Canada: SCC Affirms Duty Of Care But Reduces Auditor's Damages In Livent Decision

On December 20, 2017, the Supreme Court of Canada (SCC) released its long-awaited decision in Deloitte & Touche v. Livent Inc. (Receiver of) (Livent), which addressed the issue of the auditor's liability for failing to detect a fraud perpetrated by the directing minds of Livent Inc. (Livent). The seven-member panel was unanimous that the defendant auditor was not liable to the company for work performed in connection with a public offering — a result that drastically reduced the damages awarded. However, the panel split four to three on the question of whether the auditor was liable to the company for damages in connection with a negligent audit. The SCC reviewed the leading precedents relating to recovery for pure economic loss in the context of professional negligence. Arguably, it merely reaffirmed and did not alter the basic analytic framework for determining the liability of auditors or other professional service providers. The majority and minority of the SCC disagreed over the sufficiency of evidence of detrimental reliance to support the existence of a duty of care and causation. The SCC did not accept an argument advanced by the defendant auditor that the receiver could not stand in the shoes of the company for the purpose of advancing the claims. It also found that the defence of contributory negligence was unavailable in the circumstances. The extent to which the Livent decision will affect corporate Canada's relationship with its auditors remains to be seen; however, it could result in a reassessment of retainer terms and increased audit fees.

BACKGROUND

Livent was a theatre production company that filed for insolvency protection in 1998 after the discovery of an accounting fraud that resulted in the restatement of the company's financial statements. The defendant auditor became aware of certain red flags, but did not uncover the fraud. Livent went into receivership and the receiver sued the auditor for the liquidity deficit that arose during the seven months that elapsed between the point in time when it argued the auditor should have resigned, and the insolvency. The receiver argued that, but for the auditor's negligence, the company's life would not have been "artificially extended" and it would have suffered fewer losses during this period. Two mandates were at issue: work the auditor performed in connection with a public offering in 1997, and Livent's 1997 audit, which was finalized in April 1998.

The trial judge found the auditor was negligent and awarded damages of C$85-million. This amount represented the difference in Livent's value on the date the trial judge concluded the auditor should have resigned and the value on the date of insolvency, less a 25 per cent reduction to account for trading losses the judge deemed too remote to attribute to the auditor's negligence. The Court of Appeal for Ontario upheld the judgment.

SCC DECISION

Public Offering Engagement

The first mandate at issue primarily consisted of assistance with a press release and the provision of a comfort letter in connection with a public offering. The SCC was unanimous that, although the auditor did not act appropriately when it encountered accounting irregularities in connection with these services, the auditor did not owe a prima facie duty of care to Livent. The SCC reasoned that the services at issue were undertaken by the auditor for the purpose of soliciting investment. This engagement differed from an audit in that these services were not undertaken for the purpose of assisting Livent's shareholders in overseeing the company's management. It concluded that Livent had no right to rely on the auditor's representations for a purpose other than for which the auditor undertook to act. Any such reliance would be unreasonable and an increase in Livent's liquidation deficit was not a reasonably foreseeable injury. As a result of this determination, the damages were reduced to C$40-million.

Audit Engagement

The majority of the SCC accepted, based on its earlier decision in Hercules Managements v. Ernst & Young (Hercules Managements), that a claim by a corporation for losses resulting from a negligently performed statutory audit could succeed because a statutory audit is prepared to allow shareholders to collectively supervise management and take decisions regarding the administration of the corporation. It concluded that Livent's shareholders were deprived of the ability to perform their supervisory and decision-making function as a result of the negligent audit. Both proximity and foreseeability of harm were established.

The minority declined to find the existence of a duty. It found there was a lack of evidentiary support for the conclusion that the company relied on the faulty audit report in the sense that it would have acted differently in the absence of the auditor's negligence and concluded that no duty of care was owed. It reasoned:

"Livent led no evidence that its management did not know of Drabinsky's and Gottlieb's misfeasance; indeed, it likely could not have done so. Drabinsky and Gottlieb, the fraudsters, were themselves the management. Far from relying on the audited statements as assurance that everything was well with the company, Drabinsky and Gottlieb knew the audit reports were inaccurate. There is no evidence that anyone at a lower level of Livent management would have blown the whistle if Livent's statements had revealed the fraud at an earlier date."

The minority raised the concern that failing to hold the company to its onus to prove detrimental reliance would make the auditor "the virtual guarantor of everything Livent — not the collectivity of shareholders to which the duty was owed — did thereafter." It also raised "the spectre of indeterminate liability", observing:

"Auditors would be unable to reasonably predict when they are providing services to clients what their ultimate liability would be. It would be out of their control. No matter how bad the decisions made by the client thereafter, no matter how complex the web of dealings that led to the ultimate loss — things that cannot be foreseen in advance — the auditor would be liable for the total loss, on the basis that it would not have occurred 'but for' the negligent act [of the auditor]."

Defence of Contributory Negligence

The majority of the SCC rejected a number of defences advanced by the auditor, including the argument that its damages should be reduced to account for the contributory negligence of Livent, given that the fraud had been perpetrated by the company's directing minds. The majority declined to impute the knowledge and actions of the directing minds to Livent, concluding:

"The very purpose of a statutory audit is to provide a means by which fraud and wrongdoing may be discovered. It follows that denying liability on the basis that an individual within the corporation has engaged in the very action that the auditor was enlisted to protect against would render the statutory audit meaningless. As Livent submitted, it would be perverse to deny auditor's liability for negligently failing to detect fraud 'where the harm [to the corporation] is likely to occur and likely to be most serious.'"

While the majority concluded that the corporate identification doctrine remains good law in Canada, it only establishes a sufficient basis to attribute the acts of a directing mind to the corporation; it is not a necessary one. Courts retain the discretion to refrain from applying it in circumstances when it will not be appropriate to do so. The majority concluded that, "where, as here, its application would render meaningless the very purpose for which a duty of care was recognized, such application will rarely be in the public interest. If a professional undertakes to provide a service to detect wrongdoing, the existence of that wrongdoing will not normally weigh in favour of barring civil liability for negligence through the corporate identification doctrine."

The defendant auditor argued that application of section 3 of the Negligence Act was mandatory and that a plaintiff's fault must be factored in to the apportionment of damages in all cases. However, the SCC took the view that any fault on Livent's part was dependent on the application of the corporate identification doctrine, a doctrine it had already concluded was inapplicable in the circumstances. The SCC also pointed out that the auditor could have achieved apportionment of liability by initiating third-party claims against the individual wrongdoers but had declined to do so. The minority of the SCC, having concluded that the auditor was not liable, declined to consider this issue.

Receiver Stands in the Shoes of the Corporation for the Purpose of Pursuing a Professional Negligence Claim

The majority of the SCC also rejected the auditor's characterization of the claim as one that was, in light of the company's insolvency, essentially brought by the various stakeholders in the company who were pursing their own individual interests, as opposed to a claim brought by the company itself. The SCC held that this characterization disregarded Livent's separate corporate personality and directly contradicted the holding in Hercules Managements, to the effect that a derivative action is the appropriate vehicle for an auditor's negligence claim.

CONCLUSION

The Livent decision illustrates that, in cases involving pure economic loss flowing from the provision of professional services, the purpose of a professional's engagement is critical. The existence of a duty, and the parties to whom it is owed, depends on the nature of the specific mandate undertaken. The SCC's determination that the corporate identification doctrine does not apply in this case could also have significant implications for the allocation of losses between auditors and "directing minds" who perpetrate frauds in other cases. The availability of third-party claims, which the SCC relied on as a basis to refuse to apply principles of contributory negligence, may be cold comfort for an auditor who is found to be jointly and severally liable with an impecunious fraudster.

The extent to which the Livent decision will affect the dynamics of the audit process in Canada remains to be seen. Whether it will affect the costs of audits, the terms on which they will be conducted, the diligence audit firms will need to perform before accepting a retainer or the ability of corporations, especially those with heightened risk profiles, to obtain audited financial statements are all open questions.

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.

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