DAYS IMPEX LTD (in liquidation) AND ANOTHER v. FUNG, YU & CO (a firm) AND ANOTHER

HCA 1035/2014

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO 1035 OF 2014

___________

___________

______________

JUDGMENT

______________

INTRODUCTION

1.  The 1^st and 2^nd plaintiffs (“P1” and “P2”) are two private companies incorporated in Hong Kong which are now in liquidation[1]. The 1^st defendant (“D1”) was a firm engaged as the auditor of the plaintiffs between 2005 and 2011[2].  The 2^nd defendant (“D2”) was incorporated on 3 January 2011[3] and is alleged to be the practice successor of D1[4]. 

2.  By a Statement of Claim (“SOC”)[5]dated 15 March 2016, the plaintiffs claim against the defendants for negligence in the audit work they performed for the plaintiffs.  It is a major plank of the plaintiffs’ case that the defendants had breached their duty owed to the plaintiffs by signing off unqualified “clean” opinions on the status of the plaintiffs’ accounts and by failing to detect and report the massive import/export fraud which the controlling shareholder and director[6] had caused the plaintiffs to commit.  It is said that had the fraud been detected earlier and reported to the relevant authorities, the fraud would not have continued for so long and the plaintiffs’ losses would have been lesser[7].  It is of note that the present action is brought (in the name of the plaintiffs by the liquidators) for the benefit of the creditors and the liquidation generally.[8]

3.  The defendants have yet to file any defence.  By a Summons dated 12 August 2016[9], however, they seek to strike out the SOC in its entirety on the following grounds:

(a) the SOC discloses no reasonable cause of action;

(b) the SOC is an abuse of process for the following alternative reasons:

(i) it is a fishing expedition;

(ii) it has already been time-barred;

(iii) it is attempt for the plaintiffs to sue on reliance of their own illegality;

(iv) it would lead to a circuity of action because of the defendants’ right to set-off or counterclaim; and

(c) it is devoid of particulars and also bound to fail.

THE ISSUES

4.  Mr Lai, counsel for the defendants, re-organizes the defendants’ aforesaid grounds stated in the Summons and focuses his submission on the following issues:

(A)  whether the alleged breaches by the defendants falls outside their scope of duty of care as auditors;

(B)  whether there is an absence of factual causation between the alleged breaches and the plaintiffs’ loss;

(C)  whether there is an absence of legal causation between the alleged breaches and the plaintiffs’ loss;

(D)  whether the plaintiffs’ claim offends the principle of ex turpi causa non oritur actio;

(E)  whether there would be a circuity of action; and

(F)  whether any part of the plaintiffs’ claim has already been time-barred.

5.  In respect of D2, Mr Lai highlights the fact that it had not even been incorporated prior to 2011 and it had not signed off any of the auditor reports of the plaintiffs.  On that basis, it is submitted that there is no factual or legal basis to hold D2 liable.

LEGAL PRINCIPLES FOR STRIKING OUT

6.  There is no dispute about the legal principles for striking out and they can be summarized as follows[10]:

(1)   it is only in a plain and obvious case that the Court should exercise its summary powers to strike out a pleading or writ;

(2)   the claim must be obviously unsustainable, the pleadings unarguably bad and it must be impossible, not just improbable, for the claim to succeed before the Court will strike it out;

(3)   there should be no trial on affidavits; disputed facts are to be taken in favour of the party sought to be struck out;

(4)   the mere fact that a case is weak and not likely to succeed is no ground for striking it out;

(5)   the jurisdiction should not be exercised if it requires a minute and protracted examination of the documents and facts of the case in order to see whether the plaintiff really has a cause of action; where an application to strike out involves a prolonged and serious argument, the Court should, as a rule, decline to proceed with the argument;

(6)   the Court should not decide difficult points of law in striking out proceedings and the Court is loathe to strike out a case that involves an area of law which is in the process of developing.  That said, questions of law can be determined in strike out applications provided that they are crucial and the Court has all the relevant facts before it and these facts are certain;

(7)   it is for the party seeking to strike out a pleading or writ to demonstrate that the case is a plain and obvious one in which the other party’s claim is bound to fail;

(8)   however, where the Court comes to the conclusion after full argument that the case is plainly and obviously one for striking out it should not decline to do so on the ground that the issues are difficult or complicated.

CONSIDERATION

7.  The affirmation evidence filed for the present application consists of:

(i)   three affirmations made by Fok Hei Yu on behalf of the plaintiffs[11]; and

(ii)   one affirmation made by Yu Leung Fai on behalf of the defendants[12].

The affirmations give the background facts of this case, outline the respective cases of the parties, update the debts owed by the plaintiffs and provide information about the incorporation and practice of D2. I have regard to all of the affirmations and the documents exhibited thereto.

8.  The arguments between the parties are mainly on law including but not limited to the scope of auditor’s duty, attribution and illegality and causation.  This court has received lengthy and in-depth oral and written submissions from Mr Lai on the one hand and Mr Joffe (and with him, Ms Lam), counsel for the plaintiffs, on the other.  I note that Mr Lai’s written submission runs up to 38 pages together with 3 volumes of case authorities, whilst Mr Joffe’s written submissions runs up to 66 pages together with 6 volumes of case authorities.  The hearing of the application lasted for about one day and a half.  For all of the above, I am greatly indebted. 

(A)   Scope of auditor’s duty and sufficiency of pleadings

9.  In summary, Mr Lai submits under these heads the following:

(1)   the loan transactions entered into by the plaintiffs were not something the defendants were under a duty to advise.  They were loan transactions concluded by the father and son, in the exercise of their de jure or de facto control over the plaintiffs;

(2)   it is not pleaded that the loan transactions were subject to approval of the members of the plaintiffs and therefore the defendants were not under duty to advise on the merits of the loan transactions;

(3)   it is not pleaded (a) that reliance would be placed by the plaintiffs on the defendants’ audit opinions when entering into the loan transactions; and (b) that such reliance was known to the defendants.  Accordingly, D1 could not be said to have assumed a specific duty of care in relation to the loan transactions; and 

(4)   it is not pleaded that the members of the plaintiffs, to whom the defendants are said to have owed duty as a collective body, would have acted differently had the true picture been revealed. 

10.  In my view, Mr Lai’s aforesaid submissions entail the following preliminary questions which should first be addressed, namely (i) whether the defendants’ role as auditor should be characterized as just provision information and advice[13]; (ii) whether an auditor owes a duty to his client company to prevent the latter from entering into questionable loan transactions[14]; (iii) how and to what extent (if any) the interests of the creditors should be factored into the scope of duty of an auditor when his client company is in an insolent situation; and (iv) whether any resultant loss to the plaintiffs would have been inevitable even if there had not been any breach of duty, given that the fraudsters were themselves the controlling directors and shareholders of the plaintiffs and were not relying on the accuracy of the defendants’ advice.[15]

11.  As to (i), the stance of Mr Joffe is that:

(a)   the defendants had a duty to plan and perform the audit so as to enable them to detect material misstatements, errors and so forth which would in this case have led to the detection of fraud; and

(b)   upon detection of the material misstatements/fraud, the defendants had a duty to report the fraud not only to the companies themselves but also to the appropriate authorities.

12.  In considering the defendants’ scope of duty as auditors, I have regard to what Lord Bridge said in Caparo Industries Plc v Dickman[16]:

“ … It is never sufficient to ask simply whether A owes B a duty of care. It is always necessary to determine the scope of the duty by reference to the kind of damage from which A must take care to save B harmless.”

As Lord Oliver said in the same case[17]:

“ The question is always whether the defendant was under a duty to avoid or prevent that damage, but the actual nature of the damage suffered is relevant to the existence and extent of any duty to avoid or prevent it.”

Moreover, the same point was made by Lord Hoffmann in South Australia Asset Management Corp v York Montague Ltd, United Bank of Kuwait plc v Prudential Property Services Ltd, Nykredit Mortgage Bank plc v Edward Erdman Group Ltd[18] where his lordship said:

“ … Before one can consider the principle on which one should calculate the damages to which a plaintiff is entitled as compensation for loss, it isnecessary to decide for what kind of loss he is entitled to compensation. A correct description of the loss for which the valuer is liable must precede any consideration of the measure of damages. For this purpose it is better to begin at the beginning and consider the lender’s cause of action.

…

   A duty of care such as the valuer owes does not, however, exist in the abstract.  A plaintiff who sues for breach of a duty imposed by the law (whether in contract or tort or under statute) must do more than prove that the defendant has failed to comply.  He must show that the duty was owed to him and that it was a duty in respect of the kind of loss which he has suffered.”

13.  Having considered the submissions from both sides, I am unable to accept that an auditor’s duty is as narrow as to be restricted to the provision of information and advice, but may extend to detecting material irregularities in the company’s accounting statements.  See Barings v Coopers & Lybrand[19] in which Leggatt LJ said:

“ The primary responsibility for safeguarding a company’s assets and preventing errors and defalcations rests with the directors. But material irregularities, and a fortiori fraud, will normally be brought to light by sound audit procedures, one of which is the practice of pointing out weaknesses in internal controls. An auditor’s task is to conduct the audit as to make it probable that material misstatements in financial documents will be detected. Detection did not occur here, and there therefore is a case for [the defendants] to answer.” (Emphasis supplied)

14.  Moreover, I also agree with Mr Joffe’s submission that in appropriate cases an auditor’s duty may even extend to reporting any fraud he detected during the course of his work for a client.  Thus, in Sasea Finance Ltd v KPMG[20], it is said:

“ If, for example, the auditors discover that a senior employee of a company has been defrauding that company on a grand scale, and is in a position to go on doing so, then it will normally be the duty of the auditors to report what has been discovered to the management of the company at once, not simply, when rendering the auditors’ report, to record what has been discovered weeks or months later. …

The guidelines also acknowledge that there may be occasions when it is necessary for an auditor to report directly to a third party without the knowledge or consent of the management. Such would be the case if the auditor suspects that management may be involved in, or is condoning, fraud or other irregularities and such would be occasions when the duty to report overrides the duty of confidentiality. Among the relevant considerations would be the extent to which the fraud or other irregularity is likely to result in material gain or loss for any person or is likely to affect a large number of persons and the extent to which the non-disclosure of the fraud or other irregularity is likely to enable it to be repeated with impunity.

…

It is accepted for present purposes that it was KPMG’s duty to warn either the directors or some relevant third party of any fraud or irregularity likely to result in material loss to the company with a reasonable degree of promptitude. Why should that be? The obvious and common-sense answer is that by so doing the company may be spared such losses.” (Emphasis supplied)

15.  The reference to “The guidelines” above is the Auditing Guidelines (Feb 1990 edn).  There are similar guidelines applicable to Hong Kong issued by the Hong Kong Society of Accountants.  Of particular relevance are the following, all of which having been alluded to in the SOC and relied upon by the plaintiffs[21]:

(1)SAS 110: The Auditors’ Responsibility to Consider Fraud and Error in the Audit of Financial Statements:

“ 2. When planning and performing audit procedures and evaluating and reporting the results thereof, the auditors should consider the risk of material misstatements in the financial statements resulting from fraud or error.”

“ 57. When the auditors identify a misstatement resulting from fraud, or a suspected fraud, or error, the auditors should consider the auditors’ responsibility to communicate that information to management, those charged with governance and, in some circumstances, to regulatory and enforcement authorities.”

(2)SAS 200: Planning

“ The auditor shall plan and perform an audit with professional skepticism recognizing that circumstances may exist that cause the financial statements to be materially misstated.”

(3)SAS 240: Quality Control for Audit Work

“ The auditor shall maintain professional skepticism throughout the audit, recognizing that possibility that a material misstatement due to fraud could exist, notwithstanding the auditor’s past experience with the entity about the honesty and integrity of management and those charged with governance.”

16.  Concerning the relevancy of guidelines issued by a professional body of accountants in relation to auditing standards expected of its members, the learned authors of Jackson & Powell on Professional Liability have the following to say[22]:

“ Although auditing standards do not directly have the force of law, compliance with them is powerful evidence that the auditor has acted reasonably, whilst failure to comply without adequate explanation is powerful evidence to the contrary. There are two reasons why this is so. The first is that the FRC[23] is and the APB[24] was constituted under the aegis of the CCAB[25] and the standards accordingly represent the agreed view of all the major professional bodies of accountants as to what constitutes good practice. The second is that the standards are given additional status by the Companies Act, in that every auditor of the accounts of a company registered under the Companies Acts is required to belong to a RSB[26] …”

17.  In my humble view, the weight of the authorities is such that it is highly arguable that an auditor’s duty is more than just providing information and advice on his client’s financial statements.  Moreover, I am inclined to the view that what is said in Sasea Finance about an auditor’s duty to “blow the whistle” is also apposite to Hong Kong.  

18.  As to (ii), it is important to note that the plaintiffs’ case, properly understood, is not that the defendants’ negligence lies in not advising the plaintiffs or their management to desist from entering into the questionable loan transactions.  The plaintiffs’ case is that the defendants, as auditors, owed the plaintiffs a duty to detect and report fraud in the course of their auditing work, even to the relevant authorities if necessary, so as to avoid loss or further loss being caused to the plaintiffs.  In this regard, it is said in Sasea Finance that[27]:

“ … It is accepted for present purposes that it was KPMG’s duty to warn either the directors or some relevant third party of any fraud or irregularity likely to result in material loss to the company with a reasonable degree of promptitude. Why should that be? The obvious and common-sense answer is that by so doing the company may be spared such losses.” (Emphasis supplied)

19.  As to (iii), the issue is very much left open by case authorities.  However, my attention has been drawn to Simpson, Professional Negligence and Liability, where it is said[28]:

“ Indeed, it will commonly be the case that a company’s claim against its auditors will be of benefit to its creditors (particularly, but not exclusively, where the company is insolvent). An argument that the duties owed by the auditors are affected by whether the company is insolvent or near to insolvency, and therefore the interests of the creditors require protection, is capable of being accommodated within the existing principles applicable to the existence and scope of auditors’ duties, provided that the claim remains one by the company and for loss sustained by the company. …”

In my humble view, in a case like the present one when the liquidators are acting primarily for the benefit of creditors the above proposition is at the very least arguable and should not be shut out by way of a striking out.  

20.  As to (iv), whether a report to the relevant authorities of the fraud would have been effective in avoiding loss or further loss to the plaintiffs is a matter on which evidence would need to be heard and tested.  Thus, the English Court of Appeal in Sasea Finance said[29]:

“ Finally, Mr Brisby submits that what KPMG had to report was so grave that if independent directors failed to act quickly in such a way as to cut Fiorini and Parretti out of management then KPMG would have recognised that public interest demanded an approach to a third party, albeit after taking appropriate legal advice. Thus,Mr Brisby submits it is at least arguable that the influence of Fiorini and Parretti would have come to an end before 28 September 1990.

   As it seems to us, this is plainly an area in which evidence needs to be heard and tested before a final conclusion can be reached. We find it impossible to say that SFL has no arguable case in relation to the efficacy of ‘whistle blowing’.”

21.  Returning to Mr Lai’s submissions under these heads, I am of the view that it is not to the point that the defendants were not under a duty to advise on the merits of loan transactions in question[30], as it is not the way in which the plaintiffs have put their case against the defendants.  It is also not pertinent that the plaintiffs had not relied on the accuracy of the defendants’ advice before entering those loan transactions, as it is the plaintiffs’ case that the defendants’ alleged negligence lies in failing to detect and report the fraud to the relevant authorities[31].  Lastly, the point is not whether the plaintiffs would have acted differently in the loan transactions.  Rather, the point is whether the plaintiffs’ loss would have been avoided or contained and this is a matter on which evidence needs to be heard[32].

22.  As regards Mr Lai’s submission on the sufficiency of pleadings, with respect, it is based on the wrong footing by restricting the defendants’ scope of duty as auditors to just provision of advice.  On the other hand, the plaintiffs’ SOC contains an extensive reference to auditing standards which include the duty to detect and report fraud. 

23.  Based on the above, with respect these grounds for striking out are misconceived and have no merits.   

(B)   Factual causation

24.  Mr Lai’s submits that the defendants’ alleged breaches could not have factually caused the loan transactions to be entered into.  Insofar as the plea that the fraud would have been arrested had the defendants reported the matter to the “appropriate parties (including but not limited to Ps)”, it is submitted that the plaintiffs have failed to specify who it is said to have been misled by the defendants’ audit opinion.  Furthermore, it is submitted that, as a matter of pleading, the plaintiffs are obliged, but has failed, to identify what steps would have been taken had the report been made.

25.  With respect, Mr Lai’s aforesaid submission is again premised on the wrong footing that the defendants’ duty as auditors was limited to provision of an accurate advice in the auditor reports so that there could not be any factual causation when the plaintiffs did not in fact act on their advice before entering into the loan transactions in question.  However, as discussed above the plaintiffs’ case is based on the defendants’ failure to detect and report fraud when performing the auditing work for the plaintiffs. 

26.  As submitted by Mr Joffe, the latter case has already been clearly pleaded in the SOC as follows:

(1)   After setting out the parties and background, Section D pleads the duties of the auditors, which include inter alia duties to detect and report fraud.

(2)   Section E identifies the material misstatements in the accounts as a result of the fraud.

(3)   Section F identifies the particular breaches and areas in which, had the work been properly carried out, the defendants would have been alerted to the material misstatements and hence the fraud.

(4)   Section G draws the conclusion that inter alia the defendants ought to have detected the material matters which would have pointed to the fraud, which should then have been reported to the plaintiffs and the appropriate authorities.

(5)   Based on the above, Section H pleads that loss and damage has been suffered by the plaintiffs.  This is repeated in the Prayer.

27.  As regards Mr Lai’s point about the lack of particulars as to who are the “appropriate parties” to report to, the auditing standards set out that the fraud ought to be reported to “regulatory and enforcement authorities” and/or “directly to the third party”.  The number of such regulatory and enforcement authorities are limited, namely the Stock Exchange, the Securities and Futures Commission and the Police.  If there are any ambiguities in this regard, the appropriate application would be for further and better particulars rather than a striking out. 

28.  In my judgment, the plaintiffs have adequately pleaded their case in the SOC and this ground of the defendants for striking out has not been made out.

(C)   Legal causation

29.  Mr Lai submits that allowing a company to remain in existence does not, without more, cause losses from anything and that giving an opportunity to a company incur and to continue to incur trading losses does not cause those trading losses in the sense in which the word “cause” is used in law.  Reference is made to Alexander v Cambridge Credit[33], which was followed in Galoo v Bright Grahame Murray[34].  Based on the above, Mr Lai submits that:

(1)   the alleged failure on the part of the defendants to detect fraud, even made out, at most only provided an opportunity to the plaintiffs to sustain loss. It is insufficient to make out the legal causation;

(2)   if the plaintiffs’ acceptance of loan and/or giving security for such a loan is not loss, then the interest and bank charges (which flowed from taking out the loans) cannot conceivably be recoverable losses; and

(3)   the loans drawn by the plaintiffs were benefit to themselves.  The interest and bank charge were necessary cost incurred by the plaintiffs in obtaining those benefits and such cost cannot be regarded as loss.

30.  In Galoo v Bright Grahame Murray, ante, a case which is heavily relied on by Mr Lai, it was held that the negligent audit certificate merely created the opportunity for the company to incur and continue to incur trading losses, the cause of the losses being the unsuccessful trading. However, Galoo was distinguished in Sasea Finance on the ground that, where the auditor’s duty was to draw attention to a fraud, he was responsible for the company continuing to trade fraudulently. The Court of Appeal in Sasea Finance said that the subsequent frauds were “the kind of transaction against the risk of which [the auditor] had a duty to warn”[35].

31.  I also have regard to the following legal principles and case authorities drawn by Mr Joffe to my attention:

(a)   it is well-established that negligence needs to be an “effective cause”, but what this is in any given case is largely be a question of fact and a matter of application of judicial “common sense”: Smith New Court Securities Ltd v Scrimgeour Vickers (Asset Management) Ltd[36];

(b)   it has been held that it would be inappropriate to strike out a claim against auditors where their actions cause the company to trade in a particular way and incur further losses and it is on this basis that Galoo is distinguished: Temseel Holdings Ltd v Beaumonts Chartered Accountants (A Firm)[37];

(c)   Galoo is also further distinguished where the allegation is that the auditors should have discovered and advised that the company was trading at a loss, and steps would have been taken accordingly to prevent further trading, the failure to do so has been determined to be capable of being an effective cause in previous cases: see Rushmer v Mervyn Smith (t/a Mervyn E Smith & Co)[38]; and

(d)   once it is established that the auditors’ negligence or breach of duty was causative of the relevant loss, they remain liable not withstanding there may have been other causes of equal efficacy: WA Chip & Pulp Co Pty Ltd v Arthur Young & Co[39].

32.  Furthermore, subsequent authorities suggest that Galoo should not be understood as a case on causation.  Thus, in Equitable Life v Ernst & Young[40] the English Court of Appeal had the following to say:

“ Although Galoo was a case of summary disposal, the facts of the case were idiosyncratic. Since, ex hypothesi, the company was insolvent, the losses suffered by continuing to trade were really suffered by the creditors (or by the company’s parent), and so, although the case was not argued in that way, the real question may well have been whether the auditors owed any duty to the creditors (see Lord Hoffmann’s lecture to the Chancery Bar Association, 15 June, 1999, Common Sense and Causing Loss, pp 22–23).”

33.  Based on the above, I agree with Mr Joffe that it is inapposite for the defendants to reply on the Galoo line of authorities to suggest that there is a causation defence.  Rather the issue should be approached from the perspective of scope of duty. 

34.  In conclusion, I am not persuaded that the SOC should be struck out on the ground that there is no legal causation. 

(D)   Illegality

35.  Mr Lai distills the following principles from the highly controversial case of Stone & Rolls Ltd v Moore Stephens[41] which he submits have not been undermined by subsequent cases:

(1)   the issue of attribution very much depends on context and purpose of the proceedings in question; and

(2)   in a “one man” company case, the controlling fraudster’s knowledge could be attributed to the company in an audit negligence claim against an auditor.

36.  Mr Lai goes on and submits that the present case falls within the scope of Stone & Rolls on the plaintiffs’ own pleaded case in that:

(1)   the fraudsters were effectively the only persons owning the plaintiffs[42];

(2)   all affairs of the plaintiffs were controlled by the fraudsters[43];

(3)   the plaintiffs were at all material times utilized as part of the fraud perpetrated by the fraudsters[44]; and

(4)   accordingly, the plaintiffs should be similarly regarded as “one man” companies, and the fraudulent knowledge of the fraudsters should be attributed to the plaintiffs.

Therefore, it is submitted that the plaintiffs are barred from taking advantage of their own wrongs and hence not entitled to sue the defendants.

37.  With respect, I recognize the logic and force of Mr Lai’s aforesaid submissions.  However, Stone & Rolls, which is the foundation of his submissions, is admittedly a difficult case about the interaction between the doctrine of attribution, the fraud exception[45] and the illegality defence, as each of the Law Lords had given differing reasons for the decision so that it is difficult, if not possible, to identify its ratio. Thus, it is said in the joint judgment of Lord Toulson and Lord Hodge JJSC in Bilta (UK) Ltd v Nazir (No 2)[46]that:

“ We conclude that Stone & Rolls should be regarded as a case which has no majority ratio decidendi.”

More importantly, the decision in Stone & Rolls has been subject to such severe criticism that its value as a precedent has been very much undermined.  Thus, the learned editors of Jackson & Powell on Professional Liability, summarise the current position in UK asfollows[47]:

“ It is also now clear the directors of a company who have caused it to be involved in a fraud cannot raise a defence of illegality to a claim against them by the liquidator of the company to recover money paid away from the company as a part of the fraud. This was the result in Bilta UK Ltd v Nazir (No 2). As Lord Neuberger (with whom Lords Clarke and Carnwath agreed) explained:

‘ Where a company has been the victim of wrongdoing by its directors, or of which its directors had notice, then the wrongdoing, or knowledge, of the directors cannot be attributed to the company as a defence to a claim brought against the directors by the company’s liquidator, in the name of the company and/or on behalf of its creditors, for the loss suffered by the company as a result of the wrongdoing, even where the directors were the only directors and shareholders of the company, and even though the wrongdoing or knowledge of the directors may be attributed to the company in many other types of proceedings …

whether or not it is appropriate to attribute an action by, or a state of mind of, a company director or agent to the company or the agent’s principal in relation to a particular claim against the company or the principal must depend on the nature and factual context of the claim in question.’

This leaves open the question as to the availability of a defence ofillegality to an auditor who is alleged to have negligently failed to detect a fraud being carried out through a ‘one-man’ company or equivalent. If it does not ‘produce inconsistency and disharmonyin the law, and so cause damage to the integrity of the legal system’ [these principles will be discussed further below in E2] to allow the liquidator to claim against the ‘one man’, why should allowinga claim by the liquidator against the auditor do so? In both cases the liquidator is placing equal reliance upon the company’s participation in a fraud in order to make the claim. …

38.  In Hong Kong, Stone & Rolls has been considered by the Court of Final Appeal in Moulin Global Eyecare Trading Ltd (in liquidation) v The Commissioner of Inland Revenue[48]in which case the liquidators claimed a refund of taxes on the basis that the company did not make any of the taxable profits which the management falsely reported to the Inland Revenue in furtherance of a fraud.  The leading judgment was given by Lord Walker of Gestingthorpe NPJ who was also in the majority of the panel in Stone & Rolls.  Lord Walker said that lengthy discussion of Stone & Rolls was unnecessary and inappropriate in the case then before him[49].  His lordship recanted from the position he took in Stone & Rolls as regards the fraud exception and cited with approval the judgment of Patten LJ of the English Court of Appeal in Bilta[50] which emphasized that the context in which attribution is explored is an important factor.  Lord Walker summarised his views on the fraud exception and attribution and made, among other things, the following observations[51]:

“ (8) In cases concerned with insurance the terms of the policy are likely to be decisive, especially where a company has obtained cover against the risk of breach of duty, including fraud, by directors or employees: Arab Bank at 283, and the comments on that case in Morris at [122]–[124]. Internal fraud was the ‘very thing’ from which the insurance cover was intended to protect the company.

(9) The fraud exception does not appear to have been even raised as a defence, still less successfully relied on, in a claim by a company against its auditors for failure to detect internal fraud (as in Duke and MAN) with the sole exception of the extreme ‘one-man’ company case of Stone & Rolls (see that case at [175] and [176]).  Again, internal fraud was the ‘very thing’ from which the auditors had a duty to protect the company.”

39.  Having considered submissions from the parties, I am inclined to agree with Mr Joffe that whilst the Court of Final Appeal in Moulin was critical of Stone & Rolls, it did not directly address the situations (which did not arise in the case before it) where:

(1)   the company is seeking to sue not the wrongdoing director, but rather a third party which the company alleges is in breach of duty owed to it in failing to detect the wrongdoing. In such circumstances, whether or not an auditor can rely on the attribution of the wrongdoer’s knowledge and thus invoke the illegality defence; and

(2)   whether the company, acting by its liquidators, and hence seeking to primarily protect and address creditors’ interests, can sue the auditors alleging they are in breach of duty in failing to detect the wrongdoing.

40.  In my humble view, the above situations involve difficult points of law in an area which is in the process of developing.  In this regard, my attention has been drawn by Mr Joffe to certain Canadian case authorities to the effect that neither attribution nor the illegality defence would absolve an auditor’s duty in similar situations: see Livent Inc v Deloitte & Touche[52]. Moreover, the illegality defence has been substantially reformulated by the recent decision of the English Supreme Court in Patel v Mirza[53], which was decided after Bilta, so that it has now moved away from the rule-based approach in Tinsley v Milligan[54] to a policy and fact based approach.  The latter requires the court to consider, among other things, whether the enforcement of a claim would be harmful to the integrity of the legal system and whether the denial of that claim would be a proportional response to the illegality under consideration.  As such, the facts of an individual case now assume a greater significance than before when considering the applicability of the illegality defence.  In all the circumstances, I am unable to be satisfied that the present case is a plain and obvious one for striking out without any consideration of the evidence.

(E)   Circuity of action

41.  Mr Lai submits that the plaintiffs’ claim, if succeeded, would give rise to a cause of action available to the defendants.  This is on the basis that the defendants would have relied on the representations given by the directors of the plaintiffs which, to the knowledge of the directors, were fraudulent. The defendants signing off the auditors’ reports was a cause of their exposure to a negligence claim and therefore loss.  As the representations of the management were made within the authority of the directors, the plaintiffs would be vicariously liable for those fraudulent representations of the directors.  It is submitted that the cause of action available to the defendants would set off in full their liability owed to the plaintiffs.  This would therefore give rise to a circuity of action and amounts to an abuse of the Court’s process if the plaintiffs are allowed to pursue the action.

42.  With respect, I am unable to be satisfied that the defendants have made out a clear case of circuity of action which is sufficient for their present application for striking out.  My reasons are as follows:

(a)   it is trite that a defence of set-off and counterclaim has to be specifically pleaded and particulars of misrepresentation and fraud must be specified.  In the present case, the defendants have not even filed a defence.  Therefore, one knows not what false representations the defendants are relying on.  What we have at this stage is just a bare assertion that the defendants had been deceived by the directors of the plaintiffs;

(b)   given that the defendants are professionals and that it would be within their expertise and duty to detect any irregularities in the financial statements presented to them for auditing, evidence would need to be heard to determine whether the defendants had in fact been deceived, how that came about and to what extent they were deceived: see Barings v Coopers & Lybrand (No 2)[55]; and

(c)   the counterclaim in Barings v Coopers & Lybrand (No 2) was based on vicarious liability[56], whereas in the present case the defendants rely on the doctrine of attribution and the illegality defence.  However, as to whether the knowledge of the father and the son can in law be attributed to the plaintiffs and whether the defendants can rely on the illegality defence, this in my humble view is still an open issue which is yet to be decided.

43.  Based on the above, it is impossible for the court to form a view as to whether the defendants can establish a set off or counterclaim without proper pleadings and hearing evidence.  In short, with respect, the ground based on circuity of action is simply not a suitable matter in the present case for a strike out application.

(F)   Time limitation

44.  The usual time limitation for an action based on tort is one of 6 years from the accrual of the cause of action.  In the present case, the Writ was issued on 10 June 2014.  Thus, in any event the limitation defence would not be applicable in respect of the audits carried out on the plaintiffs’ financial years ended 31 March 2009 and 2010. 

45.  As regards the earlier audits of the plaintiffs, they would require a consideration of the applicability of the exception provided in s 31, the Limitation Ordinance, Cap 347 which provides for extension of the limitation period to 3 years from the date of knowledge, actual or imputed: Kensland Realty Ltd v Tai, Tang & Chong[57].  This is basically a fact-sensitive issue: Topping Chance Development Ltd v CCIF CPA Ltd[58].

46.  The determination of the date of actual or imputed knowledge can be a complicated matter.  In the present case, the level of complexity increases further by the issue of attribution.  This is also the added difficulty caused by the fact that the defendants have yet to have any pleadings.  In the circumstances, I am of the view that this issue of limitation is clearly more suitable to assessment at trial.

The special position of D2

47.  I note the complaint of Mr Joffe that this basis for the strike out application in respect of D2 (no participation in the audits) was raised for the first time in Mr Lai’s written submission dated 21 February 2017 and was not specifically mentioned in either the Strike Out Summons or the first supporting affirmation of Yu dated 11 August 2016.  I also bear in mind the Practice Direction 19.1 at §5 which says that the grounds for striking out ought to be clearly stated.

48.  However, I am satisfied that in the event the plaintiffs had not suffered any prejudice because of the late disclosure of this ground about D2. This is because the one day originally reserved for the hearing on 24 February 2017 was proved to be too optimistic as a result of the length and depth of the oral submissions and after that full-day of hearing the matter was adjourned part-heard to 1 March 2017.  During the interim, the plaintiff was able to file (without objection) an affirmation to deal with the position about D2[59]. Moreover, further materials (case authorities) were filed on 28 February 2017 on behalf of the plaintiff, some of those relating to the particular ground about D2.  On the resumed hearings, counsel had opportunity to address this court further on the issue. 

49.  As can be seen in the SOC, the only basis for the plaintiffs to sue D2 is stated at §5 where it is said that D2 is the “corporate practice successor of the 1^st Defendant, operating as a limited liability partnership”. From §5 onwards, D1 and D2 are collectively referred to as “the Auditors” throughout in the SOC without any distinction.  There are therefore no specific assertions made by the plaintiffs in the SOC as to what D2 had done by itself which give the plaintiffs a cause of action against it.

50.  As aforesaid, the plaintiffs’ case against the defendants is about their alleged negligence in relation to the audits of the plaintiffs’ accounts for the financial years starting in 2014 and ended in 2010.  The first auditor report (of P1) was signed off by D1 on 21 July 2006[60] and the last audit reports were signed off by D1 on 14 April 2011 (P1)[61] and 31 March 2011 (P2)[62] respectively.

51.  There is now before the court uncontroverted evidence, in the form of a Certificate of Incorporation, that D2 only came into being on 3 January 2011.  There is also undisputed evidence from the plaintiffs, in the form of audit reports exhibited to Fok’s 1^st Affirmation[63], that all the audit’s reports[64] relied upon by the plaintiffs for the present action were signed by D1, not D2. 

52.  It is plain that as a matter of law, D2, which is a separate legal entity from D1, could not possibly have done anything for the plaintiffs prior to its came into being on 3 January 2011.

53.  As to the situation after the incorporation of D2, there is the assertion of the plaintiffs in the SOC that:

“ 8. The Auditors were engaged as the auditors of [P1] and [P2] for the financial year ended 31 March 2005 onwards until 31 March 2010.”

This assertion raises a factual issue as to whether D2 had performed any service for the plaintiffs in 2011 in spite of the fact that the last audit reports of the plaintiffs were not signed off by D2. 

54.  In my view that the assertions in the SOC leave open an implicit case of D2 having assisted D1 in the audit work in 2011 which is legally possible. That implicit case is also factually possible as the marketing material of D2 (exhibited to Fok’s 3^rd affirmation) shows that there had not been any change of personnel of the practice before and after incorporation.  There is also some evidence that D1 had only become dormant a few years after D2 came into existence.  

55.  It may be that the aforesaid implicit case is not a particularly strong one.  Nevertheless, in my humble view it is not one which can be struck out now. It would be a matter for D2, if they are of the view that the aforesaid implicit case has not been adequately pleaded with clarity, to consider whether to seek further and better particulars in due course.  It is simply pre-mature at this stage for the application for striking out to be made on this ground in respect of D2. 

CONCLUSION

56.  Based on all of the above, I am not satisfied that the plaintiffs’ case against the defendants should be struck out.  The defendants’ application is therefore dismissed.

57.  I make an order nisi that the plaintiffs have the costs of this application, to be taxed if not agreed.

58.  It only remains for me to thank counsel for all of their valuable assistance.