Audit and Banking Standards

Denis LyonsDo Auditors owe a duty of care to shareholders? by Denis Lyons 

PART 1

A relaxation of the principles in Caparo Industries V Dickman (1990), a House of Lords decision and the leading case on the question of duty, could cause some concern to auditors. Up to now they have claimed that they do not owe a duty of care to individual shareholders. This applies even if banks which are effectively bankrupt are portrayed as profitable. To understand the issues involved, it is important to look at how the concept of duty has been developed by the courts and how it currently applies.

For a duty to apply three criteria must be satisfied, foreseeability, proximity and the “just and reasonable standard”. Foreseeability pertains to some harm being foreseeable by the tortfeasor, but not necessarily the actual harm caused by their actions. Proximity means a close and direct relationship as defined by Lord Bridge in Caparo.

Background

From its beginnings in the seminal case of Donoghue V Stephenson [1932] , the concept of duty of care has expanded far beyond the bounds of its inception. Lines have been drawn only for the courts to cross them in the right circumstances. At first, it was thought hat duty could not extend to negligent misstatements and pure economic loss. In the1960s case of Hedley Byrne & Co. Ltd V Heller & Partners Ltd [1964] , the concept of duty was widened to cover these areas. In the 1970s the House of Lords decision in Anns V London Borough of Merton [1978] proposed a straightforward two stage test for duty. The first issue being whether a duty was foreseeable. If so, the issue remaining was whether there were policy reasons to deny the existence of the duty. The high water mark for duty was reached in the 1980s with the case of Junior Books Ltd V Veithchi Co Ltd [1983]. Here the issue was not so much whether a factory floor was dangerous but whether it was of sufficient quality.

However, the 1990s saw a rowback from the liberal approach in Anns and Junior Books. The area came ultimately to be defined by Caparo which saw the rejection of the liberal approach. The case may be worth repeating briefly. A number of shareholders had suffered substantial losses on the basis of an allegedly negligent audit. However, the House of Lords held that no duty of care was owed by the auditors to the shareholders or members of the public. There was insufficient proximity between them and the audit had been prepared for the shareholders to exercise control over the company not for the purposes of providing information to potential investors. Also, the scope of any duty imposed needs to be considered and whether it is just and reasonable to do so in the circumstances: in Caparo these conditions were not fulfilled.

Comment

Subsequent case law seems to accept the overall statement of principle in Caparo and to explore the boundaries between the various arms of the test. It is clear that mere foreseeability is no longer enough to establish a duty. Proximity and the just and reasonable standard are of greater importance. However, these are malleable categories which may not ultimately be capable of definition. Moreover, the relationship between the proximity and just and reasonable arms of the test is far from clear. Does the former trigger the latter or vice-versa? It is hard to say from a review of the case-law. Perhaps, the answer lies more in policy than in the application of legal principle. Behind policy there usually lies the “floodgates” argument; the “horrifying vista”, at least from a judicial viewpoint, of a deluge of litigation and an undefined multitude of litigants. So, the various arms of the current test in Caparo can be used, particularly the just and reasonable criterion, to achieve the end justified by the merits of the case without opening the dreaded floodgates.
For a potential claimant, this means that the facts and circumstances of each case become all important. Unless a case comes quite clearly within the factual matrix of a precedent, it is unlikely to succeed. However, there has been some softening of the principles of Caparo recently. There is also the effect of the European Regulation of 2002 on international accounting standards to be considered. Parts 2 & 3 of this article will look at these and related issues. 

PART 2

Background

In the leading case of Caparo the scope of duty of care for auditors is defined by the purposes for which information is provided. Audited annual accounts are for control and supervision of a company by shareholders, not for investment purposes and fall outside the scope of any purported duty. A report for a prospective bidder, on the other hand, is clearly within the scope. Somewhere between these two is the locus of current judicial understanding of the scope of duty of care. Other factors which may be relevant include whether the advisor in question is in the business of giving advice and whether the claimant was reasonably entitled to rely on it. In other words whether an investor could have been expected to make further enquiries or obtain independent advice.

Since Caparo, liability to third parties has been extended to Solicitors for certain purposes. In White V Jones (1995) the House of Lord held that Solicitors could be liable to beneficiaries under a will for loss of an intended legacy due to failure to carry out a testator's instructions . In White, the negligence claim was the only cause of action open to the intended beneficiary as the estate had suffered no loss and could not sue. Even where an estate had recourse, the court of appeal has been prepared to extend the bounds of duty Carr-Glynn V Freasons (1998). The ambit of duty was later extended to include life assurance and employment references. For auditors and shareholders, the question came up up again in the case of Johnson V Gorwood & Co ( 2002). In that case the claimant's personal and business affairs were so “intertwined” that it was not possible to distinguish between the claimant and his company. The claimant was a 100% shareholder and had guaranteed the company's liabilities in connection with a proposed transaction. The distinction between company and claimant is important because a shareholder can not sue to recover damages for himself in relation to wrongs done to the company. The two are different entities in law. The proper course is to bring a derivative action on behalf of the company: the rule exists to preclude the possibility of double recovery. In Johnson, the House of Lords was prepared to extend the scope of duty, largely because the claimant was precluded from bringing a derivative action.

Comment

To what extent does the decision in Johnson undermine the principles set forth in Caparo? Is it a major inroad or something more confined to the facts of the case? In my view, the facts are uppermost. Nevertheless, the fact that the House of Lords was prepared to blur the line between personal and corporate liability is significant. The distinction goes to the very root of company law and underpins a great number of cases and business transactions. It is unlikely then that this embedded principle would be easily breached. Nevertheless, the underlying issue of auditor liability will not go away and was considered again in an Australian case David Ballard V Multiplex Ltd (2008). Like Johnson, the case concerned shareholder liability as guarantor. The defendant also claimed deprivation of income and dividends. The claimant succeeded regarding the guarantee but not the income and dividends, despite the fact that the company had been wound up and there was no prospect of double recovery. The decision in Ballard is from a Commonwealth jurisdiction and so of persuasive interest at best and not binding . It could be referred to in the absence of anything more pertinent in the domestic jurisdiction. In this sense, it could be argued that Ballard closes the double liability door opened in Johnson, but the case probably hinges more on the lack of a separate duty to the shareholder in question and is confined to its facts. Nevertheless, a company's inability or or failure to pursue a remedy, rather than a defendant's wrongdoing, should remain central to future deliberations.

PART 3

Background

Regulation (E.C.) 1606/2002 has as its main aim the efficient and cost effective functioning of European capital markets. Another important goal is the protection of investors and the maintenance of investor confidence. Still broader aims include the completion of the internal market and increased access for European companies to world capital markets.

The means to achieve this in the first instance include the convergence of accounting standards used to prepare financial statements in Europe. This is achieved under the regulation by way of the introduction of International Accounting Standards (IAS). These necessitate a “true and fair view” of the financial position of an enterprise. This should be conducive to the public good and meet basic criteria as to the quality of information required for financial statements to be useful. Under Article 3 of the Regulation, (IAS) standards can only be conducive in this way if they meet, inter alia, the criterion of reliability to make economic decisions and enable investors to assess the “stewardship of management”. Under Article 10 of the Founding Treaty E.C., member states are obliged to take appropriate measures to ensure compliance with (IAS). The process should have been completed by 2007.

Comment

Could the Regulation help to establish a duty of care for Auditors vis a vis shareholders? In the absence of case-law on point, any commentary is bound to be speculative. Nonetheless, one of the stated aims of the Regulation is the protection of investors. There is, however, no clear definition of investor for the purposes of the Regulation. An issue might be whether investor and shareholder are distinct categories or whether the former includes the latter. In the absence of a statutory definition, ordinary usage would apply. Using this criterion, investor would seem to encompass shareholder. Furthermore, Article 3 of the Regulation states that (IAS) can only be conducive to the public good if they enable investors to assess the stewardship of a company as well as other indicators. Would it be reasonable under these terms to exclude shareholders from examining the stewardship of companies they have bought into for investment purposes?
To an English court fine gradations of meaning are important. The courts are, in general, only prepared to expand the ambit of duty on an incremental basis, slowly and by analogy as described in Part 2 of this article. The European Court of Justice (ECJ) however takes a different approach. It would look at any potential liability for auditors more broadly and purposefully; some would say politically. The ECJ might say that if the overall purpose of the Regulation is to give a true and fair view of a company's accounts, then it matters little for whom the information is compiled. Any distinction between shareholders and investors is artificial. It may also be discrimanatory. If there is to be a level playing field for financial decisions, surely it should apply to all.

Whether an English court would be prepared to go that far remains to be seen, However, there seems to be sufficient uncertainty regarding the ambit and application of Regulation (E.C.) 1606/2002 for at least a referral to the (ECJ) for clarification. The outcome of such a referral could yet prove rewarding for shareholders frustrated by the constraints placed on auditor liability by the decision in Caparo.