Monday, October 19, 2015

Commodity Customers Seek High Court Review of MF Global Auditor Negligence

By Lene Powell, J.D.

A group of commodity customers asked the Supreme Court to decide whether their professional negligence claims against PricewaterhouseCoopers (PwC) were improperly barred on the basis of in pari delicto, as the Second Circuit ruled. The former customers of failed commodities brokerage MF Global contend that, as auditor, PwC failed to detect major problems in the firm’s internal controls. Barring their state law negligence claim would “eviscerate” the federal statutory and regulatory scheme designed to protect commodities customers, they argued in a petition for certiorari (In re MF Global Holdings Ltd. Investment Litigation, October 13, 2015).

MF Global failure. MF Global, Inc. was a futures commission merchant (FCM) that accepted deposits from customers to trade commodity futures. Under Section 4d of the Commodity Exchange Act and CFTC Regulation 1.20, MF Global was strictly required to keep customer funds segregated from its own house accounts. In 2010 and 2011, PwC issued “clean” audit reports for MF Global. However, under margin pressure from its large proprietary trades, MF Global management had customer accounts raided for funds to keep the firm afloat. As the brokerage neared collapse and entered into negotiations with a buyer, due diligence revealed a $900 million shortfall in customer funds. The buyer pulled out and MF Global filed for bankruptcy in October 2011, resulting in catastrophic losses for customers that were not fully recovered until 2014.

The Securities Investor Protection Corporation (SIPC) filed an action against MF Global in district court, and a SIPA trustee was appointed. Customers filed claims against MF Global, its executives, and PwC in its role as auditor. The trustee assigned the MG Global estate’s professional negligence claim against PwC to the petitioners. The district court dismissed the claim on the basis of the common law in pari delicto doctrine, saying MF Global bore at least equal responsibility for the violations. Upon appeal, the Second Circuit affirmed, explaining that petitioners had not identified any federal statute that preempted the New York law of in pari delicto.

Auditor’s role in customer protection. According to the petitioners, if PwC had adequately performed its audits, it would have discovered and reported that MF Global had virtually no internal controls for safeguarding customer deposits. The firm would then have been forced to repair the controls, and the loss of customer deposits would have been avoided.

As auditor, PwC assumed a special duty to evaluate MF Global’s controls for safeguarding customer deposits, the petitioners asserted. Audits of FCMs by independent auditors like PwC are a “keystone” of the federal statutory and regulatory regime to protect commodity investors, in part because deposits of commodity customers are not insured by FDIC or SIPC, so customers are protected only by the customer segregated funds requirements. Compliance with these requirements used to be inspected by the CFTC, but independent auditors now conduct the annual audits under Regulation 1.16. Thus, unlike audits of public companies, audits by independent auditors of FCM perform a de facto regulatory function. Private enforcement of the regulation is limited, as customers cannot directly sue auditors for failure to properly conduct a Regulation 1.16 evaluation.

Precedent in support. The petitioners argued that allowing the in pari delicto defense would immunize FCM auditors from liability and remove any threat of enforcement. They pointed to a series of Supreme Court cases in support of the argument that the in pari delicto doctrine must not interfere with the private enforcement of federal laws that protect the public.

In Perma Life, the Court said that private actions served the purpose of the antitrust laws by presenting a threat to anyone thinking of violating laws, and that focusing on the plaintiff’s wrongdoing undermined important enforcement objectives. This ruling was reinforced in Bateman Eichler, in which the Court ruled that a private action seeking to enforce federal securities laws could only be barred by in pari delicto if the plaintiff bore equal responsibility for the wrongdoing and preclusion of the suit would not interfere with enforcement of the laws and protection of the public. Finally, in Pinter v. Dahl, the Court said that plaintiff’s recovery may be barred only if preclusion of the suit would offend underlying statutory policies, including investor protection under federal securities laws.

The question is whether the reasoning in this line of cases extends to private state law claims seeking to enforce a federal regulatory regime that protects commodity investors. Applying in pari delicto would render Regulation 1.16 meaningless and erode important federal statutory and regulatory protections governing commodity customer deposits. Therefore, urged petitioners, the answer is yes.

The case is No. 15-481 (Deangelis v. Corzine, Bearing Fund LP v. PricewaterhouseCoopers LLP).

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