STUDY THE CASE OF AMATHUS DRINKS AND DISCUSS HOW COULD THE PROFESSIONAL NEGLIGENCE BE AVOIDED
DETAILS OF AMATHUS DRINKS PLC &QRS VS EAGK LLP & ANOR (2023)
The case of Amathus drinks PLC and QRS VS EAGK LLP & Anor (2023) EWHC 2312 (ch) is notable English high court judgement concerning corporate acquisition, professional negligence and legal limit of an auditor disclaimer of liability to third party (Gately legal 2023)
In August 2015, the buyers (Amathus Drinks and associated claimants) entered into a Share Purchase Agreement (SPA) to acquire the entire share capital of Bablake Wines Limited. The final purchase price was structurally tied to a pricing mechanism dependent on Completion Accounts and a Completion Certificate. The accounting firm EAGK LLP was heavily involved in the transition; they conducted preliminary due diligence, prepared the target company's statutory accounts, and ultimately issued the final Completion Certificate.
In accordance with the share purchase agreement, EAGK issued a completion certificate setting out the completion net asset figure, which was required to determine the share sale price. The certificate was addressed to the sellers of the share and the to the buyer
The Share Purchase Agreement provided that the purchase price for the company would be adjusted if Completion Net Assets (as defined in the SPA) were below the agreed price to be paid for the shares, by reference to completion accounts.
Following the purchase, the buyers discovered a massive accounting fraud involving double-counted assets, inflated cash receipts, and false invoices.
This fraud resulted in the buyers overpaying for the company by nearly £500,000. The buyers sued EAGK for negligence, alleging the firm failed to exercise reasonable skill and care in failing to detect the fraud.
EAGK applied for summary judgment to strike out the claim, arguing that their engagement terms included a Bannerman disclaimer stating they owed no duty of care to anyone other than the company and its members. While the court dismissed the contractual claim, it allowed the claim in tort (negligence) to proceed to trial
As set out in the judgment, the Buyers and the company allege that:
EAGK had both a contractual and a common law duty to exercise reasonable skill and care in preparing the statutory accounts and the Completion Certificate, including a duty to undertake a reasonable and proper investigation of the company's accounts, books and stock sheets and to draw to the attention of the buyers any material irregularities which it discovered. They allege, in summary, that the defendants acted without reasonable skill and care in failing to detect the fraud alleged to have been committed on the company, causing loss to the buyers, who were then unable to take the steps they would have taken had they been aware of the apparent fraud much sooner.
DEFINITION OF PROFESSION NEGLIGENCE
Professional negligence, means some act or omission which occurs because the person concerned has failed to exercise that degree of professional care and skill, appropriate to the circumstances of the case, which is expected of accountants and auditors.It is the legal responsibility an auditor or audit firm bears if they fail to perform their duties to the required professional standard, resulting in a quantifiable financial loss for their client or certain third parties
THREE PILLARS OF NEGLIGENCE CLAIM
1. Duty of care: The auditor had a legal obligation to act with "reasonable skill and diligence" toward the claimant.2. Breach of duty: The auditor failed to meet the standard expected of a "reasonably competent" professional in the same circumstances. Adhering to International Standards on Auditing (ISAs) is a vital defense here, as compliance is often viewed by courts as evidence of due care
3. Causation and Loss: The claimant must prove they suffered an actual financial loss and that this loss was directly caused by the auditor’s breach
SOURCES OF PROFESSIONAL NEGLIGENCE (AUDITOR LIABLITY)
1. Contractual liability. This arises from breaching terms of contract (engagement letter) with shareholders. Shareholders or company can sue auditor for breaching terms in engagement letter2. Tortious liability, this occur when auditor negligence lead to financial loss to third party who was expected to rely on auditor report. This can occur even if there is no contract between auditor and third party. Best example is Amathus drinks and EAGK case
3. statutory liability, is derived from laws like the Companies Act, which may impose specific penalties for failing to bring out material facts in an audit report
INDICATORS OF PROFESSIONAL NEGLIGENCE IN AMATHUS DRINKS CASE
1. Failure to detect fraudulent activities, The buyers alleged that EAGK acted without "reasonable skill and care" by failing to identify a massive accounting fraud that existed before the acquisition. Fraudulent activities that were not detected by the auditor include double counting of assets, inflation of cash receipts, and recording of false invoices2. Failure to conduct prosper investigation, The claimants argued that the firm breached its duty by failing to perform fundamental auditing and investigative tasks, such as:
Failing to undertake a reasonable and proper investigation of the company’s accounts, books, and stock sheets
Failing to draw the buyers’ attention to material irregularities discovered (or that should have been discovered) during the preparation of statutory accounts and the Completion Certificate
3. Assumption of responsibility through conduct. Auditor assumed the duty of care to the buyer by establishing direct communication with buyer and its team and help the in-handling requests specifically related to the Share Purchase Agreement (SPA). Also, the the audit firm knew and intended the buyer (Amathus) to rely and use its completion certificate to compute final purchase price.
4. Direct causation of quantifiable loss, the audit firm conduct caused a loss of pound 348000 to 480000 due to overpayment of shares that was caused by failed detection of fraud in the seller financial statements (Travers Smith 2023)
HOW PROFESSIONAL NEGLIGENCE COULD HAVE BEEN AVODED
Professional negligence claim can be avoided if audit firm follow internal accounting standards, comply with professional code of ethics, use properly designed engagement letter and conduct audit engagement with professional skepticism attitude.Here are ways that could be used by EAGK audit firm to avoid professional negligence claim:
Align conduct with contract. This is one of the biggest lessons in this case, EAGK had a contract with seller and limited his contract by including bannerman clause in his report, however there were direct communication with the buyer regarding the SPA deal that did exclude the seller. Direct communication with the buyer suggested continuing and direct commercial relationship with the seller. To avoid professional negligence the auditor should not establish any direct relation or communication with third party without proper safeguard.
Maintaining professional skepticism. The issue that leads to liability to the auditor is failure to detect fraud such as double counting of asset due to lack of questioning mind and relying heavily on management representation. According to ISA 200 auditor must maintain question mind and critically assess obtained evidence.
Following ISA 240 regarding fraud including testing the appropriateness of journal entries and being alert to management override is a vital defence in showing the auditor acted with "reasonable skill and diligence"
Clear engagement letter. EAGK were performing more than one work (statutory audit, completion account and completion certificate) to a seller however he used one engagement letter (audit engagement letter) instead of engagement letter for each work. Auditor should have separate engagement letter for each work and in each he would have limited the liability and duty to the third party
Limiting communication with third parities, auditor should not engage in direct communication in third party including not addressing them in his communication since this may establish duty of care to that third party
Strong fraud detection procedures. To avoid being sued the auditor should ensure that he plan and carry out strong fraud detection procedures such as looking into suspicious year end journal entries, discussion with audit team on risk of fraud in the financial statement and treating the management override of internal control as significant risk. Failure to detect fraud is one of the major sources of professional negligence
Compliance with professional ethics, compliance with professional ethics such as ensuring complying with fundament principles of code of ethics like integrity and objectives can help auditor avoid cases of professional negligence
Quality control and supervision. The audit firm should ensure that it has quality control mechanism for the entire firm and single audit engagement to ensure that all audit are conducted according to standards and comply with professional ethics. If EAGK had strong quality control system he would be able to detect fraud through mechanism like proper planning and review of audit work performed
LESSON LEARNED FROM THE CASE
Disclaimer clauses are not absolute protection. The disclaimer clause only work when auditor perform the audit work according to international standard on auditing and limit its relationship both in contract and conduct to people who appointed him to conduct the auditAuditors may owe duties to third part if their action imply responsivities. If audit in any case establish any communication to third party, make third party to rely on auditor work then auditor may owe duties to third party that can lead to auditors’ liability in case of loss to third party
Professional scepticism is essential for detecting fraud. Normal audit procedure may fail to detect fraud due to the fact that fraud may be conducted by top management who are capable of overriding internal control and hiding fraudulent activities from the auditor. Therefore, the auditor to uncover fraud must maintain professional scepticism by maintaining questioning mind and critically assessing the evidences presented to him by management or corroborating contradicting evidence with further audit procedures
Ethical conduct and clear documentation reduce legal exposure. If the auditor can prove that he complied with ethical conduct and he complied with ISAs through presenting properly prepared audit documentation, then he can avoid negligence claims, since audit documentation will be used to prove that audit was conducted with skills and due care
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