Unit 11 Pty Ltd v Sharpe Partners Pty Ltd
[2005] FCA 635
•20 MAY 2005
FEDERAL COURT OF AUSTRALIA
Unit 11 Pty Ltd v Sharpe Partners Pty Ltd [2005] FCA 635
COURTS – summary application to strike out a claim for losses allegedly suffered as a result of breach of duty by an auditor – whether the risk to which the applicant was exposed by the breach of duty provided the opportunity for, but did not cause in the required legal sense, the loss suffered – whether the claim of causation was so speculative and conjectural that it should be struck out
Federal Court Rules O 11 r 16
Australian Broadcasting Corporation v Lenah Game Meats Pty Ltd (2001) 208 CLR 199 – cited
Man Nutzfahrzeuge Aktiengesellschaft v Freightliner Ltd [2003] EWHC 2245 (Comm) (7 October 2003) – distinguished
Sew Hoy & Sons Ltd (In Receivership and In Liquidation) v Coopers & Lybrand [1996] 1 NZLR 392 – distinguished
McKellar v Container Terminal Management Services Ltd (1999) 165 ALR 409 – citedAlexander v Cambridge Credit Corporation Ltd (1987) 9 NSWLR 310 – considered
March v (E. & M.H.) Stramare Pty Ltd (1991) 171 CLR 506 – appliedMedlin v State Government Insurance Commission (1995) 182 CLR 1 – applied
Allianz Australia Insurance Limited v GSF Australia Pty Limited [2005] HCA 26 – citedGaloo Ltd (in liq) v Bright Grahame Murray [1994] 1 WLR 1360 – cited
Southern Cross Airlines Holdings Ltd v Arthur Andersen & Co [1998] FCA 280 – cited
Harris Scarfe Limited (Receivers and Managers Appointed) (in liq) v Ernst & Young (Reg) [2005] SASC 113 – distinguished
Sasea Finance Ltd (in liq) v KPMG [2000] 1 All ER 676 – cited
Stapley v Gypsum Mines Ltd [1953] AC 663 – citedUNIT 11 PTY LTD (ACN 075 979 556) v SHARPE PARTNERS PTY LTD (ACN 061 707 042) AND DAVID JOHN LAMB
VID 1164 OF 2005MERKEL J
20 MAY 2005
MELBOURNE
IN THE FEDERAL COURT OF AUSTRALIA
VICTORIA DISTRICT REGISTRY
VID 1164 OF 2005
BETWEEN:
UNIT 11 PTY LTD (ACN 075 979 556)
APPLICANTAND:
SHARPE PARTNERS PTY LTD (ACN 061 707 042)
FIRST RESPONDENTDAVID JOHN LAMB
SECOND RESPONDENTJUDGE:
MERKEL J
DATE OF ORDER:
20 MAY 2005
WHERE MADE:
MELBOURNE
THE COURT ORDERS THAT:
1.In so far as the third amended statement of claim relies on causes of action against the second respondent, it be struck out.
2.The applicant have leave to deliver within 14 days a further amended statement of claim against the second respondent to the extent it relies on a cause of action based on an alleged misappropriation of the applicant’s funds.
3.The applicant pay the second respondent’s costs of and incidental to the second respondent’s application to the Court to strike out the statement of claim of the applicant.
4.Reserve liberty to apply.
Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.
IN THE FEDERAL COURT OF AUSTRALIA
VICTORIA DISTRICT REGISTRY
VID 1164 OF 2005
BETWEEN:
UNIT 11 PTY LTD (ACN 075 979 556)
APPLICANTAND:
SHARPE PARTNERS PTY LTD (ACN 061 707 042)
FIRST RESPONDENTDAVID JOHN LAMB
SECOND RESPONDENTJUDGE:
MERKEL J
DATE:
20 MAY 2005
PLACE:
MELBOURNE
REASONS FOR JUDGMENT
Introduction
The applicant is the trustee of the Arts Investment Trust (“the Trust”), which was established pursuant to the Arts Investment Trust Deed made on 25 October 1996. The trustee’s sole activity was to invest monies entrusted to it by the TWU Superannuation Fund in high-risk commercial enterprises, which were predominantly theatrical productions. Its initial financial investment was the staging in Melbourne of the theatrical production Sunset Boulevard. Subsequent investments were made in Fiddler on the Roof, Popcorn, Nigel Productions, Concept Sports and Sam Hill Chronicles.
Mr Gregory Flood (“Flood”) was the chairman of the applicant and, in his capacity as a partner at Smith Emmerton, was the applicant’s solicitor. The other directors, Mr William Noonan (“Noonan”) and Mr Philip Lovell (“Lovell”), relied on Flood’s advice as to the investments the Trust should undertake. Flood also assisted in the preparation of the applicant’s financial accounts and the notes to those accounts.
The first respondent is a firm of accountants that conducted an accounting practice in New South Wales at the relevant time. The second respondent is alleged to have been an employee of the first respondent. The applicant alleges that it retained the first and second respondents to act as its auditors. The first respondent was served with the application and statement of claim but has not appeared in the proceeding.
The applicant incurred substantial losses as a result of the investments made by it and issued a proceeding in the Court claiming that the respondents are liable for those losses because they acted in breach of the duty of care they owed to the applicant in carrying out their audit of the financial affairs of the Trust. The applicant also alleges that the first respondent contravened ss 52 and 74 of the Trade Practices Act 1974 (Cth) (“the TPA”) and makes similar claims in relation to the second respondent pursuant to s 11 of the Fair Trading Act 1985 (Vic) (which has now been replaced by the Fair Trading Act 1999 (Vic) (“the FTA”)). The applicant’s entitlement to damages in respect of the TPA and FTA claims arises under s 82(1) of the TPA and s 159(1) of the FTA, both of which enable a person to recover the amount of their loss or damage arising from a contravention of the TPA and the FTA respectively.
The applicant’s statement of claim was struck out but was amended on two occasions. The second respondent seeks to have the third further amended statement of claim (“the statement of claim”) struck out under O 11 r 16 of the Federal Court Rules on the grounds that the statement of claim discloses no reasonable cause of action against him, that it may cause prejudice, embarrassment or delay in the proceeding and is otherwise an abuse of process of the Court.
The Statement of Claim
The applicant alleges that, by reason of its retainer of the respondents to audit its financial accounts, the respondents owed a duty of care to it. It then alleges that the respondents breached that duty by failing to ascertain the falsity of a representation, made by Flood to the respondents, that litigation had been commenced against the producers of Sunset Boulevard. For the purposes of the strike-out application, it is not in issue that the applicant has properly pleaded the duty of care owed to it by the respondents and the breach of that duty. What is in issue is whether the breach of duty caused, in the required legal sense, the loss claimed. It was not suggested that the causation issue raised by the common law claim differs in any relevant respect from the causation issue arising in relation to the TPA and FTA claims.
The losses claimed are based firstly upon an alleged misappropriation by Flood, and secondly upon the failed investments recommended by Flood. In relation to the misappropriation claim, the applicant alleges (in para 9.4) that Flood appropriated the funds of the applicant other than in accordance with the authority conferred by the Board. Further particulars of the allegation are set out in Sch 3 to the statement of claim. The second respondent concedes that, subject to the misappropriation claim being properly pleaded and particularised, it could not be struck out because the risk to which the applicant was exposed by the alleged breach of duty was capable of being causally related to the loss suffered by the applicant as a result of the alleged misappropriation.
In relation to the claim for losses arising from the failed investments, the applicant alleges that, if the respondents had not breached their duty of care, the respondents would have ascertained that Flood had misled them about the commencement of litigation against the producers of Sunset Boulevard, and would have informed Noonan and Lovell of that fact. It was then claimed that, had that occurred, the applicant would not have invested any monies in the failed investments on Flood’s recommendations, and therefore would not have suffered the losses it now seeks to recover from the respondents. The applicant also alleges that the respondents’ breach of duty caused it to lose the opportunity to invest no further funds in the failed investments recommended by Flood. The losses alleged to have been suffered from the “loss of opportunity” claim are the losses suffered as a result of the failed investments.
The second respondent’s strike out application is based on his contention that, on the facts alleged in the statement of claim, the applicant’s claim that the respondents caused its losses should be struck out because it is not reasonably arguable or, put another way, is clearly untenable and must fail. In order to determine that application, it is necessary to look more closely at the applicant’s contention that the respondents’ breach of duty was causative of the applicant’s losses.
The representation made by Flood was pleaded (at para 6.7) as follows:
“Flood represented to the auditor that litigation against the producers of ‘Sunset Boulevard’ alleging misleading and deceptive conduct and claiming damages of an unspecified amount had been commenced and that discovery proceedings and actions were in progress.
Particulars
The Applicant refers to the letter dated 14 April 1998 entitled ‘INDEPENDENT AUDIT REPORT’ from Sharpe Hume & Co. to the Trustees, the Arts Investment Trust and, in particular, to the content of the paragraph on page 2 thereof under the heading ‘Inherent Uncertainty Regarding Litigation’ which states:
Inherent Uncertainty Regarding Litigation
Without qualification to the opinion expressed above, attention is drawn to the following matter. As indicated in Note 4 ‘Sunset Boulevard’ to the financial report, The Trustees of The Arts Investment Trust (sic) is the plaintiff in litigation alleging misleading or deceptive conduct and claiming damages of an unspecified amount. Discovery proceedings and actions are in progress. As discussed in Note 4 ‘Sunset Boulevard’, the circumstances of the action is such that the ultimate outcome of the litigation cannot presently be determined with an acceptable degree of reliability, and accordingly no provision has been made in the financial statements. (emphasis added)”
The emphasised passage in the particulars is claimed by the applicant to be the statement made by Flood to the auditors, which led to them making no provision in the financial statements concerning the litigation. The claim against the auditors is based upon Flood’s representation being incorrect because, although litigation was imminent, it had not been commenced and no discovery was in progress when the statement was made. In that regard the applicant alleges (in para 6.11) that the minutes of the Board meeting held on 14 May 1997 record that:
“‘(t)he legal position in relation to breach of contract (which) was reviewed and it was unanimously agreed that legal action would be pursued…’ under the item headed ‘Sunset Boulevard’”
It is also accepted by the applicant that there was a reference to the proposed litigation in the Chairman’s Report to the Board meeting held on 26 March 1998, which referred to the “[intention] to issue proceedings immediately against [the Really Useful Group] for false and misleading conduct…”. Thus, it is common ground for the purposes of the present application that as at early April 1998 the Board of the applicant had been informed by Flood that proceedings claiming misleading and deceptive conduct in relation to Sunset Boulevard were to be issued “immediately”, but when Flood subsequently stated to the auditors that the proceedings had been issued and that discovery was in progress, that statement was not accurate.
The applicant then claims that the auditor owed a duty to review, investigate and make inquiries concerning the applicant’s minutes and affairs and:
“7.5if the review, investigations and inquiries … revealed that the Applicant had not commenced litigation against the producers of ‘Sunset Boulevard’:
7.5.1to investigate the statement made to the auditor that litigation against the producers of ‘Sunset Boulevard’ alleging misleading and deceptive conduct and claiming damages of an unspecified amount had been commenced and that discovery proceedings and actions were in progress;
7.5.2to report to Noonan and Lovell that, notwithstanding the fact that no litigation against the producers of Sunset Boulevard had been commenced, the auditor had been informed by Flood that such litigation had commenced and that discovery proceedings and actions were in progress;
7.5.3to report to Noonan and Lovell that the auditor had been misled by Flood as to whether litigation against the producers of Sunset Boulevard had commenced; and
7.5.4in particular, to report to Noonan and Lovell that Flood had misled the auditor in so far as it had been told by Flood that litigation against the producers of Sunset Boulevard alleging misleading and deceptive conduct and claiming damages of an unspecified amount had been commenced and that discovery proceeding and actions were in progress.”
The applicant’s claim in relation to causation was pleaded as follows:
“15.If, having discovered that the Applicant had not commenced litigation against the producers of ‘Sunset Boulevard’, the auditor had investigated the statement made to it that litigation against the producers of ‘Sunset Boulevard’ had been commenced and that discovery proceedings and actions were in progress, the auditor would have:
15.1reported to Noonan and Lovell that, notwithstanding the fact that no litigation against the producers of Sunset Boulevard had been commenced, the auditor had been informed by Flood that such litigation had commenced and that discovery proceedings and actions were in progress;
15.2reported to Noonan and Lovell that the auditor had been lied to and misled by Flood as to whether litigation against the producers of Sunset Boulevard had commenced; and
15.3in particular, reported to Noonan and Lovell that Flood had lied to and misled the auditor in so far as it had been told by Flood that litigation against the producers of Sunset Boulevard alleging misleading and deceptive conduct and claiming damages of an unspecified amount had been commenced and that discovery proceeding and actions were in progress.
16.Had the auditor reported to Noonan and Lovell that it had been lied to and misled by Flood in the manner described in paragraph 15 hereof, Noonan and Lovell would have:
16.1invested no monies or no further monies in investments recommended by Flood in which:
16.1.1Flood had [an] interest which was in conflict with his duties as a director of the Applicant; and
16.1.2Flood, either directly or indirectly, stood to receive a benefit independently of his position as a director of the Applicant.
namely:
(a) ‘Popcorn’
(b) ‘Nigel Productions’;
…
16.2invested no monies or no further monies in investments recommended by Flood in which Flood was a director of the respective production companies
namely:
(a) ‘Fiddler on the Roof’;
(b) ‘Concept Sports’; and
(c) ‘Sam Hill Chronicles’.…
17.By reason of the failure of the auditor to discover and report to the directors of the Applicant that it had been misled by Flood, the directors of the Applicant lost the opportunity to:
17.1invest no monies or further monies in investments recommended by Flood:
17.1.1in which Flood had [an] interest which was in conflict with his duties as a director of the Applicant and either directly or indirectly, stood to receive a benefit independently of his position as a director of the Applicant;
namely:
(a) ‘Popcorn’
(b) ‘Nigel Productions’;
17.1.2in which Flood was a director of the respective production companies;
namely:
(a) ‘Fiddler on the Roof’;
(b) ‘Concept Sports’; and
(c) ‘Sam Hill Chronicles’.
17.2alternatively, invest no monies or no further monies in any investments recommended by Flood as being suitable for the Applicant to undertake, namely:
(a) ‘Popcorn’
(b) ‘Nigel Productions’;
(c) ‘Fiddler on the Roof’;
(d) ‘Concept Sports’; and
(e) ‘Sam Hill Chronicles’.
17.3alternatively, remove Flood from any position which would have allowed him to appropriate the [monies] of the Applicant to any investment.
18. The Applicant has thereby suffered loss and damage.”
In summary, the key allegations made by the applicant are:
(a)Flood represented to the respondents that litigation had been commenced against the producers of Sunset Boulevard and that discovery was in progress;
(b)in breach of the duty of care they owed to the applicant, the respondents failed to ascertain that Flood’s representation was incorrect;
(c)the applicant made investments based on Flood’s recommendations that it would not have made had Noonan and Lovell been informed by the respondents that Flood had misled them by making the representation; and
(d)as a result, the applicant incurred losses from the investment decisions that were made.
The applicant alleges (in para 22.6) that the audit report for the 1998 financial statements also stated that Flood represented to the auditor that the litigation had been commenced and discovery was in progress. However, it is not contended that Flood made a second representation that the litigation had commenced. Rather, it was accepted that the statement in the 1998 financial accounts was based on Flood’s previous representation. Although the pleading states that in making that representation Flood “lied” to the auditors, senior counsel for the applicant accepted that the facts as alleged do not justify the conclusion that Flood made the representation knowing it was false.
In substance, the applicant’s claim is that the failure of the auditors to detect and report Flood’s inaccurate and misleading representation to Noonan and Lovell caused the loss claimed. The chain of causation pleaded is as follows:
(1)if the respondents had not breached their duty they would have discovered Flood’s misrepresentation;
(2)after the respondents discovered the misrepresentation they would have informed Noonan and Lovell that they had been misled by Flood;
(3)upon being informed that Flood misled the auditors, Noonan and Lovell would have ceased to agree to the applicant investing in investments recommended by Flood; and
(4)as a result of the breach of duty, the applicant lost the opportunity not to invest in the failed investments and incurred losses as a result of making those investments.
The causation claim is unusual in that it is not contended that Flood’s misrepresentation related to, or resulted in any misunderstanding of, the applicant’s financial affairs or related to any other matter that was relevant to any particular decision to invest in an investment recommended by Flood. Rather, it is said to relate to particular conduct of Flood (namely, that he misled the auditors because he made an incorrect statement to them) which, if known, would have led to the applicant ceasing to trust Flood and ceasing to accept and act upon his investment advice.
Strike out applications
The applicant contends that the question of causation is a question of fact that should not be decided on an application to strike out the statement of claim. The second respondent’s riposte is that, on the facts pleaded, the applicant’s claims in relation to the investments recommended by Flood are clearly untenable, as they are for losses that do not result from any risk to which the applicant was exposed as a result of the impugned conduct. Accordingly, so it is said, this is a case that is appropriate for summary dismissal.
In Australian Broadcasting Corporation v Lenah Game Meats Pty Ltd (2001) 208 CLR 199 at 268, Kirby J stated that:
“Where the law is unclear, or in a state of development, the modern approach to applications to strike out a pleading said to disclose no viable cause of action is one of caution. At least this is so where the court concludes that a closer examination of the applicable law and of the facts may reasonably be expected to add ‘colour and content to the application and development of legal principle’.”
In the context of the striking out of a pleading in negligent audit cases, in Man Nutzfahrzeuge Aktiengesellschaft v Freightliner Ltd [2003] EWHC 2245 (Comm) (7 October 2003) (“Man”) at [14] Cooke J stated:
“The law in the field of auditors’ negligence and auditors’ duties is in a state of development and transition and there are therefore real difficulties in deciding cases on a summary basis without a full investigation of the detailed facts, unless they fall fairly and squarely within the decided authorities.”
However, there are also observations in auditor negligence cases that pleadings should be struck out, if they are clearly untenable, to avoid the expense and potential delay of litigation. In Sew Hoy & Sons Ltd (In Receivership and In Liquidation) v Coopers & Lybrand [1996] 1 NZLR 392 (“Sew Hoy”) at 407 Thomas J agreed that the claim should not be struck out in the particular circumstances of that case, but observed:
“This is not to say that a claim should not be struck out if it is clearly untenable on the pleadings and the question of law is one which can stand in isolation from the facts giving rise to it. In such circumstances it has always been accepted that the issue should be determined and the litigants spared the cost and inconvenience of a full trial.”
In the present case it is not claimed that the causation issue would be elucidated by further facts. Rather, the applicant accepts that its causation claim is based on the facts pleaded, which have been fully particularised. The applicant also accepts that it must plead the causal connection between the impugned conduct and the loss claimed to be suffered as a result of the conduct: see McKellar v Container Terminal Management Services Ltd (1999) 165 ALR 409 at 419. Indeed, the applicant conceded that it was required to plead that the losses claimed were caused in the legal sense by a risk or danger to which it was exposed by the impugned conduct. The risk or danger was said to be that Flood “should not be trusted”. However, the applicant claims that the pleading in its current form sets out the facts necessary to establish the applicant’s case on causation. Having regard to the above matters, I am satisfied that the question of the tenability of the applicant’s claim, that the loss suffered was caused by the auditors breach of duty, is capable of being resolved on the facts pleaded. The real issue is whether the causation claim is so clearly untenable that it should be struck out.
Causation
The “but for” test can be a useful guide in considering causation but is not the test for causation. In Alexander v Cambridge Credit Corporation Ltd (1987) 9 NSWLR 310 (“Cambridge Credit”) at 335 Mahoney JA stated:
“With respect to those who take a different view, I do not think that the ‘but for’ test can be accepted as the test of causality in the law.”
McHugh JA stated at 358:
“In general, the application of the ‘but for’ test will be sufficient to prove the necessary causal connection. But that test is only a guide. The ultimate question is whether, as a matter of commonsense, the relevant act or omission was a cause.”
In March v E. & M.H. Stramare Pty Ltd (1991) 171 CLR 506 (“March”), Mason CJ observed at 515:
“The common law tradition is that what was the cause of a particular occurrence is a question of fact which ‘must be determined by applying common sense to the facts of each particular case’…”
More recently, in Medlin v State Government Insurance Commission (1995) 182 CLR 1 at 6 Deane, Dawson, Toohey and Gaudron JJ stated:
“For the purposes of the law of negligence, the question whether the requisite causal connexion exists between a particular breach of duty and particular loss or damage is essentially one of fact to be resolved, on the probabilities, as a matter of commonsense and experience.”
In Allianz Australia Insurance Limited v GSF Australia Pty Limited [2005] HCA 26 at [41] McHugh J described the common law concept of causation as:
“concerned with determining whether some breach of a legal norm was so significant that, as a matter of common sense, it should be regarded as a cause of damage.”
In applying the common sense criterion, courts distinguish between the cause of the loss and the occasion for the loss. As was stated by Glidewell J in Galoo Ltd (in liq) v Bright Grahame Murray [1994] 1 WLR 1360 (“Galoo”) at 1374-1375:
“‘How does the court decide whether the breach of duty was the cause of the loss or merely the occasion for the loss?’ … The answer in the end is ‘By the application of the court’s common sense.’”
Of particular relevance in the present context is the observation by Henry J in Sew Hoy at 403:
“Failure to meet it [the ‘but for’ test] must of course negate causation, but what must still be established by a plaintiff is that in a commonsense practical way the loss claimed was attributable to the breach of duty, and this justifies the Court in imposing responsibility on the defendant for the loss…but also keeping in mind that this is a strike-out application and the question therefore is whether the pleadings disclose a sufficient causative link with the losses claimed.”
Cambridge Credit was one of the earlier instances in which a court addressed the scope of liability for the consequences of a negligent audit. In that case, the auditors had failed to note that the balance sheet and other accounts did not show provisions that should have been made. If the appropriate note had been made it was likely that a receiver would have been appointed to the company. Several years later the company went into receivership. The company brought proceedings against the auditors alleging that the breach of their retainer resulted in the company carrying on business at a loss for longer than would have been the case had the auditors not breached their duty of care. The New South Wales Court of Appeal held that there was no causal connection between the breach of the retainer and the
damage that was claimed to have been caused by the failure to appoint a receiver at an earlier date. Mahoney JA observed (at 334-335):
“It may sometimes be argued that a breach exposes the plaintiff to particular dangers and that if what happens subsequent to the breach is loss from a danger of that kind, the loss may be seen as a result of the breach…But, again, I do not think that this argument is open to the company. To allow the company to continue in existence is, in a sense, to expose it to all of the dangers of being in existence. But allowing the company to remain in existence does not, without more, cause losses from anything which is, in that sense, a danger incident to existing. There are some dangers loss from which will raise causal considerations and some will not. …
In the end, the company’s case has been that the loss it claims was caused by the breach because, and because alone, the breach allowed the company to continue in existence…But the basis of the plaintiffs’ claim has been such that no inquiry is to be or has been pursued, for this purpose, into what in fact happened, why and the relationship of what happened to the breach. I do not think that there is enough to establish a causal relationship.”
Cambridge Credit is authority for the proposition that merely allowing a company to remain in existence, without more, cannot be regarded as being causative, in the legal sense, of losses incurred by the company from its continued existence. That principle was applied by the trial judge and approved by Glidewell LJ (with whom Evans LJ and Waite LJ agreed) in Galoo (at 1374):
“Trading losses…are losses which by their nature do not flow from whatever statement appears in the accounts as to the state of the company’s assets or profits; they flow from trading. If a company trades, it may suffer losses or it may enjoy profits, and those losses or gains depend upon a number of factors such as the prudence of the trading, market conditions, and so on. It does not seem to me that trading losses as such can possibly be attributed to statements as to the status of the company before that trading ever takes place…it seems to me that, for the reasons I have given…trading losses as such cannot arguably be said to be damages which flow from the auditors’ negligence.”
At 1374-1375 Glidewell LJ stated that the auditors’ breach of duty gave the companies the “opportunity” to continue to incur trading losses but did not cause those losses in the sense the word “cause” is used in law.
Cooper J adopted the same approach in Southern Cross Airlines Holdings Ltd v Arthur Andersen & Co [1998] FCA 280 (“Southern Cross”):
“It is said that the wrongful conduct of the cross-respondents allowed Southern Cross to trade when it otherwise would not have done so and thereby caused the relevant loss. That is, it is sought to say that the fact that Southern Cross traded was causative of the loss. A case sought to be made out on that basis and without more, cannot succeed as a matter of principle, for the reasons expressed in the authorities referred to above. The wrongful conduct of the cross-respondents, if made out, is properly characterised as the occasion for the loss suffered by Southern Cross and not the, or a, legal cause of it. To hold otherwise would be to apply the ‘but for’ test without regard to logic or common sense.”
In Galoo and Southern Cross the pleadings did not sufficiently link the impugned conduct with the trading losses. However, in Harris Scarfe Limited (Receivers and Managers Appointed) (in liq) v Ernst & Young (Reg) [2005] SASC 113 (“Harris Scarfe”) the amended statement of claim identified such a linkage and, as a consequence, leave was granted for the amendment to be made.
In Harris Scarfe it was claimed by the plaintiffs that, as a result of the auditors’ conduct, the companies continued to rely on the chief financial officer who was responsible for misstatements in the accounts. It was then alleged that, because of the auditors’ breaches of duty in failing to ascertain the misstatements, various mistaken beliefs were formed as to the financial performance and position of the companies. As a consequence, the companies continued to trade rather than having a controller appointed, which would have occurred had the directors been aware of the true position. The plaintiffs sought leave to claim as damages the trading losses sustained from the date when the true position ought to have been revealed to the date when the controller was appointed. The defendants asserted that leave should not be granted because the plaintiffs had failed to demonstrate that any particular losses in respect of particular transactions had been caused by the alleged wrongful conduct. After considering the authorities Bleby J granted leave to include the losses claimed finding that, unlike Cambridge Credit and Galoo, the proposed pleading did not merely rely on the companies’ continued existence. Rather, it alleged a causal link which common sense indicated, if the relevant facts were proved, that the losses were linked to the risk to which the company was exposed by the auditors’ wrongful conduct. Referring to the decision in Sew Hoy, Bleby J stated at [64]:
“A nexus is alleged by reference to a series of steps and decisions that the plaintiffs took or did not take based on their reliance on the accounts. The mistaken beliefs as pleaded by the plaintiffs led them to continue to trade in a way which was unprofitable. They did not take the steps which otherwise would have been taken because they did not know that those steps were required. Had they been fully informed they would have taken other decisions to prevent further trading losses.”
Senior counsel for the applicant claimed the loss suffered by the applicant as a loss of the opportunity to cease investing in further enterprises, as well as a claim for the losses suffered from making those investments. However, in substance, the claim is a claim for the losses suffered as a result of the failed investments or, put another way, from the applicant’s trading activities. The reason for that conclusion is that the applicant’s sole business was investing in high-risk commercial investments recommended by Flood, and the losses it is claiming are alleged to be the losses incurred in continuing that business longer than would have been the case had the respondents not breached their duty of care. As was the case in Cambridge Credit and Galoo, there were plainly many reasons why the applicant’s investments failed and it is not claimed that the representation which the auditors failed to detect and correct was relevant to any of those reasons.
However, as the decision in Harris Scarfe demonstrates, a claim for trading losses may be allowed to proceed if the statement of claim sets out a sufficient causal link between an auditor’s breach and the loss suffered. In Harris Scarfe, unlike in Cambridge Credit, the plaintiff pleaded a sufficient causal link with the consequence that the pleading did not amount to reliance on the mere fact that the companies continued in business. In the present case the applicant claims that, had Flood’s misrepresentation been discovered by the auditors and reported to Noonan and Lovell, they would have ceased to have trust and confidence in Flood and would therefore no longer have accepted and acted upon his investment advice. It is contended that those claims sufficiently relate the breach to the loss claimed. To that extent the present case is distinguishable from Cambridge Credit.
However, the second respondent contended that the negligence cases against auditors that were allowed to proceed to trial required the pleading to identify a sufficient causal link between the risks to which the claimant was exposed by the negligent conduct and the loss that was suffered by the relevant company. In Man, a contribution claim was made against the auditors on the basis that they failed to detect falsified accounting entries by an employee (Mr Ellis), which misrepresented the company’s financial position and led the company to make investment decisions it would not have made had it been aware of its true financial position.
Cooke J observed at [34]:
“Freightliner therefore put in issue the question of causation of loss by reference to Mr Ellis’ position and his potential removal from it. Although, as [the auditors] point out, there is no suggestion that Mr Ellis was guilty of any defalcation himself so that his actions were not the immediate cause of trading losses, his fabrication of accounts and lies in relation thereto had the effect, as alleged, of concealing these losses leading directly to what Man would say were reasonable business decisions as a direct consequence. It was those decisions which led to the injection of funds and incurring of losses after the date of completion. This raises a significant issue of fact in the context of arguments about causation, …”
And at [39]
“In this action, Freightliner say that, unlike in Galoo, there is a plea of loss caused as a result of the failure by the auditors in detecting Mr Ellis’ fraud in exactly the same way as if they had failed to detect defalcations which continued after they had given a clean certificate of audit (the Sasea case). This was the very thing that they were to guard against in the course of their audit. In my Judgment, this raises an arguable issue which is not capable of being determined on a summary basis but requires investigation of the facts in order to determine whether it is well founded before applying any principles of causation…”
In Man the losses incurred arose as a result of business decisions made on the basis of Ellis’ fabricated accounts and from Ellis continuing in his employment and continuing to create fictitious entries in the financial records, thereby hiding the true situation of the company. Man is clearly distinguishable from the present case. In Man the failure of the auditors to detect Ellis’ continuing fraudulent and fictitious financial entries was pleaded and found to be capable of being causally related to the loss suffered because, like a failure to detect a defalcation, the falsified financial entries were relied upon in making decisions that resulted in losses that may not have been incurred had Ellis’ fraudulent conduct been discovered by the auditors. Thus, a commonsense causal relationship was pleaded which related the risk to which the claimant was exposed by the breach of duty to the loss suffered. In the present case, although a causal relationship is pleaded, it is not suggested that the investment decisions of the applicant were in any way dependent upon, related to or influenced by Flood’s misrepresentation. Also, it is not claimed that, as was the case in Man, Flood’s conduct was fraudulent or dishonest.
Similarly, in Sasea Finance Ltd (in liq) v KPMG [2000] 1 All ER 676 (“Sasea”) criminal investigations revealed that the companies in the group were vehicles of a massive fraud perpetrated by a Mr Fiorini, a dominant figure in the group. Proceedings for negligence were brought against the auditors (“KPMG”) claiming that had they not conducted their auditing functions negligently, four fraudulent transactions would have been prevented and the losses incurred through those transactions would not have been suffered. Kennedy LJ, delivering the judgment of the Court, stated (at 679):
“It is then pleaded that had KPMG performed its duties as it should certain losses would not have occurred. Those losses are set out in para 166 of the statement of claim and include the four transactions which have been the subject of the strike-out application. The first transaction arose out of the sale by SFL on 28 September 1990 of its shares in the Rivaud group of companies…It is alleged that SFL did not receive the proceeds because Mr Fiorini diverted them to other group companies under his control with a view to siphoning them off at a later stage. The second transaction is one in which SFL alleges that Mr Fiorini in effect stole…from SFL on or about 25 October 1990. The third transaction gives rise to a similar allegation…on or about 13 November. The fourth and final transaction relates to a similar course of dealing to the first save that in this instance the company was Renta…”
And at 683:
“One of the Australian decisions referred to was Alexander v Cambridge Credit Corp Ltd…In that case it had been pointed out that to allow a company to continue in existence did not, without more, cause losses occasioned by the ordinary risks associated with carrying on business. So it will be seen that a distinction may be made between the present case and the Galoo case. We are concerned with losses brought about by fraud or irregularities the risk of which KPMG ought to have apprehended and reported. Albeit in the Galoo case the auditors had failed to detect a fraudulent overstatement of assets going back several years and by continuing to trade the companies were acting fraudulently in that they were insolvent, the auditors were not under a duty to warn against the possibility of losses of the type incurred. That much was accepted by Collins J in relation to the Fiorini thefts. However, the judge distinguished the Rivaud and Renta transactions on the basis that they were the sort of transactions which were normal for SFL and so the losses arose in the normal course of business, which the judge seemed to be suggesting, implicitly at least, was outside the scope of KPMG’s duty.
We do not agree. There does not seem to us to be any fair distinction to be drawn between the four transactions as pleaded. Each in its own way was fraudulent or irregular. Each in its own way was the kind of transaction against the risk of which KPMG had a duty to warn. The fact that similar irregularities had occurred in the past can hardly be used to narrow the scope of KPMG’s duty towards its client.”
In Sasea, the auditors failed to discover the impropriety of Fiorini. The damage suffered was a consequence of Fiorini’s misappropriation or diversion of funds to other group companies under his control with a view to siphoning them off at a later stage. Thus, in Sasea (as in Man) there was a common sense causal relationship between the risk to which the claimant was exposed as a result of the auditors’ breach of duty and the loss suffered.
Harris Scarfe is also distinguishable from the present case because the breach of duty was alleged to have led to the company having a mistaken view of its financial well being, which was arguably causative of the losses the company suffered because no corrective steps were taken in relation to the company’s financial position. In the present case the breach did not result in the concealment or misrepresentation of any relevant financial information. The risk exposed by the respondents’ failure to determine that the litigation had not been commenced was that Flood had misled the auditors in relation to a matter that had no material effect on the company’s financial position. However, the loss suffered by the applicant resulted from it continuing to invest in risky investments, albeit on the basis of Flood’s advice. The factors that influenced the decision to make the investments are entirely unrelated to Flood’s misrepresentation.
The causal link pleaded by the applicant between the breach and the loss suffered is far more indirect than the link relied upon in Man, Sasea and Harris Scarfe. While that is not dispositive of the causation issue, there remains the question of whether the link pleaded is a sufficient link between the breach of duty and the loss claimed. The problem confronting the applicant is that, even if Noonan and Lovell had been fully informed by the auditors of Flood’s misrepresentation and as to the status of the litigation, no reason is proffered as to why the applicant would not have continued to carry on its business as it had in the past. Although Flood’s statement to the respondents was inaccurate, it is not claimed that it was related to a relevant financial matter (as in Harris Scarfe) or was fraudulent or dishonest (as in Man and Sasea). Thus, this is not even a case of a failure to detect the dishonesty or fraud, and therefore the lack of probity or trustworthiness, of an employee relied upon by management. It is entirely a matter of speculation as to why Flood’s incorrect statement was made. The Board was aware late in March 1998 that the litigation was imminent. How Noonan and Lovell might have reacted to being told a short time later (ie early in April 1998) that Flood had misrepresented the situation concerning the litigation is also entirely speculative and conjectural. One can conceive of a number of responses. However, the one relied upon by the applicant of ceasing to accept Flood’s investment recommendations is among the least likely of those possible responses. It is correct that the applicant has pleaded that had Noonan and Lovell been informed of Flood’s incorrect statement to the auditors they would have ceased to invest in or act upon Flood’s recommendations but it is not suggested that that pleading is based on anything other than speculation or conjecture.
The applicant’s claim of the loss as a loss of the opportunity to cease investing in particular investments exposes the conjectural and speculative nature of the case of the applicant. On the pleadings the real loss of opportunity was the loss of the opportunity to know that Flood had made a misleading statement. As a result of that loss the applicant lost the opportunity to consider whether Flood was reliable and whether it should act on Flood’s recommendations. As a result of that loss of opportunity the applicant lost the opportunity to cease investing and therefore lost the opportunity of not making losses as a result of the failed productions.
In summary, the steps relied upon by the applicant to establish causation are so speculative and conjectural that I am satisfied that they do not go further than establishing that the respondents’ breaches might have provided the occasion for the loss suffered, in the sense that “but for” the breach the loss might not have been suffered. I am not satisfied, however, that they justify the next step and constitute a tenable claim that the breaches were causative, in the requisite legal sense, of the losses. Rather, applying common sense and experience to the facts pleaded I have come to the conclusion that the breach is not so significant that it should be regarded as a cause of the losses claimed. In my view the causation claim is so clearly untenable that it should be struck out. Put simply, the causation claim requires too many speculative steps that defy common sense and experience in order to establish the requisite causative link. Put another way, and adopting the observations of McHugh JA in Cambridge Credit at 350, I am not satisfied that the applicant has a tenable claim that the acts and omissions of the auditors that are relied upon are so connected to the losses claimed that legal responsibility for those losses should attach to those acts and omissions. Those acts and omissions are “too remote” and should be discarded as a cause in law of the losses claimed (see Stapley v Gypsum Mines Ltd [1953] AC 663 at 681 per Lord Reid).
Conclusion
For the above reasons the statement of claim against the second respondent should be struck out, but leave is to be granted to the applicant to re-plead its cause of action against the second respondent in so far as it is based on Flood’s alleged misappropriation of the applicant’s funds. I am not prepared to grant leave to replead the misrepresentation claims as the applicant has already had several attempts to plead those claims and it is not suggested that it can be improved upon by a further attempt. As the second respondent has succeeded on his application to strike out the statement of claim the applicant should pay his costs of and incidental to the application.
I certify that the preceding forty-eight (48) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Merkel.
Associate:
Dated: 19 May 2005
Counsel for the Applicant:
Mr J Santamaria QC with
Mr A Thomas
Solicitor for the Applicant:
Deacons
Counsel for the Second Respondent:
Mr D Collins SC with
Mr A Herskope
Solicitor for the Second Respondent:
Moray & Agnew
Date of Hearing:
4 March 2005
Date of Judgment:
20 May 2005
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