UK: England and Wales: unlimited companies and the liability of their members

Judgment was given last Friday in Re Lehman Brothers International (Europe) & Ors [2014] EWHC 704 (Ch). This is an important and interesting judgment concerning, amongst other things, the liability of unlimited company members. The trial judge held, for example, that the obligation of members to contribute under section 74(1) of the Insolvency Act 1986 extended not only to proved debts but also to the statutory interest on those debts and un-provable liabilities. It was also held that the so-called contributory rule - the rule that a company contributory in liquidation cannot recover anything in respect of any claims he may have as a creditor until his obligations as a contributory are fully discharged - did not apply in an administration. The judgment also contains some discussion of the history of unlimited companies in the United Kingdom, the trial judge observing (at para. [132]):

As the limited liability of members, together with a simple process of registration and incorporation, were the principal advantages of the mid-nineteenth century reforms, it is not surprising that there has been only a sparse use of unlimited companies. It appears that their introduction by the Companies Act 1862 was to compensate for the prohibition of partnerships or joint stock companies with more than twenty members or, in the case of banks, ten members. If members wished to have an association which most closely resembled the old joint stock company, the unlimited company was introduced for that purpose. There remained in some circles some stigma attached to limited liability and there were a number of businesses, including banks and building societies, which were incorporated as unlimited companies. A number of cases, though far fewer than those concerned with limited companies, dealt with issues arising out of the liability of members of unlimited companies. The use of unlimited companies, never great, declined during the nineteenth century. In the twentieth century, their principal advantage was an exemption from ad valorem stamp duty, and later capital duty, payable on the issue of new capital by a company. For this reason, their principal use for many years was as estate or investment companies, where estates or other property were transferred to companies in exchange for shares issued to or owned for the benefit of the families owning them. For the same reason, they were sometimes used in complex corporate restructurings and transactions. As appears from the facts of the present case, unlimited companies have found a place in corporate planning for US tax purposes."

Update (17 March 2014) - a summary of the decision has been published by the ICLR: see here.

USA: Lehman Brothers, the Valukas Report and the auditor's role

Anton R. Valukas, chairman of law firm Jenner and Block, published his Chapter 11 Proceedings Examiner's Report for Lehman Brothers Holdings Inc. last week: see here. To quote from the report (vol 1, p. 3):

Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non‐culpable errors of business judgment to actionable balance sheet manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome"

Much attention has focused on the devices through which the balance sheet manipulation was achieved and the role of the firm's auditors in this regard, discussed in volume 3 of the report: see here (pdf). To quote from the report (pp. 732-)

Lehman employed off‐balance sheet devices, known within Lehman as 'Repo 105' and 'Repo 108' transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008 .. Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet ... Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio ... Repo 105 transactions were not used for a business purpose, but instead for an accounting purpose: to reduce Lehman’s publicly reported net leverage and net balance sheet ...

... The Examiner concludes that sufficient evidence exists to support colorable claims against Ernst & Young LLP (“Ernst & Young”) for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings".

So, once more, the value of the external audit is under the spotlight in the USA and beyond. The UK's Financial Reporting Council has requested information from Ernst & Young as part of an enquiry into how the 'Repo' transactions were accounted for and audited in the UK. With regard to the auditor's function, an editorial in today's Financial Times newspaper offers some interesting suggestions, including:

A more manageable change might be a shift from the binary convention that accounts are either fine or qualified. One way to beef up the due diligence value of the audit would be for the auditor to pass judgment on the quality of the information provided – perhaps on some scale with reasons given. This would give the investor a clearer appraisal of the value of the financial information. It would also force the auditor to remember who its customer actually is".