In Days Impex Ltd v Fung Yu & Co(1) the Court of First Instance considered some of the legal principles surrounding the scope of an auditor's duty to detect alleged irregularities in a company's financial statements and, in appropriate circumstances, to report alleged wrongdoing to the relevant regulatory authorities. It is important to note that the judgment arises out of the defendants' unsuccessful application to have the plaintiff companies' claims struck out. Nevertheless, the judgment is an interesting review of some of the legal issues involved, including the applicability of the defence of illegality in the context of a claim brought by a liquidator on behalf of a company against its former auditor.
The case was a professional negligence claim brought by the liquidators of the two plaintiff companies against the defendant auditors for allegedly failing to detect a major fraud apparently perpetrated on the companies by a former controlling shareholder and director.(2) As is not uncommon in such cases, the defendants applied to strike out the plaintiffs' claims on various grounds, including that:
- the claims disclosed no reasonable cause of action because the alleged breach fell outside the auditor's scope of duty; and
- the claims were an abuse of process because (in effect) they were an attempt by the plaintiff companies to rely on their own alleged illegality.
Applying to strike out at an interlocutory stage places a high burden on a defendant. Despite their best efforts in this case, the defendants' application failed.
In an interesting judgment, two issues in particular stand out – namely, the scope of an auditor's duty and applicability of the defence of illegality.
The court considered that the scope of the defendants' duty could extend beyond the provision of information and advice to the companies about their financial statements, to the detection of material irregularities in those statements. In appropriate cases, this could include a duty to report alleged fraud to the relevant regulatory authorities.
In determining the scope of duty, the court referred to a number of auditing standards issued on behalf of the accountancy profession addressing an auditor's responsibility to detect material misstatements in financial statements arising from fraud and reporting the same to management and appropriate regulatory authorities. The court approved of the principle that although these standards did not have the force of law, compliance with them would suggest that an auditor had acted reasonably.
On its face, the court considered that the plaintiffs' claim raised a reasonable case.
The defendants also sought to rely on the defence of illegality, which was addressed in the English case of Stone & Rolls Ltd v Moore Stephens(3) – namely, where a one-man company suffers a fraud and brings a claim against its auditor, the knowledge of the alleged fraudulent shareholder and director could be attributed to the company. Therefore (so the argument went), it was improper for such a company to claim against its auditor because it should not benefit from its own wrongdoing.
The defendants argued that each plaintiff (in effect) could be regarded as a one-man company because (among other things) the alleged fraudster effectively owned the companies and controlled their affairs.
The court noted that Stone & Rolls Ltd had attracted severe criticism. For example, it had been observed that directors of a company who caused it to be involved in a fraud should not be permitted to raise the defence of illegality to a claim against them brought by a liquidator of the company to recover money paid out of the company as part of the fraud.(4)
The liquidators of the plaintiff companies referred the court to various decisions, including the Canadian case of Livent Inc v Deloitte & Touche,(5) which suggested that a defence of illegality did not necessarily absolve an auditor from its duty in similar circumstances.
The court noted that the context in which the attribution of knowledge arose was important – for example, whether in the context of claims against a director or an auditor. Further, the legal issues raised were difficult and this area of the law was developing.(6)
In short, the court did not consider it appropriate to strike out the claims by the liquidators alleging that the auditors were (among other things) in breach of a duty in failing to detect and report wrongdoing.
The court's judgment is an interesting review of some of the legal issues that arise in connection with the contemporary scope of an auditor's duty to detect and report wrongdoing.
Given that the court's deliberations arose in the context of an application to strike out, the court was not required to make any conclusive legal rulings. In the event that the case proceeds to trial, the court will have a better opportunity to consider the validity of the defence of illegality in situations where claims are made by liquidators of a company against an auditor for breach of duty in failing to detect alleged wrongdoing, particularly in the context of a one-man company.
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For further information on this topic please contact Adrian Chang or David Smyth at RPC by telephone (+852 2216 7000) or email (email@example.com or david.smyth @rpc.com.hk). The RPC website can be accessed at www.rpc.co.uk.