Section 52 provides that the compensation fund trustees may sue, and be sued, in the name Travel Compensation Fund'. I shall refer to the fund as TCF'.
The proceeding
This proceeding is brought by the trustees in the name of the Travel Compensation Fund. There are two sets of respondents. The first respondents, Craig Joseph Dunn, Alistair Victor Nicholas Sharp‑Paul and Terrance James Smith, all became directors of Travel Abroad on 18 September 1988. They remained directors until 21 December 1988, when the company ceased to trade. During that period, substantial moneys were received by Travel Abroad from members of the public as pre‑payments for overseas travel. Much of that money was expended on behalf of clients; some was not. Many clients of Travel Abroad had to pay twice for their travel, or elements of it. They made reimbursement claims against TCF. After investigation, they were paid.
Some of the money received by Travel Abroad from clients was held in a trust account. After the collapse of the company, the remaining moneys in this account were made available to TCF. Nonetheless, there remained a deficiency, the difference between the amount received by Travel Abroad after 18 September 1988 and the moneys properly expended or accounted for, of $404,133. In this proceeding TCF seeks to recover that sum from the first respondents, with interest.
The applicant's claim against the first respondents is based upon the fact that they were directors at the time.
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The second set of respondents, Bruce Phillips and Brian Albert McSweeney, are accountants who conducted a partnership practice known as Phillips McSweeney'. The firm audited Travel Abroad's 1987 accounts. Those accounts were supplied to TCF in September 1987, in connection with Travel Abroad's application for continued participation in the compensation scheme. TCF claims that the audit was negligently performed and that a proper audit would have revealed that Travel Abroad sustained a substantial loss in the year ended 30 June 1987. TCF says that, if the true position had been disclosed, Travel Abroad would not have been allowed to participate in the scheme after 30 June 1987; so TCF would not have suffered the subject losses. The total loss sustained by TCF in relation to payments received by Travel Abroad in 1988, some before 18 September, is $423,369. TCF claims this sum, with interest, from the second respondents. TCF also complains of the conduct of Phillips McSweeney in connection with the 1988 accounts. In respect of this year there is no complaint of negligently audited accounts; the audit was not completed before Travel Abroad ceased trading. The complaint is that, knowing the company's parlous financial position, Phillips McSweeney made statements to TCF officers which caused them to believe that the delay in preparing the 1988 accounts was caused only by operational problems, especially in the company's computer system, rather than being a reflection of a condition of insolvency. TCF says that, as a result, Travel Abroad was permitted to trade after 30 September 1988, with a consequential increase in the amount of the final deficiency. Mr Phillips and Mr McSweeney appeared in person at the hearing. They each gave evidence. Mr McSweeney was apparently more intimately involved in the Travel Abroad audits than Mr Phillips. Mr McSweeney in effect conducted the case for both men. He called some witnesses. ........................................................... Background facts Before coming to the issues in the case, I should mention some background facts. It appears that Travel Abroad was one of two companies operated by two brothers, Gregory and Nigel Lemon. The other was Wheels Abroad Pty Limited. For reasons left unexplained by the evidence, others acted as directors of the companies. But it is clear that Messrs Lemon were the effective controllers of both companies until their sale, on 18 September 1988, to a company called Industrial Performance Group Limited (IPG').
Travel Abroad and Wheels Abroad occupied adjoining space in premises at Mona Vale, a suburb of Sydney. The main activity of Travel Abroad was the marketing of pre‑paid tours to Europe. The tour package included return airfares and accommodation and, sometimes, travel within Europe. Some tours were sold by Travel Abroad directly to travellers but most of them were wholesaled by Travel Abroad through other travel agents, a commission being allowed to the other agent. Wheels Aboard was engaged in the business of selling car hire in Europe. Clients paid Wheels Abroad, in Australia, for their car hire. Upon their arrival in Europe, cars were made available to the clients, without further payment, pursuant to arrangements made between Wheels Abroad and the European car hire company.
It appears that Travel Abroad was incorporated in about 1983. Its operations were on a modest scale for some years. According to the financial statements prepared for the company by Phillips McSweeney, the total income of the company in the financial year ended 30 June 1986 was $143,399, all but $lll of which was earned from commissions and fees. In the 1987 financial year income increased sixfold to $857,952, of which $847,538 represented commissions and fees. According to Phillips McSweeney, total expenses for 1986 were $109,931, leaving a pre‑tax profit of $33,468. Again according to
Phillips McSweeney, total expenses for 1987 were $656,764, yielding a pre‑tax profit of $201,188.
By contrast, according to the accountants, the income of Wheels Abroad dropped from $1,544,574 in 1986 to $1,477,765 in 1987. Total expenses rose from $1,321,820 to $1,575,665. The 1986 profit of $222,754 became a loss of $97,900 in 1987.
The predecessor of the Travel Agents Act 1986 was the Travel Agents Act 1973. Under that Act New South Wales travel agents were required to be licensed and registered with the Travel Agents Registration Board. Upon the commencement of the 1986 Act, on 2 February 1987, all registered travel agents were automatically admitted to the new Fund. Those persons included Travel Abroad. Wheels Abroad was never the holder of a travel agent's licence or a Fund participant.
Early in 1987 the trustees decided to require participants in the Fund to provide specific financial information. The purpose was to evaluate the desirability of their continued participation. The relevant requirements were set out in a document entitled Review Criteria to Annual Financial Statements. The document not only specified the nature and form of the financial documents which the Fund expected to receive; it also specified criteria for evaluation of the information they contained. The document outlined a points system for determining compliance with those criteria. The criteria included minimum levels of share capital and reserves, working capital ratio (i.e. ratio of current assets to current liabilities), ratio of working capital to monthly overheads, net tangible asset to turnover ratio and equity ratio. Although loss making agencies were not to be automatically excluded from participation, the document envisaged special supervision of agencies who had incurred losses in the previous financial year which resulted in a diminution of 25% or more of the agency's net tangible assets. The trustees decided that all participants in the Fund should be required to submit audited financial statements complying with this document within three months of the end of their financial year. A financial questionnaire had to be completed and lodged at the same time. Phillips McSweeney prepared Travel Abroad's financial accounts for the year ended 30 June 1987. They gave a certificate, signed on behalf of the firm by Mr McSweeney, that they had audited the accounts, being a profit and loss statement for the year ended 30 June 1987, a balance sheet at that date and various notes and ancillary statements. The firm certified that the accounts ... are properly drawn up:
(i) so as to give a true and fair view of the state of affairs of the company at 30th June, 1987 and of the profit of the company for the
year ended on that date, and the other matters required by Section 269 of the Companies (NSW) Code to be dealt with in the accounts;
(ii) in accordance with the provisions of that Code; and
(iii) in accordance with applicable approved accounting standards.'
The certificate was dated 11 September 1987.
The accounts were apparently submitted to TCF before the end of September; that is, within the permitted three month period after the end of the financial year. They were examined by John Bryan Murphy, an accountant employed by the Fund on a contract basis to assist in the assessment of participants. Mr Murphy accepted the truth of the information in the financial statements. In particular, as he deposed in an affidavit filed in this proceeding, he assumed on the basis of that information:
... that all the operating expenses incurred by Travel Abroad had been fully reflected in its audited accounts and that there was no matter which had not been revealed in the accounts which may have adversely impacted on its financial position.' On the basis of that information, Mr Murphy concluded that Travel Abroad scored more than the minimum number of points required for continued participation in the Fund. Without reference to the person in charge of financial assessments, Antony Whittaker, Mr Murphy put Travel Abroad's application for continued participation before the trustees for approval. The trustees did approve, with the result that the company continued to participate in the Fund. Mr Murphy deposed that, if he had known that there was an arrangement whereby another company in effect provided a subsidy to Travel Abroad in respect of its operating expenses which enabled Travel Abroad to operate at a profit instead of at a loss', he would have referred the matter to Mr Whittaker and not put it before the trustees for approval.
Mr Whittaker deposed that, at the time, he did not see Travel Abroad's financial statements. He has since done so. In his affidavit he made this comment on the 1987 financial statements:
It is quite clear to me from my analysis of those documents that expenses incurred by Travel Abroad in the 1987 financial year were in fact paid by Wheels Abroad and Wheels Abroad was thus subsidising Travel Abroad. This fact is apparent from a comparison of the level of operating expenses revealed in the 1987 financial statements for both companies and the huge increase in percentage terms for the operating expenses of Travel Abroad disclosed in its unaudited 1988 financial statements. The extent of this subsidy is difficult to determine but if the percentage figures for 1988 are translated to 1987, the subsidy would be in the order of about $300,000.' Mr Whittaker said that, if Travel Abroad had not received a subsidy of this order, it would have had an excess of liabilities of assets and fallen within the category of loss making agencies'. He went on:
Further, Travel Abroad would not have satisfied the minimum requirements for eligibility for participation in the Fund. Had I known or suspected this was the case I would have recommended to the Trustees that Travel Abroad be required to obtain a bank guarantee in an appropriate sum and that audited financial statements be provided to the Fund for the ensuing six months period, as a precondition for Travel Abroad being permitted to continue to participate in the Fund.' It appears that, in the 1987‑1988 financial year, Travel Abroad's business expanded even more. Evidence of this expansion was given by Juliana Rose, a travel consultant who worked for Travel Abroad from November 1987 until it closed in December 1988. When Ms Rose commenced employment, the total staff of Travel Abroad and Wheels Abroad was 20 to 22 persons. During 1988 the number of staff doubled, to about 45. Ms Rose said that, during the period of her employment, the volume of business transacted by Travel Abroad increased dramatically. She also said that, as early as 1987, she became aware that Travel Abroad was not paying for airline tickets until the last possible moment. Phillips McSweeney were retained by Travel Abroad and Wheels Abroad to prepare their 1988 financial statements. Their representatives commenced working in the companies' offices in June 1988. They had access to all the companies' records including their computer. According to Fiona Hofmeyer, who was employed by Travel Abroad as a data operator, the computer was used by that company for costing information, reservations, printing invoices and other purposes. She said in her affidavit that the same system was used by the accounts department. She assisted two Phillips McSweeney representatives, John Beale, a partner in the firm, and Tim Cullen, in accessing the computer data base. She said that, as far as she is aware, both the hardware and software functioned satisfactorily. Phillips McSweeney quickly realised that Travel Abroad was in serious financial difficulties. By 24 August 1988 the firm prepared a Preliminary Amalgamated Statement of Assets
and Liabilities' covering both companies. This document purported to show the position as at 30 June 1988. A business consultant, Pamela Gilbert of International Business Analysis Pty Limited (IBA') was retained. She was shown the preliminary statement. On 26 August she wrote a letter to the directors of the two companies commenting on this document. In this letter Ms Gilbert said that the statement: ... clearly shows that the 'group' is operating with a significant deficiency. At this stage, this deficiency cannot be accurately quantified. However, it is believed to be in excess of $2 million.
Given the deficiency, along with continued delays in paying creditors, it is our opinion that the company is insolvent.'
Phillips McSweeney reached the same conclusion. On 31 August Mr Beale wrote to the directors of Travel Abroad. He said:
Following our review on the 30th August, 1988, of the Draft Amalgamated Statement of Assets and Liabilities for Travel Abroad Pty Limited and Wheels Abroad Pty Ltd as at 30th June, 1988, it is our opinion that the company is insolvent due to the company's exposure to Wheels Abroad Pty Limited. We are endeavouring to finalise the financial statements for Travel Abroad Pty Ltd for the year ended 30th June, 1988 so that we can ascertain the true position of the company.' Mr Beale went on to advise the action which ought to be taken. The suggested steps included that (a)ll deposits taken from customers be placed in a separate Trust Account identifying the payments as customer deposits'. They also included the conclusion, as quickly as possible, of the current negotiations with potential purchasers of the business'. The evidence does not reveal much about the negotiations then on foot. There may also have been other prospective purchasers; but, at about this time, there were discussions between the Lemon brothers and Mr Dunn on behalf of IPG. Negotiations over the weekend of 17‑18 September culminated in an agreement on 18 September 1988. The parties to the agreement were the Lemon brothers, as vendors, the subject companies, Wheels Abroad and Travel Abroad, and IPG as purchaser. The agreement provided for the sale by the vendors to IPG of all the shares in both companies for $200,000. The sale was to be completed 90 days after the date of the agreement. Amongst the documents annexed to the agreement was the Preliminary Amalgamated Statement of Assets and Liabilities of the two companies, previously referred to. This document showed a net deficiency of $1,153,433. There was also a document referring to the two companies' major creditors. This revealed what was called a nett cash' deficiency' of $2.9‑3,000,000 +/‑ $2‑300,000 maximum'; in other words a cash deficiency lying within the range $2.6 million to $3.3 million.
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Immediately after the execution of the agreement, the incumbent directors of Travel Abroad resigned their offices. The three directors of IPG, Messrs Dunn, Sharp‑Paul and Smith, were appointed in their place.
Mr Dunn immediately moved to control both companies. On Monday, 19 September, the day after the agreement was made, he went to Mona Vale with Julie Boyd, the Administration Manager of IPG. Mr Dunn asked Ms Boyd to familiarise herself with the companies' computer system and accounting procedures and find out the amount of money they owed their creditors. Ms Boyd remained at Mona Vale, as Administration Manager, until 21 December 1988, when the two companies ceased to trade.
Early in her time at Mona Vale, Ms Boyd encountered difficulties in obtaining accurate financial information. Mr Nigel Lemon gave her a list of overseas car rental companies who were creditors of Wheels Abroad. Some figures were uncertain but the list suggested that the debts in this category amounted to $1.4 ‑ $1.5 million. It later turned out, according to Ms Boyd, that the true figure was over $2.2 million. These debts were incurred before 18 September 1988. They were for rentals of cars supplied by the creditor company to Wheels Abroad's customers, the customers having pre‑paid their car rental before travelling overseas. Ms Boyd said that IPG opened some new bank accounts. One of them was a Travel Abroad client account. It was opened on 10 October. The intention was that all moneys received in respect of new' bookings would be deposited in this account. Some moneys were deposited in this account and were used to pay for airline tickets and other expenses incurred on behalf of clients; such as accommodation, car hire etc. It is not clear whether or not all moneys received in respect of new' bookings went into this account. But, even if they did, the assurance apparently offered by the existence of this account was compromised by its restriction to new' bookings. At Mr Dunn's direction, Ms Boyd used the account only in respect of bookings initially made after 10 October. She agreed in cross‑examination that the effect of this instruction was that, if a client had made a booking in June and paid $200 deposit, that would be regarded as an old' booking. If, after 10 October, the client paid the balance of the travel cost, the payment would not go into the trust account; the booking was not new'. Given the volume of business then being transacted by Travel Abroad, there must have been hundreds of such cases. The result was that, after 10 October and notwithstanding the opening of the trust account, substantial clients' payments continued to go into the company's own funds. Ms Boyd was unable to say what proportion of the final deficiency was attributable to the failure to place payments in respect of old' bookings in the trust account.
On 20 September, Mr McSweeney wrote a letter to the new directors. The letter inquired whether the advice previously tendered had been adopted. Mr McSweeney noted his observations about the company's position in this way:
In the course of the performance of my duties as auditor of the company, it has become clear to me that: (i) There have been a large number of transactions between the company and Wheels Abroad Pty Limited. (ii) The directors of the company are presently unable to provide full and complete details of the respective transactions between Wheels Abroad Pty Limited and the company, and (iii) It is the opinion of IBA Business Consulting services that an amalgamated statement of assets and liabilities of Wheels Abroad Pty Limited and the company indicates that the amalgamated liabilities of Wheels Abroad Pty Limited and the company exceed the amalgamated assets of Wheels Abroad Pty Limited and the company. I am concerned that you should establish to my satisfaction that the company is not insolvent and able to pay its debts as they fall due. (iv) Mr Greg Lemon, managing director of the company, has confirmed that the company is not able to pay professional fees to Phillips McSweeney (nor any other firm) to enable accounts of the company to be prepared for subsequent audit by myself.' Mr McSweeney went on to require the directors, within 21 days, to provide him with evidence of a number of things. They included evidence that the company was keeping its accounting records in such a manner as would enable the preparation of true and fair accounts and the audit of those accounts, evidence that the company was able to pay its debts as they fell due and particulars regarding arrangements with creditors. There was no express repetition of the stipulation that moneys received by clients by way of pre‑payment of future travel expenses be kept in a separate fund. This may have been intended to be covered by Mr McSweeney's request for confirmation that the steps which had been earlier recommended had been effected. Mr McSweeney ended his letter by referring to TCF: Finally I again confirm my advice to you that the Company is obliged to file audited accounts for year ended 30th June, 1988 not later than 30th September, 1988 with the Travel Agent Compensation Fund. Failure to file such accounts will jeopardise the status of your Travel Agents licence.
You have not submitted accounts to me for audit, and based upon the present position, you will not be able to submit accounts to me so that I may audit the same to enable you to meet your licence requirements.
You should make an immediate application to the Travel Agents Compensation Fund for an extension of time to file accounts.'
On 27 September Mr Beale wrote a further letter to the directors of Travel Abroad. He referred to a discussion with Mr Dunn on 23 September and indicated that he was waiting for confirmation of the changes of shareholdings and directorships. He then said:
2. We have been unable to commence the audit for the year ended 30th June, 1988 because we have not received completed financial accounts for the company. 3. We request immediate confirmation that the following requirements (as advised in our previous correspondence) have been put into place: a)A trust account has been set up and all client deposits are placed in this and that the account be only used to meet payments on behalf of those clients. b)we require confirmation that I.P.G. will guarantee payment of all debt incurred from the 20th September, 1988. c)In addition we require confirmation and supporting evidence that the company, can continue to trade on and pay its debts as they fall due. 5. Lastly we wish to remind you once again that the Travel Agents Compensation Fund requires audited accounts and financial ratios to be lodged by the 30th September, 1988. We do not consider this is possible and an immediate extension must be applied for.' Mr Beale's letter was addressed to the Mona Vale premises. According to evidence given by Mr Beale, on 28 September Mr Dunn telephoned him and requested that he seek an extension of time in which to lodge audited financial statements with TCF. According to Mr Beale, he telephoned James McDougall, the then Claims Manager of TCF, and obtained an extension of time. Mr McDougall said in evidence that he does not remember this conversation but does not dispute that it occurred. It was referred to in a letter of 29 September in which Mr Beale purports to confirm an understanding that an extension until 31 October 1988 had been granted. The confirmatory letter does not give any reason for the request for extension of time. In evidence, Mr Beale said that he told Mr McDougall on the telephone that the business had been sold and that the directors had not yet completed the financial statements. Mr McDougall did not respond to Mr Beale's letter. He apparently accepted it as accurately stating the terms of the telephone conversation. Mr Dunn retained IBA to assist with the preparation of the 1988 accounts. A meeting was held on 14 October to discuss the audit program. The only director of Travel Abroad in attendance was Mr Dunn. The other people present were representatives of IBA and Phillips McSweeney, including Mr Beale and Mr McSweeney. At about this time another firm of accountants, Bird Cameron, was retained by Phillips McSweeney to supervise the audit. Mr Beale gave evidence that he became aware at the meeting of 14 October that the company was having difficulty reconciling its computer records. He said that incorrect data had apparently been entered. Many bookings were missing or only partly entered. On 18 October Mr Dunn wrote on behalf of IPG to Mr McSweeney responding to his letter of 20 September. He referred to the position regarding the preparation of the accounts. In relation to liabilities, Mr Dunn stated that the board of IPG had resolved to meet any liabilities incurred by Travel Abroad from the date of acquisition, 18 September, and that IPG has already injected approximately $2 million into Travel and Wheels ... as working capital'. Reference was made to some of the other matters raised by Mr McSweeney, but nothing was said about keeping a separate account for client pre‑payments.
On 20 October, at the request of Mr Dunn, Mr Beale wrote to TCF requesting a further extension of time for the lodgement of the 1988 financial statements. He gave two reasons. The first was computer failure'. In relation to that matter Mr Beale said: A new computer was installed in November, 1987 to handle all bookings, receipts payments etc, however major software development problems became apparent only after several months of use.
The failures of the system have meant that the majority of transactions have had to be viewed, re imputed, amended or deleted before the accounts are in a suitable condition for Auditing.
We initially expected this work to take four weeks however, the sheer volume and added complications have increased this to 10 weeks.
The fact that the Company has grown from turnover of $8,000,000 in 1986/87 to in excess of $20,000,000 in 1987/1988 has accentuated the problems.
The Directors advise that the Company's records and in particular the Computer generated records, are now being maintained in a form that will enable them to be Audited.
During the past few weeks we have continued our Audit in areas not affected by the Computer problems and therefore, we anticipate the timely completion of the Audit once the Accounts for the year ended 30th June, 1988 have been completed.'
There is no evidence to support the claim of computer failure. The only evidence on this matter, from Ms Hofmeyer, is to the contrary. The other reason given in the letter was change of ownership'. Mr Beale said: Several days of negotiations over the past three months have resulted in further delays to the Audit, however we believe the security and management skills of the new owners will assist our task as Auditors in the future.'
The letter of 20 October succeeded in its purpose. On 28 October Max Krumbeck, the administrator of TCF, wrote a letter to Mr Beale concerning details of the new shareholdings. He added a handwritten postscript: The question of an extension has been referred to the Trustees'. On 26 October Mr McDougall faxed a message to Mr Beale stating that the trustees had approved an extension to 30 November 1988. He added that the trustees had declined other requests for extensions beyond that date. During the month of November, work on the preparation of the financial statements of Travel Abroad and Wheels Abroad proceeded; at what intensity it is difficult to say. The companies failed to honour arrangements for payments of fees to Phillips McSweeney. Although some payments were made, these failures probably impeded progress. In the meantime, Ms Boyd kept discovering unpaid accounts. She was constantly receiving telephone calls and facsimile messages from creditors. In evidence she estimated having received 50 to 100 telephone calls per day throughout September, October and November. By the end of November, it was clear that the moneys injected by IPG into the companies was inadequate. About this time Lewis Short, a person who was a substantial shareholder in, and a consultant to, IPG (though not a director) became involved in the problem. He spent some time at Mona Vale and told Ms Boyd that he thought the deficiency exceeded $4.2 million. He organised a working weekend with several staff members. The group prepared a list of assets and liabilities as at 30 November. This document revealed assets of $860,000, liabilities of $5,979,870 (of which $2,005,000 was due to IPG) and a deficiency of $5,119,870. Mr Short gave the document to Mr Dunn. Mr Dunn travelled to England to speak to the companies' major trade creditors about a proposal to convert their debts into equity. The mission was unsuccessful. The proposal depended upon the agreement of all creditors and this was not forthcoming. On 6 December 1988 Mr Krumbeck wrote to Travel Abroad noting that the 30 November extension date had not been complied with. He said that he was referring to the trustees the question of Travel Abroad's continued participation in the Fund and offered an opportunity for the company to be heard by the trustees on 16 December. This invitation was not taken up. But Mr Short and Sam Cannon, the manager of Travel Abroad, met Mr Krumbeck on 15 December. They apparently told him the position but added that it was not certain what course IPG would take. On the same day, Mr Cannon faxed a request for a further extension. At their meeting on the following day, the Travel Compensation Fund Management Committee decided not to approve this request. But, surprisingly, no decisive action was taken by TCF. So far as appears, the trustees did not deal with the matter, nor did Mr Krumbeck inform Travel Abroad of the management committee's decision. IPG was due to complete the purchase of the two companies on 18 December. It decided not to do so. On 21 December the two companies ceased trading. On that day Mr Dunn wrote to the Travel Agents Registration Board stating that IPG was not completing the agreement to purchase the two companies because of breaches of contractual conditions. Some boxes of documents, including some airline tickets and cheques, were delivered to TCF. TCF set about dealing with claims, at an ultimate loss to it of $423,369. The detail of that loss is set out in the applicant's affidavit evidence. As it is not disputed, I need not reproduce it. It is sufficient to say that the sum of $423,369 is a net loss, after taking account of some moneys received from the liquidator of Travel Abroad, being the balance of the bank trust account. There is no prospect of any further payment from the liquidator. After payment of priority creditors and the costs of the winding up, the company has no funds. The claim against the first respondents: some additional facts ........................................................... The claim against the second respondents I have already mentioned that TCF bases its case against the second respondents on alternative foundations: negligence in respect of the 1987 amount [sic - accounts] and failure to disclose to TCF, in the period July to September 1988, Travel Abroad's condition of insolvency. I do not find it necessary to deal with the second basis of claim. In my opinion, the complaint concerning 1987 is clearly established. Before going to the evidence concerning the 1987 accounts I should deal with a submission made by Mr McSweeney, on behalf of Mr Phillips and himself, that there could be no liability in negligence because his firm was not a client of TCF. He said that the second respondents did not owe TCF a duty of care. Mr McSweeney's submission must be evaluated in the light of the fact that he was aware that the 1987 audited accounts would be submitted to TCF. I admitted into evidence an extract from evidence given by Mr McSweeney during the course of an examination under s.541 of the Companies Code in relation to Travel Abroad. Mr McSweeney was asked: You I take it realised did you not that the purpose of the audit was to furnish information to the Travel Compensation Fund people?'
The audit referred to was the 1987 audit of Travel Abroad. Mr McSweeney replied: We were aware of that'. There was also tendered in evidence an affidavit, sworn in a different proceeding in this Court, by Mr Cullen. Mr Cullen was actively engaged on the 1987 audit. In that affidavit he said: 6. The trust account of Travel has been audited for the period 31 December, 1986 and again for the period to 30 June, 1987. No interim audit was done between those accounting periods. The audited accounts were to satisfy the obligation of Travel to the Travel Agents Compensation Board. The accounts of Wheels were prepared, relying on information provided by the company, without any audit.'
Leaving aside these express admissions, it is plain from the
sequence of events described above that Phillips McSweeney knew that part of their 1987 task was to supply the information necessary for TCF to consider Travel Abroad's continued participation in the Fund.
Having regard to these facts, the proposition that Phillips McSweeney owed no duty of care to TCF is untenable.
TCF was plainly a person so closely and directly affected by the audit that the auditors ought reasonably to have had them in mind in carrying out their duties. See per Lord Atkin in Donoghue v Stevenson [1932] AC 562 at 580 and the later statements of principle in Grant v Australian Knitting Mills [1936] AC 85 at 104 and Home Office v Dorset Yacht Co [1970] AC 1004 at 1027.
Evidence critical of the 1987 audit was adduced from three expert witnesses: Robert Walker, Professor of Accounting at the University of New South Wales, James Frederick Kropp, a partner in Price Waterhouse, and Albert Cachia, a partner with KPMG Peat Marwick. Professor Walker and Mr Kropp were called on behalf of the applicant, Mr Cachia on behalf of Mr Sharp‑Paul. All were impressive witnesses whom I accept without reservation.
Professor Walker prepared a report dealing with both the 1987 and 1988 audit. In his report he assumed that Phillips McSweeney was aware that Mr Gregory Lemon was in a position to control both companies, an assumption undoubtedly valid until 18 September 1988. He said that the 1987 audit failed to address the question whether the Travel Abroad statements were likely to be misstated by virtue of transactions with related parties, though this possibility was recognised in 1988. He said that the audit failed to subject the financial statements to analytical review; that is, an examination of the turnover of the travel business, and the margin of gross profit derived from it, so as to assess its viability relative to its overhead expenses. He also criticised the inadequacy of the supervision supplied in 1987.
Mr Kropp dealt with a number of specific items. He noted that a management fee of $180,000 was charged by Wheels Abroad to Travel Abroad on 30 June 1987. He thought this might not have fully reimbursed Wheels Abroad for the expenditure it incurred on behalf of Travel Abroad, with the result that Travel Abroad received an undisclosed subsidy from Wheels Abroad. The decision to pay $180,000 was made by a resolution of the directors. The resolution did not disclose the method of computation of this figure. Mr Kropp made the point that there was nothing before Phillips McSweeney to indicate the appropriateness of the figure. He drew attention to three matters:
(i) the physical premises and the functions of the various employees of the two companies were so intermingled that it would have been difficult to separate the two entities. (ii) expenses were being incurred by one or other of the companies for the benefit of both companies (eg advertising and promotion) and it would have been difficult to ascertain precisely the proportion relating to each company; and (iii) expenses were being paid by Wheels abroad which later charged Travel Abroad a management fee. No analysis of the make up of the management fee was evident in the documentation reviewed by us.' Mr Kropp commented that these matters made it difficult to determine with precision the level of any subsidy which existed in the 1987 financial year. But he obtained some assistance from consideration of information in the 1988 audit working papers and by performing analytical review procedures on the Travel Abroad results for 1987. Comparing 1987 with 1988, Mr Kropp noted that commissions and fees increased from $848,000 to $1,307,000, a rise of just over 50%; yet salary costs rose from $144,000 to $639,000, printing and stationery from $1,000 to $181,000, auditor's expenses from $16,000 to $143,000 etc. These discrepancies were partly offset by a reduction of the management fee from a total of $204,000 in 1987 to $66,000 in 1988. Nevertheless, even after allowing for this, total expenditure quadrupled from $655,000 to $2,650,000. The declared 1987 net profit before taxation, $201,000, became a loss in 1988 of $1,258,000. Focussing on only four items, advertising and promotion, salary costs, printing and stationery and telephone, and after taking into account the management fees paid in each year, Mr Kropp concluded that actual expenditure incurred in 1987 by Travel Abroad was some $620,000 higher than noted i.e. $440,000 higher than the management charge incurred'. The effect of Travel Abroad paying the true cost of management would, of course, have been to plunge it into loss in 1987. Mr Kropp estimated this loss at $112,000. Having reviewed TCF's published requirements, Mr Kropp expressed the opinion that proper Travel Abroad accounts would not have satisfied the criteria for continuation in the Fund after 30 September 1987.
In his report, Mr Kropp made criticisms of the conduct of the 1987 audit. They were similar to the comments of Professor Walker. But Mr Kropp specifically mentioned the lack of evidence that Phillips McSweeney made any inquiry as to the make up of the $180,000 management fee, discussed the fee with management, reviewed any documentation held by Wheels Abroad concerning the fee or assessed whether there was a possibility of further charges. He concluded that Phillips McSweeney did not comply with relevant auditing standards.