UK: Good News for Auditors?

Last Updated: 28 March 2002

The judgment of Mr Justice Evans-Lombe handed down on 20 March 2002, allows the proceedings brought by Baring Futures (Singapore) (“BFS”) against Deloitte & Touche (Singapore) (“D&T”), its former auditors, to proceed to full trial in May of this year. However, the judgment itself has some important implications for companies, for auditors and for insolvency practitioners in terms of representations given to auditors by representatives of a company.

As a preliminary issue, D&T had argued that the claim against them in respect of the 1992 and 1993 audits of BFS was bound to fail as, in both of these audits, they had relied on representation letters addressed to them and signed by the Finance Director of BFS, Mr Simon Jones. Mr Jones, they said, had signed these letters recklessly and thus fraudulently and it amounted to deceit. D&T said that this provided them with a complete defence of circuity of action and/or set-off extinguishing BFS’ claim.

Mr Justice Evans-Lombe held that, although certain of the representations in the letter were inaccurate and Mr Jones an unsatisfactory witness, D&T had failed to show that Mr Jones was recklessly fraudulent in signing the representation letters and therefore did not succeed on the preliminary issue.

Although this was sufficient to determine the preliminary issue, the Judge went on to deal with the issues of law which had been argued before him, namely: (1) materiality; (2) inducement; (3) causation and (4) vicarious liability.

  1. Materiality: the Judge said that he was satisfied that the representation letters were material, in the sense that D&T would not have signed their audit opinions on the statutory accounts without receiving them; although he did not decide the point, he inclined to the view that materiality was not a separate requirement of an action in deceit, but rather an aspect of proving inducement.

  2. Inducement: on the basis of Mr Jones’ evidence, the Judge said that by signing the representation letters, Mr Jones did intend to induce D&T to sign their audit opinions and that, as a matter of fact, it did so induce them.

  3. Causation:
    • in deceit claims, there is a requirement of causation over and above the requirement to prove inducement.
    • the Judge found that the signing of the audit reports induced by the representation letters was a substantial cause of D&T being sued for negligence, even if their negligent work (which was assumed for the purposes of the preliminary issue) might have been a more significant cause. The Judge followed Lord Steyn's test of causation (a substantial factor/ sufficient causal connection) in Smith New Court v Scrimgeour Vickers (Asset Management) Ltd [1997] AC 254.
    • as this is a claim in deceit and following Standard Chartered Bank v Pakistan National Shipping Corp (No. 4) [2001] QB 167, the signature of the audit reports was a cause of the loss and was to be treated as the only cause.
    • the Judge also considered "the purpose and scope of the relevant rule" as advocated by Lord Hoffman in Environment Agency v Empress Car Co (Abertillery) Ltd [1999] 2 AC 22 (the policy-based approach). He looked at two conflicting policies: (a) that allowing a company to sue its auditors in respect of a negligent audit and (b) that allowing a victim who has been deceived to sue his deceiver. The Judge came to the same conclusion under the policy test as under Lord Steyn’s test.

  4. Vicarious Liability: the Judge held that, had he found Mr Jones to have been recklessly fraudulent in signing the representation letters, he would have held that BFS was vicariously liable for his actions. Mr Jones signed the representation letters on BFS’ letterhead, as a director of BFS. On the face of it, he did so in the course of his employment and within the scope of his implied authority from the company.

    BFS argued that auditors, as officers of the company, were “insiders”. Thus BFS were not to be made liable for Mr Jones’ fraud because the rule in Lloyd v Grace Smith & Co [1912] AC 716 governs a company’s liability to “outsiders” only. The Judge did not accept that auditors are to be treated as “insiders”.

    He also held that it was not open to him to disapply the normal rules of vicarious liability in the circumstances. Where a director is acting within the scope of his authority, the fact that he acted with fraudulent intent does not matter unless the fraud has the effect of undermining the conclusion that he was in fact acting within the scope of his authority.

Implications

From this judgment, it appears that, where deceit is proved, it may be possible for auditors to escape liability for negligent audit work, if they rely on a representation from management which has been given recklessly. This possibility clearly troubled Evans-Lombe J, who said that, had he found Mr Jones to have been fraudulent, “it would be of concern to [him] that D&T were to escape liability completely, as a result of a reckless representation letter written by the very management which had prepared the financial statements which D&T were appointed to verify and concerning whose conduct of the company’s affairs D&T were appointed to provide shareholders with reliable intelligence.”

Letters of representation are commonplace in audits. It follows from this judgment that those who sign them need to be aware of the implications if they do so:

  1. knowing that the statements in the letter are untrue, without an honest belief in their truth, or indifferent as to whether or not they are true; or
  2. knowing that they have no reasonable grounds for making the statements, without an honest belief that they have such grounds, or indifferent as to whether they have or not.
In such circumstances, the company may be denied the possibility of pursuing an action against its auditors in respect of a negligent audit.

© Herbert Smith 2002

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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