Liability caps research: A new regime

Marianne Ojo’s report, Proposals for a New
Audit Liability Regime in Europe, says regulators are
concerned by the possibility of a legal situation that could bring
down one of the present Big Four accounting firms and increase
concentration within the audit industry.

Last year, the European Commission Internal
Market and Services Commissioner Charlie McCreevy said more players
were needed in the audit market to meet the demand of international
companies and ensure the market remains sustainable in the event
that one of the Big Four collapses.

The EC recently released a report on the
findings of a study on reducing audit market concentration. In the
current financial climate audit firms are at a greater risk of
litigation being brought against them, Ojo argues.

She says the collapse of a Big Four firm could
also generate a “too big to fail” hazard among audit firms.

“The consequences of increased audit
concentration within the industry stem from the possibilities of a
moral hazard situation whereby auditors not only exercise undue
risk, but also where low standard financial reporting is
encouraged,” writes Ojo.

Ojo proposes a liability cap model based on
options previously recommended by the EC. Her recommendation is
based on a combination of a single monetary cap at a European (EU)
level and individual caps based on audit fees.

The EC presented four options to limit
liability in 2007. These were: introducing a fixed monetary cap at
European level, a cap based on the size of the audited company, a
cap based on audit fees or proportionate liability.

Then, in early 2008, the EC issued a proposal
recommending that EU countries limit auditor liability.

The three options it recommended were:
applying a liability cap, introducing proportionate liability or
allowing liability to be limited by contract.

Ojo says that while a cap based on market
capitalisation would be subjective, adopting a principle of
proportionate liability also involves subjective elements.

“According to the EC, the option relating to
proportionate liability would not only consist in courts awarding
damages, which are in proportion to the auditor’s fault, but also
in contractual arrangements being negotiated between the company
and its auditors and approved by shareholders,” she says.

Preferable solution

Of the recommended options, Ojo
supports a monetary cap at EU level but believes such a cap would
have to be defined since a fixed figure does not take into
consideration the differences that exist in the audit environments
of various EU member states.

“While $7 million (€5 million) may be a
deterrent for audit companies in Italy and Germany that might not
produce such an effect in the US or the UK,” says Ojo.

“In defining what the cap should be, an
appropriate determinant would be the revenue generated by the audit
firm.”

The size of a firm would also have to be taken
into consideration, Ojo says. She feels small-sized audit firms
should be exempt from liability in the same way small companies are
not mandated by law to be subjected to audits.

“In my opinion, [this option] is preferable
for the purpose of promoting harmonisation and facilitating greater
co-operation between financial regulators on an international
basis,” concludes Ojo.

The countries in Europe where an auditor
liability cap currently exists are the UK, Austria, Belgium,
Germany, Greece and Slovenia. Sweden is also expected to bring a
liability cap into effect sometime during 2010.