The inequity of joint and several liability has long been identified (by accountants) as a major problem for the accountancy profession because it can mean one party (usually the professional accounting firm and its indemnity insurer) paying for the negligence of others irrespective of their relative share of responsibility for the damages caused.
In the absence of law reform in the UK the larger accountancy firms have begun taking steps to protect themselves from large and possibly vexatious claims. Limited liability audit companies and Jersey and the Isle of Man limited liability partnerships are all routes already chosen or being explored.
The offshore movement in particular has been seen as “tacky” – akin to flying under a flag of convenience and potentially damaging to the City of London’s reputation as a pukka financial centre. Yet in the absence of a change in the law of joint and several liability it is inevitable that accountancy firms will try any lawful means to protect themselves.
This is not just a UK problem. Every developed economy and every professional body of accountants is aware of the problem but many have found solutions or are working hard towards an answer. The matter was fully discussed at the International Meeting of Accounting Bodies in South Africa earlier this year. Moreover the problem is not just one for accountants. Letters to the Secretary of State for Trade and Industry in June and November, signed by the office bearers of several professional bodies, including engineers and actuaries, made it clear the issue affects a wide variety of professionals.
What, then, is the problem and what are the possible solutions? What are the special interests and dangers and is the public interest served in providing remedies?
With several liability where two parties cause different damages to the plaintiff, each is liable only for the losses suffered as a result of his or her actions. In joint and several liability where two parties acting independently cause the same damage to the plaintiff, each party can be pursued for 100% of the loss suffered. Proportionate liability ensures that where two parties acting independently cause the same damage to the plaintiff each party is liable only for “their share” of the loss according to some allocation of overall responsibility for that loss.
The basic legal principle in most countries is based on joint and several liability but there has been significant modification in recent years.
In the US in 1986, California provided that in cases of inter alia personal injury and property damage, the liability of each defendant for non-economic damages should be several, not joint. New York has proportionate liability in cases of personal injury for a defendant who is less than 50% to blame.
Now only eight states in the US have unmodified joint and several liability.
The 1993 Limited Liability Partnership (LLP) law encouraged the majority of large US accounting firms to register as LLPs. This does not, of course, resolve the basic problem of auditors held liable for 100% of damages, but it does give some protection for the personal assets of partners (other than the negligent partner). The partnership as a business may collapse and the personal assets of the negligent partner surrendered but the personal assets of other partners would be protected. This is the same position as auditors in the UK becoming limited liability companies or LLPs; the negligent partner would be pursued and could be ruined and the company or LLP could fail.
In December 1995 in the US, the Private Securities Litigation Reform Act was passed bringing in proportionate liability for defendants in non-fraud cases; where one defendant cannot pay there is some reduction of damages for “larger” plaintiffs – small investors have even greater protection.
In addition, losers in non-fraud lawsuits have to pay their opponents’ legal costs. The reform only applies to claims brought under the Securities Acts.
In Australia, a Federal Review of joint and several liability set up in 1994 listed clear arguments for the abolition of joint and several liability. In January 1995 a system of proportionate liability was recommended.
Meanwhile, the New South Wales Parliament brought in the possibility of “capping” liability to specified amounts. In one legal case the auditors initially failed to identify internal problems but when they later did no action was taken by the board; the auditors showed that a claim of contributory negligence against the company could succeed in reducing damages paid. A draft bill has now been produced which, if enacted, would mean defendants would be liable only for the proportion of the plaintiff’s loss that their own negligent actions caused. The draft bill does not seek to change the joint and several liability that exists between partners in a firm nor the vicarious liability of an employer for the acts and omissions of an employee.
The New Zealand law commission has also accepted the principle of contributory negligence but there is mounting pressure for full proportional liability.
In Canada where incorporation of accountancy firms is common practice, some provinces such as British Columbia hold that proportional liability applies where the plaintiff is contributorily negligent.
In the European Union some member states have a legal civil liability cap, in others auditors can limit their liability by contract and there are differences in the various courts’ opportunity to limit the amount of damages. Incorporation is one of the responses being put forward in the UK.
A firm has never lost an audit because it incorporated. For users of accounts, such as investors and company directors, the transparency of seeing what capital an audit firm actually has can be particularly advantageous.
It may seem reassuring to feel auditors have unlimited liability but it is not possible to know what those personal assets might amount to if put to the test. The key surely is – will the auditors lose focus – will they try less hard or be less rigorous if they do not face personal financial ruin? Curiously this question of focus does not seem to arise when considering the performance of an employee of a non-audit incorporated company and in any case nothing prevents a plaintiff from pursuing the negligent audit partner/director/ employee of an audit incorporated company or indeed his supervisor or technical adviser.
However, some feel incorporation does not really address the problem.
The incorporated company or indeed the limited partnership could be destroyed by having to meet huge claims when they are only partly “to blame”.
The Institute of Chartered Accountants of Scotland considered the issue of auditors’ liability in 1994 and published a wide range of recommendations which, taken together, it believed could resolve the problem. It was suggested that independent research should be undertaken to ascertain the magnitude of the problem for UK audit firms and then go on to consider the public interest consequences of a failure of one of those firms and severe losses to its insurers in the event of the success of a large claim.
If the case was proven, some of the suggestions proposed in 1994 included:
The principle of joint and several liability should not be changed.
It felt then that it might be replacing one wrong (the unfairness and damage to auditors) with another (the inability of a plaintiff to recover damages from those with deepest pockets).
An amendment to S310 of the 1985 Companies Act to require directors to have appropriate insurance cover but in return to allow them to negotiate a limit to their liability.
Auditors to be able to limit their liability in relation to statutory audit. Perhaps this would be limited by statute in the short term until the corporate governance climate encouraged more active behaviour by shareholders without which conflicts of interest could arise (as auditors are often seen effectively to be appointed by directors).
These along with other recommendations were to be seen as a whole.
Since then it has become clear that this is a major problem. Overseas governments have moved to address the problem, leaving us concerned that the UK would become the litigation capital of the world. The move by larger firms to register offshore could cause further concern, not least to the public perception of the government’s relationship with the profession and of UK audit regulation generally. Incorporation or LLP status does not address the fundamental problem as explained above. Given these developments Scots ICA debated the whole matter again at length.
The council is composed of a wide range of people. Small and large audit firms are of course represented but the vast majority of council members are not auditors. The non-practising members are users of accounts, investors, non-executive directors, academics, finance directors, people from the public sector and so on. After much consideration the Scots ICA is convinced that proportionate liability is the solution. It still feels that directors should obtain appropriate insurance cover.
Creditors, customers, lenders, other investors small and large, non-executive directors, credit agencies, members of the public and government stakeholders, all depend on audited accounts, one of the only truly verifiable pieces of information (whatever their limitations) available on a company’s performance.
It is in the public interest that these accounts should not be so qualified by an audit report issued by a litigation nervous auditor that it ceases to have real value.
An audit function should be strong and fearless and be able to recruit the best people. Young chartered accountants should not be turning away from audit because of litigation fears – a move that has been seen in some areas of the medical profession. We should want our auditors to have the resolve to comment on matters like internal audit, to add value to the audit and to take real responsibility without constant fear of huge litigation claims.
In the high-inflation days of the mid-70s almost every audit report claimed the auditor, while expressing the opinion that the accounts showed a true and fair view, was unable to say whether the company was a going concern making most sets of accounts at that time of very limited value.
Despite some well publicised cases of audit imperfection and failure, the audit function in the UK has very high standards of professionalism and integrity. We should not allow it to become weakened.
Most other countries have moved a long way towards providing a solution to this problem. The government should now look seriously at proportionate liability not simply to prevent firms registering offshore, which in any event does not address the core problem, but in the public interest to ensure that we continue to have quality people carrying out quality audits.
In return audit firms would be expected to add even more value to their audit reports and perform more of the “whistle blowing” role which the public expects of them. Although, unlike the public sector, they would not have immunity from law suits this would empower them to provide a better service.
Robert Smith is president of the Institute of Chartered Accountants of Scotland.