Opinion
No. 1:03-CV-0678-DFH-VSS.
November 24, 2004
ENTRY ON MOTION TO DISMISS
In the case of Securities Exchange Commission v. Church Extension of the Church of God, Inc., No. 1:02-cv-1118, this court appointed Jeff J. Marwil conservator and receiver for Church Extension of the Church of God, Inc. ("CEG") and United Management Services, Inc. ("UMS"). CEG is a financial arm of the Church of God. UMS is a subsidiary of CEG that managed real estate and businesses for CEG. The SEC alleged in its civil enforcement action that CEG was insolvent and had raised millions of dollars unlawfully by making false statements to prospective purchasers of investment notes, the vast majority of which were sold to members of the Church of God.
Pursuant to an agreement approved by this court between the SEC, CEG and UMS, and under supervision by this court and Marwil, CEG has undertaken a plan to liquidate its assets. The goal is to meet as many of its obligations to creditors as possible, including its obligations to holders of the investment notes. In his capacity as receiver, Marwil has filed several actions in this court, including this action. In the original complaint in this action, Marwil as receiver was the only plaintiff. The defendant is Ent Imler CPA Group, an accounting firm with its principal place of business in Indianapolis. Ent Imler provided accounting services to CEG and UMS from 1997 to 2002.
In the original complaint, Marwil alleged that defendant Ent Imler CPA Group had violated federal securities fraud and had committed malpractice. On December 11, 2003, the court granted Ent Imler's motion to dismiss the securities fraud claim because Marwil, as receiver of the issuer of the securities in question, did not have standing to assert claims directly on behalf of the noteholders. See Marwil v. Ent Imler CPA Group, No. 1:03-cv-0678 (S.D. Ind. Dec. 11, 2003). The court granted Marwil leave to amend and said that noteholders could assert the securities fraud claims on their own behalf.
On the same day, the court decided a nearly identical issue in a related case, Marwil v. Farah, 2003 U.S. Dist. Lexis 23140, 2003 WL 23095657 (S.D. Ind. Dec. 11, 2003) (holding that Marwil lacked standing to assert fraudulent conveyance claims directly on behalf of noteholders but could assert those claims on behalf of CEG).
Marwil responded by filing an amended complaint. The Amended Complaint joins claims by Marwil as receiver for CEG and UMS and by the Central Community Church of God, a non-profit corporation headquartered in Wichita, Kansas. The Central Community Church seeks to represent a class of investors who purchased investment notes offered by CEG through a series of Offering Circulars between at least 1997 and April 2002. In Count I of the Amended Complaint, Central Community Church alleges that Ent Imler violated federal securities law under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated under the Act, 17 C.F.R. § 240.10b-5, when it certified financial statements and helped to prepare Offering Circulars containing fraudulent misrepresentations that misled noteholders about the true financial condition of CEG. In Count II, Marwil alleges that Ent Imler breached its accounting services contract with CEG by failing to perform properly its obligations under the contract.
This court has subject matter jurisdiction over this action under 28 U.S.C. § 1331. The court's supplemental jurisdiction over Marwil's state law claim is authorized by 28 U.S.C. § 1367(a). His claim is part of the same case or controversy as Central Community Church's federal claim, for it arises from the same series of transactions and events and is against the same defendant. In addition, Marwil's claim falls within the reasoning of Tcherepnin v. Franz, which approved of the exercise of ancillary jurisdiction over state law claims brought by a receiver to accomplish the ends sought and directed by the SEC action in which he had been appointed a receiver. 485 F.2d 1251, 1255-56 (7th Cir. 1973), citing Esbitt v. Dutch-American Mercantile Corp., 335 F.2d 141, 142 (2d Cir. 1964).
Tscherepnin is perhaps best understood today as a practical and convenient method of exercising supplemental jurisdiction over a claim that could easily have been brought as a third party action as part of the SEC's enforcement action. CEG is a defendant in that action, and its claim against Ent Imler asserts in essence that Ent Imler may be liable for all or part of the SEC's claims against CEG. See Fed.R.Civ.P. 14(a).
Ent Imler has moved to dismiss plaintiffs' Amended Complaint. Ent Imler argues that Central Community Church's securities fraud claims should be dismissed for misjoinder, failure to plead fraud with sufficient specificity, and violation of this court's holding that Marwil has no standing to sue on behalf of noteholders. Ent Imler moves to dismiss receiver Marwil's breach of contract claim based on the doctrine of in pari delicto and the argument that a claim for accounting malpractice lies exclusively in tort. For the reasons explained below, defendant's motion is denied in its entirety.
Dismissal Standard
By moving to dismiss under Rule 12(b)(6), the defendant has invited the court to consider the case under a legal standard that is one of the most generous to plaintiffs under the law. The court must treat as true all well pleaded facts set forth in the complaint, construe the allegations liberally, and view all inferences reasonably drawn from the alleged facts in the light most favorable to the plaintiffs. Forseth v. Village of Sussex, 199 F.3d 363, 368 (7th Cir. 2000); Gould v. Artisoft, Inc., 1 F.3d 544, 548 (7th Cir. 1993). Dismissal is warranted only if it is clear that the plaintiffs can prove no set of facts consistent with the complaint that would entitle them to relief. Swierkiewicz v. Sorema N.A., 534 U.S. 506, 514 (2002); Nance v. Vieregge, 147 F.3d 589, 590 (7th Cir. 1998), quoting Hishon v. King Spalding, 467 U.S. 69, 73 (1984).
The court's consideration of a Rule 12(b)(6) motion is limited to the pleadings, which consist generally of the complaint and any exhibits or documents attached to or referenced in the complaint, as well as the parties' briefs on the motion. See Thompson v. Illinois Department of Professional Regulation, 300 F.3d 750, 753 (7th Cir. 2002); Rosenblum v. Travelbyus.com Ltd., 299 F.3d 657, 661 (7th Cir. 2002); Menominee Indian Tribe v. Thompson, 161 F.3d 449, 456 (7th Cir. 1998). Plaintiffs may posit facts in their brief. So long as those facts are not inconsistent with the complaint, the court must assume they are true for purposes of deciding the motion. See, e.g., Chavez v. Illinois State Police, 251 F.3d 612, 650 (7th Cir. 2001); Trevino v. Union Pacific Railroad Co., 916 F.2d 1230, 1239 (7th Cir. 1990).
Plaintiffs' Allegations
For the purpose of deciding defendant's motion to dismiss, the court accepts the following allegations contained in the Amended Complaint as true. CEG is an Indiana not-for-profit corporation established to raise funds for the Church of God, a church with over 2,000 affiliated congregations and over 230,000 members nationwide. CEG's primary business purpose is to fund the construction of new churches and the renovation of existing churches affiliated with the Church of God. From 1996 to April 2002, CEG raised millions of dollars by selling investment notes to Central Community Church and others. CEG offered the notes for sale through five Offering Circulars. The Offering Circulars included consolidated financial statements with detailed information about CEG and its finances and operations. Through the Offering Circulars, CEG represented to investors that the funds from the investment notes would be used primarily to make interest-bearing loans to local churches, and that CEG had a policy of maintaining liquid reserves equal to or greater than a specified percentage of its outstanding notes.On December 27, 1999, Central Community Church purchased a note from CEG for $250,000. In reliance on statements made in the Offering Circular, including statements regarding the financial condition of CEG, Central Community Church continued to make deposits as permitted under the terms of the note. On April 20, 2002, the balance of Central Community Church's note was $1,968,641.
From December 1997 until September 2002, CEG retained defendant Ent Imler to prepare its audited financial statements and to help CEG prepare the Offering Circulars. Ent Imler prepared the independent auditor's reports and consolidated financial statements that were included, with Ent Imler's consent, in the Offering Circulars. Plaintiffs allege that during the relevant period, the Offering Circulars contained a number of affirmative misrepresentations and that they omitted material facts regarding the investment notes, the financial condition of CEG and its subsidiaries, the primary use of the investment note proceeds, and the risks associated with the notes. Plaintiffs identify three sets of such misrepresentations and omissions that concealed CEG's mounting financial difficulties.
First, plaintiffs allege that CEG engaged in a series of high-risk "bargain sale" transactions from 1996 through early 2002 using inflated appraisals and other devices to exaggerate the value of the properties or businesses acquired. Ent Imler in turn used these inflated appraisal values to certify CEG's consolidated financial statements, which reflected non-cash contributions of over $24 million in phantom income during those years. In 2001, Ent Imler opined that the financial statements fairly represented the financial position of CEG and related entities. This phantom income, according to plaintiffs, allowed CEG to claim that it was solvent when it was insolvent, and therefore to deceive prospective investors into buying still more notes. In reality, CEG was experiencing substantial losses. Most of its reported income was the artificial product of the bargain sale transactions.
Bargain sale transactions can be a lawful and prudent mechanism allowing a charitable organization to recognize income from non-cash contributions. In a typical and legitimate bargain sale, a seller sells property to the charitable organization for less than full market value. For accounting purposes, the charity records the difference between the sale price and market value as income. The seller, in turn, can treat the difference between the market value and sale price as a charitable contribution for income tax purposes. The determination of market value is obviously critical to the tax and accounting legitimacy of the transaction.
Second, plaintiffs allege that from 1998 through June 30, 2001, the Offering Circulars represented that the proceeds from the sale of investment notes would be used primarily to fund church loans. Instead of going toward loans to churches, however, most of the note proceeds were used to pay debts owed to prior CEG investors and to fund the bargain sale transactions. Ent Imler had access to financial records that disclosed CEG's actual use of the note proceeds.
Third, plaintiffs allege that although the Offering Circulars claimed that CEG maintained a reserve of liquid assets equal to eight percent of its outstanding note obligations, the amount actually available as liquid reserves fell well below eight percent. Again, Ent Imler had access to financial records that disclosed the difference between reality and the claims in the Offering Circulars.
Discussion
I. Class Plaintiff: Central Community Church of God
Seeking to represent a plaintiff class of noteholders, Central Community Church alleges that Ent Imler violated federal securities law under Section 10(b) of the Securities Exchange Act and Rule 10b-5. Section 10(b) of the Act makes it unlawful "[t]o use or employ, in connection with the purchase or sale of any security . . ., any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors." 15 U.S.C. § 78j(b). Rule 10b-5 makes it unlawful "To make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. . . ." 17 C.F.R. § 240.10b-5. Defendant's three proffered grounds for dismissal of Central Community Church's claim are not persuasive.
A. Misjoinder of Plaintiffs
First, Ent Imler contends that Central Community Church's claim for securities fraud should not be joined with receiver Marwil's claim for breach of contract. Rule 20 of the Federal Rules of Civil Procedure covers permissive joinder of parties and states in relevant part:
All persons may join in one action as plaintiffs if they assert any right to relief jointly, severally, or in the alternative in respect of or arising out of the same transaction, occurrence, or series of transactions or occurrences and if any question of law or fact common to all these persons will arise in the action.
Defendant maintains that the claims, defenses, and issues under Central Community Church's fraud action lack the commonality with Marwil's contract claim that is necessary for Rule 20 joinder. The court disagrees.
CEG contracted with Ent Imler from December 1997 to September 2002 to prepare CEG's audited financial statements and to help prepare the Offering Circulars. Receiver Marwil claims that Ent Imler failed to perform its obligations under the contract by failing to perform its audit in accordance with generally accepted accounting standards ("GAAS"), by failing to test and confirm the existence of assets and the validity of transactions, and by failing to render financial statements free of material misstatements. Amended Complaint ¶ 113. Marwil's contract claim and Central Community Church's fraud claim involve exactly the same course of conduct and the same transactions by defendant: preparing and certifying audited financial statements and helping to prepare the Offering Circulars. Marwil's claim and Central Community Church's claim thus also share common issues of fact, including the valuation of CEG assets, the existence and availability of financial records disclosing CEG's use of note proceeds and liquidity of reserves, the assumptions and data underlying the valuations of assets obtained in the bargain sales, and the procedures and assumptions Ent Imler used when auditing CEG's financial statements and reviewing the Offering Circulars. The joinder of the plaintiffs' claims meets the requirements of Rule 20.
B. Pleading Fraud with Particularity
Defendant Ent Imler also argues that Central Community Church's securities fraud claim fails to meet the heightened pleading standards of both Rule 9(b) of the Federal Rules of Civil Procedure and the Private Securities Litigation Reform Act of 1995 ("PSLRA"), codified in 15 U.S.C. § 78u-4(b). Ent Imler contends that the Amended Complaint does not sufficiently plead fraudulent "scienter." Ent Imler also argues that the complaint alleges only "fraud by hindsight," which does not state a claim for securities fraud. See Asher v. Baxter International Inc., 377 F.3d 727, 730 (7th Cir. 2004) ("fraud by hindsight" is not actionable).
To state a claim for securities fraud under Section 10(b), plaintiffs must allege among other elements that the defendant acted with fraudulent "scienter," which refers to "a mental state embracing intent to deceive, manipulate, or defraud." Ernst Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976). The Seventh Circuit has long held that reckless disregard for the truth is sufficient to meet the scienter requirement of Section 10(b). "Reckless conduct may be defined as a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it." Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977). A plaintiff may plead scienter "by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness." Chill v. General Electric Co., 101 F.3d 263, 268 (2d Cir. 1996), quoting Acito v. IMCERA Group, Inc., 47 F.3d 47, 52 (2d Cir. 1995).
In an action under section 10(b) and Rule 10b-5, the plaintiff must establish that: (1) the defendant made a false statement or omission (2) of material fact (3) with scienter (4) in connection with the purchase or sale of securities (5) upon which the plaintiff justifiably relied, and (6) the false statement proximately caused the plaintiff's damages. Caremark, Inc. v. Coram Healthcare Corp., 113 F.3d 645, 648 (7th Cir. 1997).
Rule 9(b) requires that when fraud is alleged in a complaint, "the circumstances constituting fraud . . . shall be stated with particularity," but Rule 9(b) allows states of mind to be alleged generally. E.g., United States v. Northern Trust Co., 372 F.3d 886, 888 (7th Cir. 2004). The PSLRA raised the pleading standard by requiring a plaintiff's complaint to specify each statement alleged to have been misleading and the reasons why the statement is misleading. 15 U.S.C. § 78u-4(b)(1). With respect to each act or omission alleged, the complaint must state with particularity "facts giving rise to a strong inference that the defendant acted with the required state of mind." § 78u-4(b)(2).
In cases decided before the PSLRA took effect, the Seventh Circuit had interpreted Rule 9(b) to require that scienter be pled with a sufficient level of factual support to "afford a basis for believing that plaintiffs could prove scienter" — namely, "the who, what, when, where, and how: the first paragraph of any newspaper story." In re HealthCare Compare Corp. Securities Litigation, 75 F.3d 276, 281 (7th Cir. 1996), quoting DiLeo v. Ernst Young, 901 F.2d 624, 627, 629 (7th Cir. 1990). Whether that requirement was consistent with Rule 9(b)'s provision that state of mind can be averred generally is now largely moot in light of the requirements of the PSLRA.
To avoid the damning label of "fraud by hindsight," a plaintiff must plead a factual basis for believing that the defendant knew or was reckless in not knowing about misleading representations or omissions at the time the actions allegedly occurred, prior to any later disclosure. See, e.g., Arazie v. Mullane, 2 F.3d 1456, 1468 (7th Cir. 1993) (finding that plaintiff stockholders failed to allege with the particularity required by Rule 9(b) that defendant's predictions lacked a reasonable basis at the time they were made, making the action a claim for "fraud by hindsight"); Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978) (adopting phrase "fraud by hindsight" where plaintiff had "simply seized upon disclosures made in later annual reports and alleged that they should have been made in earlier ones").
The Amended Complaint in this case states the circumstances constituting Ent Imler's alleged fraud with a particularity sufficient to meet the requirements of Rule 9(b). Central Community Church also has identified details of alleged misstatements and omissions sufficient to meet the more rigorous requirements of the PSLRA. Central Community Church's allegations, if true, could support a strong inference that Ent Imler recklessly disregarded obvious evidence that the statements it reviewed, prepared, and certified contained material misrepresentations. Central Community Church refers to data, allegedly available to Ent Imler over the course of its relationship with CEG, that were directly inconsistent with the bargain sale valuations, the represented use of note proceeds, and the actual liquidity of CEG's funds. For example, the Offering Circulars represented that the proceeds from the sale of investment notes would be used primarily to fund church loans. Central Community Church alleges that Ent Imler had access to financial records showing that in 1998, 1999, and 2000, only about 35 percent, zero percent, and six percent of the proceeds, respectively, went toward funding church loans. Amended Complaint ¶¶ 39-43. Courts have found that a "strong inference" of recklessness may be supported by allegations that a defendant knew facts or had access to information suggesting that its public statements were not accurate. See Florida State Board of Admin. v. Green Tree Financial Corp., 270 F.3d 645, 665 (8th Cir. 2001) ("One of the classic fact patterns giving rise to a strong inference of scienter is that defendants published statements when they knew facts or had access to information suggesting that their public statements were materially inaccurate."); Novak v. Kasaks, 216 F.3d 300, 308 (2d Cir. 2000) ("securities fraud claims typically have sufficed to state a claim based on recklessness when they have specifically alleged defendants' knowledge of facts or access to information contradicting their public statements"); Chill, 101 F.3d at 269 ("An egregious refusal to see the obvious, or to investigate the doubtful, may in some cases give rise to an inference of . . . recklessness."), quoting Goldman v. McMahan, Brafman, Morgan Co., 706 F. Supp. 256, 259 (S.D.N.Y. 1989); Miller v. Material Sciences Corp., 9 F. Supp. 2d 925, 927-928 (N.D. Ill. 1998) (denying motion to dismiss where plaintiff alleged that defendants publicly reported sales and earnings using artificially inflated figures and defendants were aware at the time of substantial evidence that the figures were inflated).
Moreover, unlike plaintiffs in typical fraud-by-hindsight cases, Central Community Church has not asked the court to infer defendant's knowledge or reckless disregard of facts based on a later discovery that statements or omissions turned out to be false. Central Community Church has cited data that were available to Ent Imler at the time of its financial audits and that were directly inconsistent with the representations incorporated by Ent Imler. Nor are these cited data simply "red flags" that could have indicated CEG's misconduct. The cited data allegedly would have provided Ent Imler with direct evidence that CEG's representations were amiss, if Ent Imler had looked.
Drawing all reasonable inferences in favor of the plaintiff, Central Community Church's allegations would, if proven, allow a fact finder to infer that Ent Imler at least recklessly disregarded data that were materially inconsistent with CEG's representations. The securities fraud claim is sufficient to withstand defendant's motion to dismiss.
C. Simultaneous Representation of Receiver and Noteholders
As defendant notes, this court has already held that Marwil, in his capacity as receiver for CEG and UMS, lacks standing to bring claims directly on behalf of noteholders. The response to that decision was the addition of Central Community Church as a plaintiff in its own right and as representative of a putative plaintiff class. Defendant contends that this response to the court's earlier decision was some kind of ruse to avoid the court's ruling. Defendant suggests that the appropriate response is dismissal of the noteholder's claim, or disqualification of its attorneys, or both. In the court's view, however, the addition of a noteholder as a named plaintiff to assert its own claims in its own name directly responds to and cures the standing problem the court found in the initial complaint. There also is no reason to disqualify the noteholder's law firm.
There are of course potential conflicts between the receiver and the noteholders. The receiver's duty is to act in the best interests of all of CEG's creditors. The noteholders are entitled to act in their own best interests. But the potential conflicts do not disqualify one of plaintiffs' law firms from representing both the noteholder and the receiver. The interests of the noteholders and the receiver are sufficiently aligned that there is at best only a hypothetical potential for a conflict of interests. Such a potential conflict does not require disqualification, let alone dismissal or severance of the underlying claims for relief.
The court may order disqualification of attorneys upon a motion from a party or on its own initiative. Philips Medical Systems Int'l B.V. v. Bruetman, 8 F.3d 600, 606 (7th Cir. 1993). Disqualification is a drastic measure "which courts should hesitate to impose except when absolutely necessary," Freeman v. Chicago Musical Instrument Co., 689 F.2d 715, 721 (7th Cir. 1982), and courts must also be cautious about an opponent's effort to seek disqualification, perhaps as a tactical or delaying device. The party moving for disqualification has the burden of showing facts requiring such a drastic step. Weeks v. Samsung Heavy Industries Co., 909 F. Supp. 582, 583 (N.D. Ill. 1996) (the party moving for disqualification "has the burden of showing facts requiring disqualification").
Defendant has not met its burden to present facts showing that disqualification of Rubin Levin as counsel for Central Community Church is warranted in this case. Conflicts associated with simultaneous representation of co-plaintiffs are governed by Rule 1.7(b) of the Indiana Rules of Professional Conduct. The conflicts claimed by Ent Imler are at most only potential conflicts. A potential conflict does not itself preclude representation. "The critical questions are the likelihood that a conflict will eventuate and, if it does, whether it will materially interfere with the lawyer's independent professional judgment in considering alternatives or foreclose courses of action that reasonably should be pursued on behalf of the client." Comments to Rule 1.7(b), Indiana Rules of Professional Conduct, Adopted Effective January 1, 1987. Moreover, opposing counsel may properly raise the question of a conflict of interest under Rule 1.7 only where the conflict is such "as clearly to call in question the fair and efficient administration of justice." Id. Scholes v. Tomlinson, 1991 U.S. Dist. Lexis 10486, 1991 WL 152062 (N.D. Ill. July 29, 1991), upon which Ent Imler relies, provides a useful comparison with the present case. In Tomlinson, Scholes filed actions in his dual capacity as receiver for entities subject to SEC litigation and as class representative for defrauded account holders. The same law firm represented Scholes in both capacities. The Tomlinson court noted that Scholes would likely be confronted with a dilemma which would require him to weigh the interests of the class plaintiff against other creditors of the receivership entities. If Scholes then sought the advice of the law firm, the court reasoned, his counsel could not exercise independent judgment on behalf of Scholes as receiver while simultaneously representing the class. Id. at *22-23.
Scholes v. Tomlinson was one of several cases where Scholes, in his capacity as receiver for several entities, brought claims to recover assets lost in an illegal Ponzi scheme. See also Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995).
Like Marwil, Scholes was a partner with the law firm representing both receiver and class representative.
Treating as true Central Community Church's factual claims presented in the brief and consistent with the complaint, the risk of the type of conflict that concerned the Tomlinson court would be alleviated in this case. Central Community Church has presented facts supporting its assertion that in this case, its interests and those of CEG's other creditors are not likely to raise a conflict in counsel's representation. The Plan for Noteholder Repayment by CEG and UMS, approved by this court on January 31, 2003, sets forth the priorities of creditors' claims to CEG's assets. The Plan ensures that noteholders cannot be favored over CEG's other creditors in the distribution of CEG's assets. At the same time, Marwil's interests as receiver of CEG and UMS and his obligations to protect the interests of all creditors, including the noteholders, mean that his responsibilities here are virtually congruent with the interests of the noteholders. To the extent there might be some potential for conflicting interests between co-plaintiffs Marwil and the prospective class of noteholders, that prospect is so remote that there is simply no basis for disqualification, let alone dismissal of the underlying claim. Accordingly, the court denies defendant's motion to dismiss Central Community Church's claim.
II. Marwil as Receiver
A. In Pari Delicto Defense
Defendant asserts that the doctrine of in pari delicto bars Marwil's breach of contract claim on behalf of CEG. This Latin phrase literally means "of equal fault." Theye v. Bates, 337 N.E.2d 837, 844 (Ind.App. 1975). "The expression ` in pari delicto' is a portion of the longer Latin sentence, ` In pari delicto potior est conditio defendentis,' which means that where the wrong of both parties is equal, the position of the defendant is the stronger." Id. Corporations are subject to the in pari delicto defense, although to some extent the doctrine "loses its sting when the person who is in pari delicto is eliminated." Scholes v. Lehmann, 56 F.3d 750, 754-55 (7th Cir. 1995), citing McCandless v. Furlaud, 296 U.S. 140, 160 (1935).
It is important to keep in mind that defendant seeks dismissal under Fed.R.Civ.P. 12(b)(6) for failure to state a claim upon which relief may be granted. The doctrine of in pari delicto is an affirmative defense. See, e.g., Knauer v. Jonathon Roberts Financial Group, Inc., 348 F.3d 230, 237 n. 6 (7th Cir. 2003). A plaintiff need not try to plead around affirmative defenses. Doe v. GTE Corp., 347 F.3d 655, 657 (7th Cir. 2003); accord, Deckard v. General Motors Corp., 307 F.3d 556, 560 (7th Cir. 2002) ("The existence of a defense does not undercut the adequacy of the claim."). In unusual cases where the challenged complaint shows beyond dispute that an affirmative defense is valid, courts may dismiss under Rule 12(b)(6). See, e.g., Walker v. Thompson, 288 F.3d 1005, 1009 (7th Cir. 2002) ("when the existence of a valid affirmative defense is so plain from the face of the complaint that the suit can be regarded as frivolous, the district judge need not wait for an answer before dismissing the suit"); Wright Miller Federal Practice Procedure: Civil 3d § 1349 (2004). Such cases remain the exception, however. Under Rule 12(b)(6), receiver Marwil is entitled to a generous reading of the Amended Complaint and to the benefit of possible facts that may be consistent with it.
Marwil has alleged that CEG officers embarked on a fraudulent scheme to cover up CEG's financial difficulties. Ent Imler therefore contends that the fraudulent conduct of those officers is imputed to CEG so as to make CEG itself at least as culpable as Ent Imler might be. Under this view, Marwil, as receiver of CEG, should be barred from pursuing his breach of contract claim against the corporation's auditors. See Knauer, 348 F.3d at 236 (explaining the general rule in Indiana that the receiver is subject to all the defenses — including in pari delicto — that would have been available against the receivership entity); Marwil v. Farah, 2003 U.S. Dist. Lexis 23140 at *25-26 (S.D. Ind. Dec. 11, 2003) (same).
Two Seventh Circuit decisions — Knauer, 348 F.3d 230, and Scholes v. Lehmann, 56 F.3d 750 — clarify the scope of the in pari delicto defense. Both Knauer and Scholes involved actions by equitable receivers against defendants implicated in Ponzi schemes where corporate officers defrauded investors. The Seventh Circuit held in Scholes that the in pari delicto defense did not apply to the plaintiff's fraudulent conveyance action, whereas in Knauer the court applied the defense to bar the plaintiff's tort claims. The cases highlighted that the equitable alignment of plaintiff and defendant is crucial in applying the in pari delicto defense. Knauer, 348 F.3d at 236. In the Seventh Circuit's view, the key distinction between Scholes and Knauer was that in Scholes, the plaintiff receiver sought to recover diverted funds from the people who benefitted from the diversions, whereas in Knauer the receiver sued defendants who had derived no benefit from the embezzlements. Id. The application of the in pari delicto defense was appropriate in Knauer because the equitable balancing in that case favored the defendants; they had not seen a cent of the diverted funds and their "involvement in the Ponzi scheme as a whole was quite minor." Id. at 237. The Seventh Circuit emphasized that under the facts alleged in Knauer, there was "no allegation whatsoever that the defendants were directly involved in the embezzlements or benefitted from them." Id. "Had the [defendant] broker dealers been directly involved in the embezzlements, or attained some tangible benefit from them, this would be a different case." Id. at 237 n. 6.
At least at the pleading stage, the equitable alignment alleged here appears to resemble Scholes v. Lehmann more closely than Knauer. Marwil has alleged that Ent Imler was directly involved in CEG's fraudulent misrepresentations to noteholders by recklessly ignoring and perpetuating those misrepresentations. Accepting Marwil's allegations as true, as the court must at this stage, Ent Imler engaged in a course of conduct that went beyond simply facilitating the fraudulent bargain sale valuations and other alleged misrepresentations. Unlike the situation in Knauer, a fair inference from Marwil's allegations is that Ent Imler participated or played a substantial role in defrauding investors. Thus even if the former CEG officers' wrongdoings are imputed to CEG and UMS, the court could not find as a matter of law that CEG's and UMS's alleged fault in the overvaluation of bargain sale assets and other alleged misrepresentations exceeded that of Ent Imler. Accordingly, defendant's in pari delicto defense does not support dismissal at this stage under Rule 12(b)(6).
This case also resembles Baker O'Neal Holdings, Inc. v. Ernst Young LLP, 2004 U.S. Dist. Lexis 6277, 2004 WL 771230 (S.D. Ind. March 24, 2004), a case recently decided by this court, where the plaintiffs alleged that the accounting firm Ernst Young was directly involved in the fraudulent transfer of assets from Baker O'Neal Holdings by president and CEO O'Neal. The court denied defendant's motion to dismiss based on the in pari delicto defense.
B. Tort versus Contract Claims
Defendant also argues that Count II of the Amended Complaint, although labeled as breach of contract, is actually a tort claim for accountant malpractice. Defendant contends that Indiana law treats all allegations of professional malpractice as arising in tort absent a specific agreement between the parties to perform beyond the legally implied standard of care. Therefore, defendant asserts, Marwil's breach of contract claim should be dismissed for failure to state a claim upon which relief can be granted. The court disagrees.
In Count II of the Amended Complaint, Marwil alleges that Ent Imler failed to perform its obligations under its service contract with CEG in that it failed, among other things, to:
a. perform its audit in accordance with procedures that complied with [generally accepted accounting standards];
b. test the documentary evidence supporting the transactions recorded in the accounts, test the physical existence of assets, and confirm the investments, receivables and certain other assets and liabilities; and
c. render the financial statements free of material misstatements.
Amended Complaint ¶ 113. These allegations mirror to a large extent, although not perfectly, the promises set forth in the engagement letter of December 31, 1997. See Pl. Ex. C.
On this state law question, this court's role is to apply Indiana law as the court predicts the Supreme Court of Indiana would apply it to the facts in this case. See, e.g., State Farm Mutual Auto. Ins. Co. v. Pate, 275 F.3d 666, 669 (7th Cir. 2001). Decisions of intermediate appellate courts also deserve great weight in predicting state law unless there are persuasive reasons to believe the state's highest court would disagree with them. Id.
Ent Imler cites no Indiana case holding specifically that accounting malpractice cannot support a breach of contract claim. Defendant has built its argument using Indiana cases on statutes of limitations for attorney malpractice claims, plus cases from other jurisdictions extending the law on attorney malpractice to accountant malpractice claims. In Shideler v. Dwyer, 417 N.E.2d 281 (Ind. 1981), the Indiana Supreme Court considered, among other issues, whether the trial court properly denied an attorney's motion for summary judgment against a client's heir's allegations of breach of contract, negligence, fraud, constructive fraud, and breach of fiduciary duty. The summary judgment motion primarily addressed whether the action was barred by the statute of limitations. The court held that, notwithstanding the labels of the claims, the substance of the client's heir's action was for legal malpractice and injury to personal property, and thus her action was barred by the two-year statute of limitations for tort claims under Ind. Code § 34-1-2-2(1) (recodified at Ind. Code § 34-11-2-4). Id. at 280-81. A series of subsequent decisions by the Indiana courts reaffirmed the ruling in Shideler. Shideler and its progeny stand for the proposition that "legal malpractice claims are governed by tort principles regardless of whether they are brought as a tort, a breach of contract, or both." American International Adjustment Co. v. Galvin, 86 F.3d 1455, 1459 (7th Cir. 1996). The determinative issue in those cases was how to reach beyond the pleading's labels and characterize the underlying substantive claim in order to determine which statute of limitations period to apply. Shideler provided a process for doing so. See Davis v. Geo. S. Olive Co., 731 F. Supp. 1380, 1383-84 (S.D. Ind. 1990) ("Fortunately, the Indiana Supreme Court has provided a process by which a court can select the appropriate statute of limitations," citing Shideler).
Even if the court accepts the contention that tort principles apply to a claim that an accountant breached generally accepted accounting standards, Marwil's contract claim should not be dismissed. The Indiana cases on this subject did not hold that professional malpractice claims must be dismissed unless labeled correctly in the complaint. All of the cited Indiana cases were decisions on motions for summary judgment, and in all of the cases defendants raised statute of limitations issues or other defenses.
At the motion to dismiss stage, the court's duty is "to consider whether a plaintiff's allegations could provide relief under any available legal theory." Sidney S. Arst Co. v. Pipefitters Welfare Educ. Fund, 25 F.3d 417, 421 (7th Cir. 1994) (emphasis added); see also Bartholet v. Reishauer, 953 F.2d 1073, 1078 (7th Cir. 1992) ("A drafter who lacks a legal theory is likely to bungle the complaint (and the trial); you need a theory to decide which facts to allege and prove. But the complaint need not identify a legal theory, and specifying an incorrect theory is not fatal." [emphasis added]). Marwil's claim in Count II alleges conduct that could entitle him to relief, whether under tort or contract theories. The label he has attached to his claim does not govern the decision on defendant's motion to dismiss. Ent Imler has not challenged Marwil's claim on statute of limitations grounds, nor has it raised any defense that would require the court to characterize Marwil's claim at this stage as arising under either tort or contract.
Fed.R.Civ.P. 15(a) gives the district court discretion whether to grant a litigant leave to amend a complaint. Unless factors such as undue delay come into play, "[i]f the underlying facts or circumstances relied upon by the plaintiff may be a proper subject of relief, he ought to be afforded an opportunity to test his claim on the merits." Foman v. Davis, 371 U.S. 178, 182 (1962).
Moreover, Marwil also asserts that the agreement between CEG and Ent Imler contains specific obligations beyond the legally implied standard of care as expressed by generally accepted accounting standards. Without further factual development, it is not clear from the language of the December 2, 1997 engagement letter that Marwil's assertion is incorrect. If it turns out that the agreement contains terms and standards over and above the general standard of care applied to accountants, Marwil's claim could be viable as a breach of contract for the purposes of trial. Lewis v. Methodist Hospital, Inc., 326 F.3d 851, 854 (7th Cir. 2003).
Conclusion
For the foregoing reasons, defendant's motion to dismiss the Amended Complaint is hereby denied.
So ordered.