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January 25, 2013

Complaint Failed to Show Auditor Was Reckless in Failing to Uncover Ponzi Scheme

By Rodney F. Tonkovic, J.D.

A fraud action brought by the Iowa Public Employees' Retirement System (IPERS) against Deloitte & Touche LLP (Deloitte) was dismissed with prejudice by a district court. The Exchange Act fraud claims, plus claims of breach of fiduciary duty, arose out of Deloitte's audit of its client, WG Trading Company, LP (WGTC), a registered broker-dealer. The complaint was dismissed on scienter grounds. (Iowa Public Employees' Retirement System v. Deloitte & Touche LLP, January 23, 2013, Oetken, J.)

WGTC was, among other companies, involved in a fraudulent investment scheme lasting from 1996 until early 2009. The perpetrators of the multi-million dollar fraud obtained investments from institutional investors, but were actually operating a Ponzi scheme and stole the funds for their personal use. IPERS invested approximately $500 million in WGTC by purchasing promissory notes issued by another entity involved in the scheme that were used to purchase interests in WGTC. The fraud was discovered in 2009 after an SEC investigation. A receiver later made a pro rata distribution to the defrauded investors.

From 2001 through 2007, Deloitte served as WGTC's outside auditor. Throughout that period, Deloitte issued clean opinions of WGTC's financials and representing that its audits of WGTC's statements were performed in accordance with GAAS and GAAP. IPERS received several of Deloitte's audit reports before investing in WGTC. IPERS claimed that Deloitte ignored numerous red flags that would have put a reasonable auditor on notice and that, if investigated, would have revealed the Ponzi scheme. IPERS alleged that Deloitte acted recklessly in that the reason it was unaware of the massive fraud was due to the fact that its audit procedures were so substandard that the auditors must have known they were deficient.

Scienter. Deloitte maintained that IPERS failed to allege scienter with sufficient particularity to state a securities fraud claim. The first red flag alleged by IPERS concerned the ease with which the SEC was able to discover the fraud, which IPERS claimed revealed the carelessness of Deloitte's audit. The court concluded that this argument failed to support the "conscious misbehavior" required for a particularized scienter pleading. According to the court, "suggestion that the SEC investigation necessarily reveals [Deloitte's] mindset rests on a post hoc ergo propter hoc approach to the complex issue of scienter." The court explained that the SEC's report did not find irregularities with WGTC's books, but rather highlighted irregularities discovered in comparison with the books of another entity involved in the scheme, and there were no allegations that Deloitte reviewed the other entity's books.

IPERS alleged that there were numerous other red flags in WGTC's books that should have alerted Deloitte to the possibility of fraud but were disregarded. The court determined that IPERS at most pleaded that Deloitte was negligent and that it engaged in a "shoddy" audit. According to the court, most of the supposed red flags related to the books of another entity involved in the scheme and which was not a client of Deloitte. The court recognized that there were many suspicious movements of funds between this entity and WGTC, but IPERS failed to allege these red flags with sufficient particularity to give rise to an inference that Deloitte was aware of the fraud and that it failed in its auditing duties. It was not clear, the court observed, that the suspicious transactions would have been visible in WGTC's books, and Deloitte, of course, was not required to examine the books of non-clients. In sum, none of the alleged red flags were of sufficient magnitude or import to support an inference of scienter.

Aiding and Abetting. Finally, IPERS claimed that Deloitte committed a breach of fiduciary duty by aiding and abetting the fraud through its willfully substandard audit. The court found that IPERS failed to plead with sufficient particularity that Deloitte was willfully blind to the fraud. For the reasons stated in determining that the complaint failed to plead scienter, the court concluded that the allegations failed to support an inference that Deloitte was anything more than negligent.

12 Civ. 2136 (JPO)

Attorneys: Jeffrey Scott Thompson (Deputy Attorney General), Paul J. Hanly , Jr. and Thomas I. Sheridan , III (Hanly Conroy Bierstein Sheridan Fisher & Hayes, L.L.P.) for Iowa Public Employee's Retirement System. Kevin Anthony Burke (Sidley Austin L.L.P.) for Deloitte & Touche L.L.P.

Companies: Deloitte & Touche L.L.P.

LitigationEnforcement: FraudManipulation NewYorkNews

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