In recent months we have been instructed to assist clients and their legal advisors with claims against auditors or accountants, following the identification of fraud or erroneous advice, or to assist with the defence of such claims. In such cases we have been asked to comment on quantum.
In essence, in professional negligence cases, losses must arise as:
- a direct result of the negligence; and
- the losses must be foreseeable.
This means that, in general, there are two broad heads of claim being:
- Wasted costs – i.e. costs that have been incurred as a result of (caused by) the negligence that otherwise would not have been.
- Lost profit – i.e. where it can be demonstrated that profit has been lost (or losses made) as a result of the negligence.
The former head is often easier to quantify and evidence. The latter can often be confused with either trading losses that would have occurred anyway (see Galoo) or, alternatively, might be viewed as the loss of a chance to improve the situation. Accordingly, in this head it is more difficult to demonstrate causation, quantify and evidence.
This category of cost typically includes the costs of investigating and rectifying the issue. It may include any taxation over paid, assuming that it cannot be reclaimed, and/or the costs of dealing with the incorrect tax returns might be included.
Often claimants seek to include a claim for the audit fees paid to the alleged negligent auditor – on the basis of a failure of consideration. However, if the company was subject to statutory audit, it would have had to incur audit fees in any event and consequently such a claim can be difficult to bring.
Loss of profit
The loss of profit calculation (or consequential loss) may be constructed using the counterfactual of what would have happened had the auditor/accountant not been negligent. Such an approach assumes that the auditor/accountant would have notified the company of issues earlier than it actually did (or when the company identified the issues itself). Accordingly, the key questions are:
- When is it reasonable for the auditor/advisor to have been expected to notify the company of the issue(s)? This, or course, depends on the facts of each case.
- What action(s) would the company have taken to resolve them, and when? There may be several scenarios to consider based on actions actually taken once the company became aware of the issue(s).
It may be that expected performance would have seen increased profitability; it may be that there would still have been some downturn in profits due to the general economic environment or other external market factors beyond a company’s control. For example, in a recent case where we were advising an audit firm defending a professional negligence claim, we identified that the London 2012 Olympics had a significant impact on the claimant company’s tour bookings to both Europe and the rest of the world. Our market research and review of competitor companies’ accounts confirmed substantial reductions in the sector’s turnover in the 2012/13 financial year which were attributed to London 2012. Accordingly, we were able to demonstrate that the claimant company’s loss calculations were unreasonable and hence the claim put forward was overstated.
The gap between expected and actual performance may well drive losses into the future, until the actual performance post discovery matches the expected performance. However it is imperative that assumptions that are made in projecting expected performance must be supported by as much evidence as possible to be robust. The shaded area in the diagram below shows the “theoretical” losses in such cases (click on diagram to enlarge):
A further factor to consider is whether the losses claimed were foreseeable. For example, in a recent matter a company issued proceedings against its accountant (which had carried out limited due diligence) following the purchase of a business which did not perform as well had been forecast. Initially a warranty claim was brought against the vendor but the vendor went into administration. The claimant subsequently issued a claim against its advisor for not performing adequate due diligence. The accountant’s advice took into account the existence of robust warranties provided by the vendor. Could the accountant have foreseen that the vendor was going to enter into administration two years after the SPA and therefore not comply with its obligations under the warranties provided?
It must also be borne in mind that any quantum figure is likely to be reduced to take account of contributory negligence by the claimant.
The quantification of loss in such claims is not a straightforward exercise. There are both legal challenges, such as causation and foreseeability, as well as quantification and evidential problems in terms of any quantification of consequential loss. Much depends on the counterfactual put forward and the expected performance of the company in the years following the identification of the issue – this can be a speculative exercise. Assumptions that are made to project expected performance must be supported by as much evidence as possible to be robust which requires the consideration of the micro- and macro-economic environment and the performance of competitors is often useful in this respect.
Should you or your client be making a claim against an accountant/auditor for negligence, or indeed be defending such a claim, we would be pleased to lend our experience and expertise, whether that be through a brief review of some core papers or a full financial analysis and expert witness report.
Please do not hesitate to contact Geoff Mesher or Karen de Klerk if you would like to discuss further.
This publication is intended for general guidance and represents our understanding of the relevant law and practice as at August 2015. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.
Tempest Forensic Accounting UK LLP is a limited liability partnership registered in England & Wales number OC 38284 whose registered office is at Nant-Yr-Arian, Llandefalle, Brecon LD3 0NS. A list of partners (all of whom are chartered accountants and registered with the Institute of Chartered Accountants England & Wales) can be inspected by visiting the “Who we are” section of this website.