Isakov v. Ernst & Young, Ltd. (Bermuda) et al

Filing 75

MEMORANDUM DECISION granting in part and denying in part 57 Motion to Dismiss or in the alternative, to Enforce Arbitration and Forum Selection Provisions. Status Report due 4/20/12. Signed by Judge Mark R. Kravitz on 3/19/12. (Brown, S.)

UNITED STATES DISTRICT COURT
DISTRICT OF CONNECTICUT

TERENCE ISAKOV,

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Plaintiff,
v.
ERNST & YOUNG, LTD. (BERMUDA), and
ERNST & YOUNG, LTD. (BAHAMAS),
Defendants.

No. 3:10cv1517 (MRK)

MEMORANDUM OF DECISION
Plaintiff Terence Isakov brings suit on his own behalf, and on behalf of all others who
invested in the Stewardship Credit Arbitrage Fund, LLC (the "Fund") between March 15, 2006
and September 25, 2008, against Ernst & Young, Ltd. (Bermuda) & Ernst & Young, Ltd.
(Bahamas) (collectively "E&Y"). Count I arises under § 10(b) of the Securities Exchange Act of
1934 ("the Exchange Act"), 15 U.S.C. § 78j(b), and the rules and regulations promulgated
thereunder by the United States Securities and Exchange Commission ("SEC"), including Rule
10b-5, 17 CFR § 240.10b-5(b). 1 Count II is a state law claim for professional negligence or
malpractice.
Pending before the Court is E&Y's Motion to Dismiss, or in the alternative, to Enforce
Arbitration and Forum Selection Provisions [doc. # 57], which the Court grants in part and
denies in part. As discussed below, the Court finds that Dr. Isakov fails to state a § 10(b) claim
because he does not adequately allege scienter and that his claims of negligence or professional
1

Although the Third Amended Complaint states that the claims include a § 20(a) claim under the
Exchange Act, see Third Am. Compl. [doc. # 56] ¶ 16, this appears to be a vestigial sentence
from a previous draft. Only two claims for relief are formally listed, neither of which address
potential § 20(a) liability.
1

malpractice are derivative and therefore are governed by the E&Y-Fund arbitration agreement.
Dr. Isakov fails to establish the elements of a fraudulent inducement claim, but he does state a
direct negligent inducement claim that survives this motion to dismiss.

I.
The following facts are taken from Dr. Isakov's Third Amended Class Action Complaint
[doc. # 56] unless otherwise noted. As this is a motion to dismiss, all facts are read in the light
most favorable to Dr. Isakov. See Matson v. Bd. of Educ. of City School Dist. of New York, 631
F.3d 57, 63 (2d Cir. 2011).

A.
Dr. Isakov's spouse originally invested in the Fund. Thereafter, in his role as the manager
of the Isakov Family LLC, his family's investment vehicle, Dr. Isakov invested in the Fund in
January 2005. On September 1, 2006, in reliance on a Private Placement Memorandum and on
E&Y's audits, Dr. Isakov, as an individual, purchased $450,000 in Class A shares through his
IRA. The required initial minimum contribution for an investor to become a member throughout
the Class Period was $1 million, although subsequent contributions could be in lesser amounts.
The Fund's assets consisted primarily of promissory notes purchased from an affiliate,
Acorn Capital Group, LLC ("Acorn"). Marlon Quan was the sole member and/or Managing
Member of Acorn, and represented that he was Acorn's President and owner. Mr. Quan was also
the sole member of Stewardship Investment Advisors, LLC ("Advisors"), an entity that made all
of the Fund's investment and trading decisions. Mr. Quan exercised near complete control over
Acorn, Advisors, and the Fund. Dr. Isakov also alleges that, for all intents and purposes, Acorn,
Advisors, and the Fund operated as a single enterprise: they were housed in the same offices,

2

shared employees (whose number never exceeded twenty individuals), and no distinction was
made between the businesses. Mr. Quan also dominated the Off-Shore Fund, which was
essentially identical to the Fund insofar as Advisors was its investment advisor, E&Y were its
auditors, and Acorn was the source of its loans.
Gustav E. Escher, III was the Fund's "Independent Manager." As such, he was
responsible for evaluating the fairness of transactions between Acorn and the Fund. Dr. Isakov
alleges that—as a friend and former co-worker of Mr. Quan's, as a director of the Off-Shore
Fund, and as one of the Fund's subsidiaries—Mr. Escher was conflicted and his "independent"
role was negated.
Both E&Y Bermuda and E&Y Bahamas are member firms of E&Y Global, one of the
"big four" globally-respected accounting firms. Pursuant to annual engagement letters between
E&Y and the Fund, the Fund was bound by an arbitration clause requiring that
[a]ny dispute or claim arising out of or relating to services covered by this
agreement or any other services hereafter provided by or on behalf of E&Y or any
of its subcontractors or agents to the Fund or at its request (including any matter
involving any third party for whose benefit any such services are provided), shall
be submitted first to voluntary mediation, and if mediation is not successful, then
to binding arbitration, in accordance with the dispute resolution procedures set
forth in the attachment to this letter.
Defs.' Mot to Dismiss [doc. # 57-4] ¶ 22 (Engagement Letter of November 16, 2005); see also
Defs.' Mot. to Dismiss [doc. # 57-5] ¶ 25 (Engagement Letter of December 7, 2006) (same).
E&Y also served as the auditors for Acorn, and during the Class Period, E&Y had full access to
the Fund's and Acorn's financial books and records and allegedly reviewed their financial
statements.
Given Mr. Quan's various roles and Mr. Escher's conflict, Dr. Isakov alleges that E&Y
were the only disinterested, wholly independent observers of the Fund's financial condition and

3

the validity of its transactions with other entities. Given this important role, E&Y's reputation,
and the representations in Fund materials regarding E&Y, Dr. Isakov alleges that E&Y
understood that Acorn and the Fund used their audits to establish financial credibility and that
current and potential investors would place great weight on their audits in making investment
decisions. Dr. Isakov specifically alleges that, as a Fund member on behalf of his family's
investment vehicle, he received E&Y's audit reports and the annual audited financial statements
since 2005 and relied on these documents when he made his personal investment in 2006.

B.
The Fund distributed Confidential Private Placement Memoranda ("PPMs") to
prospective and existing Fund members, which identified E&Y as the Fund's auditor and
outlined a series of practices Acorn would employ to ensure that all of its loans were well
secured. The Fund's promotional materials also emphasized that E&Y was hired in part to
examine the books of intermediaries—the companies to which Acorn would make loans—and
Fund investors would be provided with audits of both the Fund and Acorn.
E&Y Bermuda issued clean audits of the Fund on March 31, 2003 for 2002; on March 5,
2004 for 2003; on March 7, 2005 for 2004 (with a disclaimer that E&Y had not been engaged to
perform an audit of the Fund's internal control over financial reporting); on March 15, 2006 for
2005; and on March 27, 2007 for 2006. E&Y Bahamas issued a clean audit of the Fund on
March 31, 2008 for 2007. In the statements issued in 2003, 2004, 2005, 2007 and 2008, E&Y
stated that the audit was conducted in accordance with generally accepted accounting principles.
According to Dr. Isakov, E&Y audits were addressed and provided to Dr. Isakov and other
members of the proposed class. However, Dr. Isakov and other class members never received the
Acorn audits, as promised in the PPMs.
4

As of April 30 2008, over 70% of the value of the Fund's assets (about $85 million) were
tied up in loans Acorn made to a single borrower—PAC Funding, LLC ("PAC"), a company
owned and controlled by Thomas J. Petters. 2 PAC claimed to be in the business of purchasing
excess foreign high-end consumer electronics and reselling them to "big box" retailers, such as
BJ's Wholesale Club, and it supposedly needed short-term loans to cover the acquisition of the
goods and the time that elapsed before it was able to resell them. Each of the PAC loans was
supposed to be secured by the underlying merchandise and a $50 million personal guarantee
from Mr. Petters. The loans were also safeguarded by a lockbox agreement, according to which
Acorn was supposed to receive payments directly from the retailers to whom PAC was selling its
merchandise as sales were made. 3 Instead, PAC made monthly payments into the lockbox
account. E&Y confirms that it did not audit Mr. Petters or his companies, contrary to the Fund's
PPM statements. See Defs.' Mot. to Dismiss [doc. # 57-1] at 1 (Mem. in Support of Mot. to
Dismiss).
PAC began falling behind in its payments in the spring of 2007. By February 2008, PAC

2

In 2001, Acorn conducted approximately 33 successful note transactions with Redtag, another
Petters corporation. In 2002, Acorn began entering into transactions with PCI, also a Petters
company, which ultimately totaled approximately 149 note transactions worth over $585 million.
In November 2004, Acorn began entering into note transactions with PAC, which ultimately
totaled 491 note transactions worth over $1.9 billion. These, as well as other agreements with
Petters companies, resulted in Acorn entering into over 670 separate loan transactions with an
aggregate value of over $2.6 billion.
3
The Complaint also notes that many of the Fund's other assets consisted of loans secured in
reliance on Benjamin Zucker's appraisals of jewelry and other antiquities, which served as
collateral for loans made to Ralph Esmerian, Inc. ("Esmerian"). Acorn began making these loans
in December 2006 and required that Esmerian pledge as security collateral with an aggregate
appraised value of at least three times the outstanding principal. In December 2007, Acorn made
additional loans to Vassal Jewels LLC ("Vassal"), which represented that the funds would be
used to purchase Esmerian stock. Again, Vassal was required to pledge collateral with an
aggregate appraised value that met or exceeded the outstanding principal. Acorn, Esmerian, and
Vassal agreed that Mr. Zucker—Mr. Esmerian's longtime friend—and another appraiser would
evaluate the collateral.
5

and Acorn had entered into a Forbearance Agreement, in which Acorn agreed to postpone
foreclosing on PAC's loans in return for a security interest in Polaroid Corp. ("Polaroid")—
another Petters company—and proof that PAC was the legal owner of at least $112 million in
accounts receivable from various retailers. In April 2008, PAC and Acorn restructured the credit
facility of the Initial Credit Agreement from a revolving credit facility to a term facility. After
further defaults, on May 14, 2008, PAC and Acorn further amended the Initial Credit Agreement
to impose burdens on Polaroid and interest in Polaroid's intellectual capital—in effect, replacing
the previous guarantees with Polaroid inventory, account receivables, and trademarks. PAC and
Acorn also engaged in a number of "round-trip loans" in early 2008, whereby PAC would send
Acorn money which Acorn would promptly re-loan to PAC.
In early 2007, the Off-Shore Fund began experiencing liquidity problems. E&Y did not
include any reference to the Off-Shore Fund's problems in any Fund audit, despite the fact that
Acorn's monies were comingled with those of the Off-Shore Fund. The Off-Shore Fund was
found to be insolvent in the fall of 2008.
In early September 2008, it was discovered that Mr. Petters was a convicted felon who
had not filed personal income tax returns since 2005. Mr. Petters had been running a large Ponzi
scheme, and the vast majority of PAC's assets—and, therefore, the Fund's secured collateral—
were illusory. 4
On October 22, 2008, Dr. Isakov and other members of the proposed class received a
memorandum from Advisors that E&Y Bahamas wished to notify them that the Acorn and Fund
audit opinions issued on March 31, 2008 for the 2007 year could not be relied upon.

4

Also in 2008, Esmerian and Vassal defaulted on their loans, and Acorn discovered that Mr.
Zucker had vastly overvalued the collateral, which was actually worth barely 1% of the
appraised value.
6

II.
The Court must apply a familiar standard when ruling on any motion to dismiss for
failure to state a claim pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure. The
Court must "accept as true all allegations in the complaint and draw all reasonable inferences in
favor of the non-moving party." Matson, 631 F.3d at 63 (quotation marks omitted). "To survive a
motion to dismiss, a complaint must contain sufficient factual matter, accepted as true, to 'state a
claim to relief that is plausible on its face.'" Ashcroft v. Iqbal, 129 S. Ct. 1937, 1949 (2009)
(quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)).

III.
Section 10(b) of the Exchange Act forbids the "use or employ, in connection with the
purchase or sale of any security . . . [of] any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the [SEC] may prescribe as necessary or
appropriate in the public interest or for the protection of investors." 5 15 U.S.C. § 78j(b); see also
17 C.F.R. § 240.10b-5 (SEC Rule implementing § 10(b)).
A claim for securities fraud pursuant to § 10(b) of the Exchange Act and SEC Rule 10b-5
requires allegations of "(1) a material misrepresentation or omission by the defendant;
(2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale
of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss
causation." Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179, 2184 (2011) (citations
and quotation marks omitted).
5

The parties do not dispute that the interests in the Fund acquired by Dr. Isakov and other class
members are "securities" pursuant to § 3(a)(10) of the Exchange Act, 15 U.S.C. § 78c(a)(10), in
that they constitute investments in a common enterprise from which the interest owners were to
receive profits solely from the efforts of the Fund's Managing Member. Nor do the parties
contest that these interests are not "covered entities" as defined by 15 U.S.C. § 77r(b).
7

The only element of Dr. Isakov's § 10(b) claim E&Y disputes is whether he has
adequately pled scienter. Scienter is a "mental state embracing intent to deceive, manipulate, or
defraud." Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 319 (2007) (quotations
omitted). The scienter element of a § 10(b) claim is subject to the heightened pleading
requirements of Fed. R. Civ. P. 9(b) and the Private Securities Litigation Reform Act of 1995
("PSLRA"), 15 U.S.C. § 78u-4. See ATSI Commc'ns v. Shaar Fund Ltd., 493 F.3d 87, 99 (2d Cir.
2007). Neither Iqbal, Twombly, Rule 9(b), nor the PSLRA require detailed factual allegations.
See Iqbal, 129 S. Ct. at 1949; Twombly, 550 U.S. at 555; In re Scholastic Corp. Sec. Litig., 252
F.3d 63, 72 (2d. Cir. 2001) (observing that neither Rule 9(b) nor the PSLRA "require the
pleading of detailed evidentiary matter in securities litigation").
However, under both Rule 9(b) and PSLRA, allegations must be made "with
particularity." Telllabs, Inc., 551 U.S. at 314. To establish a strong inference of scienter under
the PSLRA, the inference must be "more than merely plausible or reasonable—it must be cogent
and at least as compelling as any opposing inference of nonfraudulent intent." Id.; Teamsters
Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190, 194 (2d Cir. 2008). In
other words, plaintiffs must "'allege facts that give rise to a strong inference of fraudulent
intent.'" Stephenson v. PricewaterhouseCoopers, LLP, 768 F. Supp. 2d 562, 571 (S.D.N.Y.
2011) (quoting Acito v. IMCERA Grp., Inc., 47 F.3d 47, 52 (2d Cir. 1995)). A strong inference of
scienter may be established by alleging either "(1) that defendants had the motive and
opportunity to commit fraud, or (2) strong circumstantial evidence of conscious misbehavior or
recklessness." ECA & Local 134 IBEW Joint Pension Trust of Chi. v. JP Morgan Chase Co., 553
F.3d 187, 198 (2d Cir. 2009).
The standard for pleading scienter is demanding—and pleading auditor scienter even

8

more so by virtue of the relatively attenuated relationship between auditors and investors. See,
e.g., In re IMAX Sec. Litig., 587 F. Supp. 2d 471, 483 (S.D.N.Y. 2008); In re J.P. Jeanneret
Assoc., Inc., 769 F. Supp. 2d 340, 378 (S.D.N.Y. 2011) ("No Madoff-related case of which this
Court is aware has sustained a federal securities claim against a feeder fund's outside auditors;
courts confronted with such claims routinely dismiss them."). 6
Given the high bar for pleading auditor scienter, "[a]llegations of [Generally Accepted
Auditing Standards or other best practices] violations without corresponding fraudulent intent are
insufficient to state a securities fraud claim against an independent accountant." In re Tremont
Sec. Law, State Law & Sec. Litig., 703 F. Supp. 2d 362, 370 (S.D.N.Y. 2010) (citing Rothman v.
Gregor, 220 F.3d 81, 98 (2d Cir. 2000)). However, "[i]f there is evidence of corresponding
fraudulent intent, [Generally Accepted Auditing Principles and other best practices] violations
may themselves give rise to a strong inference of scienter." In re Ambac Fin. Grp. Sec. Litig.,
693 F. Supp. 2d 241, 273 n.38 (S.D.N.Y. 2010) (quotation marks and citations omitted).
Recklessness may also give rise to a strong inference of scienter if such recklessness is
"conduct that is highly unreasonable, representing an extreme departure from the standards of
ordinary care. It must, in fact, approximate an actual intent to aid in the fraud being perpetrated
by the audited company." Rothman, 220 F.3d at 98 (emphasis added) (quotation marks omitted);
6

As an initial point, Dr. Isakov's argument that this case is factually distinguishable from the
many Madoff cases involving § 10(b) claims against auditors is unconvincing. As evidence of
the distinct facts, Dr. Isakov notes that most auditors in those cases were monitoring the feeder
funds, not the Ponzi schemer. Here, however, E&Y was monitoring both the alleged feeder fund
(the Fund) and the middleman (Acorn). This is a distinction without a difference—especially as
Dr. Isakov also alleges that Acorn and the Fund essentially operated as a single enterprise. In
both cases, the auditor defendant was not responsible for auditing the Ponzi schemer. See In re
Tremont Sec. Law, State Law & Sec. Litig., 703 F. Supp. 2d 362, 371 (S.D.N.Y. 2010) (finding
critical the fact that the auditor of the feeder fund did not audit the third party Ponzi schemer).
Rather, in both situations the defendant auditors reviewed the books of the businesses that—
intentionally or unintentionally—fostered a Ponzi scheme. As a result, the Court is justified in
looking to the many Madoff cases for guidance.
9

see also South Cherry St., LLC v. Hennessee Grp. LLC, 573 F.3d 98, 109 (2d Cir. 2009) ("This
Court has also long held that the scienter element can be satisfied by a strong showing of
reckless disregard for the truth."). As many courts have noted, recklessness in this context means
that the
accounting practices were so deficient that the audit amounted to no audit at all,
or an egregious refusal to see the obvious, or investigate the doubtful, or that the
accounting judgments which were made were such that no reasonable accountant
would have made the same decisions if confronted with the same facts.
In re IMAX Sec. Litig., 587 F. Supp. 2d at 483 (quotation marks omitted); see, e.g., In re
Priceline.com Inc. Sec. Litig., 342 F. Supp. 2d 33, 57 (D. Conn. 2004).
One way in which a complaint might allege that there was effectively no audit at all
would be to claim that the auditors disregarded specific "red flags" that would alert a reasonable
auditor to the likelihood that the audited company was engaged in wrongdoing. See In re AOL
Time Warner, Inc. Sec. & "ERISA" Litig., 381 F. Supp. 2d 192, 204 n.51 (S.D.N.Y. 2004).
"Merely labeling allegations as red flags, however, is insufficient to make those allegations
relevant to a defendant's scienter." In re Marsh & Mclennan Co. Sec. Litig., 501 F. Supp. 2d 452,
487 (S.D.N.Y. 2006). Similarly, "merely alleging that the auditor had access to the information
by which it could have discovered the fraud is not sufficient." In re Tremont, 703 F. Supp. 2d at
370-71 (citing Rothman, 220 F.3d at 98). "In the accounting context, failure 'to identify problems
with the defendant-company's internal controls and accounting practices does not constitute
reckless conduct sufficient for Section 10(b) liability.'" W. Va. Inv. Mgmt. Bd. v. Doral Fin.
Corp., 344 F. App'x 717, 720 (2d Cir. 2009) (quoting Novak v. Kasaks, 216 F.3d 300, 309 (2d
Cir. 2000)) (emphasis in original). When a plaintiff alleges a series of red flags, but not that the
auditor ever became aware of them, dismissal is warranted. See Anwar v. Fairfield Greenwich
Ltd., 728 F. Supp. 2d 372, 452-53 (S.D.N.Y. 2010).
10

Finally, in determining whether the plaintiff has alleged facts supporting a strong
inference of scienter, a court must evaluate "whether all of the facts alleged, taken collectively,
give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in
isolation, meets that standard." Tellabs, 551 U.S. at 323 (emphasis in original); see also id. at
326 ("[T]he court's job is not to scrutinize each allegation in isolation but to assess all the
allegations holistically.").

IV.
In attempting to allege scienter, Dr. Isakov relies primarily on circumstantial evidence
that E&Y acted recklessly. These allegations of recklessness are based on two overarching
claims: that E&Y violated Generally Accepted Accounting Standards ("GAAS") and Generally
Accepted Accounting Practices ("GAAP") and that E&Y ignored numerous red flags.
As GAAS and GAAP violations, taken alone, are not sufficient to support an inference of
scienter, see In re Tremont, 703 F. Supp. 2d at 370, Dr. Isakov sensibly describes these alleged
violations as related to alleged red flags, see In re Ambac Fin. Grp. Sec. Litig., 693 F. Supp. 2d at
273 n.38. To establish scienter, Dr. Isakov must nonetheless allege with particularity facts
evidencing E&Y's fraudulent intent. See id.

A.
Dr. Isakov fails to adequately allege that E&Y knew of many of the alleged red flags,
which impairs his ability to allege scienter. See Stephenson v. Citco Grp. Ltd., 700 F. Supp. 2d
599, 623 (S.D.N.Y. 2010) ("[O]nly those red flags that [the auditor] is alleged to have known of,
or that are so obvious that [the auditor] must have known of them, can support an inference of
intent.").

11

Dr. Isakov maintains that E&Y should have known it was missing significant
documentation—namely, the restructuring agreements and documents related to the round-trip
loans—but he does not allege any specific facts supporting a conclusion that E&Y even knew
this documentation existed, especially as these transactions occurred in early 2008 (after the end
of the 2007 audit).
Dr. Isakov also alleges that Acorn should have known that it was missing documentation
of the existence, shipping, storage, or sale of the collateral securing all of its transactions with
PAC. However, as PAC fabricated documents including "purchase orders, bills of sale and other
documents by 'cutting and pasting' from once-legitimate documents," Third Am. Compl. [doc.
# 56] ¶ 42, Dr. Isakov has not supported his conclusion that E&Y had reason to know the
falsified documents were inaccurate. Similarly, it is not clear how E&Y should have known that
Acorn had not conducted sufficient due diligence regarding Mr. Petters's personal guarantee,
given that Acorn had bank records demonstrating that Mr. Petters had sufficient funds to cover
that guarantee.
Dr. Isakov also alleges that E&Y Bermuda neglected to correct audit reports when they
learned they were false. The Second Circuit has held that
an accountant violates the "duty to correct" and becomes primarily liable under
§ 10(b) and Rule 10b-5 when it (1) makes a statement in its certified opinion that
is false or misleading when made; (2) subsequently learns or was reckless in not
learning that the earlier statement was false or misleading; (3) knows or should
know that potential investors are relying on the opinion and financial statements;
yet (4) fails to take reasonable steps to correct or withdraw its opinion and/or the
financial statements; and (5) all the other requirements for liability are satisfied.
Overton v. Todman & Co., CPAs, P.C., 478 F.3d 479, 486-87 (2d Cir. 2007). Therefore, an
accountant is only liable for a failure to correct when it "knows or should know that potential
investors are relying on its opinion." Id. Given that E&Y Bermuda knew E&Y Bahamas had

12

drawn investors' attention to the possible faultiness of the 2008 report, and by extension to the
potential problems in earlier reports, it was reasonable for E&Y Bermuda to assume that no one
was relying on its earlier audits and to not bother to correct them.
Finally, the fact that other investors elected not to deal with Mr. Petters is utterly
irrelevant in the absence of evidence that E&Y knew of their decisions, let alone the reasons for
their decisions.

B.
Even when Dr. Isakov does plead facts which might constitute warning signs of which
E&Y was aware, these allegations do not constitute red flags supporting a strong inference of
scienter.
First, while E&Y knew or should have known that the Fund was reporting consistently
high returns as a result of their audits, this is not a sufficient red flag to support a finding of
scienter. See, e.g., Chill v. Gen. Elec. Co., 101 F.3d 263, 269-70 (2d Cir. 1996) (finding that
"unprecedented and dramatically increasing profitability" was not, by itself, a sign of fraud
sufficient to plead scienter); Stephenson v. Citco Grp. Ltd., 700 F. Supp. 2d at 624 (noting that
while the defendant "had to be aware that [its client] consistently reported excellent results, . . .
even in the present economic climate the Court is unwilling to hold that success in securities
trading is a red flag").
Second, assuming E&Y knew or should have known from its audits that Acorn was
engaged in asset-based lending or that it was not investing as diversely as the PPMs claimed,
such facts do not compel a finding of scienter. Even though there are several opportunities for
fraud risk in this type of investment, it would be going too far to claim that concentrated
investment was itself a red flag.
13

Likewise, E&Y certainly knew or should have known of Mr. Quan's and Mr. Escher's
respective roles. Mr. Quan's concentrated power and Mr. Quan's conflicts may constitute a red
flag, but one which does not support an inference of recklessness. See Stephenson v. Citco Grp.
Ltd., 700 F. Supp. 2d at 624 (noting that a similar concentration of power was something of a red
flag, but that it was nonetheless "far too mild to support an inference of recklessness on the part
of [the auditor]").

C.
Dr. Isakov does plead certain facts which may support an inference of scienter, but
ultimately the Court concludes that the more compelling explanation is simple negligence.
Dr. Isakov alleges that Acorn knew, and that E&Y should have known, that Acorn was
not enforcing the lockbox safeguards; in other words, E&Y should have known that the monies
were coming from PAC, rather than the merchandise buyers, and that the funds due were paid in
one large sum every month, rather than at irregular intervals. If such information is not regularly
an element of an audit, Dr. Isakov has not alleged that E&Y knew of the way in which the
lockbox account was paid. Assuming, in Dr. Isakov's favor, that such information is an expected
element of an audit, ignoring it might be evidence of scienter, but negligence seems to be the
more likely explanation. See Stephenson v. Citco Grp. Ltd., 700 F. Supp. 2d at 622 (finding that
defendant auditor's failure to adequately investigate its client's internal safeguards did not satisfy
the scienter requirement) (citing W. Va. Inv. Mgmt. Bd., 344 F. App'x at 720 (quoting Novak, 216
F.3d at 309)).
As E&Y was the auditor for Acorn, the Fund, and the Off-Shore Fund, it would seem
likely that they knew or should have known that the entities were co-mingling funds.
Additionally, E&Y knew or should have known that they were not receiving documentation of
14

PAC's financial status, as required by the Acorn-PAC contract. While both of these allegations
do provide some support for an inference of scienter, the Court concludes that they more strongly
support an inference of negligence.

D.
Dr. Isakov repeatedly, and correctly, reminds the Court that the facts must be examined
collectively. See Tellabs, 551 U.S. at 323. After reviewing the totality of non-conclusory
allegations, including both the alleged violations of GAAS, GAAP, and E&Y's internal best
practices and alleged red flags, however, the Court concludes that the inference that E&Y were
acting negligently is more likely than an inference that they were acting with an actual intent to
perpetuate a fraud.
Dr. Isakov makes many broad conclusory allegations, see, e.g., Third Am. Compl. [doc.
# 56] ¶ 3 (alleging that E&Y "either knew about the fraud at issue or were highly suspicious of
the same and decided that they should 'bury their heads in the sand' rather than discover the
obvious"), but he does not allege facts demonstrating that E&Y acted with fraudulent intent.
Instead, taking the facts alleged in the record as true, the strongest inference is that E&Y was
simply negligent in fulfilling its professional duties. See Tellabs, 551 U.S. at 314; Teamsters
Local 445, 531 F.3d at 194; Anwar, 728 F. Supp. 2d at 453 ("Even if the [plaintiff] alleged facts
sufficient to support a strong inference of conscious recklessness, Plaintiffs' federal securities
law claims would still be subject to dismissal because a reasonable person would not deem the
inference of scienter at least as compelling as opposing inferences one could draw from the facts
alleged." (quotation marks and alterations omitted)).
The Court reiterates that pleading auditor scienter is difficult, and even more so when the
auditor is responsible for monitoring an entity which may or may not know that it is transacting
15

with a Ponzi schemer. See Anwar, 728 F. Supp. 2d at 453 n.23 ("Plaintiffs cite no case, and the
Court has found none, in which allegations that an auditor ignored red flags at a third party, nonclient, as opposed to the audit client itself, established scienter."); In re J.P. Jeanneret Assoc.,
Inc., 769 F. Supp. 2d at 378 (noting that courts "routinely" dismiss § 10(b) claims against a
feeder fund's outside auditors). As Dr. Isakov has not adequately alleged that E&Y's actions
"approximate[d] an actual intent to aid in the fraud being perpetuated by the audited company,"
Rothman, 220 F.3d at 98 (quotation marks omitted), his § 10(b) claim is dismissed.

V.
The

Court

turns

next

to

Dr.

Isakov's

state

law

claim

for

"professional

negligence/malpractice." Third Am. Compl. [doc. # 56] at 96. E&Y argues that, to the extent that
any of Dr. Isakov's claims are cognizable, they are derivative claims under both Delaware and
Connecticut law, and Dr. Isakov is therefore bound by the terms of the engagement letters
between the Fund and E&Y which require all claims to be subject to arbitration. Dr. Isakov
counters that he is seeking individual, compensatory damages arising from his investments in the
Fund based on E&Y's clean audits, and his claims are therefore direct under both Connecticut
and Delaware law.
Keeping in mind that "a claim is not 'direct' simply because it is pleaded that way,"
Dieterich v. Harrer, 857 A.2d 1017, 1027 (Del. Ch. 2004), and that "the duty of the court is to
look at the nature of the wrong alleged, not merely at the form of words used in the complaint,"
In re Syncor Int'l Corp. Shareholders Litig., 857 A.2d 994, 997 (Del. Ch. 2004), the Court finds
that Dr. Isakov's "pure" negligence and malpractice claims are derivative.
Under both Connecticut and Delaware law, "pure" negligence claims—as opposed to
claims of negligent inducement—and professional malpractice claims require that plaintiffs
16

demonstrate injury. See Retirement Program for Emps. of the Town of Fairfield v. NEPC, LLC,
642 F. Supp. 2d 92, 96 (D. Conn. 2009) (noting that, under Connecticut law, a negligence claim
requires a showing of damages); Shawmut Bank Conn., N.A. v. Deloitte & Touche, No. CV 940462508S, 1995 WL 283917, at *1 (Conn. Super. Ct. Apr. 25, 1995) (requiring, as one of the
elements of a professional malpractice claim under Connecticut law, that "the plaintiff must
suffer actual injury"); Roache v. Charney, --- A.3d ---, 2012 WL 603593, at *2 (Del. Supr. Ct.
Feb. 24, 2012) (noting that, under Delaware law, a negligence claim requires a showing that
plaintiff suffered an injury); Nieves v. All Star Title, Inc., No. N10C-03-191 PLA, 2010 WL
2977966, at *6 (Del. Super. Ct. Jul. 27, 2010) (requiring, for a professional malpractice claim
under Delaware law, that a plaintiff establish recoverable damages).
With regard to his "pure" negligence/professional malpractice claims, Dr. Isakov's injury
can only be the diminution of the value of his shares. Under both Connecticut and Delaware law,
a claim based on an injury sustained equally by all shareholders—such as that which Dr. Isakov
alleges—is necessarily a derivative claim. See May v. Coffey, 291 Conn. 106, 115-16 (2009)
(finding a diminution of value claim—in this case, due to stocks sold at a low price—derivative
because the primary injury was to the corporation and shareholders suffered only an "indirect
injury, a reduction in the value of their existing shares") (citing cases); Feldman v. Cutaia, 951
A.2d 727, 733 (Del. 2008) (denying plaintiff standing to bring a dilution of value claim directly
because "to state a direct claim, the plaintiff must have suffered some individualized harm not
suffered by all of the stockholders at large"). As Dr. Isakov's claims of negligence and
professional malpractice are derivative, they are governed by the E&Y-Fund Arbitration
Agreement.
The parties do not challenge the validity of the E&Y-Fund Arbitration Agreement, nor

17

the provision which requires that "[a]ny dispute or claim arising out of or relating to services"
provided to the Fund by E&Y "shall be submitted first to voluntary mediation, and if mediation
is not successful, then to binding arbitration." Defs.' Mot to Dismiss [doc. # 57-4] ¶ 22
(Engagement Letter of November 16, 2005); see also Defs.' Mot. to Dismiss [doc. # 57-5] ¶ 25
(Engagement Letter of December 7, 2006) (same). The Court therefore stays Dr. Isakov's
negligence and professional malpractice claims pending the conclusion of arbitration, in
accordance with the arbitration agreement. See Ernst & Young Ltd. v. Quinn, No. 09-cv-1164
(JCH), 2009 WL 3571573, *8-9 (D. Conn. Oct. 26, 2009) (finding that the E&Y-Fund
Arbitration Agreement satisfied the Second Circuit's requirements); see also Mitshubishi Motors
Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614, 631 (1985) (discussing the strong federal
policy favoring arbitration and choice-of-forum provisions in agreements involving international
disputes); David L. Threlkeld & Co. v. Metallgesellschaft Ltd. (London), 923 F.2d 245, 250 (2d
Cir. 1991) ("The goal of the Convention [on the Recognition and Enforcement of Foreign
Arbitral Awards] is to promote the enforcement of arbitral agreements in contracts involving
international commerce so as to facilitate international business transactions on the whole.").
However,

although

he

terms

his

state

law

claims

as

"professional

negligence/malpractice," Third Am. Compl. [doc. # 56] at 96, in the text of his complaint Dr.
Isakov argues an inducement claim, see id. ¶ 183 (incorporating previous paragraphs within the
professional negligence/malpractice claim); id. ¶ 173 (stating that E&Y's statements "induced
Plaintiff and other members of the Class to make investments or contributions in the Stewardship
Fund."). Reading the Third Amended Complaint as a whole, as clarified by the briefing and oral
argument, the Court finds that Dr. Isakov attempts to state a fraudulent or negligent inducement
claim.

18

District courts in this Circuit—and elsewhere—are split on the question of whether
inducement claims constitute direct or derivative actions. In Ernst & Young Ltd. v. Quinn, 2009
WL 3571573, investors brought numerous state law claims against Ernst & Young Ltd. Bermuda
and Ernst & Young LLP based on substantially similar facts. The David B. Stenberg Inc.
Employee Pension Trust brought a derivative suit on behalf of the Fund; Susan Quinn and Peter
Pressman attempted to bring direct claims as a class action, on behalf of themselves and others
similarly situated. Judge Hall found, inter alia, that (1) the district court had jurisdiction over the
arbitration agreement between defendants and the Fund; and (2) all plaintiffs asserted derivative
claims under both Connecticut and Delaware law because the nature of the plaintiffs' injury was
necessarily linked to the nature of the injury to the Fund. Judge Hall specifically found that the
plaintiffs' fraudulent inducement claims were derivative under both Connecticut and Delaware
law because the injury was traceable to the diminution in value of the shares. See id. at *6, *8.
Based on these conclusions, Judge Hall ordered a stay of the state court proceedings and
compelled the parties to engage in arbitration. 7
Contrary precedent is found in Stephenson v. Citco Grp. Ltd., 700 F. Supp. 2d 599, in
which a district court found, under Delaware law, that negligence and fraud claims against
auditors were direct to the extent that plaintiffs alleged inducement. The Stephenson court
reasoned that such claims "are direct because they allege a harm suffered by plaintiff
independent of the partnership and a duty to plaintiff that is not merely derivative of [the
auditor's] fiduciary duties to the partnership." Id. at 612; see also Albert v. Alex. Brown Mgmt.
7

A Connecticut court also determined that, under Delaware state law, claims by Fund investors
against Ernst & Young LLP were derivative. See Quinn v. Stewardship Credit Arbitrage Fund,
LLC, No. X03-CV09-404647S, at *4 (Conn. Super. Ct. Aug. 6, 2010). Although fraud and
negligent inducement were two of the many claims alleged in the plaintiffs' complaint, the
Connecticut Superior Court did not clarify the reasons for its conclusion with regard to these
claims.
19

Serv., Inc., Nos. Civ. A. 762-N, Civ. A 763-N, 2005 WL 2130607, at *12 (Del. Ch. Aug. 26,
2005) (determining that a non-disclosure claim under state law was direct, in part because
"[g]enerally, non-disclosure claims are direct claims").
The Court finds Stephenson's reasoning more persuasive, for reasons this Court discusses
in more detail in a companion case. See Poptech, L.P. v. Stewardship Investment Advisors, LLC,
No. 3:10cv967 (MRK). Under Stephenson and related cases, Dr. Isakov may bring a fraudulent
or negligent inducement claim directly. See Stephenson v. Citco Grp. Ltd., 700 F. Supp. 2d at
612 (finding that inducement claims "are direct to the extent (and only to the extent) that they
allege (1) violation of a duty owed to potential investors at large and (2) that such violations
induced plaintiff to invest in [the corporation]").
Under both Connecticut and Delaware law, a viable claim for negligent inducement or
misrepresentation requires a misrepresentation of fact, reliance, and damages. See, e.g., Barrow
v. Walsh, No. X02UWYCV095015180, 2012 WL 669841, *13 (Conn. Super. Ct. Feb. 2, 2012)
(listing the elements as including a misrepresentation of fact that the defendant knew or should
have known was false, reasonable reliance, and pecuniary harm); Smith v. Peninsula Adjusting
Co., Inc., No. 09C-03-024 (RBY), 2011 WL 2791252, at *3 (Del. Super. Ct. Jun. 16, 2011)
(listing the elements as including a duty to provide accurate information, the supplying of false
information, failure to exercise reasonable care in obtaining or communicating the information,
and a pecuniary loss caused by justifiable reliance). Dr. Isakov alleges that E&Y had a duty to
provide accurate audits; that, as a Fund Member, he knew of E&Y's audits; that the audits
included false statements which E&Y should've known were false; and that he reasonably relied
on E&Y's March 2006 audit when purchasing shares in September 2006. Necessarily, recovery
on a claim based on such inducement would flow only to those individuals who were so induced.

20

See Stephenson v. Citco Grp. Ltd., 700 F. Supp. 2d at 612 ("For example, damages from an
inducement claim based solely on a fraudulent November 5th, 1955 report would only be
available to that subset of limited partners who invested after that date."). Dr. Isakov has
therefore stated a negligent inducement claim.
E&Y argues that Dr. Isakov was not a Fund Member at the time it issued the audits upon
which he relied in making his investments, and therefore E&Y did not owe him any duty of care
as a mere prospective investor. E&Y is correct that Dr. Isakov's family fund is not a named
plaintiff and that Dr. Iskaov cannot assert claims in his personal capacity based on a corporate
relationship. See, e.g., Chiulli v. Zola, 905 A.2d 1236, 1242 (Conn. App. Ct. 2006). However, a
question of fact remains as to whether Dr. Isakov was a Fund Member at the time he purchased
shares in his individual capacity. Dr. Isakov purchased only $450,000 in shares on September 1,
2006, despite fact that the initial minimum contribution was $1 million. As this is a motion to
dismiss and the Court must interpret all facts in Dr. Isakov's favor, the Court determines that,
solely for the purposes of this motion, Mr. Isakov was or was considered to be a Fund Member in
September 2006.
Under both Connecticut and Delaware law, a fraudulent inducement claim requires that a
statement is made with the intent that the listener act upon it. See, e.g., Biro v. Matz, 33 A.3d
742, 753 (Conn. App. Ct. 2011) (stating that one of the elements of fraudulent inducement under
Connecticut law is that a statement "was made to induce the other party to act upon it"); Duffield
Assoc., Inc. v. Meridian Architects & Eng'rs, LLC, No. S10C-03-004 RFS, 2010 WL 2802409, at
*4 (Del. Super. Ct. Jul. 12, 2010) (same). Mr. Isakov repeatedly notes that E&Y knew or should
have known that he would rely on their audits, but he provides no evidence to support a theory
that they intended their audits to induce his investment. As a result, Dr. Isakov's fraudulent

21

inducement claim fails.
In summary, Dr. Isakov's "pure" negligence and malpractice claims are stayed pending
arbitration, his fraudulent inducement claim is dismissed, and his negligent inducement claim
may proceed.

VI.
The Court GRANTS IN PART and DENIES IN PART E&Y's Motion to Dismiss, or in
the alternative, to Enforce Arbitration and Forum Selection Provisions [doc. # 57]. Because Dr.
Isakov failed to adequately plead scienter, his § 10(b) claim under the Exchange Act is
DISMISSED. As the Court finds that Dr. Isakov's negligence and professional malpractice
claims are derivative, they are governed by the arbitration agreement between the Fund and
E&Y. The Court therefore STAYS consideration of Dr. Isakov's negligence and professional
malpractice claims pending the conclusion of arbitration. Any fraudulent inducement claim is
DISMISSED, but Dr. Isakov's negligent inducement claim survives. Dr. Isakov should submit a
status report on or before April 20, 2012 to inform the Court as to whether he intends to submit
the negligent inducement claim to arbitration along with his "pure" negligence and professional
malpractice claims.

IT IS SO ORDERED.

/s/

Mark R. Kravitz
United States District Judge

Dated at New Haven, Connecticut: March 19, 2012.

22