15 January 2008

Accounts, fraud and auditors’ liabilities

Facts of the Case

The Western Star Group (Western Star) sold its wholly owned subsidiary ERF (Holdings) Plc to Man Nutzfahrzeuge AG (MN) on 8 March 2000 for £65.3 million.  The UK firm of Ernst & Young had in March 1991 been appointed and continued to act as auditors for ERF Holdings Plc and its subsidiary ERF Ltd, which manufactured trucks in the UK.

Western Star was acquired by Freightliner LLC in June 2000, after the sale of ERF (Holdings) Plc had been completed and thereafter became responsible for the liabilities incurred by Western Star in its sale of ERF (Holdings) Plc and its subsidiary together ERF.

It was common ground at the trial before Lord Justice Moore-Bick that Mr Stephen Ellis, the financial controller of ERF, had from about the middle of 1997 persistently manipulated the accounts of ERF by submitting false VAT returns with the result that ERF received regular repayments of tax to which it was not entitled.  There were false journal entries in the purchase ledger control accounts which Mr Ellis disguised by producing a false reconciliation between that and the purchase ledger itself.  Ernst & Young failed to spot this and signed off the audit for the years ending 30 June 1998 and 30 June 1999 on 4 May 1999 and 4 November 1999 without qualification.

In August 1999, representatives of MN and Western Star met to open negotiations and to discuss a method for establishing a price for ERF.  Mr Ellis was present at that meeting and at subsequent meetings between MN and Western Star.  Specifically, the trial judge held that Mr Ellis answered many questions put by MN and its auditors Deloitte & Touche at a meeting in November 1999 without at any time informing the management of ERF or Western Star, much less those representing MN, that the accounts had been falsified.

Deloitte & Touche in the course of their audit of the 31 December 2000 accounts of ERF identified the discrepancy between the purchase ledger and the purchase ledger control account, which, investigations revealed as at 30 June 2001, amounted to about £100 million.

MN and other related claimants successfully brought proceedings in 2002 to recover from Freightliner the losses incurred by MN arising out of the purchase of ERF.  Their claims were based on deceit.  They also made a claim under the share purchase agreement for fraudulent misrepresentations by Western Star.  The trial judge held that such misrepresentations had not been made fraudulently by Western Star (and that Mr Ellis’ knowledge of the falsity of the accounts could not for this purpose be imputed to Western Star) with the result that this claim was time barred under the terms of the share purchase agreement.  The right to pursue a claim in deceit in respect of statements made outside the share purchase agreement was however held to be unaffected by the terms of that agreement.

Freightliner brought (Part 20) proceedings in May 2003 against the UK firm Ernst & Young which failed at first instance and Freightliner appealed to the Court of Appeal.  Cutting across the “careful and elaborate” arguments of counsel, Lord Justice Chadwick, giving the judgment of the court, found that “the real issue on this appeal is whether the knowledge of Ernst & Young (as found by the judge) was sufficient to found a duty of care to Western Star (and, so far as relevant, to MN) in relation to the loss which was actually suffered”.

The Decision

The court saw the determinative issue as whether the judge, having found that it was foreseeable that Western Star would rely on the accuracy of the accounts in its dealings with MN, was wrong to hold that it was not foreseeable that the nature of Mr Ellis’ participation in the negotiations would give rise to Western Star incurring a liability to MN for fraudulent misrepresentation. 

The court placed particular emphasis on the key passage of Lord Bridge of Harwich, in Caparo Industries v Dickman [1990] 2 AC 605 as endorsed by Lord Hoffman in South Australia Asset Management Corp v York Montague [1997] AC 191:

“It is never sufficient to ask simply whether A owes B a duty of care.  It is always necessary to determine the scope of the duty by reference to the kind of damage from which A must take care to save B harmless”; and followed the guidance given by the House of Lords in Customs and Excise Commissioners v Barclays Bank PLC [2006] UKHL 28. There, Lord Hoffman summarised the position:

“In cases in which the loss has been caused by the claimant’s reliance on information provided by the defendant, it is critical to decide whether the defendant (rather than someone else) assumed responsibility for the accuracy of the information to the claimant (rather than someone else) or for its use by the claimant for one purpose (rather than another)”. 

Was there in relation to the loss in question “the necessary relationship (or proximity)”?  That relationship “and the forseeability of economic loss will make it unnecessary to undertake any further inquiry into whether it would be fair, just and reasonable to impose liability”.

The claim failed.  The court refused to hold that the auditors had assumed responsibility for the use of which a dishonest employee of the audited company might make of the accounts in the context of the parent company’s obligations for the sale of the company. 

Adapting the test in the Barclays Bank case the court held that “it is impossible to hold that Ernst & Young (rather than Western Star) assumed responsibility for the use by Mr Ellis, on behalf of Western Star, of the information which Ernst & Young had provided to Western Star.”

Points of Interest

As in any fraud, those who have suffered large losses look for deep pockets.  Ernst & Young as auditors who, in breach of their duty of care, failed to discover a very large discrepancy between the purchase ledger and the purchaser ledger control account when signing off an audit, were an obvious target. 

In this case ERF had arguably suffered no loss (as the sums owed were as a result of ERF’s prior receipt of tax repayments to which it was not entitled); but while its parent company Western Star had, it had also (as must be commonplace), allowed the financial controller of its subsidiary, Mr Ellis, to participate in relevant meetings during the sale negotiations.  This allowed the court to attribute the cause of Western Star’s loss to Mr Ellis’ misrepresentations outside of the share purchase agreement rather than the failure of Ernst & Young. 

The lesson here must be for a company to review carefully the terms upon which auditors are engaged, so as to ensure that it and its shareholders are fully indemnified against claims from specified third parties such as banks, lenders and purchasers of that company’s share capital who may rely on any representation (however given) that the audited accounts give a true and fair view of the assets, liabilities and financial position of the company as at the date of the audit.

Category: Article