Hong Kong: Claims Against Auditors: Summary Justice?

Last Updated: 16 February 2004

In 2003, decisions of the Hong Kong and English Courts of Appeal addressed persistent and difficult issues as regards the existence and scope of any duty of care, causation and loss in claims against auditors, and the extent to which these may be resolved summarily (i.e. without a full trial). In addition, "loss of opportunity" claims are becoming increasingly significant in this area. In the Hong Kong appellate decision in Guang Xin, the Court of Appeal was less willing than the Court of First Instance to resolve such matters summarily. A similar reluctance was demonstrated by the English Court of Appeal in its recent Equitable Life decision.

Hong Kong: Guang Xin Enterprises Ltd v Kwan Wong Tan & Fong
The plaintiff company went into creditors’ voluntary liquidation in 1998, with net liabilities said to be over HK$4 billion. The defendant firm audited the company’s accounts for 1994-1996. The company alleged the auditors were negligent in not uncovering and reporting adversely upon:

  • certain sham transactions allegedly entered into by management to disguise financial problems;
  • management’s gross over-valuation of certain assets. The company claimed, principally, that had it not been for the auditors’ alleged failure to identify this, the company would have been wound-up upon publication of the 1994 accounts, rather than continuing to incur further trading losses up to 1998.

The first instance court struck out both claims:

  • alleged sham transactions claim - it was fatal to the company’s case that some, at least, of its directors appeared to have been aware of the shams;
  • alleged trading losses claim - applying English authorities (principally the well known Galoo decision), the dominant cause of loss was held to be continuation of trading after 1994 and, as a matter of policy, the law should not hold auditors liable for loss thereby incurred. New Zealand authority to contrary effect (the Sew Hoy decision) was rejected.

In March 2003, the Court of Appeal upheld the strike-out decision, but left the door open to a reformulation of the claims:

  • alleged sham transactions claim - the company argued on appeal that, even if the board had been aware of such transactions, public revelation as a result of the auditors' report might have been enough to prompt resolution of the problems. The Court of Appeal indicated that "a pleading along these lines might be viable", provided that proper particulars were given of the steps which it was claimed would have been taken had the auditors' report revealed the alleged sham transactions and of the precise manner in which loss was alleged to have resulted;
  • alleged trading losses claim - the company only appealed in respect of one particular transaction. The Court of Appeal held that the pleading was incomprehensible and upheld the strike-out, but granted time to apply to amend the pleading.

The Court of Appeal was not prepared to accept the auditors’ suggestion that claims by insolvent companies against their auditors should be denied on the policy ground that such claims would in substance be for the benefit of creditors (to whom the auditors owed no duty). Rather, it was suggested that policy considerations of this nature were a matter for the Legislative Council, rather than the Judiciary.

England: Equitable Life v Ernst & Young
The Equitable Life Assurance Society is suing its former auditors, Ernst & Young, in connection with the recent financial difficulties faced by Equitable following the well-known House of Lords’ decision in 2000, concerning the Society’s liability to policy-holders.

Equitable advanced its claim in two ways:

  • lost sale claims - if the directors had appreciated the true financial position they would probably have put Equitable up for sale in 1998, or soon after the House of Lords’ decision in July 2000, so as to achieve an orderly sale;
  • bonus declaration claims - if the directors had been alerted to the true position, they would have cut back the bonus declarations for each year between 1997 and 2000.

In February 2003, the first instance court struck out the claim, although it subsequently allowed some elements to be reinstated following certain amendments which reduced the claim from £2.6 billion to £500 million. On 25 July 2003, the Court of Appeal substantially allowed Equitable’s appeal.

Ernst & Young argued, amongst other things, that it owed no duty to Equitable to protect it from losses suffered by business decisions of the directors, such as decisions whether to sell, or declare bonuses, where advice on those issues was not expressly requested. The Court of Appeal rejected this argument.

As to the two specific claims, the Court of Appeal held that the first instance court had been wrong to reject them summarily:

  • lost sale claims - these were reinstated in principle, subject to being formulated in terms of the loss of a chance of a sale;
  • bonus declaration claims - these were reinstated in their entirety, without the restrictions imposed at first instance.

The Court of Appeal expressed some sympathy for Ernst & Young’s point that the claims represented a significant burden for a litigant to have to bear to trial. However, there were procedural remedies to address this (e.g. requests for clarification of a party’s case). Striking out was not an appropriate solution, in the circumstances.

In the above cases, the appellate courts have shown less of an inclination to summarily dispose of certain claims against auditors than judges at first instance. Whether this trend continues remains to be seen but, no doubt, it will be welcomed in some quarters; most notably, claimants and liquidators of certain companies. It is also interesting to observe a growing tendency of some judges at first instance to scrutinise claims at a summary stage. In part, this tendency is explained by civil procedural rule changes adopted by the English Courts in 1999 and likely, in some shape or form, to be mirrored sometime in Hong Kong (an issue on which we will write more another time). That said, these cases still demonstrate that summary disposal is less suited to claims that (amongst other things) are undoubtedly complex, raise difficult issues of fact and law and require further investigation. The huge burden that this might place on a litigant (not to mention issues of cost) may well be a secondary consideration, compared to the need to ensure that such claims are properly determined.

By John Ogilvie and Graeme Johnston

© Herbert Smith 2003

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

For more information on this or other Herbert Smith publications, please email us.

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