A SIMULATED COURT CASE – BY DR STEVEN FIRER - The Liability to Third Parties of the Independent Reviewer
WHY?
Regarding a review engagement, the independent accounting professional performs enquiry and analytical procedures primarily to obtain sufficient appropriate evidence for a conclusion on the annual financial statements. Enquiry "simply" consists of the independent accounting professional seeking information from knowledgeable persons within or outside the entity. Evidence obtained through enquiry is the principal source of evidence about management's view of where material misstatements are likely to arise in the annual financial statements. Interviews provide a roadmap for the independent accounting professional to follow. An interview is only a professional conversation. The information gathered in an enquiry is not stand-alone and must be corroborated by substantive evidence. In the review engagement, substantive evidence is derived from applying analytical procedures.
Unlike the audit engagement, where the courts have addressed the auditing procedures at length, South Africa has no court judgements that address analytical procedures where such a procedure is the default method of obtaining substantive evidence.
To set out in detail how a South African court should determine whether the independent accounting professional has complied with his or her duties of care, skill and diligence in performing analytical procedures in a review engagement, I have created a simulated court case where I act as the Judge in determining whether the independent accounting professional has obtained sufficient and appropriate evidence in respect of analytical procedures.
This simulated court case deals with the liability of the independent accounting professional for a review engagement with a third party who does not have a contractual relationship with a client. However, the principles I set out as the Judge equally applies to the contractual relationship (to determine whether there has been a breach of contract) between the independent accounting professional and his or her client.
Steven Firer
JUDGMENT
FIRER J
MY UNDERSTANDING OF POLICY AND THE REVIEW ENGAGEMENT
1. Traditionally, the independent accounting professional's most important function has been to audit annual financial statements.
2. One of the major criticisms of the Companies Act 61 of 1973 was that it was designed primarily to cater to large companies' requirements; it ignored the economic and administrative issues faced by small to medium-sized companies, which included the matter of "disclosure overload".
3. The question was raised about the value of an audit of small to medium-sized companies for both management and the users.
4. Related to this was whether some other form of assurance would be appropriate as an alternative to the audit and, if so, what that alternative would be.
5. These policy decisions were an integral component of the South African company law reform programme, which was undertaken to align company law legislation with South Africa's constitutional framework. As part of this reform, it was the intention to improve the accuracy of the information contained in annual financial statements while facilitating the reduction of costs associated with the formalities of forming a company and maintaining its existence, which includes the communities need for disclosure that is credible.
6. In considering the policy objectives regarding small to medium-sized companies, the drafters of the Companies Act 71 of 2008 created the statutory independent review engagement, which will meet the unique needs of small to medium-sized companies.
7. The crucial policy objective in this context was; although small to medium-sized companies may no longer require an audit opinion, that does not diminish the need for an independent accounting professional's expertise and advice. This made the independent review engagement an attractive regulatory device.
8. The introduction of the independent review engagement will save time and money as it involves considerably less work than an audit, thus going a long way to meeting the policy objectives of the Companies Act 71 of 2008.
9. In terms of the independent accounting professional's commitment, review engagements fall between compilations, which purport to commit the independent review engagement to nothing at all in the client's annual financial statements, and audits, which can commit the independent review engagement to the proposition that the client's annual financial statements contain no material errors or irregularities.
10. My concern as regards the review engagement is the language contained in the standard review report, which seems quite confusing regarding the extent to which the independent accounting professional is taking responsibility for any representations in the annual financial statements, and it is therefore, it could potentially be questionable how much anyone may justifiably rely on such a report in making financial decisions.
11. Gary M. Young places the assurance provided by the review engagement in perspective:
"The CPA [independent accounting professional] expressing negative assurance is like the lifeguard who reports not that there are no sharks in the swimming area, but merely that he has not seen any sharks, without telling us how hard he looked for them. (Maybe the sharks are resting on the bottom. Who wants to get wet and find out?)."
12. My understanding of Gary M. Young's perspective is that the review report says in substance that the independent accounting professional has no reason to believe that the annual financial statements are incorrect, incomplete, or otherwise unsatisfactory, that the annual financial statements are free from obvious material errors, and that the independent accounting professional is not aware of any departures from the International Financial Reporting Standard for Small and Medium-sized Entities (or at least not aware of any departures not disclosed in the report).
13. As I will set out later in this judgment, one must first understand what procedures the independent accounting professional has performed and how likely or unlikely those procedures will uncover departures from the International Financial Reporting Standard for Small and Medium-sized Entities. The review report says hardly anything about what the independent accounting professional has done.
14. Who can tell, just from the report, what "inquiries to personnel" the independent accounting professional made and what "analytical procedures" the independent accounting professional performed?
15. For instance, who but an independent accounting professional or a very sophisticated user will know that these inquiries and procedures generally need not include any significant scrutiny of the client's internal financial controls?
AUDIT V REVIEW
16. The review is an alternative assurance engagement where the reviewer provides limited assurance on a set of annual financial statements compared to the reasonable assurance provided by the external auditor. Assurance is the degree or level of Trust the users can place in the information's credibility in the annual financial statements.
17. This assurance implies that the external audit will give the users a higher level of confidence that management has disclosed all the necessary information in the annual financial statements so that they can make informed business decisions regarding the entity.
18. The implication of this diminution in the level of assurance manifested in the work review is reduced; therefore, the cost of such an engagement is less. However, less work effort increases the possibility of material misstatements, fraud and incorrect disclosures not being detected by the reviewer.
19. The level of Trust or confidence is manifested by how the auditor or reviewer verifies or substantiates the assertions made by management. Assertions are representations made by management regarding the financial records of the entity. It is the management's responsibility to prepare the annual financial statements. In preparing these annual financial statements and submitting them to the auditor or reviewer for assurance, management represents or implies that the information in the annual financial statements is complete, accurate, measured, and disclosed in a financial reporting framework.
20. The conceptual difference between an audit and a review is reflected in the procedures that the auditor or reviewer adopts to verify or substantiate the assertions made by management.
21. The independent accounting professional in an audit engagement must inspect, compare, check, review, and scrutinise the vouchers supporting the transactions and examine correspondence, minute books of shareholders, directors, and Memorandum of Incorporation to establish the correctness of the accounting records.
22. For example, if the price of motor vehicles being sold were increased during the year, an independent accounting professional would have to inspect the minutes of directors' meetings authorising the price increases and then corroborate such a decision by scrutinising sales invoices to establish whether the price increase as taken effect and lastly establishing whether there has been an increase in gross margin as compared to prior years unless, of course, purchase costs have also risen.
23. There is no such requirement for the independent accounting professional in a review engagement. The independent accounting professional has only to establish the correctness of the accounting records through analysis of plausible relationships among financial and non-financial data.
24. For example: Assessment of financial results for consistency with expected values.
25. For example, if the price of motor vehicles being sold was increased during the year, there should also be an increase in gross margin compared to prior years unless purchase costs have also risen.
26. In short, how can anyone not an independent accounting professional know what reliance may reasonably be placed on a review report expressing negative assurance?
27. Therefore, any issues I decide on in this case may be subject to appeal.
INDEPENDENCE OF MR BASH
28. The Companies Act have named the review engagement as set out in ISRE 2400 the "independent review".
29. This name is to enforce the independence doctrine, the cornerstone of the accounting profession.
30. Independence is defined in the Regulations to the Companies Act 71 of 2008 which explain:
31. An independent review of a company's annual financial statements must not be carried out by an independent accounting professional involved in preparing the said annual financial statements.
32. The independent accounting professional performing the review engagement must not:
33. Have a personal financial interest in the company or a related or inter-related company.
34. Be involved in the day-to-day management of the company's business, nor have you been so involved during the previous three financial years.
35. Be a prescribed officer, or full-time executive employee, of the company or another related or inter-related company, or have been such an officer or employee at any time during the previous three financial years.
36. The plaintiff has offered no evidence that Mr Bash prepared the annual financial statements of Used Car Salesman (Pty) Limited), or is in contravention of any requirements as stated in 20.1 to 20.5, and therefore I do not propose to address the independence of Mr Bash any further in this judgment.
BACKGROUND
37. In 2015 Mr C Rook was looking for a used car business to purchase. Mr C Rook learned that the CEO of Used Car Salesman (Pty) Limited, Mr D Eception, was looking to dispose of 100% of the share capital in Used Car Salesman (Pty) Limited. In June 2015, Mr C Rook began meeting with Mr D Eception to purchase Used Car Salesman (Pty) Limited.
38. The negotiations continued into November 2015.
39. Mr Bash attended several meetings with Mr C Rook and Mr D Eception.
40. Mr Bash is an independent accounting professional registered under the Companies Act 71 of 2008 to perform review engagements.
41. He was engaged by Used Car Salesman (Pty) Limited to perform a review of the annual financial statements of Used Car Salesman (Pty) Limited for the years ended 31 August 2013 to 2015.
42. Mr D Eception told Mr C Rook that he was not good with numbers and referred Mr C Rook to Mr Bash for questions about Used Car Salesman (Pty) Limited finances.
43. Mr C Rook maintains that during negotiations, Mr Bash made several statements about the value of Used Car Salesman (Pty) Limited, such as explaining that many potential buyers have been lined up to buy the business. Mr Bash produced his valuation of Used Car Salesman (Pty) Limited.
44. On 16 September 2015, Mr Bash told Mr C Rook that a purchase deposit of R250000 would consummate the deal, where a promissory note would sufficiently secure the repayment of the R250000 in the event of the deal falling through.
45. Mr C Rook received the annual financial statements for 2013 and 2014 on 7 September 2015. Mr Bash brought the annual financial statements to a meeting and handed them to Mr C Rook.
46. Mr Bash denies making the statements Mr C Rook attributed to him, specifically the comment regarding the security of the promissory notes.
47. Mr Bash argues that Mr C Rook had his independent accounting professional and lawyer provide him with advice and that the lawyer had drafted a purchase agreement which contemplated the deposit to be held in Trust by the lawyer.
48. Mr Bash stated that although Mr D Eception asked Mr C Rook to pay the deposit directly to Used Car Salesman (Pty) Limited, Mr Bash was confident that Mr C Rook's lawyer would advise against this.
49. Mr Bash said he was surprised when he discovered that Mr C Rook had paid the deposit directly to Used Car Salesman (Pty) Limited.
50. Mr Bash acknowledges that Mr C Rook referred to the annual financial statements handed over in their negotiations and that he was silent about the credibility of the annual financial statements.
51. On 2 November 2015, Mr C Rook received the 2015 annual financial statements.
52. On 3 November 2015, Mr D Eception reported to Mr C Rook and Mr Bash that he had received an ITA34C assessment for value-added tax from the South African Revenue Services. Mr D Eception explained that although the South African Revenue Services assessed the liability on 29 September 2014, he only received it on 15 November 2015.
53. Therefore, neither 2013, 2014, nor 2015 annual financial statements accounted for a value-added tax liability of R747735. This omission rendered Used Car Salesman (Pty) Limited insolvent factually and commercially as Used Car Salesman (Pty) Limited had no funds to repay the South African Revenue Services nor Mr C Rook's deposit.
54. Used Car Salesman (Pty) Limited immediately ceased business and began liquidation proceedings.
55. Mr C Rook states that had he known of this material and significant liability, he would not have handed over any deposit to Used Car Salesman (Pty) Limited.
ISSUES
56. The issues are:
57. Are Mr Bash and his company Tick & Bash Inc., a firm of independent accounting professionals, liable to Mr C Rook for negligent misrepresentation on the review reports and statements regarding the adequacy of the promissory note?
58. If so, was the plaintiff contributorily negligent?
59. What are the plaintiff's damages?
THE REPRESENTATIONS
60. The independent accounting professional who signs a standard review report implies that he or she is unaware of any respect in which the client's annual financial statements materially fail to conform with the International Financial Reporting Standard for Small and Medium-sized Entities.
61. I understand this to mean that the independent accounting professional has performed inquiries of company personnel and applied analytical procedures to financial data to determine whether the client's annual financial statements materially conform with the International Financial Reporting Standard for Small and Medium-sized Entities.
62. Conclusion
"Based on my review, nothing has come to my attention that causes me to believe that these annual financial statements do not present fairly, in all material respects, the financial position of Used Car Salesman (Pty) Limited as of 31 August 2015 (2013 and 2014), and it's financial performance and cash flows for the year then ended, in accordance with the International Financial Reporting Standard for Small and Medium-sized Entities."
FALSITY OF THE REPRESENTATION
63. The representation made by Mr Bash that nothing came to his attention that caused him to believe that the annual financial statements of Used Car Salesman (Pty) Limited are presented fairly was incorrect, and as such, Mr Bash misrepresented or misstated to the shareholder of Used Car Salesman (Pty) Limited its financial position.
64. Mr C Rook maintains that Used Car Salesman (Pty) Limited's annual financial statements materially fail to conform with the International Financial Reporting Standard for Small and Medium-sized Entities.
65. Mr C Rook maintains that had Mr Bash performed his work sufficiently and appropriately, he would have discovered this deficiency, and the annual financial statements would have fairly represented Used Car Salesman (Pty) Limited's financial "health".
66. Alternatively, Mr Bash's review reports would have contained a qualified review conclusion.
"Based on my review, except for the material omission of a value-added tax liability in the amount of R747735, nothing has come to my attention that causes me to believe that these annual financial statements do not present fairly, in all material respects, the financial position of Used Car Salesman (Pty) Limited as of 31 August 2015 (2013 and 2014), and it's financial performance and cash flows for the year then ended, in accordance with the International Financial Reporting Standard for Small and Medium-sized Entities."
80. To determine whether Mr C R ook was negligent in making these representations, I must determine if the review reports were prepared in accordance with the appropriate legal standard of care This will be dealt with in my judgement under Cause of Action.
REGULATORY FRAMEWORK
81. Upon hearing that Mr C Rook wishes to seek compensation, my first reaction was to ask myself, "What for?" This question is important, for it directs one's mind towards the appropriate cause of action: in this case, Mr C Rook claims damages from Mr Bash and his company Tick & Bash Inc., a firm of independent accounting professionals, for negligent misrepresentation.
82. As a result, Mr C Rook's action is a straightforward delictual claim under the actio legis aquiliae.
83. Mr C Rook states that the review reports Mr Bash prepared on the company's annual financial statements, which he planned to rely on, were prepared negligently.
84. Mr C Rook further states that Mr Bash negligently advised him that a promissory note from the company would sufficiently secure the purchase deposit.
85. Mr Rook believes that due to these negligent misrepresentations, he paid a deposit of R250000 directly to the company (Used Car Salesman (Pty) Limited), secured by a promissory note from the company.
86. When the purchase deal failed, the company failed to return the deposit and subsequently was liquidated.
87. There is no dispute between the parties that Mr C Rook was entitled to the return of his deposit.
CAUSE OF ACTION
88. At the outset, it is useful to note that negligent misrepresentation and negligent misstatement are the same cause of action, and the two terms are often used interchangeably.
89. Mr C Rook is a third party as he has no contractual relationship with Used Car Salesman (Pty) Limited.
90. Therefore, the legal matrix in which Mr C Rook's claim will be placed and judged is that of "negligent misrepresentation", which causes pure economic loss, as opposed to physical injury to person or property, and is not made in a contractual context. Such a claim is recognised in South African law as one of the instances of applying the extended "actio legis aquiliae". This doctrine was established by the Appeal Court in Administrateur, Natal v Trust Bank van Afrika Bpk.
91. This action has since been affirmed in Siman and Co (Pty) Ltd v Barclays National Bank Ltd; Lillicrap, Wassenaar and Partners v Pilkington Brothers (SA) (Pty) Ltd; Bayer South Africa (Pty) Ltd v Frost; Mukheiber v Raath; Fourway Haulage SA (Pty) Ltd v SA National Roads Agency Ltd; and Delphisure Group Insurance Brokers Cape (Pty) Ltd v Dippenaar.
92. According to Corbett CJ inBayer South Africa (Pty) Ltd v Frost:21
"[T]he duty of the Court to decide whether, on the particular facts of the case, there rested on the defendant a legal duty not to make a misstatement to the plaintiff (or, to put it the other way, whether the making of the statement was in breach of this duty and, therefore, unlawful) and whether the defendant in the light of all the circumstances exercised reasonable care to ascertain the correctness of his statement; and (b) to give proper attention to the nature of the misstatement and the interpretation thereof, and to the question of causation."
93. Where Mr C Rook acts upon incorrect information supplied by Mr Bash and suffers harm, liability depends on whether Mr C Rook had a right to be given correct information and Mr Bash has to supply such information.
94. If no contractual relationship between the parties existed, as in this case, one cannot assume a right to information from the outset and must therefore proceed from the duty side to assess wrongfulness.
95. The enquiry focuses on whether the factual situation gives rise to policy considerations indicating that a legal duty to provide correct information exists. Liability for negligent misstatements is an important liability category for pure economic harm.
96. The development of the law towards recognising liability for a negligent misstatement causing pure economic harm has been described as follows:
"It is clear that in our law, Aquilian liability has long outgrown its earlier limitation to damages arising from physical or personal injury. Thus, for instance, in Administrateur, Natal v Trust Bank van Afrika Bpk 1979 (3) SA 824 (A), this Court held that Aquilian liability could, in principle, arise from negligent misstatements which caused pure financial loss, i.e. loss which was caused without the interposition of a physical lesion or injury to a person or corporeal property."
97. Courts follow a cautious approach to liability for statements, as reflected in the following extract from the judgment of the House of Lords in the well-known English case of Hedley Byrne & Co Ltd v Heller & Partners Ltd:
"Words are more volatile than deeds. They travel fast and far afield. They are used without being expended and take effect in combination with innumerable facts and other words."
98. The Court in Administrateur, Natal v Trust Bank van Afrika Bpk 1979 (3) SA 824 (A)applied the general criterion of reasonableness to determine whether a misstatement causing harm is wrongful for delictual liability. The Court accepted that the criterion of reasonableness involves policy considerations, and Rumpff CJ quoted the following passage from Fleming's Law of Torts as being correct also for South African law:
"In short, recognition of a duty of care is the outcome of a value judgment that the plaintiff's invaded interest is deemed worthy of legal protection against negligent interference by the conduct of the kind alleged against the defendant. In the decision whether or not there is a duty, many factors interplay: the hand of history, our ideas of morals and justice, the convenience of administering the rule and our social ideas as to where the loss should fall. Hence, the incidence and extent of duties are liable to adjustment in the light of the constant shifts and changes in community attitudes".
99. In the Administrateur, Natal case, the defendant bank had acted on behalf of a person who claimed compensation from the provincial authorities for the expropriation of property. The authorities eventually paid him compensation via the bank, but he was not the property owner concerned. The provincial authorities then claimed the amount they paid out as damages for alleged negligent misrepresentation by the bank.
100. The action failed because the provincial authorities had initially identified the claimant as the property owner. The Court held that the bank had no legal duty to verify the facts and that the plaintiff's mistake caused the loss. However, liability for negligent misrepresentation in instances where a duty to provide correct information existed is now well established.
101. I find that Mr Bash was negligent as the falsity of the representations were as a result of the error made which had Mr Bash understood his professional standards as he is legally obliged to do, ne would not have the error, which is analysed in detail in my judgment under review report and procedures,
WRONGFULNESS
102. Wrongfulness is often the main issue in determining liability for negligent misstatements because causing pure economic harm by negligent misstatement is not prima facie wrongful. Although one generally determines wrongfulness by looking at either the infringement of a right or the breach of duty, in these instances, there is often no infringement of one of the settled categories of rights (real, personal, personality, or intellectual property rights). Courts, therefore, ask whether the defendant had a legal duty to provide correct information to the plaintiff and whether fulfilling this duty would have prevented harm to the plaintiff.
103. The following factors are typical of what courts consider when deciding whether a legal duty to provide correct information to another person exists:
104. Public office: Was the economic loss caused by a person holding a public office, such as a notary, sworn appraiser or auditor? Such a person has a patent of credibility and efficiency conferred upon him or her by public authority'6, and members of the public are 'invited and entitled to repose confidence and trust in the acts of such persons performed in their respective capacities'.
105. Professional knowledge and competence: Was the economic loss caused while providing professional services, and was there a professional competence or skill failure? Where the defendant provides professional services and professes to possess special skills, special or exclusive knowledge, or professional competence, courts will more readily accept that it is unreasonable to cause economic loss to a person that depends on the defendant's professional competence or that relies on the correctness of information furnished in a professional capacity.
106. In EG Electric Co (Pty) Ltd v Franklin, a registered electrician, on instructions of the seller of a house, had supplied a certificate that the house's electrical wiring complied with municipal regulations. The Court held that a registered electrician owed a legal duty to provide a certificate with correct information to the purchaser of the house, who had relied on the correctness of the certificate and later had to incur costs to rectify defective wiring.
107. In Mukheiber v Raath, the parents of a healthy and normal child (their fourth) instituted action in delict against a gynaecologist, alleging that he had negligently misrepresented to them that the wife had been sterilised after the birth of their third child. Relying on this representation, they failed to take contraceptive measures, resulting in the fourth child being conceived and born. The parents claimed damages from the doctor for pure economic loss in confinement costs and child maintenance until he became self-supporting. The Supreme Court of Appeal held that the doctor had a legal duty to stop making any representation on the matter of sterilisation until he had taken reasonable steps to ensure the accuracy of his representation.
108. The factual and policy considerations indicating that such a duty existed were the following, amongst other considerations:
109. The special relationship between the doctor and the parents who consulted him.
110. It should also have been obvious to the doctor that the parents would rely on what he told them, that the representation's correctness was vital to them, and that they could suffer serious damage if the representation were incorrect.
111. The representation related to technical matters concerning a surgical procedure about which the parents would necessarily be ignorant, and the doctor should be knowledgeable.
112. Recognising legal duty, in this case, would not burden the doctor too heavily. Professional people must not act negligently and should not make unsolicited misrepresentations. The doctor had wrongfully caused financial loss to the parents through a misstatement.
113. In Axiam Holdings Ltd v Deloitte & Touche, the plaintiffs sued auditors for misstatement of an audited company's financial position, which caused the plaintiff's loss after they had purchased shares in the company.
114. The Court held that wrongfulness must be determined in light of the statement's nature, context, purpose, and relationship between parties. A court may conclude at the trial that a reasonable person would not have kept silent but would have expressed reservations about the reliability of the financial information.
115. In Cape Empowerment Trust Limited v Fisher Hoffman Sithole, the purchaser of a business relied on a certificate issued by the seller's auditor, confirming that the business had made a profit of R10 million. This was entirely untrue, and the auditor had been grossly negligent. On whether the auditor owed a legal duty to the purchaser (who was not his client) and had wrongfully caused the purchaser's economic loss, the Court decided that it was impermissible to consider the auditor's gross negligence as a policy consideration indicating a legal duty and wrongfulness.
116. This would telescope the tests for wrongfulness and negligence into one. In the context of negligent misstatements, the element of wrongfulness can exclude liability, despite all other elements of liability, including gross negligence.
117. In this context, however, I agree with the following view:
"What the SCA failed to recognise is that a negligent auditor is an anathema to society, and it is inconceivable that an auditor who is negligent in the role society has mandated for them is not wrongful. Based on Brand JA's views regarding the different roles in delictual liability of negligence and wrongfulness, according to weight to negligence in imposing liability on the auditor, it is tantamount to confusing wrongfulness and negligence. It is wrongful for an auditor to negligently render a set of AFS "unsuitable" for use, and no, it is not confusing wrongful with negligence. The act of rendering the AFS "unsuitable" is embodied in the wrongfulness element of delict."
118. In Cape Empowerment Trust Limited v Fisher Hoffman, Sithole considered the following factors in determining wrongfulness:
119. Was the representation made in a business context and in response to a serious request?
120. Was the plaintiff dependent on the defendant to provide the information or advice?
121. Was the correct information available to the plaintiff from another source?
122. What was the extent of the plaintiff's 'vulnerability to risk' – could the plaintiff reasonably have avoided the risk of harm by other means?
123. The following factors give specific content to the flexible criterion of general reasonableness (boni mores). They are the basis on which courts determine whether the plaintiff had a right to be given correct information and whether the defendant had a duty to supply such information. If misstatement by the defendant constitutes a breach of such a duty and causes harm to the plaintiff, the requirement of wrongfulness is met. Courts would impose liability if the defendant acted negligently:
124. Knowledge: Did the defendant know or foresee that the misstatement would cause harm, or did the defendant have the motive to cause harm? Such knowledge or foresight of the possibility of harm imposes a duty on the defendant not to cause the harm. Causing such harm is unreasonable and, therefore, wrongful.
125. The extent of possible liability and the economic or social consequences of imposing liability: Where recognising a duty to prevent economic loss could lead to a situation of indeterminate liability or 'one fraught with an overwhelming potential liability' or to a 'multiplicity of actions' that could be 'socially calamitous', courts will be reluctant to accept that such a duty rested on the defendant.
126. Ability to protect oneself against liability or loss: Courts can consider the ability of the person who suffered the loss to take protective measures against such loss, for example, by verifying the information received. Courts also consider the ability of the defendant to protect himself or herself against liability for such loss, for example, by obtaining a contractual warranty or insurance cover.
127. A special relationship: Courts will be inclined to accept that a relationship of Trust or dependence, or a fiduciary relationship, gives rise to a legal duty to provide correct information, as between an employer and employee,16 and a bank and its client.
128. Statutory duty: Was a duty to provide correct information provided for or implied by a statutory provision?
129. Therefore, based on the above court cases and commentary, in my opinion, to succeed in this case, Mr C Rook has to prove the following elements:
130. Mr Bash owed Mr C Rook a duty of care based on a special relationship between them, such that:
131. Mr Bash ought to have foreseen that Mr C Rook would rely on his representations, and such reliance by Mr C Rook on Mr Bash's representations would be reasonable in the circumstances of this case.
132. Mr Bash's representations were untrue, inaccurate, or misleading.
133. Mr Bash was negligent in making these representations.
134. Mr C Rook's reliance on Mr Bash's negligent misrepresentations was reasonable.
135. Mr C Rook has suffered damages because he relied on Mr Bash's negligent misrepresentations.
136. Mr C Rook argues that Mr Bash has made two negligent misrepresentations:
137. The review of the reports; and
138. The oral statements regarding the sufficiency of promissory notes given by Used Car Salesman (Pty) Limited and Mr D Eception to secure the deposit paid Mr C Rook to Used Car Salesman (Pty) Limited.
139. Because the nature of these representations is fundamentally different, each has to be independently analysed against the elements of negligent misrepresentation set out above. For convenience, I will first deal with the second representation.
STATEMENTS REGARDING PROMISSORY NOTES
140. The defence argues that the alleged misrepresentation that the R250,000 deposit would be adequately secured by two promissory notes from Used Car Salesman (Pty) Limited and Mr D Eception was not made and, in the alternatives, that the plaintiff could not reasonably rely upon such a representation when he knew it was not correct.
141. The plaintiff had his legal advisor, who recommended that the deposit be paid into the Trust, not advanced to the company directly.
142. I do not accept the plaintiff's evidence that Mr Bash told the C Rooks that the deposit would be adequately secured by a promissory note from Used Car Salesman (Pty) Limited and Mr D Eception.
143. There would be no reason for him to do so. He knew that Mr C Rook had his lawyer and accountant and would expect Mr C Rook to take their advice. I do not believe that the C Rook intended to deceive the Court; rather, I believe that they are mistaken: these statements were likely made by Mr D Eception. Mr Bash was present then, and the C Rooks mistakenly attributed the statements to him. I accept Mr Bash's evidence that he did not make these statements.
144. I found that Mr Bash did not make these representations, so I do not need to analyse this allegation further.
REVIEW REPORT AND PROCEDURES
145. It is my understanding of ISRE 2400, which I describe in the plain language of the non-independent accounting professional, that when an independent accounting professional performs a review, he or she must conduct the following procedures:
146. Making enquiries concerning financial, operating, contractual and other information and considering responses that, in addition to oral responses, may take the form of listings, schedules or other documents.
147. Applying analytical procedures such as comparing the current and prior period information and considering the reasonableness of financial and other inter-relationships. Analytical procedures performed during a review engagement would normally be less extensive than analytical procedures performed during an audit.
148. Discuss with appropriate Used Car Salesman (Pty) Limited officials concerning the information received and the information being reported.
149. When the independent accounting professional doubts the information's plausibility, sufficient additional or more extensive procedures would be carried out to resolve such doubt or confirm that a reservation is required.
150. Elke Van Wyk refers to the review engagement checklist in Mr Bash's working paper file, which asks, "[h]ave sales, withholdings, value added tax and other taxes been considered?"
151. In the checklist for each year's file, Mr Bash has answered "Y" to this question, indicating that these items have been considered. Mr Bash's files also contain copies of Used Car Salesman (Pty) Limited's monthly self-assessment remittance forms for value-added tax for 2012 and 2013; copies of the general ledger printout for account 2200, the value-added tax payable account for the fiscal year ending 31 August 2012; and documents 1894 and 1895 where Mr Bash recast the entries recorded within general ledger account 2200.
152. Elke Van Wyk concludes that Mr Bash did not test the reasonableness of value-added tax.
153. He checked the last month's self-assessment against the accounts payable in the ledger.
154. Elke Van Wyk opines that a simple reasonableness assessment of multiplying monthly sales by 7% value added tax (R700,000 monthly sales x 7% Value Added Tax = R49,000) would have demonstrated that Used Car Salesman (Pty) Limited's monthly self-assessments of R3,000 to R6,000 for value-added tax were suspect, and this would have required further inquiry.
155. Elke Van Wyk further says that in 2012 Mr Bash requested a printout of the detail for the general ledger account 2200 because he felt that the value-added tax payable of R24,626 was large.
156. Elke Van Wyk notes that this value-added tax liability would account for annual car sales of R700,000, which the company reported monthly. Elke Van Wyk concludes that Mr Bash's failure to consider that the sales figures reported by Used Car Salesman (Pty) Limited did not accord with Used Car Salesman (Pty) Limited's self-assessed value added tax liability and remittance was well below the standard expected of an independent accounting professional.
157. The defence relies on the opinion of Mrs Bailey, who opines as follows:
158. In assessing the value work completed by Mr Bash, I draw my opinions from my past experience and the standards established by my office … no specific checklist or questions exist in our review of balances owed by a company concerning value-added tax. The value-added payable balance is evaluated in a manner consistent with other accounts payable balances … our work would typically include … an explanation for the variance between the current period end balance and the prior period end balance and possibly (depending on the amount of the payable and/or the explanation for the change in balance) a reconciliation to the company's remittance advice.
159. Mrs Bailey explained that this means checking the current year against the preceding year and accepting the balance as plausible if there is no significant difference.
160. She continues: Unless an independent professional independent accounting professional has specific concerns concerning value-added tax and the plausibility of information provided by management, he/she would not be expected to perform a reconciliation to sales on the value-added tax remitted to the South African Revenue Services in a given year. In my opinion, given that the working paper files appear to suggest that nothing caused Mr Bash to question the plausibility of the value-added tax balance, I would not have expected Mr Bash to perform a reconciliation of value-added tax to sales in any of the years 2013 to 2015 inclusive.
161. I am satisfied that Mr Bash's conduct fell below the standard of care required of an independent accounting professional on a review engagement.
162. I adopt the reasoning of Mrs Bailey's description of the practice of comparing one year-end number against the preceding year-end number as a short form for assessing plausibility: it assumes that if the last year-end number is plausible, and this year-end number is not significantly different, then it, too, is plausible. As a side note, I question whether this abbreviated route is sufficient to meet the ISRE 2400 requirement of assessing plausibility, as the independent accounting professional, in this case, takes no step to determine the plausibility of the number itself, he or she compares it to the preceding year. However, I do not need to determine this point for the following reasons.
163. The abbreviated form may not be appropriate in all circumstances, as Mrs Bailey acknowledged in the cross-examination.
164. Preparing the review report on the 2013 annual financial statements, Mr Bash had specifically requested a printout of that year's value-added tax payable account. He reviewed it in detail, identifying remittances made each month from September 2012 to 31 August 2013, to address his concern that the value-added tax payable reported by Used Car Salesman (Pty) Limited had grown from R598 on 15 April 2013 to R24,626 on 31 August 2013.
165. Mr Bash noted in his working paper that "client did not make sufficient value-added tax payments during the last ½ of the year and balance has grown steadily…." Mrs Bailey was questioned about Mr Bash's review of this document. She acknowledged that Mr Bash would know that Used Car Salesman (Pty) Limited had gross monthly new vehicle sales of approximately R600,000 per month, and against those sales, the monthly value-added tax payable/remittance reported by Used Car Salesman (Pty) Limited would not be plausible and should have raised doubt about its plausibility, which would, in turn, have required Mr Bash to obtain an explanation from Used Car Salesman (Pty) Limited. Mrs Bailey conceded that Mr Bash failed to meet the standard for a reasonable public independent accounting professional by failing to seek an explanation. This concession also informs the 2014 review engagement. Taking Mrs Bailey's approach to plausibility, the failure to inquire in 2013 affects the 2014 review report: if the 2013 number cannot be said to be plausible, then it cannot be used as a benchmark for plausibility for 2014.
166. The value-added tax payable set out in 2013 (and 2014, as derived from the 2013) financial statement was implausible. Mr Bash should have inquired further and did not. The value-added tax return worksheet completed by Used Car Salesman (Pty) Limited showed sales of R517,135 in August 2014. If all were taxable, the value-added tax to be remitted for that month would be R36,199.45. If half of those sales were taxable, R18,000 should have been remitted. However, Used Car Salesman (Pty) Limited reported a tax collectable of R5,523. Thus, the magnitude of the inaccuracy of the value-added tax payable may have been R180,000 to R360,000 per year for 2013 and 2014, using the August 2014 worksheet as a guide.
167. However, that is not the issue. Mr C Rook was not looking to Mr Bash to tell him what the value-added tax payable was but to tell him that, after reviewing appropriate standards, nothing had come to his attention that caused him to believe that the financial information being reported was not in all material respects following generally accepted accounting principles.
168. It was the assurance that the review reports were "made following generally accepted standards for review engagements" and that "nothing has come to the attention that causes me to believe that these annual financial statements are not, in all material respects, following generally accepted accounting principles", that was inaccurate and misleading and, I conclude, was negligently made.
169. Mr Bash's review did not follow the generally accepted standards for review engagements. Generally accepted standards would have required him to investigate further, as Mrs Bailey properly conceded. Mr Bash could not provide the unqualified opinion as he did: it was a negligent misrepresentation.
REASONABLE RELIANCE
170. Having concluded that the review reports were negligent misrepresentations, I have to determine whether Mr C Rook's reliance on the review reports in his decision to pay the deposit to Used Car Salesman (Pty) Limited was reasonable.
171. Mr C Rook says that he reasonably relied on the annual financial statements:
172. He had no reason to believe or suspect that the annual financial statements were inaccurate, improperly, or negligently prepared.
173. He knew that Mr Bash was a qualified independent accounting professional and had been doing work for Used Car Salesman (Pty) Limited for several years. It was reasonable for him to believe that Mr Bash had detailed knowledge regarding Used Car Salesman (Pty) Limited's financial circumstances.
174. The 2013/2014 annual financial statements indicated that Used Car Salesman (Pty) Limited was making a modest profit, paying its liabilities promptly and was solvent.
175. Mr C Rook was not relying on the annual financial statements to determine a purchase price. Rather, he relied on the statements to determine the company's value in making an advance payment of R250,000.
176. Mr Bash had also made statements and provided a document which indicated that Used Car Salesman (Pty) Limited had a value above R2.8 million.
177. The C Rook understood that Mr D Eception was also the owner of Hiding Assets (Pty) Limited, which owned the land and buildings with significant value. They had no information that Mr D Eception was in personal financial difficulties.
178. The reasons offered by Mr Bash and Mr D Eception for a direct deposit to Used Car Salesman (Pty) Limited were legitimate: the payment would assist the company through a short-term cash flow problem and result in a more valuable asset on purchase.
179. The defence argues that Mr Bash could not have reasonably foreseen that the plaintiff would rely on the review reports when deciding whether to pay the deposit directly to Used Car Salesman (Pty) Limited and could not contemplate that the plaintiff would use the review reports for precisely this purpose.
180. The defence says that while Mr D Eception asked the plaintiff to make the deposit directly to Used Car Salesman (Pty) Limited, Mr Bash believed the plaintiff would not do so because he had independent legal advice. He did not anticipate that the review reports would be used as a basis for making a direct deposit to the vendor.
181. In my view, Mr C Rook reasonably relied on the review reports. Mr Bash, an independent accounting professional, provided a conclusion or comment on Used Car Salesman (Pty) Limited's financial statements, and it is this conclusion or comments that Mr C Rook relied on. He was looking to Mr Bash to assure him that the annual financial statements were in accordance with the International Financial Reporting Standard for Small and Medium-sized Entities. As the Guide issued by the SMP Committee of the International Federation of Accountants, which was designed to assist independent accounting professionals in the implementation of the International Standard on Review Engagements (ISRE) 2400 (Revised), submits (in my own words)
182. The negative assurance form of reporting used for review engagements…informs the reader that, although sufficient evidence has not been obtained to enable the public independent accounting professional to express an audit opinion, a review has been completed following the standards of this Section, and nothing has come to the attention of the public independent accounting professional that causes him or her to believe that the information being reported on is not, in all material respects, following appropriate criteria.
183. Such an assurance can only be given when the standards have been met. If the independent accounting professional cannot give the assurance, he or she may issue the report with a reservation.
184. No reservation was issued in this case, and thus Mr C Rook, as the reader of the Review reports, could reasonably assume that Used Car Salesman (Pty) Limited's annual financial statements were reviewed following the generally accepted standards and that there was nothing amiss. Mr Bash's evidence may be summarised as "I never thought that you would give the deposit directly to the company, regardless of its financial condition; I thought that your lawyer would tell you not to do that." That issue is properly one of contributory negligence, not reasonable reliance.
185. In Dimond Manufacturing Company Limited v Hamilton, the auditor was unaware that the AFS were to be used by a potential purchaser of shares in the company. A potential third-party purchaser, Mr Horwath, met with the auditor Mr Meek. At the meeting, Mr Meek handed the AFS over to Mr Horwath so that Mr Horwath make extracts of the AFS to begin negotiations to purchase the company's shares.
186. Turner J in Dimond Manufacturing Company Limited v Hamilton held that at the point where no extracts were made or handed over to Mr Howarth that he [Turner JA]: "would hold that Mr Meek had yet made no representation regarding the balance sheet [AFS]." Turner J held that as soon as the AFS was handed over to Mr Horwath:
"[There was] no doubt that at the interview ... by personally producing the balance sheet to him [Mr Horwath] and acquiescing in his copying its figures, Mr Meek made an implied representation to Mr Howarth as to the correctness of the balance sheet."
187. On the facts before me, I am satisfied that it was reasonable for Mr C Rook to rely on the review reports and the assurance they provided when advancing the deposit. He had no reason to believe that the review reports were improperly prepared. Mr Bash had been the company's independent reviewer for several years and attended the meetings between Mr C Rook and Mr D Eception, provided information and answered questions about the business's finances. Mr Bash knew that Mr C Rook relied on the review reports in his deliberations regarding the purchase of the business and should have anticipated that Mr C Rook would look at the review reports as one of the factors in deciding whether to advance the deposit.
WERE DAMAGES SUFFERED BECAUSE OF RELIANCE
188. Regarding factual causation, the SCA follows the condictio sine qua non - or "but for" test. Under this test, as Corbett CJ explained in International Shipping Co (Pty) Ltd v Bentley: "[O]ne must make a hypothetical enquiry as to what probably would have happened but for the wrongful conduct of the defendant."
189. Brand JA explains in Cape Empowerment Trust Limited v Fisher Hoffman Sithole:
"In applying this test, Binns-Ward AJ held - and I believe rightly so - that had the profit certificate reflected the true financial position of the Intella business, CET's shareholders would not have approved the transaction, which would, in turn, have caused the train of events to come to an abrupt halt."
190. On the facts before me, factual causation has been established, and I, therefore, conclude that Mr C Rook has "actually" suffered damages because of his reasonable reliance on Mr Bash's negligent misrepresentations.
191. If Mr C Rook knew or could have reasonably known the company's financial condition (and the review reports would be the major factor in this decision), it is implausible that a deposit would be paid, whether in Trust or otherwise.
CONTRIBUTORY NEGLIGENCE
192. In Froom v Butcher, Lord Denning said:
"Negligence depends on a breach of duty, whereas contributory negligence does not. Negligence is a man's carelessness in breach of duty to others. Contributory negligence is a man's carelessness in looking after his safety. He is guilty of contributory negligence if he ought reasonably to have foreseen that if he did not act as a reasonably prudent man, he might hurt himself..."
193. The defence argues that the plaintiff was contributorily negligent in failing to follow his solicitor's advice concerning deposit payment by providing the money directly to Mr D Eception.
194. Mr C Rook had been involved in several other business transactions in South Africa, and Ndou was his solicitor and had acted for him on these other matters. As Mr C Rook knew, in each of those transactions, the deposit was held in Trust until the transaction was completed. Mr Ndou was also acting for Mr C Rook on this transaction. Mr Ndou prepared draft agreements for this transaction which contemplated that the deposit would be held in his trust account until completion.
195. Mr C Rook knew the deposit would be protected if Mr Ndou held it.
196. Mr C Rook discussed the matter, and Mr C Rook decided to pay the deposit directly to API. On his instruction, C Rook revised the draft agreement, changing the deposit payment from a deposit to Mr Ndou's trust account to a direct payment to Used Car Salesman (Pty) Limited.
197. Mr C Rook and Mr Pellegrino signed the revised agreement.
198. Mr C Rook did not seek advice from Mr Ndou or his accountants regarding this change.
199. I believe most of the fault for Mr C Rook's loss lies with him. He did not act appropriately to protect his interests. I assess 50% of the fault to Mr C Rook and 50% to Mr Bash.
200.
DAMAGES
201. The damages, in this case, are quite straightforward. Mr C Rook advanced a deposit of R250,000.
202. He demanded the return of the money in December 2015. The money was not returned.
203. Mr D Eception and Used Car Salesman (Pty) Limited both became bankrupt.
204. There is no real prospect of recovery of the deposit in the bankruptcy.
205. Therefore, Mr C Rook's loss is R250,000, and Mr Bash is liable for 50% of this loss.
CONCLUSION
204 As regards this action, wrongfulness is established because the public policy requires that assurers of annual financial statements be held liable for negligent conduct and thus be incentivised to take adequate care to avoid causing harm to others.
205 It would be inconceivable for the community that an independent reviewer who made such mistakes as Mr Bash would not be held liable.
206 The community expects assurers not to make mistakes that render the annual financial statements "unusable".
207 There is a great public interest in ensuring that auditors, in assuming the role of the "SME" public watchdog, succeed in thwarting avoidable harm. If they are too easily insulated from claims for these harms because of mistakes on their side, they would have little incentive to conduct themselves in a way that avoids causing harm.
208 Policy objectives, such as the deterrent effect of liability, underpin one of the purposes of imposing delictual liability.
209 The community's convictions as to policy and law motivate liability to be imposed.
210 The independent reviewer's negligent, inaccurate statements are, therefore, wrongful.
211 A reasonable independent reviewer would have foreseen the possibility that the mistakes would cause harm.
212 When tasked with protecting the community by giving credibility to the annual financial statements, it is not reasonable to make such blatant judgment errors without adequately verifying the correct approach.
213 In conclusion, Mr C Rook will have a judgment against the defendants for R125 000, interest, and costs unless there are matters I am unaware of.
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