To catch a thief

Judgment in the recent case against Moore Stephens raised two issues of particular interest. Suzanne Kearney and Richard Highley explain the implications.

On 30 July 2009, the House of Lords dismissed a claim of negligence brought by the liquidators of Stone & Rolls against Moore Stephens, which had been S&R's auditors during the period 1996 to 1999.

The facts of the case were as follows. S&R was a company incorporated in the UK, owned and controlled by a Mr Stojevic, who persuaded Czech bank Komercni Banka to advance $90m (£55m) to S&R, which he then stole. The bank obtained judgment against Mr Stojevic and S&R, and the latter went into liquidation. S&R's liquidator brought a claim against its auditor, Moore Stephens, alleging it was negligent in failing to detect and stop the fraud that left the company insolvent, seeking damages of just under $174m.

The leading judgment given by Lord Phillips was approved by a majority of three to two. There was also a sharply worded dissenting judgment from Lord Mance.

While the legal reasoning is complex, the result is straightforward. Following the decision in Stone & Rolls v Moore Stephens, auditors of a UK company that has a sole shareholder/director who defrauds the company are safe from a negligence action brought by the company seeking to make the auditors liable for failing to spot the fraud.

The rationale is that under the defence of ex turpi causa — also known as the 'illegality defence' — UK courts will not assist a claimant in recovering compensation due to it if part of its case is to claim its own illegal conduct caused the damage or loss.

The House of Lords found in S&R that such a defence applies where — as here — the sole shareholder and directing mind of the company was the perpetrator of the fraud and, thus, the fraud should be imputed to the company.

Main issues

The S&R decision highlights several interesting issues, but consideration can be confined to what appear the two main ones.

First, the majority decision relied upon the lack of any innocent directors and shareholders in S&R to conclude that the fraudulent acts of Mr Stojevic were to be imputed to the company, thus triggering an ex turpi causa defence. This raises the prospect of future claimants arguing that such a defence should not apply where there are one or more innocent directors or shareholders.

Secondly, Lord Mance disagreed that the ex turpi causa defence should apply, even to companies where there is a sole director or shareholder, when the company is insolvent. Lord Mance accepted that the fraud should be imputed to the company, but pointed out that auditors owe additional and different duties once a company falls insolvent. For example, where fraud is suspected, instead of reporting to shareholders, auditors are under a duty to notify public authorities.

His reasoning was complex, but the nub of Lord Mance’s concern was that, in the modern world, English law should recognise that where there is insolvency, creditors are as deserving of protection against the consequences of fraud on the part of a company as the company’s shareholders. Lord Scott also noted (dissenting) that S&R would remain insolvent — regardless of the damages recoverable from Moore Stephens — and there was, therefore, no possibility of Mr Stojevic benefiting from any damages recoverable from the auditor.

The first of these two issues will spawn further legal argument. The second may yet lead to recommendations for a change in the law — either through legislation following a law commission or through the House of Lords reconsidering its decision.

Dealing with the second issue in a little more detail, what happens in the real world to auditors when they deal with strong personalities like Mr Stojevic? Over the last 20 years or so, businesses have often grown under the leadership of powerful individuals who create a cult of ‘self’ within the company they lead. What happens when the auditors of those businesses uncover problems that need voicing to external authorities or other directors of the business? Is the auditor responsible if the board of such a company ignores their advice on a problematic issue? And what happens when the auditor is ‘bullied’ into not revealing problems? Do we, the outside world, not only expect but want them to resign — and is this either realistic or desirable?

It is possible to imagine that such companies would be more likely to turn to auditors with less ability and resources to achieve a clean audit. This, in turn, increases the likelihood of corporate abuse — or even fraud.  

Furthermore, how far do we want to see auditors made liable in these circumstances, when their resignation may not be in the interests of either the company, its shareholders or creditors?  

Systemic failures

This is not economic theorising — it is a real issue. One only has to look at such recent systemic failures as MGN, Northern Rock, Royal Bank of Scotland, Stanford and Lehman Brothers — among others — to understand that these points do have resonance.

Where there is corporate failure, there will be claims against professional advisers. As noted above, corporate failure can result from dominant, all-powerful chief executives who do not want ‘bad news’, complex corporate structures, hubris and an imbalance between the need to recognise that there are problems and very large financial rewards.

The role of an auditor, and the needs of the modern economy, justifies a holistic review of auditor liability (who they should be liable to and in what circumstances), with regards to the modern model of corporate governance.

If an auditor is made responsible when the company is insolvent through a fraudulent controlling mind, which is where Lord Mance seems to be trying to lead us — or, to put it another way, financially responsible for the Robert Maxwells of this world — will the judiciary’s sense of social justice encourage audit work fit for the 21st century? This is not to suggest Lord Mance is incorrect, but hard cases can make bad law and his concerns have merely touched upon wider issues for which UK common law may, in hindsight, be judged too blunt an instrument.

Suzanne Kearney is director at loss adjuster ASL and Richard Highley is a partner at law firm Davies Arnold Cooper

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