Liability for Someone Else’s Sins: The Risks of Accounting Firm Alliances.

While there is no single model, alliances generally share some common characteristics: There is usually an umbrella membership organization that does not provide professional services to the public, but rather is involved, at varying degrees, in the activities and interaction of its member firms. Historically, alliances typically also have possessed one or more of the following attributes:

Common trade name, logo and joint marketing materials.
Consolidated reporting of alliance revenue by the umbrella entity.
“Partnering” among members to provide assistance on and/or services in support of the engagement.
Global standard-setting, peer review and quality control.
Termination (or other discipline) of member firms or their professionals for failure to adhere to alliance standards.
Centralized professional practice office or director.
Sharing of fees for services provided in the alliance or on an engagement.
Referral fees among member firms.

Participation in an alliance is not without risks. In litigation, plaintiffs may attempt to exploit the relationship among the member firms by suing not just the member that provided the services. Instead, they may sue other member firms and the umbrella organization as well in pursuit of deeper pockets or, if the member firm that provided services is based outside the United States, to avoid jurisdictional issues.

The recent lawsuits relating to the Italian dairy company Parmalat illustrate these risks. In December 2003 Parmalat filed for bankruptcy after widespread accounting irregularities were revealed. Investors immediately sued Parmalat’s auditors, the Italian member firm of Grant Thornton International and the Italian member firm of Deloitte & Touche. The investors also brought claims against the international umbrella entities and their U.S. member firms, claiming that both worldwide alliances were “united accounting firms.”

The complaints set forth several liability theories based on the relationships among the Italian firms, international entities and U.S. firms. The court overseeing the cases denied motions to dismiss filed by the umbrella entities and the U.S. member firms, concluding that those firms may ultimately have liability for the conduct of the Italian member firms. In other words, even though the Italian member firms alone served as Parmalat’s outside auditors, Grant Thornton International and Deloitte International and their U.S. member firms have been forced into defending the merits of the lawsuits.

VICARIOUS LIABILITY FOR ALLIANCE MEMBERS
The doctrine of liability that essentially makes one party responsible for the misconduct of another is known as “vicarious liability.” There are a host of legal doctrines that can result in vicarious liability in the alliance setting.

Agency. An alliance member might be considered the principal in a principal-agent relationship with other member firms. As a principal, a member firm could be sued for accounting services it had nothing to do with, along with the agent-firm that actually provided the services at issue. The most significant factor in determining whether an agency relationship exists is the purported principal’s control over the agent.

The Parmalat cases illustrate agency liability. The investors pointed out that, in connection with revelations of fraud at Parmalat, Grant Thornton International (GTI) disciplined partners at the Italian firm and ultimately expelled the Italian firm from the alliance. The court found this conduct demonstrated GTI’s control over the activities of Grant Thornton Italy. Similarly, the court found that Deloitte International’s ability to intervene in disputes between Deloitte member firms made it the principal of Deloitte Italy.

The Parmalat court also found that Grant Thornton U.S. could be sued for its Italian affiliate’s services because Grant Thorton U.S. “dominated” the entire Grant Thorton alliance. The lesson here is that dominant members of alliances might be held liable for the misconduct of other members, even when they had nothing to do with the conduct at issue.

Alter ego. A related theory is that the member firm (or umbrella entity) may be essentially the alter ego of another member firm. In considering alter ego liability, courts generally look at factors such as (1) inadequate capitalization in the purported controlled entity; (2) the entities’ failure to observe corporate formalities; (3) commingling of funds by the entities; (4) the absence of corporate records; and (5) the failure to maintain arm’s-length relationships among the entities.

In Parmalat , the court rejected the investors’ argument that Deloitte U.S. was the alter ego of Deloitte International. Although the investors focused on Deloitte U.S.’s relative size in the organization, they could not point to typical alter ego factors, such as insufficient capitalization, at Deloitte International.

Joint venture. If alliance members are found to be operating in a joint venture, that might give rise to vicarious liability for those members. Keys to finding a joint venture are shared profits and losses, and some degree of shared control by the members or umbrella organization. In Parmalat, the investors argued that Deloitte member firms auditing Parmalat acted as a joint venture and each member was therefore liable for Deloitte Italy’s alleged audit failure. Most important, the court found that the shared profit and loss element was met by Deloitte’s compensation structure, which divided fees among members; there was, however, no mutual control. Both elements must be present to find a joint venture.

Control person liability. Under federal securities laws, if an alliance member is found to control another member, the controlling member may be liable for the controlled member’s securities laws violations. Control “means the possession, direct or indirect, of the power—and exercise of that power—to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise” (17 CFR § 230.405).

In Parmalat , the court viewed control person liability as analogous to “agency” and concluded that Grant Thornton International controlled Grant Thornton Italy and that Deloitte International controlled Deloitte Italy. The court also noted that Deloitte U.S. was a control person of Deloitte International because some of the executives who ran Deloitte U.S. also managed Deloitte International.

General partnership and partnership by estoppel. If alliance members form a general partnership, the members might be vicariously liable for each other’s torts and securities violations. A general partnership will be inferred where parties agree to share profits and losses, jointly control an enterprise and actually intend to be partners. But even parties that do not intend to be partners may be found to be partners by estoppel . A partnership by estoppel will be inferred when parties simply hold themselves out as partners and someone relies on that representation. In the case of both types of partnerships, the member partners might be jointly and severally liable for each other’s misconduct.

POTENTIAL ALLIANCE LANDMINES
Certain actions of alliances and their umbrella organizations could render them vicariously liable:

Control. Members of an alliance should be aware that controlling one another, or permitting an umbrella organization to control members, creates the greatest chance for vicarious liability. In the Parmalat cases, Deloitte International was found to be the principal (and control person) of Deloitte Italy, notwithstanding their legal separateness, because Deloitte International (1) intervened in a conflict between Deloitte Italy and Deloitte Brazil and (2) ultimately removed one of the auditors from the Parmalat audit. Similarly, GTI was found to be the principal (and control person) of Grant Thornton Italy because GTI had the power to investigate, discipline and expel Grant Thornton Italy from the alliance.

Common trade name/logo. It’s common for accounting firm alliances to use a shared trade name; otherwise, the marketing synergies—one of the key reasons to form an alliance—would be diminished. Most courts do not rely solely on common names in determining whether there should be vicarious liability. Alliances should bear in mind, however, that a shared name and logo, which may not present a problem, may be considered among other multiple factors, which in the aggregate create the appearance of an agency relationship or a partnership by estoppel. Where practicable, it may be better to avoid displaying the name and logo on audit reports or other work product.

Marketing as an integrated operation. Alliances often describe themselves on Web sites or in marketing materials as “global,” “worldwide” or “borderless,” suggesting the alliance is a single, unified firm. Such descriptions alone probably will not render members or the umbrella organization vicariously liable. But courts still might find that such representations appear to convey the authority of the members to transact the umbrella entity’s business. Thus, where other agency-type elements exist, these statements may increase the possibility of vicarious liability.

Alliances frequently add disclaimers to their marketing materials explaining the legal separateness and independence of member firms from the umbrella entity and each other. While courts have treated these disclaimers in vastly different ways, the key is that actions speak louder than words. For example, in the Parmalat cases, despite Web site disclaimers indicating that GTI and Deloitte International were separate from their member firms, the court found they and the U.S. firms were vicariously liable for the Italian firm’s audit work based on their actual conduct in the matter. Thus, while disclaimers should be included on alliance promotional materials, particularly if there are boasts about the national or global coverage of an alliance, disclaimers may not insulate alliance members from vicarious liability.

Description of alliance members. What alliance members call each other matters. If members refer to each other as partners, that may give rise to a finding of partnership by estoppel; on the other hand, referring to member firms as affiliates may not. Member firms also should avoid referring to themselves as separate offices, creating an impression that they are branches of a single organization.

Sharing profits and losses. Sharing profits and losses exposes alliances to a finding that the alliance is a joint venture. Sharing profits and losses is also a factor in determining (1) whether an agency relationship exists, (2) whether entities are partners by estoppel and (3) to the extent sharing profits and losses might also be considered intermingling of funds, whether an alter ego relationship exists. It therefore may be advisable to avoid sharing profits and losses, even where members participate jointly on a single engagement. Referral fees that are not based on the profitability of the engagement and bear no relation to the actual work performed create fewer risks.

Overlap in leadership. The court in Parmalat concluded that, since Deloitte U.S. executives were also executives of Deloitte International, and one of those executives played a part in the Parmalat audits, Deloitte U.S. was a control person of Deloitte International for purposes of the securities laws. Managerial overlap among the member firms or with the umbrella organization therefore should be minimized.

The business reality is that accounting firms will not—and should not—stop building alliances. But firms can take steps to reduce the risks of vicarious liability associated with these alliances. The most important steps are to maintain the separate and independent nature of the member firms and minimize interference among the members and umbrella organizations in the management of other members. As demonstrated in the Parmalat cases, the consequences of such management and control can be significant .

—Richard I. Miller

Richard I. Miller is the general counsel of the AICPA. As an employee of the AICPA, Mr. Miller’s views, as expressed in this article, do not necessarily reflect the views of the Institute. Official positions are determined through certain specific committee procedures, due process and deliberation. He thanks Kelly M. Hnatt and Matthew P. Bosher, attorneys at Willkie Farr & Gallagher in New York, for their invaluable assistance in researching and drafting this article.