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Did Auditors Dodge a Bullet?

Published in the September 2006 issue of Litigation Notes - View Article

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The Herald newspaper recently reported that UK auditors had “dodged a liability bullet” with the settlement of the case of Royal Bank of Scotland PLC v. Bannerman Johnstone Macklay, before it could reach the House of Lords.

Bannerman Johnstone Macklay (“BJM”) were the auditors of a Scottish equipment rental company, APC Ltd. (“APC”). APC had been formed after a management buyout of an insolvent company. At the time of the buyout, APC assumed liability for about £1.9M of debt owed by its predecessor to the Royal Bank of Scotland (RBS). RBS gave APC a term loan of £1.5 M as well as granting it credit facilities. RBS also obtained an option to subscribe for a substantial equity interest in APC, which was exercised.
BJM prepared a business plan for APC following the buyout, as well as financial projections. It was also a condition of the overdraft facilities that RBS be provided with annual audited financial statements as soon as they were available and management accounts shortly after the end of each month.

An employee of BJL (McMahon) was seconded to APC as its financial controller. He was responsible for preparing daily financial reports and monthly management accounts that were provided to RBS as well as for producing year-end figures which were audited by BJM.

McMahon, together with certain executives of APC perpetrated a fraud which had the result of overstating the value of the assets on the company’s balance sheet. When this was discovered by RBS, it appointed a receiver of APC and of a subsidiary company. At that time the overdrafts of the two companies totalled about £11.8M. RBS sued BJM for negligence in its audits.

BJM applied to a judge (Lord Ordinary) of the Outer House of Scotland’s Court of Session (Scotland’s court of first instance) for an order dismissing the action on the basis that they did not owe a duty of care to RBS. The parties were in agreement that the existence of a duty of care was to be based on the tests set out in the House of Lords decision in Caparo Industries PLC v. Dickman, decided in 1990. The House of Lords decided that the existence of a duty of care depended on whether the loss was foreseeable, whether there existed a relationship of proximity between the parties, and whether it was fair, just and reasonable that the law should impose a duty of care of a given scope on the one party for the benefit of the other. The Lord Ordinary interpreted Caparo to mean that for a relationship of proximity to exist the advisor must, at the time at which the advice is given, be aware of (1) the identity of the person to whom the advice or information is to be communicated, (2) the purpose for which the person is to be provided with the advice or information and (3) the likelihood that the person to whom the advice or information is communicated will rely on it for the known purpose.

BJM attempted to argue that this three-fold test was not a sufficient basis for a relationship of proximity between them and RBS. Rather there had to be an extra ingredient, namely that BJM “intended” that RBS should rely on the audited accounts for the known purpose of lending money to and/or injecting equity capital into APC. This argument was rejected both at first instance and in appeal. The appeal court (Court of Session, Inner House) noted that BJM were more than just the statutory auditors of APC. They had a key role in the establishment and survival strategy of the company They knew that the survival of the company depended on the continued support of RBS and that the prompt provision of annual audited financial statements, monthly management accounts and daily financial reports was a condition of RBS continuing to lend money to the companies.
It may be that this result is not as dramatic as trumpeted by The Herald. There is a fine line between knowledge and intention and every case is fact specific. Accountants should be aware that if they know that their work product is going to be relied on by a third party for a particular purpose and remain silent, they may well be deemed to have intended that it be used for that purpose.

Another interesting aspect of this case was the Court’s comment to the effect that a failure by BJM to disclaim liability to third parties could be taken as a factor pointing to an assumption of responsibility.