Askenazy v. KPMG LLP

• Decision Date: 23 May 2013
• Docket Number: No. 12–P–863.,12–P–863.
• Citation: 83 Mass.App.Ct. 649,988 N.E.2d 463
• Court: Appeals Court of Massachusetts
• Parties: Dorothy ASKENAZY & others v. KPMG LLP & others.

83 Mass.App.Ct. 649

988 N.E.2d 463

Dorothy ASKENAZY & others ¹

v.KPMG LLP & others.²

No. 12–P–863.

Appeals Court of Massachusetts,

Suffolk.

Argued Dec. 6, 2012.

Decided May 23, 2013.

Gary F. Bendinger, of New York (Gregory G. Ballard, of New York, & Lisa C. Wood with him) for KPMG LLP.

Jeff Ross, of Minnesota, for the plaintiffs.

Present: BERRY, FECTEAU, & CARHART, JJ.

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.³ 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 ⁴ 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.⁵ 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.⁶ The contracts with KPMG, i.e., the engagement letters, contain broad-form arbitration provisions.⁷ 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).⁸

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,⁹ 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”).¹⁰

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.¹¹ 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.” ¹²

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.¹³Poptech, 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...