IDW Comments on the Commission Staff Working Paper: Consultation on Auditors Liability and its Impact on the European Capital Markets

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1 European Commission DG Internal Market and Services Unit F4 Auditing / Liability B-1049 Brussels Belgien By to: markt-f4@ec.europa.eu Düsseldorf 15 March /500 IDW Comments on the Commission Staff Working Paper: Consultation on Auditors Liability and its Impact on the European Capital Markets The Institut der Wirtschaftsprüfer in Deutschland e.v. (IDW) [Institute of Public Auditors in Germany, incorporated association] would like to thank you for the opportunity to provide the European Commission with its comments on the above mentioned Consultation Paper. General comments The IDW supports the European Commission s initiative seeking a solution to the issue of auditor liability at European level. We believe it is absolutely essential to counteract the risk that the number of audit firms able to audit large public interest entities could be further reduced because of liability claims resulting from audit engagements ( catastrophic claims ). Because of the fundamental differences in the liability regimes of individual European Member States, the IDW believes that harmonisation of liability regulation for auditors within the European Union will only be possible to a limited degree. Nevertheless, this potential should be used. We believe that the opportunity for harmonisation does exist in respect of the monetary amount of liability (please refer to our comments on option no. 1). In determining such an amount, we believe that an absolute maximum cap could be established at European level, which could not be exceeded by the individual Member States, although

2 Seite 2/5 zum Schreiben vom [Datum] an [Adressat] they could be permitted to set lower caps. This should apply irrespective of the legal bases on which claims are based (e.g., contract, tort, case law, statutory law) and the potential claimants (the audited entity or third parties). Due consideration needs to be given to the fact that some Member States have established special auditor liability regimes. For example, the German legal system includes both regulations on auditor liability and a monetary cap thereon. Since these regulations came into force more than 70 years ago, they have proven themselves in damage liability claims. German regulations ensure that the entity has a right of recourse which can be exercised in the case of a violation of professional duties on the part of an auditor. At the same time, the auditor is shielded from incalculable damages arising from liability by means of a monetary cap limiting the amount of damages. In Germany, persons who are not direct parties to the contract with the auditor but, nevertheless, may be affected by a violation of duties on the part of an auditor, do not have a legal right to claim damages on their own part. However, in individual cases, using particular legal instruments, they may be able to assert a claim for damages and receive appropriate compensation by means of a damage claim made by the entity. This ensures an equal treatment of all parties to whom the financial statements are addressed. It also prevents the auditor from being liable to investors for totally unrestrained amounts of damages. Bearing in mind the different legal systems in individual Member States, which are not harmonised and also the fact that some Member States currently have liability regulations, we would support the European Commission recommending a principles-based framework. It is particularly important to strive towards nondiscrimination within a domestic European market. Otherwise, there is a danger that within Europe differing jurisdictions may compete with one another in respect of auditor liability. As long as the Member States respect the maximum monetary cap at European level, they should retain final ruling over the basic features of their regulations. Member States that already have tried and tested regulations should be permitted to retain their regulations. It is unnecessary to initiate new regulations when appropriate regulations already exist. The IDW has always argued that an auditor has to be liable for professional negligence, but only to an appropriate degree. We therefore specifically support the fact that the European Commission s proposals do not contemplate an unlimited liability in respect of damages resulting from professional misconduct. In previous comment letters we have supported the view that an increase in liabili-

3 Seite 3/5 zum Schreiben vom [Datum] an [Adressat] ty will not lead to additional increase in quality. This view was confirmed in the study by London Economics. An important argument against unlimited liability is that it cannot be adequately insured, if at all. It therefore follows, that insurability equally has to be a prerequisite for any concept relating to limited liability. The IDW shares the view of the London Economics study in this respect. From the viewpoint of the claimant, it is essential that appropriate recompense of the damages suffered can actually be effected. Having said this, the IDW would like to comment on the individual possibilities proposed by the European Commission as follows: Option 1: One single monetary cap at EU level The European Commission rejects a single monetary cap on liability at a uniform level for the EU because of the danger that too high an amount might disadvantage mid-tier audit firms and a too low amount might have negative impact on the quality of auditing. Furthermore, this would not sufficiently accommodate the diversity of both the market structures among the Member States and the sizes of entities. The IDW agrees that, in general, no single monetary cap on liability within the EU should be defined in every case, because this would not take sufficient account of the differing national circumstances. As we have already stated in our general comments above, we believe it would be appropriate to stipulate an absolute maximum cap at European level. The considerations that the Commission has put forward in rejecting the introduction of a standard maximum amount for liability are, in our opinion, technically unfounded. In determining a maximum cap the insurability of the amount of damages to be covered is a significant factor. In particular, care needs to be taken that it will not become even more difficult for mid-tier audit firms to enter the audit market due to high insurance premiums; such that a maximum cap could directly become a barrier preventing medium-tier audit firms from entering the audit market. The Commission s misgiving that if the cap was set too low there might be a negative impact on the quality of the audit has already been refuted by the London Economics study, according to which unlimited liability does not ensure improved quality of auditing.

4 Seite 4/5 zum Schreiben vom [Datum] an [Adressat] Option 2: Cap depending on the company s size The EU Commission has proposed that it would be possibile to limit liability by setting a variable cap depending on the size of an entity. In this context, for e- xample, the Commission suggests that this could be measured on entities market capitalisation. In the IDW s opinion, the size of an entity is indeed one aspect which may be meaningful in determining a maximum cap on liability. However, from the IDW s point of view, the criterion market capitalisation, as proposed by the EU Commission, does not constitute an entirely appropriate basis for determining a maximum cap. There is no correlation between the market capitalisation and the level of damages caused solely by an auditor. Because listed entities have very high market capitalisation, an acceptable level of liability limitation could only be reached if the proportion of market capitalisation which could be used as a basis for this calculation would be an extremely small fraction of the company s size. This would be difficult from a political point of view. Instead of this, the IDW believes that in general the criteria in Articles 11 and 27 of the 4 th EU Directive, which are designed to deal with the issue of statutory audit, would be better suited as a basis. These criteria include balance sheet total, net turnover and average number of employees during the financial year. Classification according to these criteria would result in three size categories, for which three different maximum amounts of cap could then be recommended. Further consideration should be given to establishing an additional category for extremely large entities. The afore-mentioned classification should also apply to listed entities, as they would then be classified according to criteria based on their actual size, rather than on the basis of fictive figures. Option 3: Cap depending on the audit fees charged to the company The EU Commission further suggests determining a maximum cap in correlation with the audit fee. The IDW does not support this suggestion, since it would not lead to appropriate results. In respect of the amount of potential claims, this would disadvantage entities that have well organised accounting systems facilitating an efficient audit. Due to lower audit fees, they would also accordingly be able to claim reduced compensation. In the case of less well organised entities, the liability cap would be increased solely because a low quality accounting system in entities will result in a more time-consuming audit. In this way, deficiencies in the organisation of entities to be audited would be shifted to the auditor in case of liability claims which is an unacceptable effect. Furthermore, such a so-

5 Seite 5/5 zum Schreiben vom [Datum] an [Adressat] lution would make it more difficult for the auditor to ensure that insurance cover would be adequate for each engagement, since the extent of audit fees cannot be determined in advance. Option 4: Proportionate liability The EU Commission also suggests limiting liability proportionately. Accordingly, damages should be proportioned between the parties in such a way that it will take account of the degree of responsibility of each party. The damages suffered would be allocated proportionately, as attributable to their cause. In general, IDW supports these considerations. The German legal system has a similar regulation according to which the obligation to pay compensation to the aggrieved party by the wrong-doer is reduced when there is contributory negligence. Proportionate liability can lead to a sensible limitation of auditor liability in those legal systems where a third party can claim directly against the auditor without having to take account of the fact that the entitiy also contributed to the loss suffered. However, care should be taken that a connection can be identified between the loss incurred and the auditor s responsibility in order to ensure damages suffered can be allocated proportionately, as attributable to their cause. This would no longer be the case if it were possible for a claim to be made against the auditor without regard to the degree of his guilt, merely because proportional liability had been determined in advance. However, because of the reasons given above, even with proportional liability it will not be possible to renounce a European monetary cap on liability (refer to Options 1 and 2).