Sunday, August 16, 2009

Moore Stephens: Extending Protection for Auditors

Moore Stephens v. Stone & Rolls might well be the most important case on auditors' liability since Caparo v. Dickman . The House of Lords, by a narrow majority, extended the protection which Caparo offers to auditors even further.
The facts, as detailed by Lord Phillips, were that the sole “directing mind” of a company used the company as a vehicle for defrauding certain banks. The fraud was discovered and the company was successfully sued for deceit by the principal victims (a bank). Moore Stephens were the company’s auditors. The auditors accepted for the sake of argument that they were in breach of their duty to the company. They also accepted that, but for their breach, the fraud would have ended earlier, meaning that the company’s liability for deceit would have been lesser. The company (now in liquidation) sought to recover its losses from the auditors. The auditors contended that the claim could not succeed because it was founded on the company’s fraud and was barred by the maxim of ex turpi causa non oritur actio. Essentially two issues arose. First, as a matter of law, what is the correct test to apply in deciding whether a fraud of the “directing mind and will” will be attributed to the company? Secondly, assuming that the directing mind’s fraud is in law attributed to the company, does the ex turpi causa principle bar all claims – including claims against auditors who were appointed to do the very thing of detecting the fraud?
The first issue turns on principles of attribution developed since Lennard’s Carrying Co. v. Asiatic; the second on the absoluteness of the ex turpi causa rule as expressed in Tinsley v. Milligan. It was held that a directing mind’s fraud will be attributed to the company in all cases, except where the fraud was played directly on the company. If the company is a vehicle of the fraud, as opposed to the victim of the fraud, the directing mind’s fraud will be attributed to the company. This would mean that the fraud of the directing mind is, in law, the fraud of the company. Once such attribution occurs, the principle of ex turpi causa would apply. The auditors were appointed for the very thing of detecting the fraud. Yet, when the company brings a claim against them for negligence in failing to detect the fraud, they can rely on the ex turpi causa rule to prevent the company from pursuing the claim. The only exception to this is if the company shows that it was the direct and primary victim of the fraud. In other words, if a company’s directing mind has committed a fraud using the company as a vehicle, then the company cannot bring a claim in negligence against the auditors for failing to detect the fraud.
Caparo v. Dickman had ruled out auditors' liability in cases of claims by third parties, unless the third party could show the existence of a “special relationship”. Moore Stephens has restricted liability even further. Auditors will be liable only if the directing mind’s fraud is targeted at the company; and not in other cases. Even the fact that the company has appointed an auditor for the very purpose of detecting such frauds would not allow the company to bring a claim against the auditors.
Courts have been hesitant in enforcing auditors’ liability – the policy reason typically is that Courts will not (in Justice Cardozo’s words) put auditors under a liability “in an indeterminate amount to an indeterminate class for an indeterminate time”. Caparo’s foundations were in this policy reason. But Moore Stephens – by refusing to draw exceptions to the ex turpi causa rule – goes even further; in certain cases, auditors will not be liable even to the company which appoints them.

1 comment:

vswaminathan said...

May be, the view taken is of a ‘narrow majority’ of the HL. Nonetheless, it goes to serve some really good food for thought – especially, for our legal fraternity. On the first blush, the line of reasoning, to be precise- the rationale behind the court’s view, seems to be after all not but fair, rather represent a better practical /pragmatic and down-to-earth approach. No doubt, one needs to know what is the existing judicial view, if there be, of the Indian courts in the matter. That may propel one to have a fresh look at among others the controversy over the auditors’ legal responsibilities, which has lately surfaced, and is still kept alive, particularly in the aftermath of the notorious ‘Satyam episode’.

vswaminathan