Did auditors win or lose in court’s Livent ruling?
4-3 decision is truly a split and mixed bag
What’s unclear from the Supreme Court of Canada’s decision in Livent’s high- profile negligence suit is whether the auditing profession as a whole won or lost.
“This is a split decision with a very close result, which reflects how contentious and complex the issues are,” says Andrea Laing in Blake, Cassels & Graydon LLP’s Toronto office. “So much so that serious jurists are markedly divided on them.”
While the Chartered Professional Accountants of Canada was still studying the 4- 3 split decision, close examination reveals that the late December ruling is a mixed and uncertain bag. Deloitte, for its part, said in an email that although it was “pleased” with the decision, it was also reviewing the reasons “to better understand what the Court concluded and the longer term implications for the profession.”
Indeed, on its face the SCC’s reasoning had good news and bad news for auditors.
The bad news is that Deloitte was found negligent to the tune of some $40 million (plus interest) for a 1997 audit that failed to detect the frauds and forgeries for which the company’s principals, Garth Drabinsky and Myron Gottlieb, were ultimately convicted and imprisoned.
In the majority’s view, the $ 40 approximated the additional losses the company could have avoided had Deloitte uncovered the frauds earlier.
The court also refused to attribute any of these damages to Livent, which Deloitte claimed should have been held contributorily negligent.
The good news for auditors is that the court more than halved the $ 85 million awarded to Livent by Justice Arthur Gans of the Ontario Superior Court of Justice, a judgment confirmed on appeal to the Ontario Court of Appeal. In doing so, the court unanimously ruled that Deloitte was not responsible for damages allegedly flowing from the work it performed in relation to a public offering in 1997 by assisting with a press release and providing a comfort letter.
Here, the court reasoned that Deloitte’s services were rendered for the purpose of soliciting investment and — unlike an audit — not for the purpose of assisting shareholders in overseeing management. So although Deloitte had acted inappropriately in its response to accounting irregularities discovered while performing these services, the limited scope of its retainer precluded its liability for — as Livent argued — “artificially extending” the company’s life and increasing its “liquidity deficit.”
“The court rejected the notions that auditors have a duty at large and that they are responsible for everything that happens after the alarm bells have sounded,” Laing says.
But going forward, Deloitte vs. Livent portends uncertainty for auditors.
The majority reasoned t hat because audits are undertaken to help share- holders scrutinize management’s conduct, Deloitte’s failure to provide a sound audit impaired shareholders’ ability to react properly and avoid further losses. The minority concluded that the company had not provided any evidence that the shareholders actually relied on the faulty evidence or that Livent’s shareholders and managements would have made decisions that would have limited the company’s losses had they known of the frauds. In the minority’s view, such reliance had to be proved, not presumed.
“In the final analysis, the difference between the minority and the majority came down to whether the evidence established that the negligent audit had deprived Livent’s shareholders of an opportunity to limit the company’s losses,” Laing explains.
That’s a thin line, but an important one. In practice, the majority decision means that all plaintiffs have to do to recover is to show that auditors have messed up and that losses have followed. Chief Justice Beverley McLachlin ( now retired), who wrote the minority ruling, essentially saw the majority’s reasoning as opening a Pandora’s box.
“My colleagues’ approach suggests that an auditor will generally become the underwriter for any losses suffered by a client following a negligent audit report,” she wrote. “This, notwithstanding subsequent decisions — reliant or capricious — made by the client’s shareholders.”
The minority’s approach, which requires the shareholders to prove reliance, circumscribed would have restricted auditors’ liability to a much greater degree. Not only would shareholders have had to show that companies were negligent, they would also have to prove that they relied on the specific acts of negligence and that these acts were the cause of the alleged losses.
That approach would have made things far more cosy for auditors, because jurisprudence has consistently shown that reliance and causation are shifting conceptual targets, are highly reliant on specific facts, and pose formidable obstacles to success in recovering damages.
Also troubling for auditors’ is the majority’s rejection of Deloitte’s claim that its liability should be reduced by Livent’s contributory negligence, effected by Drabinsky and Gottlieb’s frauds. What the auditors should have done, the majority opined, was sue Drabinsky and Gottlieb for indemnity.
But, as Laing points out, suing disgraced former executives is frequently an exercise in futility.
“The availability of thirdparty claims, which the SCC relied on as a basis to refuse to apply principles of contributory negligence, may be cold comfort for an auditor who is found to be jointly and severally liable with an impecunious fraudster,” she says.
Auditors’ best bet, perhaps, is that the SCC will revisit the decision given the razor-thin majority that featured a minority composed not only of McLachlin but also of current Chief Justice Richard Wagner, the open questions that remain, and the importance of the issues.
“The dissent was an extremely strong one, highlighting the difficult issues with which both sides had to grapple extensively,” Laing says. “The result couldn’t have been any closer.”
(THE ISSUES) ARE CONTENTIOUS AND COMPLEX.