Factors that count towards liabilities

Picking up the points from the cases considered above and others, NEILL LJ has listed the following factors to be considered in fixing this liabilities: The factors to be considered in determining whether the maker or giver owed a duty of care to the recipient not to be negligent in the statement or advice include the purpose for which the statement is made, the purpose for which the statement is communicated, the relation between the matter or giver, the receipt and the relevant third party, the size of any class to which the recipient belonged, the state of knowledge of the maker or giver and any reliance by the recipient. Having regard to these factors, the defendants (accountants of the target company at whose instance they prepared draft accounts for use in take-over negotiations) owed no duty of case to the plaintiffs in respect of the draft accounts produced by them since the accounts were prepared for the target company only and not for the plaintiffs, the accounts were merely draft accounts and the auditors would not reasonably  have foreseen that the plaintiffs would treat them as final accounts, the accountants did not take part in the negotiations and the plaintiffs were aware that the target company was in a poor state and could be expected to consult their own accountants. In a case in which the auditors knew that the party who was going to purchase 50% of the company’s shares was relying on the audited accounts, the court said that they would have been liable, but no breach of duty could be located on their part. The only basis on which the investor said that he was misled was the way in which the replacement cost of the tyres of the trailer hiring company was provided, namely, the substantial portion of the cost taken into consideration when it crystallized instead of when the loss occurred. The court said that the auditors could reasonably have taken the view that the accounts as prepared would give a true and fair view of the company’s affairs. As for the standard accounting practices are not right rules, they are very strong evidence of what is the proper standard to be adopted and, unless there is some jurisdiction, a departure from them will be regarded as a breach of duty. Where the investors in a company lost their money because of the defalcations of the directors which were not detected by the auditors, it was held that the mere fact that investor’s money was held by the company in trust did not have the effect of creating a special relationship between the investors and auditors which would have created a duty of care owed by the auditors to the investors.

What is negligence?

liabilities

A negligent act is an act done without doing something which a reasonable man guided upon the considerations which ordinarily regulate the conduct of human affairs would do or an act which a prudent or reasonable man would not do in the circumstances attending holds himself out to the public as an expert trained and equipped for and qualified to render multifarious services. He has to render these services with due care, skill and diligence and according to generally accepted standards of performance. A negligent act would, therefore include a careless or reckless act or failure to perform a duty enjoined upon a person. It may not necessarily be appositive act but can also be act of omission both resulting from the failure of the person concerned to exercise the degree of professional care and skill which is expected of him under the circumstances of the case. A professional man can be charged with negligence if it is proved that he has not exercised a reasonable degree of care and skill in the performance of his duties.

Liabilities of negligence

Ordinarily, an auditor is liable to make good the loss or damage resulting from negligence on his part, such as failure to detect defalcations or discover errors which may have caused loss to the company, and this liability may extend also to third parties such as bankers, creditors, etc., who, by reason of their relying upon the audited statements or accounts have suffered loss or damage. Where the auditors stated in their official reports that the value of the asserts depended upon realization but submitted a different confidential report to the directors and the latter, going by the official report, paid away a dividend which depleted the company’s capital, the auditors were held liable to make good company’s loss. The auditor was held liable where he had failed to verify one of the assets in the balance sheet, like the petty cash. The auditors were found to be liable through failure to satisfy themselves regarding the adequacy of the provision for bad debts. Where an individual was appointed as auditor and that individual was a partner in a firm or professional accountants, that firm may be held liable for his negligence in performing the duties as auditor, particularly where the audit fee was paid direct to the firm. Shortly stated, the position is that so long as the auditor acts honestly, and without negligence and adheres to generally accepted auditing standards and follows generally recognized normal auditing procedures, he will not be held responsible for any defalcation, fraud or irregularity, which, in spite of following such procedures, he has not discovered. An auditor’s position will indeed be intolerable, if he is to be made liable for not tracking out ingenious and planned schemes of fraud, when there is nothing to arouse suspicion.

Auditor’s liabilities for misfeasance

The section 340 of the Companies Act provides the remedy to recover damages where an auditor or any other officer of the company is guilty of misfeasance. The said section is applicable only to companies in liquidation. If in the course of winding up of a company, it appears that a director, officer of the company etc. has misapplied or retained or become liable or accountable for any money or property of the company or has been guilty of any misfeasance or breach of trust in relation to the company, the section becomes applicable. The court may enquire into the conduct of the person, director etc. aforesaid and compel him to repay or restore the money or property of the company. An auditor of a company is an officer of the company for the purposes of this section and hence liable under the section. Misfeasance implies a breach of duty or negligence in the performance of duties. But mere negligence or neglect of duty will not create and liability. It must result in loss. Only misfeasance resulting in a loss to the company will be covered by this section. Failure to report illegal or ultra vires acts of the directors or instances of misapplication of funds and property of the company or its misappropriation may fasten a liability on the auditors under this section. Now new rights are not created by this section nor are any new liabilities imposed. The nature of the liabilities are akin to that of compensation under the common law. It may, however, be noted that while a suit for action under common law lies against auditors and officers of the company for negligence even when the company is carrying on the business, an action under this section lies only when the company is being wound up.

Liabilities of auditors to third parties

The court had also refused leave to the claimant to produce any new evidence and to amend the claim to add claim of negligent misstatement. Over this aspect the case came before the court of Appeal in Electra Private equity Partners (a limited partnership) versus KPMG Peat Marwick (a firm). Over both these aspects the unanimous conclusion of the court of Appeal was that the appeals should be allowed. Their Lordships said that the claimants (Electra) should be allowed to advance their claim on the alternative basis upon which they seek to do. “To put it at its lowest the events which form the basis of the allegations of negligent misstatement are closely related to some of the events which are relevant to electra’s case. It is at least arguable both that the proposed amended pleadings disclose a reasonable cause of action and that such a case is not doomed to failure. The appropriate leave to amend should be granted”. The leave was allowed at costs. The following passage in the judgment of summaries the development of law on the point of duty of care.

Limiting liabilities of auditors

One of the reasons given in the support of policy framework for limiting auditors’ liability is that particulars in the market receive information about the company from a variety of sources before it is released in a formal manner to shareholders at the annual general meeting. Secondly, the participants in the securities market can verify the accuracy of the information available to them in a number of other ways. It is a matter of profound concern that directors should bear their proper share of responsibility with respect to losses suffered by their company. It is socially and commercially unjust and inappropriate those directors should escape liability completely and that the full burden of responsibility should rest on auditors. The view propounded is also supported with the help of judicial recognition which allows the defense of contributory negligence to auditors. In this third place, it has been observed by “There has been a market tendency to blame the auditor for the failure of directors and senior management to adequately and properly supervise the business or even warn against unsound business decisions. Needless to say that is not part of the auditing function”. The Auditor’s Legal Liability Task Force of the international Federation of Accountants (IFAC) has suggested ways by which limitation of auditor liabilities might be achieved. These include replacing joint and several liabilities with proportionate liability, allowing audit firms wider organizational options, providing for the limitation of liability in contract, putting in place penalties to discourage plaintiffs filing frivolous suits, enacting statutory requirements for adequate insurance cover of both company directors and auditors, introducing statutory limits to auditor liability to third parties, strengthening privity standards and tightening that statute of limitations. Explaining the concept of capping liability it is said that “it involves the statutory imposition of a limit to the quantum of liability for which a specific party can be held liable”. Many countries e.g., Germany, Australia, Greece and Portugal have fixed statutory caps on liabilities arising from statutory audit work. In Australia, the possible statutory cap on auditors’ liability was entertained by the Companies and Securities Law Review Committee in 1986. However, no legislation was enacted by the Common Wealth Government. On the other hand, in New South wales the Professional standards Act, 1994 was enacted. This legislation requires approval by the professional Standards Council of any scheme proposed by occupational associations on behalf of their members. Under the legislation a scheme may limit the liabilities of action.

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