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Dispute Resolution Law Alert - November 2017
Submitted by // K Bowers, Partner / Solicitor Advocate
28 November 2017


Court Considers Auditor's Duty to Report Transactions

Introduction 

In the recent case of Days Impex Ltd (in liquidation) & Anor v Fung, Yu & Co (a firm) & Anor [2017] HKCU 24981, the Court of First Instance considered the duty of an auditor to detect and report fraudulent activities in the course of performing auditing work. In rejecting the Defendants' application to strike out the action, the Court held that an auditor's duty is not only restricted to the provision of information and advice, but also includes detecting material irregularities in financial statements. Additionally, the Court commented on recent developments in relation to the defence of illegality and attribution, opening up the possibility of a full consideration by the Court at the trial.

Background

The Plaintiffs in this case were private Hong Kong companies (in liquidation). The Defendants were appointed as the auditors of the Plaintiff companies from 2005 to 2011. During this period, the Plaintiffs were defrauded by their director and principal shareholder through a number of fraudulent bank loans. The Plaintiffs' case was that the Defendants breached their duty of care by failing to detect the fraudulent transactions when performing auditing work for the Plaintiffs.

The Defendants disputed that they owed a duty of care to the Plaintiffs in relation to the fraudulent transactions and applied to strike out the action. In hearing the application, the Court considered:-

1. whether the scope of the duty of care owed by the auditor includes the detection of fraud; and

2. whether the Defendants can rely on the defence of illegality and attribution.

Scope of the Auditor's Duty of Care

In considering the scope of the Defendants' duty of care, the Court rejected the argument that the Defendants' duty is restricted only to the provision of information and advice. Instead, the Court held that Defendants' duty as auditors may extend to detecting material irregularities in the accounting statements.

In reaching this finding, the Court cited the English case of Barings v Coopers & Lybrand2 which says that an auditor's task includes detecting material misstatements in financial documents. The Court also referred to the case of Sasea Finance Ltd v KPMG3 which says that an auditor's duty may extend to reporting instances of fraud detected during the course of working for a client. From these cases, the Court concluded it was highly arguable that an auditor's duty is more than the provision of information and advice, and that it may extend to reporting suspicion of fraud to management, or even to relevant authorities.

Defence of Illegality and the Issue of Attribution

Significantly, the Defendants also raised the defence of illegality in applying to strike out the action. The defence of illegality prevents a claimant from pursuing a civil claim if the claim arises in connection with an illegal act by the claimant. On this point, the Court commented that the recent English case of Patel v Mirza4 ("Patel") in the Supreme Court (UK) substantially reformulated the law in this area. Consequently, the Court required an examination of the facts of the case before it could determine the issue of illegality.

A further complication is that in order for the Defendants to rely on the defence of illegality, the fraud perpetrated by the director and principle shareholder would need to be attributed to the Plaintiffs. In relation to this, the Defendants cited the case of Stone & Rolls Ltd v Moore Stephens5 ("Stone & Rolls"), which the Court in this case commented as being highly controversial, and that it was unclear whether the facts of this case could be distinguished from the case of Moulin Global Eyecare Trading Ltd (in liquidation) v The Commissioner of Inland Revenue6 ("Moulin"), where the Court of Final Appeal was critical of Stone & Rolls. Accordingly, the Court concluded that the current case was not suitable for striking out, as a closer examination of the facts is required.

Comment 

The Court in this case held that an auditor's duty of care should extend beyond the provision of information and advice, and may include the detection of material irregularities in a company's finances. Where an auditor suspects fraud in the client company, an auditor may also have a duty to report the fraud to management or to the relevant authorities. However, as this case is still at an interlocutory stage, further consideration by the Court will be required to clarify the scope of this duty.

This case is also significant for its discussion on the defence of illegality and the principle of attribution. As both points were left open by the Court for consideration at a full trial, it will be important to see how the Court treats the Patel case in relation to the defence of illegality, and whether the facts of this case can be distinguished from Moulin in relation to the issue of attribution.

The ultimate outcome of this significant case should help to clarify some important questions relating to the scope of an auditor's duty of care, the defence of illegality and the principle of attribution. Interested parties should keep an eye on the development of this case as it proceeds through the Courts.


1. Unreported, High Court Action No 348 of 1996 (Court of First Instance, 24 October 2017)
2. [2002] 2 BCLC 410
3. [2000] 1 All ER 676
4. [2016] 3 WLR 399
5. [2009] 1 AC 1391
6. (2014) 17 HKCFAR 218


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