Two US court decisions within the last 12 months have demonstrated the perils for international networks when member practices are sued in the US. These decisions coincide with a period in which closer links are being forged within some of the largest networks.
Traditionally, most large accountancy networks have operated as relatively loose associations of national firms, with membership regulated by a non-trading "umbrella" entity which does not own any interest in the member firms. In order to protect and enhance the international brand, the umbrella entity is typically given power to lay down professional standards to be followed throughout the network, and may undertake activities such as quality review, training, arranging staff transfers and client data sharing.
Since June 2006, two of the Big 4 networks have each announced their own plans for much closer legal relationships between some or all of the European member firms within each network. In each case, rather than creating an international legal partnership to take the place of the national firms, the new arrangements involve the establishment of a new LLP as a non-trading holding entity for the national firms which are to be trading subsidiaries.
These new structures exhibit two features that merit comment here:
- Although under common ownership for the first time, the national firms will continue to trade separately from each other.
- The geographical range of these new arrangements is regional rather than worldwide.
The majority of accountancy networks have not followed this example, although some have indicated that there will be closer relationships between firms at a regional level. Clearly, developments such as these are driven by commercial factors, but issues concerning legal risk are an important part of the background to these changes.
A legal risk that is particularly associated with network structures is that a member firm may become exposed to allegations that it is vicariously liable for the acts and omissions of other member firms. Although claimants have very rarely seen fit to chance their arm before a judge in an English court on such matters, the decisions of courts in the United States have provided some of the strongest indications of the legal risks involved in closer worldwide integration of firms within accountancy networks.While that much is predictable, the outcome of US litigation in this field is proving to be less so. Over the last decade, US claimants have often failed in their attempts to construct a case against a "deep pocket" member firm such as the US firm, where that case is entirely founded either upon that firm's actual relationship (through the network) with the principal defendant firm, or on the representations made about that relationship.
Claimants have had more success in persuading US courts of the viability of their cases against umbrella organisations. They typically advance their case on one or more of the following theories of liability (which have also featured in the claims attempting to fix member firms with liability for the faults of other members):
- the "alter ego" theory, in which it is argued that the international umbrella entity is so dominated by a member firm that it primarily transacted the member firm's business rather than its own affairs;
- the "agency" theory, in which it is argued that the member firm is acting on behalf of the international entity and is under its control;
- the "partnership" theory, in which it is argued that there is a single business carried out by the member firm and the international entity together. Alternatively, it may be argued that the international entity is in effect bound by a representation made by the member firm that they are in partnership, which the claimant had relied on when engaging the services in question.
Umbrella entities have been relatively successful in dismissing alter ego and partnership claims. However, in the last 12 months US courts have made two decisions which have highlighted the dangers presented by agency allegations. In both cases, the substantive allegations of agency are now to undergo trial by jury.
The Banco Espirito Santo case
In spring last year, in Banco Espirito Santo International Ltd v BDO International BV, the Florida Court of Appeal (Third District) overturned a judgment in favour of BDO International which had been made following a successful motion at the trial of claims in tort and contract against it and its US member firm. The trial judge had found that the plaintiffs had failed to present sufficient evidence to succeed in their agency claim. However, the appellate court decided that, when seen in the light most favourable to the plaintiffs (the relevant test for the application being made), the evidence was capable of establishing the three requirements of an agency relationship so as to support a verdict in favour of the plaintiffs:
- acknowledgment by the principal that the agent will act on its behalf;
- acceptance by the agent of the undertaking; and
- control by the principal over the actions of the agent.
The necessary evidence was chiefly located by the Florida Court of Appeal in the following:
- The objects of business set out in the Articles of Association of BDO International, which included the control and management of partnerships in the international association;
- The testimony of BDO International's secretary that it "co-ordinated and monitored" the member firms;
- The Member Firm Agreement ("MFA") signed by the US firm. This stipulated that BDO International owned the intellectual property in the technical manuals containing the auditing standards and procedures which the US firm was required to follow and the software it had to use, under the terms of the MFA, in all of its audits (therefore, including the audit that was the subject of the claim). The court also considered that the terms of the MFA "imposed operating directives and restrictions that extend far beyond those utilized in mere licensing agreements" (for example, requiring firms to assist in product development) and bore similarities to operations manuals distributed to mere franchisees; and
- BDO International annual reports referred to the quality control exercised over member firms.
The Parmalat decision
On 27 January 2009, a New York court refused a motion for summary judgment made by Deloitte Touche Tohmatsu ("DTT"), its US member firm ("Deloitte US") and the individual who was CEO of both entities, in defence of the class action by investors in Re Parmalat Securities Litigation which alleges violations of US securities legislation. The Parmalat plaintiffs allege that DTT is liable for the acts of its supposed agent Deloitte Italy in auditing Parmalat, and that DTT is the alter ego of Deloitte US and that the CEO is liable under the securities laws as a "control person". A strike-out motion (directed at the adequacy of the pleaded case) in respect of the allegation of agency was dismissed by the same court in June 2005.
The summary judgment motion argued that DTT was merely a secondary actor and, as such, not liable for Exchange Act violations in light of the Supreme Court decision in Stoneridge Investment Partners LC v Scientific-Atlanta Inc1. The court rejected the contention that Stoneridge provides a defence for parties sued under US securities legislation for the acts of their agents. The court also held that summary judgment could not be ordered here because agency was capable of being established by various pieces of evidence including:
- the objects set out in DTT's Articles;
- DTT's role in setting audit methodologies and stipulating software to be used;
- the provision made in member agreements for DTT to review compliance with quality standards;
- DTT's control over the acceptance of engagements including referrals from other members;
- the use of DTT legal staff by member firms; and
- the authority conferred on DTT's CEO role, by a practice manual, to arbitrate disputes between member firms, and the role played by DTT in arbitrating such a dispute over the content of an audit opinion in respect of a Parmalat entity. In the court's view, this suggested that DTT had the power to impose its will on a firm's professional judgment
The court repeated its strike-out decision concerning s20(a) of the Securities Exchange Act that DTT could be held liable for parties under its control, irrespective of whether it exercised specific control over them in respect of the particular engagement.
Deloitte US and the CEO were also unable to persuade the court to dismiss the Parmalat claim for lack of evidence. The court found that there was sufficient potential evidence of Deloitte US control over DTT, on the basis that its executives (including the CEO) occupy key positions at DTT, it contributes a significant portion of funding for DTT, and that there was evidence of influence over DTT's decision making.
What lies ahead for International networks
There is nothing exceptional about many of the arrangements that were regarded in these two cases as constituting sufficient evidence to allow the "agency" claim to proceed to trial by jury. Networks will rightly object that, if the umbrella entities were to be shorn of all such functions, their ability to promote and safeguard the network brand in the interest of all members would be severely limited. Nevertheless, Parmalat suggests that claimants will be given added encouragement if an umbrella entity, rather than an external party, acts as arbiter between member firms, or gives the appearance of influencing the course or outcome of a member firm's engagement.
Of course, the umbrella entities faced a much higher evidential threshold on the motions which resulted in these two judgments than they would at trial. There they will be able to present evidence of member firms' autonomy and raise other matters which sit uneasily with the agency theory (such as the retention of profit by member firms). The ultimate evaluation of these factors will, however, now lie with the jury in those cases.
The real prize for US claimants is the deep pocket of any member firm that might be attacked through the umbrella entity. It is to be expected that networks will have long sought to protect their members from the risk of being required to indemnify umbrella entities against potential vicarious liabilities. While member firms have recognised the risk of claims alleging their direct control over other firms, the claim against the US firm in Parmalat demonstrates that member firms might also face claims in US litigation involving (in effect) allegations of indirect control exercised through their alleged control of umbrella entities. The liability of the member firm in question is then wholly dependent on the issue of the umbrella entity's own vicarious liability. Pending the final outcome of the claims in Banco Espirito Santo and Parmalat, a member firm that is particularly influential within a network organisation should be aware of the danger arising from any activity that might be capable of being presented as consistent with an allegation of control over the umbrella entity (for example through the actions of partners or executives who sit on the board of that entity). Firms may also wish to consider whether their insurance policies provide appropriate protection against claims based on their indirect control of other firms through umbrella entities.
The Banco Espirito Santo and Parmalat cases serve as a reminder that international networks, and leading member firms, continue to face vicarious liability risk in the US. For so long as that remains the case, the current fashion for international integration may be unlikely to lead to true global partnerships or common ownership across the members of each of the large accounting networks. Networks will undoubtedly monitor future developments in order to gauge whether the effect of recent integrations has been to increase the opportunities for claimants to select the US as a forum for litigation, and to balance this against any commercial advantage to be gained from establishing closer legal relationships between member firms in a highly globalised business environment.
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