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Auditor negligence: large settlements, still many unresolved issues

The Supreme Court decision in Deloitte & Touche v. Livent Inc. leaves many important issues unresolved in cases against auditors. As can be seen in the recent settlement of CIBC v. Deloitte & Touche, there is still considerable exposure on the part of auditors.

Livent and Deloitte Decision by the SCC

The Supreme Court of Canada decision in November 2017 dealt with the appeal of the Deloitte & Touche v. Livent Inc. decision, and it reduced the amount of the damages to $40 million. The Supreme Court saw the relevant date for quantifying Livent’s damages as the date when Deloitte issued its statutory audit report (April 1998), rather than the date when Deloitte should have resigned (August 1997). On this basis, damages were quantified at $40.425 million, reduced from $84.75 million.

A majority of the Supreme Court of Canada found that Deloitte’s negligent statutory audits had caused Livent to miss the opportunity to change management at an earlier date. As a result, Livent increased its liquidation deficit in the period during which it was in the dark about management’s fraudulent practices.

It is worth noting that a strong minority in the Supreme Court of Canada in Livent would not have found Deloitte liable to Livent at all. The minority found no evidence that Livent would have done anything differently had Deloitte delivered accurate financial statements, and all the increase in the liquidation deficit should reasonably be the responsibility of the auditors. The majority, by contrast, looked to the subsequent conduct of Livent in getting rid of management immediately on discovering management’s fraud.

Defence of ex turpi causa

One interesting consequence of both Livent and CIBC is that the courts gave short shrift to the defence of ex turpi causa, the principle that the court will not lend its assistance to a plaintiff whose fraudulent conduct gave rise to the very transaction for which the plaintiff seeks relief. The fact that the corporations for which the audits were performed had engaged in fraudulent conduct did not provide a defence for the negligent auditors. In Livent, the court said that it would not, in general, be a defence for a negligent auditor (or professional generally) to a claim in negligence to argue that the client was fraudulent.

Role of engagement letters

Deloitte, in its engagement letters with Philip Services Corp., did not specifically exclude liability for any third parties, such as lenders, that might make use of the financial statements. One would think that, in future engagement letters, auditors will make sure to include such limitations of liability.

In August 2017, Deloitte and/or its insurers agreed to pay $121,896,000 to avoid taking this matter to trial.

CIBC and High River Limited Partnership had brought a class action against Deloitte, which was consolidated with another action against Deloitte brought by the receiver of Philip Services Corp. CIBC was a lender to Philip. High River Syndicate Partnership represented a syndicate of lenders to Philip.

In 1997, a syndicate of lenders led by CIBC entered into an agreement to advance up to US$1.5 billion to Philip, relying on Philip’s 1995 and 1996 audited financial statements.

Deloitte had expressed unqualified audited opinions on both sets of financial statements. However, in 1998, Philip restated its financial statements for 1995 and 1996. The earlier statements had inflated Philips’ earnings, assets and shareholders’ equity and had understated Philip’s expenses and liabilities.

Philip defaulted on the loan and filed for insolvency protection.

In the action, CIBC and High River alleged negligent misrepresentation and reckless misrepresentation regarding Deloitte’s 1995 and 1996 audits of Philip, and claimed US$524million in shortfalls in loan repayments. The receiver alleged breach of contract and auditor’s professional negligence. The receiver alleged that Philip had relied on the negligent audit opinions pursuing a strategy of acquiring other companies. The receiver claimed US$723.7million.

The August 2017 Justice Paul Perell approved the settlement of the class action against Deloitte.

Indeterminate liability

One of the issues faced by Deloitte was the greater the knowledge of the auditor as to the intended use of the audited financial statement, including the identity of the lender and the amount of the loan, the greater the chance that the lender could subsequently argue that one of the purposes of the financial statement was precisely to facilitate the loan, again excluding the possibility of indeterminate liability.

Given that the jurisprudence on auditor’s liability is not extensive (Ernst & Young and Hercules Management, Deloitte and Livent and Deloitte and CIBC - Philips), the courts have not yet provided clear precedents on all the multiplicity of issues surrounding auditor’s liability.

Peter Macaulay is a forensic accountant whose practice focuses on damage quantification.