Should directors consider such an agreement?
The change in the law was inspired by the potential dangers to the audit market should firms be hit by potentially catastrophic liability claims. The QCA has argued that the size of any liability claims against its members’ auditors would not be big enough to create such a catastrophic claim on an audit firm. Therefore boards of member companies should resist requests from auditors to enter into such agreements. Moreover, directors must satisfy themselves that they are adhering to their fiduciary duties when considering limitations of auditor liability. One potential danger of limiting liability is that it may lead to a reduction of audit quality and scope. Liability should only be limited if it is in the best interests of the company and therefore directors must satisfy themselves on this point. For liability to be limited, investors would expect that the company received consideration in return for the concession, be it via a reduction of the audit fee, an increase in the quality and scope of the audit or a combination of the two.
What factors should directors take account of if they are considering an agreement?
In the event that directors believe that they should recommend an auditor liability limitation agreement to their shareholders, the Institutional Shareholders’ Committee has published on its website a statement that describes the key points that investors would expect directors to address. These can be summarised as follows:
1. The directors must assure themselves that the audit quality will be preserved and enhanced.
2. Investors would not expect to support any monetary limit on auditor liability but would expect an agreement to be based on proportionality or to be fair and reasonable (which in any case is a requirement of the legislation).
3. Audit committees should ensure that a full explanation of the reasons for putting such a resolution to shareholders is disclosed, particularly highlighting how audit quality will be preserved and enhanced.
4. It would be contrary to investors’ fiduciary duties to support requests to limit auditors’ liability after the audit has taken place, as any benefits to the company on quality or price in consideration to reducing their auditor’s potential liability would be impossible to obtain. See also the point on timing below.
5. Investors would expect early consultation on any proposed agreement, particularly if it did not substantially conform to the principal terms set out in the FRC’s guidance on auditor liability limitation agreements. (The guidance is available from www.frc.org.uk)
6. Directors should ensure that the effect of agreements throughout the group provide for proportionality (investors will typically only be able to vote on the group agreement and not for any agreements made by subsidiaries).
The timing of making such agreements is an important consideration. Investors are extremely unlikely to approve auditor liability limitation agreements for audit work that has already been undertaken for the reasons described above. Moreover investors expect to be consulted on their terms. For a company whose financial year ends on 31st December 2008, it would be appropriate for the AGM held during 2009 to be asked to approve the auditor liability limitation agreement for the audit of the financial year ending 31st December 2009. Audit committees should also be mindful that auditors are likely to request such agreements as part of the audit engagement process and so the timing of the relevant audit committee in relation to the AGM is likely to become important.
Finally, from an investor’s perspective, we consider that how the board and its audit committee respond to requests from auditors to limit their liability through auditor liability agreements is an important indicator of how the directors govern the company in the interests of its owners.
Editor’s Note: The QCA is interested in finding out if any members have been approached to enter into an auditor liability limitation agreement. Please let us know by emailing email@example.com
Tim Goodman is a manager within the Hermes Equity Ownership Services’ (HEOS) UK engagement team. HEOS engages with companies on behalf of its clients on corporate governance and sustainability. He is also on the QCA’s Corporate Governance Committee.