Auditor will compensate investors

ERNST & YOUNG, the accountants, will pay compensation to investors who bought shares on the back of the firm's uncritical audit report on Sound Diffusion, issued seven months before the electronics group collapsed in December 1988.

The move could widen the scope for investors to sue accountants for deficiencies in company audits that cause them to lose money. At present only investors in a company at the time the accountants complete their audit are able to sue for compensation.

The legal position was set out in a ground-breaking 1990 House of Lords ruling in the case of Caparo Industries v Dickman. The decision, which has been widely criticised by investors and bankers, said that auditors have a duty of care only when it is known in advance or is foreseeable that the claimant would rely on the report.

E&Y is offering compensation to investors who took up their entitlement in a pounds 9.94m rights issue in May 1988.

Arthur Young, which has since merged with Ernst & Whinney to form E&Y, audited the preliminary results announcement contained in the rights issue document and signed off Sound Diffusion's accounts with an unqualified audit report.

It has already paid pounds 1.35m to Tunstall Group, the Yorkshire electronics company that was Sound Diffusion's largest shareholder, as settlement of its pounds 1.9m claim against the accountants.

In reply to queries following that payout, E&Y's lawyer, McKenna & Co, has told investors that E&Y is offering compensation in line with its payment to Tunstall, which it calculates as 25 per cent of any losses.

McKenna is understood to have advised E&Y that the case is not clear-cut as to whether the accountants are liable for investors' losses. The accountants' decision to offer compensation is expected to nip in the bud any legal action that could decide that E&Y is liable for the losses of all investors and could overturn the Caparo ruling.

Both Arthur Young and Ernst & Whinney, which preceded it as auditor of Sound Diffusion, were criticised in a Department of Trade and Industry report on the collapse published last year.

The inspectors, Edmund Lawson QC and David Anton of the accountants Coopers & Lybrand, said the accountants 'failed to identify or otherwise accepted serious failures in the company's accounting practices'.

The main problem was Sound Diffusion's accounting for profits from leasing televisions to hotels, which the DTI said breached the Statement of Standard Accounting Practice number 21.

In addition the inspectors said that 'it is apparent that the rights issue was necessary for the company's survival, but this was not made clear to shareholders'.

E&Y said at the time that it was 'surprised and disappointed that the inspectors believe that accounting policies were a contributory factor to the failure of Sound Diffusion'.