Auditors are currently exposed to unlimited liability for professional default. The issue of the professional liability of auditors (and other professional groups) has been under consideration by the professions and the Commonwealth, State and Territory governments since the mid-1980s.
Two major professional accounting bodies in Australia, CPAA and the ICAA, confirmed the profession's ongoing concerns about the need for reform in this area in submissions lodged in May 2002 with the Senate Economics Reference Committee in connection with the Senate Committee's inquiry into Public Liability and Professional Indemnity Insurance.
The need to address the present unlimited liability regime has also been raised by a number of the large accounting firms in their submissions to the Ramsay review on auditor independence. This issue was raised in the context of improving the quality of the audit function by enhancing the scope of the audit and the audit report. It has been asserted that a fundamental improvement in corporate disclosure would be to expand the audit report to comment on other relevant issues such as governance, risk management and internal control, together with key indicators of the financial health of the company. However, the accounting firms considered that it would not be feasible for auditors to contemplate such an expansion in the scope of an audit within the context of the current unlimited liability environment.
Auditors, and other professional groups have traditionally dealt with their unlimited liability exposure for professional default through professional indemnity insurance. Insurance plays an important role in the Australian economy. It provides a mechanism for transferring and pooling the risk of financial loss to entities with the expertise to manage the risks involved. Professional indemnity insurance insures against loss arising from professional services offered by the insured professional.
Australia is currently experiencing a 'hard insurance market', that is, a market characterised by tougher risk selection by insurers. While the Australian experience has been exacerbated by the collapse of a major domestic player in HIH (which held around 35 per cent of the professional indemnity market), globally most classes of insurance have moved into a hard market cycle in the last two years. This has been compounded by the terrorist attacks on 11 September 2001.
Studies undertaken by MINCO have concluded that of those professionals which might be subject to claims under the Corporations Act, only accountants (and in particular, auditors) required attention in light of their potential liability in relation to Corporations Act matters and that there has clearly been a very significant increase in the size of claims, if not the number, against accountants (primarily auditors) over recent years.
The Insurance Industry Market Pricing Review, which the Australian Competition and Consumer Commission (ACCC) released in March 2002, noted that the insurance industry has experienced low returns on equity over the last nine years. The ACCC concluded that the key driver for recent premium increases has been the shift by insurers from establishing targets for business growth as measured by premium volume to setting targets for return on equity. The ACCC noted, in relation to professional indemnity insurance, that low returns had occurred due to a combination of the following factors:
- inadequate premium rates;
- realisation of the extent of past losses as liability provisions are increased to reflect emerging claims experience;
- low investment returns which represent a significant and important component of insurance profit; and
- liquidation of the HIH Group potentially removing a barrier to price increases.
The information provided by accountants demonstrates a worsening position over recent years regarding insurance cover for this profession:
- a lack of availability of insurance, in Australia and elsewhere;
- substantial increases in average premiums per partner for the major accounting firms;
- larger deductibles (that is, first part of claim to be carried by the insured) and some areas of self-insurance as a result of gaps in the cover; and
- the level of insurance cover, while high, was well below that necessary to meet some of the claims that were presently outstanding.
The recent submissions by the two professional accounting bodies indicate that the position in relation to the availability and cost of professional indemnity insurance has deteriorated in the current 'hard insurance market':
- Both CPAA and ICAA have provided anecdotal feedback from their membership about the increase in premium levels. Detailed aggregated information on trends in the professional indemnity insurance market for members of the two bodies is not available because, unlike some mutual or monopoly schemes found in some other professions, members negotiate their own insurance cover, usually through insurance brokers, with a variety of insurers.
- CPAA states:
- while premiums had remained stable prior to 2001 for about six years, premiums increased during 2001 (pre 11 September) by an average of 25 per cent;
- between September 2001 and March 2002 premiums have risen by an average of 25-35 per cent;
- premiums since March 2002 have on average increased by at least 40 per cent with many cases where increases have been between 100 to 300 per cent.
- ICAA membership feedback indicates even steeper increases in premiums:
- The minimum increase in premiums being experienced by members in the current renewal period (that is, 2002-03) is in the order of 100 to 300 per cent. This is the experience for small firms undertaking no audit, insolvency, financial planning or management work, with no past claims or notifications.
- For larger firms, with no past claims experience, who perform little if any audit or other 'higher risk' work, premium increases are in the order of 300 to 400 per cent.
- Firms that have had a claim or notification are experiencing insurance premium increases of ten fold and more.
- CPAA states:
- Both of the accounting bodies report that deductibles are increasing at similar rates to premium increases.
- Both accounting bodies state that there is clear evidence that professional indemnity insurance is being offered on increasingly restrictive terms by insurers.
- The ICAA reports that it has received feedback from some members that up to 90 per cent of a firm's activity could be uninsured because it falls under one or another exclusion clause contained in the insurance contract.
The backdrop to the CLERP 9 consideration of the issues relating to the professional liability of auditors is the important role that the independent audit function performs in relation to Australia's corporate governance framework and the efficiency of the capital market. Wider policy issues relating to the insurance industry, including the regulation of general insurance companies and the state of the professional indemnity insurance market are beyond the scope of CLERP 9.
The following policy options have been raised by the accounting profession for the purpose of establishing an appropriate framework to address the profession's concerns in relation to the present system of auditor liability:
- The incorporation of auditors.
- The law of joint and several liability in relation to actions for negligence causing property damage or purely economic loss and its replacement by proportionate liability.
- The capping of professional liability within the framework of State and Territory Professional Standards legislation.
5.2 Incorporation of auditors
The Corporations Act doe
s not allow a company to be registered as a company auditor.
If auditors were allowed to incorporate, this would address some of the concerns relating to the professional liability of auditors:
- Because of the law of joint and several liability, one of the consequences of having large accounting firms structured as a partnership is that the actions of one partner, if those actions are subsequently found to have been negligent, may have severe financial implications for all the other partners.
- Incorporation of auditors would also overcome difficulties associated with the management of large accounting partnerships.
- Over the past half century, there have been a number of significant changes within the accounting profession, especially in those firms that provide auditing and other services to listed and other economically significant corporations. These changes include:
- a progressive increase in the size of the firms, both through natural growth and through the acquisition of, or mergers with, other firms;
- the establishment of international accounting partnerships and affiliations and other links with accounting firms in other major capital markets; and
- a change in the emphasis of the business undertaken by some firms through expansion into the field of business advising and management consultancy.
- One of the factors influencing the growth in the size of accounting firms has been the need to match the growth of major clients. As a client's business grows and becomes more sophisticated, so there is a need for the accounting firm to grow and to offer the client a greater range of professional services.
- Over the past half century, there have been a number of significant changes within the accounting profession, especially in those firms that provide auditing and other services to listed and other economically significant corporations. These changes include:
MINCO has given approval to proposals to permit the incorporation of auditors which provide for a regime under which the accounting bodies (to be known as 'prescribed accounting bodies') would be responsible for the administration of the scheme. The prescribed accounting bodies would approve the bodies corporate that are authorised to act as auditors (to be known as 'authorised audit companies' (AAC's). In addition, the accounting bodies would be required to provide a framework against which potential participants in the industry could be assessed and against which their conduct could be judged.
A range of safeguards have been built into the proposed regime to protect the clients of auditors who operated through a corporate structure. These safeguards include:
- that the authorisation and regulation of audit companies would be undertaken by accounting bodies that had been approved for that purpose;
- that audit work could only be undertaken by AAC's authorised by an approved accounting body;
- requiring all members and directors of an AAC to be natural persons;
- that effective control of an AAC remains with appropriately qualified natural persons;
- ensuring that the directors responsible for company audit work undertaken by the AAC are registered company auditors who are not subject to any restriction; and
- the maintenance of professional indemnity insurance at an appropriate level and on appropriate terms to meet claims against the AAC arising out of company audit work and/or the maintenance of a specified level of assets or capitalisation.
The ICAA, in its recent submission to the Senate Economics Reference Committee, raised the proposal for auditors to conduct their business through limited liability partnerships, as an alternative option to incorporation (which the ICAA also supported). It is noted that a 1993 MINCO Working Party did not support this option for the following reasons:
'Having regard to the features of limited partnerships, in particular the inability of limited partners to participate in their management, as well as the absence of legislation permitting limited partnerships in three jurisdictions, this approach does not seem desirable or feasible. To go the further step of altering the joint and several liability of partners would also seem undesirable as it is the central feature of the partnership structure'.
A new form of limited liability partnership (the LLP) has been introduced in the United Kingdom after an extensive consultation process which commenced in 1997. Under the UK scheme, the LLP has limited liability but the members of the LLP remain personally liable for their own acts. In Australia, partnerships are regulated under State and Territory partnership legislation and by the application of the rules of equity and of the common law. The Commonwealth does not have the constitutional power to enact comprehensive legislation regulating partnerships in Australia.
In the UK, the Companies Act 1989 allows a company to be appointed as the auditor of a company. Recognised UK supervisory bodies (the major accounting bodies) are responsible for establishing the eligibility of persons and 'firms' (defined to mean bodies corporate and partnerships) to conduct audits of companies.
The legal effect of incorporation on the liability issue
Incorporation on its own will not overcome all the liability problems raised by the professional accounting bodies who view incorporation as one part of a package of reforms to address the problem. The legal effect of incorporation can be summarised as follows:
- leaves the audit company fully liable for the amount of any judgment that exceeds the amount of its professional indemnity insurance (and ultimately exposed to the possibility of being placed in liquidation);
- places auditors in a similar position to other major commercial parties without providing any special benefit or exemption from the standard liability rules;
- leaves the individual auditor member of a company who carried out a negligent audit liable as well as the company itself (this issue is addressed under the capping of liability proposal);
- protects the private assets of 'innocent' auditor members of the company from the consequences of the negligent conduct of one or more other auditor members of the company; and
- unlike proportionate liability, incorporation does not address the issue of the potential liability (which may arise from the law of joint and several liability) of an audit firm for the negligence caused by third parties where the acts of the firm only partly contributed to the damages involved.
Proposal 12 - Incorporation of auditors
The Government will amend the law to allow auditors to incorporate.
5.3 Joint and several and proportionate liability
Joint and several liability means that where the acts or omissions of a number of persons have each contributed to a plaintiff's loss, the full amount of that loss can be recovered by the plaintiff from any one of those persons (the defendants). A defendant who has paid an amount in damages to the plaintiff in excess of his or her proportionate contribution to the plaintiff's loss is entitled to recover from any other defendant an amount equal to that other defendant's contribution to the plaintiff's loss.
Proportionate liability divides the plaintiff's loss among the defendants according to their share of responsibility.
Joint and several liability throws the risk of insolvency or untraceability of any one of the defendants onto the other defendants, and permits a plaintiff to recover the whole of his or her loss from those who are solvent. Proportionate liability also allows for the sharing of liability among a number of persons. However, the difference from joint and several liability is that proportionate liability puts the risk of the insolvency or untraceability of a defendant onto the plaintiff.
Under the proportionate liability principle, the liability of each defendant is in all circumstances limited to the extent to which that party is considered to be r
esponsible for the loss. There is no right of contribution between various defendants, since none of them would, as a general rule, be liable to pay to the plaintiff any more than the proper share owing by each defendant.
The effect of insurance and the law of joint and several liability has given rise to auditors (and other professionals) often being singled out as the sole target for legal action in proceedings for property damage and purely financial loss, even when the professional is only one of the parties involved. Accordingly, a minor degree of fault can result in full liability.
This outcome has led to widespread concern over the years at the increasing level of payments which the insurance funds covering professionals are required to meet, and the consequently increasing level of the cost of that insurance. The accounting bodies state that while it is possible for a defendant who bears the full extent of a judgment to seek contribution from other defendants that have contributed to the loss, equitable apportionment in this manner is rarely achieved because of the insolvency or lack of assets on the part of the other defendants, or because they are untraceable or beyond jurisdiction.
The professional accounting bodies have said that, while accountants are willing to shoulder their responsibilities for what their actions may have caused by way of damages, it is inequitable that accountants should have to bear the liability for the failure of other parties on the basis of the law of joint and several liability.
The MINCO Working Party recommended in 1993 that:
'the arbitrary and unfair consequences of the present rules regarding joint and several liability of auditors should be addressed in a review of the law which takes into account the implications of changes in these rules beyond their impact on Corporations Law matters.'
An inquiry into the law of joint and several liability was established by the then Commonwealth and New South Wales Attorneys-General in February 1994 and was conducted by Professor Davis of the Australian National University.
- The terms of reference excluded personal injury claims.
- The Standing Committee of Attorneys-General accepted the need for the inquiry to consider the issues in a context wider than that of the corporations legislation.
The report of the Davis inquiry was released in January 1995. The key recommendation was that the present joint and several liability of defendants in actions for negligence causing property damage or purely economic loss be replaced by liability which is proportionate to each defendant's degree of fault.
On 14 July 1996, draft model provisions designed to implement the Davis report's recommendations were released for public comment. The draft model provisions, if adopted, would amend the common law, State and Territory fair trading legislation, the Trade Practices Act and the Corporations Act.
The Davis report was considered by the New South Wales Law Reform Commission in a discussion paper and a subsequent report entitled Contribution between persons liable for the same damage. The NSWLRC's discussion paper (released in 1997) and its report (released in 1999), opposed the introduction of proportionate liability, instead proposing a number of reforms to the law relating to contribution between persons liable for the same damage.
Following the release of the NSWLRC's discussion paper, the matter was removed from the agenda of the Standing Committee of Attorneys-General.
The professional accounting bodies have reiterated the critical importance of the reform of the law of joint and several liability in their recent submissions to the Senate Economics Reference Committee and have called upon the Commonwealth and State Governments to implement the Davis inquiry proposals as a matter of urgency.
The legal effect of proportionate liability on the liability issue
The legal effect of the introduction of proportionate liability in relation to actions for negligence causing property damage or purely economic loss can be summarised as follows:
- limits an auditor's liability or an audit firm's liability to the amount of the plaintiff's loss actually caused by the auditor's negligence; and
- consequently, an auditor or audit firm would no longer risk, because of the 'deep pocket' syndrome, being liable for the negligence caused by non-audit parties, such as the directors of the company. This would address the concerns of auditors that they can face a huge damages bill even though they contributed marginally to the plaintiff's loss.
Proposal 13 - Proportionate liability
The Government will seek the agreement of the States to introduce proportionate liability.
The Government recognises that the difficulties with the present joint and several rule in actions for negligence causing property damage or purely economic loss arise across the common law and are not confined to cases in relation to the Corporations Act. These issues need to be considered in a wider context than the Corporations Act, especially in view of its central importance in the general common law of negligence. If the joint and several liability rule were to be removed from one area of the law while being left to operate in others, this could lead to inappropriate and inconsistent results.
The Commonwealth envisages that the implementation of the reforms proposed by the Davis Inquiry would need to be considered in the light of:
- the position adopted by the New South Wales Law Reform Commission opposing the recommendations of the Davis Inquiry report for the introduction of a scheme of proportionate liability in actions for negligence causing property damage or purely economic loss;
- the broader tort and legal system reform currently being undertaken by the Commonwealth, State and Territory Governments; and
- relevant developments overseas since the completion of the Davis report in 1995, such as the introduction in Canada in 2001 of a modified proportionate liability regime.
5.4 Capping liability scheme
The professional bodies have also supported the introduction of a statutory 'cap' on professional liability.
New South Wales and Western Australia have introduced legislation that permits the capping of the liability of members of occupational associations in certain circumstances. These capping regimes are contained in the Professional Standards Act, which was enacted in New South Wales in 1994 and similar legislation, which was passed in Western Australia in 1997.
- A scheme limiting the liability of members of CPAA and the ICAA is in operation in New South Wales and a similar scheme will soon be submitted for approval under the Western Australian legislation.
Under the Professional Standards legislation in New South Wales and Western Australia, an occupational association can apply to the Professional Standards Council established under the legislation for acceptance of a scheme to limit liability. A scheme must exhibit features designed to:
- minimise the occurrence of events giving rise to claims;
- facilitate the handling of claims which are made; and
- increase the likelihood of claims being satisfied if liability is established.
Each scheme is designed by the applicant association. Under a scheme, the association must:
- ensure that the members of the scheme have insurance (or net business assets) to cover the relevant level of liability. An important public benefit of the scheme is
that the level of insurance required to participate in the scheme is generally greater than the minimum level of compulsory professional indemnity insurance and the professional's liability is limited to that greater amount required for insurance under the scheme;
- have a system of handling complaints and discipline of members;
- have a program of risk management in place.
The capping of liability relates to 'civil liability arising (in tort, contract or otherwise) directly or vicariously from anything done or omitted by a member of an occupational association acting in the performance of his or her occupation.' The capping regime does not apply to claims arising out of personal injury matters, fraud, misappropriation or breach of trust.
No other State or Territory has enacted similar Professional Standards legislation. Furthermore, to be fully effective, the Commonwealth would need to cap damages obtained under the Trade Practices Act.
- Section 52 of the Act prohibits a corporation from engaging in conduct that is misleading and deceptive. Damages awarded to a person under a section 52 action would appear not to be affected by State capping legislation.
- Section 74 of the Act implies warranties of due care and skill and fitness for purpose into certain contracts for the provision of services by corporations to consumers. This warranty cannot be excluded or abrogated. Liability can only be limited under the Act where the contract is not for consumer goods and services.
- To the extent that Commonwealth legislative powers permit, the Trade Practices Act extends most of these consumer protection provisions to the services of professionals, thereby enabling actions against professionals in cases such as where misleading and deceptive conduct may be alleged. Liability under the Act would not be affected by a State capping regime, because such limitations would be inconsistent with this Commonwealth legislation. To date most actions in respect of professional liability have combined an allegation of a breach of section 52 of the Trade Practices Act and negligence at common law.
Similar considerations would apply in relation to provisions of the Corporations Act which establish a cause of action relating to the personal liability of a professional.
The 1993 MINCO Working Party addressed the capping of liability option in its report. The Working Party's report considered that the capping option would have a number of significant draw-backs, including:
- its overall effect would be to reduce the pool of assets legally available to compensate plaintiffs by an amount equal to the difference between the defendant's resources (including insurance) and the cap applicable to the defendant;
- where a defendant's liability was limited to an amount less than the defendant's contribution to the plaintiff's loss, responsibility for carrying the plaintiff's loss would shift to any co-defendants;
- where the co-defendants' resources were insufficient to meet the balance of the plaintiff's damages, the scheme would shift the loss to the plaintiff:
- this raises the fundamental question of who should bear the loss caused by a professional (that is, should it be the professional or the person who suffers the loss); and
- a capping regime for professionals would also place professionals in a privileged position compared with other individuals or commercial parties who would remain liable for the full amount of any loss or damage caused. Other persons, whether acting in a private or commercial capacity, would remain exposed to the possibility of bankruptcy or insolvency.
A scheme capping professional liability would also adversely affect the operation of the Corporations Act, which relies heavily on civil liability to provide a system of compensation and deterrence for wrongful conduct, whether for claims based on the Corporations Act directly or on common law principles of negligence.
Legal effect of capping on the liability issue
The legal effect of a capping of liability regime can be summarised as follows:
- limits an auditor's liability or an audit firm's liability in accordance with an approved scheme to limit liability;
- in contrast to incorporation where the individual auditor responsible for a negligent audit would be liable to the full extent of the damage involved, capping would limit that individual's liability as well;
- a capping regime may deprive plaintiffs of what would otherwise have been their legal rights where the claim is in excess of the capped amount; and
- professionals would be placed in a privileged position compared with other defendants.
A capping regime would not be fully effective until all the States and Territories agree to enact uniform Professional Standards legislation. The Commonwealth would also need to extend the capping concept for approved professional groups to the Corporations Act and the Trade Practices Act.
The fact that only two States have so far introduced capping schemes, after more than ten years since the capping of liability concept was first mooted, indicates that the majority of jurisdictions remain to be convinced of the appropriateness of this approach.
The Commonwealth Government remains unconvinced that a capping regime for professionals is an appropriate policy response to the audit liability issue. The arguments against the introduction of a capping regime by the 1993 MINCO Working Party remain persuasive. The Government has two further concerns:
- while the objective of improving professional standards, including the introduction of compulsory professional indemnity insurance and risk management programs is admirable, professional bodies should be implementing such measures as a matter of best practice and should not require the incentive of a capping regime to achieve them; and
- the liability system under the Corporations Act and the Trade Practices Act to which auditors (and other professionals) are subject should not operate differently for them than for any other person or group in society. To introduce special rules to protect or benefit one group would give rise to the likelihood of unfair, inconsistent and arbitrary results for others - whether as co-defendants or plaintiffs. This could undermine the integrity of the Corporations Act and the Trade Practices Act.
The Government considers that an appropriate framework for addressing the issue of audit liability would be:
- to implement the proposals allowing auditors to incorporate; and
- to seek the agreement of the States and Territories to replace the present joint and several liability of defendants in actions for negligence causing property damage or purely economic loss by liability which is proportionate to each defendant's degree of fault.