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White Paper Bulletin 2 – privilege reform in regulatory investigations

  • 16 April 2021 16 April 2021

In this second article in our series on the recent BEIS White Paper, Clyde & Co’s accountants liability and regulatory team examines the Government’s proposals for statutory reform of the rules of legal professional privilege (“LPP”) in the context of the regulation of statutory audit.

This article refers to our previous articles on the Sports Direct line of decisions in relation to the FRC’s attempts to obtain access to material held by Grant Thornton which was subject to Sports Direct plc’s LPP.  You may read those articles here and here.

Context of the White Paper proposals

Readers will be aware that the FRC had sought disclosure of Sports Direct’s privileged material in its auditor’s possession/evidenced in their audit papers in the context of an FRC investigation into the auditors. Production of that privileged material was sought on the basis that, as Sports Direct (being the audit client) had provided its privileged material to its auditors under a limited waiver of privilege, (i) the limited waiver of privilege should be extended to the audit regulator or, (ii) there was no infringement of the audit client’s privilege in so doing. Those arguments were rejected by the courts.  The message was clear: the courts are cautious of taking any step that could erode the principle of LPP and so undermine the rule of law.  In that context, some may recall the comments of Andrews J in the Queen’s Bench Division decision in ENRC -v- SFO [2017] EWHC 1017 [93] in relation to the operation of LPP:

Given the tenor of the authorities, including the Three Rivers (No 5) case [2003] QB 1556 , if there is to be any change of approach to bring the law in this jurisdiction into line with the more liberal approach adopted in other jurisdictions, it will have to be made by the Supreme Court or by Parliament.

These comments were cited by the Court of Appeal in its subsequent judgement in ENRC -v- SFO [2018] Civ 2006 at [49]. 

Yet many auditors and lawyers would recognise the sense of an arrangement that reduces the time and costs involved in protecting an audit client’s LPP in the context of an FRC investigation (where currently often complex, costly and lengthy redaction exercises are required to protect the audit client’s privilege where the FRC has not reached agreement with the audit client as to any terms of waiver).  That ‘prize’ would assist not only the regulator but also the audit firms themselves.

What is proposed in the White Paper?

The FRC clearly remains dissatisfied with the present state of affairs in relation to the right to withhold documents on the basis of claims for audited entities’ privilege.  That is reflected in the White Paper.  The Government appears to have been paying attention to the above judicial comments, and has responded accordingly to the outcome of the Sports Direct litigation by proposing new laws to modulate LPP in the context of the regulation of statutory audit. 

Those proposals are set out – albeit at a high level only – under paragraph 9.4 of the White Paper.  To summarise them, the White Paper endorses the importance of the “special legal protection” which LPP affords “as an indispensable component of an effective and fair justice system”, whilst nevertheless gently proposing that there should be new laws enabling the audit regulator to access material in the possession of the audit firm which is privileged to an audit client.  The rationale is that the FRC needs this information “properly to inspect or investigate the audits” of companies where the auditors have relied on the audited entity’s privileged information … in reaching their opinion” as to the auditor’s compliance with Relevant Requirements.  The proposal for statutory override of privilege therefore appears to extend to Audit Quality Review inspections as well as disciplinary enforcement under the Audit Enforcement Procedure.

The White Paper seeks to anticipate objections to this by suggesting that any sharing of privileged material with the regulator would be “targeted only at documents belonging to the audited entity that had already been shared with the auditor”..

Analysis

The above proposals are notable for their brevity and for what they fail to say as much as for what they do say.  Although everyone would agree in principle that the audit regulator must be enabled to do its job effectively, the White Paper’s proposals do not venture any practical suggestions for how the difficulties arising from the protection of a client’s LPP should be addressed, if the LPP were to be overridden by statute for the limited purpose of audit regulation. The consultation instead invites discussion of the problems that may arise if LPP material is not made available to the regulator, and how those issues may be solved or mitigated “while respecting the overall principle” of LPP.  

The issue as to whether withholding of LPP material is “problematic” is likely to vary between different audits, depending on the significance that such material may have had in relation to the risk of material misstatement and the adequacy of disclosures in the annual report, and depending on the nature and degree of any concern that may subsequently arise as to audit quality.  In many cases it will be possible to provide sufficient information about the audit process without divulging LPP material, but there will be other cases where the FRC may be concerned at the difficulty of conducting an effective inspection or investigation without access to the LPP material.

We suggest that relevant questions as to what may constitute “appropriate safeguards” in connection with the override of LPP in the context of UK audit regulation, and issues that arise as to the scope of any such override, include:

  • Whether it is envisaged that there would be a wider loss of LPP in the documents disclosed by the audit firm to the regulator?  

    The White Paper states that “if the regulator were able to see privileged information, it would need to be strictly limited in circulation and purpose, with appropriate safeguards”.  It also refers to limiting the right of access to “documents belonging to the audited entity that had already been shared with the auditor”.  These comments appear to anticipate a limited purpose override of the audit client’s LPP rather than a general loss of privilege, but the White Paper could certainly spell that out more clearly.  
     
  • What about the audited entity’s LPP in material held by the auditor that the FRC does not request?

    A challenging situation might arise for an auditor where the FRC has had access to LPP material on the audit file but has not had access to all LPP material on the same subject-matter (for example, material about the same litigation that is the subject of the audited entity’s LPP but which is held on later audit files or on emails that the FRC has not required to be produced to it).  The effect of an override of LPP triggered by, and referable to, the FRC’s document request would be that the auditor is obliged to continue to protect the audited entity’s privilege in material that the FRC has not requested; this could present complications and scope for errors leading to loss of privilege if the auditor were to reveal LPP information mistakenly believing it had appeared in related LPP material that the FRC had requested.  This complication would not arise if the statutory overriding of LPP as regards audit regulation were to occur at the point at which the audited entity’s LPP material is provided to its auditor, rather than at the point when a regulator exercises its statutory power to obtain documents and information from the auditor.  The problem with that approach is that civil claimants might seek to test the efficacy of the audited entities’ claim to LPP attaching to material that had entered the hands of the auditor which was subject to the statutory override at that point.  In theory, the issue could be anticipated in appropriate terms of the engagement between the auditor and its client that made clear that the LLP was still claimed by the client against all third parties.  However, that does not offer a sufficiently standardised solution to the issue and it would be more conventional for any statutory override to privilege to be applied at the point when regulatory or investigatory disclosure obligations are triggered.
     
  • What would happen with the sharing of information between regulators?

    Again, this brings to mind the White Paper’s comment about the sharing of privileged information needing to be “be strictly limited in circulation and purpose, with appropriate safeguards”.  Once the material was in the hands of the FRC, one could imagine a scenario in which another UK regulator might seek to obtain a copy from the FRC via the ‘gateway’ that exists between those regulators.[1]  This could also create the related risk that other countries’ regulators might obtain the audited entity’s privileged material through existing gateways or MoUs, depending on their terms.  At a minimum there would need to be some form of safeguard mechanism to ensure that the FRC is aware of privileged material within the body of documents produced to it by a firm and is therefore equipped to take any steps necessary to protect that privilege, as far as necessary, at the point of any onward transmission of the material.  That might, for example, involve the FRC referring back to the auditor (and through it in turn to the privilege holder client) where there is a proposed transfer of material via a gateway in order to ask (i) whether there is any privileged material and, (ii) whether the privilege is waived for that limited purpose by the client.
     
  • What about the audit firm’s own privilege?

    If the audited entity’s privilege is to be overridden in respect of enforcement against auditors, the regulator may also see advantage in making a similar argument (whether now or in the future) for overriding the audit firm’s claims to privilege in order to gain access to any legal advice that it took during the audit in relation to a matter of audit judgement.  Such advice could be relevant to the FRC’s assessment of the auditor’s assessment of risk, its evaluation of audit evidence, its consultation with specialists and its decision-making.  Privilege might also be claimed by the auditor over legal advice obtained by it in connection with take-on, continuation or resignation issues; arguments for overriding that privilege would seem to be weaker. However, there is no proposal for the override in the White Paper.
     
  • What about transparency?

    Investigation is not an end in itself – its ultimate purpose is enforcement.  The White Paper does not attempt to discuss how in practice LPP would be safeguarded if the audit regulator wished to rely on the privileged material in an enforcement context, such as at a public hearing or in a Decision Notice.  The complexities arising from ‘privilege override’, such as hearings having to be in camera for at least part of the time, and redactions to Decision Notices, would hamper transparency and could diminish the effectiveness of the regulator’s work at a public trust/policy level. 
     
  • What would happen to privilege in contexts other than enforcement?

    The White Paper refers to the fact that “In some cases companies have agreed to waive privilege but only for the purpose of inspection, not investigation”.  This raises the question of whether the override of LPP should be confined to enforcement and not include AQR inspections, on the grounds that it would be disproportionate to override privilege for the purposes of an AQR. However, if any new statutory override of LPP were to be limited in that way, there could be inconsistencies between AQR findings and findings in any subsequent enforcement process.  That said, attempting to extend ‘privilege override’ to AQR inspections would present greater complexities and frequent difficulties over, for example, the question of redactions required to be made to the public reporting of AQR inspection findings.
     
  • Why should any override of audited entity privilege be confined to audit regulation and not extend to the regulation of financial reporting and corporate governance?

    The White Paper contemplates an override of audited entities’ LPP in respect of the inspection and enforcement activities of the FRC against auditors, but makes no suggestion that LLP needs to be overridden in respect of enforcement against company directors.  This imbalance is not explained, despite the potential that this carries for inconsistency of outcomes between enforcement against auditors and enforcement against company directors. The unstated underlying concern may be that the positive impact on enabling investigations by the regulator against directors would come at too high a price in respect of the interference with LPP, given that the individuals concerned are likely to have been the instigators of instructions to lawyers or recipients of the legal advice, and would be out of kilter with the protection of LPP in other investigations (such as those conducted by the Insolvency Service).

There is a danger that such an approach, and these reforms more generally, may have an unintended ‘chilling effect’ on the auditor’s ability to audit effectively.  Although the White Paper mentions briefly that any infringement of LPP must not “undermine the relationship between companies and their auditors”, it does not address the risk that such changes would pose to an audited entity’s willingness to be transparent with its auditor.  If audited entities fear their privileged material subsequently being disclosed to the FRC, clearly that stands to harm auditors’ ability to obtain the audit evidence necessary to reach sound auditor judgements.  Ironically that could ultimately impact on auditors’ ability to reach informed judgements and so undermine audit quality in general. Ultimately, a guiding purpose of the FRC is to improve audit quality and it would be regrettable if a hunger to obtain access to privileged material led to audit client’s being reluctant to share such material with their auditors.

We recognise that these are by no means straightforward issues.  However, the White Paper does not really point to them, let alone attempt to grapple with them.

Conclusion

It is perhaps surprising that neither the Law Society nor the Bar Council has yet issued a statement responding to these BEIS proposals.  There may be a sense that the rather faint proposals lack the courage of their convictions.  But it would be a mistake to underestimate the strength of feeling by the profession on the point, which is perhaps best articulated by (then) Lord Neuberger MR in a entitled “The scope and role of the Legal Professional Privilege and its proper place in the context of corporate internal investigations” given on 9 March 2016, in which he stated:

“Legal professional privilege (LPP) was developed by the judges from at least the 16th century to promote the observance of the law and administration of justice. Where a person is entitled to claim LPP in respect of a document, his right to insist on it remaining confidential for all purposes and not “disclosed and used to his prejudice” (unless statute clearly provides otherwise) whether in court or out of court, is a “fundamental human right established in the common law”.”

We will need to see the Government’s draft legislation before the real terms of debate become clear.  If the Government tables a bill that, if passed, could erode LPP there is likely to be considerable resistance from some quarters in the legal profession.  We shall have to hope that some very clever draftsmen will conceive of a mechanism that manages to further all stakeholder interests.

 

[1] The following regulators have agreed Memoranda of Understanding with the FRC for the sharing of information: the FCA, the PRA, the SFO, the Institute and Faculty of Actuaries, the Department for Business, Innovation and Skills and the Insolvency Service (temporary arrangement).  In addition, the FRC has a ‘Statement of Protocol’ with the PCAOB in the US and other international agreements with regulators in Switzerland, Canada and Japan.

 

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