NMC Health v EY – learnings from the blockbuster judgment that wasn't

NMC had entered administration in April 2020 after £billions in undisclosed debt had been uncovered. The collapse followed a December 2019 short-seller report by Muddy Waters, which alleged inflated earnings, undisclosed related-party transactions, and hidden liabilities.

The Claimants alleged that EY had failed to spot the existence of a long-running fraud orchestrated by senior management, who were essentially running two separate sets of books to artificially inflate NMC's apparent financial performance (and hence its share price) and to conceal inappropriate related party transactions intended to enrich a number of insiders. NMC Health had apparently funded these transactions through taking on large undisclosed debts, frequently backed through parent company guarantees.

The case pitted some of the leading lights of the audit liability bar against each other, with Simon Salzedo KC (author of this team's favourite bedside book Accountants' Negligence and Liability) leading the charge for the administrators, and EY deploying Laurence Rabinowitz KC, Thomas Plewman KC and Ed Harrison KC. It also raised some highly significant issues where guidance from a published judgment would have set the landscape for addressing future claims, including:

• How sophisticated does a fraud have to be for an auditor not to be liable for failing to spot it (i.e. where is the dividing line between the 'watchdog' auditor and the 'bloodhound' forensic investigator)?
• How much reliance can a group auditor place on the work of component auditors? (Here, much of the audit work was carried out by local network firms of EY.)
• If liability were established, what kind of contributory negligence discounts could an auditor expect in the modern world, in circumstances where management of the audited entity are not just negligent but actively fraudulent?
• There was also a fascinating causation angle – if the key decision-makers among those charged with governance were complicit, then what losses could NMC really have hoped to avoid if the fraud (or, more realistically, some aspects of it) were flagged up by the auditor?

Alas we will have longer to wait for answers to these questions. Quite some time after trial – presumably with the judgment almost drafted – the parties reached a settlement. The administrators walked for £105.5m of their claim, initially valued at over £2bn. This is a lot of money, but given the size of the losses it is hard to see this as anything other than a solid result for EY and, on balance, a positive for the audit profession.

This does not, of course, mean there is nothing to learn from the case, especially given the public filing of the Joint Administrators' Progress Reports at Companies House.

• The case is indicative of a broader trend of insolvency practitioners using litigation funding to pursue recovery actions against professional advisers, including auditors, in circumstances where distressed or insolvent companies have suffered significant losses. Funding is clearly out there for audit claims of this enormous magnitude and concomitant cost.
• The Progress Report confirming the settlement sum also noted that litigation funding of c£48m was repaid along with an agreed litigation funding return of c£22m. It remains to be seen whether returns on this scale will continue to incentivise litigation funders to take on further audit claims in the future, given the relatively high risks and uncertainties of returns and the number of years in which capital has to be tied up.
• If a claim were to take 5 years from start to finish, returns on this level would clearly be outpaced by, say, the compound growth of the S&P 500. However, claims against auditors logically increase in a downturn or a recession as more companies fail. This is when other asset classes struggle. The audit profession should continue to be alive to the possibility of funding for claims against them. Funding a claim by an insolvency practitioner against an auditor may be the very definition of a countercyclical investment.
• This was a claim where the administrators were incentivised with some significant uplifts to their rates, depending on the ultimate recovery. For recovery of under £100m, a Managing Director would make a no doubt still-profitable £805 per hour, increasing to £1,150 for recovery in the £100m-125m bracket, all the way up to a blockbuster £2,875 per hour for recovery at above £1bn. No doubt creditors recovering £1bn would have few complaints, but the requirement to publicly disclose these figures (including to the defendant) may give away the fact that the Claimants themselves did not fully believe in the prospects of recovering anything like their full claim value.
• The Progress Report also discloses the existence of conditional fee arrangements for the counsel team, though not their terms.
• Settlement at just above the £100m recovery level still allowed for a significant uplift, and the Progress Report suggests that c£6.45m was paid out following settlement in line with these fee arrangements. It is difficult to tell how much of this represented fees for work done in the period, and how much of this was in respect of the uplift.
• A portion of the legal costs of the administration was not covered by funding. While it is impossible to say how much of this related to the claim, it may have eaten further into recovery by creditors from bringing the action leaving a relatively thin slice of the settlement figure for distribution.

All of this suggests that the arguments being run by EY were considered to have some serious merit. Whether that was rightly or wrongly on this occasion, we will never know.

A further fascinating issue is the extent to which the commercial realities of the situation would have played into the judge's decision-making, above all as to the identity of those who would have benefitted from a large award – the insolvency practitioners, the advisors, and the main creditors of NMC Health, being a collection of banks headed by Abu Dhabi Commercial Bank.

While it is not formally a consideration in audit claims, one could argue that those banks were in a much better position to conduct due diligence on NMC when making lending decisions, than EY when auditing. It would be a strange conclusion from a common-sense perspective if the Court's conclusion led to an arguably less culpable party (EY) having to pay over large sums to an arguably more culpable party (the lending banks). Regrettably, however, such is the lot of an auditor as things stand.