Corporate Governance

Southern District of New York keeps Accounting firms on their toes-- In re Parmalat

By Leah Jensen

In re Parmalat Sec. Litig. , 2009 WL 179920 (S.D.N.Y. Jan., 2009).

Paramalat SpA collapsed in 2003 after the discovery of immense understatements of debt and overstatements of assets. The international extent of the fraud has garnered a lot of attention from accounting firms worldwide, with the latest U.S. ruling causing particular concern.

Plaintiffs filed a derivative suit under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Deloitte Touche Tohmatsu (DTT) alleging vicarious liability for fraud committed by member firm Deloitte Italy. The District Court for the Southern District of New York denied plaintiff's motion for summary judgment under both the respondeat superior claim and the joint and several liability claim.

The court first rejected defendant's contention that Stoneridge foreclosed secondary liability for Exchange Act claims under common law. The court related that Stoneridge did not foreclose the principle of respondeat superior, and principals may be held expressly liable for violations of Section 10(b) by their agents.

The court then addressed whether DTT was in fact a principal of Deloitte Italy by analyzing the elements of control. The court found several factors that mitigated in favor of substantial control. Those factors included but are not limited to DTT requiring 1) adherence to policies, and protocol regarding professional standards and methodology; 2) specific methods and procedures for conducting audits; 3) member firms to sign a license agreement mandating compliance with quality standards; 4) use of the DTT name; and 5) authority to transfer employees from one member firm to another, without the transferring firm's permission. Finally, there was evidence that DTT exercised authority specifically in the Paramalat engagement.

The court then denied the motion for summary judgment under both the theory of respondeat superior and the issue of control. The court stated that DTT's 'general structure'—encompassing its authority over member firms—accompanied by its specific use of authority in this particular engagement, presented genuine issues of material fact as to whether Deloitte Italy was an agent of DTT leaving the issue of respondeat superior for the fact-finder. Turning again to the issue of control, the court rejected the contention that DTT did not control Deloitte Italy under the language of the statute. The court rejected this argument stating that the Section 20(a) does not require control of a particular violating transaction, but only control of a person or entity liable under the chapter.

DTT then proffered good faith as an affirmative defense. The court recognized that while there may not be evidence that DTT had reason to know of the fraud, or recklessly disregarded it, this did not demonstrate good faith. The court noted that this assertion neglects to encompass the possibility that DTT was willfully blind to the violations. Additionally, while DTT argued that appropriate compliance review systems were in place, the court stated that this is only a factor in evaluating good faith, but is not dispositive. The court further held without evidence of how systems were implemented during the time in question, the court could not find good faith.

The defendants next contended that DT-US did not control DTT and is therefore entitled to summary judgment. To this, plaintiffs argued that 1) many DT-US partners occupy important management positions at DTT; 2) that member firms, including DTT depend of DT-US for funding; and 3) there are specific instances where DT-US played a key role in DTT's decision-making. The court held that each of these factors alone is not dispositive, but cumulatively show a genuine issue of fact as to DT-US' control of DTT. The court also rejected DT-US' assertion of good faith because the evidence does not sufficiently address willful blindness. Arguments that Copeland, CEO of DT-US and DTT were not in control or acted in good faith where quickly rejected based on his status in the company and a lack of evidence for the affirmative defense.

Finally, the defendants contend that they were not joint and severally liable because Section 21D(f)(2)(A) of the PSLRA limits joint and several liability to knowing violations of the securities laws, not merely reckless violations. The court rejected this argument based on legislative history.

The implication that accounting firms may be held liable for actions by their foreign affiliate may be welcome news to investors, but is sending shockwaves through the accounting world.

The primary materials for this post are available on the DU Corporate Governance Website.

Full post as published by The Race to the Bottom on March 25, 2009 (boomark / email).