Auditors Beware: Auditors Owe a Duty of Care to Company’s Investors

[this article was originally published in Skrine’s Legal Insights Issue 3/2014]

The Court of Appeal in CIMB Investment Bank Bhd v Ernst & Young & Another Appeal [2014] 6 CLJ 438 (see the Grounds of Judgment from the Kehakiman website) held that in carrying out statutory audits under the Securities Industry Act 1983 (“SIA”), the auditors of a fund management company owed a duty of care to the company’s investors.

This appellate decision is significant as it confirms the tests to be applied to ascertain whether auditors owe a duty of care to the company’s investors. On the facts of this case, the auditors’ agreement to conduct an SIA audit for a fund manager created a special relationship between the auditors and the company’s investors which gave rise to a common law duty of care on the part of the auditors to undertake a proper audit in the course of carrying out their statutory duty.

BACKGROUND FACTS

SJ Asset Management Sdn Bhd

The appeal centred on SJ Asset Management Sdn Bhd (“SJAM”), a licensed fund management company under the SIA and the Capital Markets and Services Act 2007 (“CMSA”). The appellants in one appeal were clients, or in other words investors, of SJAM. In the second appeal, the appellant had caused its clients to invest in SJAM. SJAM held, administered and managed various investments of the appellants.

SJAM had engaged the respondent auditors to perform the necessary statutory audits under the Companies Act 1965 (“CA”) and under the SIA. Pursuant to their engagement, the auditors produced audit reports.

Following complaints against SJAM, the Securities Commission (“SC”) investigated SJAM, revoked its capital market services license and eventually wound up SJAM.

The appellants, in turn, appointed their own accountants to investigate the accounts of SJAM. Based on their accountants’ findings of fraud in the management of the funds of the clients, the appellants commenced the High Court action against the auditors based on negligence. The appellants’ contentions were that they had relied on the auditors’ audit reports to make, advise on or facilitate investments in SJAM.

Preliminary Issues for Determination by the High Court

In the High Court action (reported in CIMB Investment Bank Bhd v Ernst & Young and Another Case [2014] 3 CLJ 322), the Court heard an application for the determination of the issue on whether the auditors owed a duty of care to the appellants in the two situations that arose in this case.

The first situation was when the auditors were carrying out the statutory audits in accordance with the CA for SJAM and issuing the CA audit reports. The second situation, and what was more significant in this appeal, was when the auditors were carrying out the statutory audits in accordance with the SIA for SJAM and issuing the SIA audit reports.

The High Court decided in favour of the auditors and found that the auditors owed no duty of care to the appellants in both situations. For the CA audit reports, it was held that CA audit reports were not intended for the appellants, as investors of the company, but were meant for SJAM and its shareholders in the general meeting. As for the SIA audit reports, it was held that they were not meant for making investment decisions but to enable SJAM to furnish such information to the SC.

Therefore, the appellants’ claims were dismissed. The appellants appealed to the Court of Appeal.

FINDINGS ON THE DUTY OF CARE

Guiding Principles on Establishing a Duty of Care

The Court of Appeal was guided by the Federal Court decision in The Co-operative Central Bank Ltd v KGV & Associates Sdn Bhd [2008] 2 CLJ 545 in accepting the guidelines laid down by the House of Lords in Her Majesty’s Commissioners of Customs and Excise v Barclays Bank [2007] 1 AC 181.

The Federal Court in Co-operative Central Bank acknowledged that three general tests could be used to determine whether a duty of care existed in cases that involved economic loss.

The first is the ‘assumption of responsibility’ test as to whether the defendant assumed responsibility for what he said and did vis-à-vis the claimant, or is to be treated by the law as having done so. The second is the threefold test: whether loss to the claimant was a reasonably foreseeable consequence of what the defendant did or failed to do; whether the relationship between the parties was one of sufficient proximity; and whether in all the circumstances it was fair, just and reasonable to impose a duty of care on the defendant towards the claimant. The third is the incremental test.

Against this backdrop, the Court of Appeal found that the High Court had determined the existence of the duty of care solely on the basis of the threefold test. In applying this test, the High Court had ruled that the appellants had failed to satisfy the ‘sufficient proximity’ element. The Court of Appeal held that instead, the High Court should have applied the guidelines in Barclays Bank, in particular, the first test of assumption of responsibility.

Duty of Care on the Part of the Auditors

The application of the assumption of responsibility test would mean that:

(a) reliance on the auditors’ report is no longer an essential ingredient to establish a duty of care;
(b) no anterior relationship between the appellants and the auditors is necessary to satisfy the ingredients of foreseeability and proximity; and
(c) the ingredient relating to proximity is satisfied so long as the assumption of responsibility may be inferred by reason of the existence of a special relationship.

The Court of Appeal drew a distinction between the CA audit and the SIA audit and found that Parliament could not have intended for both audits to be for the same purpose. There would be a difference in the scope and approach of the SIA audit as compared to the CA audit.

The focus of the SIA audit included the safeguarding of the assets of the appellants held by SJAM. The report by the auditors would serve to alert the SC and/or the relevant government authority to take such further action as is required. If in the course of the audit, the auditors come across a transaction or an accounting entry that does not comply with the provisions of Division 3 of Part VII of the SIA, the auditors had a duty to look deeper. The auditors could not ignore the irregularity or breach. Therefore, the SIA audit framework is a critical means of both ensuring compliance and detecting non-compliance by SJAM in relation to the management of the appellants’ assets.

The Court of Appeal also disagreed that any breach of the SIA provisions could only be enforced by the SC. Further, this was an appropriate case where the legislative framework in the SIA could be a basis to found the claim for breach of the common law duty of care arising from the careless performance of a statutory duty.

In concluding that the auditors owed a duty of care, the Court of Appeal stressed that the appellants were in an unusual situation whereby their funds and investments were in the hands of a trustee fund manager (SJAM) but over which funds they had no control. The auditors’ agreement to conduct the SIA audit for SJAM with knowledge or imputed knowledge of the unusual situation in which the appellants were placed, gave rise to a duty on the part of the auditors to undertake a proper audit in the course of carrying out their statutory duty. This obligation created a relationship between the auditors and the appellants so as to give rise to a common law duty of care.

If the auditors had not breached their duty of care, the SIA audit reports would have been qualified and the irregularity in the accounts of SJAM would have been reported to the SC. Such a report to the SC, in turn, would have caused the SC to take the appropriate action thereby causing SJAM to cease trading and consequently, diminish the losses of the appellants. However, because the audit reports that were produced by the auditors were ‘clean’, the SC took action much later and the ensuing winding up of SJAM was correspondingly delayed, thereby causing substantially more losses to the appellants.

The Court of Appeal therefore ruled that the auditors owed a common law duty of care to the appellants. The Court of Appeal ordered that the matters be remitted to the High Court for the trial on the issue of the liability of the auditors, if any, to the appellants.

CONCLUSION

This decision is significant in confirming that auditors who carry out a statutory audit under the SIA for a fund management company owe a duty of care to the investors of that company. Although the SIA has been repealed and replaced by the CMSA, it is likely that a similar duty of care on the part of the auditors would arise under the CMSA.

It is also likely that the Court would still impose such a duty in favour of the investors of the company even if the auditors build disclaimers into such a statutory audit (whether under the SIA or CMSA) to exclude liability or obligations to third parties.

MIA International Conference 2014

I will be moderating a session at the Malaysian Institute of Accountants Conference 2014 this Wednesday 5 November 2014. It will be on the new Companies Bill and its impact on Malaysian businesses and economy. It should be a very interesting session and I have been liaising with the speakers on the panel. Will keep the format as a group discussion and try to draw out all the different issues.

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What is a ‘court’ for a stay of court proceedings pending arbitration?

The Supreme Court of Victoria in Subway Systems v Ireland [2014] VSCA 142 interpreted the meaning of the term ‘court’ under the Australian Commercial Arbitration Act 2013 for the purposes of a stay of court proceedings pending arbitration. In line with the Model Law, the term ‘court’ was extended to cover an administrative tribunal. Therefore, those tribunal proceedings were stayed pending arbitration. This is also of significance to Malaysia on how the Arbitration Act 2005 may be interpreted for a stay of court proceedings pending arbitration.

Subway Decision

A dispute arose between the parties to a franchise agreement involving a Subway sandwich business. The agreement contained an arbitration clause. The franchisees sought to have the dispute heard in the Victorian Civil and Administrative Tribunal (VCAT) while Subway argued that VCAT was precluded from hearing the proceeding and must instead refer the parties to arbitration.

There is a useful summary of the principles from this decision in this Allens commentary. I quote a section from this commentary.

In interpreting the Act and the definition of the word ‘court’, the majority recognised the aims of the Model Law, of uniformity and harmonisation, given the Act’s genesis from the Model Law. The policy behind the Model Law was central to the majority’s analysis of whether VACT fell within the definition of a ‘court’ for the purposes of s8 of the Act. If VCAT was found to be a court in this instance, disputes to be heard in VCAT, where an arbitration agreement existed, would be referred to arbitration under the Act. Conversely, if VCAT was found not to be a court, parties would have a choice of forum in which to have their disputes heard: either at VCAT or under arbitration. The majority judges recognised the wholly unsatisfactory position of the latter option.

In analysing whether VCAT was a ‘court’, the Acting Appeal Justice Kyrou (in the minority) noted instances in legislation where the definition of court intentionally omitted VCAT, and observed that VCAT lacks the typical indicia of courts at common law, as it:

  • is not bound by the rules of evidence;
  • cannot enforce its own decisions;
  • is constituted by some members who are not legally trained;
  • can apply government policy; and
  • can provide advisory opinions.

Acting Appeal Justice Kyrou’s analysis focused on the text of the Act and other statutes where the word ‘court’ is applied and noted the intentional omission of VCAT in various definitions of court in legislation. This led his Honour to find that VCAT was not a ‘court’ for the purposes of s8 of the Act.

Conversely, Appeal Justice Beach (in the majority) held that VCAT possesses the six features typical of courts at common law and noted instances where the definition of courts in statutes has been held to include VCAT. President Maxwell focused on the international development, and aims, of the Model Law that were picked up in the Act and the effect of these on interpreting the definition of ‘court’ under the Act.

As a matter of statutory construction, the majority considered the text, context and purpose of the Act, and held that both the Model Law and the Act had application to ‘a body or organ of the judicial system,’ which extended to VCAT.

Malaysian Context

Section 10 of the Arbitration Act 2005 (“AA 2005″) provides that: “A court before which proceedings are brought in respect of a matter which is the subject of an arbitration agreement shall … stay those proceedings and refer the parties to arbitration … (emphasis added)”

In the AA 2005, similar to the Subway decision, there is no definition of the term ‘court’. This is in contrast with the definition in Article 2(c) of the Model Law where ‘court’ means a body or organ of the judicial system of a State. The term ‘court’ in the AA 2005 does not appear to mean only a High Court (i.e. the High Court in Malaya and the High Court in Sabah and Sarawak) since other sections in the AA 2005 refer specifically to the term ‘High Court’ and ‘High Court’ is defined in section 2 of the AA 2005 (for example, section 11 of the AA 2005 states that “a party may … apply to a High Court for any interim measure and the High Court may make the following order …”).

Further, I would also argue that there is a difference between ‘court’ (with the small ‘c’) and ‘Court’ (with the capital ‘C’). ‘Court’ is defined in the Courts of Judicature Act 1964 as the Federal Court, the Court of Appeal or the High Court. So if there is a deliberate use of ‘court’ (with the small ‘c’) in the AA 2005, could it be argued that Malaysia can also draw on the Model Law definition of ‘court’ as being a body or organ of the judicial system?

In line with this wider definition, the term ‘court’ should encompass this broader definition in order to allow the Subordinate Courts (i.e. the Magistrate and Sessions Court) to also grant a stay of proceedings to refer parties to arbitration. The Subordinate Courts do not fall within the definition of ‘Court’ under the Courts of Judicature Act 1964, but  it has been largely assumed that the Subordinate Courts would have the power to grant a stay of proceedings under section 10 of the AA 2005 (for example, see Sundra Rajoo & WSW Davidson (2007) ‘The Arbitration Act 2005: UNCITRAL Model Law as applied in Malaysia’, para 10.3).

If we accept this broader definition of ‘court’ under the Model Law, could this then be extended to other forms of statutory tribunals, the Industrial Court or other regulatory bodies for the purposes of a ‘court’ ordering a stay of proceedings? It will be interesting to see how this will develop and be argued in the Malaysian courts.

Unwinding a Winding-Up, Revisited

I had earlier written about the ability of a Court to unwind, or set aside, its winding up Order. For a long while, the weight of authority suggested that a Court could not set aside a winding up Order. The Companies Act 1965 was silent on the possibility of such a setting aside and there was only a provision for a stay of winding up under section 243. I had suggested in my earlier post that there appeared to be a narrow exception of allowing for such a setting aside, and this was implicit in the Megah Teknik decision.

There is now an unreported High Court decision applying Megah Teknik and where Datuk Wong Kian Kheong JC allowed a setting aside of a winding up Order. The grounds of judgment of Panaron Sdn Bhd v Univac Switchgear Sdn Bhd can be downloaded from the KL High Court website (and it contains the watermark). In Panaron, the High Court had unknowingly granted two winding up Orders (one in the Shah Alam High Court and the second in the Kuala Lumpur High Court). Proofs of Debt (POD) were filed in the second winding up and the Official Receiver (OR) then realised there was the earlier first winding up Order. The OR filed an application in KL for a stay of the second winding up Order (under section 243) and to transfer the 5 PODs to the first winding up.

The Court (correctly, I think) rejected the reliance of section 243 for a stay of the second winding up. That section could not properly apply to these sort of facts. The Court instead relied on the decision of Megah Teknik to exercise its inherent jurisdiction to set aside the second winding up Order.

In my earlier article, I was of the view that: “… the Court ought to have jurisdiction to set aside a winding up Order. Echoing the words of Mohd. Azmi FCJ in Badiaddin, circumstances may exist where there is a “real need to set aside the defective order to enable the Court to do justice.”

This Panaron decision at least shows one instance where there is such a defective winding up Order falling within the Badiaddin principle. That allows the exceptional ability to set aside a winding up Order. Here, the Kuala Lumpur High Court had no jurisdiction to make the second winding up Order. I would also add that the second winding up proceedings should have been void for breaching section 226(3) where all legal actions are automatically stayed upon a winding up Order being made and cannot be commenced without leave of Court. This decision of Panaron appears to lay down a wider principle that if the winding up Court had no jurisdiction to grant the winding up Order in the first place, then that winding up Order can be set aside.

In future, this Panaron decision could possibly be extended, for example, to facts where there was defective service of the 218 Notice or the winding up Petition. The respondent company might not have known about the winding up proceedings and the Order is made in default of its appearance. Before Megah Teknik and this decision, such a company would have to convince the Court to apply section 243 for a stay of the winding up Order. Perhaps, Panaron and Megah Teknik now opens the door for the argument that the winding up Court had no jurisdiction to grant the winding up Order in the first place and therefore the Order can be set aside.

I would like to also add that the new Companies Bill (to amend the Companies Act 1965) will not specifically address the issue of whether the Court can set aside a winding up Order. The Bill will tweak the present section 243 stay provision to allow for two things. The first is that the stay of a winding up will take on a more natural meaning in that the stay is for a limited time only. Presumably, this is to allow for a stay of a winding up pending appeal for instance or for a short stay to give time for the company to settle the debts. There will be a new termination provision which allows for the winding up to be terminated (i.e. permanently). This suggests that the termination will also be prospective and takes effect from the date of the termination. It does not have the same effect of a setting aside. Therefore, the Court’s exercise of an inherent jurisdiction to set aside a winding up Order will still play a significant role in the future.

Speaking at the Regional Insolvency Conference 2014 in Singapore

On 25 August 2014, I will be speaking at the Regional Insolvency Conference 2014 organised by the Law Society of Singapore. I will be a speaker at the first Plenary Session focusing on a regional update and trends in insolvency in India, Malaysia and Vietnam. I will be speaking on the Malaysian perspective.

insolvency

The main areas I will briefly touch on will be on an introduction to Malaysia’s insolvency laws, in particular, on any cross-border insolvency provisions. And then I will introduce the upcoming changes to insolvency with the new Companies Bill. Malaysia will be introducing the Corporate Voluntary Arrangement (borrowing it from the UK) and judicial management (borrowing it from Singapore).

The Uncertainty on the Law Governing the Arbitration Clause

The law governing the arbitration agreement (i.e. the arbitration clause in a contract) potentially covers matters such as the existence, legality, interpretation, termination, and the identities of the parties to the arbitration clause. It is very common to not see any express provision on the law governing the arbitration clause. Contracting parties commonly make the assumption that the governing law of the contract will be the same law governing the arbitration clause.

(1) Governing law of the contract could be a strong indication of the governing law of the arbitration clause

The English Court of Appeal decision in Sulamérica CIA Nacional de Suguros SA and others v Enesa Engenharia SA and others [2012] 1 Lloyd’s Rep 671. In essence, the English Court of Appeal set out a three-stage enquiry in determining the law governing an arbitration agreement. (1) The express choice; (2) The implied choice in the absence of such an express choice; and (3) Where the parties had not made any choice, the proper law would be the law which the arbitration agreement has its closest and most real connection with. In particular for stage (2), the English Court of Appeal held that an express choice of law governing the substantive contract is a “strong indication of the parties’ intention in relation to the agreement to arbitrate.” On the specific facts of SulAmerica, the Court of Appeal agreed that the arbitration clause should be governed by the law of the seat (English law) and not the governing law of the contract (Brazil law). Nonetheless, the SulAmerica approach creates a rebuttable presumption that an express choice of law to govern the substantive contract would also apply to the arbitration clause. There have been English decisions that have since followed the SulAmerica approach.

(2) Or should the law of the seat of the arbitration be the governing law of the arbitration clause?

FirstLink Investments Corp Ltd v GT Payment Pte Ltd and others [2014] SGHCR 12 departs from the SulAmerica approach in treating substantive law in the main contract being a strong indication of the parties’ intention to have that same substantive law be the law governing the arbitration clause. The case of Firstlink instead argues that, the natural inference ought to be that the law of the seat of arbitration should be the law governing the arbitration clause. This is because when commercial relationships break down and there is dispute resolution, the parties’ desire for neutrality comes to the fore. The law governing the performance of contractual obligations prior to the breakdown takes a backseat and primacy should be accorded to the neutral law selected by parties to govern the proceedings of dispute resolution.

In Malaysia, the High Court in Government of the Lao People’s Democratic Republic v Thai-Lao Lignite Co Ltd [2013] 3 MLJ 409, it was held that the law governing the arbitration clause should be the law of the seat of the arbitration (see [98] to [100]). On appeal, the Court of Appeal upheld the High Court decision but the Grounds of Judgment did not delve into the issue on the law governing the arbitration clause. This case is now pending an application for leave to appeal to the Federal Court.

The case of Thai-Lao Lignite demonstrates the significance of the law applicable to the arbitration clause. One of the contentions in the High Court for the setting aside of the award (as seen in the reported decision) was that Malaysian law should apply to the arbitration clause (as that is where the seat of arbitration is stipulated). From that, it would follow that the ‘party’ to the arbitration clause must be a signatory to the main agreement itself in order to be a party to the arbitration agreement. However, if the governing law of the main agreement (New York law) were to apply to the arbitration clause, under New York law, the concept of an “intended third party beneficiary” would be deemed to be a party to the arbitration agreement. Hence, a non-signatory to the main agreement but one which is an intended third party beneficiary, could rely on the arbitration clause and could be one of the claimants to initiate arbitral proceedings (just like in the facts of Thai-Lao Lignite. However, by applying Malaysian law to the arbitration clause, the High Court held that this was one of the grounds for setting aside the award. The Judicial Commissioner held that the arbitral tribunal had exceeded its jurisdiction by allowing a non-signatory and essentially, a non-party to claim in the arbitral proceedings.

(3) Takeaway Point: Expressly Provide for the Law Governing the Arbitration Clause

It is therefore best to expressly provide for the law governing the arbitration clause to negate any uncertainty. It will just require the simple provision such as “The law of this arbitration clause shall be [state the law e.g. the law of Malaysia]”

 

Delivering a Talk on Enforcing Arbitral Awards and Foreign Judgments

I have been invited by the Singapore Management University School of Law to deliver a lunchtime seminar on Enforcing Arbitral Awards and Foreign Judgments in Malaysia. This will be held on Tuesday 12 August 2014.

As part of my talk, I will set out some of the statistics for the successful (or unsuccessful) applications for the enforcement of arbitral awards under the Arbitration Act 2005.

 

SMU