There are a number of cases relating to international networks currently before the courts and this trend looks set to continue. The claims, all of which have so far been brought in the US, involve various different networks. Some have been progressing through the courts for years (the Parmalat securities litigation1 is a case in point); others are relative newcomers on the scene (such as the claims against BDO International2 and RSM International (RSMi)3). One issue arises time and again: namely the extent to which the international ‘umbrella’ organisation controls, or could be said to control, the member firm responsible for the engagement in question.
Why is the issue of control so important?
A finding of control is a critical requirement of many of the allegations made against the international entities, both under common law and statute. For a finding of agency under common law, claimants must show not only a relationship between a principal and an agent (ie the international organisation and the member firm responsible for the work in issue) but also evidence that the principal controlled the actions of the agent.
Claims brought under statute, most notably the US securities legislation and, in particular, s20(a) Securities Exchange Act, also require a finding of control. The particular requirements for s20(a) are set out in the box overleaf.
The meaning of control In spite of its importance to both common law and statutory claims, “control” remains a nebulous and therefore flexible concept. Several courts have grappled with the type of control required in order to succeed with a claim of agency or under s20(a). Some courts have concluded that actual control is required, others (and this appears to be the current trend) have ruled that the potential to control is sufficient (at least in the context of an application for dismissal or summary judgment). In addition, some courts require evidence that the international organisation exercised control over the particular engagement in question, in addition to exercising general control over the actions of member firms.
What amounts to control?
From the outset, it is important to appreciate that none of the cases considered below are determinative of the issue as to what conduct could constitute control, as they are all judgments arising from interim applications rather than a full trial of the issues of law or fact.
In some cases, it seems that the court has not needed to look too far to find evidence of either control or the potential to control. In the BDO International case, the court found that the network’s constitutional documents contained a persuasive indication of control. Indeed, it was alleged that BDO International’s Articles of Association included, as one of the entity’s objectives, “the management and control” of the member firms. Similarly, the agreements governing the relationships between the international organisations and the member firms included certain mandatory obligations, rather than being restricted to recommendations or guidance.
Other cases, notably the Parmalat litigation, are less clear-cut, forcing the court to consider whether the international organisations exercised control over the actions of member firms in areas such as marketing, quality reviews, and the audit of Parmalat itself. Here the umbrella organisations involved were Grant Thornton International (GTI) and Deloitte Touche Tohmatsu (DTT). Allegations that they directed how the member firms should refer to themselves in their marketing literature and the existence of requirements on member firms to use professional standards and general auditing procedures promulgated by them, seemed to persuade the court that the issue of control should, at the very least, be considered further at a full trial.
In respect of the Parmalat audit itself, it was alleged that DTT had exercised control and influence when it intervened in, and arbitrated, a dispute between the Brazilian and Italian audit partners. It was alleged that the Brazilian auditor expressed some concerns regarding the transfer of inter-company debt within Parmalat and the lack of documentation generally on Parmalat’s files and wanted to qualify his audit opinion. He is alleged to have discussed this with the Italian auditor, who did not agree with his views. Apparently DTT “removed” the Brazilian auditor from office, rather than let his concerns come to light. GTI allegedly exhibited control over the Parmalat audit in a different way. It is alleged that, after Parmalat’s collapse, GTI suspended the Italian audit partners involved in the audit and then, a few weeks later, expelled the Italian member firm from the network (actions which one might regard as entirely understandable in the circumstances). Nonetheless, the court seemed to find the evidence persuasive, such that the claimants have been allowed to pursue their claims to trial.
This control of, or ability to control, the particular engagement in question appears to be especially important. It is notable that it was the lack of such specific evidence which led the New York court to dismiss the claim against RSMi (a case which, on its face, appears to have bucked the current trend).
In that case, whilst there was evidence of RSMi exercising quality control over member firms, there was no evidence that it had been involved in the audit of Star Energy and, for this reason, the court was persuaded to release RMSi from the action.
Staying the right side of the controlling line
Taken at face value, the case law suggests that any control by an international organisation should be discouraged. Such a conclusion would, however, be somewhat naïve, as a degree of control is necessary in order to enable the network organisation to fulfil its various roles. Without it, it is difficult to see how the network would operate at all. So how can the risks associated with control be managed such that the rewards of network membership can still be enjoyed?
It is difficult to say with any finality, given that the courts have not conclusively determined what type of conduct would be deemed too controlling.
However, some points to bear in mind are:
- When issuing guidance to member firms, international organisations should emphasise (save where there is a genuine need for strict compliance) that the guidance is not mandatory, rather it is merely a recommendation which member firms could adopt.
- Independence statements (which should also clarify the role of the umbrella organisation) should be included in member firms’ domestic terms of business.
- Member firms and international organisations should avoid any suggestion (express or implied) that they are working either as a joint venture or in partnership with one another.
- Member firms should be encouraged to sign off opinions in their own name and there should be no direct interference by the international organisation in the work of member firms.
- Where quality reviews of member firms are being carried out, these should be confined to historic (as opposed to open or live) matters – thus removing the potential to influence the work in question.
It remains to be seen exactly what factors will ultimately determine the outcome of the cases currently progressing through the courts. Some control of member firms by umbrella organisations is, of course, necessary and/or desirable. Moreover, quality control and monitoring is arguably one of the best ways to seek to ensure that ‘mistakes’ are not made in the first place. Given the current economic climate, network organisations will be walking a tightrope for some time, seeking to balance the risks and rewards of network status.
Requirements for a finding of liability under s20(a) Securities Exchange Act:
- A violation by a primary violator (ie a mis-deed by the member firm carrying out the engagement)
- Control, either direct or indirect, of the primary violator by a third party (the international organisation)