Clarifying the law on the Liability of Auditors

The issue of the liability of auditors for negligence has been debated heavily in recent times; with the decision of the House of Lords in Moore Stephens being among the more recent pronouncements on the issue. The decision has been discussed in posts on this blog and elsewhere. In short, in Moore Stephens, the House of Lords restricted the liability of auditors, by allowing them to rely on the ex turpi causa principle in a claim by the company. Effectively, their Lordships held that when a company is guilty of a fraud, then it can bring no claim against auditors for negligence even if the very thing which the auditors were supposed to do was detect that fraud.

But when will a company be guilty of fraud? When will it have the mental state required for a person to act fraudulently? The short answer is that the knowledge of the company’s directing mind will be attributed to the company. The fraud of the directing mind would then be the fraud of the company. But what about the fraud of an agent? Would that fraud also be attributed to the company on grounds of agency? A possibility arises for some confusion in this regard. This is so because the House of Lords in Moore Stephens discussed in great detail cases relating to the attribution of an agent’s knowledge (for instance, the Hampshire Land line of cases; which properly deal with agents). Did Moore Stephens then intend to leave open the possibility for attribution of an agent’s knowledge also? A reading of the speeches of their Lordships does suggest that this is not so. This issue has now been specifically clarified in Safeway Stores v. Simon John Tigger. The Court explained, “There are essentially three different bases of liability of a company: (i) primary liability, through the application of the primary rules of attribution; (ii) liability through the application of the normal principles of agency or of vicarious liability (the general rules of attribution) and (iii) liability imposed for the purposes of a particular legislative intent (a special rule of attribution)…” The Court has clarified that for the purpose of applying the ex turpi causa defence, the attribution must be primary – that is of category (1) listed above. Thus, attribution of (say) a director’s acts through principles of agency will not allow negligent auditors to escape liability through ex turpi causa.

As stated by the Court, Moore Stephens does not detract from this – indeed, Moore Stephens affirms this position. Thus, Safeway Stores summarizes the correct legal position by saying that before the ex turpi causa defence can apply, “the company must be under a personal liability for the relevant wrongdoing. In other words, the rule does not apply where the company is only liable for the acts of its employees or agents either by virtue of the application of the doctrine of vicarious liability or where the act or conduct of an employee or agent is attributed to the company under the general principles of the law of agency. In neither of those cases is the liability of the company personal or primary or direct, nor can it be said that the company is guilty of turpitude.”

Thus, Moore Stephens cannot be used by auditors in every case where a company’s agents have acted fraudulently. This does not, however, detract from the position that the auditor’s liability is in general a limited one. Auditors may be liable for deceit, or for negligent misstatement. Insofar as liability for negligent misstatement is concerned, such liability can be fastened on the defendant only when there is an “assumption of responsibility” by the defendant coupled with detrimental reliance by the plaintiff. While this position continues with respect to auditors as well, another recent English decision highlights the need for special principles to govern the liability of auditors: Sky Subscriber Services v. HP Enterprise Services. 

In Sky Subscriber, the Court held, “in considering whether a contractual provision affects the existence or the scope or extent of a duty of care, the test is whether the parties having so structured their relationship that it is inconsistent with any such assumption of responsibility or with it being fair, just and reasonable to impose liability. In particular, a duty of care should not be permitted to circumvent or escape a contractual exclusion or limitation of liability for the act or omission that would constitute the tort…” Thus, the duty of care owed by the auditor to the company as a matter of tort law will be conditioned by the contractual clauses between the two parties. This statement was made by the Court in the context of the general law on negligent misstatement. This cannot, however, be the statement of law in relation to auditors.

The special position of auditors under company law casts upon them a statutory duty to certify accounts as true and fair. The principle in Sky Subscriber cannot automatically be applied to auditors; as auditors cannot be allowed to contract out of their statutory obligation. The danger arises because content of the statutory duty of the auditor is often framed in terms which are identical to a duty in tort – “The auditor must exercise such reasonable care as would satisfy a man that the accounts are genuine, assuming that there is nothing to arouse his suspicion and if he does that he fulfils his duty; if his suspicion is aroused, his duty is to 'probe the thing to the bottom'…” (ICAI v. P.K. Mukherji, AIR 1968 SC 1104). Prior to Sky Services, there need not have been any distinction drawn between the auditor and other professionals for the purposes of liability for negligent misstatement and for ascertaining the content of the duty of care. However, given the statutory basis behind the auditor’s duties, it appears that there is now reason for drawing that distinction. The content of the duty of care owed by one party to another may ordinarily depend on the contractual terms; in the case of the duty owed by the auditor to the company, it must depend on the construction of statutory obligations. These obligations would, in turn, depend on the meaning to be assigned to terms such as the “true and fair” view – a matter discussed here and here.