Supreme Court Split in Long-Awaited Auditor Negligence Case

Supreme Court Split in Long-Awaited Auditor Negligence Case

In Deloitte & Touche v. Livent Inc. (Receiver of), 2017 SCC 63, the Supreme Court of Canada in a split decision reviewed the analytical framework for liability in cases of negligent misrepresentation or performance of a service by an auditor.

As background, Livent was in the business of producing and staging performances in theatres in the US and Canada. Livent’s shares were listed on the US and Canadian Stock Exchanges. Two of Livent’s directors fraudulently manipulated the company’s financial records. Deloitte, Livent’s auditor, never uncovered the fraud.

In August 1997, Deloitte did identify irregularities in the reporting of profit from an asset sale. However, Deloitte did not resign. Instead they helped Livent solicit investments by assisting in the preparation and approval of a press release issued in September 1997. The press release misrepresented the basis for the reporting of the profit. Furthermore, in October 1997, Deloitte provided a comfort letter for a public offering. Deloitte also conducted Livent’s 1997 audit which was completed in April 1998.

Subsequent equity investors later discovered the fraud. Livent filed for insolvency protection in November 1998. It sold its assets and went into receivership in 1999. Livent sued Deloitte for negligent representation and breach of contract.

The trial judge held that Deloitte owed a duty of care to provide accurate information to Livent’s shareholders. Deloitte fell short of this standard of care by failing to detect the fraud and signing off on Livent’s 1997 financial statements. Damages for the breach were assessed based on the difference between Livent’s value on the date Deloitte should have resigned and the time of Livent’s insolvency. The damages were reduced by 25% to account for contingencies and trading losses, leaving a final amount of $84,750,000.00. The Court of Appeal upheld the trial decision.

Justices Gascon and Brown, writing for the majority of the Supreme Court reviewed the case law on pure economic loss arising from an auditor’s negligence. The starting point is the test set out in Anns v. London Borough of Merton, [1977] 2 All E.R. 492 (H.L.), which was later modified in Cooper v. Hobart, 2001 SCC 79. The resulting Anns/Cooper framework establishes a two stage test.

The first stage of the test asks whether a prima facie duty of care exists based on the proximity of the auditors to the person relying on their work, as well as reasonable foreseeability of an injury.

The second stage of the test asks whether there should be no duty of care for policy reasons. Factors for consideration at this stage include whether the law already provides a remedy, the spectre of unlimited liability to an unlimited class and whether there are other broad policy reasons for not recognizing a duty of care.

Applied to the facts of the case, the majority held that no proximate relationship existed between Deloitte and Livent when it came to soliciting investments. Deloitte did not undertake to assist Livent’s shareholders in overseeing management when Deloitte approved the press release and comfort letter. Therefore, Livent’s reliance on the press release and comfort letter for these purposes was not reasonable, or reasonably foreseeable. No prima facie duty of care arose under these circumstances and, therefore, no damages were awarded in respect of the solicitation.

However, Deloitte were negligent in the audit of Livent’s financial statements. Moreover, the type of injury Livent suffered was a reasonably foreseeable consequence of Deloitte’s negligence, as a properly conducted audit would have revealed the fraud at an earlier stage and limited the extent of Livent’s losses.

The majority awarded Livent $40,425,000.00 representing Livent’s losses after the 1997 audit reduced by 25% for the contingency reduction.

The Chief Justice, writing for the minority disagreed with the majority on two main points. First, she observed that the factual basis for liability due to impaired shareholder supervision was lacking.

“Livent’s theory of the case was simply that all loss as a result of improvident investments after the negligent audits was compensable, on a “but for” basis.  Livent did not prove and the trial judge did not find that Livent’s shareholders relied on Deloitte’s negligent audit statements, or that had they received and relied on accurate statements, they would have acted in a way that would have prevented Livent from carrying on business and diminishing its assets in the period between the issuance of the relevant statements and Livent’s insolvency.”

Secondly, she noted  that  Livent’s position  would result in an unfair allocation of loss as well as indeterminacy of damages.

“On the shareholder supervision theory advanced by Livent, breach of a duty owed primarily to the collectivity of shareholders (who do not advance a claim) and only derivatively to the corporation, would result in liability for every dollar that Livent spent after the point in time the shareholders became entitled to rely on the statements. The auditor would be the virtual guarantor of everything Livent — not the collectivity of shareholders to which the duty was owed — did thereafter. This would not be a fair allocation of responsibility. The same scenario would raise the spectre of indeterminate liability. Auditors would be unable to reasonably predict when they are providing services to clients what their ultimate liability would be. It would be out of their control.  No matter how bad the decisions made by the client thereafter, no matter how complex the web of dealings that led to the ultimate loss — things that cannot be foreseen in advance — the auditor would be liable for the total loss, on the basis that it would not have occurred “but for” the negligent act.”

For these reasons, the minority would have concluded that the losses would not fall within the scope of Deloitte’s duty of care and, as such, the first stage of the test was not made out. Moreover, while the second stage need not be considered the Chief Justice noted that the policy considerations of unfair allocation of loss and indeterminacy would preclude imposing liability on Deloitte.

James Thomson is a partner with BJCTB, whose practice focuses on insurance and professional liability.

James Lane’s practice includes defence of accountants, engineers and other professionals in civil claims and discipline proceedings as well as insurance defence under other specialty line coverages.