The opinion of the court was delivered by: Judge James B. Zagel
MEMORANDUM OPINION AND ORDER
McGladrey & Pullen, LLP and G. Victor Johnson, one of its partners, seek dismissal of a lawsuit alleging their various failures as the auditors of the Sentinel Management Group, Inc. The claim originated in the Sentinel bankruptcy proceeding (07 B 14987). This motion to dismiss was filed in the adversary action (08 A 167). I withdrew the reference.
There are two counts. The first is for negligent accounting malpractice. The second is for aiding and abetting.
The first stated reason for dismissal is that the suit is precluded by the doctrine of in pari delicto and by the related doctrine of imputation. This ground applies to both counts since one bad actor cannot sue another for aiding and abetting his own conduct. As the Seventh Circuit observed: "The Restatement (Second) of Torts . . . provides for civil liability for aiders and abettors by holding an actor liable for harm resulting to a third person from the tortious conduct of another if the actor knows the other's conduct constitutes a breach of duty and the actor gives substantial assistance or encouragement to the other." Boim v. Quranic Literacy Inst. and Holy Land Found. For Relief And Dev., 291 F.3d 1000, 1018 (7th Cir. 2002) (citing Restatement (Second) of Torts, § 876(b)) (emphasis added); see also Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 181-82 (1994) ("[T]here is no general presumption that the plaintiff may also sue aiders and abettors.").
The Latin maxim, like nearly all of its fratres, is a concept, not a rule. Standing alone, it decides nothing and explains little.*fn1 The usefulness of the maxim depends on the context in which it is invoked.
The complaint alleges that Sentinel Management Group, Inc. was a registered futures commission merchant ("FCM") with the Commodities Futures Trading Commission ("CFTC") and a registered investment advisor with the Securities and Exchange Commission ("SEC"). It was required, under regulation, to segregate assets for its customers and to maintain net capital adequate to meet its liabilities. The law prohibits pledging customer assets for the benefit of others. An outside audit was required by regulation, and Sentinel engaged McGladrey to audit its financial statements and perform tests of compliance with regulations of practices and procedures such as segregation of assets and maintenance of adequate net capital. If McGladrey discovered conditions which would (1) inhibit Sentinel's ability to fulfill its obligations to its customers; (2) result in material loss; or (3) result in failure to segregate, it was obliged to report these findings to Sentinel. If Sentinel failed to report them to regulators within three days, then McGladrey was required, itself, to notify regulators of regulatory violations. In any event, it is claimed the auditor must communicate to the appropriate regulators the existence of any illegal acts of which it is aware.
Under the terms of its engagement with McGladrey, Sentinel was responsible for ensuring its own legal and regulatory compliance, establishing and maintaining internal controls and policies required by regulation, providing properly stated financial statements, maintaining effective internal control over financial reporting, informing the auditors of known deficiencies and material weaknesses in such controls and informing the auditors of its view of risks of fraud and knowledge of any fraud or suspected fraud. McGladrey did tell Sentinel that the audit was "not designed to provide assurance on internal control or to identify significant deficiencies or material weaknesses."
Sentinel did not trade commodities, it managed investments. Its income was its management fees based on the assets it held under management. It marketed itself with an attractive and very commonplace objective "to achieve the highest yield consistent with the preservation of principal and daily liquidity." Its clients were supposed to be sophisticated investors and included hedge funds, futures commission merchants, financial institutions, pension plans and so forth. Sentinel had customer funds and a house account for its own securities and the benefit of insider investors. It was a privately held corporation, thinly capitalized, owned and operated by its founder, Philip Bloom, and his son, Eric Bloom, both of whom owned a significant percentage of its stock. Its chief trader, Charles Mosley, and the Blooms controlled day-to-day operations of Sentinel including its website, accounting systems, investments, dealings with Bank of New York (BNY), customer statements and various financial arrangements.
BNY extended a line of credit to provide liquidity to facilitate redemptions and to purchase securities. It is alleged, and presumed to be true for purposes of this motion, that McGladrey saw the bank records (as part of its audit program) showing where each security was lodged and cross-referenced them to Sentinel records, which showed that hundreds of millions of dollars of securities were not segregated as required by law and had been pledged to secure a loan from BNY to Sentinel. The auditors knew that Sentinel controlled $2.4 billion worth of securities on a highly leveraged basis using repurchase agreements; $155 million of these were Sentinel's own house account repurchase positions and the auditors knew that these positions were not accurately reflected in Sentinel's financial statements. It is also alleged that the auditors prepared footnotes to the financials wrongly asserting that securities were segregated for customers, falsely describing the BNY loan and concealing the extent of leverage which conceals the extent of risk. McGladrey issued its opinion, which it knew would be filed with the CFTC, that Sentinel's financial statements were "fairly stated in all material respects" when it knew this was wrong. McGladrey did not report Sentinel's violations of law and regulation to the regulators.
There is no dispute, at least between the parties here, that Sentinel fraudulently used customer assets for its own benefit and hid this fact with misstated financials and false reports to regulators. Indeed, it is not claimed that Sentinel's bosses were unaware of any of Sentinel's acts of misconduct. Its risky leveraging was hidden (in part, to allow payment of management fees) in that it was customer assets, not Sentinel equity, that was pledged to support the leveraging. The leveraging strategy (at least according to the complaint) started in 2003 and smacked of some desperation. Sentinel's repurchase agreement method of disguising its use of customer securities for leverage had a price. Sentinel would have to pay the difference between the value of securities it pledged and the cash it received from the repo lender. Funds from the BNY loan covered this cost. Sentinel achieved control of $2 billion in securities this way without using its own equity. Without pledging customer assets BNY would not have made the loan.
Sentinel failed within some months after the 2006 audit, the single audit performed by McGladrey. Its leveraged investments failed to the point that it was unable to meet its redemption obligations to its customers whose securities had not been segregated. Had the auditors done the right thing, then, it is alleged, its loans would have been unwound and higher risk securities would have been liquidated and the result would have been, if not happy, at least happier than what did occur.
The Trustee for Sentinel's bankruptcy estate says that McGladrey and Johnson (the lead partner on the audit) are at fault for not properly reporting Sentinel's violations of law, misleading bookkeeping, leveraging scheme and bad internal controls to regulators (and, perhaps, to management to whom it would come as no surprise). This because the auditors (a) "knew or should have known" that Sentinel had systematically violated segregation requirements; and (b) improperly opined on Sentinel's false financial statements. The Trustee alleges that the auditors acted negligently in failing to disclose Sentinel's abuses.
McGladrey argues that a claim on behalf of a company that perpetrated a fraud brought against its auditors for participating in the fraud or failing to discover it is barred by the doctrine of in pari delicto. See Cenco v. Seidman & Seidman, 686 F.2d 449 (7th Cir. 1982). The complaint alleges, in detail, ...