Consider a hypothetical example. You are general counsel to a well-known corporate. Your finance director has asked for your advice on two distinct, but related, contractual issues. The first is a significant contract for the provision of IT systems support with a well-known IT supplier; the second is a contract with the company’s auditors. In both cases, the finance director has asked you whether the company should agree to a limitation of liability clause in the contract. One of his concerns is whether he could be in breach of his duties as a director if he agrees to a limitation of liability clause in either contract.
With the IT supplier, you could, in theory, argue that there should be no limitation of liability. Your company has a longstanding relationship with the supplier, is a significant provider of fee income, and therefore has considerable leverage over it. Your company could use another supplier in the market. In addition, if things go wrong your company will almost certainly suffer significant losses arising out of the failure of company systems, well in excess of the proposed limitation of liability clause.
However, the IT supplier has always made it very clear that its business model cannot support unlimited liability and that to obtain insurance to cover the level of potential loss anticipated would be prohibitively expensive. It has argued in the past that it is unfair to expose it to ‘life-threatening’ claims and that clients have accepted these arguments. The draft terms limiting the IT supplier’s liability are the market norm for this type of work, so it is doubtful that the company could do much better elsewhere.
The supplier has a strong relationship with the company and has in-depth knowledge of the way the company operates. The company would like to maintain this relationship.
After consideration, your advice is that the company should not object to the IT supplier limiting its liability. You also have in mind that, because the contract is on the supplier’s standard terms of business, under the Unfair Contract Terms Act 1977 (UCTA) the court will be able to set aside the limitation of liability clause if, in the event that the company suffers loss and there is a dispute, the court deems the limitation of liability to be unreasonable by reference to the relevant criteria. In all the circumstances, you do not believe that the finance director could be said to be acting unreasonably or otherwise in breach of his duties to the company in agreeing to the limitation of liability.
For the auditors, the law on limitation of liability is new, contained in part 16 of the Companies Act 2006. You see that there are similar, if not greater, safeguards in favour of the company compared to the position with the IT supplier.
First, the limitation of liability clause is subject to a fair and reasonable override. This would be applied by the court in a way that is not dissimilar to the way UCTA works for the IT contract. If the court does not believe that the auditors’ limitation of liability clause is fair and reasonable by reference to a number of factors, it will set it aside and substitute a limit that the court believes is fair and reasonable. You consider that this mechanism is in fact likely to provide more protection in practice to the company than UCTA, because the court is able to substitute a new, higher limitation of liability, and therefore you believe that the court will be more willing to interfere with the contractual bargain that the parties have made.
Second, the limitation of liability clause must be approved by the company’s shareholders by ordinary resolution before it can have an effect (although a private company can seek a resolution waiving the need for approval, if it has not yet entered into the agreement). Providing that relevant information is disclosed by the company to the shareholders in respect of the resolution, it is difficult to see how the finance director would be in breach of his duties to the company by recommending a limitation of liability clause to the members, and ultimately agreeing to it. In your view, the fact that the Government has introduced legislation to permit limitation of auditors’ liability further supports this conclusion. Agreeing the limitation of liability would not reduce or otherwise affect the legal and professional obligations imposed on the auditors in respect of the quality of the audit (in the same way that agreeing the limitation of liability with the IT supplier does not reduce the supplier’s obligations in respect of its performance standards).
In fact, there are a number of similarities between the factors that are relevant in considering whether to agree a limitation of liability clause with the IT supplier, and those in considering whether to agree a limitation of liability with the auditors. In discussion with the auditors, they have said that the public policy arguments in favour of limitation of auditors’ liability are predicated in part on the fact that auditors cannot obtain insurance to cover the high-end claims that the audit profession has experienced in the last couple of decades, and that it is unfair to expose the auditors to ‘life-threatening’ losses. These are the same sort of arguments advanced by the IT supplier.
You have also noticed that the terms of the auditors’ limitation of liability clause compares favourably with the terms of the IT supplier’s clause, particularly as the auditors’ fees are substantially less than those of the IT supplier. Like the IT supplier, the auditors have a strong relationship with the company and have in-depth knowledge of how the company operates. The company would like to maintain this relationship. In discussions with the auditors, they recognise that market practice in this area is still evolving and that there are commercial decisions for companies as to the precise mechanics of the limitation of liability clause. It is hoped that guidance on the topic that has recently been published by a group of market participants convened by the Financial Reporting Council will assist in defining acceptable market practice for all parties.
With that in mind, in terms of the legal position, why, in light of all the above, should your advice to the finance director in respect of agreeing a limitation of liability with the auditors be any different to that in respect of agreeing a limitation of liability with the IT supplier?
Stephen Gate is a member of the legal team at Ernst & Young.FinancialManagementJuly2008
