Keith Gaines and John Tillman.

The resignation of an auditor can be a critical and highly publicised event with serious ramifications for the company, those associated with it and the auditor himself. Resignation, particularly in controversial circumstances, can expose auditors to various risks, including the risk of litigation from creditors, investors and the company.

Although auditors' liability has attracted substantial commercial and political attention in recent months, the specific obligations and risk factors associated with an auditor's resignation have received little, if any, coverage. Similarly, while the courts regularly hear auditor negligence claims (perhaps the best known current example being Equitable Life Assurance Society v Ernst & Young), few cases to date have considered an auditor's duties and potential liabilities in the resignation context.

However, it is worth noting that the Company Law Reform white paper published in March identified 'widespread support' for greater disclosure by resigning auditors, indicating the potential for legislative development in this area. The white paper comments reflect that management, creditors and investors have never been more ready to scrutinise the auditor's conduct in instances where companies are the victims of fraud or serious mismanagement.

If auditors use resignation more regularly in a bid to extricate themselves from high-risk audits, it is inevitable that attention will focus on the resignations if subsequent problems at the company are uncovered. Did the resigning auditor do all that he ought to have done when stepping down?

The resignation process is set down by the Companies Act 1985. It is mandatory, and failure to comply with aspects of the process can constitute an offence under the legislation.

The critical element is that the resigning auditor must provide the company with a specific statement (a 'resignation statement'). That statement must set out any circumstances connected with his resignation which the auditor considers should be brought to the attention of the company's members or creditors. Alternatively, the resignation statement must confirm that there are no such circumstances.

On receipt of a resignation statement containing matters which the auditor considers should be brought to the members' or creditors' attention, the company has only 14 days to do one of two things. It can either circulate the resignation statement to those entitled to receive a copy of the company's accounts (ie, its shareholders, debenture holders and those entitled to notice of an agm, collectively the 'interested parties'), or apply to the court for an order to prevent that circulation of the statement. The court will only restrain circulation if satisfied that 'the auditor is using the statement to secure needless publicity for defamatory matter'.

If the company does not notify the auditor that it is applying to restrain circulation, the auditor must then file a copy of the resignation statement with Companies House at which point it becomes available to the general public.

Where he resigns in sensitive circumstances, an auditor can face two competing, and sometimes directly opposing, pressures when he considers any resignation statement.

On one hand, it is his duty to tell the 'interested parties' anything about the circumstances of his resignation which he feels should be brought to their attention. This is a matter for the auditor's judgment. If, for example, the auditor has resigned because he suspects fraud, malpractice or mismanagement which he has not been able to resolve with the company's management, the 'interested parties' will feel that they need to know.

Failure to comply with this obligation is an offence and could have far reaching consequences for the auditor.

In contrast, the company's management may be at pains to avoid any adverse publicity. They may wish to avoid publication of a resignation statement for entirely proper reasons (such as to protect the company's reputation or its share price against what they may see as unjustified criticism) or for more partial reasons such as protecting their own position. In practical terms, management might seek to pressurise the auditor to water down or withdraw the resignation statement.

The careful and well-advised auditor should be able to protect himself against any application which the company might make to prevent circulation of his resignation statement. The company has to show that the auditor is seeking to use the statement to obtain needless publicity for defamatory matter, which is a very high hurdle - it essentially requires the company to establish bad faith on the part of the auditor.

Given the auditor's professional status and the fact that he is seeking to comply with his statutory duties, the court will obviously be slow to find that the auditor is acting in bad faith. The most obvious lines of attack would be for the company to allege that the resignation statement was recklessly inaccurate or misleading, or was being used by the auditor for a collateral purpose (such as self-promotion, or 'revenge' on the company following a disagreement). So long as the auditor takes care over the wording and factual accuracy of the resignation statement, and takes care to keep his own records of the objective reasons for his resignation, he should be able to defend his conduct against any subsequent attack.

However, the more latent and potentially far more serious exposure for the auditor arises in relation to the 'interested parties'. If he resigns because of knowledge or suspicion of fraud or mismanagement in the company but then fails or fails adequately to disclose this in a resignation statement, subsequent claims against the auditor could well follow. If the fraud or mismanagement which prompted the resignation continued undetected thereafter, the accumulated losses which the company or the interested parties might later seek to recover from the auditor could be substantial.

Whether, and to what extent, the court would impose liability on auditors in such circumstances remains untested. However, in one of the very few cases to have considered resignations to date (Jarvis plc v Pricewaterhouse-Coopers), Mr Justice Lightman suggested that the resigning auditor does owe a duty of care to the interested parties in relation to his resignation statement. This is merely one passing comment in one case, but no doubt the point will be tested before long.

Given the specific statutory duty to prepare a resignation statement for the benefit of an identified class of people (the interested parties), there are clearly arguments that the obligations on resignation are materially different from the usual obligations to report on a company's accounts, and that a wider duty of care should exist when resigning.

Given the lack of case law in this area, there is scope for substantial litigation to determine whether damages are recoverable from an auditor if he fails to make a proper resignation statement. If so, who can recover such damages, and what types of loss can they recover? The extent of any recoverable loss would itself be a highly complex and controversial issue.

In the current climate, it is probably only a matter of time before these issues of liability and damage come before the courts, and indeed any legislative changes following the Company Law Reform white paper to expand the disclosure obligations may create further questions for the court to resolve.

In the meantime, the message for resigning auditors is to take care over the resignation statement. Consider carefully what if anything the interested parties should be told about the circumstances of the resignation, and do not bow to pressure from a vocal management to tone down or remove such information.

Failure to set out the relevant facts in any resignation statement, and failure to keep full records of the objective reasons for the decision to resign, represent the greatest potential pitfalls of resignation.

Keith Gaines is a partner and John Tillman an assistant in the Dispute Resolution Group of international law firm Lovells.