An Ontario court decision ordering Deloitte & Touche to pay $85-million for negligence in its audit of defunct theatre company Livent Inc. could open the door to many new lawsuits against audit firms, especially when the cases are carefully structured to fit similar legal circumstances, legal experts said Monday.
Justice Arthur Gans of the Ontario Superior Court ruled Friday that Deloitte was negligent in its audit of the company's 1997 financial statements, marking a rare victory for creditors in a lawsuit against auditors.
Lawyer Dimitri Lascaris, who specializes in class-action lawsuits on behalf of shareholders, said Livent is the most prominent of several recent decisions that are "chipping away" at the long-standing difficulties investors have faced in suing auditors for negligence.
"It's a welcome development that a court would hold an auditing firm to account for the audits that were conducted here," Mr. Lascaris said. "Auditors are a gatekeeper and they're paid quite handsomely to protect shareholders and creditors from fraud, and if they're immunized from liability when they perform negligent audits then they have very little incentive to fulfill their duty."
The Livent case succeeded in part because it was structured so that it would not run afoul of a 1997 Supreme Court of Canada decision involving Hercules Managements Ltd., which established that auditors only owed a "duty of care" to a narrow group of parties – including the companies they are hired to work for – but not to all investors broadly.
The 1997 ruling said it would be "an unacceptably broad expansion of the bounds of liability" to hold auditors responsible to every potential investor who buys a company's shares. As a result, the ruling has sharply limited the number of auditor lawsuits filed in Canada.
The Livent case, however, was structured so it was not filed by creditors or shareholders, but by the company itself through a court-appointed special bankruptcy receiver. Although the litigation was launched by the receiver on behalf of creditors – and financed by two major creditors – Justice Gans ruled the case fit within the Hercules limitations because the plaintiff was the company itself.
Toronto lawyer James Lane, who represents auditors and other professionals being sued for misconduct, said the decision is likely to be appealed because of its potentially broad implications. If it is upheld, he said it could lead to more circumstances in which companies are sued by bankruptcy receivers on behalf of investors.
"It has the potential to create quite a loophole around the Hercules decision at the Supreme Court," he said.
Mr. Lane said the ruling may create a greater incentive for investors or creditors to force vulnerable companies into bankruptcy because they see potential for an auditor lawsuit.
Class-action lawyer Kirk Baert said the lengthy Livent decision could become a "road map" for others about how to structure a case against an auditor.
He said the Hercules decision was made decades ago before a series of large public companies collapsed amid allegations of accounting fraud. Recent court rulings have shown a greater sympathy for investors who are suing auditors. "I think if the Supreme Court had to decide that case nowadays with a large public company, you might have a different outlook," he said.
The Livent decision comes on the heels of another auditor case involving Castor Holdings Ltd., a Montreal-based real estate finance firm that went bankrupt in 1992. A Quebec court ruled in 2011 in favour of a creditor who sued audit firm Coopers & Lybrand for negligence in its audit of Castor's books, and the decision was upheld in 2013 by the province's court of appeal.
In the Castor case, investors relied on an exception in the Hercules decision that said auditors could be held liable for negligence in narrow cases when they knew and consented to a specific party relying on the audited financial statements. Avram Fishman, who was one of the plaintiff's lawyers in the Castor case, said the Livent decision now adds another route to sue an auditor. But both decisions make it clear there is still no broad ability for any shareholder to sue an auditor. "It's not an open field – it's a limited field," he said. "But certainly the door is not closed."