Livent: Limiting the Illegality Defence and Confirming “Increase in Net Deficiency” as Basis for Damages

In claims by companies against their negligent auditors, proving a breach of duty is often only the first in a number of obstacles to recovery of damages. Other obstacles include:

• the argument that the claim is barred because the fraud of the company’s directors is attributed to the company, with the result that the company cannot bring a claim arising from its own fraud (the “illegality” or ex turpi causa defence);
• the argument that losses suffered by the company are not recoverable because they were not caused by the auditors’ negligence and are too remote; and
• the appropriateness of measuring the company’s loss by reference to the increase in a company’s net deficiency of assets (“increase in net deficiency”) between (1) the date when the company would have stopped trading had the auditors not breached their duty, and (2) the date when the company was actually wound up.

These matters arose in the 2014 decision in the Ontario Superior Court of Justice ([2014] ONSC 2176) arising from Deloitte’s audits of Livent Inc, a live theatre production company listed on both Canadian and US stock exchanges, which collapsed in 1998 after it emerged that its two founders had inflated the earnings and profitability of the company for several years. In proceedings brought by Livent’s Special Receiver, Gans J found that Deloitte had been negligent in auditing the 1997 and 1998 financial statements of Livent and awarded damages of C$84.75 million plus interest. Deloitte appealed to the Ontario Court of Appeal and Livent cross-appealed.

In a 154 page judgment, the Court of Appeal dismissed both the appeal and cross-appeal (Livent Inc v Deloitte & Touche [2016] ONCA 11). The Court of Appeal’s decision provides clarification of these important principles as they apply in Canadian law, which is also likely to have some influence on the approach taken by other common law jurisdictions.

The precise scope of the illegality defence (otherwise known by the Latin maxim ex turpi causa) awaits definitive clarification in the UK following the Supreme Court decision of Jetivia SA v Bilta (UK) Ltd (in liq) [2015] 2 WLR 1168.[1] However, in Canada it is well established that ex turpi causa will only apply where permitting recovery by the plaintiff would give rise to inconsistency in the law and thereby damage the integrity of the legal system.

Highlighting the exceptional nature of the defence, the Court of Appeal suggested that there would be limited circumstances in which fraud by senior management could be attributed to the company to allow a third party auditor to rely on the ex turpi causa defence as:

• one of the “very things” an auditor is retained to do is to exercise reasonable care in relation to detecting fraud; and
• it would undermine the value of the audit process and the integrity of the justice system if auditors could defeat a claim for breach of duty in failing to detect managerial fraud by attributing that fraud to the company.

The Court of Appeal distinguished the well-known case of Stone & Rolls Ltd (in liq) v Moore Stephens [2009] 1 AC 1391, where the House of Lords held that ex turpi causa barred a claim against the company’s auditors, as a case which involved a one-man company. Following the similar views expressed by members of the UK Supreme Court in Bilta and by Lord Walker sitting in the Hong Kong Court of Final Appeal in Moulin Global Eyecare v Commissioner of Inland Revenue [2014] 17 HKCFAR 218, this decision confirms that ex turpi causa will not assist auditors facing negligence claims save possibly in cases where the fraudster was the sole director and shareholder of the company.

With respect to causation, the UK Court of Appeal decision in Galoo Ltd (in liq) v Bright Grahame Murray [1995] 1 All ER 16 is often relied upon by auditors (including Deloitte in this case) to argue that “trading losses” arising after the point at which the company would have stopped trading (had the auditors fulfilled their duty and uncovered the fraud) are not recoverable because the auditor’s negligence only created the occasion for the losses to occur but did not cause the loss itself.

The Court of Appeal directly addressed Galoo, distinguishing it on the basis that the statement of claim in that case only pleaded that the auditor’s negligence permitted the company to continue in existence. However, Livent had drawn the causal nexus – missing in Galoo – between Deloitte’s negligence and Livent’s loss. Deloitte’s breach resulted in the issue of comfort letters and audit opinions which permitted Livent to incur increased liabilities it could not repay, losses which were the reasonably foreseeable result of its breach.

As for the quantification of damages, the Court of Appeal did not disturb Gans J’s approach at first instance whereby damages were calculated by reference to the change or increase in the losses sustained by Livent between the time of Deloitte’s breach and the time of Livent’s eventual filing for bankruptcy protection. Gans J applied a 25% reduction to the headline “increase in net deficiency” amount in recognising that this related to losses which resulted from the vicissitudes of Livent’s legitimate business and were thus not recoverable.

This was the first case whereby damages in an audit negligence claim have been quantified by reference to the increase in net deficiency of the company. The affirmation of this approach by the Court of Appeal provides welcome guidance to companies and liquidators engaged in audit negligence claims as to how the courts may approach, in an appropriate case, the quantification of such losses.

[1] The illegality defence will be considered by the UK Supreme Court (9 Judges) in Mirza v Patel, to be heard on 16 to 18 February 2016.