eCaseNote 2014 No. 03

On Tangled Webs: Expanding Auditor’s Requirements for Negligence

Livent Inc. v. Deloitte & Touche LLP, 2014 ONSC 2176

Brief Summary of Events

Livent Inc. (“Livent”) was formed in 1993 as an entertainment and theatre production company. In 1998, as part of a private placement, the two founders of Livent, Garth Drabinsky and Myron Gotlieb, agreed to let two investors appoint part of a new board of directors. Robert Webster was appointed to the role of Executive Vice President of Livent, and he learned of serious accounting irregularities in the company’s financial records.
Once an investigation was undertaken, it became clear that Drabinsky and Gotlieb defrauded the corporation and its creditors. There were serious irregularities in the reporting of revenue and expenses. However, Deloitte & Touche LLP (“Deloitte”), the corporation’s auditor, produced “clean audit opinions” for the years of the fraudulent behaviour. Essentially, Deloitte cleared the financials of the corporation, upon which creditors relied in giving funds. The creditors, as a result, sued Deloitte in negligence for failing to pick up on the fraudulent behaviour which, they claim, would be readily discoverable if they followed its own accounting policies and generally accepted accounting principles (“GAAP”).

The Claim by Creditors and Decision

In a momentous decision released in April 2014, Justice Gans of the Ontario Superior Court of Justice (the “Court”) ordered Deloitte to pay $85.6 million dollars as a result of failing to pick up on the fraudulent activity. Other than the amount ordered in damages, the decision has significant ramifications for auditors, as it carves out an exceptionally high standard for auditors not to be found negligent in these particular circumstances. The Plaintiff claimed, among other things, that Deloitte ought to have picked up on the fraud, should not have issued unqualified audit opinions and, in finding out about the fraud, should have retracted the audit opinions. The Court made it clear that auditors owe a corporation and the “corporate collective” a duty to take care and avoid negligent behaviour. This duty extends to those in the “corporate collective” including creditors and shareholders. The issue, then, was whether Deloitte’s conduct constituted negligence, and on what basis their conduct was to be judged.

What Duty Do Auditors Owe?

Justice Gans held that the duty owed by an auditor is more than being “bound to arithmetic”, and that the level of care owed varies with the circumstances. In this case, the duty owed by the auditor went beyond “reasonable care and skill” based on the recognized procedures at the time, including GAAP. The Court felt that the reasonableness threshold ought to be higher as the skill required in auditing must meet changing circumstances and new procedures. As such, the auditor’s duty goes beyond clearing the numbers, and goes to looking at the financial statements to catch fraud. The Court quoted with approval the following statement from the MacDonald Commission of Inquiry that was set up by the Canadian Institute of Chartered Accountants in 1988 after various bank failures:

“Financial statements may be made instruments of management fraud by recording fictitious assets or omitting or understating liabilities. Financial statements may also be misleading as a result of improper valuations and estimates or a failure to adhere to GAAP. If done with an intention to deceive, these actions by management are also fraudulent, although there is not always a sharp line of division between mere optimism and fraudulent deception. Since the auditor’s duty is to report upon the financial statements, it is self-evident that the auditor must plan the audit program to catch fraudulent financial reporting and require appropriate correction of the financial statements [emphasis added].”

Please note that Deloitte has confirmed its intention to appeal the finding that they were negligent in this case and we will report on what occurs at the next court level. Nevertheless, this case is useful to illustrate at least one court’s intention to import a higher standard of care and skill of auditors in these circumstances.

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