London City Equities Ltd v Ernst and Young

1. [1]

   HER HONOUR: By a Notice of Motion filed on 9 May 2018 the plaintiffs, four corporate shareholders of Penrice Soda Holdings Ltd (“PSH”), seek leave to file an Amended Statement of Claim dated 4 December 2018 annexed to the affidavit of Stuart Bailey, solicitor, affirmed on 20 December 2018 (“the ASOC”), in which they each seek damages, under various heads of claim, including in negligence constituted by an alleged failure on the part of Ernst and Young (“EY”), from the auditors of PSH, to conduct successive audits over a six-year period between 2007 and 2012 with due care and skill (pars 1-34 of the ASOC); by their negligent misstatement referable to the same conduct (par 52H of the ASOC); in fraud and deceit (pars 52J and 52K of the ASOC) and under s 52 of the Trade Practices Act 1974 (Cth) (pars 53-63 of the ASOC). The 2nd to 62nd defendants are the current or former partners of EY during the relevant period.

2. [2]

   That same conduct is also relied upon as not counting in the reckoning of any limitation period which may attach to any of the claims brought by the plaintiff.

3. [3]

   The plaintiffs’ common law and statutory claims for damages are based upon a range of alternative constructions as to calculation of loss, including what is said to be the loss occasioned by the difference between the price at which the plaintiffs acquired their respective interest in PSH shares as set out in pars 15-23 and what is said to be the actual value of that interest, alternatively, the difference between the price at which they acquired their interest in the shares and the sale price that was or could have achieved at, or shortly after, May 2011.

Procedural history

1. [4]

   The substantive proceedings were initially commenced by the filing of a Statement of Claim in May 2017. The Statement of Claim was served on the defendants on 31 January 2018 after an order was made in November 2017 extending the time for service. Various proposed amendments to the Statement of Claim as originally filed have been the subject of lengthy correspondence between the parties since that time as reflected in the voluminous annexures to Mr Bailey's affidavit and an earlier affidavit of David Armstrong, solicitor, affirmed on 26 September 2018. A Notice to Produce dated 28 June 2018, served on the defendants that day, was also the subject of detailed correspondence and multiple appearances before the Registrar before the Notice of Motion was listed for hearing.

2. [5]

   On 28 September 2018, on the joint application of the parties, the hearing of the motion was vacated. The plaintiffs claimed there were concerns as to whether the defendants had complied fully with the Notice to Produce and the defendants, in circumstances where a further iteration of the ASOC had been served, complained about the service the previous evening of a substantial pleading of additional matters in the ASOC said by the plaintiffs to be based upon the documents that had been produced under the Notice to Produce to that date.

3. [6]

   On 28 September 2018, I gave directions obliging the defendants to produce all further documents identified in the Notice to Produce on or before 2 November 2018 and for the plaintiffs to serve any proposed further Amended Statement of Claim by 3 December 2018. In the event that the defendants maintained their opposition to the filing of the proposed Amended Statement of Claim they were directed to notify the plaintiffs of the basis of their objection by 20 December 2018. The proceedings were stood over to 21 December 2018.

4. [7]

   On 21 December 2018, I was informed by Mr Sexton SC, then appearing for the plaintiffs, that there had been further production of documents under the Notice to Produce allowing for the service of a further iteration of the Statement of Claim. The Court was also advised that the proposed Amended Statement of Claim (the ASOC for present purposes) remained in contest necessitating a relisting of the Notice of Motion.

5. [8]

   The Notice of Motion was relisted for hearing on 29 March 2019. At the hearing there was oblique reference to an affidavit of Andrea Martignoni, solicitor for the defendants, sworn 28 March 2019 which addressed the question of compliance with the Notice to Produce. The affidavit was not read. It appears to be agreed, for present purposes, that there is no continuing issue with compliance.

The Notice of Motion

1. [9]

   Although, as a matter of form, the plaintiffs’ application is to amend the Statement of Claim as originally filed in May 2017, in particular to permit them to plead material facts to support the existence of the duty of care they claim EY owed them as shareholders of PSH, which is foundational to the viability of their claim in negligence, because of what the defendants identify in their written submissions as incurable and manifest defects of form across the pleading as a whole, the application was treated in the written submissions of both parties as a strikeout application to be decided in accordance with the test in Batistatos v Roads and Traffic Authority of New South Wales (2006) 226 CLR 256; [2006] HCA 27.

2. [10]

   At the hearing of the Motion on 29 March 2019, the single issue the parties invited the Court to resolve was whether the plaintiffs’ “breach of duty case” as pleaded in the ASOC is tenable. The parties accepted that the High Court decision in Esanda Finance Corporation Limited v Peat Marwick Hungerfords (1997) 188 CLR 241; [1997] HCA 8, the continuing authority of which was affirmed in Woolcock Street Investments Pty Ltd v CDG Pty Ltd (2004) 216 CLR 515; [2004] HCA 16 at [24], will determine that question.

3. [11]

   If the claim in negligence (or negligent misstatement) is found to be untenable in its entirety, it was agreed that without the Court moving to strike out any part of the ASOC, the plaintiffs should be afforded the opportunity to consider the impact of such finding on the balance of the claim as pleaded, including whether any part of the ASOC in its current form is salvageable, but excluding the impact of that finding on the limitations issue which arises in relation to that part of the claim for damages under the Trade Practices Act pertaining to conduct in respect of the 2007 to 2009 audits, a claim which the plaintiffs accept is time-barred in any event.

4. [12]

   Mr Sexton further submitted that were the Court to find the claim in negligence to be tenable, but on the limited basis that the imposition of a duty of care dates from either July 2009 or alternatively from March 2010 (such that breach of that duty only becomes actionable as of those dates), the plaintiffs may wish to give consideration to only pursuing a limited claim in negligence and to redrafting the pleadings to reflect the Court’s reasons for coming to that view.

5. [13]

   Mr Sexton maintained the submission, however, that it would be contrary to principle for the Court to entertain the submission advanced by the defendants in writing that the statutory claims for damages are statute-barred insofar as they relate to any cause of action that accrued before May 2011. In that regard, I note that in oral submissions Mr Roberts SC, counsel for the defendants, did not invite the Court to make that finding at this stage. I also note his concession that a statutory claim for misleading and deceptive conduct might still stand in respect of those causes of action that had not crystallised as at May 2011 (that is, where the plaintiffs had not sustained actual or measurable loss or damage by that date) in contrast to the claims formulated on the basis of the value of the shares being less than their acquisition price, a loss which had crystallised as and from the date of the share purchases, being six years prior to commencement of proceedings. That said, it was the agreed position that consideration of that question should also await the Court's determination of the question whether the plaintiffs’ “breach of duty case” can proceed at all.

The facts in summary

1. [14]

   EY were, from at least from 2007 and at all times during the period 2007 to 2012, the auditors of PSH.

2. [15]

   Each of the plaintiffs acquired shares in PSH during 2008 and 2009 on the dates and in the amounts pleaded in the ASOC at pars 5-8 and 16-23.

3. [16]

   During 2007 PSH was the sole manufacturer in Australia of soda ash (used in the manufacture of glass containers) and sodium bicarbonate (used in various applications, including animal feed and pharmaceutical products). PSH also operated a marble and limestone mine in the Barossa Valley, South Australia (ASOC at pars 27A-27C).

4. [17]

   From at least 2007, PSH published audited Annual Reports and half-yearly financial statements in respect of which EY certified the audited financial records of the company:

5. [18]

   The plaintiffs’ challenge to the audited financial reports of PSH is set out in the ASOC at pars 27A-27BX. In summary, the plaintiffs contend that:

6. [19]

   From documents produced under the Notice to Produce the plaintiffs submit that it is apparent that:

7. [20]

   The plaintiffs submit that with that knowledge EY should not have signed off on the audits of the financial statements for FY 2009-2012, knowing that the inventory position did not improve and that the overburden could not be recorded as a current asset. Despite that knowledge or awareness, the plaintiffs submit that EY took no steps to reclassify the treatment of overburden as an asset in the previous financial statements, and that it continued to perpetrate or to allow for the perpetration of a contravention of AASB 101 in subsequent reporting periods.

8. [21]

   At page 12 of the ASOC under the subheading “Correspondence Concerning the Financial Statements of PSH” are a number of paragraphs, in particular 27AE-AL and more particularly still 27AF, 27AG, 27AJ and 27AK, upon which Mr Sexton placed particular reliance in defending the adequacy of the pleadings to allow the plaintiffs’ negligence claim to proceed, albeit on the basis of a narrowing of the plaintiffs’ claim.

9. [22]

   To avoid the risk of any overstatement of the facts pleaded as supporting the plaintiffs’ negligence claim as identified by Mr Sexton, I set out those particular paragraphs in full:

10. [23]

    I will return to consider their significance later in this judgment.

11. [24]

    On 8 August 2010, EY sent a report to the Audit Committee noting no sales and that no substantial sales were likely until FY 2014. EY also stated that since the original classification of overburden as an intangible asset to a current asset occurred in FY 2007, the time for reclassifying the overburden back to a current asset had "passed" (ASOC at par 27AM). It is the plaintiffs’ case that EY made that statement knowing that it was unjustifiable. EY had a positive obligation to ensure that the financial statements were prepared in accordance AASB 101. There was no accounting standard or law that prevented EY from reclassifying the overburden as an intangible asset.

12. [25]

    That being so, it is the plaintiffs’ case that the position taken by EY in the 8 August 2010 report to PSH cannot be reconciled with:

13. [26]

    It is the plaintiffs’ case that notwithstanding the lack of sales of overburden EY engaged in the same conduct (on the plaintiffs’ case, both false and misleading conduct) in its audited reports and financial statements through to 31 December 2011 (ASOC at pars 27A-27BM).

14. [27]

    ASIC became involved in 2012. PSH, with the assistance of EY, initially resisted reclassifying the overburden as an intangible asset. PSH agreed to adjust its treatment of the overburden on 23 August 2012 when the matter was sent to the enforcement division of ASIC (ASOC at pars 27BN-27BO).

15. [28]

    EY continued to conceal the error in booking the overburden as a current asset when it assisted PSH in preparing a letter to LCE in 2012 which stated that the impairment to the overburden "reflect[ed] changes in market conditions" (ASOC at pars 27BU-27BV). The plaintiffs contend this was a demonstrably false statement when both PSH and EY knew that the overburden had never been properly or legitimately recorded as a current asset in the first place.

The applicable law

1. [29]

   Given that Esanda Finance Corporation Limited v Peat Marwick Hungerfords (1997) 188 CLR 241; [1997] HCA 8 is the binding authority, it is necessary to refer to the decision in some detail. Esanda Finance Corporation Ltd lent monies to Excel Finance Corporation Ltd (“Excel”). Excel was unable to repay the debt, causing Esanda to suffer loss. Esanda commenced an action in this Court against Excel's auditors, Peat Marwick Hungerfords (“PMH”) in which Esanda alleged that it obtained and relied upon audited and certified accounts and an audited report of Excel for the year to 30 June 1989 in considering whether to extend loan monies. Esanda further alleged that mandatory accounting standards applied and that PMH had breached those standards in conducting the audit. It was further alleged that Esanda was a member of a class of persons whom PMH foresaw, or ought reasonably to have foreseen, might rely on the audited accounts and report and that but for the audited accounts and report, Excel would not have extended finance or suffered the consequential loss.

2. [30]

   PMH applied to strike out the claim on the ground that it disclosed no reasonable cause of action. The application was dismissed at first instance but reversed on appeal. The High Court affirmed the decision of the Full Court that the auditors, PMH, did not owe a duty of care to Esanda.

3. [31]

   At 250-251 Brennan CJ cited with approval the decision of the House of Lords in Caparo Industries Plc Dickman [1990] 2 AC 605. In that case, auditors were sued by plaintiffs who alleged that they had bought shares in reliance on the auditors' report and had suffered a loss as a result. In reliance on earlier cases in which the plaintiff had succeeded, Lord Bridge of Harwich pointed out, in a passage cited by Brennan CJ in Esanda at 250:

4. [32]

   Brennan CJ also observed that Lord Bridge of Harwich identified the elements of liability in the following passage in Caparo at 621:

5. [33]

   Likewise, Deane J, at 258 in Esanda, again by reference to Caparo observed:

6. [34]

   At 252, Brennan CJ described the features of the requisite duty of care in the following seminal passage:

7. [35]

   Toohey and Gaudron JJ, at 265, concluded that a "relationship of proximity marked either by reliance or by the assumption of responsibility does not arise unless the person providing the information or advice has some special expertise or knowledge, or some special means of acquiring information which is not available to the recipient” and "unless it is reasonable for the recipient to act on that information or advice without further inquiry ... for the purpose for which it is used”. Their Honours' reasons make clear that satisfaction of those conditions was a necessary but not sufficient condition to establish the required relationship of proximity.

8. [36]

   At 266, they remarked that the pleading was incapable of sustaining a suggestion that PMH intended or encouraged Esanda to rely upon their audit of Excel's accounts, and neither were they capable of giving rise to a relationship of proximity marked either by reliance or the assumption of responsibility for information or advice which is voluntarily provided.

9. [37]

   At 275, McHugh J observed that:

10. [38]

    At 281, McHugh J observed that there was no basis to extend the liability of auditors to those members of a class whom the auditor knows, or ought to know, will rely on the audit where the auditor has not assumed responsibility to those members or intended to induce them to rely on the audit. At 289-290, McHugh J upheld the correctness of the Full Court's observations to the following effect:

11. [39]

    McHugh J then continued, at 290, to observe that the mere fact that it was foreseeable by PMH that Esanda and other potential creditors of Excel might incur economic loss from consulting and relying upon the audit report was not enough to establish a duty of care.

The submissions of the parties

1. [40]

   The parties furnished very detailed and heavily footnoted written submissions directed, inter alia, to the question of duty of care and whether, on the case as pleaded in the ASOC, that is a triable issue.

2. [41]

   Senior counsel for each of the parties focused their oral submissions on the viability of the plaintiffs’ claim in negligence (and, by extension, the claim of negligent misstatement). They both accepted that for the Court to be satisfied that there is a triable duty of care issue depends upon the Court being satisfied there is a pleading of material facts sufficient to make out the salient features of the relationship between the parties that give rise to the imposition of a duty of care in accordance with Esanda.

3. [42]

   The plaintiffs’ case, as advanced in written submissions is that as and from at least 15 July 2009 (or, at the latest, as and from 22 March 2010) EY was aware that the plaintiffs were relying on the Annual Reports and the audited financial statements of PSH. Other than the pleading of foreseeability of economic loss by reason of the plaintiffs’ reliance upon the accuracy and completeness of the financial records of PSH in pars 30-31 of the ASOC, and the general pleading in par 29 that it was probable, in the sense that it was both foreseeable and not insignificant, that a reasonable investor in the same position as the plaintiffs would rely upon the statutory role of the company’s auditors for the purpose or intention for which that role exists, the plaintiffs do not aver in the pleadings any specific purpose for which it is said they relied upon the information contained in that material, including entering into any particular transaction, whether it be an acquisition of shares or a transfer of shares and that EY was aware of that reliance. In oral submissions, however, Mr Sexton submitted that the plaintiffs’ case, as fairly revealed by the pleadings, was cast on the basis that the plaintiffs, as existing shareholders of PSH, made enquiries of the company (and through the company of its auditors) as early as July 2007 in order to determine whether they should retain their shareholdings.

4. [43]

   Although the “25 questions” referred to in par 27AF of the ASOC set out at [22] above were not further particularised, in the plaintiffs’ written submissions I was invited to proceed on the basis that LCE’s correspondence with PSH in July 2009 was “concerned, inter alia, with the recording of the overburden” in the audited financial statements. When I raised with Mr Sexton in oral submissions whether this letter (and the letter sent on 20 August 2009, the subject of par 275) concerned the content of the audited reports that had been published over successive financial years from 2007, and the treatment of the overburden as part of the company’s inventory in those reports, he confirmed that it was the plaintiffs’ case that EY knew, by reason of the correspondence of which it was aware, not merely that the plaintiffs as members of any indeterminate class as shareholders of the company might foreseeably rely upon the audited reports for information concerning the company’s financial position, but that the plaintiffs as nominated shareholders were making enquiries of them through the letter to PSH about the financial statements and the treatment of overburden as an asset of the company. He also confirmed that it is the plaintiffs’ case that, in response to those enquiries, EY failed to correct a succession of false statements in the Annual Reports and failed to make material adjustments to the financial statements prior to that date and thereafter until the intervention of ASIC in 2012.

5. [44]

   In Mr Sexton’s submission, those facts take the proposed ASOC “outside the constraints identified in Esanda and other cases” and “why this particular case is not within the principles stated in Esanda and other cases about mere foreseeability and pure economic loss”.

6. [45]

   Despite what I consider (and what Mr Sexton impliedly accepted) is residual ambiguity in the assertion at par 27AK (set out at [22] above) that PSH responded to the enquiry from the plaintiffs in the correspondence of 7 April 2010 “with input and assistance from EY”, where the nature of the “input and assistance” from EY is not particularised and, further still, where it is not clear from the way par 27AK is pleaded whether the information PSH provided to the plaintiffs as set out in pars 27AK(a) and (b) was sought from EY and provided by them in the knowledge that it was responsive to the request from LCE on behalf of the other plaintiff shareholders set out in par 27AJ. (I note that it will be contended at hearing that the response pleaded in par 27AK was false and misleading, there being no substantial sales of overburden and no potential sales.)

7. [46]

   The defendants opposed the grant of leave to amend the ASOC. They submitted that despite repeated attempts by the plaintiffs to bring a competent claim for damages in negligence, inclusive of the most recent iteration of the ASOC, and despite the matters which are now pleaded, including those at pars 27A, 27G, 27J and 27K upon which Mr Sexton placed considerable reliance in seeking to maintain the plaintiffs’ claim, the duty of care the plaintiffs, as shareholders in PSH seek to attribute to EY as the auditor of that company, remains untenable.

8. [47]

   While the defendants do not advance the submission that Esanda is authority for the proposition that auditors will never owe a duty of care to shareholders, they maintained the submission that the question raised by the Notice of Motion is indistinguishable from the question that presented in Esanda and, in those circumstances, the underlying rationale of the decision in Esanda that no duty is owed by an auditor giving audit advice to shareholders or prospective shareholders, even where damages for pure economic loss are claimed and where the loss was reasonably foreseeable, has direct application in this case.

9. [48]

   The defendants submitted that the relative and indistinguishable position of the parties in the present case and in Esanda as shareholders of a company on the one hand, and auditors of that same company, on the other. The defendants submitted that here there are insufficient material facts in the case as pleaded in the ASOC to support the proposition that as shareholders of PSH the plaintiffs had a special relationship with EY as the company auditors, that is, a relationship extending beyond their statutory role as auditors, the plaintiffs have failed to establish an arguable case that EY owed them a duty to take reasonable care in the provision of the audited reports to PSH over successive financial years between 2007 and 2012 (or in respect of any one or more of such years).

Consideration

1. [49]

   On the pleadings as currently formulated, I am not persuaded, having regard to the principles in Esanda that there is a triable issue (in the sense of there being an arguable case) that EY owed the plaintiffs a duty to take reasonable care in the conduct of its audit and in the preparation of the audited reports of each of the reporting periods for the financial years ended 2007 to 2012 commensurate with the breadth of the plaintiffs’ claim for the damages for breach of that duty of care, including where at par 34 of the ASOC the plaintiffs allege EY knew or ought to have known that the audited accounts/reports would be communicated to them and relied upon by them with respect to acquiring and/or dealing with PSH shares, and in circumstances where it knew or ought to have known that PSH had expressly and/or impliedly invited them to act on the basis that the accounts/reports were accurate.

2. [50]

   I am, however, satisfied that despite ambiguity in the form in which the narrower case is pleaded (consistent with that advanced by Mr Sexton on the hearing of motion) and despite the plaintiffs’ failure in the current pleading to properly or adequately particularise the basis upon which they assert EY knew or ought to have known as and from either or both of July 2009 and August 2010 that, as existing shareholders of PSH, the plaintiffs would rely upon the contents of the audited reports (including, in particular, the 30 June 2009 Annual Report, 31 December 2009 financial statements and the accounting treatment of overburden in those statements as a current asset in deciding whether to retain their shareholdings), I am satisfied that the pleadings at pars 27AE-27AU under the heading "Correspondence concerning the financial statements of PSH” commencing at page 12 of the ASOC, meet the fundamental requirements of a requisite special relationship between an auditor of a public company on the one hand, and the plaintiffs as shareholders on the other, to support there being, at least an arguable case that EY owed the plaintiffs a duty of care consistent with the principles set out in Esanda.

3. [51]

   Although the complaint the defendants make about the pleadings on the issue of causation and issues related to the calculation of loss were addressed in the written submissions, at the hearing of the motion the parties agreed that in the event that I found that there was a tenable case on the question of duty of care, but that the breadth of the case on that issue as pleaded was not sustainable, the plaintiffs should be invited to replead their case rather than for the Court to undertake the task of striking out part of the claim on the existing pleadings. That being the case, to the extent that questions of causation and the basis upon which the plaintiffs assert loss should be calculated remain in contest, that can await the service of a fresh pleading. Similarly, with any further pleading of fraud or any repleading of the plaintiffs’ claim for statutory damages under the Trade Practices Act.

Orders

1. [52]

   Leave is granted to amend the Statement of Claim of 4 December 2018 to reflect the reasons for judgment on the plaintiffs’ Notice of Motion of 9 May 2018.