A Lump of Coal for Christmas: Supreme Court of Canada Confirms Auditor Negligent & Liable for $40 Million in Livent v. Deloitte

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A Lump of Coal for Christmas: Supreme Court of Canada Confirms Auditor Negligent & Liable for $40 Million in Livent v. Deloitte

December 23, 2017

Parents often threaten their children that if their behaviour did not improve they will get a lump of coal in their Christmas stockings. On December 20, 2017 a well-known accounting firm received just that from the Supreme Court of Canada, namely a judgment against it for over $40 Million – though the lump was only half the size it was initially. The Supreme Court’s decision in Livent v. Deloitte is an especially stark reminder of the importance to both clients and their professional advisors of a proper understanding of what a professional services firm is undertaking to do for its client. That understanding must be documented carefully to prevent disputes about the scope of the advisor’s undertaking from arising in the future. When the scope of the undertaking is clear, it is unlikely an auditor or other professional services can argue successfully it did not owe its client a duty of care in respect of services reasonably encompassed within that scope. In this case, the scope of the auditor’s undertaking was everything.

Livent was a well-known entertainment company that specialized in the vertical integration of live theatre productions. As the Chief Justice of the Supreme Court noted, “it brought the entire enterprise, from production to performance, under one roof – a roof that Livent, as a proprietor of theatre properties, also owned.” To show Livent was a success, its two principal shareholders, Drabinsky and Gottlieb, and “their associates cooked the books.” From 1989 to 1998, Deloitte LLP acted as auditor for Livent and its predecessors. In 1997 the auditor helped Livent prepare and approved a press release that misrepresented the financial impact of a particular transaction and provided a “comfort letter” to support a substantial debenture underwriting. In 1998, the auditor provided a “clean” audit report with respect to Livent’s 1997 financial statements. Livent subsequently sued its auditor in negligence claiming that the auditor’s failure to detect the frauds of Drabinsky and Gottlieb caused Livent to suffer substantial losses. The trial court decided the auditor was negligent in respect of the press release, the comfort letter and the 1997 audit and ordered the auditor to pay approximately $84 Million to Livent. The auditor appealed to the Ontario Court of Appeal, but failed. The auditor appealed further to the Supreme Court of Canada. The Court confirmed Deloitte’s liability – but reduced the damages award to $40 Million.

Negligence

A party that makes a claim against another based on negligence must establish four things:

The defendant owed them a duty of care.
The defendant’s conduct breached the applicable standard of care.
The plaintiff sustained loss or damages.
The damage was caused, in fact and in law, by the defendant’s breach of the standard of care.

The Supreme Court’s decision in Livent was concerned only with the first question: did the auditor owe a duty of care to Livent? Canadian courts use a two-stage analysis (the so-called “Anns/Cooper” framework) to determine whether a duty of care exists:

Did a prima facie duty of care exist?
If yes, are there are any “residual policy considerations” that should negate or limit the scope of the duty.

The majority of the Court provides a very helpful review of the principles governing how courts should apply this two-stage analysis. This Alert will focus on how a badly split Supreme Court dealt with the first issue, the existence of the duty of care. Four judges accepted that the auditor owed a duty of care to Livent, but decided it was only liable for the loss flowing from the negligently performed audit and not for the loss resulting from the press releases or the comfort letter; three would have held that the auditor was not liable for any of Livent’s losses.

Prima Facie Duty of Care

This stage of the analysis requires the court to ascertain whether the plaintiff and the auditor are in a relationship of proximity which is such a close and direct relationship that it would be “just and fair” to impose a duty of care. The courts have adopted a number of techniques to make that determination.

Prior Recognition of a Duty of Care. They first use a shortcut: if the relationship is the same or analogous to a relationship the courts have previously recognized as giving rise to a duty of care, the analysis need go no further and they accept a duty of care exists. Livent pointed to the Court’s earlier decision in Hercules Managements Ltd. v. Ernst & Young where the Court recognized that an auditor owed a duty of care to its client in the performance of a statutory audit. Livent argued that because the Court recognized a duty of care in that case, it necessarily followed that its auditor owed it a duty of care in this case. However, the majority of the Supreme Court said it was not as simple as that: the prior recognition of a duty of care was not to be accepted without question. A court must be attentive to the factors that justified the recognition of the duty of care in the earlier case. The court in the subsequent case must determine whether the relationship was “in fact, truly the same as, or analogous to, that which was previously recognized.” Furthermore, the fact that a duty of care has been recognized between an auditor and its client does not mean that a duty of care exists for all purposes.

Full Proximity Analysis. If the case does not fit into an existing category recognizing a duty of care, the court must undertake a “full proximity analysis”: it must examine all relevant factors arising from the relationship between the plaintiff and the defendant, including “expectations, representations, reliance, and the property or other interests involved as well as any statutory obligations.” Where the claim is for negligent misrepresentation or performance of a service (the most common allegations in professional negligence cases), two factors are determinative: the defendant’s undertaking and the plaintiff’s reliance. Where the defendant undertakes to provide a representation or service in circumstances that invite the plaintiff’s reasonable reliance, the defendant becomes obligated to take reasonable care, and the plaintiff has a right to rely on the defendant’s undertaking to do so. These corollary rights and obligations create a relationship of proximity.

Scope of the Undertaking is Key. A key factor in this proximity analysis – and the determinative factor in this case – is the scope of the defendant’s undertaking of responsibility: if the plaintiff’s reliance falls outside the scope of the defendant’s undertaking of responsibility, it is necessarily outside the defendant’s duty of care. In other words the “defendant cannot be liable for a risk of injury against which he did not undertake to protect.” Here, the scope of the auditor’s undertaking was determinative.

1997 Audit. The auditor’s undertaking of responsibility with respect to the 1997 audit had the same purpose as that of the auditor found liable in the Hercules case: the provision of information to allow for effective oversight of management by the company’s shareholders. It therefore followed proximity was established between Livent and the auditor, and the auditor had a duty of care to Livent with respect to the 1997 audit.

Press Release & Comfort Letter. The Supreme Court’s analysis of the auditor’s responsibility in relation to the press release and comfort letter led to a completely different result. Livent asserted that if the auditor had not continued to assist it in soliciting investment through the press release and comfort letter but had instead resigned (because it had knowledge of the financial irregularities), Livent would have known its true financial state and would have avoided deterioration of its finances. Livent alleged it detrimentally relied on the auditor’s services rendered in connection with the press release and comfort letter to “artificially extend the life of the corporation”. The Supreme Court rejected this claim because Livent’s reliance was not tied to the solicitation of investment, but was a matter of oversight of management. The Court distinguished between what the auditor undertook in relation to the investment solicitation and what it undertook in relation to the 1997 audit. If Livent’s losses related to an inability to secure investment because of the auditor’s negligence, Livent could conceivably recover those losses. But losses relating to a lack of oversight of management that artificially extended the corporation’s life were not, because the auditor never undertook, in preparing the comfort letter and assisting in the preparation of the press release, to assist Livent’s shareholders in overseeing management. Livent had no right to rely on the auditor’s representations for a purpose other than that for which it undertook to act.
Please contact your McInnes Cooper lawyer or any member of the Financial Services Team @ McInnes Cooper to discuss this topic or any other legal issue.
McInnes Cooper has prepared this document for information only; it is not intended to be legal advice. You should consult McInnes Cooper about your unique circumstances before acting on this information. McInnes Cooper excludes all liability for anything contained in this document and any use you make of it.

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