February 3, 2016

Auditors - Auditors’ liability in Canada

Judgment may have far-reaching implications for how auditors handle disagreements

The Ontario Court of Appeal's judgment on January 8 in Livent v Deloitte & Touche has the potential to impact broadly auditors' duties and liabilities in Canada. It adds to the growing body of case law on the illegality defence and arguably introduces the "deepening insolvency" theory of damages into Canada. Whether the parties will seek leave to appeal to the Supreme Court of Canada has yet to be declared.

Livent, a publicly traded company, was fraudulently manipulating its financial results at the direction of its former chief executive and chief financial officer, with the assistance of its accounting and IT departments, and to the knowledge of most of its audit committee.

After a change in management, Livent's accounting staff confessed and the fraud was discovered. Creditors put the company into receivership and bankrolled a claim in Livent's name against Livent's auditors for alleged negligence in the conduct of their audits. The claim sought the liquidation deficit differential between the moment of the auditors' allegedly negligent acts and Livent's eventual demise.

Livent's creditors would have had no claim against the auditor because of the policy in Hercules Managements Ltd v Ernst & Young that auditors should not be subject to indeterminate liability, which negates a duty of care to third parties absent specific circumstances.

The court rejected the auditors' argument the creditors should not be able to make those same recoveries through the company, finding the losses were the company's and it could not look through the company to the ultimate beneficiaries for this purpose. In doing so, it arguably interpreted Hercules as a case about legal standing to bring a claim and nothing more.

The court also side-stepped consideration of the adoption in Canada of the controversial "deepening insolvency" theory of damages (ie, recovery for damage to an already-insolvent company by reason of its increased liabilities to third parties). However, by upholding an award of damages based on the liquidation deficit differential, the court appears to have accepted it.

The court also examined the illegality defence, which attributes the illegal conduct of a company's directing minds to the company itself and provides a defence to a claim by the company – fraudulent through the attribution – against merely negligent third parties. It rejected Canadian case law applying the defence in the circumstances, in part because it found it must look through the company to the ultimate beneficiaries for this purpose and it could not deprive the innocent of a remedy.

For the same reasons, the court also rejected arguments of Livent's contributory liability. Since the illegality defence was not applicable on these facts, where the company was held to be "rife with fraud", it is questionable whether the defence could ever apply to a public company.

Finally, the court concluded the circumstances surrounding a disagreement between auditor and client led to a "complete breakdown in the relationship" at one point in time. The auditor had a legal "duty to resign" despite not having an inkling of the fraud; the auditor would have had to indicate its loss of trust in its client as the reason; and this would have led to an earlier collapse of the company and avoided the increase in its liabilities, which the court found to be the measure of its damages. This aspect of the judgment may have far-reaching implications for how auditors handle disagreements.