Canada: The Supreme Court's Decision In Livent: A Framework For Deciding Auditor's Negligence Cases

Last Updated: March 13 2018
Article by Canadian Appeals Monitor, Mira Novek and William D. Black

Most Read Contributor in Canada, September 2018

In its much anticipated decision in Deloitte & Touche v. Livent Inc. (Receiver of),1 the Supreme Court of Canada has considerably reduced the damage award payable by an auditor after it failed to detect a colossal fraud perpetrated by the directors of Livent. While the amount of the award remains significant at $40,425,000, this is less than half of the $84,750,000 initially awarded by the lower courts. In reaching this result, the Court provided clearer guidance on when an auditor may be liable to its corporate client in cases of negligent misrepresentation or performance of a service. Significantly, where a duty of care arises in respect of an auditor's representation or services, it will be limited to the purpose for which the auditor undertook to provide the representation or services. It follows that an auditor will not be liable where a corporate client detrimentally relies on the auditor's representation or services for any purpose other than that for which the auditor undertook to act. Here, the auditor was not liable to Livent for negligent misrepresentations contained in a comfort letter and press release prepared for the purpose of assisting Livent to solicit investment. As the representations were intended to provide comfort to investors rather than to inform Livent of its own financial position, any reliance Livent placed on them for the purpose of overseeing its operations fell outside the scope of the auditor's duty of care. In contrast, Livent was able to recoup its losses which followed the issuance of a negligently prepared clean audit opinion, as the Court found that Livent had relied on the statutory audit for one of its intended purposes, which was to enable shareholder oversight of management.

Background

Founded in the early 1990s by Garth Drabinsky and Myron Gottlieb, Live Entertainment Corporation of Canada, or Livent, was by all appearances a highly successful developer of popular stage productions, including the long-running Phantom of the Opera. Behind the scenes, however, Drabinsky and Gottlieb (with the help of other senior managers and many of the company's accounting staff) were manipulating the company's financial records to make Livent appear more profitable than it was in order to attract much needed funding from the capital markets. When new management discovered and exposed the fraud in 1998, Livent's dire financial situation was revealed. The company soon filed for bankruptcy protection and was placed into receivership. Drabinsky and Gottlieb were fired and ultimately convicted of fraud.

Livent's collapse set off a wave of litigation, including this action against its auditor. Livent claimed that its auditor breached the duty of care it owed Livent by failing to detect and expose the fraud, and that its reliance on the auditor's false representations of financial health impaired its ability to oversee its operations. This resulted in an "artificial extension"2 of the company's life which, in turn, permitted the continued deterioration of its assets.

Lower Court Decisions

In the Ontario Superior Court of Justice,3 Justice Gans made two core findings of negligence against the auditor in relation to two separate engagements:

  1. in August and September 1997, it breached the standard of care when it failed to act on its discovery of certain accounting irregularities, and instead provided a comfort letter (the "Comfort Letter") and helped prepare a misleading press release (the "Press Release") in order to help Livent solicit investment through a public offering; and
  2. In April 1998, it breached the standard of care when it issued a clean audit opinion in respect of Livent's 1997 financial statements.

The trial judge calculated Livent's damages as the difference between the company's value at the time of the first breach and its value at the time of its bankruptcy filing. He then reduced this by 25% to account for losses during this period that he attributed to Livent's "unprofitable but legitimate theatre business".4 In the result, he issued judgment in favour of Livent in the amount of $84,750,000.

The Court of Appeal for Ontario upheld the trial judge's award.5

On appeal to the Supreme Court of Canada, the panel split 4-3. The majority, in a decision authored by Justices Gascon and Brown, allowed the appeal in part and reduced the damage award from $84,750,000 to $40,425,000. The minority, in a strong dissent authored by outgoing Chief Justice McLachlin, would have set aside the award in its entirety.

Summary of the Decision of the Supreme Court of Canada

This case provided the Supreme Court with an opportunity to revisit its earlier decision in Hercules Managements Ltd. v. Ernst & Young,6 where it recognized that an auditor owes its corporate client a duty of care in the preparation of a statutory audit. The trial judge and the Court of Appeal in Livent had interpreted the duty recognized in Hercules broadly, as encompassing not only the statutory audit but also the services undertaken by the auditor for the purpose of assisting Livent to solicit investment, including the Comfort Letter it had provided and the Press Release it had helped prepare. The majority of the Supreme Court took a narrower view of the holding in Hercules, affirming that it did not establish a relationship of proximity "between an auditor and its client at large."7 Rather, the duty of care recognized in Hercules was limited to the preparation of a statutory audit and could not be extended to other services undertaken for other purposes. The majority emphasized the different purpose underlying the Press Release and Comfort Letter: whereas the statutory audit was "intended to inform Livent of its own financial position for various purposes, including, most importantly, shareholder oversight of management", the Press Release and Comfort Letter "were intended to inform investors of Livent's financial position".8

As there was no prior duty of care recognized between an auditor and its corporate client for the purpose of soliciting investment, the Court found it necessary to undertake a full duty of care analysis within the framework set out in Anns v. London Borough of Merton,9 and as refined in Cooper v. Hobart,10 in order to determine the existence and scope of such a duty. Under the first stage of the Anns/Cooper test, the court must determine whether a prima facie duty of care exists in reference to, first, the proximity between the parties and, second, whether the plaintiff's losses were reasonably foreseeable. Where a prima facie duty of care is established, the court may yet negate the imposition of that duty at the second stage of the test on the basis of residual policy considerations. The majority noted that this was the Court's first opportunity to apply the Anns/Cooper framework in a case of auditor's negligence, as Hercules was decided under the then-current Anns test. The key difference between the tests is that, while the Anns test only required a finding at the first stage that the injury was reasonably foreseeable, Cooper added proximity as an additional stand-alone requirement.11 The majority noted that when applied to cases of negligent misrepresentation, Cooper's more exacting framework "will give rise to a far narrower scope of reasonably foreseeable injuries and, therefore, a narrower range of prima facie duties of care."12 Correspondingly, the majority emphasized, it is also less likely to give rise to indeterminate liability, which is a significant concern for auditors who must be able to predict and manage their risk of liability.

The majority emphasized that the purpose of the auditor's undertaking will be critical to determining the existence and scope of any duty of care in cases of negligent misrepresentation or performance of a service. At the first stage of the test, the purpose of the undertaking will limit the scope of the proximate relationship and, consequently, the duty of care. As expressed by the majority:

Any reliance on the part of the plaintiff which falls outside of the scope of the defendant's undertaking of responsibility — that is, of the purpose for which the representation was made or the service was undertaken — necessarily falls outside the scope of the proximate relationship and, therefore, of the defendant's duty of care.13

The scope of the parties' proximate relationship will, in turn, limit the scope of injuries that are reasonably foreseeable as resulting from the defendant's negligence. In claims for pure economic loss arising from negligent misrepresentation or performance of a service, whether an injury is reasonably foreseeable will depend on (i) whether the defendant should reasonably foresee that the plaintiff will rely on its representation; and (ii) whether that reliance is reasonable. The determination of whether reliance is reasonable and reasonably foreseeable "will turn on whether the plaintiff had a right to rely on the defendant for that purpose."14

Applying this framework to the facts of this case, the majority concluded that the auditor's undertaking to assist Livent with the solicitation of investment gave rise to a proximate relationship. However, this proximity was limited to the purpose of that undertaking, i.e., soliciting investment. This limitation in turn narrowed the scope of reasonably foreseeable damages: while losses related to the purpose of the undertaking (such as an inability to solicit investment) might be recoverable from the auditor, losses unrelated to that purpose would not be. Here, Livent was seeking to rely on the auditor's undertaking for an outside purpose—to assist its shareholders in overseeing management—which the Court concluded was neither reasonable nor reasonably foreseeable:

Simply put, Deloitte never undertook, in preparing the Comfort Letter, to assist Livent's shareholders in overseeing management; it cannot therefore be held liable for failing to take reasonable care to assist such oversight. And, given that Livent had no right to rely on Deloitte's representations for a purpose other than that for which Deloitte undertook to act, Livent's reliance was neither reasonable nor reasonably foreseeable. Consequently, the increase in Livent's liquidation deficit which arose from its reliance on the Press Release and Comfort Letter was not a reasonably foreseeable injury.15

Having concluded that no prima facie duty of care arose in respect of Livent's reliance on the Comfort Letter and Press Release, the majority did not need to consider the existence of any residual policy considerations that might negate such a duty.

Having dismissed this portion of Livent's claim, the majority went on to find that the auditor was nonetheless liable for Livent's losses arising from the negligently prepared 1997 statutory audit. As the purposes of Livent's statutory audit were indistinguishable from the one undertaken in Hercules, the majority concluded that Hercules was dispositive of the question of whether a duty of care arose in this case. Moreover, as Livent had detrimentally relied on the 1997 statutory audit for one of its intended purposes—namely, to provide its shareholders with reliable information so that they could oversee the conduct of management—its resulting losses were reasonably foreseeable and therefore recoverable. Having found a duty of care based on a previously recognized category, the majority did not need to proceed to the second stage of the test to consider any residual policy considerations that might negate the duty. Nonetheless, it indicated that none would apply in this case, including the prospect of indeterminate liability. The majority noted, among other things, that the class of claimants (i.e., Livent) was determinate, as was the time period during which liability might flow from a single statutory audit. Since a new statutory audit is required every year, an auditor's liability in respect of any one statutory audit will be limited to one year, which the majority found to be sufficiently determinate.

The majority also rejected the auditor's arguments that recovery should be barred by the defence of illegality (which bars an otherwise valid tort claim on the basis that the plaintiff has engaged in illegal conduct) or, in the alternative, reduced on the basis of contributory negligence. Both arguments would depend on the Court imputing the fraudulent conduct of Drabinsky and Gottlieb, as the directing minds of Livent, to the corporation itself. While the majority acknowledged that the authoritative test for the corporate identification doctrine set out in Canadian Dredge & Dock Co. v. The Queen,16 might seemingly be met on the facts of this case, it reaffirmed a significant qualification to that test: "The principles set out in Canadian Dredge provide a sufficient basis to find that the actions of a directing mind be attributed to a corporation, not a necessary one."17 In other words, courts still retain the discretion not to apply the doctrine where it would not be in the public interest to do so. In this case, the majority determined that the application of the corporate identification doctrine would not be in the public interest:

[W]here, 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.18

The majority also noted that the availability of third-party claims against Drabinsky and Gottlieb weighed against the application of the doctrine. In the result, the majority concluded that the auditor was liable for Livent's losses attributable to the 1997 clean audit opinion and reduced the damage award accordingly, from $84,750,000 to $40,425,000.

Notably, in a strong dissenting opinion, the minority would have gone farther and set aside the damage award in its entirety. Among other reasons, the minority concluded that Livent had not proven detrimental reliance as a factual matter. In particular, the minority concluded it had not proven that its shareholders had in fact relied on the audit statements for the purpose of overseeing management or that, had the shareholders known about the fraud at an earlier date, they would have taken steps to prevent Livent's subsequent losses. The majority did not dispute that actual detrimental reliance had to be proven, but took a different view of the sufficiency of the record. It found that Livent's swift response once the scope of the fraud was revealed, which included firing Drabinsky and Gottlieb as well as filing for bankruptcy, "belies any suggestion that informed shareholder scrutiny would have permitted Livent to act in any manner other than expected."19

Conclusion and Implications

The full impact of the Court's decision in Livent remains to be seen. Nonetheless, the Court has set out a principled framework that is adaptable to future cases and for that reason promises to bring some additional certainty to the law in this area. Most significantly, Livent underscores that the purpose of an auditor's representation or undertaking will be critical to the determination of its liability in cases of negligent misrepresentation or performance of a service. Moreover, where a novel purpose is claimed, the courts may not simply extrapolate from the duty recognized in Hercules. Rather, they must undertake a full duty of care analysis within the Anns/Cooper framework to determine whether the plaintiff had a right to rely on the auditor's representation or services for that purpose. Moreover, even where a duty of care is established for a particular purpose, the plaintiff must still prove as a fact that it relied on the auditor's representation or services for their intended purpose.

The majority's determination that the corporate identification doctrine should not be applied on the facts of this case sets a high bar for its application in future cases of auditor's negligence. While third-party claims may provide an alternative avenue of relief, their utility will depend on the available resources of the fraudsters.

Finally, disclaimers of liability will no doubt receive renewed attention given the Court's description of auditing a large corporation as a "high risk undertakin[g]" that can attract significant liability, much like flying commercial aircraft or manufacturing pharmaceutical drugs.20 Auditors may take some comfort, however, in the majority's suggestion that "contractual disclaimers limiting liability may often be warranted."21 This is of course in addition to other inherent limitations built in to the duty of care itself. In this case, the majority notably found that liability for a statutory audit will be limited to a single year.

Case Information

Deloitte & Touche v. Livent Inc. (Receiver of), 2017 SCC 63

Docket: 36875

Date of Decision: December 20, 2017

Footnotes

1 2017 SCC 63 [Livent].

2 Ibid. at para. 101.

3 2014 ONSC 2176.

4 Ibid. at para. 326.

5 2016 ONCA 11.

6 [1997] 2 S.C.R. 165 [Hercules].

7 Livent, supra note 1 at para. 50.

8 Livent, supra note 1 at para. 15.

9 [1977] 2 All E.R. 492 (H.L.) [Anns].

10 2001 SCC 79 [Cooper].

11 Livent, supra note 1 at para. 23.

12 Livent, supra note 1 at para. 36.

13 Livent, supra note 1 at para. 31.

14 Livent, supra note 1 at para. 55.

15 Livent, supra note 1 at para. 55.

16 [1985] 1 S.C.R. 662 [Canadian Dredge].

17 Livent, supra note 1 at para. 104.

18 Livent, supra note 1 at para. 104.

19 Livent, supra note 1 at para. 83.

20 Livent, supra note 1 at para. 43.

21 Livent, supra note 1 at para. 43.

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