPs in the UK. President of Jersey’s Finance and Economics Committee told parliament that “At the time the law was passed, there were reasonable grounds for supporting that the registration of LLPs could bring substantial benefit to Jersey. In the event, despite the passage of the legislation, no LLP has been registered” (Jersey Evening Post, 29 November 2000).

However, major firms’ campaign for further liability concessions did not end with the LLP legislation. Buoyed by successes, they have demanded a ‘cap’ on auditor liability and ‘full proportional liability’, previously rejected by the Law Commission. They have no proposals for enhacing their own accountability or stakeholder rights. This campaign is being led by the Institute of Chartered Accountants in England & Wales (ICAEW), laughably known as a regulator of the auditing firms are supposed to be a protector of stakeholder rights. The ICAEw is shwing its true colours, a trade association devoted to advancing sectional private interests.

With the demise of Arthur Andersen, following a criminal conviction in connection with the audits of US energy company Enron, the firms argued that the demise of another firm would reduce competition and choice of auditors for major companies. Without providing any information about their liability costs, lawsuits or insurance cover, they claimed to be under threat. Their hope was that concessions from the UK government would strengthen their case for securing the same from the EU, US and other countries.

The UK government responded by publishing a consultation paper on the possibilities of a ‘cap’ (UK Department of Trade and Industry, 2003). The ministers led by Trade & Indutry Secretary Patricia Hewitt (former Head of Research at Andersen Consulting) indicated their willingness to enact the relevant legislation, but at the last minute the issues were referred to the Office of Fair Trading (OFT) to consider the competition aspects of providing a ‘cap’ to auditing firms. From a competition perspective, the OFT report (Office of Fair Trading, 2004) concluded that the “Arguments that allowing caps would be pro-competitive are not compelling. Some forms of cap design could distort competition ……..” (OFT, 2004, para 1.9). The report added, "Alongside regulation and reputation, liability acts as a discipline on audit quality in a context where shareholders and other third parties rely on information from an audit which is paid for by the company being audited. We are not aware of evidence suggesting that the courts in the UK have made, or are liable to make, excessive damages awards against auditors. Professional indemnity insurance is available, and LLP status – the chosen corporate form of many audit businesses – exists to protect partners’ personal assets” (OFT, 2004, para 1.2). Despite this apparent setback, major accountancy firms are continuing with the campaign to secure a ‘cap’ and further liability concessions (for example see, The Guardian, 3 August 2003; The Times, 3 August 2004; The Daily Telegraph, 8 August 2004).

To sum up, the extent of auditor liability matters to auditors, the state and the parties relying upon audit opinions. The extent of liability provides economic incentives to deliver good audits. However, in recent years, such incentives have been eliminated as the auditing industry seeks to eliminate stakeholder rights and make itself bankruptcy proof. The social bargain enshrined in the Companies Act 1948 required auditors to accept unlimited liability as a quid pro quo for a monopoly of the state guaranteed market of external audits. Audits have also enabled accountancy firms to sell numerous consultancy and advisory services to audit clients. As the income, economic and political muscle of accountancy firms grew, they began to demand liability concessions. In a one-sided set of concessions, the state has enabled accountancy firms to trade as limited liability companies and LLPs to limit their liabilities. Case law in the shape of the Caparo judgement has weakened stakeholder rights and auditor incentives to deliver good audits. This is a far cry from the unlimited liability introduced by the by the Companies Act 1948. The changes are bound to negatively affect the extent of audit quality, effort and care and will encourage auditor habit of sleeping on the job, usually in bed with management. More scandals will follow. Such a view is advanced by Joseph Stiglitz, former economic adviser to the US Clinton administration and the World Bank, who argues that the recent US accounting scandals (Enron, WorldCom, etc.) are a direct consequence of the mid-1990s liability concessions given to US auditing firms (Stiglitz, 2003). Following major scandals, US opinion formers are already calling for changes to “counter the weakening of self-policing resulting from a shift in the legal form of most professional firms – from partnerships to limited liability partnerships ….. Under the old form, each partner was liable to all acts by all partners, a powerful incentive to enforce compliance with the law. Under the new form, the liability of each partner for misconduct by other partners is limited or even eliminated, provided that the remains unaware of the misconduct” (29 December 2003).

Alberta Law Review, (1998). Limited Liability Partnerships and other hybrid business entities, Edmonton, Alberta Law Reform Institute.

Boyle, E.J., and F.N. Knopf, F.N. (1996). The Private Securities Litigation Reform Act of 1995. CPA Journal, April, pp. 44–47.

Christensen, J., and Hampton, M., (1999). All Good Things Come to an End, The World Today, August/September, pp. 14-17.

Cousins, J., Mitchell, A., Sikka, P., and Willmott, H., (1998). Auditors: Holding the Public to Ransom, Basildon: Association for Accountancy & Business Affairs.

Cousins, J., Mitchell, A., and Sikka, P., (1999). Auditor Liability: The Other Side of the Debate, Critical Perspectives on Accounting, Vol. 10, No. 3, pp. 283-311.

Goldwasser, D.L., (1997). The Private Securities Litigation Reform Act of 1995: Impact on Accountants, The CPA Journal, January, pp. 72-75.

Gwilliam, D., (1988). Making Mountains out of Mole Hills, Accountancy, March, pp. 22-23.

Hampton, M.P., and Christensen, J., (1999a). A Legislature for Hire: The Capture of the State in Jersey's Offshore Finance Centre, in M.P. Hampton and J.P. Abbott (Eds.), Offshore Finance Centres and Tax Havens: the Rise of Global Capital, Basingstoke, Macmillan.

Hampton, M.P., and Christensen, J.E., (1999b). Treasure Island revisited. Jersey's offshore finance centre crisis: implications for other small island economies, Environment and Planning, Vol. 31, pp. 1619-1637.

Hampton, M., and Christensen, J., (2002). Offshore Pariahs? Small Island Economies, Tax Havens and the Reconfiguration of Global Finance, World Development Journal, Vol. 30, No. 9, pp. 1657-1673.

King, R.R. and Schwartz, R., (1997). ‘The Private Securities Legislation Reform Act of 1995: A Discussion of Three Provisions’, Accounting Horizons, Vol. 11, No. 1, pp. 92-106.

Law Commission, (1993). Contributory Negligence as a Defence in Contract, London, HMSO.

Likierman, A., (1989). Professional Liability: Report of the Study Teams, London, HMSO.

Napier, C., (1998). Intersections of law and accountancy: unlimited auditor liability in the United Kingdom, Accounting, Organizations and Society, Vol. 23, No. 1, pp. 105-128.

Office of Fair Trading, (2004). An assessment of the implications for competition of a cap on auditors’ liability, London, OFT.

Sikka, P., (2003). The role of offshore financial centres in globalization, Accounting Forum, Vol. 27, No. 4, pp. 365-399.

Simmons & Simmons, (1996). Professional Liability Update - House of Lords Overturns BBL Decision, London, Simmons and Simmons.

Stiglitz, J., (2003). The Roaring Nineties: Seeds of Destruction, London, Penguin.

Department of Trade and Industry, (1996). Feasibility Investigation of Joint and Several Liability, London, HMSO.

Department of Trade and Industry, (2003). Director and Auditor Liability, London, DTI.

[1] Amongst major accountancy firms, only KPMG chose to incorporate its auditing business in 1995.

[2] Cousins et al. (1998, 1999) show that this actually amounted to only 2.67% of their total revenues.

[3] This was the only Bill vetoed by President Bill Clinton during his eight years in office (Clinton, 1995). His veto was overridden by the Congress.

[4] The Act established proportionate liability except in cases where defendants engage in "knowing" securities fraud (in such cases the principle of ‘joint and several liability’ remained).