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 accounts1 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 so-

called “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.