Professional Liabilities In Fraud Claims

Originally published in Fraud Intelligence published by Informa UK

Victims of fraud have extensive legal rights to help them recover assets taken by the fraudster, and to sue him for damages. But sometimes, these are not enough. The proceeds of fraud are as often dissipated as saved, leaving the victim with insufficient remedy. In these circumstances, he may look for a "deep pocket", who has been involved in the fraudulent transaction in such a way as to expose himself to liability.

To take a standard example: a fraudster may procure a corporate vehicle to enter into a transaction with the victim, so that assets are transferred from the victim to the vehicle, and then in turn to the fraudster. The transaction might be a loan, or a sale of corporate or physical assets. In each case, both vehicle and victim may well have employed a raft of professional advisers such as financiers, auditors, lawyers or valuers.

These may be attractive (sometimes too attractive) targets for recovery. The victim may be able to recover from his own advisers or (whether directly or indirectly) from those of the vehicle. The article focuses primarily on the latter. Advisers may be liable either as participants in the fraud, if they have involved themselves as conspirators, joint tortfeasors or accessories to breach of trust. Otherwise, though not themselves participants in the fraud, they may have breached obligations as a result of which they are liable for the losses suffered. This article is concerned with this second category of liability.

The professional will usually have a contract with either the victim or the vehicle (occasionally both). The contract will specify his obligations, but they almost invariably involve the duty to exercise the skill and care reasonably to be expected of a professional man in his position. He will also owe a like duty of care, for breach of which he may be liable in tort for negligence. That duty of care may extend to persons not parties to the contract. The professional will be liable if he breaches the contractual duty or duty of care, and that breach causes loss. The key to whether loss has been suffered is often whether the claimant has relied upon the professional's advice. These are the most common types of claims, and some specific examples are discussed below. There are, however, other possible duties. The assets filched may, for instance, be physical assets in the possession of a shipowner or warehouseman, who may owe duties as a bailee. Or they may be dematerialised securities held by a global custodian, giving rise to trust obligations.

The auditors of the vehicle are a common target. Often, the victim of a fraud wishes to sue them direct, despite the absence of any contractual relationship. The first question is whether they owe him any direct duty of care.

The general rule is that the auditor only owes a duty to the company he audits. The House of Lords so held in Caparo v. Dickman, dismissing a shareholder's claim to recover losses caused by purchasing more shares on the strength of the audited accounts. The court was reluctant as a matter of policy to hold the defendant liable to an unlimited class of people for an unlimited amount. It held, however, that there may be exceptional cases where the loss is foreseeable, there is sufficient proximity between the auditor and the victim and it is just and reasonable to impose a duty of care.

The courts have sometimes been prepared to impose duties on this basis. One such case is where specific representations are made to potential investors. Thus, in Morgan Crucible v. Hill Samuel, financial statements were issued for the defence of a contested takeover bid. It was held that a person who purchased shares in reliance upon them could sue. Courts have also imposed duties of care where there are groups of companies. In Barings v. Coopers & Lybrand, it was held that the auditor of a subsidiary might owe a duty to the parent company. In BCCI v. Pricewaterhouse, it was held that the auditor of one group company might owe a duty to another where there was sufficient independence between the audits.

More usually, it is the company which pursues its own auditors, either because it is itself the victim, or because a third party victim has placed it into an insolvency regime to utilise its claims.

An auditor owes its client duties in contract and tort. The starting point for determining them is the contract with the client, and the relevant statutes and regulations. The courts usually require expert evidence to establish the standards to be met. The court will also consider auditing and accounting standards issued by the accountants' professional bodies and the relevant auditor's own internal manual.

The duties of an auditor in respect of fraud detection have expanded over recent years. Famously, the original rule was that the accountant was a watchdog not a bloodhound: that he was only responsible for detecting fraud when his suspicion was excited, but when it was, he was obliged to probe it to the bottom. The modern approach is more onerous. The Statement of Auditing Standards No. 110.1 issued by the Auditing Practices Board set out a detailed approach as to how an auditor should assess the risk of fraud and error occurring, and design audit procedures to take account of that risk. Subsequent international frauds such as Enron and Worldcom, have generated still further activity, notably the International Standard on Auditing No. 240, which now governs the position.

In principle, the auditor is liable for reasonably foreseeable losses flowing from his breach. In Sasea Finance Limited v. KPMG, the Court of Appeal held that an auditor's duty was to report the fraud of a senior employee to the company's management as soon as he discovered or should have discovered it, rather than to wait until the end of the audit.

Solicitors are another common target. This was particularly so following the property crash in the late 1980s, when a number of firms which had been acting jointly for purchaser and lender were sued when the purchaser defaulted on his loan, and the lender's security was insufficient to repay it.

In general a solicitor does not owe duties to his opposite party. As in the case of auditors, there may be exceptional circumstances where a court considers the loss is foreseeable, that there is sufficient proximity between the solicitor and the third party, and the imposition of the duty of care is just and reasonable.

A particular issue arises when a solicitor is acting both for purchaser and lender. Once again, the starting point in determining the solicitor's duties is the retainer. Additionally, it was held in Mortgage Express v. Bowerman that if in the course of his duties the solicitor comes across non-confidential information which is clearly of potential significance to the lender, he should pass it on.

The victim of a fraud often expects to make full recovery in respect of his losses. The law gives remedies which support that expectation where the defendant has been dishonest. Claims against professionals who have merely been negligent are, however, different. The courts have imposed a number of limiting factors on recovery. These are often policy-based, and result in large claims often leading to lower recoveries.

The first concerns the extent of the duty of care undertaken. In South Australia Asset Management Corporation v. York Montague Limited, a valuer negligently over-valued a commercial property, on the strength of which the bank lent money. The market collapsed, the borrower defaulted, and the lender sought to recoup his losses from the valuer. The House of Lords focused on the duty which the valuer was under, holding that this was to provide information upon which the lender would determine how to act. Accordingly, the valuer was only responsible for the consequences of the information being wrong. That was the loss in value of security, and not that caused by market collapse, despite the fact that the lender argued that it would not have entered into the transaction at all had it known the property's true value.

Second, there are a number of partial defences to this type of claim which are unavailable to a defendant in fraud. One is contributory negligence: where the victim is also at fault, the court may assess his degree of blame and reduce the damages accordingly. Similarly, the professional is not liable for damages which are too remote, that is, damages not within the reasonable contemplation of the parties for the purposes of contract, or not reasonably foreseeable for the purposes of tort. The victim also has to prove that the breach caused the loss, which he may not be able to do.

Third, one particular developing area is that of the "loss of a chance". In Allied Maples v. Simmons & Simmons, the claimant alleged that its solicitors had failed to negotiate for a particular contractual clause. If the other party had agreed it, the claimant would have avoided substantial losses. The Court of Appeal distinguished this type of case from one where the claimant seeks to prove that certain events have occurred, or what he would have done if properly advised. In those cases, he must prove his case on the balance of probabilities. This case turned upon the hypothetical action of a third party in conferring a benefit on the claimant, or avoiding a loss to him. In such case, the court had to decide whether there was a real and substantial chance of the third party so acting; as opposed to a merely speculative one. If there was, then what the claimant had lost was that chance, and the court had to value it by determining the percentage chance, and awarding the claimant that percentage of his damages. Whether this is an advantage or a disadvantage depends. A claimant can still make a substantial recovery even on less than a 50% chance. Conversely, if he establishes that it was more likely than not that the third party would act favourably, he still only recovers the relevant percentage. This principle has wide potential application where the claimant alleges he would, if properly advised, have taken steps to remedy the situation the effectiveness of which depends upon the hypothetical actions of third parties. This was essentially the nature of the case put forward unsuccessfully in the Equitable Life case, although that was not itself a fraud case.

Fourth, another control is circuity of action. In Barings v. Coopers & Lybrand, a company officer had signed a representation letter to the defendant auditors, who alleged that he knew was false. Consequently, they argued that they were entitled to a complete indemnity from the company for any liability for negligence. The court rejected the allegation of fraud, but otherwise said the auditor's argument was correct. Clearly, that argument could give rise to a defence to actions against auditors in many fraud cases. Its effect is mitigated to the extent that the court contrasted the case where the auditor's enquiry is specifically about fraud. Nevertheless, this issue will no doubt be debated for some time.

There are many advantages in seeking to pursue professionals to recoup losses arising out of fraud. The defendants are often large entities in their own right, and usually have the benefit of substantial indemnity insurance cover. They are therefore worth powder and shot. Claimants also often think that professionals are the more likely to settle in order to avoid reputation or regulatory risk.

Although these are real advantages, they can be double-edged. They invariably mean that the litigation is well resourced and heavily fought, often being insurer led. Where insurers are involved, they may be much less concerned about the reputation of their insured, and much more interested in the quantum of the claim. However much the professional is open to criticism, the insurer will want to know why this has led to actual loss before paying a claim.

This issue of quantum can become very significant. It is a standard strategy in fraud litigation to identify relatively easy assets or claims first, and then to pursue more difficult ones. Claims against professionals are often in the nature of "top-up" claims after all easier recoveries have been made. The insurer will not be slow to argue that before the professional can be liable, the claimant has to show that the value of his claim exceeds the net value of recoveries made to date. When full account is taken of matters such as contributory negligence, remoteness, causation difficulties and loss of a chance, this may be difficult, even where there is no real defence on liability.

Claims against professionals can be a useful means for recouping losses arising from fraud. As in all litigation, however, the claimant should take careful stock of his position before commencing proceedings, satisfying himself that he is sufficiently confident of establishing liability in a sum sufficiently large to give a net recovery. It is not necessarily easy to establish that a professional has been liable, and even where he has, there are a number of defences relating to the quantum of the claim which are unavailable to a defendant who has actually participated in fraud. There has been a temptation to make very large claims against professionals in the hope that they will settle. Litigation is always risky and some recent well-published victories for defendants suggest that the attitudes of some "deep pockets" have been hardening.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.