RS Invs. Ltd. v. RSM US, LLP

• Decision Date: 28 February 2019
• Docket Number: No. 1-17-2410,1-17-2410
• Citation: 430 Ill.Dec. 188,2019 IL App (1st) 172410,125 N.E.3d 1206
• Parties: RS INVESTMENTS LIMITED, Corrado Investments Limited, Eden Rock Finance Master Limited, Eden Rock Asset Based Lending Master Limited, Eden Rock Unleveraged Finance Master Limited, and Solid Rock Special Situations 2 Limited D, Plaintiffs-Appellants, v. RSM US, LLP; RSM Cayman, Ltd. ; and Simon Lesser, Defendants-Appellees.
• Court: United States Appellate Court of Illinois

2019 IL App (1st) 172410

125 N.E.3d 1206

430 Ill.Dec. 188

RS INVESTMENTS LIMITED, Corrado Investments Limited, Eden Rock Finance Master Limited, Eden Rock Asset Based Lending Master Limited, Eden Rock Unleveraged Finance Master Limited, and Solid Rock Special Situations 2 Limited D, Plaintiffs-Appellants,

v.RSM US, LLP; RSM Cayman, Ltd. ; and Simon Lesser, Defendants-Appellees.

No. 1-17-2410

Appellate Court of Illinois, First District, FOURTH DIVISION.

February 28, 2019

Elizabeth B. Vandesteeg, John C. Martin, and David M. Madden, of Sugar Felsenthal Grais & Hammer LLP, of Chicago, Nicholas F. Kajon, Eric M. Robinson, and Constantine Pourakis, of Stevens & Lee, P.C., and David A. Barrett, of Boies Schiller Flexner LLP, both of New York, New York, and Courtney R. Rockett and Patrick J. Rohan, of Boies Schiller Flexner LLP, of Armonk, New York, for appellants.

Anand C. Mathew, of Honigman Miller Schwartz & Cohn LLP, of Chicago, and Kannon K. Shanmugam (pro hac vice), Joseph M. Terry (pro hac vice), Katherine M. Turner (pro hac vice), and Jessica L. Pahl (pro hac vice), of Williams & Connolly LLP, of Washington, D.C., for appellees RSM US LP and Simon Lesser.

Kenneth E. Kraus, of Ken Kraus Law, LLC, of Madison, Wisconsin, for other appellee.

PRESIDING JUSTICE McBRIDE delivered the judgment of the court, with opinion.

¶ 1 The plaintiffs are certain shareholders of Lancelot Investors Fund (Lancelot Offshore), a hedge fund that was incorporated in the Cayman Islands in 2002 and collapsed in 2008 upon the revelation that substantially all of its assets were invested in a Ponzi scheme. The fund filed for bankruptcy protection in Illinois federal court and is not a party to suit. In this action, the shareholders sued the fund's auditors¹ for apparently performing no real audits while issuing unqualified annual opinions upon which the plaintiffs relied when they initially invested $ 1.25 million in the fund in November 2004, increased their shares in each subsequent year, and maintained their $ 79 million holdings until the fund's downfall in 2008. The shareholders alleged that auditing in conformance with generally accepted accounting principles in the United States would have readily detected that the fund was lending money to a business that was conducting entirely fictitious transactions. The shareholders sought the return of their invested dollars and punitive damages due to the accountants' common law fraud and fraudulent inducement in issuing "clean" audit reports (count I), as well as negligent misrepresentations (count II), and professional negligence (count III). The trial judge, however, was persuaded by the accountants' arguments for dismissal pursuant to section 2-619 of the Code of Civil Procedure (Code) ( 735 ILCS 5/2-619 (West 2016) ). The judge found that the suit concerned an issue of corporate governance of a Cayman Islands' entity, the plaintiffs' standing was governed by Cayman Islands' reflective loss doctrine, and they lacked standing to sue for an injury that was merely derivative or reflective of the company's injury. The shareholders argue for reversal on grounds that they sued for their own direct injuries from financial statements that portrayed the fabricated enterprise as a legitimate business, were addressed to them, and were foreseeably relied upon by potential and existing investors. They also contend that in a choice of law analysis, Illinois, not Cayman Islands, has the most significant relationship to the parties and the dispute because the principal auditors were in Illinois and their fraudulent reporting also occurred in this jurisdiction.

¶ 2 A section 2-619(a)(9) motion to dismiss admits all well-pled allegations in the complaint, and in this appeal, we also take those allegations as true. Doe v. University of Chicago Medical Center , 2015 IL App (1st) 133735, ¶ 4, 391 Ill.Dec. 647, 31 N.E.3d 323, 325 ; Village of Bloomingdale v. CDG Enterprises, Inc. , 196 Ill. 2d 484, 486, 256 Ill.Dec. 848, 752 N.E.2d 1090 (2001). A section 2-619 motion is similar to a motion for summary judgment, in that it admits the legal sufficiency of the complaint and the intention is to dispose of easily proven issues of fact or issues of law. Advocate Health & Hospitals Corp. v. Bank One, N.A. , 348 Ill. App. 3d 755, 759, 284 Ill.Dec. 710, 810 N.E.2d 500, 504 (2004). A section 2-619 motion, however, is usually presented early in a case, before discovery. Advocate Health , 348 Ill. App. 3d at 759, 284 Ill.Dec. 710, 810 N.E.2d 500. Provided there is no genuine issue of material fact and the defendant is entitled to judgment as a matter of law, the motion is properly granted. Advocate Health , 348 Ill. App. 3d at 759, 284 Ill.Dec. 710, 810 N.E.2d 500. We address the ruling de novo and construe the pleadings and supporting matter in the light most favorable to the plaintiff. Advocate Health , 348 Ill. App. 3d at 759, 284 Ill.Dec. 710, 810 N.E.2d 500. Whether a party has standing to sue is also a question of law that is subject to the de novo standard. Cashman v. Coopers & Lybrand , 251 Ill. App. 3d 730, 733, 191 Ill.Dec. 317, 623 N.E.2d 907, 909 (1993).

¶ 3 We begin by summarizing the shareholders' 83-page complaint and its numerous attachments and then recap the procedural history that culminated in the dismissal order.

¶ 4 The business of the fund, Lancelot Offshore, was to make short-term loans by purchasing commercial notes issued by Thousand Lakes, LLC (Thousand Lakes). Thousand Lakes, however, was part of a multi-layered Ponzi scheme run by Thomas J. Petters. Between 2002 and 2008, the defendants were the fund's outside auditors but failed to discover that Petters and his key associates had criminal backgrounds and were falsifying most of their transactions. Thousand Lakes purported to use the money it borrowed from Lancelot Offshore to buy flat screen televisions and other high-end home electronics that it supplied to Costco, Sam's Club, and other United States retail chain stores. Thousand Lakes routinely wired money to purchase electronic goods, but the auditors failed to discover that Thousand Lakes sent the money to other entities in the Ponzi scheme, those entities almost immediately returned most of the funds to Thousand Lakes, and Thousand Lakes falsely recorded the receipts as loan payments. The auditors also failed to discover there was no merchandise, there was no transportation or warehousing of goods, and there were no transactions with the well-known retailers. Thousand Lakes created the illusion of a profitable enterprise through its "round trip" wire transactions, phony purchase orders, Petters's personal guarantees, other falsified transactions, and the support of the auditors' annual opinions. Conversations secretly recorded by law enforcement revealed that "Petters and his co-conspirators knew that the basic auditing step of observing inventory and seeking written third party confirmation was a weakness of their scheme and discussed it amongst themselves, at one point admitting that ‘the scheme would implode’ as soon as ‘investors send auditors out to visit warehouses where the merchandise is located.’ " The scheme unraveled in 2008, not because of an audit, but because a key figure confessed. The Federal Bureau of Investigation easily corroborated the informant's allegations by contacting one of the purported retailers, which recognized that the purchase order numbers were fabricated and that the orders had been manually created despite the retailer's exclusive use of an electronic inventory system. By then, Lancelot Offshore, which required a minimum initial investment of $ 1 million, had attracted at least 20 shareholders, and had lent $ 1.5 billion to Thousand Lakes. In all, Petters's Ponzi scheme netted $ 3.5 billion. By December 2009, he and his coconspirators were convicted and imprisoned for the federal crimes of mail fraud, wire fraud, money laundering, and conspiracy.

¶ 5 The plaintiffs further alleged that Lancelot Offshore had been incorporated in Cayman Islands but headquartered in Northbrook, Illinois. It was managed by Illinois resident Gregory M. Bell and his solely-owned investment firm, Lancelot Investment Management, which was also headquartered in Northbrook. Between 2002 and 2008, Lancelot Offshore attracted investors through confidential information memoranda (CIMs) that outlined the fund's activities and the extensive "protections" and "monitoring efforts" that the fund's management (Bell) supposedly employed to protect the fund's assets and investors. The fund was nearly two years old when the plaintiffs first invested. The CIMs listed the defendants as independent auditors. Subscription agreements annexed to the CIMs and signed by plaintiffs provided: "This Subscription Agreement is governed by the laws of the State of Illinois, United States. The parties hereto consent to the jurisdiction of the courts in the State of Illinois, United States with respect to any proceeding or claim arising hereunder or in respect of the Fund." One of the purported protections set out in the CIMs was that Lancelot Offshore purchased notes only where Thousand Lakes had preexisting contracts to sell goods to retailers, meaning that the fund would "assume little or no inventory risk with respect to the Underlying Goods." The CIMs also stated that each note Lancelot Offshore purchased would be secured by collateral equal to 150% of the value of the note and that Lancelot Offshore would have a "lock-box" arrangement with Thousand Lakes in which the retailers would remit their payments into a bank account that Lancelot Offshore could control. As part of a plea agreement, Bell testified that he was not involved in the Ponzi scheme, but he pled guilty and was imprisoned for covering up delinquencies in the fund's commercial notes as early as 2007 (when the Ponzi scheme was no longer taking in enough cash from new investors to pay its existing investors). Bell admitted that he knew from...