Harris Scarfe Ltd (Receivers & Managers Appointed) (in Liq) v Ernst & Young (No 7) - [2006] SASC 164

SUPREME COURT OF SOUTH AUSTRALIA
(Civil)
HARRIS SCARFE LTD (RECEIVERS & MANAGERS APPOINTED) (IN LIQ) & ORS v ERNST & YOUNG & ORS (NO 7)
[2006] SASC 164
Reasons for Decision of The Honourable Justice Bleby
5 June 2006
PROCEDURE - SUPREME COURT PROCEDURE - SOUTH AUSTRALIA - PROCEDURE UNDER RULES OF COURT - PLEADINGS - GENERALLY
Application by first defendant to strike out part of the plaintiffs’ reply on basis that it discloses no reasonable cause of action, non-compliance with rules as to pleadings, and tendency to cause prejudice, embarrassment or delay to proceeding – Plaintiffs claim for damages against auditors for failure to report the true financial position to directors of large retail group – Plaintiffs allege that directors would have appointed controller had true position been known – Breach of duty denied by first defendants, claiming that plaintiffs would have nevertheless continued to trade – Plaintiffs in reply deny that the directors would have continued to trade – Whether plaintiffs’ reply alleges alternative claim for damages of the case pleaded by the plaintiffs – Relevant paragraphs of plaintiffs’ reply merely asserting what would have happened if had continued to trade as alleged by first defendant – No alternative case for damages based on continuing to trade, and no additional or alternative loss claimed by plaintiffs’ reply – Application dismissed.

HARRIS SCARFE LTD (RECEIVERS & MANAGERS APPOINTED) (IN LIQ) & ORS v ERNST & YOUNG & ORS (NO 7)
[2006] SASC 164

BLEBY J: The plaintiffs are a group of companies now in liquidation which formerly conducted a number of retail stores in various parts of Australia, and the group’s financier, ANZ Banking Group Ltd. Ernst & Young, the first defendants, were the Harris Scarfe group auditors during each of three separate but consecutive accounting periods, namely the financial year ending 30 June 1996, the six months ending 31 December 1996 and the financial year ending 30 June 1997. Thereafter, the group’s auditors were the two firms comprising the second defendants.
The plaintiffs’ claim is for damages against the defendants for negligence, breach of contractual duty of care and misleading conduct in breach of s 56 of the Fair Trading Act 1997 (SA). In essence, the plaintiffs allege that at all material times from the year ending 30 June 1996 Harris Scarfe’s head of accounting instigated, in the group’s accounts, an understatement of liabilities and expenses, with a consequential overstatement of profits and net assets by way of adjustments to the financial records of the Harris Scarfe group. It is alleged that in respect of each of the relevant accounting periods the defendants, in breach of their duties to the plaintiffs, failed to report these irregularities in the accounts.
In their statement of claim the plaintiffs plead and repeat the allegations of breach of duty of the respective defendants in respect of each relevant accounting period when it is alleged that there was a failure to report the true financial position. The allegations of breach of duty and the pleaded consequences of that breach in respect of each accounting period are similar. I will summarise the pleading in respect of the year ended 30 June 1996, the first accounting period, in respect of the alleged breaches by the first defendants, as the issues raised by this application are the same in respect of all three accounting periods which involve the first defendants.
The plaintiffs’ pleas are founded upon the continued trading of the Harris Scarfe group having been induced by mistaken beliefs as a result of the negligence of the defendants, resulting in the deterioration of the group’s net asset position over time. They plead the relevant mistaken beliefs that were so induced. They allege that these mistaken beliefs caused the directors of the group to continue to trade all aspects of the group’s business in the same manner as they had been doing. Particulars are given of that manner of trading. It is alleged that the mistaken beliefs caused ANZ Banking Group Ltd to continue to afford financial accommodation to the Harris Scarfe group and to make further lending to members of the group. They allege that if the true facts had been known by the directors they would have acted differently and would have appointed a controller who would have realised the assets of the group. The particulars of loss pleaded are based on a calculation of the difference between a hypothetical receivership and winding up consequent upon the true position being revealed in the accounts for the financial year ended 30 June 1996, on the one hand, and the result in fact achieved as a result of the actual receivership and liquidation of the group in 2001.
It is not part of the plaintiffs’ case that, if the directors had known the true financial position of the group, they would have allowed companies in the group to continue to trade. No alternative case on damages is pleaded. Similar pleas are made in respect of each relevant accounting or reporting period.
By their defence, the first defendants deny any breach of duty, and allege that if the plaintiffs knew the true financial position of the group when the accounts were published, they would not have appointed a controller but would have continued to trade. The relevant plea in respect of the year ended 30 June 1996 is set out in part of para.45 of the defence:
45.With respect to the allegations in paragraph 64 of the Claim, EY:
45.1 denies that the conduct of the 1996 audit, or the opinions expressed in the Independent Auditor’s Report referred to in paragraphs 26 and 27:
45.1.1caused a deterioration in the financial position of HSL, HSW or HSHL; or
45.1.2otherwise caused HSL, HSW, HSHL or ANZ to suffer any loss or damage.
45.2 says that the plaintiffs have sustained no recoverable loss or damage because no controller (as defined in the Claim) would have been appointed to HSL, HSW or HSHL or any other member of the Group as a consequence of the 1996 audit, or the opinions expressed in the Independent Auditor’s Reports referred to in paragraphs 26 and 27, and EY says further that:
45.2.1in the event of the appointment of an investigating accountant by ANZ, the investigating accountant would have recommended to ANZ that:
45.2.1.1ANZ not appoint a receiver or receiver and manager over the secured assets of the Group;
45.2.1.2ANZ continue to provide financial accommodation and support to the Group; and
45.2.1.3ANZ enter into forbearance arrangements, including conditions of the provision of ongoing support, that the Group:
45.2.1.3.1refrain from opening or acquiring any further stores other than with the consent of ANZ;
45.2.1.3.2suspend dividend declarations and payments; and
45.2.1.3.3limit capital expenditure.
45.2.2ANZ would have accepted the recommendations of the investigating accountant, and acted accordingly;
45.2.3the Group would have accepted the terms upon which the ANZ was prepared to continue providing financial accommodation and support; and
45.2.4the Group would have continued to trade;
…
For the purposes of the Defence EY is the first defendants; HSL, HSW and HSHL are the plaintiff companies in the Harris Scarfe group; ANZ is the plaintiff ANZ Banking Group Ltd.
It will be noted that the defendants allege that the group would have continued to trade subject to the conditions and limitations pleaded in para.45.2.1.3. The defence does not contain any other particulars about the manner in which the group would have continued to trade. Importantly, it does not plead the financial consequences of doing so. The pleading does not allege whether the group would have traded at a profit or a loss. The first defendants merely plead that the group would have continued trading, at least for the period covered by the first defendants’ audits. Similar responses are made to the plaintiffs’ pleas in respect of the first defendants’ subsequent accounting and reporting periods.
By pleading its defence in that manner, the first defendants are not pleading that, if the plaintiffs suffered losses, they were only the losses which would have been caused by the group continuing to trade in the manner in which they did when compared with the manner in which they would have traded if the directors had knowledge of the fraud. Rather, the defendants’ plea meets head on the plaintiffs’ plea that, if the directors knew the true position, the members of the group would have been wound up, thereby denying an essential element in the causation of the plaintiffs’ alleged losses.
In response to the first defendants’ plea the plaintiffs by way of reply plead as follows:
12. As to paragraph 45 of the defence, the plaintiffs;
12.1 deny the allegations contained in paragraphs 45.2.1 to 45.2.4 of the defence;
12.2 in the alternative, say that, if Harris Scarfe had continued to trade as alleged in paragraph 45.2.4 of the defence, then the value of Harris Scarfe would not have deteriorated as it did, and therefore the plaintiffs have nevertheless suffered (and are entitled to recover) loss and damage.
Particulars of Loss and Damage
12.2.1If Harris Scarfe had continued to trade through to April 2001, and achieved during the period of the continued trading:
(a)the net profit and cashflow in the budget for the period ended 31 July 1997 prepared by Mr Bloom (in his report prepared for the first defendants, dated 14 November 2005) and relied upon by Mr Parbery (in his report prepared for the first defendant, dated 9 December 2005), and the same, or substantially the same, net profit and cashflow in subsequent audit or review periods; or
(b)some other net profit and positive cashflow;
then
(c)the value of the net assets of Harris Scarfe during the period of continued trading would have been not less than the value of the net assets of the Group as at 31 July 1996; and
(d)the plaintiffs have suffered loss not less than the loss claimed in respect of the period ended 31 July 1996 in paragraphs 271 to 280 of the Particulars, but the plaintiffs seek only to recover that loss.
12.2.2In any event, if Harris Scarfe had continued to trade:
(a)Harris Scarfe’s financial performance during the period of continued trading would have been not worse than its actual financial performance during the same period;
(b)the value of Harris Scarfe’s net assets throughout the period of continued trading would have been not less than the actual value of those net assets throughout the same period; and
(c)Harris Scarfe would not have been permitted to continue to trade beyond the end of each subsequent audit or review period unless it was generating and/or had demonstrated a likelihood of continuing to generate, a net profit and positive cashflow.
12.2.3By reason of the matters pleaded in sub-paragraph 12.2.2 above:
(a)if Harris Scarfe had continued to trade, but then during any of the subsequent audit or review periods ceased to trade, the plaintiffs have suffered loss not less than the loss claimed in the Particulars in respect of the preceding audit or review period (or in the alternative, that audit or review period), but the plaintiffs seek only to recover that loss; and
(b)if Harris Scarfe had continued to trade and during any of the subsequent audit or review periods commenced to generate net profit and positive cashflow, and not thereafter ceased to trade, the plaintiffs have suffered loss not less than the loss claimed in respect of the preceding audit or review period (or in the alternative, that audit or review period) in the Particulars, but the plaintiffs seek only to recover that loss.
As I have said, these pleas are replicated in respect of each of the relevant accounting or reporting periods.
The first defendants have applied to strike out para.12.2 and the other equivalent paragraphs of the plaintiffs’ reply on the basis that the pleadings disclose no reasonable cause of action, that they do not comply with the rules as to pleadings and that they have a tendency to cause prejudice, embarrassment or delay in the proceedings.
The first defendants complain that the plaintiffs fail to identify essential material facts, particularly concerning the manner of continued trading and the losses that would have resulted from the group’s continuing to trade. They complain that the reply contains no allegation or any material facts concerning the way in which the group would have traded had the true financial position been known to the directors. They allege that there is an implication that the group would have traded at a profit if the true financial position had been known but does not articulate how that might have been achieved. In the course of argument the reply was described as not truly representing the plaintiffs’ alternative trade on case.
In my opinion the first defendants’ application is to be resolved according to the proper understanding of the substance of the plaintiffs’ reply. It is to be resolved on the content of the pleading itself and not on the report of any experts which may or may not support the plea. I have therefore not had regard to the reports sought to be relied on by the first defendants in the application. If the plaintiffs’ experts purport to justify a case other than that pleaded then the plaintiffs may have some difficulty at trial.
When the nature of the reply is properly understood the first defendants’ argument is misconceived. It seems to assert that, by their reply, the plaintiffs are pleading an alternative claim for losses which would have been incurred by the plaintiffs’ continued trading. I consider that the reply does not do that. Furthermore, Mr Whitington QC, counsel for the plaintiffs, expressly disavowed in argument any such alternative claim by the plaintiffs.
By para.12.1 of the reply the plaintiffs deny the first defendants’ plea that the companies would have continued to trade if the true financial position were known as at 31 July 1996.
The opening words of para.12.2 do not assert an alternative claim for damages but what would have happened if the first defendants’ plea were correct. The opening words merely assert, consistent with the plaintiffs’ statement of claim, that if the group had continued to trade, then the value of the net assets of the group would not have deteriorated as it did in fact, i.e. to the point where, in 2001, the group was insolvent to the extent that it was. By implication, and without more, the plaintiffs there plead that, in order to continue to trade, the plaintiffs would either be making profits or would be making losses which would be recovered or which otherwise would be insufficient to cause insolvency or the appointment of a controller. If it were otherwise, they could not have continued to trade.
The heading “Particulars of Loss and Damage” is perhaps misleading. Upon analysis, the plaintiffs do no more than repeat the particulars of loss contained in the statement of claim.
In para.12.2.1 the plaintiffs plead what would have happened if they continued to trade at the profit and with the cashflow in the year ended 30 June 1997 apparently predicted by the defendants’ expert in his notional investigating accountant’s report on which, so the first defendants allege, the directors and the bank would have acted in deciding to continue to trade[1], or if the group had achieved some other net profit or net cashflow.[2] They plead[3] that, in either event, the value of the net assets of the group would have been not less than the value of the net assets as they were in fact as at 31 July 1996. Such a consequence is the logical consequence of the postulated premise. It does not require facts to prove it.
[1] Para.12.2.1(a).
[2] Para.12.2.1(b).
[3] Para.12.2.1(c).
By para.12.2.1(d) the plaintiffs plead that they have in fact suffered the loss pleaded in paras.271-280 of the statement of claim in respect of that accounting period, i.e. the difference, in effect, between the value of the group assets as at 31 July 1996 and the value of the group assets when the companies in fact went into liquidation. If it be the fact that, by continuing to trade, the value of the net assets of the group would have increased to a point above that which was in fact the case as at 31 July 1996, then any such additional loss is not claimed. The plaintiffs do not plead in sub-para.(d) that if the events pleaded in sub-paras.(a) and (b) had happened, the plaintiffs would have suffered loss not less than the loss particularised in the statement of claim. If they had, there would be some justification for the first defendants’ complaint. However, as para.12.2.1 is in fact pleaded, there is no such justification. The plaintiffs plead that even if it be assessed that they would have continued to trade in the manner pleaded in this sub-paragraph they nevertheless did in fact suffer the loss pleaded in paras.271-280 of the statement of claim.
They plead, in effect, that even on a trade-on case at better than break even and because the companies went into liquidation, the loss is the same or not less than that already pleaded.
Paragraph 12.2.2 of the reply assumes continued trading as pleaded by the first defendants, whether at a profit or at a loss. Once again, it assumes that there was no event or situation which would have required the appointment of a controller. The plaintiffs plead that, in such an event, the performance could not have been worse than it was in fact and the asset value could not have deteriorated to a greater extent than it did, otherwise, I add in parenthesis, consistent with the plaintiffs’ statement of claim, a controller would have been appointed, and the group could only have continued to trade beyond (in this case) 31 December 1996 if it was generating or was likely to continue to generate net profit and positive cashflow.
This paragraph does not plead an alternative method of calculating loss. It is merely putting, in an alternative manner, that the starting point for calculating the plaintiffs’ loss as alleged in the statement of claim could not be less than that pleaded in the statement of claim.
Paragraph 12.2.3 then pleads, on the assumption that the first defendants are correct, that if, instead of a controller being appointed, the group had continued to trade during that accounting period but had ceased to trade during a subsequent accounting period, then by reason of the matters pleaded in para.12.2.2 the plaintiffs’ loss would be not less than the loss they have pleaded in the statement of claim in respect of the accounting period preceding the cessation of trade, or alternatively the loss pleaded in respect of that subsequent accounting period. The plaintiffs are therefore not raising an alternative case for damages based on continuing to trade. The plea allows for the possibility of some continued trade before the appointment of a controller and the calculation of loss in the same manner as pleaded in the statement of claim, but from a later point in time than is pleaded in paras.271-280 of the statement of claim.
When the plaintiffs’ response to the first defendants’ defence is viewed in the manner I have described, there is no alternative claim for damages on an alternative assumption that, if they had known of the group’s true financial position, the directors of the Harris Scarfe group would have caused the companies to trade in a different fashion and that the companies would thereby have suffered some alternative form of loss. The allegation that the plaintiffs have failed properly to plead some alternative claim for damages, surprising as that would be by way of reply, has no substance.

The allegation that the pleading discloses no reasonable cause of action succeeds in the sense that no new cause of action is pleaded. The allegation that the pleadings do not comply with the rules as to pleadings has no substance because the plaintiffs’ plea is no more than an elaborate denial of the first defendants’ plea. There is no alternative claim based on the first defendants’ trade‑on plea. Given the nature of the plea, there is no substance to the submission that the pleadings have a tendency to cause prejudice, embarrassment or delay to the proceedings.
The first defendants’ application that the relevant paragraphs of the reply be struck out must therefore be dismissed.