Agencies advise against limitation of liability in auditor engagement letters

By:  Cydney Posner

Corporate Counsel has just reported on a final interagency advisory, issued by the Treasury Department, Federal Reserve, FDIC and various other agencies, which advises financial institutions against execution of engagement agreements with external auditors that "incorporate unsafe and unsound external auditor limitation of liability provisions with respect to engagements for financial statement audits, audits of internal control over financial reporting, and attestations on management's assessment of internal control over financial reporting."  These limitations may take the form of provisions to:

• Indemnify the external auditor against claims made by third parties;
• Hold harmless or release the external auditor from liability for claims or potential claims that might be asserted by the client; or
• Limit the remedies available to the client. (Note, however, that waivers of punitive damages are excepted and are currently "under advisement.")

In the advisory, the various agencies contend that, when financial institutions agree to limit their external auditors' liability in engagement letters or in ADR agreements, these provisions may reduce the auditor's accountability and thus "weaken the external auditors' objectivity, impartiality, and performance…." As a result, these types of provisions may reduce the reliability of audits, raising "safety and soundness concerns." For example, the agencies argue that limitation on liability provisions related to a client's knowing misrepresentations, willful misconduct or fraudulent behavior may not be viewed as consistent with the auditor's duty and obligation to comply with auditing standards; limited liability could cause an auditor to not consider fully the possibility that management fraud exists, potentially resulting in less robust challenges to and over-reliance on management's representations, rather than performance of appropriate audit procedures to corroborate them. In the agencies' judgment, concerns about potential increased costs or limitations on the ability of the parties to allocate risk do not outweigh the need to protect against these safety and soundness concerns.

Moreover, these limitations on external auditor liability may not be consistent with the auditor independence standards of the SEC, PCAOB and AICPA. Apparently, auditors have expressed varying interpretations of the meaning and scope of these provisions. In particular, the advisory states that a clause that would release, indemnify or hold an external auditor harmless from any liability resulting from knowing misrepresentations by management is inappropriate under the SEC's existing guidance on auditor independence. (See Appendix B of the advisory, copied below.)

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Appendix B

SEC's Codification of Financial Reporting Policies, Section 602.02.f.i and the SEC's December 13, 2004, FAQ on Auditor Independence Section 602.02.f.i—Indemnification by Client, 3 Fed. Sec. L. (CCH) ¶ 38,335, at 38,603–17 (2003) Inquiry was made as to whether an accountant who certifies financial statements included in a registration statement or annual report filed with the Commission under the Securities Act or the Exchange Act would be considered independent if he had entered into an indemnity agreement with the registrant. In the particular illustration cited, the board of directors of the registrant formally approved the filing of a registration statement with the Commission and agreed to indemnify and save harmless each and every accountant who certified any part of such statement, ‘‘from any and all losses, claims, damages or liabilities arising out of such act or acts to which they or any of them may become subject under the Securities Act, as amended, or at ‘common law,' other than for their willful misstatements or omissions.''

When an accountant and his client, directly or through an affiliate, have entered into an agreement of indemnity which seeks to assure to the accountant immunity from liability for his own negligent acts, whether of omission or commission, one of the major stimuli to objective and unbiased consideration of the problems encountered in a particular engagement is removed or greatly weakened. Such condition must frequently induce a departure from the standards of objectivity and impartiality which the concept of independence implies. In such difficult matters, for example, as the determination of the scope of audit necessary, existence of such an agreement may easily lead to the use of less extensive or thorough procedures than would otherwise be followed. In other cases it may result in a failure to appraise with professional acumen the information disclosed by the examination. Consequently, the accountant cannot be recognized as independent for the purpose of certifying the financial statements of the corporation.  (Emphasis added.)

U.S. Securities and Exchange Commission; Office of the Chief Accountant: Application of the Commission's Rules on Auditor Independence Frequently Asked Questions; Other Matters—Question 4 (issued December 13, 2004)

Q: Has there been any change in the Commission's long standing view (Financial Reporting Policies—Section 600—602.02.f.i. ‘‘Indemnification by Client'') that when an accountant enters into an indemnity agreement with the registrant, his or her independence would come into question?

A: No. When an accountant and his or her client, directly or through an affiliate, enter into an agreement of indemnity that seeks to provide the accountant immunity from liability for his or her own negligent acts, whether of omission or commission, the accountant is not independent. Further, including in engagement letters a clause that a registrant would release, indemnify or hold harmless from any liability and costs resulting from knowing misrepresentations by management would also impair the firm's independence. (Emphasis added.)

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