Laws Should Aid Misled Investors, Not Negligent Auditors

Our laws convey an unmistakable message when they require that audited financial statements be given to investors. The message is: “Trust auditors. Their reports will help you make better, more informed investment decisions.” But if the law so strongly encourages investors to rely on auditors, shouldn’t it also protect investors who do so?

Often, the law doesn’t protect investors. In contradictory fashion, it frequently shields negligent auditors by restricting investors’ ability to sue them for failing to conduct a proper audit, revealing a company’s true state of affairs. This contradiction in our law creates a trap for investors that’s hazardous and unfair. It needs to be reformed.

The problem stems from a 1997 case in which the Supreme Court of Canada (SCC) said shareholders couldn’t sue, even if a botched audit report induced them to invest in an insolvent company, because auditors shouldn’t have to face “indeterminate liability” — the prospect of being liable to infinite classes of potential investors, whose identity and number would be unknown to the auditors, and whose potential losses would be unascertainable in scope.

Indeterminate liability would make auditors’ insurance risks incalculable. There might, as a result, be no errors and omissions insurance available to backstop auditors; and consequently few, if any, accounting firms would be able to continue carrying on their auditing practices. This would be a commercial catastrophe. Capital markets, both public and private, really can’t function without the utility of audited financial statements.

And so the SCC denied the investors any recovery. It was a ruling based expressly on policy grounds, for the greater social good. But this judgment never sat well. It seemed too skewed in favour of one side — absolving auditors from responsibility to shareholders despite failures at the very core of the auditors’ professional function, while virtually ignoring the precept that audited financial statements are supposed to play a pivotal role in informing and influencing investors’ decision-making.

This policy choice seemed even more lopsided in subsequent years when accounting and auditing scandals roiled corporate behemoths such as Enron Corp., WorldCom Inc., YBM Magnex International Inc., Philip Services Corp. and Nortel Networks Corp. As these companies’ financial manipulations came to light, the contention that auditors need to be shielded for the good of society seemed less and less persuasive. If anything, it looked like society needed to be protected from accountants.

A legislative response, of sorts, arrived eventually as part of a broader package updating securities laws across the country. Investors were given statutory rights to sue negligent auditors — but liability under these provisions was confined to a narrow set of circumstances. What’s more, for defects in a company’s continuous disclosure, the amount that shareholders can recover from the firm’s auditors under this statutory remedy was capped at just $1 million or the amount the auditors received in fees from the company during the preceding year.

The damages cap bears no relation to the reality of investor losses. It’s paltry compared with the harm that a large group of investors might be expected to incur from a mishandled audit of even a small public issuer.

Shareholder lawsuits against auditors therefore still tend to focus heavily on non-statutory negligence claims under common law, but the results are unpredictable. Some judges hew to the SCC’s policy line shielding auditors. Others have taken innovative approaches in an effort to edge around the issue of indeterminate liability. (For example, in the recent case of Livent Inc. v. Deloitte & Touche LLP, the judges focused on the fact that a receiver brought the claim to advance shareholders’ interests as a corporate collectivity rather than as individual investors.) But even this is problematic as it’s leaving us with a confusing mash of jurisprudence that may take decades to coalesce into a clear judicial trend.

Moreover, a case-by-case approach provides only individual, ex post facto outcomes. It doesn’t resolve the forward-looking systemic question each investor needs answered, namely: Are they safe trusting an audited financial statement — or, at least, are they assured of having a substantial remedy if bad auditing fails to reveal defects in the financial statement?

Aversion to indeterminate liability shouldn’t force the law into an extreme and unsatisfactory position on this question. Nor should that aversion trump justice for harmed investors who rely on audited financial information precisely because it’s audited information.

Investor reliance on audited financial statements is perfectly reasonable. It’s in line with the commercial expectation of how audited statements often will be used. And the law itself encourages this reliance.

The law, therefore, should protect it.

Neil Gross
Executive Director

This article appears as an Inside Track op-ed in the online version of Investment Executive.

January 25, 2016