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Home / ... / Auditor Liability - Update on Recent Developments

The recent announcement by Minister Michael Ahern that he had asked the Company Law Review Group (CLRG) to consider the law in Ireland relating to auditor liability is a welcome and timely development in an issue that has been of significant concern for quite some time to the auditing profession both in this country and many other jurisdictions throughout the world.

In response to the Minister’s move, ICAI has recently published a short Discussion Paper on the subject which identifies the issues facing audit firms in Ireland under the existing liability regime and argues why reform of this regime is a strategic issue for Ireland Inc. The arguments in support of reform have been well made. For example, in an action arising as a result of a corporate collapse and where the directors and/or other senior management of the entity have been found to be principally at fault while the auditor’s culpability has been relatively minor, the auditor in question may still have to bear 100% of the losses involved due to inadequate or insignificant resources of the other defendants to the claim.

In Ireland, the situation is more acute than in most other EU countries. Irish company law prohibits corporate entities (for example, limited companies or limited liability partnerships) from acting as statutory auditors. This means that the personal assets, not just those of the audit firm, but also of all partners in the particular audit firm - even those with absolutely no involvement or culpability in the matter - are at risk. The current regime encourages plaintiffs to ‘go after’ those defendants, in this case the auditor, perceived to have the ‘deepest pockets, despite the fact that the auditor may only be responsible, if at all, to a much lesser extent for any loss arising than any other party. The key threat in such an environment is that of ‘catastrophic loss’; a loss so vast that it results in the demise of the audit firm involved, in the present environment, most likely to be one of the so-called ‘Big 4’ firms.

It is simply not true that the resources of these firms even come close to being sufficient to match the level of claims likely to arise in major lawsuits. The degree of risk to which Irish audit firms are now exposed threatens their continued long term existence and also the capacity of the ICAI to play its part in sustaining the profession as an attractive career choice for the brightest and best talent that Ireland has to offer.

The ICAI Paper discusses the case for reform of the current regime under a number of headings, including:

- The National Interest; - Competitive issues - Availability of Professional Indemnity Insurance (PII).

NATIONAL INTEREST

Ireland’s economic success has been well documented. Undoubtedly, this success has been underpinned by a healthy, appropriately regulated and high quality auditing profession. Local and, perhaps more importantly, international investors in Ireland’s economy rely on a high quality auditing profession to underpin reporting of financial information. In particular, the factors in Ireland’s success in attracting and sustaining significant business from the highly mobile international financial services industry have included the existence of a pool of high quality professional services firms and globally recognised audit firms.

The failure, therefore, of any such firm is likely to have a significant and detrimental impact on the attractiveness of Ireland as a good place to do business. Furthermore, it would leave the Irish audit market in turmoil. Indeed, it is highly likely that the remaining 3 large firms and their partners would look critically at their continuing involvement in the audit of listed entities and other higher risk / higher exposure entities – financial institutions, technology companies etc.

COMPETITIVENESS

The environment in which Irish audit firms operate differs significantly from that of most other EU States. As a minimum, in all 14 of the pre-accession Member States, incorporation of audit firms is permitted. This is not the case in Ireland. There is no compelling reason why Ireland should be out of step with its EU competitiors on this issue. Of course, incorporation is not the panacea; it does nothing to remove the potential of catastrophic loss. However, such a regime would help preserve the personal assets on innocent partners.

Evidence suggests that one reason why the mid-tier audit firms do not compete directly with the Big 4 in the audit market for listed companies and larger private companies is because the higher risks involved, including those posed by the present liability regime. This inevitably leads to a restriction in choice of auditors. Reform of the law on auditor liability will encourage such firms to enter this market and ultimately increase the choice of auditor for companies in this sector.

PII

It has long been a common perception that audit firms, in particular the Big 4, have unlimited insurance and resources to cover losses arising from corporate collapses. By extension, there is a presumption that the world’s capital markets have effectively been underwritten by the Big 4 firms. This ‘deep pockets’ presumption has undoubtedly fuelled the pursuit of auditors following corporate collapses. The reality is somewhat different.

In recent years, it has been impossible for larger audit firms to obtain commercial insurance at any price in the market that is sufficient to cover the risks to which they are exposed. Even the markets, therefore, perceives these risks to be uninsurable and as a result there has been an exodus from the marketplace for PII cover. Firms are therefore in the position of having their own captive insurance vehicles, essentially a form of self insurance, which have insufficient resources to meet the level of claims to which auditors are exposed. Any significant claim against a firm, therefore, if successful, is likely to bankrupt the firm involved.

DEVELOPMENTS ELSEWHERE

This is not an issue that is peculiar to Ireland, although we do have our own additional difficulties.

Mindful of the threat to EU capital markets posed by the demise of a large transnational audit firm, the European Commission recently commissioned London Economics to prepare a study. Running to some 400 pages, the Study on the Economic Impact of Auditors’ Liability Regimes examined ‘the impact of the current liability rules for carrying out statutory audits on the European capital markets’ as well as the current market conditions for insurance. The key results are extremely interesting:

- There is a highly concentrated market for the statutory audit of large companies; - This is unlikely to change in the short term given barriers to entry; - The current level of commercial insurance would cover less than 5% of the larger claims; - There is a very real risk that one or more Big 4 audit networks may fail; - A limitation of auditor liability would reduce that risk and would also be good for choice; - A number of models exist for achieving such a limitation.

Responding to the results of the study in an address at a FEE Conference last October, Commissioner Charlie McCreevy stated that ‘[the results] underline a concern I have had for some time: there is an increasing trend for litigation against auditors, while at the same time international audit networks are faced with a lack of available commercial insurance. Therefore, there is a real risk that at some point one of the ‘Big 4’ auditing firms might be faced with a claim that would threaten its existence. Auditing is not just any industry, but one that plays a pivotal role in our capital markets. Were the Big 4 to turn into the Big 3, or even worse, into the Big 2, capital markets at large could face very serious consequences. Companies would have difficulties obtaining audits, investor confidence could be undermined and trust in markets might be weakened generally.’ Clearly, the political and strategic imperative as been recognised elsewhere. It is expected that the European Commission will shortly issue its own report outlining a number of policy options and that these will be open to public consultation. Even more recently, the UK Companies Act, enacted at the end of last year, introduces measures aimed at creating a regime that allows for proportionality and limitation of liability through other means, for example by capping. Quite how these new measures will work in practice remains to be seen. However, the UK provisions serve to highlight that the issue has been regarded by the UK government as a priority issue in need of urgent reform. It will be interesting to see how this new regime develops.

CONCLUSION Reform of the current laws on liability facing auditors would not amount to preferential treatment for the profession. What is being sought is an opportunity to avail of the same types of liability limitations that exist for other professionals and businesses. Any reform proposals would still include auditors being accountable and financially responsible for their share of any loss arising from corporate failure. This could still amount to significant sums of money and there would correctly be no release from potential criminal proceedings.

The referral to the CLRG at last provides an opportunity to have serious though and consideration paid to this issue. The ICAI looks forward to playing its part in putting forward its own views in support of reform.

Does anyone have a listing of who audits quoted companies in Ireland and UK. How many are not Big 4?