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White Paper Bulletin 1 – audit purpose, scope, liability and engagement with shareholders

  • 9 四月 2021 9 四月 2021

We expect audit firms will be keen to see audit make an ever-stronger contribution to trust and confidence in corporate reporting. However, proposals in chapters 6 and 7 of the White Paper for changes fundamental to the purpose and scope of audit, and the nature and extent of the auditor's engagement with shareholders, must be undertaken and implemented within a fair and balanced framework in order for the reforms – and audit services as a whole – to be effective and sustainable.

Contents

We focus in this bulletin primarily on the core statutory audit, but it should also be borne in mind that many, if not all, of the same issues need careful exploration in respect of the proposed non-statutory audit expansion.

White Paper approach to auditor liability

The White Paper makes some acknowledgement of the need for consideration of the nature and extent of auditor liability. But it does not go very far, if at all, in actually addressing that.

The Government does appear to have accepted the need for caution in not pursuing certain recommendations because of the liability risks that they might entail for auditors. Notable examples include declining to make the “purpose of an audit” as formulated by the Brydon Review into a legally binding obligation (see paragraph 6.1.16); and liability being one of the reasons given for preferring managed shared audits to joint audits (see for example paragraph 8.1.10).

In relation to the proposals that are pursued in the White Paper, however, it is difficult to detect any deep-seated commitment to the idea that the Government should lend its support to enacting further liability protection for auditors.

Clearly, the Government – and auditors themselves – will be mindful that such proposals might play badly in some quarters and be a difficult "sell", even if introduced as a balancing measure as part of an overall package of reforms. Nevertheless, there is some acknowledgement of the liability issue in the White Paper, and section 6.8 concludes with an open question about whether liability risks are likely to constrain auditors from embracing the proposed reforms and innovation, and if so how such issues might be overcome. Therefore, auditors may well consider that it is important for the profession to articulate the arguments for additional liability protection, whatever may be the immediate prospects for reform, even if only with an eye on the potential for future reform at a later date.

We set out below some of the implications for liability and liability protection measures that seem to us to arise from the proposals set out in chapters 6 and 7 of the White Paper.

Confining liability only to the shareholders as a body

We consider that a key element that needs to be introduced into the reforms is to enshrine in legislation the principle from the Caparo v Dickman case (“Caparo principle”). The risk that the reforms will involve an expanded legal duty for auditors beyond simply the shareholders as a body is, in our view, a general point that runs through much if not all of the specific proposals in chapters 6 and 7. The Government appears to have accepted that a legally binding “purpose of an audit” statement would risk an expanded legal duty for auditors (and so is not pursuing it), but seems much less convinced that there is a more general risk of other proposals that are pursued having that effect (compare paragraphs 6.1.16 and 6.8.4).

In our view, the Caparo principle requires positive support so as not to erode the protection that it offers for auditors as a result of the extension to their role through the proposed reforms. The White Paper records at paragraph 6.8.4 that the Brydon Review recommended no liability extension. It does so without offering any explicit approval or dissent for that recommendation, but it is anyway not enough simply to decide not to extend liability, without positive action to ensure that outcome is achieved. The government hints in a couple of places at the risk that the reforms present of erosion of the protection offered by the Caparo principle (see, e.g., paragraph 6.8.3), but does not advance any specific proposals to address that risk. The Caparo principle is Judge-made, based on a detailed review of the regulatory and statutory framework for audit at the time of the case in 1990. At that time, the conception of audit was narrower than it currently is, even before these further reforms, which will involve recasting significant parts of the relevant regulatory, and potentially statutory, framework. To prevent uncertainty, and also, importantly, to resist opportunistic attempts by claimants to challenge the extent of future application of the Caparo principle, it is necessary and appropriate, in our view, to put the scope of the Caparo principle beyond any doubt as part of the legislative reforms being undertaken.

Although a statutory enacting of Caparo would not address situations where the auditor stepped outside of its statutory reporting role and assumed a special, additional duty (i.e. the classic ADT v Binder Hamlyn situation), such a measure would certainly leave auditors a lot freer to implement the spirit of the reforms as intended. Whilst disclaimers have, and will continue to have, a very important role to play for auditors, it is unreasonable and unrealistic to expect disclaimers to bear the full weight of managing the additional liability risks presented by the proposals, and, indeed, there may be a risk that fulsome use of disclaimers could come to be seen as incompatible with aspects of the intended enhanced dialogue with shareholders and other users of corporate reports.

The liability risks that we perceive to arise in relation to the proposals for changes to the content and form of auditor reporting, and the enhanced engagement with shareholders, and which could be addressed by codifying the Caparo principle by ensuring that liability protection for auditors from third party claims extends to the full range of such activities by auditors, include the following:

  • The White Paper proposes that there should be an express new responsibility to consider director conduct and wider financial and other information about the company (see paragraph 6.1.10), which would extend to external signals of enhanced risk profile (see paragraph 6.5.5). This is said to require changes in auditor mindset, skills and experience, although it is not clear how it will actually be implemented; we certainly agree with the White Paper that a new professional standard for auditors would be required in order to make the content and extent of this new responsibility sufficiently clear. Similarly, it is also proposed to require auditors to report on the directors' statement regarding the prevention and detection of material fraud (see paragraph 6.4.5), and also in respect of the auditors' own steps to detect fraud and consider the effectiveness of relevant internal controls (see paragraph 6.4.6). More generally, the White Paper emphasises the importance of promoting innovation in auditor reporting (see paragraph 6.5.6), and allowing freer form reporting in order to better inform users (see paragraph 6.5.4). Extensions to, and changes in the form of, auditor reporting such as these necessitate the clarity of a codified extension to Caparo. The effectiveness of innovative and freer form reporting is likely to be considerably enhanced by providing clarity in legislation to that effect, rather than leaving it to the Courts to decide how Caparo applies when disputes arise.
     
  • If a call is to be made for Caparo to be codified in statute, the ambit of any statutory codification should also take into account other standard parts of market practice that have grown up since the Caparo case itself was decided, such as an auditors' report on a company's preliminary announcement of results. Such reports do not fit neatly within the stated rationale of the Caparo decision, which is limited to the auditor report on the financial statements that is required by statute.
     
  • Outside of reporting activities, it is proposed that shareholders will be able to communicate areas of emphasis that they would like to see the audit address (see paragraph 7.3). Shareholders' views will be advisory only and (largely) mediated through the audit committee, which will communicate to shareholders a summary of the audit plan and the auditors' response to shareholder suggestions on the planning. Such interactions with shareholders during the planning process seem to us to be a source of potential difficulties arising from the possible self-interest of some stakeholders (for example, in cases where a very activist or opportunist investor seeks to direct the audit focus into particular areas with a view to gaining assurance for the purposes of a contemplated transaction or shareholder strategy). This presents a risk for auditors that they might conceivably be found to have assumed a special duty to a particular investor if they were to be made aware of any particular purpose for which that investor required the audit report. At the other end of the audit process, and potentially presenting similar risks if not adequately addressed by the reforms, auditors will be encouraged to attend AGMs to be asked questions about the audit by shareholders (see paragraphs 7.3.10 and 7.3.11). The government has hinted that it recognizes that there may be a liability risk presented by answering questions at the AGM (see paragraph 7.3.19), although oddly says nothing of such risks in respect of the planning interactions, and has not advanced any measures to deal with the risk.
     
  • The White Paper also hints at enhanced liability risk in respect of the proposal for more meaningful information to be included in the auditors' resignation statement, and for the more prevalent use of general meetings at which to question the departing auditor (see paragraph 7.3.13 to 7.3.20). In our view, the government is right to identify that the Caparo principle as it stands in common law would likely offer insufficient protection to encourage truly informative explanations to be given in such circumstances.

We anticipate that any exercise in codifying Caparo in legislation would raise a host of difficult questions to answer about the approach and manner in which that might be undertaken. Consistent with many aspects of the proposals in the White Paper, detailed implementation of such a measure would require further specific and careful analysis. The existence of such questions that would need to be addressed in any codification exercise seems to us to emphasise the threshold point that codification is a very necessary measure, given that such questions would otherwise fall to be addressed in an ad hoc manner in the course of particular legal disputes, without the ability to consider more broadly the policy considerations for an approach that will achieve a fair and balanced package of measures.

Liability Limitation Agreements

Section 6.8 of the White Paper asks whether the statutory provisions for liability limitation agreements (“LLA”) are serving a useful purpose (see paragraph 6.8.2), and also asks how liability obstacles to innovation might be overcome (see question 47). If "useful" purpose means intended purpose, then clearly the answer to the first question is “no”, other than to demonstrate the limitations of statutory reform that depends on market appetite for implementation. The strength of the original policy justification for LLAs that was accepted by the then government when introducing the Companies Act 2006 was not translated into statutory provisions that were capable of delivering effective reform, resulting in no change to the auditor’s liability position in reality. This presents, to our mind, a compelling case for further reform in order to achieve the accepted policy justification at that time. In answer to the second question raised by the White Paper in relation to LLAs, it is rather more difficult to identify alternative solutions that are workable without a more radical approach to statutory provision.

We doubt that a mandatory liability limit for statutory audits is likely to attract support from the Government, albeit we would note that it is a tried and tested approach in other jurisdictions. For example, a mandatory legal cap on the amount of an auditor’s liability exists in Germany and, although the Wirecard corporate collapse has led to a reform to increase the amount of the cap, the cap has survived that test of public opinion. It seems to us nevertheless that a German-style arrangement would only become potentially tenable in the UK in limited contexts and special circumstances.

Such a situation might arise, for example, if there were to be introduced powers to enable ARGA to compel the appointment of an auditor to a company (including compelling the auditor to accept such an appointment), either in the ordinary course or in the face of reluctance amongst audit market participants to accept appointment so that a company cannot otherwise secure the appointment of an auditor in the normal way. Such powers are discussed in section 7.2 of the White Paper, which refers to consideration of this issue by the CMA and Sir John Kingman in relation to PIEs. The Government has indicated that it is not minded to introduce such powers straight-away, but that it is considering creating the ability for such powers to be extended to ARGA in the future through secondary legislation (see paragraph 7.2.5).

It seems to us wholly untenable for an auditor to be compelled to take on an audit on the basis of unlimited legal liability, or only with the ability to try to obtain agreement to a liability cap through discussion with the company and its shareholders, which would clearly be of no utility in such a situation. If no audit market participant were willing to be appointed to the audit of a particular company, that might well be because of the perceived riskiness of the audit in question. It would not be consistent with the basic requirements of a sustainable audit market for auditors to be compelled to assume legal liability to the audited entity notwithstanding their judgment that the risks of such liability are too great for them to be willing to bear.

Given the failure of the LLA provisions in the 2006 Act, the Government is clearly aware there is no case for extending the statutory LLA regime to non-statutory audits. The Government considers that companies may be more willing to agree liability limitations on a normal contractual basis for non-statutory audit work (see in that regard paragraph 6.8.4), a proposition, of course, that remains to be tested.

Role of audit committee

Section 7.1 of the White Paper contains proposals in relation to the audit committee, which would initially apply to FTSE 350 companies with a view possibly to being extended to PIEs in due course. These proposals envisage direct regulation by ARGA, including imposition of standards and risk of enforcement action, of audit committee members, to emphasise their responsibility for monitoring and overseeing the performance of the audit, amongst other aspects of their role.

The development and implementation of these audit committee proposals will need to be thought through and treated with care, so as not to overload or deter diligent individuals from participating on audit committees. However, they do offer the potential to help strengthen the performance of audit committees which is likely to be of assistance to the auditor.

We have seen a downward trend in judicial assessments in auditor liability claims of the level of discount of damages ordered against the auditor to reflect the contributory negligence of the company for the problems that have occurred; recently, discounts have been markedly lower than some longer standing case precedents, suggesting a distinct shift in judicial attitudes. Audit committee proposals such as those contained in section 7.1 of the White Paper ought to be highly relevant in future cases to judicial consideration of contributory negligence, which it might be anticipated would halt the decline in the level of discounts in appropriate cases. However, predicting how (if at all) judicial attitudes might change is difficult, even in the face of renewed regulatory emphasis upon the role of other participants in the corporate reporting process.

In our view, it would be coherent with proposals such as these about the role of the audit committee for the reforms also to incorporate measures to address more directly the appropriate division of responsibility for liability purposes between the auditor and other persons who have a role in relation to the company’s accounting and reporting. Such measures would consider, amongst other things, the contribution of such persons other than the auditor to the problems that have occurred, regardless of their ability to pay their fair share of the damages, and might also seek to bring useful simplification to the law by avoiding the need to wrestle with legal complexities around the attribution of the acts of individuals to the company for the purpose of having narrowly to consider the fault “of the company”.

Principles of corporate auditing

The White Paper adopts the recommendation of the Brydon Review to introduce a new legal framework to empower ARGA to set and enforce new principles of corporate auditing (which would also apply to non-statutory audit) (see paragraph 6.3.5).

The Government has indicated that it considers that the principles suggested by the Brydon Review (which are set out in the box on page 101 of the White Paper) are a good starting point for ARGA’s consideration in developing the new principles.

At first blush, those principles do not seem obviously to present radical departures from existing ethical principles, which of course feature in enforcement actions.

It is difficult, for example, to regard the new principle that auditors should “act in the public interest and have regard to the interests of the users of their report beyond solely those of shareholders” as fundamentally different from the regulatory status quo in terms of the role and expectation of the auditor. However, this proposed new principle looks rather like the “purpose of an audit” statement, which the White Paper has ruled out on the basis that it might represent a liability risk for auditors (see paragraph 6.1.16); that is, the risk of auditors incurring legal duties to users whose interests auditors are said to be required to take into consideration. It is not evident from the White Paper on what basis the Government thinks that this risk is not equally an issue (or, indeed, more of an issue) in respect of an explicit principle focused on the “users” of the audit report.

We also find problematic the Government’s intention that the principles would have a form of priority over other existing requirements, including ISAs: “an auditor who has met the letter of auditing standards but has not done so in a way that is compatible with the principles would be subject to sanction, whereas an auditor who – exceptionally – had failed to comply with the letter of standards in order to comply with the principles would be able to justify their conduct”.

Given the vast array of existing requirements, broad and narrow, to which auditors are currently subject, the suggestion of introducing a further separate consideration for auditors to take into account in making decisions seems likely only to add to the burden upon them. The auditor’s position is likely only to become more complicated and hazardous, in contemplating the risk that it may act in breach of auditing standards, by any difficulty in assessing whether it is acting in accordance with the new principles. The notion that – albeit in extremis – an auditor might have to choose which to follow, and which to breach, between the ISAs and the new principles of corporate reporting only serves to emphasise that the current package of reform is not designed to alleviate the plight of auditors.

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