The recent High Court decision in Arrowhead Capital Finance Ltd (In Liquidation) v KPMG LLP will have accountants breathing a sigh of relief. The case is of particular interest to professional services firms because the claimant was not KPMG's client; it was a third party investor, who claimed that KPMG owed it a duty of care.
KPMG's client was Dragon Futures. Dragon was anxious to ensure that it would be able to recover the VAT charged on the purchase price of mobile handsets, which it was in the business of selling on. It retained KPMG to give it advice on establishing procedures to that end. The general terms and conditions attached to KPMG's letter of engagement with Dragon included a term which excluded any third party rights in the usual way.
Arrowhead, the claimant, made loans to Dragon through an intermediary. During the negotiations leading up to the loan, Dragon provided Arrowhead with documents which included reference to the advice KPMG was providing. KPMG knew that Dragon had told Arrowhead about its engagement, but had no direct contact with Arrowhead except for a conference call (and, perhaps, a meeting) at which all three were present.
Ultimately, HM Customs & Excise rejected almost all of Dragon's VAT claims. As a result, Dragon was wound up soon afterwards, with no distribution to creditors. Dragon defaulted on its loans, leaving an outstanding principal sum of more than $30 million and some $22 million of interest.
Arrowhead's claim was based on the following assertions, namely that:
- KPMG knew of the relationship between Dragon and Arrowhead;
- KPMG knew of the critical importance to Dragon's business of recovering the VAT; and
- Arrowhead would only provide the loans on the basis that KPMG was providing reasonable advice, such that Arrowhead could be assured the VAT claims would be successful.
While the court largely accepted the factual assertions advanced by Arrowhead, as set out above, this was still not enough to get it 'home and dry'. In deciding whether KPMG owed a duty of care to Arrowhead, the court applied the established tests:
- Had KPMG 'assumed responsibility' to Arrowhead?; and
- Was the threefold test from the House of Lords decision in Caparo v Dickman of forseeability, proximity, and 'fairness, justice and reasonableness' satisfied? In Caparo, the House of Lords held that the auditors owed no duty of care for their audit work either to individual shareholders or to members of the public who might be potential investors. The duty of the auditors was owed to the company, and the purpose of the audited accounts was not to enable investors to decide whether or not to invest.
The court described it as 'inconceivable' that Arrowhead could reasonably have considered KPMG was voluntarily assuming an unlimited responsibility towards potential investors in Dragon. This was particularly the case given that Arrowhead must have expected that KPMG's terms of engagement would limit KPMG's liability to Dragon and to others.
It was also significant that Arrowhead was not investing directly, but through an intermediary. While KPMG knew its involvement was being described to potential investors by Dragon, this did not mean it had accepted responsibility to Dragon other than as set out in the engagement letter, let alone to a whole chain of investors.
As to the threefold test, the court was prepared to assume for the purposes of the application that Arrowhead would be able to satisfy the requirements of forseeability and (albeit with a little more reluctance) proximity. However, the court was clear that it was not fair, just and reasonable to impose a duty; and it reached this conclusion for essentially the same reasons that it concluded there had been no assumption of responsibility.
First, Arrowhead would have known that KMPG's relationship with Dragon was on terms which contained limitations to its liability to Dragon and others. Second, Dragon was engaged in a high risk business. Third, KPMG would not have been prepared to accept responsibility to Arrowhead had it been asked to do so.
Accordingly, on whichever basis, KPMG did not owe a duty of care to Arrowhead. It is worth noting that the court also concluded Arrowhead's claim would have failed on the basis of limitation in any event.
This decision is a welcome one for accountants because it confirms that, unless there are special circumstances, they will not be held liable for the impact of their advice on third parties. The terms of KPMG's retainer letter were also a significant factor in the court's judgment, so this decision underlines the importance of robust and carefully drafted terms of engagement. Such letters should contain appropriate limitations and exclusions of liability to third parties.
What's the status of an undisclosed report prepared by an expert at the same time as a report which has been disclosed?
In Odedra and another v Ball and another the High Court considered whether to order disclosure of an expert's report prepared by the claimant's expert at the same time as the report which the claimant had actually disclosed.
The claimants had permission to rely on an expert report in proceedings and that was disclosed. The expert had also been instructed to prepare a second report, intended to assist with the claimants' interpretation of the anticipated report from the defendants' expert. The latter was not disclosed and was not relied on by the claimants. The defendants made an application for disclosure.
The defendants sought to rely on two cases:
- Vasiliou v Hajigeorgiou in which the Court of Appeal held that permission to rely on the evidence of a new expert in place of one previously appointed required the waiver of privilege in the first expert's report; and
- Edwards-Tubb v JD Wetherspoon where the above principle was applied to the report of a named expert, appointed before proceedings were commenced (but as part of the pre-action protocol process). In this instance, the party later wished to rely on a second expert's report.
In Odedra, Coulsen J found that there was no authority dealing with the status of an undisclosed report prepared by an expert at the same time as a disclosed report. He acknowledged that in certain instances openness "will trump questions of privilege" and there may be cases where an expert may have to disclose both reports as a condition of being permitted to give evidence at all. However, he also acknowledged that "there may be cases where requiring an expert to disclose everything that he produces, regardless of privilege, could give rise to injustice."
In this case, the disclosure of the undisclosed report was refused as the judge considered both experts had become "slightly confused" over what was being asked of them. Requiring disclosure of privileged reports based on a misunderstanding of the issues would be wrong and potentially unjust. However, absent that confusion, openness under the CPR may well have trumped privilege.
This case confirms there is no general rule that everything is discloseable, regardless of privilege. But there are still likely to be cases where the power to require disclosure of a privileged expert report where the expert involved has changed can also apply to an undisclosed report by a party's expert. A party may therefore be required to waive privilege in the undisclosed report before it can rely on its expert evidence. Practically, the decision may give rise to standard enquiries about other reports that may have been prepared by an expert.
R (on the application of Hill) v Institute of Chartered Accountants in England and Wales concerned a chartered accountant's application for judicial review of a decision taken in disciplinary proceedings by the ICAEW.
The Institute had commenced proceedings against the applicant on the basis that he had committed an act or default likely to bring discredit on himself, the Institute, or the profession. A Tribunal Committee found that the claim had been proved and the applicant was subsequently unsuccessful in appealing to the Institute's Appeal Committee.
The tribunal panel had consisted of the chairman, a chartered accountant and a lay member. On the fourth day of the hearing, with the consent of representatives of the Institute and the applicant's solicitor, it had been agreed that the hearing could continue past 5pm. It would do so with only a two member panel consisting of the chairman and the chartered accountant. It was also agreed that the lay panel member would be provided with a transcript of the remainder of the hearing.
The lay panel member therefore left at 5pm and the hearing continued until 6.35pm, during which time the applicant was cross-examined. The hearing was then adjourned and reconvened at a later date with a full panel, at which point no objection was made to the previous absence of the lay panel member. It was also evident that the lay panel member had read the transcript of the 95 minutes he had missed of the previous session.
The application for judicial review was made on the basis that the hearing was a nullity, because a panel member was absent during part of the cross-examination of the accountant. Furthermore, the consent of both parties to the absence could not confer powers on the tribunal which it did not have under the Institute's disciplinary bye-laws.
The judge held that the tribunal's decision to sit briefly without one member of the panel was a procedural decision. It did not affect its "jurisdiction to enter upon the inquiry", nor did it affect its "constructive jurisdiction" and was permissible under the relevant rules.
Yet, while the lay panel member was only absent for a short period, he missed a crucial part of the accountant's cross-examination. The judge found that the tribunal could have adjourned and continued the cross-examination at the adjourned hearing; particularly since this was required anyway. However, while the tribunal had failed, without justification, to conduct the proceedings in accordance with the rules of natural justice, the accountant had voluntarily waived the right to object to the panel member's temporary absence. He was therefore bound by that waiver.
Any concerns over the due process of a hearing should be raised at the hearing and in a timely fashion. If there has been a breach of the principle of natural justice and fairness, a party must be careful not to voluntarily waive any such breach.
If you intend to make an offer of settlement which has the costs consequences of Part 36 of the Civil Procedure Rules (Part 36), then make it a Part 36 offer.
This was the finding of the Court of Appeal in F & C Alternative Investments (Holdings) Ltd and others v Barthelemy and another. In complex proceedings, the defendants made an offer of settlement to the claimant in relation to all the proceedings between them. The offer stated that it was not a Part 36 offer, as it had to be made outside Part 36 due to procedural matters. Instead, they would ask the court to treat it as analogous to a claimant's Part 36 offer.
The defendants succeeded at trial and were awarded a sum greater than their offer, so 'beating' the Part 36 offer. The judge awarded the defendants indemnity costs and interest for the period commencing 21 days after the offer was made.
The judge's reasoning was that the offer was akin to a Part 36 offer. He held that where a party made an offer which had sought to comply with Part 36, while explaining why the offer could not comply with the requirements of Part 36, it might be appropriate for the court to exercise its discretion on costs by analogy with Part 36.
The claimant successfully appealed. The Court of Appeal held that the starting point was that the offer was not a Part 36 offer: the defendants had said as much when making it. The jurisdiction as to costs therefore came within Part 44.3 of the Civil Procedure Rules and Part 36 could not be invoked. Part 36 is a self contained code and there was no reason or justification to extend Part 36 beyond its expressed ambit. For an offer to be a Part 36 offer, it had to strictly comply with the Part 36 requirements. This offer did not.
The judge should have taken the offer into account when determining costs under Part 44.3. There was nothing in the claimant's behaviour in the proceedings which justified an award of indemnity costs against it. The award of indemnity costs was therefore wrong in principle and would be set aside.
If a Part 36 offer is intended, it should be so headed and comply in all respects with the formal requirements set out in Part 36. It will then be treated as a Part 36 offer by the court for costs purposes. If, for whatever reason, any other form of offer is made, it will not have the same costs consequences as a successful Part 36 offer. Additionally, this case is clear authority that a 'non-Part 36' offer will not be treated by the court as analogous to an actual Part 36 offer.
FRC Report: Independent Oversight of Regulation of the Audit, Accountancy and Actuarial Professions
On 2 July 2012, the responsibilities and activities of the Professional Oversight Board (POB) (including the statutory oversight of the regulation of statutory auditors) were transferred to the Financial Reporting Council (FRC). On 18 July, the FRC published the POB's final report to the Secretary of State for Business, Innovation & Skills on its oversight of the regulation of the audit, accounting and actuarial professions for the year to 31 March 2012.
The POB noted that recognised bodies have engaged closely with it and responded positively and constructively to its findings and recommendations in the years since the POB's inception in 2004. This has lead to incremental improvements to systems and practices.
For the year to 31 March 2012, the POB noted that much regulatory practice was of a high standard. It did, however, raise specific concerns about the ability of Chartered Accountants Ireland to meet its statutory obligations regarding inspection of UK audit firms and the quality of the recognised qualification and examinations provided by the Association of International Accountants.
More generally, it recommended that the audit monitoring process should be modified to assist with improvements to audit quality. Here it proposed naming and shaming bodies who appeared slow to respond to the POB's prior year recommendations.
The report found that audit monitoring was of generally high quality. However, initiatives to improve audit quality have not clearly been successful in bringing permanent improvements. In addition, monitoring bodies did not always question inadequate responses by audit firms sufficiently. The POB has proposed that each recognised body prepares a three year action plan to raise audit quality and reduce the number of successive findings of unsatisfactory audit inspection.
The Audit Inspection Unit (which reviews the quality of 100 statutory audits of listed and other major public interest companies) did, however, note an improvement in inspection results. See our fuller summary below.
Perhaps most tellingly, the POB identified the continuing downward pressure which audited entities are exerting in relation to audit fees. The POB warned that audit firms must establish safeguards to ensure the total number of audit hours, the determination of materiality, and the extent of work all remain at an appropriate level to protect the quality of an audit - regardless of the fee level.
Finally, the report welcomed the introduction of increased powers for the FRC, which will now be able to make directions to assist bodies in meeting their statutory obligations. It will also be able to impose financial penalties upon them. These are in addition to the existing powers to seek a High Court Order for compliance and (in certain circumstances) to revoke the recognition of a recognised body.
As alluded to in our round up of the POB's oversight report, the FRC's Audit Inspection Unit (AIU) has also reported on the 94 audit quality inspections it undertook in the year to 31 March 2012.
The AIU noted a continued improvement in audit quality, with just 10% of reviewed audits assessed as needing 'significant improvement'. But, at the same time, it stressed the importance of embedding professional scepticism in the audit process and warned of the danger of firms sacrificing audit quality in an increasingly cost-driven market place.
While the POB's report was directed to the secretary of state (by whom its powers are delegated), the AIU's report is primarily for the audit firms it inspects and the audit committees of audited entities.
The AIU's key messages to audit firms were to (as noted above):
- establish safeguards to ensure audit quality in the face of a competitive fee climate;
- apply professional scepticism, particularly in the impairment of goodwill and other intangibles; and
- challenge the assumptions in loan loss provisioning in the audit of financial institutions.
Added to the above, it also reinforced the importance of identifying and assessing threats to auditor independence and reporting these to audit committees. It reserved judgement on the practical efficacy of audit firms' quality control review teams in driving up audit quality - a matter which it will continue to focus on.
The AIU also encouraged audit committees of audited entities to consider the impact of agreed fee reductions on the proposed scope of an audit and whether the proposed scope is likely to be sufficient to ensure quality is not compromised. Furthermore, it suggested that audit committees have a role to play in ensuring audit firms apply professional scepticism - for instance, by encouraging a dialogue in relation to management judgements in order to reveal the extent of an auditor's challenge.
Consultation: FRC disciplinary schemes - proposed changes
Another month, another FRC consultation. Shortly after we went to press on the first edition of Accountability, the FRC launched a consultation on proposed changes to its disciplinary schemes for the accountancy and actuarial professions. These proposals are targeted at creating a 'more streamlined disciplinary process'. Following the restructure of the FRC and its operations, responsibility for the schemes will pass from the Accountancy and Actuarial Disciplinary Board direct to the FRC.
The proposals include introducing a procedure to enable cases to be concluded by agreement rather than tribunal (albeit with published results) and a power to impose interim orders. The FRC is clearly keen on handling disciplinary matters proactively, as it has also proposed arrangements for individual cases to be monitored by a Case Management Committee.
Among the FRC's aims is enhancing the independence of the disciplinary schemes from professional bodies. It intends to do this by removing the requirement for consultation with the relevant professional body before it launches an investigation, as well as removing the requirement that future changes to the schemes must be approved by such bodies.
In short, the proposals target improved efficiency and effectiveness as well as enhanced independence and transparency. The FRC's consultation closes on 15 September 2012.
ICAEW consults on its plans to regulate legal services
Not to be outdone by the FRC, the ICAEW has also launched a consultation on its application to become a regulator of Alternative Business Structures (ABS). ABS, which were introduced by the Legal Services Act, allow accountants, lawyers and other professionals to open up multi-disciplinary business structures. In turn, this allows for accountants to provide legal services which were previously reserved to lawyers.
Recognising the opportunities and risks ABS offer to its members (as well as a potentially increased pool of members), the ICAEW wishes to apply to become a licensing authority of ABS and an approved regulator of the (previously reserved) legal service of probate. If its application is successful, then this will enable the ICAEW to authorise firms to offer probate work and license firms as ABS.
Wragge & Co's professional liability experts can advise accountants and other professionals on these and a range of other liability risk management issues. More information about their work in the sector is available online under the firm's professional liability expertise.
Mark Grant, associate, +44 (0)121 685 2817, email@example.com
Hannah Novak, solicitor, +44 (0)121 214 1067, firstname.lastname@example.org
This analysis may contain information of general interest about current legal issues, but does not give legal advice.