U.K. faces uphill task on audit liability limitation

by Bob Reynolds

London — The accounting profession in the United Kingdom has suffered a major setback in its campaign to secure limitation of liability for auditors. An independent agency, the Office of Fair Trading, has produced a government-sponsored report that concluded that there is no need for any form of limitation.

The Big Four and the Institute of Chartered Accountants in England and Wales now have only a short time to persuade the government to introduce changes to the updated Companies Act that is currently making its way through Parliament. The easiest method would be to repeal s322, which presently prohibits auditors from agreeing a pre-arranged limit on any liability with clients.

The sponsor of the legislation, the Department of Trade and Industry, has apparently been won over to the auditors’ case, but other departments, especially the Treasury, are skeptical.

But many accountants believe, privately, that the DTI will table the proposal. Certainly, it would probably wait until after the next general election, which is anticipated in spring 2005.

The incidence of massive claims against the Big Four firms has been growing rapidly. Auditors are perceived to have deep pockets by the creditors of defaulting businesses. In reality, though, firms have insufficient capital to carry the risk, and it is becoming likely that a major firm will fall because it has no limitation on its liability.

The immediate threat is to Ernst & Young, No. 4 in the U.K. The board of the scandal-hit insurer Equitable Life has initiated a legal action against E&Y for £2.6bn ($4.8 billion). The chairman of the U.K. firm, Nick Land, said that if the claim were successful, it would shut the practice down.

Peter Wyman, a PricewaterhouseCoopers partner and former president of the Institute of Chartered Accountants in England and Wales, said, “There is too little capital in the firms to withstand claims of this magnitude. In earlier times, cases would go to appeal and could last 10 years or more. But now, the impact on the reputation of firms is critical. If several large clients conclude that their auditor might not be around in six months, then this could provoke a flight of clients. We would not be able to make sufficient cost savings to cope with the loss in cash flow and a major firm could be bankrupt within three to four months.”

This nightmare scenario prompted accountants to lobby hard for some form of liability limitation. The DTI was ultimately convinced, perhaps because Secretary of State Patricia Hewitt was formerly an Arthur Andersen consultant.

But because the DTI failed to move the Treasury on the issue, industry minister Jacqui Smith commissioned the OFT to provide independent support. The OFT’s report has been greeted with anger and contempt by accountants. Of the large institutions, only the Association of British Insurers has backed the OFT conclusions.

“There’s going to a big public row about this. I want the OFT to withdraw this report and apologize for the inaccuracies,” said Wyman.

ICAEW CEO Eric Anstee said, “At the heart of this is the capital versus risk equation, and I do not think that this has been fully appreciated. There is insufficient capital in the firms to cope with the risk posed by the threat of litigation. ... We cannot believe that the OFT did not talk to Swiss Re, the biggest reinsurer in this market, before coming to their conclusions.”

Various senior figures in accounting in London wrote to the OFT to point out the deficiencies in the report. E&Y’s Land wrote to OFT chairman John Vickers, as well as the prime minister’s office, claiming, “Our cover is not adequate to meet claims at the level we are currently facing.”

The OFT concluded that securing sufficient insurance is a current problem. However, it reasoned, the issue is a short-term matter and had no material impact on the market.

The OFT has confused the availability of professional indemnity insurance for high street practices and that for big firms. Small firms have no problem securing professional liability insurance, and prices may even be coming down shortly. “It is a bad piece of work,” said one leading lobbyist for the auditors. “If it was a conclusion based on sound evidence, then I would have accepted it. But it is just plain wrong.”

Don Hanson, managing partner of Arthur Andersen in the 1980s, said that he was prepared to put a notice up on the doors of Andersen’s Surrey Street headquarters in London saying, “Sorry, no insurance.”

Further delay may cause accountants to reconsider whether they do audits at all. Certainly, large firms have already drawn up lists of clients that could be dropped if the risk became too high. At the top of the list are financial services companies, which are, paradoxically, the principal source of audit work for the U.K. profession.

The problem is not restricted to the four global practices. Mid-tier firms, such as Grant Thornton and BDO Seidman, are also incensed. “Several of the [larger mid-tier] practices have the resources and international networks to audit FTSE companies, and a major claim would be equally devastating for us,” said one senior partner.