Not Much Remedy Available For Shareholders Against Auditors When Things Go Wrong

Corporate Commercial Law
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Following the infamous demise of VBS Mutual Bank, one of its shareholders Dyambeu Investments is reported to be mounting a lawsuit against KPMG, the erstwhile auditors of VBS Mutual Bank.

Dyambeu contends that relying on the banks financial statements prepared and signed off by KPMG, the company believed that its shares held in VBS Mutual Bank were of a significant value and thus did not sell them when the opportunity to do so arose, as they regarded it as a good investment.

Many a shareholder takes comfort in the fact that the companies in which they invest big or small are audited as required in terms of the Companies Act and the JSE Listing Requirements in the case of listed companies. Often, the track record of the auditors and the more well established they are, the more reliance is given by shareholders. It is for this reason that the South African auditing market is dominated by a few players who originate from overseas.

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Our courts have recently pronounced on the fate of shareholders who have instituted legal actions arising of what some of have dubbed the biggest corporate scandals of all times in South Africa.

The Johannesburg High Court recently thwarted the damages claims brought by shareholders of Steinhoff. Shortly thereafter, the Supreme Court of Appeal dealt a similar blow to the empowerment shareholders of African Bank who held their shares through the bank’s holding company, African Bank Limited (ABIL), a JSE listed entity.

In both Steinhoff and ABIL’s cases, the courts dismissed the shareholders claims for diminution of share value, endorsing a long-standing company law principle loosely referred to as the Foss v. Harbottle rule. The Foss v. Harbottle rule arises from an old English company law case decided in the Court of Chancery in 1843. This is company law principle that a company is separate from its shareholders and thus any losses that it may suffer are its alone. To the extent that its shareholders also suffer losses indirectly by the diminution or devaluation of their shares, the shareholders losses are regarded and termed as reflective losses, also referred to as indirect or second-degree losses.

In both the Steinhoff and the ABIL cases, the shareholders mounted damages claims against the directors and auditors of the respective companies. 

The two cases were dismissed by the Courts in their infancy. In the case of Steinhoff the case faltered at the stage where the shareholders with the assistance of litigation funders sought to obtain certification to launch a class action on behalf of shareholders, a preliminary step towards a full class action case. 

In both the Steinhoff and ABIL cases the shareholders sought relief against the auditors of the company in like manner as Dyambeu is now reported to be suing KPMG. 

The shareholders contented that had it not been for what they regarded to be credible auditors’ reports, they would not have suffered losses by the diminution of their share value. Bearing in mind that in both instances the shareholders held their shares at the holding listed entities, their claims, in line with the reflective value principle where of a second or third degree given that the operating companies are a few ladder rungs below the holding companies that are listed on the JSE.

In both cases the claims against the auditors were dismissed primarily on the basis that the auditors owe their professional responsibility to the companies and not to the shareholders of the companies in line with the Foss v. Harbottle rule. 

Citing previous Supreme Court of Appeal cases, the judges found that in general, auditors have no duty to third parties, in this case the shareholders with whom they have no relationship but they owe their duty to the company that they audit.

If the auditors perform their work negligently, it is the company and not its shareholders that is the proper plaintiff to sue for any loss caused to it by the negligence of its auditors.

When auditors produce reports regarding the company’s financial statements, individual shareholders do not have claims against the auditors because financial statements are not prepared for the benefit of shareholders individual investment decisions.

Once again relying on previous case law, the court found that imposing a legal duty on auditors in circumstances similar to the ABIL’s case such decision will raise spectre of indeterminate liability. In other words, the court sought to prevent a floodgate of claims that may visit auditors from shareholders bearing in mind that shareholders may have a long list of indirect shareholders behind them.

In the ABIL case the shareholders also sought to rely on the provisions of section 46 of the Auditing Professions Act, which entitles third parties who incur losses suffered as a result of having relied on opinions expressed by auditors pursuant to a negligent performance of duties by a registered auditor.

Section 46 did not assist the ABIL empowerment shareholders because of a rider contained in section 46 which provides that any action against and registered auditors will not only arise as a result of section 46 but can only be enforced if there is other basis in law for a third party to claim damages. Thus, the ABIL shareholders could not succeed against the auditors as the court had found that they are not entitled to claim reflective losses in the first place.

These important court decisions do well to protect the auditors from potential liabilities by shareholders of companies that they audit but they are cold comfort for shareholders who rely on the fact that their companies are audited by auditors with good reputations.

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Auditors Liability,Shareholders Remedy
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