Auditors on trial as Livent case heads to court

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A $450-million lawsuit against the auditors of Livent Inc. will finally hit a Toronto courtroom next week, and securities lawyers expect the case will help answer one of Canada's trickiest unresolved legal questions: When can auditors be held responsible for failing to detect an accounting fraud?

Shareholders in Canada have faced an uphill battle suing auditors, due in large part to a key 1997 Supreme Court of Canada decision involving Hercules Managements Ltd., which set out narrow parameters under which auditors could be successfully sued by investors.

But a surge of cases in recent years is challenging the perception that the Hercules ruling meant auditors cannot be sued.

A Quebec court ruled in 2011, for example, that audit firm Coopers & Lybrand was negligent in its auditing of real estate investment firm Castor Holdings Ltd.

Last week, a court approved a $117-million settlement reached by Sino-Forest Corp. investors with audit firm Ernst & Young, while KPMG LLP settled a lawsuit with Hollinger Inc. in 2010 for an undisclosed sum.

Nortel Networks Corp. shareholders in Canada are also attempting to sue the firm's auditors from Deloitte & Touche, but that matter is on hold, pending resolution of other disputes in Nortel's bankruptcy action.

Lawyer Dimitri Lascaris, who represented investors in the Sino-Forest case, says auditor lawsuits appear to be somewhat more successful than in the past, especially since Ontario introduced new rules in 2005 to give broader rights to shareholders to sue over inaccurate or fraudulent financial disclosure – although those rules include strict caps on the amounts that can be recovered.

The auditor trial, which is the final major lawsuit still outstanding following Livent's collapse 15 years ago, is the first big case involving a publicly traded company to go to trial since the Hercules ruling.

Most other major cases have been settled out of court or have involved private firms such as Castor, where the shareholder situation is different.

The Hercules decision said auditors owe their primary duty to the company rather than to individual investors who are making their own investment decisions, so the Supreme Court said the Hercules lawsuit should have been filed on behalf of the company itself. Because of that ruling, the Livent lawsuit was filed by the company's receiver, alleging Deloitte & Touche was negligent in the audit services it provided.

The $450-million worth of damages sought by Livent's receiver would dwarf any previous payout by an audit firm in Canada if the case were to succeed. Any funds collected would flow to Livent creditors who have not been fully repaid for their outstanding claims.

Livent creditor Richard Ross, founder of Daedalean Financial Corp., argues the four big accounting firms have a "virtual monopoly" on audit work for public companies and have a duty to be watchdogs over management who abuse investors.

"This case will address the extent to which accountants are held accountable," he says. "The court will have much to say about this in the coming months and lots of people should be listening. The thousands of creditors of and investors in Livent who suffered grievous losses certainly will be."

Daedalean and U.S.-based hedge fund Cerberus Capital Management LP, which holds Livent distressed debt, have provided much of the financing to bring the lawsuit to trial in return for a "superpriority" to have their claims paid first if there is any money awarded in the case.

The lawsuit claims the auditors breached their duty to Livent by not doing adequate work to detect the accounting fraud occurring at the company, and argues the auditors should have detected "reasonably discoverable fraudulent schemes" conducted by company founders Garth Drabinsky and Myron Gottlieb. The men were convicted of fraud in 2009 for allowing the company's financial statements to be falsified in the 1990s.

A spokesman for Deloitte & Touche said the firm would not talk about the case while it is before the court.

But in legal filings, the firm has argued it met required standards of care for auditors, and said any fraud that happened at the company was not through Deloitte's fault or neglect.

The audit firm also said the fraud was conducted by Livent itself, through its senior officers, and therefore Livent does not have the right to sue the auditors for its actions "where Livent's claims are founded on its own illegal conduct."

"Livent did not suffer any damages … . It was a party to and a beneficiary of the frauds," Deloitte said in its statement of the defence in the case.

If that position is accepted by the courts, however, it would run counter to the Supreme Court's advice that the Hercules lawsuit should have been filed on behalf of the company itself. And it would leave even greater uncertainty about whether shareholders have any route to sue an auditor when senior management have participated in a fraud.

(Janet McFarland is a Globe and Mail Business Reporter.)

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