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Prepared by: Barry J. Cooper

and Shireenjit Johl

RMIT University

Chapter 3

Legal Liability

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The legal environment

• Litigation related to alleged audit failures have caused some concern in the profession

• The requirement to hold a practising certificate imposes an obligation on auditors to carry professional indemnity insurance for possible liability to their clients and members of the public

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• This source of compensation (insurance) creates a perception that auditors have ‘deep pockets’ and, arguably, contributes to the extent of claims filed against them

• There have been major changes in the legal environment concerning auditor liability in the last few years

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• KPMG paid $136 million in 1994 over its audit of the failed merchant bank Tricontinental

• KPMG and Price Waterhouse paid $120 million over the 1991 collapse of the State Bank of South Australia

• Litigation over the Adsteam collapse involved Deloitte Touche Tohmatsu in a $20 million settlement

The litigation crisis

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• Duke Group case over an independent expert’s report prepared by Nelson Wheeler resulted in $32 million in damages was paid

• In April 2002, Arthur Andersen settled with Southern Equities (formerly Bond Corporation) a $1 billion damages claim for an undisclosed amount and an estimated $30 million in legal costs

• In the United States, a substantial number of claims as indicated by the following Table

Number of claims defended by the Big Four in the United States over a 6-year period

• It can be seen from the data that the litigation crisis may have reached its peak between 2002 and 2003

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The professional standards legislation

• The Treasury Legislation Amendment (Professional Standards) Bill 2003 was passed by the Commonwealth Government on 24 June 2004

• The Bill adapts the Professional Standards Legislation (PSL) at the State and Territory level to limit civil liability for misleading and deceptive conduct

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• The bill does this through the Commonwealth’s Trade Practices Act 1974, the Australian Securities and Investments Commission Act 2001 and the Corporations Act 2001

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• The following key points relate to subsequent state-based legislations to enact the Commonwealth based reforms:

– Limitation caps are calculated with reference to a multiple of fees charged

– The cap does not apply to liability arising from claims for death, personal injury or any conduct involving a breach of trust, fraud or dishonesty

– A minimum cap of $500 000 applies but can vary within and between occupational groups

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The impact of the CLERP 9 Act

• CLERP 9 allows companies to register as independent auditors provided have adequate and appropriate professional indemnity insurance

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• To determine the required insured amount, ASIC proposes the following formula:

– If the maximum engagement fee is estimated to be less than $50 000, the insured amount will be $500 000, for any one claim and in the aggregate; or

– If the maximum engagement fee is estimated to be more than $50 000, the insured amount will be ten times the estimated maximum engagement fee up to a maximum figure of $20 million for any one claim and in the aggregate

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Liability to shareholders and auditees

• In respect of the provision of auditing services, an auditor is liable to compensate a plaintiff if:

– a duty of care is owed to the plaintiff and the audit is negligently performed

– the plaintiff has suffered a loss as a result of the auditor’s negligence (where the causal relationship is reasonably foreseeable)

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The following issues, therefore, need to be considered and each is dealt with separately:

• Due care

• Negligence

• Privity of contract

• Causal relationship

• Contributory negligence

• Damages

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Due care

• The development of the concept of due care, as applied to the performance of an auditor’s duties, is considered by referring to cases decided in UK and Australian courts

• Consideration is also given to the relevance of the profession’s auditing and accounting standards

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Kingston Cotton Mill Co. (1896)

Facts of the case

• For several years the manager of Kingston Cotton Mill had been exaggerating the quantities and values of the company’s stock (inventory) so as to fraudulently overstate the company’s profits

• The auditor relied on a certificate signed by the manager

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• The auditor did not physically observe stock or attempt to verify the valuation of individual items

• Also, did not reconcile stock with the opening balance and purchases and sales during the year

Finding

• The Kingston Cotton Mill case laid down some fundamental auditing principles such as the ‘watchdog’ role and the notion of taking reasonable skill and care

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London and General Bank (1895)

Facts of the case

• The bank made loans to customers for which it held inadequate security

• Interest due on the loans was accrued but not received, yet dividends were paid out of profits arising from such interest

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• The auditor made a full report to the directors in respect of the valuation of these loans and the need for a provision for bad debts against both the loan and the accrued interest

• However, in his report to the shareholders, the auditor merely qualified his opinion with the following sentence: ‘The value of the assets as shown on the balance sheet is dependent upon realisation’

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Finding

• The duty of an auditor is to convey information, not to arouse enquiry

• Although an auditor might infer from an unusual statement that something was seriously wrong, it by no means follows that ordinary people would have their suspicions aroused by a similar statement

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Implications of the Kingston Cotton Mill and the London and General Bank cases

• These two cases have formed the basis for most subsequent decisions as to the determination of auditor negligence

• The auditor is not necessarily answerable for an error of judgement, provided he or she exercises the skill and care of a reasonably competent and well-informed member of the profession

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• In Thomas Gerrard & Son Ltd (1967), the judge concluded that the standards of reasonable care and skill are, on the expert evidence, more exacting todaythan those which prevailed in 1896 (as in the Kingston Cotton Mill case)

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• The narrow interpretation of the Kingston Cotton Mill Co. case concerning some audit practice was finally laid to rest by the Pacific Acceptance case

• The Pacific Acceptance case showed the changing expectations in respect of the auditor’s responsibility, with the standards of reasonable care also being raised

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Pacific Acceptance Corporation Ltd v. Forsyth (1970)

Facts of the case

• A branch manager of Pacific Acceptance made loans to a real estate speculator on the strength of security confirmed by a solicitor introduced by the speculator

• In fact, most of the security offered in the form of title deeds, registered charges and mortgages was worthless, being either forged or improperly drawn up

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• Numerous auditing deficiencies were alleged, such as the assignment of inexperienced audit staff, lack of adequate supervision, excessive reliance on management representations instead of examination of documentary evidence

Findings

• ‘Reasonable skill and care’ calls for changed standards to meet changed conditions or changed understanding of dangers, and in this sense standards are more exacting today than in 1896 (Kingston Cotton Mill case)

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• The judgement was wide ranging and important points included:

– must pay due regard to the possibility of material fraud or error in carrying out audit procedures

– Closely supervise and review the work of inexperienced staff

– Properly document audit procedures in a written audit program which is to be amended as necessary as the audit progresses

– Carry out proper objective auditing procedures

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Due care further emphasised in:

• The Royal Commission into HIH Insurance– ‘… auditors have an obligation to ensure that

they are, and are seen to be, maintaining high standards of honesty and probity, acting in the interests of the shareholders of the company … and exercising independence of mind …’

• Stanilite Pacific Ltd & Anor v. Seaton and Ors (2005) (trading as Price Waterhouse)– the judgement referred to ‘… an extension of

the duty to exercise reasonable skill and care in giving consent for their report to be included in a prospectus …’

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Negligence

• Negligence has been defined as any conduct that is careless or unintentional in nature and entails a breach of any contractual duty or duty of care in tort (that is, to those who the auditor could reasonably foresee would rely on the auditor’s report), owed to another person or persons

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• If the auditor has been negligent, then the client may sue the auditor for breach of an implicit term of the contract to exercise reasonable care and skill, so as to recover any consequential loss suffered

• The client may also sue the auditor in the tort of negligence to obtain damages sufficient to restore the client to its original position

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• Subsequent to the Pacific Acceptance case, the Australian accounting bodies issued more comprehensive and specific auditing standards and practice statements concerning the conduct of the audit

• Disputes may still arise as to whether, in a specific engagement, an auditor has complied with the standards and thus has a good defence against an action for damages on the grounds of negligence

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• In the 1992 AWA case, for example, the court considered whether the auditor had complied with a paragraph in the standards that ‘… the auditor should make management aware on a timely basis of material weaknesses which have come to his/her attention …’

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• Auditors are now subject to an increasing amount of scrutiny by regulatory bodies such as ASIC

• For example, recent media releases by ASIC include:– On 28 April 2005, a Brisbane auditor was

reprimanded by the Companies Auditors and Liquidators Disciplinary Board for failing to conduct an audit in compliance with Australian Auditing Standards

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• On 12 May 2005, a Sydney auditor was fined for breaching auditor independence provisions relating to charges of acting as auditor of a listed company while, at the same time, acting as the company secretary

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Privity of contract

• The term privity of contract refers to the contractual relationship that exists between two or more contracting parties

• An audit is assumed to be performed in accordance with professional standards unless the contract (engagement letter) contains specific wording to the contrary

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• Under contract, only the directors (on behalf of the company) or, more commonly, the liquidator or receiver, may sue the auditor in respect of losses incurred by the company arising from the auditor’s negligence

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Causal relationship

• A causal relationship exists between the breach of duty by the defendant and the loss or harm suffered by the plaintiff

• This relationship must have been reasonably foreseeable and it must be proven that the loss suffered is attributable to the negligent conduct of the auditor in a negligence case

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• Segenhoe Ltd v. Akins & Ors (1990) – court held that where an auditor has been

negligent and the company has been induced to pay a dividend out of capital — relying on an incorrectly audited profit and loss account — the auditor is liable for the loss incurred

• Galoo Ltd v. Bright Graham Murray(1994)– reaffirmed the causation relationship

requirement to establish the liability of the auditor

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• Contributory negligence relates to the failure of the plaintiff to meet certain required standards of care

• Together with the defendant’s negligence, it contributes to bringing about the loss in question

Contributory negligence

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AWA Ltd v. Daniels t/a Deloitte Haskins & Sells & Ors (1992)

• The auditor was held to have been negligent in failing to warn the appropriate level of management and to implement follow-up actions to rectify internal control weaknesses, even though that was not the main purpose of the audit

• An important development, however, was that the company was held to be guilty of contributory negligence through not establishing adequate controls in the first place

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• The court accepted that the directors of AWA had a duty to establish a sound system of internal control to safeguard the company’s assets

• Their failure to do so was held to be contributory negligence

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• Where auditors fail in their duty to act with reasonable care and skill, whether under contract or in tort, a plaintiff is entitled to recover any economic loss arising out of such a breach of duty

• Two issues need to be considered– Firstly, what is the purpose of statements that

may give rise to reliance reasonably being placed on them?

– Secondly, to what extent may responsibility for any loss be assigned on the one hand to the auditor’s negligence and, on the other, to other causes and other parties?

Damages

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• To illustrate, Cambridge Credit Corporation failed in 1974 and it was determined that the audit of the 1971 accounts had been negligently performed

• Had the auditor’s report been appropriately qualified, the amended view of the company’s financial position would have required the trustee for the debenture holders to appoint a receiver

• It was alleged that the company, through the auditor’s negligence, was allowed to remain in business for a further 3 years, incurring further losses before a receiver was finally appointed in 1974

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• Damages were claimed in the amount of losses incurred by virtue of the company being liquidated in 1974 instead of 1971

• However, the auditor appealed on the grounds that he could not have foreseen the economic downturn that caused the losses to reach the level they did

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Liability to third parties

• Action for damages may be brought against an auditor under tort (civil negligence), outside of any contractual relationship

• The Hedley Byrne case is a landmark case for professional liability to third parties and established the concepts of foreseeability and due care — both tests are essential elements in establishing auditor liabilities

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• The Hedley Byrne case involved a bank, that supplied a reference without making a careful check of its records

• The verdict was in favour of the defendant on the grounds that the disclaimer of liability was a good defence, notwithstanding that a duty of care existed

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Proximity and third party liability

• As a result of the reluctance of professional indemnity insurers to allow cases to come to court there are very few decided Australian (or overseas) cases of significance involving claims by third parties against auditors

• Most of these cases involve action being brought by companies relying on audited accounts in making a takeover bid for another company

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• Proximity is held to arise through the fact that where a company’s financial condition is such that it is a likely takeover target, auditors should be aware that potential suitors will rely on the accounts and that a duty of care thus arises

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• A number of cases have addressed third party liability over the years and include the following:– Mutual Life and Citizens Assurance Co. Ltd v.

Evatt (1968)

– Shaddock & Associates Pty Ltd v. Parramatta City Council (1981)

– JEB Fasteners Ltd v. Marks, Bloom & Co.(1981)

– Twomax Ltd v. Dickson, McFarlane & Robinson (1983)

– Caparo Industries Pty Ltd v. Dickman (1990)

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• The House of Lords in the Caparo case argued that the purpose of the financial statement on which auditors express an opinion is to assist the shareholders in their collective function of scrutinising the company’s affairs

• It would be unreasonable, therefore, to hold the auditors responsible for their use, by shareholders or others, for any other purpose

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• There is concern that Caparo appears to reverse what is seen as a socially desirable development in law of holding experts liable for the consequences of negligent advice

• Post Caparo cases include:– Morgan Crucible Co. PLC (1991)

– Lowe Lippman Figdor & Franck (1992)

– Columbia Coffee & Tea case (1992)

– Esanda Finance Corporation (1994)

– Royal Bank of Scotland PLC (2002)

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• In Australia, the common law concerning the nature and extent of an auditor’s duty of care to third parties remains complex because judgements contain differences of judicial opinion and interpretation

• However, the judgement in the Esanda case was a positive development for auditors because the Court rejected the contention that liability could be based on foreseeability of reliance alone

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• The High Court found that there had to be circumstances establishing a relationship of proximity between the auditor and the third party before a duty of care could be said to exist

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Avoidance of litigation

The following precautions may be taken by auditors wishing to avoid or minimise the consequences of litigation:

• Use engagement letters and investigate prospective clients thoroughly

• Comply fully with professional pronouncements

• Establish and maintain high standards of quality control and insurance cover

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Trade practices legislation

• In addition to the legislative rulings discussed earlier, the Trade Practices Act 1974 (TPA) (and the state Fair Trading Acts) provide further rights for individual investors and shareholders

• Section 52 of the TPA prohibits misleading and deceptive conduct

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• Investors can also make use of the Trade Practices Act (TPA) to take actions under common law for deceit and negligence

• Litigation under the TPA does not require the various factors of foreseeability andproximity as do cases under tort of negligence

• As all professionals are covered by competition laws, partnerships, audit companies or sole practitioners and their associations are subject to the competition provisions of the TPA

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• Consumer protection provisions include implied warranty provisions of Section 74 of the TPA that require a professional service to be rendered with due care and skill

• Section 87AB of the Trade Practices Act allows the professional standards legislation (PSL) referred to earlier to be applied to damages claims for misleading and deceptive conduct under Section 52 of the Trade Practices Act 1974

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• The PSL was part of the response of the Commonwealth and the States to curb large damages payouts and to ensure adequate protection is in place for those who rely on professional indemnity insurance cover

• The trade-off for consumers and the community in capping the liability of professionals is the implementation of statutory schemes that aim to improve professional standards