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By Stephen Lamont
Illustration: Mike Constable
 WHEN A BUSINESS FAILS, ENSUING LITIGATION OFTEN PITS TRUSTEES IN BANKRUPTCY AGAINST THE BANKRUPT'S AUDITORS
From a public accountant's perspective, business failure litigation can be either bane or boon depending on one's area of practice. Litigation over the collapse of a corporation can put bread on the table for those in forensic accounting. Insolvency practitioners, who marshal the assets of bankrupt business entities for the benefit of creditors, are also accustomed to litigating fraud or negligence claims arising out of the bankruptcy. On the other hand, all too often the failure of a business has been blamed on the negligence of its auditors. Professionals engaged in audit practice are well aware that they can be targets of negligence lawsuits should their clients become bankrupt. One can often characterize business failure litigation as claims brought by accountants against other accountants (with teams of accountants retained as experts by both sides).
Accountants should be aware of an emerging issue in such litigation. It concerns the statutory investigative powers given to trustees in bankruptcy to assist them in assessing and amassing the assets of a bankrupt. A recent decision of the Ontario Superior Court of Justice illustrates how the courts attempt to balance the breadth of the trustee's investigative powers against the privacy rights of the potential targets of litigation, particularly when the targets in question are the bankrupt's auditors.
In GMAC Commercial Credit Corp.-Canada v. TCT Logistics Inc. (2002), 37 CBR (4th) 267, 2002 CarswellOnt 3678 (Superior Court — Commercial List), the court was required to rule on the enforceability of a demand for documents served by the trustee in bankruptcy upon the auditors of a bankrupt corporation. In this case, there was no need for the auditors to worry in the abstract that they might be potential defendants in a negligence suit relating to the failure of the corporation. The trustee had made it clear in its demand letters to the auditors that the trustee's purposes in demanding production of working paper documentation included the consideration of potential litigation against the auditors. Of course, the trustee was at liberty to commence a negligence action against the auditors at any time and would in that case have had access to the very broad documentary production and discovery rights that flow from Ontario's Rules of Civil Procedure. What concerned the auditors about the procedures the trustee proposed to use in the TCT Logistics case, however, was that the trustee intended to review the auditors' working papers before instituting proceedings. In doing so, the trustee relied upon its statutory powers set out in section 164 of the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B.3 to review any records that relate to the bankrupt (including the records of third parties). Aside from proposing to use these investigative powers to review auditors' documents in connection with the trustee's normal administration of the estate, however, the trustee also candidly indicated that it proposed to use this review to assess the merits of a potential lawsuit against the auditors. In other words, the trustee was attempting to conduct pre-litigation discovery. Not many prospective plaintiffs enjoy an opportunity to fully review the private records of a prospective defendant before making a decision about commencing a lawsuit, but the trustee argued its statutory powers gave it that right.
In addition to this (and to make matters worse from the auditors' perspective), the trustee also indicated that it intended to allow creditors of the estate to review the auditors' documents. Needless to say, such creditors (who were faced with a significant shortfall in the estate) were keen to see if the auditors might be to blame for the mess. From the trustee's viewpoint, the creditors were arguably its clients, the persons on whose behalf it was carrying on its mandate; it did not appear appropriate for the trustee to see documents that creditors would not be permitted to see as well. Why should creditors not be able to use such documents to advance their own claims against the auditors?
Although creditors' claims against auditors of a business have faced legal hurdles in recent years following the Supreme Court of Canada's decision in Hercules managements Ltd. v. Ernst & Young, [1997] 2 S.C.R. 165, these hurdles are not insurmountable. There is no question that a creditor with a shortfall looks at a potentially negligent auditor with hungry eyes. Giving such creditors access to their working papers is usually the last thing the auditors of a failed business want to do. After all, a trustee in bankruptcy may only advance a claim against the auditors "in the shoes of" the bankrupt company itself and the auditors may therefore raise any defence that would have been available had the business itself sued them. For example, the auditors may argue that the business failure was caused by the client's negligent business activities and not by inaccuracies in its financial statements. Moreover, to the extent that a business's financial statements are inaccurate, the business itself must bear primary or partial responsibility for the contents of those financial statements. Creditors, on the other hand, can argue legitimately that they rely upon audited financial statements in choosing to advance credit. What is more important, creditors' losses are often very tangible, normally the full extent of any shortfall in recovery that they experience. Creditors' claims are simple: "Had the audited financial statements been properly audited, I would not have advanced money to this business." Notwithstanding the legal hurdles, creditors' claims have a brutal simplicity that can make them tough for an auditor to defend and expensive to lose.
Justice Farley of the Ontario Superior Court of Justice's Commercial List was required to rule on the auditors' objection to producing their documents to the trustee in these circumstances. The auditors' first argument was that the trustee itself ought not to be allowed to review the working papers both for an admittedly reasonable purpose (its administration of the bankrupt's estate) and for a completely different purpose (to consider a lawsuit against the auditors). The auditors relied on a legal doctrine known as the "implied undertaking." This doctrine protects the privacy of parties who are involved in litigation and who are therefore required to make full disclosure to their opponents of all facts and documents in their possession relating to the lawsuit. The implied undertaking in ordinary litigation prevents a party who obtains information through this discovery process from using such information for any purpose other than the prosecution or defence of the lawsuit itself. The auditors attempted to import the implied undertaking into bankruptcy proceedings, and they asked Justice Farley to rule that any information obtained in the course of the trustee's normal investigation and administration of the estate could not be used by the trustee for the purpose of commencing litigation against the party who was compelled to produce the information. Justice Farley did not accept this conclusion, however. He held that the implied undertaking was limited to matters of ordinary civil procedure, did not extend into the federal bankruptcy regime and did not restrict the powers of the trustee that flowed from that regime. This approach to bankruptcy investigations found an echo in a similar ruling last year (albeit within the very different English procedural regime) by the English Court of Appeal in Sheirson v. Rastogi, [2002] E.W.J. No. 5034.
However, Justice Farley did give more weight to the auditors' concern about the trustee providing copies of working papers to creditors and gave the auditors the relief that they sought in connection with this issue. While the trustee was entitled to obtain the benefits of its broad investigative powers for the benefit of the estate, it was not entitled to simply turn the fruits of its investigations over to individual creditors to use for their own purposes. After all, the trustee is mandated to act for the benefit of all creditors as a group and is therefore obliged to marshal the estates' assets (including proceeds of litigation) for the benefit of all creditors. To the extent that individual creditors were to bring lawsuits seeking to recover their own losses against those who had dealings with the bankrupt, this might diminish the pool of assets available to pay the trustee's claims. By helping some creditors out with their individual actions, the trustee might thus undermine the position of the other creditors. Relying in part on a previous decision of Justice Burnyeat in British Columbia, Re: Taylor Ventures Ltd. (1999), 60 BCLR (3d) 348; 9 CBR (4th) 136, 1999 CarswellBC 97 (S.C.), Justice Farley held that an informational barrier, or wall, would have to be erected around the information coming into the hands of the trustee. While the designated inspectors of the estate would have the right to review this information in order for them to oversee the trustee's actions,
to the extent that these inspectors were themselves creditors, or else representatives of creditors, they were forbidden to use the information for any other purposes. Specifically, inspectors were not permitted to use any information they obtained for the purpose of advancing the independent claims of creditors against other parties.
From a practical perspective, the application of this principle may put a halt to trustee's demands for working papers generally, or at least reduce the number of such demands. Often the driving force behind such demands is the desire of individual creditors (who are often funding the bankruptcy proceedings) to see if there is a potential target for their own claims. The problem that now faces such creditors is that if the trustee does obtain this precious information, creditors may have to avoid seeing it. If they see it, they may find that they have raised a bar to their own claims by doing so. The auditors will argue that creditors who have a peek become tainted with knowledge acquired through the results of the trustee's investigative work. Such creditors may thus be precluded from bringing a lawsuit against the auditors, even if they had all the merits on their side in such a claim.
Stephen Lamont, MA, LLB, is a lawyer with Morrison Brown Sosnovitch LLP in Toronto
Technical Editor: Mindy Paskell-Mede, BCL, LLB, is a partner with Montreal law firm Nicholl Paskell-Mede |
