Australia: Speculating Enron-Type Liabilities - Beware How Australian Law Might Respond

Last Updated: 28 February 2002
Article by Keith Steele

Co-written by Mr Damian Lovell

The recent collapse of the US giant energy trader, Enron Corporation, has raised a number of interesting legal issues concerning corporate governance and the role of auditors and the ability of investors to rely upon company accounts. It has also produced the familiar hysteria of media commentators speculating as to the assumed massive liability of those involved in the collapse: executive and non-executive directors, executives, accounting advisers and auditors, legal advisers, stock analysts, brokers, financial advisers, regulators and so on.

Such reactions to corporate failures in Australia are not unknown and tend to follow a similar path. Indeed, there are some obvious recent examples.

The assumption tends to be that all those within or connected in an advisory way to the collapsed company are liable to all of the myriad of interests who suffer financial loss from the collapse: creditors, shareholders, investors, upstream and downstream suppliers and dependant businesses, and even consumers who, it is suggested in Enron’s case, have paid higher prices than they might have had Enron’s true financial and market position and strength (or lack of it) been clear.

However, while the Enron collapse has a number of unusual aspects and will mainly be considered under the US legal system, when considering the position of potential defendants in such cases under Australian law, some caution is required to be exercised in the making of assumptions as to the nature and extent of liability which can be sheeted home in these "Blame and Claim" situations.

It is, of course, important that the conduct of those closely involved in a major corporate collapse is given close scrutiny by the regulators and liquidators in the first instance and then by the Courts in any proceedings that are brought. However, there is often a perception that every loss must be compensated, every party involved must pay, and the appropriate standard to be applied is the judgement of hindsight.

Yet the law adopts a principled approach, so that the real test is in identifying who owes a legal duty to whom and for what, so as to allow a right of legal action to recover economic loss for breach of duty. To adopt any other approach would subject those carrying on business to an impossible burden of indeterminate potential liability to indeterminate classes of persons for an indeterminate time. The High Court has recently indicated that that is not the approach of the law in this country.

As a general matter, under Australian law directors owe duties of care, diligence, and honesty to the company of which they are a director and in this regard a distinction may be drawn between the position of executive directors on the one hand and non-executive directors on the other. They are prone to suit at the instance of the company or its liquidator, but they are not generally liable for default in such duties to individual shareholders or a wider constituency. They may be personally liable to creditors for allowing an insolvent company to continue to trade, and they can also be liable for being a party to misleading, negligent or fraudulent misstatements or conduct where there is a clear connection between the conduct and reliance on it in a relationship which attracts a legal duty. But it is not so that the range of directors’ conduct which might produce a corporate collapse necessarily attracts liability for all the losses which follow.

Similarly, the assumption that auditors - thought to have deep pockets through insurance and large firm strength - are liable in negligence to all who suffer loss from a corporate collapse must be approached with great caution.

A defendant will only be liable in negligence, for failure to take reasonable care to prevent a certain kind of foreseeable harm to a plaintiff in circumstances where the law imposes a duty to take such care.

This point and the limits of such liability are clearly illustrated by the 1997 High Court decision of Esanda Finance Corporation Ltd v Peat Marwick Hungerfords (188 CLR 241).

In that case Esanda lent money to companies associated with Excel Finance Corporation which guaranteed repayment. Esanda lent the money relying on Excel’s accounts which had been audited by Peat Marwick Hungerfords. Excel defaulted and went into liquidation. Esanda sued the auditors of Excel in negligence, asserting a breach of their duty of care in relation to the conduct of the audit and the statements made in relation to the accounts relating to the true financial position of the company.

The statement of claim was struck out and Esanda’s appeal was rejected by the High Court on the basis that the auditors owed no actionable duty to Esanda on the case as pleaded.

Justice Gummow cast some dampener on the suggestion that there were extensively actionable duties owed by auditors to third parties when he said:

"…in many cases the corporate client of the auditor will be insolvent and may be in receivership, liquidation, or some other form of administration; the third party seeks to elevate itself beyond the status of creditors by seeking a solvent defendant from which to recoup the consequences of its poor business judgment in financing or otherwise dealing with the company. Secondly, the alleged negligence of the auditor necessarily will be subsidiary to the failures of the corporation which prepared the accounts the auditor certified…"

In the same case the then Chief Justice Sir Gerard Brennan observed that something more than reasonable foreseeability that a member of a class might rely on an auditor’s statement or advice was needed to found liability in negligence.

Justice McHugh in Esanda looked also at some of the policy reasons against extending the reach of an auditor’s duty of care in the field of negligent misstatement and economic loss, noting:

"It is by no means certain that the demands of corrective justice require auditors rather than sophisticated creditors and investors to absorb the losses that flow from lending to or investing in the auditor’s client…"

His Honour recognised the potential oppression of "deep pockets" litigation and that "the prospect of vexatious or near vexatious litigation is a matter to be considered in fashioning a legal rule…".

In general therefore under the present state of the law an auditor will not owe a duty of care to creditors of a company or potential investors.

In a similar vein the High Court has recently confirmed that fiduciary obligations do not impose quasi-tortious duties and will not lightly be found to exist in commercial transactions.

Of course deliberate participation in fraud and deception calculated or likely to induce particular people or members of a class to act in a particular and foreseeable way upon specific representations, or even negligent misstatements made for the clear purpose of reliance by such people, can attract liability on the part of those involved in such conduct. Both statutory and common law remedies allow for that.

But the point sought here to be made by drawing attention to Esanda is that the bold assumptions often made of widespread massive liability by all those left standing with assumed deep pockets after a major corporate wreck need to be tempered by reality. The "feeding frenzy" fuelled by those who enthusiastically and entrepreneurially speculate about and promise wide remedies for all who suffer loss requires more mature reflection – certainly in Australia.

True it is that the state of the law is not settled, and cases since Esanda have applied differing tests for identifying the existence of legal duties to third parties. The High Court, after some previous tentative pronouncements, has recently and finally departed from the previously applied test for determining when a duty of care arises and it remains to be seen how it will approach the extension of the law of negligence in new and differing circumstances.

However, even assuming liability can be established, the successful litigant has to contend with proving that the actions of the defendant directors, auditors or advisers actually caused loss. This issue cannot be divorced from the legal framework that determines the question of liability. It means that the answer to the question "what caused the loss" may differ when attributing responsibility to different people, whether for breach of the same duty or different duties.

It should also be understood that, under Australian law, damages are generally paid to compensate for loss suffered rather than containing any punitive element. The large punitive damages frequently awarded by juries in the United States are not generally awarded by courts here, nor are such cases dealt with in Australia by juries.

Recent history in Australia has also shown that launching extravagant litigation with wide-ranging allegations against multiple parties has its own risks for litigants and those tempted to invest in their cause – quite apart from the tightening of court rules and scrutiny of Australian lawyers as to what legal actions may ethically and responsibly be brought before the courts, and what justifiable foundation must first exist before an action can properly be launched.

The system and approach may be very different in the United States, at least in some jurisdictions, but careful consideration, laden with reality checking, is required for successful litigation in Australia.

Keith Steele and Damian Lovell are Sydney-based partners of Freehills National Litigation Group. Each was involved in the representation of National Australia Bank in the Ausmaq/Idoport litigation. Keith Steele was one of the authors of Economic Consequences of Litigation Worldwide (1999 - Kluwer/IBA).

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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