Auditors' Liability for Failed Finance Companies

Thursday 15 November 2012

Authors: Tim Fitzgerald and Liam McNeely

When insolvency practitioners consider who may be held accountable for corporate failures, auditors are often near the top of the list. It is easy to see why. From a practical perspective, auditors are relatively likely to be able to meet good claims, and from a legal perspective it is easy to identify the duties that the auditors owed and, in an unfortunate number of cases, breached.

A recurring difficulty in claims against auditors is establishing that the auditor caused the company's loss. This is often because the more immediate cause of the loss is the company's directors or management, who caused the company to trade in the loss-making way. The auditor's negligence may have provided the opportunity to do this (because if the auditor had not been negligent it would have identified the wrongdoing and so caused the company to stop trading before it suffered the loss), but this is often not enough. The Courts have consistently held that auditors do not "cause" loss simply by creating an opportunity for it to occur.

The Belgrave Finance case

Last week the High Court considered again what type of losses can be attributed to auditors: Belgrave Finance Limited (In Receivership and In Liquidation) v Schofield and Others [2012] NZHC 2916.

The case arose from the liquidation and receivership of Belgrave Finance. Belgrave collapsed in May 2008, owing investors more than $20 million. The company brought a claim against (among others) its auditors, for negligently carrying out its 2007 audit report (the Audit). Belgrave claimed that had the Audit been carried out in a careful, diligent and professionally appropriate manner then:

  • It would not have issued its 2007 prospectus;

  • The Trustee would have placed it in receivership; and

  • It would not have suffered loss by way of advancing funds of about $3.8m and receiving deposits from Debenture Stockholders of about $4.9m that it was unable to repay.

The auditors applied to strike out Belgrave's claim. They said that even if Belgrave's allegations were correct, Belgrave would not have a tenable argument that the auditors were responsible for the company's loss. This was because the alleged losses were too far removed from the alleged negligence.

The Court applied a leading New Zealand case, Sew Hoy & Sons Ltd (in Receivership and in Liquidation) v Coopers & Lybrand [1996] 1 NZLR 392, which spoke of the need to establish a causal "chain" in order to attribute losses to auditors' negligence. Associate Judge Matthews held that it was tenable for Belgrave to argue that the Audit caused Belgrave to carry on its business in the same manner as it had before the Audit, and thereby suffer loss, because:

  • It meant that Belgrave did not review its operations and take steps which it would otherwise have taken to change the way it traded;

  • At the same time, the Trustee did not take action (e.g. possibly to place the company into receivership) when it otherwise would have; and

  • As a result, Belgrave issued its 2007 prospectus, which led to the advances and receipts which Belgrave said constituted its loss.

The High Court held that Belgrave could rely on this chain of causation to argue that the losses flowed directly from the allegedly negligent Audit. This means that Belgrave will have the opportunity to prove its allegations at trial. Questions of whether the auditors were in fact negligent, and what proportion of the company’s losses they should be liable for (if any), will also be considered at that stage.

Lessons

As the finance company and GFC-related cases begin to come before the Courts, we are likely to see further examples of the application of these principles in the near future. It is important for insolvency practitioners and auditors to understand how they affect potential claims.

The case highlights the importance of identifying which potential plaintiff has the strongest claim. The Court distinguished between Belgrave's action and a potential action by Belgrave's investors. A claim by investors would be superficially similar, but would face additional difficulties in establishing that any breach of duty caused the investors' losses (among other things). The Audit may have created the opportunity for investors to invest, but it is unlikely to have caused them to do so.

The case also illustrates that care needs to be taken at an early stage to clearly articulate the connection between an auditor's negligence and the company's loss. In some cases (such as Belgrave), the connection will be limited to the fact that the auditors' negligence allowed the company to continue trading in the same manner as it did before an audit. This type of argument can be close to the line between causing a loss and merely creating an opportunity for a loss to occur. Other cases are stronger, such as those where the auditor also specifically considered particular business or accounting practices which the company continued to rely on after an audit. The closer the link between the auditor and the practice which led to the loss, the less likely the claim is to be struck out.


Disclaimer

This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.

For more information
  • Tim Fitzgerald

    Partner Auckland
Related areas of expertise
  • Litigation and dispute resolution