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Company accounts and liability: a true and fair view

February 2009 - Corporate & Commercial. Legal Developments by Kingsley Napley.

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With the phased implementation of the Companies Act (CA) 2006 almost complete, directors are now beginning to recognise the impact of the new legislation. One key area that CA 2006 seeks to modernise is in relation to company accounts and liability for reports.

principal changes to accountants’ liability

Perhaps the most significant changes under CA 2006 in relation to liability for companies’ accounts have impacted auditors. The previous regime prohibited auditors from entering into contracts that sought to limit their liability in the context of carrying out the auditing work. Section 310 of the Companies Act (CA) 1985 restricted companies from exempting their auditors or indemnifying them against certain liability. Indeed, the principle of joint and several liability meant that auditors found themselves having to pay the full amount of damages awarded in favour of claims brought by companies, rather than the loss for which they were responsible.

However, following Arthur Andersen’s audit of Enron, its rapid collapse thereafter as one of the world’s major accountancy firms and the spiralling costs of professional indemnity insurance, the government was forced to reconsider the existing regime. It was glaringly apparent that the concept of what amounted to almost unlimited liability of auditors needed to be reshaped to help alleviate concerns over the increased number and size of liability claims they faced.

CA 2006 tackles this issue by introducing the concept of liability limitation agreements (LLAs). While s532 CA 2006 retains the general prohibition against a company exempting or indemnifying auditors of any liability in connection with negligence, default, breach of duty or breach of trust in relation to the audit of company’s accounts, any such indemnity is void except where:

  • it is an indemnity in relation to the costs of successfully defending proceedings (s533); or
  • there is a ‘liability limitation agreement’ in place.
LLAs

As from 6 April 2008, auditors have been able to limit their potential liability to clients by entering into an LLA. The manner by which liability can be limited in such agreements is as follows:

  • a limit based on the auditor’s proportionate share of responsibility for any loss;
  • setting a cap based on either a monetary figure or a formula; or
  • by reference to a fair and reasonable test.

In addition to setting a threshold limit, LLAs may also assist auditors where an action has been brought against them by a third party, as no doubt auditors will wish to contend that their liability to a third party, if any, should be limited to the amount set out in the LLA.

Clearly, the concept of LLAs is welcomed by auditors, who are already seeking to negotiate these with their clients. For an LLA to be valid, however, it needs to be authorised by the company by way of a members’ ordinary resolution (s536 CA 2006), either by ratifying the agreement after it has been entered into, or (for a private company only) being passed before entering into the agreement and waiving the need for approval as regards its terms. Section 535 CA 2006 provides that LLAs must not apply in respect of acts or omissions occurring in the course of the auditing of accounts for more than one financial year and must specify the financial year to which they relate. As such, these agreements will most likely lead to companies seeking authority from shareholders at their annual general meetings.

Financial Reporting Council (FRC)

On 30 June 2008 the FRC (made up of representatives of companies, investors and accountants) published its guidance on LLAs. One clear message emanating from this guidance is that the existence of an LLA in no way reduces the professional duty an auditor owes to its client.

The long-awaited guidance also provides practical assistance for directors and, in particular, sets out the following:

  • the process for obtaining shareholder approval for an LLA;
  • specimen wording for inclusion in resolutions, the notice of general meetings and LLAs;
  • details on how LLAs will inter-relate with the auditor’s terms of engagement;
  • factors that company directors should bear in mind when determining whether to enter into an LLA (including their statutory duty under s172 CA 2006 and the need to ensure that they fully understand the implications of the proposed LLA); and
  • what is permissible under CA 2006 and what should be covered in the LLA.

principal changes to directors’ liability

Under CA 1985 companies are required to prepare a report containing a fair review of the development of their business. The report should span the financial year and set out recommended dividend levels. It should also contain a statement of directors confirming that the auditors are aware of all information relevant to their report. All companies also need to include a business review (other than those falling within the statutory definition of a small company). Part 15 CA 2006 provides that additional information needs to be included in this section. In addition, s463 CA 2006 sets out a clear statement of the liability of directors in respect of false and misleading statements made in their report or remuneration reports, and in any related summary financial statement.

Business review

Section 417 CA 2006 sets out the purpose of the business review, namely to inform shareholders and help them assess the performance of their directors in promoting the success of the company.

The business review itself should essentially contain a fair review of the business and include a description of the principal risks and uncertainties facing the company. Where a directors’ report does not meet the requirements of CA 2006, an offence is committed by every director of the company who was party to the approval of the accounts and is complicit (or reckless as to whether the report complied). Under s456(5) CA 2006, the Financial Reporting Review Panel (the Panel) has the authority to review directors’ reports and if the report fails to comply with the statutory requirements, it can compel a company to revise it. Indeed the courts can order the costs incurred by the company in preparing the revised report to be borne by the directors personally.

False and misleading statements

Under s463 CA 2006 a director will be liable to compensate a company for any loss suffered by it as a result of any untrue or misleading statements made in such a report, or of the omission of anything that the legislation requires to be included in circumstances where either:

  • they knew the statement to be untrue or misleading, or were reckless as to whether or not it was untrue or misleading; or
  • they knew the omission to be a dishonest concealment of a material fact.

The government has, however, provided a safe harbour for liability because it was felt that too strict a liability would encourage directors to make heavily qualified statements in the business review. Hence the liability of directors here is limited to the company only (and not to shareholders, investors or third parties). This exemption, however, does not extend to any civil penalty or criminal liability, but does offer directors comfort as claims for negligence cannot be brought against them.

Conclusion

Clearly the changes brought about by CA 2006 seek to limit the exposure of directors and liability of auditors. The changes are also intended to increase shareholder democracy in public companies, by promoting accessibility to information. To some degree, this comes at a price of increased regulation. For directors, the focus will be on understanding their duties. Companies can take advantage of the provisions of CA 2006 by careful planning and advice, particularly in relation to the LLAs, to ensure that liability caps are correctly reflected.

By Deepa Hundalani, solicitor, Kingsley Napley.

E-mail: dhundalani@kingsleynapley.co.uk.

For further information, please visit www.kingsleynapley.co.uk