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(UPDATED JUNE 2016) - January 2016

Lights, camera, financial transaction:

Auditor liability after the Livent decision

 

Peter Vlaar
Peter Vlaar,
Associate Lawyer


By Peter Vlaar

*This article was updated on June 10th, see last paragraph for update.

Overview

The Ontario Court of Appeal's decision in Livent is complex in detail but simple in outcome. Auditors carry more responsibility when auditing publicly-traded corporations because the potential fallout from their negligence is greater.

The key legal and policy points arising from Livent appeal form the basis of this short case comment. While we largely agree with the court's decision, we also offer some constructive commentary in anticipation of a potential appeal to the Supreme Court of Canada.

Background

Those who closely follow the Livent action, or remember the bright lights of 'Joseph and the Amazing Technicolor Dreamcoat', 'Kiss of the Spider Woman' or 'Show Boat', will know that Livent was once the darling of the theatre and financial community. Livent began trading on the Toronto Stock Exchange in 1993. It produced blockbuster musicals and renovated several theatre venues under the leadership of Garth Drabinsky and Myron Gottlieb. Deloitte was retained by Livent to perform annual audits between 1992 and 1998.

Livent was once the darling of the theatre and financial community.

In 1998, several new investors added Robert Webster to the Livent Board of Directors. Webster quickly learned of "serious accounting irregularities" in Livent's financial records. Drabinsky and Gottlieb were dismissed for cause. Livent was placed in receivership. Livent stock declined rapidly. The special receiver appointed to manage Livent's assets commenced an action against Deloitte, who issued clean auditing opinions despite these irregularities. On April 4, 2014, Justice Gans released a 118-page decision and ordered Deloitte to pay Livent $85.6 million dollars as a result of their negligence in performing their auditing duties. On January 8, 2016, the Ontario Court of Appeal upheld the trial decision of Justice Gans.

Issues explored by the Court of Appeal

The following legal issues will be explored:

  • Did Deloitte owe a duty of care to Livent, and if so, did the trial judge extend the duty of care beyond the duty owed to Livent?

  • What is the standard of care expected from an auditor that is retained to audit a publicly-traded company?

  • Is Livent's claim defeated by the doctrines of corporate identification or ex turpi causa?

  • If Deloitte did breach the standard of care, were Livent's losses caused by Deloitte's negligence?

  • If Livent's losses were caused by Deloitte's negligence, were they nevertheless too remote?

Analysis

A duty of care may exist in the absence of indeterminate liability

Auditors owe a duty of care to a corporation and its shareholders as a collective group, but not to any one individual investor.1 To recognize otherwise would expose auditors to indeterminate liability, which courts have taken great pains to avoid.

Of course, it makes perfect sense to deny a duty of care where damages and liability are unforeseeable. Such was the case in CIBC v Deloitte 2015 ONSC 7695, where Justice Perell declined to recognize a duty of care because the auditor had "no way of knowing or controlling to whom it could be liable... nor did it undertake directly or indirectly to assist the lenders in making any decision about how much to loan and the terms of the loan".

In Livent, the Court of Appeal easily found that Deloitte owed a duty of care because the suit was brought by Livent itself, and not by third party stakeholders. Because of this procedural quirk, Deloitte was unable to employ an indeterminacy defence that has found success in the past.

...the "overwhelming" evidence of Deloitte's negligence allowed the court to demarcate precisely when further Livent losses could have been avoided.

Despite this, the reality is that damages awarded to receivers may ultimately flow to third party stakeholders, including creditors. We believe that the Livent court easily found a duty of care, not simply because the action was brought by Livent through a special receiver, but also because the "overwhelming" evidence of Deloitte's negligence allowed the court to demarcate precisely when further Livent losses could have been avoided. Where the facts are not so neatly drawn, it is arguable that damages that ultimately inure to creditors, despite an action by a special receiver, may raise the spectre of indeterminate liability nonetheless.

The standard of care will depend on the entity being audited

It is widely understood that audits fulfil two key objectives: they ensure that the information presented by management provides a fair and accurate picture of the financial affairs of the corporation, and they provide shareholders with information for the purpose of overseeing the management and affairs of the corporation.

In Livent, the court recognized that auditing a publicly traded corporation serves a "third important and broader objective" because it impacts securities regulators and the investing public, who rely on auditors to ensure full disclosure and provide an accurate picture of a corporation's financials. This makes sense in principle. Corporations with a vested public interest should be incentivized to adopt practices that properly consider these stakeholders.

Interestingly, this idea is somewhat at odds with the court's aversion to indeterminate liability. Granted, the investing public may be fairly characterized as part of the corporate "collective" insofar as they are shareholders. However, the impact on a securities regulator is less definable. As the Supreme Court recently recognized in the Securities Act Reference in 2011, every provincial and territorial regulatory agency exercises a variety of responsibilities, including prospectus review and clearance; oversight of disclosure requirements; takeover bids and insider trading; registration and regulation of market intermediaries; enforcement of compliance with the regime; recognition and supervision of exchanges and other self-regulated organizations; and public education."2 By raising an auditor's standard of care to include these agencies, is the court placing too high a burden and too wide a scope of responsibility?

In any case, the court in Livent easily found that Deloitte breached its standard of care based on "overwhelming" evidence of negligence during the 1997 audit and the Q2 and Q3 1997 engagement.

The doctrines of corporate identification and ex turpi causa are inapplicable

In Livent, Deloitte sought to use the corporate identification doctrine to attribute the fraudulent acts of Drabinsky and Gottlieb to Livent itself. This would allow Deloitte to use the ex turpi causa doctrine to argue that Livent did not have a cause of action because it sought damages based on its own fraudulence.

The corporate identification doctrine seeks to attribute the mens rea of a "directing mind" to the corporation itself, thereby establishing the corporation's criminal liability.3 According to the leading Canadian case, Canadian Dredge, the doctrine can be applied only if the directing mind (a) was within the field of operation assigned to him; (b) was not totally in fraud of the corporation; and (c) was by design or result partly for the benefit of the company.

...ex turpi causa is a policy based defence that seeks to prevent wrongdoers from benefiting from their wrongful act.

The doctrine of ex turpi causa is a policy based defence that seeks to prevent wrongdoers from benefiting from their wrongful act. It is justified only if a ruling in favour of the plaintiff would allow them to profit from "an illegal or wrongful act, or to evade a penalty prescribed by criminal law".4

The court declined to apply either doctrine. It held that the Canadian Dredge test is not sufficient to address a defence that attributes a wrongful act to a plaintiff in order to invoke ex turpi causa. Instead, at least two additional factors must be considered: First, whether applying attribution for the purposes of ex turpi causa is consistent with the contract or relationship between the plaintiff and the defendant, and second, whether doing so is necessary to preserve the integrity of the justice system. Notably, the court sidestepped the Canadian Dredge analysis entirely and instead found that ex turpi causa was inapplicable. It reasoned that the party seeking compensation was Livent, not Drabinsky or Gottlieb, and therefore, that the fraudsters did not stand to profit from their own act.

Deloitte's negligence caused Livent to incur reasonably foreseeable liabilities

The court's analysis on causation and remoteness considered whether Deloitte's negligence caused Livent's losses, and whether these losses were reasonably foreseeable. With respect to causation, the court needed only 4 pages of its 154-page decision to uphold the trial judge's ruling. But for the negligence of Deloitte, Livent would no longer have access to the capital markets, which would have led to a position of insolvency that would have "stopped the bleeding".

With respect to remoteness, the court reminded Deloitte that their breaches did not merely create the opportunity for Livent to continue in existence, "but rather assisted it in improperly taking on further liabilities that it could not repay, due to the cash-burn nature of its business". These losses were reasonably foreseeable and certainly not too remote.

... the court also acknowledged that Deloitte did not cause all of the losses.

Despite Deloitte's obvious negligence, the court also acknowledged that Deloitte did not cause all of the losses. Instead, the court upheld the trial judge's decision to reduce the net economic loss of $113 million by 25% based on expert evidence on the money-losing nature of Livent's business (also referred to as "contingencies"). The court noted that Deloitte's unique knowledge of the nature of Livent's unprofitable business made it reasonably foreseeable that Livent's increased liabilities would not be offset by future profits.

Notably, both the trial judge and Court of Appeal acknowledged that determining remoteness through a contingencies analysis "[did] not admit of precise calculation" and was not "an all or nothing proposition because the concepts are more than a little 'soft' and difficult if not impossible to pin down". Despite this, we do not disagree with the court's contingency analysis. The principle of remoteness seeks to determine whether the precise loss suffered was reasonably foreseeable. Remoteness is not an exact science, and it is not unreasonable to use benchmarks such as time, space, and financial gain or loss. While a full review of the evidence and mathematical considerations is beyond the scope of this paper, we believe that it was not unreasonable for the trial judge to attribute 75% of the damages to Deloitte given the volume of empirical and expert evidence considered at trial.

Outlook

Livent is an appellate decision that reads like a sociology paper. Its reliance on public policy underscores the critical role that auditors play in modern capitalism. As we learned from the 2008 collapse of the Lehman Brothers and the ensuing financial crisis, the fallout from corporate failure is enduring and devastating. Those who are intimately involved in the viability of a publicly traded corporate enterprise should be keenly aware of the liabilities that follow.

Critics of the Livent decision will cry foul over the uncertainty imposed on auditors. When should an auditor be permitted to rely on a corporation's fraud to exonerate itself for its failure to detect that fraud? What is the outer limit of an auditor's liability to securities regulators and the investing public? Will future courts recognize a duty of care between an auditor and a corporation's special receiver without critically examining the stakeholders who stand to gain from an award of damages? Is it reasonable to analyze remoteness based on the "inherent vicissitudes" of a business?

These uncertainties, and the significant policy considerations undertaken at both the trial and appeal levels, appear tailor made for consideration at the Supreme Court of Canada. All eyes will be on Deloitte's next move.

* Update

On June 9, 2016, the Supreme Court of Canada granted leave to hear the appeal of Deloitte & Touche. Based on past experience it is impossible to determine what the court may decide based merely on the fact it granted leave. The court could clarify the uncertainty surrounding the outer limit of an auditor's liability, and elaborate on the significant and novel public policy considerations broached by Justice Blair of the Court of Appeal or simply affirm the lower court decision. The hearing date is still to be determined.


1 CIBC v Deloitte 2015 ONSC 7695 at para 8.
2 Reference re Securities Act [2011] 3 SCR 837 at para 40.
3 Canadian Dredge and Dock Co. v. The Queen [1985] 1 S.C.R. 662.
4 Hall v. Hebert, [1993] 2 S.C.R. 159.


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