Auditor liability to investors is changing

For approximately two decades, investors have been at a disadvantage. The general law in Canada is that investors cannot hold auditors responsible for misleading annual financial statements.

If something is wrong with the accounting, investors cannot sue the auditors for missing the problem, no matter how significant or detrimental to their investments.

But what is an audit for, if not to have a third party vouch for the reliability of the financial statements? While there are some exceptions, the landmark 1997 Hercules Managements case (heard by the Supreme Court of Canada) set the precedent that investors can’t sue auditors. The decision stated that annual audited financial statements are not meant to be used for investing decisions. Instead they are meant for shareholders (as a whole, not individually) to assess the performance of management.

It has also been made clear that investors do not hire the auditors (even though shareholders vote to appoint them every year). The corporation hires the auditors, and investors cannot sue the auditors directly, because no duty of care exists between the two.

What’s changed?

In January 2016, an appeal court ruling was handed down in the long-running Livent saga. The ruling upheld a lower court decision that found the auditors, Deloitte & Touche, liable to pay $85 million before interest and costs to the corporation.

In the original case from 2014, the receiver for Livent, representing the company itself, sued the auditors for failing in their duty of care. Livent famously collapsed in 1998 after fraud was exposed in the company’s books. Livent’s founders, Garth Drabinsky and Myron Gottlieb, both served jail time.

The original and appeal decisions have marked changes in the strong veil of protection that auditors have enjoyed for so long. While the plaintiffs in the Livent case are the creditors of the corporation, there is the possibility that new protections could extend to shareholders and potential shareholders as well.

What might seem like narrow circumstances at first actually hold potential for investors. The situation is uncommon, with the company suing the audit firm directly.

Normally, investors find themselves on the outside, pitted against both management and the auditors. In most cases of misleading accounting, the company won’t sue the auditors for missing something in financial statements compiled by its own executives. Investors might launch a derivative action on behalf of the corporation, but that still doesn’t mean there is a duty of care between the auditors and investors.

In fact, in the Livent case, Deloitte argued that it should not be held responsible because the executives had committed the fraud. The auditor said it could not be sued by the same entity that committed the wrong.

The judge found that no wrongdoer would benefit by allowing the company to sue, and clarified that one of the reasons for an audit is to take reasonable steps to detect fraud.

Since most investors already assume this to be the case, reality might be finally catching up to expectations.

In essence, the court denied the auditors’ argument, stating, “Deloitte knew at all material times that the financial statements it prepared were being used to solicit investment in Livent.” This was a sign of more interesting language to come.

Extension of the duty of care

In law, the generally acknowledged purpose of an audit is to ensure the provision of reasonably accurate information for management and shareholders, in order to oversee the performance of management.

Further into the Livent appeal decision, the judge notes, “In the case of publicly traded corporations, however, an audit has a third important and broader objective involving the responsibilities of securities regulators and the interests of the investing public. It is not only the corporation and its existing shareholders who need and rely on the auditors’ reports. Securities regulators and members of the investing public also rely on them for disclosure of a fair and accurate picture of the financial position of the corporation.”

As a result, “the auditors’ standard of care in such circumstances must reflect this reality as well,” states the judge. “It follows that the auditor of a publicly traded company acquires an added layer of responsibilities that is not necessarily present where the audit is performed in relation to a private corporation or private individuals.”

Outside the complex circumstances of the Livent case, the foregoing language is likely to cause angst for auditors and might instigate an appeal of the decision, putting it up against the Hercules precedent.

But until then, the decision could mean the landscape has shifted for auditors’ responsibilities to investors.

What this means for advisors

Wronged investors have avoided pursuing auditors in many cases over the past two decades because they thought they would lose due to existing legal precedents. Since few have taken auditor errors to court, this has led the market to believe there aren’t that many cases of misleading financial statements in Canada.

Greater responsibilities for auditors would create more incentive for investors to pursue companies for misleading accounting and financial statements and, in turn, lead to greater scrutiny of company books in general. With more financial indiscretions likely to bubble to the surface, investors should look for warning signs in financial statements (e.g., revenue recognition issues) and lax financial reporting (e.g., inappropriately adjusted earnings). Doing so can position you ahead of the wave of Canada’s changing ambivalence towards accounting shenanigans.