UK: House of Lords - auditors succeed in having neligence claim struck out

The House of Lords gave judgment in Moore Stephens (a firm) v Stone Rolls Limited [2009] UKHL 39 yesterday. By a 3:2 majority, their Lordships held that a claim for breach of duty (in contract and tort) brought by a company in liquidation (Stone & Rolls Ltd.) against its auditors (Moore Stephens) should be struck out. The claim concerned the auditor's failure to detect the fraud of the company's controller, Mr Stojevic.

For the purpose of the proceedings it was accepted that the auditors were in breach of the duty to exercise reasonable care in relation to the auditing of the accounts of Stone & Rolls Ltd. The question was whether a claim for this breach of duty was precluded by the public policy defence of ex turpi causa non oritur actio (no cause of action may be founded on an illegal act). The majority (Lords Phillips, Walker and Brown) agreed that it was. The minority (Lords Mance and Scott) disagreed. 

Reasoned opinions were provided by all five judges and a proper analysis of these will take some time. It is clear, nevertheless, that auditors are now well placed to defend negligence claims where companies are controlled by a single individual and that individual commits fraud that goes undetected. The irony is, of course, that the auditor's role is critical in such companies.  Indeed, as Lord Mance observed in his dissent (para. [206]):

The world has sufficient experience of Ponzi schemes operated by individuals owning “one man” companies for it to be questionable policy to relieve from all responsibility auditors negligently failing in their duty to check and report on such companies’ activities".

Several opinions discuss auditors' duties. Lord Walker observed (para. [179]):

Checking for fraud is part of an auditor’s task, but it is not his sole or primary task (for a reputable auditor to discover that the client company’s business is wholly fraudulent and criminal must be quite unusual).

Lord Phillips observed (para. [19]):

The leading authority is Caparo Industries Plc v Dickman [1990] 2 AC 603. The duties of an auditor are founded in contract and the extent of the duties undertaken by contract must be interpreted in the light of the relevant statutory provisions and the relevant Auditing Standards. The duties are duties of reasonable care in carrying out the audit of the company’s accounts. They are owed to the company in the interests of its shareholders. No duty is owed directly to the individual shareholders. This is because the shareholders’ interests are protected by the duty owed to the company. No duty is owed to creditors – Al Saudi Banque v Clarke Pixley [1990] Ch 313. The Auditing Standards require auditors who have reason to suspect that the directors of a company are behaving fraudulently to draw this to the attention of the proper authority. The scope of the duty ... is unquestionably imposed in the interests of, at least, the shareholders of the company".

Lord Mance stated (para. [217] - [218]):

[Auditing Standard] SAS 110.12 [issued January 1995] (para. 52) provides that:

'When a suspected or actual instance of fraud casts doubt on the integrity of the directors auditors should make a report direct to a proper authority in the public interest without delay and without informing the directors in advance'.

The text at paragraph 56 explains that matters to be taken into account when considering whether disclosure is justified in the public interest may include 'the extent to which the suspected or actual fraud is likely to affect members of the public'. Plainly, one situation in which members of the public would be affected is where the fraud conceals or risks bringing about the company’s insolvency. The viability of a company as a going concern is always a matter of audit importance.

The relationship of company and auditor is not therefore a simple two-party relationship. The company cannot in the audit context be equated with its board of directors or management. The company’s shareholders are – at least while the company is solvent - the main focus of an auditor’s activity and duties. The auditor, in undertaking the statutory role and contractual and tortious duties, is 'acting antagonistically to the directors' ".

Update: a summary of the decision has been provided here by the ICLR as part of its WLR Daily service (the summary will be removed when the decision is reported in one of the ICLR's series of law reports).