Favoring auditor protection

By Frank Bowman & Meghan L. Thomas
Illustration: Mike Constable

Recent rulings say auditors can't be held negligent because they didn't answer a question not asked of them

Since the Supreme Court of Canada's 1997 decision in Hercules Managements Ltd. v. Ernst & Young, shareholders, creditors and other third parties have repeatedly pursued actions to stretch the limits of the duty of care test established by Canada's highest court. The latest word in this arena comes from Ontario's Court of Appeal, which in Waxman v. Waxman strongly reaffirmed that auditors will not be liable to individual shareholders of their corporate client unless the mandate of the auditor has specifically been expanded beyond its usual role. Framing a claim as a "failure to warn" or trying to distinguish the situation because the company is closely held or the auditor-client relationship is long standing will not exempt a plaintiff from having to show that the auditor knew the shareholder would be relying upon the auditor for a purpose other than the customary audit retainer and that the auditor agreed to expansion of mandate.

Brothers Chester and Morris Waxman were each 50% sharehold- ers in and officers and directors of I. Waxman & Sons (IWS), a company started by their father, Isaac. IWS had used one accounting firm for many years to perform auditing services. However, the accountants had provided other discrete services, including preparing tax returns, advice on an estate freeze and assistance with special IWS projects, to individual members of the Waxman family. In late 1983, Morris sold his shares in IWS to Chester (later claiming the sale was inadvertent, disadvantageous and against his wishes). Morris later discussed the share sale with IWS' auditors and was advised to immediately seek independent legal advice — but he waited until 1988 to do so, hoping to "work things out with Chester."

Morris eventually sued Chester, and an action against the auditors soon followed. He claimed he did not know he had sold his shares and was duped into doing so by Chester. Morris claimed that the auditors should have told him about bonuses paid to Chester and his family and rates charged by Chester's sons' trucking companies and if they had, he would have become suspicious about Chester's activities and could have avoided the share sale. Since Morris had never read the financial statements prepared by the auditors, he could not claim negligent misrepresentation. Therefore, he alleged that the auditors failed to warn him about disadvantageous transactions (bonuses and trucking rates) and owed him a personal or fiduciary duty based on a longstanding relationship to IWS and the Waxmans.

After a trial, which lasted more than 200 days, the judge found the auditors to have been negligent in failing to include a related-party note on IWS' financial statements or for failing to warn Morris of related-party transactions. Chester's son Robert was running both IWS and Greycliffe, a related trucking company, and the trial judge closely scrutinized these transactions despite the auditors' assertion that all relevant personnel at IWS, including Morris, were aware of Robert's involvement and the payments being made to Greycliffe. However, although the auditors admitted that Morris and Chester were the real clients (since IWS was really a two-person company) and they had an extremely close relationship with the Waxmans, ultimately the auditors were held not liable based on the test established by the Supreme Court  in Hercules because Morris never told the auditors he was relying on them to influence his personal financial decisions and that was not the purpose for which the audit was performed. The trial judge also found that the auditors did not owe a fi-duciary duty to Morris because their man-date was not expanded to specifically protect his personal interests; the auditors' duty of care was owed to their client, IWS.

Had there been a duty of care, the trial judge held that the auditors would have been found to have breached it by failing to speak to Morris about the related-party transactions and also about very large bonuses that had been reallocated to members of Chester's family. If Morris had been told of these matters, the court opined that would have caused him to become suspicious of Chester and he would have sought independent advice and/or spoken to his son, Michael, regarding the bonuses and profit diversions. Consequently, the share sale would not have occurred because Morris would no longer have blindly signed documents offered by Chester. The findings made at trial regarding the effects of Morris's ignorance about the management of IWS finances show the strength of the Hercules principle; were it not for Hercules, the auditors would have been liable for virtually the same damages as Chester.

Morris appealed the application of Hercules as against the auditors and argued that Hercules was applied in error. He argued his loss was unique and that the auditors had a duty to warn him that his 50% interest was being inexplicably and significantly eroded by the bonuses and trucking rates. He also asserted that the long duration of the auditors' services to the Waxmans and IWS created a fiduciary relationship to Morris.

In a decision released on April 30, 2004, the Court of Appeal for Ontario dismissed Morris's appeal against the auditors. The court reaffirmed that the Hercules case is simply one example of the test for the duty of care in negligence cases established by the Supreme Court of Canada and known as the Anns test, since modified in 2001 in the case of Cooper v. Hobart. A duty of care will only be found to exist where there was a relationship of proximity between the plaintiff and the defendant, the harm that occurred was a reasonably foreseeable consequence of the defendant's acts, and there are no policy considerations in the context of the relationship of the parties or the broader legal context that dictate that a duty of care should not be found to exist.

In Waxman, the Court of Appeal found that policy considerations negated any duty of care owed. Although the auditors had a close relationship to Morris and an obligation to be mindful of his legitimate interests, their function as auditors was to permit the shareholders to oversee management decisions and not to assist them in making individual investment or business decisions. To hold that the auditors had a duty to prevent Morris from being cheated by his brother would expose the auditors to indeterminate liability (here, more than $50 million accrued over more than 10 years). The auditors never undertook a personal mandate to Morris because they were never asked to. Furthermore, such an undertaking would have put the auditors in a conflict of interest position in having to serve the interests of one shareholder over those of the other and potentially act as a whistle-blower with respect to an important corporate client.

The auditors were also found not to have had a fiduciary duty toward Morris personally, as they did not have power or discretion with respect to his personal interests. Morris had never asked the auditors for personal or business advice; in fact, Morris and Chester had typically made decisions about the business without consulting the auditors. Morris's long-term relationship with the accountants was not enough to give rise to a duty of care or a fiduciary duty to him personally.

The Waxman decision represents a significant development in the continuum of auditors' liability jurisprudence in Canada. Although the decision of the Supreme Court of Canada in Haig v. Bamford, in which accountants were held liable to a third-party investor for whose use audited financial statements had been prepared, has never been explicitly overruled, [in our view] its application has been substantially circumscribed by Hercules and similar authorities. Waxman confirms that the Su-preme Court's more stringent test for duty of care in Cooper is not only relevant in cases where a novel fact situation is presented, but also in the oft-litigated realm of auditors' liability. Foreseeability and reliance are not enough; auditors must be given an opportunity to protect themselves against liability. The Court of Appeal has made it clear that, in order to establish liability outside the traditional audit mandate, a task beyond that mandate must be explicitly requested and accepted. Waxman seems to adopt the reasoning behind the dissenting judgment in Kripps v. Touche Ross & Co. that auditors can't owe a duty to go beyond what was required by their terms of engagement or be held negligent because they failed to answer a question that was not asked. Hopefully this judgment will protect auditors from becoming victims of hindsight in future cases as well.