In a decision with far-reaching implications for the accounting industry, on April 4, 2014, Deloitte & Touche was found liable for $85 million for its negligent audits of Livent Entertainment of Canada Inc. in 1996 and 1997.1
Livent was founded as an entertainment company intended to be publicly traded on the North American markets. It raised capital through a Canadian IPO in May 1993, an equity issue in the USA in May 1995, and various other private and public debt and equity issues over the next three years, in part based on the unqualified audit opinions of Deloitte that Livent's financial statements presented "fairly, in all material respects, the financial position of the company...in accordance with generally accepted accounting principles in Canada."
That image of financial health was false. The 1998 restatement of Livent's financial statements for 1996 and 1997 resulted in a significant downward adjustment of reported income and share value fell from USD $6.75 to $0.28 per share. The company's downfall resulted in multiple judicial and quasi-judicial rulings over the next decade including criminal convictions, cross-border bankruptcy proceedings, hearings before the SEC and OSC, and prosecutions of certain Deloitte partners before the Discipline Committee of the Institute of Chartered Accountants.
Livent, by its Receiver, brought an action for negligence and breach of contract against Deloitte regarding the audit of Livent's financial statements.
Standard of Care
The Court highlighted a significant change in the standard of care to be applied to auditors in the modern era. Deloitte argued that the standard required was that of "a reasonably competent and cautious accountant". The Court held, however, that the standard of care applicable to auditors in 1990s Canada was not as limited as that asserted by Deloitte. It held that the circumstances of a particular case may dictate that more than the minimum standard of a "reasonably component and cautious accountant generally" may be required.
The Conduct of the Audit
At trial the Court found that Deloitte's conduct in the 1996 and 1997 audits fell short of the applicable standard of care. Deloitte's assessment of the engagement risk for the 1996 audit was "greater than normal", which the Court found to be a euphemism for "high risk". In addition, planning memos for 1996 provided a clear mandate to increase the level of professional skepticism on all fronts and it was anticipated that there would be more than normal Engagement Partner involvement as a result. For 1996, it was found that Deloitte did not follow its own planning memos and failed to review projections which represented over 30% of Livent's unamortized production costs at year-end, failed to adequately reconcile projected with historical results, and did not insist on management taking a reserve on preproduction costs in 1996 even though they were taken in 1994 and 1995 when the company's total capitalised preproduction costs were significantly less. In addition, Deloitte did not confirm the portion of receivables payable to a staff union even though it disputed the amount. Instead, it accepted management's representation that there was an amount in surplus which could be recovered from the union and carried forward to off-set payments the company would have to make to the union in the future.
The "Achilles' heel" of Deloitte's defence with respect to the 1997 audit was a letter of intent in respect of a transaction in which Livent sold rights in one of its theatres to an arm's length company for $7.4 million. The letter contained a put in the arm's length company's favour, which allowed it to exit the deal if construction on the theatre had not finished by a certain date. Deloitte objected to including the amount Livent received as income, as it viewed the deal as a contingent agreement, to the point of threatening to disassociate itself from the company. However, after significant pressure from management, Deloitte agreed to recognise the gain. The Court found that Deloitte should have remained firm and severed the relationship and should have disclosed the problems with Livent to both the company's Audit Committee and the regulators. At the very least, the Court held it should not have signed off on the 1997 audit opinion.
It is worth noting that before the Judge wrote the penultimate draft of his Reasons, the recent Court of Appeal decision in CIBC v. Deloitte & Touche, was brought to his attention. In that case, the Court of Appeal held that discipline decisions of the ICAO under the predecessor legislation to the Chartered Accountants Act, 2010 may be admissible in a civil proceeding. Although the Judge's analysis and conclusions were not based on any of the ICAO discipline decisions, he noted that the CIBC v Deloitte & Touche decision would arguably have permitted him to reference some or all of the ICAO discipline decisions against the Deloitte audit partners involved in the Livent audits in determining whether there was a breach of the standard of care.
The Defences of Corporate identity and ex turpi causa
Deloitte argued that a concerted effort was made to conceal the accounting frauds and irregularities from it, and even if it had been negligent, Livent's losses should not be recoverable because they were caused by its own illegal acts.
Deloitte relied on the "corporate identification doctrine" which provides that the commission of a fraud or other culpable act by the directing mind of a company and which is intended or in fact benefits the company, must ipso facto be attributed to the company and thereby deprive it of any remedy in tort. The Court found that policy reasons dictated that this doctrine should not be applied where the company itself was the aggrieved party and was claiming against a third party auditor.
These policy reasons were discussed and applied in the analysis of Deloitte's other argument that the maxim ex turpi causa non oritur actio ("from a dishonourable cause no action arises") was a bar to the company's recovery. The Court held that this doctrine was applicable only in very limited circumstances and it declined to do so here where innocent shareholders would be unjustifiably denied a remedy and where it would allow the auditor to escape liability for the very fraud it should have detected.
This case is important in arguably increasing the standard of care expected of Canadian auditors, especially in complex or high risk audits. It also confirmed the limited grounds on which an auditor can rely on frauds committed by those within the company as a defence to a claim of professional negligence.
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.