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The decision of the Association of British Insurers (ABI) to issue a "red top" alert against any listed company that attempts to agree a fixed financial cap for their auditor's liability could restrict the ability of mid-tier audit firms to compete with the Big Four.

The warning comes from City law firm Reynolds Porter Chamberlain LLP (RPC). New draft guidance on government proposals issued by the Financial Reporting Council on 17 December left the way open for accountancy firms to agree with their clients a fixed cap on their financial liabilities in the event that they are sued for negligent audit work.

“One purpose of such a cap would be to protect firms from catastrophic claims that might result from doing audit work for large listed companies,” the firm said.

Proportionality only

The ABI has said, however, that it will urge its members, who account for almost 20 per cent of investments on the London Stock Exchange, to vote against attempts by companies to agree a fixed financial cap with their audit firms.

The ABI wants limitation agreements with auditors to be based on proportionality-only instead, limiting the auditor's exposure to the extent to which it had caused the damage suffered.

Ian Gordon, senior lawyer of RPC, said that the ABI's stance could, albeit inadvertently, frustrate attempts to create a more competitive audit market.

He added that the risk of a catastrophic claim was not the only factor that restricts non-Big Four firms competing for the work of large listed companies but that it was one factor.

"By setting a fixed financial cap on their liability, medium sized firms, who may be wary of bidding for listed work, would be freer to vie with Big Four firms for the audit work of large listed companies,” Gordon said.

Independence rules and fears 

RPC explains that the Big Four firms are in a much stronger position to take on the audit work of large listed companies as smaller firms run a higher risk of being wiped out by one single successful claim against them.

Gordon said that independence rules and fears about conflicts of interest had made it very difficult for the largest companies to switch between just four firms.

"It is crucial, however, that the remaining major audit firms are not obliterated in the same way as Arthur Andersen after Enron. That would be in nobody's interests and not least those of the business community," he added.

He explained that a system of proportionate liability would not necessarily prevent the Big Four becoming the Big Three. Even covering a proportion of the damage caused by the collapse of a FTSE-100 company might, in his view, be beyond the financial resources of even one of the Big Four firms.

Credible alternatives 

Gordon said that this was recognised by the Companies Act, which clearly envisages the use of fixed liability caps.

“An inflexible approach by the ABI will create further uncertainty for the Big Four and, at the same time, could help limit the ability of other audit firms to become credible alternatives for the largest companies," he said.

Gordon suggested that an alternative could be for the ABI to accept caps at a meaningfully high level.

“There is simply no evidence to suggest that such caps would have any impact on audit quality,” he concluded.

The FRC's consultation period on Auditor Liabilty ends on 14 March 2008. Government proposals on limiting Auditor Liability are included in those elements of the Companies Act 2006, which will come into force on 6 April 2008.

Related links

• Reynolds Porter Chamberlain
• Association of British Insurers