Court of first instance considers auditor’s duty to detect and report irregularities in accounting statements

In Days Impex Ltd v Fung Yu [2017] HKEC 2269, the Court of First Instance refused to strike out a negligence claim brought against an audit firm for failing to detect a substantial fraud at two of its client companies, both of which are now in liquidation. Importantly, the Court held that an auditor’s duty is not as narrow as to be restricted to the provision of information and advice.  Instead, the duty can extend to detecting material irregularities in the client’s accounting statements and reporting any fraud or suspected fraud to the company (and, in some cases, to relevant regulatory or enforcement authorities).

Facts

Between 2005 and 2011, the Plaintiffs engaged the 1st Defendant as their auditors. The Plaintiffs, through its liquidators, then brought a claim against the Defendants for negligence in the audit work they performed. The 2nd Defendant was allegedly the practice successor of the 1st Defendant.

The Plaintiffs alleged that the Defendants had breached their duty owed to the Plaintiffs by signing off unqualified “clean” opinions on the status of the Plaintiffs’ accounts, and by failing to detect and report the massive fraud which the controlling shareholder and director had caused the Plaintiffs to commit.

The Defendants applied to strike out the Plaintiffs’ claim on the basis that the Statement of Claim disclosed no reasonable cause of action, was an abuse of process and devoid of particulars.

Findings

The Court found in favour of the Plaintiffs and refused to strike out the claim. The analysis of the Court raises important principles in terms of (i) the scope of duty of care as auditors and (ii) whether attribution or the illegality defence would absolve an auditor’s liability, if any, where there is failure to detect and/or report the wrongdoing.

Duty of care as auditors

In respect of the auditors’ duty, the Court found that, in appropriate cases, an auditor’s duty may extend to detecting material irregularities in client’s accounting statements and reporting any fraud or suspected fraud to his client company and, in some circumstances, to relevant regulatory and enforcement authorities. In reaching this conclusion, the Court considered Sasea Finance Ltd v KPMG [2000] 1 All ER 676 in which the English Court of Appeal, having regard to the Auditing Guidelines (Feb 1990 edn) in England, held that where an auditor suspects that management may be involved in, or is condoning, fraud or other irregularities, the duty to report to authorities overrides the duty of confidentiality to the client; and the auditor is to report directly to a third party without the knowledge or consent of the management. The Court alluded to the fact that there are similar guidelines issued by the Hong Kong Society of Accountants and on that basis, the Court said “it is highly arguable that an auditor’s duty is more than just providing information and advice on his client’s financial statements“.

The Court further noted that it is at least arguable that the interests of the creditors require protection and should be factored into the scope of duty of an auditor when his client company is insolvent or near to insolvency.

Attribution or Illegality

In determining whether attribution or the illegality defence is applicable in similar situations, the Court considered the decision of the Supreme Court of Canada in Livent Inc v Deloitte & Touche (2014) ONSC 2176 in which it was held that neither attribution nor the illegality defence would absolve an auditor’s liability to its own client in relation to fraud. The Court further noted that the recent decision of the English Supreme Court in Patel v Mirza [2016] 3 WLR 399 adopted a policy and fact based approach when considering the applicability of the illegality defence. As such, the Court was “unable to be satisfied that the present case is a plain and obvious one for striking out without any consideration of the evidence“.

Implications

In this particular case, whether (i) the scope of an auditor’s duty of care indeed extended to detecting and reporting material irregularities; and (ii) an audit firm can rely on the ex turpi rule to defeat a claim in negligence against the auditors is yet to be resolved. Notably, the Court remarked that these were issues in an area of law which is still developing.

However, the Court’s analysis and judgment in respect of an auditor’s wider duty to detect irregularities and report them applies to auditors generally.  Practising auditors and their advisors should be mindful of this and, going forward, bear in mind the wider scope of their duties when carrying out their professional work for clients.

 

Gareth Thomas
Gareth Thomas
Partner, Head of commercial litigation, Hong Kong
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+852 2101 4025
Dominic Geiser
Dominic Geiser
Partner, Hong Kong
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+852 2101 4629
Priya Aswani
Priya Aswani
Professional support lawyer, Hong Kong
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+852 2101 4105

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