Obligated to reveal

By Mindy Paskell-Mede

A securities regulator’s ruling may affect how the courts see liability of directors and auditors in civil liability cases

On December 21, 2006, the Alberta Securities Commission rendered a decision in J. Gordon Ironside Re, 2006 ABASC 1930 in respect of the conduct of the CEO and CFO of a publicly traded junior oil and gas company in 1997 and 1998. The judgment is more than 300 pages and touches on many issues, some of them quite technical. However, at the heart of the decision is the standard placed on executive directors to ensure that appropriate disclosure is made in securities filings. Of particular interest to accountants, the decision discussed in depth the scope of the directors’ duties towards the company’s auditors.

The comments by the com-mission, although not binding on civil courts, may nevertheless be instructive in liability suits against auditors. Canadian courts have already ruled that a company cannot complain about the auditor’s performance if the company’s “directing mind” committed fraud of which the auditor is victim (see, for example, “Who’s at fault?” June 2005, Law). The commission, by detailing the interplay expected between company representatives and its auditors, may assist civil courts further in identifying what the company is obliged to reveal.

In short, the commission concluded that the CEO and CFO of the junior oil and gas company had denied the marketplace a true picture of the company’s performance and made material misrepresentations or failed to disclose material facts and changes. The commission ruled that these individuals therefore “compromised their duty to act honestly and in good faith in favour of their own self interests — the preservation of their positions with [the company].”

The specific disclosure issues concerned, in part, the company’s statements of its oil and gas reserves, which are estimates and therefore not capable of precise quantification. It was accepted that the calculation is complex and not necessarily evident to the uninitiated. Nevertheless, the commission stated directors and officers are not permitted to claim naiveté, particularly when the company’s extensive public disclosure indicates otherwise. The CEO and CFO had the responsibility of obtaining an adequate understanding of the matters being disclosed. Although not couched in the language normally used in civil liability cases, this is akin to saying that reliance on experts cannot be in good faith if the director or officer has not bothered to learn enough about the company’s business either to meet the expectations of his or her knowledge as touted by the company’s publications, or to recognize whether the technical disclosures make sense.

The commission also commented on how to make disclosures where there are choices as to measurement. It stated if a company uses a measurement to report its assets (in this case gas reserves) that differs from industry norm, that in itself is not problematic. However, where the difference is material, then this fact must be disclosed.

The commission also considered the fact that the gas reserves are estimates. Although it agreed that forecasts and estimates are not facts, it indicated that estimates are based on underlying facts and therefore implicit representations are being made. Where the underlying facts change, there is a positive obligation to disclose the change, if failure to do so would render other disclosures misleading.

The commission also commented extensively on the relationship among the company, its representatives and the auditors, as one of the defences raised was the fact that the auditors had not detected an issue with the company’s disclosures. The commission determined, however, this was no excuse. The commission emphasized that both the CEO and CFO held professional designations as CAs and one held a law degree. Whilst recognizing that all directors and officers owe similar duties to the companies they serve, on numerous occasions the commission indicated this professional background meant the individuals knew better than what their defence position would imply. Expectations may differ based on each director’s background, experience and other qualifications. Specific reference was made to various recommendations in the CICA Handbook, and the commission observed that these are the rules that had to be applied by the firm in the presentation of its financial statements and therefore by the individuals responsible for their preparation. In other words, the CEO and CFO knew the requirements of generally accepted auditing standards, knew that the representations being made were the firm’s and knew the extent to which the auditors were entitled to rely on them.

One of the findings against the individuals was that they had actively and deliberately misled their auditors by removing various agreements from closing binders and failing to give all the relevant documents concerning various transactions to their auditors. They gave the auditors a memo that mischaracterized the transactions and failed to point out discrepancies to the auditors, despite having issued a standard form management representation letter stating that the auditors had been given complete access. The CFO had an obligation to give all relevant documents to the auditor and it was not up to the CEO to determine whether various items were material or would have made a difference to the auditor’s assessments.

The commission held that by embarking upon a deliberate scheme to deceive the auditors, the CEO and CFO were breaching their duty to act in good faith vis-à-vis the company. The following passage summarizes the commission’s attitude:

“We find that [the auditor] did not have all of the relevant, material information about the Leases when it completed the 1996, 1997 and 1998 Audits. We find that [the auditor] was denied the ability to exercise its professional judgment in evaluating the accounting treatment Former Management applied to the Leases.

“These are very serious findings. There can be no dispute as to the crucial role played by auditors in public companies. The relationship between the Company and its external auditors is one necessarily based on trust. Auditors assume that when they conduct an audit, management has been and will be forthright and provide them with all the information necessary to assist the auditors in forming an independent opinion on the financial statements. ...

“The Respondents betrayed that trust and assumption of good faith. They deliberately concealed relevant documents and misled [the auditor].

“We do not expect, accept or tolerate this behaviour from directors and officers of any issuer.”

It will be interesting to see whether Canadian judges take note of these comments from the Alberta Securities Commission in determining relative liability of directors and auditors in civil liability cases.

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