Investor protections keep crumbling

In late December 2017, the Supreme Court of Canada handed down its decision in the long-running saga of failed entertainment company Livent. The event passed with little notice from advisors, even though it could further erode investor rights.

Livent itself (through its bankruptcy receiver) had sued its former auditors because investors have been blocked from directly suing auditors for negligent audited financial statements since a 1997 Supreme Court of Canada decision.

A troubling tone was set by the 2017 decision, which was a 4-3 vote by the justices in favour of Livent on one portion of the case, and a 0-7 vote against the company on another portion. As a result, damages awarded to Livent by the lower court were cut by more than half.

Any hope resulting from the two lower court decisions dissipated. Instead, the 2017 Supreme Court decision reiterated outdated views on the objectives of financial reporting, since it largely retained the principles of its 1997 decision.

In addition, the decision cast confusion on what investor rights are in a prospectus offering.

What’s changed for investor rights?

As we wrote in 2016, after the appeal court’s ruling on Livent, 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.

After the December 2017 ruling, the newest information for advisors pertains to a potential shift in investor protections for prospectus offerings (as opposed to share purchases made in the open market).

Implied within a prospectus offering is that specific people are being asked to provide funds and are making investment decisions based heavily on the financial statements.

Livent’s auditors provided what’s known as a “comfort letter” regarding their most recent audited financial statements in a Livent prospectus offering. This prospectus-based assignment had a clear purpose—compliance with provincial securities legislation—so that investors could try to predict future cash flows, based on several years of financial statements.

The legal issues of “proximity” and “forseeability” should not have been in doubt in a prospectus offering situation. All the public accountants had to do was not financially mislead a group of investors; that was their role in the prospectus offering, and had been such for decades in countless similar situations.

Indeed, the auditors’ practice handbook at the time had a separate section that dealt specifically with public accountants’ obligations in a prospectus situation, outlining steps to be taken when circumstances suggest a change to underlying financial conditions may have occurred. However, the Supreme Court justices, in rendering their 2017 decision, did not see it this way. It appears the court confused the differing obligations contained in corporations legislation versus securities legislation.

Evidence suggests the original audit report should have been updated, or double-dated, to address various subsequent events. This did not happen, and the Supreme Court’s focus on only the original audit report, and the link to only Ontario’s Business Corporations Act requirements, seems to have missed the mark.

The major concern is whether the 2017 court decision muddies the waters for auditors’ duties in prospectus offerings. Prior to the 2017 decision, auditors had a higher duty of care to investors in prospectuses (in contrast to the audits of annual financial statements) because of the direct link between auditors and investors.

In our view, the court’s unclear reasoning should be fixed by new, explicit corporations and securities legislation that applies to both prospectuses and annual financial statements. Otherwise, the uncertainty will continue to be exploited. All of the risks and associated losses tied to misleading financial reporting cannot continue to be placed on the shoulders of investors.

Advice for advisors

Short of a legislative fix that is years away at best, the only course of action for advisors is to understand that annual financial statement audits hold little value for investors. Limited class-action lawsuits can still be launched in certain jurisdictions, but aside from that small deterrent, most annual audits only provide a false sense of security against negligent auditor work.

In short, the onus is very much on investors to proactively and intensely monitor the accounting and financial reporting of companies, with the clear understanding that legal recourse for investors is highly limited—if not completely absent—in Canada.