Opinion
DOCKET NO. A-4862-11T3
07-01-2013
SANDALWOOD DEBT FUND A, L.P., SANDALWOOD DEBT FUND B, L.P., HUDSON INVESTMENT PARTNERS, L.P., OXBRIDGE ASSOCIATES, L.P., Plaintiffs-Appellants, v. KPMG, LLP, Defendant-Respondent.
Laurence B. Orloff argued the cause for appellants (Orloff, Lowenbach, Stifelman & Siegel, P.A., attorneys; Mr. Orloff, of counsel and on the briefs; David Gorvitz, on the briefs). Gregory G. Ballard (Sidley Austin LLP) of the New York Bar, admitted pro hac vice, argued the cause for respondent (Drinker Biddle & Reath LLP, and Mr. Ballard, attorneys; Gary F. Bendinger (Sidley Austin LLP) of the New York Bar, admitted pro hac vice, Gazeena Soni (Sidley Austin LLP) of the New York Bar, admitted pro hac vice, Vincent E. Gentile, Matthew S. Barndt, and Mr. Ballard, on the brief).
NOT FOR PUBLICATION WITHOUT THE
APPROVAL OF THE APPELLATE DIVISION
Before Judges Fisher, Alvarez and St. John.
On appeal from Superior Court of New Jersey, Law Division, Essex County, Docket No. L-10255-11.
Laurence B. Orloff argued the cause for appellants (Orloff, Lowenbach, Stifelman & Siegel, P.A., attorneys; Mr. Orloff, of counsel and on the briefs; David Gorvitz, on the briefs).
Gregory G. Ballard (Sidley Austin LLP) of the New York Bar, admitted pro hac vice, argued the cause for respondent (Drinker Biddle & Reath LLP, and Mr. Ballard, attorneys; Gary F. Bendinger (Sidley Austin LLP) of the New York Bar, admitted pro hac vice, Gazeena Soni (Sidley Austin LLP) of the New York Bar, admitted pro hac vice, Vincent E. Gentile, Matthew S. Barndt, and Mr. Ballard, on the brief). PER CURIAM
Plaintiffs, Sandalwood Debt Fund A, L.P., Sandalwood Debt Fund B, L.P., Hudson Investment Partners, L.P., and Oxbridge Associates, L.P., appeal from the April 27, 2012 order of the Law Division granting defendant KPMG, LLP's motion to stay the action against it and to compel arbitration.
Plaintiffs claim error in the motion judge's order on the ground that their claims are not bound by KPMG's engagement letters with Tremont Partners, Inc. (Tremont Partners), Tremont Capital Management, Inc. (Tremont Capital), and Rye Investment Management (RIM), which provided arbitration as the sole method of dispute resolution. Following our review of the arguments advanced on appeal, in light of the record and applicable law, we affirm.
The parties do not dispute that the engagement letters required arbitration of disputes.
I.
We briefly summarize the relevant procedural history and the facts based on the record before us.
This matter relates to the fraudulent Ponzi investment scheme run by Bernard L. Madoff through his broker-dealer Bernard L. Madoff Investment Securities LLC (BMIS). Plaintiffs were limited partners of three hedge funds: (1) Rye Select Broad Market Fund, L.P.; (2) Rye Select Broad Market Prime Fund, L.P.; and (3) Rye Select Broad Market XL Fund, L.P. (collectively, Rye Funds). The Rye Funds served as feeder funds to BMIS and were being managed by Tremont Partners, as the Rye Funds' general partner. The Rye Funds are Delaware limited partnerships. Tremont Partners, in conjunction with RIM, performed management functions with regard to the Rye Funds. In 2009, Tremont Partners advised the limited partners of the Rye Funds that the funds had lost substantially all of their value and that it appeared there were no prospects for meaningful recovery of those assets.
See Commonwealth of Massachusetts v. Ponzi, 256 Mass. 159 (1926).
This structure is commonly associated with hedge funds and is used to pool together assets from both foreign and local investors in order to keep costs down, achieve better economies of scale and better tax efficiencies. Investors place their money in one of several funds known as "feeders." The feeders, in turn, invest their assets in one "master fund," which makes all the investment decisions for the portfolio. Financial Times LEXICON (2013), http://lexicon.ft.com/Term?term=master_feeder-fund (last visited June 19, 2013).
The facts surrounding Madoff's multibillion dollar Ponzi scheme are widely known and were recounted in detail by the bankruptcy court. In re Bernard L. Madoff Inv. Sec. LLC, 424 B.R. 122, 125-32 (Bankr. S.D.N.Y. 2010). When customers, such as the Rye Funds, invested with BMIS they relinquished all investment authority to Madoff. Madoff collected funds from investors claiming to invest those funds pursuant to what he styled a "split-strike conversion strategy," producing consistently high rates of return on investments. The split-strike conversion strategy supposedly involved buying a basket of stocks listed on the Standard & Poor's 100 Index and hedging through the use of options. However, Madoff never invested those customer funds. Instead, Madoff generated fictitious paper account statements and trading records in order to conceal the fact that he engaged in no trading activity whatsoever. Other now revealed irregularities make it clear that "Madoff never executed his split-strike investment and hedging strategies, and could not possibly have done so." Id. at 130. To point out just two examples, "an unrealistic number of option trades would have been necessary to implement the . . . [s]trategy" and "one of the money market funds in which customer resources were allegedly invested through BLMIS . . . has acknowledged that it did not even offer investment opportunities in any such money market fund from 2005 forward." Ibid.
KPMG, a Delaware limited liability partnership, was retained by each of the Rye Funds to audit its financial condition and prepare an annual Independent Auditors' Report. On December 23, 2011, plaintiffs brought suit against KPMG asserting professional malpractice, breach of fiduciary duty, negligent misrepresentation, and breach of contract.
A number of limited partners in the Rye Funds sued the Tremont and Rye entities which actions eventually settled. As part of that settlement the Rye Funds assigned their potential claims against KPMG to the settling parties. The plaintiffs opted out of the settlement.
KPMG moved to compel arbitration and stay the action, or in the alternative to dismiss the complaint. The motion judge granted KPMG's motion staying the action and compelling arbitration. It is from that order that plaintiffs appeal.
Plaintiffs contend that the motion judge erred in finding plaintiffs' claims to be derivative and thus compelling arbitration. KPMG claims that plaintiffs cannot establish an independent duty sufficient to justify bringing direct claims because they cannot show: (1) that KPMG was aware of the identities of the specific nonprivy parties who would be relying on their reports; (2) that there was any direct contact between plaintiffs and KPMG; and (3) that KPMG did not provide plaintiffs with any particularized information. Rather, pursuant to contract, KPMG audited the financial statements of the Rye Funds. According to KPMG, all plaintiffs' claims are subject to the engagement letters principally because the claims are derivative in nature and belong exclusively to the Rye Funds, which are bound by the arbitration provisions. Consequently, they argue that the Rye Funds' limited partners, plaintiffs herein, lack standing to assert those claims directly. KPMG also maintains that even if the claims are direct, they are still subject to the arbitration provisions in the engagement letters.
II.
As a preliminary matter, we note the applicable standard of our review on appeal. Because the matter at issue is legal in nature, our review of the motion judge's decision is plenary. First Options of Chicago, Inc. v. Kaplan, 514 U.S. 938, 947-48, 115 S. Ct. 1920, 1926, 131 L. Ed. 2d 985, 995-96 (1995) (holding the review of arbitration award requires no special standard, findings of fact must be accepted if not clearly erroneous, and questions of law are decided de novo); see also Manalapan Realty v. Twp. Comm. of Manalapan, 140 N.J. 366, 378 (1995) ("A trial court's interpretation of the law and the legal consequences that flow from established facts are not entitled to any special deference."). Where the issues involve contract interpretation and the application of case law to the facts of the case, our standard of review is de novo. Hutnick v. ARI Mut. Ins. Co., 391 N.J. Super. 524, 528 (App. Div.), certif. denied, 192 N.J. 70 (2007).
We firmly adhere to the principle that "arbitration is . . . 'favored . . . as a means of resolving disputes[.]'" Angrisani v. Fin. Tech. Ventures, L.P., 402 N.J. Super. 138, 148 (App. Div. 2008) (quoting Martindale v. Sandvik, Inc., 173 N.J. 76, 84 (2002)). "The affirmative policy of this State, both legislative and judicial, favors arbitration as a mechanism to resolve disputes." Alfano v. BDO Seidman, LLP, 393 N.J. Super. 560, 575 (App. Div. 2007). New Jersey jurisprudence and public policy favor alternative dispute resolution and are consistent with our view that "[l]itigation ought to be a last resort, not a first one." Billig v. Buckingham Towers Condo. Ass'n, 287 N.J. Super. 551, 564 (App. Div. 1996). A strong public policy favors arbitration as a means of dispute resolution and "'[a]n agreement to arbitrate should be read liberally in favor of arbitration.'" Angrisani, supra, 402 N.J. Super. at 148 (quoting Marchak v. Claridge Commons, Inc., 134 N.J. 275, 282 (1993)); see also Bruno v. Mark MaGrann Assocs., 388 N.J. Super. 539, 545 (App. Div. 2006) (citing Young v. Prudential Ins. Co. of Am., 297 N.J. Super. 605, 617 (App. Div.), certif. denied, 149 N.J. 408 (1997)).
"[D]oubts concerning the scope of arbitrable issues must be resolved in favor of arbitration, over litigation." Alfano, supra, 393 N.J. Super. at 576. "An agreement relating to arbitration should thus be read liberally to find arbitrability if reasonably possible." Jansen v. Salomon Smith Barney, Inc., 342 N.J. Super. 254, 257 (App. Div.), certif. denied, 170 N.J. 205 (2001).
III.
A. Conflict of Laws
As a threshold inquiry, we must determine whether the laws of New York, as argued by plaintiffs, or the laws of Delaware, as contended by KPMG, apply to this dispute. Because New Jersey is the forum state, our conflict of law principles apply.
In P.V. v. Camp Jaycee, 197 N.J. 132 (2008), our Supreme Court endorsed the "most significant relationship" test to decide choice-of-law questions in claims that sound in tort. New Jersey's most significant relationship test consists of two prongs. The first prong requires the court to determine whether there is an actual conflict between the laws of the states involved or whether a false conflict exists. See Id. at 143-44; see also Erny v. Estate of Merola, 171 N.J. 86 (2002); LeJeune v. Bliss-Salem, Inc., 85 F.3d 1069, 1071 (3d Cir. 1996). The conflict is determined by whether a "distinction" exists between the substance of the potentially applicable laws. Camp Jaycee, supra, 197 N.J. at 143. Where there is no actual conflict, the analysis ends. The second prong of the most significant relationship test requires the court to weigh the factors enumerated in the Restatement section corresponding to the plaintiffs' cause of action. See id. at 143-44.
Here, we must determine if a distinction exists between the relevant laws of New York and Delaware with regard to whether plaintiffs' claims are direct or derivative.
A New York appellate court has recently adopted Delaware's Tooley standard to determine if claims are direct or derivative, See Yudell v Gilbert, 949 N.Y.S.2d 380, 383-84 (App. Div. 2012). Furthermore, whether plaintiffs can bring a suit as a limited partner to vindicate claims of injuries directly felt by the partnership is a question of corporate law. On such questions of corporate law, New York law defers to the state of incorporation: New York courts "look to the law of the state of incorporation in adjudicating a corporation's 'internal affairs,' including questions as to the relationship between the corporation's shareholders and its directors." Galef v. Alexander, 615 F.2d 51, 58 (2d Cir. 1980); see also N.Y. Ltd. Liab. Co. Law § 801(a) ("[T]he laws of the jurisdiction under which a foreign limited liability company is formed govern its organization and internal affairs."); N.Y. PTR. Law. §§ 90-119. The law of the state of incorporation also governs the question whether a particular shareholder suit is direct or derivative. Seidl v. Am. Century Companies, Inc., 713 F. Supp. 2d 249, 255 (S.D.N.Y. 2010) aff'd, 427 F. Appx. 35 (2d Cir. 2011); Finkelstein v. Warner Music Grp. Inc., 820 N.Y.S.2d 264, 266 (App. Div. 2006). Here, the Rye Funds are organized under the laws of Delaware. Thus, for the foregoing reasons, Delaware law applies.
Tooley v Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004)
B. Arbitration
KPMG's argument is essentially that to the extent plaintiffs' claims are derivative, they necessarily are subject to arbitration under the Federal Arbitration Act, 9 U.S.C.A. §§ 1 to -16 (2006).
Under Tooley, the question of whether a claim is direct or derivative "must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?" Supra, 845 A.2d at 1033 (emphasis in original). Although the Tooley formulation provides a two-part analysis for determining whether an asserted claim is direct or derivative, there are some limited exceptions where the same facts may support both direct and derivative claims. See, e.g., Gentile v. Rossette, 906 A.2d 91, 99-100 (Del. 2006); Loral Space & Commc'ns Inc. v. Highland Crusader Offshore P'rs, L.P., 977 A.2d 867, 868, 870 (Del. 2009). Neither the Gentile nor the Loral framework, nor their factual underpinnings, have any application to the claims asserted by plaintiffs.
Plaintiffs contend that we should be guided by Askenazy v. KPMG LLP, 83 Mass. App. Ct. 649 (Mass. App. Ct. 2013), which involved facts almost identical to the issues before us. There, KPMG moved for arbitration asserting the same arguments concerning direct and derivative claims as here. The court in Askenazy concluded that the plaintiffs' claims, which were "inducement-based, are direct and not subject to the arbitration provisions in the engagement letters." Id. at 657. We respectfully disagree. In Askenazy the court stated:
In Stephenson v. Citco Group Ltd., 700 F. Supp. 2d 599 (S.D.N.Y. 2010), for example, the court, applying Tooley, noted that, as matter of Delaware law, some claims arising out of a case or controversy could be direct while others arising out of the same case or controversy could be derivative. Id. at 610, citing Grimes v. Donald, 673 A.2d 1207, 1212-1213 (Del. 1996). As a result, while the partnership could bring derivative claims based on the auditor's fiduciary or contractual duty to the partnership, the plaintiffs could bring direct claims based on the auditor's independent duty to them as investors.Stephenson's complaint was subsequently dismissed. Stephenson v. Pricewaterhousecoopers, LLP, 768 F. Supp. 2d 562 (S.D.N.Y. 2011), aff'd, 482 F. Appx. 618 (2d Cir. 2012). Granting the motion to dismiss the trial judge in Stephenson stated:
[Ibid.]
As one court in this district has noted in rejecting claims against auditors of other BMIS feeder funds, "[t]he notion that a firm hired to audit the financial statements of one client . . . must conduct audit procedures on a third party that is not an audit client (BMIS) on whose financial statements the audit firm expresses no opinion has no basis."
[Id. at 580-81 (citations omitted).]
Of course the grounds for dismissal in Stephenson do not resolve the competing direct or derivative claims. Plaintiffs also argue that the holding in Anwar v. Fairfield Greenwich, Ltd., 728 F. Supp. 2d 372 (S.D.N.Y. 2010), another Madoff-feeder fund matter, should guide our consideration. There, the judge determined that the investors' claims could be brought directly against certain defendants who were outsiders to the feeder funds. In that case, the plaintiffs claimed that as a result of the defendants' negligence they were: (1) induced to invest in the feeder funds; and (2) induced to retain their investments in the feeder funds. Ibid.
These were investment managers, administrators, custodians, and auditors.
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Under the doctrine first expressed in Ultramares Corp. v. Touche, 255 N.Y. 170 (1931), and established in Credit Alliance Corp. v. Arthur Andersen & Co., 493 N.Y.S.2d 435 (1985), an auditor can be held liable for damages suffered by a non-client due to reliance on negligently prepared audit reports where a sufficient relationship exists between them. In Credit Alliance, the New York Court of Appeals set forth a three-part test to determine when parties who are not in direct privity with accountants have a relationship sufficient to hold them liable in a negligence action. The court required that:
(1) the accountants must have been aware that the financial reports were to be used for a particular purpose or purposes; (2) in the furtherance of which a known party or parties was intended to rely; and (3) there must have been some conduct on the part of the accountants linking them to that party or parties, which evinces the accountants' understanding of that party or parties' reliance.
[Id. at 443.]
In Saltz v. First Frontier, the plaintiffs, trustees of funds that invested in feeder funds to Madoff, alleged that they received financial statements from the auditor defendants who "knew that their [reports] would be provided to the Fund's Members and potential investors in the Fund and would be relied on by them in making investment decisions concerning the Fund." 782 F. Supp. 2d 61, 83-4 (S.D.N.Y. 2010), aff'd sub nom., 485 F. Appx. 461 (2d Cir. 2012). The court held that such a "broad allegation of a duty owed to all potential investors is not sufficient to demonstrate a 'near privity' relationship." Id. at 84.
Plaintiffs make similar allegations here. Plaintiffs allege that KPMG knew and intended that its audit reports would be provided to investors in the Rye Funds, including plaintiffs, and that plaintiffs would rely on the audit reports regarding their initial investment, investment holdings, and additional investments in the Rye Funds. KPMG argues that the instant case is analogous to Saltz and that plaintiffs have failed to establish sufficient privity. We agree.
We consider, in particular, the requirements for recognizing liability of professionals to third parties that New York courts have developed in the analogous context of negligent misrepresentation claims. To meet these requirements, as set out in Credit Alliance Corp., supra, 493 N.Y.S.2d at 443, a plaintiff must establish: (1) defendant had awareness that its work was to be used for a particular purpose; (2) there was reliance by a third party known to defendant in furtherance of that purpose; and (3) there existed some conduct by the defendant linking it to that known third party evincing the defendant's understanding of the third party's reliance. See also Touche, supra, 255 N.Y. 170; Glanzer v. Shepard, 233 N.Y. 236 (1922).
The New York Court of Appeals has described this burden as requiring the plaintiff to demonstrate a relationship between plaintiff and defendant that is "so close as to approach that of privity, if not completely one with it." Credit Alliance Corp., supra, 493 N.Y.S.2d at 442 (emphasis and quotation marks omitted). Put another way, plaintiff must show that the benefit to the non-party was the "end and aim of the transaction." Ibid. (emphasis and quotation marks omitted). In short, a plaintiff that can satisfy these requirements will also be within the limits established under New York law for tort claims sounding in negligence that are brought by nonprivy third parties.
Here, plaintiffs do not allege that KPMG agreed to provide audit reports directly to them, or that KPMG knew that providing such information to investors was the primary purpose of its engagement. Although they allege the audit reports were addressed to the "partners," plaintiffs merely allege a broad duty, but they have not alleged that KPMG specifically addressed the audit reports to them. We do not find KPMG's conduct sufficient to establish privity because it does not demonstrate sufficient "linking conduct."
Under New York law, a plaintiff claiming negligence "against an accountant with whom he has no contractual relationship faces a heavy burden." Sec. Investor Prot. Corp. v. BDO Seidman, LLP, 222 F.3d 63, 73 (2d Cir. 2000). Accountants may not be held liable in negligence to "noncontractual parties who rely to their detriment on inaccurate financial reports," unless a plaintiff shows: (1) that the accountants were "aware that the financial reports were to be used for a particular purpose or purposes[;]" (2) "in the furtherance of which a known party or parties was intended to rely[;]" and (3) "some conduct on the part of the accountants linking them to that party or parties, which evinces the accountants' understanding of that party or parties' reliance." Credit Alliance Corp., supra, 493 N.Y.S.2d at 443. "The words 'known party or parties' in the Credit Alliance test mean what they say[;]" plaintiffs must show that the accountants knew "the identity of the specific nonprivy party who would be relying" upon their reports. Sykes v. RFD Third Ave. 1 Assocs., LLC, 912 N.Y.S.2d 172, 174 (2010) (quotation marks omitted).
Plaintiffs failed to show that KPMG was aware of the identities of the specific nonprivy parties who would be relying upon their reports. Moreover, plaintiffs' pleadings do not satisfy the third prong of the Credit Alliance test because plaintiffs have failed to allege any form of direct contact between them and KPMG. See Sec. Investor Prot. Corp., supra, 222 F.3d at 75. Plaintiffs' allegation that KPMG addressed their audit reports to "The Partners" of the funds, is not sufficient given that Tremont, not KPMG, sent the reports to the limited partners. "The fact that plaintiffs were entitled to and received a copy of the audited financial statements, or that [KPMG] knew that the investors would rely upon the information contained in the financial statements, does not establish the requisite linking conduct." CRT Invs., Ltd. v. BDO Seidman, LLP, 925 N.Y.S.2d 439, 441 (App. Div. 2011).
Having determined that no privity or near privity exists, we turn to the Tooley test. The determination of whether a claim is derivative or direct in nature is substantially the same for corporate cases as it is for limited partnership cases. Litman v. Prudential-Bache Props., Inc., 611 A.2d 12, 15 (Del. Ch. 1992). The Tooley test requires answering two questions: (1) who suffered the alleged harm and (2) who would receive the benefit of any recovery or other remedy. Tooley, supra, 845 A.2d at 1035; see also In re J.P. Morgan Chase & Co. S'holder Litig., 906 A.2d 808, 817 (Del. Ch. 2005), aff'd, 906 A.2d 766 (Del. 2006). The manner in which a plaintiff labels its claim and the form of words used in the complaint are not dispositive; rather, the court must look to the nature of the wrong alleged, taking into account all of the facts alleged in the complaint, and determine for itself whether a direct claim exists. In re J.P. Morgan Chase, supra, 906 A.2d at 817; see also In re First Interstate Bancorp Consol. S'holder Litig., 729 A.2d 851, 860 (Del. Ch. 1998)).
As to the first prong of the test set forth in Tooley, the "stockholder's claimed direct injury must be independent of any alleged injury to the corporation . . . . The stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation." Tooley, supra, 845 A.2d at 1039; In re J.P. Morgan Chase, supra, 906 A.2d at 817. If the nature of the injury is such that it falls directly on the business entity as a whole and only secondarily on individual investors as a function of and in proportion to their pro rata investment in the entity, then the claim is derivative and must be prosecuted on behalf of the entity. See Tooley, supra, 845 A.2d 1033; see also In re Syncor Int'l Corp. S'holders Litig., 857 A.2d 994, 997 (Del. Ch. 2004). Regarding the second prong of the Tooley test, in order to maintain a direct claim, stockholders must show that they will receive the benefit of any remedy. See Big Lots Stores, Inc. v. Bain Capital Fund VII, LLC, 922 A.2d 1169, 1179 (Del. Ch. 2006) (noting that a direct claim is one in which "no relief flows to the corporation").
Although the plaintiffs contend their claims are "direct," KPMG points out that the claims stem from a diminution in the value of the Rye Funds resulting from Madoff's theft of Rye Fund assets, enabled by the allegations against KPMG. The injury for which plaintiffs seek redress, therefore, was suffered by the Rye Funds. Because these injuries were suffered by the Rye Funds, and only indirectly by plaintiffs as limited partners, we agree this fact supports KPMG's assertion that plaintiffs' claims are derivative and not direct. Plaintiffs have failed to show that the injury is independent of any alleged injury to the limited partnership. See Tooley, supra, 845 A.2d at 1039; In re J.P. Morgan Chase, supra, 906 A.2d at 817.
The second prong of the Tooley test, who would receive the benefit of any recovery or other remedy, also supports KPMG's contention that the claims are derivative. Here, the claimed damages would not benefit plaintiffs alone but would inure to the benefit of the Rye Funds, and all partners accordingly. See, e.g., Litman v. Prudential-Bache Props., Inc., 611 A.2d 12, 16 (Del. Ch. 1992) (holding that where "[t]he diminution in the value of their interests flows from the damage inflicted directly on the Partnership . . . . [the] cause of action is derivative in nature").
We conclude that plaintiffs' claims are derivative, and therefore, they are bound by the provisions in the engagement letters mandating arbitration of disputes.
Affirmed.
I hereby certify that the foregoing is a true copy of the original on file in my office.
CLERK OF THE APPELLATE DIVISION