re Kingston Cotton Mill Company (No.2) (1896)
This is an appeal from an order made by Vaughan Williams J. under s. 10 of the Companies (Winding-up) Act, 1890, on Mr. Pickering and Mr. Peasegood, the auditors of the company, ordering them to pay to the liquidator certain sums of money, being the amounts of dividends improperly declared and paid out of the assets of the company on the faith of certain balance-sheets prepared and signed by the auditors. The facts are not in dispute. They will be found correctly stated in the report of the case. The appeal is based on two grounds, namely--(1.) that the auditors have not failed to discharge their duty to the company, and are under no liability to make good the money misapplied; (2.) that, even if they have, the proper remedy is by action, and not by the summary process to which the liquidator has had recourse.
It will be convenient to dispose of the second point first. It has already been decided that the auditors of this company are "officers" within the meaning of s. 10 of the Companies (Winding-up) Act, 1890. The object of that section is the same as that of s. 165 of the Companies Act, 1862, which it has replaced. That object was to facilitate the recovery by the liquidator of assets of a company improperly dealt with by its promoters, directors, or other officers. The section applies to breaches of trust and to misfeasances by such persons. I agree that the section does not apply to all cases in which actions will lie by the company for the recovery of damages against the persons named; it is easy to imagine cases of breach of contract, trespasses, negligence, or other wrongs to which the section is inapplicable, and some such have been the subject of judicial decision; but I am not aware of any authority to the effect that the section does not apply to the case of an officer who has committed a breach of his duty to the company, the direct consequence of which has been a misapplication of its assets, for which he could be made responsible by an action at law or in equity. Such a breach of duty, if established, is a "misfeasance" within the meaning of the section, or, to adopt the language used in Bentinck v. Fenn, such a breach of duty is a misfeasance in the nature of a breach of trust. This view of the section was adopted by this Court in In re London and General Bank, and is, in my opinion, correct. On this preliminary point, therefore, which, however, does not touch the merits of the case, the appellants are not entitled to succeed.
I come now to the real question in this controversy, and that is, whether the appellants have been guilty of any breach of duty to the company. To decide this question it is necessary to consider--
- what their duty was;
- how they performed it, and in what respects (if any) they failed to perform it.
The duty of an auditor generally was very carefully considered by this Court in In re London and General Bank, and I cannot usefully add anything to what will be found there. It was there pointed out that an auditor's duty is to examine the books, ascertain that they are right, and to prepare a balance-sheet shewing the true financial position of the company at the time to which the balance-sheet refers. But it was also pointed out that an auditor is not an insurer, and that in the discharge of his duty he is only bound to exercise a reasonable amount of care and skill.
It was further pointed out that what in any particular case is a reasonable amount of care and skill depends on the circumstances of that case; that if there is nothing which ought to excite suspicion, less care may properly be considered reasonable than could be so considered if suspicion was or ought to have been aroused. These are the general principles which have to be applied to cases of this description. I protest, however, against the notion that an auditor is bound to be suspicious as distinguished from reasonably careful. To substitute the one expression for the other may easily lead to serious error.
The company's articles of association contain special regulations relating to auditors: see arts. 129-140; but they do not impose upon the auditors any more onerous duties than those I have already mentioned. Auditors are, however, in my opinion bound to see what exceptional duties, if any, are cast upon them by the articles of the company whose accounts they are called upon to audit. Ignorance of the articles and of exceptional duties imposed by them would not afford any legal justification for not observing them. Some reliance was placed in this case on arts. 123 and 124. Those, however, relate to the duties of the directors, and not of the auditors. Art. 124 empowers the auditors to direct what accounts shall be kept and how they shall be kept; but there is nothing in this article which makes an auditor responsible for not ordering an account to be kept which he did not think necessary. His duty in this respect is governed by the general principles which have been already stated. If on those principles it can be truly said that an auditor ought to have required a particular account to be kept, then art. 124 prevents him from effectually urging as a defence that he had no authority to require it. But beyond that, art. 124 cannot be invoked against the auditor.
I pass now to consider the complaint made against the auditors in this particular case. The complaint is that they failed to detect certain frauds. There is no charge of dishonesty on the part of the auditors. They did not certify or pass anything which they did not honestly believe to be true. It is said, however, that they were culpably careless. The circumstances are as follows: For several years frauds were committed by the manager, who, in order to bolster up the company and to make it appear flourishing when it was the reverse, deliberately exaggerated both the quantities and values of the cotton and yarn in the company's mills. He did this at the ends of the years 1890, 1891, 1892, and 1893. There was no book or account (except the stock journal to which I will refer presently) shewing the quantity or value of the cotton or yarn in the mill at any one time. It would not be easy to keep such a book. Nor is it wanted for ordinary purposes. There is considerable waste (20 or 25 per cent. on the average) in the manufacture of yarn from cotton, and the market prices of both cotton and yarn are subject to great fluctuations. The balance-sheets of each year contained on the asset side entries of the values of the stock-in-trade at the end of the year, and those entries were stated to be "As per manager's certificate." There were also in the balance-sheets entries on the opposite side of the values of the stock-in-trade at the beginning of the year. The quantities did not appear in either case. The auditors took the entry of the stock-in-trade at the beginning of the year from the last preceding balance-sheet, and they took the values of the stock-in-trade at the end of the year from the stock journal. This book contained a series of accounts under various heads purporting to shew the quantities and values of the company's stock-in-trade at the end of each year, and a summary of all the accounts shewing the total value of such stock-in-trade. The summary was signed by the manager, and the value as shewn by it was adopted by the auditors and was inserted as an asset in the balance-sheet, but "As per manager's certificate." The summary always corresponded with the accounts summarized, and the auditors ascertained that this was the case. But they did not examine further into the accuracy of the accounts summarized. The auditors did not profess to guarantee the correctness of this item. They assumed no responsibility for it. They took the item from the manager, and the entry in the balance-sheet shewed that they did so. I confess I cannot see that their omission to check his returns was a breach of their duty to the company. It is no part of an auditor's duty to take stock. No one contends that it is. He must rely on other people for details of the stock-in-trade on hand. In the case of a cotton mill he must rely on some skilled person for the materials necessary to enable him to enter the stock-in-trade at its proper value in the balance-sheet. In this case the auditors relied on the manager. He was a man of high character and of unquestioned competence. He was trusted by every one who knew him. The learned judge has held that the directors are not to be blamed for trusting him. The auditors had no suspicion that he was not to be trusted to give accurate information as to the stock-in-trade in hand, and they trusted him accordingly in that matter. But it is said they ought not to have done so, and for this reason. The stock journal shewed the quantities--that is, the weight in pounds--of the cotton and yarn at the end of each year. Other books shewed the quantities of cotton bought during the year and the quantities of yarn sold during the year. If these books had been compared by the auditors they would have found that the quantity of cotton and yarn in hand at the end of the year ought to be much less than the quantity shewn in the stock journal, and so much less that the value of the cotton and yam entered in the stock journal could not be right, or at all events was so abnormally large as to excite suspicion and demand further inquiry. This is the view taken by the learned judge. But, although it is no doubt true that such a process might have been gone through, and that, if gone through, the fraud would have been discovered, can it be truly said that the auditors were wanting in reasonable care in not thinking it necessary to test the managing director's return? I cannot bring myself to think they were, nor do I think that any jury of business men would take a different view. It is not sufficient to say that the frauds must have been detected if the entries in the books had been put together in a way which never occurred to any one before suspicion was aroused. The question is whether, no suspicion of anything wrong being entertained, there was a want of reasonable care on the part of the auditors in relying on the returns made by a competent and trusted expert relating to matters on which information from such a person was essential. I cannot think there was. The manager had no apparent conflict between his interest and his duty. His position was not similar to that of a cashier who has to account for the cash which he receives, and whose own account of his receipts and payments could not reasonably be taken by an auditor without further inquiry. The auditor's duty is not so onerous as the learned judge has held it to be. The order appealed from must be discharged with costs.
This is an appeal by Messrs Pickering & Peasegood, auditors of the Kingston Cotton Mill Company, Limited, against an order of Vaughan Williams J. making them liable to make good to the assets of the company moneys of the company improperly applied in payment of dividends on the faith of certain balance-sheets certified by them.
A misfeasance summons was issued under s. 10 of the Companies (Winding-up) Act, 1890, against the directors and auditors. It was dismissed as to the directors, but the auditors were held liable.
Two questions of great importance arise:
- What is misfeasance within the meaning of s. 10?
- Have the auditors in the circumstances of this case committed a misfeasance?
It has been held that an auditor of a company is an officer within the meaning of the section: In re London and General Bank. But has there been any misfeasance by the auditors? This depends upon what meaning is to be assigned to the word "misfeasance" as used in this section. The learned judge in the Court below held that misfeasance covered any misconduct by an officer of the company as such for which such officer might have been sued apart from the section. In my judgment this is too wide. It would cover any act of negligence--any actionable wrong by an officer of a company which did not involve any misapplication of the assets of the company. The object of this section of the Act is to enable the liquidator to recover any assets of the company improperly dealt with by any officer of the company, and must be interpreted bearing that object in view. It doubtless covers any breach of duty by an officer of the company in his capacity of officer resulting in any improper misapplication of the assets or property of the company.
This point was taken as a preliminary point, and it was said the Court had no jurisdiction. I cannot adopt this view, and I am of opinion that, if the case relied on could be established, the auditors would have committed a breach of duty within s. 10 of the Act.
But in determining whether any misfeasance or breach of duty has been committed, it is essential to consider what the duties of an auditor are. They are very fully described in In re London and General Bank, to which judgment I was a party. Shortly they may be stated thus: It is the duty of an auditor to bring to bear on the work he has to perform that skill, care, and caution which a reasonably competent, careful, and cautious auditor would use. What is reasonable skill, care, and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watch-dog, but not a bloodhound. He is justified in believing tried servants of the company in whom confidence is placed by the company. He is entitled to assume that they are honest, and to rely upon their representations, provided he takes reasonable care. If there is anything calculated to excite suspicion he should probe it to the bottom; but in the absence of anything of that kind he is only bound to be reasonably cautious and careful.
In the present case the accounts of the company had been for years falsified by the managing director, Jackson, who subsequently confessed the frauds he had committed. It is only, however, just to him to say that they were not committed with a view of putting money in his own pocket, but for the purpose of making things appear better than they really were and in the hope of the company ultimately recovering itself. Jackson deliberately overstated the quantities and values of the cotton and yarn in the company's mills. He did this for many years. It was proved that there is great waste in converting yarn into cotton, and the fluctuations of the market in the prices of cotton and yarn are exceptionally great. Jackson had been so successful in falsifying the accounts that what he had done was never detected or even suspected by the directors. The auditors adopted the entries of Jackson and inserted them in the balance-sheet as "per manager's certificate." It is not suggested but that the auditors acted honestly and honestly believed in the accuracy and reliability of Jackson. But it is said that they ought not to have trusted the figures of Jackson, but should have further investigated the matter. Jackson was a trusted officer of the company in whom the directors had every confidence; there was nothing on the face of the accounts to excite suspicion, and I cannot see how in the circumstances of the case it can be successfully contended that the auditors are wanting in skill, care, or caution in not testing Jackson's figures.
It is not the duty of an auditor to take stock; he is not a stock expert; there are many matters in respect of which he must rely on the honesty and accuracy of others. He does not guarantee the discovery of all fraud. I think the auditors were justified in this case in relying on the honesty and accuracy of Jackson, and were not called upon to make further investigation. It is not unimportant to bear in mind that the learned judge has found the directors justified in relying on the figures of the managing director. The duties of auditors must not be rendered too onerous. Their work is responsible and laborious, and the remuneration moderate. I should be sorry to see the liability of auditors extended any further than in In re London and General Bank. Indeed, I only assented to that decision on account of the inconsistency of the statement made to the directors with the balance-sheet certified by the auditors and presented to the shareholders. This satisfied my mind that the auditors deliberately concealed that from the shareholders which they had communicated to the directors. It would be difficult to say this was not a breach of duty. Auditors must not be made liable for not tracking out ingenious and carefully laid schemes of fraud when there is nothing to arouse their suspicion, and when those frauds are perpetrated by tried servants of the company and are undetected for years by the directors. So to hold would make the position of an auditor intolerable. The appeal will be allowed.
The question on this appeal is whether auditors who are officers of the company which is in liquidation have been properly held liable under s. 10 of the Companies (Winding-up) Act, 1890, for misfeasance. The misfeasance charged against them occurred in this manner. The manager of this company since the year 1887 has been making false entries in the books of the company of the quantity and value at the end of each year of its stock-in-trade. This, it appears, was done not from any corrupt motive of personal advantage, but because he was anxious to make the company appear more prosperous than in fact it was, believing that it was passing through a period of depression which would soon come to an end.
In the years 1890, 1891, and 1892 the auditors entered in the balance-sheets the values made out by the manager with the words "As per manager's certificate," without making any investigation as to the accuracy of the figures. The result of this was that dividends were declared which ought not to have been and would not have been declared if the real state of the company had been known, and no doubt the catastrophe of the failure of the company was, if not occasioned, at least hastened by this falsification.
One of the questions argued was that, even if the auditors had committed a breach of duty in not attempting to examine the correctness of the manager's figures, the remedy should be by action and not by a summary proceeding under s. 10 of the Act of 1890. It was argued that the misfeasance intended by the section must be something in the nature of a breach of trust. The words of the section are, "any misfeasance or breach of trust in relation to the company." Therefore, misfeasance means something other than a breach of trust. It is said that it does not mean mere non-feasance: Re Wedgwood Coal and Iron Co. And a dictum of James L.J. in Coventry and Dixon's Case is relied on. It is a question of procedure. When may this summary procedure be adopted? It would be most inexpedient, and I think wrong, to so construe the word as to make it difficult to know whether a case came within it or not; and I think the only safe interpretation to adopt is that it includes all cases other than breaches of trust in which an officer of the company has been guilty of a breach of his duty as such officer which has caused pecuniary loss to the company by misapplication of its assets, and for which he might have been made liable in an action.
The question of real difficulty is whether the facts of this case do shew such a liability on the part of the auditors.
It appears that for years the auditors had been accustomed to accept without investigation the statement of the manager as to the value of the stock-in-trade at the end of each year. It seems obvious that the manager availed himself of this custom to falsify the books as to this item, knowing that if they pursued their usual course he could safely do this. The false entries began in 1887. In 1888 the stock-in-trade was valued at 21,775l. At the end of 1889 it was raised to 29,760l. The balance-sheet for 1890 began with that wrong amount. It was increased in that year to 44,482l. In the account for 1891 that amount was carried on, and was increased at the end of the year to 53,918l. The wrong entry at the beginning of each year made the increase seem less than it would have appeared if the account had commenced with the correct figure; and thus one false entry assisted another, and the balance-sheets might be inflated enormously by a continuance of these falsifications.
The manager gave no certificate. That which was referred to in the balance-sheets by that name was his signature in a book called the "stock journal." That book contained entries of all stock stated to have been purchased during the year. By far the largest items were cotton and yarn--that is, raw and spun cotton. The weights of these in pounds and the value per pound are entered, and then the total values of the lots are carried out, and the sum of these values is the addition which should account for the increase of the year.
The auditors were not able to take stock, nor could they from any documents furnished to them test the value of the stock. That would depend on market prices at the date of the balance-sheet. But the books did afford a means of testing with some approach to accuracy the quantity of cotton obtained during the year and the quantity sold as yarn, and, deducting the weight of yarn sold from the weight of cotton bought, and making a further deduction for waste in the manufacture of yarn, the increase in quantity in the year could be roughly calculated. Adding this to the amount of cotton and yarn at the beginning of the year which the books also shewed, the quantity of cotton and yarn at the end of the year is ascertained. In this simple calculation there is one uncertain item--that is, the waste.
This calculation has been made as an example for the year 1891, which is one of the years in question. The result is that the stock journal is wrong as to the quantity of cotton and yarn to an amount of 583,935 lbs. weight beyond the true quantity. The estimated waste for the year in this calculation is 380,496 lbs. weight. This was said to be taken at a low average. If the amount of waste was larger, the weight of cotton and yarn at the end of the year would be still less.
Now, the result of this investigation is to make it manifest that the value given by the manager must be greatly too much. The quantity of cotton and yarn at the beginning of the year was 1,316,270 lbs. At the end of the year it was 1,450,115. The increase during the year was, therefore, only 133,845. Taking this at 6d. a pound, which is more than the average value per pound of cotton shewn by the stock journal, the increase in value for the year would be only 3346l., while the increase stated by the manager was 9436l.--nearly three times as much. But whatever the value was, the stock journal gave the weights and brought out the value at so much per pound weight, and the weights could be checked from the books with approximate accuracy. This was not attempted, and the question is whether the neglect to do this was a breach of duty for which the auditors can be held liable. It is said that it is easy to be wise after the event. In former years when the stock journal was correctly entered the alterations in value in a year were frequently very considerable. The increase in the years now in question did not excite any suspicion in the directors. Why should it in the auditors? They had no reason to distrust the manager. Moreover, he had, or was supposed to have, taken the stock which was actually on the premises at the date to which the balance-sheets referred. The auditors could not do this. The only book from which they could obtain information as to the quantities received in the year other than the stock journal was a book called the "invoice guard book," in which were pasted the invoices received with goods supplied. But this was not necessarily accurate. Invoices received might have been omitted. Goods might in some cases have been received without invoices. Were the auditors bound to enter upon an investigation which could not bring out an accurate result in order to test the truth of a statement by the manager which no one had any reason to discredit?
It is of the highest importance that auditors, particularly, perhaps, in the case of joint stock companies, whose shareholders are dependent chiefly on their intelligence and vigilance, should perform their duty with scrupulous care. But if they have conducted their work with that amount of skill and care which can reasonably be expected from men of business in their position, is there any rule of law by which they can be made liable?
If it was the duty of the auditors to test the statements of the manager in the manner suggested, or, indeed, in any manner, they were certainly guilty of negligence, for they made no attempt whatever to test them. The question is, was it their duty?
Upon the best consideration I can give to the case, I come to the conclusion that this was not their duty; and I therefore think that the decision of the learned judge should be reversed.