Equity kicker not considered interest for purposes of Criminal Code

Equity kicker not considered interest for purposes of Criminal Code

December 31, 2007

The Court of Appeal of Ontario has upheld a landmark ruling affecting auditors across Canada.

Unanimously, the court said that a decision in 2014 by Ontario Superior Court Justice Arthur Gans ordering Deloitte & Touche to pay creditors of defunct theatre entertainment company Livent Inc. more than $118 million in damages, including interest, was correct in law.

“In my view, the record amply supports the trial judge’s findings that Deloitte was negligent in its conduct of the 1997 audit and the Q2 and Q3 1997 engagement,” Justice Robert Blair said writing for a panel of three judges in Livent (Special Receiver and Manager of ) v. Deloitte & Touche [2016] ONCA 11.

“Indeed, the evidence to that effect is overwhelming.”

Whether this case is appealed all the way to the Supreme Court of Canada has yet to be determined.

These decisions will profoundly change the way auditors carry out their duties because it is no longer enough just to be competent and careful. Today, a much higher duty of care and competence is required, said Ramy Elitzur, a professor in financial analysis at the University of Toronto’s Rotman School of Management.

Experts also say the Deloitte/Livent court rulings significantly change the Canadian landscape for auditors after an earlier watershed ruling — the 1997 Supreme Court of Canada decision Hercules Management[s] Ltd. v. Ernst & Young [1997] 2 SCR 165].

Justice Gans addressed that case in his 2014 ruling, Livent (Special Receiver and Manager of ) v. Deloitte & Touche [2014] ONSC 2176.

“The Supreme Court of Canada held that a company’s auditor does not owe a duty of care to the shareholders of its corporate client,” Gans wrote.

“The purpose of audit reports is to allow shareholders, as a class, to supervise management — not to assist them in making individual investment decisions. Therefore, shareholders do not have individual causes of action against an auditor. If the corporation suffers losses attributable to its auditor’s negligence, then the corporation itself has the cause of action, which may if necessary be pursued by way of a derivative action.”

Al Rosen, founder of Rosen & Associates Limited, litigation and investigative accountants in Toronto, said he has seen dozens of potential investor lawsuits dropped because the prospective plaintiffs were discouraged by the Hercules decision in 1997.

One major problem with that decision is it meant investors and creditors could only sue under very limited circumstances, contrary to what the Canadian Institute of Chartered Accountants Handbook said and also contrary to international financial reporting standards (IFRS), Rosen argued. Canada adopted the IFRS standards in 2011.

Dan Rothberg, a partner with Basman Smith LLP in Toronto, said the Deloitte/Livent decisions represent a significant step forward in the expansion of auditor liability since the Hercules decision in 1997.

Hercules very much restricted the ability of anybody to pursue their auditors for negligence or other similar causes, but the Livent decision discreetly expands on the liability of auditors, potentially giving recourse to any number of classes of people now, such as creditors and possible new investors, beyond just the company and its shareholders, he said.

“Given the expansion of class action suits in Canada as well, especially over the last few years, especially securities class actions, I see this as opening a door to all sorts of potential lawsuits against public company auditors, because it certainly expands the scope of responsibility of auditors’ reports,” Rothberg added.

Deloitte argued that Livent had no right to sue because the fraud was conducted by its own executives, but that was rejected by the Court of Appeal — a decision that Rosen said was “absolutely on target.”

Rosen noted that while two of Livent’s executives, Garth Drabinsky and Myron Gottlieb, also served prison terms after fraud convictions, an inability to sue would disadvantage the rest of the shareholders who were innocent bystanders and had no involvement in such activity.

Legal experts are eagerly waiting to see if Deloitte decides to seek leave to appeal these decisions all the way to the Supreme Court of Canada — and if so, whether Canada’s top court will decide to hear this case.

“The Livent matter has been before the courts for a considerable period of time and we need time to carefully consider the recently released Ontario Court of Appeal decision,” said Deloitte spokesperson Caitlin Stidwill.“The audit and legal issues in this case are exceptionally complex, and important not only to the audit profession but to the broader business community. We will carefully review the court’s decision before deciding on our next steps.”

Rothberg believes this case will be heard by Canada’s top court.

“My guess is the Supreme Court will hear it, not necessarily because the issues are so esoteric that they think the court got it wrong, but because of the public interest and the names involved, and the notoriety of the whole scandal in the first place,” he said.

Joel Watson, a partner with Shibley Righton LLP in Toronto, said Justice Blair provided an extremely well written judgment, which Watson suspects may be in anticipation of an appeal to the Supreme Court.

Watson noted that Justice Blair’s decision contained a critical passage which said that “in accordance with GAAS [generally accepted auditing standards], Deloitte was under an obligation to have proper auditing procedures in place to reduce the risk of not detecting material misstatements to an appropriately low level … Deloitte was retained to … exercise reasonable care in relation to detecting fraud. This is underscored by the fact that Deloitte knew at all material times that the financial statements it prepared were being used to solicit investment in Livent.”

Watson also highlighted this portion of Blair’s ruling, referencing a decision by Jonathan Mance, a House of Lords (now Supreme Court of the United Kingdom) judge in 2009.

“I find perceptive Lord Mance’s view in Stone & Rolls … that ‘[i]t would lame the very concept of an audit’ if the auditor could, ‘by reference to the maxim ex turpi causa, defeat a claim for breach of duty in failing to detect managerial fraud at the company’s highest level by attributing to the company the very fraud which the auditor should have detected,’ ” Justice Blair wrote.

Ex turpi causa is a legal doctrine in Latin which means one is not able to sue if they are also in criminal conduct, explained Watson. The court told Deloitte it had read that principal wrong — that auditors cannot use that defence, because they are there to catch fraud, not to rely upon that very fraud to exculpate them from culpability, he added.

Rosen said the Deloitte/Livent court decisions will put Canadian auditors on notice.

“It’s going to be a warning — sort of a shot over the bow saying ‘there are going to be situations where you cannot use Hercules to excuse you from falling below standards,’ ” he said.

But Rosen also noted he remains concerned about the scope of choices available to management with respect to its accounting, particularly now under IFRS.

“The law in Canada still supports considerable management freedom,” he said.

“For auditors the lessons are you have to be very, very careful in choosing your clients and take into account the level of risk involved way more than before,” warned Elitzur.

“You should consider a lower threshold to let go of a client, and do way more work than what you were doing before because you’re liable way more than you used to be.”

The lesson arising from these court cases is that when doubts and concerns arise, auditors need to pursue them, said Rick Robertson, an associate professor of finance and accounting at the University of Western Ontario’s Richard Ivey School of Business in London.

“I think it’s going to put greater emphasis on checking and looking for fraud or deception, which is an incredibly difficult thing to find,” he added.

This story also appeared on thebottomlinenews.ca