In the otherwise sterile dialog on the survivability of the large audit firms, there were two real developments in Europe last month:
• The June 5 recommendation from Internal Market Commissioner Charlie McCreevy, that EU member states should take measures to limit auditor liability – here.
• The June 30 guidance from Britain’s Financial Reporting Council on liability-limiting agreements between companies and their auditors -- here.
Important – both of them. But not so earth-shaking as to support the sentiment heard on the American street, that the visionary Europeans have now come to the rescue of the hapless wanderers, ready to lead them out of the arid desert of their pointless chatter to the promised land of real audit liability reform.
Expectations need to be tempered. It is indeed a major shift in regulators’ rhetoric, to have the stark picture of survivability put by Commissioner McCreevy’s invocation of higher liability risks, limited insurance coverage and little prospects for new entrants, or the FRC’s recognition under the leadership of chief executive Paul Boyle, that another large firm’s exit “would seriously threaten the effective functioning of the UK capital markets.”
But a couple splashes of cold water are called for:
First, on the continent. Piecemeal country-level liability reform is a sometime proposition at best, until the various legislatures are actually seen to act. The Brussels pronouncement offers only a menu of general possibilities, rather than specifics: monetary limits by cap or formula, proportionate contribution rather than the typical “joint and several” exposure to 100% of a loss, or limits by contract with a client. All of these would be subject to judicial review, and the explicit – and probably over-riding -- principle that limitations should not inhibit any injured parties from being “fairly compensated”.
But even assuming the passage of new local laws, the absence in Europe of a mature history of orderly, predictable government reaction to large-scale financial scandal means that politicized responses can be expected to newly-emerging corporate malfeasance.
The licensing harassment of PwC in Russia, over its withdrawn reports on energy giant Yukos, and the post-events re-writing of the Italian bankruptcy laws to enable the appointment of the special administrator of Parmalat, exemplify the likelihood of on-going interference rather than good process.
Unless the non-Anglo countries lead the world by putting auditor liability regimes in place that would allow the Big Four to take cases to trial – where today they settle far above any statutory liability limits out of anxiety that a media-sensitive judiciary cannot be relied on to enforce limitations on the books but never tested under stress – auditor survivability will still remain hostage to official caprice and vindictive scape-goating.
As for the British – auditors there are newly empowered to negotiate with their clients for proportionate or monetary liability caps, subject to shareholder approval, disclosure, and judicial assessment whether terms are fair and reasonable.
Reversing earlier prohibitions on such agreements, this authority is more than the auditors had before, but far less than their wish for mandated limits that would have done their work for them.
Wherein lies the first rub: the track record of the British profession in such negotiations is meek and dismal. In earlier experience, faced with resistance the auditors crumbled like stale tea biscuits. Today, UK investor groups are already arrayed in opposition, with stakes driven in the ground against monetary caps.
Much more to the point, there are at least three ways in which the FRC’s role in broking workable limits in the UK – assuming success – will leave open and unaffected the far larger risks in the ever-dangerous American environment:
• Cross-border enforcement of British limits will be hostage to both the unremitting hostility of the Securities and Exchange Commission to any attempts to reduce unlimited auditor liability exposure, as well as the uncertain application by US judges of limits contracted under foreign laws.
• Optimists about the efficacy of the new British legislation crucially depend on the legal bar in the UK, under the court case known as Caparo, against investors and other third-party financial statement users bringing negligence-based claims against company auditors. Nor is there any British equivalent to the rights of American shareholders under the SEC law and rules. But both of these undergird the vast structure of US shareholder class action litigation, which will be unshaken by any change across the Atlantic.
• Finally, liability-limiting agreements between British auditors and their clients will, it is expected, be binding against liquidators or trustees of a failed company. But this constraint is unlikely in other countries, including the US, where such successors can avoid or disavow such limits, in order to bring suits in their own right – examples include the claims against the Deloitte firm by successors to the company in Adelphia, Parmalat and, most recently, the funds managed by Bear Stearns.
All of which is to say that, rather than being a bandwagon of change, these two moves in Europe may – perhaps, and only at best – drag the sledge a few meters along a rough and rocky path.
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