Investor Protections Hurt by Court Decision in Livent Lawsuit
This article first appeared in Canadian Accountant, January 17, 2018 Canada's independent news source for the accounting profession
On December 20, 2017, the Supreme Court of Canada released its decision in the Deloitte LLP vs. Livent case. Livent itself (through its bankruptcy receiver) was the entity that sued its former auditors because investors have been blocked from directly suing auditors for negligent audited financial statements ever since a previous Supreme Court of Canada decision in 1997 (Hercules Managements).
A troubling tone was set by the 2017 Supreme Court of Canada (SCC) decision, which was a response to an appeal of a 2014 Ontario Court of Appeal decision that was made in favour of Livent. The result was a 4-3 vote by the SCC in favour of Livent on one portion of the case, and 0-7 vote against Livent on another portion. The former and current SCC Chief Justices were among the “Dissenters in Part” (those deciding against Livent). As a result, damages awarded to Livent were cut by more than half.
The hoped-for decision for investors did not occur. Unfortunately, archaic views about the objectives of financial reporting were largely retained by the 2017 Court, carried over from its 1997 decision. In addition, the rights of investors in a prospectus offering situation became unclear, and confusing.
Overall, the 2017 decision is sufficiently troublesome that we feel obliged to issue a serious warning. Investor protections in Canada appear to have been weakened once again.
The Livent Decision in More Detail
Two separate principal aspects of the auditors’ 2017 Appeal involved:
1. The 1997 year-end audit of Livent (the 4-3 vote by the SCC favouring Livent); and
2. A prospectus comfort letter from the auditors, to reproduce Livent’s 1996 financial statements and auditors’ report, which was provided for a 1997 Livent prospectus securities offering. Months later, in 1998, the auditors withdrew the 1996 auditors’ report. (This was the 0-7 vote by the SCC against Livent.)
The latter (prospectus securities issue) portion of the auditors’ Appeal was thus a decision reversal (overturn) by the Supreme Court from the Ontario Appeal Court’s findings. This reversal reduced Livent’s Ontario Appeal Court award by roughly $44 million, down to about $40 million, before interest.
Several matters in the 2017 SCC decision should be of major concern to investors. Especially bothersome is the SCC’s adherence to what constitutes their deemed, but highly unrealistic and impractical purpose of audited financial statements. In their previous leading case on liability involving annual audited financial statements (Hercules Managements, 1997) the SCC stated that the financial statements are to be used “as a group” by shareholders to “supervise management.”
This ‘supervisory’ concept was obsolete and illogical well before 1997, based on stock market behaviour, and auditors’ pronouncements. Nevertheless, such an archaic concept was adopted again in 2017 by the SCC; it causes considerable grief and unfairness for investors, for the multiple reasons outlined shortly. Unfortunately, what is at stake for investors is not a trivial issue. New legislation across Canada is required in order to correct the SCC decisions.
Similarly troubling is knowing whether the SCC, in rejecting Livent’s claim for prospectus-based losses, has permitted another future, yet inappropriate, defence position for auditors. Are such prospectus-based losses to be regarded as somehow not predictable, or “foreseeable” in the Court’s language, and will this mean that damages awards cannot be afforded to investors? As explained later in this report, this approach would seem to be a reversal of the previous legal precedent in Canada.1
The reasoning of the Court in the Livent case unfortunately is contradictory in important parts, and frequently resorts to the archaic ‘supervisory’ concept, even in situations that would seem to be governed by Securities Acts in Canada, where the uses of the financial statements for investing purposes should be obvious. Issuing new securities through a prospectus, and its consequences for auditors, is not new. The purchasers of new securities are identifiable, and as potential shareholders, are worthy of protection. Nevertheless, it seems that the SCC may have changed course, and weakened investor rights even further.
Those already familiar with the lack of legal investor protections that existed prior to the 2017 Livent decision, may wish to skip ahead to “Prospectus Issues” to read why that weak level of protection may have deteriorated even further in light of the Livent decision.
As occurred with the 1997 SCC decision, the interests of non-prospectus investors have also been deeply ignored in the 2017 decision made in favour of the auditors. Electing to favour the impractical and elusive ‘supervisory’ concept reveals a disconcerting bias in our view. As such, corrective legislation has to occur to overcome the Supreme Court precedent.
The Livent decision will be used by auditor defence lawyers, which is what has frequently occurred over the years with the 1997 Hercules case. The effect over the past two decades has been to virtually eliminate the Canadian courts as potential protectors of the perceived rights of investors. The side-effect is that auditors can now easily agree with various twisted and manipulated management accounting viewpoints, because the Courts are making auditors close to untouchable. Rubber-stamped audits are dangerous, and have been a continuing cause of corporate failures in Canada for decades.
Livent does not have any appeal options left to reverse the unfortunate SCC decision of 2017. Investors and investor rights groups, in turn, will have to take their only remaining course of action, to pressure lawmakers into passing new, more-balanced securities legislation (worded by independent sources). Such new legislation must discard the obsolete, ill-defined and impractical ‘supervisory’ concept as the deemed purpose of annual audited financial statements.
The ‘Supervisory’ Concept as Applied to Year-End Audits and Annual Financial Statements
The Supreme Court stated in its 2017 decision that its deemed purpose of financial reporting, to “supervise management…as a group,” was still relevant today. The Court stated that: “No party before us has suggested that the purposes for which a statutory audit is prepared, and which have been recognized in Canadian law for 20 years, have changed.” (Reference was also made to Ontario’s older 1990 Business Corporations Act).
The “no party before us” wording is curious. Long before the 1990s and Livent’s alleged creative accounting and reporting, the auditors’ fundamental CICA Handbook (the framework used to conduct audits) stated in its basic foundation Section 1000 (“Financial Statement Concepts”):
“…the objective of financial statements focuses primarily on information needs of investors and creditors…. Investors and creditors are interested, for the purposes of making resource allocation decisions, in predicting the ability of the entity to earn income and generate cash flows in the future to meet its obligations and to generate a return on investment.”
After the release of the Court’s 1997 decision, several observers noted that a serious discrepancy existed between what the CICA Handbook stated in writing for management and auditor objectives of reporting, and what the auditors were proclaiming in Court. Thus, the 2017 Court decision, which ignored the auditors’ contradictions and thereby increased the potential for more investor losses, is a major disappointment and warning sign.
Adding to the problem is that three dissenting judges in the 2017 SCC decision would appear from their commentary to believe that auditors do not have any worthwhile role in investor protection.
A one vote swing in the recent SCC decision would have resulted in zero auditor liability as the new legal precedent in Canada. As it stands, the corporation can still sue the auditors, which is a rare situation that severely limits investor recourse.
Such a level of auditor protection is totally incompatible with the use of International Financial Reporting Standards (IFRS) in Canada. IFRS provides extensive power, and freedoms of choice in financial reporting, to corporate management. The 2017 Court decision is therefore quite troublesome as auditors can continue to provide reduced scrutiny, and management can employ financial reporting choices that can more easily mislead investors.
The ‘supervisory’ concept has been simply illogical and inapplicable in Canada for a multitude of reasons, including:
1. The SCC states that the purpose of financial statements in Canada is not so that investors can make investment decisions, but rather so that shareholders as a group can supervise the decision making of management. However, corporate management is typically fully in charge under Canadian law to choose the figures and descriptions that appear in their own ‘financial report cards’ as it were. These report cards are then signed off by non-independent auditors, and finally turned over to shareholders to “supervise” management. The issue is that the SCC is speciously ignoring human nature and expecting management to give itself a failing grade when appropriate.
2. Outside of a rare proxy battle in Canada, gathering a group of tens or hundreds of thousands of shareholders together to supervise management is hypothetical in the extreme.
3. The SCC seems to believe that all investors possess the ability to identify or ferret out misleading financial reporting when it is used by corporate management. The SCC also expects investors to be able to use the aggregated and insufficient figures in financial statements in order to carry out this task. This is a level of financial literacy and analytical skill that the SCC doesn’t even expect of professional accountants.
The ‘supervisory’ concept adopted by the SCC is little more than a hindsight invention meant to provide an alternative to the widely recognized fact that annual audited financial statements are used for investment decision-making. The SCC fabricated the ‘supervisory’ concept so that auditors would not face indeterminate liability to unknown investors when signing audit reports. Complete auditor immunity was adopted instead of some reasonable form of limited or shared liability.
Our experience as forensic accountants since the 1997 SCC decision has been that many dozens of cases wherein material evidence of auditor negligence existed have not been pursued, mainly because of the Hercules case precedent. One has to wonder what role the 1997 SCC precedent had in the decision by Canada’s auditors to adopt weak IFRS, which can be more easily used to present materially misleading financial statements. The shield of complete auditor immunity is an ongoing daily impairment to investors in Canada.
Unclear at this time is what damage to investor protections and Canadian securities laws may have been rendered by the 2017 SCC decision. Implied within a prospectus offering of securities is that specific people or companies are being asked to provide funds and are making an investment decision.
The annual financial statement auditors of Livent provided a comfort letter for the use of their audited 1996 financial statements in an Autumn 1997 prospectus offering. As conditions within Livent changed after the audit report date, the comfort letter could have been written to add cautions. Such did not happen, despite the circumstances having changed. This second prospectus-based assignment had a clear legally-compulsory purpose, and required public accountant input. This focal point was compliance with Securities Acts legislation so that investors could try to predict future cash flows, based on several years of financial statements being included in the 1997 prospectus offering.
For years, logical assumptions have been made by auditors in prospectus-based situations, such as after having had discussions with the underwriters of the issuance, about the types of probable buyers of the securities. Thus, in our view, as had been occurring for many years in Canada, the legal issues of “proximity” and “forseeability” should not appear to have been in doubt in a prospectus offering situation. The public accountants clearly undertook to not financially mislead a group of investors; that was their role in the prospectus offering, and had been such for decades in countless similar situations.
However, the Supreme Court Justices, in rendering the 2017 Livent decision, did not see it this way. We are having considerable difficulty comprehending the thinking of the Court, especially because the auditors accepted a separate prospectus-oriented assignment that was governed by Provincial securities legislation; and not by Companies Act legislation which seems to guide the SCC’s thinking in terms of applying the ‘supervisory’ concept (as previously discussed).
Indeed, the auditors’ CICA Handbook had at the relevant dates a separate section that dealt with public accountants’ obligations when a prospectus offering occurs; nevertheless, the 2017 Court stated:
“Simply put, Deloitte never undertook, in preparing the comfort Letter, to assist Livent’s shareholders in overseeing management; it cannot therefore be held liable for failing to take reasonable care to assert such oversight.”
The words “…to assist Livent’s shareholders in overseeing management” are the obsolete words that were selected by the Court when dealing with the annual audit’s purpose or objective. However, why is the annual audit framework relevant in a clear Securities Act solicitation matter?
The CICA Handbook outlines the auditors’ obligations for including in a prospectus, the 1996 financial statements of Livent, and the signing of a comfort letter. The 1996 Livent statements did not have to be accepted as is (as prepared months beforehand in early 1997, when the 1996 audit report was signed).
Section 7100 of the CICA Handbook, as of the relevant dates, dealt with a comfort or consent letter for purposes of a prospectus offering, as follows:
“The auditors should perform limited enquiry and review procedures designed to determine whether management has identified events that may require an adjustment to, or disclosure in the audited financial statements in the Prospectus. The period covered by these procedures should extend from the date of the auditor’s report in the Prospectus to a date as close to the date of his consent as is reasonable and practicable.” (emphases added.)
The signed consent letter was dated October 10, 1997. We understand that such date was after a debate ensued about various financial matters involving the auditors and directors, plus some managers of Livent. Thus, updates to the 1996 financial statements for prospectus purposes surely had to be considered. Briefly, the following questions, and more, would have been relevant:
1. Was Livent still a “going concern” business, in technical terms, or was it nearly bankrupt?
2. Were some of the profits reported in 1996 now showing themselves to be non-existent, or premature, or otherwise misleading?
3. Were some of management’s explanations for 1996 now turning out to be exaggerated?
4. Should some subsequent event losses be reported?
For much of the 1990s, financial analysts had expressed concerns that expenses of Livent were being included as assets on its audited balance sheet, among other matters. Livent, at the Ontario Trial Division, as Plaintiffs, had other concerns about financial reporting in 1996 and prior years. In addition, when a separate audit was eventually conducted for 1996, in late 1998, profit figures for Livent had to be materially lowered. Months later, the original auditors withdrew their audit report for 1996. Hindsight has also shown that one or more partners of the auditing firm did not agree with. signing a consent letter. (The Trial Division’s commentary is informative, for those who wish to learn more.)
Evidence suggests that the original 1996 audit report should have been updated, or double-dated, to address various subsequent events in 1997. This did not happen. The 2017 Supreme Court’s focus on only the original 1996 audit report, and its weak linkages to Companies Acts annual audit requirements, seems deficient to us.
By the date of consent, October 10, 1997, the auditors had professional responsibilities, including under Securities legislation, in our view. They ought to have assessed the risks involved at the time, because they were required to sign an updated consent letter. Hence, “forseeability” should not have been a valid reason for reducing the auditor liability by $44 million dollars. Investors had relied upon what turned out to have been bogus financial reporting in an offering prospectus.
Our major concern is whether the 2017 Court decision “muddies the waters” for auditors’ duties in prospectus offerings. As it stood prior to the 2017 SCC decision, auditors had a higher duty of care to investors in a prospectus offering (in contrast to the audits of annual financial statements).
The Need for New Legislation
Canada has a dreadful record of not monitoring and prosecuting situations of misleading financial statements. The Hercules Managements decision by the Supreme Court of Canada in 1997 has been a major obstacle to attaining a culture of fairness for investors. Sadly, the 2017 Supreme Court’s behind-the-scenes reasoning, although still not entirely clear, absolutely must be replaced by strong, clear, and independently-written legislation (for Companies and Securities Acts). Otherwise, these flaws will continue to be exploited. All the risks and associated losses tied to misleading financial reporting cannot continue to be placed upon the shoulders of investors, while auditors freely walk away.
Canada’s history of establishing financial reporting protections has repeatedly involved lawmakers consulting only external auditors, and their close associates, to ask what is acceptable for investors. Such was clear when IFRS was adopted in Canada, which has proven to be overly pliable and is the cause of ongoing financial concerns. Accordingly, given the conflicts of interest, auditors cannot be the drafters or consultants for new reparative legislation to bring fairness to investors.
Where Investors Are Left at the Present Time
Short of a legislative fix that is years away at best, the only course of action for investors is to understand that annual financial statement audits hold very little value for investors. Limited class action lawsuits can still be launched in certain jurisdictions, but aside from that small deterrent, most annual audits only provide a false sense of security against negligent auditor work. Aside from directors (who have errors and omissions insurance), it is very much the onus of investors to proactively and intensely monitor the accounting of corporate entities, with the clear understanding that legal recourse for investors is highly limited if not completely absent in Canada.
1 Kripps et al. v. Touche Ross & Co. et al., (1997), Court of Appeal of British Columbia. Also known as the Victoria Mortgage case.
L.S. (Al) Rosen, PhD, FCA, FCPA, FCMA, CFE, CIP firstname.lastname@example.org Mark Rosen, MBA, CFA, CFE email@example.com
SCC decision empowers auditors to rubber-stamp statements, says Al Rosen
Jan 22, 2018
TORONTO – On December 20, 2017, just before the holidays, the Supreme Court of Canada (SCC) quietly released another surprising chapter in the soap opera of investors vs. “poor victimized external auditors.” As in 1997, when the SCC ruled on Hercules Managements Ltd. v. Ernst & Young, the SCC’s decision on Deloitte & Touche v. Livent Inc., largely handed the Canadian audit profession another unwarranted victory. No stern, comprehensive warning was sent by the SCC.
Too strong a criticism, you say? Not if you add up the multiple billions of dollars that financial fraudsters extract out of Canada each decade, while many regulators and auditors merely turn the other cheek. Seriously, why aren’t there more executives in jail? No prosecutions is just one reason.
In this, the first of three consecutive daily columns on the SCC’s decision, I will sketch out my initial reaction before going into the details of the Court’s decision. But suffice to say that Canadian lawmakers have yet to overturn decades of SCC auditor-protection biases, nor have they withdrawn auditors’ full control over the comparatively poor quality of financial reporting in Canada.
Provincial securities commissions also have a long-proven record of ineffectiveness; yet, they freely claim otherwise. The lengthy string of fiascos such as Nortel, business income trusts, Sino-Forest, Poseidon and dozens more speak for themselves. This century’s investor losses continue to be huge before we even count the coming collapse of marijuana companies.
Why-oh-why has the SCC provided protection to those who may aid the prolongation of financial scams? In the Livent decision, the SCC came very close in its 4-3 vote to letting Deloitte & Touche go completely free. What was the SCC thinking? Instead of considering a broad outlook of Canada’s worsening securities picture, the SCC stuck with narrowly defined pleadings in the case.
Lawmakers must create a national securities agency
In my next two columns, I will address where the SCC’s reasoning missed crucial steps. Tomorrow’s column responds to the obsolete, artificial and hypothetical SCC belief about the purposes of annual audited financial reporting. The Canadian posture changed after about 1980; yet, the 1997 and 2017 SCC decisions are contrary to what auditors proclaim to be their role — what is advertised to the public is not what is said in court.
In part three I will address the strange line of reasoning that the SCC utilized in totally rejecting Livent’s prospectus claim. Securities law and auditor practices apparently were abruptly cast aside for reasons that are not credible. Investors who buy based on a prospectus offering have traditionally been given additional information beyond an annual audit. The prospectus purpose was clear and not a mystery. Has this concept been watered down or cast aside by the Livent decision?
Trying to strike a balance between fairness to investors as well as to corporations, management, employees and others is difficult. Since 1997, the major decline of securities reporting litigation in Canada tells you all that you need to know — investors’ rights have been decimated. Pursuit against those who have manipulated profits and cash flows of corporations has become futile.
Yet, here we are, 20 years later, and three of seven Supreme Court Justices voted to retain the 1997 state of annual financial reporting. Worse, seven out of seven apparently made financial recoveries for misleading prospectus reporting very difficult or impossible. This is hardly a fair attempt to restore the investor rights that were dislodged in 1997.
In my opinion, the SCC moved backward in time in 2017. The financial damages that repeatedly occur in Canada are not mere “bad luck.” Canada’s oversight and controls in the securities industry and its financial reporting are too easy to circumvent. We need a national securities enforcement agency to counteract the imbalance of power.
Tomorrow, the faulty reasoning behind “supervising management.” The views and opinions expressed by contributing writers to Canadian Accountant are their own. Canadian Accountant and its parent company bear no responsibility for the accuracy and opinions of contributing writers.
Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE, provide independent, forensic accounting investment research. They are the co-authors of Easy Prey Investors: Why Broken Safety Nets Threaten Your Wealth. Learn more at Accountability Research Corporation and Rosen & Associates Limited.