Forms May Fail Big Four Auditing Firms

org chart.jpgA common form of business organization designed to limit liability of participants may have failed the four largest auditing firms, according to a judicial opinion last week refusing a motion for summary judgment based on the design. The case, involving claims by defrauded investors in the Italian company, Parmalat, seeks to hold liable affiliates of the Italian accounting firm found culpable in the fraud, Deloitte S.p.A. The court refused to dismiss the latter’s US affiliate, Deloitte Touche LLP, and the Swiss entity that unites them, Deloitte Touche Tohmatsu.

If sustained after further fact resolution, the result would expose Deloitte US to crushing legal liability—and likewise expand the liability exposure of the other three large auditing firms that use similar structures (Ernst & Young; KPMG; and PriceWaterhouseCoopers). That, in turn, could increase the risks that one of those four firms may soon fail, which would make it difficult or impossible for many large publicly-listed companies to find outside auditors as required by federal securities laws. Ultimately, this could mean US federal governmental takeover of the traditional process of private audits of listed companies.

At issue in the Parmalat securities case against Deloitte is the standard structure that the four large auditing firms use. They operate as networks of scores of member firms organized as separate legal entities in jurisdictions where they practice. They enter into agreements that enable identifying members with the global brand name and practice of a global firm. These structures are designed to promote a recognizable professional identity while insulating each member from the others’ liabilities. The delicacy of the balance appears in how the court last week questioned its liability limiting efficacy.

The issues involve fundamental principles often taught in the first few weeks of law school courses on business organizations (corporations). The first is the separate entity concept. This means that companies command their own assets and incur their own liabilities. Other participants, including shareholders, lenders and affiliates, are not ordinarily liable for the company’s obligations.

Students also learn early of standard limitations on this privilege. One is how a putative separate party, such as a lender, may be liable for a company’s obligations if it is seen as a principal and the firm as its agent, under traditional principles of principal-agent law. (A good example is Gay Jenson Farms Co. v. Cargill, Inc.) Another is how a putative separate party, such as a corporate parent, may be exposed to liability of its corporate subsidiaries if its exercise of control over the latter deviates from traditional means that shareholders use to exercise corporate control. (A good discussion appears in United States v. Best Foods.) [Another example of control analysis to evaluate a putative third party’s potential liability appears in Martin v. Peyton, concerning partnership.]

The Deloitte firm is organized as a network orbiting around Deloitte Touche Tohmatsu (Deloitte Central), a Swiss business form called a verein, loosely meaning an association, club or union. Among scores of network member firms of this association are Deloitte & Touche LLP (Deloitte US) and Deloitte S.p.A. (Deloitte Italy). Deloitte Italy committed securities law violations in connection with its audits of Parmalat, in a fraud involving potentially $15 billion. Securities holders seek to impose liability on Deloitte Central and Deloitte US.

The argument is that Deloitte Italy acted as an agent of Deloitte Central and/or Deloitte US acting as principal. The Deloitte defendants, acknowledging securities law violations by Deloitte Italy, first deny the existence of any principal-agent relationship between Deloitte Central and Deloitte Italy and second deny that Deloitte US controls Deloitte Central.

A principal-agent relationship arises from agreement that the agent will act for the principal under the latter’s control. Authority can be actual, apparent or implied; control, which is essential, is evaluated according to all surrounding circumstances. Deloitte Central denies giving Deloitte Italy any agency authority or exercising any control over it. But the proffered evidence raises material fact questions about these assertions.

First, all worldwide Deloitte verein members sign a charter document covering the global network. In it, they assent to terms concerning operational activities, especially applicable auditing standards to use in audits. All members sign license agreements concerning trade names and other property rights. Deloitte Central can accept or reject proposed audit engagements. Member firms cannot sue each other; members must accept referral work from each other; and employees can be transferred between members. Deloitte Central conducts network-wide legal and risk management affairs for members; members must buy required amounts of liability insurance.

Second, although such structural attributes alone may not suffice to satisfy the elements of agent authority and principal control, an additional factual contention tips the balance against summary judgment in the case. When two Deloitte member firms (Italy and Brazil) disagreed on the proper treatment of Parmalat accounting matters, Deloitte Central’s senior officials intervened, at their joint request, to resolve it. This was done in accordance with the networks’ joint practice manual. It gives authority to resolve disputes among member firms to Deloitte Central’s CEO or designee, to “arbitrate” them, suggesting a power to control. In the Italy-Brazil dispute, the Deloitte Central official issued a final recommendation, suggesting exercise of that power.

These predicates may be thin reeds upon which to disregard the separate entity status of members of the Deloitte verein network. Usually, far more is required for even a related party to be exposed to the obligations of a separate entity. For example, in the Cargill case noted above, a putative lender was liable as principal of a putative borrower as agent based on some nine separate factual findings clearly demonstrating that the financier made essentially all business and operating decisions of the other, a relation far different from that between Deloitte Central and Deloitte Italy. Still, the settlement value of the Parmalat case has increased even at this stage of denying a motion for summary judgment.

The court in the Parmalat case also rejected a separate argument that Deloitte US asserted to have the claims against it dismissed. Deloitte US argued that it does not control Deloitte Central—apparently as a way to challenge any additional principal-agent relation that could expose it to liability and in part to defend against a separate securities law claim that imposes liability on persons who control another party found liable for violations. The court rejected this argument for three reasons, all of which probe traditional concepts of control found not only in securities law, but also in the law of principal-agent, in corporate law, and in partnership law.

First, Deloitte Central and Deloitte US have overlapping senior executive officers. The court acknowledged that this fact is not conclusive. It referenced the Supreme Court’s opinion in Best Foods, noted above, which examined a corporate parent’s potential liability for obligations of its subsidiary. That case restated the general rule that a corporate parent’s liability for subsidiary obligations is limited under traditional corporate law principles that insulate shareholders from liabilities of their corporate investees.

But Best Foods also said that a subsidiary’s corporate veil can be pierced to hold the parent liable if the parent exercises control over the subsidiary outside the usual norms that shareholders use to exercise corporate control, essentially through the election of directors. In the Parmalat case, additional facts must be developed to evaluate whether Deloitte US’s relation with Deloitte Central adhered to similar conventions or departed from them.

Second, Deloitte Central’s principal source of funds is from contributions made to it by its various member firms. And Deloitte US contributes a significant portion of these. In 2001, for instance, Deloitte US contributed $80 million to Deloitte Central’s total budget, which amounted to $218 million. Beyond that contribution, Deloitte US also made loans to Deloitte Central and guaranteed its bank financing. Again, such financial support alone does not mean that Deloitte US controlled Deloitte Central, but is suggestive and is a factor tending to make summary judgment premature.

Third, additional asserted facts suggest that Deloitte US controls Deloitte Central. An example concerned the procedures and outcomes used when the network evaluated whether to reorganize itself by separating its auditing practice from its consulting practice. Deloitte US partners voted first, before other network members, leading Deloitte Central preliminarily to agree. But, thereafter, Deloitte US changed its recommendation and Deloitte Central followed that reversal, again without soliciting votes of other network members.

As with the Parmalat court’s analysis of whether Deloitte Central and Deloitte US are really principals for which Deloitte Italy acted as agent, these three factual assertions taken alone may be thin reeds upon which to determine that Deloitte US controls Deloitte Central. In the same vein, they do seem enough to prevent granting a motion for summary judgment and the case’s value rises accordingly. Moreover, it would not be impossible for these claims to be sustained when the factual record is developed.

If so, the liability exposure of Deloitte as a network and the other large auditing firms will increase considerably. This may have particular relevance to PWC, which recently found out that its affiliate in India probably committed securities fraud in facilitating the accounting fraud that plagued Satyam, the India outsourcing company. Ultimately, then, some fundamental principles of the law of business organizations may determine the fate of the auditing profession in the United States. Given existing turmoil in capital markets and plans to reform our system of corporate finance, these developments could not come at a worse time.

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