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G. Philip Stephenson, As Trustee of the Philip Stephenson Revocable v. Pricewaterhousecoopers

March 8, 2011


The opinion of the court was delivered by: Richard J. Holwell, District Judge:


Defendant PricewaterhouseCoopers, LLP ("PWC") moves to dismiss plaintiff G. Philip Stephenson's claim that PWC's fraud caused him to lose his entire investment in Greenwich Sentry, a fund which invested in Bernard Madoff's Ponzi scheme. For the reasons that follow, the Court finds that Stephenson has not adequately alleged that PWC acted with scienter and grants PWC's motion to dismiss Stephenson's fraud claim.


This action is one of several pending in this district arising out of Bernard Madoff's revelation in December 2008 that his multi-billion dollar investment firm, Bernard L. Madoff Investment Securities, LLC ("BMIS"), was a massive fraud.

Stephenson's complaint alleges as follows. Stephenson is trustee of the Philip Stevenson Revocable Living Trust ("the Trust"). (Compl. ¶ 6.) In early 2008, Stephenson decided to invest the Trust's assets as a limited partner in Greenwich Sentry, a limited partnership organized under the laws of Delaware. (Id. ¶ 9, 18.) Fairfield Greenwich (Bermuda) Ltd. ("FGB"), an investment advisor registered with the SEC whose "core product business model" was providing various management services for funds linked to BMIS, acted as general partner of Greenwich Sentry. (Id. ¶ 10.) Since Greenwich Sentry had no employees of its own, FGB was responsible for Greenwich Sentry's due diligence and risk monitoring. (Id. ¶ 51.) FGB was in turn affiliated with Fairfield Greenwich Group ("FGG"), an investment management firm that offered its investors access to BMIS through so-called "feeder funds" such as Greenwich Sentry. (Id. ¶ 11.)

As a "feeder fund", Greenwich Sentry invested substantially all of its limited partners' investments in an account controlled by BMIS which acted as trader, broker, and custodian of all funds and securities in the account and reported results back to Greenwich Sentry. (Compl. ¶ 17.) Limited partners in Greenwich Sentry could make monthly withdrawals of funds funded either from a separate Greenwich Sentry account or from BMIS itself. (Id. ¶¶ 36, 38-9.)

PWC, a limited liability partnership organized under the laws of Ontario, Canada, acted as auditor for Greenwich Sentry from 2006 through 2008. (Id. ¶ 7.) PWC is a member of PricewaterhouseCoopers International ("PWC International"), a "Big Four" accounting firm which provides auditing, accounting, and other advisory services around the world. (Id. ¶ 8.) Like the other PWC International member entities, PWC held itself out as part of a unified business entity whose members utilize common knowledge bases and apply uniform policies and procedures. For example, as part of the firm-wide "Client Acceptance Assessment" and "Know Your Client" programs, all PWC International member firms are required to conduct research regarding the connections and/or potential conflicts of interest between new and existing clients as well as to review regulatory filings. (Id. ¶¶ 70, 81.) The data complied during these required inquiries is maintained in an automated database to which all member firms, including PWC, have access. (Id. ¶ 71.)

PWC and other member firms also have access to the Global Engagement Management System in which PWC International maintains data on the relationships between firm clients and on the managers responsible for relationships with those clients. (Id. ¶ 72.) Member use this database to locate employees serving related clients and exchange information with them. (Id.) Indeed, in December 2004, at the request of a PWC International member firm in Dublin, Ireland auditing a second BMIS feeder fund, a Bermuda member firm auditing a third feeder fund met with BMIS to discuss its operations "for the purpose of gaining comfort thereon for the audits by several PWC offices of a number of funds having money managed by [BMIS]." (Id. ¶¶ 76-77.) The Bermuda member firm reported the results of the meeting in a March 15, 2005 letter to the Dublin member firm and a member firm in the Netherlands that was PWC's predecessor as auditor of Greenwich Sentry. (Id.) The Netherlands member firm in turn reported the results in a letter to an entity affiliated with FGG. (Id. ¶ 76.) This letter remained in PWC International automated files accessible to PWC. (Id. ¶ 78.)

PWC International member firms also hold themselves out as part of a firm with particular expertise in hedge funds and investment vehicles. PWC organized an Alternative Investment Funds Practice devoted to auditing hedge funds (id. ¶ 74), and PWC and its employees have been involved in developing industry standards for and guides to alternative investment auditing. (Id. ¶¶ 55-56.) PWC also audited seven other FGG feeder funds and assigned the same team auditing Greenwich Sentry to audit those funds as well. (Id. ¶ 44.)

PWC conducted an annual audit of Greenwich Sentry. For purposes of that audit, and the audit of other BMIS feeder funds, PWC developed an "Audit Plan." (Compl. ¶ 65.) The 2008 Audit Plan proposed that PWC would conduct "discussion and enquiry with [BMIS]" and "obtain an understanding of the key control activities as they relate to the operations, sub-custodian and prime broker functions." (Id.) The Audit Plan also indicated that PWC would "perform transaction testing on the investment strategy applied by [BMIS] for the applicable funds." (Id.) And the Audit Plan recognized the need to "confirm existence of investments" with BMIS and derivative contracts associated with BMIS's investment strategy, a completely automated system called the "the split strike conversion strategy" ("SSC Strategy"). (Id.) In general terms, that strategy consisted of the purchase of a basket of securities corresponding to stocks in the S&P 100 Index as well as options to hedge the risk of those securities. (See id. ¶ 42.)

On February 20, 2008, after expressing interest in Greenwich Sentry, Stephenson received documents about one of Greenwich Sentry's sister funds, Fairfield Sentry. (Compl. ¶ 18.) He was told that analogous documents for Greenwich Sentry were not yet available but that he could expect them to be similar and that they would be audited by a PWC International member firm. (Id.) These documents included a "due diligence questionnaire" that described protections in FGG funds, including the role played by PWC. (Id.) One week later, Stephenson received profit analyses for Fairfield Sentry which he was told by FGG would be representative of results he could expect as a limited partner in Greenwich Sentry. (Id. ¶ 19.)

In March 2008, Stephenson received the Greenwich Sentry Limited Partnership Agreement and fund reports showing that Greenwich Sentry earned profits of just under one percent as compared to a multi-percentage point fall in the Down Jones Industrial Average ("DJIA"). (Compl. ¶ 20.) Stephenson also received the Greenwich Sentry PPM which described the SSC Strategy and explained that the Strategy was "implemented by [BMIS] . . . through accounts maintained by the Partnership at that firm." (Id. ¶¶ 20, 42.)Stephenson understood that PWC had approved some or all of these documents and would be serving as auditor for Greenwich Sentry. (Id. ¶ 21 (ellipsis in original).) That was critical for Stephenson as an experienced investor who knew the value of strong risk management: he specifically asked FGG whether PWC had identified any issues with Greenwich Sentry and never would have invested in the fund if PWC or a firm of equal repute was not auditing the fund. (Id. ¶¶ 22-24.) For its part, PWC understood that its auditing work would be relied upon by potential investors and limited partners such as Stephenson, particularly because there was no public market for Greenwich Sentry partnership interests that would facilitate public information regarding the fund. (Id. ¶¶ 85-86.)

On April 1, 2008, Stephenson executed a subscription agreement in his individual capacity and deposited $60 million in Greenwich Sentry accounts. (Compl. ¶ 27.) On May 1, 2008, Stephenson requested transfer of his account to the Trust. (Id.) Around this time, Stephenson received the 2006 and 2007 Greenwich Sentry financial statements in which PWC delivered unqualified audit opinions affirming that the statements were prepared in accordance with Generally Accepted Accounting Practices ("GAAP") and Generally Accepted Accounting Standards ("GAAS"). (Id. ¶¶ 84-89.) After receiving those opinions, Stephenson executed a new subscription agreement in his capacity as trustee on June 1, 2008 and transferred his limited partnership interest to the Trust. (Id. ¶ 28.)

At first, the Trust's investment appeared to be paying off. By October 31, 2008, Citco Fund Services (Europe) BV and Citco (Canada) Inc., the fund administrator and sub-administrator respectively, had reported that Stephenson's original $60 million investment was worth $62,540,565. (Compl. ¶ 32.) And by the end of November 2008, the same investment had realized a 6.59% gain at a time when the DJIA experienced losses many times that percentage. (Id. ¶ 33.) Of course, as the world now knows, those gains were illusory and Madoff needed money from investors like Stephenson to pay those prescient few who cashed out before the truth came out. Indeed, on December 11, 2008, when Madoff revealed his fraud, Greenwich Sentry refused to withdraw Stephenson's investment and he has still never recovered a cent of his $60 million. (Id. ¶ 40.)

On January 26, 2009, Stephenson filed suit [1] against Citco Europe, Citco Canada, their parent Citco Group Limited (collectively "Citco"), and PWC alleging claims under New York law for breach of fiduciary duty against Citco and for gross negligence and breach of contract against Citco and PWC. On June 29, 2009, Stephenson filed an amended complaint [36] which he corrected [37] on July 2, 2009. The amended complaint alleged seven claims under New York law: breach of fiduciary duty and gross negligence against Citco, professional malpractice and fraud against PWC, and breach of contract and aiding and abetting fiduciary duty against both Citco and PWC. Stephenson's fraud claim alleged that Greenwich Sentry's financial statements were not prepared in accordance with GAAP and GAAS and that PWC's unqualified opinion to the contrary was false.

In a memorandum opinion and order dated March 31, 2010, the Court dismissed Stephenson's complaint in its entirety. See Stephenson v. Citco Group Ltd., 700 F. Supp. 2d 599 (S.D.N.Y. 2010) ("Stephenson I"). The Court held that Stephenson's contract, fiduciary duty, and aiding and abetting claims were derivative, see id. at 610-611, and could not be brought by Stephenson directly and that his fiduciary duty, gross negligence, professional malpractice, and aiding and abetting claims were preempted by the Martin Act. See id. at 618. The Court dismissed these claims with prejudice. See id. at 624.

The Court dismissed Stephenson's fraud claim on the ground that the complaint failed to allege that PWC acted with scienter. Applying the well-settled law of this Circuit, the Court held that alleged GAAP or GAAS violations do not establish scienter of their own force. See id. at 621. Though Stephenson also alleged that certain "red flags" should have put PWC on notice that there were control problems at Greenwich Sentry and that BMIS was a fraud, the Court held that the complaint did not allege that PWC had knowledge of these red flags. See id. at 624. And while PWC surely knew of BMIS's incredible success and that Madoff acted as trader, broker, and custodian, the Court found that these did not give rise to the required "strong inference" of fraudulent intent. See id. However, the Court dismissed the fraud claim without prejudice and granted Stephenson leave to amend his complaint. See id.

Stephenson filed the Second Amended Complaint (the "SAC") on June 18, 2010. Like the prior complaint, the SAC alleges that "PWC performed its audit recklessly by failing to adhere to its GAAS requirements, failing to discover the risks and failures at [Greenwich Sentry], or at or from BMIS impacting upon [Greenwich Sentry], and/or failing to report on those risks and failures or qualifying or withdrawing its Unqualified Opinion." (Compl. ΒΆ 94.) In particular, ...

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