Corporate governance

Auditors liability and duty of care

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

n October 2011, the Hong Kong

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

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

Proximity for a duty of care would arise

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

A PLUS

case, the House of Lords ruled that a person

may be liable to another party in respect of
statements that they make or advice that they
give if they voluntarily assume responsibility
to that other party, and the other party relies
upon their judgment or skill. Lightman J.
in the case of Anthony v Wright [1995] BCC
768 summarized this in the context of audit
reports as follows:
The law is well established that auditors
do not in respect of their audits owe a duty
of care to anyone other than the company
itself save in exceptional circumstances
where a special duty has been treated
as assumed to a third party A special
relationship is required and in particular
intention (actual or inferred) on the part of
the auditors that the third party shall rely,
and reliance by the third party, on the audit,
before a claim in negligence against the
auditor can be maintained.
The other is the incremental approach
suggested by Brennan J. in his judgment in
the High Court of Australia in Sutherland Shire
Council v Heyman [1984] 157 CLR 424, being
that the law should develop new categories
of negligence incrementally and by analogy
with established categories. In the case
of James McNaughton Paper Group Ltd. v
Hicks Anderson & Co. [1991] 2 QB 113, the
court identified six factors to be considered

when deciding whether to impose a duty

of care in relation to statements or advice.
In particular, the court will consider (i) the
purpose for which the statement was made;
(ii) the purpose for which the statement
was communicated; (iii) the relationship
between the adviser, the advisee and any
relevant third party; (iv) the size of any class
to which the advisee belongs; (v) the state
of knowledge of the adviser; and (vi) the
reliance on the statement by the advisee.
Each of the three approaches discussed
above were reviewed in the context of
audit negligence in the case Bank of Credit
Commercial International (Overseas) Ltd. v
Price Waterhouse (No. 2) [1998] PNLR 564.
In that case, Sir Brian Neill concluded that the
court should apply all three tests, and if the
facts were properly analysed, it was likely
that they would all lead to the same result.
Against the background set out above,
it would appear that, to the extent the
revised code introduced by the stock
exchange requires auditors to attend
AGMs and answer questions, the revised
code will not (in and of itself) alter the
existing principle that, in general, auditors
will not owe a duty of care to individual
shareholders. Nevertheless, by putting
auditors in direct discussions with individual
shareholders, there is now greater scope

for circumstances to arise in which a duty

of care to individual shareholders might be
imposed in a particular case.
Auditors should therefore be cognizant of
the legal position when answering questions
and should avoid conduct that might bring
them within the exceptional circumstances
described by the approaches discussed.
An effective precaution that auditors
may take to minimize the risk of a duty
of care to individual shareholders arising
is for auditors to circulate or read a short
disclaimer prior to answering questions,
to the effect that, notwithstanding any
answers they give or statements they make
at the AGM, they shall not have any liability,
responsibility or duty of care towards
individual shareholders or third parties.
This is likely to be sufficient to put
the auditors outside the exceptional
circumstances described by the legal
approaches.

Nathan P.W. Dentice is a partner and Veronica Siwang

To is an associate solicitor in the Hong Kong office of Reed
Smith Richards Butler, an international law firm. This article
is intended for general information purposes and does not
constitute specific legal advice. Reed Smith Richards Butler
shall not have any legal liability in respect of the matters
discussed. Where auditors have questions in relation to their
legal duties, it is recommended they seek specific legal advice.

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