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Auditors' Liability to Third Parties: Small closely-held corporations

2 minute read

In Waxman v. Waxman (2004), 186 OAC 201, the Ontario Court of Appeal considered whether the Hercules Managements analysis is applicable in a case brought by a shareholder of a small, closely- held corporation where concerns about indeterminate liability arguably do not arise.

This case involved an oppression remedy claim brought by one brother (Morris) against the other (Chester) based upon allegations that his brother had defrauded him out of an interest in the company. Morris also sued the company's auditors, alleging that they had a duty to warn him that he was being exploited by Chester. The trial judge and the Court of Appeal found in favour of Morris in respect of virtually all allegations made against Chester.

However, at both levels of Court, the case against the auditors was dismissed on the basis that the auditors did not owe Morris a duty of care – even though the auditors had acted for the corporation for some 49 years and had even acted as Morris's personal accountants from time to time.

The trial judge held that there was an undeniable relationship of proximity between the auditors and Morris. He was well known to them and there was a long history between the auditors and the corporation. The limited class of persons test was met. Nevertheless, the auditors were not liable because they were not retained to look after Morris's personal interests in general, even though they were occasionally retained for specific advice and as his accountants. The trial judge found that the audit engagements from year to year never contemplated that either of the brothers would rely on the audited financial statements for his own personal interests.

The trial judge applied the principles in Hercules Managements to hold that the audited financial statements were prepared for the purpose of permitting the controlling shareholders, the brothers, to manage their business. This has been described as the shareholder “stewardship function”. The limited purpose test was not met because Morris had used the financial statements for a personal purpose. The Court of Appeal accepted the trial judge's conclusion that to hold otherwise could expose the auditors to indeterminate liability, potentially over $50 million over the course of more than a decade.

The decision in Waxman v. Waxman is significant for two reasons. Firstly, it demonstrates that the Hercules Managements analysis will be applicable in contexts other than statutory audits, where the purpose of the audit is defined. Here, it can be presumed that the engagement letters adequately defined the purpose of the audit to enable the Courts to apply the same analysis. Secondly, it demonstrates that the Courts are concerned about indeterminate liability even in small, closely-held corporations.

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Lisa C. Munro, Q.Arb

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