Auditors personally exposed?
April 2010
Much has been written on the Companies Act 2006 and the various changes it has introduced. The new requirements regarding the signing of auditors’ reports for financial years starting on or after 6 April 2008 introduced a change which could have damaging personal side effects for those responsible for signing.
Under the new arrangements, audited reports sent to Companies House can be signed by the firm undertaking the work in the usual way. However for reports sent to shareholders of the business, the report, with limited exceptions, now needs to be signed by the senior statutory auditor responsible in their own name
Advice has been provided by accounting regulators and training groups on how the audit individual can best protect themselves but this guidance, while helpful, does not seem to have focused so far on the personal financial risk to the individual.
Employees have long been liable for negligence claims and exposed to the employer seeking to recover and while claims are rare solicitors tell us that they are seeing increasing numbers of staff targeted in this way. Senior statutory auditors should be particularly concerned that due to a legal case involving a firm of surveyors early in the last decade, the signing of audit reports personally may open them up to potentially disastrous litigation claims in the future.
Merrett v Babb 2001
This well known case in professional indemnity circles involved a chartered surveyor who signed a mortgage valuation report in his own name and subsequently found himself sued personally by the mortgagor after the firm that he had worked for had ceased business and no run-off cover had been arranged.
The case went to the Court of Appeal and the decision went in favour of the claimant with the deciding judge holding that Mr Merrett owed a duty of care to the claimant. Permission to take the case to the House of Lords has been refused and the case therefore remains good law.
Auditors appear to be personally exposed
Employees and partners or members of the largest firms may well have been assured that they are personally covered under the firm’s professional indemnity insurance. This is so, of course, and as long as the firm remains in business there should be little risk of uninsured exposure.
But what if:-
The firm goes out of business?
With increasing numbers of firms reported as finding current trading conditions challenging, is this risk increasing? Even those working for the ‘Big Four’ would do well to remember Andersons. Who, for example, would have arranged and paid for Andersons ‘run-off’ cover? Not to mention what the possible outcome might be of the latest reports of Ernst & Young's possible exposure to Lehmans. Funds may not be available for run-off cover if the employer is insolvent and while the business owners may benefit from limited liability, staff will not.
The policy of the employer is invalidated perhaps for an unconnected reason?
How great is the risk and what can the individual do about it?
Assessing the exposure for the individual auditor with accuracy is not easy as many factors come into play. One of the main determinants will be the size and strength of the employer. The risk of bigger audit firms not continuing to insure will be lower than for smaller practices.
The mindset of potential claimants is also a factor. Grim economic times and the push for greater shareholder engagement in the affairs of their companies may increase the chance of shareholder actions against audit practices but this does not necessarily mean that auditors personally will be targeted. The greatest chance of shareholders being able to enforce judgment against adequate assets usually lies in targeting a claim at a firm rather than an individual, assuming of course that the firm of auditors continues to exist.
Taking the advice of regulators in the approach to adopt when signing audit reports is sensible risk management. If litigation does target the auditor personally and is defended successfully, there are likely to be substantial legal costs involved which may not be recoverable. Legal defence costs are often insured under good quality household insurance policies but these will commonly exclude cover for employment related matters.
Section 504(3) of CA 2006
This states that “The senior statutory auditor is not, by reason of being named or identified as senior statutory auditor or by reason of his having signed the auditor's report, subject to any civil liability to which he would not otherwise be subject.
With Merrett v Babb being current case law this is a ‘civil liability’ precedent to which auditors (and indeed all professionals) were potentially exposed prior to the implementation of the latest CA. Section 504(3) seems to be saying that the new regime doesn’t set out to add to existing liability yet Merrett v Babb created a liability pre-dating the new CA.
As for solutions;-
- Sign audit reports following the advice provided by accountancy regulators and training groups.
- Insurance may not be the answer. This risk cannot be covered by the policy insuring the employer as the risk to the individual arises where the policy covering the firm does not provide indemnity.
- Policies can be arranged in Lloyd’s to cover individuals against the risk of claims in the event of the employer going out of business and this may provide protection to the employee.
- The solution that the RICS devised in response to Merrett v Babb is an interesting parallel.
The insurance market failed at the time to find an Insurer prepared to cover the risk and instead RICS created a fund from a membership levy of £15 on each of its 47,000 members in 2002, 3 and 4. The Members Support Service fund thereby created was intended to meet further claims expected against individuals but none materialised and the fund continued to be invested. In 2009 however, two matters were being litigated and the individuals targeted were assisted by the fund. The drawback with any fund compared to an insurance policy is that once it is spent it needs replenishment but perhaps this may provide a solution to the problem if claims against individuals start to emerge?
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