Legal Liability

1. Legal Liability Week 5

2. The Legal Environment • Increased litigation, especially in the US. • The effect of litigation on the profession. • Limitation of auditors’ liability – incorporation of audit firms. • Joint and several liability v. proportionate liability.

3. Key legal terms • Privity • Breach of contract • Tort • Ordinary negligence • Gross negligence • Fraud • Joint & several liability • Proportionate liability

4. Summary of types of actions

5. Breach of contract • Auditor’s failure to complete the agreed services in the engagement letter. • If client breaches its obligations, then auditor is excused from his contractual obligations. • If auditor discontinues audit without adequate cause, may be liable for economic loss suffered by client. • Other possible issues – late audit report, failure to detect fraud

6. Negligence – proving it: • The accountant had a dutyto the plaintiff to exercise due care, • The accountant breachedthat duty by not following professional standards, • The accountant's breach of due care was the proximate causeof the third party's injury, and • The third party suffered an actual damage as a result.

7. Duty of care • Obligation to perform duties with skill & care required, under the circumstances • What other professional accountants would have done, under the similar circs

8. Privity • The traditional view held that auditors had no liability under common law to third parties who did not have privity with the auditor. • Privity of contract means that the obligations that exist under a contract are between the original parties to the contract, and failure to perform with due care results in a breach of that duty only to those parties. • The landmark decision in this area, Ultramares v. Touche (1931)  auditor not liable to 3rd parties who relied on a neligently-prepared report

9. Privity – Various cases • Candler v. Crane Christmas & Co (1951) •  Judgement same as Ultramares, but the judge was of the view that accountants owed a duty of care to persons, other than their clients, whom they know would rely on their accounts • Hedley Byrne v. Heller & Partners (1963) • Duty of care owed, although no contractual relationship • Haig v. Bamford (1976) •  Duty of care owed although identity of plaintiff not known to auditor

10. Privity – Various cases (Contd.) • Scott Group v. McFarlane (1978)  foreseeability • JEB Fasteners v. Marks, Bloom & Co (1982)  reasonable foreseeability • Caparo v. Dickman (1990)  privity rule re-affirmed • McNaughton Paper Group v. Hicks Anderson (1991) • R Lowe Lippman Figdor & Fank v. AGC (Advances) Ltd (1992) • Esanda Finance v. Peat Marwick Hungerfords (1997) •  Rulings similar to Caparo case

11. Breach of standard of care • Standard of care – reasonably skill & care of another skilled person carrying out the same assignment • But does not include a guarantee • Watchdog not bloodhound • Professional skepticism, not suspicion • Over the years, the standard of care has evolved • Physical stock observation • Communication to client in instances of fraud • are now part of standard auditing procedure.

12. Duty to detect fraud • Usually considered by reviewing auditor’s approach to suspicious circumstances • Re Kingston Cotton Mill  auditors not responsible for detecting fraud schemes • Thomas Gerrard, Revelstoke Credit Union v Miller & Berry (1985)  auditors’ suspicion should have been aroused and fraud should have been detected • Cenco, Inc v. Seidman & Seidman  auditor has no duty to uncover fraud committed via collusion

13. Causal relationship • Loss is the consequence of the breach of duty, must be reasonably foreseeable • Reliance • must have relied on the FS, casual perusal or awareness not enough • If FS prepared for the purpose of an investment decision, and no other source of info available  stronger reliance connection can be drawn • JEB Fasteners  plaintiff’s loss not caused by auditor’s negligence • Contributory negligence • client’s loss may not be entirely due to auditor’s negligence  could be partly due to employee of client • AWA Limited v. Deloitte Haskins & Sells (1992)

14. Damages • Common claims – loss of investment, overpayment of investment, loss due to fraud, overpayment of dividends • Awards  usually monetary, and usually puts the plaintiff in the same position had the negligence had not occurred • No award if plaintiff has not suffered real measurable loss • Scott Group v. McFarlane • Overstatement of shareholders’ funds by NZ$38,000 • Would not necessarily result in an overpayment for the acquired company  hence no real damage was suffered

15. Auditor liability for fraud • A false representation by the accountant, • Knowledge or belief by the accountant that the representation was false, • The accountant intended to induce the third party to rely on the false representations, • The third party relied on the false representation, and • The third party suffered damages.

16. Statutory Liability • Companies Act 1965 • Securities Commission Act 1993 • Securities Commission (Amendment) Act 2000 • s.57  negligence/misrepresentation in financial info in public issues • s.153  right to civil proceedings by person/s suffering damage • S.155  SC has power to take civil actions on behalf of investors who suffer loss

17. Criminal liability • Companies Act 1965 • s.174(8)  must report to CCM if breach/non-compliance encountered in the course of audit • S.132A  insider trading is an offence

18. Approaches to minimising legal liability at the professional level • Pushing for tort reform. •  Limitation of auditor liability, e.g. proportionate liability • Establishing stronger auditing and attestation standards. • Continually updating the Code on Professional Ethics and sanctioning members who do not comply with it. • Educating users on expectation gap.

19. Approaches for minimising legal liability at the firm level • Instituting sound quality control and review procedures. • Ensuring that members of the firm are independent. • Following sound client acceptance procedures. • Being alert for risk factors that result in lawsuits. • Diligently performing and documenting work.