Auditors Must Properly Audit Their Client Companies and Would be Legally Liable if they Fail to do so, Supreme Court of Canada Holds

Written by on December 20, 2017.

Case commentary: Deloitte & Touche v Livent Inc (Receiver of), 2017 SCC 63

In a long-awaited judgment rendered today, a unanimous Supreme Court of Canada held that Deloitte & Touche (now, Deloitte LLP) owed, and breached, a duty of care by failing to perform a proper statutory audit of its client, the defunct Livent Inc. Additionally, a majority of the Court found Deloitte liable to Livent for the increase in Livent’s liquidation deficit which followed Deloitte’s impugned audit—$40.4 million.

The case concerns the collapse of Livent, formerly an entertainment company, after the 1998 discovery of accounting fraud that artificially enhanced Livent’s success and financial records. Livent’s then auditors, Deloitte, failed to uncover the fraud in a timely fashion, and issued a clean audit report on Livent’s 1997 financial statements, which were soon determined to violate applicable accounting standards.  Subsequently, Livent commenced insolvency proceedings and sold all of its assets.  It was left with a significant deficit after liquidation.  Livent’s receiver sued Deloitte for breach of contract and in tort, alleging that Deloitte’s negligent work as an auditor left Livent with an economic loss greater than what it would have been left with had Deloitte properly performed its job.  The trial judge found Deloitte liable, a judgment that was upheld by the Court of Appeal for Ontario.

On appeal, the justices of the Supreme Court of Canada unanimously held that Deloitte owed a duty of care, recognizing that liability in cases of pure economic loss can arise from negligent misrepresentation or performance of a service.

In so holding, the Court considered the well-known, two-prong Anns-Cooper test, noting that the Court had previously recognized in Hercules Managements Ltd. v. Ernst & Young, [1997] 2 SCR 165, a duty owed by an auditor in preparing a statutory audit of its corporate client.  Applying this framework, the Court found proximity and reasonable foreseeability of injury resulting from Deloitte’s failure to perform a proper audit.  Following Hercules Management, the Court found that the purpose of Deloitte’s statutory audit was to assist the collectivity of shareholders of the audited company in their task of overseeing management—a purpose that has been recognized in Canadian law for 20 years, the Court noted.  Additionally, the type of injury that ensued was a reasonably foreseeable consequence of Deloitte’s negligence.  The Court somewhat simplified this analysis, applying the “end and aim” rule, which finds liability where a person voluntarily assumes a given risk.

Having found a proximate relationship giving rise to liability based on a previously recognized category, the majority of the Court held that it would be unnecessary to consider whether residual policy considerations would negate or limit the scope of the duty of care. Nonetheless, the majority of the Court held that the proximate relationship engaged in this case would preclude indeterminate liability in any event, as it was only one plaintiff (Livent) who brought the claim, which was for a determinate value.

“Value” indeterminacy is limited by the purposes for which the audit was prepared.   An audit is performed for two purposes: (1) to protect the company itself from the consequences of undetected errors or, possibly, wrongdoing; and (2) to provide shareholders with reliable intelligence for the purpose of enabling them to scrutinize the conduct of the company’s affairs and to exercise their collective powers to reward or control or remove those to whom that conduct has been confided. Livent did not rely on Deloitte’s audit report for a collateral or unintended purpose.  Reliance on an audit for these recognized purposes did not give rise to potential indeterminacy.  That the beneficiaries of the claim may be various stakeholders of the company did not result in indeterminate liability to negate the duty of care.

Importantly, the Court noted that “Indeterminate liability is liability of a specific character, not of a specific amount,” that is, even very significant liability is not indeterminate where “such liability arises from the nature of the defendant’s undertakings and of the severe but reasonably foreseeable scale of injury that can result where such undertakings are negligently performed.”

The majority of the Court noted that the concept of indeterminate liability—previously perceived as a significant obstacle to establishing an auditor’s liability—is no more than a “residual policy consideration.” Thus, not in all cases the presence of indeterminacy would shield an auditor from liability.  In so holding, the majority of the Court held that even as a policy consideration, the presence of indeterminacy might be outweighed by other policy considerations militating in favour of liability.

The Supreme Court’s decision clarifies important aspects of an auditor’s duty of care in performing professional standards, and the company and its stakeholders’ recourse when they incur a loss as a result of the auditor’s negligent work. Canadian law requires that auditors ensure their audited clients’ financial statements are properly reported in accordance with accounting standards.  This is precisely why a company’s shareholders retain an auditor.  It is incumbent upon the auditor to be cognizant of its duties and responsibilities, and to perform the audit in accordance with professional standards.  When they fail to do so, the auditor will be liable.

The Supreme Court has spoken in unequivocal terms. Auditors can be liable, and will be held to account, for the damages their negligent work causes to their client companies and their stakeholders.

Posted in Class Actions, Securities