Transnational governance in action: The pursuit of auditor
liability reform in the EU
Anna Samsonova and Chris Humphrey
Accounting and Finance Group
Manchester Business School
University of Manchester
Booth Street West, Manchester M15 6PB
United Kingdom
Contact:
Anna.Samsonova@mbs.ac.uk or
Chris.Humphrey@mbs.ac.uk
Draft: Please to note quote without permission
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Transnational governance in action: The pursuit of auditor
liability reform in the EU
Abstract
The European Commission’s official Recommendation in 2008 that European Union (EU)
Member States should establish a specified form of limited liability for statutory auditors
contrasted significantly with its long held stance rejecting the need for regulatory action.
Such a shift in policy opinion provides a valuable opportunity to explore the practical
application of transnational policymaking and governance processes in an area of
accounting that has traditionally exhibited very diverse opinions and heated debate. The
paper’s detailed longitudinal analysis illuminates the complexities of European audit
policy making, focusing particularly on how the actions and interests of a diverse set of
actors served to shape and influence the application and development of the policy agenda.
The case findings, while lending support to an emerging body of accounting literature
highlighting the active nature of the accounting profession’s engagement with processes of
transnational governance, advocate a degree of caution in evaluating the profession’s
capacity to influence. The persuasive of the profession’s arguments in support of audit
liability limitation are seen to vary across time and context, while the precise form of the
European Commission’s Recommendation emphasizes the residing sovereign authority of
EU Member States and its constraining effect on the audit profession’s transnational
policy agendas. The key to enhanced understanding of the outcomes of transnational
governance lies not in presumption or myth, but in detailed studies of the relational
dynamics and processes underlying such governance practices in action.
Key words: transnational, policymaking, auditing, liability, European Union
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1. Introduction
Modern forms of global governance and regulation are increasingly said to be
transnational in the sense that they are shaped by non-state actors whose interests,
strategies, and activity areas stretch beyond any one country’s boundaries (Risse-Kappen,
1995; Nölke, 2003; Djelic & Sahlin-Andersson, 2006a; Perry & Nölke, 2006). The effects
of transnational actor interactions are claimed to be highly significant, both in terms of
their influence on governance processes and the development of regulatory policy,
especially in arenas with an evident commitment to the development of international
practice standards.
The past decade has witnessed a substantial growth in accounting research
concerned with issues of transnational governance and the existence of an international
financial architecture (Arnold, 2009; Humphrey et al., 2009). There has been an active
level of engagement, for example, with the work of a range of multinational agencies, such
as the World Trade Organization and the World Bank (Arnold, 2005; Neu et al., 2006) as
well the growing global significance of accounting and audit regulatory and standard
setting initiatives (Botzem & Quack, 2006; Thornburg & Roberts, 2008). In this literature,
an emerging discursive imperative has highlighted the influence of professional
(accounting) actors on the transnational regulatory landscape (Arnold & Sikka, 2001;
Barrett et al., 2005; Cooper & Robson, 2006; Suddaby et al., 2007).
This evolving body of scholarship is supportive of trends documented in other
professional domains (see, for instance, Flood’s (2011) investigation of the legal
profession) suggesting that elite professional services firms increasingly exploit the
dynamics of transnational governance to resolve issues that had failed to gain sufficient
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support at the national level. In the words of Suddaby et al. (2007), by pursuing
transnational relations and associated power structures, large professional audit networks
are superimposing an additional layer of soft regulatory authority on the ‘traditional (i.e.
coercive) power relations that exist between nation states and professional associations’
(p. 356). More specifically, such regulatory tendencies have been considered through
studies of the representation of the large audit firms on international standard setting and
regulatory governance boards (Loft et al, 2006), their interactions with, and even mutual
dependency on, different national audit oversight institutions (Shapiro & Matson, 2008;
Samsonova, 2009; Malsch & Gendron, 2011), and the mobilizing capacity of the
profession internationally to form a united policy front in the wake of the recent global
financial crisis (Humphrey et al., 2009). A clear implication of such literature is that the
capacity of the audit profession and its largest firms to shape global regulatory agendas
and actions is substantial, with some papers emphasising the success that the profession
appears to have had in securing desired outcomes or at least diverting attention away from
critical questioning of contemporary audit practice (Sikka, 2009; Arnold, 2009).
Despite such developments in the literature, Suddaby et al.’s (2007) conclusion
that, even with the growing awareness of the new transnational regulatory institutions, ‘we
have little insight into how this new and dispersed network of actors collectively or
independently interpret and use them’ (p. 357) has a residing pertinence. This paper aims
to enhance knowledge of transnational governance systems ‘in action’, and the particular
involvement of the Big Four accounting firms and their transnational institutional
arrangements, through a longitudinal analysis of the development in EU policy regarding
the limitation of the civil liability of statutory auditors. Auditor liability limitation came
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most vividly to the fore of EU public policy circles in June 2008 when, following decades
of continuing debate, the European Commission issued a Recommendation (European
Commission, 2008a) suggesting that Member States should take action to limit civil
liability of statutory auditors. Such a Recommendation, however, stood in some contrast to
the Commission’s prior, and long held, stance that auditor liability was too difficult and
complex an issue for the Commission to advocate any formal limitation.
Few subjects in the commercial world of accountancy have managed persistently
to arouse such a passionate and heated level of debate as that of auditor liability (Power,
1998; Gwilliam, 2004) – a state of affairs that makes the Commission’s decision to act
quite intriguing. The level of intrigue, though, is further heightened by the fact that the
Commission’s Recommendation has not proved to be an all-embracing solution. Instead,
as the case empirics presented here will reveal, it is an action that symbolises the
continuing problematic nature of auditor liability – with the Recommendation still
allowing a level of diversity in auditor liability regimes that the pursuit of action at the
EU-wide level had been seeking, for many years, to eliminate.
In analysing such an episode in EU regulatory policy development, the paper
serves to confirm that the complex dynamics of transnational governance and associated
interactions extend well beyond the state-profession paradigm – with the European public
policy context revealing a wider, more complex and fluid range of governance actors and
interest representations (Greenwood, 2007). The constraints and obstacles encountered by
the profession in its pursuit of auditor liability limitation at the EU level also question how
effectively the large audit networks can utilise transforming power relations between
nation states, regulators and the profession to ensure that their most prominent policy
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agendas are satisfied (for claims in this regard, see Greenwood et al., 1999; Suddaby et al.,
2007).
The paper is structured as follows. The next section reviews a growing literature on
the transnationalisation of the EU’s governance processes and outlines the European audit
policymaking arena. The third section presents the study’s methodology. The fourth
section contextualises the issue of auditor liability and details the EU’s initial attitudes to
the issue. The fifth, sixth, and seventh sections discuss, respectively, the emerging
imperative, specific workings and rationalisation of the European transnational
policymaking through the prism of the EU’s transforming policy position on the auditor
liability and the need for its limitation. The final two sections explain the significance of
the paper’s findings in terms of enhancing understanding of the nature and dynamics of
transnational governance in action.
2. European transnational governance and audit policymaking
Recent years have seen an emerging scholarly debate about a new type of polity
that stretches beyond the conventional focus on the regulatory pre-eminence of the nation
state (Risse-Kappen, 1995; Knill & Lehmkuhl, 2002; Nölke, 2003; Djelic & SahlinAndersson, 2006a). At the core of this governance mode are deemed to be transnational
relations, namely the “interactions across national boundaries when at least one actor is a
non-state agent or does not operate on behalf of the national government or an
intergovernmental organisation” (Risse-Kappen, 1995, p. 3). These actors, both individual
and collective, converge across fluid national boundaries and “structure themselves,
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connect with others and pursue their interests” (Djelic & Sahlin-Andersson, 2006b, p. 4).
The predominant view is that policymaking accordingly takes place in ‘patchwork
political structures’ (Djelic & Sahlin-Andersson, 2006b, p. 4) of regulatory networks,
wherein constellations of actors seek out the means for influencing policy outcomes at
national, regional and global levels. Within these networks occur complex socialisation
processes, epistemic exchanges, ideas promotion, and interest-driven debates around the
policy issues in question (Nölke, 2003). While retaining a form of national identity,
network participants are held out as creating transnational bodies of interest
representation, stemming from diverse cross-border industrial, corporate, or professional
affiliations.
Djelic and Sahlin (2006b; 2010) provide a view of transnational governance as a
multi-level dynamic regulatory field. They emphasise that transnational actor interactions
‘tend to emerge from complex and multi-nodal processes, where competition combines
with collaboration’, which elevates the importance of negotiation (Djelic & Sahlin, 2010:
179). Characteristic of such multidirectional interactions, however, is their ability to
‘generate and reproduce order behind an appearance of complexity and competition’
(Djelic & Sahlin, 2010, p. 195), and to shape regulatory debates which then, through
formal and/or informal channels of influence, feed into policymaking.
This governance mode virtually diffuses the decision-making authority and places
an increased emphasis on the need for policy actors to rationalise their policy choices as
well as justifying the processes by which these have been determined (Drori & Meyer,
2006; Djelic & Sahlin, 2006; 2010). Reliance on the inputs and inferences of experts has
been increasingly viewed as an instrument of such rationalisation., with the meaning of
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expertise having evolved to emphasize more market dynamics and competitiveness (see
Djelic, 2006; Djelic & Sahlin, 2010). This trend toward ‘marketisation’ has meant that
‘markets are increasingly defined and perceived as the ‘natural’ way to organize’ and to
represent ‘superior arrangements’ (Djelic & Sahlin, 2010, p. 188). Relational exchanges
within transnational policy networks in this regard are seen as one of the key ways of
transferring marketisation across multiple jurisdictions (Djelic, 2006).
The European Union has been put forward as an example of a transnational
regulatory field, in which ‘expert sovereignty tends to prevail over popular sovereignty or
parliamentary sovereignty of Member States’ (Andersen & Burns 1996, p. 229) and where
transnationalism has become a central mode of organization and rationalization of
governance processes (Andersen & Eliassen, 1996; Eberlein & Grande, 2005; Coen, 2007;
Broscheid & Coen, 2007; Greenwood, 2007; Djelic & Sahlin, 2010). The EU’s approach
to ‘the thorny issue of integrating expertise and democracy’ (Radaelli, 1999, p. 770) has
implied a growing reliance in policymaking on the expert inputs of external constituents.
This tendency has been seen as addressing the problem of a democratic deficit stemming
from EU senior politicians’ posts being designated rather than elected through an open
democratic process (Curtin, 2004; Greenwood, 2007). Eberlein and Grande (2005), for
example, talk of networks of external interest groups as soft informal institutions that
‘[…] are composed of experts and representatives of national regulatory bodies,
who come to agreement among themselves, guided or supported by European
bodies. If necessary, they are joined by economic actors or the regulatory
addressees concerned. On an informal basis, these networks develop common ‘best
practice’ rules and procedures for regulation in their sector. […] The most
important demand for this informal harmonisation undoubtedly comes from the
European Commission’ (p. 100, emphasis added).
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The European Commission, together with the European Parliament and the
Council of Ministers, are the EU’s key legislative bodies for framing regulatory agenda as
well as amending or developing new legislation. Since the 1986 Single European Act, the
Commission has experienced an ‘explosive growth of direct interest representation’
(Andersen & Eliassen, 1996, p. 45) (Mazey & Richardson, 1993; Coen, 2007; Broscheid
& Coen, 2007). Besides national representatives, the approach has also been to invite
inputs from external policy constituents, including private entities, industry unions,
professional bodies, and other market actors.
One of the Commission’s central agendas, led by the Internal Market and Services
Directorate General, has been the establishment of the European Single Market. This has
involved the creation of a uniform infrastructure for the functioning of the European
capital market for corporate financing, including harmonised financial accounting and
audit practice (Maijoor et al., 1998; Combarros, 2000; Haller, 2002; Dewing & Russell,
2002; 2008). The growing importance of financial services was also acknowledged in the
Financial Services Action Plan (European Commission, 1999) promoting an integrated
European market for financial services (Van Hulle, 2005). More recently, Green Papers
on auditing and corporate governance (European Commission, 2010a; 2010b; 2011),
issued in response to the financial crisis, continue to demonstrate the Commission’s
commitment to reform in this area.
Such regulatory initiatives and activity represent a fascinating historical arena and
provide a potentially rich, and still relatively untapped, body of empirical material for
exploring transnationalism in action, and particularly, the way in which sources of
influence in the European regulatory arena and related evolutional trajectories are both
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exercised and developed. Our specific empirical focus is on the transformation in the EU
policy with regard to the issue of auditor liability and the need for its limitation. The EU’s
initial stance on this subject was, on the grounds of complexity, to leave it untouched.
However, in just over a decade, the Commission had issued a formal recommendation that
Member States should take action to limit auditor liability (European Commission, 2008a).
This paper explains what drove this change of policy by exploring the history of
engagement among a wide spectrum of interest representations concerned with the
development of EU policy regarding the harmonisation of auditor liability limitation in
Europe. Figure 1 helps to delineate the general arena of European transnational
governance within which actor interactions on the issue of auditor liability limitation have
taken place. The arena is broadly populated by five interest groups, namely: private
professional interests, representatives of European Member States, international standardsetting and regulatory agencies, European discussion forums and advisers, and other
stakeholders.
INSERT FIGURE 1 HERE
3. Methods
Our historical account of the development of European policy debate on auditor
liability limitation over the last two decades (see Table 1 for a summary of key events)
was constructed through reference to a wide range of source material.
INSERT TABLE 1 HERE
We reviewed an extensive set of publications in the professional auditing and
business press covering the issue of audit regulation in general and auditor liability in
10
particular. We also consulted documents prepared by EU institutions and officials, such as
policy drafts, studies, communications, public consultation reports and stakeholder
responses, conference proceedings, meeting minutes, and public pronouncements.
Relevant web resources, including the web-pages of the EU’s key bodies (the European
Commission, the Parliament, and the Council of Ministers), were consulted to assist in the
mapping of a dynamically evolving gathering of policy actors involved in the liability
debate. We also benefited from access to a range of internal documents presented to us by
the members of the international audit firms who, at various points in time, had
represented the audit profession at the European level. These included minutes from
meetings with the European Commission officials, presentations made during those
meetings, relevant correspondence, internal notes, and various other materials detailing
their interactions at the EU level. Also, some valuable additional insights into the audit
community’s representation in the EU governance institutions were sourced from the
archives of the IFAC and a number of European professional bodies/organizations,
including the Fédération des Experts Comptables Européens (FEE), the European Contact
Group (ECG), and the Institute of Chartered Accountants in England and Wales
(ICAEW)1.
The robustness of findings from such documentary analysis was cross-checked
against evidence and opinions emerging from a series of interviews that we subsequently
conducted, in 2009-2010, with nine high-profile individuals – all of whom had held senior
positions of engagement and influence in the EU policy arena with respect to the auditor
liability limitation debate, including representatives of the large audit firms, professional
1
A list of the main abbreviations used in the paper is provided in Appendix A.
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accountancy organisations (such as ICAEW and FEE), European Commission, and the
commercial consultancy firm, London Economics, whose 2006 report (London
Economics, 2006) has been said to have been especially critical in convincing the
Commission as to the merits of auditor liability limitation.
For the purpose of the
historical analysis presented here, the interviews were used primarily to verify factual data
collected from documentary reviews and to assist in our assessments of key policy
standpoints taken by different interest groups.
4. The complexity of the issue of auditor liability at the EU level
The paradox of the external audit function is that while the auditor is appointed by,
and reports to, the shareholders on the financial statements of the audited (client)
company, it is the company’s management who prepare the statements and with whom the
auditor has a direct working relationship. Apart from obligations to the client company, in
some jurisdictions auditors can also be liable to certain third parties that are reasonably
considered to have relied on the audit opinion. Inter alia, those may include corporate
entities, investment institutions, lending organizations, and other stakeholders (Gwilliam,
2004).
The issue of auditor liability, aside from having been highly controversial (Power,
1998), has been made all the more complex by a longstanding disparity between the
public’s and the audit profession’s understandings of the role of the auditor (the infamous
‘audit expectations gap’ – see Humphrey et al., 1992; Porter et al., 2009) and the auditors’
self-portrayal as victims of an ‘unfair’ litigation battle (Talley, 2006; Zubli, 2007; Spence,
12
2009). Recent illustrations of such concerns are the legal cases against the Big Four2 audit
firms brought amidst the current financial crisis, including the $1bn lawsuit against KPMG
for their audit of the failed US subprime lender, New Century (Essen, 2009), and the case
against Ernst & Young following the largest bankruptcy in US history, namely Lehman
Brothers (Inman, 2010).
The legal treatment of auditor liability has changed a number of times over past
decades (Chung et al., 2010). Initially, auditors only assumed liability to contractual
parties (the principle of privity of contract), which usually meant the corporate body being
audited. The 1970s and 1980s saw the substantial extension of liability to the point where
it was asserted that virtually any party who could reasonably be considered to have relied
on an audit opinion could claim damages against auditors arising from negligent
misstatements (Huss, 1991). This was deemed an appropriate mode for disciplining
auditors and also responding to public calls for fairer treatment of ‘innocent’ third parties
(Siliciano, 1988; 1997). In subsequent years, however, these arrangements were
reconsidered in some countries. In Britain, for example, the landmark decision by the
House of Lords in the Caparo litigation case (1990) signified a move back to a more
narrow understanding of the notion of stewardship. It brought the focus back to the
company as a corporate body rather than a collection of interests of individual
shareholders and laid down stricter conditions under which a duty of care could be said to
be owed by auditors. That said, it has been argued that this period of relative calm was
The four largest international accounting firms, often referred to as the “Big Four”, include
PricewaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu, and Ernst & Young. These firms carry out the
vast majority of audits of listed companies worldwide and have long maintained the position of the global
audit market leaders. When coupled with Grant Thornton and BDO, the common reference for such a group
of firms is the “Big Four plus Two”. In the paper, when we use the term ‘large international accounting
firms’, we are generally referring to the ‘Big Four plus Two’. In the context of EU auditor liability reform,
these firms have played a major part in advocating the profession’s case for liability limitation.
2
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followed by a claimed gradual return to the expansion of privity by the British courts
accompanied, in turn, by increasing litigation levels against auditors (Napier, 1998).
The EU’s Eighth Company Law Directive on statutory audit (84/253/EEC) issued
in 1984, while establishing a general framework for its delivery, did not specifically refer
to auditors’ legal responsibilities or to the circumstances under which auditors could be
held liable; merely stating that it was up to individual Member States to determine
appropriate liability arrangements. As a result, traditionally, there has been significant
variation in the legal arrangements vis-à-vis auditor liability adapted by the EU Member
States, both in terms of the range of parties capable of claiming damages against auditors
and the scope of those claims (Directorate General for Internal Market and Services, 2006)
3
. In Member States placing an emphasis on the role of auditors as public servants and the
social meaning of audit practice (e.g. France), statute law made auditors liable not merely
to the client company’s officers but also to shareholders and other (third) parties. In other
Member States (such as Germany and Spain), auditors owed a duty of care mainly to the
client company, including its shareholders.
With regards to the scope of auditor liability, most Member States followed the
principle of joint-and-several liability which implies that any individual defendant can be
required to pay for the whole amount of damages, regardless of the degree of
responsibility of other parties. In Member States with a limited liability regime for
auditors, the limitation mechanisms were either in the form of a financial cap on the level
of possible liability claims (as in the case of Austria, Belgium, Germany, Greece, and
3
The presented details of the national liability regimes relate to the time preceding the issuance of the 2008
Recommendation by the EC.
14
Slovenia)4, through a system of proportionate liability whereby auditors are liable only for
the damages caused directly as a result of their negligent behavior (as in Spain), or by
allowing auditors to establish limited liability entities5.
In the virtual absence of a uniform European policy with respect to auditor
liability, European bodies closely associated with the audit profession were among the first
to voice concerns about such a position and the scope allowed for variation in auditor
liability regimes. Specifically, FEE (1992) in its representative role for the European
accountancy profession, noted that significant differences in EU countries’ liability
regimes were unacceptable, as was the situation ‘whereby the auditor can be asked to bear
the total loss suffered by a litigation with no contribution or sharing by the other parties
involved’ (p. 11). It recommended the replacement of the joint-and-several liability
principle with a system of proportionate liability that would allow courts to apportion
claims against auditors in proportion to the degree of their culpability. Interestingly, these
assumptions were echoed three years later by IFAC in a report presenting the results of an
opinion survey of its member bodies (IFAC, 1995). International audit firms themselves
4
The cap could be stipulated in the civil law or set out in the contract between the auditor and the client and
take the form of an absolute monetary limit or a fixed percentage of the audit fee. For example, in Greece,
the liability cap was linked to the salary of the President of the Supreme Court. In Belgium and Austria, the
law stipulated the cap with respect to claims by third parties, whereas German commercial law only capped
claims by the client (although, in certain cases, the courts could decide to extend liability, and consequently
the cap, to third parties) (Gietzmann & Quick, 1998).
5
In Britain, for example, KPMG was the first audit firm that, in 1995, chose to incorporate and form what
became known as KPMG Audit Plc. During the same period, Price Waterhouse (which later became part of
PricewaterhouseCoopers) and Ernst & Young launched a lobby campaign to push for legislation that would
allow British auditors, like their colleagues in the U.S., to form Limited Liability Partnerships (LLPs), with
the intent that it would offer a greater protection to the audit firms’ individual partners and their personal
assets (Sikka, 2008). In 2001, Ernst & Young was the first Big audit firm to register as an LLP, after relevant
provisions had been introduced by the British government in its LLP Act, 2000. More recently, changes to
the Companies Act, 2006, allowed shareholders of the audited company to agree to limit auditor liability by
contract to a level determined by the court in proportion to the extent of auditor’s responsibility for the
damages incurred (Turley, 2008).
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were also pointing explicitly to an ‘epidemic of litigation’ (Arthur Andersen & Co. et al.,
1992, p. 1). They argued that stakeholders were increasingly relying on auditors’ ‘deep
pockets’, regardless of the relative degree of their culpability, and that claims against them
were disproportionate both to their wealth and the audit fees received from their clients
(Lochner, 1993).
It was not until the mid-1990s that tangible evidence began to emerge of a growing
debate within EU governance institutions about concerns over the divergent liability
arrangements across Member States and the need for harmonisation. In 1996, for example,
the Commission initiated an independent study (Buijink et al., 1996) which concluded that
the differences in the national liability regimes were likely to have an adverse effect on the
development of the European audit market6. The study was followed, in June 1996, by a
European Commission (1996a) Green Paper to foster further debate. The Green Paper
acknowledged the claim that liability had become a principal issue for the audit
profession, noting that some harsh national liability regimes may indeed deter audit firms
from taking on high-risk clients, increase audit fees, and ultimately lead to higher audit
market concentration as a result of a debacle of some smaller audit firms with insufficient
financial resources to withstand possible litigation. It was also noted that ‘the liability of
the auditor should be limited to amounts which reflect his degree of negligence’ (European
Commission, 1996a, art. 5.6). Despite the Green Paper acknowledging the auditing
profession’s claims that the liability issue needed to be considered at an EU level, it,
6
The United Nations Conference on Trade and Development (UNCTAD), through the framework of the
annual meeting of its Intergovernmental Working Group of Experts on International Standards of
Accounting and Reporting (ISAR) also held, in March 1996, a one-day Forum on the Responsibilities and
Liabilities of Accountants and Auditors. See
http://www.unctad.org/templates/webflyer.asp?docid=3644&intItemID=2298&lang=1
16
nonetheless, suggested that the capacity for any policy action should rest with Member
States and not with the EU institutions:
Action at EU level in this field is likely to be difficult. The audit profession is not
the only profession which is struggling with problems of liability. Furthermore, the
legal traditions in Member States in the area of civil liability are quite different.
(European Commission 1996a, art. 5.7)
In December 1996, the Commission launched a consultation on the Green Paper in
the form of a conference with participants representing the Members States’ audit
regulatory bodies, users of audit reports (such as the corporate sector, investment
organizations, banks, and insurance companies), the academic community, national and
regional professional accountancy associations, and audit firms themselves (European
Commission, 1996b). This event provided a platform for a wide variety of national
and transnational interest groups (Risse-Kappen, 1995; Knill & Lehmkuhl, 2002) to
express their views on the issue of auditor liability limitation. This encounter duly
demonstrated the scale of divergence in opinion between actor groups, stemming primarily
from the distinctive features of the professional and national identities that they carried
and represented.
While major audit firms and associated professional representative
bodies (e.g. FEE) advocated a limitation of liability, other groups (specifically those
representing the users of audit services) were of the opinion that such limitation would
lead to inferior audit quality. In his overview of the collected comments on the Green
Paper, Karel Van Hulle (at that time, Head of the Commission’s Financial Information
Unit) stated:
The commentators from the accounting profession regret the absence of a clear
message in the Green Paper that a limitation of liability should be organised at
EU level. Most other respondents think that there is no justification for
17
reducing the professional liability of auditors as opposed to other professionals.
(European Commission, 1996b, p. 30)
5. A slowly emerging regulatory imperative
Despite the lack of action on auditor liability reform, it was becoming increasingly
apparent that auditing regulation had become one of the Commission’s policy priorities
(European Commission, 1998b). This emergent policy focus stimulated the Commission’s
establishment, in 1998, of a Committee of Auditing – with the intent of providing a
platform for interactive exchanges across European and international regulatory arenas
(involving, for example, the Commission’s officials, the Members States’ competent
regulatory bodies and international audit standard setters) and with providers of audit
expertise (such as large international audit firms and professional institutes). Such a
structure matched closely with the EU’s governance traditions in terms of seeking to
respect the principle of transparency in policymaking and ensure representation from
multiple players with specialized technical expertise and insights (Andersen & Eliassen,
1996; Eberlein & Grande, 2005; Greenwood, 2007).
At this stage, the primary focus of regulatory concern was on the differences in
national liability regimes and whether these presented a threat to the functioning of a
European Single Market. The Commission committed to the investigation of extant
national auditor liability practices (European Commission, 1998a: paragraphs 3.14-3.15),
leading to the publication, in January 2001, of a comparative study of fifteen Member
States (Thieffry & Associates, 2001). Although acknowledging significant differences
between countries, the study effectively disregarded the views of the profession and
18
aforementioned reports by FEE (1992) and IFAC (1995) – and, instead, lent support to the
Commission’s argument about national complexity, derived from the basic features of
countries’ legal regimes, as being an overwhelming obstacle to convergence. Events in
subsequent years arguably contributed to a change in regulatory sentiment at the European
level. In 2001-2002, the demise of the U.S. energy giant, Enron, brought with it the
collapse of Enron’s auditor Arthur Andersen, one of the then Big Five audit firms. The
post-Enron global economic and market realities, with its vivid demonstration of the
litigation risk faced by audit firms, provided a powerful reference point for the advocates
of limited liability (Talley, 2006).
It crucially contributed to further transnational
consolidation around the liability issue, with the profession presenting themselves as
victims of an inequitable litigation threat.
In particular, by emphasising their roles as the primary suppliers of audit expertise
and recipients of audit regulation, the large international audit firms gained visible access
to the key institutions of the EU’s system of transnational governance and, with time,
became crucial players in this system (Andersen & Eliassen, 1996; Djelic & Sahlin, 2010).
The European Contact Group (ECG), set up in Brussels in 1993, played a significant part
in the pursuit of such interests by acting as a European representative for the ‘Big Four
plus Two’ audit firms and coordinating their uniform policy position7.
In this capacity, the ECG took part in the meetings of the aforementioned
European Committee on Auditing. Two of the Committee meetings, in 2001 and 2002,
were instrumental in terms of putting the auditor liability issue on the Committee’s
agenda. At the Committee’s meeting in Paris in 2001, Richard Murray (a UK-based Big
7
For more information on the ECG, see http://www.europeancontactgroup.eu/index.php.
19
Four partner) pointed out that excessive auditor liability was unhealthy and that capital
markets would suffer as a result because auditors were made to bear most of the risk while
a company’s management enjoyed significant entrepreneurial rewards with low risk
attached. Alongside Murray, a second presentation at that meeting was made by Richard
Fleck8, of the UK-based law practice Herbert Smith. Fleck reviewed the developments in
company law in Britain to make a case for the need to limit existing levels of auditors’
liability exposure. In his presentation at the Committee meeting a year later, amidst the
final stages of Arthur Andersen’s collapse, Fleck forcefully argued that the unfolding
events were vivid reminders of how ‘theory […] [could] become a reality’. The minutes
from this Committee meeting (European Commission, 2002b), however, reveal a variety
of opinions on the issue of liability limitation among the participants. The representative
from Germany, for example, agreed that the Commission needed to address the liability
issue, but pointed out that achieving harmonisation would be problematic due to
significant differences among the Member States. The French representative remained
more cautious, arguing that Fleck’s analysis omitted ‘a necessary element of self-criticism
of the profession by the profession’ and adding that ‘if the large firms want to convince
EU regulators that there is a problem, they should put all the facts on the table’. The
meeting’s key outcome was a decision to include a reference to auditor liability in the
Commission’s forthcoming Communication on the statutory audit priorities in Europe in
the post-Enron era.
Despite this commitment, the personal views of some senior Commission officials
were clearly still quite sceptical over the possibility of regulatory intervention. Frits
8
Richard Fleck subsequently became the Chair of the UK’s Auditing Practices Board (APB).
20
Bolkestein (at that time a European Commissioner for the Internal Market and Taxation),
for instance, asserted at a conference at the London Underwriting Centre in March 2003:
[...] in the current economic climate, I think there would be little support for a
regulatory intervention which would generally limit auditor liability. After so many
major financial reporting scandals and potential audit failures, regulators need to act
to restore investor confidence. An intervention limiting liability, to my mind, would
not serve to revive the trust of investors (Bolkestein 2003).
In his speech, Bolkestein provided what he saw as four reasons for not limiting
liability. First, he reiterated the Commission’s longstanding stance that unlimited liability
is a driver of audit quality, adding that liability systems exist for the protection of those
who suffered damage (claimants) and not for the convenience of those who may be at
fault. Secondly, he saw the aforementioned ‘deep pocket’ approach as being principally
sound as it meant that the claimants ‘should not have to shoulder the burden of suing
separately all parties which have a partial responsibility for proper financial statements’,
noting that the concept of joint-and-several liability was adequate. Thirdly, he saw
increased auditor liability as being a self-created problem for the audit profession, in that
the (global) expansion of audit firm networks had significantly increased the risk that an
audit failure of one local member may damage the whole network. Finally, Bolkestein
reasoned that audit, by its very nature, is a function carried out in the public interest and
that third parties should be in a position to claim damages in case of fraudulent financial
reporting. He demanded greater clarity on the scale of claims against auditors, asserting
that many cases been too easily settled out of court. Crucially, though, Bolkestein admitted
that a change in the negative market sentiment towards auditors could potentially revive
the liability debate, and that, in principle, the Commission could consider updating
21
existing EU law, such as the EU’s Eighth Company Law Directive on auditing
(Bolkestein, 2003).
The above statements by Bolkestein on the impossibility of achieving a
harmonised approach to auditor liability limitation in the EU are particularly interesting.
They contrast quite markedly with his views on another harmonisation agenda, i.e. that of
international accounting standardisation, and what he saw as a long-awaited decision by
the EU to introduce a requirement that, by 2005, consolidated accounts of listed
companies needed to comply with International Accounting Standards and related changes
in the EU’s accounting Directives. On this issue, he argued that the decision would ‘put
an end to an existing ‘Tower of Babel’ position with respect to financial reporting,
improve competition and transparency’ (European Commission, 2001). He also added
that corporate scandals like Enron serve to demonstrate the importance of such reform
‘even more strongly’ (Bolkestein’s public address from 2002 quoted in European
Commission (2004)). These statements vividly reveal that, inside the European regulatory
circles of that time, the issue of harmonised financial reporting was not associated with
that of a harmonised approach to the liability of those required to attest to the truth and
fairness of such reporting. They also demonstrate that the consequences of the Enron
collapse were capable of being used to justify two quite opposite policy positions on the
part of the Commission – one actively pursuing harmonisation, the other resisting it.
In May 2003, the Commission issued a Communication (European Commission,
2003) which identified a number of targets for a European reform of audit legislation in
the post-Enron era, including a planned revision of the Eighth Company Law Directive
and the formation of an Audit Regulatory Committee to oversee its implementation. With
22
respect to the issue of audit liability, the Communication, despite the calls for reform from
the audit profession, stated that neither harmonisation nor the limiting of auditor liability
were necessary. However, it did acknowledge that there was a need ‘to examine the
broader economic impact of present liability regimes’ (European Commission 2003,
paragraph 3.10). While there was still a substantial level of disagreement between various
stakeholder groups as to how to address/resolve the liability problem, this
acknowledgement was the first sign of a shift in the Commission’s policy stance – from a
reliance on strategies of coordination and relative non-interference to a more direct
‘hands-on’ approach to audit regulation and the contemplating of legislative action at the
EU level.
6. Working transnational governance
representation of professional interests
processes
–
the
direct
The reliance of the EU’s participatory democracy on direct interest representation
has made EU governance institutions open to external attempts to influence policy (Mazey
& Richardson, 1993; Coen, 2007; Broscheid & Coen, 2007), with increasingly organised
types of lobbying (Anderssen & Eliassen, 1996; Greenwood, 2007; Directorate General
for Internal Policies of the Union; 2007; Coen & Richardson, 2009). The process of
revising the Eighth Company Law Directive on auditing duly provided a clear opportunity
for transnational, and specifically pro-profession, players to influence other levels of the
European transnational governance arena, including the European Parliament.
The ECG was at the forefront of this strategic pursuit by the audit profession
(Chapman, 2004a). In 2004-2005, the ECG representatives, led by Jeremy Jennings, ECG
23
Chair and an Ernst & Young partner based in Brussels, held talks with several senior
MEPs. The primary focus of the discussions, also pushed forward in relevant
pronouncements by FEE (2004), was on the ECG’s proposal that the revised Eighth
Directive should contain a requirement that Member States introduce a form of limitation
of auditor liability - to counterbalance what was seen as a potentially substantial expansion
of auditors’ duties in the new text of the Directive.
The documents obtained from the ECG indicate that, in addition to interacting with
the European Parliament, the Group was also leading talks with individual Member States,
which were duly demonstrating that national differences in viewpoints on the need for
liability reform remained strong. Countries with existing regimes of limited liability or
those contemplating it, such as Austria, Greece, and Spain, reacted favorably to the ECG’s
concerns. There were also a number of countries, including Belgium, Denmark,
Luxembourg and the Netherlands, who felt that it was neither appropriate nor achievable
for audit liability reform to be addressed in the revised Eighth Directive, but still supported
further debate and a European study on the issue. The UK and Ireland both called for
further investigation of the impact of existing liability regimes on the audit profession as a
way to assess better the need for, and direction of, possible regulatory intervention by the
EU. Finally, there were those countries, particularly France, who opposed the need for
liability reform in principle and demonstrated a clear reluctance to revise their existing
national practices.
Meetings with MEPs, on the other hand, revealed generally favourable views on
the audit profession’s concerns. A German MEP, Wolf Klinz (a Draftsman for the Eighth
Directive), advocated a €25 million cap on liability as a way to avoid ‘a situation where a
24
liability case could ruin whole firms’ (Chapman, 2004b). Another advocate of liability
limitation was a Dutch MEP, Bert Doorn, who was leading the issue in the JURI
Committee (Chapman, 2004b) and also acting as a Rapporteur for the Eighth Directive.
During the meetings with MEPs, the ECG submitted its version of the amendment to the
Eighth Directive regarding the issue of auditor liability for consideration by the European
Parliament. The amendment (No. 135) read as follows:
1. The Member States shall ensure that the effect of prevailing law does not place
an unlimited financial liability burden on statutory auditors and audit firms.
2. The Member States may opt to address this by one or a combination of the
following:
(a) require any liability to be allocated between the responsible parties on a basis
proportionate to their culpability,
(b) permit statutory auditors and audit firms to limit their liability on a contractual
basis
(c) limit by law the amount of compensation for financial loss for which statutory
auditors and audit firms may be liable.
In February 2005, all proposed amendments, including the one submitted by the
ECG, were presented by Wolf Klinz to the ECON Committee (European Parliament,
2005a) and later, incorporated in the final report on the new text of the revised Eighth
Directive prepared by the JURI Committee (JURI, 2005). Bert Doorn presented the report
to the European Parliament in July 2005, together with opinions of the relevant
Parliamentary Committees. In this report, the final text of the amendment regarding
auditor liability read as follows:
The Commission shall before the end of 2006 present a report on the impact of the
current national liability rules for carrying out statutory audits on the European
capital markets and on the insurance conditions for statutory auditors and audit
firms, including an analysis of the limitations of financial liability. The Commission
shall, where appropriate, carry out public consultation. In the light of that report, the
Commission shall, if it considers it appropriate, submit recommendations to the
Member States (JURI, 2005, p. 47).
25
Thus, the final text of the amendment was notably different from that initially proposed by
the ECG in that it did not contain any requirement for Member States to limit auditors’
liability. However, it did mean that the Commission was now statutorily committed to
conducting a study on the impact of the Members States’ liability practices.
Importantly, the JURI Committee’s report also stated that the final text of the
amendment was a result of ‘the compromise as agreed during the informal trilogue’
[between the European Parliament, the Commission and the Council of Ministers]. This
note provides an explanation as to why the auditing profession’s attempt to secure EUwide liability limitation was unsuccessful. In short, strong opposition from some Member
States made it problematic for the original amendment 135 to receive approval in the EU’s
two principal legislative chambers - the European Parliament and the Council of Ministers
– as these both relied on the unanimous vote of Member States. Nevertheless, the fact that
the final version of the amendment referred to the possibility of a recommendation by the
Commission on the subject of liability is evidence of some form of political compromise
between involved parties and an expectation of further policy debate. Such expectations
were heightened with the appointment, in November 2004, of Charlie McCreevy as the
European Commissioner for Internal Market and Services (replacing Frits Bolkestein).
Arguably, McCreevy’s personal professional experience as a Chartered Accountant in
Ireland contributed to him becoming sympathetic to the audit firms’ argument that the
Member States’ existing liability regimes were unfair. McCreevy asserted, fairly early
during his period of office, that ‘(P)ersonally I make no secret I have been in favour of
having some cap on auditor liability for as long as I’ve been a Chartered Accountant’
(McGinley, 2005).
26
7. Reinforcing the case for change through ‘expert’ influence
The revised Eighth Company Law Directive on Statutory Audits of Annual
Accounts and Consolidated Accounts (2006/43/EC) was officially issued in May 2006
(European Commission, 2006). In response to article 30a of the Directive which stated that
the Commission should ‘present a report on the impact of the current national liability’, it
duly appointed a UK consultancy firm London Economics to undertake a study into the
issue. The process was administered by the Auditing Unit within the Commission’s
Internal Market and Services Directorate General. The study’s findings and inferences
were to prove influential in the subsequent issuance by the EC of its 2008
Recommendation on auditor liability.
In considering the distinctive features of European transnational governance
processes, Djelic and Sahlin (2010) emphasised the blurring of responsibilities that can
occur when the leadership of regulatory debate rests among both formal EU institutions
and stakeholder groups affected by specific EU policy considerations and proposals. In
many respects, both the prior discussion of the active involvement of audit firms in the
EU’s policy formulation on audit liability limitation and the subsequent engagement of
London Economics are indicative of such processes being at work. The Commission has
introduced a variety of discussion forums, groups, and committees over the years with the
aim of developing a shared view on different policy issues (Andersen & Eliassen, 1996;
Andersen & Burns, 1996; Nugent, 2001; Schmidt, 2004; Greenwood, 2007). A particular
intent has been to draw, wherever possible, on informed experts in order to rationalise and
justify any resulting outcomes (Nugent, 2001; Schmidt, 2004) and to make a greater use of
the outputs of commercial consultancies (Radaelli, 1999; Lahusen, 2002). The London
27
Economics study fitted such aims and intentions, with its report subsequently drawing on a
wide spectrum of sources ranging from documentary/literature reviews to surveys of audit
firms, client companies, institutional investors, insurers, and other stakeholders from all of
the EU’s twenty-seven Member States.
A key liaison role was played by the European Auditor Liability Forum, set up by
the Commission in 2005 as a discussion arena for members of the regulatory, professional
and investment communities. According to Commissioner McCreevy, the time was (now)
‘ripe for EU-wide action [on liability]. The forum’s market experts will help us to analyse
all the issues’ (European Commission, 2005, p. 1). Comprising the Forum were twenty
audit market experts, representing both providers and consumers of audit services. The
audit profession was represented by seven members of the audit firms (the European
branches of the ‘Big Four plus Two’ firms as well as the ECG Chairman) and members of
two professional accountancy bodies (ICAEW and FEE). Other Forum participants
included two members of the associations of large businesses from France and Italy, two
representatives of the insurance industry (including Comité Européen des Assurances - the
European Insurance and Reinsurance Federation), two representatives of the banking
sector and three of the insurance sector, two UK-based investment organizations, and two
academics from the Universities of Bonn and Bologna.
A particularly significant contribution by the Forum to the London Economic’s
project was formulated at its first meeting when it was decided that it was critical to
understand ‘the background of litigation risks affecting firms and networks as a whole’
(European Forum on Auditor Liability, 2005, p. 2). This involved the collection of
‘concrete empirical evidence’ of the economic impact of auditor liability, and specifically,
28
gaining (unprecedented) access to the highly confidential and previously inaccessible data
on the legal claims against audit firms in the EU and United States, including details of
how these cases had been resolved. The voluntary provision of such data by the audit
firms was strategically designed to tackle the skeptics of limited liability who, as we
mentioned earlier, had questioned the severity of claimed litigation against auditors. The
ECG played a key part in facilitating access to this information, which in turn formed an
important part of the final project report by London Economics. Interestingly, due to its
high sensitivity, the information was not shared among the audit firms themselves but
collected by an independent party - AON Professional Risks (an international insurance
broker). Another task of the Forum was to review interim and final drafts of the London
Economic’s project report, which provided the opportunity for various members of the
Forum to influence the project’s focus and methods used. Some participants, for instance,
expressed their concerns over a lack of input provided by the investment community, and
so London Economics was advised to conduct further interviews and meetings to enhance
the contribution from such parties.
The final project report by London Economics (2006) concluded that the market
for international audits was highly concentrated and effectively controlled by the ‘Big
Four’ audit firm networks. Furthermore, such concentration was seen to be exacerbated by
the growing gap between the value of legal claims against auditors and available insurance
cover - which was ‘less than 5% of some of the mega-claims currently outstanding against
some of the Big Four firms’ (p. 99), leaving smaller audit firms unable to cover the
remaining amount claimed from their personal wealth. It was argued in the London
Economics report that unlimited auditor liability combined with only limited availability
29
of liability insurance left auditors unprotected against the ‘catastrophic’ consequences of
growing litigation, increasing the likelihood of another large audit firm failure (similar to
that of Arthur Andersen), and even endangering the effective functioning of the broader
economy:
A failure of one of the Big Four networks may result in a significant reduction in
large company statutory audit capacity if partners and other senior staff at the failed
firm, the remaining Big Three firms, and possibly even some mid-tier firms, were to
decide that auditing is a too risky activity and therefore shift to other business lines.
This would obviously create very serious problems for companies whose financial
statements need to be audited. In such circumstances, a major increase in the price
of statutory audits would be required to restore the equilibrium between demand for
and supply of statutory audit services. (London Economics, 2006, p. 134)
In concluding, the report claimed that limiting auditor liability would tackle the
adverse effects of auditors’ extensive litigation exposure by, inter alia, reducing
concentration in the audit market, helping to ease staffing pressure on audit firms, and
ultimately, preventing another major audit firm failure (London Economics, 2006, p. 177).
That said, a ‘one-size-fit-all’ approach (i.e. the imposition of a single liability
arrangement) was deemed unhelpful in terms of adequately catering for the variety of legal
environments and audit firm characteristics in the Member States (p. 188).
The publication of the report triggered several important developments. In January
2007, the Commission launched a public consultation aimed at collecting opinions from
various stakeholder groups on the need for a European reform of auditor liability,
including introducing a form of limited liability. The consultation document (Directorate
General for Internal Market and Services, 2007a) contained numerous references to the
findings of the London Economics report in order to justify why ‘[w]hilst the issues raised
[in relation to the liability reform] are certainly difficult and controversial, they deserve to
30
be addressed’ (Directorate General for Internal Market and Services, 2007a, p. 14). The
public consultation process allowed a wide range of transnational interests concerned with
the liability issue to voice their opinions. Analysis of all 85 responses to the consultation
from these actors (Directorate General for Internal Market and Services, 2007b)
demonstrated a clear correlation between views on liability reform and respondents’
professional and national affiliations. The strongest reform proponents were the audit
industry. The Big Six audit firms attacked the claim that limited liability would lead to
inferior audit quality. They also sought to make clear connections between the issue of
liability limitation and the viability of the audit market and emphasised that public
oversight of the audit profession was a potentially more discriminating tool for enhancing
audit quality than unlimited liability:
BDO International therefore sees the consultation as an opportunity for the
Commission to bring forward solutions which address contemporaneously the
‘catastrophic claims’ possibility, the ‘deep pocket syndrome’ and the
‘concentration/choice’ issue. (BDO, 2007)
We believe that in contrast to unfettered litigation, other recent moves to increase
the consistency of high quality auditing, many of which have been driven by the
Directive on Statutory Audit, such as independent public oversight incorporating
inspection, investigation and discipline, are more reliable drivers of audit quality.
(Grant Thornton, 2007)
With respect to the methods of limitation, the Big Six overwhelmingly and
unanimously supported introducing a liability cap:
[...] the independent study commissioned by the European Commission from
London Economics on the Economic Impact of Auditors’ Liability Regimes, which
forms a sound basis for political decisions, reported that there was no evidence that
unlimited liability promotes audit quality. (Grant Thornton, 2007)
31
The current experience with liability caps in Germany as well as academic research
demonstrates that limitations on audit liability do not adversely affect audit quality;
on the contrary, we believe a limitation can have a positive effect. (KPMG, 2007)
However, there were still points where the Big Six firms had divergent views. For
instance, while not disputing the need for auditor liability limitation, there was far less
consensus between large (Big Four) and mid-tier (BDO and Grant Thornton) firms on the
question of what size of the liability cap was most appropriate. Jeremy Newman, at that
time the BDO managing partner in the UK argued in a journal interview that the Big Four
firms would be the main beneficiaries of a high liability cap and that the mid-tier firms
would have been ‘crushed by the Big [Four] firms’ (Hawkes, 2008).
It is also worth noting that those respondents who opposed liability reform were
generally from countries with unlimited liability regimes. Their arguments centred around
the claim that the risk of auditor failure was intently associated with a loss of reputation
and not with liability exposure - and that limiting liability would impair auditors’ incentive
to achieve quality (Directorate General for Internal Market and Services, 2007b, p. 8).
Representatives of primary users of audit services, from the insurance, investment, and
banking sectors, stood in particularly strong opposition to the prospect of liability
limitation (Directorate General for Internal Market and Services, 2007b, p. 13). While
accepting the need to address the problem of audit market concentration, they opposed
liability limitation as a way to achieve it, and instead, emphasised the importance of better
auditing standards and corporate governance. Specifically, they claimed that ‘[i]f there
were a real and widely accepted need for a cap on liability all Member States would have
already introduced one at national level’ (Association of British Insurers, 2007, p. 1). It
32
was also argued that the Commission should have consulted with audit services users
before launching a consultation because ‘[t]his would have identified whether such a
Working Paper was necessary in the first place’ (Committee of European Banking
Supervisors, 2007, p. 1). Peter Montagnon, Director of Investment Affairs at the
Association of British Insurers, asserted in an article in the Financial Times (6 June, 2008)
that, while liability limitation would clearly offer auditors greater protection against
litigation, the benefits of this to investors were somewhat less evident.
Despite such criticisms, the findings of the London Economics report (and the
public comments made by proponents of liability limitation during the consultation) were
used by the Commission’s officials to justify the need for liability reform. For instance, in
responding to the results of the study in an address at a FEE Conference in October 2006,
Commissioner McCreevy emphasised that ‘[the results] underline a concern I have had for
some time: there is an increasing trend for litigation against auditors, while at the same
time international audit networks are faced with a lack of available commercial insurance.
Therefore, there is a real risk that at some point one of the ‘Big 4’ auditing firms might be
faced with a claim that would threaten its existence. Auditing is not just any industry, but
one that plays a pivotal role in our capital markets. Were the Big 4 to turn into the Big 3,
or even worse, into the Big 2, capital markets at large could face very serious
consequences. Companies would have difficulties obtaining audits, investor confidence
could be undermined and trust in markets might be weakened generally.’ (cited in Lambe
(2007)).
In a subsequent speech to the European Parliament’s Committee on Legal Affairs
(European Parliament, 2007), Commissioner McCreevy characterised auditor liability as
33
one of the six key elements in his so called ‘audit package’ of policy measures seeking to
implement the revised Eighth Directive. He emphasised the direct connection between
unlimited liability and the lack of choice in the audit market:
So why is this [audit] market so concentrated? Well mainly because of the principle
of unlimited, joint-and-several liability which is characteristic for the auditing
profession. This is exacerbated by the fact that auditors are unable to obtain
sufficient insurance cover. […] That is why in the first quarter of 2008 I intend to
put forward a Recommendation to Member States asking them to limit auditor
liability.” (European Parliament, 2007, p. 2)
The evident importance placed on the assessment of the European audit market and
the liability risks faced by audit firms in the London Economics (2006) report looks
particularly intriguing in light of the fact that, almost a decade earlier, the same
consultancy firm presented a report for IFAC (London Economics, 1998) which, likewise,
made the case for audit liability limitation. This earlier report, however, had very little
impact in European audit regulatory circles, even though its recommendations and main
conclusions were very similar to the subsequent 2006 London Economics report. The
absence of any documentary evidence as to the relative lack of influence of the earlier
London Economics report led us explicitly to discuss this matter with a number of the
interviewees.
Various reasons were provided for the differential levels of impact. One suggested
explanation was that IFAC, in the late 1990s would have been seen more as global
representative of the audit profession (than a public interested association housing several,
independent, international standard setting boards as is typically claimed today). The
earlier London Economics report, on this basis, could have been seen to be less impartial
than the subsequent study commissioned by the European Commission. Another reason
34
was that in preparing the second study, London Economics had been able to secure much
more comprehensive and persuasive supporting data regarding the scale of the claims
faced by the large international audit firms. Such data meant that discussions on liability
limitation were not being discussed in the abstract or the hypothetical – but were being
supported by hard facts and figures. In line with this form of reasoning, was the additional
suggestion that the 2006 report had been issued post-Enron, which with the dramatic
demise of Arthur Andersen had enabled people to realise that the legal liability threat for
auditors was certainly for ‘real’ and capable of having dramatic consequences. The lack
of archival discussion relating to the 1998 report makes it difficult to evaluate the
respective strength of such arguments and suggestions but collectively they do serve to
bolster Power’s (1998) claim that auditor liability has to be understood ‘not just as an
abstract problem of designing efficient incentive structures but also as the product of
social and institutional forces’ (p. 79).
8. The public policy challenge of accommodating the national in the
transnational
The significance of contextual factors and forces is also evident in the form of the
Recommendation on auditor liability limitation promised by Commissioner McCreevy and
duly issued by the European Commission in June 2008.
Formally known as “The
Recommendation Concerning the Limitation of the Civil Liability of Statutory Auditors
and Audit Firms” (2008/473/EC), it classified unlimited liability as a serious impediment
to audit market competition and the effective functioning of the European capital market:
Smooth functioning of capital markets requires sustainable audit capacity and a
competitive market for audit services in which there is a sufficient choice of audit
firms capable of conducting and willing to conduct statutory audits of companies
35
the securities of which are admitted to trading on a regulated market of a Member
State. However, increasing volatility in market capitalisation of companies has led
to much higher liability risks, whilst access to insurance coverage against the risks
associated with such audits has become increasingly limited. (European
Commission, 2008a, p. 1)
The Commission recommended that auditor liability ‘be limited except in cases of
intentional breach of duties by the statutory auditor or the audit firm’ (European
Commission, 2008a, p. 1), proposing three methods of doing so, namely: a cap on
liability, proportionate liability, or limitation by contract (between the client and an
auditor). In his above noted speech to the European Parliament’s Committee on Legal
Affairs (European Parliament, 2007), Commissioner McCreevy had stated that he did not
intend to impose the means by which liability is limited across Member States. According
to McCreevy, this “will be for each Member State to decide. Existing solutions such as a
liability cap, proportionate liability or indeed a contractual arrangement between the
auditor and the audited firm would all seem adequate means to deal with this issue”
(European Parliament 2007: 2). This was the approach duly advocated in the formal
Recommendation, providing considerable flexibility in terms of enforcement strategies. In
this respect, the regulatory impact assessment document which accompanied the
Recommendation (European Commission, 2008b) stated that ‘every Member State would
be invited to introduce a liability limitation, taking into account their own systems and
circumstances’ (p. 32-33).
For the Commission to have issued a Recommendation on the subject of auditor
liability limitation could suggest that private, pro-professional interests had secured a
victory in their battle for reform. However, with a desired reforming intent on the part of
the profession to achieve a uniform treatment of auditor liability across all Member States,
36
such a conclusion is overstated. Indeed, as our analysis has shown, the audit profession’s
initial ambition was to secure amendments on liability limitation in the revised European
Eighth Directive on auditing which came out in 2006. If adopted, this would have had a
binding effect on all Member States. The Recommendation, on the other hand, was less
exacting and imposed no legal obligation for it to be followed. Endorsement of the above
amendments in the revised Directive would have required a unanimous agreement by all
Member States when the Directive passed through the Europe’s principal legislators – the
European Council of Ministers. However, the general scepticism about the likelihood of
some Member States supporting the agreement meant that the idea of introducing such
amendments was abandoned. In essence, the Recommendation represented a compromise
decision. Furthermore, the fact that it provided flexibility for Member States to choose the
appropriate method of limiting liability effectively transferred the real capacity for steering
the direction of regulatory reform from the transnational back to the national level. So
rather than solving the problem of European diversity of liability regimes that it claimed
was the primary motive for action, the European Commission arguably has rather sidestepped the issue and transferred its resolution back to the individual governments of
Member States (also, see Ojo, 2009).
This state of affairs raises some interesting implications. At one level, it is noted
that over recent years a growing literature in auditing regulation has highlighted the
significance of the profession’s lobbying activities and the transnational scale of reach
enjoyed by the large audit firms/networks (see Suddaby et al., 2007; Thornburg &
Roberts, 2008). However, studying the profession’s engagement with the subject and the
nature of its (still, on-going) interactions with a variety of transnational actors concerned
37
with auditor liability limitation at the European level, sends a cautionary reminder to those
concerned with processes of transnational governance that due respect has to be given to
the complexities of both context and outcome. In particular, the lobbying activities of the
auditing profession, while clearly both active and complex, should not be over-presumed
in terms of their capacity to deliver professionally desired results. With Fogarty & Rigsby
(2010) generating similar results when highlighting the incapacity of the international
audit firms to secure regulatory support for desired innovations in audit practice, we
advocate a cautious approach when assuming that audit professional interests are an
implicit inviolable force or the automatic winners in the evolving transnational governance
field.
Critical in any such considerations is the need for due respect to be paid not only to
the contexts within which transnational governance interactions take place but also the
contextual factors and influences which transnational governance arrangements confront
in their day-to-day operations. In a rush to focus on the topicality of the ‘transnational’,
there is a danger that the regularities and constraints of the national can be ignored. As
Canning & O’Dwyer (2011) have recently argued, it is
misleading to assume that local regulators merely act as regulatory ‘dopes’
unproblematically establishing and enacting mandates emanating in the global
regulatory arena. […] considerable gaps can emerge between the intended purposes of
transnational regulation and the ways in which they are transformed at national level.
(p. 38)
We agree with Canning & O’Dwyer’s call for enhanced appreciation and scrutiny
of the influence of local political and social contexts in the development and interpretation
of accounting regulations and to avoid over-assumptions of the passivity of local
regulators in the face of global regulatory reform (also see Caramanis et al., 2010;
38
Jeppesen & Loft, 2011; Malsch & Gendron, 2011). However, we would go a step further,
on the basis of the case of auditor liability limitation in the European Union, by
emphasizing the connectivity between the transnational and the local. What happens, and
is deemed possible in the name of the transnational, is still shaped significantly by what is
acceptable and appropriate in the (differing) national context(s). This is of particular
contemporary significance in the field of international accounting and auditing because it
would appear that the emphasis both in terms of the literature and practical regulatory
activity has moved from a concern with the adoption of standards to their enforcement and
levels of national compliance with standards (Humphrey et al., 2009; IFAC, 2011). The
case of auditor liability limitation has demonstrated how enforcement agendas, exploring
the possibilities and probabilities as to what can and cannot be enforced at the national
level, shape the core of what legislative and regulatory proposals the EU is willing to
adopt in the first place. Such considerations essentially mean that the boundaries of the
‘transnational’ are significantly influenced by the demands and constraints of different
‘national’ contexts, which in turn emphasizes the importance of taking a longer-term
perspective when studying and evaluating the development and associated consequences
of transnational governance processes.
9. Concluding reflections: transnational governance process dynamics
and outcomes
In this paper, we have regarded transnational governance not merely as a broad
organizing force but also as a rich and dynamic body of what Djelic and Sahlin term
‘relational topographies’ (Djelic & Sahlin, 2010, p. 187) and actor interactions. This
39
approach was intended to avoid a restrictively simplistic vision of history that presumes,
with reference to theoretical preconceptions of how things should work, the sources of
influence and their likely effects. Likewise, our intention has not been to presume a
particular form of transnational governance practice - but to highlight the importance of
demonstrating and revealing empirically the complex nature and dynamics of
transnational governance in action.
Our portrayal of EU audit policymaking in relation to the subject of auditor
liability limitation confirms earlier accounts of a transnational regulatory field that
combines traditional governance by EU member states with more informal, deliberative,
and expertise-driven governance. Studying the interactions of various external policy
constituents, both individual and organizational, with differing national and sectoral
affiliations, has illustrated the capacity for different stakeholders, information sets,
arguments and rationales to shape and influence the rise (and fall) of particular policy
issues and the possibilities of debate progressing to some form of policy resolution.
Significantly, however, we find the audit profession’s pursuit of change in Member States’
auditor liability arrangements through mobilisation of the institutions and processes of
transnational governance alone does not seem automatically to have produced change in
governance outcomes, at least one that the profession would render satisfactory. Indeed,
the unspecific nature of the EC’s Recommendation on audit liability and its non-binding
legal status represents a major deviation from the initial plan of action pursued by the
profession.
The above lends support to arguments that policy solutions and compromises
reflect a combination of factors and contextual imperatives - constellations ‘produced as a
40
consequence of the intersection of a great many events’ and with the involvement of
‘people with clear views of what they were doing’ (Robson & Young (2009, p. 351)
quoting Burchell et al. (1985, p. 402)). Such perspectives reiterate the importance of not
seeing transnationalism and processes of transnational governance as absolute or given –
and place value on exploring the temporal significance of such constellations and how key
historical events and the coming together of individual actor agendas serve to shift and
shape public policy sentiment. Specifically, the particular preferences of prominent
individuals, such as MEP Bert Doorn and Commissioners Bolkestein and McCreevy or the
work of the ECG, led by Jeremy Jennings, seem to have had a direct impact on the degree
of momentum attached to the liability reform project. Furthermore, contributing to the
shifting momentum were aforementioned events associated with the collapse of Enron,
which, although initially increasing regulatory scepticism toward the audit profession,
later contributed to a heightened level of concern as to the future viability of the audit
industry in Europe, lending considerable weight to auditors’ calls for liability limitation.
These developments strongly suggest that (European) transnational governance has to be
regarded as a fluid and continuously transforming state of affairs, with shifting priorities,
sceneries, participants, and environmental imperatives.
Ironically, for a profession with acknowledged global coverage and reach, a
potentially major constraint on its public policy endeavours appears to have been the
nature of European transnational governance traditions. The paper has documented the
transnationalisation of processes of policy formulation and development with respect to
auditor liability limitation, wherein the agency of professional interests, rationalised
through expertise, has had a significant influence in terms of shaping existing conceptions
41
of the policy issues in question. However, it is evident that expert governance is still
capable of being challenged by the authority of the nation (EU member) states when it
comes to the processes of formal selection, endorsement and implementation of developed
policy proposals. In this respect, while it is important to study the global activities and
influences of the profession and its largest firms, it should be recognised, as others
engaged with accounts of transnational governance have cautioned, that ‘transnational
regulatory structures are dependent upon traditional power structures’ (Suddaby et al.,
2007, p. 356). In the EU context, this means that ‘[D]espite the independent influence of
both EU institutions and sub- and trans-national actors, as well as the extensive transfer of
competencies to supranational actors, sovereignty to date has not withered away to make
way for a European sovereign state, nor for the disappearance of sovereign Member
States’ (Aalberts, 2004, p. 41).
In general, it is important to acknowledge that there are always likely to be
competing perspectives on the balance of power within (European) transnational
governance processes – differences in viewpoint that will also shape assessments of how
appropriately reform agendas have balanced ‘public’ and ‘private’ interests. The system of
European governance offers a potentially appealing empirical setting for such studies in
that it claims to be oriented toward serving the interests of the public but heavily relies on
the inputs of a wide variety of private actors and interests in the development of its
policies. However, making such judgements is not a simple process and assessments of the
political economy of transnational governance and the way in which any private/public
dichotomy determines strategies of influence and shapes associated outcomes need to be
particularly sensitive to the temporal nature of the period subjected to study.
42
Accordingly, we prefer to regard transnational governance as ‘incremental’ rather
than absolute processes (Djelic & Sahlin, 2010, p. 181), developing along a sequence of
‘successes’ and ‘failures’, times of relative calm, episodes of dramatic transformation, and
even a retracing to a former status quo – a stance borne out most recently by the European
Commission’s (2010) Green Paper on audit policy and a subsequent proposal for a formal
EU regulation on the quality of audits (European Commission, 2011). Both initiatives
have expressed concern with the state of the European audit market, particularly in terms
of its high level of concentration and the systemic risk of a large audit firm collapse. What
is most striking, however, especially given the past level of debate and the associations
drawn between market functioning and auditor liability regimes, is that the Green Paper
made no reference to the limitation of auditor liability. Moreover, the text of the proposal
(European Commission, 2011) refers to the need to ‘increase the confidence in and the
liability of the statutory auditors [emphasis added]’ (p. 17) and its plans to publish a report
on the implementation of the 2008 Recommendation in order ‘to take the steps it considers
appropriate as a result of its findings’ (p.69). These latest public pronouncements are
suggestive of the European Commission’s declining commitment to, or possibly even a
complete departure from, the idea of further reforming auditor liability limitation in
Europe9.
From these recent developments, one can infer that the pursuit of auditor
liability limitation continues to be a work in progress. Whether it will ever be resolved, as
Power (1998, p. 79) once questioned, lies in the many hands of those who govern.
9
This pattern of behaviour has commonalities with developments in the US, where a form of proportionate
liability was first introduced by the Private Securities Litigation Reform Act of 1995 (Roberts et al., 2003)
where damage awards to plaintiffs are allocated in proportion to the auditor’s share of responsibility but may
also include punitive damages (compensating more than the actual loss). This situation has seen senior audit
industry representatives pushing for a better definition of auditor’s responsibility and arrangements that
would permit auditors to limit their liability by contract with their clients. However, the country’s Centre for
Audit Quality (2008) noted recently that despite significant support from the Committee on Capital Markets
Regulation (2006), discussions to secure movement in the US liability position had so far had little impact.
43
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Figure 1:
Key transnational interests participating in the European debate on auditor liability
Big 4
ICAEW
Representatives
of the Member
States
Private professional interests
ECG
FEE
European Union
Principal legislators
agenda setting and policy endorsement
European Parliament
(JURI and ECON Committees)
Insurers
Council of Ministers
Investors
IAASB
Executive body
policy drafting
International standardsetting and regulatory bodies
Other policy stakeholders
European
Commission
IFAC
Title:
Key transnational interests participating in the European debate onCorporations
auditor liability
Directorate General
Banks
Audit Unit
Discussion forums and advisors
London
Economics
Academics
Forum
On
Auditor
Liability
53
Table 1: A timeline of key events
Year
1996
1998
2001
2002
2003
2005
2006
2007
2008
Key events
Two studies - Buijink et al. (1996) and FEE (1996) - draw attention to the diversity of European
countries’ liability regimes as an area of concern.
The European Commission’s Green Paper (European Commission 1996) on the position and
liability of auditors in Europe is followed by an official consultation and a conference. These
acknowledge the negative effects of unlimited liability but reject the need for an action at an EU
level.
In May, the European Commission publishes a Communication (European Commission 1998b)
which leads to the establishment of the Committee on Auditing composed of external experts,
including the audit profession’s representatives.
In March, the European Commission publishes a comparative study on 15 European Member
States (Thieffry & Associates, 2001) which acknowledges the variation in national liability
regimes but claims it has no significant impact on the development of a European Single Market.
In October, Enron scandal starts unfolding.
In April, the European Commission issues a paper “A first response to Enron related policy
issues” (European Commission 2002) which outlines a series of preventive measures in Europe;
but makes no mention of the need for a reform of auditor liability.
In May, the European Commission issues a Communication “Reinforcing the statutory audit in
the EU” (European Commission 2003) setting a new regulatory framework for the statutory
audit. This is thought to signal a start of a new “hands-on” approach to audit regulation in
Europe; the issue of auditor liability is still not addressed.
The European Forum on Auditors’ Liability is set up comprising 20 experts (i.e. members of the
European regulatory, audit professional, academic, investment, banking, insurance, and corporate
communities) to assess potential solutions for moderating auditors’ litigation risk.
The EU publishes the revised Eighth Company Law Directive (2006/43/EC) on Statutory Audits
of Annual Accounts and Consolidated Accounts. Article 31 of the Directive requires that the
European Commission examines the effects of Member States’ liability regimes on the European
capital market. As a result, the Commission appoints the commercial consultancy firm, London
Economics, to carry out a study into the issue. The study report (London Economics 2006) is
published in October.
In January, the European Commission launches a public consultation on the issue of auditor
liability involving a broad range of policy stakeholders. A summary of responses to the
consultation are published in June (Directorate General for Internal Market and Services 2007b).
In June, the European Commission publishes the Recommendation Concerning the Limitation of
the Civil Liability of Statutory Auditors and Audit Firms (2008/473/EC) which suggests that the
Member States should take action to limit auditor liability using any of the several methods
proposed.
54
Appendix: Abbreviations
EC
ECG
ECON
EU
FEE
IAASB
ICAEW
IFAC
JURI
MEP
European Commission
European Contact Group
European Parliament’s Committee on Economic and Monetary
Affairs
European Union
Fédération des Experts-Comptables Européens
International Auditing and Assurance Standards Board
Institute of Chartered Accountants in England and Wales (UK)
International Federation of Accountants
European Parliament’s Committee on Legal Affairs
Member of the European Parliament
55