Does SMSF litigation risk die with trustees?
How many times have we heard that it’s only an SMSF audit; there’s not much in the fund; or it’s not high-risk? For some reason, the perception still exists that an SMSF is more straightforward to audit than any other entity.
Interestingly, the auditing standards that apply to auditing an SMSF is the same as any other entity. But the risk is doubled down by the additional complication of having to undertake an SMSF compliance audit at the same time.
Given the inherent complexity of SMSFs, it would be foolhardy for any SMSF professional to ignore the possibility of litigation risk, especially when high-voltage emotional events such as divorce and estate planning can render significant financial damage.
SMSF audit risk
The most significant risk for an SMSF auditor is where their opinion is found to be misleading and deceptive. Given the fact that the audit is undertaken several months after the end of the financial year, this gives rise to a significant time lag between discovering the offending transaction.
The reality is that the auditor is not liable for any loss suffered by the fund before the audit. It’s when the auditor doesn’t undertake the audit in line with their professional obligations under section 128F of SIS and fails to detect loss or fraud in the fund that they can be held liable.
While SMSF trustees are required to be aware of their obligations, comply with SIS and maintain accurate financial records, it is the SMSF professional’s job to ensure that the trustee has, in turn, met their duties.
Where SMSF trustees fall short in their obligations and requirements and ultimately incur an unidentified loss, those SMSF professionals failing in their duty will be in the firing line of an expensive professional indemnity claim from the trustees to recoup these losses.
Regardless of the level of financial sophistication that the trustees may or may not have, SMSF auditors and SMSF practitioners can be held liable. SMSF auditors have already been held accountable as seen in the cases of Cam & Bear Pty Ltd v McGoldrick  NSWCA 110 and Ryan Wealth Holdings Pty Ltd v Baumgartner  NSWSC 1502.
Litigation risk factors
One of the main reasons that SMSF professionals are subject to more scrutiny and potential litigation is that SMSF trustees do not have access to industry compensation.
Where an SMSF auditor fails to identify and communicate compliance breaches that may lead to financial loss — such as investing in high-risk unsecured loans — it’s not a case of will the auditor be sued, but when will the auditor be sued.
SMSF professionals should also be aware that the extent of litigation is not limited to trustees. Disgruntled beneficiaries who end up inheriting less than they think they should, due to financial loss, may also trigger a lawsuit.
Invalid trust deeds
One of the easiest ways this can happen is through amending trust deeds that have not been executed correctly or reference incorrect parties, such as the corporate trustee or the fund name. Under these circumstances, it fails to be a deed where it may not be valid.
A typical example is where the fund has invested in a limited recourse borrowing arrangement (LRBA), and the trustees have updated the trust deed to allow the fund to borrow money under the exemptions outlined in s67A and s67B of SIS. An incorrectly executed trust deed means that the trustees would be unable to borrow under the terms of the previously valid trust deed, but would have done so anyway.
In the event of the death of the trustees, the beneficiaries may wish to liquidate the assets of the fund and wind it up. Any downturn in the property market could lead to capital loss and a shortfall in the fund’s ability to pay back the LRBA. The beneficiaries would look to recoup these losses by engaging the services of an SMSF lawyer who would check the validity of all the fund’s trust deeds as a starting point.
Failure of the SMSF auditor to communicate any significant deficiencies or issues related to the trust deed in the management letter could trigger litigation from the beneficiaries. From this point of view, SMSF litigation risk does not die with the trustees.
The paradigm of litigation against SMSF professionals is not new. We are now seeing SMSF auditors in the firing line as a result of trustees looking for a scapegoat to recoup losses incurred by poor investment decisions.
While this trend will continue, the capacity for litigation from beneficiaries that extends to all SMSF practitioners is only a matter of time.
A greater understanding of this type of issues will enable SMSF professionals to employ more effective communication mechanisms and undertake thorough procedures to minimise the expectations gap and mitigate litigation risk.
Shelley Banton, executive general manager technical services, ASF Audits