Question

What are the three conditions that must be proven for an auditor to be found negligent under tort law? Based

on a review of the legal cases, which conditions appear to be most difficult to prove? Please indicate the legal

cases that set the precedents.

Answer 1

The application of the law of tort in the auditing profession, and the way in which auditors seek to limit their exposure to the ensuing liabilities, has been shaped by a number of recent landmark cases. The most notable of these are Caparo Industries Plc (Caparo) v Dickman (1990) and Royal Bank of Scotland (RBS) vs Bannerman Johnstone MacLay (Bannerman) (2002).

In the first case Caparo pursued the firm Touche Ross (who later merged to form Deloitte & Touche) following a series of share purchases of a company called Fidelity plc. Caparo alleges that the purchase decisions were based upon inaccurate accounts that overvalued the company. They also claimed that, as auditors of Fidelity, Touche Ross owed potential investors a duty of care. The claim was unsuccessful; the House of Lords concluded that the accounts were prepared for the existing shareholders as a class for the purposes of exercising their class rights and that the auditor had no reasonable knowledge of the purpose that the accounts would be put to by Caparo.

It was this case that provided the current guidance for when duty of care between an auditor and a third party exists. Under the ruling this occurs when:

• the loss suffered is a reasonably foreseeable consequence of the defendant’s conduct
• there is sufficient ‘proximity’ of relationship between the defendant and the pursuer, and
• it is 'fair, just and reasonable' to impose a liability on the defendant.

In the second case RBS alleged to have lost over £13m in unpaid overdraft facilities to insolvent client APC Ltd. They claimed that Bannerman had been negligent in failing to detect a fraudulent and material misstatement in the accounts of APC. The banking facility was provided on the basis of receiving audited financial statements each year.

In contrast to Touche Ross, who had no knowledge of Caparo’s intention to rely upon the audited financial statements, Bannerman, through their audit of the banking facility letter of APC, would have been aware of RBS’s intention to use the audited accounts as a basis for lending decisions. For this reason it was upheld that they owed RBS a duty of care. The judge in the Bannerman case also, and crucially, concluded that the absence of any disclaimer of liability to third parties was a significant contributing factor to the duty of care owed to them.

Conclusions

There is an increasing trend of litigation that is costing the audit profession billions of pounds. The potential costs and risks of auditing large, listed businesses may now be prohibitive for any firm of willing auditors outside of the Big Four.

Auditors can reduce their exposure to litigation but there is a rising groundswell of opinion that the audit profession has, for too long, borne the brunt of penalties for misdemeanours shared by other culpable parties. These penalties are prohibitive to competition, which may be damaging to capital markets.

There is widespread agreement that this situation must change. Unfortunately, any decision on the nature and timing of such a change appears to be a long way off. Until such time the audit profession will simply have to bear the burden of liability. Simon Finley is a teaching fellow at the Aston University Accounting Group Reference 1 Auditing: Commission Issues Recommendation on Limiting Audit Firms’ Liability, European Commission, 6 June 2008