The love-hate relationship with audit negligence

The love-hate relationship with audit negligence
Author:
Jeremy Marshall
Senior Investment Manager - England

Our approach to cases of audit negligence may appear somewhat confused. It is a matter of public record that we are funding a large case in connection with the Wirecard fraud in Germany, and yet we have shied away from similar cases in England. Why is this? The recent decisions of the Supreme Court in the appeals of Manchester Building Society v Grant Thornton LLP and Khan v Meadows provide the explanation.

I wouldn’t say that audit negligence cases are personal to me, but I have bitter experience of them. Early on in my career I worked on the audit negligence case brought by the liquidators of BCCI. The case ultimately settled even though the auditors were adamant that they would have won. The Chairman of Ernst & Young at the time said “We will be pleased to bury this matter once and for all and stop spending vast sums of money defending ... against a claim which we have no doubt would have failed had it gone all the way to trial”. The senior partner of Price Waterhouse said much the same thing – “We would have liked to fight this to the bitter end, to vindicate ourselves in court”. And yet the case settled for £75m (in 1998). Perhaps that is why certain funders do like them.

Then there is Barings Bank. You may have seen the film Rogue Trader. I was seconded to Barings and was listening to the bank’s tapes the day after Nick Leeson fled. A significant audit negligence action was mounted against Deloitte. Deloitte was found to be negligent in the High Court but, crucially for the damages claim, was held to be liable for a mere £1.5m of the losses suffered by Barings, as opposed to the £130m which had been claimed. And therein lies the problem.

With that quick bit of background, how do the recent Supreme Court cases fit in to all this? These two cases were heard by the same panel of 7 justices in an attempt to allow the Court to provide definitive guidance with regard to what has become known as the “SAAMCO cap”. As readers of our blog will know, funders usually like caps – the Arkin cap being their favourite – but they do not like the SAAMCO one. And here’s why.

The Courts have often struggled with cases of pure economic loss and also those cases where damage has resulted from a negligent act but where the level of damage is well outside the scope of the duty that the negligent professional had agreed to in the first place. In Meadows, for example, the Court was faced with a situation where a doctor had given negligent advice in relation to whether a pregnant woman carried the haemophilia gene (which is what she had specifically asked for advice about). The woman would not have proceeded with the pregnancy had she known that she did carry the gene. But, because the doctor got it wrong, she did and she had a child. The child was born with haemophilia. Unfortunately, it was also born with autism. Should the doctor be responsible for the damages associated with the autism (which led to a much higher level of overall damages)? In Manchester Building Society, the society asked Grant Thornton for specific advice in relation to its accounting treatment of certain transactions and Grant Thornton advised in circumstances that led the society to enter into a series of interest swaps. However, the advice was wrong and the society got into serious trouble because of the swaps. It had to terminate them, at vast expense, and it claimed those losses from Grant Thornton who, it argued, had got it into the mess in the first place.

The SAAMCO cap, as it has become known, operated to limit the damages to that amount that corresponded with the actual scope of the duty that was accepted by the negligent actor. So, for example, the argument advanced in Meadows was that the damages associated with the autism were irrecoverable because the doctor wasn’t asked to advise about autism. The argument in Manchester Building Society was that Grant Thornton’s role was that of mere auditor and shouldn’t be widened to encompass ordinary trading losses.

As to the results of the two cases, the doctor prevailed and Grant Thornton was held liable for the trading losses (albeit with a discount for the society’s contributory negligence). How can these two decisions be reconciled?

The answer is to be found in the Supreme Court’s reinterpretation of the scope of the duty and a reappraisal of the SAAMCO cap. The critical test is to establish what it is that the professional is being asked to do – the purpose of its involvement. Its liability is therefore in principle going to be ringfenced to that scope or purpose. The confusion has previously come by looking at the cases through the lens of causation – so, for example, the argument went that if Mrs Meadows hadn’t proceeded with the pregnancy, she wouldn’t have had a child with autism and so it must have been the doctor’s fault. But that analysis avoids a consideration of what the doctor had actually been asked to do and why Mrs Meadows was there in the first place – in Meadows, the doctor hadn’t been asked to consider autism at all. Indeed, had the advice that the doctor given in fact been correct, the child would still have been born with autism. Contrast that with Manchester Building Society where Grant Thornton had specifically been asked to consider the hedge accounting treatment of interest swaps. It was as a consequence of their advice that the society entered into the swaps. Had their advice been correct then there would have been no damage at all.

It is fair to say that this analysis is somewhat of a distillation of the Supreme Court’s reasoning, and if the aim of the two cases being heard together was to provide a definitive roadmap for future cases, it was an aim that was not fulfilled. Whilst the Court did agree on the result, they travelled there via a number of different routes, and they could be said to have taken some diversions. Indeed, they couldn’t ultimately agree on the standard test for establishing damages in negligence although all did agree that the purpose test was critical to the subsequent affixing of liability.

Now, as to why the Supreme Court decisions have cemented our view that English audit negligence cases should be viewed with a degree of caution. Two recent cases are helpful guides – the proposed actions by the liquidators of Patisserie Valerie and of Carillion. Both are against the incumbent auditors, both involve varying shades of responsibility being shared with the company’s management (with a strong whiff of fraud or misconduct), and both depend upon the Court accepting the argument that the auditors’ alleged negligence allowed the companies to continue to incur massive losses and engage in unprofitable business. It would appear that both liquidators are going to have to argue that the auditors were complicit in these losses being incurred because they didn’t report properly and so alert management such that the businesses may have been shut down.  Based upon the recent Supreme Court decisions, it may well be right to say that, as a matter of factual causation, the alleged negligence allowed the companies to continue to trade and so incur those losses. But that, as the Supreme Court has told us clearly, is not the key question. The key question is what was the purpose of the auditors’ involvement in the first place and can it fairly be understood that questions of trading losses should be subsumed within the scope of a statutory audit. When the boards of Patisserie Valerie and Carillion were going to their auditors, it will be a matter of factual evidence as to whether the true purpose was really carefully delineated – and in cases of internal fraud or misconduct, it is by definition somewhat unlikely that their instructions will have been so framed and there is an inevitable reliance on a degree of hindsight. These cases are almost inherently going to be subject to material discounts in relation to contributory negligence. They are expensive to run and have significant adverse cost risk in all likelihood leading to the need to post security. In these circumstances, it can quickly be seen why audit negligence cases are not necessarily the easiest cases to pursue.

Our focus on funding cases against professionals in England will be in relation to those cases where the evidence is clear that the professional was specifically asked to consider a particular issue, failed to do so and damages flowed as a result. As if often the case with negligence cases, proof of the negligence is actually not the critical aspect and indeed is often admitted. However, just as with the follow-on competition cases, you cannot jump to conclusions and assume that means certain victory. Remember the £1.5m recovery in Barings and always consider the purpose behind the instruction.