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FINANCIAL POST, WEDNESDAY, MAY 29, 2002
LEGAL POST
If Livent lied to Deloitte & Touche, does that excuse the auditor
of liability to the firm? That’s what a court case seeks to decide
Auditors take centre stage
BY SANDRA RUBIN
Senior Business Writer
he case involves allegations of fraud and transactions that didn’t show up on the
company’s balance sheet. It’s being closely watched because of the possibility it
could redefine the scope of auditor liability. Enron and Arthur Andersen? No.
Livent Inc. and Deloitte & Touche.
The suit, brought by the court-appointed special receiver, alleges that Deloitte’s
Canadian and U.S. offices breached their responsibility to Livent by failing to uncover a
fraud being carried out by some members of senior management.
In many respects, the action is strikingly similar to one filed by the litigation
supervisor in YBM Magnex International Inc. The civil suits in YBM were settled in
February without any admission of wrongdoing.
J.L. McDougall, a corporate litigator with Fraser Milner Casgrain in Toronto,
represented Deloitte & Touche in YBM and is on for the giant accounting firm again in
Livent. Mr. McDougall declined to discuss either case.
However, he filed a motion to strike the receiver’s case against Deloitte & Touche
in YBM, claiming the company did not have a cause of action against the auditors, and
neither did the individual shareholders.
He pointed, in part, to the Supreme Court of Canada’s decision on Hercules
Management Ltd. v. Ernst & Young which found that ordinarily, accountants have no
duty to individual shareholders of a corporation. Mr. McDougall also pointed to an
exclusion clause in Deloitte’s engagement letter.
The motion was fully briefed and set to be argued when YBM was settled. Some
people watching Livent strongly suspect that Mr. McDougall will bring the same motion
this time around.
If the receiver’s case – mounted in both YBM and Livent by Peter Howard and
Patrick O’Kelly of Stikeman Elliott – stands, it will set a new standard for accounting
firms in terms of liability to the companies that they audit.
The allegations in the receiver’s suit, which are unproven in a court of law, paint a
picture of Deloitte as an accounting firm that frequently changed audit partners assigned
to the file without ensuring they had experience or in-depth knowledge of theatrical
production, Livent’s line of business.
Deloitte, which provided both auditing and consulting services to Livent,
provided unqualified audit opinions from 1995 to 1997.
It acted as Livent’s auditors until the firm filed for bankruptcy protection in the
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United States and Canada in November, 1998 – immediately after restating its financial
for 1996, 1997 and part of 1998.
The statement of claim does not say that Deloitte was a knowing participant in
any fraud, merely that the accountants ought to have uncovered it in the course of their
work.
It does allege that Garth Drabinsky, Livent’s chairman, and Myron Gottlieb, its
president, “repeatedly lied to and withheld information from the auditors through their
tenure.”
It also alleges, however, that while Deloitte classified the Livent engagement as
high-risk, it failed to adequately follow up when presented with what the suit calls “red
flags.”
“Deloitte actually selected for testing as part of its random sample for testing
invoices... documentation that, upon inspection, would have revealed that direct operating
expenses and pre-production costs had been falsely reclassified as construction-related
expenses, but failed to follow up and insist upon receiving the requested documentation.”
Deloitte & Touche said in a statement it would vigorously defend the allegations.
A senior Canadian litigator, speaking on condition of anonymity, says some broad
issues stand to be resolved if the case goes to trial, issues that have become increasingly
pressing everywhere since Enron.
“Because there was fraud by management, does that excuse Deloitte completely?
What’s the obligation of an auditor when management is purposely trying to deceive it?
What is the standard? How can you blame them if the general ledger was changed, things
weren’t disclosed to them and documents were withheld, as is alleged?
“In terms of financial-statement train wrecks and things that are happening these
days, that’s reasonably unsettled in Canadian law.”
But the presence of the court-appointed receiver filing suit against professionals
such as Deloitte & Touche risks creating potential friction between traditional defence
firms, such as Stikeman Elliott, and Canada’s fledgling class-action bar, which operates
on contingency fees.
In YBM and Livent, shareholders had also sued the auditors, as part of larger suits
in connection with the fraud.
The question is can both expect recovery?
“If you’re asking whether the accounting firm or any other defendants would have
to pay twice for the same actions, the answer is no,” says Harvey Strosberg, who led a
shareholder class-action suit in YBM. He is not involved in Livent.
“But is one cutting the other’s grass? I think it is apples and oranges.”
There is no question that in some ways, a corporation – with its contractual
relationship with lawyers and accountants – is in a stronger position under the law to
successfully bring suit.
However, says Mr. Strosberg, although the class-action laws in most provinces
are not very strong in terms of giving shareholders redress in the case of market fraud, in
some instances “innocent shareholders” may be at a clear advantage.
He says courts have yet to rule whether a company involved in a fraud can
successfully sue its professional advisors for damages.
“If a corporation is making a statement into the marketplace that is fundamentally
flawed, there is no doubt that the corporation is liable,” he says. “Now, the allegation in
YBM was that there was a fraudulent activity and the accountants didn’t discover it. That
is the same thing being said in Livent.
“But can a company say: We carried on a fraudulent activity and you didn’t catch
us doing it, and therefore you’re liable? The accountants would argue that you could
never make a recovery under those circumstances because the corporation is the
wrongdoer.
“That wasn’t decided in YBM and will be decided in Livent if it goes to trial.”