A recent case has considered the standard of care owed by auditors.
The auditors were retained to prepare a report for the purposes of the "whitewash" procedure under the Companies Act 1985, allowing a sale of shares by directors of the company to a new company incorporated for that purpose, with the purchase being funded by a loan from the company.
The auditors prepared the report stating that they had enquired into the affairs of the company and that there was nothing to indicate that the opinion stated by the directors (i.e that the company was presently solvent and would be able to pay its debts in full within the following 12 months, or within 12 months of being wound up if the winding up commenced within 12 months) was unreasonable. The company subsequently went into liquidation. It transpired that the company did not have sufficient distributable profits (as required by the statute) at the time the loan was provided. The directors had significantly overvalued the worth of the company shares.
The company, in liquidation, claimed against the directors for reimbursement of the purchase price, damages for breach of fiduciary duty and damages for negligence. It also claimed against the auditors for breach of contract and negligence, on the grounds that they had failed to deliver a competent report.
The court held:
- The directors were liable in respect of the claims
against them they had allowed the company to provide unlawful
financial assistance and had preferred their own interests
over those of the company.
- The court assessed the standard of care owed by the
auditors against the best practice publication "Audit
Quality" published by the ICAEW. The court did not
accept that the techniques that the auditors should have
adopted to apply the standard would vary because of the size
of the transaction. A proper analysis of the
company's assets and business would have revealed it
was in no position to advance the loan. The court also
rejected the argument that, by analogy to negligent valuation
cases, the auditors' opinion was not so far outside
the reasonable range that they should be held liable for the
entirety of the company's loss. The auditors were in
breach of duty in that they failed to enquire into the
affairs of the company to the extent that an auditor of
reasonable competence would have done. If they had, the
certificate would not have been signed and the loan would not
have been provided.
- On the same basis, the auditors were liable to the
director shareholders for breach of duty. The measure of
damages was the loss in the value of their
- Both the directors and auditors were liable to the
company for the same damage, therefore the court was entitled
to apportion liability between them. The directors had
received the whole of the sum advanced to the company, which
was a personal "windfall" to them, to the extent
that it exceeded the true value of the shares at the date of
completion. The directors were ordered to pay this difference
in value to the company, and the auditors were required to
pay the balance.
The case reaffirms that the court is not impressed by attempts to argue that the standards to be met by auditors are somehow influenced by the value of the transaction concerned. Accordingly, auditors appointed for the purposes of the whitewash procedure must properly inform themselves of the financial status of the company in order to validly deliver their report and determine if the directors' opinion is reasonable in all the circumstances.
The decision is also interesting as to the approach taken by the court in achieving a "just and equitable" apportionment of liability between the directors and the auditors; this has particular resonance as auditors and companies embark on the negotiation of liability limitation agreements following the 6 April 2008 start date.
Finally, the court reaffirmed the first principle of damages, namely that the company was to be put into the position it would have been in had the auditors discharged their duty; the true loss was the amount the company paid out in reliance on the auditors' report; it would involve "impermissible speculation" to reduce the damages by reference to what might have happened if the transaction had taken a different form for a lower amount.
The Companies Act 1985, Sections 151, 155 and 156. Note that the restrictions on financial assistance in relation to most acquisitions of shares in private companies (including the whitewash procedure) are being repealed on 1 October 2008.
Cook and Another v Green and Others Chancery Division District Registry (Manchester), 2nd May 2008
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
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The original publication date for this article was 28/05/2008.