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By Brian Morgan
Illustration: Gary Taxali
 THERE'S NEW LEGISLATION IN ONTARIO THAT WILL HAVE A SIGNIFICANT EFFECT ON LIABILITY CLAIMS AGAINST ACCOUNTANTS
Just when accountants thought they could get back to accounting, the Ontario government has created new legal issues for them to deal with. It has passed new legislation dealing with secondary market disclosure, to add to the recent legal issues regarding conflicts of interest and the Sarbanes-Oxley Act. While the net result will be a broadening of accountants' liability, there are some mitigating features, including liability caps and proportionate liability, which will help take care of the problems created when deep-pocketed accountants face deadbeat directors.
Although this legislation has not yet been proclaimed, it's good to learn about the new principles so that accountants will be ready when the legislation comes into effect.
The new legislation, which was enacted in late 2002 as part of Ontario's Bill 198, will radically alter the principles for liability relating to misleading corporate disclosure in Ontario, including the liability of accountants for audit opinions and other statements they make regarding the financial statements and affairs of companies.
This is part of an increasing trend of governments not only to create more rights for individual compensation but also to privatize the enforcement of public interest standards. By giving individuals incentives to bring lawsuits against companies, their directors and their accountants for misleading statements, the government encourages private enforcement that can have a deterrent effect far beyond what the regulators can achieve.
Under the new legislation, a company that is a public issuer, the company's directors, certain others and experts such as its auditors and its accountants will be potentially subject to liability for misrepresentation if the statements they make to the public are not accurate. The proposed statutory civil remedy adopts recommendations made in a report of the Canadian Security Administrators in November 2000. The CSA recommended that all Canadian, provincial and territorial legislatures adopt such a regime. Ontario was the first jurisdiction to introduce the proposed legislation. However, since most public companies trade in Ontario, and other provinces may well follow suit, we may expect that this new liability regime will be generally applicable to accountants across the country.
Until now, there has been statutory liability to shareholders and investors for statements made in financial statements in a prospectus but not for financial statements not included in such documents. Liability to shareholders and other investors buying or selling securities other than under a prospectus (i.e., in the secondary market) has been left to the common law. Under common law principles, accountants have been relatively well off since the Supreme Court of Canada decision in Hercules Management Limited v. Ernst & Young (1997) 2 S.C.R. 165. Under the principles endorsed by the Supreme Court in Hercules Management, investors generally have no right to sue the auditors for misstatements in the financial statements, since the court held that a duty of care does not exist between the auditor of a corporation and its shareholders and investors unless there are special circumstances on the facts of the case. This is the case even if the auditor foresees that the shareholders and investors will be relying on the audited financial statements. Of course, disgruntled investors who sue the auditors usually claim there were special circumstances in their case. (Generally this plea is alleged and seldom proved.) Also under common law, even if there is a duty of care, there are two other hurdles facing a plaintiff. The plaintiff must prove actual reliance on the financial statements and the onus is on the plaintiff to prove that the audit opinion or other statement from the accountants was negligent.
Under the new statutory regime, all three hurdles are gone. There is a statutory right of action if a misrepresentation exists. A person who acquires or disposes of securities is deemed to have relied on the misrepresentation. In addition, the onus is on the defendant to prove a defence of reasonable care.
Specifically, the legislation provides that, where a communication from a public company contains a misrepresentation, a person or company that acquires or disposes of its securities is deemed to have relied upon the misrepresentation and has an action for damages against the company, its directors, other responsible individuals and against experts such as auditors and accountants (if the misrepresentation is contained in an expert's report, statement or opinion that is referred to in the document and if the expert consented to its use). Broadly, the right applies to both written and oral communications.
The plaintiff simply has to prove that there was a misrepresentation in the statements in question, including in the accountant's report, statement or opinion in the public communication from the company. The ball is then in the defendant's court, in order to prove it conducted a reasonable investigation and had no reasonable grounds to believe there was a misrepresentation. In effect it is a reverse onus due-diligence defence.
The legislation sets out factors to be considered in determining whether an investigation was reasonable. These include broad generalities like the knowledge, experience and function of the defendant and the role and responsibility of the defendant in the misrepresentation. It is most likely that, as a practical matter, all the usual features of defending against an allegation of negligence will exist in this area.
A defendant is not liable for misrepresentation in forward-looking information if next to it the statement contained:
• a reasonable cautionary language identifying the forward-looking information as such;
• a statement identifying material factors that could cause actual results to differ materially from a forecast or projection in the forward-looking information;
• a statement of the material factors or assumptions that were applied in making a forecast or projection contained in the forward-looking information. In addition, there needs to have been a reasonable basis for making the forecast.
A frequent problem that arises when defending lawsuits against accountants is created by the current common law principle of joint and several liability. If a misrepresentation was caused by both the auditor and others such as the directors and officers of a company, there will often be joint and several liability, under which each defendant is liable for the full damages of the plaintiff. A defendant has the right to make his or her own claim against the others who are also responsible for the misrepresentation, but if they have no (or insufficient) insurance or assets (having creditor-proofed themselves on the advice of their accountants), then the accountants will be left footing the entire bill. This is the problem of the deadbeat directors and the deep-pocketed accountants.
Ontario's new legislation has a salutary feature to remedy this problem in most cases. If more than one defendant is liable to a plaintiff for a secondary market communication, each is liable only for the proportionate share of the plaintiff's damages that corresponds to that particular defendant's responsibility. This limitation will not apply if the defendant knew the statement was a misrepresentation. In that case, there will be joint and several liability, subject to a right of contribution.
Another provision that ameliorates the broadening of accountants' liability is one providing for liability caps. There are various caps for different types of defendants. Accountants are included with other experts, and all such experts have a liability cap of the greater of $1 million and the revenue that the expert and its affiliates have earned from the company and its affiliates during the 12 months preceding the misrepresentation. Since this cap includes revenue to all the affiliates of an accounting firm, and from all affiliates of the company in question, the cap could far exceed $1 million for the large accounting firms, depending on the legal interpretation of the term "affiliates." However, this cap will avoid the catastrophic damages awards that underlie the courts' historical reluctance to create liability in the secondary securities market, reciting Justice Benjamin Cardozo's famous mantra that such liability might create "liability in an indeterminate amount for an indeterminate time to an indeterminate class."
If damages are assessed in (or amounts paid in settlement of) other related actions elsewhere in Canada under comparable legislation, those amounts count toward the liability cap for a defendant. However, the liability caps do not apply if the defendant made a representation while knowing it was a misrepresentation.
When it recommended liability caps, the CSA stated that the policy basis was the fact that the primary purpose of the legislation was to provide an effective deterrent to misrepresentations and failures to make timely disclosure and that providing compensation for investor damages was only a secondary objective. This principle also underlies the provision for proportionate liability. Since there has now been legislative recognition of the appropriateness of proportionate liability and liability caps in this area, one wonders why the same principles should not apply more broadly to civil liability for misrepresentations in the capital markets, including in prospectuses and other areas.
To attempt to prevent frivolous, coercive and unmeritorious litigation, the legislation provides that a plaintiff needs leave of the court to commence a proceeding. The court must be satisfied that the action is brought in good faith and that there is a reasonable possibility of success. In addition, court approval is needed for the discontinuance or settlement of an action. Costs are payable to the prevailing party.
The new Ontario regime of civil liability for secondary market disclosure is very different from the comparable US securities legislation. The primary basis for civil liability under US securities legislation is Rule 10b-5. In a Rule 10b-5 action, the plaintiff must prove that the defendant acted with scienter, which is a mental state embracing intent to deceive, manipulate or defraud. US courts have held that recklessness and wilful blindness are included. The new Ontario legislation doesn't require this higher state of knowledge or intent. Instead, there can be liability where there is a misrepresentation and the defendant was simply negligent.
Overall, the new legislation enacted in Ontario in these areas will have a significant effect on liability claims against accountants. It will be part of the increasingly elaborate legal framework in which accountants carry on their profession.
Brian Morgan is a senior litigation partner with the firm of Osler Hoskin & Harcourt LLP, with particular expertise in accountants' liability matters
Technical Editor: Mindy Paskell-Mede, BCL, LLB, is a partner with Montreal law firm Nicholl Paskell-Mede | 
