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March 2008

GUIDANCE ON LIABILITY LIMITATION AGREEMENTS (LLAs)

ACCA is pleased to comment on the consultation paper and draft guidance on the above. As you know, ACCA is a professional accountancy body that represents over 120,000 qualified accountants. Many of our members will act in at least one of the three relevant capacities of auditor, director and shareholder, and consequently our comments below are intended to reflect the interests of all three constituencies.

We agree that this is an issue on which there is a pressing need for guidance. Auditors, directors and shareholders, for their own particular reasons, will all be looking for guidance on this matter and will wish this to be available to them as soon as is practicable following the introduction of the new rules in April.

We appreciate the substantial work that FRC has undertaken in producing the current document and look forward to its finalisation. We feel, however, that the draft could be improved in a number of respects, which we can summarise in the following terms:

• the document could benefit by being clearer about what it is aiming to achieve. In particular, it could state, at the outset, and for the benefit of the three discrete groups of stakeholders, in what ways the guidance is aiming to help them to understand and make their respective decisions on LLAs. It will also be borne in mind that a document which aspires to provide guidance on this issue to the three separate groups of stakeholders will need to incorporate guidance of the same level of detail for all three groups.
• the draft would benefit by being presented in a more concise and practically-orientated form which could form the basis for discussion between auditors and their clients as to the merits of and procedure for adopting LLAs.
• the document should be careful not to focus disproportionately on the position of audits of large and listed companies and should give adequate attention to the circumstances of the audit of smaller companies. Smaller companies and their auditors might benefit from guidance presented in a less technical and more practical form.
• there appears to be an imbalance of attention paid to the question of why LLAs might be in the interests of each of the three stakeholder groups. The position of auditors is discussed at some length. But we suggest that the document needs to do more to address the issue of why directors and shareholders might consider it to be in their particular interests to agree to an LLA.
• the 'principal terms' set out in the draft are too long and detailed. We suggest that the terms could be substantially curtailed.

We address the individual consultation questions below.

Q1 Does the draft guidance meet the objectives summarised in paragraph 8?

We agree with the terms of the statement of purpose set out in paragraph 8.

Given that the document aims to provide helpful guidance to auditors, directors and shareholders alike, though, we think that the draft needs to strike a better balance between the interests of the company and the interests of the auditor. This is especially so of section 3, which discusses the issues that should be considered before entering into an LLA.

At paragraph 3.5 the draft sets out two examples of reasons why directors might conclude that an LLA is appropriate for them. We do not consider that the two arguments included in that paragraph amount to good reasons as to why directors might consider an LLA to be in the interests of their company. The first of the two points made merely reiterates the rationale for LLAs and does not suggest specifically why an agreement would benefit the company, always remembering that directors are obliged to act in the interests of their company alone and should not undertake actions that might conflict with their duties to it. The second reason set out in paragraph 3.5 appears to infer that audit firms will be in a position to impose terms on their client companies and that companies will have to accept those terms as a condition of engaging the firm concerned. Whether or not this will be the situation in practice, we do not consider it to be a good idea to frame the guidance in such terms, certainly in the context of explaining the benefits to companies themselves.

We therefore suggest that some additional thought goes into the passage of text dealing with the issue of why directors might consider an LLA to be in the interests of their company (as distinct from the auditor), especially since ultimate approval of any agreement will rest with the company's shareholders. Directors will need to approach the negotiation of an LLA knowing that, even if they are happy with its terms, they will still need to 'sell' it to their shareholders, so they need to have a plausible case to present to them as to why the agreement should be approved.

The development of any such case by the directors could, we suggest, include consideration of the following factors:

• LLAs embody a change in public policy of which audit firms are now entitled to take advantage and which companies must now be prepared to recognise
• Being prepared to enter into an LLA could widen the potential range of audit firms that the company is able to engage
• In the case of an LLA arrived at on the basis of proportionate liability, the auditor would remain 100% liable for the company's loss if it were the sole party responsible for that loss
• As a precautionary measure, the directors (or audit committee as the case may be) could review the audit firm's PII cover in order to assess whether it provides an appropriate level of cover in the light of the financial circumstances of the company.

Over and above the discussion of the issue by the directors, we suggest that there also needs to be specific mention in section 3 of why an LLA might be in the interests of the company's shareholders. The reasons why this might be so may well coincide with the reasons why directors should favour an agreement, but given that the shareholders are free to approve or reject the recommendation of the board, and that their approval is the decisive element in the procedure, guidance should make separate mention of their consideration of the matter.

In the first bullet point in para 3.2, where some general points about LLAs are made, it would be helpful, in our view, for the document to make the point that the reform has been made on public policy grounds and to remind readers that it has long been possible for accountants to limit their liability in respect of other types of engagement.

Q2 Should the final guidance identify which methods of setting the auditor's liability are most likely to be acceptable in particular circumstances?

Since the Act provides that parties are free to determine for themselves what should be the exact basis for limiting the auditor's liability, subject to the residual powers of the court to intervene, we do not consider it to be necessary or appropriate for the guidance to suggest that any one basis is likely to be 'right' in any given situation. We do, however, consider it to be helpful and relevant for the guidance to point out, as the draft does, that institutional investors have already announced formally that they will only be prepared to support LLAs arrived at on one basis, namely proportionate liability. Providing this information will make it effectively clear to readers that, in respect of 'major audits', only LLAs prepared on that basis are likely to be approved.

Q3 Does section 3 of the draft identify all of the main factors to be considered when addressing the case for an agreement?

We refer in our response to question 1 to additional matters which should be taken into account with respect to directors and shareholders.

There are also issues relating to timing and the means of recording the LLA. Section 5 deals with timing and makes the point that authorisation does not have to be given for the LLA before the beginning of the financial year to which the LLA relates, and adds that it can be entered into before, during or after the year concerned. LLAs can be approved either by a) the shareholders approving the principal terms or b) the shareholders approving the agreement in full after the directors have entered into it (private companies can waive their right to approve it altogether). Under b) the shareholders have the power to reject an agreement already entered into by the directors if they see fit.

The Guidance cannot interfere with the right of companies and auditors to decide how to organise the timing of the approval of their agreements. But given that a full agreement entered into by directors and auditors can be overridden subsequently by the shareholders, we consider it appropriate for the Guidance to make the point that it will be in the interests of both sides to attain shareholder approval as early in the process as possible, and that approval subsequent to the year end is not generally advisable. The auditor, in particular, will wish to establish his/her insurance situation with certainty and has an obvious interest in avoiding a situation where his insurance risk rises materially during the course of the year (as would happen where the company decided during the course of the year not to enter into the LLA). Another issue relevant to timing is that entering into an LLA after an audit is completed may give an auditor knowledge of potential liabilities that he or she may wish to avoid. This would argue in favour of the agreement having to be entered into before the work commences.

The document also presumes that an LLA will be set out in the engagement letter between the auditor and the company. We do not dispute that this is an option, although including the terms of the LLA i n the letter has the potential to create uncertainty: where the LLA is subsequently rejected by the company's members, the whole letter of engagement itself would need to be re-drafted and agreed.

According to paragraph 5.12 of the Guidance, practice to date is for the engagement letter to be signed in the final quarter of the financial year to which it relates. We suggest it might be helpful to directors and shareholders to explain why this might be the case. We would also point out that the professional rules to which members of ACCA and other bodies are subject stipulate that no work should be done for a new client until a written letter of engagement has been prepared and sent to the client. If that is not possible it should be done as soon as is practicable after the engagement commences. The letter of engagement should clearly define the scope of the member's work and the terms of the contract with the client. These terms must be accepted by the client so as to minimise the risk of disputes between the parties. Thus it is not, normally, permissible for an auditor to agree a letter of engagement with the client some way into the engagement. In view of this, the Guidance needs to make the point that the letter of engagement/terms of the LLA should be negotiated and agreed at an early stage of the process; it should, in our view, be integrated into the appointment or re-appointment process.

In our view, a more feasible standard time-table for the entering into of an LLA would be as follows:

i) the auditor and company's directors reach provisional agreement on the full terms of engagement and the full terms of the LLA (whether or not the latter are incorporated in full or in part in the engagement letter).

ii) the auditor is appointed by the shareholders (either at a general meeting or by written resolution or in accordance with the deemed re-appointment process for private companies) and at the same time they approve the principal terms of the LLA presented to them.

iii) the auditor and the client formally agree the terms of engagement and the full terms of the LLA. At this point, the auditor will be professionally entitled to begin work on the audit assignment.

Q4 The guidance is intended to be equally applicable to public and private companies. Are there different considerations for private companies, and does the guidance address them adequately?

We agree that the guidance should apply to private companies as well as to public companies. The draft guidance, however, seems to be written with public companies uppermost in mind. The final document needs, for example, to avoid the assumption that all companies will hold AGMs. The guidance should also address the particular situation of charitable companies and cross-refer to the guidance which, we understand, is currently being prepared by the Charity Commission.

Q5 Are there any other procedural issues that should be covered in sections 4 and 5 of the Guidance?

We suggest that paragraph 5.12 omits the incorrect reference to the AGM approving the accounts for the previous year.

Q6 Do you have any comments on the specimen principal terms, clauses and resolutions in Appendices B to D?

We consider it to be important that the Guidance, in presenting the specimen terms, should acknowledge that companies are not bound to use any of them and will usually wish to seek their own legal advice on whether to enter into LLAs at all and, if they decide to do so, on the actual content of their agreements.

The four suggested sets of specimen terms are very lengthy and detailed and have clearly been drafted on the basis of legal advice. Given the comparative brevity of the specimen additional terms set out in Appendix C, it appears that the specimen principal terms are intended by the authors of the document to constitute the major part of an agreement.

For the purposes of approving agreements, the legislation makes a clear distinction between principal terms and the agreement itself, the implication being that only the essential elements of the agreement are intended to be covered within the principal terms. In this light we question whether it is appropriate or necessary to include so much detailed legal text in the statement of principal terms. In particular we query whether the presentation of the essential elements of the agreement in such terms will be helpful to the company's shareholders in making their decision as to whether or not to endorse the agreement. It will also be remembered that the principal terms of an agreement will be required to be disclosed in the company's annual accounts, which means that the longer the company's statement of 'principal terms', the longer will be the required disclosure in its financial statements.

While it should remain an option for companies and their auditors to construct their principal terms and agreements as they see fit, we consider that it should be feasible to reduce the length and amount of detail contained in the specimen terms so as to produce more concise standard statements of terms. This should be capable of being done in such a way as to provide core information to the shareholders prior to their decision on the matter and to other stakeholders via the annual accounts.

As regards the details of the four draft documents, we are content for specimen terms to address the fixed cap basis (Appendix B(iii)), the fair and reasonable test (Appendix B(ii)) and proportionality (Appendix B(i)). We would prefer the specimen terms to omit version 1 of the two options on proportionality on the basis that the courts will retain the power to take into account the position of the company where it cannot recover any part of its loss from a person in respect of whom no-one is vicariously liable. More importantly, though, the essential principle underlying proportionate liability is that persons should only be liable to the extent of their deemed share of responsibility for loss: version 1 would appear to dilute this principle.

On a drafting point, we consider that in both versions 1 and 2 of Appendix B(i), in paragraph C(i) there needs to be a comma after 'the Court' in the first sentence. This would have the effect of ensuring that the principle of proportionality would apply in respect of both bilateral agreements between the parties and determinations by the Court.

Each of the four specimen documents includes the same final paragraph (E). This begins by saying that 'this Limited Liability Agreement has been approved by the company's members'. Given that the drafts in Appendix B are only intended to amount to statements of principal terms, we believe it is particularly inappropriate to include this statement, which is more relevant to the statement setting out the full agreement. As such this standard paragraph should be included in the additional terms set out in Appendix C. We reiterate the comment made earlier that the drafts appear to be longer and more detailed than is appropriate for a statement of 'principal terms'.

We offer the following specific suggestions on drafting issues:

i) The guidance could usefully provide a link to where the statutory provisions on LLAs can be found.

ii) References to the introduction of LLAs should not be framed in the future tense (e.g. para 1.1)

iii) The phrase used at the beginning of para 3.4 - 'directors will wish' (to establish) is, we feel, in appropriate. It would be more correct to say that directors will need to consider whether (an LLA is in their company's interests).

Finally, we suggest that FRC might consider creating, as well as the proposed document, a web-based guidance tool, in which i) explanatory information and ii) decision factors could be set out for the three distinct stakeholder groups.

I hope these comments will be of help and we look forward to the finalisation of the new Guidance in the near future.

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