In a decision with far-reaching implications for the accounting industry, on April 4, 2014, Deloitte & Touche was found liable for $85 million for its negligent audits of Livent Entertainment of Canada Inc. in 1996 and 1997.1
Livent was founded as an entertainment company intended to be publicly traded on the North American markets. It raised capital through a Canadian IPO in May 1993, an equity issue in the USA in May 1995, and various other private and public debt and equity issues over the next three years, in part based on the unqualified audit opinions of Deloitte that Livent’s financial statements presented “fairly, in all material respects, the financial position of the company…in accordance with generally accepted accounting principles in Canada.”
That image of financial health was false. The 1998 restatement of Livent’s financial statements for 1996 and 1997 resulted in a significant downward adjustment of reported income and share value fell from USD $6.75 to $0.28 per share. The company’s downfall resulted in multiple judicial and quasi-judicial rulings over the next decade including criminal convictions, cross-border bankruptcy proceedings, hearings before the SEC and OSC, and prosecutions of certain Deloitte partners before the Discipline Committee of the Institute of Chartered Accountants.
Livent, by its Receiver, brought an action for negligence and breach of contract against Deloitte regarding the audit of Livent’s financial statements.
Standard of Care
The Court highlighted a significant change in the standard of care to be applied to auditors in the modern era. Deloitte argued that the standard required was that of “a reasonably competent and cautious accountant”. The Court held, however, that the standard of care applicable to auditors in 1990s Canada was not as limited as that asserted by Deloitte. It held that the circumstances of a particular case may dictate that more than the minimum standard of a “reasonably component and cautious accountant generally” may be required.
The Conduct of the Audit
At trial the Court found that Deloitte’s conduct in the 1996 and 1997 audits fell short of the applicable standard of care. Deloitte’s assessment of the engagement risk for the 1996 audit was “greater than normal”, which the Court found to be a euphemism for “high risk”. In addition, planning memos for 1996 provided a clear mandate to increase the level of professional skepticism on all fronts and it was anticipated that there would be more than normal Engagement Partner involvement as a result. For 1996, it was found that Deloitte did not follow its own planning memos and failed to review projections which represented over 30% of Livent’s unamortized production costs at year-end, failed to adequately reconcile projected with historical results, and did not insist on management taking a reserve on preproduction costs in 1996 even though they were taken in 1994 and 1995 when the company’s total capitalised preproduction costs were significantly less. In addition, Deloitte did not confirm the portion of receivables payable to a staff union even though it disputed the amount. Instead, it accepted management’s representation that there was an amount in surplus which could be recovered from the union and carried forward to off-set payments the company would have to make to the union in the future.
The “Achilles' heel” of Deloitte’s defence with respect to the 1997 audit was a letter of intent in respect of a transaction in which Livent sold rights in one of its theatres to an arm’s length company for $7.4 million. The letter contained a put in the arm’s length company’s favour, which allowed it to exit the deal if construction on the theatre had not finished by a certain date. Deloitte objected to including the amount Livent received as income, as it viewed the deal as a contingent agreement, to the point of threatening to disassociate itself from the company. However, after significant pressure from management, Deloitte agreed to recognise the gain. The Court found that Deloitte should have remained firm and severed the relationship and should have disclosed the problems with Livent to both the company’s Audit Committee and the regulators. At the very least, the Court held it should not have signed off on the 1997 audit opinion.
It is worth noting that before the Judge wrote the penultimate draft of his Reasons, the recent Court of Appeal decision in CIBC v. Deloitte & Touche, was brought to his attention. In that case, the Court of Appeal held that discipline decisions of the ICAO under the predecessor legislation to the Chartered Accountants Act, 2010 may be admissible in a civil proceeding. Although the Judge’s analysis and conclusions were not based on any of the ICAO discipline decisions, he noted that the CIBC v Deloitte & Touche decision would arguably have permitted him to reference some or all of the ICAO discipline decisions against the Deloitte audit partners involved in the Livent audits in determining whether there was a breach of the standard of care.
The Defences of Corporate identity and ex turpi causa
Deloitte argued that a concerted effort was made to conceal the accounting frauds and irregularities from it, and even if it had been negligent, Livent’s losses should not be recoverable because they were caused by its own illegal acts.
Deloitte relied on the “corporate identification doctrine” which provides that the commission of a fraud or other culpable act by the directing mind of a company and which is intended or in fact benefits the company, must ipso facto be attributed to the company and thereby deprive it of any remedy in tort. The Court found that policy reasons dictated that this doctrine should not be applied where the company itself was the aggrieved party and was claiming against a third party auditor.
These policy reasons were discussed and applied in the analysis of Deloitte’s other argument that the maxim ex turpi causa non oritur actio (“from a dishonourable cause no action arises") was a bar to the company’s recovery. The Court held that this doctrine was applicable only in very limited circumstances and it declined to do so here where innocent shareholders would be unjustifiably denied a remedy and where it would allow the auditor to escape liability for the very fraud it should have detected.
This case is important in arguably increasing the standard of care expected of Canadian auditors, especially in complex or high risk audits. It also confirmed the limited grounds on which an auditor can rely on frauds committed by those within the company as a defence to a claim of professional negligence.
Livent Inc. (“Livent”) has prevailed at the Court of Appeal in its auditor’s negligence claim against Deloitte & Touche (“Deloitte”) concerning Deloitte’s failure to detect an accounting fraud carried out by Livent’s senior management. In the result, the trial judge’s $84,750,000.00 damage award (plus interest) was upheld.
Livent was a cash-intensive live entertainment company staging theatrical performances across North America. Livent accessed the North American capital markets in order to meet its voracious need for cash, on the strength of its financial statements. However, Livent’s financial performance was not as rosy as its financial statements would lead one to believe as a result of a series of fraudulent accounting practices that inflated the company’s bottom line. The accounting fraud included manipulating the amortization of millions of dollars in pre-production costs of various productions; manipulating expense entries in and out of particular accounting periods or charging them against other activities or productions; and improperly recognizing one-off revenue transactions. The Court of Appeal observed that, while the accounting fraud had been orchestrated by Garth Drabinsky and Myron Gottlieb, the founders of the company, it was found at trial that other Livent officers and employees were “knowing and willing participants.”
Deloitte issued numerous clean audit opinions over the course of its tenure as Livent’s auditor. The accounting fraud was uncovered after new management was put in place by new equity investors. After an internal investigation, Livent restated its financial statements and filed for insolvency protection in Canada and the United States. The company was then liquidated.
Livent or, more accurately the Receiver-Manager for Livent, advanced a claim against Deloitte in auditor’s negligence. Livent claimed that Deloitte did not conduct its audits in accordance with Generally Accepted Auditing Standards (“GAAS”), and that the accounting fraud could have, and should have, been detected by Deloitte.
Deloitte argued that the claim of the insolvent company was an impermissible proxy claim being advanced by Livent’s creditors and investors, to whom an auditor does not owe a direct duty of care. The Court of Appeal rejected this argument, holding that Deloitte was conflating damages suffered by the corporation with the distribution of those damages to creditors and stakeholders as part of the assets of the corporation. The allegations raised by Livent related to losses that Livent itself had suffered as a result of the alleged negligence.
Another defence raised by Deloitte was that Livent should be barred recovery under either the doctrine of corporate identification (corporate attribution) or the doctrine of ex turpi cuasa (doctrine of illegality). In essence, Deloitte took the position that the actions of senior management should be imputed to Deloitte itself, and that Livent could not advance a claim against it claiming that Deloitte was negligent in failing to uncover Livent’s own fraud. The Court refused to apply these doctrines to bar recovery. The Court reasoned that one of the most important functions of an auditor is to detect fraud by senior management. The Court held that to permit Deloitte to escape liability on this basis would risk undermining the value of the public audit process.
In setting out the standard of care to be met by Deloitte, the Court of Appeal observed that the auditor of a publicly-traded company has an added layer of responsibility that is not necessarily present in the audit of a private corporation because of the reliance on audited financial statements by securities regulators and prospective investors. The standard of care of a “reasonable auditor” in the circumstances of the case will reflect the statutory and regulatory framework and the professional requirements prevailing at the time (Canadian Institute of Chartered Accountants’ Handbook). In determining the standard of care, the Court of Appeal also had regard for Deloitte’s own manuals, “which set a standard of care Deloitte must be presumed to accept as reasonable.”
The primary standard of care issues concerned Deloitte’s failure to apply professional skepticism in the face of numerous “red flags” raised during the course of its retainer. The Court of Appeal found the evidence of Deloitte’s breach of the standard of care to be “overwhelming”. This evidence included: the failure to develop a satisfactory audit plan in the face of very aggressive and questionable accounting practices in previous years by Livent’s management; failing to adequately question management after discovering that management had lied to Deloitte; failing to take appropriate action after management tabled financial statements to the audit committee after Deloitte had expressed concerns with the financial statements (the audit committee was not advised about Deloitte’s objections and the financial statements were approved by the audit committee); and acceding to the demand of Livent’s management to change the entire Deloitte audit team after a particularly fractious interaction between management and Deloitte.
The Court of Appeal agreed with the trial judge’s conclusion that the negligence of Deloitte caused damages to Livent for the 1997 audit period onward. If Deloitte had met its standard of care the accounting fraud would have been uncovered sooner than it was ultimately discovered, and Livent would have been discovered to be insolvent and would have been liquidated at that time. Livent would not have been able to continue to access the capital markets, generating additional debt to obtain cash that then went immediately out the door to finance money-losing operations.
Damages were assessed by calculating the difference between the value of the company’s assets on the date it was ultimately liquidated, and on the date upon which it would have been liquidated had Deloitte met the standard of care. To this figure, the Court of Appeal agreed with the trial judge’s reduction of 25% for reasons of remoteness, because “Deloitte ought not to be liable for the losses attributable to Livent’s legitimate but unsuccessful ventures” operating in a high-risk industry. Even if Livent had not been able to access the capital markets during the impugned period of time, it still would have operated and still would have lost significant amounts of money.
In addition to the main appeal, Livent brought a cross-appeal seeking to overturn the trial judge’s finding that Livent was not entitled to damages arising from Deloitte’s negligence during the 1996 audit period. The trial judge found a much narrower breach of the standard of care for the 1996 period than the 1997 period and beyond. For the 1996 period the trial judge’s findings of negligence were limited to a finding that Deloitte failed to detect that several types of entries were improperly accounted for in the financial statements. The trial judge found that even if Deloitte had detected the irregularities, such detection would not have revealed instances of fraud or other irregularities sufficient to close Livent down. The Court of Appeal held that the trial judge’s factual findings in support of this conclusion were amply supported on the record, and dismissed Livent’s cross-appeal.
The Livent decision is a significant decision in the area of auditor’s negligence, and its holding that auditors can be held liable for failing to detect fraud involving the most senior levels of corporate management is contrary to some cases in the area decided in other jurisdictions. It is expected that Deloitte will seek leave to appeal this decision to the Supreme Court of Canada.