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Thomas H. Lee Equity Fund V, L.P. v. Grant Thornton LLP

August 6, 2008


The opinion of the court was delivered by: Gerard E. Lynch, District Judge


Plaintiffs Thomas H. Lee Equity Fund V, L.P., Thomas H. Lee Parallel Fund V, L.P., and Thomas H. Lee Equity (Cayman) Fund V, L.P., are investment funds associated with Thomas H. Lee Partners, L.P. ("THL"), a private equity firm. Together, plaintiffs invested more than $450 million in Refco and acquired the majority of Refco's stock through a leveraged buy-out ("LBO") in August 2004. Following Refco's collapse in the fall of 2005, plaintiffs' Refco interests became worthless, allegedly causing them losses in excess of $245 million. Plaintiffs bring this action against Refco's outside auditor, defendant Grant Thornton LLP, claiming that it made numerous misrepresentations to them in connection with the LBO. The complaint, which was originally filed in the New York State Supreme Court, asserts state law claims for aiding and abetting fraud, negligent and intentional misrepresentation, and professional malpractice. Defendant removed the case to this Court pursuant to 28 U.S.C. § 1334(b), and now moves to dismiss all claims pursuant to Fed. R. Civ. P. 12(b)(6). The motion will be granted in part, and denied in part.


I. The Alleged Refco Fraud

This action is another in a series of lawsuits arising out of the implosion of Refco, which prior to its collapse, was among the world's largest providers of brokerage and clearing services in the international derivatives, currency, and futures markets. See In re Refco, Inc. Sec. Litig., No. 07 Civ. 11604, 2008 WL 1827644, at *1 (S.D.N.Y. April 21, 2008). According to the complaint, Refco incurred significant losses in the 1990s as a result of both its own unsuccessful proprietary trading and receivables that became uncollectible when customers could not repay the loans that Refco had extended to them. (Compl. ¶ 20.*fn1 ) Rather than disclosing these losses and "writing them off as required," Refco's CEO, Phillip R. Bennett, allegedly "embarked on a fraudulent scheme to hide them and thereby mask Refco's true financial condition." (Id.)

The first step of the purported scheme involved Refco removing the uncollectible receivables from Refco's books by transferring them to Refco Group Holdings, Inc. ("RGHI"), a company controlled by Bennett that was not consolidated with other Refco entities, thereby creating a large receivable that RGHI owed to Refco that at times totaled more than $1 billion. (Id. ¶ 21.) In order to make the RGHI receivable appear to be a valuable receivable from unaffiliated third-party customers, Bennett allegedly orchestrated a series of sham "round-trip loan" transactions with unrelated entities that temporarily caused all of the RGHI receivable to be replaced by like-sized receivables from the customers. According to the complaint, all the round-trip loans followed the same general pattern:

(i) just before the close of the financial reporting period, a Refco entity . . . would make a "loan" to a third-party customer, (ii) simultaneously, the customer would make a "loan," which was unconditionally and absolutely guaranteed by Refco, in the exact same amount to RGHI; and (iii) RGHI would use these funds to pay down the RGHI Receivable. As a result, at the close of each reporting period, Refco's books would show a "loan" to the third-party customers, and the RGHI Receivable would be gone. These transactions were then unwound just a few days later, after the close of the financial reporting period, with the RGHI Receivable appearing on Refco's books.

(P. Mem. 5, citing Compl. ¶¶ 23, 25.) To enable the third-party customers to profit from this arrangement, the interest rate that RGHI paid the customers for their "loans" was between 15 and 100 basis points higher than the interest rate that the customers paid Refco on the Refco "loans." (Compl. ¶ 24.) Although characterized as loans, generally no funds were actually transferred other than the customer's profit from the interest spread. (Id.)

Refco allegedly engaged in seventeen such round-trip loans from February 1998 through August 2005. (Id. ¶¶ 22, 27, 53.) Through these sham transactions, Refco executives were able to disguise Refco's true financial condition with the aim of "eventually reap[ing] millions of dollars from the sale of all or part of Refco." (Id. ¶ 27.)

II. Grant Thornton's Refco Engagement

Beginning in the late 1980s through the audit of Refco's financial statements for the 2002 fiscal year, Arthur Anderson ("AA") served as Refco's independent auditor. (Id. ¶ 29.) Mark Ramler served as the engagement partner on the Refco audit team during the final ten years of AA's engagement. (Id.) When AA ceased functioning as an audit firm in mid-2002, Ramler joined the New York office of defendant Grant Thornton LLP ("GT"). Later that year, Ramler proposed Refco as a prospective client to GT. In March 2003, GT accepted Refco as a client and Ramler continued to serve as the engagement partner on the Refco account. (Id.)

At the outset of the Refco engagement, Ramler put GT on notice of certain concerns he had about Refco's finances. (Id. ¶ 50.) In particular, Ramler informed GT that Refco had engaged in significant related-party transactions with certain entities that either had not been audited or had been audited by firms other than AA, and that as of February 28, 2002, a related-party receivable existed between Refco and RGHI in the amount of $170 million. (Id.) Ramler also conveyed to GT his belief that "related-party transactions between [Refco and RGHI] created a high risk of material misstatement." (Id.) Despite its knowledge of these related-party transactions, however, GT allegedly "failed to implement any procedures to bring about the disclosure of the . . . 17 sham round-trip loan transactions." (Id. ¶ 53 (emphasis omitted).)

III. The LBO Transaction

In June 2004, plaintiffs, which are all investment funds associated with the THL private equity firm, agreed to invest approximately $450 million in Refco through a leveraged buy-out.*fn2 (Id. ¶ 2.) Over the course of more than ten months leading up to the closing of the LBO in August 2004, plaintiffs engaged in extensive due diligence with the aid of several third-party consultants and advisors, including KPMG LLP ("KPMG"), which plaintiffs hired to perform accounting due diligence. (Id. ¶¶ 2, 36.) KPMG was "specifically tasked by [plaintiffs] to conduct a detailed assessment of [Refco's] financial reporting for the fiscal years ended February 28, 2002, February 28, 2003 and February 24, 2004, and the risks of the proposed investment." (Id. ¶ 36.)

In the course of its making its assessment, KPMG examined Refco's audited financial statements, which were prepared by AA for the 2002 fiscal year and by GT for the 2003 and 2004 fiscal years. (Id. ¶ 37.) Both AA and GT issued clean and unqualified audit opinions during each of those fiscal years with no mention of any of the round-trip loans or related-party transactions with RGHI. (Id. ¶¶ 27, 37.) THL, on behalf of its advisor KPMG, also requested access to certain audit work papers (e.g., consolidation schedules, audited financial statements of Refco subsidiaries, audit confirmations, and other regulatory work papers) prepared by GT in connection with its audits. (See id. ¶ 38.) GT granted THL and KPMG access to its workpapers under certain terms and conditions set forth in two letters dated February 16, 2004, and May 4, 2004 ("Access Letters"), each of which was executed by representatives of GT, THL, and KPMG. (Braun Decl. Exs. B & C.) The Access Letters stated expressly that GT's audits for fiscal years 2003 and 2004, along with the workpapers prepared in connection with them, [were] not planned or conducted in contemplation of the proposed [LBO] transaction between [THL] and [Refco] . . . , were not intended for the benefit of [THL] and should not be taken to supplant other inquiries and procedures that [THL] should undertake for the purpose of satisfying itself about the financial condition of [Refco] or as to other matters pertinent to the transaction . . . . (Id.) The Access Letters also made clear that THL "does not acquire any rights" as a result of gaining access to GT's workpapers, and that GT "does not assume any duties or obligations in connection with such access." (Id.) Furthermore, the Letters authorized GT and KPMG "to discuss with each other any questions raised during the course of the review," but provided that "it is expressly understood that [GT] thereby assumes no additional responsibility with respect to its audit of [Refco's] consolidated financial statements." (Id.)

Subject to these disclaimers, GT provided KPMG with access to its workpapers and met with KPMG representatives on February 19, 2004, and May 7, 2004, to discuss GT's 2003 and 2004 audits. (Compl. ¶¶ 69, 71.) During those two meetings, Ramler and other GT personnel allegedly failed to disclose the information they possessed regarding, inter alia, the round-trip loan transactions and Ramler's concerns regarding the potential for fraud at Refco. (Id. ¶ 71.) GT personnel also represented to KPMG at the two meetings that (1) its audits for the 2003 and 2004 fiscal years "did not identify any material, unusual, extraordinary, and non-recurring income and expense items"; (2) "that there were no significant issues regarding Refco's IT control environment"; and (3) "there were no outstanding accounting or reporting issues or disagreements with Refco's management." (Id. ¶ 72.) GT allegedly reiterated "[m]any, if not all" of these representations during "telephone conferences or in regular email correspondence" with THL and its advisors between February 2004 and the closing of the LBO transaction. (Id. ¶ 75.)

Upon completion of due diligence, plaintiffs in August 2004 consummated the LBO transaction and acquired a majority ownership interest in Refco as well as numerous seats on Refco's Board of Directors.*fn3 (See id. ¶ 83.) As an express condition to the closing of the transaction, Refco was required to deliver to plaintiffs audited financial statements compliant with SEC Regulation S-X for, inter alia, fiscal year 2002. (Id. ¶ 78.) Because Refco's existing financial statements for the 2002 fiscal year (which were audited by AA) did not comply with SEC Regulation S-X, GT performed a reaudit of those statements. (Id.) According to the complaint, GT updated plaintiffs "regularly" on the progress of the reaudit between April and October 2004. (Id. ¶ 79.) GT issued a clean and unqualified reaudit opinion for Refco's 2002 financial statements on or about October 8, 2004, which again failed to disclose any components of the alleged fraudulent scheme. (Id.)

IV. Refco's IPO and Revelation of Fraud

On August 16, 2005, approximately one year after the consummation of the LBO transaction, Refco conducted its initial public offering ("IPO"), which resulted in its underwriters selling 26,500,000 shares of common stock. (Id. ¶ 82.) Two months later, on October 10, 2005, Refco announced that it had discovered an undisclosed $430 million receivable due from an entity (i.e., RGHI) controlled by Bennett. (Id. ¶ 83.) As a result, the company announced that its financial statements for the preceding four years could no longer be relied upon. (Id. ¶ 84.) Following these disclosures, Refco's stock plummeted and was de-listed by the New York Stock Exchange, leading to over $1 billion in lost market ...

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