Court of Appeal rules on audit liability

In its first full ruling on audit liability for several years, the Court of Appeal has upheld the first instance decision in the MAN/Freightliner litigation, finding that the auditors of a subsidiary were not liable to the parent in respect of losses suffered by the parent as a result of a fraud in the subsidiary: MAN Nutzfahrzeuge v Freightliner Limited [2007] EWCA Civ 910. However, the decision reinforces the desirability of disclaimers of responsibility to third parties.

Background

On 28 October 2005, Lord Justice Moore-Bick (sitting as a Judge of the Commercial Court) gave judgment on liability upholding a claim brought by MAN Nutzfahrzeuge ("MAN") against Freightliner Limited ("Freightliner") but dismissing Freightliner's third party claim against Ernst & Young UK ("E&Y").

The claim concerned the acquisition by MAN of the whole of the issued share capital of ERF (Holdings) plc which, through its subsidiary ERF Limited (together "ERF"), was a manufacturer of trucks in the UK. The acquisition was completed on 8 March 2000 for a price of £65.3 million, subject to certain adjustments. The seller was Western Star Trucks Holdings Limited ("Western Star"), a Canadian truck manufacturer, which was later acquired by Freightliner, which took on its liabilities.

Unbeknownst to the parties at the time of the sale, Steven Ellis, deputy to the Financial Controller of ERF, had for some time been manipulating the accounts of ERF. In particular, the accounts were founded on false journal entries in the purchase ledger control account. Those entries gave rise to a discrepancy between the purchase ledger itself and the purchase ledger control account. Mr Ellis disguised the discrepancy by producing a false reconciliation of the two figures.

The ERF statutory accounts for the years ended 30 June 1998 and 30 June 1999 were audited by E&Y and were provided by Western Star to MAN. Meetings took place between representatives of Western Star and representatives of MAN, at which Mr Ellis took an active part and represented that the accounts had been honestly prepared.

Following the acquisition by MAN, ERF's year end was changed to 31 December and Deloitte & Touche were appointed auditors. The discrepancy between the purchase ledger and the purchase ledger control account, which by then stood at about £19 million, came to light during their audit of the 31 December 2000 accounts. An investigation was carried out which revealed that, as at 30 June 2001, there was a deficiency of £100 million in the balance sheet of ERF.

The share purchase agreement between Western Star and MAN ("the SPA") required warranty claims to be brought within 12 months. MAN, being out of time for a straightforward warranty claim, framed its claim against Western Star as (a) a claim for fraudulent misrepresentation by Western Star in respect of the warranties and representations given in the SPA and/or (b) a claim in deceit against Western Star in respect of the representations made by Mr Ellis in the meetings.

The first instance decision

At first instance ([2005] EWHC 2347 Comm), the Judge held that, in relation to the claim for fraudulent misrepresentation, the knowledge of Mr Ellis as to the falsity of the representations on which MAN relied could not be treated as knowledge of Western Star for the purposes of deciding whether the representations contained in the SPA were made fraudulently. However, the claim in deceit succeeded because the Judge was satisfied that MAN was induced to enter into the SPA by fraudulent statements made by Mr Ellis about ERF's accounts and that Western Star was liable for that deception on the grounds that Mr Ellis was speaking on behalf of Western Star whenever he provided MAN with information about ERF's accounts or its financial position generally in the course of the meetings.

In relation to the third party claim against E&Y, the Judge held that E&Y owed no duty of care to Western Star to protect it from a loss of the kind which it sought to recover.

• On the one hand, there was the "general audit duty", "to provide shareholders with reliable intelligence for the purpose of enabling them to scrutinise the conduct of the company's affairs and to exercise their collective powers to reward or control or remove those to whom that conduct has been confided", as described by Lord Oliver in Caparo Industries plc v Dickman [1990] 2 AC 605 at 630. The loss which Freightliner sought to recover in these proceedings could not be brought within the scope of the general audit duty because it was not caused by mismanagement but by Mr Ellis' dishonest statements in the meetings with MAN.
   
• The issue was therefore whether Freightliner could succeed in establishing a "special audit duty", i.e. a duty at common law to take reasonable care when carrying out their audit to protect Western Star from the kind of harm that it suffered in this case. In the Judge's view, a special audit duty could only arise if it could be shown that the auditors "knew and intended" that their statement as to the company's accounts would be communicated to and relied on by a particular person or class of persons for a particular purpose in connection with a particular transaction. In the Judge's view, the test of knowledge and intention had found expression in the concept of assumption of responsibility which had emerged in cases during the 1990s including Henderson v Merrett Syndicates Limited [1995] 2 AC 145. The Judge held that the loss suffered by Freightliner took the form of damages for deceit arising from statements made by Mr Ellis in the course of negotiations with MAN. Whilst E&Y must have realised that the accounts would be passed to Western Star who could be expected to rely on them both for the purpose of producing consolidated accounts for the Western Star group as a whole and for the purpose of making decisions about the future conduct of ERF's business, there was no indication of, they were not asked to and did not give, any confirmation to Western Star that the accounts were accurate and could safely be relied on for any particular purpose in connection with the sale of ERF to MAN. Therefore they could not be treated as having assumed any responsibility to Western Star for their accuracy. This was even though, in relation to the 1999 accounts, E&Y were aware before the audit certificate was signed that Western Star was anxious to obtain the audited accounts as soon as possible in order that they could be made available to MAN for its consideration in connection with its purchase of ERF.

Further, the Judge relied on the principle enunciated by Lord Hoffmann in South Australia Asset Management Corporation v Montague Limited [1997] AC 191 ("SAAMCO") to the effect that the law normally limits liability for wrongful acts to those consequences which are attributable to that which made the act wrongful, which in the case of liability in negligence for providing inaccurate information means liability for the consequences of the information being inaccurate. If E&Y had undertaken a special audit duty to Western Star, the consequences of their negligence would have extended to such loss as it might have incurred in respect of the difference between the true net asset value of the company and that shown in the accounts; they would not, however, have extended to losses caused by fraud on the part of an individual for whom Western Star was vicariously liable.

The decision in the Court of Appeal

Lord Justice Chadwick, with whom Dyson and Thomas LJJ agreed, gave the decision of the Court of Appeal on 12 September 2007 ([2007] EWCA Civ 910). In his view, the focus in the arguments on whether intention that the recipient should rely on the statement (as well as knowledge that the recipient would do so) was a required element in establishing the duty of care and, if so, what sort of intention was required to be established, was not the key question: "the real issue on this appeal is whether the knowledge of E&Y (as found by the Judge) was sufficient to found a duty of care to Western Star… in relation to the loss which was actually suffered" (paragraph 39). The Judge did not review the authorities at length but took comfort from the House of Lords decision in Customs & Excise Commissioners v Barclays Bank plc [2006] UKHL 28, (a case concerning whether a bank owed a duty of care in relation to the implementation of a freezing order - see post), in which Lord Hoffmann had said this (at 35):

"In these cases in which the loss has been caused by the claimant's reliance on information provided by the defendant, it is critical to decide whether the defendant (rather than someone else) assumed responsibility for the accuracy of the information to the claimant (rather than to someone else) or for its use by the claimant for one purpose (rather than another). The answer does not depend upon what the defendant intended but, as in the case of contractual liability, upon what would reasonably be inferred from his conduct against the background of all the circumstances of the case. The purpose of the inquiry is to establish whether there was, in relation to the loss in question, the necessary relationship (or "proximity") between the parties and, as Lord Goff of Chieveley pointed out in Henderson v Merrett Syndicates Limited [1995] 2 AC 145,181, the existence of that relationship and the foreseeability of economic loss will make it unnecessary to undertake any further enquiry into whether it would be fair, just and reasonable to impose liability."

In Chadwick LJ's view, Lord Hoffmann's guidance in Barclays Bank on the approach to the assumption of responsibility test had to be read with the observations of Lord Bridge in Caparo and of Lord Hoffmann himself in SAAMCO, where the latter had said (at 211):

"Normally the law limits liability to those consequences which are attributable to that which made the act wrongful. In the case of liability in negligence for providing inaccurate information, this would mean liability for the consequences of the information being inaccurate."

It was no longer argued by Freightliner that the losses claimed fell within E&Y's general audit duty. In the view of Chadwick LJ, it was within a special audit duty owed by E&Y to Western Star to protect Western Star from the consequences of representations and warranties made in the SPA. However, that issue was not live because Freightliner no longer challenged the Judge's finding that Mr Ellis's knowledge could not be treated as Western Star's knowledge for the purposes of those warranties and representations and therefore that those representations and warranties (as to the accuracy of the accounts) had not been made fraudulently.

The issue in the appeal was whether E&Y undertook a special audit duty to Western Star in respect of representations made by Mr Ellis in the meetings with MAN as to the accuracy of the ERF accounts. Chadwick LJ held that they did not for two reasons: 

1. There was no factual basis for challenging the Judge's finding that it was not foreseeable by E&Y that Western Star and, in particular, Mr Ellis on behalf of Western Star, would make any representations as to the accuracy of ERF's accounts which went beyond those contained in the SPA. It was foreseeable that the SPA would contain representations and warranties but it would also have been expected that Western Star would be concerned to limit its exposure to those representations and warranties which were contained in the SPA. There was no reason for E&Y to think Western Star would allow a position to arise in which it was exposed to liability for extra-contractual representations made by Ellis.
    
2. Even if that had been foreseeable, mere foresight was not enough: "Something more" was required. That additional element was identified by Lord Hoffmann's guidance in Barclays Bank in relation to assumption of responsibility. It was impossible to hold that E&Y assumed responsibility for the use by Mr Ellis on behalf of Western Star of the information which E&Y had provided to Western Star (paragraph 56):

"To hold that the auditors assumed responsibility for the use which a dishonest employee of the audited company might make of the accounts in the context of the parent company's negotiations for the sale of the company would, I think, be to impose on them a liability greater than they could reasonably have thought they were undertaking."

Comment

In terms of the test for establishing a duty of care, preferences have ebbed and flowed since Caparo between the threefold test there described by Lord Bridge (foreseeability of damage, proximity and whether it it just and reasonable to impose a duty), the voluntary assumption of responsibility test and the incremental approach. Lord Oliver in Caparo viewed knowledge as key to proximity: knowledge of the transaction which the claimant had in contemplation, that the information would be communicated to him and that the claimant would rely on it in deciding whether or not to pursue the transaction.

The Court of Appeal's decision in MAN/Freightliner applies to audit liability the duty of care analysis contained in Barclays Bank, which gave primacy to the assumption of responsibility test. In the Court of Appeal's view, the key question is no longer whether, in addition to knowing that the recipient would rely, the auditor had to have intended such reliance, though Chadwick LJ did use the language of intention in his reasoning. Previous cases had differed on the question whether intention had to be shown, and in a number of cases intention had been rejected as a requirement (most recently in the interlocutory Scottish appeal court decision in Royal Bank of Scotland v Bannerman, Johnstone, Maclay [2005] CSIH 39). Chadwick LJ has interpreted Barclays Bank to mean that "something more" than knowledge/foresight  that the recipient would rely on the statement for a particular purpose is required as part of the proper application of the assumption of responsibility test, but without saying what that is.

The point may yet be ripe for consideration by the House of Lords as to whether that is the correct interpretation of Barclays Bank and, if it is, what the "something more" is that is required. It appears from the decision in this case that there must be some indication, capable of objective identification, from the auditor to the recipient that the auditor's statement can be relied upon by the recipient for its particular purpose. Auditors seeking to limit their third party liability will therefore be careful not to give any such indication to any third party. In practice, disclaimers of responsibility to third parties have been widely used by auditors since Bannerman.

The decision does leave open a risk for the auditors of a subsidiary where they provide their accounts to the client's parent in circumstances where they know the parent is intending to rely on the accuracy of the accounts for the purposes of a third party sale in which the parent is likely to be providing representations and warranties as to the accuracy of the accounts. In relation to such a fact pattern, auditors should take care to disclaim responsibility to any third party – something which was not done by E&Y in this case.

Finally, it remains to be seen whether this decision has any impact on the auditor's liability to its own client in relation to fraud. In Caparo, Lord Oliver described the other aspect of the general audit duty as being "to protect the company itself from the consequences of undetected errors or, possibly, wrongdoing…". The action by the liquidators of Stone & Rolls Limited against Moore Stephens, which is the highest profile claim presently being funded by third party funding, is continuing. It recently survived a strike-out application (Stone & Rolls Limited (in Liquidation) v Moore Stephens [2007] EWHC 1826, 27 July 2007) where Mr Justice Langley held that the detection and reporting of fraud was an incident of the duty of care owed by the auditors to their client. Whilst the MAN/Freightliner decision on the existence of a special audit duty will not be relevant, the Court of Appeal's reference to SAAMCO as relevant to determine the scope of duty could well be. The extent to which the auditor can deploy SAAMCO arguments to limit is liability as against its own client is still to be resolved.