• Proposed Advisory Regarding Financial Institutions' External Audit Engagement Letters
  • June 2, 2005 | Author: Ralph W. Davis
  • Law Firm: Waller Lansden Dortch & Davis, LLP - Nashville Office
  • On May 11, 2005, the Federal Financial Institutions Examination Council (FFIEC) published a proposed advisory that cautions regulated financial institutions against accepting certain provisions in external auditor engagement letters. The FFIEC speaks on behalf of the Office of Thrift Supervision, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration and the Office of the Comptroller of the Currency of the Department of the Treasury (collectively, the Agencies). The FFIEC is accepting comments on the proposed advisory until June 9, 2005 and will issue a final advisory thereafter.

    The FFIEC advises that any agreement by the financial institution to indemnify or limit the liability of outside auditors will be considered an unsafe and unsound practice by the regulators that make up the FFIEC. The FFIEC is concerned that certain financial institutions have agreed to limit their legal remedies against external auditors and that such limitations may weaken an auditor's objectivity, impartiality and performance. The FFIEC also advises against alternative dispute resolution (ADR) provisions in audit engagement letters.

    The advisory discusses the following types of provisions in audit engagement letters:

    • Agreements to indemnify the external auditor against claims made by third parties;
    • Agreements to hold harmless or release the external auditor from liability for claims or potential claims that might be asserted by the client financial institution; and
    • Agreements to limit the remedies available to the client financial institution.

    The FFIEC builds on the longstanding auditor independence policy of the SEC and other regulators that indemnification of auditors by the client, or releasing of auditors from liability for knowing misrepresentations of management, impairs the independence of the auditor. However, the proposed advisory goes beyond the current regulations of the SEC by proposing to restrict the use of mandatory ADR provisions. ADR provisions limit discovery and appellate review, and most ADR agreements foreclose punitive and exemplary damages. Consequently, the FFIEC is concerned that such provisions may provide an inherent limitation of the auditor's liability.

    If adopted, the advisory would eliminate the use of provisions limiting liability of the external auditor or providing for indemnification of auditors. We believe such provisions to be relatively rare, because they are restricted by existing auditor independence rules.

    The proposed advisory notes particularly that ADR agreements with auditors "present safety and soundness concerns" when they include specific limitations on liability such as:

    • Capping the amount of actual damages that may be claimed;
    • Prohibiting claims for punitive damages or other remedies; or
    • Shortening the time within which the client financial institution may file a claim.

    The proposed language regarding ADR provisions would have a much more widespread impact, given the routine inclusion of such provisions in agreements between commercially sophisticated parties.

    The proposed advisory does not allow for grandfathering of existing audit engagement letters. Consequently, the advisory suggests that financial institutions eliminate problematic language from existing agreements, though auditors will have no duty to comply with the requests of financial institutions.

    Going forward, financial institutions' boards of directors, audit committees and management should ensure that they do not enter any agreement that contains external auditor indemnification or limitation of liability provisions with respect to financial statement audits. While not expressly prohibiting ADR provisions, the Agencies recommend that financial institutions document their business rationale for agreeing to mandatory ADR or any other provisions that alter their legal rights.