SCC: Auditors may be Liable for Losses Related to Audit Opinions

On December 20, the Supreme Court of Canada (SCC) released its decision in Deloitte & Touche v. Livent Inc. In a 4-3 decision, the majority held that auditors may be liable for losses which are attributable to the purpose for which an audit opinion is provided. The decision clarifies the scope of tort liability for auditors, which was last addressed by the Court 20 years ago in Hercules Managements Ltd. v. Ernst & Young.

What You Need To Know

• Auditors may only be held liable for losses that flow from the intended purpose of an audit.
• In the case of a statutory audit, this may include losses which flow from a lack of management oversight at the client, including damages from undetected fraud perpetrated by management.
• Loss flowing from misrepresentations made in the statutory audit or other work, such as comfort letters, are unrecoverable if the work is relied upon for an unintended or collateral purpose (that is, for a purpose that the auditor did not undertake to fulfil.)
• Management or director misconduct will not necessarily be a defence to auditor negligence claims as the very purpose of the statutory audit is to avoid injury from undetected misconduct.

Background

Livent arose out of a fraud perpetrated by the company's two principals, Garth Drabinsky and Myron Gottlieb, which had the effect of significantly overstating the company's revenues and profits during a period in which the company was soliciting investment. The fraud was discovered in 1998 and Livent went into insolvency protection, resulting in significant losses.

Livent's receiver made two claims of negligence against its auditor for failure to uncover the fraud. First, the auditor helped Livent with a comfort letter used for a public offering. Second, Livent's audit for the same year did not disclose management's fraud and the auditor did not resign when faced with misleading financial statements.

SCC Decision

The majority of the Court concluded that the loss claimed by Livent in relation to the statutory audit was recoverable because it arose from a core purpose of any statutory audit—to assist shareholders in their management oversight role. Indeed, the Court noted that injury from undetected fraud is "precisely the type of injury statutory audits seek to avoid."

In contrast, the majority concluded that the auditor never undertook a responsibility to Livent's stakeholders to oversee management when the auditor assisted in preparing the comfort letter and press release. The undertaking was to assist investors not stakeholders. The auditor therefore could not be held liable for failure to take reasonable care in assisting with any management oversight in relation to the comfort letter and press release. Because the auditor had not undertaken this management oversight role, the majority held that any reliance by Livent on the auditor's representations in the course of preparing the comfort letter or press release was not reasonable or reasonably foreseeable.

The majority also considered and rejected two defences raised by the auditor. First, the majority rejected the auditor's defence of illegality, which bars an otherwise valid action on the basis that the plaintiff has engaged in illegal or immoral conduct. The majority concluded that Drabinsky and Gottlieb's wrongdoing could not be attributed to Livent because denying liability on the basis of individual misconduct would render the purpose of a statutory audit—to protect against such wrongdoing—meaningless. Second, the Court rejected the auditor's defence that Livent was contributorily negligent by virtue of management misconduct for the same reasons it had rejected the auditor's illegality defence.

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