Big Four firm Deloitte & Touche and international firm Grant Thornton lost their bid to dismiss a class-action suit brought against them by investors of now-bankrupt Italian dairy conglomerate Parmalat.A federal judge in New York recently ruled that the accounting umbrella organizations couldn't insulate themselves from the actions of local affiliates in Italy that audited the company before its collapse from financial mismanagement and fraud in 2003.

Both Deloitte and Grant Thornton contended that they did not audit Parmalat, and that they are legally separate entities from their various member firms. They argued that their Web sites indicate the fact that they are separate entities, and disclaim liability for the actions of their member firms.

However, the court found that the plaintiffs had adequately alleged claims against the Deloitte and Grant Thornton umbrella organizations. Both organizations acted as principals to their respective agents in Italy that performed the audit work.

While the ruling against the motion to dismiss is an interim ruling that doesn't decide the merits of the case, it does hold that the complaint supported claims against the Deloitte and Grant Thornton umbrella organizations for the acts of their Italian affiliates, under an agency theory.

Silver linings

Grant Thornton LLP, the U.S. member firm of Grant Thornton International, was dismissed from the class-action suit, while the claim of direct violation of the securities laws was dismissed against Deloitte & Touche USA LLP.

"Grant Thornton LLP is pleased that we were dismissed from the Parmalat class-action suits, but we believe that Grant Thornton International should also have been dismissed at this stage of the proceedings," said a Grant Thornton LLP spokesperson. "It is important to note that since this was a motion to dismiss, the facts brought by the plaintiffs are accepted as true and cannot be challenged. We believe that once Grant Thornton International is allowed to present its defense, they will be found to be innocent."

Meanwhile, a Deloitte spokesperson stated: "Deloitte & Touche USA LLP is pleased that the court granted our motion to dismiss plaintiffs' claims for direct violation of the securities laws. We are, of course, disappointed that our motion was not granted in its entirety, but the court was required by law to assume the truth of all of plaintiffs' allegations for the purposes of this preliminary motion. We are confident that when we are given the opportunity to disprove the allegations in plaintiffs' complaint, we will defeat their only remaining claim, that we are a 'control person' of Deloitte Italy under Section 20(a) of the federal securities laws."

Nevertheless, the ruling is devastating for the Deloitte and Grant Thornton international organizations, according to Stuart Grant, a partner with Wilmington, Del.-based Grant & Eisenhofer, a law firm representing Parmalat shareholders.

"They thought they would be able to pin the malfeasance on their Italian subs and everyone else could take a walk," he said. "But the judge said that when you pitch to clients as one firm, when you service your clients as one firm, when things go wrong, you're going to be held responsible as one firm."

"On occasion, global firms have been able to shirk responsibility and claim that a rogue subsidiary 'has nothing to do with us,'" said Grant. "But if you listen to their client pitch, you won't hear any of that. And when you look at them internally and see what happens when they have disputes, you see them operating as one global organization. There's nothing wrong with that, but when things go wrong, they should have to take responsibility."

"The decision applies in the context of a limited partnership," said Selva Ozelli, CPA, international tax attorney and contributor to Tax Notes International. "However, the investor control argument can also apply to a U.S. corporation's foreign operations when they are a controlled foreign corporation."

The class action represents individuals who purchased ordinary Parmalat shares and bonds. The suit alleges a massive fraud involving the understatement of Parmalat's debt by nearly $10 billion and the overstatement of net assets by over $16 billion as a result of "something akin to a Ponzi scheme," according to District Judge Lewis Kaplan, who ruled in the case.

Spoiled milk

The decision summarized Parmalat's downfall in the early 1990s.

At the time, Parmalat pursued an aggressive growth strategy financed largely by debt. However, expansion into South America turned out poorly, and the company began to lose hundreds of millions of dollars a year from its operations there. To cover these losses, service its massive debt and hide the personal diversion of funds by Parmalat chief executive Calisto Tanzi and his family, the company required constant infusions of cash.

But that cash could only be obtained so long as Parmalat appeared to be a sound investment. To further the appearance of financial health, insiders at Parmalat and Grant Thornton S.p.A. (Grant Thornton Italy) concocted a scheme involving misleading transactions and offshore entities.

For example, one transaction involved a fictitious sale of 300,000 tons of powdered milk to Cuba for $620 million. The company then obtained loans based on this transaction, which it used to service debt and obtain more loans - something akin to a Ponzi scheme, according to the court.

Parmalat was required by Italian law to change auditors in 1999. To prevent the fictitious financing transactions from being discovered, Parmalat and GT Italy transferred the arrangements to a new company, Bonlat, which would continue to be audited by Grant Thornton. Deloitte & Touche S.p.A. (Deloitte Italy) became Parmalat's new auditor. Deloitte continued to certify the company's financial statements as accurate.

The court cited the fact that Grant Thornton International cooperated in establishing one of the entities involved in the fraudulent scheme, and noted that Grant Thornton disciplined some of the partners at GT Italy for their alleged participation in the fraud.

"Independent auditors serve a crucial role in the functioning of world capital markets, because they are reputational intermediaries," stated Judge Kaplan.

"In certifying a company's financial statements, their reputations for independence and probity signal the accuracy of the information disclosed by the company, the managers of which typically are unknown to most of the investing public," he continued. "This is especially true of defendants and other global accounting firms. Certification by an entity named Deloitte & Touche, Grant Thornton or one of the small handful of other major firms is incalculably more valuable than that of a less-known firm, because the auditor 'is in effect pledging a reputational capital that it has built up over many years of performing similar services for numerous clients.' In the case of these defendants and their confreres, the relevant reputational capital is that associated with the worldwide organizations, at least to a predominant extent. In consequence, allowing those organizations to avoid liability for the misdeeds and omissions of their constituent parts arguably could diminish the organizations' incentives to police their constituent entities, with adverse consequence for participants in capital markets."

Plaintiff attorney Grant said that there was plenty of wrongdoing to go around. "It's not just doing the auditing. They were actually helping create these off-balance sheet entities to perpetuate the fraud."

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