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Auditors' Liability to Third Parties: An Overview

2 minute read

Historically, the doctrine of privity of contract prevented third parties from claiming against auditors for negligently prepared audited reports. The landscape changed with the recognition of the tort of negligent misrepresentation and the possibility that auditors could be held liable to anyone to whom they were found to owe a duty of care. The concern arose that auditors might be unfairly exposed to “liability in an indeterminate amount for an indeterminate time to an indeterminate class”, a phrase memorably coined by U.S. Justice Cardozo.

In Canada, Hercules Managements Ltd. v. Ernst Young, [1997] 2 S.C.R. 165 (“Hercules Managements”) was hailed as an answer to these concerns about auditors' indeterminate liability. The plaintiff shareholders brought claims against the companies' auditors for negligently prepared statutory audit reports upon which they claimed to have relied, causing them damages. The Court considered whether the auditors owed the shareholders a duty of care and applied the two-stage Anns test; whether a duty of care exists will depend on (a) whether a prima facie duty of care is owed, and (b) if so, whether that duty should be limited or negated by policy considerations.

Under the first stage of the test, the Court considered whether the auditors had a sufficient relationship of proximity to the plaintiffs for them to have reasonably relied on the auditors' work. The court found that a prima facie duty of care existed. This element of the test will be satisfied in the majority of cases brought by shareholders against a company's auditors.

Under the second stage of the test, the Court considered the policy concern that inevitably arises in such cases - the “spectre of indeterminate liability”. A limiting mechanism was needed to avoid this risk. The auditors would owe a duty of care to a third party plaintiff only where: (a) the plaintiff is known to the auditors or is a member of a limited class of plaintiffs known to the auditors; and (b) the plaintiff relied on the auditors' statement at issue for the precise purpose or transaction for which it was made.

In Hercules Managements, the Court held that the prima facie duty of care owed to the shareholders was negated for policy reasons. Despite the fact that the plaintiffs were members of a limited class, they had not relied on the audited financial statements for the precise purpose for which they were prepared. Rather, they used the statements for their own personal investment decisions. Therefore, the auditors were not liable to the plaintiffs.

The legacy of Hercules Managements has been a broad protection afforded to auditors against claims made by parties with whom they had no contract. Nevertheless, subsequent cases have shown the shortcomings in the Hercules Managements analysis in cases having very different facts.

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Lisa C. Munro, Q.Arb

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