UK: Auditors: Meet The Parents

In our Law-Now dated 15.03.06 "Auditors and Third Party Liability - Judicial Reassurance" we reported on the first instance decision in Man Nuzfahrzeuge AG and Others v Freightliner Ltd and Others [2005] EWHC 2347 in which a multi million pound claim made by a parent company against Ernst & Young, as auditors of its 100% owned subsidiary, was dismissed.

Last week, the Court of Appeal upheld that decision. However, the case serves as a general warning to auditors of subsidiary companies in relation to their potential exposure in circumstances where they know that the subsidiary could be sold.

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In our Law-Now dated 15.03.06 "Auditors and Third Party Liability - Judicial Reassurance" we reported on the first instance decision in Man Nuzfahrzeuge AG and Others v Freightliner Ltd and Others [2005] EWHC 2347 in which a multi million pound claim made by a parent company against Ernst & Young, as auditors of its 100% owned subsidiary, was dismissed.

The facts of the case are detailed in our previous Law-Now. For the purposes of the issues that remained to be decided when the appeal was heard, it is notable that Ernst & Young were auditors of the truck manufacturer ERF, which was 100% owned by Western Star in Canada. From 1997 onwards, ERF’s financial controller had persistently manipulated its accounts In 1999, when completing their audit, Ernst & Young were aware, that Western Star was in negotiations to sell ERF to Man and that the audited accounts would be made available to Man.

As at the original trial, the decision of the Court of Appeal was driven by specific findings of fact. The principal issue to be decided was whether, given that they were aware of the proposed sale, Ernst & Young owed a "special audit duty" to Western Star when auditing ERF.

The Court of Appeal summarised the trial judge’s reasoning for dismissing the claim against Ernst & Young as follows:

• No "general audit duty" was owed by Ernst & Young to Western Star in respect of the loss claimed in proceedings i.e. the liability for damages for deceit arising from statements made by the financial controller of ERF in the negotiations for the sale to Man
• Western Star, therefore, needed to establish that a "special audit duty" was owed by Ernst & Young
• A "special audit duty" would only arise if Ernst & Young knew, and intended, that their statement in the audited accounts would be communicated to, and relied on, by a particular person or class of person for a particular purpose in connection with a particular transaction
• The transaction giving rise to the loss was the sale of ERF by Western Star to Man and Western Star had to show that Ernst & Young owed it a duty to protect Western Star from liabilities of the kind which were suffered
• Although Ernst & Young could foresee, and must have known, that Western Star would rely on the 1999 accounts in negotiations with Man as presenting a true and fair view of ERF’s financial position this was not enough to give rise to a duty of care; it also had to be shown that Ernst & Young knew the particular purpose for which its audit statement was required
• It had not been established on the facts that Ernst & Young knew that Western Star (via the financial controller) would make the representations to Man it did as to the accuracy of the 1999 accounts to Man, and it could not, therefore, be said that when making its audit statement in relation to the 1999 accounts, Ernst & Young assumed responsibility to protect Western Star from liability for dishonest statements made by the financial controller as to the accuracy of the accounts.

Lord Justice Chadwick (with whom the other two members of the Court of Appeal agreed) upheld the dismissal of the claim against Ernst & Young.

Although on the facts this decision resulted in a victory for Ernst & Young, auditors and their advisors will note that the Court of Appeal was prepared to accept (if it had been necessary to do so) that Ernst & Young did owe a "special audit duty" to Western Star (as the parent company of ERF) to protect Western Star from the consequences of representations and warranties made and given by Western Star in the agreement for the sale of ERF on the basis of the accounts which Ernst & Young have audited.

Auditors are often under considerable pressure for audit work to be completed and their audit certificate signed off. Caution needs to be exercised in circumstances where auditors are aware that negotiations for the sale of their audit client subsidiary company are taking place, which could result in potential exposure.

In this case, the Court of Appeal also considered the test for the assumption of responsibility in the context of auditors’ liability following the decision of the House of Lords in Customs and Excise Commissioners v. Barclays Bank Plc [2006] 4 All ER 256. This concerned the extent to which a bank in receipt of a Freezing Order owed a duty of care in its handling of the frozen account to the party which has obtained a Freezing Order. The test as to whether a defendant has assumed responsibility to a claimant as explained by Lord Hoffman in the Barclays Bank case is as follows:

In applying that test, with its objective element, to the factual matrix as between Ernst & Young and Western Star, the Court of Appeal made clear that it was "impossible to hold" that Ernst & Young had assumed responsibility for the use made by the financial controller of ERF, on behalf of Western Star, of the information which the auditors had provided to Western Star.

It remains to be seen how this line of authority will develop, particularly in circumstances in which a subsidiary may be audited negligently and accounts provided to a parent company in connection with the possible sale of the subsidiary, and the negotiations proceed without the intervention of a dishonest employee.

MAN Nuzfahrzeuge AG and another v Freightliner Ltd and another [2007] EWCA Civ 910

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 26/09/2007.