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UK City litigation

Group audits

The Court of Appeal has delivered a judgment of potentially major significance for auditors of group companies. The case arose from claims brought by the liquidators of three BCCI companies against their former auditors, Price Waterhouse and Ernst & Whinney. The Court held that the auditors of the holding company and of one operating subsidiary could owe a duty of care to another operating subsidiary of which they were not the appointed auditors.

The BCCI group, which collapsed in 1991, was a global network of companies and branches. The holding company was incorporated in Luxembourg. It had two principal subsidiaries engaged in the business of banking, one incorporated in Luxembourg though having its largest presence in London and the other incorporated in the Cayman Islands. Ernst & Whinney were the auditors of the two Luxembourg companies. Price Waterhouse were the auditors of the Cayman subsidiary.

These three companies have each brought claims against their own auditors. The Court of Appeal was dealing with additional claims brought by the Cayman subsidiary against Ernst & Whinney in their capacity as auditors of the holding company and its Luxembourg subsidiary. Ernst & Whinney had applied for the claims to be struck out.

The Court thought that, arguably at least, the barrier between Ernst & Whinney on the one hand, and the Cayman subsidiary and Price Waterhouse on the other, was "a mere shadow". It was necessary, if the operations were conducted as a single business as alleged by the plaintiffs, for there to be "a constant interchange of information" between the two firms of auditors.

Ernst & Whinney was, in effect, "the supervising firm" with responsibilities extending, at least arguably, not only to the boards and regulatory authorities of the holding company and its Luxembourg subsidiary, but also to the boards and regulatory authorities of the Cayman subsidiary, as well as to Price Waterhouse as the Cayman subsidiary's auditors.

The Court considered that the strength of the link between the two banks' operations was "most strikingly illustrated" by the treasury operations of the Cayman subsidiary (conducted by the Luxembourg subsidiary's employees from its offices in London) and the transfer of funds (passed between Cayman and London).

The Court, therefore, rejected Ernst & Whinney's application, but pointed out that the facts were "most unusual", emphasizing that its conclusion should not be used to argue in another case that the court should be more ready than in the past to impose liability.

Making directors personally liable

To pierce the corporate veil of limited liability protecting a company and establish a cause of action against its directors in their personal capacity, there needs to be an assumption of responsibility, creating a special relationship between the plaintiff and the director. To succeed in a claim, the plaintiff must show that it reasonably relied on the assumption of personal responsibility. Traditionally, these claims have been difficult to establish.

When the Judge at first instance in Williams v Natural Life Health Foods held that the managing director and principal shareholder of the company was personally liable for the loss caused to the plaintiffs by his company's negligent misstatement, the decision was viewed as a breakthrough.

In this case, financial projections provided to the plaintiffs by the company, on the basis of which the plaintiffs entered into a franchise agreement with the company, turned out to be inaccurate. The plaintiffs had not known the director and had had no material pre-contractual dealings with him, but they referred to the pivotal role the director had in the company's affairs, including his prominent role in producing the projections.

The Judge's decision was upheld by a majority of the Court of Appeal, but was unanimously overturned by the House of Lords on the basis that there had been no personal dealings between the director and the plaintiffs and no exchanges or conduct that could have conveyed to them that he had assumed personal responsibility to them.

This decision reinforces the fact that although the law does recognize a category of care in which a director will be fixed with personal liability for negligent misstatement by his company, it is a rare category and a severely restricted one.

Advisers limiting liability

In the context of a party seeking and relying on advice from more than one adviser (eg accountants, lawyers) which turns out to be negligent, a plaintiff may sue only one of its advisers or, after obtaining judgment against more than one of them, pursue only one for the whole of an award of damages, primarily because that adviser (no doubt insured) is a deep pocket target.

Accountancy firms have suffered more than most in this way and so have been attempting to cap their maximum liability.

In the venture capital market, the British Venture Capital Association (BVCA) has reached a Memorandum of Understanding with the big six accountancy firms, seeking to introduce a cap on maximum liability and emphasize the concept of proportionality.

For smaller transactions (less than £10 million (US$16.4)) the cap on liability is limited to the transaction value. For mid-market transactions (£10 million to £55 million) the cap is limited to £10 million, plus one-third of the amount by which the transaction value exceeds £10 million. For larger transactions (over £55 million) the cap is £25 million, with an acknowledgement that the accountants will wish to introduce a proportionality clause seeking to ensure that a defendant's liability bears a reasonable relationship to the extent of its error.

The Memorandum is not legally binding and specific engagement terms can still be contracted between the parties on each transaction. However, if the Memorandum becomes standard practice for venture capital firms, the limitations on pursuing a big six accountant on a due diligence transaction will impact on the possible exposure of other advisers on such transactions. As it becomes more difficult to sue, or recover from, a big six accountant, the plaintiff will look to its other advisers to recover the balance of any loss.

Neil Mirchandani of Lovell White Durrant, London.

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