What is an Auditors Limited Liability Agreement

The Companies Act 2006 (CA2006) introduced the concept of a liability limitation agreement in respect of auditor’s liability. The relevant provisions have been in effect since the 6th April 2008. It is defined as “an agreement that purports to limit the amount of a liability owed to a company by its auditor in respect of any negligence, default, breach of duty or breach of trust, occurring in the course of the audit of accounts, of which the auditor may be guilty in relation to the company.”

Creation

Members of a PLC may approve an Auditors Liability Limitation Agreement (ALLA) either by passing a resolution at a general meeting approving the “principal terms” before the ALLA is signed, or else approve the entire document by resolution at a general meeting after signing. An ALLA without the consent of Company members will be void. In obtaining valid shareholder consent to the ALLA, Directors must act independently and competently to promote success of the Company, to avoid incurring personal liability. As members at a general meeting must also approve the remuneration of auditors, it would be sensible to have both resolutions happen at the same general meeting. If the ALLA is part of the auditor’s engagement letter, it should be referred to in the main body of the letter. If it is to be separate, it will be necessary to link the two. If the ALLA is entered into after the engagement letter, it must be entered into for valuable consideration or as a Deed in order to be valid.

Principle Terms

At the meeting, the ALLA can either have its “principle terms” approved prior to entering into the agreement, or else have the contract in its entirety approved after execution. The “principal terms” of the ALLA identify the acts or omissions covered by it, the financial year to which it relates, and the level of limitation on the liability of the auditor (S536 (4)). Approval may be withdrawn under S536 (5) by the members of the company passing an ordinary resolution at any time before the financial year in question has commenced.

Possible Types of Liability Limitations

The Financial Reporting Council ALLA Guidance 2008 makes suggestions as to the types of contractual limits that can be set. Specimen clauses are in the Appendices. The preferred limitation method, a limit based on the auditor’s proportionate share of the responsibility for any loss, is set out in Appendix B. Using this method the company would be unable to seek compensation from the auditor for any loss due to the acts of any other party. Other methods would be to limit the liability of the auditor using the “fair and reasonable” test, in the form of a monetary cap on liability, or calculated on the basis of an agreed formula. If the Company has institutional shareholders, it should consider their policies in relation to ALLAs when drafting clauses.

Validity and Requirements

An ALLA will be valid as long as it is approved by the company’s members and meets the requirements of S535 which governs its terms (S.534 (2) CA2006). It must apply to a specified financial year under S535 (1). The limitation on liability need not be expressed as a sum of money (S535 (4)).

A company is required to disclose any ALLA entered into. The Companies (Disclosure of Auditor Remuneration and Liability Limitation Agreements) Regulations 2008 provide at regulation 8 that a company, which has entered into an ALLA, must disclose the principal terms of the ALLA in a note to the accounts for the relevant financial year. The date of the approval resolution passed by the company’s members must also be revealed.

Restrictions on Effect

The effect of an ALLA is restricted under S537 CA2006. Auditors are subject to professional standards, must abide by their contractual obligations, and have a duty to act with reasonable care and diligence. These requirements will not be affected by an ALLA. An ALLA will be effective only to the extent that it is “fair and reasonable” in the particular circumstances. This means that auditors remain liable for the consequences of their own negligence. The Act does not specify a test to determine what is “fair and reasonable”.

Consequences

An ALLA will bring an increased risk that the company may be unable to recover part of any loss suffered due to auditing services obtained, while enabling the company to obtain necessary audit services at an affordable price.