Fortune Favours The Brave
A regular podcast for business leaders exploring how businesses can harness risks and use them to their advantage. In each episode Howden Insurance Brokers will discuss a topical challenge or issue and what business leaders can do to overcome it.
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Fortune Favours The Brave
The Tangenty Tangents of Audit - the landscape of civil claims and risk mitigation strategies
In the second of a two-part series Neil Williams of Howden is joined by guests Richard Highley and Julian Bub-Humfreys from DAC Beachcroft as well as Thomas Plewman from Brick Court Chambers to discuss audit reform and emerging trends in regulation. In this episode, we explore the current state of civil claims and discuss risk-mitigation strategies.
If you missed the first in the series, find it here.
Welcome to Howden's podcast Fortune Favors the Brave. We all take risks in our everyday life, and business is no different. In this podcast, we're speaking to the experts about a topical challenge or issue and what business leaders can do to overcome it.
Speaker 2:Welcome back to the second part of this Howden Fortune Favors, the Brave podcast on audit risks for accountants and audit reform. I'm joined again by Julian Bubb-Humphreys and Richard Hiley from DACB Solicitors and Thomas Pluman KC of Brick Court Chambers. So in this second part we're going to talk about civil claims and civil risks. Thomas, do you want to kick us off and talk about the claims you're seeing at the moment and the claims environment more generally? Thomas, do you want to kick?
Speaker 3:us off and talk about the claims you're seeing at the moment and the claims environment more generally. Yes, there was obviously something of a flurry of judgments a few years back, slightly less in the last year or two, and what does that really indicate? Does it indicate any kind of decline in these claims? My own impression is the opposite. There are plenty of big claims out there and, as ever, the claims are driven by corporate collapse, and the rate of corporate collapse is what determines their frequency.
Speaker 2:Richard Julian, have you got anything to add on that space?
Speaker 4:Well, I certainly think that we're all waiting for that is, the litigators, the lawyers. We're all waiting for the next prompt for corporate insolvencies. Back in the 90s, I'm old enough to remember that it was driven by difficult economic conditions. Are we about to see difficult financial conditions because of the current economic climate, with higher taxes, higher costs, inflation, the fact that debt remains at an all-time high and seems to be getting higher? Well, you know, the litigators hold their breath and look on.
Speaker 5:The number of big claims that are out. There is a steady drumbeat, but they don't necessarily come to court. I think the flurry of judgments, thomas, that you referred to have given tools for claimant firms to get claims off the ground by reference to some kind of strategy that the audit identity embarked upon in reliance on the auditor's opinion. Now, as defendant lawyers, we might have some justifiable scepticism about whether that strategy A was a strategy B was actually embarked upon in reliance on the auditor's report, and C whether it occasioned any loss. But that doesn't mean that claims aren't being pitched in this way. As any search of the court file will show.
Speaker 5:If you and those particulars of claim are all available online, you can pull them down. You can see the sorts of claims that are being constructed and it's quite interesting when you speak to firms that have been, you know, that have faced such claims audit firms that have faced such claims. Because when you describe the, when you describe how such claims audit firms that have faced such claims because when you describe the um, when you describe how such claims are put, they all think you're talking about them. Um, because, because, because it can get somewhat formulaic because these claims are frequently pitched in a very similar way Um, but it. But it's not specific to that audit firm. It tends to be just driven by this route. This kind of trading loss claim that can be brought and, frankly, whether those claims are good claims or bad claims is, as ever, going to hinge on the evidence and the analysis.
Speaker 3:Sometimes they are, sometimes they aren't, but what they are is out there and we haven't seen a less of yeah, I think the other thing I'd say about that is it has always been true in this market that the claims come from an identified loss that's been suffered and then an ability to identify a ground of criticism of an auditor. Identify a ground of criticism of an auditor, and much as I act for auditors, there is always something that can be found with the benefit of hindsight and the claimant market then wants to square the circle and say, well, on that basis, there is liability, and yet all defense cases, all liability defense cases, are fought in a different space altogether by and large, which is the connection between those two things causation, scope of duty, issues of that kind.
Speaker 2:One thing that I've had a sense of and appreciated slightly anecdotal, is that perhaps complaints to the regulators are being used as a precursor to civil claims. Has anybody else got the same sense of that, actually?
Speaker 5:no, I think the interplay between the regulatory sphere and the civil claims sphere is an interesting one and it's a delicate one. But of course the audit file is the audit file and any forensic accountant can look at that audit file, form whatever judgments or craft whatever allegations they want to out of that file and pursue that claim not beholden to the timelines or so on of the FRC. If there's been a major corporate insolvency and it can be suggested by both the regulator and the civil claimant or an insolvency practitioner that something in the audit should have been done differently. And had it only been done differently something would have turned out differently and we would often disagree with that. So that's simplistic logic and actually when you get into the weeds it's not nearly so simple as all that. But both the regulator and the civil claimant are perfectly capable of reaching that conclusion themselves. But it's interesting that you say that. What kind of conversations have you been having?
Speaker 3:Well, if I can pitch in, I'd say in my experience in large-scale liability claims, the claimant is always interested in what evidence they can get emerging from the regulatory response. But of course there are timing issues. The FRC in theory is trying to speed up the rate of investigation, but some investigations at least still take a long time, and a much longer time if they're going to proceed to a disciplinary hearing. So they don't always get the material in time for the trial. But those are shifting, shifting deck chairs, if you like.
Speaker 2:Thomas, do you want to just pick up a bit more on the legal environment as it currently stands?
Speaker 3:Yes, I think the recent cases that have really potentially shifted the dial. There was the Asset Co decision, which is now a few years ago, but then more recently the Manchester Building Society and Grant Thornton case in the Supreme Court on this rather slippery concept of the scope of duty which has been kicking around since the 90s and since the Sarnco decision in the 90s. I can't go into all of the detail. That was a case about hedge accounting ultimately, and both advice and then audit acceptance of the application of hedge accounting to the Manchester Building Society, and it later was determined that hedge accounting was inappropriate. And the Manchester Building Society then said well, they were forced to close out a series of interest rate swaps at a time that they were deeply underwater and suffered some quite large losses as a result. And the question was is that a loss which it was Grand Thornton as the auditor's duty to guard them against? And the Supreme Court ultimately did a number of things. I mean, it confirmed the importance of the scope of duty principle and it's as well to explain it. So it is to ask the question what are the risks of harm as to which the defendant, that is, the auditor, owed the claimant a duty of care? And that won't be everything. And then, looking at it backwards, as it were, is there a sufficient nexus between the loss that was actually suffered and those risks of harm to which the audit duty related was a consequence of the society's decision to conclude 50-year interest rate, to buy 50-year interest rate swaps rather than 20-year interest rate swaps? And it was said well, that can't be something that it was for the auditor to protect the society from. And in the end the court found the opposite, said well, the core reason why the society did invest in the interest rate swaps was because of the advice that it could apply hedge accounting principles. Had it not been able to apply that principles, it wouldn't have been able to afford to do so, and so Grant Thornton was held liable.
Speaker 3:How did the case shift those principles compared to the past? What it did was slightly move away from what had previously been a popular analysis of the counterfactual, in which you sought to ask yourself. You sought to test the proposition by asking, to ask yourself. You're sought to test the proposition by asking, well, if the advice given or the financial statements, if it was the sign-off on the financial statements, if that had been factually correct, not the advice, had been correct, the underlying facts had lived up to what the advice was, would the loss still have been suffered? And that was a very useful device developed by Lord Hoffman in the Psalmco case. But the Supreme Court in Manchester Building Society said it's a cross-check only. The question is what was the purpose of the advice or the work that the auditor gave or did? And was the purpose of that to guard against risks of this particular kind? And I rather fear that that may lead to an expansion of the scope within which auditor's duty is found to apply and hence to an expansion of liability. But that remains to be seen.
Speaker 4:It is important and relevant, isn't it that with Manchester Building Society, the advice relied on was not simply the audit, it was not just a firm of auditors auditing a set of financial statements, failing to point out, to identify that the financial statements were not correct in some respect, which might lead to a qualified audit or material uncertainty.
Speaker 4:Rather, it was advice given by Grant Thornton on a specific issue which was found to be wrong. And the specific issue was can you use hedge accounting to manage the volatility on the balance sheet for this audit client? In the regulatory context, answer yes or no? And the answer was actually no. You couldn't use hedge. It would have been no but was yes. But that is not, I mean, one of the things which, when we talk about risk management, which we particularly emphasize, is about mission creep. But when you do go beyond the scope of what you originally retained to do, you start to enter this more dangerous territory, because if you're starting to give advice rather than simply carry out an audit, then liabilities which might not otherwise rest with you will come and hit you.
Speaker 3:That's obviously right, I should say about it. Under SOMCO and the cases that followed it, the distinction that the law sought to make was between what were called information cases and advice cases, and the Supreme Court in Magistral Bullying Society rejected that terminology as not actually helping because everything is on a spectrum. But in the end what Magistral Society says is you've got to look critically at the purpose of whatever it was that the auditor did and what losses it was designed to protect its client from, and then the nexus of those to the losses that were actually suffered. And that's a question of degree in every case. So I agree with you.
Speaker 3:In that case, grand Thornton had given separate advice at the start that hedge accounting was permissible and could be applied in the way that they wanted to apply it. But it also was said to have in effect confirmed that by its sign-off on the financial statements. Year to year thereafter and of course each year further interest rate swaps were concluded. So I don't think it's safe to conclude that there was only liability for those quite extreme losses because of the early advice. But it is definitely safe to conclude that giving the early advice, the mission creep, significantly exacerbated the problem and the potential for liability.
Speaker 5:This just sort of goes to emphasize why no one wants to end up taking these cases to court, because you end up in the Court of Appeal, you end up in the supreme court and um, you know, moving away from this kind of um, you know discussing all of these things that the lawyers like to discuss, but um, I mean, I, I would say this as a, as a, as a brute and simple uh defense lawyer, but um, the, the, the order is not there to underwrite the negative consequences, you know, to underwrite the negative consequences of any business decision that you make. Uh, and I think lord justice leggett um made a very sensible point, which is that if you're going to claim for a loss um attendant on the audit report, it has to flow from something in the audited accounts that was incorrect. You can't um you, you have to have that, that missing middle between your loss and um and the respect of the order to make out your claim. But yeah, we'll see how the law develops.
Speaker 2:We will indeed, and thanks very much to all. It's an excellent discussion there on some of the legal points. Just moving on, what can we do to manage the risk? I think, Julian, you wanted to talk about the limitation of liability and I'm particularly interested to hear on this subject. What thoughts have you got?
Speaker 5:Well, the year's 2006. I was just starting my AS levels. I was a golden summer. But, more importantly, the Companies Act 2006, an instrument of which I was blissfully unaware at the time, came into law. And the Companies Act 2006 provided for limitation of liability agreements for auditors, a tool that has very seldom been used in the profession, but one that we think the time has come. So the big problem that auditors have is that they, as a matter of course, they can't limit their liability against their audit clients in the simple way that many other professionals can, which, when you think about it, is kind of nuts. So the Companies Act 2006, agreeing with that proposition, said OK, well, fine, we'll set up a mechanism for overriding that presumption limitation of liability agreement, so you can limit liability. You can limit your liability to what's fair and reasonable in the circumstances. I can't agree with what that is, but nonetheless you have to renew that limitation of liability every financial year. You have to obtain shareholder approval which may have been the big sticking point either in a general meeting for a public company or by a written resolution of shareholders for a private company. If the court says that's not fair and reasonable, the court won't void the agreement but will amend the agreement to a level set by the court. That all sounds brilliant.
Speaker 5:It just hasn't been used because there's been such enormous pushback from the audited entities. It's not market, but we think that the ground is changing now. Um, so, for for a few reasons, the de-risking of audit firms, um, that's not a trend that's going to go away, and one way of de-risking is to limit your liability. Um, we know that, you know, we, we've had inquiries about this. We know that, um, at least one of the big firms is starting to do this as a matter of course, and this is such a tight industry I mean problematically so, according to the Competition and Markets Authority, but nonetheless, if one firm does it and then another firm does it and then another firm does it, all of a sudden, half the market is doing it, and then the other half of the market needs to catch up. We hope, for the sake of the audit industry, that in 10 years time, 12 years time, it will just be a matter of course.
Speaker 5:Annual general meeting of shareholders Tick, tick, tick. Approve appointment of new directors, remuneration committee Blah, blah, blah. Oh, there's the limit of liability for the auditors. Proxy advisors yeah, go for it. That's market, that's standard, um and uh, that would be a great, a great boon for, for, for the audit firms.
Speaker 5:Um, might it lead to to fewer knockout claims? Um, well, hopefully, um, from from a litigator's perspective, it's quite. It'll be quite interesting to see what, what happens. Perhaps, if claims are brought that are more, um, let us say, of a sane value, then they may be defended um in a way that, um, some knockout claims of the past have been settled because, um, uh, I think everyone in in in these circumstances, aware of the dynamic that, um, you don't want to be the uh, you know, you don't want you, you don't want to be dealing with a, with a limits loss, basically as a market, um, but something more manageable. Maybe maybe you say, okay, fine, we'll, we'll take, take that on. Um, we're not there yet, um, but uh, we hope to be, and the the frc is the regulator is not averse to this.
Speaker 5:Um highly commend uh, very well written um guidance note. It's available on the frc website. It's been sitting there since june 2008. Um and uh, yeah, anyone who is in the audit firm market or or a broker or an underwriter should go and have a look at that, because it could be um a huge, huge risk management tool, um, and if it does become market, then that is a? Um, essentially a huge positive for the audit absolutely.
Speaker 2:I couldn't agree more from an insurance perspective. You know insurers are going to be very interested in that. Particularly if the limitations of liability are set at a sensible level, it could be a game changer in terms of the insurance environment of course it's important to remember that that it can only protect above the level of what is.
Speaker 3:So the limit has to be fair and reasonable in all of the circumstances and that's an untested proposition because people haven't been doing it. And how big might that be? One can see that there will be. If it comes to be adopted more widely, there will inevitably be litigation in which that standard is tested. The idea of reasonableness, of limitation clauses, is a to some extent well-travelled road under the Unfair Contract Terms Act, but this is specific to the audit industry and the nature of the audit engagement. So what will be found to be reasonable? Well, one doesn't know.
Speaker 3:The other point I would make about it, if there's time, is that this is not just financial liability in the sense of what the number is. The other issue is time bar provisions. So at common law, six years to bring a claim, plus the circumstances under which that can extend. Under the Limitation Act, an agreement that any claim has to be brought within, say, three years might be something which the audit industry would take some comfort from achieve greater certainty. That is probably, although it's not decided, a limitation of liability in the sense that the companies act, uh, proscribe, proscribes and unless the requirements are satisfied, but seems to me would be one which would be patently reasonable yeah, absolutely.
Speaker 2:And that time bar point could have a significant impact, couldn't it, richard? I think you wanted to.
Speaker 4:Yeah, so, and I I'd love to see that first case and how the courts uh treat the the uh reasonable and fair test. But what I just wanted to say when uh clients come to us uh right now and ask about limitation liability agreements and how to go about them and what terms to include, we have emphasised, don't be mean, don't set it too low. Set it high, have some protection and an enforceable agreement. Don't set it too low and then face the risk of settlement negotiations where something's gone wrong and the other side being able to wheel out the leverage that well, patently you've chosen two lower levels, so therefore you can forget about that and you're going to have to pay, to pay more and we can ignore the agreement. Nor do you want to end up in court and find yourself without the protection of the agreement just because you set the level too low.
Speaker 5:Just picking up Thomas's point about the time bar, it's not just a risk limitation tool, it has huge practical benefits as well. So I don't know what on earth I was doing six years ago. By the time one gets to trial, that could be sort of nine, ten years on, one, the you know, the audit team is likely to have been scattered to the far winds. They'll be working for different firms, they'll be gone into industry, they'll have decided to become a trapeze artist, whatever, um and and and the documents may not, um, you know, may be more difficult to collate. Frankly, the standard, you know, the standard expected of an auditor, may have moved on in that time and although everything should be judged by the standards that were in place at the time, it's hard not to have that hindsight reasoning. It just makes a lot more sense to get on with it. Of course, the long time bar allows more time for settlement negotiations. But if the two parties are really serious about engaging in those settlement discussions, that can always be extended by agreement.
Speaker 2:Um, so I think that I think that's certainly something that should be tried and so, richard, just to just to wrap up, um, one of the things I'm particularly interested in is the paper trail, and you've mentioned the engagement letter previously. Are there any particular points that you'd make there in terms of risk management?
Speaker 4:I'm sometimes surprised when we come across instances and there's not a letter of engagement for every audit year. There's not a letter of engagement, for that matter, for just accountancy instructions which don't concern auditors. As a lawyer, it's crazy to come across instances where accountants are acting without an engagement letter. Understand the difficulty of having an instruction and we could come back to this issue of mission creep. What an engagement letter should do is, at the outset, set out the scope of the engagement with an audit. It should be limited to the work necessary to conduct a statutory audit For an accountancy instruction instruction to an accountancy firm which is not audited. It needs to set out the scope of that instruction, including areas which you are not advising on.
Speaker 4:And this question of mission creep, if you find, as an accountancy firm, if you find yourself advising on areas which are not covered by the letter of engagement, you need your risk team, you need your training to remind you, change the letter of engagement, amend the letter of engagement. And why is it so important? Because there are so many terms within the letter of engagement which prove very, very helpful. Come the civil claim to restrict liability, to reduce liability. For example, in audit claims, there's something called the Bannerman Clause, which makes it very clear that the only liabilities which you might be exposed to are those owed to the company and to the shareholders as a body Outside the audit sphere. You'll have reduced limitation periods. You will have liability caps. These clauses are very, very significant when it comes ultimately to the amount you would have to pay to settle a case or for which you would find liability if it goes to trial or for which you would find liable if it goes to trial.
Speaker 3:And there's another element of that, which is any such letter that I've ever seen would have in it a law and jurisdiction clause. And if we're talking engagements that have an international component to them, I would say although others might differ that despite everything else, you probably would prefer to be sued here than in some foreign jurisdiction, and the means of guaranteeing that you can only be sued here is the jurisdiction clause, exclusive jurisdiction clause within the engagement letter.
Speaker 2:I'd echo all of the points that have been made. I just think the paper trail is such an important part of the process in terms of protecting your position. I've seen so many cases where the missing engagement letter, the missing attendance note, could have made all of the difference and yet, you know, spending 10 minutes on that could save a significant amount of time and money in defending a professional indemnity claim.
Speaker 5:Yeah, and also just one tiny, tiny practical point. But if you're undertaking a role of a component auditor, just paper trail around. That as well is often overlooked.
Speaker 2:And so, just turning to you, richard, any final thoughts as we draw this to a conclusion.
Speaker 4:Perhaps my favourite hobby horse whenever I'm talking about accountants is the question of whether the time's been reached where we start to appreciate auditors. Stop criticising auditors. Appreciate auditors, stop criticizing auditors, and regulation has a role to play here. Going back to the early 2000s, I think most audit firms, most accountancy firms, would accept that audit quality needed to improve and that the relationship with the regulator was possibly too forgiving. I don't want to put it any higher than that.
Speaker 4:That has changed and in recent years there has been very significant criticism, regular criticism of auditors, both by its regulator because of the focus on the need to impose sanctions by way of deterrence to encourage certain audit behaviours and also by the media. Auditors are an easy target when there are losses. Why haven't the auditors done a better job? I think the time is now right to reassess that, because the ability to do an audit depends on the quality of audit staff, on the quality of our eyes, and you want to both recruit and retain really excellent people, and if the environment is seen as too harsh, too negative, then that will prove a challenge.
Speaker 2:Thank you, richard. I think that's a really important and, quite frankly, fundamental point to end on. All that remains is for me to thank my guests, julian, thomas and Richard, and to thank you, the audience, for listening. I hope you enjoy the rest of your day.
Speaker 1:Thank you for listening to this episode of Fortune Favors the Brave from Howden. To hear more episodes and subscribe to our channel, search Fortune Favors the Brave on your favourite podcast app.