The blame game

By Mindy Paskell-Mede

When management fails to act in good faith in the best interest of the company, just who can or can’t be sued?

As directors of companies find themselves more in the spotlight and as discussion as to what proper corporate governance involves keeps growing, the
respective responsibility of ac­­countants and directors is gaining the attention of litigants. When management of the company misrepresents the financial situation or
misappropriates the company’s assets, who is at fault? Between the company’s directors and outside accountants, who can be sued and what will their relative contributions be?

This issue is even more important in situations where defendants are not held jointly and severally liable to the plaintiffs but are only required to pay that portion of the damages attributable directly to their own misconduct. (In joint and several regimes, which govern most civil lawsuits in Canada, once a defendant is found to have caused any part of the damages suffered by the plaintiff, he or she can be obliged to pay the entire award, with the ability to sue others who contributed to that damage, assuming they are sufficiently solvent.) There are a few Canadian statutes that establish a regime that is not entirely joint and several, and British Columbia’s Negligence Act is one of them.

The issue of the comparative liability between nonexecutive directors and the company’s accountants was discussed at length in the case of San Jose Mines Ltd. et al v. Coutu Estate et al, in the context of a third-party action taken by the defendant accountants against the companies’ outside directors and shareholders. Justice Pitfield, in a decision rendered on January 18, 2006 (corrected on January 24) on a motion to dismiss that third-party action, found in favour of the defendant accountants, permitting them to go forward with their action. The test on a preliminary motion to dismiss, such as this one, is whether or not the third-party action described in the defendant accountants’ pleading has a chance of success or is doomed to fail. Therefore, although the judgment does not mean that liability will be found, it states that the accountants have the right to pursue the directors and shareholders.

The litigation arose out of what the plaintiff companies characterized as illegal activities of the president of the principal company in the group, who was also a director. It is alleged he conducted some secret business transactions on behalf of the plaintiff companies without informing other directors and shareholders. It is also alleged that he and his family improperly benefited from these transactions.

In the principal action, the plaintiffs sued the president for failing to act honestly and in good faith in the best interests of the company. They allege he went so far as to represent himself to various regulatory authorities as the sole beneficial shareholder and sole officer and director of one of the plaintiff companies.

The plaintiffs also sued the accountants who had been engaged to prepare financial statements and to provide tax, investment and business advice. They assert that the accountants provided advice to the company president with respect to these illegal transactions. They also assert that the financial statements improperly recorded the misappropriations. It is alleged that the accountants knew the company was not family-owned, that the other directors did not know about these transactions and that the president’s family members had not been properly appointed as directors or officers. (It does not appear from the judgment that the plaintiffs alleged that the accountants actually knew the transactions were unauthorized or that the ultimate beneficiaries were the president and his family.)

The accountants assert they had no knowledge that the president was acting outside his authority in concluding the transactions and that they were not negligent in failing to detect any irregularities. They then sued the outside directors, alleging the directors should have known that the defendants had been engaged to act on behalf of the corporate entities, should have known of the major transaction engaged in by the president, and failed to alert the accountants to the fact the president was acting outside his authority, if that was indeed the case.

The accountants allege that the directors performed none of their duties, other than to sign approvals of various agreements. If the president lacked legal authority, then the directors are responsible, either because they abdicated their duties or because they approved the president’s actions, leading the accountants to reasonably believe the president’s actions were authorized. The accountants allege that the directors ought to have participated in the companies’ activities, convened required meetings, prevented the president from engaging professionals and instructing them in a manner outside his authority, and warned the accountants about any unauthorized activity. It is asserted that the directors failed to supervise the president’s activities, failed to supervise dealings with the companies’ assets and signed critical documents with insufficient knowledge as to what they represented.

At this juncture of the proceedings, prior to any evidence being adduced, the outside directors took an application to have the third-party claim against them struck. To be successful at this stage, they would have been required to demonstrate that in law, there was no prospect that the third-party claim could succeed.

First, they asserted because the defendant accountants have alleged contributory negligence on the part of the plaintiff companies, they can only be held liable for their share of the damages. Therefore, the defendant accountants can’t claim contribution from the directors. Logically, no part of the amount awarded against the defendant accountants could be attributable to breaches committed by the directors, as a result of the lack of joint and several liability in such circumstances. Second, they argued they are being sued as directors of the companies and so any acts committed by them are, at law, acts of the companies. This, they say, shields them from personal liability.

The judge addressed each of these arguments in turn. The court agreed that if at trial it were ultimately determined that the plaintiffs were in fact contributorily negligent, there would be no need for the accountant defendants to seek contribution from anyone else. By virtue of BC’s Negligence Act, “each person at fault would be severally liable for the damage occasioned by that person’s fault only.” However, because that determination would be made only at the end of the trial, the defendants were not prevented from suing other persons allegedly at fault.

This is where the directors’ second argument is critical. If in fact they were acting merely as agents of the plaintiffs, then the question of their liability could be pleaded as part of the defence against the plaintiffs. If the directors’ conduct was culpable, the plaintiffs would simply never collect that portion of the judgment attributable to that culpability in the first place.

The judge agreed that this was the correct principle to apply. However, to the extent that the defendant directors failed in their duties as directors, the defendant accountants might succeed in demonstrating that this materially contributed to the loss. If this were ultimately the determination of the underlying case, the directors would have to contribute to the judgment award.

The court also pointed out that each director is accused of having negligently omitted to warn the accountants that the president may have been acting without appropriate authority. It is possible the directors have a duty to the accountants, and if so, there might have been a breach of that duty, giving rise to a cause of action. Such an action would be against the directors personally and not in their role as agent.

One would imagine the same results would apply, even more straightforwardly, in a case governed by the joint and several liability regime
In those circumstances, even if a plaintiff were to be found contributorily negligent, it would still be entitled to execute judgment for the full amount of its damages from any one of the defendants alone, leaving them the risk of collection from others who might be as culpable.

Mindy Paskell-Mede, BCL, LLB, is partner at Nicholl Paskell-Mede in Montreal. She is Technical editor for Law