Audit firms’ liability cap recommended by European Commission

Unlimited liability coupled with insufficient insurance coverage is no longer tenable for audit firms

BRUSSELS – The European Commission has issued a recommendation to cap auditors’ civil liability. The main purpose of this recommendation is to encourage the growth of alternative audit firms in a competitive market but it is also a response to the increasing trend of litigation and lack of sufficient insurance cover in this sector. It aims to protect European capital markets by ensuring that audit firms remain available to carry out audits on companies listed in the EU.

“After in-depth research and extensive consultation, we have concluded that unlimited liability combined with insufficient insurance cover is no longer tenable,” said Charlie McCreevy, internal market and services commissioner. “It is a potentially huge problem for our capital markets and for auditors working on an international scale. The current conditions are not only preventing the entry of new players in the international audit market, but are also threatening existing firms. In a context of high concentration and limited choice of audit firms, this situation could lead to damaging consequences for European capital markets.”

The recommendation leaves it to each member state to decide on the appropriate method for limiting liability, and introduces a set of key principles to ensure that any limitation is fair for auditors, the audited companies, investors and other stakeholders.

The key principles to be followed by member states when they select a limitation method are:
•the limitation of liability should not apply in the case of intentional misconduct on the part of the auditor;
•a limitation would be inefficient if it does not also cover third parties; and
•damaged parties have the right to be fairly compensated.

The CEA, the organisation for the European insurance and reinsurance industry, was quick to voice its disappointment with the move. “As a stakeholder who contributed to the discussions on the relevance and conditions of auditors’ professional liability, the CEA, representing the European insurance and reinsurance industry, regrets that the EC has not heeded its opposition to such a cap,” it said. CEA president Gérard de la Martinière said: “It is unfortunate that the strong arguments from an industry that invests more than €7,200 billion, much of it in the capital markets, have not been heard.”

The CEA statement stressed that it had always argued that such a cap will not prevent large/catastrophic losses and will not improve the insurability of large auditing firms and the availability of insurance coverage. “This is especially true against the background of the current financial turmoil, where most ‘subprime’-type claims have a US element or where the allegations or acts are deemed to be intentional. A cap on liability implemented in Europe will make no difference at all and will not prevent large losses,” it said.

‘In issuing its recommendation, the EC has clearly decided to protect the community of auditors in Europe, particularly the larger ones, with a cap on their liability. However, the result is likely to be that victims – shareholders and institutional investors – will seek other ways to recover a large loss. This could shift the problem to directors and officers or errors and omissions insurance, putting up costs, reducing availability or both,’ continued the CEA statement.