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Publications
Auditors – Still ‘Deep Pockets’?
London & Bermuda Newsletter
With the souring of the economy and a surge in reported fraud, auditors – and consequently, their insurers – are increasingly exposed to potential claims for negligence. Recent events will not allay their concerns.
At the end of July 2009, the House of Lords delivered its decision in Moore Stephens v Stone & Rolls Ltd [2009] UKHL 39. Favourable to the auditors, the decision was greeted in some circles with exclamations about the additional protection it afforded to accountants. Closer analysis, however, suggests there is little change in the law. And in September, the government announced that it would not enact legislation to limit auditors’ liability.
Moore Stephens signed unqualified audit reports for Stone & Rolls (S&R) in the three financial years 1996 to 1998. The previously dormant company was run and controlled by Mr Stojevic, described by Lord Phillips as “the sole directing mind and will and the beneficial owner of S&R”. The company did not carry on any significant business and was used solely as a vehicle to defraud various European banks by means of fictitious transactions which provided the appearance of a stable and profitable business which the banks funded by letter of credit. When, in due course, the final letters of credit were not repaid and the company went into liquidation in 2002, claims in the amount of some $174 million were made against S&R. Neither the company nor Mr Stojevic had identifiable assets and the liquidator brought a claim for negligence against the auditors.
The auditors applied to strike out the claim on the principle of ex turpi causa, most commonly paraphrased as “no one can found a cause of action on his own criminal conduct”. If the principle applied, it barred the company (acting by its liquidators) from advancing the claim against the auditors at all, as the claim would be based on the company’s own fraud. The issue which exercised the nine judges considering this preliminary question was whether ex turpi causa could apply in the circumstances, given the equally well known principle (known as the principle in Hampshire Land) that the knowledge of a dishonest agent cannot be attributed to his innocent principal. Under that argument, Mr Stojevic and S&R were separate legal personalities and the innocent company should not be fixed with his fraud in its claim against the auditors.
The Underlying Decisions
At first instance, Langley J held that there was no compelling reason why S&R should not be subject to the principle of ex turpi causa. However he did agree with the liquidators’ further argument that the auditors could nonetheless be held liable, given that S&R’s illegal conduct was “the very thing” the auditors were under a duty to detect.
The Court of Appeal reversed this decision. The victims of the fraud were the banks, not S&R. S&R was not an “innocent” party and S&R, in the circumstances, could properly be fixed with the dishonest intention of Mr Stojevic. The concept of “the very thing” was one of causation and could not displace the operation of the defence of ex turpi causa.
The House of Lords
The company’s appeal to the House of Lords was dismissed and the claim remained struck out. However, the ultimate decision was by a bare majority (3-2) and even the majority varied in its reasoning. Lords Walker and Brown agreed that the principle in Hampshire Land did not apply, as there were no innocent directors or shareholders. They also agreed that the argument of “the very thing” would not apply.
The lead judgment was given by Lord Phillips, who, while agreeing that ex turpi causa provided a defence, analysed the issue from the point of view of the auditors’ duty of care. On this analysis, the ultimate beneficiaries of the claim (if successful) would be the banks; however, the auditors’ duty of care does not, under English law, extend to the victims of any fraud perpetrated by the company and Lord Phillips did not contemplate any expansion of the duty of care.
In their dissenting judgments, Lords Mance and Scott stated that the auditors of S&R (as officers of the company) owed a duty of care to the company’s creditors in circumstances where the company is or could become insolvent. It is not clear whether this view was conceived as an extension of the principles in Caparo v Dickman, laid down by the House of Lords in 1990, which established that the auditor owes a duty to the company alone.
A Damp Squib?
The overall effect of the case is that if the person responsible for a fraud is in effect the “sole directing mind and will” of the company in question, the defence of ex turpi causa will defeat a claim against the auditors. That principle is not limited to so-called “one-man” companies, but will hold where other directors and/or shareholders are complicit in the fraud, whether actively or passively; however, the result would be different in circumstances where there are innocent directors and shareholders. It was emphasised that the present case was “rare and extreme” and the decision very fact-sensitive. In consequence, it is unlikely to assist the “big four” accounting firms, whose clients are unlikely to be “one-man bands”. And those firms, in turn, will be unable to avail themselves of the non-contractual limitation of liability they had been seeking, now that the government has pronounced against it. At what price, then, their insurance?
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