Has KPMG's case strengthened protection on advisory work?

by Richard Highley

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20 Jul 2012

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KPMG WAS RECENTLY dragged into a legal dispute over VAT which resulted in further analysis of the questions about whether a firm can be sued because of its advisory work. In the case of Arrowhead Capital Finance v KPMG, the investor of a company, Arrowhead, tried to sue the firm after the company collapsed – with Arrowhead claiming it based its investment on KPMG's due diligence work.

KPMG succeeded in striking out the claim in the High Court. The claimant, Arrowhead, was an investor which ploughed some $30m (£19m) into the business. The case confirms that, protected by the right terms of engagement, accountants remain a "hard target" for sophisticated investors seeking to convince UK courts that duties of care are owed by accountants. However, doing so would require the court to ignore contractual terms of engagement freely negotiated between parties of equal bargaining power.

The firm undertook due diligence on Dragon's supply chain. When part of that chain was found to be contaminated by carousel fraud, Dragon was unable to recover VAT from HMRC and, as a result, ceased trading. The third-party investor, Arrowhead, lost its entire investment and claimed $50m against KPMG, which included a large sum of interest.

However, the claim depended on establishing that the firm owed a duty of care to Arrowhead. The claimant pointed the court to documents which were used by Dragon to attract potential investors and referred to KPMG's involvement.

KPMG's engagement letter with Dragon included limitations on the extent of its responsibility and a cap on its financial liability.

The following factorswere key to the judge's decision:

(a) The court concluded it was inconceivable that KPMG, having agreed engagement terms, would have voluntarily assumed an unlimited responsibility towards potential investors in Dragon;

(b) There was very little, if any, evidence of direct communication between Arrowhead and KPMG, except the possibility of a call between the two. But if it took place, it was after Arrowhead had started to invest in Dragon; and

(c) Arrowhead was a sophisticated investor dealing with known risks. Arrowhead made a high-risk investment for which it was going to be richly rewarded if it was successful (the interest rate originally agreed was 22%).

FUTURE PROOFING

The decision does not create new law; it followed a well-trodden path applying the "assumption of responsibility" test and the threefold test (foreseeability, proximity and whether it is just, fair and reasonable) towards determining whether KPMG owed a duty of care.

The judge accepted that Arrowhead's loss was a reasonably foreseeable consequence of KPMG's alleged failings and, with some hesitation, agreed that the relationship between the parties was one of sufficient proximity to establish a duty of care. But the Court stated it would not be fair, just and reasonable to impose a duty of care on KPMG.

It illustrates that UK courts have little sympathy towards sophisticated investors that seek redress against professionals against whom they have no obvious contractual remedy. The lack of any evidence of direct contact between Arrowhead and KPMG prior to the investment was fatal to arguing a duty of care was owed. Arrowhead could have chosen to instruct its own professional advisors to undertake an independent review of the supply chain but it chose not to.

KMPG was firmly vindicated. Nevertheless, this decision is a reminder (if one is needed) to accountants of the dangers of contact with prospective investors. It is often not possible or appropriate to prevent clients from disseminating material to third parties which refers to their advice. However, the ability of an accountant to discourage or strike out claims may depend on there being no arguable case that the accountant assumed responsibility towards the third-party investor, and that in turn means limiting direct contact with the third party and denying any assumption of responsibility in writing.

Thankfully, accountants with prudent terms in their engagement letters remain a "hard target" for investors that rely on their work but with whom they have little or no direct contact.

Richard Highley is a partner at international law firm DAC Beachcroft and specialises in disputes relating to accountants.

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