Auditors' Liability to Third Parties: An emerging defence – Part I

Interesting policy issues arise when auditors of corporations whose management has fraudulently misrepresented the company's financial statements find themselves defending claims brought on behalf of the corporation by entities such as trustees, receivers, and liquidators. The question then becomes: should the corporation, or those standing in its shoes, be able to rely on the company's own illegal conduct to recover damages? In the United States (U.S.), such claims are often met with the defence of in pari delicto.

Because a corporation can only act through its officers and directors, in pari delicto rests upon principles of agency and corporate attribution. Where the actions of officers and directors can be reasonably imputed or attributed to the corporation, it is not necessary to precisely weigh culpability; if the malfeasant acts of the officers and agents are equally or more responsible than those of the defendant auditors for the wrong upon which the claim is based, the defence of in pari delicto will bar the plaintiff's claim. In certain U.S. jurisdictions, this equitable defence is determined as a threshold issue and thereby allows for summary dismissal of a claim.

There is a distinction between fraud committed on behalf of a corporation and fraud committed against it. Therefore, an important exception has developed to this broad defence in the interests of fairness. Acts of officers or agents which can be said to be wholly adverse to the interests of the corporation are generally not attributed to it and in pari delicto does not apply. This is known as the adverse interest exception and is, itself, subject to certain exceptions. The sole act or exception to the adverse exception operates to attribute to the corporation the wrongful conduct of individuals who exercise such dominion over the corporation that their conduct can only be considered that of the corporation. The innocent decision maker exception to the adverse interest exception provides that the wrongful acts will not be attributed to the corporation where there were other innocent stakeholders who were unaware of the wrongdoing, since it would be unfair to punish them.

The in pari delicto defence is well-established in the U.S. in cases involving auditors; however, it remains novel in Canadian law.

In the United Kingdom, a related doctrine, ex turpi causa non oritur actio, has been recently invoked to provide auditors with similar protection. Both doctrines stem from the wider common law doctrine of illegality which, broadly speaking, will not allow a wrongdoer to benefit from his or her own illegal conduct. However, the doctrines are not identical. For example, unlike in pari delicto, ex turpi causa does not demand a prima facie weighing of the plaintiff's culpability. Culpability of the plaintiff, to whatever degree, is enough to bar a claim. By way of contrast, it is only where the claimant is equally or more culpable than the defendant that in pari delicto may provide a defence.

Although both in pari delicto and ex turpi causa are concepts familiar to Canadian law, they have yet to be applied meaningfully in the context of auditors' negligence law. However, as we discuss in a later blog, the Canadian courts are soon likely to articulate a position on in pari delicto/ex turpi causa.