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Federal Court Dismisses Investors’ Claims Against Auditors of Madoff Feeder Funds

Yet another decision has held that the auditors of a fund that invested with Madoff may not be held liable to the investors of the feeder fund. In re Tremont Securities Law, State Law and Insurance Litigation (S.D.N.Y. March 30, 2010).

Tremont Partners managed several hedge funds that served as “feeder funds” for Bernard L. Madoff Investment Securities LLC (BMIS). Under the partnership agreements with the investors, Tremont acted as the general partner with sole discretion to delegate management of the funds’ assets. Tremont delegated to Madoff the authority to act as asset manager. Tremont’s funds were audited by E&Y and KPMG during the years prior to the uncovering of Madoff’s fraud. In their class action lawsuit, the investors alleged that the auditors had violated professional auditing standards by ignoring various “red flags” and were complicit in the fraud because they had failed to uncover the Ponzi scheme despite unfettered access to the funds’ records.

Judge Thomas P. Griesa began his analysis by noting that a claim of securities fraud required scienter, or “the actual intent to deceive, manipulate or defraud.” Allegations of GAAS violations without corresponding fraudulent intent were not enough to set forth a securities fraud claim against an independent accountant. The court noted that “the more compelling inference as to why Madoff’s fraud went undetected for two decades was his proficiency in covering up his scheme and eluding the SEC and other financial professionals.” The critical fact for the court was that the auditors were never engaged to audit BMIS or opine on its financial statements: The notion that a firm hired to audit the financial statements of one client [the Tremont Funds] must conduct audit procedures on a third party that is not an audit client (BMIS) on whose financial statements the audit firm expresses no opinion has no basis. To impose liability on the Auditors would expand their limited, circumscribed duty impermissibly.

The court’s decision in Tremont thus stands as a bulwark against further attempts to expand auditor liability in order to spread the risks of losses due to financial fraud.

For further information, please contact Vince Gentile at (609) 716-6619 or Vincent.Gentile dbr.com.

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Pennsylvania Supreme Court Restricts Auditors’ Use of Imputation Defense

The Pennsylvania Supreme Court has held that the imputation defense is unavailable to a corporation’s outside auditor who is alleged to have knowingly and actively assisted the corporation’s managers to render fraudulent financial reports. Official Committee of Unsecured Creditors of Allegheny Health Education and Research Foundation v. PricewaterhouseCoopers, LLP (Pa. Feb. 16, 2010) (AHERF). The decision is not altogether bad news for the auditor defense bar because it also holds that Pennsylvania law continues to allow the auditor to assert the imputation defense to claims of simple audit negligence.

Pennsylvania law now occupies the middle ground between those jurisdictions that recognize the auditors’ right to assert the imputation defense based on management fraud, and those, like New Jersey, that would bar auditors from asserting the imputation defense and leave the culpability of corporate insiders to be resolved as a matter of comparative fault. See NCP Litigation Trust v. KMPG, LLP (N.J. 2006).

AHERF was a Pennsylvania nonprofit corporation that operated an integrated system of hospitals, medical schools and physician practices, and grew through an aggressive acquisitions strategy. Coopers & Lybrand (PwC’s predecessor) had served as AHERF’s independent auditor. When AHERF’s growth plan failed, the corporation filed a bankruptcy petition. The committee of creditors, acting on the debtor’s behalf, then brought claims against AHERF’s officers and insiders as well as PwC. The claims against PwC alleged professional negligence, breach of contract, and aiding and abetting the breach of fiduciary duty by the AHERF officers, and sought damages equal to the full amount of AHERF’s insolvency.

PwC established that AHERF’s officers, including its chief executive and financial officers, had fraudulently misstated AHERF’s finances between 1996 and 1997. The district court ruled that the fraud of the corporate officers would be imputed to AHERF and, in turn, to the creditors committee, which stood in AHERF’S shoes. The court then applied the in pari delicto rule to bar AHERF from asserting the claims against the auditor. The creditors committee appealed, arguing that the imputation defense should not apply because the auditors were alleged to have wrongfully colluded with AHERF’s insiders in misstating the corporation’s finances. Because the issues presented questions of first impression under Pennsylvania law, the U.S. Court of Appeals for the Third Circuit asked the Pennsylvania Supreme Court to determine whether the imputation doctrine should apply in this context.

The Supreme Court emphasized the equitable bases for the defense of in pari delicto (a shorthand version of the Latin phrase “in pari delicto potior est conditio defendentis,” which means ”in case of equal fault the position of the defending party is stronger”). The court noted that an equitable principle should not be applied to produce an inequitable result. Likewise, the imputation doctrine was an equitable, agency-based rule intended to shield innocent third parties who do business with agents of the principal. The theory presumes that, assuming the agent’s actions were for the benefit of the principal, the consequences of the agent’s fraud should fairly be borne by the principal rather than the third party.

The Pennsylvania Supreme Court found that imputation generally would not apply in situations where the third-party professional colluded with an agent against the corporate principal. That result flowed from the rationale that imputation was meant to protect innocent third parties but not those who know or have reason to know that an agent is not likely to transmit material information to the principal. PwC had argued that, even if the auditors could be considered culpable, that should not preclude the in pari delicto defense: “[w]here a sophisticated corporate entity with in-house certified public accountants deliberately misstates its own financial statements and withholds material information from its outside auditor, the corporation bears at least equal fault as the auditor who did not detect the corporation’s fraud (or even is alleged to have aided and abetted that fraud).” The court rejected that interpretation.

AHERF holds that, under Pennsylvania law, in pari delicto can only be asserted in cases in which the plaintiff’s culpability is equal or greater than the defendant’s. While this equal or greater fault requirement was not universally accepted, the court wanted to ensure that it was not simply reduced to the role of “mediat[ing] disputes among wrongdoers.” In addition, allowing the defense only where the plaintiff was substantially responsible served to deter illegal conduct and created incentives to greater oversight of corporate agents.

 

The court rejected a blanket rule that would disqualify auditors from asserting an in pari delicto defense, noting the “the special – and crucial – role assumed by independent auditors as a check against potential management abuses” and “the growing prevalence of breathtaking malpractice claims against auditors in the corporate insolvency setting; the corresponding litigation burden; and the resultant impact on the profession as a whole, as well as those they serve.”

Pennsylvania has thus clearly rejected the New Jersey rule announced in the NCP case. In NCP, the New Jersey Supreme Court held that in pari delicto could not be applied in an audit malpractice case because the auditors, whether alleged to be negligent or otherwise culpable, were by definition not the kind of “innocent” third parties meant to be protected by the doctrine. Rather than apply the doctrine in a way that would bar many “innocent” parties (including shareholders and creditors) from recovery, the New Jersey rule requires the relative faults of the corporate plaintiff and the auditors to be sorted out as matters of comparative negligence and apportionment by the fact finders.

The new Pennsylvania rule adopts the New Jersey rule but only for cases involving auditor collusion. It otherwise permits in pari delicto to be asserted as the basis for a pretrial motion to dismiss. AHERF seems to invite potential plaintiffs to include allegations of auditor participation and knowing involvement in the illegal activities of corporate management in order to avoid dismissal. While the “innocence” of the auditors may be apparent on the face of some complaints, in many cases this will be far from clear. It remains to be seen whether the AHERF rule will permit questions of imputation (including whether the plaintiff’s culpability equals or exceeds that of the auditor) to be resolved without costly and burdensome discovery.

This article is an abridged version of an article published by Vince Gentile in Law360 in June 2010. For further information, please contact Vince Gentile at (609) 716-6619 or Vincent.Gentile dbr.com

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Expert’s Income Is Off Limits to Opposing Party

One of the best ways to discredit an opposing party’s expert is to expose the expert’s bias. Revealing an expert’s “positional bias” – whether he or she primarily works for plaintiffs or a certain type of defendant – can have a great impact on the expert’s credibility with the jury. Trial lawyers often impugn the testimony of such experts as “hired guns.” New Jersey’s Appellate Division has recently reiterated the importance of evidence suggesting positional bias, but has nonetheless limited the type of personal financial information that must be disclosed by expert witnesses – striking a balance between the expert’s privacy and the opposing party’s entitlement to relevant evidence.

In In the Matter of Central Orthopedic Assocs. (N.J. App. Div. November 16, 2009), the Appellate Division overturned a trial court order permitting discovery of the income of a physician expert witness. The court rejected the notion that a licensed professional “surrenders all rights of privacy upon providing an expert opinion to a litigant for monetary consideration” and sent the matter back to the trial court with some guidance on how courts should address requests to pry into an expert’s finances. While the court recognized that a party is entitled to know how much its adversary paid for the expert witness it has retained, the court was more cautious in allowing discovery about the expert’s income derived from other sources, including from litigants in other cases.

Before ordering the turnover of an expert’s personal financial information, courts should determine whether there are other less intrusive sources of that information. For example, testimony from the expert admitting that he or she predominantly represents certain parties (plaintiffs or defendants) or companies in a specific industry generally suffices to demonstrate the expert’s bias and eliminates the need to explore more sensitive areas of the expert’s personal life. If an expert denies that he or she predominantly represents one side or a particular client or kind of client, however, and the opposing party can make a preliminary showing otherwise, then more intrusive discovery into the sources of an expert’s income may be warranted.

Courts should rarely, if ever, order disclosure of the actual amount of an expert’s annual income. As the Appellate Division explained, the actual amount of an expert’s income is not particularly relevant. What good does it do to learn that the opposing party’s expert earns $200,000 a year? Instead, the focus should be on what percentage of the expert’s income is derived from providing expert testimony and opinions. The court instructed “it is the percentage of income derived from a particular source that is relevant in showing positional bias, not necessarily the particular amount.” Revealing that 90 percent of an expert’s income is derived from providing testimony to plaintiffs in medical malpractice cases, for example, certainly could suggest positional bias.

To strike the proper balance between allowing the opposing party an opportunity to obtain relevant information and protecting against unnecessary intrusion into an expert’s sensitive personal information, the Appellate Division suggests that courts perform in-camera inspection of the expert’s financial information. The trial judge can then determine whether there is a legitimate basis for a party to argue bias from the information provided. If the judge believes the financial evidence is sufficient to argue bias (i.e., the expert’s various sources of income suggest a leaning toward one side or the other), the court may then order the expert to disclose only the percentage of the expert’s annual income that is derived from rendering the expert services used in the lawsuit. The court allayed another concern by noting that disclosing the information for the court’s in-camera review would not strip the information of its confidential nature.

The court suggested that the following disclosures would moot any more intensive financial discovery of the expert: (i) what percentage of the expert’s income is derived from providing litigation services; and (ii) of that amount, what percentage is derived from representing plaintiffs and defendants. The actual amount of the expert’s income need not be revealed to the opposing party. Of course, in particular cases, disclosure of financial information may be warranted. For example, the expert may have done business or have on-going businesses with the party who has retained him or her, and such relationships and the nature and amount of economic benefits flowing from those relationships may be valid grounds for discovery.

The Central Orthopedic decision allows experts to breathe a small sigh of relief – their annual income, or other personal financial details, generally will not be subject to public disclosure simply because they have provided expert services in litigation. As the court recognized, the opposite conclusion could have had a “chilling effect … on the willingness of professionals to provide services.” Courts will have to continue to define the boundaries of this discovery landscape, balancing access to potentially relevant information with exposure of sensitive personal information. For now, the court has held that serving as an expert does not necessarily render your bank book an open book.

For further information, please contact Kris Dress at (609) 716-6621 or Kristine.Dress dbr.com.

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Failure to Retain Tax and Audit Records May Subject Accountants to Liability

Record retention is an important aspect of all fiduciary relationships, a truism that applies equally to accountants. In Weissglass, et al. v. Deloitte & Touche USA LLP (N.J. Law Div. Dec. 15, 2009), a New Jersey trial court decided whether an accounting firm’s allegedly insufficient record retention could support a claim for professional negligence.

In Weissglass, plaintiffs were the principals and shareholders of the Magruder Color Company, Inc. (Magruder), a manufacturer in the graphic arts industry. In the early 1970s, Magruder hired defendant Deloitte and Touche USA LLP (Deloitte) to provide tax, audit, accounting and other financial services.

Plaintiffs’ complaint alleges that Deloitte was liable for breach of contract, negligence and accounting malpractice, among other things, for errors and omissions arising out of audit, tax and related professional services they rendered for the 1994 to 1996 tax years, for which Deloitte had issued unqualified audit opinions. The allegations arose out of changes Magruder made to its method of accounting for inventory on Deloitte’s advice. As a result of those changes, the IRS initiated an investigation of Magruder’s 1995 and 1996 tax returns. Deloitte represented and assisted Magruder throughout the six-year IRS investigation. On November 2, 2001, the IRS examiner concluded that Deloitte had made miscalculations that were not supported by its available records. Deloitte argued that the “miscalculations” should have been recorded differently so as to be permissible, but could not provide adequate documentation to support the change. As a result, Magruder was forced to concede that it had overstated certain costs, and in 2004, the IRS Commissioner issued a final adjustment that significantly increased Magruder’s tax liability. On Magruder’s appeal to the Tax Court, significant portions of Magruder’s proposed expert evidence were excluded, in part because Deloitte’s failure to retain records deprived the expert of contemporaneous documentation of the matters in dispute. Magruder later settled the case with the IRS in 2007 for over $1 million in additional taxes and interest.

Two years later, Magruder filed suit against Deloitte to recover the additional taxes, interest and other costs it incurred as a result of its appeal and settlement with the IRS. Deloitte moved to dismiss the lawsuit raising two arguments. First, Deloitte argued that the complaint was barred by the six-year statute of limitations. Second, it contended that New Jersey’s Accountant Liability Act, N.J.S.A. 2A:53A-25, barred plaintiffs’ negligence claims. On the first point, the court rejected Deloitte’s argument that the complaint was untimely. Deloitte argued that the statute of limitations began to run on November 2, 2001, when the IRS examiner announced his decision. The court rejected that position, finding that the appropriate starting date was the date plaintiffs received the first adverse decision, which was the final adjustment of the IRS Commissioner.

The second argument required the court to construe the Accountant Liability Act (the Act). The Act was designed to preclude third parties from recovering from accountants for negligent acts, unless the accountant knew that its services for a specified transaction were for the benefit of the third party and that the third party intended to rely on their services, and that the accountant directly expressed to the third party by words or conduct its understanding of their reliance. The court found that Deloitte knew that plaintiffs intended to rely on its advice and expressed its understanding thereof when it prepared certain tax forms for plaintiffs in connection with its engagement with Magruder. The court, however, dismissed plaintiffs’ claims of accounting malpractice and negligence because they failed to identify a specific transaction with Magruder that gave rise to liability. Plaintiffs’ general reliance on Deloitte’s preparation of tax forms in connection with its services to Magruder was equivalent to general reliance on annual audits, which the New Jersey Supreme Court has found insufficient to support a cause of action for accountant negligence or malpractice under the Act.

Although the outcome of this case is still in doubt, it illustrates that the failure to preserve records may pose a significant threat of liability to accountants.

For further information, please contact Matt Barndt at (609) 716-6634 or Matthew.Barndt dbr.com.

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Fifteen Minute Conversation Is Enough to Disqualify Expert

One of the rewarding aspects of practicing in a firm of professionals is the opportunity to seek advice and input from your colleagues. That kind of routine exchange during a brief conversation between law firm partners resulted in the disqualification of one of the attorneys as an expert witness, and the disqualification of his entire law firm from representing one of the parties to a lawsuit.

In X.S. Smith, Inc. v. Giordano, Halleran and Ciesla (N.J. Law Div. April 23, 2010), the plaintiff filed a legal malpractice suit against the defendant law firm based on a commercial real estate transaction the firm had handled for it. Plaintiff retained as its expert Stuart Reiser, Esq. Reiser’s expert report was served on defense counsel at the Bressler, Amery and Ross law firm. The Bressler firm retained Bruce J. Ackerman, Esq. as a defense expert. Upon receipt of Ackerman’s expert report, Reiser revealed to plaintiff’s counsel that he had previously discussed the case with Ackerman when they were both partners at another law firm, Shapiro & Croland. Shortly thereafter, Ackerman left the firm. A timesheet showed a 15-minute conversation during which Reiser consulted with Ackerman about some of the issues in the case.

Based on this contact, plaintiff moved to disqualify Ackerman as the defense expert and Bressler, Amery and Ross as defense counsel. Although Ackerman testified that he had no recollection of the conversation and that any conversation that may have occurred was “off the cuff,” the court reasoned that the information conveyed from the plaintiff to its attorneys and its expert was privileged and confidential. Consequently, when Reiser spoke to Ackerman (then his partner) about the case, this privilege was extended to Ackerman. Based on the confidential information relayed to him, the court disqualified Ackerman as well as Bressler, Amery and Ross, which had received the confidential information from Ackerman.

The X.S. Smith decision demonstrates that sharing confidential information with one’s colleagues within the same firm can have unintended consequences. Given the mobility of professionals today among firms, it is not unusual for those discussions to be used as a basis for disqualifying one of the professionals from a later expert engagement. As X.S. Smith shows, it is irrelevant whether the conflict was known, or even foreseeable, when the communication occurred. The key is whether confidential information was disclosed in the earlier conversation. That determination may often turn on whether corroboration of the communication exists, including in the form of time records, which can be considered to confirm the value of the communication.

For further information, please contact Monica Wahba at (973) 549-7375 or Monica.Wahba dbr.com.

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