UK: When Can A Company Sue Its Auditors For Failure To Uncover Fraud - The Final Word?

Last Updated: 3 August 2009
Article by Julian Randall, Catherine Manson and Tim Strong

The long awaited judgment in Stone & Rolls v Moore Stephens was handed down by the House of Lords yesterday.

In opinions running to some 130 pages, the House of Lords has upheld the Court of Appeal's decision by a 3-2 majority. Several of their Lordships remark on the novelty of Moore Stephens' argument in this jurisdiction and the complexities of deciding it. They all reached their decisions by different routes. Comments by both the majority and the minority on each other's conclusions and reasoning suggest a long and possibly vigorous debate between them. It is questionable that the legal position has been greatly clarified.

The facts

Stone & Rolls is a company in liquidation. At all material times until its liquidation, the company was controlled and indirectly beneficially owned by one Zvonko Stojevic. Mr Stojevic used the company as a vehicle for letter of credit fraud. The company would present false documents purportedly evidencing grain trades in order to draw down on letters of credit issued in its favour. The sums extracted from various banks were applied elsewhere for the benefit of Mr Stojevic and others. When the music stopped, one of the banks sued both the company and Mr Stojevic in deceit and was awarded substantial damages against both. The company could not pay and consequently went into liquidation. The liquidators, in the name of the company, then brought a claim against Moore Stephens, the company's auditors, alleging: first, that they were negligent in failing to spot the fraud; and, secondly, that had they spotted it the company would not have been exposed to liabilities arising from the fraud. The company sought just under US$174m.

Moore Stephens (which in any event denied breach of duty) applied to strike out the claim on the basis that the loss the company was claiming arose directly from its own fraudulent activities.

The issue

There is a tension between the obvious public interests that auditors should detect and report fraud and the unfair burden this can place on auditors (who are, after all, professionals and not insurers of the companies they audit). Caparo Industries Plc v Dickman, 20 years ago, sought to relieve some of the burden on auditors by setting down that, while the public at large might well rely on audited accounts, the purpose (and thus the scope of the auditor's duty) extended only to the reporting to the company itself. Auditors' duties are therefore generally owed to the company alone and only the company can sue for their breach. This decision insulated auditors in particular from claims by persons who had bought shares in the company relying on the audited accounts.

Caparo caused few practical problems in relation to fraud. A fraud will always cause the company harm one way or another. Either the fraud is against the company or it will be against a third party who will generally have a right to sue the company for its losses. So, even after Caparo, the company, perhaps in liquidation, could sue for the loss caused to the company by the fraud (quite possibly in order to hand over the damages to any defrauded third parties).

What is to be done, however, if the company itself is dishonest? It is well established ("the illegality principle") that a court will not assist a claimant to recover compensation for the consequences of his own illegal conduct.

The majority in the House of Lords felt that it would be artificial to pretend that Stone & Rolls was not in reality dishonest and it would be inappropriate to create a special exception to normal legal principles just to find auditors liable in these sorts of circumstance. The minority clearly felt strongly that policy dictated a different result and that result could be accommodated within general principle.

As Lord Mance put it: "The world has sufficient experience of Ponzi schemes operated by individuals owning "one man" companies for it to be questionable policy to relieve from all responsibility auditors failing to check and report on such companies' activities. The speeches of my noble and learned friends in the majority have that effect."

The decisions below

At first instance, Langley J declined to strike out the claim. The Court of Appeal unanimously allowed Moore Stephens' appeal. The Court of Appeal found that Mr Stojevic's conduct and knowledge were attributable to the company, such that the company was the perpetrator of the fraud (not the victim) and, therefore, the claim was barred by the illegality principle.

As stated, the House of Lords was split.

The majority (Lords Phillips, Walker and Brown) has held that, in the case of a "oneman" company where the directing mind and will of the company is also its owner, its fraudulent conduct is to be treated as the company's conduct and the illegality principle will defeat the company's claim against its auditors for failure to detect the fraud.

Lord Phillips concluded that the illegality principle provides a defence because all those whose interests were to be protected by the auditors' duty - in this case Mr Stojevic, the sole will, mind and beneficial owner of the company - were party to the illegal conduct. He also suggested that there is no duty owed to the company to report fraud externally if there is no-one to whom fraud can effectively be reported internally; this is a public duty and its breach cannot provide the crook with a remedy in damages.

The fact the company had gone into liquidation (and its creditors would therefore benefit from any recovery) could not provide the company with remedies it would not have if it were solvent.

The minority (Lords Scott and Mance) view was that Mr Stojevic was acting outside the scope of his authority as a shadow director and the company was properly categorised as a victim of the fraud.

Lord Mance appears to accept that where a company, owned and controlled by wrongdoers, is solvent at the audit date, "there is nothing to report, no-one to complain and no loss." However, where a company is insolvent, he considers that the auditors' duty extends, like directors', beyond the protection of the interests of shareholders because the auditors ought to have detected the company was insolvent as a result of the fraud.

In Lord Mance's closely reasoned judgment, he maintained that this approach was consistent with Caparo although it appears to involve assessing the auditors' duty by reference to who, at any one time, is the dominant interest behind a company and thus to cut across conventional concepts of separate corporate personality. In the view of the majority, if a company is dishonest as a matter of fact it should not be able to sue. The fact that damages might or might not go to the creditors cannot determine the company's legal rights.

It is difficult to draw very clear conclusions from such a disparate set of judgments, but some things are clear.

1 The principle that no claimant can rely on his own dishonesty in order to bring a claim applies to tort claims.

2 A company may be dishonest even though it has no independent will of its own.

3 The claimant argued throughout this litigation that the illegality defence does not apply where the matter in question (here detecting fraud) was the "very thing" the auditors were obliged to do. None of their Lordships considered this principle to be relevant.

4 None of their Lordships challenged the restrictions set down in Caparo. There was no appetite for extending any direct duty from the auditors to third parties who had been deceived by the fraudulent company.

By majority:

5 That where there is no innocent constituency within the company to whom the auditor can report, the company effectively becomes its dishonest controller and can be in no better position to sue its adviser than a dishonest natural person would be.

A number of issues are not resolved.

1 Much time was spent before the House examining the rules of attribution; that is when and how to fix a company with the knowledge of its dishonest agents. The majority largely short circuited this debate by holding, on the extreme facts of this case, detailed analysis was not needed.

2 This leaves open the question as to where one draws the line. When is a controller so dominant that the company becomes its alter ego. How many shares need to be held by an innocent person in order for the company not to be dishonest. The House of Lords rejected any wider principle that where the directing mind and will of a company perpetrated fraud that company's claim should be barred by reason of its own illegality. Rather, the majority limited the effect to "one-man" companies. The judgment has left open exactly what that means. Both Lords Phillips and Walker were willing to contemplate the illegality principle applying where there is some innocent constituency in the company. For example, Lord Walker suggested the expression should cover cases where there is one single dominant director and shareholder even if there are other directors or shareholders who are subservient to the dominant personality (but who are recklessly indifferent) and where there are two or more individual directors and shareholders acting closely in concert. While it is clear that the majority wished to limit the circumstances in which this rule could apply, it is hard to see a principled basis for a distinction between a true one man company and a company completely controlled by one man which happens to have a couple of innocent shareholders.

3 There may well be further debate about the relevance of contributory negligence to auditors' negligence claims in this context. Lord Mance regretted the lack of argument about the ability of contribution to resolve the question of relative fault as between the company and the auditor as, in his opinion, "if contributory negligence is available as a defence, it would cater for or assuage concerns about the general appropriateness of allowing recovery expressed in some of the majority judgments". Lord Phillips was not convinced that the law, in its current state, could help. "Moore Stephens' liabilities would reflect S&R's liabilities to the banks and the damages paid by Moore Stephens would be paid, indirectly to the banks. Lack of care on the part of the banks in their dealings with S&R ought to be taken into account for the purposes of contributory negligence. Yet such lack of care could not be prayed in aid by S&R in answer to the claims framed by the banks in deceit...Nor is there any obvious mechanism by which such lack of care could be relied upon by Moore Stephens in answer to the claim brought by S&R."

4 Lord Phillips appeared (albeit obiter) to suggest that there might be another route to challenge a claim against auditors for failure to detect fraud. He referred to Moore Stephens having been retained by deception to audit a wholly fictitious business. Arguably, this rendered the audit contract unenforceable and Lord Phillips found it hard to see how there was any duty owed in these circumstances. Lord Mance gives Lord Phillips' comments short shrift and considered that to hold otherwise would "emasculate audit responsibility and the auditor's well recognised duty to approach their audit role if not as bloodhounds, then certainly as watchdogs".

Conclusion

It must be remembered that this was a strike out application on assumed facts. It may be possible successfully to argue points on attribution or duty at trial which will be difficult on a strike out application.

That said, the majority in the House has been careful to couch their judgments in very narrow terms and, unless it is clear that there is no innocent constituency in the company, striking out a claim on the grounds of the illegality defence as Moore Stephens has done is likely to be very difficult. The question whether the claimant is a "oneman" company will be one of fact. Claimants will be alive to this and will seek to frame their cases to avoid the sort of concession made in this case. Lord Scott even thought it inappropriate to strike out this case because, despite the agreed statement of facts, he felt it was not clear from the pleadings that Mr Stojevic was the sole beneficial owner of the company.

As a result of the House of Lords judgment, the scope to invoke the illegality principle in auditors' negligence cases is narrow. Even where it may be invoked, it is unlikely that auditors will be able to strike out claims other than in the clearest cases of a "one-man" company.

It seems unlikely that this judgment will (as Lord Mance feared) greatly weaken the obligations on auditors. They are already subject to significant regulatory sanctions and are scarcely likely to audit less carefully because in some very particular circumstances general legal principle might bar a claim for damages against them.

As a final note, this case was trumpeted as the first case in the UK of any substance to be backed by commercial third party funders. Those third party funders will now be facing a large costs bill. We will see in due course whether this impacts on funders' willingness to get behind large commercial cases. But one thing that is clear is that the mere fact a funder has evaluated a claim and decided to back it is no guarantee that the claim has merits.

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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