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Securities Fraud Action Can Proceed Against Multinational Accounting Firms

A federal judge has ruled that a private securities fraud action involving an Italian company that collapsed upon the discovery of a massive fraud, reportedly involving the understatement of debt and the overstatement of assets, may proceed against the multinational accounting firms with which the company's Italian auditors were connected (In re Parmalat Securities Litigation, SD NY 04 CIF. 0030). The investors alleged that the accounting firms, through their agents Deloitte Italy and GT-Italy, misrepresented that the financial statements of the company and its subsidiaries were accurate and complete when they actually significantly understated the company's debt and overstated its revenue and net assets.

In allowing the action to proceed against Deloitte Touche Tohmatsu ("DTT") and Grant Thornton International ("GTI"), the court noted that independent auditors serve a crucial role in the functioning of world capital markets because they are reputational intermediaries. When such firms certify a company's financial statements, the court said that their reputations for independence and probity signal the accuracy of the information disclosed by the company since the managers are typically unknown to most investors.

In the court's view, this is especially true of global accounting firms. Certification by an entity named Deloitte & Touche, Grant Thornton or one of the small handful of other major firms is incalculably more valuable than that of a less known firm because the auditor, in effect, is pledging its reputational capital that it has built up over many years of performing similar services for numerous clients. The relevant reputational capital is that associated with the worldwide organizations. The court reasoned that allowing those organizations to avoid liability for the misdeeds and omissions of their constituent parts could arguably diminish the organizations' incentives to police their constituent entities with adverse consequences for investors.

In pleading the existence of an agency relationship, the investors set forth allegations from which it could be inferred that DTT was in ultimate control of the audit. The investors maintained that DTT took actions in directing the removal of auditors on the Parmalat audit. The court could not determine whether this was simple collaboration or an agency relationship, but held that a trier of fact could reasonably infer that Deloitte Italy or other member firms auditing Parmalat were agents of DTT. The court concluded that the investors' allegations were enough to give them a chance to prove the existence of an agency relationship sufficient to hold DTT liable for the acts of Deloitte Italy and the other member firms that conducted the Parmalat audit.

The court found that the investors sufficiently alleged an agency relationship between GTI and GT-Italy. The complaint contended that GTI exercised control over GT-Italy in a manner typical of a principal-agent relationship. It further alleged that GTI investigated and disciplined the Italian member firm and ultimately expelled it from the group. GTI's ability to discipline individual partners of GT-Italy, suggested that it had the power to direct the policies and practices of that firm, a defining characteristic of agency, according to the court.

However, the investors were unable to show that DTT was the agent or alter ego of Deloitte USA . Without pleading any facts that would tend to show that Deloitte USA used the close relationship to dominate DTT, an alter ego relationship could not be inferred from the close relationship and overlap in executives. The investors also failed to state a claim against GT-USA on the basis that GTI was its agent or alter ego.

The court also considered 1934 Act section 20(a), under which an individual who controls another is liable for the primary violation of the controlled person unless the controlling person acted in good faith and did not induce the cause of action. Investors can state a claim under the statute if they plead a primary violation by a controlled person and control of the primary violator by the defendant.

It is undisputed that the investors alleged primary violations by GT-Italy ad Deloitte Italy . They also adequately stated that DTT and GTI were principals that controlled their respective agents, Deloitte Italy and GT-Italy. Therefore, the court found that the investors stated a sufficient control person claim with respect to those two entities. Although a defendant ultimately may not be held liable as both a primary violator and a controlling person, the court noted that such alternative theories of liability are permissible here.

The investors also asserted that Deloitte & Touche LLP, the auditing arm of Deloitte Touche USA , and GT-USA controlled DTT and GTI, respectively. They contended that Deloitte & Touche LLP and DTT had overlapping chief executive and financial officers, that the top executives of Deloitte & Touche LLP traditionally ran both organizations, and that Deloitte & Touche LLP's relative size among member firms gave it practical control of DTT. They also claimed that GT-USA controlled GTI by virtue of its size within the organization, the unified structure of the international accounting organization and the contractual relationships among member firms. Both GT-USA and Deloitte & Touche LLP also were alleged to have had access to all of the books and papers of the member firms, including those in Italy .

According to the court, the allegations that the top executives of Deloitte & Touche LLP held the top two positions at DTT and that at least one of those executives was involved in the Parmalat audit were sufficient to give rise to an inference of control. The claim with respect to GT-USA, however, fell short. The only non-conclusory allegations of control were that of relative size and GT-USA's access to member firms' books and records.

Although relative size may indicate control, the court said that it is not sufficient where, as here, it was not alleged that this size gave it voting control or even considerable influence. The right to access another firm's books and records, without more, did not suggest any concomitant right to control that firm with respect to the transaction in question. Consequently, the court found that investors did not state a claim against GT-USA under section 20(a).