Opinion
No. 88/2012.
08-19-2014
BOARD OF TRUSTEES OF THE 1199 SEIU REGIONAL PENSION FUND, Plaintiff, v. ARCARA & BORCZYNSKI, LLP, Defendant. Arcara & Borczynski, LLP, Third–Party Plaintiff, George Kennedy, Carol Ames, Marshall Blake, and Charles Giles, Third–Party Defendants.
Steven Ward Williams, Esq., of Counsel, Smith, Sovik, Kendrick & Sugnet, P.C., attorneys for plaintiff. Ronald S. Herzog, Esq., of Counsel, LeClairryan, P.C., attorneys for defendant.
Steven Ward Williams, Esq., of Counsel, Smith, Sovik, Kendrick & Sugnet, P.C., attorneys for plaintiff.
Ronald S. Herzog, Esq., of Counsel, LeClairryan, P.C., attorneys for defendant.
Opinion
TIMOTHY J. WALKER, J.
Plaintiff, Board of Trustees of the 1199 SEIU Regional Pension Fund (the “Fund”) commenced this action against Defendant, Arcara & Borczynski, LLP, the Fund's auditors (“Arcara”), based upon alleged audit deficiencies and related conduct. Specifically, Plaintiff asserts that Defendant's failure to disclose irregularities with regard to the Fund's investments prior to the collapse of the Bernard L. Madoff “Ponzi” scheme in December 2008 (the “Madoff Scheme”) caused the Fund to sustain significant losses. Defendant now moves for summary judgment dismissing all of the claims against it.
Background
The following material facts are undisputed, unless otherwise stated. Plaintiff is the Board of Trustees of a multi-employer employee benefit plan (as defined under ERISA, 29 USC § 1002 [37][A] ), created in 1976 for members of the SEIU Local 1199 Upstate, AFL–CIO (the “Board”). Defendant is a Buffalo, N.Y. accounting firm. Beginning in 2001, Plaintiff engaged Defendant on an annual basis, through separate engagement letters, to audit the Fund's financial statements.
From about 2002 through 2008, Plaintiff invested as much as twenty percent (20%) of the Fund's assets in a hedge fund namely, the Income Plus Investment Group (“Income Plus”). Plaintiff was advised to invest in Income Plus by its investment advisors, J.P. Jeanneret Associates Inc. and Marco Consulting (“Jeanneret”) (Arcara Affid. ¶ 9; see generally In re J.P. Jeanneret Assoc., Inc., 769 FSupp 2d 340, 347 [SDNY 2011] [sustaining certain federal securities and other claims against Jeanneret] ).
In turn, Income Plus invested up to forty percent (40%) of its clients' funds with Beacon Associates LLC I (“Beacon”), a Madoff “feeder fund”, or directly with Madoff (Arcara Affid. Ex. D2008 Report at p. 14). Plaintiff did not control Income Plus' investments.
Income Plus was audited by Margolin Winer & Evans LLP (“Margolin”), which issued unqualified audit opinions concerning Income Plus' financial statements for the period 2003–2007, or up until the Madoff Scheme was exposed in December 2008. Defendant received copies of those audit reports from Jeanneret in connection with its annual audit of the Fund. Defendant was never retained to audit Income Plus or Madoff.Significant here, in Margolin's 2007 audit report, it reported Income Plus' total assets at $295,167,763, representing that the funds were invested in “private investment funds”; U.S. Treasury Bills; securities purchased under agreements to resell; and two “receivables” totaling $36 million (Arcara Affid. Ex. D, PL–1159). At Note 6 of the audit report, Margolin stated that, as of December 31, 2007, Income Plus invested in one separately managed account; one limited liability company; and eleven corporations (id. PL–1165). Margolin further provided a “Condensed Schedule of Investments” relating to the private investment funds, including over $19 million invested in Beacon. Note 6 stated:
All investments are in private investment funds located primarily in the United States of America. The Fund is not able to obtain the specific investments at some of the underlying private investment funds due to the lack of available data.
(Arcara Affid. Ex. D, 2007 Report at PL–1166 [emphasis added] ). Notes similar to Note 6 appear in each such audit report from 2003 through 2010.
From 2003 through 2007, Defendant issued unqualified, favorable audit opinions concerning the Fund. However, after the Madoff Scheme was exposed, Income Plus reported a loss of $102,603,347 “in connection with a securities fraud perpetrated by Bernard L. Madoff and certain entities affiliated with Mr. Madoff.” The losses through Beacon alone were $13,074,757 (Arcara Ex. D, PL–1200, 1233). For 2007, the Fund “restated” the value of its Income Plus investment from $20,000,000, to $3.4 million; and down to $578 as of December 2008, after a redemption of $4.6 million (Ex C, PL0326)—an apparent loss of $15 million. The name “Madoff” does not appear in Defendant's 2009 audit report.
PLEADINGS
Plaintiff commenced this action in January 2012, soon thereafter filing an amended and second amended complaint, asserting six (6) causes of action: negligence/professional malpractice; breach of contract; fraud; negligent misrepresentation; breach of fiduciary duty; and constructive fraud.
Defendant raised a number of affirmative defenses, including the statute of limitations; the absence of a fiduciary relationship; and the Martin Act (GBL § 352 ). Defendant also commenced a third-party action against the individual trustees of the Fund, asserting causes of action for contribution and indemnification.
DISCUSSION
1. Standard of Review
On a motion for summary judgment, the moving party bears the initial burden of making a prima facie showing of entitlement to judgment as a matter of law by tendering sufficient evidence to eliminate any material issue of fact (Winegrad v. New York Univ. Med. Ctr., 64 N.Y.2d 851, 853 [1985] ). The court must view the evidence in the light most favorable to the non-moving party (Evans v. Mendola, 32 AD3d 1231, 1233 [4th Dept 2006] ). The movant must demonstrate the merits of its claims or defenses and cannot meet its burden merely by identifying gaps in the other party's proof (Edwards v. Arlington Mall Assocs., 6 AD3d 1136, 1137 [4th Dept 2004] ). Unless the movant establishes entitlement to judgment as matter of law, the burden does not shift to the opposing party to raise an issue of fact and the motion must be denied (Loveless v. Am. Ref-fuel Co. of Niagara, LP, 299 A.D.2d 819, 820 [4th Dept 2002] ). Once the moving party establishes its entitlement to judgment through the tender of admissible evidence, the burden shifts to the non-moving party to raise a triable issue of fact (Gern v. Basta, 26 AD3d 807, 808 [4th Dept], lv denied 6 NY3d 715 [2006] ).
2. The Malpractice Cause of Action
The criteria for an accounting malpractice cause of action are: failure to exercise due care and “proof of a material deviation from the recognized and accepted professional standards for accountants and auditors”, measured by generally accepted auditing standards (GAAS) or generally accepted accounting principles (GAAP) promulgated by the American Institute of Certified Public Accountants (AICPA); which proximately causes damage to plaintiff (Cumis Ins. Society Inc. v. Tooke, 293 A.D.2d 794, 797–798 [3rd Dept 2002], citing Ackerman v. Price Waterhouse, 84 N.Y.2d 535, 541 [1994] ; see also N.Y. PJI 2:154, [2013] ).
Here, the parties dispute the scope of Defendant's duty. Plaintiff alleges that Defendant failed to follow GAAS when performing its audits or, specifically, to confirm the existence and valuation of the Fund's investments, including those invested in Income Plus. Plaintiff alleges that Defendant failed to obtain sufficient information, ignored certain other information and, despite doing so, issued favorable audit reports regarding the Fund's financial statements. As a result of Defendant's negligent audits, and subsequent false representations, Plaintiff alleges it lost an opportunity to recover the value of the Fund's investments before the Madoff debacle.
Plaintiff admits that paragraph 9 of its pleading incorrectly asserts that its assets were invested in Beacon Andover Group, Beacon Associates LLC and Beacon Associates LLC II (Williams Affirm. ¶ 35 n. 2); rather, the only investment at issue is in Income Plus, which then invested in Beacon and Madoff.
Defendant asserts that it had no duty to verify the investments in Income Plus or Madoff. Instead, it was merely obligated to “obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion of the financial statements under audit” (AU 326.01), while overall responsibility for the financial statements remained with Plaintiff. Relevant here, Defendant alleges that it was permitted to rely upon the audit reports concerning Income Plus, prepared by the “well regarded” auditor Margolin, and not conduct further inquiry. Defendant contends further that this court may take judicial notice of the “fact that nobody discovered the Madoff fraud” (Defendant's memorandum of law, at 20 n. 11), an incorrect statement of fact. In Matter of Jeanneret Assoc. Inc, (769 FSupp2d 340, 350–351 [SDNY 2011] ), the court detailed how Jeanneret (which was also Income Plus' investment manager) contracted with Ivy Asset Management (“Ivy”), and directed millions of dollars in investments in Madoff or feeder accounts; that, as early as 1997, Ivy had become suspicious of Madoff's alleged trading strategies namely, that they could be illegitimate; and that, as a result, Ivy eliminated its investments in Madoff or feeder accounts by 2000, without notifying most of the investors.
As the District Judge stated: “[one principal of Ivy] actually argued, as early as 1998, that Ivy should divest itself of its Madoff investments completely.... [A second principal], however, vetoed that idea, saying, “... it is important to maintain at least some level of Ivy fund investments with Madoff in order to send a message to [our] ... clients that we have confidence in him.” ... This is an extraordinary statement, given that Ivy (or at least [one of its principals] ) apparently did not have a great deal of confidence in Madoff. [The other principal] reasoned as follows: Amount [sic] we now have with [Madoff] in Ivy's partnership is probably less than $5 million. The bigger issue is the 190 mill or so that our relationships have with him which leads to two problems, we are on the legal hook in almost all of the relationships and the fees generated are estimated based on 17+% returns ....[to be] $1,275 Million' “ (369 Fsupp2d at 350–351 [emphasis supplied] ).
In support of its motion, Defendant submits the affidavit of Joseph Arcara, CPA; copies of the Fund's audit reports, as well as those pertaining to Income Plus; and copies of the engagement letters. In opposition, Plaintiff submits the affidavit of its expert and exhibits attached to its counsel's affidavit. Plaintiff's expert, Kurt Hunzinger, C.P.A., opines that Income Plus was a “service organization” with regard to the Fund by holding, servicing and initiating Transactions material to its financial results, and thus, under GAAS, Defendant should have obtained a report on Income Plus's “internal controls surrounding the investments and related transactions”; and that, in some cases, a Statement on Auditing Standards (SAS) 70 report is available for such service entities (Hunzinger Affid. ¶ 7 [citing AU 324.09, 324,010, 332.20] ). According to Hunzinger, if such a report is not available, the auditor is required to make further inquiries and obtain more information, and that
... in the absence of an adequate SAS 70 Report or other information regarding a third-party organization, an auditor has a duty under GAAS to inform its client that an audit opinion cannot be rendered because sufficient information could not be obtained or, at the very least, issue a qualified opinion or a disclaimer of opinion which would include an explanation of the reason for issuing one of theses types of opinions.... The failure to obtain and review SAS 70 reports or other sufficient audit evidence is a violation of GAAS....
(id. ¶ 12). Here, Hunzinger states, Defendant's working papers for the audits in question indicate that Defendant had determined that there was no SAS 70 Report available for Income Plus. Therefore, Defendant was required to undergo other procedures, which it failed to do or, essentially, issue a qualified or no opinion (Hunzinger Affid. ¶¶ 21–25).
Commentators have provided this definition of an SAS 70 report: “The Type 2 SAS report is a report by the service auditor on a service organization's description of the controls that may be relevant to a user organization's internal control as it relates to an audit of financial statements, on whether such controls were suitably designed to achieve specified control objectives, on whether they had been placed in operation as of a specific date, and on whether the controls that were tested were operating with sufficient effectiveness to provide reasonable, but not absolute, assurance that the related control objectives were achieved during the period specified (see generally, AU Sec. 324, “Service Organizations, as adopted on an interim basis by the PCAOB in its Rule 3200T” Liability of Attorneys and Accountants for Securities Transactions § 6:30 Robert J. Haft, Arthor F. Haft and Michele H. Hudson).
Defendant contends that an SAS 70 report would have been irrelevant, because Income Plus was not a “service organization” with respect to the Fund (cf. J Sherinsky, “Replacing SAS 70,” Journal of Accountancy Aug 2010 (www.journalofacountancy.com /issues/2010/Aug/20103009 [discretionary broker accounts are examples of “service organizations”] ). Counsel's “expertise” notwithstanding, Plaintiff has raised an issue of fact on this point.
In any event, the parties agree that GAAS outine the duties of an outside auditor conducting an audit of its client's financial statements. They disagree as to the scope of those standards, in part because of a dearth of case law. Defendant relies upon extensive case law concerning federal securities laws, where a common pleading defect is a failure to plead scienter (see, e.g., Meridian Horizon Fund, LP v. Tremont Group Holdings, Inc., 747 FSupp.2d 406, 412 [SDNY2010] ), which is not an element of a negligence cause of action. Whether a party owes a duty, and the scope of that duty are issues for the court to determine (532 Madison Ave. Gourmet Foods, Inc v. Finlandia Center, Inc., 96 N.Y.2d 280, 288 [2001] ). Defendant asserts that Plaintiff attempts to “expand the scope” of the common law duty owed by an auditor to include an obligation to confirm the existence and value of the investments of the company audited—here, those in Income Plus and Income Plus' investments in Beacon. Defendant refers generally to the engagement letters and the representation letters Plaintiff was required to sign each year in order to obtain Defendant's audit reports (Arcara Affid. Exs. A–1 through A–10 and B–1 through B–10). The representation letters detail the Fund's obligations with respect to the audits and, in some respects, the obligations Defendant did not have. Defendant emphasizes that Plaintiff's decision to invest in Income Plus had nothing to do with Defendant, and that Defendant was not hired to audit Madoff or any feeder funds. However, Plaintiff does not allege that Defendant was required to audit Income Plus or Madoff.
The Meridian court dismissed the entire complaint against the auditors, specifically determining that the state-law malpractice claim was pre-empted by the Martin Act, a finding that was subsequently disavowed by the New York State Court of Appeals (see Assured Guaranty (UK) Ltd v. J.P. Morgan Investment Management, Inc., 18 NY3d 341 [2011] ).
Defendant's duty ultimately rests on the scope of the audits. As described in Defendant's engagement letters:
The objective of our audit is the expression of an opinion as to whether your financial statements are fairly presented, in all material respects, in conformity with U.S. [GAAP], ... Our procedures will include tests of documentary evidence supporting the transactions recorded in the accounts and direct confirmation of investments, plan obligations, benefit obligations, and certain other assets and liabilities by correspondence with financial institutions ..., and other third parties....
(Arcara Affid. Ex. A). The term “direct confirmation of investments” is not defined. Thus, Plaintiff has raised an issue of material fact as to whether Defendant was required to advise it that the Funds invested in entities that provided insufficient information concerning the particular assets owned.
Turning to proximate cause, the issue is “whether it was reasonably foreseeable that the damage incurred would follow from the wrongful act” (In re Gouiran Holdings, Inc., 165 BR 104, 106 [EDNY 1994], citing Saugerties Bank v. Delaware & Hudson Co., 236 N.Y. 425, 430 [1923] ).
Defendant asserts that, even if it owed a duty to investigate the nature and extent of the Fund's investments with third parties, it would not have uncovered the Madoff Scheme.
This contention requires little further discussion. Defendant relies upon two decisions in which supreme court determined that two pension funds had no malpractice claim against their auditors with respect to investments in Madoff or feeder funds (see Board of Trustees of the Upstate New York Engineers Training Fund v. Schultheis v. Panettieri, LLP, Index No 11–4248 Sup Ct. Onondaga County [2012], Herzog Affirm. Exs. D [complaint] & E [decision]; and Board of Trustees of the IBEW Local 43 Elec. Contractors Health & Welfare v. D'Arcangelo & Co., LLP, Index No 12–3710 [Sup Ct Onondaga County 2012], id., Ex. H & I). In each case, the court determined that any failure by the auditor was too attenuated as a matter of law to have proximately caused the plaintiff's losses (id. ). D'Arcangelo referenced a footnote in the Beacon audit, which was virtually identical to Note 6 referenced above, which stated that Beacon's auditors “[were] not able to obtain the specific investments at some of the underlying private investment funds due to lack of available data” (In Re Beacon Associates Litigation, 745 FSupp2d 386, 417 no.19 [SDNY 2010] ). In Beacon, the District Judge determined that the note:
pertains to investments comprising approximately twenty-five percent of the Beacon Fund's asset (i.e. the non-Madoff Holdings). Moreover, even if this note was read to refer to Madoff, it would simply corroborate the inference that [the auditor] did not investigate Madoff, rather than the inference that [the auditor] was aware of the various alleged red flags
(745 FSupp at 417 no. 19). In D'Arcangelo, Justice Karalunas relied upon Beacon to determine, as she had in the Schultheis case, that the complaint failed to adequately plead proximate cause (D'Arcangelo, Herzog Ex. I at p. 6).
The specific allegations of the amended complaint completely undercut plaintiff's assertion that it seeks to impose liability upon defendant only for its failure to properly audit the financial statements of plaintiff, the actual client. The complaint would require defendant to impose audit procedures on the Beacon and Madoff investment funds. Moreover, the complaint alleges that because defendant failed to so examine the third-party funds, defendant did not “cast doubt” on plaintiff's financial statements, which would have prompted plaintiff to redeem its investments before the Madoff Scheme was exposed. As this court held previously, the causal chain is simply too attenuated
(Id. [emphasis added] ).
This Court disagrees, adopting instead the reasoning set forth in Board of Trustees for and on behalf of the Service Employees Benefit Fund v. Bonadio & Co, LLP et al., (Index No. 11/7719 [Sup Ct Onondaga County 2012], Plaintiff's Ex.5, and the Second Department decisions in Sacher v. Beacon Assoc. Mgt. Corp, 114 Ad3d 655 [2nd Dept 2014], and Hecht v. Andover Assoc. Mgt. Corp., 114 AD3d 638 [2nd Dept 2014] ).
Accordingly, Plaintiff has raised an issue of material fact as to proximate cause.
3. The Breach of Contract Cause of Action
Defendant asserts that the remaining claims are duplicative of the claim for professional negligence. In D'Arcangelo, the court dismissed the breach of contract claim as duplicative of the professional negligence claim, stating that a fair reading of the complaint demonstrated that the action was “entirely directed at recovery for a claimed failure of D'Arcangelo to conduct its audit in accordance with the GAAS”, and that claim was encompassed within the negligence cause of action (Board of Trustees of the IBEW Local 43 v. D'Arcangelo & Co., LLP, 2012 WL 6681765, *2 [NDNY Dec. 21, 2012] ).
Therefore, the breach of contract cause of action is dismissed as duplicative (see, e.g., DiTondo v. Meagher, 85 AD3d 1385 [3rd Dept 2011] ).
4. The Negligent Misrepresentation, Breach of Fiduciary Duty and Constructive Fraud Causes of Action
A cause of action for negligent misrepresentation may be deemed duplicative of one for professional malpractice where both are based upon the same allegations and all allege the same damages (see Symbol Technologies Inc. v. Deloitte & Touche LLP, 69 AD3d 191, 199 [2nd Dept 2009] ; see also Bonadio, at 9–10). Defendant contends that Plaintiff cannot plead a “special relationship” outside an “ordinary business relationship” (see Niagara Foods Inc. v. Ferguson Elec. Service Co., 86 AD3d 919, 920 [4th Dept 2001] ). The Court agrees. Generally, auditors owe no fiduciary duty to the companies they audit. In fact, their independence is an important factor in the process (see generally Friedman v. Anderson, 23 AD3d 163, 166 [1st Dept 2005] ; AICPA Professional Standards, Code of Professional Conduct §§ ET 100–1.06, 100–1.07 [2010] [independence] ).
Likewise, to state a cause of action for constructive fraud, a plaintiff must allege that “(1) a representation was made, (2) the representation dealt with a material fact, (3) the representation was false, (4) the representation was made with the intent to make the other party rely upon it, (5) the other party did, in fact, rely on the representation without knowledge of its falsity, (6) injury resulted and (7) the parties are in a fiduciary or confidential relationship” (Del Vecchio By Del Vecchio v. Nassau County, 118 A.D.2d 615, 618 [2nd Dept 1986] ). Absent a fiduciary or confidential relationship, Plaintiff cannot maintain this cause of action.
6. The Fraud Cause of Action
To state a fraud claim against an auditor, a plaintiff must allege that the auditor had knowledge of its malpractice and of the client's resulting injury, coupled with a subsequent intentional, material misrepresentation causing damage (Simcuski v. Saeli, 44 N.Y.2d 442, 451 [1978] ).
The standard for pleading auditor fraud is demanding (citations omitted). Where plaintiffs allege violations of generally accepted auditing standards against an independent auditor, they must also allege corresponding fraudulent intent ... While a showing of recklessness will permit an inference that a fraud was in fact perpetrated, this recklessness must involve conduct that is highly unreasonable, and must “in fact, approximate an actual intent to aid in the fraud being perpetrated by the audited company” [id., cit om] ). The complaint must allege that the auditor's practices were so deficient as to amount to no audit at all, that there was “a refusal to see the obvious, a failure to investigate the doubtful” [cit om], or the auditor's judgments were such that “no reasonable accountant would have made the same decisions if confronted with the same facts' “ (citations omitted).
(CRT Investments, Ltd. v. Merkin, 2010 WL 4340433, *12 [Sup Ct New York County 2010], aff'd sub nom. CRT Investments, Ltd. v. BDO Seidman, LLP, 85 AD3d 470 [1st Dept 2011] ); see also In re Tremont, 703 FSupp2d 362, 371 [SDNY 2010] ). As is clear from the case law in this area, a number of other accounting firms failed to investigate “red flags” concerning investments at the feeder funds or Madoff's accounts. More importantly, Plaintiff failed to submit evidence that Defendant intentionally misrepresented the existence or value of the Fund's investments.
Accordingly, it is hereby
ORDERED, that Defendant's motion for summary judgment is denied as to the first cause of action; and it is further
ORDERED, that Defendant's motion for summary judgment is granted as to the remaining causes of action, which are hereby dismissed.
This constitutes the Decision and Order of this Court. Submission of an order by the Parties is not necessary. The delivery of a copy of this Decision and Order by this Court shall not constitute notice of entry.