‘Watchdogs not Bloodhounds’ – an auditors duty of care

Since snails were found in a bottle of ginger ale and carbolic acid was discovered in bottles of lemonade, the Courts have accepted that there does not always need to be a legal contract between parties for a wrongdoer to owe a level of responsibility to the victim. This “duty of care” as it is called, is the basis of the tort of negligence.

Caparo -v- Dickman

In the famous case of Caparo Industries plc v Dickman, the most senior judges in the land clarified the relationship between a tortfeasor and third parties as follows:

  • The damage must be reasonably foreseeable as a result of the actions of the tortfeasor
  • The parties must be in a proximate relationship
  • It would be fair and reasonable to impose a liability.

In that case, Caparo Industries purchased a company called Fidelity Ltd whose accounts had been prepared by Dickman. Following purchase, it was found that the accounts were not a true reflection of the state of the company. Caparo sued and although the Court of Appeal stated that there was a duty of care owed by the auditor, this was overturned by the House of Lords who felt that whilst the auditor owed a duty of care to the shareholders as a body, he did not owe a duty of care to an individual.

What is an auditor?

Except for small companies and some charities, a company is required to have its accounts audited. The accounts are prepared ostensibly as a report from the directors to its shareholders, telling the latter how the company is doing. It is the auditor’s job to review the accounts and state whether or not they represent a “true and fair view” of the state of the company. That “true and fair view” can be a limited view (and will usually be identified by a disclaimer in the report) depending on how much information the directors have provided. What if the report is wrong? Firstly, you have to ask yourself why the report was wrong. Is it an error by the directors in the information they provided? Or was it the auditors who were at fault in analysing it? Did the auditors put a disclaimer in their report? Importantly, should the auditors have picked up the problem? The auditors’ duty is only to give a “true and fair view” of the accounts, it is not a guarantee.

Watchdogs not Bloodhounds

To use the expression from Re Kingston Cotton Mill Co (No 2), auditors are “watchdogs not bloodhounds”: whilst they have an obligation to detect and investigate obvious errors, they are not obliged to actively seek out questionable activity and neither do they guarantee the accuracy of the accounts. There is therefore a limit on what can be expected of them. The case of Man –v- Freightliner [2007] EWCA Civ 910 is a good example of this. MAN AG, a German holding company, wished to purchase a subsidiary of the American company, Freightliner. Ernst & Young were the auditors of the subsidiary, ERF, a trucking company in the UK. Following purchase of ERF, MAN discovered that the Financial Controller of ERF had been manipulating the accounts of ERF for some time and the company was not as profitable as it was initially thought. MAN brought proceedings against Freightliner who in turn sued Ernst & Young. Interestingly, Ernst & Young admitted that their conduct of the audit would probably be considered negligent but despite this, the Court of Appeal did not find Ernst & Young liable in this instance. The retainer with Ernst & Young was for the accountants to prepare an audit on the company’s accounts. It was not a Due Diligence enquiry for and on behalf of MAN and they could not be expected to know that MAN would have relied on the audit report. Secondly, the Court concluded that the report had not been causative of loss – it was the fraudulent representations of the dishonest Financial Director which had caused that loss. Conclusion There is a requirement under the Companies Act which states that the auditor must not “knowingly or recklessly [cause] a report… to include any matter that is misleading, false or deceptive in a material particular” (s507). It probably does not take the matter much further than the case law as there is still an element of objectivity in the test and of course, the report can most certainly be the subject of a disclaimer.

So where exactly are we?

Although there seemed an element of hope that auditors may be liable to third parties as well as to the shareholders of the companies they serve, this liability is being increasingly curtailed. The Courts seem to be accepting that, provided the auditor is not reckless, disregarding obvious indicators of problems, it is prepared to take a pragmatic view. The Auditors Report is after all, only a brief snapshot of a company, such snapshot being based upon the information provided to the Auditor by the Directors. It is not a guarantee of the state of the company and, unless the Auditors are aware that it is supposed to be a due diligence exercise and relied upon by others, the Courts appear to be reluctant to extend the duty that far. Would it be different if the affected shareholders bring a claim? There is a distinct possibility if the decision in Caparo is anything to go by. There were hints of it in the proposed litigation between Equitable Life and Ernst &Young ten years ago but sadly, that case was withdrawn before it reached the courts. At the end of the day, it is all going to come down to the disclaimers in the report and what the Courts consider would be fair and reasonable in the circumstances.

Free professional negligence helpline

If you feel that you have a claim for auditor negligence, please call solicitor Emma Slade on 0808 139 1595 for a free initial assessment. Alternatively, you can contact us by e-mail at [email protected]


Leave a Reply