The measure of damages is determined by using the formulae, Loss (L) = Actual Liquidation Deficit (ALD) – Estimated Liquidation Deficit (ELD). The ALD is usually easily determined and agreed upon-it represents the losses suffered at the time of the liquidation of the business’s assets. The ELD is simple in theory but invariably in dispute and much harder to resolve. The question to ask is what the loss was at the date on which the auditors breached their standard of care to the business known as the Measurement Date. Had the fraud been discovered by the auditors, when it should have been, the business would have become insolvent then and the losses lower as no further investment would have been possible.
Therefore the court must analyze and determine the following:

• What was the standard of care in the circumstances?;
• Was it breached?;
• If so, when did the breach occur which effectively caused the losses to be incurred?;
• What is the correct measure or amount of those losses? and;
• Were all of the losses suffered reasonably foreseeable, and if not, what deduction should be made?

The Duty of Care of Auditors:

There is little dispute that an auditor owes a duty of care to the client company. The articulation of that general standard is found in Kingston Cotton Mill Co. (No. 2),  and subsequently adopted by the Supreme Court of Canada (SCC) in Hercules Management Ltd. V. Ernst & Young.
It is the duty of an auditor to bring to bear on the work he has to perform that skill, care, and caution which a reasonably competent, careful, and cautious auditor would use. What is reasonable skill, care, and caution must depend on the particular circumstances of each case.

Functions of an Audit:

Audits fulfill two key objectives.

Firstly, they ensure that the financial information presented by management provides a fair and accurate picture of the financial affairs of the corporation and of any changes in the financial position of the corporation.

Secondly, they provide shareholders with information for the purpose of overseeing the management and affairs of the corporation (including the ability to measure the level of honesty with which management performs its duties.

In the case of publicly-traded corporations, an audit has a third important objective involving the responsibilities of securities regulators and the interests of the investing public. It is not only the corporation and its existing shareholders who need and rely on the auditors’ reports. Securities regulators and members of the investing public also rely on them for disclosure of a fair and accurate picture of the financial position of the corporation. The auditors’ standard of care in such circumstances must reflect this reality as well. (Livent Inc. v. Deloitte& Touche and Deloitte & Touche LLP)

Duty Not Owed to Investors:

However, the duty is not owed, generally speaking, to any investors in the business. Auditors do not owe a duty of care to investors as individuals and that a claim for auditor’s negligence causing harm to the corporation rests with the corporation; it must be pursued either by the corporation or by way of a derivative action on behalf of the corporation, as the SCC also noted in Hercules.

The Duty is Contextual:

The duty is therefore contextual. It arises from the particular facts of each case. This includes the factual setting of the audit, the terms of the engagement letter, the legislative framework, and the professional standards of auditors existing at the relevant time.

The relevant sources to establish the standard in the circumstances are any applicable legislation, the handbooks of the Canadian Institute of Chartered Accountants (CICA) the Institute of Chartered Accountants of Ontario (ICAO) and any internal handbooks or policies of the auditing partnership.

Once determined, the standard of care is applied to the facts to determine if it was breached. If it was, and assuming causation is found, damages are then assessed.

Back to Damages:

The measure of damages is the same whether viewed as a tort or a breach of contract. The company is to be put in the same position it would have been had the tort of negligence, or the breach of contract never occurred. The formulae for doing so is as stated earlier-L=ALD-ELD. The Measurement date is a finding of mixed fact and law made by the trial judge based on the evidence. That is the date which, but for the breach of the standard of care, would have brought the fraud to light and thereby ended the company’s business. The amount of the loss is also a finding made by the trial judge again based on the evidence most often given by experts on business valuation. Finally, the judge must determine whether all of the losses were reasonably foreseeable. This involves asking the whether some or all of the losses are too unrelated to the wrongful act (breach of the standard) to hold the auditors fairly liable? If there are any such losses, their value would be deducted from the total determined by the loss formulae.

If you have a question about civil fraud, asset recovery, injunctive relief, enforcement of foreign judgments or similar, the highly skilled Toronto corporate lawyers at Milosevic & Associates can help. We can provide you with advice and guidance suited to your unique situation. Call us at 416-916-1387 or contact us online to learn more about how we can help.