LITIGATION & DISPUTE RESOLUTION SJ Berwin LLP
Liability to third AUDITORS HAVE HAD AN UNCERTAIN TIME OVER THE
past year, the high-value claims against KPMG and
parties and clients: Ernst & Young being the higher-profile examples of
this. Some commentators have even drawn parallels
are auditors with the demise of Arthur Andersen in the wake of
Enron, and spoke of the Big Four accounting firms
watchdogs or being reduced to the Big Two.
bloodhounds? However, auditors appear to have come out on top,
with Ernst & Young, in particular, winning the battle
of brinkmanship in its war with Equitable, and
demonstrating that auditors are no longer the deep-
pocketed easy target for claimants who make bad
business decisions.
Statute also seems to be following in the wake of
the key court decisions of the year, as the Company
Law Reform Bill opens the way to limiting the
amount of liability of auditors. This could see the
end of multi-billion-pound litigation that threatens
the very survival of large accountancy firms. The
question of interest that emerges from this trend is
whether this is a judicial and legislative policy
decision – which potentially does a disservice to
companies that are highly reliant on their expensive
auditors – or if this is a long-overdue clarification of
the law, which has finally come into line with
commercial reality.
WHAT IS THE AUDITOR’S JOB?
When auditors’ negligence is mentioned, lawyers
inevitably think of Lord Denning’s ground-breaking
dissenting judgment in Candler v Crane, Christmas &
Co, which paved the way for establishing the
principle that accountants owed a duty of care to
third parties, and which was famously expounded in
Caparo Industries Plc v Dickman. Since then, the
principle has almost been taken for granted, and the
courts have seen claims made against auditors not
only by the companies that employed them, but
also by directors, shareholders, potential investors
and creditors. The courts have elaborated numerous
tests of foreseeability, proximity and assumption of
responsibility, and have adopted an incremental
approach in an effort to curtail this tendency.
The result has been that the position of auditors
has been somewhat compromised by the
‘The position of auditors has been somewhat compromised by
the uncertainty in the case law and the seemingly limitless
liability imposed on them by statute.’
uncertainty in the case law and the seemingly
limitless liability imposed on them by statute.
It is therefore useful to look, as a starting point, at
the scope of an auditor’s duty in relation to an audit
report.
The purpose of the annual accounts is principally to
inform shareholders of how the company is doing.
The directors generally prepare these accounts and
a directors’ report, which are independently verified
and signed off by the auditors in the form of an
auditors’ report and certificate. This may be
qualified or unqualified depending on the
circumstances (for example, if the directors have
provided all the necessary information). In the audit
certificate, the auditors state if in their opinion the
accounts represent a ‘true and fair view’ of the
company’s affairs.
However, what happens when there is an error or
there has been fraudulent activity which is hidden in
the accounts? Are the auditors responsible for
picking this up, and if so, to what extent are they
responsible?
Generally an auditor’s duty is derived from:
a) statute – particularly s235 of the Companies Act
1985 and the numerous accounting standards
which define what comprises a ‘true and fair
view’;
b) the contract of engagement with its client,
which will contain in express terms the scope of
the retainer (including any disclaimer) and will
also imply terms of reasonable care and skill;
c) the tortious duty of care; and
d) fiduciary duties of loyalty, confidentiality and the
duty not to exercise undue influence1.
However, despite the far-reaching claims that have
been made against auditors, the courts have striven
to keep a firm guard on the floodgates as regards
the duties auditors owe.
As Caparo has made clear, the duty owed by
auditors is to ensure the company’s financial
information, as prepared by the directors,
accurately reflects the company’s position. There
are two purposes to this: first, to protect the
company from the consequences of undetected
errors (such as declaring dividends out of capital),
and secondly, to enable the shareholders to
scrutinise the conduct of management with a view
to exercising their power to reward or remove the >
February 2006 The In-House Lawyer 73
LITIGATION & DISPUTE RESOLUTION SJ Berwin LLP
WHAT ARE THE LESSONS
OF EQUITABLE ?
The collapse in September 2005 of the Equitable
Life litigation against Ernst & Young, although
instructive in itself, deprived the law of an up-to-
date exposition of the extent of auditors’ duties.
The facts are well known. In summary, Equitable had
suffered a significant blow in 2000 when the House of
Lords ruled that it must honour its guaranteed
annuity rates to policyholders, despite falling interest
rates. As a result, Equitable noticed a shortfall in the
accounts of over £1bn, and brought a claim against its
auditors, Ernst & Young, for negligently preparing its
accounts in the late 1990s. Equitable claimed that it
had thereby lost the opportunity of selling its
business, which it claimed it would have done had it
known the full extent of the shortfall.
In the end, Equitable withdrew its mammoth claim due
to problems in proving causation (Equitable’s evidence
showed that the directors would not in fact have sold
the business, even if they had been aware of the
directors. It was emphasised in Caparo, however,
that this duty was owed to shareholders as a body,
rather than as individuals, and that an action
therefore should be brought in the name of the
company, which was indistinguishable from the
body of shareholders. The purpose was to draw a
line between what was held to be a reasonable duty
owed to the company’s owners as a whole, and the
more unreasonable obligation to specific
shareholders making individual investment
decisions.
This general view has since been upheld by the
regulatory bodies. For example, Statement of
Auditing Standard 100 states that the purpose of
the audit is for an auditor to give ‘reasonable
assurance that the financial statements give a
true and fair view’ – that is, not a guarantee.2
However, Statement of Auditing Standard 110.1
states that auditors should recognise that fraud or
error may ‘materially affect the financial
statements’.3 This goes further than Lopes LJ’s
famous statement in Re Kingston Cotton Mill Co (No
2) that auditors were ‘watchdogs not bloodhounds’,
and while their job was to detect and investigate
obvious errors, they were not expected to
guarantee the accuracy of the company’s accounts.
In short, there is a fine balance to be struck, as
Equitable Life and Man v Freightliner show (see
boxes above and on pxx).
74 The In-House Lawyer February 2006
shortfall) rather than in proving that negligence had
occurred. However, the case still had some useful
lessons for lawyers and auditors alike:
■ It is not enough for a claimant to get carried
away with a claim of negligence – it is also crucial
to think through the next hurdle of proving that
the breach actually caused the loss claimed.
■ Such cases involve extensive factual and expert
evidence and a forensic exercise into the
accounts. This is one of the reasons why the
Court of Appeal overturned Langley J’s decision
to strike out the claim at first instance and
decided that the case should proceed to a full
hearing.
■ The legal costs of the case were widely reported
as running into tens of millions of pounds. This
highlighted the need for the courts to strike a
balance between the spirit of the CPR (in the
expeditious and proportionate resolution of
disputes), and the desire to allow parties to have
their day in court in a case of such magnitude
and potentially wide-reaching impact.
WHAT DOES THE COMPANY LAW REFORM BILL
PROPOSE TO DO IN RELATION TO AUDITORS’
LIABILITY?
Although the courts have been reluctant to expand
auditor’s liability, paradoxically, statute has allowed any
claim that is made to be limitless in quantum. Section
310 of the Companies Act 1985 makes void any
provision which limits the liability of an auditor in the
context of negligence or breach of any other duty.
The Company Law Reform Bill, which is before the
House of Lords, sets to change all that by allowing
‘liability limitation agreements’ between companies
and auditors. These would limit the amount of
liability owed to a company by its auditor in respect
of any negligence, default or any other breach of
duty in relation to an audit.
The Bill states, however, that such an agreement
must only limit liability to an amount which is ‘fair and
reasonable in all the circumstances’. No figure or
specific formula is given for what constitutes
‘fair and reasonable’. Presumably this has been left to
be negotiated and approved in every individual case,
as what is ‘fair and reasonable’ for Bloggs and Co may
not necessarily be so for Deloitte or KPMG.
Nevertheless, some guidance or reference to
insurance policies could have been given to avoid
LITIGATION & DISPUTE RESOLUTION SJ Berwin LLP
Candler v Crane, Christmas & Co
[1951] 2 KB 164
Caparo Industries Plc v Dickman
[1990] 2 AC 605
Equitable Life Assurance Society v Hyman
[2000] 3 All ER 961
Re Kingston Cotton Mill Co (No 2)
[1896] 2 Ch 279 CA
Man Nutzfahrzeuge AG and Ors v
Freightliner Ltd and Ors
[2005] EWHC 2347 (Comm)
WHAT ARE THE LESSONS
OF MAN V FREIGHTLINER ?
Just as Ernst & Young emerged from the successful
conclusion of their dispute with Equitable, they
faced another battle, having been joined as a Part 20
defendant into Man’s claim against Freightliner. If
lawyers and auditors had been deprived of a modern
statement of the law in Equitable, Man left little
doubt as to which way the law was heading.
The case involved falsification of financial information
by the financial controller of ERF, a subsidiary of
Freightliner which had subsequently been sold to
Man. When Man discovered after the acquisition that
ERF was in fact insolvent, it sued Freightliner for
deceit. Freightliner, however, joined Ernst & Young
into a Part 20 claim, submitting that the auditors had
been in breach of their duty of care to the extent
that they had contributed to the losses suffered.
Although the claim in deceit against Freightliner
succeeded, the Court held that no duty as claimed
was owed by Ernst & Young. Freightliner had failed to
show that its auditors had, on the facts, assumed
uncertainty, as has been achieved in the case of law
firms. The risk remains that, if this becomes law,
there will be a spate of cases on this issue, with
claimants pushing at a closing door where, for
example, there has been an undetected fraud.
CONCLUSION
The law has evolved from opening the way for
auditors’ liability in relation to third parties as well as
their clients, to placing stringent limits on the
extent of that liability. This is because the
commercial reality nowadays is very different to
that on which present companies legislation is
based. Directors prepare accounts and, although
auditors are in practice involved in the process at
the working draft stage, they cannot know every
aspect of the running of complex, and often
international, corporate structures. Pragmatism
dictates that they must rely to some extent on
internal accounting procedures, although the courts
have required auditors to take an independent view
as to the reliability of such procedures4.
Although the trend in the case law and legislation is
bringing the law into line with this reality and taking
some of the pressure off auditors, it is to be hoped
that it will not lead to a laxness in vigilance, as
responsibility for the accuracy of the audit statement
so as to be under a duty to protect it from the loss
claimed. Although the Court stated that aspects of
Ernst & Young’s advice had not been ‘commercially
wise’, the allegations did not relate to the services
that the auditors were engaged to perform (a general
audit rather than a due diligence exercise for the
purchaser). Further, the auditor’s advice had not
contributed to the loss, which was caused by the
dishonest statements of the financial controller and
not by the mismanagement of the company.
In short, the main lessons that can be derived from
this case are as follows:
■ Although Man’s claim in deceit against the
vendors succeeded (the assessment of
damages being deferred), the auditors were held
blameless for their role in signing off the audit.
■ Although auditors are obliged to follow up on
instances of material error or obvious fraud
which come to their attention, it is not their job
actively to seek out fraudulent activity. In the
words of Lopes LJ, auditors are ‘watchdogs not
bloodhounds’.
auditors are often the only independent
whistleblower that shareholders can rely on when
the management of a company goes wrong. The
need to strike a balance between the necessary
assumption of responsibility by auditors, and the
need to discourage ambulance-chasing claimants,
will no doubt be reflected in carefully worded
disclaimers and the testing of what comprise ‘fair
and reasonable’ limits on liability.
Written by Shaistah Akhtar, assistant solicitor,
commercial litigation, SJ Berwin LLP
E-mail: shaistah.akhtar@sjberwin.com.
NOTES
1) Jackson & Powell on Professional Negligence,
5th edition, Sweet and Maxwell, 2002
15-031 – 15-044.
2) Ibid – 15-094.
3) Ibid – 15-095.
4) Ibid – 15-106 – 15-107.
February 2006 The In-House Lawyer 75