HCA1035/2014 DAYS IMPEX LTD (in liquidation) AND ANOTHER v. FUNG, YU & CO (a firm) AND ANOTHER - LawHero
HCA1035/2014
高等法院（民事訴訟）Deputy High Court Judge Lee23/10/2017
HCA1035/2014
A A
HCA 1035/2014
B IN THE HIGH COURT OF THE B
HONG KONG SPECIAL ADMINISTRATIVE REGION
C C
COURT OF FIRST INSTANCE
D ACTION NO 1035 OF 2014 D
___________
E E
BETWEEN
F F
DAYS IMPEX LIMITED (in liquidation) 1st Plaintiff
G DAYS INTERNATIONAL LIMITED (in liquidation) 2nd Plaintiff G
H and H
I FUNG, YU & CO. (a firm) 1st Defendant I
(馮兆林余錫光會計師行)
J J
nd
FUNG, YU & CO. CPA LIMITED 2 Defendant
K (馮兆林余錫光會計師事務所有限公司) K
L
___________ L
M Before: Deputy High Court Judge Lee in Chambers M
Dates of Hearing: 24 February and 1 March 2017
N N
Date of Judgment: 24 October 2017
O O
P
______________ P
JUDGMENT
Q Q
______________
R R
S S
T T
U U
V V
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A INTRODUCTION A
1. The 1st and 2nd plaintiffs (“P1” and “P2”) are two private
B B
companies incorporated in Hong Kong which are now in liquidation 1 .
C The 1st defendant (“D1”) was a firm engaged as the auditor of the plaintiffs C
between 2005 and 2011 2. The 2nd defendant (“D2”) was incorporated on
D D
3 January 2011 3 and is alleged to be the practice successor of D1 4.
E E
2. By a Statement of Claim (“SOC”) 5 dated 15 March 2016, the
F plaintiffs claim against the defendants for negligence in the audit work they F
performed for the plaintiffs. It is a major plank of the plaintiffs’ case that
G G
the defendants had breached their duty owed to the plaintiffs by signing off
H unqualified “clean” opinions on the status of the plaintiffs’ accounts and H
by failing to detect and report the massive import/export fraud which the
I I
controlling shareholder and director had caused the plaintiffs to commit.
6
J It is said that had the fraud been detected earlier and reported to the relevant J
authorities, the fraud would not have continued for so long and the
K K
plaintiffs’ losses would have been lesser . It is of note that the present
7
L L
action is brought (in the name of the plaintiffs by the liquidators) for the
M
benefit of the creditors and the liquidation generally. 8 M
N N
1
The petitions for winding up of the plaintiffs were filed on 14 September 2011 and the winding
up orders were made on 10 February 2012.
O 2
D1 was engaged as P1’s auditor since 2005 and as P2’s auditor since 2006. O
3
See D2’s Certificate of Incorporation: [C/11/486]
4
See [A/2/6/§5]
P 5
[A/2/5-34] P
6
Nanik Dayaram (“the father”), who was the head of the family and the Days Group to which P1
and P2 belonged. The father indirectly controlled 99.99% of P1’s shares (the remaining 0.01%
Q Q
shares were held by his wife and his son) and 100% of P2’s shares. He was also a director of
both P1 and P2. See Annex 1 and Annex 2 of the SOC for a summary of the shareholding and
directorships: [A/2/31]
R R
7
The father and his son, Mahesh, were convicted of various counts of conspiracy to defraud and
each was sentenced to 10 years’ imprisonment (HCCC 2/2014): [C/7/69-72]. The conviction
appeal by them was dismissed, the sentence appeal having been abandoned (CACC 274/2015):
S S
[C/12/487]
8
The primary victims of the fraud were the banks which advanced the loans. According to
written submission of the plaintiffs, the losses are estimated at HK$200 million to HK$250
T T
million. The amount of damages attributable to the alleged negligence, however, may be
different.
U U
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A A
3. The defendants have yet to file any defence. By a Summons
B dated 12 August 2016 9, however, they seek to strike out the SOC in its B
entirety on the following grounds:
C C
(a) the SOC discloses no reasonable cause of action;
D D
(b) the SOC is an abuse of process for the following alternative
E reasons: E
(i) it is a fishing expedition;
F F
(ii) it has already been time-barred;
G G
(iii) it is attempt for the plaintiffs to sue on reliance of their
H
own illegality; H
(iv) it would lead to a circuity of action because of the
I I
defendants’ right to set-off or counterclaim; and
J (c) it is devoid of particulars and also bound to fail. J
K K
THE ISSUES
L L
4. Mr Lai, counsel for the defendants, re-organizes the defendants’
M aforesaid grounds stated in the Summons and focuses his submission on M
the following issues:
N N
(A) whether the alleged breaches by the defendants falls outside
O O
their scope of duty of care as auditors;
P (B) whether there is an absence of factual causation between the P
alleged breaches and the plaintiffs’ loss;
Q Q
(C) whether there is an absence of legal causation between the
R alleged breaches and the plaintiffs’ loss; R
S (D) whether the plaintiffs’ claim offends the principle of ex turpi S
causa non oritur actio;
T T
9
[A/3/35-38]
U U
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A A
(E) whether there would be a circuity of action; and
B B
(F) whether any part of the plaintiffs’ claim has already been time-
barred.
C C
D 5. In respect of D2, Mr Lai highlights the fact that it had not even D
been incorporated prior to 2011 and it had not signed off any of the auditor
E E
reports of the plaintiffs. On that basis, it is submitted that there is no
F factual or legal basis to hold D2 liable. F
G G
LEGAL PRINCIPLES FOR STRIKING OUT
H H
6. There is no dispute about the legal principles for striking out
I and they can be summarized as follows 10: I
J (1) it is only in a plain and obvious case that the Court should J
exercise its summary powers to strike out a pleading or writ;
K K
(2) the claim must be obviously unsustainable, the pleadings
L unarguably bad and it must be impossible, not just improbable, L
for the claim to succeed before the Court will strike it out;
M M
(3) there should be no trial on affidavits; disputed facts are to be
N taken in favour of the party sought to be struck out; N
O (4) the mere fact that a case is weak and not likely to succeed is O
no ground for striking it out;
P P
(5) the jurisdiction should not be exercised if it requires a minute
Q and protracted examination of the documents and facts of the Q
case in order to see whether the plaintiff really has a cause of
R action; where an application to strike out involves a prolonged R
and serious argument, the Court should, as a rule, decline to
S S
proceed with the argument;
T T
10
Hong Kong Civil Procedure 2018, Vol 1, para 18/19/4
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A A
(6) the Court should not decide difficult points of law in striking
B out proceedings and the Court is loathe to strike out a case that B
involves an area of law which is in the process of developing.
C C
That said, questions of law can be determined in strike out
D applications provided that they are crucial and the Court has D
all the relevant facts before it and these facts are certain;
E E
(7) it is for the party seeking to strike out a pleading or writ to
F demonstrate that the case is a plain and obvious one in which F
the other party’s claim is bound to fail;
G G
(8) however, where the Court comes to the conclusion after full
H argument that the case is plainly and obviously one for H
striking out it should not decline to do so on the ground that
I I
the issues are difficult or complicated.
J J
CONSIDERATION
K K
7. The affirmation evidence filed for the present application
L consists of: L
M (i) three affirmations made by Fok Hei Yu on behalf of the M
plaintiffs 11; and
N N
(ii) one affirmation made by Yu Leung Fai on behalf of the
O defendants 12. O
P The affirmations give the background facts of this case, outline the P
respective cases of the parties, update the debts owed by the plaintiffs and
Q Q
provide information about the incorporation and practice of D2. I have
R regard to all of the affirmations and the documents exhibited thereto. R
S S
11
Dated respectively 5 December 2016, 20 February 2017 and 27 February 2017: see [B/51];
T [A/38-3]; and [A/38-12] T
12
Dated 11 August 2016: see [B/42]
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A A
8. The arguments between the parties are mainly on law
B including but not limited to the scope of auditor’s duty, attribution and B
illegality and causation. This court has received lengthy and in-depth oral
C C
and written submissions from Mr Lai on the one hand and Mr Joffe (and
D with him, Ms Lam), counsel for the plaintiffs, on the other. I note that D
Mr Lai’s written submission runs up to 38 pages together with 3 volumes
E E
of case authorities, whilst Mr Joffe’s written submissions runs up to 66
F pages together with 6 volumes of case authorities. The hearing of the F
application lasted for about one day and a half. For all of the above, I am
G G
greatly indebted.
H H
(A) Scope of auditor’s duty and sufficiency of pleadings
I I
9. In summary, Mr Lai submits under these heads the following:
J J
(1) the loan transactions entered into by the plaintiffs were not
K K
something the defendants were under a duty to advise. They
were loan transactions concluded by the father and son, in the
L L
exercise of their de jure or de facto control over the plaintiffs;
M M
(2) it is not pleaded that the loan transactions were subject to
N
approval of the members of the plaintiffs and therefore the N
defendants were not under duty to advise on the merits of the
O loan transactions; O
P
(3) it is not pleaded (a) that reliance would be placed by the P
plaintiffs on the defendants’ audit opinions when entering into
Q the loan transactions; and (b) that such reliance was known to Q
the defendants. Accordingly, D1 could not be said to have
R R
assumed a specific duty of care in relation to the loan
S transactions; and S
T T
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A A
(4) it is not pleaded that the members of the plaintiffs, to whom
B the defendants are said to have owed duty as a collective body, B
would have acted differently had the true picture been
C C
revealed.
D D
10. In my view, Mr Lai’s aforesaid submissions entail the following
E preliminary questions which should first be addressed, namely (i) whether E
the defendants’ role as auditor should be characterized as just provision
F F
information and advice ; (ii) whether an auditor owes a duty to his client
13
G G
company to prevent the latter from entering into questionable loan
H
transactions 14 ; (iii) how and to what extent (if any) the interests of the H
creditors should be factored into the scope of duty of an auditor when his
I I
client company is in an insolent situation; and (iv) whether any resultant
J loss to the plaintiffs would have been inevitable even if there had not been J
any breach of duty, given that the fraudsters were themselves the
K K
controlling directors and shareholders of the plaintiffs and were not relying
L on the accuracy of the defendants’ advice. 15 L
M 11. As to (i), the stance of Mr Joffe is that: M
N (a) the defendants had a duty to plan and perform the audit so as N
to enable them to detect material misstatements, errors and so
O O
forth which would in this case have led to the detection of
P fraud; and P
(b) upon detection of the material misstatements / fraud, the
Q Q
defendants had a duty to report the fraud not only to the
R companies themselves but also to the appropriate authorities. R
S S
13
See §31 and §39(1) and (2) of Mr Lai’s written submission
T 14
Ibid, at §28 T
15
Ibid, at §39(3) and (4)
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A A
12. In considering the defendants’ scope of duty as auditors, I
B have regard to what Lord Bridge said in Caparo Industries Plc v Dickman 16: B
C “ … It is never sufficient to ask simply whether A owes B a duty C
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
D D
care to save B harmless.”
E E
As Lord Oliver said in the same case 17:
F “ The question is always whether the defendant was under a duty F
to avoid or prevent that damage, but the actual nature of the
G
damage suffered is relevant to the existence and extent of any G
duty to avoid or prevent it.”
H H
Moreover, the same point was made by Lord Hoffmann in South Australia
I Asset Management Corp v York Montague Ltd, United Bank of Kuwait plc I
v Prudential Property Services Ltd, Nykredit Mortgage Bank plc v Edward
J J
Erdman Group Ltd 18 where his lordship said:
K K
“ … Before one can consider the principle on which one should
calculate the damages to which a plaintiff is entitled as
L compensation for loss, it is necessary to decide for what kind of L
loss he is entitled to compensation. A correct description of the
loss for which the valuer is liable must precede any consideration
M M
of the measure of damages. For this purpose it is better to begin
at the beginning and consider the lender’s cause of action.
N … N
A duty of care such as the valuer owes does not, however, exist
O in the abstract. A plaintiff who sues for breach of a duty imposed O
by the law (whether in contract or tort or under statute) must do
P more than prove that the defendant has failed to comply. He P
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.”
Q Q
R R
S S
16
[1990] 2 AC 605, at 627D
T 17
Ibid, at 652, quoting Brennan J in Sutherland Shire Council v Heyman (1985) 60 ALR 1 at 48. T
18
[1996] 3 All ER 365 at 369g and 370e
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A A
13. Having considered the submissions from both sides, I am
B unable to accept that an auditor’s duty is as narrow as to be restricted to the B
provision of information and advice, but may extend to detecting material
C C
irregularities in the company’s accounting statements. See Barings v
D Coopers & Lybrand 19 in which Leggatt LJ said: D
E
“ The primary responsibility for safeguarding a company’s assets E
and preventing errors and defalcations rests with the directors.
But material irregularities, and a fortiori fraud, will normally be
F brought to light by sound audit procedures, one of which is the F
practice of pointing out weaknesses in internal controls. An
G auditor’s task is to conduct the audit as to make it probable that G
material misstatements in financial documents will be detected.
Detection did not occur here, and there therefore is a case for
H H
[the defendants] to answer.” (Emphasis supplied)
I I
14. Moreover, I also agree with Mr Joffe’s submission that in
J J
appropriate cases an auditor’s duty may even extend to reporting any fraud
K he detected during the course of his work for a client. Thus, in Sasea K
Finance Ltd v KPMG 20, it is said:
L L
“ If, for example, the auditors discover that a senior employee of a
M company has been defrauding that company on a grand scale, M
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
N N
management of the company at once, not simply, when rendering
the auditors’ report, to record what has been discovered weeks
O or months later. … O
The guidelines also acknowledge that there may be occasions
P P
when it is necessary for an auditor to report directly to a third
party without the knowledge or consent of the management.
Q Such would be the case if the auditor suspects that management Q
may be involved in, or is condoning, fraud or other irregularities
R and such would be occasions when the duty to report overrides R
the duty of confidentiality. Among the relevant considerations
would be the extent to which the fraud or other irregularity is
S S
likely to result in material gain or loss for any person or is likely
T 19
[1997] 1 BCLC 427, at 435h–i T
20
[2000] 1 All ER 676, at 681d–h and 682d–e
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A A
to affect a large number of persons and the extent to which the
non-disclosure of the fraud or other irregularity is likely to
B enable it to be repeated with impunity. B
…
C It is accepted for present purposes that it was KPMG’s duty to C
warn either the directors or some relevant third party of any fraud
D or irregularity likely to result in material loss to the company D
with a reasonable degree of promptitude. Why should that be?
The obvious and common-sense answer is that by so doing the
E E
company may be spared such losses.” (Emphasis supplied)
F F
15. The reference to “The guidelines” above is the Auditing
G G
Guidelines (Feb 1990 edn). There are similar guidelines applicable to
H
Hong Kong issued by the Hong Kong Society of Accountants. Of H
particular relevance are the following, all of which having been alluded to
I I
in the SOC and relied upon by the plaintiffs 21:
J J
(1) SAS 110: The Auditors’ Responsibility to Consider Fraud and
K
Error in the Audit of Financial Statements: K
“ 2. When planning and performing audit procedures and
L evaluating and reporting the results thereof, the auditors L
should consider the risk of material misstatements in the
M
financial statements resulting from fraud or error.” M
“ 57. When the auditors identify a misstatement resulting from
N
fraud, or a suspected fraud, or error, the auditors should N
consider the auditors’ responsibility to communicate
that information to management, those charged with
O governance and, in some circumstances, to regulatory O
and enforcement authorities.”
P P
(2) SAS 200: Planning
Q “ The auditor shall plan and perform an audit with professional Q
skepticism recognizing that circumstances may exist that cause
R
the financial statements to be materially misstated.” R
S S
T T
21
See Section D2 of the SOC: [A/2/9/§§17 – 23]
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A A
(3) SAS 240: Quality Control for Audit Work
B “ The auditor shall maintain professional skepticism throughout B
the audit, recognizing that possibility that a material misstatement
C
due to fraud could exist, notwithstanding the auditor’s past C
experience with the entity about the honesty and integrity of
management and those charged with governance.”
D D
E
16. Concerning the relevancy of guidelines issued by a E
professional body of accountants in relation to auditing standards expected
F F
of its members, the learned authors of Jackson & Powell on Professional
G Liability have the following to say 22: G
H
“ Although auditing standards do not directly have the force of law, H
compliance with them is powerful evidence that the auditor has
acted reasonably, whilst failure to comply without adequate
I explanation is powerful evidence to the contrary. There are two I
reasons why this is so. The first is that the FRC 23 is and the
J APB 24 was constituted under the aegis of the CCAB 25 and the J
standards accordingly represent the agreed view of all the major
professional bodies of accountants as to what constitutes good
K K
practice. The second is that the standards are given additional
status by the Companies Act, in that every auditor of the accounts
L of a company registered under the Companies Acts is required to L
belong to a RSB 26 …”
M M
17. In my humble view, the weight of the authorities is such that
N N
it is highly arguable that an auditor’s duty is more than just providing
O information and advice on his client’s financial statements. Moreover, O
I am inclined to the view that what is said in Sasea Finance about an
P P
auditor’s duty to “blow the whistle” is also apposite to Hong Kong.
Q Q
R R
S
22
8th ed of the work, at §17-092 S
23
Financial Reporting Council
24
Auditing Practices Board
T 25
Consultative Committee of Accounting Bodies T
26
Recognised Supervisory Body
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A A
18. As to (ii), it is important to note that the plaintiffs’ case,
B properly understood, is not that the defendants’ negligence lies in not B
advising the plaintiffs or their management to desist from entering into the
C C
questionable loan transactions. The plaintiffs’ case is that the defendants,
D as auditors, owed the plaintiffs a duty to detect and report fraud in the D
course of their auditing work, even to the relevant authorities if necessary,
E E
so as to avoid loss or further loss being caused to the plaintiffs. In this
F regard, it is said in Sasea Finance that 27: F
G “ … It is accepted for present purposes that it was KPMG’s duty to G
warn either the directors or some relevant third party of any fraud
H
or irregularity likely to result in material loss to the company H
with a reasonable degree of promptitude. Why should that be?
The obvious and common-sense answer is that by so doing the
I company may be spared such losses.” I
(Emphasis supplied)
J J
19. As to (iii), the issue is very much left open by case authorities.
K However, my attention has been drawn to Simpson, Professional Negligence K
and Liability, where it is said 28:
L L
“ Indeed, it will commonly be the case that a company’s claim
M M
against its auditors will be of benefit to its creditors (particularly,
but not exclusively, where the company is insolvent). An
N argument that the duties owed by the auditors are affected by N
whether the company is insolvent or near to insolvency, and
O
therefore the interests of the creditors require protection, is O
capable of being accommodated within the existing principles
applicable to the existence and scope of auditors’ duties, provided
P that the claim remains one by the company and for loss sustained P
by the company. …”
Q Q
In my humble view, in a case like the present one when the liquidators are
R R
acting primarily for the benefit of creditors the above proposition is at the
S very least arguable and should not be shut out by way of a striking out. S
T 27
Supra, at 681j – 682e T
28
Vol 2, §13.88.1
U U
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A A
20. As to (iv), whether a report to the relevant authorities of the
B fraud would have been effective in avoiding loss or further loss to the B
plaintiffs is a matter on which evidence would need to be heard and tested.
C C
Thus, the English Court of Appeal in Sasea Finance said 29:
D D
“ Finally, Mr Brisby submits that what KPMG had to report was so
grave that if independent directors failed to act quickly in such a
E way as to cut Fiorini and Parretti out of management then KPMG E
would have recognised that public interest demanded an approach
F to a third party, albeit after taking appropriate legal advice. Thus, F
Mr Brisby submits it is at least arguable that the influence of Fiorini
and Parretti would have come to an end before 28 September
G G
1990.
H As it seems to us, this is plainly an area in which evidence needs H
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
I I
relation to the efficacy of ‘whistle blowing’.”
J J
21. Returning to Mr Lai’s submissions under these heads, I am of
K the view that it is not to the point that the defendants were not under a duty K
to advise on the merits of loan transactions in question 30, as it is not the
L L
way in which the plaintiffs have put their case against the defendants.
M It is also not pertinent that the plaintiffs had not relied on the accuracy of M
the defendants’ advice before entering those loan transactions, as it is the
N N
plaintiffs’ case that the defendants’ alleged negligence lies in failing to
O detect and report the fraud to the relevant authorities 31. Lastly, the point O
is not whether the plaintiffs would have acted differently in the loan
P P
transactions. Rather, the point is whether the plaintiffs’ loss would have
Q been avoided or contained and this is a matter on which evidence needs to Q
be heard 32.
R R
S S
29
Ibid, at 684h – 685b
30
Submissions (1) and (2) above.
T 31
Submission (3) above. T
32
Submission (4) above.
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A A
22. As regards Mr Lai’s submission on the sufficiency of pleadings,
B with respect, it is based on the wrong footing by restricting the defendants’ B
scope of duty as auditors to just provision of advice. On the other hand,
C C
the plaintiffs’ SOC contains an extensive reference to auditing standards
D which include the duty to detect and report fraud. D
E E
23. Based on the above, with respect these grounds for striking
F
out are misconceived and have no merits. F
G (B) Factual causation G
24. Mr Lai’s submits that the defendants’ alleged breaches could
H H
not have factually caused the loan transactions to be entered into. Insofar
I I
as the plea that the fraud would have been arrested had the defendants
J
reported the matter to the “appropriate parties (including but not limited J
to Ps) ”, it is submitted that the plaintiffs have failed to specify who it is
K K
said to have been misled by the defendants’ audit opinion. Furthermore,
L it is submitted that, as a matter of pleading, the plaintiffs are obliged, but L
has failed, to identify what steps would have been taken had the report been
M M
made.
N N
25. With respect, Mr Lai’s aforesaid submission is again premised
O on the wrong footing that the defendants’ duty as auditors was limited to O
provision of an accurate advice in the auditor reports so that there could
P P
not be any factual causation when the plaintiffs did not in fact act on their
Q Q
advice before entering into the loan transactions in question. However,
R
as discussed above the plaintiffs’ case is based on the defendants’ failure to R
detect and report fraud when performing the auditing work for the plaintiffs.
S S
26. As submitted by Mr Joffe, the latter case has already been
T T
clearly pleaded in the SOC as follows:
U U
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A A
(1) After setting out the parties and background, Section D pleads
B the duties of the auditors, which include inter alia duties to B
detect and report fraud.
C C
(2) Section E identifies the material misstatements in the accounts
D as a result of the fraud. D
E
(3) Section F identifies the particular breaches and areas in which, E
had the work been properly carried out, the defendants would
F have been alerted to the material misstatements and hence the F
fraud.
G G
(4) Section G draws the conclusion that inter alia the defendants
H ought to have detected the material matters which would have H
pointed to the fraud, which should then have been reported to
I I
the plaintiffs and the appropriate authorities.
J (5) Based on the above, Section H pleads that loss and damage J
has been suffered by the plaintiffs. This is repeated in the
K K
Prayer.
L L
27. As regards Mr Lai’s point about the lack of particulars as to
M who are the “appropriate parties” to report to, the auditing standards set out M
that the fraud ought to be reported to “regulatory and enforcement
N N
authorities” and/or “directly to the third party”. The number of such
O regulatory and enforcement authorities are limited, namely the Stock O
Exchange, the Securities and Futures Commission and the Police. If there
P P
are any ambiguities in this regard, the appropriate application would be for
Q further and better particulars rather than a striking out. Q
R R
28. In my judgment, the plaintiffs have adequately pleaded their
S case in the SOC and this ground of the defendants for striking out has not S
been made out.
T T
U U
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A A
(C) Legal causation
B 29. Mr Lai submits that allowing a company to remain in existence B
does not, without more, cause losses from anything and that giving an
C C
opportunity to a company incur and to continue to incur trading losses does
D D
not cause those trading losses in the sense in which the word “cause” is used
E
in law. Reference is made to Alexander v Cambridge Credit 33, which was E
followed in Galoo v Bright Grahame Murray . 34
Based on the above,
F F
Mr Lai submits that:
G (1) the alleged failure on the part of the defendants to detect fraud, G
even made out, at most only provided an opportunity to the
H H
plaintiffs to sustain loss. It is insufficient to make out the
I legal causation; I
(2) if the plaintiffs’ acceptance of loan and/or giving security for
J J
such a loan is not loss, then the interest and bank charges
K (which flowed from taking out the loans) cannot conceivably K
be recoverable losses; and
L L
(3) the loans drawn by the plaintiffs were benefit to themselves.
M The interest and bank charge were necessary cost incurred by M
the plaintiffs in obtaining those benefits and such cost cannot
N N
be regarded as loss.
O O
P P
Q Q
R R
S S
T 33
(1987) 9 NSWLR 310 T
34
[1994] 1 WLR 1360, at 1374G– H
U U
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A A
30. In Galoo v Bright Grahame Murray, ante, a case which is
B heavily relied on by Mr Lai, it was held that the negligent audit certificate B
merely created the opportunity for the company to incur and continue to
C C
incur trading losses, the cause of the losses being the unsuccessful trading.
D However, Galoo was distinguished in Sasea Finance on the ground that, D
where the auditor’s duty was to draw attention to a fraud, he was responsible
E E
for the company continuing to trade fraudulently. The Court of Appeal in
F Sasea Finance said that the subsequent frauds were “the kind of transaction F
against the risk of which [the auditor] had a duty to warn” 35.
G G
H 31. I also have regard to the following legal principles and case H
authorities drawn by Mr Joffe to my attention:
I I
(a) it is well-established that negligence needs to be an “effective
J J
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”:
K K
Smith New Court Securities Ltd v Scrimgeour Vickers (Asset
L Management) Ltd 36; L
M
(b) it has been held that it would be inappropriate to strike out a M
claim against auditors where their actions cause the company
N to trade in a particular way and incur further losses and it is N
on this basis that Galoo is distinguished: Temseel Holdings
O O
Ltd v Beaumonts Chartered Accountants (A Firm) 37;
P (c) Galoo is also further distinguished where the allegation is that P
the auditors should have discovered and advised that the
Q Q
company was trading at a loss, and steps would have been
R taken accordingly to prevent further trading, the failure to do R
so has been determined to be capable of being an effective
S S
35
Supra, at 683e– f.
T 36
[1997] AC 254, at 284 – 285 T
37
[2003] PNLR 27, at §§52 – 57
U U
V V
- 18 -
A A
cause in previous cases: see Rushmer v Mervyn Smith (t/a
B Mervyn E Smith & Co) 38; and B
(d) once it is established that the auditors’ negligence or breach
C C
of duty was causative of the relevant loss, they remain liable
D not withstanding there may have been other causes of equal D
efficacy: WA Chip & Pulp Co Pty Ltd v Arthur Young & Co 39.
E E
F
32. Furthermore, subsequent authorities suggest that Galoo F
should not be understood as a case on causation. Thus, in Equitable Life
G G
v Ernst & Young 40 the English Court of Appeal had the following to say:
H H
“ Although Galoo was a case of summary disposal, the facts of the
case were idiosyncratic. Since, ex hypothesi, the company was
I insolvent, the losses suffered by continuing to trade were really I
suffered by the creditors (or by the company’s parent), and so,
J
although the case was not argued in that way, the real question J
may well have been whether the auditors owed any duty to the
creditors (see Lord Hoffmann’s lecture to the Chancery Bar
K Association, 15 June, 1999, Common Sense and Causing Loss, K
pp 22–23).”
L L
33. Based on the above, I agree with Mr Joffe that it is inapposite
M M
for the defendants to reply on the Galoo line of authorities to suggest that
N there is a causation defence. Rather the issue should be approached from N
the perspective of scope of duty.
O O
P 34. In conclusion, I am not persuaded that the SOC should be P
struck out on the ground that there is no legal causation.
Q Q
R R
S S
38
[2009] EWHC 94 (QB), at §73. I note that in that case the plaintiff failed on the facts.
However, that does not apply the legal proposition under consideration.
T 39
(1987) 12 ACLR 25 at 42 – 43; (1988) 13 ACLR 283 T
40
[2003] 2 BCLC 603, at §133
U U
V V
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A A
(D) Illegality
B 35. Mr Lai distills the following principles from the highly B
controversial case of Stone & Rolls Ltd v Moore Stephens 41 which he
C C
submits have not been undermined by subsequent cases:
D D
(1) the issue of attribution very much depends on context and
E purpose of the proceedings in question; and E
F
(2) in a “one man” company case, the controlling fraudster’s F
knowledge could be attributed to the company in an audit
G negligence claim against an auditor. G
H H
36. Mr Lai goes on and submits that the present case falls within
I the scope of Stone & Rolls on the plaintiffs’ own pleaded case in that: I
J (1) the fraudsters were effectively the only persons owning the J
plaintiffs 42;
K K
(2) all affairs of the plaintiffs were controlled by the fraudsters 43;
L (3) the plaintiffs were at all material times utilized as part of the L
fraud perpetrated by the fraudsters 44; and
M M
(4) accordingly, the plaintiffs should be similarly regarded as
N “one man” companies, and the fraudulent knowledge of the N
fraudsters should be attributed to the plaintiffs.
O O
Therefore, it is submitted that the plaintiffs are barred from taking advantage
P P
of their own wrongs and hence not entitled to sue the defendants.
Q Q
R R
S S
41
[2009] 1 AC 1391
42
The SOC, at §10.
T 43
Ibid, at §13. T
44
Ibid, at §29.
U U
V V
- 20 -
A A
37. With respect, I recognize the logic and force of Mr Lai’s
B aforesaid submissions. However, Stone & Rolls, which is the foundation B
of his submissions, is admittedly a difficult case about the interaction
C C
between the doctrine of attribution, the fraud exception 45 and the illegality
D defence, as each of the Law Lords had given differing reasons for the D
decision so that it is difficult, if not possible, to identify its ratio. Thus, it
E E
is said in the joint judgment of Lord Toulson and Lord Hodge JJSC in Bilta
F (UK) Ltd v Nazir (No 2) 46 that: F
G “ We conclude that Stone & Rolls should be regarded as a case G
which has no majority ratio decidendi.”
H H
More importantly, the decision in Stone & Rolls has been subject to such
I severe criticism that its value as a precedent has been very much I
undermined. Thus, the learned editors of Jackson & Powell on
J J
Professional Liability, summarise the current position in UK as follows : 47
K K
“ It is also now clear the directors of a company who have caused
L
it to be involved in a fraud cannot raise a defence of illegality to L
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
M was the result in Bilta UK Ltd v Nazir (No 2). As Lord Neuberger M
(with whom Lords Clarke and Carnwath agreed) explained:
N N
‘ Where a company has been the victim of wrongdoing by
its directors, or of which its directors had notice, then the
O wrongdoing, or knowledge, of the directors cannot be O
attributed to the company as a defence to a claim brought
P against the directors by the company’s liquidator, in the P
name of the company and/or on behalf of its creditors,
for the loss suffered by the company as a result of the
Q Q
wrongdoing, even where the directors were the only
directors and shareholders of the company, and even
R though the wrongdoing or knowledge of the directors R
S S
45
Re Hampshire Land [1896] 2 Ch 743 which stands for the proposition that the knowledge of
the fraudulent directors is not attributed to the companies.
T 46
[2016] AC 1, at §154 T
47
8th ed of the work, at §§17-104 to 17-105
U U
V V
- 21 -
A A
may be attributed to the company in many other types of
proceedings …
B B
whether or not it is appropriate to attribute an action by,
or a state of mind of, a company director or agent to the
C company or the agent’s principal in relation to a particular C
claim against the company or the principal must depend
D on the nature and factual context of the claim in question.’ D
This leaves open the question as to the availability of a defence of
E illegality to an auditor who is alleged to have negligently failed to E
detect a fraud being carried out through a ‘one-man’ company or
F equivalent. If it does not ‘produce inconsistency and disharmony F
in the law, and so cause damage to the integrity of the legal system’
[these principles will be discussed further below in E2] to allow
G G
the liquidator to claim against the ‘one man’, why should allowing
a claim by the liquidator against the auditor do so? In both cases
H the liquidator is placing equal reliance upon the company’s H
participation in a fraud in order to make the claim. …
I I
38. In Hong Kong, Stone & Rolls has been considered by the
J Court of Final Appeal in Moulin Global Eyecare Trading Ltd (in liquidation) J
v The Commissioner of Inland Revenue 48 in which case the liquidators
K K
claimed a refund of taxes on the basis that the company did not make any
L L
of the taxable profits which the management falsely reported to the Inland
M
Revenue in furtherance of a fraud. The leading judgment was given by M
Lord Walker of Gestingthorpe NPJ who was also in the majority of the
N N
panel in Stone & Rolls. Lord Walker said that lengthy discussion of Stone
O & Rolls was unnecessary and inappropriate in the case then before him 49. O
His lordship recanted from the position he took in Stone & Rolls as regards
P P
the fraud exception and cited with approval the judgment of Patten LJ of
Q the English Court of Appeal in Bilta 50 which emphasized that the context Q
in which attribution is explored is an important factor. Lord Walker
R R
S S
48
(2014) 17 HKCFAR 218
T 49
Ibid, at §101 T
50
[2014] 1 All ER 168
U U
V V
- 22 -
A A
summarised his views on the fraud exception and attribution and made,
B among other things, the following observations 51: B
C “ (8) In cases concerned with insurance the terms of the policy C
are likely to be decisive, especially where a company has
obtained cover against the risk of breach of duty, including
D D
fraud, by directors or employees: Arab Bank at 283, and
the comments on that case in Morris at [122]–[124].
E Internal fraud was the ‘very thing’ from which the E
insurance cover was intended to protect the company.
F F
(9) The fraud exception does not appear to have been even
raised as a defence, still less successfully relied on, in a
G claim by a company against its auditors for failure to G
detect internal fraud (as in Duke and MAN) with the sole
H exception of the extreme ‘one-man’ company case of H
Stone & Rolls (see that case at [175] and [176] ). Again,
internal fraud was the ‘very thing’ from which the auditors
I had a duty to protect the company.” I
J J
39. Having considered submissions from the parties, I am inclined
K to agree with Mr Joffe that whilst the Court of Final Appeal in Moulin was K
critical of Stone & Rolls, it did not directly address the situations (which
L L
did not arise in the case before it) where:
M M
(1) the company is seeking to sue not the wrongdoing director,
but rather a third party which the company alleges is in breach
N N
of duty owed to it in failing to detect the wrongdoing. In such
O circumstances, whether or not an auditor can rely on the O
attribution of the wrongdoer’s knowledge and thus invoke the
P P
illegality defence; and
Q (2) whether the company, acting by its liquidators, and hence Q
seeking to primarily protect and address creditors’ interests,
R R
can sue the auditors alleging they are in breach of duty in
S failing to detect the wrongdoing. S
T T
51
Supra, at §106
U U
V V
- 23 -
A A
40. In my humble view, the above situations involve difficult
B points of law in an area which is in the process of developing. In this B
regard, my attention has been drawn by Mr Joffe to certain Canadian case
C C
authorities to the effect that neither attribution nor the illegality defence
D would absolve an auditor’s duty in similar situations: see Livent Inc v D
Deloitte & Touche 52 . Moreover, the illegality defence has been
E E
substantially reformulated by the recent decision of the English Supreme
F Court in Patel v Mirza 53, which was decided after Bilta, so that it has now F
moved away from the rule-based approach in Tinsley v Milligan 54 to a
G G
policy and fact based approach. The latter requires the court to consider,
H among other things, whether the enforcement of a claim would be harmful H
to the integrity of the legal system and whether the denial of that claim
I I
would be a proportional response to the illegality under consideration. As
J such, the facts of an individual case now assume a greater significance than J
before when considering the applicability of the illegality defence. In all
K K
the circumstances, I am unable to be satisfied that the present case is a plain
L L
and obvious one for striking out without any consideration of the evidence.
M M
(E) Circuity of action
N N
41. Mr Lai submits that the plaintiffs’ claim, if succeeded, would
O give rise to a cause of action available to the defendants. This is on the O
basis that the defendants would have relied on the representations given by
P P
the directors of the plaintiffs which, to the knowledge of the directors, were
Q fraudulent. The defendants signing off the auditors’ reports was a cause Q
of their exposure to a negligence claim and therefore loss. As the
R R
52
2014 ONSC 2176; 2016 ONCA 11. I note that leave to appeal to the Supreme Court of Canada
S has been granted on 9 June 2016. Leave has also been granted for the Canadian Coalition for S
Good Governance and the Chartered Professional Accountants of Canada to intervene on
3 February 2017. The appeal was heard and reserved on 15 February 2017.
T 53
[2016] 3 WLR 399 T
54
[1994] 1 AC 340
U U
V V
- 24 -
A A
representations of the management were made within the authority of the
B directors, the plaintiffs would be vicariously liable for those fraudulent B
representations of the directors. It is submitted that the cause of action
C C
available to the defendants would set off in full their liability owed to the
D plaintiffs. This would therefore give rise to a circuity of action and D
amounts to an abuse of the Court’s process if the plaintiffs are allowed to
E E
pursue the action.
F F
42. With respect, I am unable to be satisfied that the defendants
G G
have made out a clear case of circuity of action which is sufficient for their
H present application for striking out. My reasons are as follows: H
(a) it is trite that a defence of set-off and counterclaim has to be
I I
specifically pleaded and particulars of misrepresentation and
J fraud must be specified. In the present case, the defendants J
have not even filed a defence. Therefore, one knows not
K K
what false representations the defendants are relying on.
L What we have at this stage is just a bare assertion that the L
defendants had been deceived by the directors of the plaintiffs;
M M
(b) given that the defendants are professionals and that it would
N be within their expertise and duty to detect any irregularities N
in the financial statements presented to them for auditing,
O evidence would need to be heard to determine whether the O
defendants had in fact been deceived, how that came about
P P
and to what extent they were deceived: see Barings v Coopers
Q & Lybrand (No 2) 55; and Q
R R
55
[2002] 2 BCLC 410, at §37, where Evans-Lombe J listed out the matters which need to
S S
demonstrate in order that the case in deceit can succeed, namely: “(i) one or more representations
by [the Finance Director of the plaintiff], (ii) which were false, (iii) which were made deceitfully
(in this case recklessly, so as to amount to deceit), (iv) which were intended to, and did, induce
T [the defendants] to engage in, or abstain from, certain conduct, (v) which caused loss to [the T
defendants], and (vi) for which [the plaintiff] is responsible.”
U U
V V
- 25 -
A A
(c) the counterclaim in Barings v Coopers & Lybrand (No 2) was
B based on vicarious liability 56, whereas in the present case the B
defendants rely on the doctrine of attribution and the illegality
C C
defence. However, as to whether the knowledge of the
D father and the son can in law be attributed to the plaintiffs and D
whether the defendants can rely on the illegality defence, this
E in my humble view is still an open issue which is yet to be E
decided.
F F
G 43. Based on the above, it is impossible for the court to form a G
view as to whether the defendants can establish a set off or counterclaim
H H
without proper pleadings and hearing evidence. In short, with respect, the
I ground based on circuity of action is simply not a suitable matter in the I
present case for a strike out application.
J J
K (F) Time limitation K
L
44. The usual time limitation for an action based on tort is one of L
6 years from the accrual of the cause of action. In the present case, the
M M
Writ was issued on 10 June 2014. Thus, in any event the limitation defence
N
would not be applicable in respect of the audits carried out on the plaintiffs’ N
financial years ended 31 March 2009 and 2010.
O O
45. As regards the earlier audits of the plaintiffs, they would
P P
require a consideration of the applicability of the exception provided in s 31,
Q the Limitation Ordinance, Cap 347 which provides for extension of the Q
limitation period to 3 years from the date of knowledge, actual or imputed:
R R
S S
56
That vicarious liability does not depend on any attribution of wrongdoings by an employee to
T the employer is made plain the judgment of in Bilta, supra, at §§70 (per Lord Sumption) and T
186 (Lord Toulson & Lord Hodge).
U U
V V
- 26 -
A A
Kensland Realty Ltd v Tai, Tang & Chong 57 . This is basically a fact-
B sensitive issue: Topping Chance Development Ltd v CCIF CPA Ltd 58. B
C C
46. The determination of the date of actual or imputed knowledge
D
can be a complicated matter. In the present case, the level of complexity D
increases further by the issue of attribution. This is also the added difficulty
E E
caused by the fact that the defendants have yet to have any pleadings. In
F the circumstances, I am of the view that this issue of limitation is clearly F
more suitable to assessment at trial.
G G
H The special position of D2 H
47. I note the complaint of Mr Joffe that this basis for the strike
I I
out application in respect of D2 (no participation in the audits) was raised
J for the first time in Mr Lai’s written submission dated 21 February 2017 J
and was not specifically mentioned in either the Strike Out Summons or
K K
the first supporting affirmation of Yu dated 11 August 2016. I also bear
L in mind the Practice Direction 19.1 at §5 which says that the grounds for L
M
striking out ought to be clearly stated. M
N 48. However, I am satisfied that in the event the plaintiffs had not N
suffered any prejudice because of the late disclosure of this ground about
O O
D2. This is because the one day originally reserved for the hearing on
P 24 February 2017 was proved to be too optimistic as a result of the length P
and depth of the oral submissions and after that full-day of hearing the
Q Q
matter was adjourned part-heard to 1 March 2017. During the interim,
R the plaintiff was able to file (without objection) an affirmation to deal with R
S S
T 57
(2008) 11 HKCFAR 237 T
58
[2015] 3 HKC 71
U U
V V
- 27 -
A A
the position about D2 59. Moreover, further materials (case authorities)
B were filed on 28 February 2017 on behalf of the plaintiff, some of those B
relating to the particular ground about D2. On the resumed hearings,
C C
counsel had opportunity to address this court further on the issue.
D D
49. As can be seen in the SOC, the only basis for the plaintiffs to
E E
sue D2 is stated at §5 where it is said that D2 is the “corporate practice
F successor of the 1st Defendant, operating as a limited liability partnership”. F
From §5 onwards, D1 and D2 are collectively referred to as “the Auditors”
G G
throughout in the SOC without any distinction. There are therefore no
H specific assertions made by the plaintiffs in the SOC as to what D2 had H
done by itself which give the plaintiffs a cause of action against it.
I I
50. As aforesaid, the plaintiffs’ case against the defendants is about
J J
their alleged negligence in relation to the audits of the plaintiffs’ accounts
K for the financial years starting in 2014 and ended in 2010. The first K
L
auditor report (of P1) was signed off by D1 on 21 July 2006 60 and the last L
audit reports were signed off by D1 on 14 April 2011 (P1) 61
and 31 March
M M
2011 (P2) 62 respectively.
N N
51. There is now before the court uncontroverted evidence, in the
O form of a Certificate of Incorporation, that D2 only came into being on O
3 January 2011. There is also undisputed evidence from the plaintiffs, in
P P
the form of audit reports exhibited to Fok’s 1st Affirmation 63, that all the
Q Q
R R
S
59
Fok’s 3rd affirmation dated 27 February 2017. S
60
[C/8/117-118]
61
[C/8/255-256]
T 62
[C/8/413-414] T
63
[B/6/52/§5]
U U
V V
- 28 -
A A
audit’s reports 64 relied upon by the plaintiffs for the present action were
B signed by D1, not D2. B
C C
52. It is plain that as a matter of law, D2, which is a separate legal
D
entity from D1, could not possibly have done anything for the plaintiffs D
prior to its came into being on 3 January 2011.
E E
53. As to the situation after the incorporation of D2, there is the
F F
assertion of the plaintiffs in the SOC that:
G G
“ 8. The Auditors were engaged as the auditors of [P1] and [P2]
for the financial year ended 31 March 2005 onwards until
H 31 March 2010.” H
I This assertion raises a factual issue as to whether D2 had performed any I
service for the plaintiffs in 2011 in spite of the fact that the last audit reports
J J
of the plaintiffs were not signed off by D2.
K K
54. In my view that the assertions in the SOC leave open an
L L
implicit case of D2 having assisted D1 in the audit work in 2011 which is
M legally possible. That implicit case is also factually possible as the M
marketing material of D2 (exhibited to Fok’s 3rd affirmation) shows that
N N
there had not been any change of personnel of the practice before and after
O incorporation. There is also some evidence that D1 had only become O
dormant a few years after D2 came into existence.
P P
Q
55. It may be that the aforesaid implicit case is not a particularly Q
strong one. Nevertheless, in my humble view it is not one which can be
R R
struck out now. It would be a matter for D2, if they are of the view that
S the aforesaid implicit case has not been adequately pleaded with clarity, to S
T T
64
[C/8/114-435]
U U
V V
- 29 -
A A
consider whether to seek further and better particulars in due course. It is
B simply pre-mature at this stage for the application for striking out to be B
made on this ground in respect of D2.
C C
D D
CONCLUSION
E 56. Based on all of the above, I am not satisfied that the plaintiffs’ E
case against the defendants should be struck out. The defendants’
F F
application is therefore dismissed.
G G
57. I make an order nisi that the plaintiffs have the costs of this
H H
application, to be taxed if not agreed.
I I
58. It only remains for me to thank counsel for all of their valuable
J assistance. J
K K
L L
(Alex Lee)
M M
Deputy High Court Judge
N N
Mr Victor Joffe, leading Ms Rachel Lam, instructed by
O O
Stephenson Harwood, for the 1st and 2nd plaintiffs
P Mr Adrian Lai, instructed by Norton Rose Fulbright Hong Kong, P
for the 1st and 2nd defendants
Q Q
R R
S S
T T
U U
V V
DAYS IMPEX LTD (in liquidation) AND ANOTHER v. FUNG, YU & CO (a firm) AND ANOTHER
A A
HCA 1035/2014
B IN THE HIGH COURT OF THE B
HONG KONG SPECIAL ADMINISTRATIVE REGION
C C
COURT OF FIRST INSTANCE
D ACTION NO 1035 OF 2014 D
___________
E E
BETWEEN
F F
DAYS IMPEX LIMITED (in liquidation) 1st Plaintiff
G DAYS INTERNATIONAL LIMITED (in liquidation) 2nd Plaintiff G
H and H
I FUNG, YU & CO. (a firm) 1st Defendant I
(馮兆林余錫光會計師行)
J J
nd
FUNG, YU & CO. CPA LIMITED 2 Defendant
K (馮兆林余錫光會計師事務所有限公司) K
L
___________ L
M Before: Deputy High Court Judge Lee in Chambers M
Dates of Hearing: 24 February and 1 March 2017
N N
Date of Judgment: 24 October 2017
O O
P
______________ P
JUDGMENT
Q Q
______________
R R
S S
T T
U U
V V
- 2 -
A INTRODUCTION A
1. The 1st and 2nd plaintiffs (“P1” and “P2”) are two private
B B
companies incorporated in Hong Kong which are now in liquidation 1 .
C The 1st defendant (“D1”) was a firm engaged as the auditor of the plaintiffs C
between 2005 and 2011 2. The 2nd defendant (“D2”) was incorporated on
D D
3 January 2011 3 and is alleged to be the practice successor of D1 4.
E E
2. By a Statement of Claim (“SOC”) 5 dated 15 March 2016, the
F plaintiffs claim against the defendants for negligence in the audit work they F
performed for the plaintiffs. It is a major plank of the plaintiffs’ case that
G G
the defendants had breached their duty owed to the plaintiffs by signing off
H unqualified “clean” opinions on the status of the plaintiffs’ accounts and H
by failing to detect and report the massive import/export fraud which the
I I
controlling shareholder and director had caused the plaintiffs to commit.
6
J It is said that had the fraud been detected earlier and reported to the relevant J
authorities, the fraud would not have continued for so long and the
K K
plaintiffs’ losses would have been lesser . It is of note that the present
7
L L
action is brought (in the name of the plaintiffs by the liquidators) for the
M
benefit of the creditors and the liquidation generally. 8 M
N N
1
The petitions for winding up of the plaintiffs were filed on 14 September 2011 and the winding
up orders were made on 10 February 2012.
O 2
D1 was engaged as P1’s auditor since 2005 and as P2’s auditor since 2006. O
3
See D2’s Certificate of Incorporation: [C/11/486]
4
See [A/2/6/§5]
P 5
[A/2/5-34] P
6
Nanik Dayaram (“the father”), who was the head of the family and the Days Group to which P1
and P2 belonged. The father indirectly controlled 99.99% of P1’s shares (the remaining 0.01%
Q Q
shares were held by his wife and his son) and 100% of P2’s shares. He was also a director of
both P1 and P2. See Annex 1 and Annex 2 of the SOC for a summary of the shareholding and
directorships: [A/2/31]
R R
7
The father and his son, Mahesh, were convicted of various counts of conspiracy to defraud and
each was sentenced to 10 years’ imprisonment (HCCC 2/2014): [C/7/69-72]. The conviction
appeal by them was dismissed, the sentence appeal having been abandoned (CACC 274/2015):
S S
[C/12/487]
8
The primary victims of the fraud were the banks which advanced the loans. According to
written submission of the plaintiffs, the losses are estimated at HK$200 million to HK$250
T T
million. The amount of damages attributable to the alleged negligence, however, may be
different.
U U
V V
- 3 -
A A
3. The defendants have yet to file any defence. By a Summons
B dated 12 August 2016 9, however, they seek to strike out the SOC in its B
entirety on the following grounds:
C C
(a) the SOC discloses no reasonable cause of action;
D D
(b) the SOC is an abuse of process for the following alternative
E reasons: E
(i) it is a fishing expedition;
F F
(ii) it has already been time-barred;
G G
(iii) it is attempt for the plaintiffs to sue on reliance of their
H
own illegality; H
(iv) it would lead to a circuity of action because of the
I I
defendants’ right to set-off or counterclaim; and
J (c) it is devoid of particulars and also bound to fail. J
K K
THE ISSUES
L L
4. Mr Lai, counsel for the defendants, re-organizes the defendants’
M aforesaid grounds stated in the Summons and focuses his submission on M
the following issues:
N N
(A) whether the alleged breaches by the defendants falls outside
O O
their scope of duty of care as auditors;
P (B) whether there is an absence of factual causation between the P
alleged breaches and the plaintiffs’ loss;
Q Q
(C) whether there is an absence of legal causation between the
R alleged breaches and the plaintiffs’ loss; R
S (D) whether the plaintiffs’ claim offends the principle of ex turpi S
causa non oritur actio;
T T
9
[A/3/35-38]
U U
V V
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A A
(E) whether there would be a circuity of action; and
B B
(F) whether any part of the plaintiffs’ claim has already been time-
barred.
C C
D 5. In respect of D2, Mr Lai highlights the fact that it had not even D
been incorporated prior to 2011 and it had not signed off any of the auditor
E E
reports of the plaintiffs. On that basis, it is submitted that there is no
F factual or legal basis to hold D2 liable. F
G G
LEGAL PRINCIPLES FOR STRIKING OUT
H H
6. There is no dispute about the legal principles for striking out
I and they can be summarized as follows 10: I
J (1) it is only in a plain and obvious case that the Court should J
exercise its summary powers to strike out a pleading or writ;
K K
(2) the claim must be obviously unsustainable, the pleadings
L unarguably bad and it must be impossible, not just improbable, L
for the claim to succeed before the Court will strike it out;
M M
(3) there should be no trial on affidavits; disputed facts are to be
N taken in favour of the party sought to be struck out; N
O (4) the mere fact that a case is weak and not likely to succeed is O
no ground for striking it out;
P P
(5) the jurisdiction should not be exercised if it requires a minute
Q and protracted examination of the documents and facts of the Q
case in order to see whether the plaintiff really has a cause of
R action; where an application to strike out involves a prolonged R
and serious argument, the Court should, as a rule, decline to
S S
proceed with the argument;
T T
10
Hong Kong Civil Procedure 2018, Vol 1, para 18/19/4
U U
V V
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A A
(6) the Court should not decide difficult points of law in striking
B out proceedings and the Court is loathe to strike out a case that B
involves an area of law which is in the process of developing.
C C
That said, questions of law can be determined in strike out
D applications provided that they are crucial and the Court has D
all the relevant facts before it and these facts are certain;
E E
(7) it is for the party seeking to strike out a pleading or writ to
F demonstrate that the case is a plain and obvious one in which F
the other party’s claim is bound to fail;
G G
(8) however, where the Court comes to the conclusion after full
H argument that the case is plainly and obviously one for H
striking out it should not decline to do so on the ground that
I I
the issues are difficult or complicated.
J J
CONSIDERATION
K K
7. The affirmation evidence filed for the present application
L consists of: L
M (i) three affirmations made by Fok Hei Yu on behalf of the M
plaintiffs 11; and
N N
(ii) one affirmation made by Yu Leung Fai on behalf of the
O defendants 12. O
P The affirmations give the background facts of this case, outline the P
respective cases of the parties, update the debts owed by the plaintiffs and
Q Q
provide information about the incorporation and practice of D2. I have
R regard to all of the affirmations and the documents exhibited thereto. R
S S
11
Dated respectively 5 December 2016, 20 February 2017 and 27 February 2017: see [B/51];
T [A/38-3]; and [A/38-12] T
12
Dated 11 August 2016: see [B/42]
U U
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A A
8. The arguments between the parties are mainly on law
B including but not limited to the scope of auditor’s duty, attribution and B
illegality and causation. This court has received lengthy and in-depth oral
C C
and written submissions from Mr Lai on the one hand and Mr Joffe (and
D with him, Ms Lam), counsel for the plaintiffs, on the other. I note that D
Mr Lai’s written submission runs up to 38 pages together with 3 volumes
E E
of case authorities, whilst Mr Joffe’s written submissions runs up to 66
F pages together with 6 volumes of case authorities. The hearing of the F
application lasted for about one day and a half. For all of the above, I am
G G
greatly indebted.
H H
(A) Scope of auditor’s duty and sufficiency of pleadings
I I
9. In summary, Mr Lai submits under these heads the following:
J J
(1) the loan transactions entered into by the plaintiffs were not
K K
something the defendants were under a duty to advise. They
were loan transactions concluded by the father and son, in the
L L
exercise of their de jure or de facto control over the plaintiffs;
M M
(2) it is not pleaded that the loan transactions were subject to
N
approval of the members of the plaintiffs and therefore the N
defendants were not under duty to advise on the merits of the
O loan transactions; O
P
(3) it is not pleaded (a) that reliance would be placed by the P
plaintiffs on the defendants’ audit opinions when entering into
Q the loan transactions; and (b) that such reliance was known to Q
the defendants. Accordingly, D1 could not be said to have
R R
assumed a specific duty of care in relation to the loan
S transactions; and S
T T
U U
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A A
(4) it is not pleaded that the members of the plaintiffs, to whom
B the defendants are said to have owed duty as a collective body, B
would have acted differently had the true picture been
C C
revealed.
D D
10. In my view, Mr Lai’s aforesaid submissions entail the following
E preliminary questions which should first be addressed, namely (i) whether E
the defendants’ role as auditor should be characterized as just provision
F F
information and advice ; (ii) whether an auditor owes a duty to his client
13
G G
company to prevent the latter from entering into questionable loan
H
transactions 14 ; (iii) how and to what extent (if any) the interests of the H
creditors should be factored into the scope of duty of an auditor when his
I I
client company is in an insolent situation; and (iv) whether any resultant
J loss to the plaintiffs would have been inevitable even if there had not been J
any breach of duty, given that the fraudsters were themselves the
K K
controlling directors and shareholders of the plaintiffs and were not relying
L on the accuracy of the defendants’ advice. 15 L
M 11. As to (i), the stance of Mr Joffe is that: M
N (a) the defendants had a duty to plan and perform the audit so as N
to enable them to detect material misstatements, errors and so
O O
forth which would in this case have led to the detection of
P fraud; and P
(b) upon detection of the material misstatements / fraud, the
Q Q
defendants had a duty to report the fraud not only to the
R companies themselves but also to the appropriate authorities. R
S S
13
See §31 and §39(1) and (2) of Mr Lai’s written submission
T 14
Ibid, at §28 T
15
Ibid, at §39(3) and (4)
U U
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A A
12. In considering the defendants’ scope of duty as auditors, I
B have regard to what Lord Bridge said in Caparo Industries Plc v Dickman 16: B
C “ … It is never sufficient to ask simply whether A owes B a duty C
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
D D
care to save B harmless.”
E E
As Lord Oliver said in the same case 17:
F “ The question is always whether the defendant was under a duty F
to avoid or prevent that damage, but the actual nature of the
G
damage suffered is relevant to the existence and extent of any G
duty to avoid or prevent it.”
H H
Moreover, the same point was made by Lord Hoffmann in South Australia
I Asset Management Corp v York Montague Ltd, United Bank of Kuwait plc I
v Prudential Property Services Ltd, Nykredit Mortgage Bank plc v Edward
J J
Erdman Group Ltd 18 where his lordship said:
K K
“ … Before one can consider the principle on which one should
calculate the damages to which a plaintiff is entitled as
L compensation for loss, it is necessary to decide for what kind of L
loss he is entitled to compensation. A correct description of the
loss for which the valuer is liable must precede any consideration
M M
of the measure of damages. For this purpose it is better to begin
at the beginning and consider the lender’s cause of action.
N … N
A duty of care such as the valuer owes does not, however, exist
O in the abstract. A plaintiff who sues for breach of a duty imposed O
by the law (whether in contract or tort or under statute) must do
P more than prove that the defendant has failed to comply. He P
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.”
Q Q
R R
S S
16
[1990] 2 AC 605, at 627D
T 17
Ibid, at 652, quoting Brennan J in Sutherland Shire Council v Heyman (1985) 60 ALR 1 at 48. T
18
[1996] 3 All ER 365 at 369g and 370e
U U
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A A
13. Having considered the submissions from both sides, I am
B unable to accept that an auditor’s duty is as narrow as to be restricted to the B
provision of information and advice, but may extend to detecting material
C C
irregularities in the company’s accounting statements. See Barings v
D Coopers & Lybrand 19 in which Leggatt LJ said: D
E
“ The primary responsibility for safeguarding a company’s assets E
and preventing errors and defalcations rests with the directors.
But material irregularities, and a fortiori fraud, will normally be
F brought to light by sound audit procedures, one of which is the F
practice of pointing out weaknesses in internal controls. An
G auditor’s task is to conduct the audit as to make it probable that G
material misstatements in financial documents will be detected.
Detection did not occur here, and there therefore is a case for
H H
[the defendants] to answer.” (Emphasis supplied)
I I
14. Moreover, I also agree with Mr Joffe’s submission that in
J J
appropriate cases an auditor’s duty may even extend to reporting any fraud
K he detected during the course of his work for a client. Thus, in Sasea K
Finance Ltd v KPMG 20, it is said:
L L
“ If, for example, the auditors discover that a senior employee of a
M company has been defrauding that company on a grand scale, M
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
N N
management of the company at once, not simply, when rendering
the auditors’ report, to record what has been discovered weeks
O or months later. … O
The guidelines also acknowledge that there may be occasions
P P
when it is necessary for an auditor to report directly to a third
party without the knowledge or consent of the management.
Q Such would be the case if the auditor suspects that management Q
may be involved in, or is condoning, fraud or other irregularities
R and such would be occasions when the duty to report overrides R
the duty of confidentiality. Among the relevant considerations
would be the extent to which the fraud or other irregularity is
S S
likely to result in material gain or loss for any person or is likely
T 19
[1997] 1 BCLC 427, at 435h–i T
20
[2000] 1 All ER 676, at 681d–h and 682d–e
U U
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- 10 -
A A
to affect a large number of persons and the extent to which the
non-disclosure of the fraud or other irregularity is likely to
B enable it to be repeated with impunity. B
…
C It is accepted for present purposes that it was KPMG’s duty to C
warn either the directors or some relevant third party of any fraud
D or irregularity likely to result in material loss to the company D
with a reasonable degree of promptitude. Why should that be?
The obvious and common-sense answer is that by so doing the
E E
company may be spared such losses.” (Emphasis supplied)
F F
15. The reference to “The guidelines” above is the Auditing
G G
Guidelines (Feb 1990 edn). There are similar guidelines applicable to
H
Hong Kong issued by the Hong Kong Society of Accountants. Of H
particular relevance are the following, all of which having been alluded to
I I
in the SOC and relied upon by the plaintiffs 21:
J J
(1) SAS 110: The Auditors’ Responsibility to Consider Fraud and
K
Error in the Audit of Financial Statements: K
“ 2. When planning and performing audit procedures and
L evaluating and reporting the results thereof, the auditors L
should consider the risk of material misstatements in the
M
financial statements resulting from fraud or error.” M
“ 57. When the auditors identify a misstatement resulting from
N
fraud, or a suspected fraud, or error, the auditors should N
consider the auditors’ responsibility to communicate
that information to management, those charged with
O governance and, in some circumstances, to regulatory O
and enforcement authorities.”
P P
(2) SAS 200: Planning
Q “ The auditor shall plan and perform an audit with professional Q
skepticism recognizing that circumstances may exist that cause
R
the financial statements to be materially misstated.” R
S S
T T
21
See Section D2 of the SOC: [A/2/9/§§17 – 23]
U U
V V
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A A
(3) SAS 240: Quality Control for Audit Work
B “ The auditor shall maintain professional skepticism throughout B
the audit, recognizing that possibility that a material misstatement
C
due to fraud could exist, notwithstanding the auditor’s past C
experience with the entity about the honesty and integrity of
management and those charged with governance.”
D D
E
16. Concerning the relevancy of guidelines issued by a E
professional body of accountants in relation to auditing standards expected
F F
of its members, the learned authors of Jackson & Powell on Professional
G Liability have the following to say 22: G
H
“ Although auditing standards do not directly have the force of law, H
compliance with them is powerful evidence that the auditor has
acted reasonably, whilst failure to comply without adequate
I explanation is powerful evidence to the contrary. There are two I
reasons why this is so. The first is that the FRC 23 is and the
J APB 24 was constituted under the aegis of the CCAB 25 and the J
standards accordingly represent the agreed view of all the major
professional bodies of accountants as to what constitutes good
K K
practice. The second is that the standards are given additional
status by the Companies Act, in that every auditor of the accounts
L of a company registered under the Companies Acts is required to L
belong to a RSB 26 …”
M M
17. In my humble view, the weight of the authorities is such that
N N
it is highly arguable that an auditor’s duty is more than just providing
O information and advice on his client’s financial statements. Moreover, O
I am inclined to the view that what is said in Sasea Finance about an
P P
auditor’s duty to “blow the whistle” is also apposite to Hong Kong.
Q Q
R R
S
22
8th ed of the work, at §17-092 S
23
Financial Reporting Council
24
Auditing Practices Board
T 25
Consultative Committee of Accounting Bodies T
26
Recognised Supervisory Body
U U
V V
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A A
18. As to (ii), it is important to note that the plaintiffs’ case,
B properly understood, is not that the defendants’ negligence lies in not B
advising the plaintiffs or their management to desist from entering into the
C C
questionable loan transactions. The plaintiffs’ case is that the defendants,
D as auditors, owed the plaintiffs a duty to detect and report fraud in the D
course of their auditing work, even to the relevant authorities if necessary,
E E
so as to avoid loss or further loss being caused to the plaintiffs. In this
F regard, it is said in Sasea Finance that 27: F
G “ … It is accepted for present purposes that it was KPMG’s duty to G
warn either the directors or some relevant third party of any fraud
H
or irregularity likely to result in material loss to the company H
with a reasonable degree of promptitude. Why should that be?
The obvious and common-sense answer is that by so doing the
I company may be spared such losses.” I
(Emphasis supplied)
J J
19. As to (iii), the issue is very much left open by case authorities.
K However, my attention has been drawn to Simpson, Professional Negligence K
and Liability, where it is said 28:
L L
“ Indeed, it will commonly be the case that a company’s claim
M M
against its auditors will be of benefit to its creditors (particularly,
but not exclusively, where the company is insolvent). An
N argument that the duties owed by the auditors are affected by N
whether the company is insolvent or near to insolvency, and
O
therefore the interests of the creditors require protection, is O
capable of being accommodated within the existing principles
applicable to the existence and scope of auditors’ duties, provided
P that the claim remains one by the company and for loss sustained P
by the company. …”
Q Q
In my humble view, in a case like the present one when the liquidators are
R R
acting primarily for the benefit of creditors the above proposition is at the
S very least arguable and should not be shut out by way of a striking out. S
T 27
Supra, at 681j – 682e T
28
Vol 2, §13.88.1
U U
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A A
20. As to (iv), whether a report to the relevant authorities of the
B fraud would have been effective in avoiding loss or further loss to the B
plaintiffs is a matter on which evidence would need to be heard and tested.
C C
Thus, the English Court of Appeal in Sasea Finance said 29:
D D
“ Finally, Mr Brisby submits that what KPMG had to report was so
grave that if independent directors failed to act quickly in such a
E way as to cut Fiorini and Parretti out of management then KPMG E
would have recognised that public interest demanded an approach
F to a third party, albeit after taking appropriate legal advice. Thus, F
Mr Brisby submits it is at least arguable that the influence of Fiorini
and Parretti would have come to an end before 28 September
G G
1990.
H As it seems to us, this is plainly an area in which evidence needs H
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
I I
relation to the efficacy of ‘whistle blowing’.”
J J
21. Returning to Mr Lai’s submissions under these heads, I am of
K the view that it is not to the point that the defendants were not under a duty K
to advise on the merits of loan transactions in question 30, as it is not the
L L
way in which the plaintiffs have put their case against the defendants.
M It is also not pertinent that the plaintiffs had not relied on the accuracy of M
the defendants’ advice before entering those loan transactions, as it is the
N N
plaintiffs’ case that the defendants’ alleged negligence lies in failing to
O detect and report the fraud to the relevant authorities 31. Lastly, the point O
is not whether the plaintiffs would have acted differently in the loan
P P
transactions. Rather, the point is whether the plaintiffs’ loss would have
Q been avoided or contained and this is a matter on which evidence needs to Q
be heard 32.
R R
S S
29
Ibid, at 684h – 685b
30
Submissions (1) and (2) above.
T 31
Submission (3) above. T
32
Submission (4) above.
U U
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A A
22. As regards Mr Lai’s submission on the sufficiency of pleadings,
B with respect, it is based on the wrong footing by restricting the defendants’ B
scope of duty as auditors to just provision of advice. On the other hand,
C C
the plaintiffs’ SOC contains an extensive reference to auditing standards
D which include the duty to detect and report fraud. D
E E
23. Based on the above, with respect these grounds for striking
F
out are misconceived and have no merits. F
G (B) Factual causation G
24. Mr Lai’s submits that the defendants’ alleged breaches could
H H
not have factually caused the loan transactions to be entered into. Insofar
I I
as the plea that the fraud would have been arrested had the defendants
J
reported the matter to the “appropriate parties (including but not limited J
to Ps) ”, it is submitted that the plaintiffs have failed to specify who it is
K K
said to have been misled by the defendants’ audit opinion. Furthermore,
L it is submitted that, as a matter of pleading, the plaintiffs are obliged, but L
has failed, to identify what steps would have been taken had the report been
M M
made.
N N
25. With respect, Mr Lai’s aforesaid submission is again premised
O on the wrong footing that the defendants’ duty as auditors was limited to O
provision of an accurate advice in the auditor reports so that there could
P P
not be any factual causation when the plaintiffs did not in fact act on their
Q Q
advice before entering into the loan transactions in question. However,
R
as discussed above the plaintiffs’ case is based on the defendants’ failure to R
detect and report fraud when performing the auditing work for the plaintiffs.
S S
26. As submitted by Mr Joffe, the latter case has already been
T T
clearly pleaded in the SOC as follows:
U U
V V
- 15 -
A A
(1) After setting out the parties and background, Section D pleads
B the duties of the auditors, which include inter alia duties to B
detect and report fraud.
C C
(2) Section E identifies the material misstatements in the accounts
D as a result of the fraud. D
E
(3) Section F identifies the particular breaches and areas in which, E
had the work been properly carried out, the defendants would
F have been alerted to the material misstatements and hence the F
fraud.
G G
(4) Section G draws the conclusion that inter alia the defendants
H ought to have detected the material matters which would have H
pointed to the fraud, which should then have been reported to
I I
the plaintiffs and the appropriate authorities.
J (5) Based on the above, Section H pleads that loss and damage J
has been suffered by the plaintiffs. This is repeated in the
K K
Prayer.
L L
27. As regards Mr Lai’s point about the lack of particulars as to
M who are the “appropriate parties” to report to, the auditing standards set out M
that the fraud ought to be reported to “regulatory and enforcement
N N
authorities” and/or “directly to the third party”. The number of such
O regulatory and enforcement authorities are limited, namely the Stock O
Exchange, the Securities and Futures Commission and the Police. If there
P P
are any ambiguities in this regard, the appropriate application would be for
Q further and better particulars rather than a striking out. Q
R R
28. In my judgment, the plaintiffs have adequately pleaded their
S case in the SOC and this ground of the defendants for striking out has not S
been made out.
T T
U U
V V
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A A
(C) Legal causation
B 29. Mr Lai submits that allowing a company to remain in existence B
does not, without more, cause losses from anything and that giving an
C C
opportunity to a company incur and to continue to incur trading losses does
D D
not cause those trading losses in the sense in which the word “cause” is used
E
in law. Reference is made to Alexander v Cambridge Credit 33, which was E
followed in Galoo v Bright Grahame Murray . 34
Based on the above,
F F
Mr Lai submits that:
G (1) the alleged failure on the part of the defendants to detect fraud, G
even made out, at most only provided an opportunity to the
H H
plaintiffs to sustain loss. It is insufficient to make out the
I legal causation; I
(2) if the plaintiffs’ acceptance of loan and/or giving security for
J J
such a loan is not loss, then the interest and bank charges
K (which flowed from taking out the loans) cannot conceivably K
be recoverable losses; and
L L
(3) the loans drawn by the plaintiffs were benefit to themselves.
M The interest and bank charge were necessary cost incurred by M
the plaintiffs in obtaining those benefits and such cost cannot
N N
be regarded as loss.
O O
P P
Q Q
R R
S S
T 33
(1987) 9 NSWLR 310 T
34
[1994] 1 WLR 1360, at 1374G– H
U U
V V
- 17 -
A A
30. In Galoo v Bright Grahame Murray, ante, a case which is
B heavily relied on by Mr Lai, it was held that the negligent audit certificate B
merely created the opportunity for the company to incur and continue to
C C
incur trading losses, the cause of the losses being the unsuccessful trading.
D However, Galoo was distinguished in Sasea Finance on the ground that, D
where the auditor’s duty was to draw attention to a fraud, he was responsible
E E
for the company continuing to trade fraudulently. The Court of Appeal in
F Sasea Finance said that the subsequent frauds were “the kind of transaction F
against the risk of which [the auditor] had a duty to warn” 35.
G G
H 31. I also have regard to the following legal principles and case H
authorities drawn by Mr Joffe to my attention:
I I
(a) it is well-established that negligence needs to be an “effective
J J
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”:
K K
Smith New Court Securities Ltd v Scrimgeour Vickers (Asset
L Management) Ltd 36; L
M
(b) it has been held that it would be inappropriate to strike out a M
claim against auditors where their actions cause the company
N to trade in a particular way and incur further losses and it is N
on this basis that Galoo is distinguished: Temseel Holdings
O O
Ltd v Beaumonts Chartered Accountants (A Firm) 37;
P (c) Galoo is also further distinguished where the allegation is that P
the auditors should have discovered and advised that the
Q Q
company was trading at a loss, and steps would have been
R taken accordingly to prevent further trading, the failure to do R
so has been determined to be capable of being an effective
S S
35
Supra, at 683e– f.
T 36
[1997] AC 254, at 284 – 285 T
37
[2003] PNLR 27, at §§52 – 57
U U
V V
- 18 -
A A
cause in previous cases: see Rushmer v Mervyn Smith (t/a
B Mervyn E Smith & Co) 38; and B
(d) once it is established that the auditors’ negligence or breach
C C
of duty was causative of the relevant loss, they remain liable
D not withstanding there may have been other causes of equal D
efficacy: WA Chip & Pulp Co Pty Ltd v Arthur Young & Co 39.
E E
F
32. Furthermore, subsequent authorities suggest that Galoo F
should not be understood as a case on causation. Thus, in Equitable Life
G G
v Ernst & Young 40 the English Court of Appeal had the following to say:
H H
“ Although Galoo was a case of summary disposal, the facts of the
case were idiosyncratic. Since, ex hypothesi, the company was
I insolvent, the losses suffered by continuing to trade were really I
suffered by the creditors (or by the company’s parent), and so,
J
although the case was not argued in that way, the real question J
may well have been whether the auditors owed any duty to the
creditors (see Lord Hoffmann’s lecture to the Chancery Bar
K Association, 15 June, 1999, Common Sense and Causing Loss, K
pp 22–23).”
L L
33. Based on the above, I agree with Mr Joffe that it is inapposite
M M
for the defendants to reply on the Galoo line of authorities to suggest that
N there is a causation defence. Rather the issue should be approached from N
the perspective of scope of duty.
O O
P 34. In conclusion, I am not persuaded that the SOC should be P
struck out on the ground that there is no legal causation.
Q Q
R R
S S
38
[2009] EWHC 94 (QB), at §73. I note that in that case the plaintiff failed on the facts.
However, that does not apply the legal proposition under consideration.
T 39
(1987) 12 ACLR 25 at 42 – 43; (1988) 13 ACLR 283 T
40
[2003] 2 BCLC 603, at §133
U U
V V
- 19 -
A A
(D) Illegality
B 35. Mr Lai distills the following principles from the highly B
controversial case of Stone & Rolls Ltd v Moore Stephens 41 which he
C C
submits have not been undermined by subsequent cases:
D D
(1) the issue of attribution very much depends on context and
E purpose of the proceedings in question; and E
F
(2) in a “one man” company case, the controlling fraudster’s F
knowledge could be attributed to the company in an audit
G negligence claim against an auditor. G
H H
36. Mr Lai goes on and submits that the present case falls within
I the scope of Stone & Rolls on the plaintiffs’ own pleaded case in that: I
J (1) the fraudsters were effectively the only persons owning the J
plaintiffs 42;
K K
(2) all affairs of the plaintiffs were controlled by the fraudsters 43;
L (3) the plaintiffs were at all material times utilized as part of the L
fraud perpetrated by the fraudsters 44; and
M M
(4) accordingly, the plaintiffs should be similarly regarded as
N “one man” companies, and the fraudulent knowledge of the N
fraudsters should be attributed to the plaintiffs.
O O
Therefore, it is submitted that the plaintiffs are barred from taking advantage
P P
of their own wrongs and hence not entitled to sue the defendants.
Q Q
R R
S S
41
[2009] 1 AC 1391
42
The SOC, at §10.
T 43
Ibid, at §13. T
44
Ibid, at §29.
U U
V V
- 20 -
A A
37. With respect, I recognize the logic and force of Mr Lai’s
B aforesaid submissions. However, Stone & Rolls, which is the foundation B
of his submissions, is admittedly a difficult case about the interaction
C C
between the doctrine of attribution, the fraud exception 45 and the illegality
D defence, as each of the Law Lords had given differing reasons for the D
decision so that it is difficult, if not possible, to identify its ratio. Thus, it
E E
is said in the joint judgment of Lord Toulson and Lord Hodge JJSC in Bilta
F (UK) Ltd v Nazir (No 2) 46 that: F
G “ We conclude that Stone & Rolls should be regarded as a case G
which has no majority ratio decidendi.”
H H
More importantly, the decision in Stone & Rolls has been subject to such
I severe criticism that its value as a precedent has been very much I
undermined. Thus, the learned editors of Jackson & Powell on
J J
Professional Liability, summarise the current position in UK as follows : 47
K K
“ It is also now clear the directors of a company who have caused
L
it to be involved in a fraud cannot raise a defence of illegality to L
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
M was the result in Bilta UK Ltd v Nazir (No 2). As Lord Neuberger M
(with whom Lords Clarke and Carnwath agreed) explained:
N N
‘ Where a company has been the victim of wrongdoing by
its directors, or of which its directors had notice, then the
O wrongdoing, or knowledge, of the directors cannot be O
attributed to the company as a defence to a claim brought
P against the directors by the company’s liquidator, in the P
name of the company and/or on behalf of its creditors,
for the loss suffered by the company as a result of the
Q Q
wrongdoing, even where the directors were the only
directors and shareholders of the company, and even
R though the wrongdoing or knowledge of the directors R
S S
45
Re Hampshire Land [1896] 2 Ch 743 which stands for the proposition that the knowledge of
the fraudulent directors is not attributed to the companies.
T 46
[2016] AC 1, at §154 T
47
8th ed of the work, at §§17-104 to 17-105
U U
V V
- 21 -
A A
may be attributed to the company in many other types of
proceedings …
B B
whether or not it is appropriate to attribute an action by,
or a state of mind of, a company director or agent to the
C company or the agent’s principal in relation to a particular C
claim against the company or the principal must depend
D on the nature and factual context of the claim in question.’ D
This leaves open the question as to the availability of a defence of
E illegality to an auditor who is alleged to have negligently failed to E
detect a fraud being carried out through a ‘one-man’ company or
F equivalent. If it does not ‘produce inconsistency and disharmony F
in the law, and so cause damage to the integrity of the legal system’
[these principles will be discussed further below in E2] to allow
G G
the liquidator to claim against the ‘one man’, why should allowing
a claim by the liquidator against the auditor do so? In both cases
H the liquidator is placing equal reliance upon the company’s H
participation in a fraud in order to make the claim. …
I I
38. In Hong Kong, Stone & Rolls has been considered by the
J Court of Final Appeal in Moulin Global Eyecare Trading Ltd (in liquidation) J
v The Commissioner of Inland Revenue 48 in which case the liquidators
K K
claimed a refund of taxes on the basis that the company did not make any
L L
of the taxable profits which the management falsely reported to the Inland
M
Revenue in furtherance of a fraud. The leading judgment was given by M
Lord Walker of Gestingthorpe NPJ who was also in the majority of the
N N
panel in Stone & Rolls. Lord Walker said that lengthy discussion of Stone
O & Rolls was unnecessary and inappropriate in the case then before him 49. O
His lordship recanted from the position he took in Stone & Rolls as regards
P P
the fraud exception and cited with approval the judgment of Patten LJ of
Q the English Court of Appeal in Bilta 50 which emphasized that the context Q
in which attribution is explored is an important factor. Lord Walker
R R
S S
48
(2014) 17 HKCFAR 218
T 49
Ibid, at §101 T
50
[2014] 1 All ER 168
U U
V V
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A A
summarised his views on the fraud exception and attribution and made,
B among other things, the following observations 51: B
C “ (8) In cases concerned with insurance the terms of the policy C
are likely to be decisive, especially where a company has
obtained cover against the risk of breach of duty, including
D D
fraud, by directors or employees: Arab Bank at 283, and
the comments on that case in Morris at [122]–[124].
E Internal fraud was the ‘very thing’ from which the E
insurance cover was intended to protect the company.
F F
(9) The fraud exception does not appear to have been even
raised as a defence, still less successfully relied on, in a
G claim by a company against its auditors for failure to G
detect internal fraud (as in Duke and MAN) with the sole
H exception of the extreme ‘one-man’ company case of H
Stone & Rolls (see that case at [175] and [176] ). Again,
internal fraud was the ‘very thing’ from which the auditors
I had a duty to protect the company.” I
J J
39. Having considered submissions from the parties, I am inclined
K to agree with Mr Joffe that whilst the Court of Final Appeal in Moulin was K
critical of Stone & Rolls, it did not directly address the situations (which
L L
did not arise in the case before it) where:
M M
(1) the company is seeking to sue not the wrongdoing director,
but rather a third party which the company alleges is in breach
N N
of duty owed to it in failing to detect the wrongdoing. In such
O circumstances, whether or not an auditor can rely on the O
attribution of the wrongdoer’s knowledge and thus invoke the
P P
illegality defence; and
Q (2) whether the company, acting by its liquidators, and hence Q
seeking to primarily protect and address creditors’ interests,
R R
can sue the auditors alleging they are in breach of duty in
S failing to detect the wrongdoing. S
T T
51
Supra, at §106
U U
V V
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A A
40. In my humble view, the above situations involve difficult
B points of law in an area which is in the process of developing. In this B
regard, my attention has been drawn by Mr Joffe to certain Canadian case
C C
authorities to the effect that neither attribution nor the illegality defence
D would absolve an auditor’s duty in similar situations: see Livent Inc v D
Deloitte & Touche 52 . Moreover, the illegality defence has been
E E
substantially reformulated by the recent decision of the English Supreme
F Court in Patel v Mirza 53, which was decided after Bilta, so that it has now F
moved away from the rule-based approach in Tinsley v Milligan 54 to a
G G
policy and fact based approach. The latter requires the court to consider,
H among other things, whether the enforcement of a claim would be harmful H
to the integrity of the legal system and whether the denial of that claim
I I
would be a proportional response to the illegality under consideration. As
J such, the facts of an individual case now assume a greater significance than J
before when considering the applicability of the illegality defence. In all
K K
the circumstances, I am unable to be satisfied that the present case is a plain
L L
and obvious one for striking out without any consideration of the evidence.
M M
(E) Circuity of action
N N
41. Mr Lai submits that the plaintiffs’ claim, if succeeded, would
O give rise to a cause of action available to the defendants. This is on the O
basis that the defendants would have relied on the representations given by
P P
the directors of the plaintiffs which, to the knowledge of the directors, were
Q fraudulent. The defendants signing off the auditors’ reports was a cause Q
of their exposure to a negligence claim and therefore loss. As the
R R
52
2014 ONSC 2176; 2016 ONCA 11. I note that leave to appeal to the Supreme Court of Canada
S has been granted on 9 June 2016. Leave has also been granted for the Canadian Coalition for S
Good Governance and the Chartered Professional Accountants of Canada to intervene on
3 February 2017. The appeal was heard and reserved on 15 February 2017.
T 53
[2016] 3 WLR 399 T
54
[1994] 1 AC 340
U U
V V
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A A
representations of the management were made within the authority of the
B directors, the plaintiffs would be vicariously liable for those fraudulent B
representations of the directors. It is submitted that the cause of action
C C
available to the defendants would set off in full their liability owed to the
D plaintiffs. This would therefore give rise to a circuity of action and D
amounts to an abuse of the Court’s process if the plaintiffs are allowed to
E E
pursue the action.
F F
42. With respect, I am unable to be satisfied that the defendants
G G
have made out a clear case of circuity of action which is sufficient for their
H present application for striking out. My reasons are as follows: H
(a) it is trite that a defence of set-off and counterclaim has to be
I I
specifically pleaded and particulars of misrepresentation and
J fraud must be specified. In the present case, the defendants J
have not even filed a defence. Therefore, one knows not
K K
what false representations the defendants are relying on.
L What we have at this stage is just a bare assertion that the L
defendants had been deceived by the directors of the plaintiffs;
M M
(b) given that the defendants are professionals and that it would
N be within their expertise and duty to detect any irregularities N
in the financial statements presented to them for auditing,
O evidence would need to be heard to determine whether the O
defendants had in fact been deceived, how that came about
P P
and to what extent they were deceived: see Barings v Coopers
Q & Lybrand (No 2) 55; and Q
R R
55
[2002] 2 BCLC 410, at §37, where Evans-Lombe J listed out the matters which need to
S S
demonstrate in order that the case in deceit can succeed, namely: “(i) one or more representations
by [the Finance Director of the plaintiff], (ii) which were false, (iii) which were made deceitfully
(in this case recklessly, so as to amount to deceit), (iv) which were intended to, and did, induce
T [the defendants] to engage in, or abstain from, certain conduct, (v) which caused loss to [the T
defendants], and (vi) for which [the plaintiff] is responsible.”
U U
V V
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A A
(c) the counterclaim in Barings v Coopers & Lybrand (No 2) was
B based on vicarious liability 56, whereas in the present case the B
defendants rely on the doctrine of attribution and the illegality
C C
defence. However, as to whether the knowledge of the
D father and the son can in law be attributed to the plaintiffs and D
whether the defendants can rely on the illegality defence, this
E in my humble view is still an open issue which is yet to be E
decided.
F F
G 43. Based on the above, it is impossible for the court to form a G
view as to whether the defendants can establish a set off or counterclaim
H H
without proper pleadings and hearing evidence. In short, with respect, the
I ground based on circuity of action is simply not a suitable matter in the I
present case for a strike out application.
J J
K (F) Time limitation K
L
44. The usual time limitation for an action based on tort is one of L
6 years from the accrual of the cause of action. In the present case, the
M M
Writ was issued on 10 June 2014. Thus, in any event the limitation defence
N
would not be applicable in respect of the audits carried out on the plaintiffs’ N
financial years ended 31 March 2009 and 2010.
O O
45. As regards the earlier audits of the plaintiffs, they would
P P
require a consideration of the applicability of the exception provided in s 31,
Q the Limitation Ordinance, Cap 347 which provides for extension of the Q
limitation period to 3 years from the date of knowledge, actual or imputed:
R R
S S
56
That vicarious liability does not depend on any attribution of wrongdoings by an employee to
T the employer is made plain the judgment of in Bilta, supra, at §§70 (per Lord Sumption) and T
186 (Lord Toulson & Lord Hodge).
U U
V V
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A A
Kensland Realty Ltd v Tai, Tang & Chong 57 . This is basically a fact-
B sensitive issue: Topping Chance Development Ltd v CCIF CPA Ltd 58. B
C C
46. The determination of the date of actual or imputed knowledge
D
can be a complicated matter. In the present case, the level of complexity D
increases further by the issue of attribution. This is also the added difficulty
E E
caused by the fact that the defendants have yet to have any pleadings. In
F the circumstances, I am of the view that this issue of limitation is clearly F
more suitable to assessment at trial.
G G
H The special position of D2 H
47. I note the complaint of Mr Joffe that this basis for the strike
I I
out application in respect of D2 (no participation in the audits) was raised
J for the first time in Mr Lai’s written submission dated 21 February 2017 J
and was not specifically mentioned in either the Strike Out Summons or
K K
the first supporting affirmation of Yu dated 11 August 2016. I also bear
L in mind the Practice Direction 19.1 at §5 which says that the grounds for L
M
striking out ought to be clearly stated. M
N 48. However, I am satisfied that in the event the plaintiffs had not N
suffered any prejudice because of the late disclosure of this ground about
O O
D2. This is because the one day originally reserved for the hearing on
P 24 February 2017 was proved to be too optimistic as a result of the length P
and depth of the oral submissions and after that full-day of hearing the
Q Q
matter was adjourned part-heard to 1 March 2017. During the interim,
R the plaintiff was able to file (without objection) an affirmation to deal with R
S S
T 57
(2008) 11 HKCFAR 237 T
58
[2015] 3 HKC 71
U U
V V
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A A
the position about D2 59. Moreover, further materials (case authorities)
B were filed on 28 February 2017 on behalf of the plaintiff, some of those B
relating to the particular ground about D2. On the resumed hearings,
C C
counsel had opportunity to address this court further on the issue.
D D
49. As can be seen in the SOC, the only basis for the plaintiffs to
E E
sue D2 is stated at §5 where it is said that D2 is the “corporate practice
F successor of the 1st Defendant, operating as a limited liability partnership”. F
From §5 onwards, D1 and D2 are collectively referred to as “the Auditors”
G G
throughout in the SOC without any distinction. There are therefore no
H specific assertions made by the plaintiffs in the SOC as to what D2 had H
done by itself which give the plaintiffs a cause of action against it.
I I
50. As aforesaid, the plaintiffs’ case against the defendants is about
J J
their alleged negligence in relation to the audits of the plaintiffs’ accounts
K for the financial years starting in 2014 and ended in 2010. The first K
L
auditor report (of P1) was signed off by D1 on 21 July 2006 60 and the last L
audit reports were signed off by D1 on 14 April 2011 (P1) 61
and 31 March
M M
2011 (P2) 62 respectively.
N N
51. There is now before the court uncontroverted evidence, in the
O form of a Certificate of Incorporation, that D2 only came into being on O
3 January 2011. There is also undisputed evidence from the plaintiffs, in
P P
the form of audit reports exhibited to Fok’s 1st Affirmation 63, that all the
Q Q
R R
S
59
Fok’s 3rd affirmation dated 27 February 2017. S
60
[C/8/117-118]
61
[C/8/255-256]
T 62
[C/8/413-414] T
63
[B/6/52/§5]
U U
V V
- 28 -
A A
audit’s reports 64 relied upon by the plaintiffs for the present action were
B signed by D1, not D2. B
C C
52. It is plain that as a matter of law, D2, which is a separate legal
D
entity from D1, could not possibly have done anything for the plaintiffs D
prior to its came into being on 3 January 2011.
E E
53. As to the situation after the incorporation of D2, there is the
F F
assertion of the plaintiffs in the SOC that:
G G
“ 8. The Auditors were engaged as the auditors of [P1] and [P2]
for the financial year ended 31 March 2005 onwards until
H 31 March 2010.” H
I This assertion raises a factual issue as to whether D2 had performed any I
service for the plaintiffs in 2011 in spite of the fact that the last audit reports
J J
of the plaintiffs were not signed off by D2.
K K
54. In my view that the assertions in the SOC leave open an
L L
implicit case of D2 having assisted D1 in the audit work in 2011 which is
M legally possible. That implicit case is also factually possible as the M
marketing material of D2 (exhibited to Fok’s 3rd affirmation) shows that
N N
there had not been any change of personnel of the practice before and after
O incorporation. There is also some evidence that D1 had only become O
dormant a few years after D2 came into existence.
P P
Q
55. It may be that the aforesaid implicit case is not a particularly Q
strong one. Nevertheless, in my humble view it is not one which can be
R R
struck out now. It would be a matter for D2, if they are of the view that
S the aforesaid implicit case has not been adequately pleaded with clarity, to S
T T
64
[C/8/114-435]
U U
V V
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A A
consider whether to seek further and better particulars in due course. It is
B simply pre-mature at this stage for the application for striking out to be B
made on this ground in respect of D2.
C C
D D
CONCLUSION
E 56. Based on all of the above, I am not satisfied that the plaintiffs’ E
case against the defendants should be struck out. The defendants’
F F
application is therefore dismissed.
G G
57. I make an order nisi that the plaintiffs have the costs of this
H H
application, to be taxed if not agreed.
I I
58. It only remains for me to thank counsel for all of their valuable
J assistance. J
K K
L L
(Alex Lee)
M M
Deputy High Court Judge
N N
Mr Victor Joffe, leading Ms Rachel Lam, instructed by
O O
Stephenson Harwood, for the 1st and 2nd plaintiffs
P Mr Adrian Lai, instructed by Norton Rose Fulbright Hong Kong, P
for the 1st and 2nd defendants
Q Q
R R
S S
T T
U U
V V