Who’s at fault?

By Trevor McCann
Illustration: Gary Clement

When auditors fail to detect fraud, it’s vital they have the proper representation letters from the client

In a decision rendered last year in Hart Building Supplies Ltd. v. Deloitte & Touche, the British Columbia Supreme Court held that a company cannot claim against its auditors for losses flowing from a fraud committed by its “directing mind,” that is, the individual managing or controlling the conduct of a corporation in the course of its business. It also underlined the importance of auditors obtaining proper representation letters from their clients and dem- onstrated the assistance those letters can have in liability claims against auditors concerning their alleged failure to detect management fraud.

In 1995, Garibaldi Building Supplies Ltd., a building supply store in Prince George, BC, was in receivership. Calvin Larson was general manager of Garibaldi, which was controlled by Transcontinental Investment Corp. Trans-continental created Hart Building supplies for the purpose of acquiring Garibaldi’s asset from its receiver, including Garibaldi’s inventory, land and building. According to the deal, Transcontinental would control a majority of Hart’s shares. Larson was to be kept on and would acquire 15% of Hart’s shares. Larson also became a director of Hart and president and general manager. He directed all Hart’s operations and all Hart employees reported to him, including the company’s controller. Larson also designed and implemented internal management systems and controls and had authority to sign contracts on behalf of Hart.

Deloitte & Touche was retained to conduct audits of Hart for each of the financial years ended January 31, 1996 through 2000. For each of those years, Larson signed representation letters to the auditors on behalf of Hart. Those representation letters included statements that Hart acknowledged its responsibility for presenting the financial statements in accordance with GAAP, that the financial statements were free of material errors and omissions and that there had been no irregularities that involved management or employees that could have a material effect on the financial statements. The representation letters also included Hart’s recognition that there was a risk material fraud may not be detected by the audits and an express statement that all excess or obsolete inventory had been identified by the company and that no inventories were stated at an amount in excess of net realizable value.

In September 2000, Hart was placed into receivership. Larson confessed to management of Transcontinental that he had been falsifying Hart’s inventory records in each year of its operations by altering written records of physical inventory counts to match computerized inventory records. The overstatement included an original overstatement at the time of Hart’s purchase of Garibaldi’s assets from Garibaldi’s receiver and increased over time, since Hart did not write off damaged or obsolete inventory, inventory lost as a result of theft and donations of inventory to local charities.

At the outset of litigation, both Trans-continental and Hart brought suit against the auditors, Deloitte & Touche, alleging they negligently and in breach of contract failed to detect the fraudulent overstatement of inventory by Larson in the course of their audits. Transcontinental discontinued its claim on the grounds the auditors owed it no duty of care and Hart continued the suit alone.

The auditors brought a motion for summary judgment, seeking dismissal of Hart’s claim on the basis of the “corporate identification doctrine,” which holds that the fault of a director who is active in the management of corporation is the fault of the corporation itself.

The court referred to a discussion of the doctrine in the Supreme Court of Canada decision in Canadian Dredge and Dock Co. Ltd. v. The Queen (1985), a case dealing with corporate criminal liability. In that matter, the court held that the defendant companies were criminally liable for the bid-rigging carried out by their managers. The court held that the fraud must be that of the directing mind of the corporation (although there may be more than one) and that the person must be acting within the scope of his or her authority in carrying out assigned functions within the corporation. In respect of this last criterion, the court held that the action must be within the field of operation assigned to the individual and not “totally in fraud of the corporation,” in that it was either by design or in result partly for the benefit of the corporation.

In the Hart case, the court found without any difficulty that Larson was the directing mind of Hart. The court also found that there was no doubt that Larson’s dealings with the recording of inventory and with Hart’s computer systems were within the scope of his normal functions and authority with the corporation.

Hart counterargued that the company ultimately did not benefit from Larson’s misrepresentations of its financial situation. The court found that submission could not succeed, given the law as set out in the Dredge case, since the corporation will be liable for the fraudulent or wrongful act of its directing mind unless the wrongful act was totally in fraud of the corporation. In fact, Larson had testified that he intended to keep Hart afloat during difficult financial times in the Prince George region. Further, he did not receive any personal benefit from his actions other than a continued salary from Hart.

Hart also submitted that the court should refuse to apply the corporate identification doctrine for policy reasons underlying tort law, since Hart was a victim of Larson’s deception. It cited authority that courts may refuse to attribute the actions of a directing mind to a corporation where recovery by the plaintiff would properly compensate the victims of the wrongdoing and deter future wrongdoing.

After making reference to the Dredge case, the judge referred to the representation letters given by Hart to the auditors and stated: “If it was open to this court to consider whether the objectives of tort liability will be met by dismissing Hart’s claims in the circumstances of this particular case, I would conclude that those objectives favour the defendant’s position. In the circumstances of this case, Hart’s auditors are also victims of Larson’s deception.”

Hart’s claim against its auditors was dismissed without the court examining the audit work on inventory conducted by the auditors.