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Corporate governance

Auditors’ liability and duty of care
when responding to AGM questions
Nathan Dentice and Veronica To examine possible effects of
changes to the Code on Corporate Governance Practices,
which forms part of the stock exchange Listing Rules

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n October 2011, the Hong Kong
stock exchange published various
changes to the Code on Corporate
Governance Practices, which forms
Appendix 14 of Listing Rules. The revised
code came into effect on 1 April. Among
other matters, the revised code requires
a listed issuer to ensure that the issuer’s
external auditors attend annual general
meetings to answer questions about the
conduct of the audit, the preparation and
content of the auditor’s report, accounting
policies and auditor independence. This
changes the previous position under section
141(7) of the Companies Ordinance, in which
auditors were entitled, but not required, to
attend AGMs.
The new requirement to attend and
answer questions at AGMs raises a question
as to whether the revised code might extend
an auditor’s legal duties and liabilities
for negligence and economic loss to the
company’s shareholders as individuals,
in addition to the auditor’s existing duties
towards the company.
The current position under Hong Kong
law is that, generally, auditors only owe a
duty of care to their client, being the company
they are auditing. Nevertheless, a duty of
care to third parties, such as shareholders,
creditors and potential investors, may arise in
exceptional circumstances.
The leading case on the question of an
auditor’s duty of care to third parties is
Caparo Industries plc. v Dickman [1990]
2 AC 605. In that case, Caparo brought an
action against the auditors of an electronics
company, Fidelity, after an accomplished
takeover of Fidelity. Caparo began to buy
shares shortly before Fidelity published its
annual audited accounts to shareholders.
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June 2012

Caparo then purchased more shares in
reliance on those accounts so as to take over
Fidelity. In its claim against the auditors of
Fidelity, Caparo asserted that the audited
accounts were incorrect and that it would not
have purchased the shares had it known of
Fidelity’s true state of affairs.
The House of Lords determined that, in
general, auditors only owe a duty of care to
shareholders as a body and not to individual
shareholders. They reasoned that the
purpose of audited accounts is to enable the
company’s management and shareholders
to make informed decisions in respect of
the company and not to assist potential
investors in deciding whether or not to
invest in the company. To impose a duty on
the auditors to all such investors would be to
expose them to (in the words of Lord Oliver
of Aylmerton) “a liability wholly indefinite in
the area, duration and amount and would
open up a limitless vista of uninsurable risk
for the professional man.”
As regards existing shareholders, the
House of Lords held that, while existing
shareholders are entitled to rely on the
audited accounts to protect their collective
interest in the proper management of the
company, they are not entitled to rely on
the auditor’s statutory report as a basis for
making their own investment decisions.
The House of Lords then adopted a
threefold test for the purpose of determining
whether the auditors nevertheless owed
a duty of care to Caparo in the particular
circumstances of the case. First, the
damage must be reasonably foreseeable
as a consequence of the auditor’s conduct.
Second, there must be a close relationship
of proximity between the parties such as
to justify the imposition of a duty of care.

Proximity for a duty of care would arise
where (i) advice is required for a purpose
and the auditor was fully aware of the nature
of the transaction that the advisee had in
contemplation; (ii) the auditor knew that
the advice would be communicated to the
advisee; (iii) the auditor knew that it was
very likely that the advisee would rely on that
advice in deciding whether to engage in the
transaction; and (iv) the advice was so acted
upon by the advisee to his detriment. Third,
the situation must be such that it is fair, just
and reasonable that the law should impose
a duty upon the auditor. After examining the
circumstances of the case, the House of Lords
determined that no duty of care was owed to
Caparo by the auditors of Fidelity.
The decision in Caparo Industries plc.v
Dickman represented a deliberate effort
by the House of Lords to restrict the extent
to which auditors might be liable to third
parties. Underpinning the decision were
important policy considerations, including
a recognition that, if auditors routinely
owed duties to all those parties who might
rely upon audited accounts, the potential
liabilities in respect of audit work would
be enormous and unquantifiable, placing a
heavy burden on auditors and potentially
resulting in significant increases in the costs
of audit services.
While the decision in Caparo Industries
plc. v Dickman represents the leading case
on the question of an auditor’s duty of care
to third parties, there exist two other legal
approaches that the courts might adopt for
the purposes of deciding whether to impose
a duty of care in a particular case. One is the
“assumption of responsibility” approach,
which arises from Hedley Byrne & Co. Ltd. v
Heller & Partners Ltd. [1964] AC 465. In this

the court identified six factors to be considered when deciding whether to impose a duty of care in relation to statements or advice. they shall not have any liability. (v) the state of knowledge of the adviser. being that the law should develop new categories of negligence incrementally and by analogy with established categories. 2) [1998] PNLR 564.A PLUS case. and reliance by the third party. Against the background set out above. An effective precaution that auditors may take to minimize the risk of a duty of care to individual shareholders arising is for auditors to circulate or read a short disclaimer prior to answering questions. This is likely to be sufficient to put the auditors outside the exceptional circumstances described by the legal approaches. Sir Brian Neill concluded that the court should apply all three tests.” The other is the incremental approach suggested by Brennan J. Auditors should therefore be cognizant of the legal position when answering questions and should avoid conduct that might bring them within the exceptional circumstances described by the approaches discussed. (iii) the relationship between the adviser. an international law firm. the House of Lords ruled that a person may be liable to another party in respect of statements that they make or advice that they give if they voluntarily assume responsibility to that other party.W. it would appear that. the court will consider (i) the purpose for which the statement was made. in his judgment in the High Court of Australia in Sutherland Shire Council v Heyman [1984] 157 CLR 424. In particular. Nathan P. the advisee and any relevant third party. in the case of Anthony v Wright [1995] BCC 768 summarized this in the context of audit reports as follows: “The law is well established that auditors do not in respect of their audits owe a duty of care to anyone other than the company itself save in exceptional circumstances where a special duty has been treated as assumed to a third party… A special relationship is required and in particular intention (actual or inferred) on the part of the auditors that the third party shall rely. the revised code will not (in and of itself) alter the existing principle that. (iv) the size of any class to which the advisee belongs. responsibility or duty of care towards individual shareholders or third parties. This article is intended for general information purposes and does not constitute specific legal advice. and the other party relies upon their judgment or skill. to the effect that. Each of the three approaches discussed above were reviewed in the context of audit negligence in the case Bank of Credit Commercial International (Overseas) Ltd. Lightman J. Reed Smith Richards Butler shall not have any legal liability in respect of the matters discussed. it was likely that they would all lead to the same result. Nevertheless. v Price Waterhouse (No. there is now greater scope for circumstances to arise in which a duty of care to individual shareholders might be imposed in a particular case. on the audit. in general. v Hicks Anderson & Co. to the extent the revised code introduced by the stock exchange requires auditors to attend AGMs and answer questions. by putting auditors in direct discussions with individual shareholders. before a claim in negligence against the auditor can be maintained. and (vi) the reliance on the statement by the advisee. In the case of James McNaughton Paper Group Ltd. Where auditors have questions in relation to their legal duties. June 2012 45 . auditors will not owe a duty of care to individual shareholders. notwithstanding any answers they give or statements they make at the AGM. Dentice is a partner and Veronica Siwang To is an associate solicitor in the Hong Kong office of Reed Smith Richards Butler. [1991] 2 QB 113. (ii) the purpose for which the statement was communicated. it is recommended they seek specific legal advice. and if the facts were properly analysed. In that case.