The Supreme Court of Canada says accounting firm Deloitte LLP is liable for negligent work as the auditor of defunct theatre company Livent Inc., but has rejected part of Deloitte's liability and reduced its required payments.
Livent collapsed in 1998 amid allegations of accounting fraud, and the company's bondholders have spent years battling Deloitte through the court system, alleging the audit firm was negligent in its work and ignored red flags of improper activity.
Wednesday's ruling marks the final chapter in the long-running case, and will be critical for the accounting industry broadly, which has worried that the top court's decision could expose auditors to many more lawsuits whenever fraud occurs at the company.
The complex ruling does not open a door to a wide array of future lawsuits by investors, but establishes conditions that must be met for an auditor to be held responsible.
The ruling, for example, said Deloitte could not be held liable for its work in 1997 to help Livent raise new funds from investors – which included providing a comfort letter for investors – because Deloitte did not have legal responsibilities to the company as an auditor in that role. However, the court said Deloitte did have a duty of care to the company in its work on the audit of Livent's 1997 financial statements.
"By negligently conducting the audit, and impairing Livent's shareholders' ability to oversee management, Deloitte exposed Livent to reasonably foreseeable risks, including losses that would have been avoided with a proper audit.... Deloitte owed Livent a duty of care, which it breached," the ruling said.
The Supreme Court was split in its decision, with four justices supporting the ruling and three others – including former chief justice Beverley McLachlin – dissenting and arguing Deloitte breached its duty of care but is not liable for covering such large losses primarily caused by Livent's actions.
In its arguments before the Supreme Court in February, Deloitte's lawyer argued the courts have held the firm responsible for far too much of the loss at Livent, going well beyond the direct impact of its audit work.
The Ontario Superior Court ruled in 2014 that Deloitte was negligent in its work for Livent, and awarded a total of $85-million in damages plus accrued interest, now totalling more than $130-million. Deloitte appealed the decision to the Ontario Court of Appeal, but lost, and further appealed to the Supreme Court.
In its Wednesday ruling, the Supreme Court said Deloitte is only responsible for $40.4-million in damages, which was the portion specifically linked to the work on the 1997 financial statement audit.
Toronto lawyer Garth Myers, who specializes in class-action lawsuits in securities cases at Koskie Minsky LLP, said it is positive that the Supreme Court agreed an auditor can be liable to a company when it does a bad job on an audit.
"The auditors will have to absorb the losses caused by their negligence, and not the company, so that's good news," he said.
However Mr. Myers said the ruling doesn't help the cause of investors who buy shares on the stock market only to see fraud allegations later emerge. The ruling doesn't change prior legal decisions that said auditors are not directly accountable to people who buy shares in the market.
"In this case, the Supreme Court of Canada reiterated that auditors won't be liable to secondary-market purchasers who rely on their negligent audit reports to inform their investment decisions," Mr. Myers said.
"I don't think anything in the decision changes that, and I think it will be secondary-market purchasers who are left holding the bag where auditors like Deloitte fail to disclose irregularities in issuers' financial statements."
A 1997 Supreme Court decision involving Hercules Management Ltd. set out very narrow parameters for lawsuits against auditors to succeed, concluding auditors owed their duty to the company that hired them, and not to other stakeholders who also used the audited financial statements.
As a result of that decision, Livent's bondholders did not sue Deloitte directly. Instead, the legal action was launched by the defunct company's special receiver on behalf of the company itself, although bondholders led and financed the litigation and will receive much of the award.
The ruling has confirmed that the indirect route can be used in such cases, but Mr. Myers said it doesn't offer much help to shareholders because money recovered by bankrupt companies typically all goes to creditors.
Chartered Professional Accountants of Canada, which intervened in the Livent case before the Supreme Court on behalf of the accounting industry, had no immediate comment on the potential impact of the ruling for the audit profession, saying in a statement it needs to study the decision in depth "and make a full assessment before we can provide any informed view."
Livent staged live theatre shows such as Phantom of the Opera and Show Boat in the 1990s, but collapsed in 1998 after new owners bought the company and raised concerns about accounting problems. Company founders Garth Drabinsky and Myron Gottlieb were convicted of fraud and sentenced to jail terms, but have since been released.