One of the recurring suggestions in would-be reformers’ standard litany of proposed changes for litigation relief is the introduction of auditor liability caps. For example, the Committee on Capital Markets Regulation interim report (about which refer here) proposed the “elimination or reduction of gatekeeper litigation, either through a cap on auditor liability or creation of a safe harbor for certain auditor practices.” Similarly, in early 2007, the European Commission launched a study (about which refer here) on “whether there is a need to reform the rules on auditor liability in the EU.”

But while these initiatives are only at the proposal or study phase, the U.K. has moved forward to permit “auditor liability limitation agreements,” under legal provisions that recently went into effect. The newly effective provisions are part of the Companies Act of 2006 (refer here for the Act’s text). The auditor liability limitation provisions are contained in Sections 532 to 538 of the Act, which took effect on April 6, 2008, according to the Act’s implementation timetable (here). For background regarding the Act, refer here.

The Act allows auditors to limit their liability by contract, provided that their client’s shareholders approve. Section 534(1) of the Act allows auditors to limit their liability “in respect of any negligence, default, breach of duty or breach of trust, occurring in the course of an audit of accounts.” The limitation cannot cover more than one financial year and it must be approved by a resolution of shareholders. Under Section 537, the liability limitations are not effective except to the extent they are “fair and reasonable” in the particular circumstances.

The Act itself does not specify the particular kinds of limitations that are allowable nor does it prescribe the form the limitation is to take. However, a working group of the Financial Reporting Council, the supervisory body for U.K. auditors, has proposed “draft guidance” (here) suggesting ways that the limitation agreement might be framed. The FRC guidance document even includes specimen language to be used as a reference in preparing limitation agreements.

The FRC guidance suggests three alternative ways the auditor’s liability might be limited: (a) proportionality, “where the auditor’s liability is limited to his share of the company’s loss, taking into account the liability of others”; (b) fair and reasonable, “where the auditor’s liability is limited to such amount as is fair and reasonable in accordance with Section 537 of the Act”; or (c) monetary cap, “where the auditor’s liability is limited to a particular amount, which is either stated or calculated in some way, e.g.. as a multiple of audit fees.”

The Act’s auditor liability limitation provisions represent an interesting experiment, but it will be even more interesting to see how widespread the acceptance of auditor liability limitations agreements becomes. The Act’s requirements themselves may deter widespread adoption, particularly the one-year time limitation and the requirement for shareholder approval. One might also conjecture that there might be some stigma associated with a company’s agreement to limit its auditor’s liability, to the extent the existence of an agreement is interpreted to suggest that the only way the company could procure an auditor’s services was by granting the auditor a liability limitation. There is also legal uncertainty surrounding such issues as the extraterritorial effect of any limitations, which may be of particular concern for auditors of companies that have shareholders, creditors or other business partners outside the U.K.

It is probably also relevant that the auditor liability provisions were adopted as part of the Companies Act, which also contains provisions defining directors’ duties and incorporating new statutory procedures for bringing claims against directors. One wonders whether a company’s directors, newly sensitized to their duties and potential litigation risks, will be comfortable relieving their auditors of liability to the company for negligence or other misconduct. Even though the liability limitation has to be approved by shareholders, you can imagine the second-guessing and accusations that might surface if problems do arise later.

Within its draft guidance document, the FRC anticipates that companies may well wrestle with the question whether (or even why) they should agree to limit their auditor’s liability, and expressly observes that directors “will wish to establish that it is in the company’s interest to enter into a liability limitation agreement.” The guidance document does not attempt to suggest what interest a company would have in limiting its auditor’s liability.

Along with the question of what the take-up of the limitation agreement will be for U.K. companies is the question whether other jurisdictions will adopt the U.K. approach or similar auditor liability limitation provisions. A March 2006 report by Michael Gass and Ashwani Kochlar of Edwards Angell Palmer & Dodge entitled “U.K. Gives Auditor Liability Agreements a Greenlight, But U.S. is Unlikely to Do the Same” (same) takes a look at the new U.K. provisions and considers the possibilities for reform efforts in the U.S. The report concludes that current U.S. reform efforts are “ill-timed” and that given the turmoil in the financial markets, “garnering attention and support to adopt proposals … will be challenging” – unless one of the Big Four accounting firms implodes, in which case “all bets are off.”

The Blog also has an interesting post here discussing the newly effective U.K. provisions and expressing skepticism for the likelihood of auditor liability reform in the U.S. anytime soon.

Readers interested in the topic of auditor liability caps may want to refer back to my earlier post, here, in which I discuss the very interesting alternative proposal of George Washington University law professor Lawrence Cunningham. Professor Cunningham suggests having the audit firms issue bonds to the capital markets as a way to provide financial protection for their liability risks. 

U.K. Government to Appeal BAE Systems Ruling: In a recent post (here), I reviewed the April 10, 2008 decision by the U.K.’s High Court of Justice against the British government’s decision to terminate the investigation of alleged bribery involving BAE Systems in connection with a Saudi arms deal.

On April 22, 2008, Transparency International, on its own behalf as well as on behalf of several other organizations, wrote (here) to the U.K. Attorney General “urging the government not to appeal the judgment.” The letter stated that “halting the investigation has caused untold damage, both to the reputation of the U.K. and to global efforts to improve governance and combat corruption.” The letter also urged that the action to drop the investigation has “reduced [the U.K.’s] standing among its peers” in the OECD, and any move by the government to appeal “would compound the reputational damage to the U.K.” and would undermine the implementation of the United Nations Convention Against Corruption.

Nevertheless, on April 22, 2008, the Serious Fraud Office announced (here) that it will “seek permission to appeal to the House of Lords” against the lower court’s April 10 judgment. The SFO’s announcement quoted the current SFO director as saying that the April 10 judgment “raises principles of general public importance affecting, among other things, the independence of prosecutors and the role of the court in reviewing a prosecutor’s evaluation of the public interest in a case like this.”

It is very hard to argue that the U.K.’s efforts to suppress the BAE Systems investigation will not undermine its efforts elsewhere to fight corrupt practices. The unmistakable message is that the U.K. only cares about small scale corruption involving the less powerful, those whom the U.K. feels it can safely push around; but that these impediments can be overcome if the bribe is large enough and the corrupt official powerful enough. Nothing could do more to breed cynicism over anticorruption efforts that for the U.K. government to successfully suppress this investigation.

Hat tip to the Sox First blog (here) for the links to the Transparency International and Serious Fraud Office announcements.

Time Out for an Idol Thought: I was delighted to learn that my former partner from the Ross, Dixon & Bell law firm, Bill Hopkins, now apparently known by his nom de plume Will Hopkins, is a finalist in the American Idol songwriting competition. The Law Blog has an excellent interview of Bill, er, Will, here.

Hopkins, we shall call him, left active law practice to try to write music about the same time I left the law firm to become involved on the business side of insurance. Everyone must follow their own muse, I suppose.

Speakers’ Corner: On Monday April 28, 2008, I will be speaking as a panelist at the C5 Conference on Securities Litigation in London, on a panel entitled "Liability Never Goes Away:Managing Risk and Tackling D&O Liability" The conference features a number of very distinguished speakers. A copy of the seminar materials, including conference agenda, can be found here. If you are attending the conference, I hope you will make it a point to greet me.