David Lewin, Managing Director
In the September 2009 issue in this series, Recent Legislative and Judicial Developments in Continental Europe Affecting the Casualty Insurance Industry, we referred briefly to the ongoing discussions around the controversial topic of auditors’ liability.
Following publication of the draft bill on November 13, 2009, this is a good time to
provide more detailed insight.
Under Section 1.1 of the current Accounts Audit Act (Law 19/1988 of July 12, AAA),
as amended, the main purpose of an audit is the issuance of a report on a company’s
accounts that may produce effects relating to third parties. The audit of the annual accounts attests that the accounts provide a fair view of the company’s business, financial position, results, and resources obtained and applied during the period reviewed. The auditor is required to affirm that the report of management agrees with the accounts reviewed (Section 1.2, AAA).
Section 11.1 of AAA provides that auditors are liable for any damage arising out of the breach of their obligations in accordance with the general civil law rules. In essence, this means that the auditor can be liable in contract and in tort to the client (the audited company) and/or third parties. In principle, that liability is based on fault and is unlimited to the extent that the auditor will respond with all his/her current and future assets pursuant to the general rule set forth in Section 1.911 of the Civil Code. Section 11.2 of AAA adds that whenever the audit is carried out by an auditor working in or for an audit firm, both the auditor and the firm shall be jointly and severally liable.
Both the auditors and their firms are required to set up various forms of security to enable them to respond to all damages they may cause in the performance of their activities. Security shall be provided in several forms, one of which is professional indemnity insurance. The limits of cover are fixed, with an initial base amount (currently EUR300,506), subject to increase depending on annual revenues. For audit firms the base amount will be multiplied by the number of partners at the firm.
Circumstances have not been positive for auditors in recent years in Spain. There is a general perception that auditors are “guarantors” of the financial health of companies, or, as one Justice of the Supreme Court described it, “notaries.” Case law has highlighted the public interest of audit reports and extended the duty of care of auditors not only to the audited company itself and the shareholders, but to third parties that may maintain relations with the company. Consequently, third parties may also rely on the audit report.
The Supreme Court has pursued a variety of theories to assert causation between the auditor’s actions and a harmful result. It has applied the doctrine of improper joint and several liability. (1) According to this doctrine created by case law, liability can be imposed on a joint and several basis where it is impossible to discern or individualize the conduct of the people involved in the event giving rise to damage. The so called “PSV case” is representative of this approach. The claimants in this case were 450 individual members of a building cooperative association. They sued the association’s auditor, the audit firm and the audit firm’s insurance company. They did not sue the managers and administrators of both the cooperative and their management company who were directly culpable for the financial disaster that ended in the bankruptcy of the cooperative. The manager was found guilty of several criminal charges and convicted. All efforts of the defendants to join the other potential defendants to the proceedings were useless. The Supreme Court on October 14, 2008 ruled against the auditor, the audit firm and their insurer. They were ordered to indemnify jointly and severally for all damages claimed, without any limitations on the extent to which the auditor or the audit firm contributed to the causation of the damages suffered by the claimants.
The proposed reform of the AAA is based on the Directive 2006/43/EC of the European Parliament and the Council of May 17, 2006 and the Commission Recommendation of June 5, 2008, concerning the limitation of the civil liability of statutory auditors and audit firms.
The most significant proposed change includes the introduction of a new Paragraph 2 and the amendment of current Paragraph 2 which is numbered 3, in Section 11 of the AAA.
The liability of an auditor or of the audit firm shall be enforceable on a personal and individualized basis, excluding any damage caused by the audited company or the third party. Joint and several liability may be asserted only where the cause of the damage cannot be individualized or the degree of contribution to the harmful result of the agents involved cannot be established precisely.
The proposed amendment to current Paragraph 2, future Paragraph 3, provides that both the auditor and his/her firm will be jointly and severally liable for the audit report issued on behalf of the audit firm, but “within the limits indicated in the preceding paragraph” (our emphasis). This means that they will be jointly and severally liable for their share or quota of liability that has been individually identified and allocated.
The proposed reform also seeks to reduce the limitation term of contractual actions against auditors from the current 15-year term to four years. This term would begin on the date of the audit report.
It would seem that the Spanish legislator has followed the method outlined in Section 5 of the Commission Recommendation. This establishes a set of principles by virtue of which a statutory auditor or an audit firm is not liable beyond its actual contribution to the loss suffered by a claimant and is, accordingly, not jointly and severally liable with other wrongdoers.
From an insurance perspective, it would be reasonable to assume that auditor professional indemnity cover requirements and, therefore, premiums, will be reduced.
However, the question arises as to whether the proposed legislation effectively limits the auditor’s liability. The fact that joint and several liability may be asserted where the cause of the damage cannot be individualized or liability cannot be allocated among the various wrongdoers, paves the way to imposing joint and several liability. In practice it may be very difficult to ascertain who is to be blamed and in what percentages for the damage. From this perspective, the auditor’s legal position may not have improved, and may have worsened to some extent. The doctrine of improper joint and several liability created by recent case law has been codified as law.
In conclusion, the resulting limitation of liability should logically lead to the reduction of insurance cover requirements, but it remains to be seen how the proposed new rules, if they are finally approved in the current terms, will be construed by courts.
1 Decisions of October 9 and 14, 2008 (RJ 2008\6042 and RJ 2008\6931); March 5, 2009 (RJ 2009\1631); and May 27, 2009 (JUR 2009\279232).
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