Opinion
No. 651135/2014.
11-14-2014
ISRAEL DISCOUNT BANK OF NEW YORK, on its own behalf and as agent for Bank Leumi USA, Capital One, N.A., and Bank Hapoalim, B.M., Plaintiff, v. EISNERAMPER LLP, Defendant.
Otterbourg P.C., for plaintiff. Winston & Strawn LLP, for defendant.
Otterbourg P.C., for plaintiff.
Winston & Strawn LLP, for defendant.
Opinion
SHIRLEY WERNER KORNREICH, J.
Defendant EisnerAmper LLP (EisnerAmper) moves, pursuant to CPLR 3211, to dismiss the complaint. Defendant's motion is granted for the reasons that follow.
Procedural History & Factual Background
On April 11, 2014, plaintiff Israel Discount Bank of New York (IDB) commenced this action on its own behalf (and, purportedly, on behalf of three other banks) against EisnerAmper, an accounting firm, to hold EisnerAmper liable for its allegedly negligent auditing of non-party Oak Rock Financial, LLC (Oak Rock). IDB's complaint, filed on April 23, 2014 (Dkt.9), does not indicate what causes of action are being asserted. However, IDB admitted in its opposition brief [IDB Br. at 3] and at oral argument [Dkt. 66 (9/30/14 Tr. at 3–4) ] that it is only asserting a single cause of action for fraud and not asserting claims for negligence or professional malpractice.
The complaint is partially redacted pursuant to a so-ordered stipulation (Dkt.10). Additionally, pursuant to an order dated September 11, 2014 (Dkt.57), the parties were permitted to file their briefs and certain exhibits under seal. The court was provided with unredacted copies. Nonetheless, the court quotes from or discusses some of the sealed material where such evidence is essential to this decision and no good cause for sealing exists.
Turning now to the allegations, as this is a motion to dismiss, the facts recited are taken from the complaint.
Oak Rock, founded in 2001 by non-party John Murphy, is “a specialty asset-based lending company.” Complaint ¶¶ 12–13. Until the fraud at Oak Rock (discussed below) was discovered, Oak Rock was solely managed and controlled by Murphy. ¶ 12. Oak Rock makes “revolving asset-based loans” to installment financing dealers. ¶ 13. Simply put, Oak Rock funds the dealers' financing and collateralizes that funding with the receivables in which the dealers have a security interest. Id. Oak Rock, in turn, finances its lending with credit facilities with a lower cost of debt than Oak Rock charges the dealers. ¶ 15. Thus, Oak Rock leverages its ability to obtain relatively low-cost debt and creates credit lines for merchants via the dealers, with the dealers doing the actual merchant lending. The merchant lending is secured by the merchants' receivables, which is the collateral that flows upward to Oak Rock and its own financers, such as IDB, as the asset that backs this lending channel.
EisnerAmper issued unqualified Independent Auditors' Reports on Oak Rock's balance sheet and other financial statements for the years 2002 through 2011. ¶ 19. For 2002 through 2005, these audited reports were prepared by an EisnerAmper partner, Steve Singer. ¶ 20. Singer retired from EisnerAmper in 2006. ¶ 21. Thereafter, the audited repots were prepared by another partner, Steven Guzik. ¶ 22. Guzik, allegedly, “had virtually no experience in auditing asset based lenders.” ¶ 23. According to the complaint, at least four other EisnerAmper employees [see ¶¶ 24–27] also worked on Oak Rock audited reports, “[s]ome or all” of whom “lacked appropriate experience in auditing asset based lenders.” ¶ 28.
Each year, before EisnerAmper conducted its audit, Oak Rock signed substantially similar engagement letters. For instance, the engagement letter dated January 11, 2011 (for the 2010 audit) provided that “[t]he objective of [EisnerAmper's] audit is to express an opinion about whether [Oak Rock's] financial statements are fairly presented, in all material respects, in conformity with accounting principles generally accepted in the United States [GAAP] .” The engagement letter then explained that the audit would be conducted in accordance with generally accepted auditing standards (GAAS), which required that EisnerAmper “plan and perform the audit to obtain reasonable, rather than absolute, assurance about whether the financial statements are free of material misstatement whether caused by error or fraud. Accordingly, a material misstatement may remain undetected.” The engagement letter further provided that “[t]he engagement is being undertaken solely for [Oak Rock's] benefit and the parties do not intend to provide contractual rights to any other person ” [emphasis added]. The engagement letter also noted that “the financial statements are the responsibility of the management of [Oak Rock]” and that “[m]anagement is responsible for designing and implementing programs and controls to prevent and detect fraud.”
At the beginning of each audit report, EisnerAmper attached virtually identical short letters describing the report. These letters form the basis for IDB's fraud claim. The letter preceding the reports for 2009 and 2010, dated April 12, 2011, began by reiterating, as set forth in the engagement letter, that “[t]hese financial statements are the responsibility of [Oak Rock's] management. [EisnerAmper's] responsibility is to express an opinion on these financial statements based on our audits.” The letter continued by stating:
We conducted our audits in accordance with [GAAS]. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misrepresentation. An audit incudes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that out audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of [Oak Rock] as of December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended, in conformity with [GAAP].
Complaint ¶ 29.
Oak Rock's balance sheets indicated that, for the years in question, its largest asset was its loan receivables (e.g., in 2010, Oak Rock's balance sheet indicates that it had approximately $145 million in outstanding loan receivables while it earned approximately $12.6 million of income). ¶¶ 30–31.
IDB began lending money to Oak Rock in July 2001 with a credit facility, whereby IDB obtained first priority security interests in Oak Rock's assets. ¶ 39. As a result, since 2001, IDB had a direct interest in Oak Rock's receivables. On May 9, 2006, IDB, as an agent for another lender bank (Bank Leumi USA), entered into an Amended and Restated Credit Agreement, under which Oak's Rock's credit facility was increased to $50 million. ¶ 40. Oak Rock and IDB further entered into an amended security agreement covering Oak Rock's collateral. ¶ 42.The credit agreement prohibited Oak Rock from borrowing “more than the greater of the Borrowing Base,' which was equal to 80% of the Borrower's Eligible Client/Dealer Loans, and the Maximum Revolving Credit Agreement.” ' ¶ 41. Essentially, this borrowing cap was pegged to the value to Oak Rock's collateral, such that the amount borrowed would be tied to the value of its receivables.
In addition, the credit agreement obligated Oak Rock to deliver audited annual balance sheets and financial statements to IDB and its other lenders. ¶ 43. Over the following years, the credit and security agreements were amended numerous times, adding other lenders and altering the amount of the credit facility, but the financial statement reporting obligation remained. ¶¶ 44, 48, 52, 59, 67, 69. As noted earlier, throughout this time period, EisnerAmper issued audited financial statement reports vouching for Oak Rock's financials. IDB and Oak Rock's other lenders received these audit reports from Oak Rock before entering into each of the subsequent amended credit agreements and, allegedly, relied on their veracity in deciding to extend more credit to Oak Rock. ¶¶ 52, 61, 63, 68, 71.
While Oak Rock's audits indicated that Oak Rock was financially stable, it was not. Murphy was falsifying the age of the receivables, making Oak Rock appear to be eligible for further credit under its facility when it was actually in dire financial straits. Consequently, although much of the receivables were so long overdue as not be deemed collectible and, hence, not eligible under the credit agreements to permit increased lending, Murphy falsified the age of the receivables to keep its credit facility open. Murphy's actions gave Oak Rock continued access to its lender's money.
Murphy's fraud was eventually discovered by Thomas Stevens, the president of one of Oak Rock's minority equity investors, Oasis Capital Magement LLC. ¶¶ 16, 73. In mid-April 2013, during a visit to Oak Rock's offices, Stevens noticed unusual collection activity from one of Oak Rock's customers. ¶ 73. After investigating further, Stevens discovered that Oak Rock's collateral records did not match the records Murphy produced to Stevens. Id. Stevens confronted Murphy about this discrepancy, and, in response, Murphy confessed his fraud. ¶ 74. Murphy admitted he was creating false records to keep Oak Rock's credit facility open. Id. For instance, as of February 28, 2013, Oak Rock's records indicated that it had $2.5 million of borrowing availability when, in fact, it had none. Id. Indeed, based on Oak Rock's actual collateral value, it was over-advanced by $47 million. Id. Stevens demanded that Murphy resign, which he did on April 17, 2013. ¶ 75. Stevens immediately replaced Murphy as Oak Rock's manager. ¶ 73. The following day, on April 18, 2013, Stevens notified IDB of Oak Rock's fraud. ¶ 79. As of that date, Oak Rock owed its lenders approximately $90 million, about $33 million of which was owed to IDB. Id.
The lenders declared Oak Rock in default on April 23, 2013 and accelerated the debt. ¶¶ 80–81. On April 29, 2013, the lenders commenced an involuntary Chapter 7 proceeding in the United States Bankruptcy Court for the Eastern District of New York (In re: Oak Rock Financial LLC, Case No. 8–13–72251). ¶ 82. In an order dated May 6, 2013, the bankruptcy court converted the case to a Chapter 11 proceeding and, to date, Oak Rock continues to operate as a debtor-in-possession. ¶ 84. On December 20, 2013, Murphy pled guilty to bank fraud and conspiracy to commit bank fraud, committed between January 2009 and April 2013. ¶ 85.
The lenders have taken extensive discovery in the bankruptcy proceeding, which has resulted in the detailed complaint.
In this action, IDB seeks to hold EisnerAmper liable for the false information in Oak Rock's financial statements that IDB allegedly relied on in lending money to Oak Rock. It is undisputed that, each year, Oak Rock's financial statements contained myriad inaccuracies, which are set forth extensively in the complaint. See, e.g., ¶ 90 (false statements in 2010 financial statements). However, as noted earlier, in a highly unusual (and possibly intentional) decision, the complaint does not identify the cause or causes of action being asserted against EisnerAmper. Rather, a long, detailed narrative is presented, spanning 96 pages. When the court first read the complaint, it was unsure what claims were being asserted, and assumed that, based on the nature of the accusations, IDB was attempting to assert a malpractice claim against EisnerAmper. EisnerAmper's counsel, understandably, thought so as well, and devoted a significant portion of its moving brief to explain, quite correctly, why such a claim fails as a matter of law. In opposition, IDB claimed its complaint was misunderstood, and, in reality, was only a claim for fraud. Specifically, IDB alleges that EisnerAmper's false statements in its audit reports about Oak Rock's financials, which IDB claims were the result of a grossly negligent audit process, amount to actionable fraud.
Discussion
On a motion to dismiss, the court must accept as true the facts alleged in the complaint as well as all reasonable inferences that may be gleaned from those facts. Amaro v. Gani Realty Corp., 60 AD3d 491 (1st Dept 2009) ; Skillgames, LLC v. Brody, 1 AD3d 247, 250 (1st Dept 2003), citing McGill v. Parker, 179 A.D.2d 98, 105 (1992) ; see also Cron v. Harago Fabrics, 91 N.Y.2d 362, 366 (1998). The court is not permitted to assess the merits of the complaint or any of its factual allegations, but may only determine if, assuming the truth of the facts alleged, the complaint states the elements of a legally cognizable cause of action. Skillgames, id., citing Guggenheimer v. Ginzburg, 43 N.Y.2d 268, 275 (1977). Deficiencies in the complaint may be remedied by affidavits submitted by the plaintiff. Amaro, 60 NY3d at 491. “However, factual allegations that do not state a viable cause of action, that consist of bare legal conclusions, or that are inherently incredible or clearly contradicted by documentary evidence are not entitled to such consideration.” Skillgames, 1 AD3d at 250, citing Caniglia v. Chicago Tribune–New York News Syndicate, 204 A.D.2d 233 (1st Dept 1994). Further, where the defendant seeks to dismiss the complaint based upon documentary evidence, the motion will succeed if “the documentary evidence utterly refutes plaintiff's factual allegations, conclusively establishing a defense as a matter of law.” Goshen v. Mutual Life Ins. Co. of NY, 98 N.Y.2d 314, 326 (2002) (citation omitted); Leon v. Martinez, 84 N.Y.2d 83, 88 (1994).
All discussions of the viability of a claim by a creditor of a fraud-committing company against that company's auditor must begin with Chief Judge Cardozo's opinion in Ultramares Corp. v. Touche, 255 N.Y. 170 (1931). In Ultramares, after noting that “[t]he assault upon the citadel of privity is proceeding in these days apace,” the Court set forth a rule prohibiting a party not in privity with an accountant from maintaining a negligence claim absent conditions of near-privity. Id. at 180. This standard was clarified by the Court in Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536 (1986) :
Before accountants may be held liable in negligence to noncontractual parties who rely to their detriment on inaccurate financial reports, certain prerequisites must be satisfied: (1) the accountants must have been aware that the financial reports were to be used for a particular purpose or purposes; (2) in the furtherance of which a known party or parties was intended to rely; and (3) there must have been some conduct on the part of the accountants linking them to that party or parties, which evinces the accountants' understanding of that party or parties' reliance.
Id. at 551. For the reasons set forth in EisnerAmper's moving brief—which IDB does not dispute—IDB cannot maintain a negligence claim against EisnerAmper. Simply put, the requisite “linking conduct” is not present. See CRT Investments, Ltd. v. Merkin, 29 Misc.3d 1218(A), at *12–13 (Sup Ct, N.Y. County 2010) (Lowe, J.), aff'd sub nom. CRT Investments, Ltd. v. BDO Seidman, LLP, 85 AD3d 470, 472 (1st Dept 2011) (“The fact that plaintiffs were entitled to and received a copy of the audited financial statements, or that [the auditor] knew that the investors would rely upon the information contained in the financial statements, does not establish the requisite linking conduct”).
Nonetheless, “even where the law does not permit a claim of negligence to be brought against a professional by a person not in privity with the professional, this rule does not emancipate accountants from the consequences of fraud.” ' Houbigant, Inc. v. Deloitte & Touche LLP, 303 A.D.2d 92, 95 (1st Dept 2003), quoting Ultramares, 255 N.Y. at 189. To state a claim for auditor fraud, the usual fraud elements—“a material misrepresentation of a fact, knowledge of its falsity, an intent to induce reliance, justifiable reliance by the plaintiff and damages”—must be pled with the specificity required by CPLR 3016(b). Eurycleia Partners, LP v. Seward & Kissel, LLP, 12 NY3d 553, 559 (2009) ; see Pludeman v. Northern Leasing Sys., Inc., 10 NY3d 486, 491 (2008).
The parties primarily dispute whether IDB adequately pleaded the element of scienter, the requisite intent to defraud. “The standard for pleading auditor scienter is demanding.” Meridian Horizon Fund, LP v. Tremont Group Holdings, Inc., 747 FSupp2d 406, 412 (SDNY 2010) ; see CRT, 85 A.D.2d at 472 (“Plaintiffs' allegations of GAAS violations without corresponding fraudulent intent' are insufficient to state a securities fraud claim against an independent accountant”), quoting Rothman v. Gregor, 220 F3d 81, 98 (2d Cir2000).
“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. ” ' CRT, 29 Misc.3d 1218(A), at *13 (emphasis added), quoting Rothman, 220 F3d at 98. “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, or the auditor's judgments were such that no reasonable accountant would have made the same decisions if confronted with the same facts.” CRT, 29 Misc.3d 1218(A), at *13 (citations and quotation marks omitted); see Iowa Pub. Employee's Ret. Sys. v. Deloitte & Touche LLP, 919 FSupp2d 321, 337 (SDNY 2013) (“Where an auditor was not aware of facts indicating that a transaction was suspicious or part of a fraud, the auditor's failure to investigate the transaction—even if negligent—does not provide a basis for a fraud claim”), aff'd 558 FedAppx 138 (2d Cir2014), quoting In re CBI Holding Co., Inc., 419 BR 553, 567 (SDNY 2009), accord Rothman, 220 F3d at 98.
IDB correctly observes that many of the New York state and federal auditor fraud cases arise in the securities context, where an investment decision was made in reliance on audited financial statements. However, contrary to IDB's contentions, the legal standards set forth in those cases govern. An auditor fraud claim is a cause of action for common law fraud, and it is well settled that securities fraud claims are subject to the usual New York common law fraud elements. See Abu Dhabi Commercial Bank v. Morgan Stanley & Co., 888 FSupp2d 431, 456 n. 136 (SDNY 2012) (Scheindlin, J.), citing Marcus v. AT & T Corp., 138 F3d 46, 57 n. 2 (2d Cir1998) and In re Merrill Lynch Auction Rate Secs. Lit., 2012 WL 1994707, at *3 (SDNY 2012) (Preska, C.J.) (“The parties agree that the elements of common law fraud essentially mirror those involved in the section 10(b) claims”); see also People v. Bank of N.Y. Mellon Corp., 40 Misc.3d 1232(A), at *13 (Sup Ct, N.Y. County 2013) (Friedman, J.) (citing examples of New York's common law standard mirroring federal securities law). Moreover, it is well established that the scienter element of a New York common law fraud claim “is essentially the same as that under federal securities laws.” Saltz v. First Frontier, LP, 782 FSupp2d 61, 75 (SDNY 2010).
Indeed, as the First Department's decision in CRT (a case with virtually identical allegations) makes clear by quoting the Second Circuit's decision in Rothman, the scienter pleading requirements in auditor fraud cases applied by the federal courts are equally applicable to auditor fraud claims in this court. IDB cites no appellate case to refute the notion that auditor fraud claims are governed by the same standards no matter if the auditor's representations induced the purchase of securities or, as here, the lending of money under a credit facility. There is no reason to hold auditors to a different standard in lawsuits brought by investors or lenders. As auditors do not and usually cannot know who is relying on their work (the very reason non-clients are usually barred from suing auditors), different liability standards are not likely to incentivize better audits.
While the federal courts apply the heightened pleading standards of the Private Securities Litigation Reform Act and Federal Rule of Civil Procedure 9(b) to auditor fraud claims arising from the sale of securities [see Iowa Pub., 558 FedAppx at 139 ], the actual substantive standard employed by the federal courts is virtually identical to the standard approved by the First Department. Compare id. at 140 (“[plaintiff] alleges that [the] auditing practices were so deficient that the audits amounted to no audit at all, or an egregious refusal to see the obvious, or investigate the doubtful” '), aff'g 919 FSupp2d at 333–34 (“ “recklessness requires accounting practices [that] were so deficient that the audit amounted to no audit at all,' meaning an egregious refusal to see the obvious, or to investigate the doubtful. In other words, in order to be reckless in this sense, an auditor's behavior must not only approximate an actual intent to aid in the fraud being perpetrated by the audited company, but also must reflect accounting judgments that no reasonable accountant would have made ... if confronted with the same facts.' In the Second Circuit, strong indicators of recklessness can constitute factual allegations indicating that defendants (1) possessed knowledge of facts or access to information contradicting their public statements or (2) failed to review or check information that they had a duty to monitor, or ignored obvious signs of fraud” ') (citations omitted), with CRT, 29 Misc.3d 1218(A), at *13 (setting forth virtually identical standard, relying of federal case law, affirmed by the First Department). While, of course, IDB is not required to meet the heightened pleading standards applicable in federal court, the complaint's failure to state a claim is not due to the lack of specificity, which, as noted earlier, is not an issue with IDB's complaint. Rather, the fatal flaw the complaint suffers from is that its robust allegations do not substantively meet the governing standard, which, in the First Department, does not differ from the standard applied by the federal courts.
IDB's reliance on Sterling Nat'l Bank v. Ernst & Young, LLP, 9 Misc.3d 1129(A), at *4 (Sup Ct, N.Y. County 2005) is misplaced. There, while the court was distinguishing certain “federal cases cited by defendants,” the context was the rejection of the proposition that a motive to deceive must be pled to establish scienter. Indeed, this is normally a requirement in federal securities cases, and, in fact, is generally a requirement under the common law as well. See Basis Pac–Rim Opportunity Fund (Master) v. TCW Asset Mgmt Co., 40 Misc.3d 1240(A), at *5–6 (Sup Ct, N.Y. County 2013) (collecting cases). However, in federal auditor fraud cases, “[p]laintiffs may allege scienter by either (1) showing the defendants' motive and opportunity to perpetrate fraud, or (2) alleging strong circumstantial evidence of conscious misbehavior or recklessness.” Iowa Pub., 919 FSupp2d at 331 (citation and quotation marks omitted; emphasis added). Simply put, IDB's attempt to distinguish federal auditor fraud securities cases misses the mark.
IDB's complaint does not satisfy this standard. IDB makes much of the fact that EisnerAmper committed myriad GAAS violations. Indeed, the complaint devotes 7 pages to quoting the various GAAS standards that IDB allegedly failed to follow. However, as noted earlier, GAAS violations, without fraudulent intent, do not constitute fraud. See CRT, 85 A.D.2d at 472. Rather, the relevant inquiry is whether EisnerAmper's audit was intentionally deficient for the purpose of aiding in the fraud or, alternatively, EisnerAmper's work was so deficient so as not to constitute an audit at all. As IDB does not allege actual intent to aid Oak Rock's fraud, IDB must adequately plead the latter circumstance.
IDB alleges (and it certainly does seem) that EisnerAmper's audit was, at a minimum, negligent. IDB contends that, in connection with the 2010 audit, EisnerAmper focused on “significant audit areas and the various ways fraud could occur.” See Complaint ¶ 142. The audit team “determined that financial fraud would more likely be in the form of overstatement of net income and assets because reducing income and assets could potentially impair Oak Rock's ability to borrow additional fund from [IDB] and stop/slow the growth of the Company.” ¶ 143. Specifically, EisnerAmper was concerned about Oak Rock falsifying records of its loans and the value and collectability of the collateral-which, in fact, is what Murphy was doing. As IDB points out and EisnerAmper does not deny, EisnerAmper failed to independently verify the accuracy of Oak Rock's records to see if this was occurring. But, while IDB maintains this necessarily was part of EisnerAmper's audit responsibilities, EisnerAmper's engagement letter is explicit about the fact that “the financial statements are the responsibility of the management of [Oak Rock]” and that “[m]anagement is responsible for designing and implementing programs and controls to prevent and detect fraud.” Ergo, robust fraud detection is beyond the scope of EisnerAmper's engagement. Similarly, with respect to Oak Rock's collateral aging records, which were prepared by Murphy, EisnerAmper did not verify that the information contained therein was accurate; it was not. Here, too, IDB maintains that EisnerAmper did not do enough, which, perhaps, is true given the relative importance of the aging data to the accuracy of Oak Rock's financial heath as depicted in its balance sheet. Nonetheless, while these failings would likely be sufficient to state a claim for auditor malpractice (a claim IDB does not and cannot allege), EisnerAmper's audit does not amount to fraud.
Indeed, while IDB alleges that EisnerAmper's audit was inadequate, IDB's complaint documents the extensive audit work performed by EisnerAmper. See, e.g., Complaint ¶¶ 154, 167, 171, 189, 191, 271. Though EisnerAmper did not robustly diligence the sources of the receivables, such as the merchants and dealers (who may or may not have cooperated with EisnerAmper's inquiries), the amount of work performed by EisnerAmper is not compatible with the notion that no real audit occurred. Rather, EisnerAmper conducted an audit that had methodological gaps which, we now know, are precisely where Oak Rock's fraud was being hidden.
In that regard, this case is not unique. IDB claims EisnerAmper failed to act on “red flags” of fraud, which, with the benefit of hindsight, fraud victims tend to claim should have been recognized and that disaster would have been averted but for the auditor's inaction. This theory has come before courts frequently in the aftermath of the Madoff Ponzi scheme. See McBride v. KPMG Int'l, 2014 WL 4063044, at *14 n. 4 (Sup Ct, N.Y. County 2014) (collecting cases). The takeaway from those cases is that courts must be wary of relying on the clarity of hindsight when red flag allegations are asserted. See Zutty v. Rye Select Broad Market Prime Fund, L.P., 33 Misc.3d 1226(A), at *11 (Sup Ct, N.Y. County 2011) ; see also Matana v. Merkin, 989 FSupp2d 313, 328 (SDNY 2013), citing SSR II, LLC v. John Hancock Life Ins. Co. (U.S.A.), 37 Misc.3d 1204(A), at *6 (Sup Ct, N.Y. Count 2012) (noting that “in almost every case courts have not held investment advisors liable for failing to deduce that Madoff was running a Ponzi scheme.”).
CRT, 29 Misc.3d 1218(A), was such a case. There, Justice Lowe explained (and was affirmed by the Appellate Division) that missing red flags and violating GAAS is not fraud. Id. at *13. To support fraud for GAAS violations, the auditor must actually know about the red flags and unjustifiably ignore them. See Saltz, 782 FSupp2d at 76–77. “[M]erely alleging that the auditor had access to the information by which it could have discovered the fraud is not sufficient.” Id. at 77, quoting In re IMAX Secs. Lit., 587 FSupp2d 471, 484 (SDNY 2008). “[O]nly those red flags that [the auditor] is alleged to have known of, or that are so obvious that [the auditor] must have known of them, can support an inference of intent.” See Saltz, 782 FSupp2d at 76, quoting Stephenson v. Citco Group Ltd., 700 FSupp2d 599, 623 (SDNY 2010), citing In re Priceline.Com Inc. Secs. Lit., 342 FSupp2d 33, 57 (D Conn 2004) (“Even if the court could infer that [auditor] was aware of the [nine] red flags set forth herein, which is no small leap, the red flags are not so egregious as to render [auditor's] audit a farce”).
In this case, IDB claims EisnerAmper ignored red flags of fraud by failing to sufficiently investigate concerns such as the aging of the collateral, credit loss rate, and willingness to write off loans and continue lending to uncreditworthy dealers. These concerns, however, are not red flags of fraud. At most, they are an identification of the assets that mattered most to Oak Rock's financial health and areas of heightened risk, which, if fraud is occurring, would be where it most likely is occurring. A red flag, in contrast, is some indication that fraud is actually occurring. IDB has not identified any actual red flags that Murphy was indeed perpetrating a fraud in these identified high risk areas, which red flags were known to defendant and ignored.
Regardless, even if the risks identified by EisnerAmper constitute the sort of “obvious” red flags needed to give rise to fraud claim, EisnerAmper did not simply ignore them. They did some diligence, which—again, in hindsight—was inadequate. Instead of conducting a robust fraud investigation, EisnerAmper employed allegedly deficient analytical methods to vet the accuracy of Oak Rock's records. At most, this was negligent. The court cannot deem EisnerAmper's audit to be so recklessly egregious as to warrant an inference of fraudulent intent. While there is no defined line between negligence and actionable recklessness, the “red flags” in this case are, regardless of what became clear in hindsight, more benign than in actionable red flag cases. See, e.g., State St. Trust Co. v. Ernst, 278 N.Y. 104, 117 (1938) (auditor knew account was being padded and had an insubstantial reserve); DaPuzzo v. Reznick Fedder & Silverman, 14 AD3d 302, 303 (1st Dept 2005) (auditor “gave in to the CFO's demands to fix the financial reports to represent a more favorable financial position in order not to jeopardize its fee”); Curiale v. Peat, Marwick, Mitchell & Co., 214 A.D.2d 16, 19–20 (1st Dept 1995) (auditor knew that its client's SEC filings contained false information). IDB's fraud claim is dismissed. In light of this dismissal, the court need not reach the two other issues raised on the motion to dismiss—IDB's demand for punitive damages and its capacity to sue on behalf of the other lenders.
Finally, it should be noted that, while not a basis for this decision, the recently filed adversary proceeding (brought by the Official Committee of Oak Rock's unsecured creditors) against IDB in Oak Rock's bankruptcy proceeding suggests that, even if this case survived dismissal, its viability would be very much in question. The recently unsealed adversary complaint [see In re: Oak Rock Financial LLC, Case No. 8–14–08231, Dkt. 21 (Bankr EDNY Oct. 6, 2014) ] alleges that IDB “had more contact, control and information about [Oak Rock] than any other lender and was responsible for managing [Oak Rock's] collateral. ” Id. ¶ 2 (emphasis added). The facts alleged in the adversary complaint, if true, would preclude an assertion of reasonable reliance and likely implicate the in pari delicto doctrine. See Kirschner v. KPMG LLP, 15 NY3d 446, 464 (2010). Accordingly, it is
The adversary complaint is dated August 17, 2014 and was unsealed on October 6, 2014.
ORDERED that the motion to dismiss by defendant EisnerAmper LLP is granted, and the Clerk is directed to enter judgment dismissing the Complaint with prejudice.