UK: Accountants´ Liability Briefing
Highlighting Recent Developments in Accountants´ Liability

Rising to the Challenge
The last twelve months will not be remembered as the happiest of periods for the accountancy profession, least of all in the United States. A series of high-profile corporate collapses has dealt a blow across the world to public confidence in existing systems of corporate governance and financial reporting, and in the role played by accountants in auditing and advising their clients

The UK accountancy profession has been fighting hard to avoid an excessive, knee-jerk response. Much has been said about the distinguishing features of UK accounting standards, and the advantages that their principles-based approach has over the more rules-based approach adopted in the United States. Nonetheless, change is on the agenda, and the ICAEW has already introduced new recommended best practice on audit independence, including a two-year cooling-off period before an auditor joins a client. The issues of audit firm rotation, and the extent to which auditors should perform or even offer other services, continue to be debated.

What the last twelve months have particularly demonstrated is the growing importance of the global regulatory context. There is an increasingly international dimension to the regulation of accounting and auditing and the establishment of workable systems of corporate governance, and the review of the legal and regulatory framework in this country cannot fail to be influenced by the reforms which have been implemented with almost indecent haste in the United States. Moreover, the Sarbanes-Oxley Act has raised the spectre of UK accountancy firms concerned in the audit of US listed companies becoming subject to the extra-territorial jurisdiction of US courts and to the authority exercised by the SEC and a new independent regulatory board.

The last twelve months have also provided a chilling reminder of the impact that can be wrought on any firm by a single engagement, and the importance of proper risk management. Legislative change to enable auditors to limit liability remains a distant prospect, particularly as the Government has held back from making detailed proposals on the subject in its White Paper while it considers the fallout from recent events. But legislative change of this nature could not in any event protect firms from the catastrophic consequences which befell Andersen as a result of Enron.

The message is clear: auditors must expect issues involving independence and other ethical criteria to attract ever- increasing scrutiny from regulators. It is perception of independence which will be most important, whatever the underlying realities of the situation, and this means that even greater care will have to be given to whether it is appropriate to accept particular clients or jobs, and to the making of difficult audit judgements which may have some impact on the auditor/client relationship. Firms of every size should give serious consideration to strengthening their consultation and other risk management procedures in these areas.

Caparo Revisited – Or how to take on duties to banks without even realising
Royal Bank of Scotland v Bannerman Johnstone Maclay
A recent Scottish legal decision may prompt risk management teams in the audit sector to reassess their firms’ legal exposure to audit clients’ principal lenders. In a judgment handed down on 23 July 2002 Lord MacFadyen, sitting in the Outer House of the Court of Session (the equivalent of the English High Court), refused to strike out a claim against auditors by a bank which asserted that it had relied on audited accounts in deciding whether to lend funds to a customer. The auditors concerned had not been approached directly by the bank and had probably never considered that they might be at risk of a claim. Nonetheless, the Judge held that it was arguable that the auditors had sufficient knowledge of the bank’s reliance for a duty of care to arise

The Royal Bank of Scotland ("RBS") was principal lender to APC Limited, a plant hirer to the construction industry. It was a requirement of RBS’s facility letters that APC provide audited financial statements within six months of its financial year-end. APC’s auditors, Bannerman Johnstone Maclay ("BJM"), gave clean opinions on its accounts for the periods ended 30 November 1995 and 31 March 1997. These audited accounts were passed by APC to RBS, which contended that it relied on them in extending further loans to APC and taking an equity stake in the business.

In September 1998, while BJM were working on their audit of a further year’s accounts, RBS appointed receivers to the business. After trying unsuccessfully to recover its loans and investment, RBS started proceedings against BJM contending that the 1995 and 1997 accounts had been wrong and BJM’s audits had been negligent. It claimed that BJM owed it a duty of care on the following basis:

• BJM were closely involved in the financial affairs of APC, knew that it was a cash-hungry business and knew that RBS provided its working capital;
• It could be assumed that for the purpose of considering whether APC was a going concern BJM would have obtained copies of RBS’s facility letters, from which they would have seen the requirement that audited accounts be supplied to it, together with monthly management accounts;
• BJM accordingly knew or should have known that RBS would rely on the audited accounts as a cross-check on the management accounts and in particular in deciding whether to maintain, increase or withdraw its financial support.

BJM sought to strike out the claim on the basis that the facts asserted by RBS were not sufficient to give rise to a duty of care. They argued in particular that a duty of care could not arise in such circumstances unless the auditor intended that the bank should act in reliance on the information supplied.

The Judge held that the facts pleaded by RBS were sufficient in law to give rise to a duty of care. Relying on passages in the judgments of the House of Lords in Caparo v Dickman (1990), he stated that for a duty to arise the adviser must know at the time when the advice is given (1) the identity of the person to whom it is to be communicated, (2) the purpose for which the person is to be provided with it, and (3) that the person is likely to rely on it for the known purpose. In a more recent case, Galoo v Bright Grahame Murray (1994), the Court of Appeal appeared to suggest that it was also necessary that the adviser should intend that the person receiving the information would rely on it. However, the Judge fairly convincingly demonstrated that this interpretation was out of line with Caparo and other House of Lords authority and declined to follow it.

Another argument raised by BJM as to why a duty could not be held to exist was robustly dealt with by the Judge. BJM contended that it would be inappropriate to place responsibility on them in circumstances where they had no choice but to issue their audit reports, regardless of whether RBS or anyone else was going to rely on them. The Judge suggested, however, that they could have issued a disclaimer to RBS, and that as they had not done so they could be taken to have assumed responsibility to RBS.

The decision is in some respects unsatisfactory, and it is to hoped that it will be further tested. The weakest element in RBS’s case would seem to have been whether BJM had sufficient actual, rather than constructive, knowledge of RBS’s proposed reliance, a point which (possibly because of the limitations inherent in a strike-out application) was not argued. It would no doubt have been difficult for BJM to contend that they did not know that RBS was the main provider of funds, or that it would see the audited accounts, but what actual knowledge did the audit partner have of the use RBS proposed to make of them at the time he signed the audit reports? Why, for example, should it have been in his contemplation at that time that RBS would indeed lend further money or take an equity stake in the business?

Nonetheless, the decision is a stark warning that unanticipated claims of this nature can still arise. In the light of Caparo it was generally assumed that auditors would not be exposed to claims by banks unless specifically put on notice that a bank proposed to rely on the audited accounts for a particular purpose – in which event the standard response was and is to issue a letter of disclaimer. In the present case, however, RBS never contacted BJM directly to put them on notice of its intended reliance. Instead (on its own case) it simply went ahead and placed reliance on the accounts believing that BJM knew what it was doing and did not object.

What can be done to address this problem for so long as the present decision stands? The safest route would be to send a standard disclaimer to all lenders of which the audit team become aware in the course of their work, but it may be felt that this would be unduly onerous or impractical. Another possibility would be to consider adding a standard disclaimer to every audit report, making it clear that responsibility is not accepted to lenders or other third parties unless specifically accepted in writing by the audit firm. This would be a difficult decision to take politically, and could not provide real certainty at least until the meaning of section 310 of the Companies Act 1985 is definitively tested, for it is unclear whether the section simply prevents an auditor from restricting his liability to the company (the more likely interpretation) or prevents him from restricting his liability for a breach of duty to anyone "in relation to the company" (an interpretation which is possible on a literal reading of the section, though by any purposive test unlikely).

One other feature of the decision is of interest. For a few months around the end of 1995 one of BJM’s employees was seconded to APC as financial controller. RBS alleged that while he was there he participated with members of APC’s management in the financial irregularities and fraud that led to the collapse of the company. It contended that BJM was vicariously liable for the secondee’s fraudulent acts and sought to recover its losses by that route also.

The Judge applied the test of "direction and control" set out in the House of Lords decision in Mersey Docks and Harbour Board v Coggins & Griffith (1947). Responsibility for the acts of an employee seconded elsewhere will normally be determined by asking who has the right to direct and control the manner in which the employee discharges his duty. The Judge’s conclusion was that it was APC that had direction and control of the employee during his secondment. Although BJM continued to pay him, the employee had in effect become a member of APC’s management team, and only APC, through its board of directors, had the right to direct how that team operated. The Judge was also influenced by the consideration that BJM as auditors had to make their own independent assessment of financial information produced by APC, and that it would be inappropriate for BJM to seek to direct how that was done.

This aspect of the decision is welcome, but it should not be assumed that the position will be the same in all secondment relationships – for example, where the secondee is more junior or does not have a primarily financial role. Normally it will be good practice to try to deal with the position in the secondment contract, so as to avoid unwelcome claims and surprises.

Document Retention and Destruction: Some Hard Lessons
The worldwide collapse of Andersen, and a less publicised ruling of an Australian court in tobacco-related litigation, have re-emphasised the need for caution in devising and implementing policies for retaining and disposing of documents. In this article we examine the background to these cases and the lessons to be learned.

THE BASICS

In principle the owner of property is free to do what he wishes with it, including destroying it. But this principle is hedged around with restrictions of a legal, ethical or practical nature: the law, for example, would not countenance a form of destruction which caused harm to others.

For the accountant, the main restrictions on his ability to do what he wishes with his documents are legal and professional. The accountant must also bear in mind that some documents in his possession may not belong to him at all and that destruction without consent of the owner (usually the client) will be unlawful. Examples of documents owned by the client will include correspondence with the Inland Revenue in relation to tax compliance work, and the ‘accounting records’ which a corporate client is obliged to keep by virtue of section 221 of the Companies Act 1985.

In most situations, however, the accountant will be the owner of the documents he receives and creates in the course of his work. In the audit context, the position is summarised in SAS 230: "There are no specific statutory requirements regarding the period of retention of audit working papers. Auditors exercise judgement to determine the appropriate period of retention bearing in mind possible needs of their client, for example that audited information may need to be included in a prospectus at some future date, and their own needs, including any regulatory requirements. Prior to their destruction, auditors consider whether there is likely to be a need to refer to them again."

From a practical perspective, document retention periods are commonly linked to the primary limitation period of six years within which claims based on allegations of bad work must usually be brought.

However, some firms, and particularly the larger ones, have a policy of not retaining all of their audit and other working papers. Approaches vary, but in broad terms such a policy will involve reviewing files at the end of each engagement with a view to pruning out documents which do not provide necessary support to the opinion given. Andersen had such a policy.

This form of partial destruction policy is not on its face unlawful or contrary to professional requirements, including SAS 230. But there is one other legal requirement to preserve documents which, if triggered, over-rides all other considerations, and it was breach of this which was argued by the US Attorney General in the criminal prosecution of Andersen.

It was accepted at Andersen’s trial that large numbers of documents had been disposed of over a period of some three to four weeks before the firm received a federal subpoena for their production on 8 November 2001. Andersen argued that during this period it was merely implementing its own document management policies, which required destruction of unnecessary paper.

The prosecution contended, however, that in the first half of October it became apparent to Andersen that Enron’s affairs might give rise to legal or regulatory proceedings in which its papers might be needed as evidence, and that as soon as that became apparent there was an over-riding legal obligation to preserve them. The specific form of the requirement will vary with the nature of the proceeding: in the event, Andersen were charged with breach of a US statutory provision making it a crime to "alter, destroy, mutilate or conceal an object with intent to impair the object’s integrity or availability for use in an official proceeding".

Andersen is appealing its conviction. Important questions in the appeal will include whose activities the prosecution and the jury were focussing on, and whether they were indeed done with the requisite intent. But a successful appeal will be cold comfort for Andersen’s former partners and employees: the damage has already been done.

In this civil claim in Australia Mrs Rolah McCabe, who was dying of tobacco-related cancer, sued BAT for damages on the basis that it had failed to take sufficient steps to reduce the risk of her becoming addicted to tobacco. In March 2002 a Judge in the Supreme Court of Victoria struck out BAT’s defence on the basis that it had destroyed thousands of potentially relevant documents, thereby making a fair trial impossible. In a detailed written judgment the judge found that after a wave of tobacco-related litigation was contemplated in the early 1980s BAT and its lawyers devised a document destruction policy which, while couched in other terms, was in reality intended to prejudice the ability of potential claimants to bring proceedings against it.

Whether the Judge’s choice of sanction in striking out BAT’s defence was appropriate is to be argued on appeal. Again, however, the case illustrates the dangers in destroying documents when there is reason to believe that legal proceedings are likely, even if the identity of the specific claimant is not yet known.

English law operates in broadly the same way as US and Australian law in applying sanctions to the destruction of potentially relevant documents when it is known that they might be needed for the purposes of legal or regulatory proceedings. Two key lessons can therefore be drawn:

• First, and most obviously, whenever it can be seen that documents might be needed for the purposes of any form of investigation or proceedings it is essential that they be preserved intact. Any existing policy of partial or complete destruction should be suspended in so far as it applies to them. It should be added that the temptation to add to or alter the papers in any way should likewise be resisted. They should be held securely in conditions where tampering is unlikely to occur.

• Secondly, in both Andersen and McCabe, reliance was placed by the defence on legal advice which was said to have confirmed that what was being done was perfectly lawful. This required each defendant to waive privilege in the relevant legal advice, a process from which the lawyers who gave it do not appear to have emerged with much credit. In McCabe, a key difficulty lay in what was identified in the judgment as a gulf between the real motivation behind BAT’s destruction policy and the stated reasons for its adoption as suggested by its lawyers. The lesson is a stark one. If the real reason for adopting a policy by which documents will be destroyed is to reduce the risk of having to disclose damaging material in future litigation, the policy is going to be extremely difficult to justify. Merely saying that it was adopted on legal advice will not carry weight unless the advice itself is disclosed, but advice that is centred around how to make destruction for an unpalatable reason appear innocuous will hinder more than it helps. The safer course will therefore be to adopt retention policies based primarily around anticipated future needs for documents, in line with SAS 230, with the option to destroy them if, after review at the end of that period, there is no identifiable reason to continue holding them.

In summary, then, firms’ document retention and destruction policies should be revisited with a view to ensuring that they can withstand judicial scrutiny if documents disposed of in accordance with them turn out to have been of potential relevance to legal or regulatory proceedings. Policies of destruction which are motivated explicitly or implicitly by what a court might regard as illegitimate self-interest may in the current climate carry greater risk than that which they are intended to guard against. The aim should rather be to devise a policy which will result in the retention of documents for so long as there might be some realistic need for them. It will also be essential to include in the policy a pre-destruction review as contemplated by SAS 230, together with the clearest of warnings that if at any time there is reason to think that documents might be needed in connection with any form of legal or regulatory investigation they must be maintained intact under secure conditions.

Review
THE PERILS OF ACTING FOR BOTH SIDES
In Sayers v Clarke-Walker (June 2002) the claimant, Mr Sayers, agreed to buy a business on partially deferred payment terms. The defendants, Clarke-Walker, who had for a long time acted as the business’s accountants and auditors and also advised the vendors, were asked if they would also act for Mr Sayers in relation to the transaction. Clarke-Walker responded very properly by consulting their professional body and putting in place the arrangements recommended by that body to enable them to act for everyone, but it seems that they nonetheless felt concerned about the situation and made it quite clear to Mr Sayers in particular that he ought to obtain independent financial advice about the transaction. This advice, and the suggestion that tax counsel might also be consulted, was apparently reinforced by Mr Sayers’ own solicitor.

Mr Sayers needed to finance the purchase out of the business’s future income, and Clarke-Walker put in place arrangements by which this could be done. Unfortunately they failed to consider some adverse tax consequences for Mr Sayers inherent in these arrangements or to advise him about a relatively simple means by which these could be avoided.

At trial Clarke-Walker’s counsel argued that Mr Sayers’ had acted unreasonably in failing to take up the suggestion that he get independent advice: if he had followed it it was likely that the adverse tax consequences would have been identified and avoided. The Judge nonetheless found in favour of Mr Sayers, and the Court of Appeal confirmed that decision. They took the view that Mr Sayers was entitled to assume that he had received the advice that a competent generalist accountant would have given, and that a competent generalist would have identified the problem inherent in the financing arrangements. It was therefore no defence for Clarke-Walker to say that if Mr Sayers had taken other advice the problem could have been avoided.

In this case the failure to advise on the tax issues appears to have been simple oversight, but there are other ways in which problems can arise where the accountant is acting for both sides. What if, for example, the accountant identified a possible problem for one party in such a situation but knew that its solution would involve some expense to his other client? Would it be enough for him simply to advise the first client to take independent advice?

The decision in the Sayers case makes it clear that such a step would not in itself be sufficient. But more importantly, the accountant in such a position would be at risk of breaching ethical guidance. If the accountant were acting only for the party for whom there might be a potential problem, it would be obvious that he would have to advise him about it. The mere fact that to give the advice might disadvantage another client would not be a valid excuse for failing to do so. Accountants acting for both sides to a transaction need to be very careful to ensure that issues of this sort are identified, and that once they are identified they are dealt with appropriately.

LEGAL PRIVILEGE IN TAX CASES – SANITY RESTORED
Inland Revenue Inspectors have wide powers under section 20(1) of the Taxes Management Act 1970 to obtain documents relating to possible tax liabilities. The statute imposes some restrictions on these powers: in particular, legally privileged material in the hands of a legal adviser cannot be obtained, and an accountant’s working papers which are his own property are also exempt from production. However, in a case in 1990 (R v Inland Revenue Commissioners ex parte Taylor) the Inland Revenue successfully argued that copies of legally privileged material which happened to have found their way to an accountant acting as tax adviser could be obtained under section 20(1).

Although there was some limited support for such an interpretation in the statute itself, the result in Taylor produced a curious anomaly. Why should a legally privileged document be immune from production if it happens to be in the possession of a lawyer but subject to production if it happens to be held by anyone else?

Happily, the House of Lords has now resolved this anomaly. In R v Special Commissioner ex parte Morgan Grenfell (May 2002) it ruled that if a document is legally privileged it is immune from production under section 20(1) regardless of whose hands it happens to be in. The result is to be welcomed, but accountants should also bear in mind that if they receive a notice under section 20(1) they have a duty to ensure that privileged material, and other documents outside the scope of the notice, are withheld from production. Care will be needed to ensure that this is done.

TRADING LOSS CLAIMS RULED OUT IN HONG KONG
In Guang Xin Enterprises v Kwan Wong Tan & Fong (May 2002) the liquidators of Guang Xin claimed damages from their former auditors, KWTF, for failing to detect that the values of certain investments were grossly overstated and that certain transactions were not genuine. The liquidators contended that if the true position had been revealed the company would have ceased trading, thus avoiding various trading losses, and that the fictitious transactions would also have ceased, thus avoiding a number of other losses. KWTF applied to strike out the claim relying on the decision of the English Court of Appeal in Galoo v Bright Grahame Murray (1994).

The Hong Kong court agreed that the trading loss claims could not be pursued. All that the audit report had done was to give the company the opportunity to incur losses through continuing to trade: it had not in any meaningful sense caused them. But the losses flowing from continued fictitious transactions were treated differently. It has long been clear that an auditor is liable for losses flowing from a pattern of fraudulent activity which his audit should have detected, and Galoo did not affect that position. This aspect of the claim therefore looks set to continue.

LIMITATION OF ACTIONS – SANITY RESTORED
The extraordinary decision of the Court of Appeal in Brocklesby v Armitage & Guest (1999) meant that accountants and other professionals could no longer be sure when they would be protected by the statute of limitations from claims in relation to work done many years previously. The Court of Appeal were prepared to interpret what had always been assumed to be a very narrow and specific provision relating to "deliberate concealment" of causes of action as of general application to any situation where a breach of duty occurred which the client could not immediately discover. This potentially threw into disarray firms’ document retention policies because of the difficulties inherent in trying to defend claims long after the event without the benefit of file evidence as to what had been asked for or done.

The House of Lords has now corrected the position. In Cave v Robinson Jarvis & Rolf (2002) it ruled that the "deliberate concealment" provision is not of general application. Thus although document retention policies will need to be revisited in the light of Enron and related issues (see separate article) there is no longer a need to consider extending them significantly beyond the basic six year limitation period applicable in relation to most claims.