9.401 Auditing Chapter 4 Legal Liability

Auditors and the Law Professionals must fulfill implied or express contracts with reasonable level of care Professionals must fulfill implied or express contracts with reasonable level of care Powerful force exerted on auditors, getting stronger Powerful force exerted on auditors, getting stronger  Increased volatility, losses, complexity  Deep pockets  Out of court settlements  “expectations gap”

Expectations Gap Public believes a clean audit opinion means: Public believes a clean audit opinion means:  F/S are free of error  No fraud has occurred  Business is in sound health Importance of clear audit reports, engagement letters, public education, clear GAAS Importance of clear audit reports, engagement letters, public education, clear GAAS

Sources of Auditor Liability Auditors can have liability under: Auditors can have liability under:  Statutory law  Responsibilities under CBCA etc.  Contract law  Responsibility by virtue of contracts with client  Common law  Law developed through past court decisions  Criminal law  Responsibility under Criminal Code of Canada

Key elements of liability To be successful: To be successful:  Duty of Care  Breach of duty  Loss  Causal link between breach of duty and loss

Auditor Liability to Clients Generally through contract law. Generally through contract law. Client generally asserts auditor was negligent in performance of duties Client generally asserts auditor was negligent in performance of duties

Defenses against Client Claims Lack of Duty (eg. Review vs. Audit: see next slide) Lack of Duty (eg. Review vs. Audit: see next slide) Absence of Misstatement Absence of Misstatement Absence of Negligence Absence of Negligence Contributory Negligence Contributory Negligence No damages No damages Absence of Causal Connection Absence of Causal Connection

Audits vs. Review vs. Compilation Progressively lower levels of assurance, less work done by auditor, less responsibility Progressively lower levels of assurance, less work done by auditor, less responsibility  Audit: “f/s present fairly…”  Review: “nothing has come to our attention”  Compilation: “we do not express an opinion..”

Liability to Third Parties Liability under common law Liability under common law Most common defense is that there is no duty of care (=lack of privity) Most common defense is that there is no duty of care (=lack of privity)

Are auditors liable? Smith v. London Assurance Corp (1905) Smith v. London Assurance Corp (1905)  first American case involving an auditor : held liable towards their client for failing to audit a branch office as stipulated in the engagement contract and failing to detect an embezzlement Ultramares Corporation v. Touche (1931) Ultramares Corporation v. Touche (1931)  if negligence were so great as to constitute gross negligence, might conclude that auditor had engaged in constructive fraud and could be liable to third parties  actual fraud = intentional act to deceive, mislead or injure the rights of another person.  Auditors not liable for ordinary negligence in USA for the next 35 years

Due Care to whom? Foss v Harbottle (1842) Foss v Harbottle (1842)  no duty to financial stakeholders Heaven v. Pender (1883) Heaven v. Pender (1883)  duty to 3rd parties for physical damage only Ultramares v. Touche (1931) Ultramares v. Touche (1931)  duty to 3rd parties for gross negligence but not ordinary negligence Headley Byrne v. Heller (1964) Headley Byrne v. Heller (1964)  duty to 3rd party the auditor knows or should know will rely

Due Care to whom? Haig v. Bamford (1976) and Toromont v. Thorne (1975) Haig v. Bamford (1976) and Toromont v. Thorne (1975)  duty to known third parties or known limited class of third parties Dupuis v. Pan American Mines (1979) Dupuis v. Pan American Mines (1979)  duty to recipients of prospectus Caparo Industries Plc. V. Dickman (1989) Caparo Industries Plc. V. Dickman (1989)  duty only to known 3rd parties of sufficient proximity if fair and reasonable

Recent developments: Auditors Not Legally Liable to Investors, Top Court Rules Hercules Management Ltd v. Ernst and Young Hercules Management Ltd v. Ernst and Young An auditor who signs a company's financial statements has no legal liability to shareholders or investors An auditor who signs a company's financial statements has no legal liability to shareholders or investors The court’s concern is to protect auditors (for public policy reasons) from unlimited liability to thousands of investors who may use the audit opinion for many different purposes The court’s concern is to protect auditors (for public policy reasons) from unlimited liability to thousands of investors who may use the audit opinion for many different purposes

Liability to 3 rd parties: Causal Connections Causality may be disproved if: Causality may be disproved if:  User did not rely on f/s to make decision  Event gives rise to loss, not f/s

Liability to 3 rd parties: Confidentiality Confidentiality may conflict with not associating with false and misleading Confidentiality may conflict with not associating with false and misleading  Consolidata Services v. Alexander Grant (1981) should have maintained confidentiality  Fund of Funds v Auther Anderson (1982) should have broken confidentiality to avoid misleading statements  Transamerica vs. Dunwoody (1996): auditor was correct in maintaining confidentiality

Criminal Liability Generally rare. Occurs if: Generally rare. Occurs if:  Gross negligence  Deliberate Proceeds of Crime Legislation: Proceeds of Crime Legislation:  Guilty if auditor accepts property if they know or should know that property was obtained illegally  Participating in money laundering is illegal

Canadian Trends in legal liability Ontario Securities Commission interested in increasing auditors liability to shareholders by revising securities legislation Ontario Securities Commission interested in increasing auditors liability to shareholders by revising securities legislation Charter of Rights and Freedoms may move the Canadian system closer to the USA Charter of Rights and Freedoms may move the Canadian system closer to the USA Class Action suits allowed in Quebec (1979), Ontario (1993) and British Columbia (1995) Class Action suits allowed in Quebec (1979), Ontario (1993) and British Columbia (1995) Contingency fees for lawyers being considered Contingency fees for lawyers being considered PA firms are finding it difficult to acquire adequate insurance PA firms are finding it difficult to acquire adequate insurance Limited liability partnerships Limited liability partnerships Proportionate liability Proportionate liability

Is there an auditor liability crisis in Canada? Jury trials in USA - Judge in Canada Jury trials in USA - Judge in Canada Punitive damages rare in Canada Punitive damages rare in Canada Unsuccessful party must pay 50 to 60 % of the legal fees of the opposing side and other costs in Canada Unsuccessful party must pay 50 to 60 % of the legal fees of the opposing side and other costs in Canada Class actions are rare in Canada Class actions are rare in Canada nothing comparable to SEC in Canada nothing comparable to SEC in Canada