LEUNG ALFRED CHEUK WAH v. ERNST & YOUNG LLP, CHINA/HONG KONG AND OTHERS

HCA 390/2005

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO. 390 OF 2005

____________

____________

______________

J U D G M E N T

______________

Introduction

1.  This is an appeal by the Plaintiff against an order of Master Ho dated 30 March 2006 whereby he struck out the Plaintiff’s claim against the 1^st Defendant on the basis that the statement of claim discloses no reasonable cause of action and/or that it is scandalous, frivolous or vexatious.

2.  The 1^st Defendant, an internationally known accountancy practice, had audited the financial statements of the 2^nd Defendant for the years ended 2001 and 2002.  It had also been engaged to act as the reporting accountant in respect of its application to list its shares on the Hong Kong Stock Exchange.  Following its listing the Plaintiff, as a private investor, purchased the 1^st Plaintiff’s shares in August 2002 following which, for him, he suffered catastrophic losses as the 2^nd Defendant’s share price fell very sharply.  What had caused this fall in the share price was that it had been fraudulently operated by a number of its directors, being the 3^rd to the 8^th Defendants in the action.  The 2^nd Defendant, in fact, had no substance.  The directors had succeeded in masking these facts from its previous auditors as well as from the 1^st Defendant, although the Plaintiff does not accept this for one moment, as I will need to relate presently.

3.  Put shortly, the Plaintiff has now lost his entire investment of $427,800.  He had purchased, between August and October 2002, a total of $4.6 million shares at an average price of $0.093 per share.  This was the value of his investment on 16 December 2002 when the stock market authorities suspended trading in the 2^nd Defendant’s shares.  Once the enormity of the deceit was uncovered the price was reduced to nothing, resulting in a total loss for the Plaintiff and for all of the investors which, he calculates to be $101.28 million.

4.  The Plaintiff’s claim is to recover the loss of $427,800 in addition to which he claims $500,000 for emotional damages and a further $5 million as punative damages, making a total of $5,927,800.

5.  It is right to say that at a very early stage the ICAC became involved and arrests followed.  These were of the six directors who are Defendants in this action as well as some members of the 1^st Defendant’s staff who were subsequently released without charge.  The directors were charged, prosecuted and convicted but those convictions were subsequently overturned on appeal and they are currently being re-tried in the High Court.  Of the 1^st Defendant’s staff the ICAC investigators have exonerated them of any wrongdoing and it is right to say that some are currently prosecution witnesses in the trial of the other Defendants.  By way of emphasis, Mr Coleman SC, who appears for the 1^st Defendant, says that not only have his client’s staff not been charged they are also not under any immunity or partial immunity in giving their evidence for the prosecution.  What he gets from all of this is that it must be plain to the prosecuting authorities that there is no evidence to suggest that they were in anyway complicit in the allegedly fraudulent activities of the 2^nd Defendant’s directors.

The nature of the claim against the 1^st Defendant

6.  The case is that the 2^nd Defendant’s accounts were false in every material respect and thereby presented a completely unreal picture of its financial position.  The particular accounts that are relied on are those for the years ended 1998 to 2000 inclusive and for the seven months ended the 31 October 2000.  This is much aggravated by the fact that the 1^st Defendant, who prepared the last two sets of accounts, incorporated all of these accounts into its accountant’s report for the 2^nd Defendant’s prospectus of 30 March 2001.  This prospectus was prepared for the purposes of the 2^nd Defendant’s application to be listed on the Stock Exchange.  The Plaintiff says that this prospectus must have carried much weight with the investing public who would have been impressed by the apparent financial well-being of the 2^nd Defendant and fortified by the fact that this position was being endorsed by the 1^st Defendant, an auditor of international repute.  What I think he wishes to say is that whilst it is bad enough for a private company to put forward false audited accounts it is quite another matter, in terms of gravity, for a would-be public company to mislead the investing public by such means.

7.  The allegations that he makes against the 1^st Defendant and its staff is that it was seriously negligent in the conduct of its audit of the accounts that it actually audited.  It failed to identify a number of irregularities in the 2^nd Defendant’s accounts which were created by the alleged fraud committed by some of its directors.  Negligence is the least serious of the Plaintiff’s allegations against the 1^st Defendant.  He also suggests that the audit itself was fraudulent in that an unidentified partner of the 1^st Defendant conspired with other Defendants and endorsed financial misstatements in the 2^nd Defendant’s accounts so as to defraud the investing public.  This is a far more serious way putting the case which is to the effect that the 1^st Defendant through one of its partners had become aware of the false accounting position and despite this was prepared to say that this was the true accounting and financial position.

The 1^st Defendant’s case

8.  On a strike out application such as this I am required to take the Plaintiff’s pleaded case at face value unless it is plain that the facts relied on or any part of those facts are obviously unsustainable.  One obvious error is that, contrary to the plea that the 1^st Defendant audited the 2^nd Defendant’s accounts for the years 1998 to 2000 inclusive, it only audited the accounts for the years ended 2001 and 2002.  Its other appointment was as the reporting accountant in respect of its application to list its shares on the Hong Kong Stock Exchange and it was in that capacity that the audited accounts for the previous years that I have referred to were included in the 2^nd Defendant’s prospectus.

9.  There are two affirmations by Mr Kevin Wong, a partner in the 1^st Defendant [pages 19-26 and 48-53 of the Bundle], which speak to the fact that all the accounts audited by the 1^st Defendant were done in accordance with the Auditing Guidelines issued by the Hong Kong Institute of Certified Public Accountants, as were the additional procedures that it needed to carry out as the Prospectus and Reporting Accountant in preparation for the application to list on the Stock Exchange.  Such matters, whilst crucial at the trial of this action, if the matter was to reach that stage, cannot assist on a strike out application such as this.

10.  A fact that is not in dispute, which I am entitled to have regard to, is that at no time, either as auditor or reporting accountant, did the 1^st Defendant or its staff have any dealings, contact or relationship with the Plaintiff nor did it have any knowledge that he might consider purchasing shares in the 2^nd Defendant or that he would consider doing so without seeking independent advice.

The purpose of the prospectus

11.  I will in due course have to refer to a number of authorities which establish the status in law of a company prospectus and the duties that arise upon its publication and to whom that duty arises.  In this instance, the purpose of the prospectus was to set out the terms of the offer made by the 2^nd Defendant to the investing public as well as to professional and institutional investors by providing relevant and appropriate information about the company.  The prospectus is a page 83 of the Bundle.  It states that applicants for shares were required to lodge the prescribed application forms on or before 4 April 2001.  A point that Mr Coleman seeks to make is that the prospectus and the information in it was not there for the purpose of being relied on by the public to purchase shares in the market once the company had been floated on the Stock Exchange.

The Plaintiff’s purchase of shares

12.  The Plaintiff purchased his shares between August and October 2002 which was after the publication of the financial accounts audited by the 1^st Defendant for the year ended March 2001 on 26 July 2001, and the year ended March 2002 on 25 July 2002.

The Principles — Order 18 r. 19 RHC

13.  Mr Coleman accepts, as he must, that he faces a stern challenge.  It is asking a lot to drive a Plaintiff from the judgment seat at this earliest possible stage in the action.  Such an order can only go in plain and obvious cases where on his pleaded case, accepting the facts at face value, the Plaintiff’s case is plainly unsustainable.  It is this which Mr Coleman contends for.  It is helpful to divide the Plaintiff’s claim into its constituent parts and to consider whether, taking the pleaded facts at their highest, the Plaintiff is bound to fail.

Negligent misstatement

14.  In this regard it is helpful to consider the duty of an auditor.  The principle by which a claimant may be able to succeed in claiming damages from a negligent misstatement has been correctly stated by Mr Coleman at paragraph 21 of his written argument.  A Plaintiff must plead and prove, not only that the loss for which compensation is claimed was caused by the Defendant’s breach of duty owed to the Plaintiff and was foreseeable, but also that the claim arose from a transaction or class of transactions that was within the contemplation of the Defendant at the time that he undertook the relevant duty and for the purpose of which he provided his services.  It is therefore incumbent upon the Plaintiff to show that the Defendant had in contemplation the transaction by which the claimant suffered loss in order for the Defendant to have assumed a duty to exercise due care and skill to protect the Plaintiff from the loss that resulted from it.

15.  The leading case in relation to whom an auditor owes his duty of care is the decision of the House of Lords in Caparo Industries plc v Dickman and Ors [1990] 2 AC 605.  The headnote to the report at pages 606C to F and 606H to 607A sufficiently sets out the court’s approach when faced with such a situation.  The case itself concerned a public company which had taken over another such company.  It brought an action against its directors alleging fraudulent misrepresentation against its auditors claiming that they were negligent in carrying out the audit and making their report which they were required to do under certain sections of the Companies Act 1985.  On the trial of a preliminary issue against the auditors, the judge held that the auditors did not owe the Plaintiffs’ a duty of care at common law, either as a shareholder of the company that it had taken over or as an investor holding its shares.  The Court of Appeal held that a duty of care was owed to the Plaintiff as shareholder but not as investor.  The House of Lords allowed the auditor’s appeal.

“… that liability for economic loss due to negligent mis-statement was confined to cases where the statement or advice had been given to a known recipient for a specific purpose of which the maker was aware and upon which the recipient had relied and acted to his detriment; that since the purpose of the statutory requirement for an audit of public companies under the Act of 1985 was the making of a report to enable shareholders to exercise their class rights in general meeting and did not extend to the provision of information to assist shareholders in the making of decisions as to future investment in the company, and since, additionally, thee was no reason in policy or principle why auditors should be deemed to have a special relationship with non-shareholders contemplating investment in the company in reliance on the published accounts, even when the affairs of the company were known to be such as to render it susceptible to an attempted take-over, the auditors had not owed any duty of care to the plaintiffs in respect of their purchase of F. Plc.’s shares (post, pp. 621D-G, 623D, 626C-E, …

…

Per Lord Bridge of Harwich, Lord Roskill, Lord Ackner and Lord Oliver of Aylmerton.  Whilst recognising the importance of the underlying general principles common to the whole field of negligence, the law has now moved in the direction of attaching greater significance to the more traditional categorisation of distinct and recognisable situations as guides to the existence, the scope and the limits of the varied duties of care which the law imposes (post, pp. 618C-D, 628D-F, 629E, 633E-G, 635B-C).

Dicta of Brennan J in Sutherland Shire Council v. Heyman (1985) 60 A.L.R. 1, 43-44 considered.”

16.  At page 623D-F, Lord Bridge of Harwich drawing support from the dissenting judgment of Denning LJ in Candler v Crane Christmas & Co. [1951] 2 KB 164, 179, 180-181, 182-184 concluded that auditors did not owe a duty of care to members of the public at large.

“These considerations amply justify the conclusion that auditors of a public company’s accounts owe no duty of care to members of the public at large who rely upon the accounts in deciding to buy shares in the company.  If a duty of care were owed to widely, it is difficulty to see any reason why it should not equally extend to all who rely on the accounts in relation to other dealings with a company as lenders or merchants extending credit to the company.  A claim that such a duty was owed by auditors to a bank lending to a company was emphatically and convincingly rejected by Millett J. in A1 Saudi Banque v. Clarke Pixley [1990] Ch. 313.  The only support for an unlimited duty of care owed by auditors for the accuracy of their accounts to all who may foreseeably reply upon them is to be found in some jurisdictions in the United States of America where there are striking differences in the law in different states.  In this jurisdiction I have no doubt that the creation of such an unlimited duty would be a legislative step which it would be for Parliament, not the courts, to take.”

17.  This decision was followed by Evans-Lombe J in the case of Barings plc v Coopers and Lybrand (2002) 2 BCLC 364.  This was litigation that followed the fall-out from the activities of the rogue trader Nicholas Leeson resulting in the collapse of Barings Bank.  The judge’s conclusions are well summarized in the headnote at pages 365 and 366.

“  (1)  Where a claimant claimed damages in tort flowing from a negligent misstatement he was required to plead and prove not only that the loss for which compensation was claimed was caused by the defendant’s breach of duty to the claimant and was foreseeable, but also that the claim arose from a transaction or class of transactions that was within the contemplation of the defendant at the time he undertook the relevant duty and for the purpose of which, inter alia, he provided his services, and further, that the claimant relied on those services for the purpose of that transaction.  Accordingly, the claimant had to establish that the defendant had in contemplation the transaction by which the claimant suffered loss in order for the defendant to have assumed a duty to exercise due care and skill to protect the claimant from the loss resulting from it, either because the defendant had been directly informed that the claimant either would or was likely to embark on the transaction in reliance on his advice or other statement or that, from the surrounding circumstances of the case, it could be inferred that he knew of the transaction and the reliance.  ‘Knowledge’ on the part of the defendant embraced not only actual knowledge but such knowledge as would be attributed to a reasonable person placed in the defendant’s position but in both cases the claimant was required to plead the circumstances on the basis of which he alleged that the defendant knew of the intended transaction of the claimant and his reliance on the defendant for the purpose of it.  Caparo Industries plc v Dickman [1990] BCLC 273 applied.

   (2)  Accordingly, in the case of a claim in tort against an auditor the claimant had to plead and prove, in addition to a relationship between the auditor and the claimant capable of giving rise to a duty of care and that the loss flowing from the auditor’s breach of that duty was caused by the auditor’s negligent report and was foreseeable, that, at the time he undertook those services, the auditor had in contemplation that they would be relied on by the claimant for the purpose of a particular transaction or class of transactions that was likely to result and that the claimant had, in fact, relied on the auditor’s report when embarking on such transaction which resulted in the loss for which compensation was claimed.”

18.  I also need to refer to one further case which is Al-Nakib Investments (Jersey) Ltd v Longcroft [1990] 3 ALL ER 321.  Mervyn Davies J was faced, like me, with a strike out application in a case where a prospectus had been issued inviting the subscription of shares by way of a rights issue.  The prospectus and an interim report contained material misrepresentations.  The Plaintiff purchased shares through the rights issue but it also subsequently purchased shares on the stock market relying on the statement in the prospectus and in the interim report.  The judge held, relying on Caparo Industries plc v Dickman, that;

“Although directors of a company owed a duty of care to prsons who subscribed for shares in reliance on a prospectus they did not owe a duty of care to a shareholder or anyone else who relied on the prospectus for the purpose of deciding whether to purchase shares in the company through the stock market, because the prospectus was addressed to shareholders for the particular purpose of inviting a subscription for shares and if it was used by a shareholder for the different purpose of buying shares in the stock market there was not a sufficiently proximate relationship between the directors and the shareholder for a duty of care to arise on the part of the directors.  It followed that any reliance on the part of the plaintiff on the prospectus or the interim report issued by the company in connection with a rights issue to buy shares in CT plc and M Ltd in the stock market did not give rise to a duty of care on the part of the defendants.  It followed that the claims in the statement of claim arising out of transactions 2 to 6 would be struck out on the grounds that they disclosed no reasonable cause of action (see p. 327 f to h and p. 329 bc post)”

Conclusion

19.  It seems to me that the Plaintiff, who has researched and argued his case with great skill and commitment must be in great difficulty.  What he is really doing is arguing for a change in the law to afford greater protection to potential investors in companies listed on the Stock Exchange.  What he seeks is the sort of consumer protection which is available in some of the state jurisdictions of the United States, which Millett J (as he then was) in Al Saudi Bank v Clarke Pixley (1990) Ch 313 had referred to.  That position has not been arrived at in Hong Kong.  I am satisfied that the cases  which Mr Coleman has referred me to represent the current state of the law in our jurisdiction with the consequence that the Plaintiff must find himself, on the pleaded facts, in the position of being owed no duty of care by the 1^st Defendant as auditors and reporting accountants of the 2^nd Defendant.  His action therefore is doomed to fail and this being the position the 1^st Defendant is entitled to have it struck out in its entirety.

20.  The Plaintiff is simply not in the class of person to whom a duty of care is owed and he seeks to sue on a prospectus that was not prepared for nor intended to create any duty of care in respect of investors in the company after the 2^nd Defendant had been floated on the stock market.  Much as his losses and their consequences are to be regretted, I am left with no alternative but to dismiss his appeal with an order nisi that he should pay the 1^st Defendant its costs on a party and party basis.