PRINCIPLES OF FRAUD EXAMINATION

Chapter 11: Accounting Principles and Fraud

Case Study: Livent Inc. and Deloitte

Case Narrative
Livent staged live-theatre shows such as The Phantom of the Opera and Show Boat. The
company collapsed in 1998 after new investors raised concerns about accounting problems
they had uncovered at the company.

Garth Drabinsky, a colourful impresario and public face of the company, was suspended as
Livent’s vice-chairman and chief creative director in 1998 amid allegations of accounting
irregularities. Myron Gottlieb, who served as president, was also suspended. Livent
subsequently filed for bankruptcy and went into receivership. Drabinsky and Gottlieb were
found guilty in 2009 of orchestrating a fraud that saw Livent's financial statements misstated
in every quarter between 1993 and 1998. They were sentenced to five years and four years in
prison, respectively, but have since been released.

In January 2016, the Ontario Court of Appeal upheld a landmark 2014 decision that ordered
the Deloitte accounting firm to pay $118 million in damages for negligence in its work as the
auditor of failed live-theatre company Livent Inc. Appeal Court Justice Robert Blair ruled that
the original trial judge was correct in concluding Deloitte was negligent in its work on the
audit of Livent's 1997 year-end financial statements, as well as the interim statements for the
second and third quarters of 1997. "In my view, the record amply supports the trial judge's
findings that Deloitte was negligent in the conduct of the 1997 audit and the Q2 and Q3 1997
engagement," he wrote in a decision supported by two other judges on the appeal panel.
"Indeed the evidence to that effect is overwhelming."

Ontario Superior Court Justice Arthur Gans had ruled in April, 2014, that auditors at Deloitte
breached their "duty of care" to the corporation. In his original ruling, Justice Gans said that
auditors "seemed to turn a blind eye to warning signs" about a controversial transaction in
1997 to sell air rights to develop a condominium-hotel above Livent's Pantages Theatre in
Toronto. He said he was "at a loss" to understand how Deloitte provided a clean audit opinion
for 1997, and ruled that another decision to allow for $27.5 million in write-downs in 1998
"left me breathless."

Justice Gans' decision was widely watched because Canadian investors have faced an uphill
battle suing auditors, largely as a result of a 1997 Supreme Court of Canada decision involving
Hercules Management Ltd., which set out narrow parameters for lawsuits to succeed. The
Livent decision, however, was seen as a break from that precedent, laying out a new path for
aggrieved investors and creditors to succeed in lawsuits against auditors. Because the Hercules
decision concluded that auditors owe a duty of care to the corporation that hires them – and
not to shareholders or creditors directly – the Livent lawsuit was filed by Livent itself through
its special receiver, although the creditor group led and financed the litigation and will receive
much of the award.

Deloitte challenged the move in its appeal, saying the lawsuit was essentially filed by creditors
in reality and not really the corporation. But Justice Blair rejected the argument, saying he had

This case study was contributed by Dominic Peltier-Rivest. It is based on excerpts from the January 8, 2016,
Globe & Mail article entitled “Court upholds ruling on Deloitte’s negligence over Livent” and the December 20,
2017, Toronto Star article entitled “Deloitte partially liable for Livent’s losses, Supreme Court rules.”
 PRINCIPLES OF FRAUD EXAMINATION

Chapter 11: Accounting Principles and Fraud

Case Study: Livent Inc. and Deloitte

"no difficulty" in concluding the losses were suffered by Livent so it was the legitimate party
suing. He also rejected Deloitte's arguments that the company had no right to sue because the
fraud was conducted by Livent's own senior executives, which meant the company itself
essentially conducted the fraud and should not be allowed to sue over its own conduct. Justice
Blair said such a claim would effectively mean auditors could never be sued by a company for
failing to act on evidence of fraud by executives, which would "risk undermining the public
audit system." He said he agreed with Justice Gans' original decision that blaming the
company for fraud by its executives "would have the perverse effect of depriving the innocent
participants" with a remedy for auditor negligence. Justice Blair also agreed with Justice Gans'
conclusion that Deloitte should have resigned as Livent's auditor in 1997 due to the number of
problems it had identified at the company.

Livent bondholder Richard Ross, who headed the creditor group suing Livent, said the group
is "gratified" that the appeal court upheld the trial decision, and he hopes the case will soon be
over. "We hope that this will be the end of this legal saga and that some measure of
compensation will now be available to the creditors for the massive losses they incurred in the
Livent fiasco," he said.

However, Deloitte has appealed the Court of Appeal’s decision to the Supreme Court of
Canada. But in December 2017, in a 4-3 ruling, the Supreme Court found Deloitte was liable
for negligently auditing Livent’s 1997 financial statements, though not for other conduct. The
court concluded that an audit firm can only be held responsible where a company’s financial
losses relate to the actual purpose of the auditors’ work. Lower court decisions left Deloitte on
the hook for almost $118 million, but the Supreme Court ruling reduced the damages award to
$40 million. Writing for a majority of the Supreme Court, justices Clement Gascon and
Russell Brown confirmed that Deloitte negligently audited Livent’s financial statements,
resulting in the company losing millions more than it would have if the auditors had
uncovered the fraud earlier. “As a consequence, Livent’s corporate life was artificially
prolonged, resulting in the interim deterioration of its finances,” the judges wrote. They
reasoned that Livent would not have taken on greater debt through financing, instead limiting
the damage by declaring bankruptcy sooner. Specifically, the court found Deloitte liable for its
April 1998 audit of Livent’s 1997 financial statements. It said Deloitte was responsible for
75% of the difference in the company’s financial position between the time of the audit
opinion and Livent’s bankruptcy in November 1998.

Q1: Please summarize the case background.

Perpetrator: Garth Drabinsky vice chairman, Myron Gottlieb, who served as president
Victim organization: Livent and Deloitte
Legal outcome: served a few years in prison each
Total losses: 40 million for Deloitte (lowered by Supreme Court)
Deloitte issued a clean opinion which was not the case, and kept Livent in business and
postponed bankruptcy.

This case study was contributed by Dominic Peltier-Rivest. It is based on excerpts from the January 8, 2016,
Globe & Mail article entitled “Court upholds ruling on Deloitte’s negligence over Livent” and the December 20,
2017, Toronto Star article entitled “Deloitte partially liable for Livent’s losses, Supreme Court rules.”
 PRINCIPLES OF FRAUD EXAMINATION

Chapter 11: Accounting Principles and Fraud

Case Study: Livent Inc. and Deloitte

Q2: Please categorize & explain fraud schemes perpetrated in this case.
- Improper disclosure
- Fictitious revenue
- Write down profit in wrong years
- Timing differences
- Asset valuation

Q3: Please recommend & explain prevention measures related to the Sarbanes-Oxley Act that
would be effective in this case.

- No longer give consulting AND auditing services to the same clients

- Tax services are acceptable concurrently
- Hot lines - whistle blowing mechanism
- New partner on audit every 5 years
- More independence on the auditing work

This case study was contributed by Dominic Peltier-Rivest. It is based on excerpts from the January 8, 2016,
Globe & Mail article entitled “Court upholds ruling on Deloitte’s negligence over Livent” and the December 20,
2017, Toronto Star article entitled “Deloitte partially liable for Livent’s losses, Supreme Court rules.”