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The role of the Auditors in the UK Corporate Governance

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par N'semy Aubin Mabanza
University of Wales, Cardiff Law School - LLM (Master of laws) in Commercial Law 2004
  

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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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