Auditors' Liability For Failure To Identify Fraud

In an important decision last week, the Court of Appeal

considered whether or not a company which had committed fraud

could nevertheless claim against its own auditors for failing

to detect and report that fraud. The Court of Appeal held that

it could not and struck out the alleged US$ 170 million claim

against the auditors. This was because in bringing the claim,

the company had to rely on its own fraud.

In reaching this decision, the Court of Appeal unanimously

overturned the first instance decision of the court below. For

our Law Now on that decision, please

Click here.

The case concerned a company where an individual, Mr S, was

the directing mind and will. It was essentially a "one

man" company. The company practiced various frauds on a

bank. The bank succeeded in its claim against the company. The

company then went into liquidation, and the liquidators claimed

against the auditors. So, although the claim was brought by the

liquidators, the main beneficiaries of any award would be the

bank. There was no question of any duty of care being owed

directly to the bank by the auditors.

The court was faced with two key questions. First, was the

fraud practiced by Mr S to be attributed to the company?

Secondly, if so, did this preclude the company from claiming

against the auditors, based on the principle that a claimant

cannot rely on its own illegal or immoral act to make a claim

(the Illegality Defence).

In a decision which brings welcome clarity to both these

areas, the court held that:

the company was treated as itself having knowledge of the

fraud;

there is an established principle that knowledge of a

director's fraud committed against a company of which he

or she is director is not attributed to that company (the

Hampshire Land principle). This is because the company is the

primary victim of the fraud;

here, the company was not the primary victim of the

fraud. That was the bank. So the fraud of Mr S could be

attributed to the company which was, in reality the

perpetrator of the fraud;

to bring its claim against the auditors, the company had

to rely on its own illegal act. This precluded it from doing

so;

it did not matter that "the very thing" the

auditors were engaged to do was to detect whether the company

was engaged in fraud. The Illegality Defence is based on an

unforgiving and uncompromising principle founded in public

policy, rather than something which can be applied at the

court's discretion. The judge at first instance had been

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