David Lewin, Managing Director
The September 2010 issue of this series covered the controversial topic of auditors’ liability, and subsequently the September 2011 issue referred to the Consolidated Text of the Accounts Audit Act of July 1, approved by Royal Legislative Decree 1/2011 (RLD 1/2011), which abrogated the Accounts Audit Act (AAA) then in force. The RLD 1/2011 has been in force since July 3, 2011. The following provides an update to the September 2010 report and expands on the issue.
Unlimited Auditors’ Liability Under Spanish Accounts Audit Act
To review, subsections 1.2 and 1.3 of the AAA (in force until July 3, 2011) stated that the main purpose of an audit is the reporting on a company’s accounts that may produce effects regarding third parties. The audit of the annual accounts purports to check that the accounts give a fair view of the company’s business, financial position and results, and also of the resources obtained and applied during the period reviewed. The auditor must also ensure that the management report agrees with the accounts reviewed. This is the scope of the lex artis ad hoc, or professional diligence of the auditors. These rules, which remain unchanged, are now set forth in Section 1 of the RLD 1/2011.
Under Section 11.1 of the AAA, auditors were liable for any damage arising out of the breach of their obligations in accordance with the general civil law rules subject to the qualifications made in the subsections. In essence, this meant that the auditor could be liable in contract and in tort to clients (audited companies) and/or third parties. In principle, that liability was based on fault and was unlimited to the extent that the auditor would respond to obligations with all current and future assets pursuant to the general rule set forth in Section 1911 of the Civil Code. Section 11.2 of the AAA added that when an audit was carried out by an auditor working in or for an audit firm, both the auditor and the firm would be jointly and severally liable.
As discussed in the September 2010 issue of this series, there is a general perception that auditors are “guarantors” of companies’ financial health. Case law has highlighted the public interest of audit reports and extended the auditor’s duty of care not only to the audited company and its shareholders, but also to third parties that may engage with the company.(1) Consequently, third parties are entitled to rely on audit reports.
So although auditors do not issue the annual accounts of a company, and their activity is limited to expressing an opinion on whether the financial situation of a company reflects its “true image” or not, the markets consider that such opinion plays an essential role. This is reflected in the relevant case law.
PSV Cooperative Case Overview
The Supreme Court case of October 14, 2008 (RJ 2008/6913) involving the bankruptcy of the PSV housing promotional cooperative (PSV cooperative) is the leading case in defining the role of the audit report in cases of damages to third parties. It also establishes the joint and several and unlimited liability of the auditor, the audit firm and their insurer.
This judgment concerns one of the major audit firms in a case with strong political and social implications, the bankruptcy of PSV cooperative. The management company of the cooperative did not use all of the money deposited by the individual members for the purchase of land and payment of construction work, but instead diverted it to other purposes. As a result, PSV cooperative went into bankruptcy in 1993, construction stopped, and the cooperative members were obliged to make additional payments to re-start the work and enter into new agreements with building companies to finish the construction of houses. These agreements incurred higher costs.
In 1992, PSV cooperative did not call the mandatory annual meeting to review the 1991 accounts, and none of the PSV cooperative members requested that it be held or took any other action. In 1993, PSV cooperative called the annual meeting to approve the 1991 and 1992 accounts that were already audited. This audit had a substantial qualification, stating that the accounts had been properly prepared save for an amount of EUR30 million. Despite this significant qualification, the members of PSV cooperative (including the claimants) approved the annual accounts.
However, the accounts of PSV cooperative contained even larger irregularities, and the auditors overlooked other issues. The claimants (450 individual members) sued the auditor and its insurance company but did not sue the managers and administrators of PSV cooperative and its management company, which were blamed for the financial problems that caused the bankruptcy. The managers were ultimately found guilty of several criminal charges and convicted.
PSV Cooperative Case Findings
The Supreme Court applied two theories when it analyzed the case: the theories of conditio sine qua non (the necessary condition) and the equivalence of conditions. In the theory of the necessary condition, any condition necessary or indispensable for the effect is considered a cause of the result. In the theory of the equivalence of conditions, when there are several contributory causes to damage, all of them should be considered equal in their influence as a cause because if by theoretically removing one, the consequence disappears as well.
In order to analyze whether the wrongful audit report could be considered a “cause” or not, the judgment recognized that all of the causal background of the damages needed to be considered along with an assessment of whether the audit report was material or adequate to produce the damage, taking into account the assessment of likelihood.
Contrary to the Court of Appeal’s opinion, which considered that the material cause of damage to PSV cooperative was fraudulent mismanagement, the Supreme Court stated that the failures in the audit work are to be considered a “cause.” Even if it was not the main cause of the PSV cooperative’s financial crisis, it contributed to it, depriving the PSV cooperative members of information about its equity and financial situation. To this end, the court made a dual assessment of likelihood and concluded that if PSV cooperative members would have had such information available, it is likely that they would have changed their attitude towards the PSV cooperative. They would have been likely to replace the periodic approvals of accounts with a reaction against the mismanagement of the cooperative. Therefore, in the opinion of the Supreme Court, it is likely that the claimants would have “reacted” against such an irregular situation.
The court did not take into consideration some alien events that would have interfered with the causation process or contributed to the harmful result. The court did not address PSV cooperative management and the fact that some members were convicted and served time in jail.
Lastly, the Supreme Court stated that the claimants’ interests and those of the remaining members of PSV cooperative were protected by the rule that the auditors breached. Accordingly, the harmful result had to be attributed to them. The duty of care is extended not only to the client (the PSV cooperative association) but to its members and third parties that may engage with the company. Consequently, the implication of the judgment is that third parties are entitled to rely on the audit report.
The Supreme Court found against the auditor and its insurer and ordered them to indemnify the PSV cooperative members jointly and severally the extra apportionment (EUR1,955,049.45) plus legal interest accrued from the date of the claim filing and the extra costs that the PSV cooperative members had to pay due to shutting down and then recommencing construction.
The Supreme Court confirmed this doctrine in other decisions(2), ruling for the unlimited liability of the auditor and the audit firm. It stressed the importance of the audit report as a warranty for the audited company and interested third parties.
The PSV cooperative case is an example of the scope of the joint and several liability doctrine. It allowed the claimants to address their indemnity claim not against the directors who produced the incorrect accounts, or the company that approved them in a general members meeting, but against the auditor and the audit company.
Amendments of the Accounts Audit Act, According to European Trends
The trend in European legislation is directly opposed to the Spanish case law doctrine of unlimited liability based on the AAA. In November 2009 there was a proposed reform of the AAA 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. During the legislative process, several amendments to the draft bill were included. Finally, this reform became Law 12/2010, which amended the AAA. It was published on July 1, 2010, and took effect on July 2, 2010.
Section 11.2 introduced by Law 12/2010 provided that the liability of auditors and audit firms would be enforceable in proportion to the direct liability for the damages and loss of profits they could cause by their professional activity. The liability of an auditor or the audit firm would be enforceable on a personal and individualized basis, excluding any damage caused by the audited company itself or a third party.
The most significant change of Law 12/2010 was the introduction of the limitation of the auditor’s liability, which seems to follow the method outlined in Section 5 of the Commission Recommendation. It 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 accordingly is not jointly and severally liable with other wrongdoers. However, Law 12/2010 did not clarify which criteria would have to be followed to set out the proportion of liability for which the auditor and the audit firm would be liable.
The limitation term of contractual actions against auditors was also reduced from 15 years to four years. This term would run from the date of the audit report.
Current Status of Auditors’ Liability
The RLD 1/2011 was published on July 2, 2012. The main goal of the text is to consolidate the rules that govern the account’s audit activity by regulating, harmonizing and clarifying the rules that amended the original wording of Law 19/1998. The resulting consolidated text is not a mere reproduction of the former legal texts, but goes further in modifying their structure and makes some adjustments and terminology clarifications.
Liability of auditors is now set forth in Section 22.2 RLD 1/2011, which in principle contains the same wording as Section 11.2 of the AAA as amended by Law 12/2010. It introduces a new paragraph in Section 22.2 by which the liability of auditors comprises the damages and loss of profits they could cause both to the audited company or a third party.
In addition, Section 22.2 defines third party as any person or entity, public or private, which proves that she/he/it acted or failed to act in reliance of the audit report, with it being the essential and appropriate element for forming their consent, motivating their conduct or making their decision.
The Section 22.2 now in force maintains the Law 12/2010 criterion of the enforcement of liability of auditors and audit firms in proportion to the direct liability for the damages and loss of profits they could have caused by their professional activity.
Furthermore, the rule has introduced a new paragraph that expressly provides that the audit report is the essential and appropriate element to form the consent or motivate the conduct of third parties, that is, to directly attribute the proportion of liability to the auditor.
The requirement for auditor liability regarding third party claims is that the act or decision adopted by the third party was rationally based on the audit report. This means that the claimant must have been led by the information contained in the audit report to make the investment decision that went wrong.
Finally, auditors and audit firms will continue to face the requirement to set up a security (bond) in order to respond to all damages that may arise while their activities are being performed. The bond required for the first year of activity is EUR300,000 for individuals. For audit firms, the amount is multiplied by the number of firm members. After the first year of activity, the bond will be increased by 30 percent of the turnover that exceeds the amount equivalent to that of the minimum bond corresponding to the audit activity of the previous year’s accounts.
This system of proportional limited liability may signal a change in the auditors’ liability regime. In our opinion, this new system does not provide a place for decisions like PSV, in which the auditor, the audit firm and their insurer were found jointly and severally liable for all damages suffered by third parties. Under RLD 1/2011, the sued auditor would be responsible to the injured third party only for the amount of damage equal to its share of liability in the event triggering the claim.
There have been no court decisions since the recent enactment of the rule. The question arises as to whether the new legislation effectively limits the auditor’s liability and how this is determined. However, we should assume that this significant amendment may lead to a reduction in insurance premiums and lower indemnity awards. The potential risk of substantial damages based on unlimited liability has decreased, but it remains to be seen how the courts will construe the new rules.
1 Supreme Court decision of December 10, 1998 (RJ 1998/9883).
2 Decisions of October 9, 2008 (RJ 2008/6042); March 5, 2009 (RJ 2009/1631); May 27, 2009 ( JUR 2009/279232); and December 15, 2010 (RJ 2011/1550).
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David Lewin, Managing Director