Askenazy, et al. v. KPMG LLP, et al. (Lawyers Weekly No. 11-066-13)

FECTEAU, J.  KPMG LLP (KPMG) appeals from the denial, by a judge of the Superior Court, of its motion to compel arbitration, pursuant to G. L. c. 251, § 18(a)(1).  KPMG claims error in the judge’s order on the ground that the plaintiffs’ claims are derivative, and thus the plaintiffs ought to be bound by KPMG’s engagement letters with Tremont Partners, Inc. (Tremont Partners), and Tremont Capital Management, Inc. (Tremont Capital), which provided arbitration as the sole method of dispute resolution.  In a lengthy and well-reasoned memorandum, the judge allowed most of the plaintiffs’ claims against KPMG to proceed on the basis that the claims were direct and not derivative.  We affirm.

Background.  This matter relates to the fraudulent Ponzi investment scheme run by Bernard L. Madoff.  The plaintiffs here were limited partners of the Rye Select Broad Market Prime Fund, L.P.; and the Rye Select Broad Market XL Fund, L.P. (collectively, Rye Funds), two hedge funds serving as so-called “feeder” funds to Madoff’s company, and being managed by Tremont Partners as the Rye Funds’ general partner.  In 2008, after Madoff admitted his fraud and was arrested, the Rye Funds were discovered to be valueless and the plaintiffs’ investments unrecoverable.  The plaintiffs brought suit in 2010 against Tremont Partners; its upstream corporate parent, Tremont Capital; KPMG; and various other entities.

The specific remaining claims against KPMG sound in tort:  fraud in the inducement, negligent misrepresentation, G. L. c. 93A violations, aiding and abetting fraud, and professional malpractice.  Over a period of years, KPMG performed various audit and tax services for the Rye Funds.  In general, the plaintiffs allege that KPMG did not adequately perform its auditing and tax functions and, essentially, by certifying its auditing results and failing to bring to the plaintiffs’ attention various “red flags” regarding Madoff’s scheme, aided and abetted that scheme, and defrauded the plaintiffs.

KPMG claims that it was not employed by any of the plaintiffs and did not provide them with any particularized information, but rather, pursuant to contract, KPMG audited the financial statements of, and provided tax services to, the Rye Funds.  The contracts with KPMG, i.e., the engagement letters, contain broad-form arbitration provisions.  According to KPMG, all of the plaintiffs’ claims against KPMG are subject to these engagement letters principally because the claims are derivative in nature, and thus belong exclusively to the Rye Funds, which are bound by the arbitration provisions; consequently, the Rye Funds’ limited partners, i.e., the plaintiffs herein, lack standing to assert those claims directly.  KPMG also claims that even if the claims are direct, they are subject to the arbitration provisions in the engagement letters.  We examine KPMG’s contentions only to the extent necessary to determine whether the plaintiffs’ claims are subject to the broad-form arbitration provisions contained in the engagement letters — which none of the plaintiffs signed — and not whether the claims have been pleaded sufficiently to withstand scrutiny under Mass.R.Civ.P. 12(b)(6), 365 Mass. 754 (1974).

Direct versus derivative.  KPMG’s argument is essentially that to the extent that the plaintiffs’ claims are derivative, they necessarily are subject to arbitration under the Federal Arbitration Act (FAA), 9 U.S.C. §§ 1 et seq. (2006), a point with which the plaintiffs do not disagree.  Thus, as noted supra, the bulk of KPMG’s argument focuses on whether the plaintiffs’ claims are derivative.  While the parties do not dispute that Delaware law applies, KPMG asserts that the judge misapplied the standards of Delaware law applicable to this issue, and particularly Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), to conclude that some of the plaintiffs’ claims were directly alleged as they demonstrated individualized harm to the individual investors.

In Tooley, supra at 1033, the court set, as a matter of Delaware law, a prospective rule for determination whether a claim is direct or derivative, and the issue turns solely on:  “(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the suing stockholders, individually).”  The complexity in analyzing whether a claim is direct or derivative can be found in the language of Tooley, described as the headwaters of two divergent streams of interpretation:  one in which courts conclude that, to be a direct claim, the plaintiff’s harm cannot be related in any way to the harm suffered by the partnership, otherwise the claim is derivative; the other being that direct and derivative claims can spring from the same underlying events and conduct, so long as the plaintiff alleges an individualized harm that was not also suffered by the partnership generally.  Poptech, L.P. v. Stewardship Inv. Advisors, LLC, 849 F. Supp. 2d 249, 262-263 (D. Conn. 2012).  We conclude that the cases that follow the latter stream offer the more cogent and persuasive analyses.

In Stephenson v. Citco Group Ltd., 700 F. Supp. 2d 599 (S.D.N.Y. 2010), for example, the court, applying Tooley, noted that, as matter of Delaware law, some claims arising out of a case or controversy could be direct while others arising out of the same case or controversy could be derivative.  Id. at 610, citing Grimes v. Donald, 673 A.2d 1207, 1212-1213 (Del. 1996).  As a result, while the partnership could bring derivative claims based on the auditor’s fiduciary or contractual duty to the partnership, the plaintiffs could bring direct claims based on the auditor’s independent duty to them as investors.  Ibid.  See Anwar v. Fairfield Greenwich Ltd., 728 F. Supp. 2d 372, 400-402, 454-457 (S.D.N.Y. 2010) (with reference to Delaware law, investors in Madoff feeder fund had standing to bring direct claims for negligent misrepresentation and other torts against fund’s auditors, based on allegations that auditors owed responsibilities to investors, regardless of duties to funds); Newman v. Family Mgmt. Corp., 748 F. Supp. 2d 299, 316 (S.D.N.Y. 2010) (were claims adequately pleaded, plaintiffs could assert direct claims for fraud and misrepresentation based on inducement, where recovery would flow only to those investors who alleged they “were so induced”).

Turning to the application of Tooley here, the judge ruled that the plaintiffs’ claims that they were induced to invest in the Rye Funds, to stay invested, and in some cases to make additional investments, describe individualized harm independent of harm to the Rye Funds, and rest on a duty to each plaintiff that is not merely derivative of KPMG’s fiduciary duties as the Rye Funds’ auditor, but rather arises from KPMG’s misstatements and professional incompetence.  Additionally, the judge ruled that the plaintiffs’ claims against KPMG for losses sustained by the plaintiffs as a result of paying taxes on so-called “phantom income” are also direct and not derivative because “the Rye Funds were pass-through tax entities, so the profits and losses of the Funds were allocated to the individual partners.  The plaintiffs allege that, as a result of false information provided to them by KPMG in their Form K-1 tax statements, they each paid taxes on income which did not exist.  Because the Rye Funds themselves did not pay taxes, these tax related losses are necessarily individual.”

Concluding that the plaintiffs had standing to pursue their claims directly by means of this lawsuit, the judge relied on the rationale and the conclusion in Stephenson, 700 F. Supp. 2d at 610.  There, the plaintiff was a limited partner in a feeder fund called Greenwich Sentry which had invested most of its assets with Madoff.  Id. at 602.  The plaintiff alleged claims of negligence and fraud based on the auditor’s misrepresentations, which induced the plaintiff either to invest in the fund or alternatively to increase his investment.  Id. at 611-612.  Significant to the case at bar, in determining that the plaintiff’s tort-based claims were direct to the extent that they alleged inducement, the judge, id. at 608, quoted from Tooley, 845 A.2d at 1039:  “[t]he stockholder’s claimed direct injury must be independent of any alleged injury to the corporation.  The stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing any injury to the corporation.”  In short, the plaintiff’s inducement-based claims alleged direct injury, particularly, “some injury other than that to the corporation” which involved a particular subset of the limited partners, i.e., only those limited partners that were so induced, and did not involve a harm to the partnership that would affect all of its limited partners in proportion to each one’s ownership interest.  Stephenson, supra at 612, quoting from Big Lots Stores, Inc. v. Bain Capital Fund VII, LLC, 922 A.2d 1169, 1177 (Del. Ch. 2006).

Similarly, Poptech, L.P. is persuasive that inducement constitutes a “separate and individual injury, and therefore permits a plaintiff to state a direct claim,” especially in light of the facts before us; here, KPMG’s misrepresentations induced the plaintiffs to invest, forgo other investment opportunities, and ultimately pay taxes based on phantom income as reported to them by KPMG.  Poptech, L.P., 849 F. Supp. 2d at 263 (“The injury . . . in such a claim is not only the loss of the shares, but the fact that those shares were lost as a result of the inducement.  The Court does not believe that this necessarily benefits some shareholders unfairly at the expense of others, because shareholders who were fraudulently induced to invest in a corporation are not similarly situated to shareholders who did not rely on misrepresentations or omissions”).  See Little v. Cooke, 274 Va. 697, 710 (2007) (error, in derivative action, to award damages for income tax liability incurred on account of sale of real estate; damages not recoverable because investors of partnership, and not partnership itself, “incurred whatever income tax liability resulted from the sale”).

KPMG’s reliance upon KPMG LLP v. Cocchi, 132 S. Ct. 23, 24 (2011), is misplaced.  There, the United States Supreme Court issued an order that granted certiorari and summarily vacated a decision of a Florida appellate court that had upheld the denial of a motion to compel arbitration based on the nonarbitrability of two of the investor’s four claims.  See generally KPMG LLP v. Cocchi, 51 So. 3d 1165 (Fla. Dist. Ct. App. 2010).  The Court did not express disagreement with the Florida appellate court’s ruling that the negligent misrepresentation and deceptive practice claims were direct and not derivative.  132 S. Ct. at 26.  Instead, the Court confirmed that, “when a complaint contains both arbitrable and nonarbitrable claims, the [FAA] requires courts to ‘compel arbitration of pendent arbitrable claims . . . , even where the result would be the possibly inefficient maintenance of separate proceedings in different forums.’”  Ibid., quoting from Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213, 217 (1985).  Because the Florida appellate court had not “examine[d the] complaint with care to assess whether any individual claim must be arbitrated” and failed to determine the arbitrability of the remaining two claims (breach of fiduciary duty and professional malpractice), the Court remanded the case for such a determination.  Ibid.

On remand, the Florida appellate court again affirmed that the negligent misrepresentation and deceptive practice claims were direct and therefore not arbitrable, but remanded the arbitrability of the other two claims to the trial court for determination in the first instance.  See KPMG LLP v. Cocchi, 88 So. 3d 327, 330-331 (Fla. Dist. Ct. App. 2012).

Similarly, KPMG can take little relief from cases such as Agile Safety Variable Fund, L.P. vs. Tremont Group Holdings, Inc., Colo. Dist. Ct., No. 10CV2904 (April 25, 2012) (plaintiffs’ claims derivative as “limited partners suffered harm because the entire fund was diminished,” and complaint did “not sufficiently allege . . . [that] the individual limited partners suffered an economic loss distinct from that sustained by the [funds] as a whole”), or Sandalwood Debt Fund A, L.P. vs. KPMG LLP, N.J. Super. Ct. Law Div., No. L-10255-11 (April 27, 2012) (granting KPMG’s motion to stay and compel arbitration, finding that Sandalwood had not suffered individualized harm and that recovery was not based on “anything other than Sandalwood standing in the shoes of [the funds]“).

Thus, we conclude that the plaintiffs’ claims here, inducement-based, are direct and not subject to the arbitration provisions in the engagement letters.

Arbitration and nonsignatories.  The judge also was unpersuaded by KPMG’s alternative contention that even if the plaintiffs’ claims were direct and not derivative, the plaintiffs are bound, nonetheless, by the arbitration provisions because their claims either arise out of the engagement letters or otherwise are based upon aspects of them.  The judge concluded, correctly in our view, that the plaintiffs were not bound to arbitrate.  The plaintiffs were neither party, nor expressly assented, to the engagement letters.  Moreover, the plaintiffs are neither implicitly nor equitably bound to arbitrate because their claims are extracontractual, neither contract-based nor dependent upon third-party beneficiary status, nor do the plaintiffs seek to enforce the liability of KPMG because of the engagement letters.

For this proposition, KPMG relies on New York law, where the engagement occurred, as applicable.  However, even when considered under New York law, a party cannot be compelled to arbitrate its dispute “unless the evidence establishes the parties’ ‘clear, explicit and unequivocal’ agreement to arbitrate.”  God’s Battalion of Prayer Pentecostal Church, Inc. v. Miele Assocs., LLP, 6 N.Y.3d 371, 374 (2006), quoting from Matter of Waldron (Goddess), 61 N.Y.2d 181, 183 (1984).  Nonsignatories may be forced to arbitrate only if their “conduct evinces an intent to be bound.”  Sozzi v. Moishe’s Moving Sys., Inc., 16 Misc. 3d 1121(A) (N.Y. Sup. Ct. Aug. 7, 2007) (nonsignatory to insurance policy containing arbitration provision bound nonetheless to arbitrate because intent to be bound shown by his asserting breach of contract claim based on policy).

This concept sometimes has been referred to as a branch or an alternative theory of equitable estoppel; however, as with those cases discussed supra, in which a judge could find an intent to be bound by the agreement or an attempt to selectively enforce part of the agreement but not the arbitration provision, such an intent must be clearly shown.  See Thomson-CSF, S.A. v. American Arbitration Assn., 64 F.3d 773, 778-780 (2d Cir. 1995); E.I. Dupont de Nemours Co. v. Rhone Poulenc Fiber & Resin Intermediates, S.A.S., 269 F.3d 187, 194-198 (3d Cir. 2001); InterGen N.V. v. Grina, 344 F.3d 134, 145-146 (1st Cir. 2003).  We see neither an intent by the plaintiffs to be bound by the engagement letters nor any effort by them to selectively enforce a portion of the letters while avoiding the arbitration provisions.

Conclusion.   Based on the foregoing, we affirm the order on KPMG’s motion to compel arbitration as it properly was decided.  Specifically, the claim of aiding and abetting breach of fiduciary duty is to be dismissed, and the remaining claims against KPMG shall go forward.

So ordered.

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