Judgments - Moore Stephens (a firm) (Respondents) v Stone Rolls Limited (in liquidation (Appellants)

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266.  None of the previous cases, Pendleburys, Galoo and Berg, deals with the position of a company insolvent at the date of the audit due to past fraud, where the loss claimed consists in the continuation of the scheme of fraud to the further detriment of the company and its creditors, existing or future. In West Mercia and Yukong the directors knew of the company’s potential insolvency and their actions constituted breaches of fiduciary duty designed to defeat creditor rights in insolvency. A director may now also incur responsibility to the company for wrongful trading under the Insolvency Act 1986, s.214; and the common law duty discussed in paragraphs 235 to 240 above covers some of the same ground. Here, however, there is no doubt that Mr Stojevic was in deliberate breach of fiduciary duty. If Moore Stephens had known about or shut a Nelsonian eye to Mr Stojevic’s breach of duty, there could be little doubt about their liability (see Hobhouse J’s dicta in Berg, p.55 (quoted in para 265 above). But the present appeal proceeds on the basis that they negligently failed to detect the scheme of fraud and the company’s insolvency and so allowed the scheme to continue to the company’s further detriment.

267.  The decisions in Caparo and Al Saudi Banque establish that auditors’ duties are normally limited to the protection of the company’s interests for the benefit of its shareholders. There was no question of any insolvency on the facts of Caparo. The facts in Al Saudi Banque were closer, and the scheme of fraud remarkably similar, to the present. But the claimants were the banks, and their claim was dismissed on the basis that the auditors had not been appointed by them and “were under no statutory obligation to report to them” (p.336E). In both Caparo and Al Saudi Banque, the concern was about the uncertain and unknown exposure in respect of third party investment or lending which would follow from permitting third party claims.

268.  Other than in special situations, therefore, auditors owe no direct duties towards third parties. But none of the above cases addresses the present situation of a claim by the company against its auditors for failure to pick up a fraudulent scheme rendering it increasingly insolvent. But in Caparo, both Lord Bridge and Lord Oliver recognised the company’s standing to bring claims for loss which it has suffered by its officers’ fraud (see para 214 above); and, further, Lord Oliver described an auditor’s duty as being, first of all, “to protect the company itself from the consequences of undetected errors, or, possibly, wrongdoing", before identifying a second duty “to provide shareholders with reliable intelligence” (para 214 above).

269.  In my opinion it is in no way inconsistent with Caparo or Clarke Pixley to hold auditors responsible to the company they audit in the present circumstances. I underline four points in this connection. First, the concern about indefinite exposure to third parties does not exist in the context of a claim by the company. S & R’s claim is to recover its own (not its creditors’) loss by reason of the continuing scheme of fraud. Loss to the company is not the same as loss to its creditors, although there may or may not be an overlap. An insolvent company may by fraud raise £1m from bank A which it uses in a Ponzi type scheme to pay off a borrowing from bank B. Bank A is £1m worse off, and bank B £1m better off. But the company itself is no worse off from the continuing fraud. It is liable to pay bank A £1m, but it has benefited by £1m by paying off bank B using bank A’s £1m. Of course if (as here) it raises £1m by fraud and pays only £500,000 to bank B and if its directing mind makes off with the other £500,000, then the company is £500,000 worse off due to the continuation of the fraud, but that is and remains its own loss. Secondly, S & R’s claim is for precisely the same loss as a company with some shareholders innocent of involvement in top management’s fraud would be entitled to claim from negligent auditors who had failed to detect and report the fraud (paras 249 to 255 above). Thirdly, it cannot be suggested that the care to be expected of Moore Stephens as auditors varied according to whether all of S & R’s shares happened to be owned and/or controlled by Mr Stojevic. Their express contractual duty was under Auditing Standard SAS 110.10 and 110.12 to report to a proper authority without delay where suspected or actual fraud cast doubt on the integrity of directors. This duty in fact exists under SAS 110 irrespective of whether there are or are not independent shareholders of integrity. Auditors would not in any event necessarily have any idea whether any such shareholders exist.

270.  Fourthly, quite apart from the express provisions of Auditing Standard SAS 110, a situation of insolvency introduces new considerations for reasons previously explained. The identity of interest which normally exists between a company and its shareholders ceases, and the duties of auditors, like those of directors, must recognise this. The company as a legal personality continues and the auditors’ duty continues to be, in Lord Oliver’s words in Caparo, “to protect the company itself from the consequences of undetected errors or, possibly, wrongdoing". If, in Hobhouse J’s words in Berg, “those in charge of the affairs of a company or in control of it are acting contrary to the principles governing insolvency", then the auditors can no longer treat them as representing the company, and must take other action - according to SAS 110 “without informing the directors in advance". In reality, a public report to shareholders (however many of them were involved in the fraud) would itself bring matters to an end. Resignation - and it is part of S & R’s pleaded case that Moore Stephens should, after detecting the fraud, have resigned as well as reported it to the authorities - would by statute have involved an express duty on the part of Moore Stephens to report to creditors: s.394(1) of the Companies Act (para 215 above). I believe that it would in any event probably be auditors’ professional and common law duty to report suspicions of fraud to the proper authorities. But Auditing Standard SAS 110 puts this beyond doubt. Even if Moore Stephens had been aware that directors known or suspected to be acting fraudulently were the beneficial owners of all the company’s shares, they would under SAS 110 still have been obliged to report the circumstances to regulators or other authorities, without informing management in advance, in order to protect the interests of the company. In fact, as I have said, auditors may often not know whether or not all such directors own all the shares. It would be a strange policy and law that exempts auditors from all responsibility to the company, according to the chance that the directors on whose integrity they undertake to report prove to be the sole “beneficial owners” of all the company’s shares.

271.  It follows that in my opinion Moore Stephens cannot invoke the maxim ex turpi causa or deny causation by reference to the knowledge of and involvement in the fraud of Mr Stojevic, if Moore Stephens ought with proper skill and care to have detected that S & R was subject to a continuing scheme of fraud in circumstances in which S & R was insolvent and being rendered increasingly so. Under English law, S & R is thus in my opinion entitled to pursue its present claim against Moore Stephens.

272.   American cases appear to have taken a different view on this particular point under Texan and Pennsylvanian state law: Federal Deposit Insurance Corpn. v. Ernst & Young and Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc. 267 F.3d 340 (3rd Cir. 2001): see para 261 above. They come from a different legal background, one where creditors may at least in some States have direct remedies, and their reasoning does not answer the considerations which lead me to a different conclusion. For the reasons I have given, I do not consider that they represent English law.

Contributory fault

273.  The last matter on which I wish to comment - though not to reach any conclusions - is the question of contributory fault. Mr Brindle opened his oral submissions by accepting that it would be open to the court to apportion fault between the company and its auditor if recovery against the auditor were permitted in respect of fraud by the company’s directing mind. It suited Mr Brindle’s case to present Moore Stephens’ defence of ex turpi causa as an extreme and novel response to the present situation, and to proffer at the outset the more balanced discretionary possibility of a reduction of the claim on account of the company’s contributory fault. However, I regret that, as part of the whole picture, the House has not heard full argument on this aspect. (Indeed, I consider that the House’s resulting inability on this appeal to review the complete picture is a further reason for not determining the whole claim against Moore Stephens at this stage. If contributory negligence is available as a defence, it would cater for or assuage concerns about the general appropriateness of allowing recovery expressed in some of the majority judgments.) The starting point would be to consider the extent to which contributory fault is available in respect of non-fraudulent management failings, either the very failings which the auditors ought with care to have identified or different management failings which nonetheless contributed to the same loss as that which the auditor’s negligence allowed to occur. The House’s decision in Reeves makes clear that, in a simple two-party situation, it is possible for recovery, for breach of a duty to prevent the very thing complained of happening, to be reduced on a broad brush basis on account of the claimant’s conduct in bringing about the thing. In Professional Negligence by Jackson & Powell (6th Ed. 2007), chap 17, a number of authorities are cited in which contributory fault has also been recognised as a ground for reduction of liability in auditor’s negligence claims.

274.  However, the obvious conundrum, if the fraud of top management is not attributed to the company for the purpose of the maxim ex turpi causa, is why it should be attributed to the company for the purpose of contributory fault under the Law Reform (Contributory Negligence) Act 1945. Mr Brindle’s justification for doing this is that, when considering the allocation of fault to the company under the Act, the court is in effect considering a claim against the company. But, even if a “fault” is in this way equated with a claim, the question arises in the context of an audit of a solvent company, how management fraud may be balanced against an auditor’s negligence, when an auditor’s primary responsibility is in respect of innocent shareholders, whose conduct will not usually be susceptible to criticism. And a similar difficulty arises about weighing the significance of fraud by a directing mind who is also sole beneficial shareholder, if, as I consider, the auditor may be answerable to the company for negligent failure to detect and report on such a fraud. Despite such problems, contributory fault, including Leeson’s fraud which the judge had held (rightly or wrongly, I need not consider) to be attributable to the company, was recognised as a ground for a substantial reduction in recovery against the auditors in Barings Plc v. Coopers & Lybrand [2003] EWHC 1319 (Ch). The subject was also discussed by the Full Court of South Australia in Duke Group Ltd. v Pilmer 73 SASR 180 (1999) (reversed in part on a different point at [2001] BCLC 773). The court there concluded that, while the company’s directors’ knowledge of their own fraud on the company would not be attributed to the company, the company could and would nonetheless be liable vicariously for such directors’ misconduct and treated as at fault on the same basis, for the purposes of enabling negligent auditors to reduce their liability in tort. (This was a Pyrrhic victory, since at the time contributory negligence was not available in Australia in relation to the concurrent contractual claim against the auditors.) The Full Court’s reasoning was avowedly pragmatic and it relied as it said on its “view that this is the fairer and more appropriate outcome". There is obvious attraction in such pragmatism in the present context. Not having heard argument on any such aspects, I say no more.

Conclusion

275.  For the reasons I have given, I consider that this appeal should be allowed on the ground that Moore Stephens’s duty was to the company, that it is not sufficient for Moore Stephens to argue that every relevant emanation of the company consisted of Mr Stojevic as its directing mind and sole shareholder, if Moore Stephens failed in breach of duty to the company to detect the continuing scheme of fraud being pursued by Mr Stojevic and to detect that the company was (in fact, due to such scheme of fraud) insolvent or potentially so. In that context, Moore Stephens cannot attribute to the company itself, for the purpose of invoking against it the maxim ex turpi causa, the knowledge of and involvement in the fraud of Mr Stojevic which (it is for present purposes to be assumed) they ought to have detected and reported to regulators or other proper authorities in the company’s interests. What would have happened upon such detection and report is simply a matter of causation.

276.  The company’s ability to recover its own loss in such circumstances is in my view not only also right in principle, but also desirable. It means that recovery does not depend on the happenstance of whether or not all the company’s shareholders were involved in the fraud. Whether a company is a one-person company or not may itself also be unclear, until one has penetrated a web of nominee or trust shareholdings. The result I reach reflects the various categories of person interested in the company, with whom in mind the auditors ought to plan and conduct their work. The contrary result espoused by the majority of your Lordships will weaken the value of an audit and diminish auditors’ exposure in relation to precisely those companies most vulnerable to management fraud. The (too topical) lesson for creditors or depositors might be said to be that they should not expose themselves to one-person companies, at least without extensive due diligence. That is neither attractive nor realistic as an answer, when one-person companies can be large financial enterprises offering banking facilities to or inviting deposits or investments from many ordinary members of the public. It is in relation to exactly such companies that auditors ought to be encouraged to exercise the skill and care anyway due, rather than to feel that the risks of incurring liability to the company for a negligent audit are reduced. For completeness and not because it in any way influences my conclusion, I note that auditors are now also able to enter into fair and reasonable liability limitation agreements under ss.534-538 of the Companies Act 2006, though how far this is proving acceptable to their client companies or others I am unaware.

277.  I would therefore allow this appeal, and restore the judge’s order dated 11 September 2007 dismissing Moore Stephens’s application for summary judgment on, or to strike out, the claim against them and giving directions for the further conduct of the proceedings.. The critical issue dividing the House is ultimately whether auditors, who should, in the performance of their contractual and tortious duties towards a company, have detected and (under the express terms of their engagement) then have reported to the appropriate authorities a scheme of fraud by top management rendering the company as a separate legal person increasingly insolvent, owe any enforceable duty towards the company to do this, so avoiding further loss to the company. In my opinion, they do.

Annex

Overseas authority on attribution

(para 248)

i.  Canadian Dredge & Dock Co. Ltd. v The Queen (1985) 19 DLR (4th) 314 was decided by the Canadian Supreme Court, after reference to English case-law including Tesco Supermarkets Ltd. v Nattrass. It concerned a criminal prosecution. Not surprisingly in this context, the Supreme Court took a limited view of the circumstances in which the company could disclaim the acts and state of mind of its directing mind. Estey J described these as being “when the directing mind ceases completely to act, in fact or in substance, in the interests of the corporation", or “where all of the activities of the directing mind are directed against the interests of the corporation with a view to damaging that corporation, whether or not the result is beneficial economically to the directing mind". Only then, might there “be said to be fraud on the corporation” or an act “totally in fraud of the corporate employer” (p.351). Two comments may be made. First, the language of fraud on a company was being used in the unfamiliar context of a charge against the company. In such a context, as I have said, the hurdle for disclaimer of responsibility was, not surprisingly, set high. Second, the phraseology developed in the judgment and used in subsequent Canadian cases (and some other common law cases: see e.g. In re The Mediators, Inc., paras. 6-7, discussed in paragraph 239 above, and Duke Group Ltd. v Pilmer 73 SASR 180 (1999), para.632. indicates a test which is both more rigid and more extreme than that which English law would adopt, particularly since the Privy Council’s decision in Meridian.

ii.  Despite the first point, the reasoning in Canadian Dredge has been transposed in Canada to the context of an auditor’s negligence claim in a first instance decision. Hart Building Supplies Ltd. v. Deloitte & Touche [2004] BCSC 55 was a case where Mr Larson, a director and the directing mind and a 15% shareholder, had falsified Hart’s inventory records and inflated its profits by false invoices “to try to help Hart’s business", and so misled the auditors. The company’s claim was brought at the instance of its innocent 85% shareholder against the auditors for negligence. The judge in applying “the law as set out in Canadian Dredge“ took principles which may be appropriate when determining a company’s liability to the third party and applied them, without question, to the different situation of a company seeking redress from a third party on the face of it in breach of duty to the company. For reasons I have given, this does not represent English law, and it has also been subjected to trenchant Canadian critique: Emaciating the statutory audit - a comment on Hart Building Supplies Ltd. v. Deloitte & Touche by Ass. Prof. Darcy MacPherson, University of Manitoba: (2005) 41 Can Bus LJ 471.

iii.  Australian authority has adopted a more sceptical attitude to the scope and appropriateness of application of Canadian Dredge in the audit context: Edwards Karwacki Smith & Co. Pty. Ltd. v Jacka Nominees Pty. Ltd. (1994) 15 ACSR 502, where the Supreme Court of West Australia, after reviewing inter alia Canadian Dredge, refused summary disposal of a claim against auditors for negligently failing to discover that the directing mind of a “one-man company” had been fraudulently concealing the true state of the business and so fraudulently inducing investors in it.

iv.  American authority is copious and less easy to digest (as well appears from the May 2008 continuing legal education study paper of the American Law Institute and Bar Association which the House was shown). Various broad approaches emerge. One takes the general law’s theory of attribution or “imputation” and subjects it to an “adverse interest” exception (itself stated in differing terms, some resembling the Canadian Dredge test, others considerably more nuanced), which is then in turn subject to a “sole actor” exception. Another suggests that, in the context of a professional duty to check upon and report fraud such as the audit duty, either the general theory of imputation or the ex turpi causa doctrine (known in the United States as the in pari delicto defense) itself requires modification.

v.  The early case of Cenco Inc. v. Seidman & Seidman 686 F 2d 449 (1982) (USCA, 7th Circ.) concerned a claim by a still solvent company to recover damages from auditors who had failed to discover a fraud at top management and board level, consisting of inflating the value of inventory, and so of stock which was used to buy up other companies. Speaking for the court and applying the common law of Illinois, Judge Posner upheld the trial judge’s directions to a jury which had led the jury to dismiss Cenco’s claim. He differentiated fraud by top management involving theft from the company from the actual fraud which involved “turning the company into an engine of theft against outsiders". The case is therefore distinguishable from the present, which I would, for reasons indicated in paras 230 to 234, place in the former category for the purposes of the company’s claim against Mr Stojevic or its auditors. Judge Posner went on to say that, even in deciding how to treat the latter category, the Illinois courts would be guided by “the underlying objectives of tort liability". Holding that these justified the judge’s directions, he adopted a two-pronged “cost-benefit” analysis. To allow recovery would, first, benefit stockholders without differentiating between innocent and guilty stockholders and, second, shift the loss to all stockholders (who the court said were “slipshod in their oversight [of their chosen board] and so share responsibility for the fraud”), thus, in the court’s view, reducing the incentive for stockholders to hire and monitor honest stockholders (pp.455-456).

vi.  In Schacht v. Brown 711 F 2d 1343 (1983) (also USCA, 7th Circ.), top management had fraudulently continued an insurance company in business past its point of insolvency and systematically looted it of its most profitable and least risky business and income, aggravating its insolvency. Cenco was distinguished on various grounds: first, as decided under Illinois law, whereas the issue in Schacht arose under federal law and the court could say that “we therefore write on a clean slate and may bring to bear federal policies in deciding the estoppel question"; second, on the ground that the fraud in Schacht, including the “Pyrrhic ‘benefit’” of its artificially prolonged life, was not sufficient to engage the Cenco analysis of a company operating as the engine of fraud on others; and, third, on the ground that the two-pronged analysis adopted in Cenco led in Schacht to a different answer, because in Schacht the company was insolvent, there was no indication that the fraudulent top management would benefit from any recovery and “no evidence here of the existence of large corporate shareholders capable of conducting an independent audit, as in Cenco, and whose lack of investigatory zeal would be rewarded by a decision favourable to the [liquidator]” (p.1349).

vii.  Similar thinking appears in (a) In re Jack Greenberg Inc. (Larry Waslow, Trustee v. Grant Thornton LLP) (U.S. Bankruptcy Court, E.D. Penn., Phil. Div.) 240 BR 486 (1999), where the court emphasised that “while the imputation doctrine may be applied in auditor liability cases, the doctrine was not crafted with that purpose in mind” and should be allowed “to be invoked only where the objectives of tort liability dictate” (p.508); (b) NCP Litigation Trust v. KPMG LLP 901 A.2d 871 (N.J. 2006), where the Supreme Court of New Jersey differentiated between shareholders engaged in a fraud involving inflation of profits and other innocent shareholders, holding that imputation could only be asserted to preclude recovery by the former, disagreed with the suggestion in Cenco that “imputation must be applied to shareholder suits to deter future such wrongdoing", noted differences between Illinois and New Jersey law, and, referring to Schacht, also concluded that the management’s fraud “inflating a corporation’s revenues and enabling a corporation to continue in business ‘past the point of insolvency’ cannot be considered a benefit to the corporation", but that, even if it could, “any benefit would not be a complete bar to liability, but only a factor in apportioning damages” (p.888); and (c) In re Sunpoint Securities, Inc. (U.S. Bankruptcy Court, E.D. Texas, Tyler Div.) (377 BR 513 (2007).

viii.  One, though by no means the only, strand of the reasoning in Schacht and Jack Greenberg, involves a possible distinction between situations of solvency and insolvency. This is controversial in American law, particularly in the light of s.541 of the Federal Bankruptcy Code (according to which the bankruptcy estate “is comprised of ….. all legal or equitable interests of the debtor in property as of the commencement of the case”), and there is authority rejecting such a distinction in cases covered by s.541: Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc. 267 F.3d 340 (3rd Cir. 2001). Earlier authorities had rejected the defence of in pari delicto as an answer to claims by receivers against negligent auditors: Federal Deposit Insurance Corpn v. O'Melveny & Myers 61 F.3d 17, 19, (1995) and Scholes v. Lehmann 56 F. 3d 750, 754, (1995). The court in Lafferty distinguished these authorities on the ground that receivers are not within s.541 (Lafferty, p.358). However, in a still more recent decision, Knauer v. Jonathon Roberts Financial Group, Inc. 348 F.3d 230, (2003) the Court of Appeals for the Seventh Circuit has taken the view that receivers do stand in the shoes of the company in relation to entities deriving no benefit from the fraud, as opposed to direct beneficiaries of the fraud.

ix.  The “cost-benefit” analysis and other techniques deployed in American case-law do not find any easy match in English law. Case-law in some states permitting direct claims against auditors by injured third parties (including creditors) also complicates any appreciation of the practical significance of American authority: see e.g. Bily v. Arthur Young & Co. 3 Cal.4th 370 (1992). However, the general message in the recent case-law that I have examined is one of increasing reluctance to hold that top management fraud provides a defence to a negligent auditor, and this at least corresponds with my conclusions as to the right approach in principle in English law.

 
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