Second Circuit Upholds Dismissal of Claims Against Auditor in Madoff Ponzi Scheme

Posted by Kathy Bazoian Phelps

The Second Circuit has upheld the district court’s decision in Stephenson v. PricewaterhouseCoopers LLC, 768 F. Supp. 2d 562 (S.D.N.Y. 2011), dismissing an investor’s claims for professional malpractice and fraud against the auditor of a Madoff feeder fund, Greenwich Sentry. Stephenson v. PricewaterhouseCoopers LLC. 2012 U.S. App. LEXIS 10017(2d Cir. May 18, 2012).

On the malpractice claim, the Second Circuit agreed with the district court’s conclusion that:

Stephenson has standing to bring a claim that PWC’s negligence induced him to invest in Greenwich Sentry (the “inducement” claim), but that he lacks standing to assert a claim based on his decision to remain invested in Greenwich Sentry through December 2008 (the “holding” claim). Stephenson's inducement claim arose from his alleged reliance, as an individual investor, on PWC’s unqualified audits of Greenwich Sentry.

The court further affirmed the district court’s dismissal of the malpractice claim, noting:

Although Stephenson has standing to assert his inducement claim directly, the complaint fails to demonstrate that PWC owed him a duty as a potential investor in the fund. To prevail on a negligence claim under New York law against an accountant with which the plaintiff has no contractual relationship, the plaintiff must show that (1) the accountant was aware “that the financial reports were to be used for a particular purpose”; (2) “in the furtherance of which a known party . . . was intended to rely”; and (3) some conduct on the part of the accountant linking it to the party which “evinces the accountant['s] understanding of the party[’s] . . . reliance” (the “Credit Alliance test”).

The plaintiff could not establish the “known party” prong of the Credit Alliance test, so the malpractice claim was dismissed.

In dismissing the fraud claim against the auditor, the district court had observed:

But an unseen red flag cannot be heeded. Hence courts in this Circuit have consistently dismissed fraud claims against auditors-including against auditors of BMIS feeder funds-that have not sufficiently alleged that an auditor knew of red flags.

Stephenson v. PricewaterhouseCoopers LLP, 768 F. Supp. 2d 562, 571 (S.D.N.Y. 2011).

The Second Circuit affirmed the dismissal of the fraud claim, holding:

[W]e conclude that the district court properly dismissed the SAC for failure to allege that PWC's conduct was so reckless as to raise a “strong inference” that it intended to deceive Stephenson. The district court properly found that: (1) despite the fact that PWC's audit did not comply with generally accepted accounting standards, it was not so poor as to raise an inference of an intent to defraud; (2) PWC lacked awareness of almost all of the red flags alleged by Stephenson; and (3) an intent to defraud could not be inferred from those flags of which PWC was necessarily aware. See, e.g., Novak, 216 F.3d at 309 (“[T]he failure . . . to interpret extraordinarily positive performance . . . as a sign of problems and thus to investigate further does not amount to recklessness.”); Chill, 101 F.3d at 270 (“The fact that [the defendant] did not automatically equate record profits with misconduct cannot be said to be reckless.”). Thus, we affirm the district court's dismissal of the SAC for failure adequately to plead scienter.

Claims for professional malpractice and fraud against auditors and other types of defendants are discussed in detail in The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes.