The LCO notes that many professional advisors to OBCA corporations use contractual caps to limit their liability vis-à-vis the corporation. The LCO recognizes that in this context the will of private parties should generally be given effect through the fundamental principles of contract law. Contractual limitations on professional liability provide a reasonable and negotiated balance between the professional’s engagement and the level of risk that a professional can reasonably be expected to bear. Limiting liability by contract also affords some certainty to parties as to the upper limit of the professional’s risk of exposure. On the other hand, there is a risk that contractual limitations may undermine the credibility of a professional’s opinion and create a perception that professional services rendered under the protection of limitation clauses are of lesser quality than those that are not. Concerns may also arise in respect of contractual limitations when a professional is sued by shareholders or other stakeholders who are not parties to the contract. 

 

On this issue, the LCO notes that professional advisors to OBCA corporations can contractually cap their liability vis-à-vis the corporation and shareholders if all the shareholders expressly consent in writing to the liability cap. As discussed in the Introduction to this Report, many corporate law rules that are mandatory for offering corporations are optional or default for non-offering corporations. For example, the requirement to appoint an auditor can be opted out of in non-offering OBCA corporations if the shareholders unanimously consent to it. On the same basis, the shareholders of a non-offering corporation, who are few in number and who have a relatively significant economic stake in the corporation, may consent to a contractual cap on the liability for professional advisors who are engaged by the corporation. This unanimous shareholder consent would then prevent claims for damages beyond the agreed-to cap. The LCO recognizes that obtaining unanimous shareholder consent is not practically feasible in the context of offering OBCA corporations because of the large number of widely-disbursed shareholders. Nonetheless, the LCO does not suggest that the approval of a contractual cap by a simple (or super) majority of shareholder votes should bind the entire class of shareholders in a public (or private) company.  As such, the LCO is not in favour of the relatively new UK model, discussed in earlier parts of the Report.

 

The LCO further notes that professional advisors concerned about rising third-party insurance premiums or coverage limitations have reasonably addressed their concerns through the market, for example, by negotiating large retentions or deductibles with their insurers and/or by pursuing self-insurance for certain layers of risk and liability exposure where it is more cost-effective to do so.

 

The LCO believes the issue at hand is fundamentally about the distribution of risk.

 

In the context of OBCA corporations, should the risk of an insolvent co-defendant be borne entirely by other co-defendants, such as the corporation, directors, officers, auditors, lawyers, engineers and other professional advisors? Or, should potential plaintiffs such as retail investors, institutional investors and other stakeholders such as employees or customers bear all or part of the risk of an insolvent co-defendant?

 

The legal rule should allow for the risk of loss to be distributed fairly and efficiently. Policy arguments on these grounds should examine, for example, who can best bear the loss, who can best distribute the loss by way of third party insurance or self-insurance, and who was in the best position to avoid the loss.

 

To mitigate the exposure to risk, professional advisors routinely utilize various forms of insurance. Many professional advisors use some sort of third party professional liability insurance, also called malpractice insurance or errors and omissions insurance.[123] This insures the professional advisor up to a certain cap.  Professional advisors may be responsible for a certain amount before the third party insurance coverage kicks in. This can be in the form of a deductible or self-insured retention.

 

Audit firms are increasingly making use of self-insurance, which is a broad term for the general practice of setting aside funds to be used should losses occur.[124] This form of self-insurance can be operationalized in two ways: first, by the use of “captives”, or affiliates created, funded and utilized by enterprises in order to offset the risk of loss; second, by the use of risk-retention pools, formed by members who contribute premiums and receive typical insurance benefits.[125] The cost of insurance coverage is not fixed or static, but varies according to many external circumstances, including but not limited to litigation exposure. 

 

In contrast to the complex insurance options and possibilities available for defendant auditors and other professional advisors, it is uncertain what reasonable options would be available to potential plaintiffs, particularly retail investors and unsophisticated consumers and employees, to insure themselves against the risk of a co-defendant’s insolvency or otherwise distribute the loss. They would likely have to absorb the loss personally.

 

In contrast, a professional firm that ends up bearing the risk of a co-defendant’s insolvency in a joint and several liability scheme can distribute the risk through some form of insurance and distribute the cost of the premium or self-insurance through changes to pricing to their clients.

 

As a result, professional advisors are generally in a better position to bear or distribute the risk than potential plaintiffs, such as retail investors or other stakeholders such as employees and customers.  Professional advisors will no doubt continue to exercise prudent business practices to mitigate the risk of loss.  The cost of third party insurance or self-insurance, as the case may be, can be reasonably distributed through changes in pricing of services to clients.

 

Finally, the LCO also notes that a growing body of literature addresses novel market-based mechanisms for dealing with audit failure, particularly financial statement insurance and catastrophic bond securitization. These mechanisms could reasonably address some of the concerns of professional advisors about excessive exposure to liability.[126]  Financial statement insurance would  require significant structural changes in public accounting, but is generally simple as used in private market mergers and acquisitions transactions:

 

…[A] seller represents that its financial statements fairly present financial condition and results in conformity with GAAP; an insurer engages an auditor to review the statements and backs the representation with insurance.[127]

 

Instead of engaging an auditor backed by insurance, issuers would buy insurance from an insurer, who must pay for covered losses.[128]

 

Catastrophic bond securitization (also known as insurance-based securitization) would involve  the transfer of liabilities to a special purpose entity that, in turn, attracts investors who enjoy a return on investment in accordance with the risk of default.[129]

 

Professional advisors can benefit by continuing to look to emerging risk management techniques in order to counter the concerns of exposure to litigation risk.

 

Novel mechanisms, particularly catastrophic bond securitization, distribute risk away from insurance companies and audit professionals. The use of these tools represents several distinct advantages over reform of joint and several liability. First, by distributing risk away from professionals and insurance companies, they reduce pressure on those parties emerging from the threat of catastrophic loss. While catastrophic loss remains a hypothetical possibility, insurance against such an event should be easier to obtain when the risk of loss is distributed among a larger number of actors, particularly investors of the catastrophic bonds.

 

 

 

As the Report indicates, our assessment of joint and several liability under the OBCA persuades us that the positive ramifications of its application outweigh what may be viewed as its less desirable ramifications. The common law tests for professional negligence sufficiently address concerns about excessive or unfair liability; there are insufficient public data on the specific deleterious effects of joint and several liability on insurance premiums, insurance coverage, pricing of audit services, and entry into the professions; and trends in other jurisdictions toward proportionate liability, particularly the United States, do not provide a sufficient grounding for reform, particularly in light of the more litigious environment in the US.

 

1.     Common Law Protections are Sufficient

 

The LCO is of the view that the Canadian common law provides for multiple layers of protection for defendants in the context of claims of professional negligence to ensure that they are not unfairly saddled with liability. Before the issue of joint and several liability arises, a plaintiff must pass a number of legal tests, including establishing that each defendant owed him or her a duty of care and that each defendant caused the harm to the plaintiff.

 

The Supreme Court of Canada addressed the issue of the professional advisor’s duty of care in the context of a negligence claim in Hercules Management Ltd. v. Ernst & Young.[130] In the case, Ernst & Young was hired to provide audit services for the plaintiff firms and their shareholders. Eventually, shareholders and investors of the firms brought an action against Ernst & Young for losses allegedly suffered as a result of audit reports filed in three specific years. The auditor brought a motion for summary judgment against the plaintiffs, alleging, among other things, that they did not owe the individual plaintiffs any duty of care. The motion was granted against four of the plaintiffs. The plaintiffs’ subsequent appeals, including to the Supreme Court, were ultimately dismissed. While the defendants did owe the plaintiff class a prima facie duty of care, on the facts of the case the Supreme Court refused to find that the defendants owed the plaintiffs a duty of care. While the plaintiffs were sufficiently close to the defendants that the defendants could have foreseen reliance on their audit reports, the Supreme Court held that the use of the audit reports by the plaintiff class was not consistent with the purpose for which they were prepared. The prima facie duty of care was overturned by policy considerations.

 

More generally, a plaintiff alleging negligent misrepresentation by a defendant must prove, among other things, that the defendant owed a duty of care to the plaintiff.  The Supreme Court in Hercules applied a two-stage test from Kamloops to determine whether a duty of care is owed to a plaintiff in this context.[131]  The test reads as follows.

 

(1) Is there a sufficiently close relationship between the parties (the local authority and the person who has suffered the damage) so that, in the reasonable contemplation of the authority, carelessness on its part might cause damage to that person? If so,

(2) Are there any considerations which ought to negative or limit (a) the scope of the duty and (b) the class of persons to whom it is owed or (c) the damages to which a breach of it may give rise?[132]<