Sterling Natl. Bank v Ernst & Young, LLP

[*1] Sterling Natl. Bank v Ernst & Young, LLP 2005 NY Slip Op 51850(U) [9 Misc 3d 1129(A)] Decided on January 7, 2005 Supreme Court, New York County Cahn, J. Published by New York State Law Reporting Bureau pursuant to Judiciary Law § 431. This opinion is uncorrected and will not be published in the printed Official Reports.

Decided on January 7, 2005
Supreme Court, New York County

Sterling National Bank, Plaintiff,

against

Ernst & Young, LLP, and KAPIL JAIN, Defendants.



121916/2003

Herman Cahn, J.

Plaintiff, Sterling National Bank, brings this action against defendants Ernst & Young LLP and Kapil Jain, for fraud, aiding and abetting fraud, recklessness, and gross negligence. The claims are based on defendants' role as the auditor of Allied Deals, Inc. It is claimed that Allied Deals was nothing more than a Ponzi scheme created to defraud banks.

Defendants move to dismiss the amended complaint, CPLR 3211 (a) (7).

BACKGROUND

Allied Deals, Inc. held itself out to be a metals trading company that brokered deals between buyers and sellers of metals throughout the world. Its chief executive financial officer Anil Anand allegedly had a close personal and social relationship with defendant Kapil Jain. Further, Jain was also the personal tax advisor of Narendra Rastogi, Allied Deals' CEO.

Jain himself is a partner of defendant Ernst & Young LLP and was responsible for audits and reports of Allied Deals for the fiscal years ended July 31, 1998, 1999, and 2000.

To facilitate sales of metal, Allied Deals would, among other things, obtain loans from banks to assist the buyer with the purchase of the metal. Plaintiff Sterling National Bank was among the banks that had loaned Allied Deals substantial sums, secured by Allied Deals' accounts receivable. Allied Deals had established a credit facility with Sterling that was set to expire on June 30, 2001. In deciding whether to renew the credit facility, Sterling reviewed Allied Deals' financial statements for the year ended July 31, 2000 (the 2000 Financial Statements) and E&Y's accompanying Report of Independent Auditors dated October 6, 2000, which certified the financial statements (the Report).

The Report gave a "clean" opinion of the 2000 Financial Statements. It states, in pertinent part: "We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. . . . We believe that our audits and the report of other auditors provide a reasonable [*2]basis for our opinion.In our opinion, based on our audits and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Allied Deals, Inc. and subsidiaries at July 31, 2000 and 1999 . . . in conformity with accounting principles generally accepted in the United States."

On May 7, 2002, Allied Deals filed for protection under Chapter 7 of the Bankruptcy Code. On May 13, 2002, the United States Attorney for the Southern District of New York filed a thirty-count indictment alleging that Allied Deals, its president, 14 other individuals, and 25 entities controlled by Rastogi and his co-conspirators engaged in a scheme of fictitious metal trades that defrauded major international banks and financial institutions of $600 million. The principals of Allied Deals, including Anand and Rastogi, pleaded guilty to bank fraud. Five key "employees" of Allied Deals were also convicted of bank fraud.

On December 23, 2003, Sterling commenced this action, alleging that defendants committed fraud (first cause of action), aided and abetted Allied Deals' fraud (second cause of action), engaged in reckless conduct tantamount to fraud (third cause of action), and engaged in grossly negligent conduct tantamount to fraud (fourth cause of action). Sterling also seeks punitive damages. It essentially alleges that the "clean" opinion of the 2000 Financial Statements was false. Jain allegedly misrepresented in the Report that the opinion was based, in part, on the report of other auditors concerning the financial statements of a subsidiary of Allied Deals, Suhaina General Trading. Instead of a report, Jain had received only a draft from the firm which apparently performed that audit, AGN MAK, on the day that he certified the Report. Jain also allegedly knew that E&Y did not independently verify information concerning Allied Deals' accounts receivable in violation of generally accepted auditing standards (GAAS). In addition, Jain allegedly failed to investigate fraud warnings about Suhaina General mentioned in a memo to Jain dated November 21, 2001, from Ali Issa, a partner in an E&Y affiliated office. Issa concludes in the memo, "Based on the above and our concerns arising from a review of the transactions cycle set out in Appendix 1, we have become very concerned about this client and ours [sic] continued association with them"

(Ex. C to Amended Complaint). Thus, Sterling asserts that the Report falsely stated that the financial statements presented fairly, in all material aspects, the financial position of Allied Deals and its subsidiaries, in conformity with generally accepted accounting principles (GAAP).

Sterling argues that Jain disregarded the warnings because of his relationship with Anand. In addition, it is alleged that the motive for defendants' fraudulent statements was that Jain wanted to keep Allied Deals as a client and to remain as Rastogi's personal tax advisor (see Amended Complaint ¶¶ 24, 29, 54). Rastogi and Anand also allegedly discussed bribing E&Y with cash (id ¶ 23).

DISCUSSION

On a CPLR 3211 motion to dismiss the court must accept as true the facts as alleged in [*3]the complaint and submissions in opposition to the motion, accord plaintiff the benefit of every possible favorable inference, and determine only whether the facts as alleged fit within any cognizable legal theory (Sokoloff v Harriman Estates Dev. Corp., 96 NY2d 409, 414 [2001]).

In support of dismissal, defendants maintain that: 1) Sterling did not plead fraud with particularity, as required under CPLR 3016 (b); 2) the fourth cause of action, "gross negligence tantamount to fraud," does not exist as a separate cause of action under New York law; 3) defendants were unaware of Allied Deals' fraud; and 4) punitive damages are not warranted.

I. Fraud

Defendants argue that scienter cannot be inferred from the allegations. They also contend that Sterling's reliance solely on the Report was not justifiable. Finally, defendants assert that the alleged misrepresentations did not proximately cause Sterling's injuries.

A. Scienter

The amended complaint sufficiently pleads scienter with respect to the Report's false statements regarding the receipt of a report from other auditors. Jain himself had allegedly written a memo to "Files" indicating that he did not have such a report (Amended Complaint ¶ 38). He also allegedly initialed the draft that he had received from AGN MAK, on the same day that he had "signed off" on the Report (Amended Complaint ¶ 40). Though defendants characterize Jain's conduct as a mere failure to follow audit procedure, rather than fraud, that issue cannot be determined on a motion to dismiss.

Nor does it avail defendants to argue that Sterling is complaining only that the draft was unsigned. Because Jain had allegedly received AGN MAK's draft on the same day that he "signed off" on the Report, it is reasonable to infer that Jain did have enough time to investigate any issues that AGN MAK's draft would have raised. The AGN MAK draft allegedly indicates that Suhaina General's net income for the ten-month period ended July 31, 2000 was in excess of $7,000,000. Further, Suhaina General was acquired by Allied Deals for $5,000,000 (see Amended Complaint ¶ 42). It is argued that the fact that Suhaina General's purchase price was $2 million less than its net income should have raised a warning of something wrong.

With respect to the Report's other alleged misrepresentations, Sterling maintains that defendants were on notice of fraud at Allied Deals, but failed to conduct investigations in accordance with proper auditing standards. For example, in August and September 2000, E&Y allegedly discovered that Allied Deals' vendors and lenders had made advances against the same goods (see Amended Complaint ¶ 53). Meanwhile, Issa's memo raised concerns that Suhaina General's transactions were settled in cash, which Issa noted was "very unusual"; its gross margin exceeded industry norm; Rastogi had lied to E&Y about the fact that he was the beneficial owner of most of the customers of Suhaina General; it had a very unusually high percentage of confirmations for customers; and there were rumors in the market that Rastogi and his two brothers owned companies that were "rotating the same inventory between themselves and their customers (related parties) to increase/overstate their turnover and net profit" (see id. ¶ 32 [a]-[e]).

Defendants contend that Jain's relationships with Anand and Rastogi, as well as his alleged desire to keep Allied Deals as a client, are insufficient to infer fraud. They also argue that an auditor's failure to investigate warning signals s does not give rise to fraud, citing a line of [*4]federal cases alleging securities fraud (see The Limited, Inc. v McCrory Corp., 683 F Supp 387, 394 [SD NY 1988]). Defendants also point out that they received Issa's memo after E&Y had completed its audit, and after Sterling had already renewed Allied Deals' credit facility.

Defendants' arguments are unpersuasive at this stage of the litigation. To plead scienter, Sterling is not required to allege a motive to deceive. Rather, an intent to deceive may be based only on allegations that defendants knew that the representations were false at the time they were made (Abrahami v UPC Constr. Co., 224 AD2d 231, 233 [1st Dept 1996]). Unlike the federal cases cited by defendants, New York courts have held that "[a]n auditor's failure to independently verify financial statements may give rise to a claim for fraud, especially where the auditor 'had notice of particular circumstances raising doubts as to the veracity of the such information'" (Houbigant, Inc. v Deloitte & Touche, 303 AD2d 92, 100 [1st Dept 2003][citing Foothill Capital Corp. v. Grant Thornton, LLP, 276 AD2d 437 (1st Dept 2000)]; Joel v Weber, 166 AD2d 130, 136 [1st Dept 1991]);[FN1] Such are the allegations here.

Even though Issa's memo postdates the Report, it states that two of the concerns were previously raised to Jain in 2000 (see Jacob Opp. Aff., Ex C). On this motion, Sterling is entitled to the inference that Jain knew of these concerns during E&Y's audit of Allied Deals. Defendants question whether concerns based on market rumors constitute notice, but that issue must await discovery as to what Issa had communicated to Jain.[FN2]

The amended complaint sufficiently "contains some rational basis for inferring that the alleged misrepresentation[s] w[ere] knowingly made" (Houbigant, 303 AD2d at 98), and adequately pleads scienter. Defendants' remaining arguments on the issue of scienter are unavailing. For instance, defendants claim that Sterling did not allege which provisions of GAAS and GAAP had been violated (Mem. at 18 n 10), but the amended complaint clearly cites three alleged auditing standards (see Amended Complaint ¶ 66 [a]).

B. Reliance

"[I]n order to be actually deceived by a false representation, a party must not only reasonably believe that the representation is true, but he must also be justified in taking action in [*5]reliance thereon" (Lanzi v Brooks, 54 AD2d 1057, 1058 [3d Dept 1976], affd 43 NY2d 778 [1977]; Stuart Silver Assocs. v Baco Dev. Corp., 245 AD2d 96, 98-99 [1st Dept 1997]).

Defendants argue that Sterling's reliance on the Report was not justifiable, because it apparently did not investigate or verify the information contained therein, citing cases involving sophisticated business people (see e.g. UST Private Equity Investors Fund v Salomon Smith Barney, 288 AD2d 87, 88 [1st Dept 2001]; Shea v Hambros PLC, 244 AD2d 39, 46-47 [1st Dept 1998]; Abrahami v UPC Constr. Co., 224 AD2d 231 [1st Dept 1996], supra). Defendants stress that Sterling was not entitled to rely "blindly" on the Report, and they suggest that Sterling should have engaged its own auditors to conduct field examinations. According to defendants, Sterling's reliance on the Report was justifiable only if it contained information to which Sterling did not have access. Defendants also argue that the information contained in the Report was outdated, given the nature of the business of Allied Deals in the commodities market.

However, defendants do not dispute that the Report gave a "clean" opinion of the 2000 Financial Statements. It does not set forth any restrictions upon the information contained therein (cf. Rotterdam Ventures v Ernst & Young, 300 AD2d 963, 965 [3d Dept 2002][comfort letters stated that they were not to be used for any purpose, including purchase or sale of securities]). Defendants' arguments seem to be based on the premise that audits performed by certified public accountants, even when purportedly conducted in accordance with GAAS, may nevertheless be unreliable and trigger a duty to investigate, on the part of anyone who relies on them. This is an unusually low standard of competence for a professional.

Pleading the element of justifiable reliance on an auditor's report does not require Sterling to allege that it conducted an additional audit. A requirement for an additional audit would undermine the integrity and purpose of all audits conducted in accordance with GAAS. Defendants' characterization of the additional audit as an "independent appraisal" seems to indicate a claim that its audit was not independent; a difficult argument for E&Y to make, since a public auditor has an obligation to maintain independence from its client (see Fidelity & Deposit Co. of Md. v Andersen & Co., 131 AD2d 308, 310 [1st Dept 1987]). Nor does the claimed duty to investigate the auditor's representations require a separate audit, because the duty does not extend beyond the "exercise of ordinary intelligence" (see Stuart Silver Assocs., 245 AD2d at 98-99; Cohen v Colistra, 233 AD2d 542, 543 [3d Dept 1996]).

The cases cited by defendants are distinguishable. The financial statements in Abrahami were not audited, but compiled (see Abrahami, 224 AD2d at 231). Reliance upon compilations of financial statements is not justifiable as a matter of law (see Evans v Israeloff, Trattner & Co., 208 AD2d 891, 892 [2d Dept 1994]). Neither Shea nor Stuart Silver Associates involved the representations contained in an independent auditor's written opinion. In any event, the amended complaint alleges that Sterling conducted a due diligence investigation (see Amended Complaint ¶ 56). Although defendants contend that the allegation is conclusory, it is not inherently incredible, such that it may not be accepted as true (see Skillgames, LLC v Brody, 1 AD3d 247, 250 [1st Dept 2003]).

Finally, the issue of whether the information in the Report was so outdated as to negate any justifiable reliance cannot be determined on a pleading motion.

C. Causation

Defendants contend that Sterling renewed its loan agreement with Allied Deals based on [*6]a pre-existing relationship and not based on the Report. Defendants also argue that the Amended Complaint's allegations do not show a causal link between Sterling's alleged injury and defendants' conduct, citing Aronoff v Ernst & Young (283 AD2d 301 [1st Dept 2001]). On the contrary, defendants maintain that the criminal conduct of Allied Deals was the sole cause of Allied Deals' default on Sterling's loan.

"To establish causation, plaintiff must show both that defendant's misrepresentation induced plaintiff to engage in the transaction in question (transaction causation) and that the misrepresentations directly caused the loss about which plaintiff complains (loss causation)" (Laub v Faessel 297 AD2d 28, 31 [1st Dept 2002]). Here, the allegations sufficiently plead causation. Contrary to defendants' arguments, "[t]he fraudulent misrepresentations on the part of defendants need not be the sole inducing cause of the damage. It is sufficient if such representations be an inducing cause" (State St. Trust Co. v Ernst, 278 NY 104, 122 [1938]; Curiale v Peat, Marwick, Mitchell & Co., 214 AD2d 16, 27 [1st Dept 1995]). Thus, the amended complaint adequately pleads transaction causation when it states that Sterling would not have made loans to Allied Deals had E&Y not given a "clean" opinion regarding the 2000 Financial Statements (Amended Complaint ¶ 74).

As to loss causation, "[a] fraudulent misrepresentation is a legal cause of a pecuniary loss resulting from action or inaction in reliance upon it if, but only if, the loss might reasonably be expected to result from the reliance" (Stutman v Chemical Bank, 95 NY2d 24, 30 [2000][citing Restatement (Second) of Torts § 548A]). Defendants' representations gave the impression that Allied Deals was a bona fide business, when in fact Allied Deals was a criminal enterprise that had little or no actual business from its inception (id. ¶ 5.).[FN3] Had defendants' audit fairly represented its financial condition, it would be evident that Allied Deals would never have been able to repay a loan. The accounts receivable, its primary asset, were non-existent (Amended Complaint ¶ 48). Thus, it is foreseeable that Sterling would suffer losses once it was induced by defendants' representations to transact with Allied Deals (see Hotaling v A.B. Leach & Co., 247 NY 84, 93 [1928]["The loss sustained is directly traceable to the original misrepresentation of the character of the investment the plaintiff was induced to make"]).

The court rejects the argument that, as a matter of law, the criminal conduct of the principals of Allied Deals constituted an intervening cause. Because Sterling alleges that defendants knowingly gave a false "clean" opinion, the particular reason why the 2000 Financial Statements were inaccurate is irrelevant. Sterling suffers the same injury even in the absence of criminal fraud (for instance, if Allied Deals had only mistakenly overstated its accounts receivable). It is a foreseeable result that Allied Deals would default on its loans when its true financial condition became known (see Restatement [Second] of Torts § 548A, comment b).

However, the basic point is that on a CPLR 3211 motion to dismiss, the Amended Complaint contains sufficient allegations. Whether those allegations will be proven, is something that will be decided at a later stage of the litigation.

II. "Gross Negligence Tantamount to Fraud" [*7]

Defendants argue that the fourth cause of action should be dismissed because it is duplicative of the first cause of action, and because New York does not recognize a separate cause of action for "gross negligence tantamount to fraud" (see Ambassador Factors v Kandel & Co., 215 AD2d 305 [1st Dept 1995]).

When the complaint is read liberally, it is clear that Sterling merely separated out the allegations of gross negligence into a separate cause of action for the sake of clarity. This is true for the third cause of action as well. Separating these allegations into causes of action was unnecessary. However, the court will overlook this defect because defendants have not demonstrated any prejudice (CPLR 3026; see Woodford v Benedict Community Health Ctr., 188 AD2d 863, 865 n [3d Dept 1992][plaintiff unnecessarily separated special damages from a cause of action for breach of contract]).

Contrary to defendants' argument, this cause of action is not duplicative of the first cause of action. Though the first, third, and fourth causes of action all sound in fraud, the element of scienter in the third and fourth causes of action is based on different allegations, pled in the alternative. Here, "a showing of gross negligence or recklessness will permit the trier of fact to draw the inference that a fraud was in fact perpetrated" (Rotterdam Ventures, 300 AD2d 963, supra; see also Curiale, 214 AD2d at 28).

Defendants apparently argue that the inferences of fraud should not be drawn from allegations of recklessness, given the extent to which Allied Deals and its principals went to conceal their fraud (see In re Livent, Inc. Securities Litigation, 78 F Supp 2d 194, 217 [SD NY 1999]). However, only through discovery may it become clear whether E&Y was grossly negligent or reckless and if so, whether such conduct supports an allegation of fraudulent intent. Whether Allied Deals had succeeded in hiding evidence of its fraud from its auditors is another issue of fact to be determined at trial (see Foothill Capital Corp., 276 AD2d at 438). Therefore, the motion to dismiss the fourth cause of action, is denied.

III. Aiding and Abetting

In the second cause of action, the amended complaint alleges that defendants aided and abetted Allied Deals to commit bank, mail and wire fraud. According to Sterling, the "clean" opinion from a major accounting firm was a critical element of Allied Deals' fraud (Amended Complaint ¶ 81).

A high degree of scienter is necessary to extend fraud liability under an aiding and abetting theory (National Westminster Bank USA v Weksel, 124 AD2d 144, 150 (1st Dept 1987). "[W]here the actual assistance allegedly given the fraud is not clearly substantial, the allegations of scienter must be all the more detailed if the requisite connection of the purported aider and abettor with the fraud is to be made out" (ibid.).

Here, the allegations of defendants' knowledge of Allied Deals' fraud are conclusory (see Amended Complaint ¶ 84). Though Sterling also alleges that E&Y and Jain recklessly assisted Allied Deals to commit fraud (see ibid.), the predominant view is that actual knowledge of the tort is required to establish aider and abettor liability (see e.g. Kaufman v Cohen, 307 AD2d 113, 125 [1st Dept 2003][actual knowledge required for aiding and abetting breach of fiduciary duty]; see also Kolbeck v LIT America, Inc., 939 F Supp 240, 246 [SD NY 1996], affd 152 F3d 918 [2d Cir 1998][discussing New York cases]; but see Liberman v Worden, 268 AD2d 337, 338 [1st Dept 2000][dismissed aiding and abetting causes of action for lack of allegations that defendants [*8]had actual, or even constructive, knowledge of the misconduct]). Thus, Jain's alleged knowledge that the audit was not conducted properly cannot serve as actual knowledge of Allied Deals' fraud. Therefore, the second cause of action is dismissed.

IV. Punitive Damages "[I]t has long been recognized that the goal [of punitive damages] is one of deterrence, and that among torts, the deterrent value of punitive damages is most effective against frauds, and is especially appropriate when the fraud is aimed at the public generally and involves 'high moral culpability.' Punitive damages require a demonstration that the wrong complained of rose to a level of 'such wanton dishonesty as to imply a criminal indifference to civil obligations'"

(164 Mulberry Street Corp. v Columbia Univ., 4 AD3d 49, 60 [1st Dept 2004][citing Walker v Sheldon, 10 NY2d 401, 405 (1961)]).

Sterling argues that E&Y's conduct was sufficiently egregious to warrant punitive damages, because defendants "permitted" Allied Deals to engage in criminal fraud, in the face of knowledge (or reckless disregard) of that fraud. Moreover, Sterling claims that such conduct was not an isolated incident. In 1999, E&Y paid $335 million to settle an accounting fraud lawsuit over alleged problems with its audits of another public corporation (see Opp. Mem., Ex 9 at 2). In the past year, federal agencies brought proceedings against E&Y for violating auditor independence rules, overbilling clients for expenses and illegal marketing of tax shelters (Amended Complaint ¶ 103). Sterling mentions lawsuits against E&Y for failing to follow up on fraud warnings concerning Freightliner and Equitable Life (ibid.). Finally, Sterling cites a bench-trial decision awarding $18.7 million in punitive damages against E&Y (see Reilly v Ernst & Young LLP, 2003 WL 22761810 [Pa Common Pleas 2003]).

Contrary to defendants' argument, the requirement that a defendant's conduct must be directed at the public generally for an award of punitive damages applies only in breach of contract cases, not in tort cases (Don Buchwald & Assocs. v Rich, 281 AD2d 329, 330 [1st Dept 2001]; Sherry Assocs. v Sherry-Netherland, Inc., 273 AD2d 14, 15 [1st Dept 2000]; see also Giblin v Murphy, 73 NY2d 769, 772 [1988]; Borkowski v Borkowski, 39 NY2d 982, 983 [1976]). Although, the court is not persuaded that E&Y's alleged conduct provides an adequate foundation of egregious behavior to warrant punitive damages (see Simon v Ernst & Young, 223 AD2d 506 [1st Dept 1996]), it will not dismiss the punitive damage claims at this early stage of the litigation. A CPLR 3211 motion is simply not a vehicle to decide issues of fact. It is simply a vehicle to decide whether a complaint contains sufficient allegations to state a cause of action or whether documents, or applicable statutes bar the claims. Sufficient allegations have been pleaded to warrant the punitive damage claims to continue.

CONCLUSION

Accordingly, it is

ORDERED that defendants' motion to dismiss is granted only to the extent that the second cause of action is dismissed and is otherwise denied; and it is further

ORDERED that defendants are directed to serve an answer to the complaint within 10 days after service of a copy of this order with notice of entry. [*9]

Dated: January 7, 2005

ENTER:

___________/S/___________________

J.S.C. Footnotes

Footnote 1: Defendants attempt to distinguish Houbigant by citing Giant Group v Arthur Andersen LLP (2 AD3d 189 [1st Dept 2003]). Houbigant clearly criticized cases that improperly imported a summary judgment standard of pleading fraud and cases that imposed a "stricter than necessary" pleading standard (see Houbigant, 303 AD2d at 98). As examples, the Court specifically mentioned LaSalle Natl. Bank v Ernst & Young (285 AD2d 101 [1st Dept 2001]) and Lampert v Mahoney, Cohen & Co. (218 AD2d 580, 582 [1st Dept 1995]). It is clear, that the First Department follows Houbigant (Semi Tech Litigation LLC v Ting, ___ AD3d ___, 2004 WL 2903366 [1st Dept 2004]; Knight Securities LP v Fiduciary Trust Co., 5 AD3d 172 [1st Dept 2004]; Franklin High Income Trust v APP Global Ltd., 7 AD3d 400 [1st Dept 2004]).

Footnote 2:Defendants contend that Sterling had the luxury of conducting extensive pre-action discovery, given its involvement in Allied Deals' bankruptcy proceedings and its access to materials from the federal prosecution of the principals of Allied Deals (see Mem. at 13). However, defendants do not state that Sterling had an opportunity to depose Issa.

Footnote 3:Thus, this case differs from Aronoff, where the acquiring company "in fact, was financially healthy" at the time of the audit, but later imprudently acquired another company that precipitated its collapse (Aronoff, 283 AD2d at 301).