EFAMA COMMENTS ON COMMISSION CONSULTATION ON AUDITORS LIABILITY AND ITS IMPACT ON THE EUROPEN CAPITAL MARKETS

Transcription

1 EFAMA COMMENTS ON COMMISSION CONSULTATION ON AUDITORS LIABILITY AND ITS IMPACT ON THE EUROPEN CAPITAL MARKETS FINANCIAL LIABILITY OF STATUTORY AUDITORS GENERAL COMMENTS EFAMA 1 would like to comment on the European Commission s report issued on 18 January 2007, which examines the impact of the current liability rules for the carrying out of statutory audits on European capital markets and on the insurance conditions, as provided for by the 8 th Company Law Directive on Statutory Audits. As a preparatory step, the Commission had appointed a consultant, London Economics, to carry out a research on these aspects. This study, which was published in October, is now used as a basis for its own report. The study emphasized four points: 1. the low probability that new audit firms establish themselves on the audit market of large companies; 2. a reduction in audit firms insurance capacity which could lead to jeopardize an entire network; 3. a decrease in the audit offer due to the failure of a network; 4. a reduction in the risk of failure, by a limitation of the statutory auditors liability (with several methods of such limitation being mentioned). These viewpoints suggested that the risks and liability incurred by statutory auditors, as well as their insurance coverage, are such that they are likely to result in the failure of an entire network. They imply that a limitation of their liability at European level would reduce this risk and would be sufficient to increase the audit offer, in particular for large companies. EFAMA members agree that there is no clear demonstration of the necessity to further limit the financial liability of statutory auditors by introducing a uniform/pan-european regime. As long as proof is not made that a European action would get better results than actions at national level, the subsidiarity principle should be taken into account. Indeed, there is no evidence that the current regime could lead to potentially catastrophic claims, which could result in the collapse of a network or could not be covered by insurance. In particular, it is 1 EFAMA is the representative association for the European investment management industry. Through its 23 national member associations and over 40 corporate members, EFAMA represents (at end September 2006) about EUR 15 trillion in assets under management, of which EUR 7.6 trillion managed by around 46,000 investment funds. For more information, please visit 18 Square de Meeûs B-1050 Bruxelles Fax info@efama.org

2 2 inappropriate to measure risks according to the amounts of liability claims, rather than according to the amounts of final settlements, which are much lower. The failure of a network appears to be linked to a large extent to a reputation risk, which should be distinguished from legal risks and from the financial consequences of the statutory auditors liability. It is therefore appropriate not to dismiss any measures aimed at enhancing the quality of statutory audits and protecting the reputation of audit firms as a failure of audit quality could cause a firm to fail. In this context, a limitation of the financial liability of statutory auditors cannot be put forward as a remedy against the risk of failure and problems of reputation. Also it is questionable that such a limitation would appropriately address the issue of concentration (e.g. the temporary or partial reduction in the audit offer resulting from a failure). This would considerably understate other factors causing a process of concentration or influencing the choice of an audit firm. This could even fail to encourage, if not discourage, other audit firms to operate on the least competitive audit market segments, e.g. if liability were linked to the size of the audit firm. Additional liability limitations, in particular at EU level, would not be suited to the risk territoriality and to the national liability regimes in force, which generally include appropriate provisions. Incidentally, such limitations would have no effect on claims originating abroad, e.g. in the U.S., which represent a majority of the main claims reported in Europe. A limitation of liability would reduce the incentives for high-quality audits and the possibility of legal actions for market players in case of an auditor s professional negligence. This would harm the quality of statutory audit, its perception by the users of financial statements, and would ultimately have an impact on the investor confidence and on capital markets. EFAMA regrets that these considerations, as well as the viewpoint of all interested parties, have been not very much taken into account and that the analysis has been conducted essentially from an auditor's perspective. 1. THERE IS NO CLEAR DEMONSTRATION THAT LIABILITY CLAIMS COULD LEAD TO THE FAILURE OF A NETWORK In order to appreciate the risk of a network collapsing as a result of a claim against an EU statutory auditor, it is necessary to measure the amounts of final settlements to be paid by statutory auditors. This implies an assessment of: - the claims relating to statutory audit and the amounts of final settlements, in particular in the EU; - the share of the final settlements attributable to the insurance companies and to the defendants other than auditors (in particular companies); - the total amount of reserves available to the audit firms concerned to pay their final share. However, these elements do not seem available at present, or are not taken into account, e.g. the plurality of defendants (more than two thirds of the claims related to audit services), the absence of major exposure risks being reported in the audit firms financial statements and the

3 3 fact that the amount of final settlements represents only a small portion of the claims (12% in the United States for ). Measuring risks and insurance or re-insurance cover according to the amounts of liability claims rather than to the amounts of final settlements gives an incorrect picture of reality. 2. A DECREASE IN THE INSURANCE CAPACITY DOES NEITHER IMPLY AN IMPOSSIBILITY OF INSURANCE COVERAGE NOR THE NECESSITY TO FURTHER LIMIT THE AUDITORS LIABILITY The fact that audit firms may have difficulties in obtaining insurance coverage - in particular due to a lack of information on their risks and difficulties for insurance companies to further mutualize or diversify those risks,- does not necessarily imply the existence of catastrophic claims, an impossibility of insurance coverage and therefore the necessity to further limit the auditors financial liability. It is essential in this respect: - to have solid and recent data available, reflecting the real risks incurred by the European audit firms alone; - based on these data, to explore, together with insurers, the conditions of an increase in coverage; - to envisage additional liability limitations only if residual and foreseeable risks could lead to the failure of a network. As it does not follow this approach, the London Economics study does not demonstrate the necessity to further limit the financial liability of statutory auditors at EU level. Also it mentions that the lack of availability of insurance is a questionable concept that is more reflective of a lack of capacity at prices that are perceived by audit firms as affordable. In particular, we would like to stress that recent ratios of final settlements/liability claims are not available except for claims against U.S. audit firms in the U.S. Also it is impossible to determine whether the increase in settlements, which has been observed, has continued and applies also to the European Union. Furthermore, the consultation document does not take into account the fact that statutory auditors liability is already limited by different means and provisions defined at Member States level, such as: necessity for an auditor s professional negligence, for a casual link between an auditor's fault and the damage, burden of proof with the plaintiff, statute of limitation, plurality of defendants, This does not allow the conclusion that auditors are facing an unlimited liability regime. As an auditor s professional negligence generally is necessary to involve his or her liability, it is unfair to state that plaintiffs can claim damages from the auditor, regardless of the degree of involvement of the auditor, or to assert that an auditor could be considered by plaintiffs as an insurance or gatekeeper against any deficiencies (cf., respectively 2.1 and 2.4 of the Commission consultation document). Also it contradicts the fact set out in this document that

4 4 companies are already liable for wrongdoings related to preparing and presenting financial statements. It would not be acceptable to hold other market participants responsible for auditors negligence, e.g. based on the fact that the liability risk can be diversified across a wider range of policyholders. 3. THE RISK OF FAILURE OF A NETWORK, WHICH COULD LEAD TO A TEMPORARY OR PARTIAL REDUCTION IN THE AUDIT OFFER, IS MAINLY LINKED TO A LOSS OF INTERNATIONAL REPUTATION Market players, including companies, are attached to the existence of an audit offer, which fosters competition, mutualisation/diversification of risks, audit quality and independence. The failure of a network could indeed result in a temporary or partial reduction of the audit offer on certain audit market segments and therefore justifies: - the identification of the failure risk factors and the prevention of this risk; - the increase in the audit offer on the most concentrated audit market segments, taking into account the selection criteria applied by market players (in particular companies and their shareholders). The failure of a network, as well as its success, is closely linked to its international reputation. There is no clear and proven causal relation between such a failure and the financial consequences of auditor's liability. The failure of Arthur Andersen, for example, did not result from its professional liability, but from a loss of image and reputation. The continuing presence of auditing services remains a concern with a much larger scope than the liability limitation issue and/or a change in the ownership rules applying to audit firms. 4. LIMITING THE AUDITOR'S LIABILITY IN THE EU DOES NOT SOLVE THE PROBLEMS OF REPUTATION AND CONCENTRATION Any confusion between the risk of reputation and the financial consequences of statutory auditors liability should be avoided. Measures designed or taken in the recent years to enhance the quality of statutory audit, reduce the litigation risks of the audit firms and protect their reputation should therefore not be neglected. In this respect, the risk management systems put in place by audit firms, the quality controls established by audit firms and public authorities, as well as the role of these authorities in case of investigations and auditors professional negligence, play an increasingly important role, which should be taken into account. In particular, the dialogue between a public oversight body and audit firms is not only a powerful tool to improve audit quality over time ( 2.9 of the consultation document), but also, as a consequence, a way of better preventing risks of litigations, reducing the financial consequences for audit firms and contributing to the development of audit offer.

5 5 A limitation of liability would not only reduce the incentives for high-quality audits, but also the possibility of legal actions for market players in case of an auditor s professional negligence (market participants including analysts, financial intermediaries, investors, shareholders, companies ). This would harm the quality of statutory audit, its perception by the users of financial statements, and would ultimately have an impact on the investor confidence and on capital markets. In this respect, it should be clarified that acts of negligence by auditors alone are not in the scope of the Commission s consultation or of possible measures at EU level. The increase in the audit offer on the most concentrated audit market segments is an essential issue, which goes well beyond the issue of professional liability. Limiting the professional liability in order to increase the presence of audit firms on these segments considerably understates other factors leading to situations of concentration or influencing the choice of an auditor (including skills, reputation, costs, multinational presence). It is therefore questionable that such limitation would appropriately address the issue of concentration, in particular on the international audit market. This could even fail to encourage, if not discourage, the presence of more audit firms on the least competitive audit market segments, as smaller firms may have higher individual exposures relative to their size and lower possibilities to diversify their risks. 5. ADDITIONAL LIABILITY LIMITATIONS, IN PARTICULAR AT EU LEVEL, WOULD NOT BE APPROPRIATE TO THE RISK TERRITORIALITY AND TO NATIONAL LEGAL REGIMES Legal regimes and risks vary from one country to another (in particular from one EU Member State to another, and from the EU to the U.S.). In many countries, legal systems include provisions, which reduce the number of important claims and the amount of final settlements. This does not justify a mandatory or recommended introduction of additional liability limitation rules or legal instruments, at national or EU level. We would like to emphasize at last that these limitations would have no effect on claims originating abroad, and especially in the U.S. (representing a majority of the main claims reported in Europe). 6. POSSIBLE APPROACHES CONSIDERED: ASSESSING FEASIBILITY, OPPORTUNITY AND POTENTIAL CONSEQUENCES Various possible approaches to auditor s liability limitations are explored (different liability caps and proportionate liability, rather than joint and several). However, the question of whether any change is appropriate still remains unresolved.

6 6 As mentioned, there is no clear demonstration of the necessity to further limit the auditors liability. Moreover, it is questionable that any further limitation would appropriately address the issue of competition. We wish to underline that any change that would be envisaged should also be subjected to: - Legal feasibility and compatibility with the existing national liability regimes in the European Union; - Efficiency of possible proposals in relation to the risks identified (especially regarding the risk territoriality); - Accompanying measures, in the following areas: internal and external quality control, regulation, other forms of liability and sanctions; - Impact assessment and balance between the various interested parties (besides auditors, financial analysts, investors, companies, regulatory authorities and receivers). In particular, providing that the claims come from investors, companies or receivers, it is essential to take into account the effects of possible further auditor s liability limitations on these stakeholders. SPECIFIC COMMENTS Finally, we would like to offer some additional specific comments, as follows: Option 1: One single monetary cap at EU level Examples of caps are given, with an indication that those caps were developed purely for domestic cases. First, it is not specified whether they apply to all sorts of litigations, or to specific litigations only, e.g. between auditors and companies, as is the case in certain countries. Second, such limitations would have no effect on claims originating in third countries. Third, it is right to say that a single European-wide cap might amount to a one size fits all solution for 27 Member States, which would fail to take account of the diversity of circumstances in different Member States in terms of audits and company size. However this diversity of circumstances also applies to risks and liability regimes, making it difficult, if not inappropriate, to envisage any measures at EU level. Option 2: Cap depending on the company s size According to the consultation document, an efficient cap is characterized as one that reduces risk of collapse and does not lead to the creation of barriers to entry for smaller firms, which amounts to saying that the lower the cap is, the more efficient it is. This assertion does not take into consideration the detrimental impact of caps on audit quality, although this is an essential criterion and one mentioned in the consultation document.

7 7 Option 3: Cap depending on the audit fees charged to the company This option is based on the main assumption that the fees charged by the auditor to its client reflect the audit risks and the liability risks. This is questionable, as audit efforts should normally correspond to audit fees; enhance audit quality and reduce the audit risks to an acceptably low level; and finally reduce the auditor s liability risks. Option 4: Proportionate liability It is important to take into account the fact that statutory auditors liability is already limited by different means and provisions defined at Member States level, such as the necessity for an auditor s professional negligence or for a casual link between an auditor's fault and the damage. Most EFAMA Members believe that working on the assumption that each party has a degree of responsibility and is liable for a portion of loss does not reflect the diversity of circumstances. Moreover, it would not be acceptable to hold other market participants responsible for auditors negligence. However, some of our Members are instead of the opinion that auditors should be allowed to enter into a liability limitation agreement that is ratified by shareholders annually, but not to limit liability to less than an amount that is fair and reasonable having regard to the auditors' responsibilities, the auditors' contractual obligations and the professional standards expected of them. In such case, it should be for the Courts to determine what is fair and reasonable on a case-by-case basis. Steffen Matthias Secretary General