November 16th, 2011

Continental European Legislative and Judicial Trends: Negligent Auditor Liable to Capital Insurance Policyholder

Posted at 1:00 AM ET

David Lewin, Managing Director
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Swedish Tax Law and Capital Insurance

Under Swedish tax law, each transaction in securities, such as those involving shares and funds, triggers a 30 percent tax on profits. Consequently, capital insurance (Kapitalförsäkring) - a type of savings product - has become increasingly popular.

Capital insurance offers policyholders two major advantages: profits from transactions made within the product are tax-free, and policyholders are not obligated to submit fiscal declarations with respect to the transactions.

Instead, policyholders are subject to a variable yearly yield tax (avkastningsskatt) on the capital in the product, which in recent years has ranged from 1.1 percent to 1.2 percent - regardless of whether the transactions have yielded a profit.

Main Features of Capital Insurance

Capital insurance (not to be confused with the “traditional” Swedish endowment assurance that is also named “Kapitalförsäkring”) is built around a securities portfolio, where (värdepappersdepå) policyholders place various securities, such as shares and funds, depending on the preferred investment type.

The securities portfolio is established and owned by the insurer. According to policy conditions, the policyholder - not the insurer - is entitled to profits generated by it. Therefore, losses are the policyholder’s - not the insurer’s. The fact that the policyholder carries the risk of losses is, of course, a prerequisite for the classification of capital insurance as an insurance contract.

Based on a power of attorney issued by the insurer, the policyholder is permitted to freely make any transactions with portfolio assets. The only requirement for the policyholder is that a minimum value be maintained.

Case Facts and Background

A policyholder decided to sell 54,000 Class A shares and 280,000 Class B shares of a company called 24h Poker. The shares were placed in a capital insurance securities portfolio against settlement consisting of 91 shares in a company called Daydream for each share in 24h Poker. Daydream was listed on the Stockholm Stock Exchange.

The policyholder’s decision was based on information in Daydream’s annual financial report (årsredovisning) and a prospectus issued to the 24h Poker shareholders. Daydream’s auditor had issued a clean audit report, which was also referenced in the prospectus. Ultimately, the value of the Daydream shares was substantially lower than stated in the annual financial report and the prospectus.

Warning Issued by Auditors Disciplinary Board

Daydream’s auditor was reported to the Committee for the Authorization of Public Accountants (Revisorsnämnden), not only by the new board of Daydream, but also by the Stockholm Stock Exchange. The committee decided to warn the auditor for its failure to observe generally accepted accounting standards (god redovisningssed), neglect in sufficiently ascertaining the reasonableness of Daydream’s assumptions regarding future turnover and failure to ensure that Daydream’s calculations were based on relevant figures.

The Dispute

The policyholder initiated legal proceedings before the Stockholm District Court, seeking a declaratory judgment that the auditor’s firm and the auditor shall be jointly and severally liable for the loss suffered by the policyholder. The loss resulted from the diminished value of the capital insurance securities portfolio, which in turn, was caused by the auditor’s negligent omissions in connection with the audit of Daydream’s accounts.

Applicable Statutory Provisions

The applicable statutory provisions, the Companies Act (Aktiebolagslagen) Chap. 29 § 1 compared to Chap. 29 § 2, stipulates that an auditor shall compensate the company for loss caused intentionally or by negligence in the performance of duties as an auditor, by violation of the Companies Act (Aktiebolagslagen), the Act on Annual Financial Report  (Årsredovisningslagen) or the Articles of Association (Bolagsordningen). The same applies when loss is suffered by a shareholder or “someone else” (a different party).

Auditor’s Position

The auditor rejected the claim and argued that the policyholder was not the owner of the securities portfolio, and therefore, did not suffer loss as a shareholder. T he shareholder was the insurer. T he policyholder could not be considered to be “someone else” (någon annan) in the sense meant by the applicable provisions of the Companies Act.

The District Court’s Decision

The common ground before the Stockholm District Court (Stockholms tingsrätt) was that the insurer was the owner of the content of the securities portfolio, the Daydream shares, and was consequently the shareholder. Because of policy conditions, the policyholder suffered a loss resulting from the diminished value of the portfolio. The crucial question was whether the policyholder could be considered to be a member of the second category, “someone else,” in the relevant Companies Act provisions and consequently entitled to compensation from the auditor for his loss.

The Court found in favor of the policyholder. In summary, its reasoning was that even if the insurer is noted as owner of the shares (the Daydream shares), it is common ground that the policyholder had the right to exercise essential parts of the rights arising out of the ownership. The policyholder had the right to sell the shares in the securities portfolio or to replace them with other securities, as long as he maintained the minimum value of the portfolio assets according to the insurance contract. As far as has been established, the insurer has not reserved any rights to exercise any function as owner. Such reservation would also appear to be without effect, as the policyholder has been entitled to remove the shares from the portfolio if he wished to do so. Accordingly, the insurer’s status as owner of the shares lacked real substance.

The auditor’s firm and the auditor have appealed against the judgment on material grounds, as well as on the ground that the District Court allegedly committed a number of procedural errors.

Commentary

This case is likely to be watched for reasons beyond only the size of the suit. No legal precedent exists for the interpretation of “someone else” (någon annan) in the Companies Act Chap. 29 § 1 compared to § 2.

An eminent Swedish law professor specializing in professional liability described the judgment at this point as the most far reaching on auditor’s liability ever rendered in Sweden. He expressed concern over potential serious tax consequences for policyholders, should the judgment be upheld.

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