Sunday, August 02, 2009

UK Appeals Court Rules Company Engaged in Fraud Could Not Claim Losses Against Its Auditor

A divided UK high court of appeals has ruled that it would be against public policy to allow a company that was used by its beneficial owner as a vehicle to defraud banks to recover losses against the audit firm that failed to detect the fraud. The appeals court invoked the doctrine of ex turpi causa non oritur actio, which holds that a court will not assist a claimant to recover a benefit from his or her own wrongdoing. The doctrine is akin to the US doctrine of in pari delicto, the equal fault defense.

It was a 3-2 ruling, with the main opinion by Lord Phillips, senior Lord of Appeal. In dissent, Lord Mance cited US case law for the increasing reluctance of courts to hold that top management fraud provides a defense to a negligent auditor. Moore Stephens v. Stone Rolls Limited, July 30, 2009, Appellate Committee of the House of Lords.

The duties of an auditor are founded in contract, said Lord Phillips, and the extent of the duties undertaken by contract must be interpreted in the light of the relevant statutory provisions and Auditing Standards. There is a duty of reasonable care in carrying out the audit of the company's accounts that is owed to the company in the interests of its shareholders. No duty is owed directly to the individual shareholders. This is because the shareholders' interests are protected by the duty owed to the company. No duty is owed to creditors. The Auditing Standards require auditors who have reason to suspect that the directors of a company are behaving fraudulently to draw this to the attention of the proper authority.

It was conceded that the audit firm here owed a duty to the company to ensure, so far as reasonable care permitted, that the accounts showed a true and fair view of its affairs. For purposes of the motion, it was also assumed that the auditor was in breach of this duty. It was further conceded that, had the audit firm performed its duty, it would have discovered the fraud. Finally, it was conceded that the audit firm would then have reported the fraud to the authorities, which would have brought corporate operations to a halt. Thus, as a matter of causation, the assumed breach of duty resulted in the losses sustained by the company as a result of the continuing fraud.

But the ex turpi causa doctrine provided a defense to the audit firm, ruled the court, because
all whose interests formed the subject of any duty of care owed by the auditor to the company, namely the company's beneficial owner, were party to the illegal conduct that formed the basis of the company's claim. And the beneficial owner’s conduct could be attributed to the company. While the beneficial owner was using the company for his own dishonest purposes, acknowledged the court, it was in a manner that resulted in substantial payments being made to the company. It has never been suggested that the beneficial owner’s conduct did not fail to be attributed to the company so as to render the company liable in deceit. The fraudulent business must be treated as the business the company carried on, said the court, in the first instance, to benefit the company.

In dissent, Lord Mance
noted that the world has sufficient experience of Ponzi schemes operated by individuals owning "one man" companies for it to be questionable policy to relieve from all responsibility auditors negligently failing in their duty to check and report on such companies' activities.

Lord Mance also reviewed US cases, particularly the cost-benefit analysis enunciated by Judge Posner in the 1982 Seventh Circuit case, Cenco, Inc. v. Seidman & Seidman. While the cost-benefit analysis and other techniques deployed in American case-law do not find any easy match in English law, noted Lord Mance, the general message in the recent US case-law is one of increasing reluctance to hold that top management fraud provides a defense to a negligent auditor, and this corresponds with his conclusions as to the right approach in principle in English law.