The role of the auditor comes under examination each time a scandal emerges – my interest in the subject stems from the issue of auditor liability – what exactly are they responsible for? A source of constant worry for anyone who earns a living from expressing an opinion is that of liability when it becomes clear that the opinion expressed was incorrect or flawed in some respect. It is a worry that an auditor can never walk away from and it is understandable that they would wish to protect themselves – but the balance at present is not right and the limitations of liability that auditors are trying to impose on their clients are not always reasonable.
When I was training to be an accountant the classic debate for discussion on auditing revolved around whether the role of an auditor was that of a watch dog or a bloodhound. My contention is, that in the context of hedge funds at least, the auditor has become neither – perhaps more of a poodle. The investment manager needs to appoint one of the major firms to ensure credibility – that can make it an expensive exercise – sometimes with very little benefit to the investors and actually very little responsibility economically on the part of the auditor.
Auditor liability has been a sensitive subject and governments have found it difficult to resist the pressures to limit the burdens of liability for the auditor. It is a sound principle that where an expert needs to express an opinion – they need to do a sufficient amount of work to satisfy themselves in expressing that opinion. However, economics always comes into play – would a commercial organisation be prepared to pay an open ended bill for an auditors time in satisfying themselves over an opinion – of course not – there is always downward pressure on audit fees – or is all that matters a respectable name expressing an opinion at a commercially acceptable rate?
It is economics that drives some of the problems we face in receiving audit reports in the hedge fund world.
Let us take a hypothetical situation. Lets assume a hedge fund with assets of say $500m needs an audit and that the going rate for a straightforward audit by a major auditing firm is say $50,000. Let us also assume that this fund is domiciled in the Cayman Islands but administered in another jurisdiction e.g. Ireland, so that the audit work and audit opinion sign off are in different jurisdictions and where the operation of contractual limits of liability may differ. Let us also assume that the audit engagement terms limit liability for the audit to the fee paid for it. The balance of probabilities on a wrong opinion in this scenario lend itself to the audit being staffed with as junior as possible staff (i.e. the cheapest) that would be able to carry out the programme of work as the downside risk even taking into account reputational issues is still extremely low on getting the opinion wrong. What is likely to matter far more to the audit firm, other things being equal, are the economics of retaining the hedge fund as a client to capture the annuity income through reappointment as auditor. In such circumstances the real incentives are neither to be bloodhound nor watch dog but a poodle albeit well trained.
Does this mean that investors in hedge funds get what they pay for? What it means is that investors need to consider very carefully the terms under which their auditors are appointed and they need to pay particular attention to what liability terms have been agreed upon and to whom they report and even where the work will be done and how related firms will apportion work between them. Yes, even major firms have restricted reliance on audit reports and I am aware of a firm that has tried to address the report to the fund’s directors rather than its shareholders which throws open what the purpose of the audit report might be in the first place! The relationship that exists between the auditor and the hedge fund is a contractual one and the parties negotiating the contracts do not necessarily always have at the forefront of their minds in their decision making the likely impact on the investors if things go wrong. The auditor is a necessary appointment but the choice is generally limited to a major name, often with little time being spent on the terms under which they are appointed.
Why is this important? Let us assume that a major fraud with devastating consequences occurs in our hedge fund example, that an auditor conducting their work under acceptable standards should have spotted. In most jurisdictions the contractual terms are likely to prevail – and even if the auditor had been grossly negligent in the conduct of their work there is a real possibility that their liability in this example would be restricted to the $50,000 fee paid. Is that what the investors would have expected when investing in the fund? Almost certainly not – but that may be the reality of the prospect they face. It is what makes it so important for investors to look very carefully at the basis on which auditors are appointed on their funds. Sometimes having a major name as an auditor is not necessarily the panacea that an investor would need.
There needs to be a continuing debate on the role of the auditor – as often the auditor is the only independent entity that has access to the books and records of the vehicles in which investors place their money and there need to be real economic incentives to ensure that the work they perform is to the right standard with people having the requisite experience to reach appropriate conclusions so that they can be watch dogs with bloodhound abilities.
A $50,000 liability in the scenario described is likely to still keep the poodle’s tail wagging.
©Jaitly LLP
