Our experts look at the legal and industry news affecting accountants and other financial professionals on a range of liability risk management issues.
Bannerman clause is successfully upheld
In a significant and helpful decision for auditors, the Commercial Court in Barclays Bank v Grant Thornton has confirmed the efficacy of a 'Bannerman clause' intended to preclude liability to third parties for the content of an audit report.
Grant Thornton provided audit services to the Von Essen Hotels Group. They certified that non-statutory audit reports for 2006 and 2007 gave a true and fair view of the group's financial affairs. But two key employees of the Von Essen hotel group had provided false information to Grant Thornton about the group's performance. The effect of this was (Barclays said) to make it appear that the group was able to meet covenants in a loan facility being provided by Barclays, when in fact it could not.
Barclays said that it relied upon the erroneous audit reports in advancing loans to Von Essen, and that as a result, it sustained losses of some £45 million when the Von Essen group went into administration in April 2011.
Barclays claimed that Grant Thornton owed it a duty of care in respect of the audit reports; and that that duty of care was breached by Grant Thornton's failure to uncover the alleged fraud of the two employees.
The audit reports contained a disclaimer on their first page: a 'Bannerman clause' stating that the auditor did not accept or assume responsibility in respect of the reports to anyone other than the company and its director. The disclaimer was largely in the form of the standard wording recommended by the ICAEW for statutory audit reports - amended to reflect the fact the reports were non-statutory.
As this was a summary judgment application, to test whether the claim could succeed the Judge proceeded on the basis that the key factual assertions made by Barclays were true. This included an assumption that Grant Thornton knew Barclays would rely upon the audit reports in deciding whether to continue lending to Von Essen.
Barclays' awareness of the disclaimer
The first question to consider was whether the disclaimer had been sufficiently brought to the attention of Barclays. It had: even if the relevant person at Barclays had not read it, as he claimed, Barclays ought reasonably to have been aware of it, since it appeared in the first two paragraphs of a two-page audit report.
The reasonableness of the disclaimer
The central issue was whether the clause was reasonable, by reference to the 1977 Unfair Contract Terms Act. The Court found that it was. In particular:
- Although the stated purpose for the reports related to the loan facility (it was a requirement of the loan facility that the reports should be produced to Barclays), it was not true to say that the only party Grant Thornton could expect to rely on the reports was Barclays. Von Essen - to whom the reports were addressed - would rely on them too.
Barclays was not an addressee of the Grant Thornton engagement letter or the audit reports, it had no contact with Grant Thornton in relation to the audit or the reports and it was Von Essen who sent the reports on to Barclays.
- In a separate engagement for an unrelated acquisition, Barclays had specifically ensured that Grant Thornton accepted responsibility to it, as well as to the company. That had not been done here.
- Barclays was a sophisticated commercial party, used to reading auditors' reports (and therefore, to these sorts of disclaimers, which are commonplace).
- Barclays did not engage or pay Grant Thornton for these non-statutory reports - it was "seeking a free ride".
- Indeed, if the disclaimer were struck down then Barclays might be in a better position than it would have been had it entered into a direct engagement and paid for the reports: on the evidence, Grant Thornton would in that case have obtained a limitation of its liability to Barclays.
- The disclaimer was clear and obvious on the face of the report.
- The disclaimer had a legitimate purpose. Grant Thornton was entitled to seek to avoid litigation, and to expect that any party wanting to rely on the reports would approach it to negotiate terms for doing so (including as to payment of fees and a limitation on liability).
- Indeed, given their wider relationship, Barclays was well aware of the possibility of a direct engagement and what the likely terms of that would be.
The Judge commented that in the circumstances, had there not been any disclaimer, it would be "clearly arguable" that Grant Thornton would have owed a duty of care to Barclays.
But the existence of the disclaimer was critical, and meant that here Grant Thornton owed no duty of care to Barclays. The question to be asked was whether a reasonable person in the position of Barclays could properly consider that Grant Thornton was undertaking responsibility to it. Grant Thornton could not have 'assumed responsibility' to Barclays in circumstances where such an assumption of responsibility was specifically disavowed.
This decision is comforting for auditors, if unsurprising since many cases post Caparo alighted upon the absence of a disclaimer when one could have been sought as a reason for finding that a duty was owed to a third party.
Different circumstances can naturally produce different results; but this decision underlines the point that, properly drafted, a Bannerman clause can protect against negligence claims by third parties who have relied on a report that was not prepared for them.
Care is required when leadership and audit roles are swapped
In February 2015, the Financial Reporting Council (FRC) published its decision in relation to disciplinary proceedings against KPMG LLP and Mr James Marsh, a partner of KPMG LLP and its current Chief Operating Officer.
KPMG and Mr Marsh were both reprimanded and ordered to pay fines of £350,000 and £60,000 respectively (reduced to £227,500 and £39,000 in light of concessions made). This case concerned the breach of the FRC's Ethical Standard for Auditors, the Auditing Practices Board's Ethical Standards and KPMG's own compliance policies designed to ensure the independence of audits. It demonstrates that rule breaches will be pursued by the FRC even when the breaches are unintentional, have not resulted in independence being compromised and no dishonesty was involved.
Mr Marsh was Chief Executive Officer of Cable & Wireless Worldwide Plc ('CWW') between 2010 and 28 June 2011. Mr Marsh had accumulated 651,559 shares in CWW. After leaving CWW, Mr Marsh re-joined KPMG on 3 October 2011 and then became its Chief Operating Officer on 11 May 2012. CWW was an audit client of KPMG in 2011 and 2012. Mr Marsh, as COO, was involved in determining partner remuneration including the remuneration of the partner responsible for the audit of CWW. Between 14 October 2011 and 31 January 2012, Mr Marsh disposed of his shares in CWW.
The allegations against KPMG were that upon Mr Marsh re-joining the firm:
- it failed to require the immediate sale of his shares in CWW;
- it lacked sufficient or appropriate procedures to prevent and identify the failure of Mr Marsh to sell his shares in CWW;
- it lacked an appropriate control environment that placed adherence to ethical principles and compliance with APB Ethical Standards above commercial considerations; and
- that it appointed Mr Marsh as COO (a role in which he was able to influence the conduct and outcome of the CWW audit) at a time when CWW was a listed audit client and Mr Marsh had, less than two years previously, been in a position at CWW to exert significant influence over the financial statements of CWW.
- The allegation against Mr Marsh personally concerned his failure to dispose of the CWW shares before re-joining KPMG as a partner.
In spite of there being no actual evidence of Mr Marsh exercising any influence over the audit report of CWW, the FRC upheld all the complaints. In fact, the substantive work on the CWW audit had been completed before Mr Marsh was appointed COO for KPMG. The audit report was signed on 23 May 2012 (12 days after his appointment as COO) thereby meaning he had no real time window to exercise any influence. Further, the audit itself was likely to be lost as CWW had voted by 18 June 2012 to accept a takeover bid from Vodafone and was then subsequently acquired by Vodafone on 27 July 2012.
Mr Marsh's ability to influence partner remuneration of KPMG partners (and therefore the remuneration of the KPMG partner responsible for the CWW audit) only came into effect in October 2012 (many months after the CWW audit was completed). Mr Marsh had also had a £60,000 reduction in pay and he had undertaken mandatory training.
Notwithstanding all of the above, the FRC held that both KPMG and Mr Marsh were in breach and fined them £350,000 and £60,000 respectively.
And vice versa...
On the same day the FRC published this decision, it also published its decision in a separate case. KPMG Audit Plc was also fined £250,000 (subsequently reduced to £162,500) regarding its failure to resign as auditors of car dealer, Pendragon Plc, following former KPMG partner, Mel Egglenton, being appointed as a non-executive director at Pendragon within nine months of leaving KPMG.
The FRC held that Mr Egglenton "might have been in the chain of command" and that his appointment would require KPMG's audit resignation. KPMG also failed to provide Pendragon's audit committee with full written disclosure of relationships that bore on its objectivity and independence. The FRC also flagged up that Gregg Watts, KPMG's audit engagement partner for Pendragon, failed to take all reasonable steps to preserve client confidentiality.
Again, this was a case where there was no actual evidence of independence being compromised or of dishonesty, however clear breaches of the rules designed to prevent precisely those things had taken place and were therefore punished.
Alternative dispute resolution must be considered to avoid cost penalties being imposed
The case of Jane Laporte & anr v The Commissioner of Police of the Metropolis has provided further confirmation that refusing to engage in alternative dispute resolution - such as mediation - is a high-risk strategy. We have previously reported on the decision in Garritt-Critchley, where a defendant was ordered to pay the claimant's costs on the indemnity basis after unreasonably refusing to mediate.
Now, in Jane Laporte & anr v The Commissioner of Police of the Metropolis  EWHC 371 (QB), a defendant that was completely successful in defending the claim brought against it has nevertheless been sanctioned in costs because it failed to engage in mediation.
The case is a useful reminder of the principles that the court will apply in deciding whether a refusal to mediate was reasonable. In reaching his decision, the judge considered the six factors that the Court of Appeal had identified in Halsey v Milton Keynes General NHS Trust  1 WLR 3002 for assessing whether a refusal to mediate was reasonable.
Five of them were not relevant:
- the nature of the dispute was not such that mediation was inherently unsuitable;
- the merits of the case were not so clear-cut that the defendant could refuse mediation with impunity (even though the defendant did ultimately successfully defend the claim);
- other settlement methods had not been attempted;
- the costs of mediation would not have been disproportionate to the sums at stake in the litigation;
- and mediation need not have prejudiced the trial date.
The sixth factor was the critical one: whether the mediation had a reasonable prospect of success. If not, it might be reasonable for an offer of ADR to be refused. The judge noted earlier commentary from the Court of Appeal that this should be treated with caution: mediation has a way, on occasion, of resolving the seemingly unresolvable.
Moreover, a party cannot rely on his own unreasonableness (e.g. that a mediation would never succeed because that party would not accept even a reasonable settlement). But the burden is on the unsuccessful party to show that there was a reasonable prospect that mediation would have been successful.
Here, the main reason the defendant gave for refusing to mediate was that it had "come incrementally to the view that the claimants would only accept a financial offer and that the defendant was unlikely to make one and so ADR was not appropriate."
This was not sufficient for the refusal to be reasonable. The claimant had not insisted that the making of a monetary offer was a precondition of ADR, and nor had the defendant ruled out the possibility of making such an offer. It was usual for each party to a dispute to try to 'manage the expectations' of the other side before a mediation, but this did not mean there was no point mediating: "tactical positioning should not too readily be labelled as intransigence".
There was a reasonable chance that ADR would have been successful, in whole or in part, and the defendant was not justified in coming to the opposite conclusion. As a result, even though the defendant won on every substantive issue, the Judge reduced the defendant's costs recovery by a third.
This case is a salutary reminder that if a party does intend not to engage in ADR, then it needs to be satisfied that its refusal is justified by reference to the six Halsey criteria. Otherwise, it is at serious risk on costs. It will also usually be sensible to set out its reasons carefully and in writing to the other side.
Unco-operative and unhelpful expert witness causes indemnity costs to be awarded
Generally when parties are engaged in litigation the successful party will recover at least some of its costs from the losing party on what is known as the standard basis - costs can only be recovered if they are proportionate and reasonable. The court also has the discretion to award costs on the indemnity basis, which removes the need for proportionality to be considered.
In the case of Siegel v Pummell, the court exercised its discretion to award a claimant some of its costs on the indemnity basis because of the conduct of the defendant's expert witness. The case involved an assessment of damages in a personal injury claim following a road traffic accident. Although the issues are raised in a personal injuries context, the risk of indemnity costs being awarded as a result of an unco-operative and unhelpful expert witness applies to all civil litigation cases where expert evidence is required.
In December 2014, the claimant was awarded significant damages and the defendant was ordered to pay the claimant's costs on the standard basis, to be assessed if not agreed. The claimant sought indemnity costs from 4 September 2014, alleging inappropriate conduct of behalf of the defendant which justified increased costs from that date.
The alleged inappropriate conduct of the defendant included:
- the conduct of the defendant's expert;
- improper allegations of dishonesty; and
- serving evidence and witness statements late in unsatisfactory circumstances.
The court did not accept improper conduct arose as a result of the allegations of dishonesty or the late service of evidence.
Three allegations were made as to the conduct of the defendant's expert witness. Two of them were rejected, including the fact that the experts were unable to prepare a joint statement (which the claimant alleged was the sole responsibility of the defendant's expert). The court concluded that in relation to this allegation the solicitors for both parties were trying to advance the process but were 'hamstrung' by the attitude of both experts, who "were incapable of approaching the exercise in anything like the co-operative spirit which it requires". Indemnity costs were not appropriate as a result.
The court did, however, find that the fact it was obliged to ask the defendant's expert (in the middle of his evidence) to provide a written statement as to what exactly his evidence was and the basis for his assertions arose as a result of serious shortcomings in the way he had approached the giving of his evidence.
While the written statement was helpful, it required the claimant's expert to be recalled to deal with the new basis upon which the defendant's evidence was being presented. The court concluded that this conduct on the part of the defendant's expert "was so out of the norm that it justifies an order for indemnity costs".
An expert witness's primary duty is of course to the court and not to those who instruct him. The purpose of expert evidence is to assist the court; parties and experts alike should always remember this. Evidence should always be clear and capable of being understood by the court and all parties involved, both in written format and when oral evidence is given. If the expert's evidence, or the focus of it, changes during cross-examination and other witnesses have to be recalled as a result, it is easy to see how cost penalties may follow.
It is also worth remembering that not all experts on opposing sides will get on and very often they will not agree, but experts should always try to put any personal animosity aside to ensure they do what they are retained to do - to help the court make an informed decision.
- The FRC survey on 'Extended auditor's reports: A review of experience in the first year' reports on the positive changes that have been implemented by auditors;
- The FRC consultation on amendments to UK GAAP.
The FRC survey on 'Extended auditor's reports: A review of experience in the first year' reports on the positive changes that have been implemented by auditors
Earlier this month the FRC issued the results of its survey on extended auditor's reports - a review of experience in the first year. The results are very positive and confirm not only that auditors met the new requirements but, in many cases, they have made changes that go beyond the changes required by the FRC.
The financial crisis highlighted concerns about the effectiveness of company stewardship generally and the effectiveness of the audit report in this process. In particular, concerns were raised as to whether audit reports provided adequate transparency. Changes were made to the UK Corporate Governance Code and to Auditing Standards as a result.
Changes to the Accounting Standards required auditors to include within their reports:
- A description of those assessed risks of material misstatement that were identified by the auditor and which had the greatest effect on the overall strategy; the allocation of resources in the audit; and directing the efforts of the engagement team;
- An explanation of how the auditor applied the concept of materiality;
- A summary of the audit scope, including an explanation of how the scope was responsive to the assessed risks of material misstatement and the concept of materiality.
No prescribed form of extended audit report was introduced. Instead, the FRC allowed individual auditors to innovate as they thought fit within the framework of the new requirements.
The survey included a review of a number of extended auditor's reports, the majority of which were issued by the Big 4. Those reports showed that each of the audit firms had adopted different approaches to the new extended report requirements and had been innovative in different ways.
The FRC summarised significant innovation findings in the following areas:
- Disclosing the materiality benchmark used;
- Disclosing the magnitude of unadjusted differences being reported to the Audit Committee;
- Reporting of detailed audit findings with respect to identified risks;
- Experimentation with detailed broader explanation of the audit scoping process;
- Improved presentation of auditor's reports through the use of diagrams and graphs;
- Addressing going concern disclosures in auditor's reports;
- Locating the auditor's opinion at the beginning of the auditor's report rather than at the end;
- Moving generic descriptions of the scope of an audit to a website.
There is however room for improvement. The report confirms that further improvements might be made in the following areas:
- Increasing the granularity of risk reporting (being as entity-specific as possible);
- Improving the discussion of the auditor's application of materiality and why a particular benchmark or level was chosen and addressing other aspects of materiality;
- Making clearer links between the discussions of risks and materiality and the description of how these influenced the scope of the audit;
- Ensuring auditor reports accurately reflect the work performed.
The FRC expressly states its hope that publishing this report will act as a catalyst to maintain the momentum of the initiative in the UK and Ireland as well as influencing international practice.
The FRC consultation on amendments to UK GAAP
On 19 February 2015, the FRC published its consultation on the implementation of the EU Accounting Directive. The EU Accounting Directive seeks, among other things, to simplify reporting and financial statements for small companies and micro-entities. It also gave Member States the option to increase thresholds for what constitutes a small company.
BIS has already published its proposals for how the EU Accounting Directive will be incorporated into UK Company law (see our last edition of Accountability. The FRC has now published its proposals to amend UK and Irish accounting standards.
The consultation is accompanied by the following financial reporting exposure drafts ('FREDs'), which provide an overview of the proposed new financial reporting framework:
- FRED 58 Draft FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime which introduces a simplified standard for micro-entities;
- FRED 59 Draft amendments to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland - Small entities and other minor amendments. This sets out the revised presentation and disclosure requirements for financial reporting by small entities in a new section of FRS 102, Section 1A Small Entities. It is proposed that small entities will apply the recognition and measurement requirements of FRS 102 with different presentation and disclosure requirements and that this section, within FRS 102, will replace the existing Financial Reporting Standard for Smaller Entities (FRSSE). A number of other necessary amendments are proposed to maintain consistency between FRS 102 and company law; and
- FRED 60 Draft amendments to FRS 100 Application of Financial Reporting Requirements and FRS 101 Reduced Disclosure Framework. This proposes amendments to FRS 100 to reflect the revised framework of accounting standards, including the proposed replacement of the FRSSE with a new section in FRS 102 and the proposed introduction of micro-entity accounting standard, draft FRS 105. The FRED also proposes minor amendments to FRS 101 to maintain consistency between FRS 101 and company law.
The FRC consultation closes on 30 April 2015. The proposed changes to financial reporting are to become effective for financial years beginning on or after 1 January 2016 with early application permitted for accounting periods beginning on or after 1 January 2015.
Our professional liability experts can advise accountants and other professionals on these and a range of other liability risk management issues.