The Tortious Liability of Auditors to Third Parties:A Reassessment

K M Hogg BA LLM (Qld). Lecturer in Law, T C Beirne School of Law, University of Queensland.

Introduction

In view of the recent decisions in R Lowe Lippmann Figdor & Franck v AGC (Advances)Ltd, l Columbia Coffee & Tea v Churchil[2 and Esanda Finance Corporation Ltd v PeatMarwick Hungerfords (Reg),3 the Australian law relating to the liability of an auditor toa person other than the audit client warrants reassessment. While there is no direct deci­sion of the High Court on this issue, there is no reason why the law cannot be definedwith clarity. An analysis of the High Court authorities relating to claims for economicloss and negligent misstatement reveals not only the relevant test to be applied to deter­mine the liability of an auditor to a third party, it also shows the weight that should be at­tributed to both the statutory obligations imposed on auditors by the Corporations Lawand the various policy considerations raised by judicial and academic commentators.

The relevant issues are discussed in two Parts. Part One considers how the High Courtwould deal with a claim brought by a third party against a negligent auditor. Part Twoanalyses the approach taken by the State Supreme courts in the three recent decisions. Inthe course of this analysis, it will be seen that the reasoning in Lowe Lippmann, ColumbiaCoffee & Tea and Esanda is either flawed or, at best, misleading.

Part One: An auditor's duty to a third party - the High Court's approach

The starting point for any consideration of the duty of care in a case of economic lossmust be the High Court's proximity concept. Liability for foreseeable economic loss de­pends upon the existence of the requisite relationship of proximity between the parties.Although the High Court has not directly decided the issue, it is apparent that in the con­text of negligent misstatement the relevant proximity factor is seen in tenus of the testformulated by Barwick CJ in Mutual Life and Citizens' Assurance Co Ltd v Evatt.4 Theweight of opinion in several High Court cases dealing with liability for negligent mis­statement favours the Barwick test.5 According to,this test, a duty of care in making astatement will arise in circumstances where the following elements are satisfied:

1 [1992] 2 VR 671 (hereafter'Lowe Lippmann'). (Supreme Court of Victoria, Appeal Division).2 (1992) 10 ACLC 1659 (hereafter 'Columbia Coffee & Tea'). (Supreme Court of New South Wales).3 (1994) Aust Torts Rep 81-265 (hereafter'Esanda '). (Supreme Court of South Australia, Full Court).4 (1968) 122 CLR 556 (hereafter'Evatt'). In L Shaddock &Associates Pty Ltdv Parramatta City Council (1981)

150 CLR 225, it was unnecessary for the High Court to choose between this test and the narrower test laiddown by the Privy Council in Evatt and, for reasons to be explained later, this test was not applied in SanSebastian Pty Ltd v The Minister (1986) 162 CLR 340.

5 In L Shaddock & Associates Pty Ltd v Parramatta City Council (1981) 150 CLR 225, 251, Mason J (withwhom Aicken J agreed) accepted Barwick CJ's formulation as a 'statement of the conditions which give riseto a duty of care'. Later, in San Sebastian Ply Ltd v The Minister (1986) 162 CLR 340, 371-372 Brennan Jexpressly adopted the test, while the majority joint judgment of Gibbs CJ, Mason, Wilson and Dawson JJ (at356) took the view that the test had received majority endorsement by the Court in Shaddock.

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1. the speaker realises or ought to realise that the recipient of the information and ad­vice is relying on his or her skill and judgment;

2. the speaker realises or ought to realise that the recipient intends to act upon the in­formation or advice in respect of his or her property or in connection with a matterof serious or business consequence; and

3. the recipient's reliance upon the information or advice provided by the speaker wasreasonable.6

The operation of this test in the context of determining the liability of an auditor to athird party is best illustrated by a comparison with the tests formulated in other jurisdic­tions. Both the House of Lords and the New Zealand Court of Appeal have directly de­cided the question of the scope of an auditor's liability for negligent misstatement

In Scott Group Ltd v McFarlane,? the New Zealand Court of Appeal, by a majority oftwo to one,8 held that an auditor owed a duty of care in statement to the plaintiff companywhich undertook a takeover of the audit client in reliance upon the accounts prepared bythe defendant9 The defendant had no knowledge nor any reason to suspect, at the time ofmaking the statement, that the company would be subject to a takeover bid. Nevertheless,the majority found that the relevant duty could be based on the fact that it was reasonablyforeseeable to a person in the defendant auditor's position that the statement would be re­lied upon for that purpose.10

Although the foreseeability test applied by the majority in Scott Group to determinethe existence of the relevant duty of care has enjoyed support elsewhere,11 when theHouse of Lords came to consider the issue of an auditor's liability to a third party in Ca­paro Industries Pic v Dickman12 it did not follow the lead of the New Zealand Court ofAppea1. 13 The House of Lords formulated a much narrower test, insisting that at the timeof making the statement the defendant auditor have actual knowledge of the purpose forwhich the plaintiff relies upon the statement14 As it was found that the defendant audi­tors had no knowledge that the accounts would be relied upon for the purposes of invest­ment, the plaintiff company was unable to recover the loss suffered when it increased itsshareholding in the client company in reliance upon the accounts which contained anoverstatement of the value of the shares.

There is, of course, a clear divergence between the Australian law and the approachtaken by the New Zealand Court of Appeal in Scott Group.15 As already indicated, theproximity concept is fundamental to the High Court's theory of negligence and it would

6 Evatt (1968) 122 CLR 556, 571-572.7 [1978] 1 NZLR 553 (hereafter the'Scott Group').8 Woodhouse and Cooke IJ, Richmond P dissenting.9 However, the plaintiff's action failed because it was found that no actual loss had been suffered in the takeover.

In fact, the plaintiff had made a profit.to The evidence showed that while the company whose accounts were audited was rich in assets it had

unimpressive earnings: see Scott Group [1978] 1 NZLR 553, per Cooke J.11 For instance, in the Scottish case of Twomax Ltd v Dickson, McFarlane & Robinson [1982] SC 113, andJEB

Fasteners Ltd v Marks Bloom & Co (A Firm) [1981] 3 All ER 289.12 [1990] 2 AC 605 (hereafter 'Caparo').13 The doctrinal background to these cases shows that the refusal of the House ofLords to follow the New Zealand

approach was not surprising. The decision in Scott Group [1978] 1NZLR 553 was based on an application ofthe two stage test of liability laid down by Lord Wilberforce inAnnsv Merton London Borough Council [1978]AC 728, 751-752. The increasing disillusionment of the House of Lords with the notion of a single theory ofnegligence in general, and the two stage formulation in particular, culminated in its decision in Caparo [1990]2 AC 605. See K M Hogg, 'Negligence and Economic Loss in England, Australia, Canada and New Zealand'(1994) 43 International and Comparative Law Quarterly 116.

14 The House of Lords relied heavily on the dissenting judgment of Lord Denning in Candler v Crane Christmas& Co [1951] 2 KB 164. See, for instance, the judgment of Lord Bridge in Caparo [1990] 2 AC 605.

15 [1978]] NZLR 553.

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not countenance imposing liability solely on the basis offoreseeability of harm. The HighCourt's test is obviously closer to the approach taken by the House of Lords in Caparo.The requirement that the defendant have knowledge that the plaintiff intends to use his orher statement for the purposes of a particular transaction is clearly an element of the testof liability that would be applied by the High Court. There is, however, one importantdistinction between the Australian and English tests which relates to the nature of theknowledge possessed by the defendant. As pointed out, the House of Lords insisted uponactual knowledge on the part of the auditor. However, the elements of the test formulatedby Barwick CJ would be satisfied and the proximity requirement fulfilled if, even thoughthe defendant had no such actual knowledge, the circumstances were such that the defen­dant ought to have known that the plaintiff intended to use the information and advice fora particular purpose.16

Accordingly, it is suggested that the High Court would allow recovery by a third partyagainst an auditor if the elements of Barwick CJ's formulation in Evatt were satisfied.This means that the plaintiff would have to establish that the auditor knew, or ought tohave known, of the plaintiff's reliance upon the accounts and that this reliance was rea­sonable. The only other basis upon which a plaintiff may be able to establish a relevantduty on the part of the auditor is the following test laid down by the High Court in SanSebastian Pty Ltd v The Minister: 17

In cases of negligent misstatement, reliance plays an important role, particularly so when thedefendant directs his statement to a class of persons with the intention of inducing members ofthe class to act or refrain from acting, in reliance on the statement, in circumstances where heshould realise that they may thereby suffer economic loss if the statement is not true.18

While, for reasons to be explained later, the San Sebastian test only provides a limitedexception to the operation of the general test formulated by Barwick CJ in Evatt, it maybe of some assistance in determining the liability of an auditor to a third party. In circum­stances where there is no evidence of knowledge or constructive knowledge on the partof the defendant of the plaintiff's reliance, liability could be imposed on the auditor onthe basis that the relevant statement was made to the plaintiff, or a class of persons whichincluded the plaintiff, with the intention of inducing them to act in reliance thereon.

The relevance ofthe statutory background and policy factorsIn the absence of a direct decision by the High Court on this issue, much of the debateconcerning the direction that our law will take has centred on the statutory duties and re­sponsibilities of auditors and various policy considerations. For instance, some commen­tators have pointed to the fact that the Corporations Law provides for a scheme ofdisclosure of the accounts of public companies.19 The public nature of these documentshas been used to argue that common law liability for any misstatement contained in the

16 For an explanation of the importance of this distinction and a discussion of a case demonstrating the point, seeM Davies, 'The Liability of Auditors to Third Parties in Negligence' (1991) 14 University ofNew South WalesLaw Journal 171, 187.

17 (1986) 162 CLR 340 (hereafter'San Sebastian').18 Jd 355 per Gibbs CJ, Mason, Wilson and Dawson JJ.19 R Baxt, 'The Liability of Accountants and Auditors for Negligent Statements in Company Accounts' (1973)

36 Modern Law Review 42 ('Baxt MLR'); R Baxt, 'The Liability of Auditors - The Pendulum Swings Back'(1990) 8 Companies and Securities Law Journal 249 ('Baxt C & SU'); G Gay & P Schelluch, 'The Auditor'sLiability to the Company, Shareholders and Third Parties' (1991) 9 Companies and Securities Law Journal59.

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accounts could be imposed on the basis of the reasonable foreseeability of the plaintiff'sreliance.20

The statutory background to the question of an auditor's liability has also been used toargue against the adoption of the narrow approach taken by the House of Lords in Ca­paro.21 In defining the scope of the defendant auditors' liability, the House of Lordsfocussed on the purpose for which the accounts were prepared. Their Lordships decidedthat the accounts were not prepared for the information of investors or potential investorsin the company but merely 'to provide an account of the stewardship of the directors tothe shareholders as a body'.22 As a result, it was found that the auditors had no actualknowledge of the plaintiff's reliance. Several writers have suggested that in light of thestatutory scheme governing the provision of audits and company accounts in this country,it would be inappropriate to apply the House of Lords' interpretation of the purpose of anaudit in the Australian context.23 On this basis, it has been argued that the 'conserva­tism'24 evident in Caparo should not be followed by our courtS.25

Without detracting from the merit of some of the arguments raised in this debate, it issuggested that there is little point in speculating as to the direction the High Court willtake on the issue of an auditor's liability to third parties. As already indicated, the HighCourt will impose liability on an auditor if the elements of the test formulated by BarwickCJ in Evatf26 are satisfied. It is more useful in this context to briefly consider the rele­vance of the statutory background to the operation of the High Court's test. As alreadyseen, one of the elements of the Barwick formulation is the requirement that the plain­tiff's reliance upon the defendant's statement be reasonable in the circumstances. In lightof the disclosure requirements, it could be argued that any reliance upon a statementmade in the audited accounts of a public company would be reasonable. After all, it mightbe said that the very purpose of the relevant enactment is to provide a statement uponwhich existing and potential shareholders and creditors can rely. It is suggested, however,that while the publication of the auditor's statement will be relevant, the High Court willnot allow legislative motive to conclusively determine the question of reasonableness.Instead, the Court will look at all the circumstances of the case including the nature of theinformation relied upon, the purpose of the transaction for which it was used and whetherthe plaintiff had the opportunity to obtain or verify the information elsewhere.27

In addition, it is suggested that the requirement that the defendant know, or have themeans of knowing, of the plaintiff's reliance would not be satisfied simply by pointing tothe fact that the auditor's report was disclosed to the public. The publication of the rele-

20 See, for instance, Baxt MLR, supra note 19, 49, and Baxt C & SU, supra note 19, 254-255. Certainly, theCourt of Appeal in Scott Group [1978] 1 NZLR 553 considered the public nature of the accounts upon whichthe plaintiff company relied as being an important factor in determining that reliance was foreseeable to aperson in the position of the defendant auditor - see the judgment of Cooke J, and at 575 per Woodhouse J.

21 [1990] 2 AC 605.22 [1990] 2 AC 605, 660 per Lord Jauncey.23 Baxt C & SU, supra note 19,256-257; Gay & Schelluch, supra note 19,61-63.24 To adopt a term used by Baxt C & SU, supra note 19, 249.25 Gay & Schelluch, supra note 19, did not suggest an alternative approach to the Caparo test, while Baxt C &

SU, supra note 19, 255, appears to put forward a test based on foreseeable and reasonable reliance.26 (1968) 122 CLR 553, 571-572.27 Baxt C & SU, supra note 19, 255, has pointed out that while reliance by a major investor on the audited

accounts of a public company may not be rea~onable and therefore not provide a sufficient basis for theimposition of liability, the small, private investor is in a different position.

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vant documents may make a plaintiff's reliance reasonably foreseeable. However, theknowledge element of the Barwick test requires that at the time of making the report thedefendant be at least equipped with knowledge of the particular transaction for which theplaintiff uses the statement. If the auditor knows no more than that the document will bemade available to the public,28 then the only basis upon which liability to a third party29could be established is by showing that the plaintiff was a person, or a member of a classof persons, which the defendant intended to induce to act in a particular way in relianceupon the report.30

In addition to the statutory background, it has also been suggested that the policy con­siderations relevant to an action involving a claim by a third party against an auditorshould playa role in detennining the scope of an auditor's liability.31 Again, there is littlepoint in such speculation as the High Court is likely to take a common law rather than aprofession specific approach32 to liability in this context. In other words, liability will bedetermined by the application of principle rather than weighing competing interests. TheHigh Court's approach will not operate to protect, for example, every investor who entersa transaction in reliance upon audited accounts. On the other hand, it does not precludethe possibility of liability to a third party.33

Part Two: The recent Supreme Court decisions

After providing a brief outline of the facts and decisions in Lowe Lippman, ColumbiaCoffee & Tea and Esanda,34 this part analyses the approach taken by the State SupremeCourts under the following headings:(i) Columbia Coffee & Tea: An assumption of responsibility in an Audit Manual?

(ii) The application of the San Sebastian principle: Lowe Lippmann and Esanda.

The Facts and the Decisions

(a) Lowe Lippmann35

At first instance, Vincent J36 held that the defendant auditor, Lowe Lippmann, whoaudited the accounts of a company called Lyvetta Weaving Mills Ltd owed a duty of care

28 M Davies, supra note 16, 194, ha~ suggested that the objective element of the knowledge requirement wouldallow the court to take into account matters such as current business factors: 'By introducing a degree ofobjectivity to the court's assessment, the "knew or ought to have known" approach has the advantage that itgives the court the opportunity to consider current business practice and commercial conditions in determiningwhether the auditor ought to have known that the audited accounts would be passed on to, and relied on by,third parties. '

29 Note, however, the decision in Caparo [1990] 2 AC 605 to the effect that an auditor would have actualknowledge of the shareholders' use of an audit report.

30 It is suggested that the circumstances in which it could be shown that an auditor made a statement in an auditreport with the intention of inducing a class of persons to act in a particular way in reliance thereon would bevery rare.

31 For instance, Baxt C & SU, supra note 19, suggests that a narrow and restrictive test of liability fails toencourage investment by not providing protection to investors, particularly small investors.

32 To adopt the term used by B Feldthusen, Economic Negligence (2nd ed, Toronto: Carswell, 1989). AsFeldthusen suggests, a profession specific approach is not the best solution to the problems raised in this context.He contends (at 125) that it should not be preferred to the common law approach.

33 Accordingly, the High Court's approach may not be welcomed by auditors who, in light of recent massivesettlements of claims by client companies (see report of settlement of claim with respect to the audit ofTricontinental by Peat Marwick Hungerford for $M136, The Sydney Morning Herald, January 26,1994,31)will argue that their liability should not be extended further to include a duty to third parties.

34 See supra notes 1-3.35 [1992] 2 VR 671.36 Supreme Court of Victoria

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in statement to the company's major creditor, the plaintiff finance company, AGC (Ad­vances) Ltd. This decision was overturned on appeal by the defendant to the Appeal Di­vision of the Supreme Court of Victoria. Although there was evidence that the auditorknew that the plaintiff company was going to rely on the 1980-1981 audited accounts toreview its loan facility to Lyvetta, the court held that no duty of care was owed to AGC.37The principal judgment was delivered by Brooking J38 who held that there would be noliability for any loss suffered by the plaintiff in the absence of an intention on the part ofthe defendant auditor to induce AGC to act in reliance upon the accounts. In reaching thisconclusion,39 his Honour drew on the High Court's decision in San Sebastian.40

(b) Columbia Coffee & Tea41

In this case Rolfe J, in the Supreme Court of New South Wales, dealt with the question ofwhether the defendant auditors owed a duty of care to a company called Donyoke whichhad purchased shares in Columbia Coffee & Tea Pty Ltd ('Columbia'). Columbia had re­tained the defendant auditors to conduct its 1987 annual audit and an interim audit in late1987. The auditors had no actual knowledge that their reports would be used by the deci­sion makers within Donyoke to detennine whether to purchase shares in Columbia. Infact, at the time the audits were prepared, Donyoke was not even in existence since it wasnot incorporated until 1988.

Rolfe J found that a duty of care was owed on the basis of a statement contained in thedefendant auditors' Audit Manual. However, the plaintiff company's action failed be­cause it was unable to establish that there was any causal connection between the audi­tor's breach of duty42 and the alleged damage.43

(c) Esanda44

This case involved an appeal from a decision45 dismissing an application to strike out aplea of negligent misstatement from a statement of claim. The plaintiff, Esanda FinanceCorporation, brought the action against the audit firm Peat Marwick Hungerfords whichhad audited the 1989 accounts of a company called Excel Finance. It was claimed that inreliance upon these audited accounts, the plaintiff entered into certain transactions46

which caused it to suffer a loss.On appeal, the Full Court of the Supreme Court of South Australia held unani­

mously47 that the relevant paragraphs of the statement of claim should be struck out asthey failed to disclose a cause of action.48 According to the pleadings, the plaintiff's con­tention of negligent misstatement was based upon the Statements of Accounting Stand­ards and the claim that the plaintiff's reliance was foreseen, or ought reasonably to havebeen foreseen, by the defendant auditors. The Full Court applied the reasoning in San Se­bastian49 and held that in the absence of a plea that the defendants intended to induce the

37 The defendant virtually conceded negligence at the trial.38 With whom Gobbo J agreed. Tadgell J delivered a separate judgment in which he also expressed his agreement

with the reasoning of Brooking J.39 [1992] 2 VR 671,683-684.40 (1986) 162 CLR 340.41 (1992) 10 ACLC 1659.42 It was claimed that the auditors had understated the creditors of Columbia.43 (1992) 10 ACLC 1,659, 1,672.44 (1994) Aust Torts Rep 81-265.45 Bollen J, Supreme Court of South Australia, (1993) Aust Torts Rep 81-243.46 The plaintiff company lent money to companies associated with Excel, accepted a guarantee from Excel and

purchased debts from Excel upon terms which included an indemnity against any shortfall.47 The principal judgments were delivered by King CJ and Olsson 1. Millhouse J delivered a short judgment in

which he expressed his agreement with the reasons given by his brother judges.48 The plaintiff also brought a claim under the Fair Trading Act 1987 (SA), s 56.49 (1986) 162 CLR 340.

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plaintiff company to act in reliance upon the accounts, the plaintiff's case could not suc­ceed.

(i) Columbia Tea: An assumption ofresponsibility in an Audit Manual?Rolfe J found that the auditors owed a duty of care to 'anyone who might reasonably andrelevantly rely upon the accounts for the purposes of ordering their business affairs' .50 Aspointed out earlier, the action failed because the plaintiff company was unable to estab­lish that there was any causal connection between the auditors' breach of duty and the al­leged damage. The decision not to allow recovery in the particular circumstances wascorrect. However, it is respectfully submitted that the reasoning is totally misconceivedand based on a misunderstanding of the operation of the proximity principle and, in par­ticular, the High Court's approach to liability for negligent misstatement.

The court's decision on the duty of care was based on the fact that the defendant audi-tors' Audit Manual contained the following statement:

It is the policy of the finn that any audit which we undertake will be conducted in such a wayas will fulfil our responsibilities properly. This will involve a competent examination of the ac­counts and records to the extent required by the appointment, followed by a clear and forthrightreport as to the results of the audit. The use of the word 'responsibilities' in this statement ratherthan the word 'contracts' is deliberate. It acknowledges that there will be interested parties whoread and rely upon our reports, and this extends beyond the persons who employ us in the firstinstance or those to whom the report is addressed initially.

The court took the view that an assumption of responsibility on the part of the auditorsflowed from this statement. According to Rolfe J, it showed that the defendants had ac­cepted that their common law duty extended to persons other than the client company.His Honour stated:

It was an acceptance, as I understand the words used, of responsibility to anyone who may rea­sonably and relevantly rely upon the audited accounts for the putpose of ordering their businessaffairs.51

On this basis, it was concluded that there was an assumption of responsibility on thepart of the auditors such as to give rise to a duty of care to Donyoke as a potential pur­chaser of shares in the client conlpany, Columbia.52 The fact that Donyoke was not incor­porated at the time the relevant reports were undertaken was considered irrelevant, as thecourt took the view that the defendant's duty was wide enough to encompass 'those whomight rely on the 1987 audit certificate in arranging their business affairs' .53

It is submitted that the recognition of the existence of a duty of care on this basis isopen to question.54 There is no High Court authority55 for the proposition that such astatement of acceptance of 'responsibility'56 can constitute a sufficient basis for the im­position of liability for negligent misstatement.57 As already seen, the requisite proximityin a case of negligent misstatement is found in the satisfaction of the Barwick formula-

50 (1992) 10 ACLC 19659,1 9671.51 Ibid52 Ibid53 Ibid54 In the subsequent decision of Esanda, the Supreme Court of South Australia refused to follow the decision of

Rolfe J on this point: see (1994) Aust Torts Rep 81-265,61,156 per King CJ, and 61,166 per Olsson J.55 For that matter, the writer knows of no case where a Commonwealth court has imposed liability on this basis.56 To use that term in the sense it was defined in the statement quoted from the Audit Manual.57 To the contrary, the High Court regards an assumption of responsibility as being 'imposed' by the law when

the elements of the Barwick test are satisfied: Evatt (1968) 122 CLR 553, 570.

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tion or, in exceptional circumstances, the test laid down in San Sebastian.58 Neither testwas met on the facts of Columbia Coffee & Tea.59

Rolfe J sought to justify his approach by reference to community standards and expec-tations.60 His Honour stated:

I believe the reasoning I have applied is consistent with the statements by the various membersof the High Court that one must have regard to prevailing community standards and perceptionsin detennining whether it is appropriate to impose a duty of care.61

The comment that there is High Court support for such an approach is somewhat sur­prising. Although Rolfe J quoted at length from recent judgments of the Court, there isnothing in these passages that shows that the High Court regards community practice andstandards as a relevant determinant of liability.62 To the contrary, the High Court's ap­proach is to apply a principle: the proximity concept. In the context of negligent misstate­ment, the proximity principle requires the application of an established test of liability.

The court's confusion as to the role of the proximity principle and its operation in acase of negligent misstatement may stem from the selection of quotations from HighCourt judgments upon which Rolfe J sought to rely. To begin with, his Honour quoted atlength from the judgment of Brennan J in Hawkins v Clayton.63 While the reasoning ofBrennan J in that case would warrant consideration in a case dealing with the liability ofa professional person to his or her client, it is submitted that the passage quoted by RolfeJ in which Brennan J criticises the proximity concept would do little to further the court'sunderstanding of the operation of that approach.64 In addition, authorities such asHawkins v Clayton65 and Sutherland Shire Council v Heyman66 upon which the court re­lied are only of limited assistance in a case of negligent misstatement. While these deci­sions may be useful in furthering an understanding of the High Court's general theory ofnegligence, the starting point regarding liability for negligent misstatement must be theHigh Court cases dealing with that type of claim.67

As already indicated, in Columbia Coffee & Tea, the court took the view that the plain­tiff's case failed on the question of causation. Rolfe J rejected evidence presented on be­half of the plaintiff to the effect that the directors of the plaintiff company had relied uponthe audited accounts in making their decision to purchase shares in Columbia.68 For thisreason, the court decided that there was no causal connection between the defendants'breach of duty and any loss suffered by the plaintiff company as a consequence of its pur-

58 (1986) 162 CLR 340.59 An application of the Barwick test fails because the requirement that the defendant, at the time of making the

relevant statement, have actual or constructive knowledge that the plaintiff would rely upon it for the purposeof purcha()ing shares in Colwnbia Coffee & Tea was not satisfied. The San Sebastian test also fails becausethere is nothing to suggest that the defendant auditors made the statement with the intention of inducing theplaintiff company or its chief decision makers to act in reliance upon it.

60 There was expert evidence given by a chartered accountant as to the practice of accountants in considering andusing audit reports: (1992) 10 ACLC 1,659.

61 ld 1,671-1,672.62 Perhaps Rolfe J was referring to comments made by Deane J in Sutherland Shire Council v Heyman (1985)

157 CLR 424, 497, to the effect that the proximity approach is flexible enough to allow the common law to'reflect the influence of contemporary standards and demands'. At no stage, however, did Deane J suggest thatsuch factors provide sufficient basis for the imposition of liability.

63 (1988) 164 CLR 539.64 Brennan J has constantly maintained his dissatisfaction with the proximity theory which, notwithstanding his

Honour's dissent, must now be regarded as the orthodox approach to liability for negligence in Australia.65 (1988) 164 CLR 539.66 (1985) 157 CLR 424.67 The reliance by both the court and counsel for the defendants upon the authority of the decision of the House

of Lords in Caparo [1990] 2 AC 605 was, it is subn1itted, also ill founded.68 (1992) 10 ACLC 1,659,1,672-1,673.

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chase of shares in Columbia. However, consideration of the fact that the plaintiff com­pany did not act to its detriment in reliance upon the accounts should have been under­taken at the duty stage. As discussed earlier, the plaintiff's actual reliance upon thedefendant's misstatement is a central feature of the test for determining the existence of aduty of care in negligent misstatement The fact that there was no actual reliance by theplaintiff company in Columbia Coffee & Tea should have totally precluded a finding thata duty of care was owed by the defendant.

(ii) The application ofthe San Sebastian test

(a) Lowe Lippmann69

It is not surprising that reservation has been expressed both in academic commentary70and judicial dicta71 about the decision in Lowe Lippmann. It is submitted that both thereasoning of the court and the actual decision in Lowe Lippmann are open to attack on anumber of grounds. To begin with, the court's application of the principle laid down inSan Sebastian to the facts of the case before it is questionable. San Sebastian was a caseinvolving a statement which had been made by the defendants to the public at large.72

The situation that arose in Lowe Lippmann was entirely different to the facts of San Se­bastian.73 Although the audited accounts were prepared for the client company, Lyvetta,the defendant auditor knew that they would be communicated to and relied upon by theplaintiff finance company.74

However, Brooking J sought to justify the application of the San Sebastian test on thebasis that the defendant auditor did not make the statement in response to an inquiry bythe plaintiff. According to Brooking J, in both cases the statements were 'volunteered' .75The fact that the audited accounts were prepared in response to a request by the clientcompany and not the plaintiff did not, however, make the test laid down in San Sebastianthe appropriate determinant of the existence of a duty of care. The correct test to be ap­plied in such a case is the Barwick formulation outlined earlier.

The reasoning of Barwick CJ in Evatt confirms this view. When formulating this test,Barwick CJ used the term 'recipient' to describe a person in the position of the plaintiff.His Honour defined this term as follows:

I have used throughout the description 'recipient' to cover both the case where the incorrect ut­terance is sought by a question or inquiry and the case where it is volunteered by the speaker.76

Barwick CJ's comment that the situation where information or advice is 'volunteered'

69 [1992] 2 VR 671.70 M Davies, 'Auditors' Liability to Third Parties: R Lowe Lippmann Figdor & Frank (afirm) v AGe (Advances)

Ltd (1993) 1 Torts Law Journal 114.71 Columbia Coffee & Tea (1992) 10 ACLC 1,659, 1,665.72 A proposal for the development of W0011oomool00 in Sydney, which was prepared by the State Planning

Authority of New South Wales, was put on public display by the Authority and the Sydney City Council. Partof the proposal involved encouraging developers to buy land in the area with a view to building high densityoffice blocks.

73 See also the explanation of the distinction between these two cases given by Davies, supra note 70, 116.74 The court accepted that the auditor knew that AGC would probably rely on the report in reviewing its loan

facility. A partner of the defendant firm was informed in a telephone conversation with an officer of AGe thatthe finance company required the audited accounts for review purposes. The defendant also knew throughprevious dealings with Lyvetta that AGC was its principal creditor: [1992] 2 VR 671, 682.

75 Id 679. Notwithstanding the telephone conversation mentioned in the previous footnote (note 74), Brooking Jtook the view that the accounts were volunteered because that conversation had no 'causal connection with thesubsequent supply to AGC of the audited accounts': id 680. Brooking J stated that the defendant auditor onlyprepared the accounts to fulfil statutory and contractual obligations: id 682. As Davies, supra note 70, 117,points out, this was the only material respect in which the case differed from Hedley Byrne [1964] AC 465.

76 Evatt (1968) 122 CLR 553, 571-572.

would be 'relatively rare' tends to suggest that he was only using this term to cover unso- licited information where there is no request by the plaintiff or any other person. While his Honour did not refer specifically to the situation where a statement is made in re- sponse to a request by one party but, to the defendant's knowledge communicated to and relied upon by a third party, it is nevertheless clearly encompassed in this definition.

In addition, there is nothing in the reasoning of the court in San Sebastian to preclude the application of the Barwick formulation in a case like Lowe Lippmann. The joint judg- ment of Gibbs CJ, Mason, Wilson and Dawson JJ allowed only a very limited exception to the application of the Barwick test. The principle their Honours formulated is very nar- row in its scope. It was devised in the context of the plaintiffs' appeal which was argued on the basis that the defendants owed them a duty of care in statement because a repre- sentation had been made with the intention of inducing them to rely upon that repre- ent tat ion.^^ The test was designed by the court in order to limit liability in circumstances where a statement was made to the public at large.78

In fact, the joint judgment made it quite clear that this was not the exclusive test of li- ability in a case of unsolicited information and advice. The following passage outlining the circumstances in which liability can arise from a 'volunteered' statement is important:

The maker of a statement may come under a duty to take care through a combination of circum- stances or in various ways, in the absence of a request by the recipient. The author, though vol- unteering the information or advice, may be known to possess skill and competence in the area which is the subject of the communication. He may warrant the correctness of what he says or assume responsibility for its correctness. He may invite the recipient to act on the basis of the information or advice, or intend to induce the recipient to act in a particular way. He may actu- ally have an interest in the recipient so acting.79

Although some general comments about the significance of a request for information or advice were made in the joint judgment, there is nothing in their Honour's reasoning to suggest that the Barwick test would be inappropriate in a case like Lowe Lippmann. No definition was given of what was meant by the reference to the situation where there is no 'antecedent request or advice.'80 However, the High Court's acceptance of the suggestion made elsewhere8' that instances of liability for misstatement volunteered negligently will be 'rare' tends to indicate that the Court was alluding to a situation like San Sebastian where the statement is totally unsolicited. In any event, even if their Honours' comments about the significance of the absence of a request can be read as applying to a situation where a statement requested by another party is relied upon by the plaintiff, they still do not preclude the application of the Barwick test. The Court simply stated:

The existence of an antecedent request for information or advice certainly assists in demonstrat- ing reliance which is the cornerstone of liability for negligent misstatementF2

If, as this comment suggests, the only difficulty caused by the absence of a direct re- quest by the plaintiff is the need to establish the requisite degree of reliance, then there is no reason why the Barwick test should not be applied in a case like Lowe Lippmann. The

77 See (1986) 162 CLR 340, 357 where the joint judgment sets out the appellants' submissions on this point. 78 The reasoning of the fifth member of the court, Brennan J, also confirms that the test applied in San Sebastian

was only intended to provide a very limited exception to the application of the Barwick test. His Honour's approach was to adapt the Banvick test to circumstances where the statement is made with the intention of inducing the plaintiff to rely upon that statement: (1986) 162 CLR 340,372.

79 Id 357 per Gibbs CJ, Mason, Wilson and Dawson JJ. 80 Their Honours simply distinguished Evatt (1968) 122 CLR 553 and L Shaddock & Associates Pty Ltd v

Parramatta City Council (1981) 150 CLR 225, cases where the statement was made in response to a request made on behalf of the plaintiff: (1 986) 162 CLR 340, 356.

81 In Evatt (1968) 122 CLR 553,571 -572, and Lexnlead (Basingstoke) Ltd v Lewis [I9821 AC 225,264. 82 San Sebastian (1986) 162 CLR 340, 356-357 per Gibbs CJ, Mason, Wilson and Dawson JJ.

Tortious Liability of Auditors 89

relationship of reliance can be established by the fact that the defendant had actual knowledge not only that the statement would be communicated to a particular person but also that that person would rely upon the statement for a particular purpose.83 Subject to the additional element of reasonable it is suggested that the High Court would find a sufficient relationship of proximity to give rise to liability for any foreseeable harm.85

It is respectfully submitted that the insistence by Brooking J in Lowe Lippmann on the requirement of an intention on the part of the auditors to induce AGC to act in reliance upon the accounts is the result of a flawed interpretation of the reasoning in Sun Se- bastian. In addition, it reveals a misunderstanding of the nature of common law liability for negligent misstatement. Liability is imposed for negligent misstatement on the basis that the defendant has assumed the responsibility for the exercise of reasonable care when speaking, or preparing to speak. The High Court has made it quite clear that this as- sumption of responsibility is imposed by the law.86 It does not depend upon any intention on the part of the defendant. As Barwick CJ explained in Evatt, what is necessary is that:

The person giving the information or advice must do so willingly and knowingly in the sense that he is aware of the circumstances which create the relevant relation~hip.~~

Provided the facts of the particular case fall within the court's view of the circum- stances in which an assumption of responsibility will be imposed, the defendant will be liable. As indicated earlier, the High Court takes the view, subject to the limited Sun Se- bastian exception, that these circumstances will arise if the conditions of the Barwick for- mulation are met.

Brooking J sought to justify his refusal to apply the Barwick formulation in favour of the imposition of the requirement of intention on the facts of the case in the following manner:

If there were not some furtherrestriction, an auditor who intended only to fulfil his statutory du- ties and the contractual obligations he had assumed in light of those duties would face the dan- ger of being sued by all sorts of third persons if, on the day before the audit report was signed, the company informed him of its intention to broadcast the audited accounts by distributing them to all those with whom it had or hoped to have business dealings. The auditor would then know, when he made his report, that the company intended to supply it to third persons, and it would apparently make no difference to the auditor's position if he had unavailingly protested when told of the intention to broadcast the accounts.88

In so far as this statement suggests that there are no steps that could be taken by an auditor to protect against liability, it is misleading. Presumably, the hypothetical audit re- ferred to by Brooking J would not be required to be disclosed to the public as his Honour

83 That was the approach taken by the Supreme Court of New South Wales in Pisano v Fairfield City Council (1991) Aust Torts Reports 81-126 where the plaintiff purchaser relied on a s 31 7A certificate furnished by the defendant council to the vendor but communicated to and relied upon by the plaintiff to the defendant's knowledge.

84 It is suggested that it was reasonable in the circumstances for the creditor to rely on the auditor's statement of the value of the assets.

85 This was the basis on which Vincent J at first instance found for the plaintiff company. Davies, supra note 70, 1 19, comments that the defendant's insurer settled the case for an undisclosed amount after AGC sought special leave to appeal to the High Court of Australia.

86 Evatt (1968) 122 CLR 553,570 per Barwick CJ. The English courts have also questioned the notion that the assumption of risk must be 'voluntary': Caparo [IYYO] 2 AC 605; Smith v Bush [I9901 1 AC 831.

87 Id Evan 570. This approach is evident in the English cases where an assumption of responsibility was found and liability imposed notwithstanding a statement in the form of a disclaimer of an intention not to be responsible to the plaintiff for the statement made. Seealso BTAwtralia Ltdv Raine & Horne [I9831 3 NSWLR 221.

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said that the auditor only becomes aware of its communication to third parties when toldby the company. In such a case, while 'protesting' to the company may be to no avail, asBrooking J suggests, a communication of a disclaimer to the known third parties couldpreclude a finding that a duty of care was owed to them. It has been pointed out else­where89 that a disclaimer may not always protect an auditor. However, in the situationoutlined it is suggested that liability would not arise because any reliance by third party,after the communication of the disclaimer of responsibility, on a report that is not to bemade public would be unreasonable.90

(b) Esanda91

The actual decision reached by the Full Court of the Supreme Court of South Australia inthis case was correct. The plaintiff's case with respect to negligent misstatement was sim­ply based on the existence of the Australian Accountancy Standards and the claim that thereliance upon the audited accounts was reasonably foreseeable. As already seen in rela­tion to Columbia Coffee & Tea, a mere statement in an audit manual does not indicate anassumption of responsibility on the part of the auditor to a third party. Similarly, a set ofstandards cannot provide, on its own, the basis for the imposition of a common law dutyof care.92 The plaintiff's plea that the reliance upon the audited accounts was reasonablyforeseeable, while a necessary element of the duty of care in statement, is also insufficienton its own to establish liability. The plaintiff must also establish proximity of relationshipbetween the defendant auditors' alleged negligent misstatement and the alleged damagesuffered. As already seen, in an action for negligent misstatement, such proximity islikely to be found only in the presence of the elements of the Barwick formulation, or al­ternatively, evidence of an intention on the part of the defendant to induce the plaintiff toact in a particular way in reliance upon the statement.

As discussed earlier, the court in Esanda held that in the absence of a plea that therewas an intention on the part of the defendant auditors to induce the plaintiff to act in reli­ance upon the accounts, the relevant paragraphs in the statement of claim should bestruck out because they failed to disclose a cause of action. Like the Supreme Court ofVictoria in Lowe Lippmann, the South Australian court based its decision on San Se­bastian.

Although, as will be submitted later, some of the court's reasoning in relation to SanSebastian provides a misleading impression of the Australian law relating to negligentmisstatement, the application of San Sebastian in Esanda was not as indefensible as itwas in Lowe Lippmann. Clearly, the facts of Esanda in so far as they are disclosed in thestatement of claim are entirely distinguishable from the circumstances which arose in theVictorian case. In Esanda, the plaintiff did not claim that there was any knowledge on thepart of the defendant auditors of its reliance upon the audited accounts. There is no sug­gestion in the pleadings that the defendants were told that the plaintiff company would berelying on the accounts for the purpose of the particular transactions entered into. Nor isthere any suggestion that the defendants were equipped with knowledge of circumstanceswhich should have made them aware of these transactions and the plaintiff's relianceupon the accounts for the purpose thereof. In Esanda, therefore, unlike Lowe Lippmann,the knowledge element of the Barwick test would not have been satisfied. Accordingly,in such a situation, it was not incorrect to apply the San Sebastian test.

However, this does not mean that the reasoning of the court in Esanda was without itsflaws. The High Court would not have applied San Sebastian as the exclusive determi-

89 Davies, supra note 16, 196-197; Davies, supra note 70, 119.90 See also, Davies, supra note 16, 197.91 (1994) Aust Torts Rep 81-265.92 See (1994) Aust Torts Rep 81-265, 61,156 per King CJ, and 61,166 per Olsson J.

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nant of the validity of the plaintiff's statement of claim. Instead, it is suggested that theHigh Court would have based the decision to strike out the relevant paragraphs of thestatement of claim, at least in part, on the ground that a plea of facts consistent with theelements of the Barwick formulation was absent. The Court would then, as an alternativebasis for allowing the appeal, have applied the intention requirement laid down in San Se­bastian.

However, King CJ and Olsson J did not even mention, let alone apply, the Barwicktest.93 Instead their Honours presented the San Sebastian test as the only relevant princi­ple to be applied in a case involving a claim by a third party against a negligent auditor.King CJ treated San Sebastian as laying down the exclusive test of liability in a casewhere a person who relied upon the statement was not the person,'to whom the statementhad been directly addressed' .94 However, as pointed out earlier, the scope of the San Se­bastian exception to the application of the general Barwick formulation is not this broad.There is nothing in either the judgment of Barwick CJ in Evatt or the reasoning in SanSebastian to suggest that the fact that the statement was not directly addressed to theplaintiff precludes the imposition of liability on the basis of the Barwick test. The prob­lems with the approach taken by Olsson J are even more obvious. His Honour treated SanSebastian as laying down the relevant principle to be applied in all cases of negligentmisstatement. The fact that Olsson J totally overlooked the test formulated by Barwick inEvatt is somewhat surprising in light of the considerable reliance upon, and extensive ci­tation from, the judgments in San Sebastian. After all, that decision of the High Courtclearly establishes the Barwick formulation as the general test for determining the exist­ence of a duty of care in a case of negligent misstatement.

ConclusionThis paper has attempted to show that the High Court's approach to the liability of anauditor to third parties who rely upon the audited accounts of a client company can beclearly stated. As a general rule, the requisite proximity to give rise to the relevant dutyof care will be found in the satisfaction of the test laid down by Barwick CJ in Evatt.95

The operation of this test in the context of a third party's claim against an auditor is yet tobe considered by the High Court. How the Court would deal in a particular case with therequirement that the defendant auditor have actual or constructive knowledge of the thirdparty's reliance remains to be seen. We also have to await the Court's consideration of thecircumstances in which a third party's reliance upon an audited account will be reason­able.

The liability imposed on the basis of the High Court's approach may provide somecomfort for investors and existing creditors. At the same time, there may be little joy~Jor

the already embattled auditors.96 The impact of the imposition of this liability on eitherof the competing interest groups is not, however, a concern for the courts. The HighCourt's treatment of the issue of liability for negligent misstatement does not permit aprofession specific approach.

The difficulties encountered in the three recent decisions considered in this paper canbe explained, perhaps, on the basis that the courts sought to find a solution to the issuesraised in a particular professional context.97 The problem with this approach is that it

93 King CJ dismissed the decision in Evatt on the basis that it only dealt with the circumstances in which a dutyof care will be owed and not the class of persons to whom the defendant speaker will be liable: id 61,153.Olsson J, on the other hand, simply treated the decision in Evatt as an 'illustration of the general duty of carein its application to particular instances of negligent misstatement': id 61,162.

94 Id 61,153.95 (1968) 122 CLR 553,571-572.96 See the article entitled 'Huge Liability Claims Spark Auditor Exodus', The Financial Review, March 2, 1993.97 See, for instance, the judgment of Millhouse J in Esanda (1994) Aust Torts Rep 81-265, 61,157.

92 KMHogg

overlooks the fact that the High Court's theory of negligence liability centres on the ap­plication of principle. Questions such as whether auditors should be protected from theimposition of further liability or, alternatively, whether liability should be extended to en­courage investment in Australian companies, are issues that the High Court should leaveto Parliament.