On June 6, 2008, the European Commission published a recommendation calling for EU Member States to develop liability caps for auditors, or permit listed companies to develop such caps in consultation with their shareholders and governing boards, subject to judicial review and disclosure. These caps would pertain to statutory audits of listed companies.
As noted in an article by Jennifer Hughes in the June 7 Financial Times, "EU Calls For Limits to Auditors' Liability," EU Internal Markets Commissioner Charlie McCreevy said of auditor liability: “It is a potentially huge problem for our capital markets. The current conditions are not only preventing the entry of new players in the international audit market but are also threatening existing firms.”
Key points in the European Commission's (EC's) recommendation include:
The civil liability of statutory auditors and of audit firms arising from a breach of their professional duties should be limited except in cases of intentional breach of duties by the statutory auditor or the audit firm.
The limitation of liability should apply against the company audited and any third party entitled under national law to bring a claim for compensation.
Any limitation of civil liability should not prevent injured parties from being fairly compensated.
The EC explains in this Frequently Asked Questions (FAQ) document: “It is in the public interest to ensure sustainable audit capacities and a competitive market for audit firms at international level… liability risks arising from the increasing litigation trend combined with insufficient insurance cover may deter auditors from providing audit services for listed companies. If these structural obstacles (liability risks/lack of insurance) persist, mid-tier audit firms are unlikely to become a major alternative to the ‘Big 4’ audit networks on European capital markets… there is also a risk of losing some of the existing players. One of the reasons might be that catastrophic claims cause the collapse of one of the major audit networks.”
After noting that the EC adopted a recommendation on May 8 ‘strengthening the robustness and independence of inspections of firms auditing listed companies,’ the FAQ states: “Audit quality should be driven more by sound regular inspections whilst liability should complement such efforts but not make the audit business unattractive.” Furthermore, “audit regulators - not judges or courts - will in future play a pivotal role in maintaining the high audit quality which companies and investors deserve.”
The FT’s Hughes also quoted PwC partner Peter Wyman, saying, “This is a very significant step for auditors not just in Europe, but across the world because Europe will provide a lead.” Additional details on the EC recommendation are in this FEI summary (summary downloadable by FEI members only, see info on FEI membership).
U.S. Treasury ACAP Debates Liability; To Publish Addendum in FR for Comment
In related news, the U.S. Treasury Advisory Committee on the Auditing Profession (ACAP) voted on June 3 to formally publish in the Federal Register - and seek public comment on - an Addendum to its May 5 Draft Report. There will be a 30 day comment period on the Addendum (presumably, 30 days after it is published in the Federal Register (FR), as of June 9, the Addendum had not yet been published in the FR.) As previously reported, the comment deadline on the May 5 Draft Report is June 13.
The Addendum includes one recommendation and three matters for further consideration: (1) a recommendation that the PCAOB reconsider the form and content of the auditor’s report, (2) whether engagement partners (not just the ‘firm’) should sign audit reports, (3) whether audit firms should be required to make public a set of audited financial statements for their own firm, and (4) whether it would be appropriate to transfer to federal court jurisdiction certain claims against auditors and related issues regarding a uniform standard of care.
ACAP discussed auditor liability more broadly at its June 3 and prior meetings, but has yet to reach a consensus on any recommendation pertaining to auditor liability, including the federal vs. state court jurisdiction matter noted in its Addendum.
Here are a few highlights from ACAP’s June 3 meeting, particularly on the liability issue:
Ernst & Young General Counsel Kathryn A. Oberly, testified that changes in the law - including the ‘water[ing] down’ and eventual abandon[ment] of the privity requirement’ - combined with the explosion in market cap of public companies, has largely resulted in the threat of catastrophic loss to audit firms sued in connection with their role in auditing public companies.
PwC General Counsel Charles W. Gerdts III (testimony) and attorney Michael R. Young of Willkie, Farr & Gallagher (testimony), explained that the threat of catastrophic loss limited audit firms’ abilities to exercise their right to take the matter to trial, instead having no real choice but to settle, rather than – as Oberly soberly put it – ‘bet the firm.’
AON Deputy Chairman Barry Matthews warned ACAP in his testimony: “I want you to know that at no time have we encountered a situation in which there existed as substantial a threat to the continued viability and sustainability of the audit firms as that created today by the potential for mega professional liability claims brought in US courts.”
ACAP member Professor Gary John Previts, President of the American Accounting Association, said: “Right now we have a federally sanctioned cartel, that’s a personal observation, but how else in the world can you get 12,000 public companies audited within 90 days of year-end?” He asked, “What high standard, what impossible standard, do you hold them to, to accomplish that feat,” and likened the current model to “the difficulty of trying to make the Western Union model work in the 21st century.”
Previts referenced earlier remarks of ACAP member and former SEC Division of Corporation Finance Director Alan Beller, who said: “One of the things this committee is charged with doing is to look over hills and corners; I’d like to look over a five-year corner, five-years from now I think it is a certainty the U.S. capital markets will be less than 30% of global market cap, [it’s in the] low 30s today; [the] second point [is], it is quite likely that one or more of the Big 4 [audit firms] will have established real global operating entities that function as single entities with single systems of corporate governance.” Beller continued: “It is 100% certain to me that if we do not find a better path, a different path, from the one we currently are on, the chances are precisely zero that the American firms will be part of those global networks.”
On the subject of audit firm transparency as it may relate to potential efforts for liability reform, ACAP co-chair Don Nicolaisen said: “Not withstanding commentary I’ve heard from firms, and others, I do think there is tremendous value to having audited financial information for the largest firms, I say that for a number of reasons, one is, if they are desirous of some sort of litigation reform, for us to go to Congress and make a recommendation and say we don’t have any financial information but we want you to consider [liability reform], doesn’t have any appeal. Simply giving you my expressed view on this, similar to Arthur’s view, [ACAP co-chair Arthur Levitt, Jr.] we feel strongly [audit] firms that occupy this space, importance to our capital markets, responsible for auditing 95% plus of market cap, to operate without a baseline of financial information is not acceptable, that doesn’t mean it may not be acceptable to the committee, I want to make sure you understand where I am coming from, Arthur is in the same place.”
More generally, Nicolaisen said, “those who have recommendations how to move forward with a solution that provides either transparency [e.g., providing audited or certain other information about the firms to the public] combined with liability matters or ends up with a position saying both [transparency and liability were] discussed and no resolution, at some point we’re not going to fruitfully continue dialogue, either there is a solution reasonably obvious or not.”
Additional details from ACAP’s June 3 meeting (human capital, including education, training, and general recruitment and retention was also discussed) can be found in this FEI summary (summary downloadable by FEI members only, see info on FEI membership).
Noting that ACAP’s next public meeting is July 22, Nicolaisen said, “we encourage comments from the public on anything we’ve done between now and the end of June, even if it trickles in the first few days in July [it’s] OK too.”
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The current conditions are not only preventing the entry of new players in the international audit market but are also threatening existing firms.
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