28 June 2004
You can understand why accountants complain about their potential exposure. Enron and the collapse of Arthur Andersen are still fresh in the mind, and it is clear from recent events that a blue-chip multinational’s financial outlook can turn sour very quickly.
You only have to look at last year’s two biggest cases, Equitable Life v Ernst & Young (2003) and Barings Futures (Singapore) v Deloitte & Touche (Singapore) (2003), where the potential exposure was enormous, to see that the extent to which auditors have to take responsibility for such problems – the extent of their duty of care – is a crucial issue to the profession.
The bedrock of the law in this area is the House of Lords decision in Caparo v Dickman (1990). This sets down a line that auditors are anxious to protect, but which has repeatedly come under attack from claimants. It is no surprise, then, that the extent to which accountants can or should limit their liability continues to be a key issue.
Evidence of the continued debate on the proper extent of an auditor’s duty of care can be seen from three of the main cases of last year. These were all attempts by auditors to obtain summary judgment on, and/or strike out claims, on the basis that the duties claimed fell foul of the decision in Caparo. Each attempt failed.
Independents’ Advantage Insurance v Cook (2003) concerned a claim by an insurance company that provided bonds which were required to be put up by travel agents operating as members of the Association of British Travel Agents (ABTA) and the International Air Transport Association (IATA). A bond had been issued in reliance on the company accounts. The travel agent went into liquidation, the bond was called on and a claim against the auditor resulted. The auditor claimed that no duty of care was owed to the insurer. Summary judgment was refused by the judge and on appeal. The Court of Appeal considered that, while recent cases established that auditors owe a duty to ABTA and IATA, whether the duty could be extended further still, to the insurer, was on the margins of the existing decisions. The law on the scope of the duty of an auditor is still in a state of development and transition. The right course, unless the case is plainly and obviously within decided authority, was to let the matter go to trial.
One day later, the Court of Appeal gave its decision in Equitable Life v Ernst & Young. Equitable’s claim was that its management had made ill-informed decisions in the belief that the society’s accounts were free from material error. It was said that if the true position had been known to the directors, they would have sold or tried to sell the business and would not have declared certain bonuses to policyholders. The auditors applied to strike out the claims made against them and at first instance they succeeded. The real issue on the appeal was the harm from which the auditor was under a duty to protect Equitable. The Court of Appeal allowed the claims for the loss of a chance to sell and for the bonus declarations to continue to trial. It again stressed that it was inappropriate to strike out claims in developing areas of law. Novel points of law, it said, should be based on actual findings of fact.
The final case was Man v Freightliner and Ernst & Young (2003). As a result of an internal fraud, a takeover was based on inaccurate accounts. The purchaser brought a claim for breach of warranty and deceit and the seller issued a Part 20 claim against its auditor (which was also involved in the sale). The auditor applied for summary judgment. Any duty of care could not, it argued, extend to investment decisions on the basis of the Caparo decision. However, Mr Justice Cooke declined to give summary judgment. Referring to both the Equitable Life and Independents cases, the judge decided that it was necessary to determine the facts at trial before addressing the legal principles. He also noted that exceptions to the general principle were contemplated in Caparo.
It would be wrong to say that these decisions (being only strike-out and summary judgment applications) have substantively affected the Caparo test. What can be taken from them is that the courts clearly regard the scope of the auditor’s duty to be a developing area, and is therefore reluctant to dispose of complicated,
fact-sensitive cases on a summary basis.
This leaves auditors in a position of some uncertainty. In light of this, accountants are right to be looking over their shoulders and seeing what can be done to limit both their duty of care and their liability.
As far as third-party liability in respect of audits is concerned, the Scottish case of Royal Bank of Scotland v Bannerman (2002) emphasised the potential importance of including a disclaimer in audit opinions. In Bannerman, the auditors failed to strike out a claim by the company’s bank that it was owed a duty of care in relation to its reliance on the accounts in making decisions on lending to the company. The failure to disclaim responsibility was a material factor in the decision. In response to this case, the Institute of Chartered Accountants in England & Wales (ICAEW), in January 2003, recommended a form of disclaimer to limit a potential duty of care to third parties.
There are, of course, limits to what can be excluded in relation to statutory audits. Section 310 of the Companies Act 1985 forbids the company from exempting its auditor from liability to it arising from the statutory audit. The longstanding pressure for a change to this section to allow such an exemption seems to be having effect. In December 2003, the Department of Trade and Industry (DTI) issued a consultation paper on auditors’ liability. In the paper, the DTI set out three possible options: to do nothing (unless forced to by the EU); to allow a cap to be agreed by the parties; or allow a cap subject to parameters being set by the Secretary of State. The deadline for responses was 12 March 2004 and further developments are awaited. The grapevine suggests that the Government is in favour of allowing a cap and that the reform may be tacked onto the Companies Bill currently en route through Parliament. However, this remains a controversial issue and is one on which heated debate will no doubt continue for some time before a conclusion is reached.
The accountancy profession must also consider how best to limit its liability in other areas not covered by the statutory prohibition. The recent case of University of Keele v Price Waterhouse (2004) shows the importance of careful drafting of exclusion clauses in engagement letters.
Price Waterhouse advised the university on the introduction of a profit-related pay tax saving scheme, which ultimately did not work. Negligence was admitted, but a hearing was still necessary to determine the construction of an exclusion clause in the engagement letter. This excluded liability for failure to realise the anticipated savings or benefits. Another part of the clause accepted liability for loss directly resulting from any negligence subject to a liability cap. The problem was that part of the loss claimed was a direct loss for the failure to make savings. The question for the Court of Appeal was: which part of the letter prevailed? The court concluded (upholding the judgment of Judge Hart) that the part referring to direct loss did and that the loss was not excluded. However, this was simply a question of construction of the clause itself. No recourse to the contra proferentem doctrine or issues of repugnancy (relied on by the judge at first instance) was considered necessary.
The attacks on Caparo have yet to make any real headway. The Man and Equitable Life cases are listed for trial in 2005 and Bannerman is still on its way to the Court of Session. The profession will be watching these carefully. One thing is certain, though: any attempt to extend the auditor’s duty of care will be vigorously opposed. In the meantime, the outcome of the DTI consultation on capping liability is awaited with interest.
Nicholas Heaton is a dispute resolution partner at Lovells and was assisted with this article by assistant Andrew Wigston