Chapter 8
Liability of professional service providers and advisers

A special case for auditors


8.36The accounting and auditing professions, including their national professional body, the New Zealand Institute of Chartered Accountants (NZICA), have strongly communicated to us that the audit industry presents unique problems that proportionate liability as well as capping of liability could fix.

8.37We identify two main considerations that may distinguish the case for capping auditor liability from that for other professionals. Despite our recommendation to reject proportionate liability, we accept that the question of capped liability deserves to be considered separately for auditors.152

CER considerationsTop

8.38The first aspect of the audit profession that is distinct from other professions is the current and likely development of the audit market in New Zealand, especially the market for “large” audits. Within large audits we include audits of listed companies, audits of other securities or financial markets “issuers” under the present Securities Act 1978 regime and its successor, the Financial Markets Conduct Act 2013.153 Since the Auditor Regulation Act 2011, which came into force in 2012, auditors conducting these audits must be licensed under that Act, with at least one licensed partner who is responsible for the engagement.154 This tends to narrow the competitive field for such engagements to large or very large firms.
8.39The market for audit services is increasingly becoming a trans-Tasman one. Large New Zealand firms told us that Australian offices of the largest firms (the “Big Four”),155 rather than mid-sized New Zealand firms, are their principal competitors for large audit engagements. We accept this and note that this trend will continue given the introduction of the Accounting Infrastructure Reform Bill in Parliament in December 2013. This Bill should remove the existing prohibition on audit firms being incorporated. The provisions of the bill recognise that audit firms that are companies or overseas companies may in future be engaged to conduct issuer or FMC reporting entity audits.156 This will remove a remaining barrier that could have prevented some overseas auditors competing in New Zealand, because they had already incorporated in their home jurisdiction. In return, New Zealand firms will be able to incorporate and achieve the benefits of shareholders’ limited liability and separate legal personality, while still carrying out audit work.
8.40The nature of the market for issuer or FMC reporting entity audits has CER dimensions. In our Issues Paper we discussed what weight we should give to CER considerations when assessing the case for reform.157 While we have not found CER considerations to have altered our conclusion on proportionate liability, we consider that such considerations have much greater weight in the large audit market. Regulatory schemes for auditing are already converging and this will continue. This has helped facilitate what is most likely already a natural interest by Australian audit offices in selected New Zealand clients and assignments. This might suggest that the trans-Tasman audit market is already a CER success story – except that the market appears somewhat unbalanced in its present state. This is because the availability of capped liability in Australia means that in that one important respect there is not a satisfactorily level field of competition. Australian firms will benefit from capped liability in their home market, and may benefit in New Zealand if their engagements allow them to rely on capped liability, including by having the law of an Australian state specified as the law of the contract. It is not certain that this result can be achieved; there will be conflict of laws arguments to be dealt with if such a contract is ever the subject of litigation. But at the very least, Australian firms operating in New Zealand can rely on capped liability at home, and the prospect of or potential for capped liability for some New Zealand engagements. However, New Zealand firms cannot presently pursue either option.

8.41This is a relatively unusual case for CER, where firms from the entering State already enjoy superior conditions to the incumbent. Thus it is not a case of changing New Zealand conditions to promote entry. Rather, there is a good argument to pursue capped liability for New Zealand auditors of issuers or FMC reporting entities – not to further open the market, but rather to ensure the market operates fairly for incumbents and New Zealand auditors are not excluded from the market of large audits.

8.42The argument is that New Zealand auditors and firms ought to have the same or similar ability to cap liability as their Australian competitors. If both national and state regimes provide for capping, then it ought to be possible to adopt mutual recognition, so that New Zealand and Australian firms operating in New Zealand or any Australian jurisdiction will have similar access to capped liability.

Catastrophic riskTop

8.43The other major consideration that we have given weight to is that auditors, particularly auditors of the largest firms, are more likely to be exposed to the flow-on effects of a major catastrophic event than are other professionals. The auditor will typically be one of the first additional parties aggrieved investors or other creditors may look to if the insolvency of the principal firm or body makes direct recovery of losses impractical. This by itself would not be particularly remarkable or cause for concern given that pursuing the auditor is never straightforward.158 And it is tempting to treat New Zealand auditors as facing only low risk of catastrophic liability. However, their rarity makes such events even harder to predict, and if one was to occur, the likely severity of harm remains a significant concern that should be managed, to the extent possible. Introducing capped liability for auditors is one prudent step that can be taken to limit the impact of a catastrophic collapse. If auditors’ maximum liability is capped at or about the same level as Australian schemes, say NZD$80 million, and the auditor must carry suitable professional indemnity cover liability up to that level, then the risk of a local Enron–Arthur Andersen collapse is significantly reduced.
8.44Capped liability is unlikely to be a complete answer to preventing catastrophic loss to audit firms. A local scheme may not cope with an overseas event with multinational effects. For example, if a “Big Four” firm suffers catastrophic damage from a very large event in an overseas market, capping of local liability may not be enough to save its New Zealand office.159 And capped liability would no doubt apply only for negligence, as opposed to deliberate, intentional or fraudulent wrongdoing – so a firm could still bring on its own disaster. However, having a cap and defined liability exposure should encourage and enable firms to put in place their own systems to ensure that, at worst, a firm’s liability is restricted to the applicable capped level.
152We acknowledge that auditors in Australia have the advantage, like other Australian potential defendants, of proportionate liability being likely to apply to them. And as we note in the text, Australian auditors will inevitably be undertaking engagements in New Zealand, given CER and trans-Tasman Mutual Recognition arrangements. But it is not clear that Australian auditors will be able to “import” proportionate liability when operating in New Zealand. In any case, it is quite unrealistic to consider proportionate liability for one profession, or part of one profession, in New Zealand, especially when other measures such as a capping scheme can address the potential disadvantages that could be suffered by New Zealand auditors.
153Under the Financial Markets Conduct Act 2013 the general category will become either: “FMC reporting entities” as defined in s 451; or quite likely the subset of “FMC reporting entities considered to have a higher level of public accountability”, defined at s 461K. The 461K definition is likely to include companies and other entities that can be expected to have their audits carried out by the largest audit firms operating in New Zealand – whether they are New Zealand-based or overseas firms licensed to operate here.
154Auditor Regulation Act 2011, ss 8 and 9.
155The “Big Four” includes; Ernst & Young, Price Waterhouse Coopers, KPMG, and Deloitte.
156Accounting Infrastructure Reform Bill 2013 (180-1), cl 5.
157Issues Paper, above n 127, at [6.16]–[6.26].
158The question of whether and when auditors can or should be liable in negligence to investors and other third parties remains at best opaque in New Zealand law, even though New Zealand law is theoretically more open to the possibility than, say, Australia or Canada: compare Scott Group Ltd v McFarlane [1978] 1 NZLR 553 (CA); and Boyd Knight v Purdue [1999] 2 NZLR 278 (CA); to Esander Finance Corp Ltd v Peat Marwick Hungerfords (1997) 188 CLR 241 (HCA); and Hercules Managements Ltd v Ernst & Young [1997] 2 SCR 165.
159Although the availability of local cover may help save some of the local infrastructure.