UK: Auditors and third party liability – judicial reassurance

By Richard Curd and Elizabeth O'Connell

Man Nuzfahrzeuge AG and Others v Freightliner Ltd and Others [2005] EWHC 2347

The issue of auditors’ liability to third parties has been brought sharply into focus recently with The Company Law Reform Bill which embodies some significant changes in relation to auditors’ liability, namely the ability to negotiate "Liability Limitation Agreements" (For more on this,Click Here). However, with regard to third party claims, the Government has decided not to codify any statement of auditors’ duty of care, as expressed by the House of Lords in Caparo Industries v Dickman [1990] 2 AC 605, [1990] 1 All ER 568, HL. Auditors therefore remain reliant on the judiciary to determine the circumstances in which damages for economic loss can be recovered by third parties who allege they have relied on the audited accounts to their detriment.

The recent case of MAN v Freightliner is a useful reminder of the judicial principles governing this area of law which, following the controversy generated by the decision in Royal Bank of Scotland v Bannerman [2005] CSIH, provides some comfort to auditors

(*For more on the Bannerman case please see the end of this article). The Bannerman case aroused considerable interest principally because of the court’s finding that the absence of a disclaimer could point to the assumption of responsibility by the defendant auditors to the claimant bank (notwithstanding the absence of any direct contact between them) as the auditors knew the bank would rely upon the audited accounts when making its lending decision.

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The issue of auditors’ liability to third parties has been brought sharply into focus recently with The Company Law Reform Bill which embodies some significant changes in relation to auditors’ liability, namely the ability to negotiate "Liability Limitation Agreements" (For more on this,Click Here). However, with regard to third party claims, the Government has decided not to codify any statement of auditors’ duty of care, as expressed by the House of Lords in Caparo Industries v Dickman [1990] 2 AC 605, [1990] 1 All ER 568, HL. Auditors therefore remain reliant on the judiciary to determine the circumstances in which damages for economic loss can be recovered by third parties who allege they have relied on the audited accounts to their detriment.

The recent case of MAN v Freightliner is a useful reminder of the judicial principles governing this area of law which, following the controversy generated by the decision in Royal Bank of Scotland v Bannerman [2005] CSIH, provides some comfort to auditors (*For more on the Bannerman case please see the end of this article). The Bannerman case aroused considerable interest principally because of the court’s finding that the absence of a disclaimer could point to the assumption of responsibility by the defendant auditors to the claimant bank (notwithstanding the absence of any direct contact between them) as the auditors knew the bank would rely upon the audited accounts when making its lending decision.

The proceedings arose out of the acquisition of the truck manufacturer, ERF, in June 1996, by a Canadian manufacturer, Western Star, which was subsequently acquired (July 2000) by Freightliner, (an American subsidiary of Daimler-Chrysler AG). MAN (a subsidiary of a large German industrial group) acquired ERF in early 2000 by way of a share purchase agreement from Freightliner. It subsequently transpired that from about the middle of 1997, the accounts of ERF (both the monthly management accounts and the year-end statutory accounts) had been persistently manipulated by its financial controller, Mr Ellis, who from about the same time had also been responsible for systematic frauds on HM Customs and Excise by means of false claims for the repayment of VAT.

MAN issued proceedings against Freightliner seeking to recover damages for the false accounting under warranties in the share purchase agreement. It was accepted that, as a result of Mr Ellis’s manipulations, the relevant books of account had not given a true and fair view of ERF’s financial position, and that there had accordingly been breaches of the share purchase agreement by Freightliner. The latter brought a Part 20 Claim against ERF’s UK based accountants, Ernst & Young, and against Western Star’s Canadian accountants, Ernst & Young Canada, contending that if, as the Trial Judge held, it was liable to MAN in respect of Mr Ellis’ fraud, it was entitled to recover from E&Y (UK) on the grounds that its liability had resulted from the breach of one or more duties owed by E&Y (UK) to Western Star in relation to the audit of ERF and the due diligence exercise.

It is a well established principle that although the auditors’ primary duty is owed to the company pursuant to the contract under which they are engaged, they also owe a duty of care under the general law to the shareholders, as a body, who can be expected to exercise their rights and powers in a general meeting on the basis of the audited accounts: Caparo Industries Plc v Dickman. In the MAN case this was referred to as the "general audit duty" which it was accepted E&Y (UK) owed to Western Star.

The Trial Judge rejected Freightliner’s argument that Western Star was able to rely on a breach by E&Y (UK) of this general audit duty and to recover in its own name losses in the form of any liability it may have incurred to MAN as a result of the dishonesty of Mr Ellis. Moreover, the loss in this case was not one which arose out of the mismanagement of ERF but the dishonest acts of Mr Ellis, including statements of Mr Ellis during the course of the negotiations in respect of the sale of the company. Furthermore, Freightliner’s argument that the general audit duty included specific duties - such as a duty to inform Western Star that the audit partner had become concerned about Mr Ellis’ competence and integrity, and a duty to investigate a tip-off and to modify the audit work in light of it - simply served to reinforce the Caparo principle that any such duty was owed to the shareholders as a body and not to individuals.

In light of the fact that Freightliner could not rely on a breach of the general audit duty to recover its loss, the Trial Judge went on to consider whether E&Y (UK) owed Western Star a "special audit duty": a duty at common law to take reasonable care when carrying out their audit to protect it from the kind of harm it suffered in this case.

In deciding the circumstances in which the auditors of a company owe a duty of care to a third party with whom they have no contractual relationship the Courts have been divided in their approach: the "threefold" test of forseeability, proximity and fairness as rooted in Caparo and the assumption of responsibility test originating in Hedley Byrne & Co Ltd v Heller & Partners Ltd [1964] AC 465 and adopted in Henderson v Merrett [1995] 2 AC 145. Although the principles relating to both approaches are well established (and should at least in theory result in the same outcome as per Sir Brian Neill in Bank of Credit and Commerce International (Overseas) Ltd v Price Waterhouse [1998] BCC 617), their application in any particular case may not be straightforward because the Courts have been wary of imposing a duty on professional advisors to anyone other than their clients.

An auditor will only be held to owe a duty to a third party if it can be shown that they knew, and intended, that their statement as to the audit client’s accounts would be communicated to, and relied upon, by a particular person or class of persons for a particular purpose in connection with a particular transaction. Whether an auditor has assumed responsibility to someone other than his client is a matter to be determined objectively by reference to all the circumstances of the case. As the Trial Judge put it:

"it was common ground that whether an auditor has assumed responsibility to someone other than his client is a matter to be determined objectively…close attention must be paid to the particular statement on which the Claimant seeks to rely, the circumstances in which and purpose for which that statement was made and the type of loss which the Claimant is seeking to recover. The auditors will only be held to have incurred such a duty if it can be shown that they knew and intended that their statement as to the company accounts would be communicated to and relied on by a particular person or class of persons for a particular purpose in connection with a particular transaction."

The transaction which gave rise to the loss in the present case was the sale of ERF by Western Star to MAN. It is that transaction which needed to be analysed, therefore, in considering whether E&Y (UK) assumed a responsibility to Western Star or indeed, anyone else, for the accuracy of its audit. The Trial Judge held that given the nature of the relationship between Western Star and ERF and between E&Y (UK) and E&Y (Canada), E&Y (UK) must have realised that both the 1998 and 1999 audit reports would be passed to Western Star, who could be expected to rely on them both for the purposes of producing consolidated accounts for the Western Star Group as a whole and for the purposes of making decisions about the future conduct of ERF’s business. The Trial Judge was not persuaded, however, that at the time it produced its 1998 audit report, E&Y (UK) could be taken to have known that Western Star would rely on it for any other purpose. The fact that E&Y (UK) may have recognised that Western Star might have decided to dispose of ERF at some uncertain date in the future did not give rise to a relationship between them that would normally be regarded as sufficiently close to support a duty of care; this serves to reinforce the point that mere forseeability that audited accounts may be used for another purpose is insufficient to give rise to a duty of care.

This point was amplified in relation to the 1999 accounts. In September 1999, E&Y (UK) were aware of the existence of the negotiations with MAN and it was made clear before the audit report was signed that Western Star was anxious to obtain the audited accounts as soon as possible in order that they could be made available to MAN for its consideration in connection with the purchase of ERF. It was submitted on behalf of E&Y (UK) that they did not provide a copy of the true 1999 accounts for any purpose relating to the sale of ERF and did not undertake any responsibility to Western Star for their accuracy in relation to any aspect of that transaction. The Trial Judge found that the circumstances were such that it was foreseeable that Western Star would rely on the accounts in the negotiations with MAN as presenting a true and fair view of ERF’s financial position. The Trial Judge reiterated that this was not enough to give rise to a duty of care; it was also necessary for

"there to have been a relationship between the parties of such proximity as to support the conclusion that there was an assumption of responsibility…in such cases it becomes necessary to look carefully at the precise purpose for which the statement was communicated to the Claimant. These are likely to be important considerations because unless it can be shown that the statement was communicated to the Claimant for a particular purpose relating to the harm he has suffered he is unlikely to be able to show that the Defendant assumed responsibility to take care when making it to protect him from that harm."

There was no evidence of anything passing between Western Star and E&Y (UK) to indicate that Western Star was intending to rely on the accounts for any particular purpose in its negotiations with MAN and, in signing the audit certificate, E&Y (UK) were not assuming responsibility for the accuracy of the accounts for any purposes of that kind. E&Y (UK) knew that MAN was carrying out a due diligence exercise but, apart from making their audit papers available to Deloitte & Touche, they were not consulted about it and played no part in it.

Furthermore, the Trial Judge found that the loss suffered by Freightliner in this case took the form of a liability in damages for deceit arising from the statements made by Mr Ellis in the course of the negotiations with MAN, rather than the inaccuracy of the accounts themselves, and that this was not a loss that E&Y (UK) assumed a responsibility to protect Western Star from.

One further issue that is illustrated by the MAN case (and leaving aside the general issue as to when a disclaimer may be appropriate post Bannerman) is the care that needs to be exercised when drafting any form of disclaimer. Before releasing its working papers to Deloitte & Touche for the purpose of the due diligence exercise, E&Y (UK) insisted on receiving "hold harmless" letters from both Western Star and MAN. The letters made it clear that although E&Y (UK) were prepared to allow access to their working papers and to provide information and explanations in relation to the work they had done for the purposes of the audit, they were not willing to accept liability for the consequences of giving MAN access to the information which would not otherwise have come into its hands. The Trial Judge found that although "Information" was defined in the letters as meaning any information derived by the recipients from the working papers, that did not include the audit report produced by E&Y (UK) itself on the basis of the work reflected in the papers. The "hold harmless" letters could not therefore be understood as relating to wider questions of responsibility or to any liability that might arise out of the use to which the statutory audit might be put.

The MAN case therefore usefully illustrates the circumstances in which an auditor will be found to owe a third party a duty of care:

In light of the Government’s decision not to codify the law in this area, the MAN decision can be seen as judicial reassurance that well-established principles remain just that. It is worth noting that E&Y (UK) succeeded at trial on, in essence, the same grounds that were unsuccessfully advanced at a strike out application in respect of the Part 20 claim. Auditors and their insurers will hope that (whilst there will be situations which are particularly fact sensitive and the Court will wish to make a detailed investigation before passing judgment), clear cases will continue to be dealt with in favour of auditors without the need for a full blown trial.

*Full Article on the Bannerman Case

Audit opinion letters to include disclaimer of liability to third parties?
Originally published in Law Now , 08.01.2003

By Peter Bateman

On 5 December it was reported in the Financial Times that PricewaterhouseCoopers (PWC) is to change the wording of its standard audit opinion letter to include an express disclaimer of liability to third parties who may rely on the audited accounts. It is believed that PWC is the first major firm of accountants to include such a disclaimer in its audit opinion letter, although given the enthusiasm of disaffected investors, lenders and others for going after the deep pockets of accountants, it might seem surprising that such disclaimers are not already standard in the industry. So what lies behind PWC's decision?

Liability of auditors for statutory accounts

Most companies are required by the Companies Act 1985 (the Act) to prepare accounts on an annual basis comprising (at least) a profit and loss account for the past year and a balance sheet showing the company's assets and liabilities at the year end. A company's directors are responsible for preparing and approving accounts that give a true and fair view of the profit or loss during the year, and the state of affairs of the company at the year end. The auditors must make a report to the company's members giving an opinion on whether the directors have done so, and whether the accounts have been properly prepared in accordance with the Act.

The primary source of an auditor's duties is contractual. The audit engagement letter creates a contract between the audit firm and the company, and will set out (amongst other things) the scope of the audit to be carried out. In addition, the auditor usually assumes a tortious duty of care to the client company, which normally coincides with its contractual duty.

Accountants' engagement letters in connection with particular transactions or advice usually include limitations on the accountants' liability in contract and tort to the contracting party, as well as restrictions on the way in which the advice and opinions may be used and the third parties to whom they may be disclosed. These limitations and restrictions are in practice the most effective way of limiting liability to third parties.

As accountants are required by statute to produce reports on companies' accounts which will necessarily be seen by third parties, and used by them for a variety of different purposes, the issue of accountants' liability for such reports is critical. As a matter of public policy, Parliament has decided that auditors should not be able to exclude or limit their liability to the company itself for negligence or other breach of duty: this is reflected in section 310 of the Act. However, liability of auditors to third parties (such as existing shareholders, potential investors, banks and other creditors) has been left for determination by the Courts. Generally, they have tried to limit the extent to which auditors may be held liable in tort to third parties, for the reasons explained by Lord Bridge in the leading case of Caparo Industries plc v Dickman [1990] 1 All ER 568:

Nevertheless, the Courts have accepted that in certain circumstances auditors can be held to have assumed a duty of care to third parties.

In Caparo, the House of Lords clarified that the auditors' statutory duty is owed to the members as a body, to enable them to exercise class rights in general meeting (for example, to approve or disapprove the election or re-election of directors, or the appointment or reappointment of the auditors), but not to individual shareholders or the public at large who may rely on the accounts when deciding whether or not to invest in the company. However, the existence of this statutory duty does not preclude the existence of a duty of care in tort, which will be found where all of the following ingredients are present:

• the damage suffered by the third party was reasonably foreseeable;

• there is a relationship of sufficient proximity between the auditors and the third party; and

• it is fair, just and reasonable in the circumstances for the law to impose a duty of care.

It is apparent from the cases which have followed Caparo that whether or not a duty of care will be found to exist in any particular case will be determined principally by the facts in that case; previous decisions may not always offer much guidance. As a result, auditors have had to be wary about their potential liability to third parties. The ICAEW's 1994 paper on 'Managing the professional liability of accountants' warns accountants that "it would be prudent to assume that a duty of care will exist in a situation where the accountant knows of the existence of a third party whom he reasonably expects to receive and rely on the accountant's work for a particular transaction or purpose and to whom damage will be caused if the work has been done negligently. The danger of a duty being imposed will be increased where that third party has no other source of advice and where the purpose of the accountant's work is to induce the third party to take the particular action he has taken".

Some comfort for auditors who are sued in tort by banks who have lent money to a company in reliance on statutory accounts was provided by the decision of the High Court in Al Saudi Banque v Clarke Pixley [1990] Ch.313 (the judgment of Millet J subsequently being approved by the House of Lords in Caparo). In that case, the auditors were held not liable to the group of lending banks: the Court pointed out that the banks had played no part in appointing the auditors, who had no statutory duty to report to them; and the auditors did not supply a copy of their report to the banks, or to the company with the intention or in the knowledge that it would be supplied to the banks. However, the case also illustrates that liability will depend on the particular facts in each case: where these differ in any material respect from the situation in Al Saudi Banque a different conclusion could conceivably be reached.

Effectiveness of Disclaimers

It is evident from case law that a disclaimer which is sufficiently clear and prominent is usually effective to exclude liability even if the damage is reasonably foreseeable and there is a relationship of sufficient proximity. Put another way, such a disclaimer should be enough to prevent the maker of the statement from being taken to have assumed responsibility to the third party. Disclaimers of this type are used to enable companies to carry on their business without being exposed to unacceptable levels of uninsurable risk.

Attempts to exclude or limit liability for negligence by means of a contractual term (such as in an engagement letter) or a notice (such as in an audit opinion letter which is reproduced in the accounts) are subject to a test of reasonableness under section 2(2) of the Unfair Contract Terms Act 1977 (UCTA 1977). Whether or not a disclaimer of an auditor's liability for negligence in giving an opinion on the accounts is reasonable will depend on all the circumstances: factors of particular importance will include the 'nature and quality' of the auditor's negligence, the comparative resources of the parties, the availability of insurance, the nature of the transaction, the scale of potential loss and the fees paid.

Although auditors may well include in their audit engagement letters restrictions on the persons to whom the company may provide the audit report or for what purpose, they have not to date included in their audit opinion letters a disclaimer of liability to third parties, even though neither the Act nor auditing standards prohibit it. Reasons for this probably include:

• a belief that it is better to rely on the courts to determine liability on a case by case basis, based on the principles in Caparo and the cases following it. It may even be felt that the inclusion of a disclaimer of liability to a particular class of persons could in some circumstances be more of a hindrance than a help: it could establish the foreseeability of particular damage, or a relationship of proximity to that class, but could nevertheless be held void for unreasonableness;

• pressure from clients: since clients expect the audited accounts to provide third parties with some assurance as to the 'accuracy' of the company's accounts, they may well feel that a disclaimer of liability to third parties undermines this assurance; and

• reluctance to provide an excuse to increase the potential liability of auditors through legislation. In their interim report published in March 2000, the Company Law Review Steering Group recommended that section 310 of the Act should be amended to allow auditors - subject to the approval of the company's shareholders - to limit their liability in contract to the company or the shareholders in their audit engagement contract, and that auditors should be expressly permitted to limit their liability in tort to third parties (with such limitations being presumed to be reasonable for the purposes of UCTA 1977 provided they go no further than certain guidelines to be agreed after public consultation). This proposal was designed to counter-balance both the increasing amount of information which the auditors are required to review and the Steering Group's proposal to set out in statute an extended range of persons to whom auditors would be deemed to owe a duty of care - namely existing shareholders and creditors, those who become shareholders or creditors in reliance on the accounts, and possibly employees.

Royal Bank of Scotland plc v Bannerman Johnstone Maclay (a firm) (The Times, 23rd July, 2002)

According to PWC, the decision to change the form of their audit opinion letter was prompted by the ruling in July this year of the Scottish Outer House (equivalent to the English High Court) in this case. The ruling was made in a preliminary hearing to decide whether or not the Bank's claims should be allowed to proceed to a full trial. Bannerman Johnstone Maclay were auditors of a plant hire company which borrowed money from the Bank and then went into receivership. The Bank alleged that the auditors had owed them a duty of care, which had been breached when the accounts were negligently audited, causing loss to the Bank. In response, the auditors contended that the Bank's claim should be struck out on the grounds that it failed to establish a relationship of sufficient proximity between the auditors and the Bank.

In ruling that the Bank's claims should be admitted to full trial, the Outer House held that it was at least arguable that in the present circumstances a relationship of sufficient proximity could be established. The Court considered that the following factors might assist the Bank in establishing such a relationship:

• the auditors knew that RBS was a shareholder and substantial creditor of the company, as well as its principal banker;

• the company had a close relationship with the auditors, and one employee of the firm was seconded to the company to work as its financial controller;

• the company's business was very cash-dependent and it relied heavily on funds being available on overdraft from the Bank;

• in order to satisfy themselves that the company would be able to continue as a going concern for the next 12 months (required for the audit opinion), the auditors must have been aware of the existence of the overdraft and its terms. These terms included an obligation on the company to provide the Bank with copies of the monthly management accounts and the audited annual accounts;

• the auditors must have known that the Bank would use the audited accounts to check the validity of the management accounts and thus to decide whether or not to continue lending to the company; and

• despite knowing that under the terms of the overdraft facility the audited accounts would be supplied by the company to the Bank, and the Bank would rely on them in making its lending decisions, the auditors had not disclaimed liability to the Bank (even though it was open to them to have done so).

Contrary to the arguments put forward by the auditors, it was not necessary for the Bank to show that the auditors intended the Bank to rely on the accounts for a particular purpose; it was enough that the auditors knew that the Bank was likely to do so. In deciding the latter point, the Court followed a clear line of authority that no such intention is required.

As it is a preliminary ruling, the decision of the Outer House in Bannerman cannot be taken as changing the law as to when auditors may be held to have assumed a duty of care to third parties. Indeed if the case goes to full trial it may well be that the auditors will be held on the facts not to be liable to the Bank. Instead, the real significance of the case lies in the importance attached by the Court to the fact that the auditors had not included a disclaimer. Although judgments of the Scottish Court of Session are not binding in the English courts, they can be of persuasive authority. In view of this, it would be surprising if most major firms of auditors were not at least to consider including a disclaimer as a matter of course in all their audit opinions, or at least those given where the auditors know that it is likely that a third party will rely on the accounts for a particular purpose.

Consequences

PWC's standard audit opinion letter will now include the following sentence:

"We do not, in giving this opinion, accept or assume responsibility for any other purpose or to any other person to whom this report is shown or in to whose hands it may come save where expressly agreed by our prior consent in writing."

It is believed that other large accounting firms are considering adopting similar wording. Other consequences are likely to include:

• lenders wishing to rely on statutory accounts for a particular purpose may have to negotiate with the borrower's auditors as to the terms on which the auditors are prepared to allow the lender to rely on the company's accounts - in particular, the extent to which the auditors' liability will be limited or excluded. The same is likely to be true for other third parties wishing to rely on statutory accounts for their own particular purposes;

• auditors may charge fees to third parties who wish expressly to rely on the audited accounts. Environmental consultants, for example, often charge non-clients who wish to rely on a report that was prepared for a client: where the consultant's overall exposure to liability for the report will not be increased (due, for example, to caps being imposed on liability, or existing insurance cover), the level of the fee is usually a 'nominal' one to cover the 'administrative cost' to the consultant. If the consultant's exposure is likely to be increased, however, the fee may reflect the cost to the consultant of obtaining additional insurance. In the case of auditors, in the absence of a disclaimer the Bannerman case suggests that auditors' exposure to liability for negligence is likely to be increased in circumstances where auditors know that a third party is likely to rely on the accounts for a particular purpose. It is therefore possible that insurance premiums could rise for auditors who do not as a matter of course include a disclaimer in their audit opinion letters;

• on the other hand, audit clients with sufficient bargaining power may try to insist that the disclaimer be taken out;

• future parts of the White Paper on Modernising Company Law may follow the recommendation of the Company Law Steering Group that auditors be permitted, subject to shareholder approval, to limit their liability to the company contractually and in tort to third parties; and

• until the proposed changes to section 310 come into force, it is likely that there will be more challenges made by third parties under UCTA 1977 to the reasonableness of disclaimers and other restrictions on auditors' liability.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 15/03/2006.