Auditors’ Liability to Third Parties: Massive Liability May Not Be Indeterminate

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Paradoxically, the application of the Hercules Managements duty of care test in cases like Widdrington (Estate of) v. Wightman, 2011 QCCS 1788, affirmed QCCA 1184 (“Castor Holdings”) may actually work to expand, rather than narrow, liability.

In Castor Holdings, the plaintiff claimed against the auditors of Castor Holdings, a private investment bank, for misrepresentations made in various financial statements. The audited financial statements were intended for several purposes, among them, to obtain financing. The plaintiff had invested in the company and suffered a loss when it was discovered that the financial statements bore no resemblance to reality.  This case was a “test” case, whose results were binding in 75 other cases with claims totalling over $1 billion.

Because the applicable law was in issue, the trial judge applied both the civil law and, in obiter dicta, the common law Hercules Managements test and found liability under both regimes.

The trial judge found that the auditors were negligent and that they should have caught the discrepancies between the financial statements that were prepared by management and the accounting records they examined.  There were numerous examples of audit practice which fell below the standard of care. However, despite the massive potential liability, the trial judge found that the usual concerns of indeterminate liability did not arise here. Firstly, the financial statements were prepared for a purpose which was known to the auditors, although that purpose was very broad. Secondly, the class of investors was identifiable to the auditors, despite the fact that the auditors may not have known all of the individual investors.

The decision was upheld by the Quebec Court of Appeal on civil law principles. Because the auditors are likely to appeal the decision, the final impact of Castor Holdings is yet to be determined.

The result in Castor Holdings appears to produce a paradox. While the decision may be consistent with Hercules Managements from one perspective, from another, it does little to assuage the policy concerns about indeterminate liability which the Supreme Court of Canada sought to address.  It is clear as a result of Castor Holdings that massive liability is not necessarily the same as indeterminate or unfair liability.  Here, the trial judge noted that the auditors could have taken steps to protect themselves when they saw the broad purposes for which their work product was being used.