1.6 Current position under Common law :English Law and
USA.
The CA 1900 provided that in an attempt to ensure the auditors
from the management,
the auditor should not be an officer of the company.
In addition to the classic
provisions, there is the influence of the European Company
Law. The implementation
of the EEC Council Directive of 1984 in the CA1989 is
considered as the result of the
legislation on the qualification of auditors. Under s.25 of
CA 1989, to be eligible for
appointment as a company auditor, persons must be
members of a recognised
supervisory body, and be eligible under its rules to be
appointed as company auditor
which in turn requires that they be independent of the
company concerned and hold
appropriate qualifications. This is important for the
objectivity and the integrity of
the audit.
83.A.Chambers,'Tolley's corporate governance'.
84.ibid
85.ibid
On the other hand, section 53 of CA 1989 stated that
where a firm is appointed,
company auditor it is the firm which must be a member of a
recognised supervisory
body and be eligible for appointment as company auditor
under the rules of the
relevant body. In addition under CA1989, a person whose
function is to report to the
members and who originally was frequently also member,
the auditor has always
been appointed by the members. One of the most important
tasks of the auditors is to
communicate effectively with the shareholders.
In Re London and General Bank it was
held that the Standard of care and skill
auditors must exhibit in carrying out their tasks is
that of the ordinary reasonable
86
auditor. In view of the professional qualifications now
required, and the increased
rights to inspect records and demand information and
explanations, it may be doubted
87
whether a Standard based on the nineteenth century case
law is still appropriate.
As to the specific issues of the case, Justice
Lindley had the following to say:
`It is a mere truism to say that the value of
loans and securities depends upon
their realisation. We are told that a statement
to that effect is so unusual that
the mere presence of those words is enough to excite
suspicion.But,as already stated,
the duty of an auditor is to convey information, not to
arouse enquiry ,and 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 if ,as in this case, its
language expresses no more than an ordinary person would infer without
it.'
88
Under English law, the Kingston Cotton Mill
Co. case and the Re London and
General Bank case have formed the basis
for all subsequent decisions as to the
89
determine of auditor's negligence. Also, the crucial
importance in both instances is
the recognition of auditing as a profession. Finally, we may
consider that auditors do
not guarantee that the financial statements a true
and fair view any more than
86.[1895]2 Ch 673 at 682-3,CA.
87.Farrar's Company Law.
88.[1896]2 Ch 279
89.[1895]2 Ch 673 CA.
solicitors guarantee to win a case; the auditors
warrant to bring to bear the highest
degree of work in the performance of their duties. The
reform of the joint and several
liability rule not in favour, attention has concentrated
instead on the rules governing
whether and in which circumstances auditors owe a duty
of a care to persons other
90
than the company which has engaged them. Under the
present rules, each party is
liable for 100% of the loss through dishonest or unauthorised
dealing or concealment
of matters from the auditors, with a right of contribution
against the others who are
910
92
also liable. In practice, it is the auditors who are
sued because of their insurance
cover.
On the other hand, s. 310 of CA has prevented auditors
limiting or excluding their
liability, or being indemnified against liability, by
contract with the company.
Moreover, there is the work of the Courts which have
operated not on any special
rules applicable to auditors but on the application in
the auditing context of the
general Common law rules governing liability for
economic loss caused by
93
negligent misstatement.
Under the English law, before the Hedley Byrne v
Heller, there was no liability for a
negligent misrepresentation made by one person to another
even where the person
acted upon the representation to his or her detriment;
Hedley Byrne has proved to be
94
of crucial relevance to claims against accountants and
auditors. Here, it was held
that in certain circumstances, liability could be incurred
for a negligent misstatement
where there was a special relationship between
the parties.
90.Gower and Davies , ' Principles of Modern Company law
.'
91.Farrar's company law'.
92.ibid
93.Gower and Davies , ' Principles of Modern Company law
' .
94.[1963]2 All ER 575.
In the Hedley Byrne case, the test for
liability is:
*Whether the plaintiff is a person, or within a class of
persons, who the defendant in preparing, or reporting on the accounts knew,
or ought to have known would rely
upon the accounts for a purpose which the defendant knew,
or ought to have known.
In general, the liability of the auditors to third
parties is more likely to arise if the
audited accounts are shown to the third party either
by or in the presence of the
auditor.The scope of the auditors's duties to the company and
to shareholders was set
95
out in Caparo Industries Plc v Dickman. Here
,the plaintiffs (Caparo Industries plc),
which had purchased the shares of another (Fidelity
plc), brought a lawsuit against
the directors of Fidelity plc and against the auditors.
The plaintiffs claimed that the
auditors were negligent in carrying out their audit. As the
auditors owed both current
shareholders and potential shareholders a duty of care
regarding the audit of Fidelity's
financial statements; that the auditors should have known
that Fidelity's profits were
not as high as reported; that Fidelity' s share price
had fallen significantly; that
Fidelity required financial assistance; that it was
susceptible to a take - over bid;
and that reliance would be placed on the accuracy of the
financial statements by any
potential bidder.
It was held that the auditors do not owe a `duty of care' to
those third parties who may
place trust in their work or for decisions as to whether or
not to extend credit to the
company. Lord Bridge of Harwich cited the CA1985 and referred
to the decision of
Bingham J of the Court of Appeal. In his opinion, Bingham J
discussed the role of the
statutory auditor under CA1985, stated that the role of
statutory derives from the
nature of the public limited liability company.
95.[1990]AC 605 HL.
The shareholders of the plc are its owners, but
they are too numerous and too
unskilled to undertake the day-to-day management of the
company. Consequently,
the responsibility for the day-to-day management is
delegated to the directors of the
company; there is a potential for abuse if the
shareholders only receive information
from the directors of the company. On the other hand,
section 384 of CA1985
provides that the shareholders of the company should
an appoint auditor whose
duty it is to investigate and form an opinion on
the adequacy of the company's
financial statements.
The statutory of the framework for company accounts and
audits led them to the
following conclusions; the statutory provisions establish a
relationship between those
responsible for the accounts(directors) or for the report (the
auditors) and some other
96
classes of persons and this relationship imposes a duty of
care owed to those persons.
Among these »persons» is the company itself, to
which apart altogether from the
statutory provisions, the directors are in a fiduciary
relationship and the auditors in a
97
contractual relationship by virtue of their employment by the
company as its auditors.
Under Common law once the duty of care is established, for
liability to imposed on
the auditor, the auditor's breach of the duty
(negligence) must have caused the loss
or damage suffered by the third party; the Courts have
relied on the «but for» test
98
for proving causation. However, in recent cases some judges
have taken a «common
99
sense» approach to the causation issue. In the
Australian case of Alexander v
Cambridge Credit Corporation Limited the
New South Wales Court of Appeal
95.Gower and Davies , 'Principles of Modern Company Law'.
96 .ibid
97.ibid
98.ibid
99.ibid
approved the common sense approach to the issue of causation
in a case involving
100
auditors. Here, in 1971 the auditors of Cambridge Credit
failed to note in the annual
certificate that the accounts did not show provisions
which should have been made.
The company claimed damages for negligent breach of
contract against the auditors
claiming that « but for» the breach by the auditors
the company would have gone into
receivership in 1971. It was held that there was no
causal connection between the
1971 breach and the losses suffered later on. In reaching
this decision, all the judges
considered that « but for» test was
not enough to determine the causation
requirement; McHugh J stated:
«In general, the application of the «but
for» test will be sufficient to prove the necessary cause or connection.
But that test is only a guide. The ultimate question is whether, as a matter
of common sense, the relevant act or omission was the cause».
In the UK, the Galoo v Bright Grahame Murray
case follows the Cambridge Credit
as it concerned a claim against auditors and the decision is
important for its finding on
101
the causation issue. Here, the auditors of Galoo and its
parent company were claimed
to have negligently performed their duties over a five year
period by failing to detect
the Court of Appeal argued that although the auditors'
negligence gave Galoo the
opportunity to continue to incur trading losses, it
did not cause those losses.
The plaintiffs claimed for the losses resulting
from the continuation of trading
after the date on which, had the auditors not been
negligent, the company' s true
position would have been discovered. The Court of Appeal
argued that although the
auditors' negligence gave Galoo the opportunity to continue
to incur trading losses, it
did not cause those losses.
100.[ 1987 ] 9 nswlr 310 /credy
101.[1994] BCC 319
According to Glidewell L J, a plaintiff is entitled
to claim damages for breach of
contract by the defendant where the breach is the effective
or dominant cause of his
loss and does not merely provide him with the opportunity to
sustain loss. Further,
in considering whether a breach of duty by the defendant is
the effective cause of loss
or merely the occasion for the loss, the Court has to
reach a decision by applying
common sense to the facts of the case. It was held
that on the facts the auditors'
breach of duty clearly provided the plaintiff with the
opportunity to incur and to
continue to incur trading losses, but it could not be said to
have caused those losses.
On the other hand, the study of Company Law in the USA shows
that the laws differ
among the various States. In addition, the Federal
Government law constitutes a
separate system of law. The two most important Federal
statutes affecting auditors
are the Securities Act of 1933 and the Securities
Exchange Act of 1934,which are
administered by the SEC. The 1933 Act requires audited
financial statements to be
included in registration statements filed with the SEC
when non-exempt entities
initially offer securities for sale to the public. On the
other hand, The 1934 Act
requires public companies with assets in excess of $ 5
million and more than 500
stockholders to file annual reports with the SEC,
including audited financial
statements.
In general, the liability of the auditors to third parties
under Federal Securities law is
102
greater than under the Common Laws of the various States.
However, in most cases
the auditor can defend against suits brought by third
parties under Federal Securities
Law by establishing either that the auditor performed his
or her professional duties
103
with «due diligence» or that there was no intent
on the part of the auditor to deceive.
102. A . Chambers , ' Tolley ' s Corporate Governance'.
103.ibid
However, under common law there have been several ways of
viewing (see USA)
auditors' duty of care to third parties; the first
view is consistent with the Caparo
decision and argues that the auditor does not owe a
specific duty of care to third
104
parties. This is referred to as the strict
privy of contract doctrine;
this doctrine was first introduced into the area of
auditor' s legal liability by the
105
Ultramares Corp.v Touches case in the early
1930s. Here, the Court found the
auditors guilty of negligence but ruled that
accountants should not be liable to
any third party for negligence. The Ultramares case
also introduced the concept
of foreseability, which suggests that if the auditor
foresaw or could be expected to
foresee that certain persons would use the auditor's
report then the auditor might
be held liable for ordinary negligence by the
group of persons.
Even though Ultramares introduced the concepts of
foreseability and gross
negligence which may constitutes fraud into the
discussion of auditors' s liability,
the privy of contract was established as matter of policy
via now famous quote from
Chief Justice Cardozo:
`If liability for negligence exists ,a thoughtless slip
or blunder, the failure to detect
forgery beneath the cover of deceptive entries, may
expose accountants to a liability
in an indeterminate amount for an indeterminate time to
an indeterminate class. The
hazards of a business conducted on these terms are so
extreme as to enkindle doubt
whether a flaw may not exist in the implication of a duty
that exposes to these consequences'.
In addition, Courts in the USA have not found auditors
liable under Common law for
ordinary negligence to third parties; to be held liable,the
auditor must not only foresee
the use of the audit report by the parties, the auditor
must also acknowledge the use
106
of the audit report by the third parties. However,
the Caparo case is similar to
Ultramares in its lack of extension of an auditor duty of care
to third parties;
104 . ibid
105. (1939) 255 NY.
106. A. Chambers , ' Tolley ' s Corporate Governance'
it can also be compared with the Credit Alliance
Corporation v. Arthur Anderson
107
& Co. decision. Here, the New York Court
of Appeal reaffirmed the basis rational of
Ultramares and specific three following additional
prerequisites before an auditor may
be held liable for ordinary negligence to third parties:
1) the auditor must have been aware that financial
statements were to be used for a
particular purpose or purposes by a known
party or parties;
2) in furtherance of the particular purpose, the known parties
were intended to rely on
the financial statements; and
3) there must be some conduct on the part of the
auditor linking the auditor to the
known party or parties that demonstrates the
auditor' s understanding of the
reliance.
More recently, the California Supreme Court in Bily
v. Arthur Young & Co. ended
108
the foreseeability standard in that stated:
`We conclude that an auditor owes no general duty of care
regarding the conduct of an audit to persons other than the client. An auditor
may, however, be held liable for negligent misrepresentations in an audit
report to those persons who act in reliance upon those misrepresentations in a
transaction which the auditor intended to influence...Finally, an auditor may
also be held liable to reasonable foreseeable third persons for intentional
fraud in the preparation and dissemination of an audit report.'
As G .Quillen pointed out, Bily 's decision has had a profound
impact on professional
liability litigation; there has been a well recognized
«expectations gap» between
auditors own understanding of their role and the
expectations that clients, third
parties, judges and juries often have; Courts, clients,
and third parties often seemed
to expect auditors to be able to detect any type of
financial statement misstatement,
and assumed that if the auditor 's report did not disclose
a misstatement it must be a
109
result of fraud or negligence. Bily has elevated the level
of discussion of subsequent
110
accountant liability cases; recent judicial decisions
confirm Bily's influence.
107.1985.483 NE 2d 110.
108.3 Cal.4th 370 (1992).
109.G.Quillen,'The Profound Influence of Bily vs. Arthur
Young', published in ABTL Report
Volume XXIII No.3,June 2001.
110.ibid
For example, In Marini v . Pricewaterhouse
case, the Court applied the essential
teachings of Bily, and it demonstrates that Bily
changed the landscape of auditor
111
liability litigation. Here, plaintiffs were
individuals including Mr. Marini, the
Chairman of the board of directors of a corporate audit
client of Pricewaterhouse
( « PW » ). The individual was also a
guarantor of some of the corporation's debt
obligations. Plaintiff sued PW for negligence, negligent
misrepresentation, intentional
misrepresentation and breach of contract. It was
held that claims for auditor
negligence can be asserted by the auditor 's client only,
and not by third parties.
As we can see, under the Federal decisions, Bily impact is
still important. It was also
applied in at least three significant decisions, one decided
under the federal securities
laws, and two in Securities and Exchange Commission (
« SEC » ) enforcement
112
proceedings against auditors. In Reiger v .
Pricewaterhouse Coopers LLP, the
plaintiffs alleged that the defendant («PW»)
violated Section 10b and Rule 10b-5 of
the Securities Exchange Act of 1934 in a case in which
PW's audit client restated
113
financial numbers which had been previously reported on by
PW. Here, the Court
ruled that plaintiffs failed to allege scienter on the
part of PW and granted PW's
motion to dismiss without leave to amend; it cited several
federal cases stating that
auditors will rarely, if ever, have a rational motive for
participating in a client's fraud.
In addition, the Court cited Bily as follows:
« Second, because an independent accountant often
depends on its client to provide
the information base for the audit, it is almost always
more difficult to establish
scienter on the part of the accountant than on the part of
its client...»
111 . 70,Cal.App.4th 685 (1999)
112. G. Quillen,' The Profound Influence of Bily vs. Arthur
Young'; ABTL Report.
113. Reiger , F.Supp.2d.1003 (S.D .Cal. 2000)
1.7 Recent development of Audit
liability
The most common on the corporate governance debate are
the duties of care which
are in relation to conduct and supervision of the
company's affairs, and in particular
the preparation of the company's accounts. The auditors can
be held liable in relation
to their audit of the company 's accounts,
if they conduct their business
negligently. On the other hand, there is now a
fair amount of case law which
recognises that common sense and logic an important role
to play when it comes to
114
determining the cause of a plaintiff's loss.
In South Australia Asset Management Corporation
v York Montague Ltd, a
valuer had provided a lender with a negligent over-valuation
of a property offered as
115
security for a mortgage advance. The lender gave evidence
that the loan would never
have been entered into in the first place if the lender had
been aware of the true value
of the property. The House of Lords had to determine the
lender's loss, which had
been increased by a drop in property values throughout
the market. It was held that
the valuer was not liable for the loss due to the drop in the
market.
The House of Lords stated that generally a wrong-doer
would only be liable for the
foreseeable consequences of the action being taken in
reliance on that information.
The decision makes it clear that a negligent
valuer will only be liable for the
consequences of a lender's bad investment which are
within the scope of the duty
which the valuer owes to the lender.
The damages awarded against the auditors can be far in
excess of their ability to pay,
either from their own resources through their professional
cover; the liability system
116
is regarded as a risk transfer mechanism and the auditors
are the prime transferees.
114.M.Robertson and K . Burkhart , ' Liability of Auditors to
third Parties'.
115.[1996] All ER 365.
116. G.W. Cosserat ,' Modern Auditing '.
On the other hand, the Supreme Court of Canada, in
Hercules Management Ltd
stated that accountants can be held responsible in
delict or tort to non- clients
117
for the negligent acts they commit in exercising their
protection. In an attempt
to determine class or classes of plaintiffs to whom
auditors owe duty of care, a
duty of care the Court held that auditors are liable to
plaintiffs who are members of a
limited class whose use of and reliance on financial
statements are known to them.
Here the Court recognised that in many cases a duty of
care exists when it is proved
that the accountant ought to have reasonably foreseen that
shareholders, as a class,
will rely on his representations and that the reliance by
shareholders was reasonable
(such as in the Caparo Industries plc case).
According to the Court, the normal
purpose for which auditors' reports are used, in order
to give rise to a duty of care
on their part, is to guide the shareholders as a group
in supervising or overseeing
management and not to assist them in making personal
investment decision, the
auditors should not, as a matter or policy, be
exposed to indeterminate liability.
More recently, in Price Waterhouse v Kwan
the Court of Appeal held that the
auditors owe a duty of care in tort to the Solicitors 's
clients who invested through the
118
Solicitors `nominee company. Here, the Court found that there
was a clear prima facie
case for imposing the duty of care which should be
confirmed at trial unless there
emerged some evidence providing policy reasons
sufficient to lead to the opposite
conclusion.
117. (1997) D.L.R. (4th ) 577 (S.C.C.).
118 . (2000) 6 NZBLC 102,945
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